FOUNDATION OF FINANCE (BWFF1013)

FIRST SEMESTER 2012/2013 (A121)

CHAPTER 6-COST OF CAPITAL
Section A
Please circle TRUE or FALSE to the following statements.
1)

The 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.
Answer: TRUE/FALSE

2)

The 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 tax
deductibility of interest.
Answer: TRUE/FALSE

3)

Corporations have two costs of common equity, one for retained earnings and one if
the company issues new common stock.
Answer: TRUE/FALSE

4)

Financing with new common stock is generally more costly than financing with
retained earnings due to increasing tax rates.
Answer: TRUE/ FALSE- due to increasing transaction costs & floatation costs. Only
interest on bond is a tax deductible item.

5)

The cost of debt measures the cost of a bank loan, while the cost of preferred stock is
used as a proxy for the cost of a new bond issue.
Answer: TRUE/FALSE cost of debt=cost of bond, cost of preferred stock is not a
proxy for cost of new bond issue

6)

An increase in a corporation's marginal tax rate will decrease the corporation's cost of
debt, but have no impact on its cost of preferred stock or cost of common equity.
Answer: TRUE/FALSE

7)

If a firm's tax rate increases then its weighted average cost of capital (WACC)
increases also.
Answer: TRUE/FALSE WACC will decrease assuming that debt is part of the
companys capital structure

Section B
Please circle the correct answer.

1)

A company has preferred stock that can be sold for RM21 per share. The preferred
stock pays an annual dividend of 3.5% based on a par value of RM100. Flotation
costs associated with the sale of preferred stock equal RM1.25 per share. The
company's marginal tax rate is 35%. Therefore, the cost of preferred stock is:
A)
B)
C)
D)

18.87%.
17.72%.
14.26%.
12.94%.

Div=100 x 0.035 = 3.5

Net Price = 21-1.25=19.75
Cost of preferred stock =3.5/19.75 = 17.72%
2)

Asian Trading Company paid a dividend yesterday of RM5 per share. The dividend is
expected to grow at a constant rate of 8% per year. The price of Asian Trading
Company's stock today is RM29 per share. If Asian Trading Company decides to
issue new common stock, flotation costs will equal RM2.50 per share. Asian Trading
Company's marginal tax rate is 35%. Based on the above information, the cost of
retained earnings is:
A)
B)
C)
D)

28.38%.
24.12%.
26.62%.
31.40%.

Cost of retained earnings = [{5 (1+0.08)}/29] + 0.08 = 26.62%

3)

Seafood Products Corp. is expected to pay a dividend of RM2.60 next year. Dividends
are expected to grow at a constant rate of 8% per year, and the stock price is currently
RM20.00. New stock can be sold at this price subject to flotation costs of 15% of the
market price. The company's marginal tax rate is 35%. Compute the cost of internal
equity (retained earnings) and the cost of external equity (new common stock),
respectively.
A)
B)
C)
D)

0, 21.00%
8.00%, 23.29%
21.00%, 23.29%
23.00%, 25.48%

Net price = 20 - (15% x 20) = 17

Retained earnings = {2.6/20} + 0.08 = 21%
New common stock = {2.6/17} + 0.08 = 23.29%

4)

Five Rivers Casino is undergoing a major expansion. The expansion will be financed
by issuing new 15-year, RM1,000 par, 9% annual coupon bonds. The market price of
the bonds is RM1,070 each. Five Rivers flotation expense on the new bonds will be
RM50 per bond. Five Rivers marginal tax rate is 35%. Using the approximation
method, what is the yield to maturity (YTM) on the newly-issued bonds?
A)
B)
C)
D)

6.95%
7.99%
8.78%
9.82%

Net price = 1070 50 = 1020

YTM = {90 + [(1000-1020)/15]} / (1000+1020)/2 = 8.78%
5)

Atlas Corporation wishes to estimate its cost of retained earnings. The firm's beta is
1.3. The rate on 6-month T-bills is 2%, and the return on the S&P 500 index is 15%.
What is the appropriate cost for retained earnings in determining the firm's cost of
capital?
A)
B)
C)
D)

17.0%
19.5%
18.9%
22.1%

Cost of retained earnings = 2% + 1.3 (15% -2% ) = 18.9%

6)

Given the following information on S & G Inc.'s capital structure, compute the
company's weighted average cost of capital (WACC).

Type of Capital
Bonds
Common Stock (Internal
Only)
Preferred Stock

Percent of Capital Structure

40%
55%

Before-Tax Component Cost

7.5%
15%

5%

11%

The company's marginal tax rate is 40%.

A)
B)
C)
D)

13.3%
7.1%
10.6%
10%
WACC = 0.4 x (7.5 [1-0.4]) + 0.55 x 15% + 0.05 x 11% = 10.6%

Section C
Answer the following questions.
1)

Meacham Corp. wants to issue bonds with a 9% coupon rate, a face value of
RM1,000, and 12 years to maturity. Meacham estimates that the bonds will sell for
RM1,090 and that flotation costs will equal RM15 per bond. Meacham Corp.
common stock currently sells for RM30 per share. Meacham can sell additional
shares by incurring flotation costs of RM3 per share. Meacham paid a dividend
yesterday of RM4.00 per share and expects the dividend to grow at a constant rate of
5% per year. Meacham also expects to have RM12 million of retained earnings
available for use in capital budgeting projects during the coming year. Meachams
capital structure is 40% debt, 20% common stock and 40% retained earnings.
Meachams marginal tax rate is 35%.
a)

Calculate the after-tax cost of debt assuming Meachams bonds are its only
debt.
Calculate the cost of retained earnings.
Calculate the cost of new common stock.
Calculate the weighted average cost of capital (WACC).

b)
c)
d)
Answer:
a. YTM with Net Proceeds = (90+((1000-1075)/12)/ (1000+1075/2) = 8.07%
After-tax cost of debt = 8.07%(1 - .35) = 5.25%
b. ((RM4.00(1.05))/RM30) + 5% = 19%
c. ((RM4.00(1.05))/(RM30 - RM3)) + 5% = 20.56%
d. WACC = (.4)(5.25%) + (.4)(19%) + (.2)(20.56%) = 13.81%