Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy PDF

CHAPTER 12: THE COST OF CAPITAL, CAPITAL STRUCTURE, AND DIVIDEND POLICY 1.The Institutional Brokers’ Estimate Service (IBES) summarizes analysts’. a.short-term earnings forecasts b.long-term earnings growth rates c.bankruptcy forecasts d.short-term earnings forecasts and long-term earnings growth rates ANSWER: d 2.Studies analyzing the historical returns earned by common stock investors have found that the returns from average risk common stock investments over the years have averaged (arithmetically) percentage points than the returns on Treasury bills. a.6 to 8, higher b.1 to 2, lower c.3 to 4, higher d.8 to 9, higher ANSWER: d 3.The cost of equity capital for non-dividend paying stocks can be determined by a.using the Capital Asset Pricing Model b.estimating ke for comparable dividend-paying stocks in their industry c.forecasting the liquidation proceeds from the sale of the company’s assets. d.using the CAPM and by estimating ke for comparable dividend-paying stocks in their industry ANSWER: d 4.For a company that is not planning to change its target capital structure, the proportions of debt and equity used in calculating the weighted cost of capital should be based on the current weights of the individual components. a.book value b.market value c.replacement value d.accounting value ANSWER: b 5.The cost of capital is a.the rate of return required by investors in the firm’s securities b.the minimum rate of return required on new investments of high risk undertaken by the firm c.approximately 10 percent for most firms d.concerned with plant and equipment only ANSWER: a © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 6. A firm can raise up to $700 million for investment from a mixture of debt, preferred stock and retained equity. Above $700 million, the firm must issue new common stock. Assuming that debt costs and preferred stock costs remain unchanged, the marginal cost of capital for amounts up to $700 million will be the marginal cost of capital for amounts over $700 million. a.less than b.equal to c.greater than d.cannot be determined from the information given ANSWER: a 7.The CAPM assumes that the only risk of concern to the investor is , which is measured by. a.Unsystematic risk, beta b.Systematic risk, the return to the market portfolio c.Systematic risk, beta d.Unsystematic risk, the return to the market portfolio ANSWER: c 8.If a firm adopts a large proportion of above-average-risk investment projects that are not offset by below-average-risk investment projects a.its cost of capital will rise b.the average risk premium for the firm will decline c.the risk-free rate will increase as more risk is added d.its cost of capital will fall ANSWER: a 9.The most appropriate weights to use in calculating a firm’s cost of capital are the proportions of the components in the firm’s capital structure. a.historical average b.long-range target c.current d.industry average ANSWER: b 10.For firms subject to the 34% marginal tax rate, the after-tax cost of is roughly two-thirds the cost of preferred stock. a.retained earnings b.new common stock c.long-term debt d.retained earnings and new common stock ANSWER: c © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 11.There are four major components that determine the risk premium. They include all the following except a.interest rate risk b.business risk c.reinvestment rate risk d.financial risk ANSWER: c 12.The required rate of return on any security consists of a a.risk premium plus an expected inflation rate b.risk free rate plus a risk premium c.inflation rate plus a marketability premium d.risk free rate plus an inflation premium ANSWER: b 13.All of the following are true EXCEPT: a.The claims of preferred stockholders on the firm’s earnings are junior to those of debt-holders. b.The risk of recapitalization increases a firm’s required rate of return. c.Long-term state government securities are always less risky than corporate long-term securities of the same maturity. d.The cost of capital to the firm is equal to the equilibrium rate of return demanded by investors in the capital markets for securities with that degree of risk ANSWER: c 14.Break points can be determined by dividing the amount of funds available from each financing source at a fixed cost by theproportion for that financing source. a.weighted capital structure b.target capital structure c.economic capital structure d.divisional capital structure ANSWER: b 15.If a preferred stock is callable, then the calculation of the cost of preferred stock financing is a.similar to that for bonds b. equal to Dp/Pn c.equal to Dp less flotation costs d. less than Dp/Pn ANSWER: a © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 16.The constant growth valuation model approach to calculating the cost of equity assumes that a.earnings and dividends grow at a constant rate, but stock price growth is indeterminate b. the growth rate is greater than or equal to ke c.dividends are constant d.earnings, dividends, and stock price will grow at a constant rate ANSWER: d 17.The total return to stockholders, ke, is composed of the a.opportunity cost plus a risk premium b.dividend yield plus the price appreciation of the security c.opportunity cost plus an inflation premium d.dividend yield minus the risk premium ANSWER: b 18.If a firm is losing money then the after-tax cost of debt is a.equal to kd(1 – T) b.found by trial and error c.equal to the pretax cost of debt d.equal to the yield to first call date ANSWER: c 19.The historic beta of a firm is of little use as a forecast of the firm’s future systematic risk characteristics when a.the firm is growing at a rate of 7-10 percent a year b.the firm is expanding an existing product line c.the firm is expanding into a new product line d.all of these answers are correct ANSWER: c 20.All of the following methods may be used to determine the cost of equity capital (ke) for a non-dividend-paying stock except a.the risk premium on debt approach b.the Capital Asset Pricing Model approach c.comparing with similar dividend-paying stocks in the industry d.the simulation with growth expectations approach ANSWER: d © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 21.The cost of external equity is greater than the cost of internal equity because