Question 1

An all-equity firm produced a dividend flow of $20,000 last year.The market value of the firm is $650,000 and the dividend is expected to increase at 4% each year.What is the cost of equity capital for this firm?

Accepted Answer

C) Cost of capital = Dividend flow × (1 + growth rate) / Market value of firm + growth rate
Cost of capital = $20,000 × (1 + 0.04) / $650,000 + 0.04 = 7.2 %

Question 2

The outstanding debt of Berstin Corp.has ten years to maturity,a current yield of 7%,and a price of $95.Assume the debt has a face value of $100.What is the pretax cost of debt if the tax rate is 30%.

Accepted Answer

D) Current yield = coupon / price;
0.07 = coupon / 95; hence, coupon = 0.07 × 95 = 6.65;
yield to maturity = pretax cost of debt;
using a financial calculator, -95 PV, 100 FV, 6.65 PMT, 10 N, CPT I = 7.37%

Question 3

Your estimate of the market risk premium is 6%.The risk-free rate of return is 4.5% and General Motors has a beta of 1.6.What is General Motors' cost of equity capital?

Accepted Answer

A) Apply the CAPM equation.
0.045 + 1.6 × 0.06 = 0.141 = 14.1%

Question 4

The outstanding debt of Berstin Corp.has five years to maturity,a current yield of 6%,and a price of $95.Assume the debt has a face value of $100.What is the pretax cost of debt if the tax rate is 30%?

Accepted Answer

C) Current yield = coupon / price;
0.06 = coupon / 95; hence, coupon = 0.06 × 95 = 5.7.
yield to maturity = pretax cost of debt;
using financial calculator, -95 PV, 100 FV, 5.7 PMT, 5 N, CPT I = 6.9%

Question 5

An all-equity firm produced a dividend flow of $30,000 last year.The market value of the firm is $875,000 and the dividend is expected to increase at 3% each year.What is the cost of equity capital for this firm?

Accepted Answer

A) Cost of capital = Dividend flow × (1 + growth rate) / Market value of firm + growth rate
Cost of capital = $30,000 × (1 + 0.03) / $875,000 + 0.03 = 6.53%

Question 6

Should a firm with high retained earnings have a lower cost of equity?

Accepted Answer

The answer of Should a firm with high retained earnings...

Question 7

A firm has a pre-tax cost of debt of 8.5%.If the firm has a marginal tax rate of 40%,what is its effective cost of debt?

Accepted Answer

A) 8.5% × (1 - .40) = 5.1%

Question 8

The after-tax cost of debt ________ the before-tax cost of debt for a firm that has a positive marginal tax rate.

Accepted Answer

The after-tax cost of debt is calculated by subtracting the tax savings from the before-tax cost of debt. Since a firm with a positive marginal tax rate will receive tax savings from the interest payments, the after-tax cost of debt will be lower than the before-tax cost of debt. Therefore, the correct answer is C, which states that the after-tax cost of debt is always less than the before-tax cost of debt.

Question 9

An all-equity firm produced a dividend flow of $40,000 last year.The market value of the firm is $800,000 and the dividend is expected to increase at 5% each year.What is the cost of equity capital for this firm?

Accepted Answer

C) Cost of capital = Dividend flow × (1 + growth rate) / Market value of firm + growth rate
Cost of capital = $40,000 × (1 + 0.05) / $800,000 + 0.05 = 10.25%

Question 10

A firm has outstanding debt paying annual coupons,with a coupon rate of 10%,and 8 years to maturity.The firm's bonds are currently trading at a price of $875.50 per $1000 face value.What is the firm's cost of debt if it has a tax rate of 25%?

Accepted Answer

C) First calculate yield to maturity. FV = 1000; PV = -875.50; PMT = 100; N = 8.
YTM = 12.55%
Cost of debt = 0.1255 × (1 - 0.25) = 9.4%

Question 11

The outstanding debt of Berstin Corp.has eight years to maturity,a current yield of 8%,and a price of $95.Assume the debt has a face value of $100.What is the pretax cost of debt if the tax rate is 30%?

Accepted Answer

C) Current yield = coupon/price;
0.08 = coupon / 95; hence, coupon = 0.08 × 95 = 7.6;
yield to maturity = pretax cost of debt;
using financial calculator, -95 PV, 100 FV, 7.6 PMT, 8 N, CPT I = 8.5%

Question 12

Your estimate of the market risk premium is 7%.The risk-free rate of return is 4% and General Motors has a beta of 1.5.What is General Motors' cost of equity capital?

Accepted Answer

B) Apply the CAPM equation.
0.04 + 1.5 × 0.07 = 0.145 = 14.5%

Question 13

A firm has outstanding debt with a coupon rate of 7%,seven years maturity,and a price of $1000 per $1000 face value.What is the after-tax cost of debt if the marginal tax rate of the firm is 30%?

Accepted Answer

A) YTM = coupon rate in this case. Therefore, after-tax cost = coupon rate × (1 - tax rate).
Therefore after-tax cost = 0.07 × (1 - 0.3) = 4.9%.

Question 14

Is it incorrect to use the coupon rate of debt toward cost of debt?

Accepted Answer

The answer of Is it incorrect to use the coupon...

Question 15

A firm has outstanding debt paying annual coupons,with a coupon rate of 5%,and 10 years to maturity.The firm's bonds are currently trading at a price of $950 per $1000 face value.What is the firm's cost of debt if it has a tax rate of 15%?

Accepted Answer

C) First calculate yield to maturity. FV = 1000; PV = -950; PMT = 50; N = 10.
YTM = 5.7%
Cost of debt = 0.057 × (1 - 0.15) = 4.8%

Question 16

Between the two models Constant Dividend Growth Model (CDGM)and Capital Asset Pricing Model (CAPM),which is a better method for computation of the cost of equity?

Accepted Answer

The answer of Between the two models Constant Dividend Growth...

Question 17

A firm has $2 million market value and it sells preferred stock with a par value of $100.If the coupon rate on the preferred stock is 8% and the preferred stock trades at $90,what is the cost of preferred stock financing?

Accepted Answer

B) Cost of preferred stock financing = Dividend rate × Par value / Price
Cost of preferred stock financing = 8 × 100 / 90 = 8.89%

Question 18

A firm has $3 million market value and it sells preferred stock with a par value of $100.If the coupon rate on the preferred stock is 9% and the preferred stock trades at $95,what is the cost of preferred stock financing?

Accepted Answer

B) Cost of preferred stock financing = Dividend rate × Par value / Price
Cost of preferred stock financing = 9 × 100 / 95 = 9.47%

Question 19

What is the difference between the effective cost of debt and the cost of debt?

Accepted Answer

The answer of What is the difference between the effective...

Question 20

A firm has $1 million market value and it sells preferred stock with a par value of $100.If the coupon rate on the preferred stock is 7% and the preferred stock trades at $95,what is the cost of preferred stock financing?

Accepted Answer

D) Cost of preferred stock financing = Dividend rate × Par value / Price
Cost of preferred stock financing = 7 × 100 / 95 = 7.37%

Quiz 12: Determining the Cost of Capital