CHAPTER 10 DETERMINING THE COST OF CAPITAL (Difficulty: E = Easy M = M!"iu# a$" T = T%u&'
T)u!*Fals! Easy: (10. 1 ) C os t o f cap i tal 1
.
An sw e r : a
Di ff : E
The cos cost of capit pital shou hould refle flect the the average age cost of the the variou ious sources of long-term funds a firm uses to support its assets. a. True b. Fals e
(10. 1 ) C apita l 2
.
Answ er : a
Di f f : E
Capi Capita tal l can can be defi define ned d as as the the fund funds s sup suppl plie ied d by by inv inves esto tors rs. . a. True b. Fals e
(10. 1 ) C ompon en t c o st s o f c api t al 3
.
Ans w er : a
Di ff : E
The The comp compon onen ent t costs costs of capi capita tal l are are mark market et-d -det eter ermi mine ned d vari variab able les s in as much as they are based on investors' reuired returns. a. True b. Fals e
(10. 2 ) C os t o f deb t !
.
An sw er : b
Di ff : E
The before-tax cost of debt" #hich is lo#er than the after-tax cost cost" cost" is used used as the the compo compone nent nt cost cost of debt debt for for purp purpose oses s of devel developi oping ng the the firm's $%CC. a. True b. Fals e
(10. 2 ) C os t o f deb t &
.
An sw er : b
Di ff : E
The The cost cost of of debt debt is is eua eual l to one one minu minus s the the marg margin inal al ta ta rat rate e mult multip ipli lied ed by the coupon rate on outstanding debt. a. True b. Fals e
(10. 3 ) C os t o f pre f err e d st ock (
.
Ans w er : b
Di D i ff : E
The The cost cost of of issu issuin ing g pref prefer erre red d stoc stock k by a corpo corpora rati tion on mus must t be ad)u ad)ust sted ed to an after-ta figure because of the *+ percent dividend eclusion provision for corporations holding other corporations' preferred stock. a. True b. Fals e
Chapter 10: Determining the Cost of Capital
Page 1
(10. 4 ) C os t o f com m o n s tock *
.
Answ er : a
Diff: E Di
The The cost cost of of comm common on sto stock ck is is the the rate rate of of retu return rn sto stock ckho hold lder ers s reu reuir ire e on the firm's common stock. a. True b. Fals e
(10. 4 ) etain e d ea r nin ! s ,
.
Answ er : b
Di ff : E
n cap capital bud budgeti eting and cos cost of cap capital ana analys lyses" the the firm sho should al#ays consider retained earnings earnings as the first source of capital" since this is a free source of funding to the firm. a. True b. Fals e
(10. 4 ) etain e d ea r nin ! s
.
Answ er : b
Di ff : E
Fund unds acui uired by the the firm thr through ugh retain aining ear earning ings have no cos cost becau because se there there are no divi dividen dend d or inter interest est paym payment ents s assoc associa iated ted #ith #ith them" but capital raised by selling ne# stock or bonds does have a cost. a. True b. Fals e
(10. 4 ) C os t o f int e rna l e"# it$
.
1+
Ans w er : b
Di D i ff : E
The cost of euity raised by retaining earnings can be less than" eual eual to" to" or great greater er than than the the cost cost of eter eternal nal eui euity ty rais raised ed by selling ne# issues of common stock" depending on ta rates" flotation costs" the attitude of investors" and other factors. a . Tr ue b . Fa lse
(10. 4 ) C os t o f e%t e rna l e"# it$
.
11
Ans w er : b
Di D i ff : E
The The f fir irm' m's s cost cost of ete etern rnal al eui euity ty capi capita tal l i is s t the he same same as the the r re eui uire red d rate of return on the firm's outstanding common stock. a . Tr ue b . Fa lse
(10. 4 ) C os t o f e%t e rna l e"# it$
.
12
Ans w er : b
Di D i ff : E
The The co cost of of eu eui ity ca capital fro from th the sal sale e of of ne ne# com comm mon sto stoc ck /r /re0 is genera generall lly y eual eual to the the cost cost of euit euity y capit capital al from from reten retenti tion on of earnings /rs0" divided by one minus the flotation flotation cost as a percentage of sales price /1 - F0. a . Tr ue b . Fa lse
Page 2
Chapter 10: Determining the Cost of Capital -
(10.4) &lotation cost and capital c'oice
.
13
Answer: b
Diff: E
The higher the firm's flotation cost for ne# common euity" the more likely the firm is to use preferred stock #hich has no flotation cost and retained earnings #hose cost is the average return on assets. a. True b. False
(10.10) Cost of capital
.
1!
Answer: b
Diff: E
ou are the president of a small" publicly-traded corporation. ince you believe that your firm's stock price is temporarily depressed" all additional capital funds reuired during the current year #ill be raised using debt. Thus" the appropriate marginal cost of capital for the current year is the after-ta cost of debt. a. True b. False
Medium: (10.2) Afterta% cost of debt
.
1&
Answer: b
Diff:
t is not possible for a firm's use of debt to increase but its afterta cost of debt to decline. a. True b. False
(10.2) Afterta% cost of debt
.
1(
Answer: a
Diff:
% firm going from a lo#er to a higher ta bracket could increase its use of debt" yet actually #ind up #ith a lo#er after-ta cost of debt. a. True b. False
(10.4) Cost of e"#it$
.
1*
Answer: b
Diff:
ince *+ percent of preferred dividends received by a corporation is ecluded from taable income" the component cost of euity for a company #hich pays half of its earnings out as common dividends and half as preferred dividends should" theoretically" be Cost of euity rs/+.3+0/+.&+0 4 rps/1 - T0/+.*+0/+.&+0. a. True b. False
Chapter 10: Determining the Cost of Capital
Page 3
(10.*) +nflation effects
.
1,
Answer: b
Diff:
f epectations for long-term inflation rose" but the slope of the 56 remained constant" this #ould have a greater impact on the reuired rate of return on euity" rs" than on the interest rate on long-term debt" rd" for most firms. n other #ords" the percentage point increase in the cost of euity #ould be greater than the increase in the interest rate on long-term debt. a. True b. False
(10.10) ,ACC
.
