Question 1

A firm has a capital structure with $75 million in equity and $45 million of debt. The cost of equity capital is 10% and the pretax cost of debt is 7%. If the marginal tax rate of the firm is 40%, compute the weighted average cost of capital of the firm.

Accepted Answer

Weighted average cost of capital = (Cost of equity * (Equity/Total capital)) + (Cost of debt * (Debt/Total capital) * (1-tax rate))

WACC = (0.10*75/120) + (0.07*45/120)*(1-0.4) = 0.078 or 7.8%

Question 2

A firm has a capital structure with $75 million in equity and $75 million of debt. The cost of equity capital is 10% and the pretax cost of debt is 7%. If the marginal tax rate of the firm is 35%, compute the weighted average cost of capital of the firm.

Accepted Answer

A) 11ea84dc_f52a_8fd6_9a63_b5ed33dc7cbf_TB1316_00_TB1316_00 11ea84dc_f52a_8fd7_9a63_f96a9c7ef340_TB1316_00_TB1316_00

Question 3

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 6% and the preferred stock trades at $98, what is the cost of preferred stock capital?

Accepted Answer

B) 11ea84dc_f527_3464_9a63_81dead890ca1_TB1316_00_TB1316_00 Cost of preferred stock capital = (6% × $100) / $98 = 6.12%

Question 4

A firm has outstanding debt with a coupon rate of 8%, nine years maturity, and a price of $1,000. What is the after-tax cost of debt if the marginal tax rate of the firm is 40%?

Accepted Answer

B) YTM = coupon rate in this case since the bond is selling at par. Therefore, 11ea84dc_f526_e641_9a63_97a52087cc61_TB1316_11_TB1316_11 Therefore, after-tax cost = 0.08 × (1 - 0.4) = 4.8%.

Question 5

The outstanding debt of Berstin Corp. has eight years to maturity, a current yield of 7%, and a price of $85. What is the pretax cost of debt if the tax rate is 40%?

Accepted Answer

C) Current yield = Coupon / Price;
0.07 = Coupon / $85; hence, Coupon = 0.07 × $85 = $5.95.
Yield to maturity = Pretax cost of debt; 11ea84dc_f527_f7b9_9a63_895aeb3550ed_TB1316_00_TB1316_00

Question 6

The outstanding debt of Berstin Corp. has five years to maturity, a current yield of 6%, and a price of $95. 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 7

SIROM Scientific Solutions has $5 million of outstanding equity and $5 million of bank debt. The bank debt costs 4% per year. The estimated equity beta is 2. If the market risk premium is 8% and the risk-free rate is 4%, compute the weighted average cost of capital if the firm's tax rate is 35%.

Accepted Answer

C) Cost of debt = rate on bank debt
Cost of equity = Risk-free rate + Beta × Market risk premium 11eaabab_c080_b878_b90e_4b45e1fd9ae4_TB5536_00 Weight of debt = 1- Weight of equity. 11eaabab_c080_df89_b90e_6f8e6171d241_TB5536_00 Cost of equity = 0.04 + 2 × 0.08 = 0.2 or 20%
Weight of equity = 5/(5 + 5) = 0.5 or 50%
Weight of debt = 1 - 0.5 = 0.5 or 50% 11eaabab_c080_df8a_b90e_0795b9f6f3c4_TB5536_00

Question 8

Your estimate of the market risk premium is 9%. The risk-free rate of return is 4.1% and General Motors has a beta of 1.8. What is General Motors' cost of equity capital?

Accepted Answer

A) Apply the CAPM equation.
Cost of equity = 0.041 + (1.8 × 0.09) = 0.203 = 20.3%

Question 9

A firm has outstanding debt with a coupon rate of 5%, ten years maturity, and a price of $1,000. What is the after-tax cost of debt if the marginal tax rate of the firm is 35%?

Accepted Answer

The after-tax cost of debt is calculated as follows: 
After-tax cost of debt = Before-tax cost of debt × (1 − Marginal tax rate)
Before-tax cost of debt = coupon rate = 5%
Marginal tax rate = 35%
After-tax cost of debt = 5% × (1 − 0.35) = 3.25%
Therefore, the after-tax cost of debt is 3.3% (rounded to one decimal place) which is option C.

Question 10

An all-equity firm had a dividend expense of $20,000 last year. The market value of the firm is $600,000 and the dividend is expected to increase at 5% each year. What is the cost of equity for this firm?

Accepted Answer

C) Cost of equity = Dividend (in one year) / Current Price + Dividend Growth Rate
Cost of equity = ($20,000 × (1 + 0.05) / $600,000 )+ 0.05 = 8.50%

Question 11

A firm has a pre-tax cost of debt of 9.0%. If the firm has a marginal tax rate of 35%, what is its effective cost of debt?

Accepted Answer

A) 9.0% × (1 - 0.35) = 5.9%

Question 12

SIROM Scientific Solutions has $10 million of outstanding equity and $5 million of bank debt. The bank debt costs 5% per year. The estimated equity beta is 2. If the market risk premium is 9% and the risk-free rate is 3%, compute the weighted average cost of capital if the firm's tax rate is 30%.

