Q&A Hero

Q: The cost of debt increases relative to the investor's required return due to flotation costs, but decreases relative to the investor's required return due to the tax deductibility of interest.

Q: The firm's cost of capital is important when evaluating the firm's overall value, but it should not be used to evaluate individual projects which have their own unique characteristics.

Q: The firm's cost of capital may also be referred to as the firm's opportunity cost of capital.

Q: The cost of capital is the rate that must be earned on an investment project if the project is to increase the value of the common shareholders' investment.

Q: In order to create value, a corporation must earn a rate of return on its invested capital that is higher than the market's required rate of return on that invested capital.

Q: If a firm has decided to move from a situation in which it uses a company-wide cost of capital to divisional costs of capital, what problems is it likely to encounter?

Q: What are the implications for a firm's capital investment decisions of using a company-wide cost of capital when the firm has multiple operating divisions that have unique risk attributes and capital costs?

Q: Texas Transport has five possible investment projects for the coming year. Each project is indivisible. They are:ProjectInvestment (million)IRRA$618%B$1015%C$920%D$412%E$324%The firm's weighted marginal cost of capital schedule is 12 percent for up to $6 million of investment; 16 percent for between $6 million and $18 million of investment; and above $18 million the weighted cost of capital is 18 percent. The optimal capital budget isA) $12 million.B) $18 million.C) $23 million.D) $28 million.

Q: Why should firms that own and operate multiple businesses that have different risk characteristics use business-specific, or divisional costs of capital? A) Not all divisions have equal risk and the firm might accept projects whose returns are higher than are deemed appropriate. B) Not all business divisions have equal risk and the firm will likely become less risky in the future. C) Not all lines of business have equal risk and it is likely that the firm will accept projects whose returns are unacceptably low in relation to the risk involved. D) Use of the same weighted average cost of capital for all divisions may result in too much money being allocated to the least risky division.

Q: Using the weighted average cost of capital as the required rate of return for every project will A) cause a firm to reject projects that should have been accepted. B) cause a firm to accept projects that were too risky. C) result in maximization of shareholder wealth. D) A and B above

Q: Mountain Retreat and Resort is undergoing a major expansion. The expansion will be financed by issuing new 15-year, $1,000 par, 9% annual coupon bonds. The market price of the bonds is $1,070 each. The firm's flotation expense on the new bonds will be $50 per bond. The firm's marginal tax rate is 35%. What is the relevant cost of the new bonds for capital budgeting purposes? A) 5.14% B) 5.69% C) 8.45% D) 4.82%

Q: Valley Flights, Inc. has a capital structure made up of 40% debt and 60% equity and a tax rate of 30%. A new issue of $1,000 par bonds maturing in 20 years can be issued with a coupon of 9% at a price of $1,098.18 with no flotation costs. The firm has no internal equity available for investment at this time, but can issue new common stock at a price of $45. The next expected dividend on the stock is $2.70. The dividend for the firm is expected to grow at a constant annual rate of 5% per year indefinitely. Flotation costs on new equity will be $7.00 per share. The company has the following independent investment projects available:ProjectInitial OutlayIRR1$100,00010%2$10,008.5%3$50,00012.5%Which of the above projects should the company take on?A) Project 3 onlyB) Projects 1 and 2C) Projects 1 and 3D) Projects 1, 2 and 3

Q: QRM, Inc.'s marginal tax rate is 35%. It can issue 10-year bonds with an annual coupon rate of 7% and a par value of $1,000. After $12 per bond flotation costs, new bonds will net the company $966 in proceeds. Determine the appropriate after-tax cost of new debt for the firm to use in a capital budgeting analysis. A) 2.62% B) 4.87% C) 7.50% D) 7.8%

Q: Donner, Inc. will finance a proposed investment by issuing new securities while maintaining its optimal capital structure of 60% debt and 40% equity. The firm can issue bonds at a price of $950.00 before $15 flotation costs. The 10-year bonds will have an annual coupon rate of 8% and a face value of $1,000. The company can issue new equity at a before-tax cost of 16% and its marginal tax rate is 34%. What is the appropriate cost of capital to use in analyzing this project? A) 3.63% B) 8.77% C) 9.97% D) 11.81%

Q: Blammo, Inc. has a target capital structure of 30% debt and 70% equity. The firm is planning to invest in a project that will necessitate raising new capital. New debt will be issued at a before-tax yield of 14%, with a coupon rate of 10%. The equity will be provided by internally generated funds so no new outside equity will be issued. If the required rate of return on the firm's stock is 22% and its marginal tax rate is 35%, compute the firm's cost of capital. A) 18.00% B) 18.13% C) 19.68% D) 15.55%

Q: All the following variables are used in computing the cost of debt EXCEPT A) maturity value of the debt. B) market price of the debt. C) number of years to maturity. D) risk-free rate.

