Week 5: Cost of Capital Theory

Financial managers must determine their firm's overall cost of capital based on all sources of financing.

• True

• False

The relative proportion of debt, equity, and other securities that a firm has outstanding constitute its ________.

• asset ratio

• current ratio

• capital structure

• retained earnings

1. The book value of a firm's equity is $100 million and its market value of equity is $200 million. The face value of its debt is $50 million and its market value of debt is $60 million. What is the market value of assets of the firm?

• $150 million

• $160 million

• $260 million

• $250 million

Answer explanation

C) Market value of debt plus market value of equity gives market value of assets.

$200 + $60 = $260 million

A levered firm is one that has ________ outstanding.

• debt

• equity

• preferred stock

• equity options

For an unlevered firm, the cost of capital can be determined by using the ________.

• yield on the traded debt

• Capital Asset Pricing Model

• dividend yield

• preferred stock yield

1. Assume Bismuth Electronics has a book value of $6 billion of equity and a face value of $19.7 billion of debt. The market values of equity and debt are $2.5 billion and $18.5 billion. A Wall Street financial analyst determines values of equity and debt as $3 billion and $20 billion. Which of the following values should be used for calculating the firm's WACC?

• $6 billion of equity and $19.7 billion of debt

• $2.5 billion of equity and $20 billion of debt

• $3 billion of equity and $19.9 billion of debt

• $2.5 billion of equity and $18.5 billion of debt

The after-tax cost of equity is ________ the pretax cost of equity.

• higher than

• lower than

• the same as

• less than or equal to

Answer explanation

cost of equity has no tax

1. Assume JUP has debt with a book value of $24 million, trading at 120% of par value. The firm has book equity of $28 million, and 2 million shares trading at $20 per share. What weights should JUP use in calculating its WACC?

• 41.86% for debt, 58.14% for equity

• 37.67% for debt, 62.33% for equity

• 33.49% for debt, 66.51% for equity

• 29.30% for debt, 70.70% for equity

Answer explanation

A) Market Value Debt = $24 million × 120% = $28.8 million

Market Value Equity = 2 million × $20 = $40 million

Total Market Value = $68.8 million

Weight of debt = $28.8 million / $68.8 million = 41.86%

Weight of equity = $40 million / $68.8 million = 58.14%

Outstanding debt of Home Depot trades with a yield to maturity of 5%. The tax rate of Home Depot is 40%. What is the effective cost of debt of Home Depot?

• 4.50%

• 4.65%

• 3.60%

• 3%

Answer explanation

D) Multiply the yield to maturity by 1 minus the tax rate.

0.05 × (1 - 0.4) = 0.030 = 3.00%

Assume preferred stock of Ford Motors pays a dividend of $4 each year and trades at a price of $35. What is the cost of preferred stock capital for Ford?

• 11.4%

• 12.6%

• 13.7%

• 14.9%

Answer explanation

Divide the dividend by the preferred stock price.

$4 / $35 = 0.114 or 11.4%