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6 Jul 2018

1. Corporate finance has three main areas of concern:

a. Capital Budgeting: What long-term investments should the firm take?

b. Capital structure: Where will the firm get the long-term financing to pay for its investments? Also,

what mixture of debt and equity should it used to fund operations?

c. Working capital management: How should the firm manage its everyday financial activities?

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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.

Excel Online Structured Activity: Statement of cash flows

You have just been hired as a financial analyst for BarringtonIndustries. Unfortunately, company headquarters (where all of thefirm's records are kept) has been destroyed by fire. So, your firstjob will be to recreate the firm's cash flow statement for the yearjust ended. The firm had $100,000 in the bank at the end of theprior year, and its working capital accounts except cash remainedconstant during the year. It earned $5 million in net income duringthe year but paid $700,000 in dividends to common shareholders.Throughout the year, the firm purchased $5.4 million of machinerythat was needed for a new project. You have just spoken to thefirm's accountants and learned that annual depreciation expense forthe year is $450,000; however, the purchase price for the machineryrepresents additions to property, plant, and equipment beforedepreciation. Finally, you have determined that the only financingdone by the firm was to issue long-term debt of $1 million at a 7%interest rate. The data has been collected in the Microsoft ExcelOnline file below. Open the spreadsheet and perform the requiredanalysis to answer the question below.
Statement of cash flows
Cash at the Beginning of Year $100,000.00
Change in Net Operating Working Capital Except Cash $0.00
Net Income $5,000,000.00
Common Dividends $700,000.00
Machinery Equipment Purchases $5,400,000.00
Depreciation Expense $450,000.00
Long-Term Debt $1,000,000.00
Interest Rate on Long-Term Debt 7.00%
Statement of Cash Flows
I. Operating Activities Formulas
Net income #N/A
Depreciation expense #N/A
Change in net operating working capital exceptcash $0.00
Net cash provided by (used in) operations #N/A
II. Long-Term Investing Activities
Additions to property, plant and equipment #N/A
Net cash used in investing activities #N/A
III. Financing Activities
Increase in long-term debt #N/A
Payment of common dividends #N/A
Net cash provided by financing activities #N/A
IV. Summary
Net increase (decrease) in cash #N/A
Cash at beginning of year $100,000.00
Cash at end of year #N/A

What was the firm's end-of-year cash balance? Recreate thefirm's cash flow statement to arrive at your answer. Write out youranswer completely. For example, 5 million should be entered as5,000,000. Round your answer to the nearest dollar, ifnecessary.

1. Which of the following is true of the change in the weighted average cost of capital of a firm? a. A decrease in the weighted average cost of the capital increases the value of the firm. b. An increase in the weighted average cost of the capital increases the value of the firm. c. A decrease in the weighted average cost of the capital decreases the value of the firm. d. A decrease in the weighted average cost of the capital increases the cash flow generated by the investments. e. Any change in the weighted average cost of capital results in no change in the value of the firm.

2. The cost of debt to the firm is adjusted for _____. a. marginal revenue generated b. taxes c. interest rate d. internal rate of return e. return to investors

3. The firm's cost of external equity capital is the same as the required rate of return on the firm's outstanding common stock. a. True b. False

4. The target capital structure of a firm is the capital structure that: a. minimizes the operating risk of the firm's assets. b. maximizes the tax shield created by debt. c. minimizes the default risk of long-term debt. d. maximizes the price of the firm's stock. e. minimizes the risk premium paid on long-term debt.

5. The correct discount rate for a firm to use in capital budgeting, assuming that new investments are as risky as the firm's existing assets, is its marginal cost of capital. a. True b. False

6. The component costs of capital are market-determined variables in as much as they are based on investors' required returns. a. True b. False

7. The rates of return, or costs, that a firm must pay to raise funds to invest in capital budgeting projects are determined by: a. the marginal revenue generated by investment in the new projects. b. the investors who purchase the firm's stocks and bonds. c. the internal rate of return of the firm. d. the cash flow generated by the investment in the additional projects. e. the dividend payout ratio fixed by the firm.

8. The marginal cost of capital _____ as more capital is raised during a given period. a. remains the same b. decreases c. increases d. changes in an unpredictable way e. approaches zero 10. The firm's cost of capital represents the maximum rate of return that a firm can earn from its capital budgeting projects to ensure that the value of the firm increases. a. True b. False

12. Omega Inc. has a history of abnormally high growth due to general economic fluctuations. Estimating the cost of common equity using the discounted cash flow approach is difficult because: a. the dividend yield is extremely difficult to estimate. b. the proper growth rate is difficult to establish. c. the market price of the common equity is very volatile. d. the firm grows at a constant rate in perpetuity. e. the firm's historical data of dividend yield is unavailable.

