Question 1

Zappin' Skeeters Corporation needs to know its cost of retained earnings. Based on the following information, compute the cost of retained earnings: The stock sells for $25, flotation costs are $3 and the firm is in the 35% tax bracket.

Accepted Answer

The cost of retained earnings can be calculated using the following formula:
Cost of Retained Earnings = (Dividend Growth/(Market Price - Flotation Cost)) + Growth Rate

Dividend Growth = $0 (since retained earnings are not paid out as dividends)
Market Price = $25
Flotation Cost = $3
Growth Rate = Unknown
Therefore, we need to find the growth rate to calculate the cost of retained earnings.

We can use the Gordon growth model to find the growth rate:
Cost of Equity = (Dividend Expected Next Year / Market Price) + Growth Rate
Dividend Expected Next Year = Dividend Payout Ratio x Earnings Per Share = 0 x EPS (since earnings are retained)
Cost of Equity = (0/EPS) + Growth Rate
Cost of Equity = Growth Rate

Assuming a sustainable growth rate of 5% (based on industry averages), we can calculate the cost of retained earnings as follows:

Cost of Retained Earnings = (0.05/(25-3)) + 0.05
Cost of Retained Earnings = 0.01256 or 12.56%

Therefore the best choice is C) 12.56%.

Question 2

California Best (CB), a sport shoe store, expects an operating income of $2.3 million this year. CB has no long-term debt. The firm is considering as expansion project. The current risk-free rate of return is 7% and the current market risk premium is 8.3%. If CB's beta is 20% greater than the overall market, what is the firm's cost of capital? Assume that CB has a marginal tax rate of 40%.

Accepted Answer

Solution: k_a = k_e= 7% + 1.2(8.3%) = 16.96%

Question 3

Sharp's current capital structure of 60 percent equity, 35 percent debt, and 5 percent preferred stock is considered optimal. This year Sharp expects to have earnings after tax of $3.6 million and to pay out $600,000 in dividends. Sharp can also raise up to $2 million in long-term debt at a pretax interest rate of 10.6 percent (all debt over $2 million will cost 11.4% pretax), and sell preferred stock at a cost of 11.5 percent. Sharp's marginal tax rate is 40 percent. The current value of Sharp's common stock is $36 and a dividend of $2.15 is expected to be paid during the coming year. Dividends have been growing at an annual compound rate of 8 percent a year and are expected to continue growing at that rate. New shares can be sold to net the firm $34.50. Sharp has an opportunity to invest in the following capital projects. Which one(s) should be accepted?

Accepted Answer

Solution: Equity break point = $3,000,000/0.6 = $5,000,000 Debt break point = $2,000,000/0.35 = $5,714,286 k_e = $2.15/$36 + 0.08 = 0.140 k_i= 0.106(1 - 0.4) = 0.0636 k'_e = $2.15/$34.50 + 0.08 = 0.142 k_a1 = 0.6(0.140) + 0.35(0.0636) + 0.05(0.115) = 0.112 k_a2 = 0.6(0.142) + 0.35(0.0636) + 0.05(0.115) = 0.113 k_a3 = 0.6(.142) + 0.35(0.114)(0.6) + 0.05(0.115) = 0.115 IRR₁ = $3,000,000/$552,893 = 5.426 or 13% IRR₂ = $2,500,000/$693,481 = 3.605 or 12% IRR₃ = $2,000,000/$345,220 = 5.793 or 11.4% (by calculator)

Question 4

Sadaplast has a target capital structure of 65% common equity, 30% debt, and 5% preferred stock. The cost of retained earnings is 14% and the cost of new equity is 15.5%. Sadaplast expects to have a net income of $85 million in the coming year. If the firm sells bonds, up to $25 million can be sold at par value to yield an after-tax cost of 5.4%. An additional $20 million of debentures could be sold to yield an after-tax cost of 7.0%. The after-tax cost of preferred stock financing is estimated to be 11%. Sadaplast has a dividend payout ratio of 25%. What is Sadaplast's cost of capital between the first and second break points?

Accepted Answer

Solution: RE = .75($85 million) = $63.75 million BP_e= $63.75 million / 0.65 = $98.077 million BP_d = $25 million / 0.30 = $83.333 million BP_d' = $45 million / .30 = $150 million k_a= 0.65(0.14) + 0.30(0.07) + 0.05(0.11) = 0.1175 or 11.75%

Question 5

The cost of debt must account for all of the following inputs EXCEPT:

Accepted Answer

The answer of The cost of debt must account for...