1
Answer: c
Diff:
uppose the debt ratio /78T%0 is 1+ percent" the current cost of debt is , percent" the current cost of euity is 1( percent" and the ta rate is !+ percent. %n increase in the debt ratio to 2+ percent #ould decrease the #eighted average cost of capital. a. True b. False c. 5ore information is needed to determine the effect on the $%CC.
(10.10) ,ACC
.
2+
Answer: a
Diff:
The cost of debt" rd" is al#ays less than rs" so rd/1 - T0 #ill certainly be less than rs. Therefore" as long as the firm is not completely debt financed" the #eighted average cost of capital #ill al#ays be greater than rd/1 - T0. a. True b. False
(10.10) ,ACC and ta% rate
.
21
Answer: b
Diff:
The lo#er the firm's ta rate" the lo#er #ill be the firm's after-ta cost of debt and $%CC" other things held constant. a. True b. False
(10.10) -pecific so#rce capital cost
.
22
Answer: b
Diff:
Firms should use their #eighted average cost of capital /$%CC0 #hen they are funding their capital pro)ects #ith a variety of sources. 9o#ever" #hen the firm plans on using only debt or only euity to fund a particular pro)ect" it should use the after-ta cost of the specific source of capital to evaluate that pro)ect. a. True b. False
Page 4
Chapter 10: Determining the Cost of Capital -
Multi+l! C'%ic!: C%$c!+tual Easy: (10.1) Capital components
.
23
Answer: c
$hich of the follo#ing is not considered a capital component for the purpose of calculating the #eighted average cost of capital as it applies to capital budgeting: a. b. c. d. e.
6ong-term debt. Common stock. %ccounts payable. ;referred stock. %ll of the above are considered capital components for $%CC and capital budgeting purposes.
(10.1) Capital components
.
2!
$hich of the follo#ing is a. b. c. d. e.
Answer: e not considered
.
Answer: c
6ong-term debt. Common stock. hort-term debt used to finance seasonal current assets. ;referred stock. %ll of the above are considered capital components for $%CC and capital budgeting purposes.
(10.) DC& cost of e"#it$ estimation
.
Diff: E
$hich of the follo#ing is not considered a capital component for the purpose of calculating the #eighted average cost of capital as it applies to capital budgeting: a. b. c. d. e.
2(
Diff: E
a capital component:
6ong-term debt. Common stock. ;ermanent short-term debt. ;referred stock. %ll of the above are considered capital components.
(10.1) Capital components 2&
Diff: E
Answer: b
Diff: E
$hich of the follo#ing factors in the discounted cash flo# /7CF0 approach to estimating the cost of common euity is the least difficult to estimate: a. b. c. d. e.
<pected gro#th rate" g. 7ividend yield" 718;+. =euired return" rs. <pected rate of return" s. r %ll of the above are eually difficult to estimate.
Chapter 10: Determining the Cost of Capital
∧
Page 5
(10.10) Capital components
.
2*
Answer: d
a. b. c. d. e.
rd @ rs @ $%CC. rs @ rd @ $%CC. $%CC @ rs @ rd. rs @ $%CC @ rd. >one of the statements above is correct.
(10.10) Capital components
.
2,
Diff: E
For a typical firm #ith a given capital structure" #hich of the follo#ing is correct: />ote? %ll rates are after taes.0
Answer: a
Diff: E
$hich of the follo#ing statements is most correct: a. f a company's ta rate increases but the yield to maturity of its noncallable bonds remains the same" the company's marginal cost of debt capital used to calculate its #eighted average cost of capital #ill fall. b. %ll else eual" an increase in a company's stock price #ill increase the marginal cost of common stock" rs. c. %ll else eual" an increase in interest rates #ill decrease the marginal cost of common stock" rs. d. %ns#ers a and b are correct. e. %ns#ers b and c are correct.
(10.10) Cost of capital components and ,ACC
.
2
Answer: c
Diff: E
$hich of the follo#ing statements is most correct: a. The $%CC is a measure of the before-ta cost of capital. b. Typically the after-ta cost of debt financing eceeds the after-ta cost of euity financing. c. The $%CC measures the marginal after-ta cost of capital. d. tatements a and b are correct. e. tatements b and c are correct.
(10.10) ,ACC and capital components
.
3+
Answer: a
Diff: E
% company has a capital structure #hich consists of &+ percent debt and &+ percent euity. $hich of the follo#ing statements is most correct: a. The cost of euity financing is greater than or eual to the cost of debt financing. b. The $%CC eceeds the cost of euity financing. c. The $%CC is calculated on a before-ta basis. d. The $%CC represents the cost of capital based on historical averages. n that sense" it does not represent the marginal cost of capital. e. The cost of retained earnings eceeds the cost of issuing ne# common stock.
Page 6
Chapter 10: Determining the Cost of Capital -
(10.11) &actors infl#encin! ,ACC
.
31
Answer: a
Diff: E
$yden Arothers uses the C%;5 to calculate the cost of euity capital. The companyBs capital structure consists of common stock" preferred stock" and debt. $hich of the follo#ing events #ill reduce the companyBs $%CC: a. b. c. d. e.
% reduction %n increase %n increase %n increase %n increase stock.
in in in in in
the market risk premium. the risk-free rate. the companyBs beta. epected inflation. the flotation costs associated #ith issuing preferred
Medium: (10.*) CA/ cost of e"#it$ estimation
.
32
a. b. c. d. e.
The The The The %ll
.
Diff:
epected rate of return on the market" r5. stock's beta coefficient" bi. risk-free rate" r=F. market risk premium /=;50. of the above are sub)ect to dispute.
(10.) CA/ and DC& estimation 33
Answer: e
n applying the C%;5 to estimate the cost of euity capital" #hich of the follo#ing elements is not sub)ect to dispute or controversy:
Answer: a
Diff:
$hich of the follo#ing statements is most correct: a. Aeta measures market risk" but if a firm's stockholders are not #ell diversified" beta may not accurately measure stand-alone risk. b. f the calculated beta underestimates the firm's true investment risk" then the C%;5 method #ill overestimate rs. c. The discounted cash flo# method of estimating the cost of euity can't be used unless the gro#th component" g" is constant during the analysis period. d. %n advantage shared by both the 7CF and C%;5 methods of estimating the cost of euity capital" is that they yield precise estimates and reuire little or no )udgement. e. %ll of the statements above are false.