a.it decreases the earnings per share b.it increases the market price of the stock c.of the flotation costs d.dividends are increased ANSWER: c 22.Retained earnings are a cheaper source of funds than the sale of new equity because a.retention defers the payment of taxable dividends to shareholders b.there are no flotation costs c.new shares are usually priced below current market price d.all these ANSWER: d 23.Historic average capital costs are new (marginal) resource allocation decisions. a.not relevant for making b.very useful when making c.necessary for making d.the relevant costs for making ANSWER: a 24.Which of the following is not a typical source of debt funds for a small firm? a.investment banking firms b.commercial finance companies c.Small Business Administration d.leasing companies ANSWER: a 25.If a firm will use only equity funds during the current capital budgeting period then the is the correct capital cost to use for computing the cost of funds for the firm. a.cost of equity capital b.weighted cost of funds c.historical cost of funds d.all of these answers are correct ANSWER: b © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 26.The optimal capital budget is determined by comparing the expected project returns to the company’s a.computed break points b.cost of equity schedule c.marginal cost of capital schedule d.optimal opportunity curve ANSWER: c 27.The cost of depreciation-generated funds is equal to a.the cost of equity capital b.zero, because depreciation is a non-cash expense c.the investment opportunity cost d.the weighted cost of capital ANSWER: d 28. refers to the variability in the firm’s operating earnings. a.Business risk b.Financial risk c.Marketability risk d.Interest rate risk ANSWER: a 29.The major components that determine the risk premium on a specific security at any point in time include all of the following except a.business risk b.financial risk c.interest rate risk d.real rate of return risk ANSWER: d 30.Rank in ascending order (lowest to highest) the relative riskiness of the various types of corporate and government securities. a.common stock, preferred stock, corporate debt, long-term government debt b.corporate debt, long-term government debt, preferred stock, common stock c.long-term government debt, corporate debt, preferred stock, common stock d.corporate debt, preferred stock, long-term government debt, common stock ANSWER: c © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 31.Rank in ascending order (lowest to highest) investors’ required rates of return on the various types of corporate securities. a.preferred stock, corporate debt, common stock b.common stock, preferred stock, corporate debt c.preferred stock, common stock, corporate debt d.corporate debt, preferred stock, common stock ANSWER: d 32.Which of the following statements (if any) is (are) true concerning companies that do not pay dividends? a.The cost of equity capital can be estimated using the Capital Asset Pricing Model. b.The cost of equity capital is equal to the growth short-term rate of earnings per share. c.The dividend capitalization model can be used to determine an accurate cost of equity capital. d.The cost of equity capital cannot be determined by using the CAPM, the risk premium on debt approach, or by estimating k e for comparable dividend-paying stocks in their industry. ANSWER: a 33.The optimal capital budget is indicated by the point at which the and the intersect. a.depreciation schedule; investment opportunity schedule b.investment opportunity curve; marginal cost of capital curve c.investment opportunity curve; average cost of capital curve d.efficient portfolio curve; marginal cost of capital curve ANSWER: b 34.During the 1980s, the cost of capital for U.S. firms averaged about 3.3 percentage points higher than Japanese firms. During 1990 this disadvantage may have disappeared due to: a.higher exports to the U.S. b.higher real interest rates in Japan c.larger shareholder interest d.higher Japanese stock market ANSWER: b 35.If a firm sells assets, generating cash flows, the cost of these funds is. a.the firm’s cost of equity b.the firm’s cost of cash flows c.the firm’s weighted cost of capital d.zero ANSWER: c © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 36.Small firms are reluctant to obtain capital through the sale of common stock because of: a.potential loss of voting control b.high issuance costs c.high cost of debt d.both the potential loss of voting control and the high issuance costs ANSWER: d 37.Determine the (after-tax) percentage cost of a $50 million debt issue that the Mattingly Corporation is planning to place privately with a large insurance company. Assume that the company has a 40% marginal tax rate. This long- term debt issue will yield 12% to the insurance company. a.4.8% b.7.2% c.12.0% d.10.6% ANSWER: b RATIONALE: Solution: ki = kd(1 – T) = 12%(1 – 0.40) = 7.2% 38.Calculate the after-tax cost of preferred stock for Ohio Valley Power Company, which is planning to sell $100 million of $3.25 cumulative preferred stock to the public at a price of $25 per share. Flotation costs are $1.00 per share. Ohio Valley has a marginal income tax rate of 40%. a.13.0% b.7.8% c.8.12% d.13.54% ANSWER: d RATIONALE: Solution: kp = $3.25/($25 – $1) = 13.54% 39.The Allegheny Valley Power Company common stock has a beta of 0.80. If the current risk-free rate is 6.5% and the expected return on the stock market as a whole is 16%, determine the cost of equity capital for the firm (using the CAPM). a.14.1% b.7.6% c.6.5% d.13.0% ANSWER: a RATIONALE: Solution: ke = rf + β(km – rf) = 6.5% + 0.80(16% – 6.5%) = 14.1% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 40.The following financial information is available on Rawls Manufacturing Company: Current per share market price $48.00 Current (t = 0) per share dividend $3.50 Expected long-term growth rate 5.0% Rawls can issue new common stock to net the company $44 per share. Determine the cost of internal equity capital using the dividend capitalization model approach. (Compute answer to the nearest 0.1%.) a.12.3% b.13.4% c.13.0% d.12.7% ANSWER: d RATIONALE: Solution: ke = $3.50(1.05)/$48 + 0.05 = 0.1266 (or 12.7%) 41.The following financial information is available on Rawls Manufacturing Company: Current per share market price $48.00 Beta 1.1 Expected