Test bank with answer chapter09 the cost of capital

All else equal, an increase in a company’s stock price will increasethe marginal cost of retained earnings, ks.. All else equal, an increase in a company’s stock price will increasethe m

(Difficulty: E = Easy, M = Medium, and T = Tough)Multiple Choice: Conceptual

Easy:

purpose of calculating the weighted average cost of capital (WACC) as itapplies to capital budgeting?

a Long-term debt

b Common stock

c Accounts payable and accruals

d Preferred stock

is correct? (Note: All rates are after taxes.)

a kd > ke > ks > WACC

b ks > ke > kd > WACC

c WACC > ke > ks > kd

d ke > ks > WACC > kd

e None of the statements above is correct

a If a company’s tax rate increases but the yield to maturity of itsnoncallable bonds remains the same, the company’s marginal cost of debtcapital used to calculate its weighted average cost of capital willfall

b All else equal, an increase in a company’s stock price will increasethe marginal cost of retained earnings, ks

c All else equal, an increase in a company’s stock price will increasethe marginal cost of issuing new common equity, ke

d Statements a and b are correct

e Statements b and c are correct

CHAPTER 9 THE COST OF CAPITAL

Capital components Answer: c Diff: E

a Since the money is readily available, the cost of retained earnings isusually a lot cheaper than the cost of debt financing

b When calculating the cost of preferred stock, a company needs to adjustfor taxes, because preferred stock dividends are tax deductible

c When calculating the cost of debt, a company needs to adjust for taxes,because interest payments are tax deductible

d Statements a and b are correct

e Statements b and c are correct

to estimating the cost of common equity is the least difficult to estimate?

a Expected growth rate, g

b Dividend yield, D1/P0

c Required return, ks

d Expected rate of return, kˆs

e All of the above are equally difficult to estimate

a The WACC measures the after-tax cost of capital

b The WACC measures the marginal 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 A company’s target capital structure affects its weighted average cost

d Flotation costs can increase the weighted average cost of capital

e An increase in the risk-free rate is likely to increase the marginalcosts of both debt and equity financing

WACC Answer: e Diff: E

(WACC) Which of the following statements is most correct?

a The after-tax cost of debt is generally cheaper than the after-tax cost

d Statements a and b are correct

e Statements a and c are correct

following events will reduce the company’s WACC?

a A reduction in the market risk premium

b An increase in the flotation costs associated with issuing new commonstock

c An increase in the company’s beta

d An increase in expected inflation

e An increase in the flotation costs associated with issuing preferredstock

a The WACC is a measure of the before-tax cost of capital

b Typically the after-tax cost of debt financing exceeds the after-taxcost of equity financing

c The WACC measures the marginal after-tax cost of capital

d Statements a and b are correct

e Statements b and c are correct

percent equity Which of the following statements is most correct?

a The cost of equity financing is greater than or equal to the cost ofdebt financing

b The WACC exceeds the cost of equity financing

c The WACC is calculated on a before-tax basis

d The WACC represents the cost of capital based on historical averages

In that sense, it does not represent the marginal cost of capital

e The cost of retained earnings exceeds the cost of issuing new commonstock

Internal vs external common equity Answer: e Diff: E

new common stock, which has a greater cost than the cost of retainedearnings The firm, however, would like to avoid issuing costly new common

raise new common stock?

a Increasing the company’s dividend payout ratio for the upcoming year

b Reducing the company’s debt ratio for the upcoming year

c Increasing the company’s proposed capital budget

d All of the statements above are correct

e None of the statements above is correct

return of 21 percent, before any risk adjustment The risk-free rate is 10percent, and the required rate of return on the market is 16 percent Theproject being evaluated is riskier than Boe’s average project, in terms of

c The accept/reject decision depends on the risk-adjustment policy of the

project’s expected return by 1 percentage point, then the projectshould be accepted

the project acceptable regardless of the amount of the adjustment

e Projects should be evaluated on the basis of their total risk alone.Thus, there is insufficient information in the problem to make anaccept/reject decision

a below-average risk project has a WACC of 8 percent, and an above-averagerisk project has a WACC of 12 percent Which of the following independentprojects should the company accept?