Chapter 10: Determining the Cost of Capital
Page 7
(10.) Cost of e"#it$ estimation
.
3!
Answer: d
Diff:
$hich of the follo#ing statements is most correct: a. %lthough some methods of estimating the cost of euity capital encounter severe difficulties" the C%;5 is a simple and reliable model that provides great accuracy and consistency in estimating the cost of euity capital. b. The 7CF model is preferred over other models to estimate the cost of euity because of the ease #ith #hich a firm's gro#th rate is obtained. c. The bond-yield-plus-risk-premium approach to estimating the cost of euity is not al#ays accurate but its advantages are that it is a standardied and ob)ective model. d. 7epreciation-generated funds are an additional source of capital and" in fact" represent the largest single source of funds for some firms. e. >one of the statements above is correct.
(10.) CA/ cost of e"#it$ estimation
.
3&
Answer: e
Diff:
$hich of the follo#ing statements is most correct: a. The C%;5 approach to estimating a firm's cost of common stock never gives a better estimate than the 7CF approach. b. The C%;5 approach is typically used to estimate a firm's cost of preferred stock. c. The risk premium used in the bond-yield-plus-risk-premium method is the same as the one used in the C%;5 method. d. n practice /as opposed to in theory0" the 7CF method and the C%;5 method usually produce eactly the same estimate for rs. e. The statements above are all false.
(10.) iscellaneo#s concepts
.
3(
Answer: a
Diff:
$hich of the follo#ing statements is most correct: a. uppose a firm is losing money and thus" is not paying taes" and that this situation is epected to persist for a fe# years #hether or not the firm uses debt financing. Then the firm's after-ta cost of debt #ill eual its before-ta cost of debt. b. The component cost of preferred stock is epressed as rps/1 - T0" because preferred stock dividends are treated as fied charges" similar to the treatment of debt interest. c. The reason that a cost is assigned to retained earnings is because these funds are already earning a return in the businessD the reason does not involve the opportunity cost principle. d. The bond-yield-plus-risk-premium approach to estimating a firm's cost of common euity involves adding a sub)ectively determined risk-premium to the market risk-free bond rate. e. %ll of the statements above are false.
Page 8
Chapter 10: Determining the Cost of Capital -
(10.) iscellaneo#s concepts
.
3*
Answer: a
Diff:
$hich of the follo#ing statements is most correct: a. The before-ta cost of preferred stock may be lo#er than the beforeta cost of debt" even though preferred stock is riskier than debt. b. f a company's stock price increases" this increases its cost of common stock. c. f the cost of euity capital increases" it must be due to an increase in the firm's beta. d. tatements a and b are correct. e. %ns#ers a" b" and c are correct.
(10.10) Capital components
.
3,
Answer: d
Diff:
$hich of the follo#ing statements is most correct: a. Capital components are the types of capital used by firms to raise money. %ll capital comes from one of three components? long-term debt" preferred stock" and euity. b. ;referred stock does not involve any ad)ustment for flotation cost since the dividend and price are fied. c. The cost of debt used in calculating the $%CC is an average of the after-ta cost of ne# debt and of outstanding debt. d. The opportunity cost principle implies that if the firm cannot invest retained earnings and earn at least rs" it should pay these funds to its stockholders and let them invest directly in other assets that do provide this return. e. The cost of common stock" rs" is usually less than the cost of preferred stock.
(10.10) Capital components
.
3
Answer: e
Diff:
$hich of the follo#ing statements is most correct: a. n the #eighted average cost of capital calculation" #e must ad)ust the cost of preferred stock for the ta eclusion of *+ percent of dividend income. b. $e ideally #ould like to use historical measures of the component costs from prior financings in estimating the appropriate #eighted average cost of capital. c. The cost of common stock /rs0 #ill increase if the market risk premium and risk-free rate decline by a substantial amount. d. tatements b and c are correct. e. >one of the statements above is correct.
Chapter 10: Determining the Cost of Capital
Page 9
(10.10) Cost of capital estimation
.
!+
Answer: c
Diff:
$hich of the follo#ing statements is most correct: a. The cost of capital used to evaluate a pro)ect should be the cost of the specific type of financing used to fund that pro)ect. b. The cost of debt used to calculate the #eighted average cost of capital is based on an average of the cost of debt already issued by the firm and the cost of ne# debt. c. Ene problem #ith the C%;5 approach to estimating the cost of euity capital is that if a firm's stockholders are" in fact" not #ell diversified" beta may be a poor measure of the firm's true investment risk. d. The bond-yield-plus-risk-premium approach is the most sophisticated and ob)ective method of estimating a firm's cost of euity capital. e. The cost of euity capital is generally easier to measure than the cost of debt" #hich varies daily #ith interest rates" or the cost of preferred stock since preferred stock is issued infreuently.
(10.10) ,ACC
.
!1
Answer: d
Diff:
$hich of the follo#ing statements is most correct: a. The #eighted average cost of capital for a given capital budget level is a #eighted average of the marginal cost of each relevant capital component #hich makes up the firm's target capital structure. b. The #eighted average cost of capital is calculated on a before-ta basis. c. %n increase in the risk-free rate is likely to increase the marginal costs of both debt and euity financing. d. %ns#ers a and c are correct. e. %ll of the ans#ers above are correct.
(10.11) ,ACC concepts
.
!2
$hich
of
incorrect:
the
Answer: c
follo#ing
statements
about
the
cost
of
Diff:
capital
is
a. % company's target capital structure affects its #eighted average cost of capital. b. $eighted average cost of capital calculations should be based on the after-ta-costs of all the individual capital components. c. f a company's ta rate increases" then" all else eual" its #eighted average cost of capital #ill increase. d. The cost of retained earnings is eual to the return stockholders could earn on alternative investments of eual risk. e. Flotation costs can increase the cost of preferred stock. (10.12) isk treatment
.
!3
Answer: e
Diff:
$hich of the follo#ing methods of estimating the cost of common euity for a firm treats risk eplicitly: a. b. c. d.
Page 10
7CF method. C%;5 method. Composite method. Aond-yield-plus-risk-premium method. Chapter 10: Determining the Cost of Capital -
e. %ns#ers b and d are correct. (10.14) ,ACC concepts
.
