Chap011 - Chapter 11: Cost of Capital Chapter 11 Cost of...

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Chapter 11: Cost of Capital Chapter 11 Cost of Capital Discussion Questions 11-1. Why do we use the overall cost of capital for investment decisions even when only one source of capital will be used (e.g., debt)? 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. How does the cost of a source of capital relate to the valuation concepts presented previously in Chapter 10? 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, do we use the historical costs of existing debt and equity or the current costs as determined in the market? Why? 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. Why is the cost of debt less than the cost of preferred stock if both securities are priced to yield 10 percent in the market? 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 35 percent tax bracket an aftertax rate of 6.5 percent. The answer is the yield multiplied by the difference of (one minus the tax rate). 11-5. What are the two sources of equity (ownership) capital for the firm? The two sources of equity capital are retained earnings and new common stock. 11-1
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Chapter 11: Cost of Capital 11-6. Explain why retained earnings have an associated opportunity cost? Retained earnings belong to the existing common stockholders. If the funds are paid out instead of reinvested, the stockholders could earn a return on them. Thus, we say retaining funds for reinvestment carries an opportunity cost. 11-7. Why is the cost of retained earnings the equivalent of the firm's own required rate of return on common stock (K e )? Because stockholders 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. Why is the cost of issuing new common stock (K n ) higher than the cost of retained earnings (K e )? 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.
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This note was uploaded on 01/31/2012 for the course FINC 3343 taught by Professor Terry during the Spring '11 term at University of Arkansas at Little Rock.

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Chap011 - Chapter 11: Cost of Capital Chapter 11 Cost of...

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