rate of return on market 12.0% Risk-free rate 6.0% Rawls can issue new common stock to net the company $44 per share. Determine the cost of internal equity capital using the capital asset pricing model approach. (Compute answer to the nearest 0.1%.) a.12.9% b.12.6% c.13.0% d.11.8% ANSWER: b RATIONALE: Solution: ke = rf + β(km – rf) = 0.06 + 1.1(0.12 – 0.06) = 0.126 or 12.6% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 42.The following financial information is available on Rawls Manufacturing Company: Current per share market price $48.00 Current per share dividend $3.50 Current per share earnings $6.00 Beta 1.1 Expected rate of return on market 12.0% Risk-free rate 6.0% Expected long-term growth rate 5.0% Rawls can issue new common stock to net the company $44 per share. Determine the cost of external equity capital using the dividend capitalization model approach. (Compute answer to the nearest 0.1%.) a.12.7% b.14.4% c.12.6% d.11.4% ANSWER: d RATIONALE: Solution: ke′ = (D1/Pnet) + g = [$3.50(1.05)/$44] + 0.05 = 0.1335 or 13.4% 43.Determine the weighted cost of capital for the Mills Company that will finance its optimal capital budget with $120 million of long-term debt (kd = 12.5%) and $180 million in retained earnings (ke = 16.0%). Mills’ present capital structure is considered optimal. The company’s marginal tax rate is 40%. (Compute answer to nearest 0.1%.) a.14.3% b.12.6% c.14.6% d.11.9% ANSWER: b RATIONALE: Solution: ka = 0.40 × 12.5%(1 – 0.4) + 0.60 × 16.0% = 12.6% 44.What is the cost of a preferred stock with a $100 par value that pays a $9.60 dividend per year? The security has a flotation cost of $3.37 and will be retired at its par value in 20 years. a.9.6% b.9.9% c.10.0% d.10.6% ANSWER: c RATIONALE: Solution: Try kp = 10% $9.60(8.514) + $100(0.149) = $96.63 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 45.What is the cost of equity for East Roon, if the firm is expected to always pay a constant dividend of $2.22? The firm’s common stock is presently selling for $18.50. a.8.3% b.12.0% c.10.2% d.cannot be determined from the information given ANSWER: b RATIONALE: Solution: ke = $2.22/$18.50 = 0.12 or 12% 46.According to Value Line, Bestway has a beta of 1.15. If 3-month Treasury bills currently yield 7.9 percent and the market risk premium is estimated to be 8.3 percent, what is Bestway’s cost of equity capital? a.17.45% b.8.36% c.9.55% d.16.2% ANSWER: a RATIONALE: Solution: ke = 7.9% + 1.15(8.3%) = 17.45% 47.Northeast Airlines (NA) has a current dividend of $1.80. Dividends are expected to grow at a rate of 7 percent a year into the foreseeable future. What is NA’s cost of external equity if its stock can be sold to net $46 a share? a.10.9% b.11.2% c.7.2% d.21.0% ANSWER: b RATIONALE: Solution: ke = $1.80(1.07)/$46 + 0.07 = 0.112 or 11.2% 48.A firm with a 40 percent marginal tax rate has a capital structure of $60,000,000 in debt and $140,000,000 in equity. What is the firm’s weighted cost of capital if the marginal pretax cost of debt is 12 percent, the firm’s average pretax cost of debt outstanding is 8%, and the cost of equity is 14.5 percent? a.13.75% b.11.59% c.12.31% d.10.45% ANSWER: c RATIONALE: Solution: ka = 0.3(0.12)(1 – 0.4) + 0.7(0.145) = 0.1231 or 12.31% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 49.Crickentree has a target capital structure of 30 percent debt and 70 percent equity. If the firm expects to have a net income of $1.7 million and a dividend payout ratio of 40 percent, what will be its equity break point? a.$2,428,571 b.$1,457,143 c.$3,400,000 d.$971,429 ANSWER: b RATIONALE: Solution: x = $1.7(1 – 0.4)/0.7 = $1.457 or $1,457,143 50. Easy Slider Inc. sold a 15 year $1,000 face value bond with a 10 percent coupon rate. Interest is paid annually. After flotation costs, Easy Slider received $928 per bond. Compute the after-tax cost of debt for these bonds if the firm’s marginal tax rate is 40 percent. a.6.0% b.7.2% c.7.8% d.6.6% ANSWER: d RATIONALE: Solution: (Try 11%) ki = 11%(0.6) = 6.6% $928 = $100(7.191) + $1,000(0.209) ≈ $928 so kd = 11% ki = 11%(0.6) = 6.6% 51. Alpha Products maintains a capital structure of 40 percent debt and 60 percent common equity. To finance its capital budget for next year, the firm will sell $50 million of 11 percent debentures at par and finance the balance of its $125 million capital budget with retained earnings. Next year Alpha expects net income to grow 7 percent to $140 million, and dividends also are expected to increase 7 percent to $1.40 per share and to continue growing at that rate for the foreseeable future. The current market value of Alpha’s stock is $30. If the firm has a marginal tax rate of 40 percent, what is its weighted cost of capital for the coming year? a.9.64% b.8.63% c.9.84% d.11.67% ANSWER: a RATIONALE: Solution: ke = $1.40/$30 + 0.07 = 0.1167 ka = 0.6(0.1167) + 0.4(0.11)(1 – 0.4) = 0.0964 or 9.64% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 52.Wellington Gas has a target capital structure of 50 percent common equity, 40 percent debt, and 10 percent preferred stock. The cost of retained earnings is 16 percent, and the cost of new equity (external) is 16.7 percent. Wellington can sell debentures that will have an after-tax cost of 8.3 percent and the after-tax cost of preferred stock will be 11.9 percent. What is the marginal cost of capital before and after the break point? a.12.51% and 12.86% b.11.18% and 11.53% c.14.23% and 14.68% d.12.51% and 11.53% ANSWER: a RATIONALE: Solution: ka1 = 0.5(0.16) + 0.4(0.083) + 0.1(0.119) = 0.1251 ka2 = 0.5(0.167) + 0.4(0.083) + 0.1(0.119) = 0.1286 53.GQ earned $740,000 before taxes this year. The firm has a debt ratio of 30 percent, a marginal tax rate of 35 percent, and a dividend payout ratio of 40 percent. GQ has no preferred stock. What is GQ’s break point for equity? a.$634,286 b.$962,000 c.$412,286 d.