!!
Answer: e
Diff:
$hich of the follo#ing statements is most correct: a. ince stockholders do not generally pay corporate taes" corporations should focus on before-ta cash flo#s #hen calculating the #eighted average cost of capital /$%CC0. b. $hen calculating the #eighted average cost of capital" firms should include the cost of accounts payable. c. $hen calculating the #eighted average cost of capital" firms should rely on historical costs rather than marginal costs of capital. d. %ns#ers a and b are correct. e. >one of the ans#ers above is correct.
Multi+l! C'%ic!: P)%,l!#s Easy: (10.) Cost of common stock
.
!&
Answer: d
Diff: E
Aouchard Company's stock sells for 2+ per share" its last dividend /7+0 #as 1.++" and its gro#th rate is a constant ( percent. $hat is its cost of common stock" rs: a. &.+G b. &.3G c. 11.+G d. 11.3G e. 11.(G
(10.) Cost of common stock
.
!(
Answer: b
Diff: E
our company's stock sells for &+ per share" its last dividend /7+0 #as 2.++" and its gro#th rate is a constant & percent. $hat is the cost of common stock" rs: a. .+G b. .2G c. .(G d. .,G e. 1+.+G
(10.) Cost of common stock
.
!*
Answer: e
Diff: E
The Hlobal %dvertising Company has a marginal ta rate of !+ percent. The last dividend paid by Hlobal #as +.+. Hlobal's common stock is selling for ,.& per share" and its epected gro#th rate in earnings and dividends is & percent. $hat is Hlobal's cost of common stock: a. b. c. d. e.
12.22G 1*.22G 1+.33G .((G 1(.++G
Chapter 10: Determining the Cost of Capital
Page 11
(10.) ,ACC wit' &lotation Costs
.
%n analyst has Christopher Co.?
!,
collected
Answer: a
the
follo#ing
information
Diff: E
regarding
The companyBs capital structure is *+ percent euity" 3+ percent debt. The yield to maturity on the companyBs bonds is percent. • • The companyBs year-end dividend is forecasted to be +.,+ a share. • The company epects that its dividend #ill gro# at a constant rate of percent a year. • The companyBs stock price is 2&. • The companyBs ta rate is !+ percent. • The company anticipates that it #ill need to raise ne# common stock this year. ts investment bankers anticipate that the total flotation cost #ill eual 1+ percent of the amount issued. %ssume the company accounts for flotation costs by ad)usting the cost of capital. Hiven this information" calculate the companyBs $%CC. •
a. b. c. d. e.
1+.!1G 12.&(G 1+.*,G 13.&&G .2G
Medium: (10.*) Cost of common stock
.
!
Answer: d
Diff:
The common stock of %nthony teel has a beta of 1.2+. The risk-free rate is & percent and the market risk premium /r5 - r=F0 is ( percent. $hat is the companyBs cost of common stock" rs: a. *.+G b. *.2G c. 11.+G d. 12.2G e. 12.!G
(10.) Cost of common stock
.
&+
Answer: b
Diff:
5artin Corporation's common stock is currently selling for &+ per share. The current dividend is 2.++ per share. f dividends are epected to gro# at ( percent per year" then #hat is the firm's cost of common stock: a. b. c. d. e.
Page 12
1+.+G 1+.2G 1+.(G 1+.,G 11.+G
Chapter 10: Determining the Cost of Capital -
(10.) ,ACC and diidend !rowt' rate
.
&1
a. b. c. d. e. .
Diff:
2.(,G 3.!!G !.(!G (.*&G ,.1(G
(10.10) ,ACC &2
Answer: c
Hrate#ay nc. has a #eighted average cost of capital of 11.& percent. ts target capital structure is && percent euity and !& percent debt. The company has sufficient retained earnings to fund the euity portion of its capital budget. The before-ta cost of debt is percent" and the companyBs ta rate is 3+ percent. f the epected dividend net period /710 and current stock price are & and !&" respectively" #hat is the companyBs gro#th rate:
Answer: d
Diff:
% companyBs balance sheets sho# a total of 3+ million long-term debt #ith a coupon rate of percent. The yield to maturity on this debt is 11.11 percent" and the debt has a total current market value of 2& million. The balance sheets also sho# that that the company has 1+ million shares of stockD the total of common stock and retained earnings is 3+ million. The current stock price is *.& per share. The current return reuired by stockholders" r" is 12 percent. The company has a target capital structure of !+ percent debt and (+ percent euity. The ta rate is !+G. $hat #eighted average cost of capital should you use to evaluate potential pro)ects: a. ,.&&G b. .33G c. .3(G d. .,*G e. 1+.(*G
(10.10) ,ACC
.
&3
Answer: b
Diff:
% company has determined that its optimal capital structure consists of !+ percent debt and (+ percent euity. Hiven the follo#ing information" calculate the firm's #eighted average cost of capital. rd (G Ta rate !+G ;+ 2& Hro#th +G 7+ 2.++ a. b. c. d. e.
(.+G (.2G *.+G *.2G ,.+G
Chapter 10: Determining the Cost of Capital
Page 13
(10.10) ,ACC
.
Answer: c
Diff:
Iohnson ndustries finances its pro)ects #ith !+ percent debt" 1+ percent preferred stock" and &+ percent common stock.
&!
The company can issue bonds at a yield to maturity of ,.! percent. The cost of preferred stock is percent. • The company's common stock currently sells for 3+ a share. • • The company's dividend is currently 2.++ a share /7+ 2.++0" and is epected to gro# at a constant rate of ( percent per year. %ssume that the flotation cost on debt and preferred stock is • ero" and no ne# stock #ill be issued. The companyBs ta rate is 3+ percent. • •
$hat is the companyBs #eighted average cost of capital /$%CC0: a. ,.33G b. .32G c. .*G d. .G e. 13.1&G (10.10) ,ACC
.
Answer: e
Diff:
7obson 7airies has a capital structure #hich consists of (+ percent long-term debt and !+ percent common stock. The companyBs CFE has obtained the follo#ing information?
