CFA 36: Cost of Capital
The cost of equity is equal to the:
expected market return.
rate of return required by stockholders.
cost of retained earnings plus dividends. B is correct. The cost of equity is defined as
the rate of return required by stockholders.
Which of the following statements is correct?
The appropriate tax rate to use in the adjustment of the before-tax cost of debt to
determine the after-tax cost of debt is the average tax rate because interest is
deductible against the company's entire taxable income.
For a given company, the after-tax cost of debt is generally less than both the cost of
preferred equity and the cost of common equity.
For a given company, the investment opportunity schedule is upward sloping because
as a company invests more in capital projects, the returns from investing increase. B is
correct. Debt is generally less costly than preferred or common stock. The cost of debt
is further reduced if interest expense is tax deductible.
Using the dividend discount model, what is the cost of equity capital for Zeller Mining if
the company will pay a dividend of C$2.30 next year, has a payout ratio of 30 percent, a
return on equity (ROE) of 15 percent, and a stock price of C$45?
9.61 percent.
10.50 percent.
15.61 percent. C is correct. First calculate the growth rate using the sustainable growth
calculation, and then calculate the cost of equity using the rearranged dividend discount
model:
g = (1 - Dividend payout ratio)(Return on equity) = (1 - 0.30)(15%) = 10.5%
re = (D1 / P0) + g = ($2.30 / $45) + 10.50% = 15.61%
Dot.Com has determined that it could issue $1,000 face value bonds with an 8 percent
coupon paid semi-annually and a five-year maturity at $900 per bond. If Dot.Com's
marginal tax rate is 38 percent, its after-tax cost of debt is closest to:
,6.2 percent.
6.4 percent.
6.6 percent. C is correct. FV = $1,000; PMT = $40; N = 10; PV = $900
Solve for i. The six-month yield, i, is 5.3149%
YTM = 5.3149% × 2 = 10.62985%
rd(1 − t) = 10.62985%(1 − 0.38) = 6.5905%
The cost of debt can be determined using the yield-to-maturity and the bond rating
approaches. If the bond rating approach is used, the:
coupon is the yield.
yield is based on the interest coverage ratio.
company is rated and the rating can be used to assess the credit default spread of the
company's debt. C is correct. The bond rating approach depends on knowledge of the
company's rating and can be compared with yields on bonds in the public market.
Morgan Insurance Ltd. issued a fixed-rate perpetual preferred stock three years ago
and placed it privately with institutional investors. The stock was issued at $25 per share
with a $1.75 dividend. If the company were to issue preferred stock today, the yield
would be 6.5 percent. The stock's current value is:
$25.00.
$26.92.
$37.31. B is correct. The company can issue preferred stock at 6.5%.
Pp = $1.75/0.065 = $26.92
A financial analyst at Buckco Ltd. wants to compute the company's weighted average
cost of capital (WACC) using the dividend discount model. The analyst has gathered the
following data:
Before-tax cost of new debt 8 percent
Tax rate 40 percent
Target debt-to-equity ratio 0.8033
Stock price $30
Next year's dividend $1.50
Estimated growth rate 7 percent
Buckco's WACC is closest to:
, 8 percent.
9 percent.
12 percent. B is correct.
Cost of equity = D1/P0 + g = $1.50 / $30 + 7% = 5% + 7% = 12%
D / (D + E) = 0..8033 = 0.445
WACC = [(0.445) (0.08)(1 − 0.4)] + [(0.555)(0.12)] = 8.8%
The Gearing Company has an after-tax cost of debt capital of 4 percent, a cost of
preferred stock of 8 percent, a cost of equity capital of 10 percent, and a weighted
average cost of capital of 7 percent. Gearing intends to maintain its current capital
structure as it raises additional capital. In making its capital-budgeting decisions for the
average-risk project, the relevant cost of capital is:
4 percent.
7 percent.
8 percent. B is correct. The weighted average cost of capital, using weights derived
from the current capital structure, is the best estimate of the cost of capital for the
average-risk project of a company.
Fran McClure of Alba Advisers is estimating the cost of capital of Frontier Corporation
as part of her valuation analysis of Frontier. McClure will be using this estimate, along
with projected cash flows from Frontier's new projects, to estimate the effect of these
new projects on the value of Frontier. McClure has gathered the following information
on Frontier Corporation:
Current Year ($) Forecasted for Next Year ($)
Book value of debt 50 50
Market value of debt 62 63
Book value of shareholders' equity 55 58
Market value of shareholders' equity 210 220
The weights that McClure should apply in estimating Frontier's cost of capital for debt
and equity are, respectively:
wd = 0.200; we = 0.800.
wd = 0.185; we = 0.815.
wd = 0.223; we = 0.777. C is correct.
wd = $63/($220 + 63) = 0.223
The cost of equity is equal to the:
expected market return.
rate of return required by stockholders.
cost of retained earnings plus dividends. B is correct. The cost of equity is defined as
the rate of return required by stockholders.
