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Which of the following statements is correct about using the capital asset pricing model (CAPM) to determine a firm's component costs of capital?
The capital asset pricing model (CAPM) assumes investors are well diversified, whereas the discounted cash flow (DCF) approach assumes the firm grows at a constant growth rate.
Each approach that is used to estimate the cost of common equity could provide a different estimate because each approach is based on different assumptions. The CAPM assumes investors are well diversified, whereas the constant growth model assumes the firm's dividends and earnings will grow at a constant rate far into the future. See 11-1: Component Costs of Capital
J. Ross and Sons Inc. has a target capital structure that calls for 40 percent debt, 10 percent preferred stock, and 50 percent common equity. Ross' common stock currently sells for $40 per share. The firm recently paid a dividend equal to $2 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year. If it issues new common stock, the firm will incur flotation costs equal to 7 percent. What is the firm's cost of retained earnings?
15.50%
Cost of retained earnings = (Dividend expected to be paid at the end of year 1/Current market price of stock) + Growth rate = {[$2 × (1 + 10%)]/$40.00} + 10% = ($2.20/$40) + 10% = 15.50% See 11-1: Component Costs of Capital
The marginal cost of capital (MCC) schedule generally rises, which implies that the weighted average cost of capital _____.
generally increases because the firm incurs higher flotation costs and higher financial risk as it raises more funds through new debt and new equity issues
As a company raises larger and larger amounts of funds during a given time period, the costs of those funds begin to rise, and as this occurs, the weighted average cost of capital (WACC) of each new dollar also rises. Thus, companies cannot raise unlimited amounts of capital at a constant cost. At some point, the cost of each new dollar will increase, no matter what its source—debt, preferred stock, or common equity. See 11-2: Weighted Average Cost of Capital (WACC)
Following is information about Seasonal Products (SP) Corporation. The company has no preferred stock.
Type of Proportion of Type of Capital After-Tax Cost Capital Capital Structure
Debt, rdT 6.5% Debt 40.0%
Common equity Equity 60.0
Retained earnings, rs 12.0
New issue, re 15.0
The firm expects to retain $300,000 in earnings this year to invest in capital budgeting projects. If the SP's capital budget is expected to equal $550,000, what required rate of return, or marginal cost of capital, should be used when evaluating capital budgeting projects?
Following is information about Sleek Pleats (SP) Corporation. The company has no preferred stock.
Type of Proportion of the
Type of Capital After-Tax Cost Capital Capital Structure
Debt, rdT 7.0% Debt 30.0%
Common equity Equity 70.0
Retained earnings, rs 14.0
New issue, re 16.0
The firm expects to retain $210,000 in earnings this year to invest in capital budgeting projects. If the SP's capital budget is expected to equal $290,000, what required rate of return, or marginal cost of capital, should be used when evaluating capital budgeting projects?
11.9%
The marginal cost of capital (MCC) for this firm is the weighted average of the after-tax cost of debt and the cost of common equity. Either the cost of retained earnings, rs, or the cost of new common equity, re, but not both, is used in the computation of the weighted average cost of capital. To determine which cost of equity should be used to compute the MCC, we can compute the break point for retained earnings and compare it to the total funds needed to fund capital budgeting projects. Retained earnings break point = Retained earnings/Proportion of common equity in the capital structure = $210,000/0.70 = $300,000. As a result, the firm can raise $300,000 in total funds before it must issue new common stock to satisfy its capital budgeting needs. Because SP's capital budget is $290,000, the firm will have enough retained earnings to satisfy the equity portion of the total funding, which means no new equity must be issued to raise the funds that are needed to purchase acceptable capital budgeting projects. That is, the equity portion of the total funding is $203,000 = $290,000(0.7), which is less than the $210,000 SP expects to generate in retained earnings this year. As a result, SP's marginal cost of capital at $290,000 is: MCC = 0.3(7%) + 0.7(14%) = 2.1% + 9.8% = 11.9%. See 11-2: Weighted Average Cost of Capital (WACC)
The before-tax cost of debt, rd, is the same as the _____.