Q: XRT, Inc. is issuing a $1,000 par value bond that pays 8.5% interest annually. Investors are expected to pay $1,100 for the 12-year bond. The firm will pay $50 per bond in flotation costs. What is the after-tax cost of new debt if the firm is in the 35% tax bracket? A) 8.23% B) 4.55% C) 4.70% D) 7.45%

Q: TC, Inc. has $15 million of outstanding bonds with a coupon rate of 10 percent. The yield to maturity on these bonds is 12.5 percent. If the firm's tax rate is 30 percent, what is relevant cost of debt financing to TC, Inc.? A) 13.75 percent B) 8.75 percent C) 7.00 percent D) 3.75 percent

Q: A corporate bond has a face value of $1,000 and a coupon rate of 9%. The bond matures in 14 years and has a current market price of $946. If the corporation sells more bonds, it will incur flotation costs of $26 per bond. If the corporate tax rate is 35%, what is the after-tax cost of debt capital? A) 5.57% B) 6.56% C) 8.18% D) 7.31%

Q: A corporate bond has a face value of $1,000 and a coupon rate of 5%. The bond matures in 15 years and has a current market price of $925. If the corporation sells more bonds, it will incur flotation costs of $25 per bond. If the corporate tax rate is 35%, what is the after-tax cost of debt capital? A) 3.74% B) 4.45% C) 5.29% D) 6.78%

Q: A firm's cost of capital is the required rate of return on the firm's average project.

Q: If the before-tax cost of debt is 7% and the firm has a 40% marginal tax rate, the after-tax cost of debt is 2.8%.

Q: The after-tax cost of debt is equal to one minus the marginal tax rate times the yield to maturity on the firm's outstanding debt.

Q: Calculating the cost of capital for divisions within a company is not recommended because the data is too fragmented and all divisions are part of the same company in any case.

Q: A firm's capital structure and its target capital structure proportions are important determinants of a firm's weighted average cost of capital. Explain.

Q: Last year Gator Getters, Inc. had $50 million in total assets. Management desires to increase its plant and equipment during the coming year by $12 million. The company plans to finance 40 percent of the expansion with debt and the remaining 60 percent with equity capital. Bond financing will be at a 9 percent rate and will be sold at its par value. Common stock is currently selling for $50 per share, and flotation costs for new common stock will amount to $5 per share. The expected dividend next year for Gator is $2.50. Furthermore, dividends are expected to grow at a 6 percent rate far into the future. The marginal corporate tax rate is 34 percent. Internal funding available from additions to retained earnings is $4,000,000. a. What amount of new common stock must be sold if the existing capital structure is to be maintained? b. Calculate the weighted marginal cost of capital at an investment level of $12 million.

Q: Office Clean Corporation has a capital structure consisting of 30 percent debt and 70 percent common equity. Assuming the capital structure is optimal, what amount of total investment can be financed by a $35 million addition to retained earnings without selling new common stock?

Q: Meacham Corp. wants to issue bonds with a 9% coupon rate, a face value of $1,000, and 12 years to maturity. Meacham estimates that the bonds will sell for $1,090 and that flotation costs will equal $15 per bond. Meacham Corp. common stock currently sells for $30 per share. Meacham can sell additional shares by incurring flotation costs of $3 per share. Meacham paid a dividend yesterday of $4.00 per share and expects the dividend to grow at a constant rate of 5% per year. Meacham also expects to have $12 million of retained earnings available for use in capital budgeting projects during the coming year. Meacham's capital structure is 40% debt and 60% common equity. Meacham's marginal tax rate is 35%. a. Calculate the after-tax cost of debt assuming Meacham's bonds are its only debt. b. Calculate the cost of retained earnings. c. Calculate the cost of new common stock. d. Calculate the weighted average cost of capital assuming Meacham's total capital budget is $30 million.

