Question 1

Appalachian Mountain Goods has paid increasing dividends of $.0.12,$0.18,$0.20,and $0.25 a share over the past four years,respectively.The firm estimates that future increases in its dividends will be equal to the arithmetic average growth rate over these past four years.The stock is currently selling for $12.60 a share.The risk-free rate is 3.2 percent and the market risk premium is 9.1 percent.What is the cost of equity for this firm if its beta is 1.26?

Accepted Answer

($0.18 - $0.12)/$0.12 = 0.50($0.20 - $0.18)/$0.18 = 0.111111($0.25 - $0.20)/$0.20 = 0.25g = (0.50 + 0.111111 + 0.25)/3 = 0.287037R_E = 0.032 + 1.26(0.091) = 0.14666 Average R_E = (0.14666 + 0.312573)/2 = 22.96 percent

Question 2

Four years ago,the Morgan Co.issued 15-year,7.0 percent semiannual coupon bonds at par.Today,the bonds are quoted at 101.6.What is this firm's pretax cost of debt?

Accepted Answer

The bond was issued at par, which means the coupon rate is equal to the yield to maturity (YTM) at the time of issuance. Since the coupon rate is 7.0 percent semiannually, the annual coupon payment is:

Coupon payment = 7.0% x $1,000 = $70

Since the bond is currently quoted at 101.6, its price is:

Price = 101.6% x $1,000 = $1,016

The bond has 15 years to maturity and pays semiannual coupons, so it has a total of 30 coupon payments. To calculate the YTM, we can use the following formula:

Price = (Coupon payment / YTM) x [1 - 1/(1+YTM)^n] + $1,000/(1+YTM)^n

where n is the number of periods (i.e., 30 for this bond).

Solving this equation for YTM gives us:

YTM = 6.79%

Therefore, the firm's pretax cost of debt is 6.79%. The correct answer is C).

Question 3

USA Manufacturing issued 30-year,8.5 percent semiannual bonds 6 years ago.The bonds currently sell at 101 percent of face value.What is the firm's aftertax cost of debt if the tax rate is 30 percent?

Accepted Answer

Aftertax cost of debt = 8.402444 percent × (1 - 0.30) = 5.88 percent

Question 4

The Green Balloon just paid its first annual dividend of $0.12 a share.The firm plans to increase the dividend by 3.5 percent per year indefinitely.What is the firm's cost of equity if the current stock price is $6.50 a share?

Accepted Answer

Using the dividend discount model, we can calculate the cost of equity:

$6.50 = $0.12 / (r - 0.035)
$r - 0.035 = $0.12 / $6.50
$r = ($0.12 / $6.50) + 0.035
$r = 0.018 + 0.035
$r = 0.0535 or 5.35%

Therefore, the cost of equity is 5.41% (rounded to two decimal places), which is closest to option B.

Question 5

A firm has multiple divisions of similar nature,yet varying degrees of risk.Which one of the following would be the most appropriate,yet relatively easy,means of assigning discount rates to each of its proposed investments?

Accepted Answer

Using the firm's WACC plus or minus a subjective adjustment allows for a relatively easy way to account for the varying degrees of risk across different projects while still being grounded in the firm's overall cost of capital.

Question 6

The market rate of return is 14.8 percent and the risk-free rate is 4.45 percent.Galaxy Co.has 54 percent more systematic risk than the overall market and has a dividend growth rate of 5.5 percent.The firm's stock is currently selling for $39 a share and has a dividend yield of 3.6 percent.What is the firm's cost of equity?

Accepted Answer

R_E = 0.0445 + 1.54(0.148 - 0.0445)] = 0.20389R_E = 0.038 + 0.055 = 0.093Average R_E = (0.20389 + 0.093)/2 = 14.84 percent

Question 7

The common stock of Contemporary Interiors has a beta of 1.65 and a standard deviation of 27.4 percent.The market rate of return is 13.2 percent and the risk-free rate is 4.8 percent.What is the cost of equity for this firm?

Accepted Answer

R_E = 0.048 + 1.65(0.132 - 0.048) = 18.66 percent

Question 8

Kelly's uses the firm's WACC as the required return for some of its projects.For other projects,the firms uses a rate equal to WACC plus 1 percent,while another set of projects is assigned rates equal to WACC minus some amount.Which one of the following factors should be the key factor the firm uses to determine the amount of the adjustment it will make when assigning the project a discount rate?

Accepted Answer

The risk level of the project should be the key factor to determine the amount of adjustment to the discount rate. Projects with higher risk should have a discount rate higher than WACC, while projects with lower risk can have a discount rate lower than WACC. Factors such as firm beta, date for project commencement, division within the firm, or current debt-equity ratio may be relevant but do not necessarily determine the risk level of the project.

Question 9

Trendsetters has a cost of equity of 18.1 percent.The market risk premium is 10.2 percent and the risk-free rate is 4.4 percent.The company is acquiring a competitor,which will increase the company's beta to 1.6.What effect,if any,will the acquisition have on the firm's cost of equity capital?