a Project A has average risk and a return of 9 percent

b Project B has below-average risk and a return of 8.5 percent

c Project C has above-average risk and a return of 11 percent

d All of the projects above should be accepted

e None of the projects above should be accepted

Divisional risk Answer: a Diff: E N

is 100 percent equity financed Division A’s cost of equity capital is 9.8

Conglomerate’s composite WACC is 11.9 percent Assume that all Division Aprojects have the same risk and that all Division B projects have the same

in Division B Which of the following projects should Conglomerate accept?

a Division A project with an 11 percent return

b Division B project with a 12 percent return

c Division B project with a 13 percent return

d Statements a and c are correct

e Statements b and d are correct

point?

a An increase in its net income

b An increase in its dividend payout

c An increase in the amount of equity in its capital structure

d An increase in its capital budget

e All of the statements above are correct

point?

a An increase in the dividend payout ratio

b An increase in the debt ratio

c An increase in the capital budget

d An increase in flotation costs

e All of the statements above are correct

Miscellaneous cost of capital concepts Answer: c Diff: E N

a Since debt capital is riskier than equity capital, the cost of debt isalways greater than the WACC

b Because of the risk of bankruptcy, the cost of debt capital is alwayshigher than the cost of equity capital

c If a company assigns the same cost of capital to all of its projectsregardless of the project’s risk, then it follows that the company willgenerally reject too many safe projects and accept too many riskyprojects

d Because you are able to avoid flotation costs, the cost of retainedearnings is generally lower than the cost of debt

e Higher flotation costs tend to reduce the cost of equity capital

Miscellaneous concepts Answer: e Diff: E

a Higher flotation costs reduce investor returns, and therefore reduce acompany’s WACC

b The WACC represents the historical cost of capital and is usuallycalculated on a before-tax basis

c The cost of retained earnings is zero because retained earnings arereadily available and do not require the payment of flotation costs

d All of the statements above are correct

e None of the statements above is correct

Medium:

a In the weighted average cost of capital calculation, we must adjust thecost of preferred stock for the tax exclusion of 70 percent of dividendincome

b We ideally would like to use historical measures of the component costsfrom prior financings in estimating the appropriate weighted averagecost of capital

c The cost of a new equity issuance (ke) could possibly be lower than thecost of retained earnings (ks) if the market risk premium and risk-freerate decline by a substantial amount

d Statements b and c are correct

e None of the statements above is correct

a The cost of retained earnings is the rate of return stockholdersrequire on a firm’s common stock

b The component cost of preferred stock is expressed as kp(1 - T), becausepreferred stock dividends are treated as fixed charges, similar to thetreatment of debt interest

c The bond-yield-plus-risk-premium approach to estimating a firm’s cost

of common equity involves adding a subjectively determined risk premium

to the market risk-free bond rate

d The higher the firm’s flotation cost for new common stock, the morelikely the firm is to use preferred stock, which has no flotation cost

e None of the statements above is correct

Cost of capital estimation Answer: c Diff: M

a The cost of capital used to evaluate a project should be the cost ofthe specific type of financing used to fund that project

b The cost of debt used to calculate the weighted average cost of capital

is based on an average of the cost of debt already issued by the firmand the cost of new debt

c One problem with the CAPM approach in estimating the cost of equitycapital is that if a firm’s stockholders are, in fact, not welldiversified, beta may be a poor measure of the firm’s true investmentrisk

d The bond-yield-plus-risk-premium approach is the most sophisticated andobjective method of estimating a firm’s cost of equity capital

e The cost of equity capital is generally easier to measure than the cost

of debt, which varies daily with interest rates, or the cost ofpreferred stock since preferred stock is issued infrequently

encounter severe difficulties, the CAPM is a simple and reliable modelthat provides great accuracy and consistency in estimating the cost ofequity capital

b The DCF model is preferred over other models to estimate the cost ofequity because of the ease with which a firm’s growth rate is obtained

c The bond-yield-plus-risk-premium approach to estimating the cost ofequity is not always accurate but its advantages are that it is astandardized and objective model

d Depreciation-generated funds are an additional source of capital and,

in fact, represent the largest single source of funds for some firms

e None of the statements above is correct

following elements is not subject to dispute or controversy?