Q: The average cost associated with each additional dollar of financing for investment projects is A) the incremental return. B) the marginal cost of capital. C) CAPM required return. D) the component cost of capital.

Q: PrimaCare has a capital structure that consists of $7 million of debt, $2 million of preferred stock, and $11 million of common equity, based upon current market values. The firm's yield to maturity on its bonds is 7.4%, and investors require an 8% return on the firm's preferred and a 14% return on PrimaCare's common stock. If the tax rate is 35%, what is PrimaCare's WACC? A) 7.21% B) 8.12% C) 10.18% D) 12.25%

Q: Kokapeli, Inc. has a target capital structure of 40% debt and 60% common equity, and has a 40% marginal tax rate. If the firm's yield to maturity on bonds is 7.5% and investors require a 15% return on the firm's common stock, what is the firm's weighted average cost of capital? A) 7.20% B) 10.80% C) 12.00% D) 12.25%

Q: Given the following information on S & G Inc.'s capital structure, compute the company's weighted average cost of capital. Type of Capital Percent of Capital Structure Before-Tax Component Cost Bonds 40% 7.5% Preferred Stock 5% 11% Common Stock (Internal Only) 55% 15% The company's marginal tax rate is 40%. A) 13.3% B) 7.1% C) 10.6% D) 10%

Q: For a typical corporation, which of the following capital structures will result in the lowest weighted average cost of capital? A) 40% debt, 20% preferred stock, 40% common equity B) 50% debt, 10% preferred stock, 40% common equity C) 60% debt, 10% preferred stock, 30% common equity D) 60% debt, 15% preferred stock, 25% common equity

Q: CrochetCo is considering an investment in a project which would require an initial outlay of $350,000 and produce expected cash flows in years 1-5 of $95,450 per year. You have determined that the current after-tax cost of the firm's capital (required rate of return) for each source of financing is as follows:Cost of Long-Term Debt7%Cost of Preferred Stock11%Cost of CommonStock15%Long-term debt currently makes up 25% of the capital structure, preferred stock 15%, and common stock 60%. What is the net present value of this project?A) -$9,306B) $2,149C) $5,983D) $11,568

Q: The DEF Company is planning a $64 million expansion. The expansion is to be financed by selling $25.6 million in new debt and $38.4 million in new common stock. The before-tax required rate of return on debt is 9 percent and the required rate of return on equity is 14 percent. If the company is in the 35 percent tax bracket, what is the firm's cost of capital? A) 8.92% B) 9.89% C) 11.50% D) 10.74%

Q: Beauty Inc. plans to maintain its optimal capital structure of 40 percent debt, 10 percent preferred stock, and 50 percent common equity indefinitely. The required return on each component source of capital is as follows: debt8 percent; preferred stock12 percent; common equity16 percent. Assuming a 40 percent marginal tax rate, what after-tax rate of return must the firm earn on its investments if the value of the firm is to remain unchanged? A) 12.40 percent B) 12.00 percent C) 11.12 percent D) 10.64 percent

Q: WineCellars Inc. currently has a weighted average cost of capital of 12%. WineCellars has been growing rapidly over the past several years, selling common stock in each year to finance its growth. However, due to difficult economic times this year, WineCellars decides to cut its dividend and increase its retained earnings so that the common equity portion of its capital structure will include only retained earnings and no new common stock will be sold. WineCellars' weighted average cost of capital this year should be A) zero, since no new stock will be sold. B) less than 12%. C) equal to 12%. D) greater than 12%.

Q: Coyote Inc. operates three divisions. One division involves significant research and development, and thus has a high-risk cost of capital of 15%. The second division operates in business segments related to Coyote's core business, and this division has a cost of capital of 10% based upon its risk. Coyote's core business is the least risky segment, with a cost of capital of 8%. The firm's overall weighted average cost of capital of 11% has been used to evaluate capital budgeting projects for all three divisions. This approach will A) favor projects in the core business division because that division is the least risky. B) favor projects in the related businesses division because the cost of capital for this division is the closest to the firm's weighted average cost of capital. C) favor projects in the research and development division because the higher risk projects look more favorable if a lower cost of capital is used to evaluate them. D) not favor any division over the other because they all use the same company-wide weighted average cost of capital.

