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Principles of Finance > Chapter 10 - Cost of Capital > Flashcards

Chapter 10 - Cost of Capital Flashcards

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1
Q

What is the required return necessary to make a capital budgeting project worthwhile?

A

Cost of capital

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2
Q

What is the rate that a company is expected to pay on average to all its security holders to finance its assets?

A

Weighted Average Cost of Capital (WACC)

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3
Q

Fill in the Blank: Minimum/Maximum

The WACC represents the _______ return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital

A

Minimum

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4
Q

What is the formula to find WACC?

A

(Weight A % x weight A interest) + (Weight B % x weight B interest)

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5
Q

Solve the problem:

You borrow a total of $100,000. $40,000, with a 10% interest rate, came from your parents and $60,000, with a 15% interest rate, came from your friends. Calculate WACC

A 
WACC = (0.4 x 10%) + (0.6 x 15%)
WACC = 13%
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6
Q

What is WACC equal to?

A

YTM

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7
Q

How do you calculate N when it’s semi-annual?

A

of years x 2

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8
Q

How do you calculate PMT when it’s semi-annual?

A

(FV x coupon rate) / 2

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9
Q

True or False:

When you are calculating YTM using a calculator the PV value is negative

A

True

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10
Q

What is the formula to find the after-tax cost of debt?

A

YTM(1-tax rate)

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11
Q

Solve the problem:

YTM = 10%
Tax Rate = 25%

Calculate the after-tax cost of debt

A

A-T CoD = 0.1(1-0.25)

A-T CoD = 7.5%

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12
Q

When is a bond considered a par bond?

A

When bond price = face value

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13
Q

Fill in the Blank: < > =

When a bond is a par bond CR _ YTM

A

=

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14
Q

What is the rate of return investors require on the firm’s common equity using retained earnings?

A

The cost of equity

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15
Q

What is the cost of equity also known as?

A

Opportunity cost

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16
Q

What are the two models that you can use to calculate the cost of equity?

A

CAPM and the capital growth model

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17
Q

What is the formula to calculate cost of equity using CAPM?

A

Risk-free rate + beta(market risk premium)

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18
Q

What is the formula to calculate the market risk premium?

A

Market return - risk-free rate

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19
Q

What is the formula to calculate cost of equity using the capital growth model (CGM)?

A

[D(1) / P(0)] + g

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20
Q

Solve the problem:

Jarett & Sons’ common stock currently trades at $30 a share. It is expected that D(1) = $1, and the constant growth rate is 4% a year.

What is the cost of equity?

A 
CoE = (D1/P0) + g
CoE = (1/30) + 0.04
CoE = 7.33%
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21
Q

What is the formula to calculate the cost of equity when issuing new common stock?

A

[D1 / (P0 - F$)] + g

22
Q

What is the formula to calculate the flotation cost in dollar form?

A

P(0) x flotation cost %

23
Q

Solve the problem:

Jarett & Sons’ common stock currently trades at $30 a share. It is expected that D(1) = $1, and the constant growth rate is 4% a year.

If the company issued new stock, it would incur a 10% flotation cost. What would be the cost of equity from the new stock?

A 
F$ = P(0) x F%
F$ = 30 x 10%
F$ = 3
CoE = [D1 / (P0 - F$)] + g
CoE = [1 / (30 - 3)] + 0.04
CoE = 7.7%
24
Q

Solve the problem:

D0 = $4.19, P0 = $50, and g = 5%.

Calculate the cost of equity using the CGM

A 
D1 = D0 (1+g)
D1 = 4.19 (1+0.05)
D1 = 4.3995
CoE = [D1 / (P0] + g
CoE = [4.3995 / 50] + 0.05
CoE = 13.8%
25
Q

Solve the problem:

D0 = $4.19, P0 = $50, g = 5%, and F = 15%.

Calculate the cost of equity using the CGM

A 
D1 = D0 (1+g)
D1 = 4.19 (1+0.05)
D1 = 4.3995
F$ = P0 x F%
F$ = 50 x 0.15
F$ = 7.5
CoE = [D1 / (P0] + g
CoE = [4.3995 / (50- 7.5)] + 0.05
CoE = 15.35%
26
Q

Solve the problem:

B = 1.2, RFR = 6%, MR = 13%

Calculate the cost of equity using CAPM

A 
CoE = RFR + B(MRP)
CoE = 0.06 + 1.2(0.13 - 0.06)
CoE = 14.4%
27
Q

When a company issues new common stock what do they have to pay to the underwriter?

A

Flotation costs

28
Q

Why is the cost of retained earnings cheaper than the cost of issuing new common stock?

A

Flotation costs

29
Q

List 4 factors that affect a company’s WACC

A
  1. Market conditions
  2. Capital structure
  3. Dividend policy
  4. Investment policy
30
Q

Which of the 4 factors that affect a company’s WACC can the firm not control?

A

Market conditions

31
Q

List 2 examples of market conditions

A
  1. Interest rate

2. Tax rate

32
Q

Should a company use the composite WACC as the hurdle rate for each of its projects?

A

No

33
Q

Should the WACC be adjusted to reflect the project’s risk?

