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**Unformatted text preview: **CHAPTER 11
The Cost of Capital
Multiple Choice: Conceptual
Capital components
1. Long-term debt.
Common stock.
Permanent short-term debt.
Preferred stock.
All of the above are considered capital components. Capital components Diff: E Long-term debt.
Common stock.
Short-term debt used to finance seasonal current assets.
Preferred stock.
All of the above are considered capital components for WACC and
capital budgeting purposes. Capital components Answer: d For a typical firm with a given capital structure, which
following is correct? (Note: All rates are after taxes.)
a.
b.
c.
d.
e. kd >
ks >
WACC
ks >
None Diff: E
of the ks > WACC.
kd > WACC.
> ks > kd.
WACC > kd.
of the statements above is correct. Capital components
4. Answer: c Which of the following is not considered a capital component for the
purpose of calculating the weighted average cost of capital as it
applies to capital budgeting?
a.
b.
c.
d.
e. 3. Diff: E Which of the following is not considered a capital component?
a.
b.
c.
d.
e. 2. Answer: e Answer: a Diff: E Which of the following statements is most correct?
a. If a company's tax rate increases but the yield to maturity of its
noncallable bonds remains the same, the company's marginal cost of
debt capital used to calculate its weighted average cost of capital
will fall.
b. All else equal, an increase in a company's stock price will increase
the marginal cost of common stock, k s.
c. All else equal, an increase in interest rates will decrease the
marginal cost of common stock, k s.
d. Answers a and b are correct.
e. Answers b and c are correct.
Chapter 12 - Page 1 DCF cost of equity estimation
5. Expected growth rate, g.
Dividend yield, D 1/P0.
Required return, k s.
ˆ
Expected rate of return, ks .
All of the above are equally difficult to estimate. Factors influencing WACC Answer: a Diff: E Wyden Brothers uses the CAPM to calculate the cost of equity capital.
The company’s capital structure consists of common stock, preferred
stock, and debt.
Which of the following events will reduce the
company’s WACC?
a.
b.
c.
d.
e. A reduction
An increase
An increase
An increase
An increase
stock. in
in
in
in
in the market risk premium.
the risk-free rate.
the company’s beta.
expected inflation.
the flotation costs associated with issuing preferred Cost of capital components and WACC
7. Diff: E Which of the following factors in the discounted cash flow (DCF)
approach to estimating the cost of common equity is the least difficult
to estimate?
a.
b.
c.
d.
e. 6. Answer: b Answer: c Diff: E Which of the following statements is most correct?
a. The WACC is a measure of the before-tax cost of capital.
b. Typically the after-tax cost of debt financing exceeds the after-tax
cost of equity financing.
c. The WACC measures the marginal after-tax cost of capital.
d. Statements a and b are correct.
e. Statements b and c are correct. WACC and capital components
8. Answer: a Diff: E A company has a capital structure which consists of 50 percent debt and
50 percent equity. Which of the following statements is most correct?
a. The cost of equity financing is greater than or equal to the cost of
debt financing.
b. The WACC exceeds the cost of equity financing.
c. The WACC is calculated on a before-tax basis.
d. The WACC represents the cost of capital based on historical averages.
In that sense, it does not represent the marginal cost of capital.
e. The cost of retained earnings exceeds the cost of issuing new common
stock. Capital components
Chapter 12 - Page 2 Answer: d Diff: M 9. Which of the following statements is most correct?
a. Capital components are the types of capital used by firms to raise
money.
All capital comes from one of three components: long-term
debt, preferred stock, and equity.
b. Preferred stock does not involve any adjustment for flotation cost
since the dividend and price are fixed.
c. The cost of debt used in calculating the WACC is an average of the
after-tax cost of new debt and of outstanding debt.
d. The opportunity cost principle implies that if the firm cannot invest
retained earnings and earn at least k s, it should pay these funds to
its stockholders and let them invest directly in other assets that do
provide this return.
e. The cost of common stock, k s, is usually less than the cost of
preferred stock. Capital components
10. Answer: e Diff: M Which of the following statements is most correct?
a. In the weighted average cost of capital calculation, we must adjust
the cost of preferred stock for the tax exclusion of 70 percent of
dividend income.
b. We ideally would like to use historical measures of the component
costs from prior financings in estimating the appropriate weighted
average cost of capital.