Question 6

There are two primary ways that capital is raised. Which of the following statements is/are correct?
I. Capital is raised internally by using retained earnings.
II. Capital is raised externally by selling fixed assets.

Accepted Answer

Capital can be raised internally by using retained earnings, which is the profits that are not distributed to shareholders as dividends but kept within the company for reinvestment. However, selling fixed assets is a way to generate cash flow, but it is not a method to raise capital as it does not increase the equity or ownership of the company. Therefore, statement II is incorrect.

Question 7

Far Out Tech (FOT) has a debt ratio of 0.3 and it considers this to be its optimal capital structure. FOT has no preferred stock. FOT has analyzed four capital projects for the coming year as follows: 
FOT expects to earn $2.7 million after tax next year and pay out $700,000 in dividends. Dividends are expected to be $1.05 a share during the coming year and are expected to grow at a constant rate of 10 percent a year for the foreseeable future. The current market price of FOT stock is $22 and up to $2 million in new equity can be raised for a flotation cost of 10 percent. If more than $2 million is sold then the flotation cost will be 15 percent. Up to $2 million in debt can be sold at par with a coupon rate of 10 percent. Any debt over $2 million will carry a 12 percent coupon rate and be sold at par. If FOT has a marginal tax rate of 40 percent, in which projects should it invest?

Accepted Answer

Solution: Break point for common equity = $2,000,000/0.7 = $2,857,143 Second equity break point = $4,000,000/0.7 = $5,714,286 Debt break point = $2,000,000/0.3 = $6,666,667 k_e = $1.05/$22 + 0.10 = 0.148 k'_e1 = $1.05/$19.80 + 0.10 = 0.153 k'_e2 = $1.05/$18.70 + 0.10 = 0.156 k_a1 = 0.7(0.148) + 0.3(0.10)0.6 = 0.122 k_a2 = 0.7(0.153) + 0.3(0.10)0.6 = 0.125 k_a3 = 0.7(0.156) + 0.3(0.10)0.6 = 0.127 k_a4 = 0.7(0.156) + 0.3(0.12)0.6 = 0.131

Question 8

Wright Express(WE) has a capital structure of 30% debt and 70% equity. WE is considering a project that requires an investment of $2.6 million. To finance this project, WE plans to issue 10-year bonds with a coupon interest rate of 12%. Each of these bonds has a $1,000 face value and will be sold to net WE $980. If the current risk-free rate is 7% and the expected market return is 14.5%, what is the weighted cost of capital for WE? Assume WE has a beta of 1.20 and a marginal tax rate of 40%.

Accepted Answer

Solution: try 12%: $120(5.650) + $10000(.322) = $1,000 try 13%: $120(5.426) + $1000(0.295) = $946.12 11ea10f6_a157_daac_b6b3_11ed067ff555_TB2040_00 k_e = 7% + $1.20(14.5% - 7%) = 16% k_a= 0.3(12.4%)(1 - 0.4) + 0.7(16%) = 13.4%

Question 9

Investors can form earnings growth expectations from various sources, including

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The answer of Investors can form earnings growth expectations from...

Question 10

Haulsee Inc. pays no dividend currently but is expected to start paying a small dividend next year. The 5-year old firm has a beta of 1.25 and current earnings of $0.90 per share. The current Treasury bill rate is 6.10% and the market risk premium is 8.8%. Determine Haulsee's cost of equity if the firm's tax rate is 40%.

Accepted Answer

Solution: k_e = 6.10 + 1.25(8.8) = 17.1%

Question 11

Bay State Technology has determined that its cost of equity is 15% and its after-tax cost of debt is 7.2%. Bay State expects to earn $14 million after taxes next year and, as a new firm, does not pay any dividends. The stock sells for $24. Bonds are currently selling at par value. Compute Bay State's weighted cost of capital. A partial balance sheet is shown below:

Accepted Answer

11ea10f6_a158_28ce_b6b3_b396a6c620c4_TB2040_00 Capital structure: Debt = $1/$3.4 = 29.41% Equity=2.4/3.4 = 70.59% k_a = 0.2941(7.2%) + 0.7059(15.0%) = 12.71%

Question 12

What is the weighted average cost of capital for Mud Bug Corporation?

Accepted Answer

The answer of What is the weighted average cost of...

