6.3 Cost of Capital - New

Question 1

The FLF Corporation is preparing to evaluate capital expenditure proposals for the coming year. Because the firm employs discounted cash flow methods, the cost of capital for the firm must be estimated. The following information for FLF Corporation is provided:
* The market price of common stock is $60 per share.
* The dividend next year is expected to be $3 per share.
* Expected growth in dividends is a constant 10%.
* New bonds can be issued at face value with a 10% coupon rate.
* The current capital structure of 40% long-term debt and 60% equity is considered to be optimal.
* Anticipated earnings to be retained in the coming year are $3 million.
* The firm has a 40% marginal tax rate.

The after-tax cost to FLF Corporation of the new bond issue is

A. 4%
B. 10%
C. 6%
D. 14%

Answer 1

C. 6%

Because the bonds are issued at their face value, the pretax effective rate is 10%. However, interest is deductible for tax purposes, so the government absorbs 40% of the cost, leaving 6% after-tax cost.

Question 2

`Williams, Inc., is interested in measuring its overall cost of capital and has gathered the following data. Under the terms described as follows, the company can sell unlimited amounts of all instruments.
* Williams can raise cash by selling $1,000, 8%, 20-year bonds with annual interest payments. In selling the issue, an average premium of $30 per bond would be received, and the firm must pay flotation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8%.
* Williams can sell 8% preferred stock with a par value of $100 for $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share.
* Williams’ common stock is currently selling for $100 per share. The firm expects to pay cash dividends of $7 per share next year, and the dividends are expected to remain constant. The stock will have to be underpriced by $3 per share, and flotation costs are expected to amount to $5 per share.
* Williams expects to have available $100,000 of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing.
* Williams’ preferred capital structure is
- Long-term debt 30%
- Preferred stock 20%
- Common stock 50%

The cost of funds from retained earnings for Williams, Inc, is

A. 7.6%
B. 8.1%
C. 7.4%
D. 7.0%

Answer 2

D. 7.0%

Because retained earning is internally generated (that is, no issue costs are involved), its cost is simply the component cost of common stock, i.e., the next dividend divided by the market price ($7 / $100 = 7.0%)

Question 3

A firm has sold 1,000 shares of $100 par, 8% preferred stock at an issue price of $92 per share. Stock issue costs were $5 per share. The firm pays taxes at the rate of 40%. What is the firm’s cost of preferred stock capital?

A. 8.00%
B. 8.70%
C. 8.25%
D. 9.20%

Answer 3

D. 9.20%

Because the dividends on preferred stock are not deductible for tax purposes, the effect of income taxes is ignored. Thus, the relevant calculation is to divide the $8 annual dividend by the quantity of funds received from the issuance. In this case, the funds received equal $87 ($92 proceeds - $5 issue costs). Thus, the cost of capital is 9.2% ($8 / $87).