Finance Quiz on Cost of Capital

Podcast

Play an AI-generated podcast conversation about this lesson

Questions and Answers

What is referred to as the financing cost associated with new funds through long-term borrowing?

Equity cost

Pretax cost of debt (correct)

Net proceeds

Cost of capital

What are flotation costs in relation to issuing new securities?

Only the underwriting costs for investment bankers

Total costs of issuing and selling a security (correct)

Costs associated with legal fees only

Costs solely related to administrative expenses

Which of the following components is NOT part of flotation costs?

Administrative costs

Return on equity (correct)

Underwriting costs

Legal expenses

What would happen to a firm's ability to invest in future projects if its cost of capital increases?

The firm will likely invest less Signup and view all the answers

Which average cost of financing would indicate that an investment with a 7% expected return should be rejected?

10% weighted average cost Signup and view all the answers

What would be the weighted average cost of capital if a firm has a 50-50 mix of 6% debt and 14% equity?

10% Signup and view all the answers

If the expected return for an investment is higher than the cost of capital, what is the likely recommendation?

Accept the investment Signup and view all the answers

What effect does a negative event, such as a product recall, generally have on a firm's cost of capital?

It increases the cost of capital Signup and view all the answers

What is the net proceeds to Duchess Corporation for each bond sold?

$960 Signup and view all the answers

What is the before-tax cost of debt based on the bond sale?

9% Signup and view all the answers

Which method can be used to determine the before-tax cost of debt?

Finding the yield to maturity on similar risk bonds Signup and view all the answers

How can the after-tax cost of debt be calculated?

Multiplying the before-tax cost by (1 minus the tax rate) Signup and view all the answers

If the tax rate for Duchess Corporation is 40%, what is the after-tax cost of debt if the before-tax cost is 9%?

5.4% Signup and view all the answers

What is the effect of flotation costs on the pricing of bonds?

They decrease the sale price of the bonds Signup and view all the answers

What does YTM represent in the context of bonds?

The discount rate that equates cash inflows with outflows Signup and view all the answers

What can be concluded about Duchess Corporation's bond pricing given current market rates exceed the coupon rate?

The bonds must be sold at a discount Signup and view all the answers

What was a significant effect of the financial crisis on long-term debt accessibility?

Long-term debt was largely inaccessible due to high credit costs. Signup and view all the answers

Why do firms often avoid using both short and long-run weighted average cost of capital?

There is a general uncertainty regarding cost of capital. Signup and view all the answers

What are book value weights used for in a firm's financial structure?

To measure the proportion of each type of capital using accounting values. Signup and view all the answers

Which weighting scheme is preferred from a strictly theoretical perspective?

Target market value proportions. Signup and view all the answers

What specific condition did Chuck Solis face regarding his loans?

He had three loans maturing in six years without penalty. Signup and view all the answers

Which scenario would result in Chuck Solis choosing the least costly alternative?

The interest rate for the new loan was lower than the combined rates of the three loans. Signup and view all the answers

What is a characteristic of market value weights in a firm's financial structure?

They measure proportion using market values. Signup and view all the answers

What would be an implication of using historical weights for firms?

They may not accurately represent the current financial structure. Signup and view all the answers

Study Notes

Learning Goals

LG1 Understands the basic concept and sources of capital associated with the cost of capital.
LG2 Explains the marginal cost of capital.
LG3 Determines the cost of long-term debt and explains why the after-tax cost of debt is the relevant cost of debt.
LG4 Determines the cost of preferred stock.
LG5 Calculates the cost of common stock equity and converts it into the cost of retained earnings and new issues of common stock.
LG6 Calculates the weighted average cost of capital (WACC) and discusses alternative weighting schemes.

Overview of the Cost of Capital

The cost of capital is the firm's financing cost and the minimum rate of return for a project to increase firm value.
Financial managers are ethically bound to only invest in projects expected to return more than the cost of capital
It reflects the entirety of the firm's financing activities.
To capture all relevant financing costs, consider the overall cost of capital, not just individual sources.

Overview of the cost of Capital (cont.)

