What return on equity do investors seem to expect for a firm with a $50 share price, an expected dividend of $5.50, a ? of .9, and a constant growth rate of 4.5%?
Answer (B) is correct. Dividing the $5.50 dividend by the $50 share price produces an 11% dividend yield. Adding the 11% yield to the 4.5% growth rate produces a total return of 15.5%. The beta coefficient is irrelevant.
In calculating the component costs of long-term funds, the appropriate cost of retained earnings, ignoring flotation costs, is equal to
Answer (A) is correct. Common shareholders expect retained earnings to be paid out in the form of dividends. Thus, the cost of retained earnings is an opportunity cost, i.e., the rate that investors can earn elsewhere on investments of comparable risk.
Which of the following, when considered individually, would generally have the effect of increasing a firm’s cost of capital?
I. The firm reduces its operating leverage.
II. The corporate tax rate is increased.
III. The firm pays off its only outstanding debt.
IV. The Treasury Bond yield increases.
Answer (C) is correct. Debt generally has a lower initial cost than equity. By removing debt from the firm’s financing structure, the cost of capital is thereby increased. Similarly, the increase in yield on Treasury bonds, a risk-free rate, would cause the yield on all other bonds to also increase.
Angela Company’s capital structure consists entirely of long-term debt and common equity. The cost of capital for each component is shown below.
Long-term debt 8%
Common equity 15%
Angela pays taxes at a rate of 40%. If Angela’s weighted average cost of capital is 10.41%, what proportion of the company’s capital structure is in the form of long-term debt?
Answer (B) is correct. The effective rate for Angela’s debt is the after-tax cost [8% × (1.0 – .40 tax rate) = 4.8%]. The formula for weighted-average cost of capital can be solved as follows: (Debt weight × Cost of debt) + (Equity weight × Cost of equity) = WACC (Debt weight ×.048) + (Equity weight × .15) = .1041 [(1 – Equity weight) × .048] + (Equity weight × .15) = .1041 .048 – (.048 × Equity weight) + (Equity weight × .15) = .1041 – (.048 × Equity weight) + (Equity weight × .15) = .0561 Equity weight × .102 = .0561 Equity weight = .55 Since equity is 55% of the capital structure, debt makes up 45%.
Joint Products, Inc., a corporation with a 40% marginal tax rate, plans to issue $1,000,000 of 8% preferred stock in exchange for $1,000,000 of its 8% bonds currently outstanding. The firm’s total liabilities and equity are equal to 10,000,000. The effect of this exchange on the firm’s weighted average cost of capital is likely to be
Answer (D) is correct. The payment of interest on bonds is tax-deductible, whereas dividends on preferred stock must be paid out of after-tax earnings. Thus, when bonds are replaced in the capital structure with preferred stock, an increase in the cost of capital is likely because there is no longer a tax shield.
Zeta Corporation’s current-year earnings are $2.00 per share. Using a discounted cash flow model, the controller determines that Zeta’s common stock is worth 14 per share. Assuming a 5% long-term growth rate, Zeta’s required rate of return is which one of the following?
Answer (A) is correct. The dividend discount model (also known as the dividend growth model) is a method of arriving at the value of a stock by using expected dividends per share and discounting them back to present value. The formula is as follows:
DPS/(cost of capital-dividend growth rate)
The current-year earnings per share are $2.00. In order to calculate the correct dividend per share amount when given only the amount of the last annual dividend paid, it is necessary to adjust to the expected dividend using the growth rate of the company. Thus, the dividends per share equal $2.10 [$2 × (1 + .05)]. The rate of return can now be solved for as follows: $2.10 ÷ (x – .05 = 14 2.10 = $14x – .70 2.80 = $14x x = 20%
A company has a weighted-average cost of capital of 12.8%. If the after-tax cost of debt is 8%, and the weight on debt is 20%, what is the company’s cost of equity? Assume the company has no preferred stock.
Answer (B) is correct. The company’s cost of equity can be calculated using the WAAC formula. WACC = Weight on equity × Cost of equity + Weight on debt × Cost of debt 1. 12.8% = 80% × Cost of equity + 20% × 8% 2. 12.8% = 80% × Cost of equity + 1.6% 3. 11.2% = 80% × Cost of equity 4. 14% = Cost of equity
Ten years ago, Ellison Group issued perpetual preferred shares with a par value of $50 and an annual dividend rate of 6%. Currently, there are no dividends in arrears. Since the issue date, interest rates have risen, and the shares are now selling at $38. The market’s current required rate of return on these shares is
Answer (C) is correct. The required rate of return on these shares is calculated by dividing the dividend by the issue price. Thus, $3 (6% × $50) must be divided by $38 to yield 7.89%.
The weighted-average cost of capital is equal to the
Answer (A) is correct. The weighted-average cost of capital represents the minimum rate of return at which a company produces value for its investors. Therefore, it is the return on assets that covers the company’s costs.
Beck, Inc., issued $100,000, 15-year term bonds with a coupon rate of 8% at par. Interest is paid annually to bondholders. Beck’s effective income tax rate is 35%. Beck used the proceeds to complete the purchase of a supplier whose effective income tax rate is 20%. What is the after-tax cost of debt?
Answer (C) is correct. Since the bond is issued at par, the coupon rate is equal to the effective rate. The after-tax cost of debt is found by multiplying the effective rate by 1 minus the effective tax rate. Therefore, the answer is 5.2% [8% × (1 – .35 .