yield to maturity (YTM) associated with the firm's bonds
The yield to maturity (YTM) on a bond is the average rate of return that investors require to provide funds to the firm in the form of debt. This yield is a cost to the firm for using investors' funds. See 11-1: Component Costs of Capital
The average rate of return that investors require to provide funds to the firm in the form of debt is the ________.
average yield to maturity (YTM) on the firm's bonds
The yield to maturity (YTM) is equal to the average rate of return that investors require to provide funds to the firm in the form of debt. See 11-1: Component Costs of Capital
Tangerine Inc.'s target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon rate, semiannual interest payments, a current maturity of 20 years, and a market value equal to their par value of $1,000. The firm's marginal tax rate is 40 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to determine its cost of retained earnings. What is Tangerine's component cost of retained earnings?
16.0%
Cost of retained earnings per bond-yield-plus-risk-premium approach = Bond yield to maturity (YTM) + Risk premium = 12% + 4% = 16% See 11-1: Component Costs of Capital
Omega Inc. expects its net income to be $525,000 this year. The firm's dividend payout ratio is 60 percent. The firm is financed with 30 percent debt, and it has no preferred stock outstanding. What is the retained earnings break point for Omega Inc.?
Which of the following mathematical expressions is used to calculate the after-tax cost of debt, rdT?
rdT = Bondholders' required rate of return (YTM) – Tax savings
The after-tax component cost of debt is equal to the bondholders' required rate of return minus tax savings the interest payment (expense) provides. See 11-1: Component Costs of Capital
Marvelous Manufacturing (MM) generated the following information for its capital budgeting manager:
Capital Structure
Project Cost IRR Type of Capital Proportion
W $65,000 15% Debt 30%
X 70,000 13 Common equity 70
Y 75,000 12
Z 70,000 11
MM's weighted average cost of capital (WACC) is 12 percent if the firm does not have to issue new common equity; if new common equity is needed, its WACC is 16 percent. If MM expects to generate $70,000 in retained earnings this year, which project(s) should be purchased? Assume that the projects are independent and indivisible.
According to the bond-yield-plus-risk-premium approach, a firm's cost of retained earnings, rs, can be estimated by adding a risk premium of 3 to 5 percentage points to its _____.
before-tax interest cost of debt, rs
Empirical work suggests that the cost of retained earnings, rs, can also be estimated by adding a risk premium of 3 to 5 percentage points to the before-tax interest rate on the firm's own long-term debt, rd. See 11-1: Component Costs of Capital
The target capital structure of a firm is the capital structure that _____.
maximizes the price of the firm's stock
Each firm has an optimal capital structure—a mix of debt, preferred stock, and common equity—that causes its stock price to be maximized. Therefore, a rational, value-maximizing firm will establish a target (optimal) capital structure and then raise new capital in a manner that will keep the actual capital structure on target over time. See 11-2: Weighted Average Cost of Capital (WACC)
Marigold Inc.'s common stock currently sells for $40 per share, but the firm will net only $34 per share if it issues new common stock. The firm recently paid a dividend equal to $2 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year. What is Marigold's cost of new common equity?
16.47%
Cost of newly issued common stock = [Dividend expected at the end of year 1/Net funds received from issue] + Growth rate = {[$2.00 × (1 + 0.10)]/$34} + 0.10 = 0.1647 = 16.47 % See 11-1: Component Costs of Capital
Coral Inc.'s preferred stock currently sells for $90 a share and pays a dividend of $10 per share. However, the firm will net only $80 per share if it issues new preferred stock. What is Coral's cost of preferred stock? Coral's marginal tax rate is 35 percent.
12.50%
Cost of newly issued preferred stock = Preferred dividend/Net funds raised from the issue of preferred stock = $10/$80 = 12.50% See 11-1: Component Costs of Capital
SW Inc.'s preferred stock, which pays a $5.25 dividend each year, currently sells for $62.50. The company's marginal tax rate is 40 percent. When it issues preferred stock, SW normally incurs flotation costs equal to 8 percent. What is the cost of preferred stock, rps, that should be included in the computation of the SW Inc.'s weighted average cost of capital (WACC)?