c. The cost of common stock (k s) will increase if the market risk
premium and risk-free rate decline by a substantial amount.
d. Statements b and c are correct.
e. None of the statements above is correct. Cost of capital estimation
11. Answer: c Diff: M Which of the following statements is most correct?
a. The cost of capital used to evaluate a project should be the cost of
the specific type of financing used to fund that project.
b. The cost of debt used to calculate the weighted average cost of
capital is based on an average of the cost of debt already issued by
the firm and the cost of new debt.
c. One problem with the CAPM approach to estimating the cost of equity
capital is that if a firm's stockholders are, in fact, not well
diversified, beta may be a poor measure of the firm's true investment
risk.
d. The bond-yield-plus-risk-premium approach is the most sophisticated
and objective method of estimating a firm's cost of equity capital.
e. The cost of equity capital is generally easier to measure than the
cost of debt, which varies daily with interest rates, or the cost of
preferred stock since preferred stock is issued infrequently. Cost of equity estimation Answer: d Diff: M Chapter 12 - Page 3 12. Which of the following statements is most correct?
a. Although some methods of estimating the cost of equity capital
encounter severe difficulties, the CAPM is a simple and reliable
model that provides great accuracy and consistency in estimating the
cost of equity capital.
b. The DCF model is preferred over other models to estimate the cost of
equity because of the ease with which a firm's growth rate is
obtained.
c. The bond-yield-plus-risk-premium approach to estimating the cost of
equity is not always accurate but its advantages are that it is a
standardized and objective model.
d. Depreciation-generated funds are an additional source of capital and,
in fact, represent the largest single source of funds for some firms.
e. None of the statements above is correct. CAPM cost of equity estimation
13. Answer: e Diff: M Which of the following statements is most correct?
a. The CAPM approach to estimating a firm's cost of common stock never
gives a better estimate than the DCF approach.
b. The CAPM approach is typically used to estimate a firm's cost of
preferred stock.
c. The risk premium used in the bond-yield-plus-risk-premium method is
the same as the one used in the CAPM method.
d. In practice (as opposed to in theory), the DCF method and the CAPM
method usually produce exactly the same estimate for k s.
e. The statements above are all false. CAPM cost of equity estimation
14. Answer: e Diff: M In applying the CAPM to estimate the cost of equity capital, which of
the following elements is not subject to dispute or controversy?
a.
b.
c.
d.
e. The
The
The
The
All expected rate of return on the market, k M.
stock's beta coefficient, b i.
risk-free rate, k RF.
market risk premium (RP M).
of the above are subject to dispute. CAPM and DCF estimation Chapter 12 - Page 4 Answer: a Diff: M 15. Which of the following statements is most correct?
a. Beta measures market risk, but if a firm's stockholders are not well
diversified, beta may not accurately measure stand-alone risk.
b. If the calculated beta underestimates the firm's true investment
risk, then the CAPM method will overestimate k s.
c. The discounted cash flow method of estimating the cost of equity
can't be used unless the growth component, g, is constant during the
analysis period.
d. An advantage shared by both the DCF and CAPM methods of estimating
the cost of equity capital, is that they yield precise estimates and
require little or no judgement.
e. All of the statements above are false. Risk treatment
16. Diff: M Which of the following methods of estimating the cost of common equity
for a firm treats risk explicitly?
a.
b.
c.
d.
e. DCF method.
CAPM method.
Composite method.
Bond-yield-plus-risk-premium method.
Answers b and d are correct. WACC
17. Answer: e Answer: d Diff: M Which of the following statements is most correct?
a. The weighted average cost of capital for a given capital budget level
is a weighted average of the marginal cost of each relevant capital
component which makes up the firm's target capital structure.
b. The weighted average cost of capital is calculated on a before-tax
basis.
c. An increase in the risk-free rate is likely to increase the marginal
costs of both debt and equity financing.
d. Answers a and c are correct.
e. All of the answers above are correct. WACC concepts
18. Answer: e Diff: M Which of the following statements is most correct?
a. Since stockholders do not generally pay corporate taxes, corporations
should focus on before-tax cash flows when calculating the weighted
average cost of capital (WACC).
b. When calculating the weighted average cost of capital, firms should
include the cost of accounts payable.
c. When calculating the weighted average cost of capital, firms should
rely on historical costs rather than marginal costs of capital.
d. Answers a and b are correct.
e. None of the answers above is correct. WACC concepts Answer: c Diff: M Chapter 12 - Page 5 19. Which of the
incorrect? following statements about the cost of capital is a. A company's target capital structure affects its weighted average
cost of capital.
b. Weighted average cost of capital calculations should be based on the
after-tax-costs of all the individual capital components.
c. If a company's tax rate increases, then, all else equal, its weighted
average cost of capital will increase.
d. The cost of retained earnings is equal to the return stockholders
could earn on alternative investments of equal risk.
e. Flotation costs can increase the cost of preferred stock.