a The expected rate of return on the market, kM

b The stock’s beta coefficient, bi

c The risk-free rate, kRF

d The market risk premium (RPM)

e All of the above are subject to dispute

CAPM and DCF estimation Answer: a Diff: M

a Beta measures market risk, but if a firm’s stockholders are not welldiversified, beta may not accurately measure stand-alone risk

b If the calculated beta underestimates the firm’s true investment risk,then the CAPM method will overestimate ks

c The discounted cash flow method of estimating the cost of equity can’t

be used unless the growth component, g, is constant during the analysisperiod

d An advantage shared by both the DCF and CAPM methods of estimating thecost of equity capital, is that they yield precise estimates andrequire little or no judgement

e None of the statements above is correct

a The weighted average cost of capital for a given capital budget level

is a weighted average of the marginal cost of each relevant capitalcomponent that makes up the firm’s target capital structure

b The weighted average cost of capital is calculated on a before-tax basis

c An increase in the risk-free rate is likely to increase the marginalcosts of both debt and equity financing

d Statements a and c are correct

e All of the statements above are correct

a The WACC should include only after-tax component costs Therefore, therequired rates of return (or “market rates”) on debt, preferred, andcommon equity (kd, kp, and ks) must be adjusted to an after-tax basisbefore they are used in the WACC equation

b The cost of retained earnings is generally higher than the cost of newcommon stock

c Preferred stock is riskier to investors than is debt Therefore, ifsomeone told you that the market rates showed kd > kp for a givencompany, that person must have made a mistake

d If a company with a debt ratio of 50 percent were suddenly exemptedfrom all future income taxes, then, all other things held constant,this would cause its WACC to increase

e None of the statements above is correct

WACC Answer: e Diff: M

a An increase in flotation costs incurred in selling new stock willincrease the cost of retained earnings

b The WACC should include only after-tax component costs Therefore, therequired rates of return (or “market rates”) on debt, preferred, andcommon equity (kd, kp, and ks) must be adjusted to an after-tax basisbefore they are used in the WACC equation

c An increase in a firm’s corporate tax rate will increase the firm’scost of debt capital, as long as the yield to maturity on the company’sbonds remains constant or falls

d Statements b and c are correct

e None of the statements above is correct

a Since stockholders do not generally pay corporate taxes, corporationsshould focus on before-tax cash flows when calculating the weightedaverage cost of capital (WACC)

b All else equal, an increase in flotation costs will increase the cost

of retained earnings

c When calculating the weighted average cost of capital, firms shouldrely on historical costs rather than marginal costs of capital

d Statements a and b are correct

e None of the statements above is correct

a Because we often need to make comparisons among firms that are indifferent income tax brackets, it is best to calculate the WACC on abefore-tax basis

b If a firm has been suffering accounting losses and is expected tocontinue suffering such losses, and therefore its tax rate is zero, it

is possible that its after-tax component cost of preferred stock asused to calculate the WACC will be less than its after-tax componentcost of debt

c Normally, the cost of external equity raised by issuing new commonstock is above the cost of retained earnings Moreover, the higher thegrowth rate is relative to the dividend yield, the more the cost ofexternal equity will exceed the cost of retained earnings

d The lower a company’s tax rate, the greater the advantage of using debt

in terms of lowering its WACC

e None of the statements above is correct

Risk-adjusted cost of capital Answer: c Diff: M

has the same risk as a typical restaurant company, and its computer

Kemp estimates that its composite corporate cost of capital is 10 percent.The company’s consultant has suggested that they use an 8 percent hurdlerate for the restaurant division and a 12 percent hurdle rate for thecomputer division However, Kemp has chosen to ignore its consultant, andinstead, chooses to assign a 10 percent cost of capital to all projects inboth divisions Which of the following statements is most correct?