13. The cost of debt is equal to one minus the marginal tax rate multiplied by the coupon rate on outstanding debt. a. True b. False

14. Bouchard Company's stock sells for $20 per share, its last dividend (D0) was $1.00, its growth rate is a constant 6 percent, and the company would incur a flotation cost of 20 percent if it sold new common stock. Which of the following is the cost of issuing new common stock? (Round off the answer to two decimal places.) a. 11.96 percent b. 12.25 percent c. 12.63 percent d. 10.24 percent e. 11.42 percent

15. Which of the following is a capital component for the purpose of calculating the weighted average cost of capital in capital budgeting? a. The after-tax cost of long-term debt b. The after-tax cost of common stock c. The after-tax cost of preferred stock d. The after-tax cost of retained earnings e. The after-tax cost of new equity

16. Which of the following statements is true of the impact of tax on the cost of capital of a firm? a. All else being equal, an increase in the corporate tax rate results in a decrease in the weighted average cost of capital. b. The before-tax cost of debt is the cheapest component of the cost of capital since the tax paid is a deductible expense. c. The before-tax cost of debt is always less than the after-tax cost of debt of a firm. d. The tax paid on dividends of preferred stock reduces the amount of funds that the firm can use for financing capital budgeting projects. e. All else being equal, an increase in the equity capital that a firm raises by retaining earnings results in in the increase in the tax rate applicable to the firm.

18. A firm's weighted average cost of capital (WACC) is: a. set by the board of directors of the firm because it is the benchmark they use to evaluate upper management. b. regulated by the Internal Revenue Service (IRS) because tax-deductible debt is included in the computation. c. determined by the financial markets because investors provide the funds used by firms and these funds have costs, which are the returns demanded by investors. d. the same as the firm's internal rate of return (IRR). e. the total net present value (NPV) of all the capital budgeting projects in which the firm invests in any year.

19. Everything else equal, an asset's value is directly related to: a. the cost of raising additional capital. b. the rate of return investors require to invest in that asset. c. the risk associated with the investment in that asset. d. the cash flow the asset is expected to generate. e. the rate of return that the firm must earn to satisfy investors' demands.

24. If a project's _____ exceeds the firm's cost of capital, its NPV will be positive. a. marginal cost of capital b. cash flow c. rate of return expected by investors d. internal rate of return (IRR) e. discount rate

25. The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors. a. True b. False

26. The before-tax cost of debt, rd, is the same as the: a. average yield to maturity (YTM) associated with the firm's bonds. b. dividend yield associated with the firm's common stock. c. average coupon rate of the firm's bonds. d. return on equity if the firm has no preferred stock. e. the firm's marginal tax rate.

29. As per the Bond-Yield-Plus-Risk-Premium Approach, analysts estimate the cost of common equity by adding a risk premium of 3 to 5 percentage points to: a. the cost of preferred stock of the firm. b. the risk free rate of the common equity of the firm. c. the interest rate on the long term debt of the firm. d. the return on the firm's investment in municipal bonds. e. the growth rate of the firm.

30. The marginal cost of capital (MCC) is the cost of the last dollar of new capital that the firm raises, and the marginal cost declines as more and more of a specific type of capital is raised during a given period. a. True b. False

31. Which of the following statements is true of flotation costs? a. Flotation costs decrease the cost of preferred stock to the issuing firm. b. Flotation costs are added to the issue price of preferred stock to compute the cost of preferred stock. c. Floatation costs are added to the cost of debt to compute the weighted average cost of capital of a firm. d. Floatation costs result in higher funds available from the issue of preferred stock to the firm. e. Floatation costs increase the rate the issuing firm must earn to pay the preferred dividend.

34. Under normal circumstances, the weighted average cost of capital is used as the firm's required rate of return because: a. as long as the firm's investments earn returns greater than the cost of capital, the value of the firm will not decrease. b. returns below the cost of capital will cover all the fixed costs associated with the capital and provide excess returns to the firm's stockholders. c. it is comparable to the average of all the interest rates on debt that currently prevail in the financial markets. d. it is an indication of the return the firm is expecting to earn in future from all of its expansion plans. e. the weighted average cost of capital remains unchanged if the components costs of capital changes.

