Deck 10: The Cost of Capital

Question 1

Which of the following statements is correct?

A) A company with access to global capital markets should have a lower cost of equity than a purely domestic company because equity risk is shared among a greater number of investors who have different risk requirements, thus magnifying the diversification effect.
B) A company with access to global capital markets should use a global market index instead of a purely domestic one to reflect the greater diversification potential of international markets.
C) The beta coefficient of a company with access to global capital markets should be computed against the global market index and will likely be lower than if a domestic index were used because of lower correlation.
D) All of the statements above are correct.
E) Only statements a and b are correct.

Answer 1

All of the statements above are correct.

Question 2

When attempting to determine the cost of equity for companies from emerging market nations with segmented capital markets, most procedures suggested in the literature focus at the country level rather than at the firm or even industry level. What is the reason for this?

A) Reliable data on companies and even industries in emerging market nations are hard to find and usually unreliable.
B) Most local companies in emerging market nations are closely held and thus, do not have a cost of equity.
C) The assumption that all companies in an emerging market nation have the same cost of equity is not unreasonable because of the lack of sophistication of investors.
D) All of the statements above are correct.
E) Only statements a and c are correct.

Answer 2

Reliable data on companies and even industries in emerging market nations are hard to find and usually unreliable.

Question 3

The country-risk-rating approach for estimating the cost of equity in an emerging market has several advantages over the country-spread approach. These advantages include all except which of the following statements?

A) It can be applied to well over 100 countries whereas the country-spread approach is limited to countries that have issued dollar-denominated sovereign debt.
B) It can be applied to specific industries instead of being restricted to country-level cost of equity estimates like the country-spread approach.
C) It overcomes the "double counting" problem that plagues the country-spread approach.
D) It overcomes some econometric deficiencies and measurement problems associated with the country-spread approach.
E) All of the statements above are advantages of the country-risk-rating approach over the country-spread approach.

Answer 3

It can be applied to specific industries instead of being restricted to country-level cost of equity estimates like the country-spread approach.

Question 4

Capital market integration refers to the extent to which similar assets in different countries are priced equally. Markets that are not fully integrated are partially segmented, or prices are driven in part by purely local phenomena. Which of the following statements about capital market integration is incorrect?

A) The so-called euromarket, or the international market for financial securities (both debt and equity), should be more integrated than any domestic capital market because it spans many highly developed countries.
B) Domestic capital markets in developed industrial nations are extensively though not entirely integrated.
C) Domestic capital markets in emerging market countries are clearly segmented when compared to developed countries, some more so than others.
D) The CAPM in its usual form works reasonably well in largely integrated capital markets with the specification of the proper market index and beta coefficient, but the model cannot be used reliably in segmented markets without substantive revisions.
E) None of the statements are incorrect, in fact, all of the statements above are correct.

Question 5

On what proposition is the concept of global CAPM with partially segmented capital markets based?

A) The correlations of returns between emerging markets and developed markets are often near zero or even negative, so significant diversification potential exists with these securities. There are no other systematic risk factors in this case that need to be priced.
B) The correlations of returns between emerging markets and developed markets are often near zero or even negative, so significant diversification potential exists with these securities. However, even though no risk premium is attributed to correlations with developed markets, local factors generate systematic risk and must be priced.
C) The cost of capital in emerging market countries is equal to the risk-free rate from integrated markets plus an integrated risk premium component, and an additional segmented market component.
D) The cost of capital in emerging market countries is equal to the local government bond rate in the emerging market country as the risk-free rate plus an integrated market risk premium plus a segmented market risk premium.
E) None of the statements above is correct.

Question 6

The country-spread approach for estimating the cost of equity in an emerging market uses the U.S. risk-free rate and the market risk premium for a U.S. index but makes two country-specific adjustments to the CAPM. Also, it has some major theoretical problems. Which of the following statements about this approach is correct?

A) It adds a country risk premium to the CAPM estimate that is calculated as the spread between U.S. dollar bonds issued by the foreign country's government and the required return on U.S. Treasury bonds.
B) It likely overstates the true cost of equity for an average firm in the foreign country because it "double counts" country risk factors in the two adjustments and it ignores other risks that might be relevant such as liquidity.
C) It adjusts the beta to reflect that the market return variance (or standard deviation) is likely to be different than the equivalent number for the U.S. market.
D) All of the statements above are correct.
E) All of the statements above are incorrect.

Question 7

There are conflicting studies which conclude that the WACC for a global firm is higher than the WACC for a purely domestic firm on the one hand and lower on the other. Regarding this controversy, which of the following statements is incorrect?

