prashantsahni

The 6% semiannual coupon, 7-year notes of Woodbine Transportation, Inc. trade for a price of $94.54. What is the company’s after-tax cost of debt capital if its marginal tax rate is 30%?

A) 2.1%.

B) 4.2%.

C) 4.9%.

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To determine Woodbine’s before-tax cost of debt, find the yield to maturity on its outstanding notes:

PV = -94.54; FV = 100; PMT = 6 / 2 = 3; N = 14; CPT → I/Y = 3.50 × 2 = 7%

Woodbine’s after-tax cost of debt is kd(1 - t) = 7%(1 - 0.3) = 4.9%

prashantsahni

The debt of Savanna Equipment, Inc. has an average maturity of ten years and a BBB rating. A market yield to maturity is not available because the debt is not publicly traded, but the market yield on debt with similar characteristics is 8.33%. Savanna is planning to issue new ten-year notes that would be subordinate to the firm’s existing debt. The company’s marginal tax rate is 40%. The most appropriate estimate of the after-tax cost of this new debt is:

A) 5.0%.

B) Between 3.3% and 5.0%.

C) More than 5.0%.

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The after-tax cost of debt similar to Savanna’s existing debt is kd(1 - t) = 8.33%(1 - 0.4) = 5.0%. Because the anticipated new debt will be subordinated in the company’s debt structure, investors will demand a higher yield than the existing debt carries. Therefore, the appropriate after-tax cost of the new debt is more than 5.0%.

prashantsahni

Which of the following is least likely to be useful to an analyst who is estimating the pretax cost of a firm’s fixed-rate debt?

A) The yield to maturity of the firm’s existing debt.

B) The coupon rate on the firm’s existing debt.

C) Seniority and any special covenants of the firm’s anticipated debt.

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Ideally, an analyst would use the YTM of a firm’s existing debt as the pretax cost of new debt. When a firm’s debt is not publicly traded, however, a market YTM may not be available. In this case, an analyst may use the yield curve for debt with the same rating and maturity to estimate the market YTM. If the anticipated debt has unique characteristics that affect YTM, these characteristics should be accounted for when estimating the pretax cost of debt. The cost of debt is the market interest rate (YTM) on new (marginal) debt, not the coupon rate on the firm’s existing debt. If you are provided with both coupon and YTM on the exam, you should use the YTM.

prashantsahni

Which of the following is least likely to be useful to an analyst when estimating the cost of raising capital through the issuance of non-callable, nonconvertible preferred stock?

A) The stated par value of the preferred issue.

B) The firm’s corporate tax rate.

C) The preferred stock’s dividend rate.

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The corporate tax rate is not a relevant factor when calculating the cost of preferred stock.
The cost of preferred stock, kps is expressed as:
kps = Dps / P
where:
Dps = divided per share = dividend rate × stated par value
P = market price

prashantsahni

The after-tax cost of preferred stock is always:

A) equal to the before-tax cost of preferred stock.

B) less than the before-tax cost of preferred stock.

C) higher than the cost of common shares.

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The after-tax cost of preferred stock is equal to the before-tax cost of preferred stock, because preferred stock dividends are not tax deductible. The cost of preferred shares is usually higher than the cost of debt, but less than the cost of common shares.

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%