a While Kemp’s decision to not risk adjust its cost of capital will lead

it to accept more projects in its computer division and fewer projects

in its restaurant division, this should not affect the overall value ofthe company

b Kemp’s decision to not risk adjust means that it is effectivelysubsidizing its restaurant division, which means that its restaurantdivision is likely to become a larger part of the overall company overtime

c Kemp’s decision to not risk adjust means that the company will accepttoo many projects in the computer business and too few projects in the

value of the company

d Statements a and b are correct

e Statements b and c are correct

company’s WACC is 12 percent This is also the correct cost of capital for

though the company’s projects have different risks, the cost of capital foreach project should be the same because the company obtains its capital

likely to happen over time?

a The company will take on too many low-risk projects and reject too manyhigh-risk projects

b The company will take on too many high-risk projects and reject toomany low-risk projects

c Things will generally even out over time, and therefore, the risk ofthe firm should remain constant over time

d Statements a and c are correct

e Statements b and c are correct

Risk-adjusted cost of capital Answer: e Diff: M

which of the following results is likely?

a Accepting poor, high-risk projects

b Rejecting good, low-risk projects

c Accepting only good, low-risk projects

d Accepting no projects

e Answers a and b are correct

projects, the firm will most likely become

a Riskier over time, and its value will decline

b Riskier over time, and its value will rise

c Less risky over time, and its value will rise

d Less risky over time, and its value will decline

e There is no reason to expect its risk position or value to change overtime as a result of its use of a single discount rate

companies Division A would have a cost of capital of 8 percent, while

divisions are the same size, Pearson’s composite weighted average cost of

hurdle rates to each division based on their relative risk Now, however,Pearson has chosen to use the corporate WACC, which is currently 10 percent,for both divisions Which of the following is likely to occur as a result

of this change? Assume that this change is likely to have no effect on theaverage risk of each division and market conditions remain unchanged

a Over time, the overall risk of the company will increase

b Over time, Division B will become a larger part of the overall company

c Over time, the company’s corporate WACC will increase

d Statements a and c are correct

e All of the statements above are correct

Divisional risk and project selection Answer: e Diff: M N

has a WACC of 12 percent Ferdinand Water Co is safer than Smith and has

Project X has an IRR of 10.5 percent, and has the same risk as a typical

same risk as a typical project undertaken by Smith Electric Co

Now assume that Smith Electric Co and Ferdinand Water Co merge to form anew company, Leeds United Utilities The merger has no impact on the cash

CFO is trying to establish hurdle rates for the new company’s projects thataccurately reflect the risk of each project (That is, he is using risk-adjusted hurdle rates.) Which of the following statements is most correct?

a Leeds United Utilities’ weighted average cost of capital is 11 percent

b Project X has a positive NPV

c After the merger, Leeds United Utilities should select Project X andreject Project Y

d Statements a and b are correct

e All of the statements above are correct

a A relatively risky future cash outflow should be evaluated using arelatively low discount rate

b If a firm’s managers want to maximize the value of the stock, theyshould concentrate exclusively on projects’ market, or beta, risk

c If a firm evaluates all projects using the same cost of capital, thenthe riskiness of the firm as measured by its beta will probably declineover time

d If a firm has a beta that is less than 1.0, say 0.9, this would suggestthat its assets’ returns are negatively correlated with the returns ofmost other firms’ assets

e None of the statements above is correct

Miscellaneous concepts Answer: a Diff: M

a Suppose a firm is losing money and thus, is not paying taxes, and thatthis situation is expected to persist for a few years whether or not

will equal its before-tax cost of debt

b The component cost of preferred stock is expressed as kp(1 - T), becausepreferred stock dividends are treated as fixed charges, similar to thetreatment of debt interest

c The reason that a cost is assigned to retained earnings is becausethese funds are already earning a return in the business; the reasondoes not involve the opportunity cost principle

d The bond-yield-plus-risk-premium approach to estimating a firm’s cost

of common equity involves adding a subjectively determined risk premium

to the market risk-free bond rate

e None of the statements above is correct

Multiple Choice: Problems

Easy:

$2.00, its growth rate is a constant 5 percent, and the company will incur

firm’s cost of new equity, ke?

expected to pay a year-end dividend of $2.50 per share (D1 = $2.50) Thedividend is expected to grow at a constant rate of 4 percent per year Thecompany has insufficient retained earnings to fund capital projects and

Cost of retained earnings Answer: d Diff: E

40 percent debt and 60 percent common equity The current market price ofthe firm’s stock is P0 = $28; its last dividend was D0 = $2.20, and its

cost of retained earnings, ks, be?

42 An analyst has collected the following information regarding Christopher Co.:

 The company’s capital structure is 70 percent equity and 30 percent debt

 The yield to maturity on the company’s bonds is 9 percent

 The company’s year-end dividend is forecasted to be $0.80 a share

 The company expects that its dividend will grow at a constant rate of 9percent a year

 The company’s tax rate is 40 percent

this year, and total flotation costs will equal 10 percent of theamount issued

Assume the company accounts for flotation costs by adjusting the cost ofcapital Given this information, calculate the company’s WACC

43 Flaherty Electric has a capital structure that consists of 70 percent equity

and 30 percent debt The company’s long-term bonds have a before-tax yield

to maturity of 8.4 percent The company uses the DCF approach to determine

share The year-end dividend (D1) is expected to be $2.50 per share, andthe dividend is expected to grow forever at a constant rate of 7 percent ayear The company estimates that it will have to issue new common stock to

issued is 10 percent, and the company’s tax rate is 40 percent What is thecompany’s weighted average cost of capital, WACC?

WACC Answer: b Diff: E

following information:

 Its capital structure consists of 40 percent debt and 60 percent commonequity

coupon that are trading at par

 The company’s tax rate is 40 percent.

 The risk-free rate is 5.5 percent.

 The market risk premium is 5 percent.

 The stock’s beta is 1.4.

What is the company’s WACC?

division has average risk, and its institutional foods division has average risk Dandy adjusts for both divisional and project risk by adding

percentage points What is the risk-adjusted required rate of return for alow-risk project in the yogurt division?

net income this year, and 60 percent of the net income will be paid out as

it having to issue any new common stock?

47 The common stock of Anthony Steel has a beta of 1.20 The risk-free rate is

5 percent and the market risk premium (kM - kRF) is 6 percent Assume thefirm will be able to use retained earnings to fund the equity portion of itscapital budget What is the company’s cost of retained earnings, ks?

issues additional stock, it must pay its investment banker a flotation cost

of $1.00 per share What is the cost of external equity, ke?

value bond, which matures in 20 years, currently sells at a price of

interest rate, not the EAR, what is the firm’s component cost of debt forpurposes of calculating the WACC?

WACC Answer: e Diff: M N

50 Trojan Services’ CFO is interested in estimating the company’s WACC and has

collected the following information:

and sell in the market today for $920

 The risk-free rate is 6 percent.

 The market risk premium is 5 percent.

 The stock’s beta is 1.2.

 The company’s tax rate is 40 percent.

and 30 percent debt

include flotation costs as part of its cost of capital

What is Trojan’s WACC?

retained earnings to fund the equity portion of its capital budget Also,assume the firm accounts for flotation costs by adjusting the cost of

average cost of capital

WACC Answer: b Diff: M

52 Hatch Corporation’s target capital structure is 40 percent debt, 50 percent

company’s cost of capital can be summarized as follows:

 The company’s bonds have a nominal yield to maturity of 7 percent.

dividend of $4 a share

pay a dividend of $2 a share at the end of the year (i.e., D1 = $2.00).The dividend is expected to grow at a constant rate of 7 percent ayear

portion of its capital budget

 The company’s tax rate is 40 percent.

