Reading 33: cost of capital- foundational topics

Question 1

An analyst gathered the following data about a company:

capital structure required rate of return
30% debt 10% debt
20% preferred stock 11% for preferred stock
50% common stock 18% for common stock

Assuming a 40% tax rate, what after-tax rate of return must the company earn on its investments?

13.0%.
14.2%.
18.0%.

Answer 1

WACC = (wd)(kd)(1 – t) + (wps)(kps) + (wce)(kce) = (0.3)(0.1)(1 – 0.4) + (0.2)(0.11) + (0.5)(0.18) = 13% (LOS 33.a)

Question 2

A company is planning a $50 million expansion. The expansion is to be financed by selling $20 million in new debt and $30 million in new common stock. The before-tax required return on debt is 9% and 14% for equity. If the company is in the 40% tax bracket, the company’s marginal cost of capital is closest to:
7.2%.
10.6%.
12.0%.

Answer 2

wd = 20 / (20 + 30) = 0.4, wce = 30 / (20 + 30) = 0.6 WACC = (wd)(kd)(1 – t) + (wce)(kce) = (0.4)(9)(1 – 0.4) + (0.6)(14) = 10.56% = MCC (LOS 33.a, 33.b)

Question 3

A company has $5 million in debt outstanding with a coupon rate of 12%. Currently, the yield to maturity (YTM) on these bonds is 14%. If the firm’s tax rate is 40%, what is the company’s after-tax cost of debt?
5.6%.
8.4%.
14.0%.

Answer 3

kd(1 – t) = (0.14)(1 – 0.4) = 8.4% (LOS 33.c)

Question 4

A company’s $100, 8% preferred is currently selling for $85. What is the company’s cost of preferred equity?
8.0%.
9.4%.
10.8%.

Answer 4

B kps = Dps / Pps, Dps = $100 × 8% = $8, kps = 8 / 85 = 9.4% (LOS 33.d)

Question 5

If the risk-free rate is 2% and the market rate of return is 5%, the cost of equity for a company with a beta of 0.8 is closest to:
2.4%.
4.0%.
4.4%.

Answer 5

ke = 2% + 0.8(5% – 2%) = 4.4%. (LOS 33.e)

Question 6

An analyst is estimating an equity beta for Jay Company, which has a thinly traded stock. Jay is in the same line of business as Cass Company, which trades more frequently and has a beta of 1.2. Jay’s debt-to-equity ratio is 2.0 and Cass’s debt-to-equity ratio is 1.6. Both companies have a tax rate of 30%. For Jay, the analyst should use an adjusted equity beta closest to:
0.57.
1.24.
1.36.

Answer 6

Unlevered beta for Cass = 1.2{1/1+[(1-.03)1.6]}= 0.566 Unadjusted equity beta for Jay = 0.566{1+[(1-0.3)2.0]} Adjusted equity beta for Jay = (2/3 × 1.358) + 1/3 = 1.239 (LOS 33.f)

Question 7

When the equity portion of the financing for new capital projects will be raised by issuing new equity shares, equity flotation costs should be:
used to adjust the estimated cost of equity capital.
treated as part of each project’s initial cash outflow.
disregarded because they are unlikely to be material.

Answer 7

The correct treatment of flotation costs is to treat them as part of each project’s initial cash outflow. (LOS 33.g)