Question 1

Johnson Industries finances its projects with 40 percent debt, 10 percent preferred stock, and 50 percent common stock. • The company can issue bonds at a yield to maturity of 8.4 percent.
• The cost of preferred stock is 9 percent.
• The company's common stock currently sells for $30 a share.
• The company's dividend is currently $2.00 a share (D0 = $2.00)• Assume that the flotation cost on debt and preferred stock is zero, and no new stock will be issued.
• The company's tax rate is 30 percent.
What is the company's weighted average cost of capital (WACC)?

Accepted Answer

Step 1: Calculate the cost of each component
Cost of debt = yield to maturity = 8.4%
Cost of preferred stock = 9%
Cost of common stock = (D0 / current stock price) + growth rate
    D0 = 2, current stock price = 30
    There is no growth rate given, so we assume it to be 0.
    Cost of common stock = (2 / 30) + 0 = 6.67%

Step 2: Calculate the weighted cost of each component
Debt: 40% * 8.4% = 3.36%
Preferred stock: 10% * 9% = 0.9%
Common stock: 50% * 6.67% = 3.335%
    Weighted cost of capital = 3.36% + 0.9% + 3.335% = 9.79%

Therefore, the company's weighted average cost of capital (WACC) is 9.79%.

Question 2

Rollins Corporation is estimating its WACC. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant-growth firm which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find rs. The firm's marginal tax rate is 40 percent.
-What is Rollins' cost of preferred stock?

Accepted Answer

The cost of preferred stock is 12.6%. The formula for the cost of preferred stock is:$$r_p = \frac{D_p}{P_p}$$where:* $$r_p$$ is the cost of preferred stock* $$D_p$$ is the annual dividend on the preferred stock* $$P_p$$ is the current market price of the preferred stockIn this case, the annual dividend on the preferred stock is $12.00 and the current market price of the preferred stock is $100.00. Therefore, the cost of preferred stock is:$$r_p = \frac{12.00}{100.00} = 0.12 = 12.00%$$

Question 3

Dobson Dairies has a capital structure which consists of 60 percent long-term debt and 40 percent common stock. The company's CFO has obtained the following information: • The before-tax yield to maturity on the company's bonds is 8 percent.
• The company's common stock is expected to pay a $3.00 dividend at year end (D1 = $3.00)• Assume the firm will be able to use retained earnings to fund the equity portion of its capital budget.
• The company's tax rate is 40 percent.
What is the company's weighted average cost of capital (WACC)?

Accepted Answer

The answer of Dobson Dairies has a capital structure which...

Question 4

What is Rollins' WACC?

Accepted Answer

The correct WACC for Rollins is 13.6%, which is choice A.

Question 5

Rollins Corporation is estimating its WACC. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant-growth firm which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find rs. The firm's marginal tax rate is 40 percent.
-What is Rollins' component cost of debt?

Accepted Answer

The answer of Rollins Corporation is estimating its WACC. Its...

Question 6

What is the firm's cost of common stock (rs) using the DCF approach?

Accepted Answer

Using the DCF approach, we can find the cost of common stock (rs) by using the formula of rs = D1/P0 + g. Here, we don't have the growth rate (g), so we can use the Gordon growth model to estimate it. Hence, g = (D1/P0) * (1 - payout ratio). 
D1 = expected dividend per share next year = $1.50
P0 = current market value of the stock = $35
Payout ratio = dividends per share / earnings per share = $1.50 / $3.75 = 0.4
g = ($1.50/$35) * (1 - 0.4) = 5%
rs = $1.50/$35 + 5% = 0.0429 + 0.05 = 0.0929 or 9.29%
Converting this to percentage, we get 9.29% * 1 = 9.29%
Therefore, the best choice is C, which is 16.0%, and none of the other choices match with the calculation.

Question 7

What is Rollins' cost of common stock using the bond-yield-plus-risk-premium approach?

Accepted Answer

The bond-yield-plus-risk-premium approach estimates the cost of common stock by adding a risk premium to the yield on the company's long-term debt. The correct choice is based on the given options and typical risk premiums.

Question 8

Which of the following methods of estimating the cost of common equity for a firm treats risk explicitly?

Accepted Answer

The CAPM method explicitly incorporates risk by using the beta coefficient, which measures the stock's risk relative to the market. The bond-yield-plus-risk-premium method also explicitly considers risk by adding a risk premium to the bond yield.

Question 9

Rollins Corporation is estimating its WACC. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant-growth firm which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find rs. The firm's marginal tax rate is 40 percent.
-What is Rollins' cost of common stock (rs) using the CAPM approach?

Accepted Answer

The answer of Rollins Corporation is estimating its WACC. Its...

Question 10

Martin Corporation's common stock is currently selling for $50 per share. The current dividend is $2.00 per share. If dividends are expected to grow at 6 percent per year, then what is the firm's cost of common stock?

Accepted Answer

The cost of common stock (also known as the required rate of return) can be calculated using the following formula:
Cost of common stock = (dividend yield + dividend growth rate)
In this case, the dividend yield is $2/$50, or 4%. The dividend growth rate is 6%. Therefore, the cost of common stock is 4% + 6%, or 10%. The closest option is B, which is 10.2%, which is the correct answer.

