6.2 Cost of Capital - Current Flashcards
A corporation issued $100,000, 15-year term bonds with a coupon rate of 8% at par. Interest is paid annually to bondholders. The corporation’s effective income tax rate is 35%. The corporation used the proceeds to complete the purchase of a supplier whose effective income tax rate is 20%. What is the after-tax cost of debt?
A. 8%
B. 6.4%
C. 5.2%
D. 3.6%
C. 5.2%
After tax cost of debt
= Before-tax cost of debt x (1 - Tax rate)
= 8% x (1 - 35%)
= 5.2%
The company has $150 par value preferred stock with a market price of $120 a share and pays a $15 per share annual dividend. The company’s current marginal tax rate is 40%. Looking to the future, the company anticipates maintaining its current capital structure. What is the component cost of preferred stock?
A. 6%
B. 7.5%
C. 10%
D. 12.5%
D. 12.5%
Component cost of preferred stock uses the following formula:
Dividend yield (component cost) =
cash dividend on preferred stock / market price of preferred stock
= $15/$120 = 12.5%
A firm has determined that it can minimize its weighted-average cost of capital (WACC) by using a debt-equity ratio of 2/3. If the firm’s cost of debt is 9% before taxes, the cost of equity is estimated to be 12% before taxes, and the tax rate is 40%, what is the firm’s WACC?
A. 6.48%
B. 7.92%
C. 9.36%
D. 10.80%
C. 9.36%
A firm’s WACC is derived by weighting the (after-tax) cost of each component of the financing structure by its proportion of the financing structure as a whole. The WACC can be calculated as follows:
Debt 40% x component cost 5.4% = 2.16%
Equity 60% x component cost 12.0% = 7.20%
= 9.36%
WACC = 9.36% = (3/5 x 12%) + {2/5 x [9% x (1 - 0.4)]}
A firm’s $1,000 par value preferred stock paid its $100 per share annual dividend on April 4 of the current year. The preferred stock’s current market price is $960 a share on the date of the dividend distribution. The firm’s marginal tax rate (combined federal and state) is 40%, and the firm plans to maintain its current capital structure relationship. The component cost of preferred stock to the firm would be closest to
A. 6%
B. 6.25%
C. 10%
D. 10.4%
D. 10.4%
The component cost of preferred stock is equal to the dividend yield, i.e., the cash dividend divided by the market price of the stock. (Dividends on preferred stock are not deductible for tax purposes; therefore, there is no adjustment for tax savings.) The annual dividend on preferred stock is $100 when the price of the stock is $960. This results in a cost of capital of about 10.4% ($100 ÷ $960).
A firm has announced that it plans to finance future investments so that the firm will achieve an optimum capital structure. Which one of the following corporate objectives is consistent with this announcement?
A. Maximize earnings per share.
B. Minimize the cost of debt.
C. Maximize the net worth of the firm.
D. Minimize the cost of equity.
C. Maximize the net worth of the firm.
Financial structure is the composition of the financing sources of the assets of a firm. Traditionally, the financial structure consists of current liabilities, long-term debt, retained earnings, and stock. For most firms, the optimum structure includes a combination of debt and equity. Debt is cheaper than equity, but excessive use of debt increases the firm’s risk and drives up the weighted-average cost of capital.
What is the weighted average cost of capital for a firm using 65% common equity with a return of 15%, 25% debt with a return of 6%, 10% preferred stock with a return of 10%, and a tax rate of 35%?
A. 10.333%
B. 11.275%
C. 11.725%
D. 12.250%
C. 11.725%
The cost for equity capital is given as 15%, and preferred stock is 10%. The before-tax rate for debt is given as 6%, which translates to an after-tax cost of 3.9% [6% × (1.0 – .35)]. The rates are weighted as follows:
Long-term debt: 25% x component cost 3.9% = 0.975%
Preferred stock: 10% x component cost 10% = 1%
Common stock: 65% x component cost 15% = 9.75%
= 11.725%
What is the weighted average cost of capital for a firm with equal amounts of debt and equity financing, a 15% before-tax company cost of equity capital, a 35% tax rate, and a 12% coupon rate on its debt that is selling at par value?
A. 11.40%
B. 13.50%
C. 8.775%
D. 9.60%
A. 11.40%
The 12% debt coupon rate is reduced by the 35% tax shield, resulting in a cost of debt of 7.8% [12% × (1.0 – .35)]. The average of the 15% equity capital and 7.8% debt is 11.4%.