&&
• •
•
The before-ta yield to maturity on the companyBs bonds is , percent. The companyBs common stock is epected to pay a 3.++ dividend at year end /71 3.++0" and the dividend is epected to gro# at a constant rate of * percent a year. The common stock currently sells for (+ a share. %ssume the firm #ill be able to use retained earnings to fund the euity portion of its capital budget. • The companyBs ta rate is !+ percent. $hat is the companyBs #eighted average cost of capital /$%CC0: a. 12.++G b. ,.+3G c. .3!G d. ,.++G e. *.(,G
Page 14
Chapter 10: Determining the Cost of Capital -
Multiple part: (The following information applies to the next six problems.)
=ollins Corporation is estimating its $%CC. ts target capital structure is 2+ percent debt" 2+ percent preferred stock" and (+ percent common euity. ts bonds have a 12 percent coupon" paid semiannually" a current maturity of 2+ years" and sell for 1"+++. The firm could sell" at par" 1++ preferred stock #hich pays a 12 percent annual dividend" but flotation costs of & percent #ould be incurred. =ollins' beta is 1.2" the risk-free rate is 1+ percent" and the market risk premium is & percent. =ollins is a constantgro#th firm #hich )ust paid a dividend of 2.++" sells for 2*.++ per share" and has a gro#th rate of , percent. The firm's policy is to use a risk premium of ! percentage points #hen using the bond-yield-plus-risk-premium method to find rs. The firm's marginal ta rate is !+ percent. (10.2) Cost of debt
.
&(
Answer: e
Diff:
Answer: d
Diff: E
Answer: c
Diff: E
$hat is =ollins' component cost of debt: a. 1+.+G b. .1G c. ,.(G d. ,.+G e. *.2G
(10.3) Cost of preferred stock
.
&*
$hat is =ollins' cost of preferred stock: a. b. c. d. e.
1+.+G 11.+G 12.+G 12.(G 13.2G
(10.*) Cost of common stock: CA/
.
&,
$hat is =ollins' cost of common stock /rs0 using the C%;5 approach: a. b. c. d. e.
13.(G 1!.1G 1(.+G 1(.(G 1(.G
(10.) Cost of common stock: DC&
.
&
Answer: c
Diff: E
$hat is the firm's cost of common stock /rs0 using the 7CF approach: a. b. c. d. e.
13.(G 1!.1G 1(.+G 1(.(G 1(.G
Chapter 10: Determining the Cost of Capital
Page 15
(10.) Cost of common stock: isk premi#m
.
(+
Answer: c
a. b. c. d. e.
13.(G 1!.1G 1(.+G 1(.(G 1(.G
(10.10) ,ACC
.
(1
Diff: E
$hat is =ollins' cost of common stock using the bond-yield-plus-riskpremium approach:
Answer: a
Diff: E
$hat is =ollins' $%CC: a. b. c. d. e.
13.(G 1!.1G 1(.+G 1(.(G 1(.G
(The following information applies to the next three problems.)
I. =oss and ons nc. has a target capital structure that calls for !+ percent debt" 1+ percent preferred stock" and &+ percent common euity. The firm's current after-ta cost of debt is ( percent" and it can sell as much debt as it #ishes at this rate. The firm's preferred stock currently sells for + per share and pays a dividend of 1+ per shareD ho#ever" the firm #ill net only ,+ per share from the sale of ne# preferred stock. =oss's common stock currently sells for !+ per share. The firm recently paid a dividend of 2 per share on its common stock" and investors epect the dividend to gro# indefinitely at a constant rate of 1+ percent per year. (10.3) Cost of preferred stock
.
(2
Answer: b
$hat is the firm's cost of ne#ly issued preferred stock" rps: a. b. c. d. e.
1+.+G 12.&G 1&.&G 1(.&G 1,.+G
(10.) Cost of common stock
.
(3
Diff: E
Answer: c
Diff: E
$hat is the firm's cost of common stock" rs: a. b. c. d. e.
Page 16
1+.+G 12.&G 1&.&G 1(.&G 1,.+G
Chapter 10: Determining the Cost of Capital -
(10.10) ,ACC
.
(!
Answer: d
a. b. c. d. e.
.&G 1+.3G 1+.,G 11.!G 11.G
(10.) Cost of e"#it$
.
(&
Diff: E
$hat is the firm's #eighted average cost of capital /$%CC0:
Answer: a
Diff:
%llison
(10.10) ,ACC Answer: b
.
((
Diff:
9illiard Corp. #ants to calculate its #eighted average cost of capital /$%CC0. The companyBs CFE has collected the follo#ing information? The companyBs long-term bonds currently offer a yield to maturity of , percent. • The companyBs stock price is 32 per share /;+ 320. • The company recently paid a dividend of 2 per share /7+ 2.++0. The dividend is epected to gro# at a constant rate of ( • percent a year /g (G0. • The company pays a 1+ percent flotation cost #henever it issues ne# common stock /F 1+G0. • The companyBs target capital structure is *& percent euity and 2& percent debt. The companyBs ta rate is !+ percent. • The company anticipates issuing ne# common stock during the • upcoming year. •
$hat is the companyBs $%CC: a. b. c. d. e.
1+.(*G 11.22G 11.!*G 12.+2G 12.&(G
Chapter 10: Determining the Cost of Capital
Page 17
Page 18
Chapter 10: Determining the Cost of Capital -
Fi$a$cial Calculat%) S!cti%$ Multi+l! C'%ic!: P)%,l!#s Medium: (The following information applies to the next four problems. calculator required.)
Financial
ou are employed by CHT" a Fortune &++ firm that is a ma)or producer of chemicals and plastic goods? plastic grocery bags" styrofoam cups" and fertiliers. ou are on the corporate staff as an assistant to the Jice;resident of Finance. This is a position #ith high visibility and the opportunity for rapid advancement" providing you make the right decisions. our boss has asked you to estimate the #eighted average cost of capital for the company. Follo#ing are balance sheets and some information about CHT. Assets
Current assets >et plant" property" and euipment
3,"+++"+++ 1+1"+++"+++
otal Assets
51360006000
7iabilities and E"#it$
%ccounts payable %ccruals Current liabilities
1+"+++"+++ "+++"+++ 1"+++"+++
6ong term debt /!+"+++ bonds" 1"+++ face value0 Total liabilities
!+"+++"+++ &"+++"+++
Common tock 1+"+++"+++ shares0 =etained
3+"+++"+++ &+"+++"+++ ,+"+++"+++
otal liabilities and s'are'olders e"#it$
51360006000
ou check The all !treet "ournal and see that CHT stock is currently selling for *.&+ per share and that CHT bonds are selling for ,,.&+ per bond. These bonds have a *.2& percent annual coupon rate" #ith semi-annual payments. The bonds mature in t#enty years. The beta for your company is approimately eual to 1.1. The yield on a (-month Treasury bill is 3.& percent and the yield on a 2+-year Treasury bond is &.& percent. The epected return on the stock market is 11.& percent" but the stock market has had an average annual return of 1!.& percent during the past five years. CHT is in the !+ percent ta bracket.