$288,600 ANSWER: c RATIONALE: Solution: Retained earnings = $740,000(1 – 0.35)(1 – 0.4) = $288,600 Break point = $288,600/0.7 = $412,286 54.Groves, Inc. pays an annual dividend of $1.22. This dividend is expected to continue growing at a rate of about 5 percent each year. The firm is in a fairly risky business and has a beta of 1.45. The expected market rate of return is 13.5 percent, and the risk-free rate is 9.3 percent. What is the cost of equity for Groves? a.19.6% b.13.5% c.15.4% d.6.1% ANSWER: c RATIONALE: Solution: ke = 0.093 + 1.45(0.135 – 0.093) = 0.154 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 55.PDQ Inc. has a weighted cost of capital of 14.6 percent and has an opportunity to invest in the following average risk projects: Project Cost Annual Cost Flow Project life 1 $10,000 $1,992.43 10 years 2 $21,000 $4,526.84 8 years 3 $18,500 $4,580.34 7 years In which projects should PDQ invest? Assume no capital rationing. a.1 & 2 b.2 & 3 c.1 & 3 d.cannot be determined from the information provided ANSWER: c RATIONALE: Solution: IRR1 = $10,000/$1,992.43 = 5.019 so IRR = 15% IRR2 = $21,000/$4,526.84 = 4.639 so IRR = 14% IRR3 = $18,500/$4,580.34 = 4.039 so IRR = 16% Invest in projects 1 and 3 because their IRR is greater than 14.6% 56. Mid-South Utilities will sell $10 million of $100 par value preferred stock that will pay an annual dividend of $9.75. Mid-South will receive $93.98 per share after flotation costs. If the issue must be retired in 20 years, what is the cost of the preferred issue? a.10.37% b.10.50% c.10.23% d.9.75% ANSWER: b RATIONALE: Solution: 10.5% (by calculator) 57.Witin’s stock price is currently $34.25 and the current quarterly dividend is $0.25. Consensus estimates for Witin indicate a growth rate in earnings of 10% into the foreseeable future. If Witin plans to sell 1 million shares to raise new capital for expansion, what is the cost of new equity if the issuance costs are 8%? a.13.49% b.10.87% c.13.21% d.13.17% ANSWER: a RATIONALE: Solution: ke = + 0.10 = 0.1349 or 13.49% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 58.Weltron has a target capital structure of 35% debt and 65% equity. If the firm expects net income of $12.3 million and an annual dividend of $0.12 per share, what is the expected equity break point? There are 12 million shares outstanding. a.$18,923,076 b.$16,707,692 c.$10,061,538 d.$2,215,385 ANSWER: b RATIONALE: Solution: Payout = 12,000(0.12) = $1,440,000 BP = (12.3 – 1.44)/0.65 = $16,707,692 59.Pluega Inc. issued a $100 million 8.27% coupon debenture bond due in the next 20 years. The bonds each sold for $996. If the bonds pay interest semi-annually, what is Pluega’s after cash cost of debt? Assume 40% tax rate. a.4.96% b.8.30% c.4.99% d.3.32% ANSWER: c RATIONALE: Solution: 8.31(1 – 0.4) = 4.986 or 4.99% (by calculator) 60. Haulsee Inc. pays no dividend currently but is expected to start paying a small dividend next year. The 5-year old firm has a beta of 1.25 and current earnings of $0.90 per share. The current Treasury bill rate is 6.10% and the market risk premium is 8.8%. Determine Haulsee’s cost of equity if the firm’s tax rate is 40%. a.9.48% b.17.1% c.14.9% d.cannot determined from the information provided ANSWER: b RATIONALE: Solution: ke = 6.10 + 1.25(8.8) = 17.1% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 61.Sharp’s current capital structure of 60 percent equity, 35 percent debt, and 5 percent preferred stock is considered optimal. This year Sharp expects to have earnings after tax of $3.6 million and to pay out $600,000 in dividends. Sharp can also raise up to $2 million in long-term debt at a pretax interest rate of 10.6 percent (all debt over $2 million will cost 11.4% pretax), and sell preferred stock at a cost of 11.5 percent. Sharp’s marginal tax rate is 40 percent. The current value of Sharp’s common stock is $36 and a dividend of $2.15 is expected to be paid during the coming year. Dividends have been growing at an annual compound rate of 8 percent a year and are expected to continue growing at that rate. New shares can be sold to net the firm $34.50. Sharp has an opportunity to invest in the following capital projects. Which one(s) should be accepted? Project Cost Annual Cash Flow Project Life 1 $3.0 million $552,893 10 years 2 $2.5 million $693,481 5 years 3 $2.0 million $345,220 10 years a. 1 and 2 b. 1 and 3 c. 1, 2, and 3 d. cannot be determined from the information provided ANSWER: a RATIONALE: Solution: Equity break point = $3,000,000/0.6 = $5,000,000 Debt break point = $2,000,000/0.35 = $5,714,286 ke = $2.15/$36 + 0.08 = 0.140 ki = 0.106(1 – 0.4) = 0.0636 k′e = $2.15/$34.50 + 0.08 = 0.142 ka1 = 0.6(0.140) + 0.35(0.0636) + 0.05(0.115) = 0.112 ka2 = 0.6(0.142) + 0.35(0.0636) + 0.05(0.115) = 0.113 ka3 = 0.6(0.142) + 0.35(0.114)(0.6) + 0.05(0.115) = 0.115 IRR1 = $3,000,000/$552,893 = 5.426 or 13% IRR2 = $2,500,000/$693,481 = 3.605 or 12% IRR3 = $2,000,000/$345,220 = 5.793 or 11.4% (by calculator) © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 62.Far Out Tech (FOT) has a debt ratio of 0.3 and it considers this to be its optimal capital structure. FOT has no preferred stock. FOT has analyzed four capital projects for the coming year as follows: Project Net Investment IRR 1 $3,000,000 13.5% 2 $1,500,000 18.0% 3 $2,000,000 12.6% 4 $1,600,000 16.0% FOT expects to earn $2.7 million after tax next year and pay out $700,000 in dividends. Dividends are expected to be $1.05 a share during the coming year and are expected to grow at a constant rate of 10 percent a year for the foreseeable future. The current market price of FOT stock is $22 and up to $2 million in new equity can be raised for a flotation cost of 10 percent. If more than $2 million is sold then the flotation cost will be 15 percent. Up to $2 million in debt can be sold at par with a coupon rate of 10 percent. Any debt over $2 million will carry a 12 percent coupon rate and be sold at par. If FOT has a marginal tax rate of 40 percent, in which projects should it invest? a. 1, 2, 3, & 4 b. 2 c. 1, 2, and 4 d. 2 and 4 ANSWER: c RATIONALE: Solution: Break point for common equity = $2,000,000/0.7 = $2,857,143 Second equity break point = $4,000,000/0.7 = $5,714,286 Debt break point = $2,000,000/0.3 = $6,666,667 ke = $1.05/$22 + 0.10 = 0.148 k′e1 = $1.05/$19.80 + 0.10 = 0.153 k′e2 = $1.05/$18.70 + 0.10 = 0.156 ka1 = 0.7(0.148) + 0.3(0.10)0.6 = 0.122 ka2 = 0.7(0.153) + 0.3(0.10)0.6 = 0.125 ka3 = 0.7(0.156) + 0.3(0.10)0.6 = 0.127 ka4 = 0.7(0.156) + 0.3(0.12)0.6 = 0.131 63.Temple Company’s common stock dividends have grown over the past 5-year period from $0.60 per share to $0.89 (today). Assume that Temple’s dividends are expected to grow at this rate for the foreseeable future. Temple’s stock is currently selling for $12 per share. New common stock can be sold to net the