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s11 - Chapter 11 Cost of Capital COST OF CAPITAL ANSWERS TO...

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Chapter 11: Cost of Capital 11-1 Chapter 11 COST OF CAPITAL ANSWERS TO QUESTIONS: 1. Retained earnings are an internally generated source of financing whereas other sources of financing (long-term debt, preferred stock, and newly issued common stock) are external sources of financing. 2. The retained earnings figure on a firm's balance sheet represents the cumulative earnings that have been retained in the business (assuming no stock dividends or other accounting entries have been made to change the figures). Normally, the earnings retained by the firm constantly are reinvested in the business in the form of inventory, fixed assets, cash, etc. Therefore, the balance sheet retained earnings figure has little, if any, relationship to the amount of retained earnings a firm can generate in a given year. 3. Corporate long-term debt is more risky than government long-term debt because the corporate debt is subject to business and financial risk whereas the government debt is not subject to these risks. The U.S. government, of course, has the power to print money to meet its interest and principal repayment obligations. The difference in interest yields on government debt and on high quality corporate debt is usually less than 1% and often as low as 0.5%. 4. Common stock is more risky than preferred stock because the dividends paid to common stockholders are paid from cash remaining after the payment of preferred stock dividends, and, therefore, are the first to be cut if the firm encounters difficulties. In addition, the market price fluctuations of common stock tend to be greater than those of preferred stock or long-term debt. 5. Because the cost of external common stock exceeds the cost of retained earnings at any given time, one might be inclined to categorically suggest lowering the amount of external capital to be raised by lowering dividends. While such a policy may be sensible for a firm whose established dividend policy is residual, it may not be the best policy for a company whose clientele expect stable dividends. The company paying stable dividends could find that its cost of equity capital is increased because of stock price declines associated with the lower dividends. On the other hand, many finance professionals would argue that any stock price declines will be temporary. The literature of agency theory argues that dividend payments at the same time that new equity is being sold performs a useful bonding and monitoring function for the principals of the firm. The literature on signaling indicates that changes in dividend payouts may be interpreted as a signal of the firm's expected future earnings. 6. The optimal capital budget occurs at the point where the investment opportunities curve and the marginal cost of capital curve intersect. In other words, the optimal capital budget includes all projects whose expected returns exceed the marginal cost of capital and excludes all projects whose expected returns are less than the marginal cost of capital.
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