Question 1

The CEO of Harding Media Inc. as asked you to help estimate its cost of common equity. You have obtained the following data: D0 = $0.85; P0 = $22.00; and gL = 6.00% (constant). The CEO thinks, however, that the stock price is temporarily depressed, and that it will soon rise to $40.00. Based on the dividend growth model, by how much would the cost of common from reinvested earnings change if the stock price changes as the CEO expects?

Accepted Answer

$\begin{array}{lrr}
&\text { Oid Price }& \text { New Price }\
\mathrm{D}_{0} & \$ 0.85 & \$ 0.85 \
P_{0} & \$ 22.00 & \$ 40.00 \
\mathrm{~g} & 6.00 \% & 6.00 \% \
\mathrm{D}_{1}=\mathrm{D}_{0} \times(1+\mathrm{g}) & \$ 0.901 & \$ 0.901 \
\mathrm{r}_{\mathrm{s}}=\mathrm{D}_{1} / \mathrm{P}_{0}+\mathrm{g} & 10.10 \% & 8.25 \%\
\text { Difference } r_{\text {s0 }}- r_{\text {s1 }}&-1.84\%
\end{array}$

Question 2

To help estimate its cost of common equity, Maxwell and Associates recently hired you. You have obtained the following data: D0 = $0.90; P0 = $27.50; and gL = 7.00% (constant). Based on the dividend growth model, what is the cost of common from reinvested earnings?

Accepted Answer

$\begin{array}{l}
\begin{array} { l } 
D _ { 0 } \
P _ { 0 } \
D _ { 1 } = D _ { D } \times ( 1 + \text { D } \
D _ { 5 } = D _ { 1 } / P _ { 0 } + \text { g }\
r_{s}=D_{1} / P_{n}+g
\end{array}
\begin{array} { l } 
50.90 \
27.50 \
7.00 \% \
\$ 0.963\
10.50 \%
\end{array}
\end{array}$

Question 3

The reason why reinvested 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 distribute those earnings to its investors. Thus, the cost of reinvested earnings is based on the opportunity cost principle.

Accepted Answer

The statement accurately describes the reason why reinvested earnings have a cost equal to rs, which is based on the opportunity cost principle. Investors expect to earn rs on investments with the same risk as the firm's common stock, and if the firm cannot earn rs on the earnings that it retains, it should distribute those earnings to investors. Therefore, the cost of reinvested earnings is the same as the cost of equity capital, which is represented by rs.

Question 4

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.

Accepted Answer

Unfortunately, this is true.

Question 5

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.

Accepted Answer

Increased inflation results in a parallel upward shift in the SML, which means equal percentage increases in the required return on debt and equity.

Question 6

As a consultant to Basso Inc., you have been provided with the following data: D1 = $0.67; P0 = $27.50; and gL = 8.00% (constant). What is the cost of common from reinvested earnings based on the dividend growth approach?

Accepted Answer

$\begin{array}{lr}
\mathrm{D}_{1} & \$ 0.67 \
\mathrm{P}_{0} & \$ 27.50 \
\mathrm{~g} & 8.00 \% \
\mathrm{I}_{\mathrm{s}}=\mathrm{D}_{1} / \mathrm{P}_{0}+\mathrm{g} & 10.44 \%
\end{array}$

Question 7

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

Accepted Answer

$\begin{array} { l r } 
r _ { R F } & 5.00 \% \
RP _ { M } & 6.00 \% \
b&1.05\
r _ { 5 } = R F + ( R P M \times b ) & 11.30\%\
\end{array}$

Question 8

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.

Accepted Answer

An increase in the slope of the SML would result in a higher required rate of return on equity, rs. Since equity is riskier than debt, the impact would be greater on rs than on rd for most firms. This would lead to an increase in the use of debt and a decrease in the use of equity, as debt becomes relatively cheaper (compared to equity). However, an excessive use of debt would increase the overall riskiness of the firm, which may limit the shift toward debt.

Question 9

When estimating the cost of equity by use of the dividend growth 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.

Accepted Answer

Unfortunately, this is true.

Question 10

As the assistant to the CFO of Johnstone Inc., you must estimate its cost of common equity. You have been provided with the following data: D0 = $0.80; P0 = $22.50; and gL = 8.00% (constant). Based on the dividend growth model, what is the cost of common from reinvested earnings?

Accepted Answer

$\begin{array}{l}
\begin{array} { l } 
D _ { 0} \
P _ { 0 } \
D _ { 1 } = D _ { D } \times ( 1 + \text { D } \
D _ { 2 } = D _ { 1 } / P _ { 0 } + g\
r_{s}=D_{1} / P_{n}+g
\end{array}
\begin{array} { l } 
30.80 \
22.50 \
8.00 \% \
\$ 0.864\
11.84\%
\end{array}
\end{array}$

Question 11

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.

