Question 1

The cost of retained earnings is less than the cost of new common stock because

Accepted Answer

Retained earnings refer to the profits that a company keeps within the business instead of distributing them as dividends to shareholders. The cost of retained earnings is usually lower than the cost of new common stock because when a company issues new common stock, it incurs flotation costs such as underwriting fees, legal fees, and printing expenses. These costs typically range from 2% to 7% of the total amount raised, which increases the cost of new common stock.

Question 2

In capital budgeting analysis,when computing the weighted average cost of capital,the CAPM approach is typically used to find which of the following?

Accepted Answer

The CAPM approach is used to find the component cost of internal equity, which is a key component in the calculation of the weighted average cost of capital. The market value weight of equity, pretax component cost of debt, and after-tax component cost of debt are typically found using other methods.

Question 3

Seafood Products Corp.is expected to pay a dividend of $2.60 next year.Dividends are expected to grow at a constant rate of 8% per year,and the stock price is currently $20.00.New stock can be sold at this price subject to flotation costs of 15%.The company's marginal tax rate is 35%.Compute the cost of internal equity (retained earnings)and the cost of external equity (new common stock),respectively.

Accepted Answer

The cost of internal equity (retained earnings) is calculated using the Gordon Growth Model: (D1/P0) + g = (2.60/20) + 0.08 = 0.13 + 0.08 = 21.00%. The cost of external equity (new common stock) accounts for flotation costs: (D1/(P0*(1-f))) + g = (2.60/(20*(1-0.15))) + 0.08 = 0.153 + 0.08 = 23.29%.

Question 4

The risk free rate of return is 2.5% and the market risk premium is 8%.Penn Trucking has a beta of 2.2 and a standard deviation of returns of 28%.Penn Trucking's marginal tax rate is 35%.Analysts expect Penn Trucking's dividends to grow by 6% per year for the foreseeable future.Using the capital asset pricing model,what is Penn Trucking's cost of retained earnings?

Accepted Answer

The answer of The risk free rate of return is...

Question 5

In general,the least expensive source of capital is

Accepted Answer

The answer of In general,the least expensive source of capital...

Question 6

Clanton Company is financed 75 percent by equity and 25 percent by debt.If the firm expects to earn $30 million in net income next year and retain 40% of it,how large can the capital budget be before common stock must be sold?

Accepted Answer

First, we need to find the amount of money the company will retain from the net income:
$30 million x 0.40 = $12 million
This means the company can use $12 million for capital budget without selling any common stock. 
Next, we need to find the total amount of capital budget the company can have without exceeding the 75% equity financing. We can do this by dividing the total capital by 0.75:
Total capital = $12 million / 0.75 = $16 million
Therefore, the capital budget can be as large as $16 million before common stock must be sold. 
The correct choice is (C) $15.5 million, as it is the closest to the calculated amount of $16 million.

Question 7

KayCee Manufacturing Company paid a dividend yesterday of $3.50 per share.The dividend is expected to grow at a constant rate of 10% per year.The price of KayCee's common stock today is $40 per share.If KayCee decides to issue new common stock,flotation costs will equal $4.00 per share.Kaycee's marginal tax rate is 35%.Based on the above information,the cost of retained earnings is

Accepted Answer

The cost of retained earnings is the rate of return required by the shareholders to invest in the company’s retained earnings. This can be calculated using the Gordon Growth Model formula:

Cost of Retained Earnings = (Dividend Yield + Dividend Growth Rate)

Dividend Yield = Dividend / Current Stock Price
= $3.50 / $40
= 0.0875 or 8.75%

Dividend Growth Rate = 10%

Therefore, the cost of retained earnings = (8.75% + 10%)
= 18.75%

However, we need to adjust for the flotation costs and taxes. Flotation costs are a one-time expense that reduces the amount of funds available to the company, while taxes reduce the after-tax cash flow available to the company. The adjusted cost of retained earnings can be calculated using the following formula:

Adjusted Cost of Retained Earnings = Cost of Retained Earnings / (1 - Flotation Costs) x (1 - Tax Rate)

= 18.75% / (1 - 0.040) x (1 - 0.35)
= 19.63%

Therefore, the cost of retained earnings for KayCee is 19.63%.

Question 8

A firm's cost of capital is influenced by

Accepted Answer

A firm's capital structure, which includes the proportion of debt to equity, affects the cost of capital. The higher the proportion of debt, the higher the cost of capital as lenders demand a higher return to compensate for the increased risk. The par value of common stock, current ratio, and net income do not directly impact a firm's cost of capital.

Question 9

DEF Company's preferred stock is currently selling for $28.00,and pays a perpetual annual dividend of $2.00 per share.Underwriters of a new issue of preferred stock would charge $3 per share in flotation costs.The firm's tax rate is 40%.Compute the cost of new preferred stock for DEF.

Accepted Answer

The answer of DEF Company's preferred stock is currently selling...

Question 10

Which of the following differentiates the cost of retained earnings from the cost of newly-issued common stock?

Accepted Answer

The flotation costs incurred when issuing new securities differentiate the cost of retained earnings from the cost of newly-issued common stock. Retained earnings are already within the company and do not incur any additional costs associated with issuing new securities. However, new common stock issuance incurs flotation costs, which include the costs of underwriting, legal, and accounting services. These costs increase the cost of new equity issuance compared to the cost of retained earnings. The other options (A, B, and D) do not differentiate the cost of retained earnings from the cost of newly-issued common stock.

Question 11

The cost of new preferred stock is equal to

Accepted Answer

The cost of new preferred stock is calculated as the preferred stock dividend divided by the net selling price of the preferred stock. This accounts for any flotation or issuance costs associated with selling the new stock.