Accepted Answer

A) Cost of debt = rate on bank debt = 5%
Cost of equity = Risk-free rate + Beta × Market risk premium 11eaabab_c080_9165_b90e_8f60b2cfcd53_TB5536_00 Weight of debt = 1- Weight of equity. 11eaabab_c080_b876_b90e_1d13125579bc_TB5536_00 Cost of equity = 0.03 + 2 × 0.09 = 0.21 or 21%
Weight of equity = 10/(10 + 5) = 0.66666667 or 66.67%
Weight of debt = 1 - 0.66666667 = 0.33333333 or 33.33% 11eaabab_c080_b877_b90e_198e391d11bb_TB5536_00

Question 13

A firm has outstanding debt with a coupon rate of 8%, seven years maturity, and a price of $1,000. What is the after-tax cost of debt if the marginal tax rate of the firm is 35%?

Accepted Answer

A) YTM = coupon rate in this case since the bond is selling at par. Therefore, 11ea84dc_f526_e640_9a63_1fa72cac5c72_TB1316_11_TB1316_11 Therefore, after-tax cost = 0.08 × (1 - 0.35) = 0.052 or 5.2%.

Question 14

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 8% and the preferred stock trades at $92, what is the cost of preferred stock capital?

Accepted Answer

First, we need to calculate the preferred stock's yield, using the formula: Yield = Annual Dividend / Market Price.
The Annual Dividend can be calculated as follows: 
Coupon rate * Par Value = 8% * $100 = $8
So, the Yield = $8 / $92 = 0.087= 8.70%
Therefore, the cost of preferred stock capital is 8.70%.

Question 15

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

Accepted Answer

First, we need to calculate the yield to maturity (YTM) using the current yield and price of the bond:
YTM = current yield + ((face value - price) / years to maturity) * 100
YTM = 7% + ((100 - 95) / 10) * 100
YTM = 7.5%
Next, we need to calculate the after-tax cost of debt using the YTM and tax rate:
After-tax cost of debt = YTM * (1 - tax rate)
After-tax cost of debt = 7.5% * (1 - 0.3)
After-tax cost of debt = 5.25%
Finally, we need to convert the after-tax cost of debt to the pretax cost of debt:
Pretax cost of debt = after-tax cost of debt / (1 - tax rate)
Pretax cost of debt = 5.25% / (1 - 0.3)
Pretax cost of debt = 7.37%
Therefore, the answer is D.

Question 16

An all-equity firm had a dividend expense of $45,000 last year. The market value of the firm is $800,000 and the dividend is expected to increase at 7% each year. What is the cost of equity for this firm?

Accepted Answer

C) 11ea84dc_f527_d0a8_9a63_0df424a8580b_TB1316_00_TB1316_00 Cost of equity = ($45,000 × (1 + 0.07) / $800,000) + 0.07 = 13.02%

Question 17

An all-equity firm had a dividend expense of $30,000 last year. The market value of the firm is $900,000 and the dividend is expected to increase at 6% each year. What is the cost of equity for this firm?

Accepted Answer

A) Cost of equity = 11ea84dc_f527_8286_9a63_299a564afe88_TB1316_00_TB1316_00 11ea84dc_f527_a997_9a63_5f18972cdd50_TB1316_00_TB1316_00

Question 18

SIROM Scientific Solutions has $12 million of outstanding equity and $4 million of bank debt. The bank debt costs 4% per year. The estimated equity beta is 1. If the market risk premium is 8% and the risk-free rate is 4%, compute the weighted average cost of capital if the firm's tax rate is 30%.

Accepted Answer

C) Cost of debt = rate on bank debt
Cost of equity = Risk-free rate + Beta × Market risk premium 11eaabab_c080_df8b_b90e_0f1f2fc6bda3_TB5536_11 Weight of debt = 1- Weight of equity. 11eaabab_c080_df8c_b90e_2d668e7b0010_TB5536_00 Cost of equity = 0.04 + 1 × 0.08 = 0.12 or 12%
Weight of equity= 12/(12 + 4) = 0.75 or 75%
Weight of debt = 1 - 0.75 = 0.25 or 25% 11eaabab_c081_069d_b90e_d11a3f8a9842_TB5536_00

Question 19

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 5% and the preferred stock trades at $91, what is the cost of preferred stock capital?

Accepted Answer

D) 11ea84dc_f527_3463_9a63_851c368b94c9_TB1316_00_TB1316_00 Cost of preferred stock capital = (5% × $100) / $91 = 5.49%

Question 20

A firm has a capital structure with $50 million in equity and $100 million of debt. The cost of equity capital is 11% and the pretax cost of debt is 5%. If the marginal tax rate of the firm is 40%, compute the weighted average cost of capital of the firm.

Accepted Answer

Weighted average cost of capital (WACC) = (E/V) * Re + (D/V) * Rd * (1 - T)

Where,
E = Market value of equity
V = Total market value of firm (Equity + Debt)
Re = Cost of equity capital
D = Market value of debt
Rd = Pretax cost of debt
T = Marginal tax rate

Given, 
E = $50 million
D = $100 million
Re = 11%
Rd = 5%
T = 40%

V = E + D = $50 million + $100 million = $150 million

WACC = (50/150) * 0.11 + (100/150) * 0.05 * (1-0.40) = 0.5667 = 5.67%

Therefore, the best choice is C.

Quiz 13: The Cost of Capital