A firm needs to raise $50,000,000 for expansion. The two available options are to sell 7%, 10-year bonds at face value or to sell 5% preferred stock at par for which annual dividends would be paid. The firm’s effective income tax rate is 30%. Which one of the following best describes the difference in the firm’s cash flow for the second year after issue?
A. Cash flow with the bond issue is $225,000 higher.
B. Cash flow with the stock issue is $700,000 higher.
C. Cash flow with the stock issue is $525,000 higher.
D. Cash flow with the bond issue is $50,000 higher.
D. Cash flow with the bond issue is $50,000 higher.
Under the bond issue option, cash flows will consist of interest payments as well as the tax shield effect of debt. Therefore, cash outflows will be $2,450,000 {$50,000,000 x [.07 x (1 - .3)]}. Under the preferred stock option, cash flows will consist of payments of dividends, with no tax shield effect. Therefore, cash outflows will be $2,500,000 ($50,000,000 x .05). Therefore, cash flow is $50,000 higher under the bond issue option.
A company’s capital structure consists entirely of long-term debt and common equity. The cost of capital for each component is shown below.
Long-term debt 8%
Common equity 15%
The company pays taxes at a rate of 40%. If the weighted-average cost of capital is 10.41%, what proportion of the company’s capital structure is in the form of long-term debt?
A. 55%
B. 45%
C. 66%
D. 34%
B. 45%
The effective rate for debt (8%) is a pre-tax rate. But the component cost of debt used to calculate the weighted-average cost of capital (WACC) is an after-tax rate. The effective rate for debt is given as 8%. The component cost of debt is the after-tax cost, or .048 [(1.0 – .40 tax rate) × .08]. The formula for the WACC is solved as follows:
(Debt weight × Cost of debt) + (Equity weight × Cost of equity) = WACC
(Debt weight × .048) + (Equity weight × .15) = .1041
[(1 – Equity weight) × .048] + (Equity weight × .15) = .1041
.048 – (.048 × Equity weight) + (Equity weight × .15) = .1041
– (.048 × Equity weight) + (Equity weight × .15) = .0561
Equity weight × .102 = .0561
Equity weight = .55
Equity is 55% of the capital structure and debt is 45%.
Short-term, unsecured promissory notes issued by large firms are known as
A. Bankers’ acceptances.
B. Repurchase agreements.
C. Commercial paper.
D. Agency securities.
C. Commercial paper.
Commercial paper is the term for the short-term (typically less than 9 months), unsecured, large denomination (often over $100,000) promissory notes issued by large, credit-worthy companies to other companies and institutional investors. In many instances, the maturity date is only a few days after issuance.
Which of the following, when considered individually, would generally have the effect of increasing a firm’s cost of capital?
I. The firm reduces its operating leverage.
II. The corporate tax rate is increased.
III. The firm pays off its only outstanding debt.
IV. The Treasury Bond yield increases
A. I, III and IV.
B. III and IV.
C. I and III.
D. II and IV.
B. III and IV.
Debt generally has a lower initial cost than equity. By removing debt from the firm’s financing structure, the cost of capital is thereby increased. Similarly, the increase in yield on Treasury bonds, a risk-free rate, would cause the yield on all other bonds to also increase.
Reducing operating leverage means reducing the amount of fixed costs used in the organization’s production process would lower the cost of capital.
Joint products, Inc., a corporation with a 40% marginal tax rate, plans to issue $1,000,000 of 8% preferred stock in exchange for $1,000,000 of its 8% bonds currently outstanding. The firm’s total liabilities and equity are equal to $10,000,000. The effect of this exchange on the firm’s weighted average cost of capital is likely to be
A. A decrease, since a portion of the debt payments are tax deductible.
B. An increase, since a portion of the debt payments are tax deductible.
C. A decrease, since preferred stock payments do not need to be made each year, whereas debt payments must be made.
D. No change, since it involves equal amounts of capital in the exchange and both instruments have the same rate.
B. An increase, since a portion of the debt payments are tax deductible.
The payment of interest on bonds is tax-deductible, whereas dividends on preferred stock must be paid out of after-tax earnings. Thus, when bonds are replaced in the capital structure with preferred stock, an increase in the cost of capital is likely because there is no longer a tax shield.
A firm has $10 million in equity and $30 million in long-term debt to finance its operations. The firm’s beta is 1.125, the risk-free rate is 6%, and the expected market return is 14%. The firm issued long-term debt at the market rate of 9%. Assume the firm is at its optimal capital structure. The firm’s effective income tax rate is 40%. What is the firm’s weighted average cost of capital?
A. 7.8%
B. 10.5%
C. 9.5%
D. 8.6%
A. 7.8%
Using the Capital Asset Pricing Model, the cost of equity is calculated as follows.