A) It is hypothesized that the WACC for a global firm is higher than the WACC for a domestic company because of the existence of political and currency risk, higher agency costs from operating in a foreign market, and asymmetric information about how to operate successfully in the foreign market.
B) It is hypothesized that because returns in foreign capital markets are not highly correlated with returns from the U.S. market, great diversification potential exists when investors hold a globally-diversified portfolio, and this reduces the WACC for an MNE below that which would exist for a purely domestic company.
C) It is hypothesized that because capital markets in emerging markets are neither deep nor liquid, the WACC starts to increase at lower levels of capital raised for an MNE than for a domestic company raising capital in the deep and liquid U.S. market.
D) It is hypothesized that global companies face an investment opportunity schedule (IOS) above and to the right of the IOS for a purely domestic firm, so the intersection with the MCC will occur at a rate that is greater than for a domestic company even if the MCC for the global company is below that of the domestic firm for the first dollar of new capital raised.

Question 8

Which of the following statements is correct?

A) A company with access to global capital markets should use a global market index instead of a purely domestic one to reflect the greater diversification potential of international markets.
B) The correlation of returns between emerging markets and developed markets are often near zero or even negative, so significant diversification potential exists with these securities. There are no other systematic risk factors in this case that need to be priced.
C) The country-risk-rating approach to estimating the cost of equity in an emerging market can be applied to specific industries instead of being restricted to country-level cost of equity estimates like the country-spread approach.
D) It is hypothesized that because capital markets in emerging markets are neither deep nor liquid, the WACC starts to increase at lower levels of capital raised for an MNE than for a domestic company raising capital in the deep and liquid U.S. market.
E) All of the statements above are correct.

Question 9

Which of the following statements is incorrect?

A) A company with access to global capital markets should use a global market index instead of a purely domestic index to reflect the greater diversification potential of international markets.
B) The assumption that all companies in an emerging market nation have the same cost of equity is not unreasonable because of the lack of sophistication of investors.
C) The so-called euromarket, or the international market for financial securities (both debt and equity), should be more integrated than any domestic capital market because it spans many highly developed countries.
D) The country-spread approach for estimating the cost of equity adjusts the beta to reflect that the market return variance (or standard deviation) is likely to be different than the equivalent number for the U.S. market.

Question 10

Chappelle Systems has 8 percent semiannual coupon bonds outstanding with a $1,000 face value that sell for $1,072.66. The bonds have 15 years to maturity, but can be called in 5 years at a call price of $1,030. Chappelle's tax rate is 40 percent. What is Chappelle's after-tax cost of debt if interest rates are assumed to remain at their current level?

A) 4.07%
B) 4.32%
C) 5.39%
D) 6.78%
E) 7.20%

Question 11

Rock Construction has preferred stock outstanding that sells for $98.50. If the firm were to issue new preferred stock, it would incur a 2 percent flotation cost. If the preferred stock pays a $7 annual dividend, what is the firm's cost of preferred stock?

A) 6.75%
B) 7.00%
C) 7.25%
D) 7.50%
E) 7.75%

Question 12

The CFO of Vaimato Industries needs to borrow money (a one-year loan) in the coming months to support the start up of a new project. The interest rate in the U.S. for a dollar loan was quoted as 14 percent (before taxes). A euro loan is also available at an interest rate of 8.60 percent. In both cases the marginal tax rate is 40 percent. The spot exchange rate (American terms) is $1.2135/€ and the one-year forward rate is $1.2500/€. What is the after-tax cost of debt for the cheapest source of funds?

A) 14.00%
B) 13.87%
C) 10.55%
D) 8.40%
E) 8.32%

Question 13

Leary Inc. has 10-year, 9 percent semiannual coupon bonds outstanding that were issued by its French subsidiary. The bonds are guaranteed by Leary. The bonds have a €1,000 face value and sell for €956.48. Leary's tax rate is 40 percent. If the euro is expected to depreciate by 0.01739, what is Leary's after-tax cost of foreign-denominated debt to U.S. investors?

A) 3.61%
B) 3.97%
C) 4.13%
D) 4.38%
E) 4.50%

Question 14

Travers Inc. is a globally diverse MNE that operates in many integrated foreign markets. The firm estimates its cost of common equity using the CAPM approach. An analyst is estimating the cost of common equity for one of Travers' foreign subsidiaries. With respect to a domestic market index (in the host country) that has an equity risk premium of 7 percent, Travers has a beta of 1.4. With respect to a world market index that has an equity risk premium of 5 percent, Travers has a beta of 1.1. If the appropriate risk-free rate for all CAPM calculations is the U.S. Treasury rate of 4 percent, how large an error would the analyst make if she used the wrong version of the CAPM?

