Ch.14 Cost of Capital

Question 1

The return to an investor is the same as _________

Answer 1

the cost to the company

Question 2

Cost of capital provides us with an indication of __________________

Answer 2

how the market views the risk of the assets

Question 3

Knowing the cost of capital can also help determine the ________________________________________

Answer 3

required return for capital budgeting projects

Question 4

T or F
Required Rate or return = cost of capital

Answer 4

true

Question 5

What is the cost of equity?

Answer 5

the return required by equity investors given the risk of the cash flows from the firm

Question 6

Equity investors receive cashflow from the firm in two forms

Answer 6

Dividends (periodic)
Selling shares (Terminal)

Question 7

There are two major methods for determining the cost of equity

Answer 7

Dividend growth model (DGM)
SML or CAPM

Question 8

What is the condition for the dividend growth model approach

Answer 8

dividend is expected to grow at a stable rate for the foreseeable future; cost of capital > growth of dividend

Question 9

Suppose ABC Co is expected to pay a dividend of $1.50 per share next year. There has been a steady growth in dividends of 5.1% per year and the market expects that to continue. The current price is $25. What is its cost of equity?

Answer 9

11.1%

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Question 10

Example: XYZ Co is has a ROE of 15% and their payout ratio is 35%. If management is not planning on raising additional external capital, what is XYZ’s growth rate?

Answer 10

g = (1-0.35) x 0.15 = 9.75%

Question 11

What are the pros and cons of dividend growth model

Answer 11

Advantage – easy to understand and use

Disadvantages
- Only applicable to companies currently paying dividends
- Not applicable if dividends aren’t growing at a reasonably constant rate
- Extremely sensitive to the estimated growth rate – an increase in g of 1% increases the cost of equity by 1%
- Does not explicitly consider risk

Question 12

ABC Co has a beta of 0.58 and the current risk-free rate is 6.1%. If the expected market risk premium is 8.6%, what is its cost of equity capital?

Answer 12

RE = 6.1 + 0.58(8.6) = 11.1%

Question 13

If the estimate of cost of equity derived from two models diverged a lot:

Answer 13

Use an average of the two rates
Use cost of equity estimate using SML

Question 14

Pros and cons of SML

Answer 14

pros:
- Explicitly adjusts for systematic risk
- Applicable to all companies, as long as we can compute beta

Cons:
- Have to estimate the expected market risk premium, which does vary over time
- Have to estimate beta, which also varies over time
- We are relying on the past to predict the future, which is not always reliable

Question 15

Suppose our company has a beta of 1.5. The market risk premium is expected to be 9% and the current risk-free rate is 6%. We have used analysts’ estimates to determine that the market believes our dividends will grow at 6% per year and our last dividend was $2. Our stock is currently selling for $12.65. What is our cost of equity?

Answer 15

Using SML: RE = 6% + 1.5*9% = 19.5%

Using DGM: RE = (2*1.06 / 12.65) + 0.06 = 22.76%

Question 16

A firm is considering a project that is virtually risk-free. The company has a beta of 1.3 and a debt-equity ratio of.4. The appropriate discount rate to use in analyzing this project is:
- the cost of equity capital
- the firm’s latest WACC
- An adjusted WACC based on a beta 1.0
- Zero
-

Answer 16

The treasury bill rate

Question 17

The outstanding bonds of Frank’s Recycled Goods are priced at $987 and mature in 11 years. These bonds have a 6.5% coupon and pay interest annually. The firm’s tax rate is 34%. What is Frank’s after-tax cost of debt?
- 4.40%
- 2.43%
- 6.68%
- 2.27%
- 5.48%

Answer 17

4.40%

Question 18

Asalanka Homes has a beta of 1.1. The market risk premium is 6% and the risk-free rate of return is 2.5%. By how much will the cost of equity increase if the company completes an acquisition such that their company beta rises to 1.24?
- 1.25%
- 0.56%
- 0.14%
- 1.02%
- 0.84%

Answer 18

0.84%

Question 19

Rosie’s Grill has a beta of 1.2, a stock price of $26 and an expected annual dividend of $1.30 a share, which is to be paid next month. The dividend growth rate is 4%. The market has a 10% rate of return and a risk premium of 6%. What is the average expected cost of equity for Rosie’s Grill?
11,40%
10.3%
10.1%
9.2%
9.7%

Answer 19

10.1%

Question 20

Murtagh Co. is operating at its target capital structure with market values of $110 million in equity and $175 million in debt outstanding. Murtagh Co. plans to finance a new $32 million project using the same relative weights of debt and equity. Ignoring flotation costs, how much new debt must be issued to fund the project?
17.22 million
12.45 million
19.65 million
13.76 million
15 million

Answer 20

19.65 million

Question 21

Given the following information, what is the value of Tyler Corporation?

Common Stock: 2.2 million shares outstanding, price = $35 per share
Bond Issue 1: $50 million total face value, price = 102% of face value
Bond Issue 2: $17.5 million total face value, price = 82% of face value
97.25 million
107.93 million
142.35 million
144.5 million
138.65 million

Answer 21

142.35 million

Question 22

Blue Ribbon, Inc. wants to have a weighted average cost of capital of 10%. The firm has an after-tax cost of debt of 4% and a cost of equity of 12%. What debt-equity ratio is needed for the firm to achieve their targeted weighted average cost of capital?
.33
.25
.50
.75
.67

Answer 22

.33

Question 23

Divisions, where the company is involved in different lines of business, also require separate discount rates because they have different levels of risk

t or f

Answer 23

t

Question 24

A firm with a IRR of 16%, WACC of 15%, and a RE of 17% should be

Answer 24

rejected
so, if it’s accepted it’s a incorrect acceptance

Question 25

A firm with a IRR of 14%, WACC of 15%, and a RE of 12% should be

Answer 25

Accepted
so, if it’s rejected it’s a incorrect rejection