Accepted Answer

R_E = 0.044 + 1.6(0.102) = 20.72 percentIncrease in cost of equity = 20.72 percent - 18.1 percent = 2.62 percent

Question 10

The Cracker Barrel has a beta of 0.98,a dividend growth rate of 3.2 percent,a stock price of $33 a share,and an expected annual dividend of $1.06 per share next year.The market rate of return is 11.2 percent and the risk-free rate is 3.7 percent.What is the firm's cost of equity?

Accepted Answer

R_E = 0.037 + 0.98(0.112 - 0.037) = 0.1105R_E = ($1.06/$33) + 0.032 = 0.064121Average R_E = (0.1105 + 0.064121)/2 = 8.73 percent

Question 11

Electronic Products has 35,000 bonds outstanding that are currently quoted at 102.3.The bonds mature in 11 years and carry a 9 percent annual coupon.What is the firm's aftertax cost of debt if the applicable tax rate is 30 percent?

Accepted Answer

Aftertax cost of debt = 8.667318 percent × (1 - 0.30) = 6.07 percent

Question 12

The common stock of Wiley and Sons has a beta that is 25 percent larger than the overall market beta.Currently,the market risk premium is 9.5 percent while the U.S.Treasury bill is yielding 4.7 percent.What is the cost of equity for this firm?

Accepted Answer

R_E = 0.047 + 1.25(0.095) = 16.58 percent

Question 13

Madison Square Stores has a $20 million bond issue outstanding that currently has a market value of $18.6 million.The bonds mature in 6.5 years and pay semiannual interest payments of $35 each.What is the firm's pretax cost of debt?

Accepted Answer

Current bond price = (18.6/20) × $1,000 = $930

Question 14

Musical Charts just paid an annual dividend of $2.45 per share.This dividend is expected to increase by 3.3 percent annually.Currently,the firm has a beta of 1.09 and a stock price of $36 a share.The risk-free rate is 4.2 percent and the market rate of return is 12.6 percent.What is the cost of equity capital for this firm?

Accepted Answer

R_E = 0.042 + 1.09(0.126 - 0.042)] = 0.13356 Average R_E = (0.13356 + 0.103301)/2 = 11.84 percent

Question 15

Judy's Boutique just paid an annual dividend of $1.65 on its common stock.The firm increases its dividend by 2.5 percent annually.What is the rate of return on this stock if the current stock price is $38.20 a share?

Accepted Answer

The correct answer is A.The rate of return on a stock is calculated by dividing the annual dividend by the current stock price. In this case, the annual dividend is $1.65 and the current stock price is $38.20. Therefore, the rate of return is $1.65/$38.20 = 0.0693, or 6.93%.

Question 16

Birds of a Feather has 10-year bonds outstanding that carry an annual coupon of 8 percent.The bonds mature in 7 years and are currently priced at 110 percent of face value.What is the firm's pretax cost of debt?

Accepted Answer

The answer of Birds of a Feather has 10-year bonds...

Question 17

Tennessee Valley Antiques would like to issue new equity shares if its cost of equity declines to 10.5 percent.The company pays a constant annual dividend of $1.80 per share.What does the market price of the stock need to be for the firm to issue the new shares?

Accepted Answer

P₀ = $1.80/0.105 = $17.14

Question 18

Farm Equipment,Inc.announced this morning that its next annual dividend will be decreased to $1.80 a share and that all future dividends will be decreased by an additional 1.5 percent annually.What is the current value per share of this stock if the required return is 16.5 percent?

Accepted Answer

Using the constant growth model:

P0 = D1 / (r - g)

where: 
D1 = next year's dividend = $1.80 
r = required return = 16.5% or 0.165 
g = growth rate = -1.5% or -0.015 (since the dividend is decreasing)

Plugging in the values:

P0 = $1.80 / (0.165 - (-0.015)) 
P0 = $1.80 / 0.18 
P0 = $10

Therefore, the current value per share of this stock is $10. Choice B is the correct answer.

Question 19

The computation of which one of the following requires assigning every proposed investment to a particular risk class?

Accepted Answer

The computation of the subjective cost of capital requires assigning every proposed investment to a particular risk class based on the analyst's subjective judgment of the investment's risk level. This cannot be determined by a formula or objective criteria, unlike the pure play cost of capital, cost of equity, aftertax cost of debt, and WACC.

Question 20

Titans,Inc.has 6 percent bonds outstanding that mature in 14 years.The bonds pay interest semiannually and have a face value of $1,000.Currently,the bonds are selling for $993 each.What is the firm's pretax cost of debt?

Accepted Answer

The pretax cost of debt is calculated using the yield to maturity (YTM) formula for bonds. Given the bond's current price, face value, coupon rate, and time to maturity, the YTM is approximately 6.08 percent.

Quiz 12: Cost of Capital