Accepted Answer

The cost of external equity raised by issuing new stock is typically higher than the required rate of return on the firm's outstanding common stock, as new investors require a higher return to compensate for the increased risk associated with investing in a new security.

Question 12

To help them estimate the company's cost of capital, Smithco has hired you as a consultant. You have been provided with the following data: D1 = $1.45; P0 = $22.50; and gL = 6.50% (constant). Based on the dividend growth approach, what is the cost of common from reinvested earnings?

Accepted Answer

$\begin{array}{lr}
\mathrm{D}_{1} & \$ 1.45 \
\mathrm{P}_{0} & \$ 22.50 \
\mathrm{~g} & 6.50 \% \
\mathrm{I}_{\mathrm{s}}=\mathrm{D}_{1} / \mathrm{P}_{0}+\mathrm{g} & 12.94 \%
\end{array}$

Question 13

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.

Accepted Answer

In general, this statement is false, because the firm should be viewed as an ongoing entity, and using debt (or equity) to fund a given project will change the capital structure, and this factor should be recognized by basing the cost of capital for all projects on a target capital structure. Under some special circumstances, where a project is set up as a separate entity, then "project financing" may be used, and only the project's specific situation is considered. This is a specific situation, however, and not the "in general" case.

Question 14

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.

Accepted Answer

For capital budgeting and cost of capital purposes, it is important to assume that the capital is obtained in accordance with the target capital structure of the firm, which is usually a combination of debt, preferred stock, and common equity. This assumption helps in determining the appropriate cost of capital for the firm and in making investment decisions.

Question 15

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the dividend growth method, and the bond-yield-plus-risk-premium method. However, only the dividend growth method is widely used in practice.

Accepted Answer

All three methods (CAPM, dividend growth, and bond-yield-plus-risk-premium) are used in practice, each offering different advantages and fitting different scenarios based on the availability of data, the nature of the company, and the preferences of the analyst.

Question 16

You have been hired as a consultant by Feludi Inc.'s CFO, who wants you 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 common from reinvested earnings?

Accepted Answer

$\begin{array} { l r } 
r _ { R F } & 4.10 \% \
R _ { M } & 5.25 \% \
b&1.30\
r _ { 5 } = R F + \left( R P _ { M } \times b \right) &10.925\%
\end{array}$

Question 17

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.

Accepted Answer

The answer of Suppose you are the president of a...

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.

Accepted Answer

The answer of The cost of equity raised by retaining...

Question 19

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

Accepted Answer

By definition, both the market and an average stock have betas of 1.0. Since we know this to be the case, we can obviously determine beta for the market or an average stock with precision.

Question 20

Collins Group
The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.
 $\begin{array}{l}
\text { Assets }\
\begin{array}{lr}
\text { Current assets } & \$ 38,000,000 \
\text { Net plant, property, and equipment } & 101,000,000\
\text { Total assets }&\$ 139,000,000\
\
\text { Liabilities and Equity }\
\text { Accounts payable } & \$ 10,000,000 \
\text { Accruals } & 9,000,000 \
\text { Current liabilities } & \$ 19,000,000 \
\text { Long-term debt }(40,000 \text { bonds, } \$ 1,000 \text { par value) } & 40,000,000\
\text { Total liabilities }&\$ 59,000,000 \
\text { Common stock ( } 10,000,000 \text { shares) } & 30,000,000 \
\text { Retained earnings } & 50,000,000 \
 \text { Total shareholders' equity } & 80,000,000 \
\text { Total liabilities and shareholders' equity } & \$ 139,000,000
\end{array}
\end{array}$ 
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%.
-Refer to the data for the Collins Group. Based on the CAPM, what is the firm's cost of common stock?

Accepted Answer

$\begin{array}{l}
\mathrm{RF}& 5.50\% \
\text { Expected } \mathrm{r}_{\mathrm{M}} &11.50\%\
\mathrm{R} \mathrm{P}_{\mathrm{M}}=\text { Expected return on Mark }&6.00 \%\
\mathrm{b} & 1.25\%\
\mathrm{r}_{\mathrm{S}}=\mathrm{r}_{\mathrm{RF}}+\mathrm{r}_{\mathrm{RF}}\left(\mathrm{RP}_{\mathrm{M}} \times \mathrm{b}\right)&13.00\%
\end{array}$

Quiz 11: Determining the Cost of Capital

To help estimate its cost of common equity, Maxwell and Associates recently hired you. You have obtained the following data: D0 = $0.90; P0 = $27.50; and gL = 7.00% (constant) . Based on the dividend growth model, what is the cost of common from reinvested earnings?

As a consultant to Basso Inc., you have been provided with the following data: D1 = $0.67; P0 = $27.50; and gL = 8.00% (constant) . What is the cost of common from reinvested earnings based on the dividend growth approach?