Question 1

Firm X has a tax rate of 21%. The price of its new preferred stock is $75 and its flotation cost is $3.15. The cost of new preferred stock is 8%. What is the firm's dividend?

Accepted Answer

The cost of new preferred stock is given as 8%, which is essentially the dividend rate. To find the dividend, you multiply the net price (after flotation costs) by this rate. The net price is $75 - $3.15 = $71.85. Therefore, the dividend is 8% of $71.85, which is $71.85 * 0.08 = $5.748, or rounded to $5.75.

Question 2

The coupon rate on an issue of debt is 8%. The yield to maturity on this issue is 10%. The corporate tax rate is 21%. What would be the approximate after-tax cost of debt for a new issue of bonds?

Accepted Answer

K_d = 10%(1 − 0.21) = 7.9%

Question 3

The pre-tax cost of debt for a new issue of debt is determined by

Accepted Answer

The pre-tax cost of debt for a new issue of debt is determined by the yield to maturity of outstanding or comparable bonds. This is because investors will expect a return similar to what they would get from other similar investments. The coupon rate of existing debt may impact the cost of issuing new debt if it is significantly higher or lower than current market rates, but it is not the primary factor in determining the cost of new debt. The required rate of return on issued stock is not relevant to the cost of debt.

Question 4

A firm is paying an annual dividend of $2.65 for its preferred stock that is selling for $57.00. There is a selling cost of $3.30. What is the after-tax cost of preferred stock if the firm's tax rate is 21%?

Accepted Answer

The cost of preferred stock is calculated as the dividend divided by the net proceeds from selling the stock. The net proceeds are the selling price minus any selling costs. Here, the net proceeds are $57.00 - $3.30 = $53.70. The cost of preferred stock is therefore $2.65 / $53.70 = 0.0493 or 4.93%. Taxes do not affect the cost of preferred stock because dividends are paid from after-tax income.

Question 5

A firm's cost of financing, in an overall sense, is equal to its

Accepted Answer

The firm's cost of financing is indeed equal to its weighted average cost of capital (WACC), which reflects the required yield or rate of return that investors seek for various kinds of securities the firm issues. Thus, all the options provided are aspects of the firm's overall cost of financing.

Question 6

If flotation costs go down, the cost of new preferred stock will

Accepted Answer

If flotation costs go down, the cost of new preferred stock will go down as well. This is because flotation costs are the fees associated with raising capital, and if these costs decrease, the overall cost of raising capital decreases, which in turn leads to a decrease in the cost of new preferred stock.

Question 7

The coupon rate on a debt issue is 6%. If the yield to maturity on the debt is 9%, what is the after-tax cost of debt in the weighted average cost of capital if the firm's tax rate is 21%?

Accepted Answer

K_d = 9%(1 − 0.21) = 7.11%

Question 8

Flotation cost is the

Accepted Answer

Flotation cost refers to the cost incurred by a company in issuing new stock. It includes expenses such as underwriting fees, legal fees, printing fees, and accounting fees.

Question 9

The cost of a firm's debt is determined by taking the

Accepted Answer

The cost of a firm's debt is the yield on bonds issued minus the corporation's marginal tax rate. This is because interest paid on debt is tax-deductible, so the after-tax cost of debt is lower than the before-tax cost. Therefore, the cost of debt to the corporation is the yield on the bonds minus the tax savings from the interest payments.

Question 10

Ten years ago, Stigler Company issued $100 par value preferred stock yielding 6%. The preferred stock is now selling for $102 per share. What is the approximate current yield or cost of the preferred stock? (Disregard flotation costs.)

Accepted Answer

The current yield of the preferred stock is calculated by dividing the annual dividend by the current market price of the stock. The annual dividend is $6 (6% of $100 par value). The current market price is $102 per share. Therefore, the current yield is $6 / $102 = 0.0588 or 5.9%.

Question 11

A firm has $50 million in assets and its optimal capital structure is 60% equity. If the firm has $12 million in retained earnings available to invest, at what asset level will the firm need to issue additional stock? (Assume no growth in retained earnings.)

Accepted Answer

The firm can finance 60% of its assets with equity. With $12 million in retained earnings, the firm can support $20 million in assets ($12 million / 0.60). Beyond this, additional stock would be needed.

Question 12

Lewis, Schultz, and Nobel Development Corp. has an after-tax cost of debt of 4.5%. With a tax rate of 21%, what is the yield on the debt?

Accepted Answer

K_d = Yield(1 − tax rate) 4.5% = Yield (1 − 0.21) Yield = 5.70%

Question 13

A firm's debt-to-equity ratio varies at times because

Accepted Answer

All of these options are accurate statements that explain why a firm's debt-to-equity ratio may vary at times. A company will want to sell common stock when prices are high and bonds when interest rates are low, as this can help them minimize costs over the long run. Additionally, the market may allow for some leeway in the debt-to-equity ratio before penalizing the firm with a higher cost of capital, giving them some flexibility in their financing decisions.

Question 14

Why is the cost of debt normally lower than the cost of preferred stock?

Accepted Answer

The cost of debt is lower than the cost of preferred stock because interest on debt is tax deductible, which reduces the net cost of borrowing. Unlike preferred stock dividends, which are not tax deductible, interest on debt is tax deductible. Therefore, the after-tax cost of debt is lower than the after-tax cost of preferred stock.

Question 15

If the flotation cost goes up, the cost of retained earnings will

Accepted Answer

Flotation costs are associated with issuing new securities and do not affect the cost of retained earnings, which are profits reinvested in the company rather than distributed to shareholders.

Question 16

Using the constant dividend growth model for common stock, if the market price of stock (P₀) goes up,

Accepted Answer

According to the constant dividend growth model, as the market price of the stock goes up, the expected rate of return (and thus the assumed cost) decreases. This is because the dividend yield (annual dividend divided by the current market price) decreases, but the expected capital gains yield (the assumed growth rate of the stock's price) remains the same. Therefore, the cost of equity capital (the rate of return required by investors) decreases.

Question 17

The after-tax cost of preferred stock to the issuing corporation

Accepted Answer

The after-tax cost of preferred stock to the issuing corporation is the same as the before-tax cost because dividends on preferred stock are not tax-deductible.

Question 18

The cost of equity capital in the form of new common stock will be higher than the cost of retained earnings because of

Accepted Answer

Flotation costs refer to the costs incurred when issuing new securities, such as underwriting fees, legal fees, and other expenses. These costs increase the cost of equity capital in the form of new common stock, making it higher than the cost of retained earnings. The other options are not directly related to the cost of equity capital.

Question 19

A firm's preferred stock pays an annual dividend of $2, and the stock sells for $65. Flotation costs for new issuances of preferred stock are 5% of the stock value. What is the after-tax cost of preferred stock if the firm's tax rate is 21%?

Accepted Answer

The answer of A firm's preferred stock pays an annual...

Question 20

Tobin's Barbeque has a bank loan at 8% interest and an after-tax cost of debt of 6%. What will the after-tax cost of debt be if a new loan is taken out yielding 11%.

Accepted Answer

The answer of Tobin's Barbeque has a bank loan at...

Quiz 11: Cost of Capital