Miscellaneous concepts
20. Answer: a Diff: M Which of the following statements is most correct?
a. Suppose a firm is losing money and thus, is not paying taxes, and
that this situation is expected to persist for a few years whether or
not the firm uses debt financing. Then the firm's after-tax cost of
debt will equal its before-tax cost of debt.
b. The component cost of preferred stock is expressed as k ps(1 - T),
because preferred stock dividends are treated as fixed charges,
similar to the treatment of debt interest.
c. The reason that a cost is assigned to retained earnings is because
these funds are already earning a return in the business; the reason
does not involve the opportunity cost principle.
d. The bond-yield-plus-risk-premium approach to estimating a firm's cost
of common equity involves adding a subjectively determined riskpremium to the market risk-free bond rate.
e. All of the statements above are false. Miscellaneous concepts
21. Answer: a Diff: M Which of the following statements is most correct?
a. The before-tax cost of preferred stock may be lower than the beforetax cost of debt, even though preferred stock is riskier than debt.
b. If a company's stock price increases, this increases its cost of
common stock.
c. If the cost of equity capital increases, it must be due to an
increase in the firm's beta.
d. Statements a and b are correct.
e. Answers a, b, and c are correct. Multiple Choice: Problems
Chapter 12 - Page 6 Cost of common stock
22. Answer: d Diff: E Bouchard Company's stock sells for $20 per share, its last dividend (D 0)
was $1.00, and its growth rate is a constant 6 percent.
What is its
cost of common stock, k s?
a. 5.0%
b. 5.3%
c. 11.0%
d. 11.3%
e. 11.6% Cost of common stock
23. Answer: b Diff: E Your company's stock sells for $50 per share, its last dividend (D 0) was
$2.00, and its growth rate is a constant 5 percent. What is the cost of
common stock, k s?
a. 9.0%
b. 9.2%
c. 9.6%
d. 9.8%
e. 10.0% Cost of common stock
24. Answer: e The Global Advertising Company has a marginal tax rate of 40 percent.
The last dividend paid by Global was $0.90. Global's common stock is
selling for $8.59 per share, and its expected growth rate in earnings
and dividends is 5 percent. What is Global's cost of common stock?
a.
b.
c.
d.
e. 12.22%
17.22%
10.33%
9.66%
16.00% WACC with Flotation Costs
25. Diff: E An analyst has Answer: a
collected the following information Diff: E regarding Chapter 12 - Page 7 Christopher Co.:
• The company’s capital structure is 70 percent equity, 30 percent
debt.
The yield to maturity on the company’s bonds is 9 percent.
The company’s year-end dividend is forecasted to be $0.80 a share.
The company expects that its dividend will grow at a constant rate
of 9 percent a year.
The company’s stock price is $25.
The company’s tax rate is 40 percent.
The company anticipates that it will need to raise new common stock
this year.
Its investment bankers anticipate that the total
flotation cost will equal 10 percent of the amount issued. Assume
the company accounts for flotation costs by adjusting the cost of
capital. Given this information, calculate the company’s WACC. •
•
•
•
•
• a.
b.
c.
d.
e. 10.41%
12.56%
10.78%
13.55%
9.29% Cost of common stock
26. Answer: d Diff: M The common stock of Anthony Steel has a beta of 1.20.
The risk-free
rate is 5 percent and the market risk premium (k M - kRF) is 6 percent.
What is the company’s cost of common stock, k s?
a. 7.0%
b. 7.2%
c. 11.0%
d. 12.2%
e. 12.4% Cost of common stock
27. Diff: M Martin Corporation's common stock is currently selling for $50 per
share. The current dividend is $2.00 per share.
