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%
