Cost of Capital Paper 5

1

A firm seeking to optimize its capital budget has calculated its marginal cost of capital and projected rates of return on several potential projects. The optimal capital budget is determined by






2

A company has made the decision to finance next year’s capital projects through debt rather than additional equity. The benchmark cost of capital for these projects should be






3

The firm’s marginal cost of capital






4

Datacomp Industries, which has no current debt, has a beta of .95 for its common stock. Management is considering a change in the capital structure to 30% debt and 70% equity. This change would increase the beta on the stock to 1.05, and the after-tax cost of debt will be 7.5%. The expected return on equity is 16%, and the risk-free rate is 6%. Should Datacomp’s management proceed with the capital structure change?






5

Lox has sold 1,000 shares of $100 par, 8% preferred stock at an issue price of $92 per share. Stock issue costs were 5 per share. Lox pays taxes at the rate of 40%. What is Lox’s cost of preferred stock capital?






6

The management of Old Fenske Company (OFC has been reviewing the company’s financing arrangements. The current financing mix is $750,000 of common stock, $200,000 of preferred stock ($50 par) and $300,000 of debt. OFC currently pays a common stock cash dividend of $2. The common stock sells for $38, and dividends have been growing at about 10% per year. Debt currently provides a yield to maturity to the investor of 12%, and preferred stock pays a dividend of 9% to yield 11%. Any new issue of securities will have a flotation cost of approximately 3%. OFC has retained earnings available for the equity requirement. The company’s effective income tax rate is 40%. Based on this information, the cost of capital for retained earnings is






7

Pane Software, Inc., has total capital of $100 million, and its cost of capital is 12%. A new project has been proposed that will require additional capital of $10 million. The firm estimates that the additional capital can be raised at a pre-tax cost of 10%. The company’s marginal income tax rate is 36%. What discount rate should Pane use in evaluating the new project?






8

Peson, Inc., a manufacturer of printers, is attempting to determine its cost of common equity for cost of capital purposes. Peson’s long-term debt is rated AA by Standard & Poor’s. Peson’s common shares trade on the NASDAQ and the current market price is $26.87. The most recent yearly common share dividend Peson paid common shareholders was $1.04. The consensus forecast of security analysts who follow Peson’s common shares is that earnings growth will average 12.5% over the long term. Peson’s marginal income tax rate is 40%. Using the dividend discount model, what is Peson’s cost of equity capital for cost of capital purposes?






9

A profitable firm is reviewing alternatives to raise additional capital. It estimates that it can issue debt at a yield of 6% or, alternately, issue preferred shares at a yield of 7%. If the firm’s marginal income tax rate is 37%, what would be the cost for each alternative?






10

Mackinaw Coats, Inc., is planning to issue additional shares of common stock in a public offering. The current market price of Mackinaw stock is $38, and the dividend for the past year was $2.25. A well-known investment advisory firm forecasts dividend growth of 8%, and an investment banker estimates that the flotation costs would be 6% of the issue price. What cost of equity should Mackinaw use in its cost of capital calculation?






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