company $11 per share. Determine the costs of internal and external equity to Temple. a. 18.1%; 18.9% b. 15.9%; 16.6% c. 16.2%; 16.9% d. 15.9%; 18.9% ANSWER: c RATIONALE: Solution: $0.89 = $0.60(FVIFg,5) g = 8.2% by calculator or interpolation ke = $0.96/$12 + 0.082 = 0.162 or 16.2% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy k′e = $0.96/$11 + 0.082 = 0.169 or 16.9% 64.Whipple Industries, Inc. is in the process of determining its optimal capital budget for next year. The following investment projects are under consideration: Required Expected Rate Project Investment of Return A $2 million 20.0% B 3 million 15.0 C 1 million 13.5 D 4 million 13.0 E 1 million 12.5 F 3 million 12.0 G 5 million 11.5 The firm’s marginal cost of capital schedule is as follows: Amount of Funds Raised Cost $0 – $6 million 12.0% $6 million – $12 million 12.5% $12 million – $18 million 13.5% Over $18 million 15.0% Determine Whipple’s optimal capital budget (in dollars) for the coming year. a.$11 million b.$10 million c.$5 million d.$14 million ANSWER: a RATIONALE: Solution: Required Cumulative Expected Marginal Project Investment Investment Rate of Return Cost of Capital A $2 million $ 2 million 20.0% 12.0% B 3 million 5 million 15.0 12.0 C 1 million 6 million 13.5 12.0 D 4 million 10 million 13.0 12.5 E 1 million 11 million 12.5 12.5 F 3 million 14 million 12.0 12.5 and 13.5 G 5 million 19 million 11.5 13.5 and 15.0 Optimal Capital budget: $11 million (Projects A,B,C,D,E) © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 65. American Dental Laser is selling a 10 year $1,000 face value bond with an 8% coupon rate. Interest is paid annually. The price to the public is $820 and the issue costs per bond are $10 each. Compute the pretax cost of debt for these bonds. a. 11.1% b. 11.3% c. 11.5% d. 11.8% ANSWER: b RATIONALE: Solution: $810 = $80(PVTFAkd,10) + $1,000(PVIFkd,10) Try 11%: $80(5.889) + $1,000(0.352) = $823.12 Try 12%: $80(5.650) + $1,000(0.322) = $774.00 kd = 11% + (12% – 11%) = 11.3% 66. Mid-States Utility Company just issued at $3.20 cumulative preferred stock at a price to the public of $30 a share. The flotation costs were $1.50 a share and the issue will be retired in 20 years at its $30 par value. What is the cost of this preferred issue? a. 11.3% b. 10.3% c. 10.7% d. 11.6% ANSWER: a RATIONALE: Solution: $28.50 = $3.20(PVIFAkp,20) + $30(PV1Fkp,20) Try 11%: $3.20(7.963) + $30(0.124) = $29.20 Try 12%: $3.20(7.469) + $30(0.104) = $27.02 kp = 11% + (12% – 11%) = 11.3% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 67. Wright Express (WE) has a capital structure of30% debt and 70% equity. WE is considering a project that requires an investment of$2.6 million. To finance this project, WE plans to issue 10-year bonds with a coupon interest rate of 12%. Each of these bonds has a $1,000 face value and will be sold to net WE $980. If the current risk-free rate is 7% and the expected market return is 14.5%, what is the weighted cost of capital for WE? Assume WE has a beta of 1.20 and a marginal tax rate of 40%. a.14.9% b.12.4% c.13.4% d.16.0% ANSWER: c RATIONALE: Solution: Try 12%: $120(5.650) + $10,000(0.322) = $1,000 Try 13%: $120(5.426) + $1,000(0.295) = $946.12 kd = 12% + (13% – 12%) = 12.4% ke = 7% + $1.20(14.5% – 7%) = 16% ka = 0.3(12.4%)(1 –0.4) + 0.7(16%) = 13.4% 68. California Best (CB), a sport shoe store, expects an operating income of$2.3 million this year. CB has no long-term debt. The firm is considering as expansion project. The current risk-free rate of return is 7% and the current market risk premium is 8.3%. If CB’s beta is 20% greater than the overall market, what is the firm’s cost of capital? Assume that CB has a marginal tax rate of 40%. a. 8.3% b. 16.96% c. 9.96% d. 15.3% ANSWER: b RATIONALE: Solution: ka = ke = 7% + 1.2(8.3%) = 16.96% 69. Columbia Gas Company’s (CG) current capital structure is 35% debt and 65% equity. This year CG has earnings after tax of $5.31 million and is paying $1.6 million in dividends. To finance a transmission pipe line, CG can borrow $2 million at a cost of 10%, the same rate that CG is currently paying on a total of $15 million long-term debt. CG has 1,000,000 shares outstanding and its current market price is $31. If CG’s long-term growth rate of dividends is expected to be 8%, what is the weighted cost of capital for the firm? Assume a marginal tax rate of 40%. a. 10.9% b. 13.6% c. 19.6% d. 16.9% ANSWER: a RATIONALE: Solution: kd = 10%(1 – 0.4) = 6% ke = $1.6(1.08)/$31 + 0.08 = 0.136 or 13.6% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy ka = 0.35(6%) + 0.65(13.6%) = 10.9% 70.Heleveton Industries is 100% equity financed. Its current beta is 1.1. The expected market risk premium is 8.5% and the risk-free rate is 4.2%. If Heleveton changes its capital structure to 25% debt, it estimates its beta will increase to 1.2. If the after-tax cost of debt will be 6%, should Heleveton make the capital structure change? a.Yes, cost of capital decreases by 2.52% b.Yes, cost of capital decreases 1.67% c.No, stock price would decrease due to increased risk d.No, cost of capital increases by 0.85% ANSWER: b RATIONALE: Solution: Old ke = 4.2 + 1.1(8.5) = 13.55% = ka New ke = 4.2 + 1.2(8.5) = 14.4% New ka = 0.7(14.4) + 0.3(6) = 11.88% Stock price is maximized where the cost of capital is minimized. 71.Sadaplast has a target capital structure of 65% common equity, 30% debt, and 5% preferred stock. The cost of retained earnings is 14% and the cost of new equity is 15.5%. Sadaplast expects to have a net income of $85 million in the coming year. If the firm sells bonds, up to $25 million can be sold at par value to yield an after-tax cost of 5.4%. An additional $20 million of debentures could be sold to yield an after-tax cost of 7.0%. The after-tax cost of preferred stock financing is estimated to be 11%. Sadaplast has a dividend payout ratio of 25%. What is Sadaplast’s cost of capital between the first and second break points? a. 12.25% b. 11.27% c. 11.75% d. 12.73% ANSWER: c RATIONALE: Solution: RE = 0.75($85 million) = $63.75 million BPe = $63.75 million/0.65 = $98.077 million BPd = $25 million/0.30 = $83.333 million BPd′ = $45 million/0.30 = $150 million ka = 0.65(0.14) + 0.30(0.07) + 0.05(0.11) = 0.1175 or 11.75% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 72. Bay State Technology has determined