A

Yes

34
Q

Solve the problem:

The company has a target capital structure of 35% debt and 65% common equity. It’s before-tax cost of debt is 8%, and it’s tax rate is 25%. P(0) = 22, D(0) = 2.25, and g = 5%.

What is the company’s cost of equity?

A 
D(1) = D(0) (1+g)
D(1) = 2.25 (1.05)
D(1) = 2.3625
CoE = (D1/P0) + g
CoE = (2.3625 / 22) + 0.05
CoE = 15.74%
35
Q

True or False:

The cost of capital used in capital budgeting should reflect the average cost of the various sources of investor-supplied funds a firm uses to acquire assets

A

True

36
Q

True or False:

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt

A

True

37
Q

True or False:

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm’s common stock

A

True

38
Q

True or False:

For capital budgeting and cost of capital purposes, the firm should always consider retained earnings as the first source of capital (i.e., use these funds first) because retained earnings have no cost to the firm

A

False

39
Q

True or False:

The reason why retained earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm’s common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should pay those earnings out to its investors. Thus, the cost of retained earnings is based on the opportunity cost principle.

A

True

40
Q

True or False:

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. Since we cannot be sure that the estimate obtained with any of these methods is correct, it is often appropriate to use all three methods, then consider all three estimates, and end up using a judgmental estimate when calculating the WACC.

A

True

41
Q

True or False:

The cost of debt, rd, is normally less than rs, so rd(1 - T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 - T).

A

True

42
Q

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

a. Long-term debt.
b. Accounts payable.
c. Retained earnings.
d. Common stock.
e. Preferred stock.

A

b. Accounts payable.

43
Q

For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure.

a. rs > re > rd > WACC.
b. re > rs > WACC > rd.
c. WACC > re > rs > rd.
d. rd > re > rs > WACC.
e. WACC > rd > rs > re.

A

b. re > rs > WACC > rd.

44
Q

Which of the following statements is CORRECT?

a. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation.
b. All else equal, an increase in a company’s stock price will increase its marginal cost of retained earnings, rs.
c. All else equal, an increase in a company’s stock price will increase its marginal cost of new common equity, re.
d. Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt.
e. If a company’s tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall.

A

e. If a company’s tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall.

45
Q

Which of the following statements is CORRECT?

a. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.
b. When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.
c. Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM.
d. If a company’s beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence must issue new stock.
e. Higher flotation costs reduce investors’ expected returns, and that leads to a reduction in a company’s WACC.

A

a. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.

46
Q

Which of the following statements is CORRECT?

a. A change in a company’s target capital structure cannot affect its WACC.
b. WACC calculations should be based on the before-tax costs of all the individual capital components.
c. Flotation costs associated with issuing new common stock normally reduce the WACC.
d. If a company’s tax rate increases, then, all else equal, its weighted average cost of capital will decline.
e. An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.

A

d. If a company’s tax rate increases, then, all else equal, its weighted average cost of capital will decline.

47
Q

For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is CORRECT?

a. The interest rate used to calculate the WACC is the average after-tax cost of all the company’s outstanding debt as shown on its balance sheet.
b. The WACC is calculated on a before-tax basis.
c. The WACC exceeds the cost of equity.
d. The cost of equity is always equal to or greater than the cost of debt.
e. The cost of retained earnings typically exceeds the cost of new common stock.

A

d. The cost of equity is always equal to or greater than the cost of debt.

48
Q

Which of the following statements is CORRECT?

a. The component cost of preferred stock is expressed as rp(1 - T). This follows because preferred stock dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes.
b. A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firm’s stockholders would themselves expect to earn a return on earnings that were paid out rather than retained and reinvested.
c. No cost should be assigned to retained earnings because the firm does not have to pay anything to raise them. They are generated as cash flows by operating assets that were raised in the past, hence they are “free.”
d. Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into the foreseeable future. In this case, the firm’s before-tax and after-tax costs of debt for purposes of calculating the WACC will both be equal to the interest rate on the firm’s currently outstanding debt, provided that debt was issued during the past 5 years.
e. If a firm has enough retained earnings to fund its capital budget for the coming year, then there is no need to estimate either a cost of equity or a WACC.

A

b. A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firm’s stockholders would themselves expect to earn a return on earnings that were paid out rather than retained and reinvested.

49
Q

Which of the following statements is most correct?

a. The WACC measures the after-tax cost of capital.
b. The WACC measures the cost of capital.
c. There is no cost associated with using retained earnings.
d. Statements a and b are correct.
e. All of the statements above are correct.

A

d. Statements a and b are correct.

50
Q

Hamilton Company’s 8 percent coupon rate, quarterly payment, $1,000 par value bond, which matures in 20 years, currently sells at a price of $686.86. The company’s tax rate is 40 percent. Based on the nominal interest rate, what is the firm’s component cost of debt for purposes of calculating the WACC (Compute after the cost of debt)?

a. 3.05%
b. 7.32%
c. 7.36%
d. 12.20%
e. 12.26%

A 
N = 20 x 4 = 80
PV = -686.86
PMT = (1,000 x 0.08) / 4 = 20
FV = 1,000
I = 3.05 x 4 = 12.2
ATCoD = 12.2 (1 - 0.4)
ATCoD = 7.32%

Principles of Finance (8 decks)

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