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Exam 9: The Cost of Capital

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Question 51

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Which of the following statements is CORRECT?

A) WACC calculations should be based on the before-tax costs of all the individual capital components.
B) Flotation costs associated with issuing new common stock normally reduce the WACC.
C) If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline.
D) An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.
E) A change in a company's target capital structure cannot affect its WACC.

F) C) and D)
G) B) and E)

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Question 52

Multiple Choice

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Which of the following statements is CORRECT?

A) When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.
B) Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM.
C) If a company's beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough reinvested earnings to take care of its equity financing and hence must issue new stock.
D) Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC.
E) When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.

F) B) and C)
G) A) and D)

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Question 53

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The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant.

Collins Group The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below. The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%. -Refer to the data for the Collins Group. Based on the CAPM, what is the firm's cost of common stock?

When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of r_s.

If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the required rate of return on equity, r_s, than on the interest rate on long-term debt, r_d, for most firms. Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity. However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit the shift toward debt.

The cost of external equity capital raised by issuing new common stock (r_e) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (r_s), divided by one minus the percentage flotation cost required to sell the new stock, (1 − F)."

You are a finance intern at Chambers and Sons and they have asked you to help estimate the company's cost of common equity. You obtained the following data: D₁ = $1.25; P₀ = $27.50; g_L = 5.00% (constant) ; and F = 6.00%. What is the cost of equity raised by selling new common stock?

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the dividend growth method, and the bond-yield-plus-risk-premium method. Since we cannot be sure that the estimate obtained with any of these methods is correct, it is often appropriate to use all three methods, then consider all three estimates, and end up using a judgmental estimate when calculating the WACC.

Kenny Electric Company's noncallable bonds were issued several years ago and now have 20 years to maturity. These bonds have a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000. If the firm's tax rate is 40%, what is the component cost of debt for use in the WACC calculation?

If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the dividend growth model, and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method. All this makes it especially difficult to estimate the cost of equity for a private company.

To help estimate its cost of common equity, Maxwell and Associates recently hired you. You have obtained the following data: D₀ = $0.90; P₀ = $27.50; and g_L = 7.00% (constant) . Based on the dividend growth model, what is the cost of common from reinvested earnings?