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
Answer (A) is correct.
In economics, a basic principle is that a firm should increase output until marginal cost equals marginal revenue. Similarly, the optimal capital budget is determined by calculating the point at which marginal cost of capital (which increases as capital requirements increase) and marginal efficiency of investment (which decreases if the most profitable projects are accepted first) intersect.
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
Answer (D) is correct. A weighted average of the costs of all financing sources should be used, with the weights determined by the usual financing proportions. The terms of any financing raised at the time of initiating a particular project do not represent the cost of capital for the firm. When a firm achieves its optimal capital structure, the weighted-average cost of capital is minimized.
The firm’s marginal cost of capital
Answer (D) is correct. The marginal cost of capital is the cost of the next dollar of capital. The marginal cost continually increases because the lower cost sources of funds are used first. The marginal cost represents a weighted average of both debt and equity 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?
Answer (C) is correct. The important consideration is whether the overall cost of capital will be lower for a given proposal. According to the Capital Asset Pricing Model, the change will result in a lower average cost of capital. For the existing structure, the cost of equity capital is 15.5% [6% + .95 (16% – 6%)]. Because the company has no debt, the average cost of capital is also 15.5%. Under the proposal, the cost of equity capital is 16.5% [6% + 1.05 (16% – 6%)], and the weighted average cost of capital is 13.8% [.3(.075) + .7(.165)]. Hence, the proposal of 13.8% should be accepted.
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?
Answer (D) is correct. Because the dividends on preferred stock are not deductible for tax purposes, the effect of income taxes is ignored. Thus, the relevant calculation is to divide the $8 annual dividend by the quantity of funds received from the issuance. In this case, the funds received equal $87 ($92 proceeds – $5 issue costs). Thus, the cost of capital is 9.2% ($8 ÷ $87).
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
Answer (C) is correct. The cost of new common stock is the next dividend ($2.20) divided by the net proceeds of the stock. If this were to involve a new sale of stock, the flotation costs would be deducted from the selling price to get the net proceeds. However, this was for retained earnings, so there is no deduction. The calculation is to divide the $2.20 dividend by the $38 selling price to get 5.8%. Add the 10% growth rate and the answer is 15.8%.
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?
Answer (A) is correct. The discount rate used in evaluating the new project should be the after-tax cost of the additional capital. Therefore, the discount rate to be used by Pane in evaluating its new project should be 6.40% [10% × (1 – .36 .
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?
Answer (D) is correct. Under the dividend growth model, the cost of equity equals the expected growth rate plus the quotient of the next dividend and the current market price. The next dividend is calculated as $1.17 [$1.04 dividend × (1 + .125 growth)]. Thus, the cost of equity capital is 16.85% [12.5% + ($1.17 ÷ $26.87)]. This model assumes that the payout ratio, retention rate, and the earnings per share growth rate are all constant.
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?
Answer (B) is correct. The cost of the debt would be 3.78% [6% × (1 – .37)] since interest payments are tax-deductible by the firm. The preferred shares would cost 7%.
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?
Answer (D) is correct. The next dividend that Mackinaw will pay is $2.43 ($2.25 × 1.08). The net issue proceeds are $35.85 ($38 ÷ 1.06) after taking the flotation costs into account. Therefore, the cost of capital is 14.8% [($2.43 ÷ $35.85) + .08].