Deck 10: The Cost of Capital

Question 1

Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt.

Answer 1

False

Question 2

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.

Answer 2

True

Question 3

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

Answer 3

False

Question 4

The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

Question 5

"Capital" is sometimes defined as funds supplied to a firm by investors.

Question 6

The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

Question 7

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the DCF method is widely used in practice.

Question 8

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

Question 9

For capital budgeting and cost of capital purposes, the firm should always consider retained earnings as the first source of capital--i.e., use these funds first--because retained earnings have no cost to the firm.

Question 10

The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and retained earnings, whose cost is the average return on the assets that are acquired.

Question 11

For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity.

Question 12

The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC.

Question 13

The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

Question 14

The reason why retained earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm's common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should pay those earnings out to its investors. Thus, the cost of retained earnings is based on the opportunity cost principle.

Question 15

The cost of capital used in capital budgeting should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets.

Question 16

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, is not deductable by the issuing firm.

Question 17

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost.

Question 18

The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.

Question 19

In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project.

Question 20

If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.

Question 21

When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to use long-term or short-term rates for rRF, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and (3) how to measure the market risk premium, RPM. These problems leave us unsure of the true value of rs.

Question 22

When estimating the cost of equity by use of the DCF method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return. This problem leaves us unsure of the true value of rs.

Question 23

If the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common stock If the expected growth rate is not zero, then the cost of external equity must be found using a different formula.

Question 24

If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the DCF model, and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method. All this makes it especially difficult to estimate the cost of equity for a private company.

Question 25

Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets. They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.

Question 26

If expectations for long-term inflation rose, but the slope of the SML remained constant, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Therefore, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt.

Question 27

The cost of debt, rd, is normally less than rs, so rd(1 - T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 - T).

Question 28

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. Since we cannot be sure that the estimate obtained with any of these methods is correct, it is often appropriate to use all three methods, then consider all three estimates, and end up using a judgmental estimate when calculating the WACC.

Question 29

Suppose the debt ratio is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC).

Question 30

If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity. However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit the shift toward debt.

Question 31

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the CAPM method always provides an accurate and reliable estimate.

Question 32

Since 70% of the preferred dividends received by a corporation are excluded from taxable income, the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be
Cost of equity = rs(0.30)(0.50) + rps(1 - T)(0.70)(0.50).

Question 33

The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 - F)."

Question 34

When working with the CAPM, which of the following factors can be determined with the most precision?

A) The market risk premium (RPM).
B) The beta coefficient, bi, of a relatively safe stock.
C) The most appropriate risk-free rate, rRF.
D) The expected rate of return on the market, rM.
E) The beta coefficient of "the market," which is the same as the beta of an average stock.

Question 35

The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant.

Question 36

For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure.

A) rs > re > rd > WACC.
B) re > rs > WACC > rd.
C) WACC > re > rs > rd.
D) rd > re > rs > WACC.
E) WACC > rd > rs > re.

Question 37

Schalheim Sisters Inc. has always paid out all of its earnings as dividends, hence the firm has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC?

A) The market risk premium declines.
B) The flotation costs associated with issuing new common stock increase.
C) The company's beta increases.
D) Expected inflation increases.
E) The flotation costs associated with issuing preferred stock increase.

Question 38

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

A) Long-term debt.
B) Accounts payable.
C) Retained earnings.
D) Common stock.
E) Preferred stock.

Question 39

Bankston Corporation forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Since new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock?

A) Increase the dividend payout ratio for the upcoming year.
B) Increase the percentage of debt in the target capital structure.
C) Increase the proposed capital budget.
D) Reduce the amount of short-term bank debt in order to increase the current ratio.
E) Reduce the percentage of debt in the target capital structure.

Question 40

When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs.

Question 41

Which of the following statements is CORRECT?

A) In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income.
B) We should use historical measures of the component costs from prior financings that are still outstanding when estimating a company's WACC for capital budgeting purposes.
C) The cost of new equity (re) could possibly be lower than the cost of retained earnings (rs) if the market risk premium, risk-free rate, and the company's beta all decline by a sufficiently large amount.
D) Its cost of retained earnings is the rate of return stockholders require on a firm's common stock.
E) The component cost of preferred stock is expressed as rp(1 - T), because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt.

Question 42

Bosio Inc.'s perpetual preferred stock sells for $97.50 per share, and it pays an $8.50 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is the company's cost of preferred stock for use in calculating the WACC?

A) 8.72%
B) 9.08%
C) 9.44%
D) 9.82%
E) 10.22%

Question 43

Which of the following statements is CORRECT?

A) The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital.
B) The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt.
C) The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets.
D) There is an "opportunity cost" associated with using retained earnings, hence they are not "free."
E) The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year.

Question 44

O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of equity from retained earnings based on the CAPM?