If dividends are
expected to grow at 6 percent per year, then what is the firm's cost of
common stock?
a.
b.
c.
d.
e. 10.0%
10.2%
10.6%
10.8%
11.0% WACC
28. Answer: b Answer: b Diff: M A company has determined that its optimal capital structure consists of Chapter 12 - Page 8 40 percent debt and 60 percent equity. Given the following information,
calculate the firm's weighted average cost of capital.
kd = 6%
Tax rate = 40%
P0 = $25
Growth = 0%
D0 = $2.00
a.
b.
c.
d.
e. 6.0%
6.2%
7.0%
7.2%
8.0% WACC
29. Answer: c
Johnson Industries finances its projects with 40 percent
percent preferred stock, and 50 percent common stock.
•
•
•
•
•
• Diff: M
debt, 10 The company can issue bonds at a yield to maturity of 8.4 percent.
The cost of preferred stock is 9 percent.
The company's common stock currently sells for $30 a share.
The company's dividend is currently $2.00 a share (D 0 = $2.00), and
is expected to grow at a constant rate of 6 percent per year.
Assume that the flotation cost on debt and preferred stock is zero,
and no new stock will be issued.
The company’s tax rate is 30 percent. What is the company’s weighted average cost of capital (WACC)?
a. 8.33%
b. 9.32%
c. 9.79%
d. 9.99%
e. 13.15% Chapter 12 - Page 9 WACC
30. Answer: e Diff: M Dobson Dairies has a capital structure which consists of 60 percent
long-term debt and 40 percent common stock.
The company’s CFO has
obtained the following information:
•
• •
• The before-tax yield to maturity on the company’s bonds is 8 percent.
The company’s common stock is expected to pay a $3.00 dividend at
year end (D1 = $3.00), and the dividend is expected to grow at a
constant rate of 7 percent a year. The common stock currently sells
for $60 a share.
Assume the firm will be able to use retained earnings to fund the
equity portion of its capital budget.
The company’s tax rate is 40 percent. What is the company’s weighted average cost of capital (WACC)?
a. 12.00%
b. 8.03%
c. 9.34%
d. 8.00%
e. 7.68%
WACC and dividend growth rate
31. Answer: c Diff: M Grateway Inc. has a weighted average cost of capital of 11.5 percent.
Its target capital structure is 55 percent equity and 45 percent debt.
The company has sufficient retained earnings to fund the equity portion
of its capital budget. The before-tax cost of debt is 9 percent, and the
company’s tax rate is 30 percent. If the expected dividend next period
(D1) and current stock price are $5 and $45, respectively, what is the
company’s growth rate?
a.
b.
c.
d.
e. 2.68%
3.44%
4.64%
6.75%
8.16% Chapter 12 - Page 10 Multiple part:
(The following information applies to the next six problems.)
Rollins Corporation is estimating its WACC. Its target capital structure is
20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its
bonds have a 12 percent coupon, paid semiannually, a current maturity of 20
years, and sell for $1,000. The firm could sell, at par, $100 preferred stock
which pays a 12 percent annual dividend, but flotation costs of 5 percent
would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent,
and the market risk premium is 5 percent. Rollins is a constant-growth firm
which just paid a dividend of $2.00, sells for $27.00 per share, and has a
growth rate of 8 percent.
The firm's policy is to use a risk premium of 4
percentage points when using the bond-yield-plus-risk-premium method to find
ks. The firm's marginal tax rate is 40 percent.
Cost of debt
Answer: e Diff: M
32. What is Rollins' component cost of debt?
a. 10.0%
b. 9.1%
c. 8.6%
d. 8.0%
e. 7.2% Cost of preferred stock
33. Answer: c Diff: E 10.0%
11.0%
12.0%
12.6%
13.2% Cost of common stock: CAPM What is Rollins' cost of common stock (k s) using the CAPM approach?
a.
b.
c.
d.
e. 13.6%
14.1%
16.0%
16.6%
16.9% Cost of common stock: DCF
35. Diff: E What is Rollins' cost of preferred stock?
a.
b.
c.
d.
e. 34. Answer: d Answer: c Diff: E What is the firm's cost of common stock (k s) using the DCF approach?
a.
b.
c.
d.
e. 13.6%
14.1%
16.0%
16.6%
16.9% Chapter 12 - Page 11 Cost of common stock: Risk premium
36. Diff: E What is Rollins' cost of common stock using the bond-yield-plus-riskpremium approach?
a.
b.
c.
d.
e. 13.6%
14.1%
16.0%
16.6%
16.9% WACC
37. Answer: c Answer: a Diff: E What is Rollins' WACC?
a.
b.
c.
d.
e. 13.6%
14.1%
16.0%
16.6%
16.9% (The following information applies to the next three problems.)