Q: The common stock of Cranberry Inc. is selling for $26.75 on the open market. Next year's dividend is expected to be $3.68, and the growth rate of this company is estimated to be 5.5%. If Richard Dean, an average investor, is considering purchasing this stock at the market price, what is his expected rate of return?

Q: Miller's preferred stock is selling at $54 on the market and pays an annual dividend of $4.20 per share. a. What is the expected rate of return on the stock? b. If an investor's required rate of return is 9%, what is the value of the stock to that investor? c. Considering the investor's required rate of return, does this stock seem to be a desirable investment?

Q: Tannerly Worldwide's common stock is currently selling for $48 a share. If the expected dividend at the end of the year is $2.40 and last year's dividend was $2.00, what is the rate of return implicit in the current stock price?

Q: You purchased one share of Sophia Enterprises common stock for $30 today. If the stock pays a dividend of $6.50 in one year, and sells for $32.50 at that time, what will the dividend yield, growth rate, and total rate of return be for the year?

Q: U.S Technologies preferred stock sells for $80 and pays $9 each year in dividends. What is the expected rate of return?

Q: LED Corp.'s common stock paid $2.50 in dividends last year (D0). Dividends are expected to grow at a 12-percent annual rate forever. If LED's current market price is $40.00, and your required rate of return is 23 percent, should you purchase the stock? A) No, the percentage return on the stock is too high, thus it is too risky. B) Yes, the stock is expected to return more than you require. C) No, the stock is overpriced. D) Not enough information is given.

Q: Bevel Building Products, Inc., whose common stock is currently selling for $12 per share, is expected to pay a $1.80 dividend, and sell for $14.40 one year from now. What are the dividend yield, growth rate, and total rate of return, respectively? A) 15%; 20%; 35% B) 10%; 5%; 15% C) 15%; 12%; 27% D) 20%; 15%; 35%

Q: Crandle's common stock is currently selling for $79.00. It just paid a dividend of $4.60 and dividends are expected to grow at a rate of 5% indefinitely. What is the required rate of return on Crandle's stock? A) 11.11% B) 11.76% C) 12.2% D) 14.21%

Q: Jackson Corp. common stock paid $2.50 in dividends last year (D0). Dividends are expected to grow at a 12-percent annual rate forever. If Jackson's current market price is $40.00, what is the stock's expected rate of return (nearest .01 percent)? A) 5.50% B) 11.00% C) 18.25% D) 19.00%

Q: South Stage, Inc. preferred stock pays an annual dividend of $2.75 per share. If the stock is currently selling for $27.50 per share, what is the expected rate of return on this stock? A) 2.75% B) 10.0% C) 17.5% D) 27.5%

Q: Beaver Corp. preferred stock has a market price of $14.50. If it has a yearly dividend of $3.50, what is your expected rate of return if you purchase the stock at its market price? A) 41.43% B) 19.45% C) 22.36% D) 24.14%

Q: The expected rate of return on a share of common stock whose dividends are growing at a constant rate (g) is which of the following, where D1 is the next dividend and Vc is the current value of the stock? A) (D1 + g)/Vc B) D1/Vc + g C) D1/g D) D1/g + Vc

Q: TC Corp. paid a dividend today of $5 per share. The dividend is expected to grow at a constant rate of 6.5% per year. If TC Corp. stock is selling for $50.00 per share, the stockholders' expected rate of return is A) 11.50%. B) 13.56%. C) 15.49%. D) 16.50%.

Q: Given the constant growth dividend valuation model, the expected percentage growth in value of a stock is equal to the capital gains yield for that stock.

Q: An investor's required rate of return for a common stock can be estimated by summing the stock's dividend yield and annual growth rate, assuming the growth rate is constant over time.

Q: The expected rate of return implied by a given market price equals the required rate of return for investors at the margin.

Q: How does internal growth versus the infusion of new capital affect the original shareholders?

Q: The price of DDS Corporation stock is expected to be $45 in 5 years. Dividends are anticipated to increase at an annual rate of 10 percent from the most recent dividend of $1.00. If your required rate of return is 15 percent, how much are you willing to pay for DDS stock?

