Exam 13: Cost of Capital

The capital structure is industry specific and not firm specific. That is, all firms in a particular industry will have the same capital structure.

Overland paid a dividend of $3 last year and its stock is selling at $75 per share. A constant growth rate of 5% is expected. Overland's flotation costs for a new issue are 10% and the marginal tax rate is 40%.Calculate the cost of new equity.

To determine a firm's WACC, it is necessary to compensate for the effect of:

Cost of capital calculations assume that capital is usually raised:

The cost of retained earnings differs from the cost of new equity due to:

Short-term US Treasury Bills yield 6%, the market's current yield is 14%, and a company's beta is 1.2. According to the CAPM approach, the estimated cost of retained earnings is 15.6%.

The following information pertains to the capital program of a firm: Target capital structure: 30% debt, 20% preferred stock, 50% equity. Unadjusted component costs of capital k_d = 10% k_p = 12% k_e = 14% Flotation Costs, Taxes, and Retained Earnings Flotation costs are 8% on common and preferred stock and zero on debt The total effective tax rate (federal and state) is 40% Retained earnings of $1,250,000 are expected next year. Investment Opportunities Project Investment A \1 million 13.0\% B \ 2 million 12.5\% C \ 3 million 11.8\% D \ 1 million 11.0\% a. Adjust the component costs of capital for taxes and flotation costs, and calculate the WACC before and after the first break. b. Calculate the location of the break point. c. Sketch the MCC and the IOS on the same graph. What is the cost of capital for the year? Why? d. Which projects should the firm undertake? Why?

Which of the following would increase the WACC?

The Valentine Company has the following capital accounts stated at market value and component capital costs. Component Value Cost Debt \ 890 5.2\% Preferred \ 375 8.3\% Equity \ 1,435 14.5\% What is Valentine's WACC?

The following information pertains to the capital structure of a firm: Debt: One thousand bonds with a face value of $1000 and a 10-year term were issued three years ago with a coupon rate of 10%. Today the bonds are selling to yield 10%. Preferred stock: Ten thousand shares of preferred stock are outstanding with a $9 annual dividend and a $100 face value. Today the shares are selling to yield a 9% return. Common equity: 100 thousand shares of common stock are outstanding at a current market price of $30 per share. Develop the firm's market value based capital structure.

The cost of particular capital components may be ____ the returns paid to investors in the underlying securities.

Because people are less concerned about the precision of the capital structure than they are about the accuracy of component costs, a target structure is often combined with the current component costs in arriving at a WACC.

A project has an IRR of 16% and is being considered by a firm with $5 million in debt and $15 million in equity. Assuming the debt costs 12% (after-tax value), what is the most equity can cost for the project to be acceptable to the firm? (hint: set the IRR equal to WACC)

Which is not considered a part of the firm's capital structure?

A firm's correctly computed capital structure is 30% debt, 20% preferred stock, and 50% equity. If retained earnings of $1 million are expected, how much capital will have been raised when retained earnings are exhausted and new common equity must be issued?

The dividends paid to investors are adjusted for floatation expenses to arrive at the company's cost.

Common equity does not come from:

Last year's dividend was $2.00, the anticipated constant growth rate is 5%, the selling price today is $30 per share, and flotation costs for new equity are estimated to be 10%. What is the estimated cost of retained earnings?

Bonds issued last year by Gowen Inc. carried a coupon rate of 7%. Bonds issued today by Gowen Inc. would carry a coupon rate of 9%. Assume a corporate tax rate of 40%. What is the after tax cost of debt?

The target capital structure for Petersen, Inc. is 30% debt, 20% preferred stock and 50% equity. The after-tax cost of debt is 6%; the cost of preferred stock is 10% and the cost of equity is 14%. (Floatation costs are already included in the costs of preferred stock and equity.) What is Petersen's WACC based on the target capital structure?