that its cost of equity is 15% and its after-tax cost of debt is 7.2%. Bay State expects to earn $14 million after taxes next year and, as a new firm, does not pay any dividends. The stock sells for $24. Bonds are currently selling at par value. Compute Bay State’s weighted cost of capital. A partial balance sheet is shown below: Current liabilities $ 300,000 Long-term debt 1,000,000 Common stock at $1 par 100,000 Paid in capital 900,000 Retained earnings 3,000,000 Total liabilities and stockholders’ equity $5,300,000 a. 13.4% b. 13.1% c. 11.6% d. 12.7% ANSWER: d Solution: RATIONALE: $1,000,000 Capital structure: Debt = Market value of Equity: 100,000 shares($24) = 2,400,000 Total $3,400,000 Capital structure: Debt = $1/$3.4 = 29.41% Equity = 2.4/3.4 = 70.59% ka = 0.2941(7.2%) + 0.7059(15.0%) = 12.71% 73.Mahlo is planning to diversify into the bakery industry. As a result, its beta should drop from 1.4 to 1.2 and the expected long-term growth rate of dividends will drop from 12% to 9%. The risk-free rate is 4%, the expected market risk premium is 9%, and the current dividend per share paid by Mahlo is $2.10. Should Mahlo complete the diversification into the bakery industry? a.No, stock price drops about $11.70 b.Yes, stock price increases about $9.40 c.Yes, stock price increases about $1.80 d.No, stock price drops about $9.40 ANSWER: a RATIONALE: Solution: Current ke = 0.04 + 1.4(0.09) = 0.166 or 16.6% P0 = $2.10(1.12)/(0.166 – 0.12) = $51.13 New ke = 0.04 + 1.2(0.09) = 0.148 or 14.8% New P0 = $2.10(1.09)/(0.148 – 0.09) = $39.47 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 74.Which of the following statements regarding the cost of capital is/are correct? I. The weighted cost of capital is the discount rate used when computing the net present value. II.The aftertax cost of capital is weighted by the proportions of the capital components in the firm’s long range target capital structure. a.Only statement I is correct b.Only statement II is correct c.Both statements I and II are correct d.Neither statement I nor II is correct ANSWER: c 75.The cost of debt must account for all of the following inputs EXCEPT: a.Bond ratings. b.Issuance costs. c.Flotation costs. d.The tax rate. ANSWER: a 76.There are two primary ways that capital is raised. Which of the following statements is/are correct? I. Capital is raised internally by using retained earnings. II.Capital is raised externally by selling fixed assets. a.Only statement I is correct b.Only statement II is correct c.Both statements I and II are correct d.Neither statement I nor II is correct ANSWER: a 77.Investors can form earnings growth expectations from various sources, including a.potential sales growth. b.current earnings and retention rates. c.assumed product development. d.investors’ required rate of return. ANSWER: b © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 78.What is the weighted average cost of capital for Mud Bug Corporation? Source of Capital Capital Components Cost Long Term Debt $60,000 5.6% Preferred Stock $15,000 10.6% Common Stock $75,000 13.0% a. 6.9% b. 8.5% c. 10.2% d. 9.8% ANSWER: d 79.Zappin’ Skeeters Corporation needs to know its cost of retained earnings. Based on the following information, compute the cost of retained earnings: The stock sells for $25, flotation costs are $3 and the firm is in the 35% tax bracket. Year Dividen d 2014 $1.55 2013 $1.40 2012 $1.35 2011 $1.32 a. 15.71% b. 9.11% c. 12.56% d. 10.72% ANSWER: c 80.The cost of internal equity is cheaper than the cost of external equity. Which of the following statements is/are correct? I. External equity may incur expenses which are deducted from the capital received for the sale of the security. II. Corporations generally discount the price of the securities that are sold to the public in order to raise capital. a.Only statement I is correct b.Only statement II is correct c.Both statements I and II are correct d.Neither statement I nor II is correct ANSWER: a © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 81.What is the cost of preferred stock if the stock is selling for $208, the dividend is $35 and flotation costs are 5% of the selling price? a. 17.7% b. 25.2% c. 12.5% d. 10.8% ANSWER: a 82.What would be the weighted average cost of capital for Limp Linguini Noodle Makers, Inc. under the following conditions: *The capital structure is 40% debt and 60% equity *The before-tax cost of debt (which includes flotation costs) is 20% and the firm is in the 40% tax bracket *The firm’s beta is 1.7 *The risk-free rate is 7% and the market risk premium is 6% a. 15.12% b. 18.7% c. 17.2% d. 12% ANSWER: a RATIONALE: Determine the cost of equity: 1.7(6%) + 7% = 17.2% Determine the cost of debt: 20% × 0.60 = 12 Determine the weighted cost of capital: 17.2(0.60) + 12(0.40) = 15.12% 83.A firm has a beta of 1.2. The return in the market is 14% and the risk-free rate is 6%. The estimated cost of common stock equity is: a.6% b. 7.2% c. 15.6% d. 14% ANSWER: c RATIONALE: Solution: 1.2(14% – 6%) + 6% = 15.6% 84.The optimal capital budget occurs at the point where two curves intersect. Which of the following is/are one of those curves? I. Weighted marginal cost of capital curve II. Investment opportunity curve a.Only statement I is correct b.Only statement II is correct c.Both statements I and II are correct d.Neither statement I nor II is correct ANSWER: c © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 85.The cost of common stock equity may be estimated by using which of the following? a.Earnings curve b.Dupont analysis c.Capital asset pricing model d.Price/Earnings ratio ANSWER: c 86.A firm is determining its cost of common stock equity. It last paid a dividend of $.52, the dividends are growing at 5%, flotation costs are $2 per share and the firm will net $72 per share upon the sale of the stock. What is the firm’s cost of common equity? a.3.49% b.8.22% c.6.11% d.5.76% ANSWER: d RATIONALE: Solution: $0.52(1 + 0.05) = $0.55(0.55172) + 0.05 = 5.75% 87.Surfin’ Bubba Surfboard Shop is currently selling for $34.25 a share with a current dividend of $1.00. It is estimated that Surfin’ Bubba will have a growth rate in earnings of 10% into the foreseeable future. If Surfin’ Bubba plans to raise new capital for expansion, what is the cost of new equity if flotation costs are 8% of the