Chapter 10: Determining the Cost of Capital
Page 19
(10.2) Afterta% cost of debt
.
(*
Answer: d
a. b. c. d. e.
2.&2G !.2+G !.3&G &.+!G &.3*G
(10.*) CA/ cost of e"#it$
.
(,
Answer: b
1+.1+G 12.1+G 12.3+G 1&.!+G 1&.(+G
(10.10) ,ei!'ts for ,ACC
.
Answer: d
#e #e #e #e #e
&*.(G (&.2G ((.*G (*.,G *2.!G
and and and and and
#d #d #d #d #d
!2.!G 3!.,G 33.3G 32.2G 2*.(G
(10.10) ,ACC
.
Diff:
Answer: b
Diff:
,.(&G ,.2G .1,G .*&G .,3G
(10.2) Component cost of debt
.
Answer: e
$hat is the best estimate of the $%CC for CHT: a. b. c. d. e.
*1
Diff:
$hich of the follo#ing is the best estimate for the #eights to be used #hen calculating the $%CC: a. b. c. d. e.
*+
Diff:
Ksing the C%;5 approach" #hat is the best estimate of the cost of euity for CHT: a. b. c. d. e.
(
Diff:
$hat is best estimate for the after-ta cost of debt for CHT:
9amilton Company's , percent coupon rate" uarterly payment" 1"+++ par value bond" #hich matures in 2+ years" currently sells at a price of (,(.,(. The company's ta rate is !+ percent. Aased on the nominal interest rate" not the <%=" #hat is the firm's component cost of debt for purposes of calculating the $%CC: a. 3.+&G b. *.32G c. *.3(G d. 12.2+G e. 12.2(G
Page 20
Chapter 10: Determining the Cost of Capital -
(10.10) ,ACC
.
*2
Answer: a
Diff:
% stock analyst has obtained the follo#ing information about I-5art" a large retail chain? /10 The company has noncallable bonds #ith 2+ years maturity remaining and a maturity value of 1"+++. The bonds have a 12 percent annual coupon and currently sell at a price of 1"2*3.,&(!. /20 Ever the past four years" the returns on the market and on I-5art #ere as follo#s? ear 2++( 2++* 2++, 2++
5arket 12.+G 1*.2 -3., 2+.+
I-5art 1!.&G 22.2 -*.& 2!.+
/30 The current risk-free rate is (.3& percent" and the epected return on the market is 11.3& percent. The company's ta rate is 3& percent. The company anticipates that its proposed investment pro)ects #ill be financed #ith *+ percent debt and 3+ percent euity. $hat is the company's estimated #eighted average cost of capital /$%CC0: a. ,.+!G b. .++G c. 1+.2&G d. 12.33G e. 13.1!G
Chapter 10: Determining the Cost of Capital
Page 21
CHAPTER 10 ANS-ERS AND SOL.TIONS
Page 22
Chapter 10: Determining the Cost of Capital -
1.
(10.1) Cost of capital
Answer: a
Diff: E
2.
(10.1) Capital
Answer: a
Diff: E
3.
(10.1) Component costs of capital
Answer: a
Diff: E
!.
(10.2) Cost of debt
Answer: b
Diff: E
&.
(10.2) Cost of debt
Answer: b
Diff: E
(.
(10.3) Cost of preferred stock
Answer: b
Diff: E
*.
(10.4) Cost of common stock
Answer: a
Diff: E
,.
(10.4) etained earnin!s
Answer: b
Diff: E
.
(10.4) etained earnin!s
Answer: b
Diff: E
1+.
(10.4) Cost of internal e"#it$
Answer: b
Diff: E
11.
(10.4) Cost of e%ternal e"#it$
Answer: b
Diff: E
12.
(10.4) Cost of e%ternal e"#it$
Answer: b
Diff: E
13.
(10.4) &lotation cost and capital c'oice
Answer: b
Diff: E
1!.
(10.10) Cost of capital
Answer: b
Diff: E
1&.
(10.2) Afterta% cost of debt
Answer: b
Diff:
1(.
(10.2) Afterta% cost of debt
Answer: a
Diff:
1*.
(10.4) Cost of e"#it$
Answer: b
Diff:
1,.
(10.*) +nflation effects
Answer: b
Diff:
1.
(10.10) ,ACC
Answer: c
Diff:
2+.
(10.10) ,ACC
Answer: a
Diff:
21.
(10.10) ,ACC and ta% rate
Answer: b
Diff:
22.
(10.10) -pecific so#rce capital cost
Answer: b
Diff:
23.
(10.1) Capital components
Answer: c
Diff: E
2!.
(10.1) Capital components
Answer: e
Diff: E
2&.
(10.1) Capital components
Answer: c
Diff: E
.
(10.) DC& cost of e"#it$ estimation
Answer: b
Diff: E
2*.
(10.10) Capital components
Answer: d
Diff: E
2,.
(10.10) Capital components
Answer: a
Diff: E
2(
The debt cost used to calculate a firm's $%CC is rd/1 - T0. f rd remains constant but T increases" then the term /1 - T0 decreases and the value of the entire euation" rd/1 - T0" decreases. tatement b is falseD if a
company's stock price increases" and all else remains constant" then the dividend yield decreases and rs decreases. This can be seen from the euation rs 718;+ 4 g. tatement c is false" since an increase in interest rates #ill cause an increase in the cost of common stock" rs. Conseuently" statements d and e are false too. 2.
(10.10) Cost of capital components and ,ACC
Answer: c
Diff: E
$%CC measures the marginal after-ta cost of capitalD therefore" statement a is false. The after-ta cost of debt financing is less than the after-ta cost of euity financingD therefore" statement b is false. The correct choice is statement c. 3+.
