Chapter 09

Foundations of Finance, 7e (Keown)Chapter 9 The Cost of Capital 9.1 Learning Objective 1True or False1) In order to create value a corporation must earn a rate of return on its invested capital that is higher than the market's required rate of return on that invested capital. ns!er"#$%&'iff" 1(e)!ords"$equired $ate of $eturn* Invested +apital ,) #he cost of capital is the rate that must be earned on an investment project if the project is to increase the value of the common shareholders- investment.ns!er"#$%&'iff" 1(e)!ords"+ost of +apital* .hareholder /alue0) #he firm-s cost of capital ma) also be referred to as the firm-s opportunit) cost of capital.ns!er"#$%&'iff" 1(e)!ords"+ost of +apital* Opportunit) +ost of +apital 1) #he firm-s cost of capital is important !hen evaluation the firm-s overall value* but should not be used to evaluate individual projects !hich have their o!n unique characteristics.ns!er"2L.&'iff" 1(e)!ords"+ost of +apital3) #he cost of debt increases relative to the investor's required return due to flotation costs* but decreases relative to the investor's required return due to the ta4 deductibilit) of interest.ns!er"#$%&'iff" 1(e)!ords"+ost of 'ebt* 2lotation +osts* #a4es* InterestMultiple Choice1) 5igher flotation costs !ill result in all of the follo!ing e4cept" ) higher after6ta4 cost of debt7) higher !eighted average cost of capital +) higher cost of retained earnings') higher cost of common equit) !hen ne! common shares are soldns!er"+'iff" 1(e)!ords"2lotation +osts* +ost of $etained &arnings1+op)right 8 ,911 :earson &ducation* Inc.9., Learning Objective ,True or False1) 2lotation costs cause a corporation's cost of capital to be lo!er than its investors' required returns.ns!er"2L.&'iff" 1(e)!ords"2lotation +osts* +ost of +apital* $equired $eturns,) #he cost of a particular source of capital ;debt* preferred stock* common stock) is equal to the investor's required rate of return after adjusting for the effects of both flotation costs and corporate ta4es.ns!er"#$%&'iff" 1(e)!ords"+ost of +apital* 2lotation +osts* +orporate #a4es0) #he cost of debt capital is obtained b) substituting the net proceeds per bond for the bond price in the bond valuation equation and solving for the required return.ns!er"#$%&'iff" ,(e)!ords"+ost of 'ebt1) #he cost of preferred stock is equal to the preferred stock dividend divided b) the net proceeds per preferred share.ns!er"#$%&'iff" 1(e)!ords"+ost of :referred .tock* odel ma) be used to estimate the cost of retained earnings.ns!er"#$%&'iff" 1(e)!ords"+apital sset :ricing >odel* +ost of $etained &arnings,+op)right 8 ,911 :earson &ducation* Inc.A)reasonable estimate of the market risk premium based on historical data and e4pert opinion is bet!een 3B and @B.ns!er"#$%&'iff" 1(e)!ords">arket $isk :remium* +apital sset :ricing >odel9) #he market risk premium remains constant over time because the risk free rate of return moves inversel) !ith beta.ns!er"2L.&'iff" 1(e)!ords">arket $isk :remium* +apital sset :ricing >odel19)firm's cost of capital is the required rate of return on the firm's average project.ns!er"#$%&'iff" 1(e)!ords"+ost of +apital* $equired $eturn11) #he firm financed completel) !ith equit) capital has a cost of capital equal to the required return on common stock.ns!er"#$%&'iff" 1(e)!ords"+ost of +apital* $equired $eturn on +ommon .tock1,) #he after6ta4 cost of equit) equals one minus the marginal ta4 rate times the required rate of return on common stock.ns!er"2L.&'iff" 1(e)!ords"+ost of +ommon &quit)10) If preferred stock pa)s a C3 annual dividend and sells for C39 the cost of preferred stock financing is 19B since dividends are not ta4 deductible and preferred stock is sold !ithout flotation costs. ns!er"2L.&'iff" 1(e)!ords"+ost of :referred .tock* 2lotation +osts11) Other things equal* management should retain profits onl) if the compan)'s investments !ithin the firm are at least as attractive as the stockholders' other investment opportunities.ns!er"#$%&'iff" 1(e)!ords"+ost of $etained &arnings* .hareholder /alue 13) 2inancing !ith ne! common stock is generall) more costl) than financing !ith retained earnings due to increasing ta4 rates.ns!er"2L.