Cost of Capital

The cost of equity is equal to the:

• expected market return.

• rate of return required by stockholders.

• cost of retained earnings plus dividends.

Which of the following statements is correct?

• The appropriate tax rate to use in the adjustment of the before-tax cost of

  debt to determine the after-tax cost of debt is the average tax rate because

  interest is deductible against the company's entire taxable income.

• For a given company, the after-tax cost of debt is generally less than both

  the cost of preferred equity and the cost of common equity.

• For a given company, the investment opportunity schedule is upward slop-

  ing because as a company invests more in capital projects, the returns from

  investing increase.

Dot.Com has determined that it could issue $1,000 face value bonds with an

8 percent coupon paid semi-annually and a five-year maturity at $900 per bond.

If Dot.Com’s marginal tax rate is 38 percent, its after-tax cost of debt is closest

to:

• 6.2%

• 6.4%

• 6.6%

• 6.8%

Answer explanation

C is correct. FV = $1,000; PMT = $40; N = 10; PV = $900

Solve for i. The six-month yield, i, is 5.3149%

YTM = 5.3149% × 2 = 10.62985%

rd(1 − t) = 10.62985%(1 − 0.38) = 6.5905%

A financial analyst at Buckco Ltd. wants to compute the company's weighted

average cost of capital (WACC) using the dividend discount model. The analyst

has gathered the following data (see attachment):

Buckco’s WACC is closest to:

• 8%

• 9%

• 10%

• 12%

Answer explanation

Cost of equity = D1/P0 + g = $1.50/$30 + 7% = 5% + 7% = 12%

D/(D + E) = 0.8033/1.8033 = 0.445

WACC = [(0.445) (0.08)(1 − 0.4)] + [(0.555)(0.12)] = 8.8%

Two years ago, a company issued $20 million in long-term bonds at par value

with a coupon rate of 9 percent. The company has decided to issue an addi-

tional $20 million in bonds and expects the new issue to be priced at par value

with a coupon rate of 7 percent. The company has no other debt outstanding

and has a tax rate of 40 percent. To compute the company's weighted average

cost of capital, the appropriate after-tax cost of debt is closest to:

• 4.2%

• 4.8%

• 5.4%

• 5.8%

Answer explanation

The relevant cost is the marginal cost of debt. The before-tax marginal cost of debt can be estimated by the yield to maturity on a comparable outstanding.

After adjusting for tax, the after-tax cost is 7(1 − 0.4) = 7(0.6) =

4.2%.

Wang Securities had a long-term stable debt-to-equity ratio of 0.65. Recent

bank borrowing for expansion into South America raised the ratio to 0.75.

The increased leverage has what effect on the asset beta and equity beta of the

company?

• The asset beta and the equity beta will both rise.

• The asset beta will remain the same and the equity beta will rise.

• The asset beta will remain the same and the equity beta will decline.

Answer explanation

Asset risk does not change with a higher debt-to-equity ratio.

Equity risk rises with higher debt

Fran McClure of Alba Advisers is estimating the cost of capital of Frontier

Corporation as part of her valuation analysis of Frontier. McClure will be using

this estimate, along with projected cash flows from Frontier's new projects, to

estimate the effect of these new projects on the value of Frontier. McClure has

gathered the following information on Frontier Corporation (See attachment)

The weights that McClure should apply in estimating Frontier's cost of capital

for debt and equity are, respectively:

• wd = 0.200;

  we = 0.800.

• wd = 0.185;

  we = 0.815.

• wd = 0.223;

  we = 0.777.

• wd = 0.300;

  we = 0.700.

Answer explanation

wd = $63/($220 + 63) = 0.223

we = $220/($220 + 63) = 0.777

An analyst gathered the following information about a company and the

market: (See attachment)

Using the Capital Asset Pricing Model (CAPM) approach, the cost of retained

earnings for the company is closest to:

• 13.6%

• 15.7%

• 16.1%

• 17.8%

Answer explanation

Using the CAPM approach, 4% + 1.3(9%) = 15.7%.