Reading 45: Cost of Capital - LOS a ～ Q11-13

corporate, increase, average, capital, company

Q11. Assume that a company has equal amounts of debt, common stock, and preferred stock. An increase in the corporate tax rate of a firm will cause its weighted average cost of capital (WACC) to:

A) rise.

B) fall.

C) more information is needed.

Q12. A company has the following capital structure:

Target weightings: 30% debt, 20% preferred stock, 50% common equity.
Tax Rate: 35%.
The firm can issue $1,000 face value, 7% semi-annual coupon debt with a 15-year maturity for a price of $1,047.46.
An 8% dividend preferred stock issue has a value of $35 per share.
The company’s growth rate is estimated at 6%.
The company's common shares have a value of $40 and a dividend in year 0 of D₀ = $3.00.

The company's weighted average cost of capital is closest to:

A) 9.84%.

B) 9.28%.

C) 10.53%.

Q13. Helmut Humm, manager at a large U.S. firm, has just been assigned to the capital budgeting area to replace a person who left suddenly. One of Humm’s first tasks is to calculate the company’s weighted average cost of capital (WACC) – and fast! The CEO is scheduled to present to the board in half an hour and needs the WACC – now! Luckily, Humm finds clear notes on the target capital component weights. Unfortunately, all he can find for the cost of capital components is some handwritten notes. He can make out the numbers, but not the corresponding capital component. As time runs out, he has to guess.

Here is what Humm deciphered:

Target weights: w_d = 30%, w_ps = 20%, w_ce = 50%, where w_d, w_ps, and w_ce are the weights used for debt, preferred stock, and common equity.
Cost of components (in no particular order): 6.0%, 15.0%, and 8.5%.
The cost of debt is the after-tax cost.

If Humm guesses correctly, the WACC is:

A) 11.0%.

B) 9.2%.

C) 9.0%.