(10.10) ,ACC and capital components
Answer: a
Diff: E
tatement a is correctD the other statements are false. tatement b is incorrectD $%CC is an average of debt and euity financing. ince debt financing is cheaper and is ad)usted do#n#ard for taes" it should" #hen averaged #ith euity" cause the $%CC to be less than the cost of euity financing. tatement c is incorrectD $%CC is calculated on an after-ta basis. tatement d is incorrectD the $%CC is based on marginal" not embedded" costs. tatement e is incorrectD the cost of issuing ne# common stock is greater than the cost of retained earnings. 31 .
(10.11) &actors infl#encin! ,ACC
Answer: a
Diff: E
tatement a is correctD the other statements are false. f =;5 decreases" the cost of euity #ill be reduced. %ns#ers b through e #ill all increase the companyBs $%CC. 32.
(10.*) CA/ cost of e"#it$ estimation
Answer: e
Diff:
33.
(10.) CA/ and DC& estimation
Answer: a
Diff:
3!.
(10.) Cost of e"#it$ estimation
Answer: d
Diff:
3&.
(10.) CA/ cost of e"#it$ estimation
Answer: e
Diff:
3(.
(10.) iscellaneo#s concepts
Answer: a
Diff:
3*.
(10.) iscellaneo#s concepts
Answer: a
Diff:
tatement a is correct. 5ost preferred stock is o#ned by corporations #hich receive a *+ percent eclusion of dividends. Conseuently" the before-ta coupons on preferred stock are often lo#er than the before-ta coupons on debt" despite the fact that preferred stock is riskier than debt. %ll the other statements are false.
3,.
(10.10) Capital components
Answer: d
Diff:
3.
(10.10) Capital components
Answer: e
Diff:
tatement e is correct. Knlike interest epense on debt" preferred dividends are not deductible" hence there are no ta savings associated #ith the use of preferred stock. The component costs of $%CC should reflect the costs of ne# financing" not historical measures. The cost of common stock #ould decline" not increase" if the market risk premium and risk-free rate decline.
!+.
(10.10) Cost of capital estimation
Answer: c
Diff:
!1.
(10.10) ,ACC
Answer: d
Diff:
tatements a and c are both correctD therefore" statement d is the correct choice. tatement a recites the definition of the #eighted average cost of capital. tatement c is correct because rd r=F 4 6; 4 5=; 4 7=; #hile rs r=F 4 /r5 - r=F0b. f r=F increases then the values for rd and rs #ill increase. !2.
(10.10) ,ACC concepts
Answer: c
Diff:
tatement c is the correct choice. % ta rate increase #ould lead to a decrease in the after-ta cost of debt and" conseuently" the firm's $%CC #ould decrease.
!3.
(10.12) isk treatment
Answer: e
Diff:
!!.
(10.14) ,ACC concepts
Answer: e
Diff:
!&.
tatement e is correct. %fter-ta account for the ta deductibility The impact of accounts payable is marginal" not the embedded" cost of
cash flo#s must be considered in order to of interest payments on corporate debt. reflected in cash flo#s" not $%CC. The capital is the relevant cost of capital.
(10.) Cost of common stock
Answer: d
Diff: E
The cost of common stock is? rs 1/1.+(082+ 4 +.+( +.+&3 4 +.+( +.113 11.3G.
!(.
(10.) Cost of common stock
rs !*.
!.
&+ .
F&+
F+.+/1.+& 0 F,.&
Diff: E
Answer: e
Diff: E
Answer: a
Diff: E
4 &G .2G.
(10.) Cost of common stock
rs !,.
F2.++/1.+& 0
Answer: b
4 +.+& +.1(++ 1(.++G.
(10.) ,ACC wit' &lotation Costs
$%CC #drd/1 - T0 4 #cere. rd is given G. Find re? re 718L;+/1 - F0M 4 g +.,8L2&/1 - +.10M 4 +.+ +.12&&&(. >o# you can calculate $%CC? $%CC /+.30/+.+0/+.(0 4 /+.*0/+.12&&&(0 1+.!1G. (10.*) Cost of common stock
The rs
(10.) Cost of common stock F2.++/1.+ (0
rs
Answer: d
Diff:
cost of common euity as calculated from the C%;5 is r=F 4 /r5 - r=F0b &G 4 /(G01.2 12.2G.
F&+
4 +.+(G 1+.2!G
≈
Answer: b
Diff:
Answer: c
Diff:
1+.2G.
&1 .
(10.) ,ACC and diidend !rowt' rate
olve for rs?
$%CC 11.&G #drd/1 - T0 4 #cers 11.&G +.!&/+.+0/+.*+0 4 +.&&rs rs 1&.*&G.
olve for g?
1&.*&G 718;+ 4 g 1&.*&G &8!& 4 g
g !.(!G. &2.
&3.
&! .
(10.10) ,ACC
Answer: d
Diff:
$eights should be based on the target capital structure? #d !+G and #e (+G. The cost of debt should be based on the yield of 11.11G. $%CC +.(+ /12G0 4 +.! /1-.!0 /11.11G0 .,*G. (10.10) ,ACC
Answer: b
Diff:
Diff:
Find the cost of common stock? rs 718;+ 4 g 2/1.+082& 4 +GD rs +.+, ,G. Finally" calculate $%CC" using rs +.+," and rd +.+(" so $%CC /78%0/1 - Ta rate0rd 4 /<8%0rs +.!/1 - +.!0/+.+(0 4 +.(/+.+,0 +.+(2! ≈ (.2G. (10.10) ,ACC
Answer: c
The cost of common stock is?
rs 718;+ 4 g 2.1283+ 4 +.+( 13.+*G.
The cost to the company of the bonds is the T5 multiplied by 1 minus the ta rate? rd T5/1 - T0 ,.!G/+.*0 &.,,G. The cost of the preferred is given as G. The #eighted average cost of capital is then $%CC #d/rd0 4 #ps/rps0 4 #ce/rs0 $%CC +.!/&.,,G0 4 +.1/G0 4 +.&/13.+*G0 .*G. &&.