J. Ross and Sons Inc. has a target capital structure that calls for 40 percent
debt, 10 percent preferred stock, and 50 percent common equity. The firm's
current after-tax cost of debt is 6 percent, and it can sell as much debt as
it wishes at this rate. The firm's preferred stock currently sells for $90
per share and pays a dividend of $10 per share; however, the firm will net
only $80 per share from the sale of new preferred stock. Ross's common stock
currently sells for $40 per share. The firm recently paid a dividend of $2
per share on its common stock, and investors expect the dividend to grow
indefinitely at a constant rate of 10 percent per year.
Cost of common stock
38. Diff: E Answer: b Diff: E What is the firm's cost of common stock, k s?
a.
b.
c.
d.
e. 10.0%
12.5%
15.5%
16.5%
18.0% Cost of preferred stock
39. Answer: c What is the firm's cost of newly issued preferred stock, k ps?
a.
b.
c.
d.
e. 10.0%
12.5%
15.5%
16.5%
18.0% Chapter 12 - Page 12 WACC
40. Answer: d
What is the firm's weighted average cost of capital (WACC)?
a.
b.
c.
d.
e. 9.5%
10.3%
10.8%
11.4%
11.9% Cost of equity
41. Diff: E Answer: a Diff: M Allison Engines Corporation has established a target capital structure
of 40 percent debt and 60 percent common equity. The firm expects to
earn $600 in after-tax income during the coming year, and it will
retain 40 percent of those earnings. The current market price of the
firm's stock is P 0 = $28; its last dividend was D 0 = $2.20, and its
expected growth rate is 6 percent. Allison can issue new common stock
at a 15 percent flotation cost. What will Allison's marginal cost of
equity capital (not the WACC) be if it must fund a capital budget
requiring $600 in total new capital?
a. 15.8%
b. 13.9%
c. 7.9%
d. 14.3%
e. 9.7% WACC
42. Answer: b Diff: M Hilliard Corp. wants to calculate its weighted average cost of capital
(WACC). The company’s CFO has collected the following information:
•
•
•
•
•
•
•
• The company’s long-term bonds currently offer a yield to maturity
of 8 percent.
The company’s stock price is $32 per share (P 0 = $32).
The company recently paid a dividend of $2 per share (D 0 = $2.00).
The dividend is expected to grow at a constant rate of 6 percent a
year (g = 6%).
The company pays a 10 percent flotation cost whenever it issues new
common stock (F = 10%).
The company’s target capital structure is 75 percent equity and 25
percent debt.
The company’s tax rate is 40 percent.
The company anticipates issuing new common stock during the
upcoming year. What is the company’s WACC?
a.
b.
c.
d.
e. 10.67%
11.22%
11.47%
12.02%
12.56%
Chapter 12 - Page 13 CHAPTER 12
Answers and Solutions
1. Capital components Answer: e Diff: E 2. Capital components Answer: c Diff: E 3. Capital components Answer: d Diff: E 4. Capital components Answer: a Diff: E The debt cost used to calculate a firm's WACC is k d(1 - T).
If kd
remains constant but T increases, then the term (1 - T) decreases and
the value of the entire equation, k d(1 - T), decreases. Statement b is
false; if a company's stock price increases, and all else remains
constant, then the dividend yield decreases and k s decreases. This can
be seen from the equation k s = D1/P0 + g. Statement c is false, since an
increase in interest rates will cause an increase in the cost of common
stock, ks. Consequently, statements d and e are false too.
5. DCF cost of equity estimation Answer: b Diff: E 6. Factors influencing WACC Answer: a Diff: E Statement a is correct; the other statements are false.
If RP M
decreases, the cost of equity will be reduced. Answers b through e will
all increase the company’s WACC.
7. Cost of capital components and WACC Answer: c Diff: E WACC measures the marginal after-tax cost of capital; therefore,
statement a is false. The after-tax cost of debt financing is less than
the after-tax cost of equity financing; therefore, statement b is false.
The correct choice is statement c.