A) 3.8%
B) 3.9%
C) 4.2%
D) 4.4%
E) 4.7%

Question 15

An analyst has collected data about Devers Co. and a world market index. The index implies an equity risk premium of 5 percent, and Devers has a beta of 1.2 with respect to the index. When the residuals from the beta regression are collected and included in the regression model as an additional factor, a segmented market risk premium of 13 percent is calculated and the segmented beta with respect to this factor is 0.8. The appropriate risk-free return is 4 percent. If Devers is estimating the cost of common equity for subsidiaries in developed, integrated foreign markets, what is the appropriate cost of common equity?

A) 10.0%
B) 12.1%
C) 16.8%
D) 18.3%
E) 20.4%

Question 16

An analyst has collected data about Conyers Inc. and a world market index. The index implies an equity risk premium of 6 percent, and Conyers has a beta of 1.3 with respect to the index. When the residuals from the beta regression are collected and included in the regression model as an additional factor, a segmented market risk premium of 14 percent is calculated and the segmented beta with respect to this factor is 0.7. The appropriate risk-free return is 5 percent. If Conyers is estimating the cost of common equity for subsidiaries in developing, segmented foreign markets, what is the appropriate cost of common equity?

A) 12.8%
B) 15.5%
C) 17.8%
D) 20.1%
E) 22.6%

Question 17

Permian Trucking's CFO is interested in estimating the company's WACC and has collected some information for this purpose. The company has bonds outstanding that mature in 26 years with an annual coupon of 7.5 percent. The bonds have a face value of $1,000 and sell in the market today for $920. The risk-free rate is 6 percent. The market risk premium is 5 percent; the stock's beta is 1.2; and the company's tax rate is 40 percent. The company's target capital structure consists of 70 percent common equity and 30 percent debt. The company uses the CAPM to estimate the cost of common equity and plans on using retained earnings to fund the equity portion of its capital budget. What is Permian's WACC?

A) 9.11%
B) 9.32%
C) 9.53%
D) 9.89%
E) 10.07%

Question 18

Carbone Meats has a target capital structure that consists of 30 percent debt, 50 percent common equity, and 20 percent preferred stock. The tax rate is 30 percent. The company has projects in which it would like to invest with costs that total $1,500,000. Carbone will retain $500,000 of net income this year. The last dividend was $5, the current stock price is $75, and the long-run constant growth rate of the company is 10 percent. If the company raises capital through a new equity issuance, the flotation costs are 10 percent. The cost of preferred stock is 9 percent and the cost of debt is 7 percent. (Assume debt and preferred stock have no flotation costs.) What is the weighted average cost of capital at the firm's optimal capital budget?

A) 10.82%
B) 10.99%
C) 11.48%
D) 11.81%
E) 12.34%

Question 19

Labree Laboratories estimates its cost of common equity by calculating it using three different methods and taking the average of the methods. Labree's stock is currently selling for $50, and its expected dividend for next year is $2.50. The dividend is expected to grow at a constant rate of 7 percent. The firm also has bonds outstanding that yield 8 percent. Analysts estimate that Labree's common equity has a risk premium of 3 percent over its bond yield. Labree's beta is 1.1. If the risk-free rate is 4 percent and the market risk premium is 6 percent, what is the best estimate of Labree's cost of common equity?

A) 10.5%
B) 11.0%
C) 11.2%
D) 11.7%
E) 12.0%

Question 20

If a firm uses the cost of capital for funds raised in a particular year to evaluate that year's capital budgeting projects, are the firm's managers making a mistake? Explain.

Question 21

The WACC is supposed to be a marginal cost of capital, but the XYZ firm is not issuing any new debt this year. However, XYZ does have bonds outstanding from an issue six years ago. How should the firm estimate its cost of debt?

Question 22

If a firm's debt is not publicly traded, how can you estimate the cost of debt?

Question 23

If a firm were to replace its perpetual preferred stock with sinking fund preferred stock, what factors must the firm consider?

Question 24

What is the difference between the domestic and global CAPMs?

Question 25

A firm's target capital structure plays an important role in determining its weighted average cost of capital. Why might a firm's current capital structure deviate from its target?

Question 26

Since operating in foreign countries is riskier than operating in the U.S., must the cost of foreign-denominated debt be riskier and have a higher yield than domestic debt?

Question 27

Describe the three methods of estimating a firm's cost of common equity.

Question 28

A firm's CFO has said that since the calculated WACC is 9.25 percent, any project with a return greater than 9.25 percent will be accepted, as long as there is money available. Is there anything wrong with this attitude? Explain.

Question 29

How can operating internationally affect a firm's investment opportunities and its ability to raise capital?

