33 - Cost of Capital

Question 1

Which of the following is least likely to be useful to an analyst who is estimating the pretax cost of a firm’s fixed-rate debt?

Answer 1

Ideally, an analyst would use the YTM of a firm’s existing debt as the pretax cost of new debt. When a firm’s debt is not publicly traded, however, a market YTM may not be available. In this case, an analyst may use the yield curve for debt with the same rating and maturity to estimate the market YTM. If the anticipated debt has unique characteristics that affect YTM, these characteristics should be accounted for when estimating the pretax cost of debt. The cost of debt is the market interest rate (YTM) on new (marginal) debt, not the coupon rate on the firm’s existing debt. If you are provided with both coupon and YTM on the exam, you should use the YTM.

Question 2

The cost of preferred stock is most appropriately estimated as the preferred dividend divided by the preferred stock’s:

Answer 2

The cost of preferred stock, kps, is Dps / price.

Question 3

The most accurate way to account for flotation costs when issuing new equity to finance a project is to:

Answer 3

Adjusting the cost of equity for flotation costs is incorrect because doing so entails adjusting the present value of cash flows by a fixed percentage over the life of the project. In reality, flotation costs are a cash outflow that occurs at the initiation of a project. Therefore, the correct way to account for flotation costs is to adjust the cash flows in the computation of project NPV, not the cost of equity. The dollar amount of the flotation cost should be considered an additional cash outflow at initiation of the project.

(Module 33.2, LOS 33.g)