Ch 12 - CHAPTER 12 THE COST OF CAPITAL ANSWERS TO END OF CHAPTER QUESTIONS 1 There are at least 3 uses of the weighted average cost of capital(a

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CHAPTER 12 THE COST OF CAPITAL ANSWERS TO END OF CHAPTER QUESTIONS: 1. There are at least 3 uses of the weighted average cost of capital. (a) The cost of capital serves as a hurdle rate in the evaluation of capital budgeting proposals. Projects with returns that equal or exceed the cost of capital should be accepted while others should be rejected (this is true for projects with risk similar to the average project the firm is engaged in). (b) Since minimizing the weighted average cost of capital maximizes shareholder wealth, knowledge of the cost of capital is important so we can identify the mix of capital that will yield the lowest cost of capital. (c) Knowledge of the cost of capital is useful in evaluating management performance. Good management is one that consistently produces a return on capital that exceeds the firm's cost of capital, thereby adding to shareholder wealth. 2. The marginal cost of capital is the cost incurred by the firm to raise the next increment of capital . It reflects the current opportunity cost of the funds available to a firm. The historical cost of capital does not reflect the current market value of these funds. Because outlays for capital projects must be made with today’s dollars, these outlays should reflect current (marginal) capital costs. 3. Retained earnings are an internally generated source of financing, they are earnings that “belong” to shareholders but have been retained in the firm for reinvestment. External equity represents additional investment in the firm through the sale of new common stock. From a cost of capital perspective retained earnings or internal equity is cheaper than external equity because no flotation expenses are incurred. 4. Estimates of dividend and earnings growth rates can be obtained from historical data or alternatively from forecasts by security analysts. Theoretically, forecast data is superior. Security analyst forecast data is available from a number of research and other financial services firms such as Value Line and Merrill Lynch. Some organizations (e.g., Zacks Investment Research and Thomson Financial/First Call) provide consensus estimates, which are averages of several analysts’ forecasts. 5. a. When the risk-free rate is the 90-day Treasury bill rate, the market risk premium that should be used when applying the CAPM is measured relative to the 90-day Treasury bill rate. Historically, over the period 1926 to 2004 this premium has averaged about 8.6 percent. b.
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This note was uploaded on 05/01/2008 for the course FIN 3113 taught by Professor Titus-piersma during the Spring '08 term at Oklahoma State.

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Ch 12 - CHAPTER 12 THE COST OF CAPITAL ANSWERS TO END OF CHAPTER QUESTIONS 1 There are at least 3 uses of the weighted average cost of capital(a

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