&'iff" 1(e)!ords"+ost of formula to determine the cost of equit) capital regardless of the length of the project under consideration.ns!er"2L.&'iff" 1(e)!ords"+apital sset :ricing >odel* $isk6free $ate of $eturn,,) #he capital asset pricing model uses three variables to evaluate required returns on common equit)"the risk free rate* the beta coefficient* and the market risk premium.ns!er"#$%&'iff" 1(e)!ords"+:>1+op)right 8 ,911 :earson &ducation* Inc.,0) #he investor's required rate of return !ill equal the firm's cost of capital if corporate transactions costs are taken into account.ns!er"2L.&'iff" 1(e)!ords"+ost of +apital* $equired $ate of $eturn,1) #he cost of debt measures the cost of a bank loan* !hile the cost of preferred stock is used as a pro4) for the cost of a ne! bond issue.ns!er"2L.&'iff" 1(e)!ords"+ost of 'ebt* +ost of :referred .tock* 7onds,3) :referred dividends are paid !ith before6ta4 dollars because the dividend rate is kno!n* !hereas common stock dividends are paid !ith after6ta4 dollars.ns!er"2L.&'iff" 1(e)!ords":referred 'ividends* +ommon 'ividends* #a4es,?) n increase in a corporation's marginal ta4 rate !ill cause the corporation's after ta4 cost of debt to increase* other things remaining the same.ns!er"2L.&'iff" 1(e)!ords"+ost of 'ebt* #a4es,@) 7ecause investors like dividends* the higher the compan)'s dividend gro!th rate* the lo!er the compan)'s cost of common equit).ns!er"2L.&'iff" ,(e)!ords"+ost of +ommon &quit)* 'ividend =ro!th $ate,A) n increase in a corporation's marginal ta4 rate !ill decrease the corporation's cost of debt* but have no impact on its cost of preferred stock or cost of common equit).ns!er"#$%&'iff" ,(e)!ords"+ost of 'ebt* +ost of :referred .tock* +ost of +ommon &quit)* >arginal #a4 $ateMultiple Choice1) #!o factors that cause the investor's required rate of return to differ from the compan)'s cost of capital are") ta4es and risk.7) transactions costs and risk.+) ta4es and transactions costs.') risk and opportunit) cost differences.ns!er"7'iff" 1(e)!ords"+ost of +apital* #a4es* #ransactions +osts3+op)right 8 ,911 :earson &ducation* Inc.,) #!o considerations that cause a corporation's cost of capital to be different than its investors' required returns are) corporate ta4es and flotation costs.7) individual ta4es and corporate ta4es.+) individual ta4es and dividends.') corporate ta4es and the earned income ta4 credit.ns!er"'iff" 1(e)!ords"+ost of +apital* $equired $ate of $eturn* #a4es* 2lotation +osts0) 'ue to changes in regulator) requirements* the transactions costs associated !ith selling corporate securities increased b) C1 per share. #his change !ill ) cause the cost of capital to decrease.7) cause the cost of capital to increase.+) have no effect on the cost of capital because transactions costs are e4pensed immediatel).') cause the cost of capital to decrease onl) if investors ma) be billed for part of the increase in transactions costs.ns!er"7'iff" 1(e)!ords"2lotation +osts* +ost of +apital1) Eones 'istributing +orp. can sell common stock for C,@ per share and its investors require a 1@B return. 5o!ever* the administrative or flotation costs associated !ith selling the stock amount to C,.@9 per share. Fhat is the cost of capital for Eones 'istributing if the corporation raises mone) b) selling common stockG) ,@.99B7) 1A.A9B+) 1A.00B') [email protected]!er"7'iff" ,(e)!ords"+ost of +apital* 2lotation +osts3)compan) has preferred stock that can be sold for C,1 per share. #he preferred stock pa)s an annual dividend of 0.3B based on a par value of C199. 2lotation costs associated !ith the sale of preferred stock equal C1.,3 per share. #he compan)'s marginal ta4 rate is 03B. #herefore* the cost of preferred stock is") [email protected]) 1@.@,B.+) 11.,?B.') 1,.91B.ns!er"7'iff" ,(e)!ords"+ost of :referred .tock* 2lotation +osts* odel 1) 'ickerson +orporation-s common stock is currentl) selling for C0A. Last )ear's dividend !as C1.99 per share. Investors e4pect dividends to gro! at an annual rate of @ percent indefinitel). 