9.13%
Component cost of preferred stock = Preferred stock dividend/[Current market price of the preferred stock × (1 – Percentage cost of issue of preferred stock)] = $5.25/[$62.50 × (1 – 0.08)] = $5.25/$57.50 = 0.0913 = 9.13% See 11-1: Component Costs of Capital
Under normal circumstances, the weighted average cost of capital (WACC) is used as the firm's required rate of return because _____.
as long as the firm's investments earn returns greater than its WACC, the value of the firm will not decrease
WACC represents the minimum rate of return the firm must earn on its investments (assets) to maintain its current value. Each firm has an optimal capital structure—a mix of debt, preferred stock, and common equity—that causes its stock price to be maximized. The cost of capital used in capital budgeting should be calculated as a weighted average, or combination, of the various types of funds generally used, regardless of the specific financing used to fund a particular project. See 11-1: Component Costs of Capital
The Jackson Company just paid a dividend equal to $3.00 per share on its common stock, and it expects this dividend to grow by 7 percent per year indefinitely. The firm has a beta coefficient equal to 1.50, the risk-free rate is 10 percent, and the expected return on the market is 14 percent. According to the capital asset pricing model, what is Jackson's cost of retained earnings, rs?
16%
Required rate of return as per capital asset pricing model (CAPM) approach = Risk-free rate + (Market return – Risk-free rate) × Beta coefficient = 10% + [(14% – 10%) × 1.50] = 10% + 6% = 16% See 11-1: Component Costs of Capital
The rates of return, or costs, that a firm must pay to raise funds to invest in capital budgeting projects are determined by the _____.
investors who purchase the firm's stocks and bonds in the financial markets
The rates of return, or costs, that a firm must pay to raise funds to invest in capital budgeting projects are determined by the investors who purchase the firm's stocks and bonds. Investors require minimum rates of return to provide funds to the firm. See 11-4: WACC versus Required Rate of Return of Investors
A firm should continue to invest in capital budgeting projects until its marginal cost of capital is equal to the _____.
marginal return (internal rate of return, IRR) generated by the last project purchased
A firm should continue to invest in capital budgeting projects until its marginal cost of capital is equal to the marginal return (internal rate of return, IRR) generated by the last project purchased. See 11-3: Combining the MCC and Investment Opportunity Schedules (IOS)
Everything else equal, an asset's value is _____.
Beige Inc. plans to issue preferred stock that pays a dividend equal to $11.52 per share and sells for $120 per share to raise funds to support future growth. It will cost 4 percent, or $4.80 per share, to issue the new preferred stock, which means that Beige will net $115.20 per share. What is the cost of preferred stock Beige should use when computing its weighted average cost of capital (WACC)?
10.0%
Beige's cost of preferred stock = Preference dividend/(Current market price – Flotation costs) = $11.52/($120.00 – $4.80) = $11.52/$115.20 = 0.10 = 10.0% See 11-1: Component Costs of Capital
Luxury Production Materials (LPM) generated the following information for its capital budgeting manager:
Capital Structure
Project Cost IRR Type of Capital Proportion
D $70,000 18.0% Debt 60.0%
E 65,000 15.0 Common equity 40.0
F 75,000 14.0
G 72,000 12.0
LPM’s weighted average cost of capital (WACC) is 13 percent if the firm does not have to issue new common equity; if new common equity is needed, its WACC is 16 percent. If LPM expects to generate $80,000 in retained earnings this year, which project(s) should be purchased? Assume that the projects are independent and indivisible.
The _____ on a bond is the cost to the firm for using bondholders' funds.
yield to maturity (YTM)
The yield to maturity (YTM) of the bond is a cost to the firm for using investors' funds. See 11-1: Component Costs of Capital
Which of the following statements concerning the effect of taxes on a firm's cost of capital is correct?
All else equal, an increase in the corporate tax rate will result in a decrease in the firm's weighted average cost of capital.
The after-tax cost of debt equals the before-tax interest rate (yield) on debt less the tax savings that results from the tax deductibility of interest. To determine the after-tax cost of debt, an adjustment must be made to the before-tax cost of debt to account for tax savings associated with tax payments. An increase in the corporate tax rate results in a decrease in the weighted average cost of capital. See 11-1: Component Costs of Capital
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