350_Ch10[1] - Chapter 10 The Cost of Capital Answers to...

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Chapter 10: The Cost of Capital Integrated Case 1 Chapter 10 The Cost of Capital Answers to End-Of-Chapter Questions 10-1 Probable Effect on r d (1 – T) r s WACC a. The corporate tax rate is lowered. + 0 + b. The Federal Reserve tightens credit. + + + c. The firm uses more debt; that is, it increases its debt/assets ratio. + + 0 d. The dividend payout ratio is increased. 0 0 0 e. The firm doubles the amount of capital it raises during the year. 0 or + 0 or + 0 or + f. The firm expands into a risky new area. + + + g. The firm merges with another firm whose earnings are counter-cyclical both to those of the first firm and to the stock market. h. The stock market falls drastically, and the firm’s stock falls along with the rest. 0 + + i. Investors become more risk averse. + + + j. The firm is an electric utility with a large investment in nuclear plants. Several states propose a ban on nuclear power generation. + + + 10-2 An increase in the risk-free rate will increase the cost of debt. Remember from Chapter 6, r = r RF + DRP + LP + MRP. Thus, if r RF increases so does r (the cost of debt). Similarly, if the risk-free rate increases so does the cost of equity. From the CAPM equation, r s = r RF + (r M – r RF )b. Consequently, if r RF increases r s will increase too. 10-3 Each firm has an optimal capital structure, defined as that mix of debt, preferred, and common equity that causes its stock price to be maximized. A value-maximizing firm will determine its optimal capital structure, use it as a target, and then raise new capital in a manner designed to keep the actual capital structure on target over time. The target proportions of debt, preferred stock, and common equity, along with the costs of those components, are used to calculate the firm’s weighted average cost of capital, WACC. The weights could be based either on the accounting values shown on the firm’s balance
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2 Integrated Case Chapter 10: The Cost of Capital sheet (book values) or on the market values of the different securities. Theoretically, the weights should be based on market values, but if a firm’s book value weights are reasonably close to its market value weights, book value weights can be used as a proxy for market value weights. Consequently, target market value weights should be used in the WACC equation. 10-4 In general, failing to adjust for differences in risk would lead the firm to accept too many risky projects and reject too many safe ones. Over time, the firm would become more risky, its WACC would increase, and its shareholder value would suffer. The cost of capital for average-risk projects would be the firm’s cost of capital, 10%. A somewhat higher cost would be used for more risky projects, and a lower cost would be used for less risky ones. For example, we might use 12% for more risky projects and 9% for less risky projects. These choices are arbitrary. 10-5
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This note was uploaded on 09/30/2011 for the course FIN 350 taught by Professor Chen during the Spring '07 term at S.F. State.

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350_Ch10[1] - Chapter 10 The Cost of Capital Answers to...

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