FIN 2800 Chapter Notes - Chapter 9: Capital Asset Pricing Model, Capital Structure, Preferred Stock

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erindog119

9 Nov 2016

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Cost of capital: represents the firm"s cost of financing and is the minimum rate of return. Net proceeds: funds actually received by the firm from the sale of a security. Flotation costs: total costs of issuing and selling a security: underwriting costs: compensation earned by investment bankers for selling the security, administrative costs: issuer expenses such as legal and accounting costs. Cost of preferred stock: the ratio of the preferred stock dividends to the firm"s net proceeds from the sale of preferred stock. Does not look at risk, uses market price. Can be easily adjusted for flotation costs: capital asset pricing model: describes the relationship between the required return and the no diversifiable risk of the firm as measured by the beta coefficient. Directly considers the firm"s risk (beta) in determining the required return or cost of common stock equity. Can"t be easily adjusted for flotation costs because market price isn"t included.

Related Questions

Weighted Average Cost of Capital

A firm has determined its optimal capital structure, which is illustrated by the information below.

Source of Capital (Target Market Proportions)

Long term debt (20%)

Preferred Stock (10)

Common Stock Equity (70)

To expand operations, the firm is considering the following sources of financing its capital expenses:

Debt -The firm can sell 12-year, 1,000 par value bond paying a 7% annual coupon for $960. To issue the bond the firm will have to pay bond issuance or flotation cost of 2 percent of the face value of the bond.

Preferred Stock- the firm has determined that it can issue preffered stock at a par value price of $75 per share. The stock will pay $10 annual dividend. The cost of issuing and selling the stock is $3 per share.

Common Stock: A firms common stock is currently selling for $18 per share. The dividend expected to be paid at the end of the coming year is $1.74. The firms dividends have been growing at a constant rate of 4% per year for the last four years and are expected to sustain that growth rate thereafter.

New common stock issue- if the firm decides to issue new common stock, its underwriter indicated that the issue will have to be underpriced by $1 below the current share price. Further, the firm will have to pay $1 per share in issuance or floatation cost.

Additionaly, the firms marginal corporate tax rate is 40 percent.

(Given the information above)

A) find the firms before-tax cost of debt financing

B) find the firms after-tax cost of debt financing

C) find the firms cost of preffered stock financing

D) find the firms cost of financing using the retained earnings

e) find the firms cost of financing using a new common stock issue

f)find the firms weighted average cost of capital, if the firm uses debt, preffered stock and retained earnings to finance its investments. Given this result, explain what rate of return the firm should require from its investors.

g) Find the firms weighted average cost of capital, if the firm uses debt, preffered stock, retained earnings, and new stock issue to finance its investments. Given this results, explain what rate of return the firm should require from its investments.

turquoiseelephant380

Thanks in advance!

______ The most significant portion of the return on a share of common stock is in the form of interest.

______ Bonds are a form of equity financing that pays interest.

______ The less certain a cash flow, the higher the risk, and the lower the present value of the cash flow.

______ The tax deductibility of interest lowers the cost of debt financing, which causes the cost of debt financing to typically be lower than the cost of equity financing.

______ A preferred stockholder typically has the right to receive dividend payments before any dividends are paid to common stockholders.

______ Several investment banking firms may join together to share the financial risk associated with underwriting a new security issue.

______ In theory, to maximize their rate of return, investors should purchase a particular stock when they believe that it is undervalued and then sell it when they feel that it is overvalued.

______ In an inefficient market, stock prices adjust quickly to new public information.

Strange Sights Paranormal Investigators Inc. has a target capital structure that calls for:

40% debt

10% preferred stock

50% common equity

The firms current bonds have a before tax cost of debt of 10% and the firm is in the 40% tax bracket. The firm can sell as much debt as it wishes at this rate. The firms preferred stock currently sells for $90 a share and pays a dividend of $10 per share; however, the firm will pay flotation cost of $10 per share. Strange sights' common stock sells for $40 a share with flotation costs of $6 per share from the sale of new common stock. The firm recently paid a dividend of $2 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10% per year. Assume the firm has sufficient retained earnings to fund the equity portion of its capital budget.

1. What is the firms cost of retained earnings? (15.5%)

2. What is the firms cost of newly issued common stock? (16.5%)

3. What is the firms cost of newly issued preferred stock? (12.5%)

4. What is the firms weighted average cost of capital? (11.7%)

The answers are giving in ( ) as a guide, I must show how I got them. Please help!!!!!

peachzebra922

FIN 2800 Chapter Notes - Chapter 9: Capital Asset Pricing Model, Capital Structure, Preferred Stock

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