THE COST OF CAPITAL
Creating Value at GE
Why should the cost of capital be calculated as a weighted average
of the various types of funds a firm generally uses, not the cost of
the specific financing used during a given year?
Identify the firm’s three major capital structure components, and
give their respective component cost symbols.
Why might there be two different component costs for common
equity? Which is the one that is generally relevant, and for what
type of firm is the second one likely to be relevant?
Why is the after-tax cost of debt rather than the before-tax cost used
to calculate the WACC?
Why is the relevant cost of debt the interest rate on new debt, not
that on already outstanding, or old, debt?
A company has outstanding long-term bonds with a face value of
$1,000, an 11 percent coupon, and an 8 percent yield to maturity.
If the company were to issue new debt, what would be a reasonable
estimate of the interest rate on that debt? If the company’s tax rate is
40 percent, what would its after-tax cost of debt be? (8.0%; 4.8%)
Is a tax adjustment made to the cost of preferred stock? Why or why
not?
A company’s preferred stock currently trades at $80 per share and
pays a $6 annual dividend per share. If the company were to sell a
new preferred issue, what would the cost of that capital be? Ignore
flotation costs. (7.50%
Why must a cost be assigned to retained earnings?
What three approaches are used to estimate the cost of common equity?
Identify some problems with the CAPM approach.
Which of the two components of the DCF formula, the dividend
yield or the growth rate, is more difficult to estimate? Why?
What’s the logic behind the bond-yield-plus-risk-premium approach?
Suppose you are an analyst with the following data: rRF 5.5%; rM
rRF 6%; b 0.8; D1 $1.00; P0 $25.00; g 6%; rd firm’s bond
yield 6.5%.
What is this firm’s cost of equity using the CAPM, DCF,and bond-yield-plus-risk-premium approaches?
Use the mid-range of the judgmental risk premium for the bond-yield-plus-risk-premium approach. (CAPM 10.3%; DCF 10%; Bond yield RP 10.5%
Explain briefly the two approaches that can be used to adjust for
flotation costs.
Would firms that have many good investment opportunities be
likely to have higher or lower dividend payout ratios than firms
with few good investment opportunities? Explain.
A firm has common stock with D1 $1.50; P0 $30; g 5%; and
F 4%. If the firm must issue new stock, what is its cost of issuing
new external equity? (10.21%
Write out the equation for the WACC.
Is short-term debt included in the capital structure used to calculate
WACC? Why or why not?
Why does the WACC at every amount of capital raised represent the
marginal cost of that capital?
A firm has the following data: Target capital structure of 46 percent
debt, 3 percent preferred, and 51 percent common equity; Tax rate
40%; r d 7%; r p 7.5%; and r s 11.5%. Assume the firm will not
be issuing new stock. What is this firm’s WACC? (8.02% 8%
What two factors that affect the cost of capital are generally beyond
the firm’s control?
What are three factors under the firm’s control that can affect its cost
of capital?
Suppose interest rates in the economy increase. How would such a
change affect each component of the WACC?
Why is the cost of capital sometimes referred to as a “hurdle rate”?
How should firms evaluate projects with different risks?
Should divisions within the same firm all use the firm’s composite
WACC when considering capital budgeting projects? Explain.
Identify some problem areas in cost of capital analysis. Do these
problems invalidate the cost of capital procedures discussed in the
chapter?