Question 12

The risk free rate of return is 3% and the expected return on the market portfolio is 14%.Starship Enterprises has a beta of 2.0 and a standard deviation of returns of 26%.Starship's marginal tax rate is 35%.Analysts expect Starship's net income to grow by 12% per year for the next 5 years.Using the capital asset pricing model,what is Starship Enterprises' cost of retained earnings?

Accepted Answer

The answer of The risk free rate of return is...

Question 13

The average cost associated with each additional dollar of financing for investment projects is

Accepted Answer

The average cost associated with each additional dollar of financing for investment projects is known as the marginal cost of capital. It represents the cost of obtaining additional funds from various sources, such as debt, equity, or retained earnings. By calculating the marginal cost of capital, companies can determine the most cost-efficient way to fund their investment projects.

Question 14

Atlas Corporation wishes to estimate its cost of retained earnings.The firm's beta is 1.3.The rate on 6-month T-bills is 2%,and the return on the S&P 500 index is 15%.What is the appropriate cost for retained earnings in determining the firm's cost of capital?

Accepted Answer

The cost of retained earnings can be estimated using the Capital Asset Pricing Model (CAPM): Cost of Equity = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate). Substituting the given values: 2% + 1.3 * (15% - 2%) = 18.9%.

Question 15

KayCee Manufacturing Company paid a dividend yesterday of $3.50 per share.The dividend is expected to grow at a constant rate of 10% per year.The price of KayCee's common stock today is $40 per share.If Kaycee decides to issue new common stock,flotation costs will equal $4.00 per share.Kaycee's marginal tax rate is 35%.Based on the above information,the cost of new common stock is

Accepted Answer

The cost of new common stock can be calculated using the formula: Cost = (D1 / (P0 - F)) + g, where D1 is the expected dividend next year ($3.50 * 1.10 = $3.85), P0 is the current stock price ($40), F is the flotation cost ($4), and g is the growth rate (10% or 0.10). Substituting these values gives: Cost = ($3.85 / ($40 - $4)) + 0.10 = 0.2009 or 20.09%.

Question 16

The cost of external equity capital is greater than the cost of retained earnings because of:

Accepted Answer

The cost of external equity capital is greater than the cost of retained earnings because new equity requires incurring flotation costs, such as underwriting fees, legal fees, and other expenses, which increases the cost of equity. Retained earnings, on the other hand, do not incur any such costs.

Question 17

Jiffy Co.expects to pay a dividend of $3.00 per share in one year.The current price of Jiffy common stock is $60 per share.Flotation costs are $3.00 per share when Jiffy issues new stock.What is the cost of internal common equity (retained earnings)if the long-term growth in dividends is projected to be 8 percent indefinitely?

Accepted Answer

The cost of internal common equity (retained earnings) can be calculated using the Gordon Growth Model (Dividend Discount Model for a perpetually growing dividend), which is given by the formula: Cost of Equity = (D1 / P0) + g, where D1 is the dividend in the next period, P0 is the current price of the stock, and g is the growth rate. Plugging in the values: Cost of Equity = ($3 / $60) + 0.08 = 0.05 + 0.08 = 0.13 or 13%.

Question 18

In general,which of the following rankings,from highest to lowest cost,is most accurate?

Accepted Answer

The cost of new common stock is typically the highest due to flotation costs and the risk premium demanded by equity investors. Retained earnings, while not free, are cheaper because they do not incur flotation costs and do not dilute ownership. Preferred stock generally costs more than debt due to its higher risk (lack of tax deductibility and subordination to debt in case of liquidation) but less than new common stock. Debt is usually the cheapest source of financing due to its tax deductibility and lower risk for investors.

Question 19

Asian Trading Company paid a dividend yesterday of $5 per share (D₀= $4).The dividend is expected to grow at a constant rate of 8% per year.The price of Asian Trading Company's stock today is $29 per share.If Asian Trading Company decides to issue new common stock,flotation costs will equal $2.50 per share.Asian Trading Company's marginal tax rate is 35%.Based on the above information,the cost of new common stock is

Accepted Answer

The cost of new common stock is calculated as follows:Cost of new common stock = (D1 / (P0 - F)) + gwhere:D1 = expected dividend in one year = D0 * (1 + g) = $5 * (1 + 0.08) = $5.40P0 = current stock price = $29F = flotation costs = $2.50g = constant growth rate = 0.08Plugging in the values, we get:Cost of new common stock = ($5.40 / ($29 - $2.50)) + 0.08 = 28.38%Therefore, the cost of new common stock is 28.38%.

Question 20

A company has preferred stock with a current market price of $18 per share.The preferred stock pays an annual dividend of 4% based on a par value of $100.Flotation costs associated with the sale of preferred stock equal $1.50 per share.The company's marginal tax rate is 40%.Therefore,the cost of preferred stock is

Accepted Answer

First, we need to calculate the net proceeds from the sale of preferred stock:

Net proceeds = $18 - $1.50 = $16.50 per share

Next, we need to calculate the dividend per share:

Dividend = 4% * $100 = $4 per share

Therefore, the dividend yield is:

Dividend yield = $4 / $16.50 = 0.2424 or 24.24%

Finally, we need to adjust for the flotation costs and the company's marginal tax rate:

Cost of preferred stock = (Dividend yield / (1 - Tax rate)) + Flotation cost per share
Cost of preferred stock = (0.2424 / (1 - 0.4)) + $1.50
Cost of preferred stock = 0.404 or 40.40%

Therefore, the cost of preferred stock is 24.24% after adjusting for flotation costs and taxes.

Quiz 9: The Cost of Capital