Study Questions Chapter 12 - 12-1 Define the term cost of...

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Unformatted text preview: 12-1. Define the term cost of capital. Cost of capital is the rate that must be earned on an investment project if the project is to increase the value of the common stockholder’s investment and is also is the key determinant of the capital cost associated with a firm’s investment. 12-2. Why do we calculate a firm’s weighted average cost of capital? A firm’s weighted average cost of capital is calculated because it will reflect the combined cost of all the sources of financing used by the firm. This shows the after-tax cost of each of the sources of capital used by a firm to finance a project where the weights reflect the proportion of total financing raised from each source. 12-3. In computing the cost of capital, which sources of capital do we consider? In computing the cost of capital we stick with three basic types of financing, debt, preferred stock, and common stock. 12-4. How does a firm’s tax rate affect its cost of capital? What is the effect of the flotation costs associated with a new security issue? A firm’s tax rate affects the cost of capital because then we discount the after-tax cash flows. Therefore we need to adjust the cost of capital for any influence incurred by the firm’s tax rate. The flotation cost will decrease the amount of capital that a firm can work with, but must be include in the cost of capital. For example, if a firm issued stock at $12 a share with a 10% rate of return, but incurs a transaction cost of $2 a share. The firm needs to earn $1.20 to satisfy the investors. Yet the flotation cost lowered the firm’s money to $10 a share, so the rate of return must be 12%. Thus the flotation cost affects the cost of capital. ...
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