price? a.13.49% b.11.57% c.12.21% d.10.87% ANSWER: a RATIONALE: Solution: $1.00 × $1.10 = $1.10 88. What is Bodacious Bodywear’s weighted average cost of capital under the following conditions: *The firm has 30% debt, 10% preferred stock, and 60% equity *The cost of common equity is 14% and the cost of preferred stock is 9% *The firm’s debt has a before-tax cost of debt of 10% (including flotation costs) *The firm is in the 40% tax bracket a.11.1% b.8.5% c.12.3% d.10.5% ANSWER: a RATIONALE: Solution: (0.60 × 14%) + (0.10 × 9%) + (10% × 0.6 × 0.30) = 11.1% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 89.In determining the cost of debt, several factors must be considered. All of the following are those factors EXCEPT: a. the firm’s before-tax cost of debt b.the firm’s tax rate c. flotation costs d.the firm’s growth rate of dividends ANSWER: d 90.What is the cost of equity for Fat Rat Laboratories, Inc.? The stock has the following dividends, the stock sells for $70 with flotation costs of $6 and it expects to pay a dividend of $3.20 next year (rounded). YEARS DIVIDENDS 2014 $2.94 2013 2.70 2012 2.49 2011 2.29 a. 14.00% b.13.57% c. 12.26% d.10.00% ANSWER: a RATIONALE: Find the growth rate using a financial calculator: N=3 PV = –2.29 FV=2.94 Solve for I = 8.68% rounded to the nearest whole % = 9% Use the constant dividend model Price = © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 91. What is the cost of debt for Foggy Futures Weather Forecasters? The firm is in the 40% tax bracket. The optimal capital structure is listed below: Source of Capital Weight Long-Term Debt 25% Preferred Stock 20% Common Stock 55% The firm can issue $1,000 par value, 8% coupon interest bonds with a 20 year Debt: maturity date. The bond has an average discount of $30 and flotation costs of $30 per bond. The selling price is $1,000. Preferred The firm can sell preferred stock with a dividend that is 8% of the current price. Stock: The stock costs $95. The cost of issuing and selling the stock is expected to be $5 per share. The firm’s common stock is currently selling for $90 per share. The firm expects to pay cash dividends of $7 per share next year. The dividends have Common been growing at 6%. The stock must be discounted by $7 and flotation costs are Stock: expected to amount to $5 per share. Retained The firm expects to have enough retained earnings in the coming year to be Earnings: used in place of any new stock being issued. a. 5.18% b. 3.6% c. 7.5% d. 12.2% ANSWER: a RATIONALE: Solution using a financial calculator: N = 20 PV = –(1,000 – 60) PMT = 80 FV = 1,000 Solve for I = 8.64% × (1 – 0.40) = 5.18% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 92. What is the cost of preferred stock for Foggy Futures Weather Forecasters? The firm is in the 40% tax bracket. The optimal capital structure is listed below: Source of Capital Weight Long-Term Debt 25% Preferred Stock 20% Common Stock 55% The firm can issue $1,000 par value, 8% coupon interest bonds with a 20 year Debt: maturity date. The bond has an average discount of $30 and flotation costs of $30 per bond. The selling price is $1,000. Preferred The firm can sell preferred stock with a dividend that is 8% of the current price. The stock costs $95. The cost of issuing and selling the stock is expected to be $5 Stock: per share. The firm’s common stock is currently selling for $90 per share. The firm expects Common to pay cash dividends of$7 per share next year. The dividends have been growing Stock: at 6%. The stock must be discounted by $7 and flotation costs are expected to amount to $5 per share. Retained The firm expects to have enough retained earnings in the coming year to be used Earnings: in place of any new stock being issued. a. 4.9% b. 11.55% c. 7.88% d. 8.44% ANSWER: d RATIONALE: Solution: 0.08 × $95 = $7.60 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 93. What is the cost of common stock for Foggy Futures Weather Forecasters? The firm is in the 40% tax bracket. The optimal capital structure is listed below: Source of Capital Weight Long-Term Debt 25% Preferred Stock 20% Common Stock 55% The firm can issue $1,000 par value, 8% coupon interest bonds with a 20 Debt: year maturity date. The bond has an average discount of $30 and flotation costs of $30 per bond. The selling price is $1,000. The firm can sell preferred stock with a dividend that is 8% of the current price. Preferred The stock costs $95. The cost of issuing and selling the stock is expected to be Stock: $5 per share. The firm’s common stock is currently selling for $90 per share. The firm Common expects to pay cash dividends of $7 per share next year. The dividends have Stock: been growing at 6%. The stock must be discounted by $7 and flotation costs are expected to amount to $5 per share. Retained The firm expects to have enough retained earnings in the coming year to be Earnings: used in place of any new stock being issued. a. 12.25% b. 19.75% c. 14.97% d. 13.22% ANSWER: c RATIONALE: Solution: 14.97% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 94. What is the cost of retained earnings for Foggy Futures Weather Forecasters? The firm is in the 40% tax bracket. The optimal capital structure is listed below: Source of Capital Weight Long-Term Debt 25% Preferred Stock 20% Common Stock 55% The firm can issue $1,000 par value, 8% coupon interest bonds with a 20 Debt: year maturity date. The bond has an average discount of $30 and flotation costs of $30 per bond. The selling price is $1,000. The firm can sell preferred stock with a dividend that is 8% of the current Preferred price. The stock costs $95. The cost of issuing and selling the stock is expected Stock: to be $5 per share. The firm’s common stock is currently selling for $90 per share. The firm Common expects to pay cash dividends of $7 per share next year. The dividends have Stock: been growing at 6%. The stock must be discounted by $7 and flotation costs are expected to amount to $5 per share. Retained The firm expects to have enough retained earnings in the coming year to be Earnings used in place of any new stock being issued. a. 10.12% b. 19.63% c. 13.78% d. 12.11% ANSWER: c RATIONALE: Solution: © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 95.Using rounded whole percents for the various costs and weighted costs, what is the weighted average cost of