Required rate of return = Risk-free return x beta(market return - risk-free return)
= 6% + 1.125(14% - 6%)
= 15%
The firm calculates its WACC as follows:
75% debt x 9% x (1.0-.4) = 4.05%
25% equity x 15% = 3.75%
= 7.80%
A company is in the process of considering various methods of raising additional capital to grow the company. The current capital structure is 25% debt totaling $5 million with pre-tax cost of 10%, and 75% equity with a current cost of equity of 10%. The marginal income tax rate is 40%. The company’s policy is to allow a total debt to total capital ratio of up to 50% and a maximum weighted-average cost of capital (WACC) of 10%. The company has the following options:
Option 1: Issue debt of $15 million with a pre-tax cost of 10%.
Option 2: Offer shares to the public to generate $15 million. The cost of equity is 10%.
Which option should the company select?
A. Option 1 because it has the lower WACC of 7.72%.
B. Either Option 1 or 2 because both will yield a WACC of 10%.
C. Option 1 because the equity to total capital ratio will be 43%.
D. Option 2 because the equity to total capital ratio will be 86%.
D. Option 2 because the equity to total capital ratio will be 86%.
Before considering any options, the total capital is $20 million ($5 million / 25%) and equity is $15 million ($20 million total capital - $5 million debt). if the company issues $15 million in debt, the capital structure will consist of 57% debt and 43% equity, which exceeds the 50% debt to total equity limit. If the company issues $15 million in stock, the capital structure will consist of 14% debt and 86% equity with a WACC of 9.44% {[14% x 10% x (1]40%)] + [86% x 10%]}. Thus, the company should choose Option 2 because it meets all requirements.
A company has a weighted-average cost of capital of 12.8%. If the after-tax cost of debt is 8%, and the weight on debt is 20%, what is the company’s cost of equity? Assume the company has no preferred stock.
A. 11.2%
B. 26.0%
C. 14.0%
D. 18.0%
C. 14.0%
The company’s cost of equity can be calculated using the WACC formula.
WACC = Weight on equity x Cost of equity + Weight on debt x Cost of debt
12.8% = 80% x cost of equity + 20% x 8%
12.8% = 80% x cost of equity + 1.6%
11.2% - 80% x cost of equity
14% = cost of equity
In calculating the component costs of long-term funds, the appropriate cost of retained earnings, ignoring floatation costs, is equal to
A. Zero, or no cost.
B. The same as the cost of preferred stock.
C. The weighted average cost of capital for the firm.
D. The cost of common stock.
D. The cost of common stock.
Common shareholders expect retained earnings to be paid out in the form of dividends. Thus, the cost of retained earnings is an opportunity cost, i.e., the rate that investors can earn elsewhere on investments of comparable risk.
What is the weighted average cost of capital for a firm with 40% long-term debt, 20% preferred stock, and 40% common equity if the respective before-tax costs for these components are 8%, 13%, and 17%? The firm’s tax rate is 35%.
A. 12.60%
B. 11.48%
C. 10.52%
D. 10.22%
B. 11.48%
The firm calculates its WACC as follows:
Long term debt 40% x component cost 8% x (1.0 - .35) = 2.08%
Preferred stock 20% x component cost 13% = 2.60%
Common stock 40% x component cost 17% = 6.80%
= 11.48%
A firm’s target or optimal capital structure is consistent with which one of the following?
A. Minimum risk.
B. Minimum cost of debt.
C. Maximum earnings per share.
D. Minimum weighted-average cost of capital.
D. Minimum weighted-average cost of capital.
Ideally, a firm will have a capital structure that minimizes its weighted-average cost of capital. This requires a balancing of both debt and equity capital and their associated risk levels.
The weighted-average cost of capital is equal to the
A. Cost of the firm’s equity capital at which the market value of the firm will remain unchanged.
B. Minimum rate a firm must earn on high-risk projects.
C. Average rate of return a firm earns on its assets.
D. Rate of return on assets that covers the costs associated with the funds employed.
D. Rate of return on assets that covers the costs associated with the funds employed.
The weighted-average cost of capital represents the minimum rate of return at which a company produces value for its investors. Therefore, it is the return on assets that covers the company’s costs.
When calculating the cost of capital, the cost assigned to retained earnings should be
A. Higher than the cost of external common equity.
B. Lower than the cost of external common equity.
C. Zero.
D. Equal to the cost of external common equity.
B. Lower than the cost of external common equity.
Newly issued or external common equity is more costly than retained earnings. The company incurs insurance costs when raising new, outside funds.