Which of the following statements is correct?
The appropriate tax rate to use in the adjustment of the before-tax cost of debt to
determine the after-tax cost of debt is the average tax rate because interest is
deductible against the company's entire taxable income.
For a given company, the after-tax cost of debt is generally less than both the cost of
preferred equity and the cost of common equity.
For a given company, the investment opportunity schedule is upward sloping because
as a company invests more in capital projects, the returns from investing increase. B is
correct. Debt is generally less costly than preferred or common stock. The cost of debt
is further reduced if interest expense is tax deductible.
Using the dividend discount model, what is the cost of equity capital for Zeller Mining if
the company will pay a dividend of C$2.30 next year, has a payout ratio of 30 percent, a
return on equity (ROE) of 15 percent, and a stock price of C$45?
9.61 percent.
10.50 percent.
15.61 percent. C is correct. First calculate the growth rate using the sustainable growth
calculation, and then calculate the cost of equity using the rearranged dividend discount
model:
g = (1 - Dividend payout ratio)(Return on equity) = (1 - 0.30)(15%) = 10.5%
re = (D1 / P0) + g = ($2.30 / $45) + 10.50% = 15.61%
Dot.Com has determined that it could issue $1,000 face value bonds with an 8 percent
coupon paid semi-annually and a five-year maturity at $900 per bond. If Dot.Com's
marginal tax rate is 38 percent, its after-tax cost of debt is closest to:
,6.2 percent.
6.4 percent.
6.6 percent. C is correct. FV = $1,000; PMT = $40; N = 10; PV = $900
Solve for i. The six-month yield, i, is 5.3149%
YTM = 5.3149% × 2 = 10.62985%
rd(1 − t) = 10.62985%(1 − 0.38) = 6.5905%
The cost of debt can be determined using the yield-to-maturity and the bond rating
approaches. If the bond rating approach is used, the:
coupon is the yield.
yield is based on the interest coverage ratio.
company is rated and the rating can be used to assess the credit default spread of the
company's debt. C is correct. The bond rating approach depends on knowledge of the
company's rating and can be compared with yields on bonds in the public market.
Morgan Insurance Ltd. issued a fixed-rate perpetual preferred stock three years ago
and placed it privately with institutional investors. The stock was issued at $25 per share
with a $1.75 dividend. If the company were to issue preferred stock today, the yield
would be 6.5 percent. The stock's current value is:
$25.00.
$26.92.
$37.31. B is correct. The company can issue preferred stock at 6.5%.
Pp = $1.75/0.065 = $26.92
A financial analyst at Buckco Ltd. wants to compute the company's weighted average
cost of capital (WACC) using the dividend discount model. The analyst has gathered the
following data:
Before-tax cost of new debt 8 percent
Tax rate 40 percent
Target debt-to-equity ratio 0.8033
Stock price $30
Next year's dividend $1.50
Estimated growth rate 7 percent
Buckco's WACC is closest to:
, 8 percent.
9 percent.
12 percent. B is correct.
Cost of equity = D1/P0 + g = $1.50 / $30 + 7% = 5% + 7% = 12%
D / (D + E) = 0..8033 = 0.445
WACC = [(0.445) (0.08)(1 − 0.4)] + [(0.555)(0.12)] = 8.8%
The Gearing Company has an after-tax cost of debt capital of 4 percent, a cost of
preferred stock of 8 percent, a cost of equity capital of 10 percent, and a weighted
average cost of capital of 7 percent. Gearing intends to maintain its current capital
structure as it raises additional capital. In making its capital-budgeting decisions for the
average-risk project, the relevant cost of capital is:
4 percent.
7 percent.
8 percent. B is correct. The weighted average cost of capital, using weights derived
from the current capital structure, is the best estimate of the cost of capital for the
average-risk project of a company.
Fran McClure of Alba Advisers is estimating the cost of capital of Frontier Corporation
as part of her valuation analysis of Frontier. McClure will be using this estimate, along
with projected cash flows from Frontier's new projects, to estimate the effect of these
new projects on the value of Frontier. McClure has gathered the following information
on Frontier Corporation:
Current Year ($) Forecasted for Next Year ($)
Book value of debt 50 50
Market value of debt 62 63
Book value of shareholders' equity 55 58
Market value of shareholders' equity 210 220
The weights that McClure should apply in estimating Frontier's cost of capital for debt
and equity are, respectively:
wd = 0.200; we = 0.800.
wd = 0.185; we = 0.815.
wd = 0.223; we = 0.777. C is correct.
wd = $63/($220 + 63) = 0.223