A firm faces investment opportunities.
Investment A: Cost = $100,000; Life = 20 years; Expected Return = 7%; Least costly financing source is debt (bonds) = 6%.
Investment B: Cost = $100,000; Life = 20 years; Expected Return = 12%; Least costly financing source is equity = 14%.

Overview of the cost of Capital (cont. 2)

With a 50-50 mix of debt and equity, the weighted average cost is 10%.
Investment A is rejected (7% return < 10% WACC); Investment B is accepted (12% return > 10% WACC).

Focus on Ethics

Vioxx was an immediate success reaching $2.5 billion in annual sales.
Merck found patients who took Vioxx had an increased risk of heart attacks and strokes.
Despite the risks, Merck continued to market Vioxx.
Vioxx was withdrawn from the market in 2006, impacting reputation, profits, and stock price.
The Vioxx recall increased Merck's cost of capital.

Overview of the Cost of Capital: Sources of Long-Term Capital

Sources of long-term capital include current liabilities, long-term debt, stockholders' equity, preferred stock, common stock equity, and retained earnings.

Cost of Long-Term Debt

Pretax cost of debt is the financing cost of new funds through long-term borrowing (typically corporate bonds).
Net proceeds are the funds the firm receives from security sales.
Flotation costs include underwriting costs (investment bankers' compensation) and administrative costs (legal, accounting, printing).

Cost of Long-Term Debt (cont.)

Duchess Corporation is selling $10 million worth of 20-year, 9% coupon bonds with a $1,000 par value.
Current market interest rates are higher than 9%, so bonds are sold at $980.
Flotation costs are $20 per bond.
Net proceeds per bond are $960.

Cost of Long-Term Debt (cont. 2)

Before-tax cost of debt (rd) is the rate of return a firm pays on new borrowing.
Calculated in three ways: 1) observing the yield to maturity (YTM) on existing similar bonds, 2) calculating YTM from bond cash flows, or 3) approximating the cost.

Cost of Long-Term Debt (cont. 3)

Duchess Corporation's cash flows:
- End of year(s) 0: $960
- End of years 1–20: -$90
- End of year 20: -$1,000
YTM can be determined by finding the discount rate that equates the present value of bond outflows to the initial outflow.

Cost of Long-Term Debt (cont. 4)

-The before-tax cost of debt is the rate of return companies must pay on new borrowing.

The before-tax cost of debt can be calculated using market quotations, calculations of the YTM or approximations.

Cost of Long-Term Debt (cont. 5)

Calculating the before-tax cost of debt for various companies.
Approximating the cost of debt.

Cost of Long-Term Debt: After-Tax Cost of Debt

Interest payments to bondholders are tax-deductible.
This reduces taxable income and the firm's tax liability.
After-tax cost of debt (rd') = before-tax cost of debt (rd) × (1 – tax rate).

Cost of Long-Term Debt: After-Tax Cost of Debt (cont.)

Duchess Corporation has a 40% tax rate.
Before-tax cost of debt is 9.452%.
After-tax cost of debt is 5.67%.

Cost of Preferred Stock

Preferred stockholders receive stated dividends before common stockholders.
Dividends may be stated as a dollar amount or an annual percentage rate of the stock's par (face) value.
Cost of preferred stock (rp) = preferred stock dividend / net proceeds from sale.

Cost of Preferred Stock (cont.)

Duchess Corporation is considering issuing 10% preferred stock.
Expected to sell for $87 per share.
Issuance costs are $5 per share.
Dividend is $8.70 per share.
Net proceeds are $82 per share.
Cost of preferred stock is 10.6%.

Cost of Common Stock

Cost of common stock is the return required by investors in the marketplace.
Two forms of common stock financing: retained earnings and new issues of common stock.
Cost of common stock equity (rs) is the rate at which investors discount expected dividends to determine the share value.

Cost of Common Stock (cont.)

Constant-growth valuation (Gordon) model assumes the stock's value equals the present value of all future dividends (growing at a constant rate).
Formula: P₀= D₁/ (rs – g)

Cost of Common Stock (cont. 2)

Solving for rs: rs = D₁/P₀ + g

Cost of Common Stock (cont. 3)

Duchess Corporation's common stock is currently selling for $50 per share.
Expected dividend (D₁) for 2016 is $4.
Dividends from 2010-2015.
Annual rate at which dividends grew (g) was approximately 5%.