A) 11.30%
B) 11.64%
C) 11.99%
D) 12.35%
E) 12.72%

Question 45

Which of the following statements is CORRECT?

A) A change in a company's target capital structure cannot affect its WACC.
B) WACC calculations should be based on the before-tax costs of all the individual capital components.
C) Flotation costs associated with issuing new common stock normally reduce the WACC.
D) If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline.
E) An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.

Question 46

For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is CORRECT?

A) The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet.
B) The WACC is calculated on a before-tax basis.
C) The WACC exceeds the cost of equity.
D) The cost of equity is always equal to or greater than the cost of debt.
E) The cost of retained earnings typically exceeds the cost of new common stock.

Question 47

Teall Development Company hired you as a consultant to help them estimate its cost of capital. You have been provided with the following data: D1 = $1.45; P0 = $22.50; and g = 6.50% (constant). Based on the DCF approach, what is the cost of equity from retained earnings?

A) 11.10%
B) 11.68%
C) 12.30%
D) 12.94%
E) 13.59%

Question 48

The MacMillen Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 12%. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO's position is accepted, what is likely to happen over time?

A) The company will take on too many high-risk projects and reject too many low-risk projects.
B) The company will take on too many low-risk projects and reject too many high-risk projects.
C) Things will generally even out over time, and, therefore, the firm's risk should remain constant over time.
D) The company's overall WACC should decrease over time because its stock price should be increasing.
E) The CEO's recommendation would maximize the firm's intrinsic value.

Question 49

Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant). What is the cost of equity from retained earnings based on the DCF approach?

A) 9.42%
B) 9.91%
C) 10.44%
D) 10.96%
E) 11.51%

Question 50

Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A's cost of capital is 10.0%, Division B's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A's projects are equally risky, as are all of Division B's projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept?

A) A Division B project with a 13% return.
B) A Division B project with a 12% return.
C) A Division A project with an 11% return.
D) A Division A project with a 9% return.
E) A Division B project with an 11% return.

Question 51

LaPango Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?

A) Project B, which is of below-average risk and has a return of 8.5%.
B) Project C, which is of above-average risk and has a return of 11%.
C) Project A, which is of average risk and has a return of 9%.
D) None of the projects should be accepted.
E) All of the projects should be accepted.

Question 52

Which of the following statements is CORRECT?

A) The "break point" as discussed in the text refers to the point where the firm's tax rate increases.
B) The "break point" as discussed in the text refers to the point where the firm has raised so much capital that it is simply unable to borrow any more money.
C) The "break point" as discussed in the text refers to the point where the firm is taking on investments that are so risky the firm is in serious danger of going bankrupt if things do not go exactly as planned.
D) The "break point" as discussed in the text refers to the point where the firm has raised so much capital that it has exhausted its supply of new retained earnings and thus must raise equity by issuing stock.
E) The "break point" as discussed in the text refers to the point where the firm has exhausted its supply of new retained earnings and thus must begin to finance with preferred stock.

Question 53

If a typical U.S. company correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely

A) become riskier over time, but its intrinsic value will be maximized.
B) become less risky over time, and this will maximize its intrinsic value.
C) accept too many low-risk projects and too few high-risk projects.
D) become more risky and also have an increasing WACC. Its intrinsic value will not be maximized.
E) continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital.

Question 54

Scanlon Inc.'s CFO hired you as a consultant to help her estimate the cost of capital. You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30. Based on the CAPM approach, what is the cost of equity from retained earnings?

A) 9.67%
B) 9.97%
C) 10.28%
D) 10.60%
E) 10.93%

Question 55

Which of the following statements is CORRECT?

A) Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.
B) The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes.
C) If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.
D) Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt.
E) Higher flotation costs tend to reduce the cost of equity capital.

Question 56

Norris Enterprises, an all-equity firm, has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than an average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT?

A) The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.
B) The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return.
C) Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment.
D) The accept/reject decision depends on the firm's risk-adjustment policy. If Norris' policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project.
E) Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision.

Question 57

Which of the following statements is CORRECT?

A) When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.
B) When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.
C) Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM.
D) If a company's beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence must issue new stock.
E) Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC.

Question 58

A company's perpetual preferred stock currently sells for $92.50 per share, and it pays an $8.00 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price. What is the firm's cost of preferred stock?

A) 7.81%
B) 8.22%
C) 8.65%
D) 9.10%
E) 9.56%

Question 59

Which of the following statements is CORRECT?

A) The WACC is calculated using before-tax costs for all components.
B) The after-tax cost of debt usually exceeds the after-tax cost of equity.
C) For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock.
D) Retained earnings that were generated in the past and are reported on the firm's balance sheet are available to finance the firm's capital budget during the coming year.
E) The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital.

Question 60

Which of the following statements is CORRECT?

A) When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation.
B) All else equal, an increase in a company's stock price will increase its marginal cost of retained earnings, rs.
C) All else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re.
D) Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt.
E) If a company's tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall.