capital for Foggy Futures Weather Forecasters? The firm is in the 40% tax bracket. The optimal capital structure is listed below: Source of Capital Weight Long-Term Debt 25% Preferred Stock 20% Common Stock 55% The firm can issue $1,000 par value, 8% coupon interest bonds with a 20 year Debt: maturity date. The bond has an average discount of $30 and flotation costs of $30 per bond. The selling price is $1,000. Preferred The firm can sell preferred stock with a dividend that is 8% of the current price. Stock: The stock costs $95. The cost of issuing and selling the stock is expected to be $5 per share. The firm’s common stock is currently selling for $90 per share. The firm expects to pay cash dividends of $7 per share next year. The dividends have Common been growing at 6%. The stock must be discounted by $7 and flotation costs are Stock: expected to amount to $5 per share. Retained The firm expects to have enough retained earnings in the coming year to be Earnings: used in place of any new stock being issued. a. 12% b.8% c. 15% d.18% ANSWER: a RATIONALE: What is the cost of debt of Foggy Futures Weather Forecasters? The firm is in the 40% tax bracket. The optimal capital structure is listed below: Source of Capital Weights Costs Weighted Costs Debt 25% 5% 1% Retained Earnings 75% 14% 11% 12% Cost of Debt using a financial calculator: N = 20 PV = –940 PMT = 80 FV = 1,000 I = 8.64 × (1 – 0.40) = 5.18 rounded to the nearest whole percent 5% Cost of Retained Earnings: + 0.06 = 13.77% rounded to the nearest whole percent 14% Using whole percents: (0.25 × 5) + (0.75 × 14) = 11.75% = 12% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 96. In considering the SML concept, the required returns for any individual security are dependent on certain values. List and discuss those values. ANSWER: 1.The risk-free rate: The 3-month or 6-month Treasury Bill rate is generally used for this value. 2.The expected market return: This is the return that investors expect to earn on stocks with a beta of 1.0. 3.The beta of the corporation: Beta is normally estimated by using historic values reflecting the relationship between a security’s returns and the market returns. 97.What are the reasons that the cost of external equity is greater than the cost of internal equity? ANSWER: 1. External equity has issuance costs associated with new shares. These costs are generally significant enough that they cannot be ignored. 2. The price of the new shares being sold to the public is normally set to an amount less than the market price of the stock before the announcement of the new issue. 98.Firms can raise capital in two ways. Why is it that internal funding does not have a zero cost? ANSWER: Firms using internal funding, or retained earnings, incur an opportunity cost. When funds are generated through the earnings of the firm, either managers can pay out funds as dividends to common stockholders, or the funds can be retained and reinvested in the firm. If the funds are paid out to stockholders, they could reinvest the funds elsewhere to earn an appropriate return, given the risk of the investment. If managers decide to retain earnings and reinvest them in the firm, there must be investment opportunities in a firm offering a return equivalent to the returns available to stockholders in alternative investments on a risk-adjusted basis. 99.How is the marginal cost of the various component capital sources determined? ANSWER: The marginal cost of funds is the cost of the next increments of capital raised by the firm. When computing the marginal cost of the various component capital sources, companies typically estimate the component costs they anticipate encountering, or paying, during the coming year. If capital costs change significantly during the year, it may be necessary to recompute the new capital costs and use the new estimates when evaluating projects from that time forward, 100.What is the investment opportunity curve and how is it accomplished? ANSWER: The investment opportunity curve is the graph which illustrates the comparison between the expected project return to the company’s marginal cost of capital schedule. It is accomplished by first plotting the returns expected from the proposed capital expenditure projects against the cumulative funds required. The optimal capital budget is indicated by the point at which the investment opportunity curve and the marginal cost of capital curve intersect. © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy 101.Sources of debt capital to small firms are limited. Generally, what are the sources of funds for the small firm? ANSWER: Until a small firm has grown to a relatively large size, it must rely on the following sources for debt funds: 1.The owners’ own funds and loans from friends. 2.Loans from commercial banks and savings and loan associations. 3.Small Business Administration loans. 4.Commercial finance company loans. 5.Leasing companies. 6.Venture capital firms that normally demand some equity interest in the firm through conversion features or warrants. 7.Private placements of debt issues with insurance companies and large corporations, often with a conversion feature or warrants. 102.What does the optimal capital budget maximize? How it is determined? ANSWER: The optimal capital budget maximizes the value of the firm and occurs at the point where the firm’s investment opportunity curve and weighted marginal cost of capital curve intersect. 103.Explain how the investment opportunity curve is determined. ANSWER: The investment opportunity curve is obtained by plotting the returns expected from proposed capital expenditure projects against the cumulative funds required. 104.In many instances book value, rather than market value, may be used to determine the weighted average cost of capital. This is because of all of the following EXCEPT: a.market values change daily b.the market prices of the various sources of capital are not easily estimated. c.many firms have several different issues of debt which may not be publicly held. d.book value is a more accurate value in determining the actual cost of capital ANSWER: d © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 12: The Cost of Capital, Capital Structure, and Dividend Policy PDF

Document Details

Tags

Related

Summary

Full Transcript

Upgrade to continue