(10.10) ,ACC
Answer: e
Diff:
The firm #ill not be issuing ne# euity because there are adeuate retained earnings available to fund available pro)ects. Therefore" $%CC should be calculated using rs. rs 718;+ 4 g 3.++8(+.++ 4 +.+* +.12 12G. $%CC #drd/1 - T0 4 #cers /+.(0/+.+,0/1 - +.!0 4 /+.!0/+.120 +.+*(, *.(,G. &(.
(10.2) Cost of debt
Time line? + r d / 2 ? 1 2 3 ! !+ (-month NOOOOOOOOOOOPOOOOOPOOOOOOOOPOOOOOOOOOPOOOQQQOOOOOOOR ;eriods
Answer: e
Diff:
=
;5T (+ JA 1"+++
(+
(+
(+
(+ FJ 1"+++
ince the bond sells at par of 1"+++" its T5 and coupon rate /12 percent0 are eual. Thus" the before-tax cost of debt to =ollins is 12 percent. The cost of debt euals? after-tax rd"%fter-ta 12.+G/1 - +.!+0 *.2G. Financial calculator solution?
nputs? > !+D ;J -1"+++D ;5T (+D FJ 1"+++D Eutput? (.+G rd82. rd (.+G × 2 12G. rd/1 - T0 12.+G/+.(0 *.2G. &*. &, .
(10.3) Cost of preferred stock
Cost of preferred stock?
Answer: d
Diff: E
rps 1281++/+.&0 12.(G.
(10.*) Cost of common stock: CA/
Answer: c
Diff: E
Answer: c
Diff: E
Answer: c
Diff: E
Cost of common stock /C%;5 approach0? rs 1+G 4 /&G01.2 1(.+G. &.
(10.) Cost of common stock: DC&
Cost of common stock /7CF approach0? F2.++/1.+, 0
rs
F2*
4 ,G 1(.+G.
(+ .
(1 .
(10.) Cost of common stock: isk premi#m
Cost of common stock /Aond yield-plus-risk-premium approach0? rs 12.+G 4 !.+G 1(.+G. (10.10) ,ACC
Answer: a
Diff: E
$%CC #drd/1 - T0 4 #psrps 4 #cers +.2/12.+G0/+.(0 4 +.2/12.(G0 4 +.(/1(.+G0 13.&(G ≈ 13.(G. (2.
(10.3) Cost of preferred stock
rps
F1+ F,+
Answer: b
Diff: E
Answer: c
Diff: E
12.&G.
(3 .
(10.) Cost of common stock F2.++/1.1+ 0
rs
F!+.++
4 +.1+ 1&.&G.
(!. (&
(10.10) ,ACC
Answer: d
Diff: E
.
(10.) Cost of e"#it$
Answer: a
Diff:
#alculate the retained earnings brea$ point:
Hiven? >et income (++D 7ebt +.!D <uity +.(D 7ividend payout +.(. Areak point=< (++/1 - +.(08+.( !++. %llison #ill need ne# euity capitalD capital budget eceeds Areak point=<. %se the di&idend growth model to calculate r e:
re
7+ ( 1
+
g)
;+ ( 1
−
F)
4 g
2.2+( 1.+() 2,( 1
−
+.+* 4 +.+( +.1&* ((.
(10.10) ,ACC
+.1&) ≈
4 +.+(
1&.,G. Answer: b
Diff:
The correct ans#er is b" 11.22G. %s there are no retained earnings" the euity portion of the capital budget must be funded using ne# common euity. $%CC $d/rd0/1 - T0 4 #ce/re0 +.2&/+.+,0/1 - +.!0 4 +.*&L/2.++ 1.+(08/32/1 - +.100 4 +.+(M
+.2&/+.+!,+0 4 +.*&/+.133(0 +.1122 11.22G. (*.
(10.2) Afterta% cost of debt
>!+
: ;J-,,.&+ !.2
Answer: d
;5T3(.2&
Diff:
FJ1"+++
rd !.2/20 ,.!G. rd after-ta ,.!G/1-+.!+0 &.+!G. (,.
(10.*) CA/ Cost of E"#it$
Answer: b
Diff:
rs &.&G 4 1.1/11.&G-&.&G0 12.1+G. (.
*+.
(10.10) ,ei!'ts for ,ACC
Answer: d
Diff:
Kse market values for estimating the #eights" since target values are not available. 5arket value of euity Je *.&+/1+ million0 *& million. 5arket value of debt Jd ,,.&+/!+"+++0 3&.&, million. $e *&8/*&43&.&,0 +.(*, (*.,G. $d 3&.&,8/*&43&.&,0 +.322 32.2G. (10.10) ,ACC
Answer: e
Diff:
Answer: b
Diff:
$%CC #cers 4 #drd/1 - T0 $%CC +.(*, /12.1+G0 4 +.322 /,.!G/1-+.!+00
*1 .
$%CC +.(*, /12.1+G0 4 +.322 /&.+!G0 .,3G. (10.2) Component cost of debt
Time line? + rd :
1
2
3
!
,+ NOOOOOOOOPOOOOOOPOOOOOOOPOOOOOOOPOOOQQQOOOOORSuarters ;5T 2+ 2+ 2+ 2+ 2+ JA (,(.,( FJ 1"+++
Financial calculator solution? #alculate the nominal 'TM of bond:
*2 .
nputs? > ,+D ;J -(,(.,(D ;5T 2+D FJ 1"+++. Eutput? 3.+&G periodic rate. >ominal annual rate 3.+&G × ! 12.2+G. #alculate rd after-tax: rd"%T 12.2+G/1 - T0 12.2+G/1 - +.!0 *.32G. (10.10) ,ACC
Answer: a
Diff:
$%CC L/+.*0/rd0/1 - T0M 4 L/+.30/rs0M. a. Kse bond information to solve for rd? > 2+D ;J -1"2*3.,&(!D ;5T 12+D FJ 1"+++. olve for rd G. b. To solve for rs" #e can use the 56 euation" but #e need to find beta. Ksing 5arket and I-5art return information and a calculator's regression feature #e find b 1.3&,&. o rs +.+(3& 4 /+.113& - +.+(3&0/1.3&,&0 +.131! 13.1!G. c. ;lug these values into the $%CC euation and solve?
$%CC L/+.*0/+.+0/1 - +.3&0M 4 L/+.30/+.131!0M +.+,+! ,.+!G.