Question 30

How can a firm estimate its cost of common equity if it operates in a partially segmented foreign market?

Question 31

If a multinational firm uses different WACCs in its different geographic and operating segments, what are some factors that might cause the various segment WACCs to differ, and what is the relationship between the corporate WACC and the divisional WACCs

Question 32

Porter Enterprises has preferred stock outstanding that sells for $97.75. If the firm were to issue new preferred stock, it would incur a 1.5 percent flotation cost. If the preferred stock pays a $7.25 annual dividend, what is the firm's cost of preferred stock?

Question 33

St. Claire Medical Supply has 8.5 percent semiannual coupon bonds outstanding with a $1,000 face value that sell for $950. The bonds have 10 years to maturity, but can be called in 5 years at a call price of $1,085. St. Claire's tax rate is 40 percent. What is St. Claire's after-tax cost of debt, if interest rates remain at their current level?

Question 34

Logan Inc. has 12-year, 8 percent semiannual coupon bonds outstanding that were issued by its British subsidiary. The bonds are guaranteed by Logan. The bonds have a £1,000 face value and sell for £1,042.82. Logan's tax rate is 40 percent. If the pound is expected to appreciate by 0.02156, what is Logan's after-tax cost of foreign-denominated debt to U.S. investors?

Question 35

Comcastle Communications is a globally diverse MNE that operates in many integrated foreign markets. The firm estimates its cost of common equity using the CAPM approach. An analyst is estimating the cost of common equity for one of Comcastle's foreign subsidiaries. With respect to a domestic market index (in the host country) that has an equity risk premium of 8 percent, Comcastle has a beta of 1.4. With respect to a world market index that has an equity risk premium of 6 percent, Comcastle has a beta of 1.0. If the appropriate risk-free rate for all CAPM calculations is the U.S. Treasury rate of 5 percent, how large an error would the analyst make if he used the wrong version of the CAPM?

Question 36

An analyst has collected data about Ivory Trucking and a world market index. The index implies an equity risk premium of 6 percent, and Ivory has a beta of 1.4 with respect to the index. When the residuals from the beta regression are collected and included in the regression model as an additional factor, a segmented market risk premium of 18 percent is calculated and the segmented beta with respect to this factor is 0.9. The appropriate risk-free return is 5 percent. If Ivory is estimating the cost of common equity for subsidiaries in developed, integrated foreign markets, what is the appropriate cost of common equity?

Question 37

An analyst has collected data about Gaines Consulting and a world market index. The index implies an equity risk premium of 7 percent, and Gaines has a beta of 1.5 with respect to the index. When the residuals from the beta regression are collected and included in the regression model as an additional factor, a segmented market risk premium of 16 percent is calculated and the segmented beta with respect to this factor is 0.8. The appropriate risk-free return is 4 percent. If Gaines is estimating the cost of common equity for subsidiaries in developing, segmented foreign markets, what is the appropriate cost of common equity?

Question 38

Overholser Tennis Equipment's CFO is interested in estimating the company's WACC and has collected some information for this purpose. The company has bonds outstanding that mature in 15 years with an annual coupon of 8 percent. The bonds have a face value of $1,000 and sell in the market today for $940. The risk-free rate is 4 percent; the market risk premium is 5 percent; the stock's beta is 1.3; and the company's tax rate is 40 percent. The company's target capital structure consists of 70 percent common equity and 30 percent debt. The company uses the CAPM to estimate the cost of common equity and plans on using retained earnings to fund the equity portion of its capital budget. What is Overholser's WACC?

Question 39

DeSimone Inc. has a target capital structure that consists of 30 percent debt, 50 percent common equity, and 20 percent preferred stock. The tax rate is 30 percent. The company has projects in which it would like to invest with costs that total $2,000,000. DeSimone will retain $750,000 of net income this year. The last dividend was $3, the current stock price is $50, and the long-run constant growth rate of the company is 9 percent. If the company raises capital through a new equity issuance, the flotation costs are 10 percent. The cost of preferred stock is 10 percent and the cost of debt is 8 percent. (Assume debt and preferred stock have no flotation costs.) What is the weighted average cost of capital at the firm's optimal capital budget?

Question 40

Morenz Paving estimates its cost of common equity by calculating it using three different methods and taking the average of the methods. Morenz's stock is currently selling for $30, and its expected dividend for next year is $1.50. The dividend is expected to grow at a constant rate of 8 percent. The firm also has bonds outstanding that yield 9 percent. Analysts estimate that Morenz's common equity has a risk premium of 2 percent over its bond yield. Morenz's beta is 1.3. If the risk-free rate is 5 percent and the market risk premium is 6 percent, what is the best estimate of Morenz's cost of common equity?