Topic 1:
What are the effects of change in debt/equity ratio on the cost of debt and equity?
Topic 2:
This question is based on your Web Field Trip.
What are some of the differences between the theoretical M&M propositions and the practical applications for managers? Where do managers say value is created?
Web Field Trip
This Web Field Trip looks at capital structure and Modigliani and Miller’s (M&M) “irrelevance propositions”. Go to http://pages.stern.nyu.edu/~adamodar/New_Home_Page/articles/MM40yearslater.htm and read the article “After the Revolution”.
Be prepared to discuss your findings in the Discussion area.
Assignment:
What is the weighted average cost of capital?
Fjord Luxury Liners has preferred shares outstanding that pay an annual dividend equal to $10 per year. If the current price of Fjord preferred shares is $147, what is the after-tax cost of preferred stock for Fjord? (Round intermediate calculations to 4 decimal places, e.g. 1.2514 and final answer to 2 decimal places, e.g. 15.25%.)
After-tax cost f preferred stock = ______________%
Describe the alternatives to using a firm’s WACC as a discount rate when evaluating a project.
What are direct out-of-pocket costs?
Explain why the cost of capital for a firm is equal to the expected rate of return to the investors in the firm.
Perpetual Ltd. has issued bonds that never require the principal amount to be repaid to investors. Correspondingly, Perpetual must make interest payments into the infinite future. The bondholders receive annual payments of $84 and the current price of the bonds is $814.
Pre-tax cost of debt = ____________%
The parts of this question must be completed in order. This part will be available when you complete the part above.
The Imaginary Products Co. currently has debt with a market value of $225 million outstanding. The debt consists of 9 percent coupon bonds (semiannual coupon payments) which have a maturity of 15 years and are currently priced at $1,320.10 per bond. The firm also has an issue of 2 million preferred shares outstanding with a market price of $20. The preferred shares pay an annual dividend of $1.20. Imaginary also has 14 million shares of common stock outstanding with a price of $20.00 per share. The firm is expected to pay a $2.20 common dividend one year from today, and that dividend is expected to increase by 6 percent per year forever. If Imaginary is subject to a 40 percent marginal tax rate, then what is the firm’s weighted average cost of capital?
Calculate the Weights for debt, common equity, and preferred equity. (Round intermediate calculations to 4 decimal places, e.g. 1.2514 and final answer to 2 decimal places, e.g. 15.25%.)
Debt = ___________%
Preferred equity = ______________%
Common equity = ________________%
The parts of this question must be completed in order. This part will be available when you complete the part above
The parts of this question must be completed in order. This part will be available when you complete the part above
The parts of this question must be completed in order. This part will be available when you complete the part above
The parts of this question must be completed in order. This part will be available when you complete the part above
Hurricane Corporation is financed with debt, preferred equity, and common equity with market values of $20 million, $10 million, and $30 million, respectively. The betas for the debt, preferred stock, and common stock are 0.2, 0.5, and 1.3, respectively. If the risk-free rate is 3.87 percent, the market risk premium is 6.02 percent, and Hurricane’s average and marginal tax rates are both 30 percent.
What is the company’s cost of capital? (Round intermediate calculation to 4 decimal places, e.g. 1.2512 and final answer to 2 decimal places e.g. 5.21%.)
Cost of debt = ____________%
Cost of common equity = ____________%
Cost of preferred equity = ____________%
The parts of this question must be completed in order. This part will be available when you complete the part above.
For a typical firm, which of the following financial instruments has the lowest cost of capital?
[removed] |
retained earnings |
[removed] |
new common stock |
The cost of capital is:
[removed] |
the opportunity cost of using funds on projects |
[removed] |
the required rate of return for new projects that have risk that is similar to that of the overall firm |
[removed] |
the rate of return the firm earns on its investments to satisfy the required rate of return for the firm’s investors |
The cost of capital of a company that uses 45 percent debt that has an after-tax cost of debt of 10 percent and 55 percent equity that has a cost of 15 percent is:
The best method to use when estimating a firm’s discount rate is the
[removed] |
net present value approach. |
[removed] |
internal rate of return approach. |
[removed] |
weighted average cost of capital approach. |
[removed] |
capital asset pricing model. |
According to the finance balance sheet equation,
[removed] |
the book value of a firm’s assets plus the book value of its liabilities must equal the book value of its equity. |
[removed] |
the market value of a firm’s assets must equal the market value of its liabilities. |
[removed] |
the market value of a firm’s assets must equal the market value of its liabilities and the market value of its equity. |
[removed] |
the book value of a firm’s assets plus the market value of its liabilities must equal the market value of its equity. |
A firm’s cost of capital is a weighted average of all its
[removed] |
investment costs. |
[removed] |
financing costs. |
[removed] |
working capital costs. |
[removed] |
operating costs. |
Although the CAPM is theoretically the correct model to use when estimating the expected rate of return on an investment, it is difficult to apply in practice because
[removed] |
individual project betas are almost impossible to determine. |
[removed] |
analysts do not have a way to directly estimate the returns related to each individual project. |
[removed] |
firms do not issue publicly traded shares for each individual project. |
Which of the following capital component costs must be adjusted for taxes?
[removed] |
Cost of common stock. |
[removed] |
Cost of preferred stock. |
When estimating the risk-free rate to use in the CAPM for determining the firm’s cost of equity it is best to use the
[removed] |
federal funds rate. |
[removed] |
90-day treasury bill yield. |
[removed] |
long-term treasury bond yield. |
Global Inc. has a preferred share issue outstanding with a current price of $26.80. The firm is expected to pay a dividend of $1.90 per share a year from today. What is the firm’s cost of preferred equity?