What is the company’s weighted average cost of capital (WACC)?

(WACC) The company’s CFO has collected the following information:

percent

 The company’s stock price is $32 a share (P0 = $32).

 The company recently paid a dividend of $2 a share (D0 = $2.00).

 The dividend is expected to grow at a constant rate of 6 percent a year(g = 6%)

common stock (F = 10 percent)

percent debt

 The company’s tax rate is 40 percent.

portion of its capital budget

What is the company’s WACC?

WACC Answer: c Diff: M

preferred stock, and 50 percent common stock

 The company can issue bonds at a yield to maturity of 8.4 percent.

 The cost of preferred stock is 9 percent.

 The market risk premium is 5 percent.

 Johnson Industries’ beta is equal to 1.3.

equity portion of its capital budget

 The company’s tax rate is 30 percent.

What is the company’s weighted average cost of capital (WACC)?

55 Helms Aircraft has a capital structure that consists of 60 percent debt and

40 percent common stock The firm will be able to use retained earnings tofund the equity portion of its capital budget The company recently issued

percent, the market risk premium is 6 percent, and Helms’ beta is equal to

weighted average cost of capital (WACC)?

WACC Answer: e Diff: M

long-term debt and 40 percent common stock The company’s CFO has obtained thefollowing information:

 The before-tax yield to maturity on the company’s bonds is 8 percent.

end (D1 = $3.00), and the dividend is expected to grow at a constant rate

of 7 percent a year The common stock currently sells for $60 a share

equity portion of its capital budget

 The company’s tax rate is 40 percent.

What is the company’s weighted average cost of capital (WACC)?

percent debt, 50 percent common equity, and 20 percent preferred stock

the company raises capital through a new equity issuance, the flotation

capital at the firm’s optimal capital budget?

WACC Answer: a Diff: M

large retail chain:

and currently sell at a price of $1,273.8564

the market is 11.35 percent The company’s tax rate is 35 percent Thecompany anticipates that its proposed investment projects will befinanced with 70 percent debt and 30 percent equity

What is the company’s estimated weighted average cost of capital (WACC)?

common stock and 30 percent long-term debt In order to calculate Clark’sweighted average cost of capital (WACC), an analyst has accumulated thefollowing information:

for $1,075

 The risk-free rate is 5 percent.

 The market risk premium is 4 percent.

 The beta on Clark’s common stock is 1.1.

 The company’s retained earnings are sufficient so that they do not have

to issue any new common stock to fund capital projects

 The company’s tax rate is 38 percent.

Given this information, what is Clark’s WACC?

WACC Answer: d Diff: M

capital (WACC) The company’s CFO has collected the following information:

 The target capital structure consists of 40 percent debt and 60 percentcommon stock

 The company has 20-year noncallable bonds with a par value of $1,000, a

9 percent annual coupon, and a price of $1,075

 Equity flotation costs are 2 percent.

 The company’s common stock has a beta of 0.8.

 The risk-free rate is 5 percent.

 The market risk premium is 4 percent.

 The company’s tax rate is 40 percent.

portion of its capital structure, so it does not intend to issue anynew common stock

What is the company’s WACC?

information about the company:

 Naulls Industries currently has a capital structure that consists of 75percent common equity and 25 percent debt

 The risk-free rate, kRF, is 5 percent.

 The market risk premium , kM - kRF, is 6 percent.

 Naulls’s common stock has a beta of 1.2.

percent and a face value of $1,000 The bonds sell today for $1,200

 The company’s tax rate is 40 percent.

What is the company’s current WACC?

