Exam 9: The Cost of Capital

Debt is generally the least expensive source of capital. This is primarily due to

Nico Trading Corporation is considering issuing long-term debt. The debt would have a 30 year maturity and a 10 percent coupon rate. In order to sell the issue, the bonds must be underpriced at a discount of 5 percent of face value. In addition, the firm would have to pay flotation costs of 5 percent of face value. The firm's tax rate is 35 percent. Given this information, the after tax cost of debt for Nico Trading would be 11.17 percent.

Table 9.3 Balance Sheet General Talc Mines December 31, 2003 -Promo Pak has compiled the following financial data: (a) Calculate the weighted average cost of capital using book value weights. (b) Calculate the weighted average cost of capital using market value weights.

The weighted average cost that reflects the interrelationship of financing decisions can be obtained by weighing the cost of each source of financing by its target proportion in the firm's capital structure.

Table 9.3 Balance Sheet General Talc Mines December 31, 2003 - Given this after-tax cost of each source of capital, the weighted average cost of capital using book weights for General Talc Mines is ________. (See Table 9.3)

The approximate before-tax cost of debt for a 10-year, 8 percent, $1,000 par value bond selling at $1,150 is

Table 9.2 A firm has determined its optimal structure which is composed of the following sources and target market value proportions. Debt: The firm can sell a 15-year, $1,000 par value, 8 percent bond for $1,050. A flotation cost of 2 percent of the face value would be required in addition to the premium of $50. Common Stock: A firm's common stock is currently selling for $75 per share. The dividend expected to be paid at the end of the coming year is $5. Its dividend payments have been growing at a constant rate for the last five years. Five years ago, the dividend was $3.10. It is expected that to sell, a new common stock issue must be underpriced $2 per share and the firm must pay $1 per share in flotation costs. Additionally, the firm has a marginal tax rate of 40 percent. -The firm's cost of a new issue of common stock is ________. (See Table 9.2)

The constant growth model uses the market price as a reflection of the expected risk-return preference of investors in the marketplace.

The cost of capital is the rate of return a firm must earn on investments in order to leave share price unchanged.

Table 9.1 A firm has determined its optimal capital structure which is composed of the following sources and target market value proportions. Debt: The firm can sell a 12-year, $1,000 par value, 7 percent bond for $960. A flotation cost of 2 percent of the face value would be required in addition to the discount of $40. Preferred Stock: The firm has determined it can issue preferred stock at $75 per share par value. The stock will pay a $10 annual dividend. The cost of issuing and selling the stock is $3 per share. Common Stock: A firm's common stock is currently selling for $18 per share. The dividend expected to be paid at the end of the coming year is $1.74. Its dividend payments have been growing at a constant rate for the last four years. Four years ago, the dividend was $1.50. It is expected that to sell, a new common stock issue must be underpriced $1 per share in floatation costs. Additionally, the firm's marginal tax rate is 40 percent. -The firm's cost of a new issue of common stock is ________. (See Table 9.1)

The cost of retained earnings equity for Tangshan Mining would be 18.00 percent if the expected return on U.S. Treasury Bills is 5.00 percent, the market risk premium is 10.00 percent, and the firm's beta is 1.3.

Table 9.2 A firm has determined its optimal structure which is composed of the following sources and target market value proportions. Debt: The firm can sell a 15-year, $1,000 par value, 8 percent bond for $1,050. A flotation cost of 2 percent of the face value would be required in addition to the premium of $50. Common Stock: A firm's common stock is currently selling for $75 per share. The dividend expected to be paid at the end of the coming year is $5. Its dividend payments have been growing at a constant rate for the last five years. Five years ago, the dividend was $3.10. It is expected that to sell, a new common stock issue must be underpriced $2 per share and the firm must pay $1 per share in flotation costs. Additionally, the firm has a marginal tax rate of 40 percent. -The firm's before-tax cost of debt is ________. (See Table 9.2)

A company's historical target capital structure is 40 percent debt and 60 percent equity. The company expects to issue more equity in the upcoming year moving its capital structure to 50 percent debt and 50 percent equity for the long term. The company should use the current 40 percent debt/60 equity for its average weighted cost of capital.

The cost of capital acts as a major link between the firm's long-term investment decisions and the wealth of the owners as determined by investors in the marketplace.

Generally, the order of cost, from the least expensive to the most expensive, for long-term capital of a corporation is

Since the net proceeds from sale of new common stock will be less than the current market price, the cost of new issues will always be less than the cost of existing issues.

Since retained earnings is a more expensive source of financing than debt and preferred stock, the weighted average cost of capital will fall once retained earnings have been exhausted.

Weights that use accounting values to measure the proportion of each type of capital in the firm's financial structure are called market value weights.

Table 9.2 A firm has determined its optimal structure which is composed of the following sources and target market value proportions. Debt: The firm can sell a 15-year, $1,000 par value, 8 percent bond for $1,050. A flotation cost of 2 percent of the face value would be required in addition to the premium of $50. Common Stock: A firm's common stock is currently selling for $75 per share. The dividend expected to be paid at the end of the coming year is $5. Its dividend payments have been growing at a constant rate for the last five years. Five years ago, the dividend was $3.10. It is expected that to sell, a new common stock issue must be underpriced $2 per share and the firm must pay $1 per share in flotation costs. Additionally, the firm has a marginal tax rate of 40 percent. -The weighted average cost of capital up to the point when retained earnings are exhausted is ________. (See Table 9.2)

The cost of retained earnings equity for Tangshan Mining would be 18.00 percent if the expected return on U.S. Treasury Bills is 5.00 percent, the market return is 10.00 percent, and the firm's beta is 1.3.