36. The cost of issuing preferred stock by a corporation must be adjusted to an after-tax figure because of the 70 percent dividend exclusion provision for corporations holding other corporations' preferred stock. a. True b. False

38. The after-tax cost of debt is used to calculate the weighted average cost of capital since we are concerned with the after-tax cash flows of the firm. a. True b. False

39. Beige Inc. plans to issue preferred stock that pays an $11.50 dividend per share and sells for $120 per share in the market. It will cost 4 percent, or $4.80 per share, to issue the new preferred stock, so Beige will net $115.20 per share. Which of the following is Beige's cost of preferred stock? (Round off the answer to two decimal places.) a. 8.89 percent b. 12.25 percent c. 11.50 percent d. 15.20 percent e. 9.98 percent

40. The Jackson Company has just paid a dividend of $3.00 per share on its common stock, and it expects this dividend to grow by 10 percent per year, indefinitely. The firm has a beta of 1.50; the risk-free rate is 10 percent; and the expected return on the market is 14 percent. Which of the following is the required rate of return as per the capital asset pricing model (CAPM) approach? a. 9 percent b. 12 percent c. 7 percent d. 16 percent e. 18 percent

41. J. Ross and Sons Inc. has a target capital structure that calls for 40 percent debt, 10 percent preferred stock, and 50 percent common equity. Ross' common stock currently sells for $40 per share. 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 percent per year. Which of the following is the firm's cost of retained earnings? (Round off the answer to two decimal places.) a. 16.34 percent b. 10.42 percent c. 15.50 percent d. 12.20 percent e. 13.25 percent

42. Omega Inc.'s net income is expected to be $600,000 and the firm's payout ratio is 60 percent. The firm's common stock ratio is 30 percent and it has no preferred stock outstanding. Which of the following is the retained earnings break point for Omega Inc.? a. $400,000 b. $250,000 c. $375,000 d. $100,000 e. $800,000

43. Marigold Inc.'s common stock currently sells for $40 per share, but the firm will net only $34 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 percent per year. Which of the following is the cost of newly issued common stock? (Round off the answer to two decimal places.) a. 12.24 percent b. 13.56 percent c. 14.12 percent d. 16.47 percent e. 17.53 percent

44. Super Solutions Inc. is a constant growth firm, which just paid a dividend of $3.00, sells for $33.00 per share, and has a growth rate of 6 percent. Which of the following is the cost of retained earnings using the discounted cash flow (DCF) approach? (Round off the answer to two decimal places.) a. 12.55 percent b. 15.64 percent c. 16.25 percent d. 13.35 percent e. 12.40 percent

45. The _____ is equal to the average rate of return that investors require to provide funds to the firm in the form of debt. a. Coupon rate b. Yield to maturity (YTM) c. Maturity value d. Discount rate e. Internal rate of return

46. Oval Inc. has just paid a dividend of $1.50 per share on its common stock, and it expects this dividend to grow by 4 percent per year, indefinitely. The firm plans to issue common stock at $16. The firm's investment bankers believe that new issues of common stock would have a flotation cost equal to 4 percent of the current market price. Which of the following is the cost of newly issued common stock? (Round off the answer to two decimal places.) a. 14.16 percent b. 10.15 percent c. 15.36 percent d. 13.80 percent e. 16.92 percent

47. Diggin Tools just issued new preferred stock, which sold for $85 in the stock markets. Holders of the stock will receive an annual dividend equal to $9.35. The flotation costs associated with the new issue were 6 percent and Diggin's marginal tax rate is 30 percent. Which of the following is the component cost of preferred stock, rps? (Round off the answer to two decimal places.) a. 10.75 percent b. 10.52 percent c. 12.25 percent d. 11.70 percent e. 11.05 percent

48. Rollins Corporation is constructing its MCC schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm's marginal tax rate is 40 percent. Which of the following is Rollins' component cost of debt? (Round off the answer to one decimal place.) a. 8.4 percent b. 7.2 percent c. 6.8 percent d. 5.3 percent e. 9.5 percent

50. Coral Inc.'s preferred stock currently sells for $90 a share and pays a dividend of $10 per share; however, the firm will net only $80 per share from the sale of new preferred stock. What is the firm's cost of newly issued preferred stock? (Round off the answer to two decimal places.) a. 11.15 percent b. 12.50 percent c. 16.45 percent d. 10.52 percent e. 13.46 percent

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