Assignment Chapter 10
Indicate whether the statement is true or false.
"Capital" is sometimes defined as the funds supplied by investors.
The cost of capital should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets.
The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.
The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC.
The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.
The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.
The cost of common stock is the rate of return the marginal stockholder requires on the firm's common stock.
For capital budgeting and cost of capital purposes, the firm should always consider retained earnings as the first source of capital, i.e., use these funds first, because retained earnings have no cost to the firm.
Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost.
The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.
The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.
The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 F)."
If the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common stock (re) is equal to the cost of equity capital from retaining earnings (rs) divided by one minus the percentage flotation cost required to sell the new stock, (1 F). If the expected growth rate is not zero, then the cost of external equity must be found using a different procedure.
Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. Thus, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt.
The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and retained earnings, whose cost is the average return on assets.
If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.
In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project.
Suppose the debt ratio (D/TA) is 10%, the current cost of debt is 8%, the current cost of equity is 16%, and the tax...
Please join StudyMode to read the full document