Cost of Common Stock (cont. 4)

Cost of common stock equity (rs) = ($4/$50) + 0.05 = 0.130, or 13%.

Cost of Common Stock (cont. 5)

Capital asset pricing model (CAPM) describes the relationship between the required return (rs) and the firm's non-diversifiable risk (measured by beta, b).
Formula: rs = Rf + [b × (rm – Rf)]

Cost of Common Stock (cont. 6)

Duchess Corporation:
RF (risk-free rate) = 7%
b (beta) = 1.5
rm (market return) = 11%
rs = 7% + [1.5 × (11% – 7%) = 7% + 6% = 13%.

Cost of Common Stock: Cost of Retained Earnings

The cost of retained earnings is the same as the cost of an equivalent fully subscribed issue of additional common stock.
Cost of retained earnings = cost of common stock equity.

Cost of Common Stock: Cost of New Issues of Common Stock

Cost of a new issue of common stock is the cost of existing common stock, net of underpricing and flotation costs.
New shares are underpriced if sold below their current market price (P₀).
Formula: rn = D₁/Nn + g

Cost of Common Stock: Cost of New Issues of Common Stock (cont.)

Net proceeds from selling new common stock (Nn) is always less than the current market price (P₀).
Cost of new issues (rn) will always be greater than the cost of existing issues (rs).
Cost of new common stock normally exceeds other long-term financing costs.

Cost of Common Stock: Cost of New Issues of Common Stock (cont. 2)

Duchess Corporation common stock sells for $50.
New shares can be sold for $47.
Underpricing is $3.
Flotation costs are $2.50 per share.
Total underpricing and flotation costs = $5.50.
Cost of new common stock = ($4/$44.50) + 0.05 = 14%.

Weighted Average Cost of Capital (WACC)

WACC reflects the expected average future cost of capital over the long run.
Weights each type of capital by its proportion in the firm’s capital structure.
Formula: ra = (w₁ × r₁) + (wp × rp) + (ws × rs)

Weighted Average Cost of Capital (cont.)

Weights must be non-negative and sum to 1.0.

Weighted Average Cost of Capital (cont. 2)

Duchess Corporation:
- Long-term debt = 40%
- Preferred stock = 10%
- Common stock equity = 50%
- rd = 5.6%
- rp = 10.6%
- rs = 13%
- WACC ≈ 9.8%

Calculation of the Weighted Average Cost of Capital for Duchess Corporation

Table 9.1 summarizes the calculation of WACC
Weights, costs, and weighted costs are shown.
WACC for Duchess Corporation is approximately 9.8%.

Focus on Practice

Financial markets experienced recession in 2008/2009, causing difficulty in tracking WACC.
Credit costs increased, Treasury bond yields fell.
Some companies abandoned the one-size-fits-all approach to address cost of capital uncertainty.

Weighted Average Cost of Capital: Weighting Schemes

Book value weights use accounting values to measure capital proportions.
Market value weights use market values to measure capital proportions.
Historical weights are based on actual capital structure proportions.
Target weights represent desired capital structure proportions.
Target market value proportions are the preferred weighting scheme.

Personal Finance Example

Chuck Solis has three outstanding loans maturing in 6 years.
Loan 1: $26,000; 9.6%
Loan 2: $9,000; 10.6%
Loan 3: $45,000; 7.4%
New loan for $80,000 available at 9.2% for 6 years.

Personal Finance Example (cont)

Calculate weighted average cost for each current debt to determine the best option.
Calculate the new cost for a new loan. Given the present cost of current debts, it is better to continue paying off the current debts instead of acquiring the new loan.

Studying That Suits You

Use AI to generate personalized quizzes and flashcards to suit your learning preferences.

Description

Test your understanding of financing costs, flotation costs, and the weighted average cost of capital with this finance quiz. Explore key concepts such as the relationship between cost of capital and investment decisions, and evaluate real-world applications of these principles. Perfect for finance students and professionals alike.