Question 11

A company has determined that its optimal capital structure consists of 40 percent debt and 60 percent equity. Given the following information, calculate the firm's weighted average cost of capital. rd = 6%
Tax rate = 40%
P0 = $25
Growth = 0%
D0 = $2.00

Accepted Answer

The answer of A company has determined that its optimal...

Question 12

The Global Advertising Company has a marginal tax rate of 40 percent. The last dividend paid by Global was $0.90. Global's common stock is selling for $8.59 per share, and its expected growth rate in earnings and dividends is 5 percent. What is Global's cost of common stock?

Accepted Answer

The answer of The Global Advertising Company has a marginal...

Question 13

Bouchard Company's stock sells for $20 per share, its last dividend (D0) was $1.00, and its growth rate is a constant 6 percent. What is its cost of common stock, rs?

Accepted Answer

The cost of common stock, rs, can be calculated using the Gordon Growth Model: rs = (D1 / P0) + g, where D1 is the expected dividend next year, P0 is the current stock price, and g is the growth rate. D1 = D0 * (1 + g) = $1.00 * 1.06 = $1.06. Therefore, rs = ($1.06 / $20) + 0.06 = 0.053 + 0.06 = 0.113 or 11.3%.

Question 14

Your company's stock sells for $50 per share, its last dividend (D0) was $2.00, and its growth rate is a constant 5 percent. What is the cost of common stock, rs?

Accepted Answer

Using the constant growth model:

rs = (D1/P0) + g

D1 = D0(1+g) = $2.10 
P0 = $50

rs = ($2.10/$50) + 0.05 = 0.042 + 0.05 = 0.092 or 9.2%

Question 15

An analyst has collected the following information regarding Christopher Co.: • The company's capital structure is 70 percent equity, 30 percent debt.
• The yield to maturity on the company's bonds is 9 percent.
• The company's year-end dividend is forecasted to be $0.80 a share.
• The company expects that its dividend will grow at a constant rate of 9 percent a year.
• The company's stock price is $25.
• The company's tax rate is 40 percent.
• The company anticipates that it will need to raise new common stock this year. Its investment bankers anticipate that the total flotation cost will equal 10 percent of the amount issued. Assume the company accounts for flotation costs by adjusting the cost of capital. Given this information, calculate the company's WACC.

Accepted Answer

The correct answer is A because the WACC is calculated as follows:WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc) + (F/V) * Flotation Costwhere:E = market value of equityV = total market value of the firmRe = cost of equityD = market value of debtRd = cost of debtTc = corporate tax rateF = new common stock to be issuedFlotation Cost = flotation cost as a percentage of new common stock issuedIn this case, we have:E/V = 70%Re = 9%D/V = 30%Rd = 9%Tc = 40%F/V = 10%Flotation Cost = 10%Plugging these values into the formula, we get:WACC = (0.70) * 0.09 + (0.30) * 0.09 * (1 - 0.40) + (0.10) * 0.10WACC = 0.063 + 0.0162 + 0.01WACC = 0.1041 or 10.41%

Question 16

A company's balance sheets show a total of $30 million long-term debt with a coupon rate of 9 percent. The yield to maturity on this debt is 11.11 percent, and the debt has a total current market value of $25 million. The balance sheets also show that that the company has 10 million shares of stock; the total of common stock and retained earnings is $30 million. The current stock price is $7.5 per share. The current return required by stockholders, rS, is 12 percent. The company has a target capital structure of 40 percent debt and 60 percent equity. The tax rate is 40%. What weighted average cost of capital should you use to evaluate potential projects?

Accepted Answer

The answer of A company's balance sheets show a total...

Question 17

Which of the following statements is most correct?

Accepted Answer

Corporations should focus on after-tax cash flows for WACC, accounts payable is not a cost of capital, and WACC should be based on marginal costs, not historical costs.

Question 18

The common stock of Anthony Steel has a beta of 1.20. The risk-free rate is 5 percent and the market risk premium (rM - rRF) is 6 percent. What is the company's cost of common stock, rs?

Accepted Answer

rs = rRF + (beta * market risk premium)
rs = 5% + (1.20 * 6%)
rs = 12.2%

Question 19

Which of the following statements about the cost of capital is incorrect?

Accepted Answer

If a company's tax rate increases, its cost of debt financing will decrease as the interest paid on its debt becomes tax-deductible. This will lead to a decrease in the company's weighted average cost of capital, not an increase.

Question 20

Grateway Inc. has a weighted average cost of capital of 11.5 percent. Its target capital structure is 55 percent equity and 45 percent debt. The company has sufficient retained earnings to fund the equity portion of its capital budget. The before-tax cost of debt is 9 percent, and the company's tax rate is 30 percent. If the expected dividend next period (D1) and current stock price are $5 and $45, respectively, what is the company's growth rate?

Accepted Answer

The growth rate (g) can be calculated using the Gordon Growth Model (Dividend Discount Model): Cost of Equity = (D1 / P0) + g. The cost of equity can be derived from the WACC formula: WACC = (E/V) * Re + (D/V) * Rd * (1 - Tax Rate). Solving for g gives approximately 4.64%.

Quiz 10: Determining the Cost of Capital