[FIN 401] - Midterm Exam Guide - Everything you need to know! (17 pages long)

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7 Feb 2017

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Chapter #14: cost of capital: some preliminaries, the cost of equity, costs of debts and preferred stock, weighted average cost of capital, divisional and project costs of capital, flotation costs and the weighted average, calculating wacc for loblaws. Determine a firm"s cost of equity capital. Determine a firm"s overall cost of capital. Be able to correctly include flotation costs in capital budgeting proejcts. Understand pitfalls associated with a firm"s overall cost of capital and how to manage them. Reutrn earned on assets depends on the risk of those assets. The return to an inverstor is the same as the cost to the company. Our cost of capital provides us with an indication of how the market views the risk of our assets. Knowing our cost of capital can also help us determine our required return for capital budgeting projects. Required return same as appropriate discount rate based on risk of the cash flows.

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During the past few years, Harry Davis Industries (HDI) has beenconstrained by high cost of capital to make many capitalinvestments. Recently, though, capital costs have been decliningand the company has decided to look seriously at a major expansionprogram that had been proposed by the marketing department. Assumethat you are an assistant to the CFO. Your first task is estimateHDIâs cost of capital. The CFO has provided you with the followingdata, which is considered to your task:

The current price of HDIâs 12% coupon , seminal annual,non-callable bonds with 15 years to maturity is $1153.72. HDI doesnot use short-term interest bearing debt on a permanent basis. Newbonds would be privately placed with no flotation costs.
The current price of HDIâs 10%, $100 par value, quarterlydividend, perpetual preferred stock is $113.10. HDI would incurflotation cost of $2.00 per share.
HDIâs common stock is currently selling for $50 per share. Itslast dividend (d₀) was $4.19, and dividends are expectedto grow at a constant rate of 5% in the foreseeable future. HDIâsbeta is 1.2; the yield on T-Bonds is 7%; and the market riskpremium is estimated to be 6%. For the bond-yield-plus-risk-premiumapproach, the firm uses a 4% point risk premium.
HDIâs target capital structure:30% long-term, 10% pref. stock,and 60% common equity.
The firmâs tax rate is 40%

To structure the task somewhat, CFO has asked you to answer thefollowing questions:

1. The after-tax cost of HDIâs debt, K_dis ___________

2. The firmâs cost of preferred stock,K_p, is __________

3. Using CAPM the firmâs cost of equity,K_e is _______

4. The estimated cost of equity using DiscountedCash Flow (DCF) model is ______

5. The cost of equity, K_e, based on thebond-yield-plus-risk-premium method is ____

6. The overall cost of equity, K_e is__________

7. The weighted average cost of capital (WACC) is_________

8. HDI estimates that if it issues new common stock,the flotation cost will be 15%. HDI incorporates theflotation costs into the DCF approach. The estimatedcost of newly issued common stock, taking into account theflotation cost is _________

9. Suppose HDI has historically earned 15% on equity (ROE) andretained 35% of earnings, and investors expect this situation tocontinue in the future. How could you use this information toestimate the future dividend growth rate, and what growth ratewould you get? Is thisconsistent with the 5% growth rate given?

HDI is interested in establishing a new division, which willfocus primarily on developing new internet-based projects. Intrying to determine the cost of capital for this new division, youdiscover that stand-alone firms involved in similar projects haveon average the following characteristics:

- Capital structure of 10% debt and 90% equity.

- Cost of debt of 12% and beta of 1.7.

10. Given this information, your estimate of the divisionâs costcapital is _______

apricotraven928

Bremond Equipment Supply Corporation (BESC) needs to determine its Weighted Average Cost of Capital in order to make a few capital budgeting decisions. The firm has already established the proporation of its capital. Use these proportions in calculating the firm's WAAC.

	Target Market
Source of Capital	Proportions
Long-term debt	69%
Preferred stock	5%
Common stock equity	26%

Debt: BESC can sell a 15-year, semi-annual,$1,000 par value, 8.75 percent bond for $985. A flotation cost of 1.75 percent of the face value would be required in addition to the discount of $15.

Preferred Stock: BESC has determined it can issue preferred stock at $70 per share par value. The stock will pay an $8.00 annual dividend. The cost of issuing and selling the stock is $2 per share.

Common Stock: BESC's common stock is currently selling for $42 per share. The dividend expected to be paid at the end of the coming year is $5.35 Its dividend payments have been growing at a constant rate for the last five years. Five years ago, the dividend was $3.00. It is expected that to sell, a new common stock issue must be underpriced at $4 per share and the firm must pay $1 per share in flotation costs.

Additionally, the firm's marginal tax rate is 40 percent.

To help determine the firmâs WACC, we will break this problem down into steps:

Calculate the rate for the new bond issue, notice is has semi-annual compounding.

Calculate the after-tax cost of the bond issue.

Calculate the cost of the new issue of preferred stock.

Calculate the growth rate of the common stock dividends.

Calculate the cost of the new common stock issue.

Finally, calculate the firm's weighted average cost of capital assuming the firm has exhausted all retained earnings.

pinkcicada746

Guys this is very Important Please Please make sure of all the answers. Thanks in Advance.

1)The cost of retained earnings can be less than, equal to, or greater than the cost of new common stock, depending on taxes, flotation costs, investorsâ attitudes, etc.

A)True

B)False

2) Hilliard Corp. needs to estimate its cost of capital. The companyâs CFO has the following information:

The companyâs target capital structure is 25% debt and 75% equity; its tax rate is 40%.

Long-term bonds yield 8%; the cost of retained earnings is 12.63%, that of new common stock is 13.36%.

Since the firm expects to have no retained earnings, it plans to issue new common stock.

Hilliardâs weighted average cost of capital is:

a. 10.67%.

b. I l .22%.

c. 11.47%.

d. 12.02%.

e. 12.56%.

3) If a company uses the same discount rate to evaluate all projects,

A) it will become riskier over time, and its value will decline.

B )it will become riskier over time, and its value will rise.

C) it will become less risky over time, and its value will rise.

D )it will become less risky over time, and its value will decline.

E) there is no reason to expect its risk position or value to change.

4) Tropicaliâs overall average cost of capital is 10%. Its frozen foods division is riskier than the firm as a whole, its fresh produce division has risk similar to the firmâs, and its institutional foods division has less risk. Tropicali adjusts for both divisional and project risk by adding/subtracting 2 percentage points to/from its corporate cost of capital. The hurdle rate for a low-risk project in the frozen foods division is:

a. 6%.

b. 8%.

c. 10%.

d. 12%.

e. 14%.

sangriasardine840

[FIN 401] - Midterm Exam Guide - Everything you need to know! (17 pages long)

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