8. WACC and capital components Answer: a Diff: E Statement a is correct; the other statements are false. Statement b is
incorrect; WACC is an average of debt and equity financing. Since debt
financing is cheaper and is adjusted downward for taxes, it should, when
averaged with equity, cause the WACC to be less than the cost of equity
financing. Statement c is incorrect; WACC is calculated on an after-tax
basis.
Statement d is incorrect; the WACC is based on marginal, not
embedded, costs.
Statement e is incorrect; the cost of issuing new
common stock is greater than the cost of retained earnings.
9. Capital components Chapter 12 - Page 14 Answer: d Diff: M 10. Capital components Answer: e Diff: M Statement e is correct.
Unlike interest expense on debt, preferred
dividends are not deductible, hence there are no tax savings associated
with the use of preferred stock.
The component costs of WACC should
reflect the costs of new financing, not historical measures. The cost
of common stock would decline, not increase, if the market risk premium
and risk-free rate decline.
11. Cost of capital estimation Answer: c Diff: M 12. Cost of equity estimation Answer: d Diff: M 13. CAPM cost of equity estimation Answer: e Diff: M 14. CAPM cost of equity estimation Answer: e Diff: M 15. CAPM and DCF estimation Answer: a Diff: M 16. Risk treatment Answer: e Diff: M 17. WACC Answer: d Diff: M Statements a and c are both correct; therefore, statement d is the
correct choice.
Statement a recites the definition of the weighted
average cost of capital. Statement c is correct because k d = kRF + LP +
MRP + DRP while k s = kRF + (kM - kRF)b. If kRF increases then the values
for kd and ks will increase.
18. WACC concepts Answer: e Diff: M Statement e is correct.
After-tax cash flows must be considered in
order to account for the tax deductibility of interest payments on
corporate debt.
The impact of accounts payable is reflected in cash
flows, not WACC. The marginal, not the embedded, cost of capital is the
relevant cost of capital.
19. WACC concepts Answer: c Diff: M Statement c is the correct choice. A tax rate increase would lead to a
decrease in the after-tax cost of debt and, consequently, the firm's
WACC would decrease.
20. Miscellaneous concepts Answer: a Diff: M 21. Miscellaneous concepts Answer: a Diff: M Statement a is correct. Most preferred stock is owned by corporations
which receive a 70 percent exclusion of dividends.
Consequently, the
before-tax coupons on preferred stock are often lower than the beforetax coupons on debt, despite the fact that preferred stock is riskier
than debt. All the other statements are false. 22. Cost of common stock Answer: d Diff: E Chapter 12 - Page 15 The cost of common stock is:
ks = $1(1.06)/$20 + 0.06 = 0.053 + 0.06 = 0.113 = 11.3%.
23. Cost of common stock
ks = 24. Diff: E Answer: e Diff: E Answer: a Diff: E $2.00(1.05)
+ 5% = 9.2%.
$50 Cost of common stock
ks = 25. Answer: b $0.90(1.05)
+ 0.05 = 0.1600 = 16.00%.
$8.59 WACC with Flotation Costs WACC = wdkd(1 - T) + wceke. kd is given = 9%. Find k e:
ke = D1/[P0(1 - F)] + g
= $0.8/[$25(1 - 0.1)] + 0.09
= 0.125556.
Now you can calculate WACC:
WACC = (0.3)(0.09)(0.6) + (0.7)(0.125556) = 10.41%.
26. Cost of common stock
The
ks =
=
= 27. Diff: M cost of common equity as calculated from the CAPM is
kRF + (kM - kRF)b
5% + (6%)1.2
12.2%. Cost of common stock
ks = 28. Answer: d Answer: b Diff: M Answer: b Diff: M $2.00(1.06)
+ 0.06% = 10.24% ≈ 10.2%.
$50 WACC
Find the cost of common stock:
ks = D1/P0 + g = $2(1.0)/$25 + 0%; k s = 0.08 = 8%. Finally, calculate WACC, using k s = 0.08, and k d = 0.06, so
WACC = (D/A)(1 - Tax rate)k d + (E/A)ks
= 0.4(1 - 0.4)(0.06) + 0.6(0.08) = 0.0624 ≈ 6.2%. 29. WACC
The cost of common stock is: Chapter 12 - Page 16 Answer: c Diff: M k s = D1/P0 + g = $2.12/$30 + 0.06 = 13.07%. The cost to the company of the bonds is the YTM multiplied by 1 minus
the tax rate:
kd = YTM(1 - T) = 8.4%(0.7) = 5.88%.
