CH11SOLS - Chapter 11 Discussion Questions 11-1. Though an...

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Chapter 11 Discussion Questions 11-1. Though an investment financed by low-cost debt might appear acceptable at first glance, the use of debt could increase the overall risk of the firm and eventually make all forms of financing more expensive. Each project must be measured against the overall cost of funds to the firm. 11-2. The cost of a source of financing directly relates to the required rate of return for that means of financing. Of course, the required rate of return is used to establish valuation. 11-3. In computing the cost of capital, we use the current costs for the various sources of financing rather than the historical costs. We must consider what these funds will cost us to finance projects in the future rather than their past costs. 11-4. Even though debt and preferred stock may be both priced to yield 10 percent in the market, the cost of debt is less because the interest on debt is a tax-deductible expense. A 10 percent market rate of interest on debt will only cost a firm in a 40 percent tax bracket an aftertax rate of 6 percent. The answer is the yield multiplied by the difference of (one minus the tax rate). 11-5. The two sources of equity capital are retained earnings and new common stock. 11-6. Retained earnings belong to the existing common shareholders. If the funds are paid out instead of reinvested, the shareholders could earn a return on them. Thus we say retaining funds for reinvestment carries an opportunity cost. 11-7. Because shareholders can earn a return at least equal to their present investment. For this reason, the firm's rate of return ( K e ) serves as a means of approximating the opportunities for alternate investments. 11-8. In issuing new common stock, we must earn a slightly higher return than the normal cost of common equity in order to cover the distribution costs of the new security. In the case of the Baker Corporation, the cost of new common stock was six percent higher. 11-9. The weights are determined by examining different capital structures and using that mix which gives the minimum cost of capital. We must solve a multidimensional problem to determine the proper weights. 11-10. The logic of the U-shaped approach to cost of capital can be explained through Figure 11-1. It is assumed that as we initially increase the debt-to-equity mix the cost of capital will go down. After we reach an optimum point, the increase use of debt will increase the overall cost of financing to the firm. Thus we say the weighted average cost of capital curve is U-shaped. Foundations of Fin. Mgt. 6/E Cdn. • Block, Hirt, Short S-29
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11-11. Other possible ratios influencing the cost of capital might be: times interest earned fixed charge coverage and indirectly net income / sales net income / total assets net income / shareholders’ equity 11-12. If the firm cannot earn the overall cost of financing on a given project, the investment will have a negative impact on the firm's operations and will lower the overall wealth of
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This note was uploaded on 11/01/2011 for the course BUS Ethics101 taught by Professor Jsmith during the Fall '11 term at Lakehead.

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CH11SOLS - Chapter 11 Discussion Questions 11-1. Though an...

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