Question 61

Rivoli Inc. hired you as a consultant to help estimate its cost of capital. You have been provided with the following data: D0 = $0.80; P0 = $22.50; and g = 8.00% (constant). Based on the DCF approach, what is the cost of equity from retained earnings?

A) 10.69%
B) 11.25%
C) 11.84%
D) 12.43%
E) 13.05%

Question 62

To help finance a major expansion, Castro Chemical Company sold a noncallable bond several years ago that now has 20 years to maturity. This bond has a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000. If the firm's tax rate is 40%, what is the component cost of debt for use in the WACC calculation?

A) 4.35%
B) 4.58%
C) 4.83%
D) 5.08%
E) 5.33%

Question 63

(The following information applies to Problems 91, 92, 93, and 94.)
Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.
The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%.
What is the best estimate of the firm's WACC?

A) 10.85%
B) 11.19%
C) 11.53%
D) 11.88%
E) 12.24%

Question 64

Butcher Timber Company hired your consulting firm to help them estimate the cost of equity. The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of equity can be estimated using a risk premium of 3.85% over a firm's own cost of debt. What is an estimate of the firm's cost of equity from retained earnings?

A) 12.60%
B) 13.10%
C) 13.63%
D) 14.17%
E) 14.74%

Question 65

Trahan Lumber Company hired you to help estimate its cost of capital. You obtained the following data: D1 = $1.25; P0 = $27.50; g = 5.00% (constant); and F = 6.00%. What is the cost of equity raised by selling new common stock?

A) 9.06%
B) 9.44%
C) 9.84%
D) 10.23%
E) 10.64%

Question 66

Weaver Chocolate Co. expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, its expected constant dividend growth rate is 6.0%, and its common stock currently sells for $32.50 per share. New stock can be sold to the public at the current price, but a flotation cost of 5% would be incurred. What would be the cost of equity from new common stock?

A) 12.70%
B) 13.37%
C) 14.04%
D) 14.74%
E) 15.48%

Question 67

You were hired as a consultant to Quigley Company, whose target capital structure is 35% debt, 10% preferred, and 55% common equity. The interest rate on new debt is 6.50%, the yield on the preferred is 6.00%, the cost of retained earnings is 11.25%, and the tax rate is 40%. The firm will not be issuing any new stock. What is Quigley's WACC?

A) 8.15%
B) 8.48%
C) 8.82%
D) 9.17%
E) 9.54%

Question 68

Several years ago the Jakob Company sold a $1,000 par value, noncallable bond that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually. The bond currently sells for $925, and the company's tax rate is 40%. What is the component cost of debt for use in the WACC calculation?

A) 4.28%
B) 4.46%
C) 4.65%
D) 4.83%
E) 5.03%

Question 69

Sorensen Systems Inc. is expected to pay a $2.50 dividend at year end (D1 = $2.50), the dividend is expected to grow at a constant rate of 5.50% a year, and the common stock currently sells for $52.50 a share. The before-tax cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of 45% debt and 55% common equity. What is the company's WACC if all the equity used is from retained earnings?

A) 7.07%
B) 7.36%
C) 7.67%
D) 7.98%
E) 8.29%

Question 70

You were recently hired by Scheuer Media Inc. to estimate its cost of capital. You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.00% (constant); and F = 5.00%. What is the cost of equity raised by selling new common stock?

A) 10.77%
B) 11.33%
C) 11.90%
D) 12.50%
E) 13.12%

Question 71

(The following information applies to Problems 91, 92, 93, and 94.)
Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.
The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%.
Which of the following is the best estimate for the weight of debt for use in calculating the WACC?

A) 8.67%
B) 19.60%
C) 20.58%
D) 21.61%
E) 22.69%

Question 72

You were hired as a consultant to Giambono Company, whose target capital structure is 40% debt, 15% preferred, and 45% common equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of retained earnings is 12.75%. The firm will not be issuing any new stock. What is its WACC?

A) 8.98%
B) 9.26%
C) 9.54%
D) 9.83%
E) 10.12%

Question 73

(The following information applies to Problems 91, 92, 93, and 94.)
Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.
The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%.
What is the best estimate of the after-tax cost of debt?

A) 4.64%
B) 4.88%
C) 5.14%
D) 5.40%
E) 5.67%

Question 74

(The following information applies to Problems 91, 92, 93, and 94.)
Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.
The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%.
Based on the CAPM, what is the firm's cost of equity?

A) 11.15%
B) 11.73%
C) 12.35%
D) 13.00%
E) 13.65%

Question 75

Assume that Kish Inc. hired you as a consultant to help estimate its cost of capital. You have obtained the following data: D0 = $0.90; P0 = $27.50; and g = 7.00% (constant). Based on the DCF approach, what is the cost of equity from retained earnings?

A) 9.29%
B) 9.68%
C) 10.08%
D) 10.50%
E) 10.92%