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DSM09.MyLab: Chapter 14 - Cost of Capital
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Terms in this set (28)
long-term debt
A tax adjustment must be made in determining the cost of:
less than the return paid to debt holders due to tax benefits of interest paid
The effective cost of debt is:
Cost of equity = risk-free rate + beta(market return - risk-free rate)
So, the cost of equity =
4% + .90(12% - 4%)
= 11.2%
A firm has a beta of 0.90. If market returns are 12% and the risk-free rate is 4%, the estimated cost of equity is __________.
Kps = $8/($100 - $3) = $8/$97
= .08247 or 8.25%
A firm has issued 8% preferred stock, which sold for $100 per share par value. The flotation costs of the stock equaled $3 and the firm's marginal tax rate is 40%. The cost of the preferred stock is;
target capital structure
The firm's optimal mix of debt and equity is called its:
firm's equity beta
To use the CAPM to estimate the cost of equity you need to know the:
CAPM model
E(Rj) = Rf + Bj(E(Rm) - Rf) where;
E(Rj) = required return or expected return
Rf = risk-free rate
Bj = Beta of security j
E(Rm) = expected return on the market
use divisional costs of capital
Firms may often find that they have different divisions with differing degrees of risk. One way to adjust for this in capital budgeting is to:
any cash balances.
Net debt equals total debt outstanding minus:
since interest is tax deductible you need to multiply that rate by (1 - T), where T is the marginal tax rate, in order to get an after-tax cost of debt. So,
Effective cost of debt =
6.2%(1 - .25) = 4.65%.
The debt issued by Coastal Construction has a coupon rate of 5% and a yield to maturity of 6.2%. The company is in the 25% tax bracket. Coastal Construction's effective cost of debt is:
NYSE
Which of these firms is NOT one of the top three credit rating agencies?
WACC =
(.45)(7%) + (.15)(10%) + (.40)(14%)
= 3.15% + 1.5% + 5.6%
= 10.25%
A firm has determined its cost of each source of capital and its optimal capital structure which is comprised of the following sources;
Long-term debt = 45%, after-tax cost = 7%
Preferred stock = 15%, after-tax cost = 10%
Common stock equity = 40%, after-tax cost = 14%
The weighted average cost of capital for this firm is;
Weighted average cost of capital formula
WACC = Wd(kd)(1-T) + Wps(kps) + Wce(kce)
Where;
Wd = weight of debt
kd = cost of debt
T = marginal tax rate
Wps = weight of preferred stock
kps = cost of preferred stock
Wce = weight of common equity
kce = cost of common equity
after-tax and current
The specific cost of each source of long-term financing is based on __________ costs.
cost of financing
The WACC represents the average __________ for the firm.
Retained earnings
For which source of funding does the firm not incur flotation costs?
Current stock price
Which of the following inputs is needed when you use the constant dividend growth model (CDGM) to estimate the cost of equity?
CDGM model
Cost of equity = (expected dividends / current stock price) + growth rate in dividends
FV = $1,000; N = 20; PMT = $90; PV = -$950;
CPT I/Y and you get 9.57%
The approximate before-tax cost of debt for a 20-year, 9%, $1,000 par value bond selling for $950 is __________.
The yield to maturity of the existing debt outstanding.
Which of the following should be used as the firm's cost of debt?
You should always use market values to determine the total value of the firm and then compute the weights as a percentage of market value.
In this case Corona's total value is $10 million debt + $30 million in equity = $40 million.
Equity represents $30m/$40m, or 75% of that amount.
Corona Publishing has debt outstanding with a market value of $10 million. The company's common stock has a book value of $20 million and a market value of $30 million. What weight for equity should Corona use in its WACC calculation?
a decrease in NPV.
An increase in the risk adjusted discount rate (RADR) will result in:
Cost of equity =
(1$1.50 / $45) + .04 = .073 or 7.3%
The stock of Canadian Ski Wear is currently trading at $45 a share and the equity beta of the company is estimated to be 1.3. The company is expected to pay a dividend of $1.50 a share next year, and this dividend is expected to grow at a rate of 4% per year. The rate on the 10-year U.S. Treasury bond is 4% and you estimate the market risk premium to be 5%. Using the {CDGM}, what is the company's cost of equity?
E(Rj) = Rf + Bj(E(Rm) - Rf) where:
E(Rj) = required return or expected return
Rf = risk-free rate
Bj = Beta of security j
E(Rm) = expected return on the market
So, Cost of equity = 4% + 1.3(5%) = 10.5%
The stock of Canadian Ski Wear is currently trading at $45 a share and the equity beta of the company is estimated to be 1.3. The company is expected to pay a dividend of $1.50 a share next year, and this dividend is expected to grow at a rate of 4% per year. The rate on the 10-year U.S. Treasury bond is 4% and you estimate the market risk premium to be 5%. Using the {CAPM}, what is the company's cost of equity?
Common stock
For most firms the largest component in their capital structure is;
CAPM
The cost of common stock equity may be estimated by using the __________.
Preferred stock
The largest component of a typical firm's capital structure is;
Higher; lower
Firms with ___________ credit ratings are able to offer ____________ coupon rates.
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