prashantsahni

Justin Lopez, CFA, is the Chief Financial Officer of Waterbury Corporation. Lopez has just been informed that the U.S. Internal Revenue Code may be revised such that the maximum marginal corporate tax rate will be increased. Since Waterbury’s taxable income is routinely in the highest marginal tax bracket, Lopez is concerned about the potential impact of the proposed change. Assuming that Waterbury maintains its target capital structure, which of the following is least likely to be affected by the proposed tax change?

A) Waterbury’s after-tax cost of noncallable, nonconvertible preferred stock.

B) Waterbury’s return on equity (ROE).

C) Waterbury’s after-tax cost of corporate debt.

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Corporate taxes do not affect the cost of preferred stock to the issuing firm. Waterbury’s after-tax cost of debt, and consequently, its weighted average cost of capital will decrease because the tax savings on interest will increase. Also, since taxes impact net income, Waterbury’s ROE will be affected by the change.

prashantsahni

Which of the following statements is most accurate regarding a firm’s cost of preferred shares? A firm’s cost of preferred stock is:

A) the dividend yield on the firm’s newly-issued preferred stock.

B) the market price of the preferred shares as a percentage of its issuance price.

C) approximately equal to the market price of the firm’s debt as a percentage of the market price of its common shares.

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The newly-issued preferred shares of most companies generally sell at par. As such, the dividend yield on a firm’s newly-issued preferred shares is the market’s required rate of return. The yield on a BBB corporate bond reflects a pre-tax cost of debt. Both remaining choices make no sense.

prashantsahni

Axle Corporation earned £3.00 per share and paid a dividend of £2.40 on its common stock last year. Its common stock is trading at £40 per share. Axle is expected to have a return on equity of 15%, an effective tax rate of 34%, and to maintain its historic payout ratio going forward. In estimating Axle’s after-tax cost of capital, an analyst’s estimate of Axle’s cost of common equity would be closest to:

A) 8.8%.

B) 9.0%.

C) 9.2%.

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We can estimate the company’s expected growth rate as ROE × (1 − payout ratio): g = 15% × (1 − 2.40/3.00) = 3%
The expected dividend next period is then £2.40(1.03) = £2.47. Based on dividend discount model pricing, the required return on equity is 2.47 / 40 + 3% = 9.18%.

prashantsahni

A $100 par, 8% preferred stock is currently selling for $80. What is the cost of preferred equity?

A) 10.0%.

B) 10.8%.

C) 8.0%.

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kps = $8 / $80 = 10%

prashantsahni

The expected dividend one year from today is $2.50 for a share of stock priced at $22.50. The long-term growth in dividends is projected at 8%. The cost of common equity is closest to:

A) 15.6%.

B) 18.0%.

C) 19.1%.

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Kce = ( D1 / P0) + g
Kce = [ 2.50 / 22.50 ] + 0.08 = 0.19111, or 19.1%

prashantsahni

The cost of preferred stock is equal to the preferred stock dividend:

A) divided by the market price.

B) divided by its par value.

C) multiplied by the market price.

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The cost of preferred stock, kps, is Dps ÷ price.

prashantsahni

The expected annual dividend one year from today is $2.50 for a share of stock priced at $25. What is the cost of equity if the constant long-term growth in dividends is projected to be 8%?

A) 18%.

B) 19%.

C) 15%.

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Ks = (D1 / P0) + g = (2.5/25) + 0.08 = 0.18 or 18%.

prashantsahni

A company has $5 million in debt outstanding with a coupon rate of 12%. Currently the YTM on these bonds is 14%. If the tax rate is 40%, what is the after tax cost of debt?

A) 7.2%.

B) 5.6%.

C) 8.4%.

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(0.14)(1 - 0.4)

prashantsahni

A firm has $4 million in outstanding bonds that mature in four years, with a fixed rate of 7.5% (assume annual payments). The bonds trade at a price of $98 in the open market. The firm’s marginal tax rate is 35%. Using the bond-yield plus method, what is the firm’s cost of equity risk assuming an add-on of 4%?

A) 12.11%.

B) 11.50%.

C) 13.34%.

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If the bonds are trading at $98, the required yield is 8.11%, and the market value of the issue is $3.92 million. To calculate this rate using a financial calculator (and figuring the rate assuming a $100 face value for each bond), N = 4; PMT = 7.5 = (0.075 × 100); FV = 100; PV = -98; CPT → I/Y = 8.11. By adding the equity risk factor of 4%, we compute the cost of equity as 12.11%.

prashantsahni

Which of the following statements about the cost of capital is CORRECT?

A) Ideally, historical measures of the component costs from prior financing should be used in estimating the appropriate weighted average cost of capital.

B) The cost of issuing new equity could possibly be lower than the cost of retained earnings if the market risk premium and risk-free rate decline by a substantial amount.

C) In the weighted average cost of capital calculation, the cost of preferred stock must be adjusted for the cost to issue new preferred stock.

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The marginal cost of capital will increase or stay the same as more capital is raised. Marginal costs of capital, not historical costs, should be used in estimating the weighted average cost of capital.