Cost of Capital Paper 5


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


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


The firm’s marginal cost of capital


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?


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?


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


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?


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?


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?


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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