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Exam 10: The Cost of Capital

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Question 21

True/False

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The lower the firm's tax rate,the lower will be its after-tax cost of debt and also its WACC,other things held constant.

A) True
B) False

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Question 22

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For a company whose target capital structure calls for 50% debt and 50% common equity,which of the following statements is CORRECT?

A) The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet.
B) The WACC is calculated on a before-tax basis.
C) The WACC exceeds the cost of equity.
D) The cost of equity is always equal to or greater than the cost of debt.
E) The cost of retained earnings typically exceeds the cost of new common stock.

F) A) and B)
G) A) and E)

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Question 23

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Bankston Corporation forecasts that if all of its existing financial policies are followed,its proposed capital budget would be so large that it would have to issue new common stock.Since new stock has a higher cost than retained earnings,Bankston would like to avoid issuing new stock.Which of the following actions would REDUCE its need to issue new common stock?

Which of the following statements is CORRECT?

Daves Inc.recently hired you as a consultant to estimate the company's WACC.You have obtained the following information.(1) The firm's noncallable bonds mature in 20 years,have an 8.00% annual coupon,a par value of $1,000,and a market price of $1,225.00.(2) The company's tax rate is 40%.(3) The risk-free rate is 4.50%,the market risk premium is 5.50%,and the stock's beta is 1.20.(4) The target capital structure consists of 35% debt and the balance is common equity.The firm uses the CAPM to estimate the cost of equity,and it does not expect to issue any new common stock.What is its WACC? Do not round your intermediate calculations.

Eakins Inc.'s common stock currently sells for $15.00 per share,the company expects to earn $2.75 per share during the current year,its expected payout ratio is 70%,and its expected constant growth rate is 6.00%.New stock can be sold to the public at the current price,but a flotation cost of 8% would be incurred.By how much would the cost of new stock exceed the cost of retained earnings? Do not round your intermediate calculations.

If a firm is privately owned,and its stock is not traded in public markets,then we cannot measure its beta for use in the CAPM model,we cannot observe its stock price for use in the DCF model,and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method.All this makes it especially difficult to estimate the cost of equity for a private company.

When working with the CAPM,which of the following factors can be determined with the most precision?

If expectations for long-term inflation rose,but the slope of the SML remained constant,this would have a greater impact on the required rate of return on equity,r_s,than on the interest rate on long-term debt,r_d,for most firms.Therefore,the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt.

The cost of debt,r_d,is normally less than r_s,so r_d(1 - T)will normally be much less than r_s.Therefore,as long as the firm is not completely debt financed,the weighted average cost of capital (WACC)will normally be greater than r_d(1 - T).

Assume that you are on the financial staff of Vanderheiden Inc. ,and you have collected the following data: The yield on the company's outstanding bonds is 7.75%,its tax rate is 40%,the next expected dividend is $0.65 a share,the dividend is expected to grow at a constant rate of 6.00% a year,the price of the stock is $17.00 per share,the flotation cost for selling new shares is F = 10%,and the target capital structure is 45% debt and 55% common equity.What is the firm's WACC,assuming it must issue new stock to finance its capital budget?

Which of the following statements is CORRECT?

Assume that you are a consultant to Broske Inc. ,and you have been provided with the following data: D₁ = $0.67;P₀ = $45.00;and g = 8.00% (constant) .What is the cost of equity from retained earnings based on the DCF approach?

The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

For capital budgeting and cost of capital purposes,the firm should assume that each dollar of capital is obtained in accordance with its target capital structure,which for many firms means partly as debt,partly as preferred stock,and partly common equity.

Weaver Chocolate Co.expects to earn $3.50 per share during the current year,its expected dividend payout ratio is 65%,its expected constant dividend growth rate is 6.0%,and its common stock currently sells for $30.00 per share.New stock can be sold to the public at the current price,but a flotation cost of 5% would be incurred.What would be the cost of equity from new common stock? Do not round your intermediate calculations.

Keys Printing plans to issue a $1,000 par value,20-year noncallable bond with a 7.00% annual coupon,paid semiannually.The company's marginal tax rate is 40.00%,but Congress is considering a change in the corporate tax rate to 45.00%.By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted?

If the expected dividend growth rate is zero,then the cost of external equity capital raised by issuing new common stock (r_e)is equal to the cost of equity capital from retaining earnings (r_s)divided by one minus the percentage flotation cost required to sell the new stock, (1 - F).If the expected growth rate is not zero,then the cost of external equity must be found using a different formula.

Which of the following statements is CORRECT?

You were hired as a consultant to Quigley Company,whose target capital structure is 35% debt,10% preferred,and 55% common equity.The interest rate on new debt is 6.50%,the yield on the preferred is 6.00%,the cost of retained earnings is 14.75%,and the tax rate is 40%.The firm will not be issuing any new stock.What is Quigley's WACC? Round final answer to two decimal places.Do not round your intermediate calculations.