Question 13

Columbia Gas Company's(CG) current capital structure is 35% debt and 65% equity. This year CG has earnings after tax of $5.31 million and is paying $1.6 million in dividends. To finance a transmission pipe line, CG can borrow $2 million at a cost of 10%, the same rate that CG is currently paying on a total of $15 million long-term debt. CG has 1,000,000 shares outstanding and its current market price is $31. If CG's long-term growth rate of dividends is expected to be 8%, what is the weighted cost of capital for the firm? Assume a marginal tax rate of 40%.

Accepted Answer

Solution: k_d = 10%(1 - 0.4) = 6% k_e = $1.6(1.08)/$31 + 0.08 = .136 or 13.6% k_a= 0.35(6%) + 0.65(13.6%) = 10.9%

Question 14

American Dental Laser is selling a 10 year $1,000 face value bond with a 8% coupon rate. Interest is paid annually. The price to the public is $820 and the issue costs per bond are $10 each. Compute the pretax cost of debt for these bonds.

Accepted Answer

Solution: $810 = $80(PVIFA_kd,10) + $1000(PVIF_kd,10) try 11%: $80(5.889) + $1000(0.352) = $823.12 try 12%: $80(5.650) + $1000(0.322) = $774.00 kd =11% +($13.12/$13.12 + $36)(12% - 11%) = 11.3%

Question 15

Mahlo is planing to diversify into the bakery industry. As a result, its beta should drop from 1.4 to 1.2 and the expected long-term growth rate of dividends will drop from 12% to 9%. The risk-free rate is 4%, the expected market risk premium is 9%, and the current dividend per share paid by Mahlo is $2.10. Should Mahlo complete the diversification into the bakery industry?

Accepted Answer

Solution: Current k? = 0.04 + 1.4(0.09) = 0.166 or 16.6% P₀ = $2.10(1.12) / (0.166 - 0.12) = $51.13 New k_e = 0.04 + 1.2(0.09) = 0.148 or 14.8% New P₀ = $2.10(1.09) / (0.148 - 0.09) = $39.47

Question 16

Whipple Industries, Inc. is in the process of determining its optimal capital budget for next year. The following investment projects are under consideration: 
The firm's marginal cost of capital schedule is as follows:

Determine Whipple's optimal capital budget (in dollars) for the coming year.

Accepted Answer

Solution:
 11ea10f6_a157_b399_b6b3_1b296171fb9a_TB2040_00 Optimal Capital budget: $11 million (Projects A,B,C.D,E)

Question 17

Mid-States Utility Company just issued at $3.20 cumulative preferred stock at a price to the public of $30 a share. The flotation costs were $1.50 a share and the issue will be retired in 20 years at its $30 par value. What is the cost of this preferred issue?

Accepted Answer

11ea10f6_a157_b39a_b6b3_21be7420efb2_TB2040_00 11ea10f6_a157_daab_b6b3_7dc2c0a34db7_TB2040_00

Question 18

Which of the following statements regarding the cost of capital is/are correct? I. The weighted cost of capital is the discount rate used when computing the net present value.
II) The after-tax cost of capital is weighted by the proportions of the capital components in the firm's long-range target capital structure.

Accepted Answer

I is correct as the weighted cost of capital is commonly used as the discount rate when computing the NPV of a project. 
II is also correct as the after-tax cost of capital for each capital component is weighted by the proportions they make up in the firm's long-range capital structure. Therefore, both statements are correct.

Question 19

Heleveton Industries is 100% equity financed. Its current beta is 1.1. The expected market risk premium is 8.5% and the risk-free rate is 4.2%. If Heleveton changes its capital structure to 25% debt, it estimates its beta will increase to 1.2. If the after-tax cost of debt will be 6%, should Heleveton make the capital structure change?

Accepted Answer

Solution: Old k_e = 4.2 + 1.1(8.5) = 13.55% = k_a New k_e = 4.2 + 1.2(8.5) = 14.4% New k_a = .7(14.4) + .3(6) = 11.88% Stock price is maximized where the cost of capital is minimized.

Question 20

Temple Company's common stock dividends have grown over the past 5-year period from $0.60 per share to $0.89 (today). Assume that Temple's dividends are expected to grow at this rate for the foreseeable future. Temple's stock is currently selling for $12 per share. New common stock can be sold to net the company $11 per share. Determine the costs of internal and external equity to Temple.

Accepted Answer

Solution: $0.89 = $0.60 (FVIF_g,5 ) g = 8.2% by calculator or interpolation k_e= $0.96/$12 + 0.082 = 0.162 or 16.2% k'_e = $0.96/$11 + 0.082 = 0.169 or 16.9%

Quiz 12: The Cost of Capital