WACC and dividend growth rate Answer: c Diff: M

target capital structure is 55 percent equity and 45 percent debt Thecompany has sufficient retained earnings to fund the equity portion of itscapital budget The before-tax cost of debt is 9 percent, and the company’stax rate is 30 percent If the expected dividend next period (D1) is $5 andthe current stock price is $45, what is the company’s growth rate?

optimal capital budget for the upcoming year Kenforest is considering thefollowing projects:

independent The company adjusts for risk by adding 2 percentage points tothe WACC for high-risk projects and subtracting 2 percentage points from theWACC for low-risk projects Which of the projects will the company accept?

company’s long-term bonds is 8 percent, and the firm estimates that its

5.5 percent, the market risk premium is 5 percent, and the company’s tax

equity What is the beta on Bradshaw’s stock?

a 1.07

b 1.48

c 1.31

Required rate of return Answer: c Diff: M

risk-free rate, kRF, is 7 percent and kM is 14 percent Suppose the firm sells

10 percent of its assets with beta equal to 1.25 and purchases the same

overall required rate of return, and what rate of return must the newassets produce in order to leave the stock price unchanged?

a new division that will increase the assets of the firm by 50 percent.Sun State currently has a required rate of return of 18 percent, U.S.Treasury bonds yield 7 percent, and the market risk premium is 5 percent

If Sun State wants to reduce its required rate of return to 16 percent,what is the maximum beta coefficient the new division could have?

67 Heavy Metal Corp is a steel manufacturer that finances its operations with

40 percent debt, 10 percent preferred stock, and 50 percent equity The

common stock trades at $30 a share, and its current dividend (D0) of $2 a

flotation cost of external equity is 15 percent of the dollar amount

will not have enough retained earnings to fund the equity portion of itscapital budget What is the company’s tax rate?

WACC and cost of preferred stock Answer: b Diff: T

68 Anderson Company has four investment opportunities with the following costs

(paid at t = 0) and expected returns:

The company has a target capital structure that consists of 40 percent

company has $1,000 in retained earnings The company expects its year-enddividend to be $3.00 per share (D1 = $3.00) The dividend is expected togrow at a constant rate of 5 percent a year The company’s stock price iscurrently $42.75 If the company issues new common stock, the company willpay its investment bankers a 10 percent flotation cost

The company can issue corporate bonds with a yield to maturity of 10

cost of preferred stock be (including flotation costs) and it still beprofitable for the company to invest in all four projects?

(The following information applies to the next three problems.)

company can raise debt at a 12 percent interest rate and the last dividend paid

issues new common stock, the flotation cost incurred will be 10 percent Globalplans to finance all capital expenditures with 30 percent debt and 70 percentequity

rather than issue new common stock?

Cost of external equity Answer: b Diff: E

sufficient retained earnings to fund the equity portion of its capitalbudget?

(The following information applies to the next two problems.)

Byron Corporation’s present capital structure, which is also its target capitalstructure, is 40 percent debt and 60 percent common equity Assume that the firmhas no retained earnings The company’s earnings and dividends are growing at aconstant rate of 5 percent; the last dividend (D0) was $2.00; and the current

cost will be incurred The firm’s marginal tax rate is 40 percent

72 What is the component cost of the equity raised by selling new common stock?

(The following information applies to the next six problems.)

Rollins Corporation has a target capital structure consisting of 20 percent debt,

insufficient retained earnings to fund the equity portion of its capital budget.Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20

that pays a 12 percent annual dividend, but flotation costs of 5 percent would beincurred Rollins’ beta is 1.2, the risk-free rate is 10 percent, and the marketrisk premium is 5 percent Rollins is a constant growth firm that just paid adividend of $2.00, sells for $27.00 per share, and has a growth rate of 8percent The firm’s policy is to use a risk premium of 4 percentage points whenusing the bond-yield-plus-risk-premium method to find ks Flotation costs on newcommon stock total 10 percent, and the firm’s marginal tax rate is 40 percent

76 What is Rollins’ cost of retained earnings using the CAPM approach?