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2 Apr 2018

Which of the following statements (if any) is (are) true concerning companies that do not pay dividends? a. The cost of equity capital cannot be determined by using the CAPM, the risk premium on debt approach, or by estimating ke for comparable dividend-paying stocks in their industry. b. The dividend capitalization model can be used to determine an accurate cost of equity capital. c. The cost of equity capital is equal to the growth short-term rate of earnings per share. d. The cost of equity capital can be estimated using the Capital Asset Pricing Model.

The optimal capital budget is determined by comparing the expected project returns to the company's

a.

cost of equity schedule
b.

marginal cost of capital schedule
c.

computed break points
d.

optimal opportunity curv

The managerial implications of capital structure theory include all of the following except:

a.

optimal capital structure is influenced heavily by the business risk facing the firm
b.

changes in capital structure result in changes in the market value of the firm's equity
c.

capital structure changes transmit important information to investors
d.

tax shield benefits from equity lead to increased firm value

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Lelia Lubowitz
Lelia LubowitzLv2
3 Apr 2018

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Related questions

The major components that determine the risk premium on a specific security at any point in time include all of the following except

a.

interest rate risk
b.

business risk
c.

financial risk
d.

real rate of return risk

If a firm sells assets, generating cash flows, the cost of these funds is ____.

a.

the firm's cost of cash flows
b.

the firm's weighted cost of capital
c.

zero
d.

the firm's cost of equity

Which of the following statements (if any) is (are) true concerning companies that do not pay dividends?

a.

The cost of equity capital cannot be determined by using the CAPM, the risk premium on debt approach, or by estimating ke for comparable dividend-paying stocks in their industry.
b.

The dividend capitalization model can be used to determine an accurate cost of equity capital.
c.

The cost of equity capital is equal to the growth short-term rate of earnings per share.
d.

The cost of equity capital can be estimated using the Capital Asset Pricing Model.

Please double check your work

1) Foliage Company’s 10 year bonds, which have a coupon of 4%, currently trade in the market at a 4.8%yield to maturity. If its marginal tax rate is 35%, what is the company’s after-tax cost of debt?


2) Foliage Company’s investment bankers told the company that it could issue a preferred stock with adividend of $5.50 and a price of $98. Issuance costs would be 1.2%. What is the company’s cost ofpreferred stock?

3) Foliage Company’s future earnings and dividends are expected to grow at a constant rate of 3% peryear. Its common stock currently trades at $15 per share. It paid a dividend of $2 per share yesterday.The company has a beta of 1.75. The current risk free rate is 2%, and the required return on the marketis assumed to be 12%. The company can issue bonds at a 4.8% yield to maturity.
a) Calculate the firm’s cost of equity using CAPM.

b) Calculate the firm’s cost of equity using the Dividend Yield + Growth rate model.

c) Calculate the firm’s cost of equity using the Bond Yield + Risk premium approach (assume the mid
point of the risk premium range of 3-5%).

d) Based on the above, what do you want to assume for the company’s estimated cost of equity?

4) Assuming the company’s current capital structure is its target capital structure, if Foliage Companyhas the following capital structure, what is the firm’s weighted average cost of capital (WACC)? (Usehighest cost of equity estimate in your calculations.)
Debt $100,000,000

Preferred Stock 20,000,000

Common Stock 200,000,000

5) If Foliage changes its target capital structure to increase the amount of debt by 50% and reduce the
amount of common equity by 25% (and does this by borrowing $50,000,000 and using the borrowedfunds to retire $50,000,000 of common stock), what is its new WACC? Why did the WACC decline?

Eco Plastics Company: The target capital structure for ECO is given by the weights in the following table:

Source of Capital Weight
Long-term debt 30 %
Preferred stock 20
Common stock equity 50
Total 100 %

At the present time, Eco can raise debt by selling 20 year bonds with a $1,000 par value and a 10.5% annual coupon interest rate. Eco's corporate tax rate is 40%, and its bonds generally require an average discount of $45 per bpnd and flotation costs of $32 per bond when being sold. Eco's outstanding preferred stock pays a 9 % dividend and has a $95-per-share par value. The cost of issuing and selling additional preferrerd stock is expected to be $7 per share. Because ECO is a young firm that requires lots of cash to grow it does not currently pay a dividend to common stockholders. To track the cost of common stock the CFO uses the capital asset price model (CAPM). The CFO and the firm's investment advisors believe that the appropriate risk-free rate is 4 % and that the market's expected return equals 13%. Using data from 2012 through 2015, Eco's CFO estimates the firm's beta to be 1.3. Although Eco's current target capital structure includes 20 % preferred stock, the company is considering using debt financing to retire the outstanding preferred stock, thus shifting their target capital struture to 50% long term debt and 50% common stock. If Eco shifts its capital mix from preferred stock to debt, its financial advisors expect its beta to increase to 1.5. A) Calculate Eco's current after-tax cost of long term debt. B) Calculate Eco's current cost of preferred stock C) Calculate Eco's current cost of common stock D) Caluclate Eco's current weighted average cost capital E (1) Assuming that the debt financing costs do not change, what effect would a shift to a more highly leveraged capital structure consisting of 50% long term debt, 0% perferred stock, and 50% common stock have on the risk premium for Eco's common stock? What would be Eco's new cost of common equity? (2) What would be Eco's new weighted average cost of capital? (3) Which capital structure-the original one or this one-seems better? Why?

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