2lotation costs of 1B !ill be incurred !hen ne! stock is sold.a. Fhat is the cost of internal common equit)Gb. Fhat is the cost of ne! common equit)Gns!er"a. '1 H C1.99 K 1.9@ H C1.,A+ost of internal common equit) H C1.,ALC0A M .9@ H 1A.,?Bb. +ost of ne! common equit) H C1.,AL;C0A K .9?)M .9@ H 1A.@0B'iff" ,(e)!ords"+ost of $etained &arnings* +ost of anagement desires to increase its plant and equipment during the coming )ear b) C1, million. #he compan) plans to finance 19 percent of the e4pansion !ith debt and the remaining ?9 percent !ith equit) capital. 7ond financing !ill be at a 9 percent rate and !ill be sold at its par value. +ommon stock is currentl) selling for C39 per share* and flotation costs for ne! common stock !ill amount to C3 per share. #he e4pected dividend ne4t )ear for =ator is C,.39. 2urthermore* dividends are e4pected to gro! at a ? percent rate far into the future. #he marginal corporate ta4 rate is 01 percent. Internal funding available from additions to retained earnings is C1*999*999.a. Fhat amount of ne! common stock must be sold if the e4isting capital structure is to be maintainedGb. +alculate the !eighted marginal cost of capital at an investment level of C1, million.ns!er"a.&quit) needed H C1, million K 9.? H C@., millionLess additions to $L&1.9 million++ H 9.1 K 3.91B M 9.? K 11.3?B H 9.01B'iff" ,(e)!ords"fter6ta4 +ost of 'ebt* +ost of arginal +ost of +apital ?) #he common stock for &l /iss +ompan) currentl) sells for C,9 per share. #he firm just paid a dividend of C1.39* and the dividend three )ears ago !as C1.09. 'ividends per share are anticipated to gro! at the same rate in the future as the) have over the past three )ears. 2lotation costs for ne! shares !ill be ?B of the selling price. +alculate the follo!ing"a. the cost of retained earningsb. the cost of e4ternal equit) capitalns!er"a. g H 1.A9B '1 H C1.39 K 1.919 H C1.3@+ost of retained earnings H C1.3@LC,9 M .919 H 1,.@3Bb. +ost of e4ternal equit) H C1.3@L;C,9 K .91) M .919 H 10.,3B'iff" ,(e)!ords"+ost of $etained &arnings* +ost of H @.3@Bb. fter6ta4 cost of e4isting debt H @.3@B K ;1 6 .01) H 3Bc. fter6ta4 cost of ne! debt H A.9,B K ;1 6 .01) H 3.,9B'iff" ,(e)!ords"fter6ta4 +ost of 'ebt* Jield to >aturit)* 2lotation +ostsA) #oto and ssociates' preferred stock is selling for C,@.39 a share. #he firm nets C,3.?9 after issuance costs. #he stock pa)s an annual dividend of C0.99 per share. Fhat is the cost of e4isting* and ne!* preferred stock respectivel)Gns!er"+ost of e4isting preferred stock H C0.99LC,@.39 H 19.91B+ost of ne! preferred stock H C0.99LC,3.?9 H 11.@,B'iff" ,(e)!ords"+ost of &4isting :referred .tock* +ost of ilton :arker has a capital structure that consists of C@ million of debt* C, million of preferred stock* and C11 million of common equit)* based upon current market values. :arker's )ield to maturit) on its bonds is @.1B* and investors require an AB return on :arker's preferred and a 11B return on :arker's common stock. If the ta4 rate is 03B* !hat is :arker's F++G) @.,1B7) A.1,B+) 19.1AB') 1,.,3Bns!er"+'iff" ,(e)!ords"Feighted verage +ost of +apital* +apital .tructure,3+op)right 8 ,911 :earson &ducation* Inc.Essay 1) >eacham +orp. !ants to issue bonds !ith a 9B coupon rate* a face value of C1*999* and 1, )ears to maturit).>eacham estimates that the bonds !ill sell for C1*999 and that flotation costs !ill equal C13 per bond.>eacham +orp. common stock currentl) sells for C09 per share. >eacham can sell additional shares b) incurring flotation costs of C0 per share.>eacham paid a dividend )esterda) of C1.99 per share and e4pects the dividend to gro! at a constant rate of 3B per )ear.>eacham also e4pects to have C1, million of retained earnings available for use in capital budgeting projects during the coming )ear.>eacham-s capital structure is 19B debt and ?9B common equit). >eacham-s marginal ta4 rate is 03B.a. +alculate the after6ta4 cost of debt assuming >eacham-s bonds are its onl) debt.b. +alculate the cost of retained earnings.c. +alculate the cost of ne! common stock.d. +alculate the !eighted average cost of capital assuming >eacham-s total capital budget is C09 million.ns!er"a. J#> !ith