## Concept Checkers The Cost of Capital

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1. A company has \$5 million in debt outstanding with a coupon rate of 12 percent. Currently the yield to maturity (YTM) on these bonds is 14 percent. If the firm's tax rate is 40 percent, what is the company's after-tax cost of debt?

2. The cost of preferred stock is equal to:

A. the preferred stock dividend divided by its par value.

B. the preferred stock dividend multiplied by the net market price.

C. [(1 - tax rate) times the preferred stock dividend] divided by [the net price].

D. the preferred stock dividend divided by the market price net of flotation costs.

3. A company's \$100, 8 percent preferred is currently selling for \$85. If new shares are issued, the flotation costs will be 6 percent. What is the company's cost of preferred equity?

4. The expected dividend is \$2.50 for a share of stock priced at \$25. What is the cost of equity if the long-term growth in dividends is projected to be 8 percent?

5. The expected dividend is \$2.50 for a share of stock priced at \$25. What is the cost of new equity if flotation costs are 10 percent and the long-term growth in dividends is projected to be 8 percent?

6. The most expensive source of capital is:

B. preferred stock.

C. retained earnings.

D. new common stock.

7. An analyst gathered the following data about a company: Capital Structure Required Rate of Return 30% debt 10% for debt

20% preferred stock 11% for preferred stock

50% common stock 18% for common stock

Assuming a 40 percent tax rate, what after-tax rate of return must the company earn on its investments?

8. A company is planning a \$50 million expansion. The expansion is to be financed by selling \$20 million in new debt and \$30 million in new common stock. The before-tax required return on debt is 9 percent and 14 percent for equity. If the company is in the 40 percent tax bracket, what is the company's marginal weighted average cost of capital?

Use the following data to answer Questions 9 through 14.

• The company has a target capital structure of 40% debt and 60% equity.

• Bonds with face value of \$1,000 pay 10% coupon (semiannual payout), mature in \$849.54.

• Risk-free rate is 10%, and market risk premium is 5%.

• The company is a constant-growth firm that just paid a dividend of \$2.00, sells for a growth rate of 8%.

9. The company's after-tax cost of debt is:

10. The company's cost of equity using the capital asset pricing model (CAPM) approach is:

11. The company's cost of equity using the discounted cash flow approach is:

20 years, and sell for

\$27.00 per share, and has

12. The company's WACC (using the cost of equity from CAPM) is:

13. If the flotation cost for new equity is 10 percent, the company's cost of new equity capital will be:

14. The company's WACC using new capital will be:

15. A firm with a debt-to-equity ratio of 0.5 and a dividend payout ratio of 40 percent projects earnings to be \$20 million. What is the retained earnings/new equity break point?

16. Which of the following factors is least likely to influence the firm's cost of capital?

A. General economic conditions.

B. Marketability of the firm's securities.

C. Amount of financing the firm requires.

D. The exchange on which the firm's stock is traded.

17. What happens to a company's WACC if the firm's corporate tax rate increases and the Federal Reserve causes an increase in the risk-free rate, respectively? (Consider the events independently, and assume a beta of less than 1.) WACC will:

A. decrease, increase.

B. decrease, decrease.

C. increase, increase.

D. remain the same, increase.

18. Given the following information on a company's capital structure, what is the company's WACC? The marginal tax rate is 40 percent.

Type of Percent of Before-Tax

Capital Capital Structure Component; Cost

Preferred stock 5% 11%

Common stock 55% 15% 