Q: You are considering the purchase of Zee Company stock. You anticipate that the company will pay dividends of $3.50 per share next year and $4.00 per share the following year. You believe that you can sell the stock for $20.00 per share two years from now. If your required rate of return is 10 percent, what is the maximum price that you would pay for a share of Zee Company stock?

Q: Diana Ltd. paid a $2.50 per share dividend yesterday. The dividend is expected to grow at 10 percent per year for the foreseeable future. Diana Ltd. has a beta of 1.6, a standard deviation of returns of 30 percent, and a required return of 18%. What is the value of a share of Diana Ltd. common stock?

Q: Castle, Inc. paid a dividend yesterday of $2 per share. Castle management expects the dividend to increase next year to $3 annually. If the dividend is expected to stay at $3 per year for the foreseeable future, what is the value of the stock to an investor with a required rate of return of 10%? A) $7.50 B) $30.00 C) $32.00 D) $50.00

Q: You observe Thundering Herd Common Stock selling for $40.00 per share. The next dividend is expected to be $4.00, and is expected to grow at a 5% annual rate forever. If your required rate of return is 12%, should you purchase the stock? A) yes, because the present value of the expected future cash flows is greater than $40 B) no, because the present value of the expected future cash flows is less than $40 C) yes, because the present value of the expected future cash flows is less than $40 D) no, because the present value of the expected future cash flows is greater than $40

Q: Shasta Co. just paid a dividend of $1.65 (D0) on its common stock. This company's dividends are expected to grow at a constant rate of 3% indefinitely. If the required rate of return on this stock is 11%, compute the current value per share of Shasta stock. A) $20.63 B) $21.24 C) $15.00 D) $55.00

Q: Distant Thunder, Inc. paid a dividend of $5.00 per share on its common stock yesterday. Dividends are expected to grow at a constant rate of 10% for the next two years, at which point the dividends will begin to grow at a constant rate indefinitely. If the stock is selling for $50 today and the required return is 15%, what it the expected annual dividend growth rate after year two? A) 3.365% B) 3.878% C) 4.556% D) 5.000%

Q: If you expect NoDiv Corporation to sell for $75 per share in three years while paying no dividends along the way, and if your required rate of return is 16% per year, how much is the stock worth today? A) $42.68 B) $48.05 C) $51.10 D) $74.64

Q: Waterfront Solutions, Inc. paid a dividend of $5.00 per share on its common stock yesterday. Dividends are expected to grow at a constant rate of 4% for the next two years, at which point the stock is expected to sell for $56.00. If investors require a rate of return on Waterfront's common stock of 18%, what should the stock sell for today? A) $50.22 B) $48.51 C) $44.76 D) $40.22

Q: Beaver Corporation stock is currently selling for $58.00. It is expected to pay a dividend of $5.00 at the end of the year. Dividends are expected to grow at a constant rate of 7.5% indefinitely. Compute the required rate of return on Beaver Corporation stock. A) 12.48% B) 15.65% C) 13.64% D) 16.12%

Q: Kinard's Kennels Inc. ROE is 20%. Their dividend payout ratio is 70%. The last dividend, just paid, was $2.00. If dividends are expected to grow by the company's internal growth rate indefinitely, what is the current value of Kinard's common stock if its required return is 18%? A) $17.67 B) $16.89 C) $14.92 D) $11.52

Q: Shackleford Corporation net income this year is $800,000. The company generally retains 35% of net income for reinvestment. The company's common equity currently has a book value of $5,000,000. They just paid a dividend of $1.37, and the required rate of return on this stock is 12%. Compute the value of this stock if dividends are expected to continue growing indefinitely at the company's internal growth rate. A) $22.61 B) $11.42 C) $15.63 D) $4.35

Q: Southland Tours has net income of $2 million this year. The book value of Southland Tours common equity is $8 million dollars. The company's dividend payout ratio is 60% and is expected to remain this way. What is Southland Tours' internal growth rate? A) 6% B) 9% C) 10% D) 15%