The cost of the preferred is given as 9%.
The weighted average cost of capital is then
WACC = wd(kd) + wps(kps) + wce(ks)
WACC = 0.4(5.88%) + 0.1(9%) + 0.5(13.07%) = 9.79%.
30. WACC Answer: e Diff: M The firm will not be issuing new equity because there are adequate
retained earnings available to fund available projects. Therefore, WACC
should be calculated using k s.
ks = D1/P0 + g
= $3.00/$60.00 + 0.07
= 0.12 = 12%.
WACC = wdkd(1 - T) + wceks
= (0.6)(0.08)(1 - 0.4) + (0.4)(0.12)
= 0.0768 = 7.68%.
31. WACC and dividend growth rate
Solve for ks: 32. Diff: M Answer: e Diff: M WACC = 11.5% = w dkd(1 - T) + wceks
11.5% = 0.45(0.09)(0.70) + 0.55k s
k s = 15.75%. Solve for g: Answer: c 15.75% = D 1/P0 + g
15.75% = $5/$45 + g
g = 4.64%. Cost of debt
Time line: Chapter 12 - Page 17 0 kd / 2 = ? 1 2 3 4 40 6-month ├───────────┼─────┼────────┼─────────┼─── ···───────┤ Periods
PMT = 60
VB = 1,000 60 60 60 60
FV = 1,000 Since the bond sells at par of $1,000, its YTM and coupon rate (12
percent) are equal. Thus, the before-tax cost of debt to Rollins is 12
percent. The after-tax cost of debt equals:
kd,After-tax = 12.0%(1 - 0.40) = 7.2%.
Financial calculator solution:
Inputs: N = 40; PV = -1,000; PMT = 60; FV = 1,000;
Output: I = 6.0% = k d/2.
kd = 6.0% × 2 = 12%.
kd(1 - T) = 12.0%(0.6) = 7.2%.
33. Cost of preferred stock
Cost of preferred stock: 34. Answer: d Diff: E k ps = $12/$100(0.95) = 12.6%. Cost of common stock: CAPM Answer: c Diff: E Answer: c Diff: E Answer: c Diff: E Cost of common stock (CAPM approach):
ks = 10% + (5%)1.2 = 16.0%.
35. Cost of common stock: DCF
Cost of common stock (DCF approach):
$2.00(1.08)
ks =
+ 8% = 16.0%.
$27 36. Cost of common stock: Risk premium Cost of common stock (Bond yield-plus-risk-premium approach):
ks = 12.0% + 4.0% = 16.0%.
37. WACC Answer: a Diff: E WACC = wdkd(1 - T) + wpskps + wceks
= 0.2(12.0%)(0.6) + 0.2(12.6%) + 0.6(16.0%) = 13.56% ≈ 13.6%.
38. Cost of common stock
ks = 39. 40. Diff: E Answer: b Diff: E Answer: d Diff: E $2.00(1.10)
+ 0.10 = 15.5%.
$40.00 Cost of preferred stock
kps = Answer: c $10
= 12.5%.
$80 WACC Chapter 12 - Page 18 41. Cost of equity Answer: a Diff: M Calculate the retained earnings break point:
Given:
Net income = $600; Debt = 0.4; Equity = 0.6; Dividend payout = 0.6.
Break pointRE = $600(1 - 0.6)/0.6 = $400.
Allison will need new equity capital; capital budget exceeds Break
pointRE.
Use the dividend growth model to calculate k e:
ke = D0 (1 + g)
$2.20(1.06)
+g=
+ 0.06
P0 (1 − F )
$28(1 − 0.15) = 0.0979 + 0.06 = 0.1579 ≈ 15.8%.
42. WACC Answer: b Diff: M The correct answer is b, 11.22%. As there are no retained earnings,
the equity portion of the capital budget must be funded using new
common equity.
WACC = Wd(kd)(1 - T) + wce(ke)
= 0.25(0.08)(1 - 0.4) + 0.75[($2.00 x 1.06)/($32(1 - 0.1))
+ 0.06]
= 0.25(0.0480) + 0.75(0.1336)
= 0.1122 = 11.22%. Chapter 12 - Page 19 ...

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