Q: Dynamic Industries paid a dividend of $1.65 on its common stock yesterday. The dividends of Wallace Industries are expected to grow at 9% per year indefinitely. If the risk-free rate is 3% and investors' risk premium on this stock is 8%, estimate the value of Wallace Industries stock 2 years from now. A) $106.84 B) $100.43 C) $91.81 D) $54.71

Q: Bensen Co. paid a dividend of $5.25 on its common stock yesterday. The company's dividends are expected to grow at a constant rate of 8.5% indefinitely. The required rate of return on this stock is 15.5%. You observe a market price of $78.50 for the stock. Should you purchase this stock? A) No, the market price is above the intrinsic value of the stock. B) Yes, the market price is below the intrinsic value of the stock. C) No, the growth rate in dividends is too far below the required return. D) Yes, but only if you can keep the stock for at least 5 years.

Q: Bensen Co. paid a dividend of $5.25 on its common stock yesterday. The company's dividends are expected to grow at a constant rate of 8.5% indefinitely. If the required rate of return on this stock is 15.5%, compute the current value per share of Bensen Co. stock. A) $81.38 B) $76.43 C) $56.23 D) $43.90

Q: You are considering the purchase of a share of Ranch's common stock. You expect to sell it at the end of 1 year for $32.00. You will also receive a dividend of $2.50 at the end of the year. Ranch just paid a dividend of $2.25. If your required return on this stock is 12%, what is the most you would be willing to pay for it now? A) $28.57 B) $33.05 C) $20.83 D) $30.80

Q: An example of the growth factor in common stock is A) acquiring a loan to fund an investment in Asia. B) retaining profits in order to reinvest into the firm. C) issuing new stock to provide capital for future growth. D) two strong companies merging together to increase their economy of scale.

Q: The Western State Company's common stock is expected to pay a $2.00 dividend in the coming year. If investors require a 17% return and the growth rate in dividends is expected to be 8%, what will the market price of the stock be? A) $11.76 B) $24.00 C) $23.11 D) $22.22

Q: All of the following affect the value of a share of common stock EXCEPT A) the dollar amount of the dividends. B) investors' required rate of return. C) the future growth rate for dividends. D) the stock and paid-in-capital amounts on the balance sheet.

Q: Using the dividend valuation method, an analyst determines the value of Company A's stock to be $10 and the value of Company B's stock to be $14. Based on this information, which of the following statements is most accurate? A) Company B must be riskier than Company A, and risk requires a reward. B) Other things being equal, if Company A and Company B have the same firm value, Company B must have more debt, thus leveraging its returns for the benefit of shareholders. C) Other things being equal, if Company A and Company B have the same firm value, Company A may have more shares of stock outstanding than Company B. D) Company B's required rate of return is higher than Company A's required return.

Q: TellTrue Corporation has preferred stock which paid an annual dividend in 2009 of $5 per share. TellTrue also has common stock which paid a dividend in 2009 of $5. Which of the following statements is MOST correct concerning TellTrue stock? A) The price of the preferred stock should equal the price of the common stock since the dividends are the same. B) The price of the common stock could be higher than the price of the preferred stock if the common stock dividends are expected to grow in the future. C) The price of the preferred stock is expected to be higher than the price of the common stock because the required return on preferred stock is higher than the required return on common stock. D) If the required return on the preferred stock is the same as the required return on the common stock, then the price of preferred stock should equal the price of the common stock if markets are efficient.

Q: Backford Company just paid a dividend yesterday of $2.25 per share. The company's stock is currently selling for $60 per share, and the required rate of return on Backford Company stock is 16%. What is the growth rate expected for Backford Company dividends assuming constant growth? A) 9.47% B) 9.89% C) 10.87% D) 11.81%

Q: Perrine Industrial Inc. just paid a dividend of $5 per share. Future dividends are expected to grow at a constant rate of 7% per year. What is the value of the stock if the required return is 16%? A) $33.44 B) $55.56 C) $59.44 D) $65.87

Q: A financial analyst expects Crane Service Inc. to pay a dividend of $2 per share one year from today, a dividend of $3 per share in years two, and estimates the value of the stock at the end of year two to be $22. If your required return on Crane Service stock is 14 %, what is the most you would be willing to pay for the stock today if you plan to sell the stock in two years? A) $20.99 B) $26.75 C) $26.90 D) $27.00