Cost of Capital Problem [30 Points]

You need to determine the appropriate discount rate to use to evaluate an average-risk capital project. Your company is financed with debt and common stock, with a Long-Term-Debt/Total Capital ratio of .40 based on market values. This capital structure has been determined to be optimal for this company. The marginal tax rate is 34%.

Your company currently has an issue of long-term bonds outstanding with 15 years remaining to maturity, a 12.5% coupon rate (semi-annual payments) and a $1,000 par value. The next coupon payment is due in exactly six months. The total face value of the issue is $40 million. These bonds are currently yielding 9.5% in the market. Your investment banker feels that new 20-year annual-payment bonds could be sold at par at the same yield to maturity as the existing bonds. Your company also has $15 million of trade credit (accounts payable) and a short-term bank loan for $6 million (8.0% rate) that is used to carry the company through the peak selling season, after which it is paid off within a few months.

Your common stock is not publicly traded, so you don't know your company's Beta. However, you have located a company that is very similar in terms of operations, and their publicly traded stock reflects a Beta of 1.25. The other company's capital structure is 20% debt and 80% common equity. The yield on T-bills is currently 4.5%, the yield on 20-year Treasury Bonds is 7.6%, and the S&P 500 had an average annual increase of 25% over the last year.

Given this information, complete the following table. Support your answers with the appropriate computations and written explanations to justify any assumptions you made.

Multiple Guess: Select the single best response to each question and record your selection on the Scan-tron answer sheet.

1. Which of the following statements is (are) true?

A. The target, or optimal, capital structure is the one that would result in the lowest weighted average cost of debt.

B. When management accepts typical investment projects with expected rates of return greater than the marginal cost of capital, the price of the common stock should rise because value is being created.

C. Retained Earnings is always the best source of capital since it has no cost unlike debt and new common stock.

D. More than one of the above.

E. None of the above.

2. Everything else held constant, which of the following should DECREASE the company's weighted average cost of capital?

A. An increase in the corporate tax rate.

B. An increase in the general level of demand for corporate common stock.

C. An increase in the expected rate of inflation.

D. More than one of the above.

E. None of the above.

3. Which of the following statements is (are) true?

A. Modiglianni and Miller showed that capital structure does not matter to the value of the firm because it does not affect the firm's cost of capital.

B. Modiglianni and Miller showed that capital structure does matter to the value of the firm because debt reduces the cost of capital, thus increasing the value of the firm.

C. Modiglianni and Miller showed that common stock financing is better than debt financing for companies because common stock always has a higher rate of return than debt.

D. Two of the above.

E. None of the above.

4. Debt creates risk for the firm by

A. increasing the probability of bankruptcy.

B. increasing the variability of operating profit.

C. increasing the risk of financial distress.

D. Two of the above.

E. All of the above.

5. The adjusted T-Bill Method

A. is used to estimate the risk-free rate of interest in the CAPM.

B. helps to adjust for the additional default risk in long term bond rates.

C. attempts to capture the influence of expected inflation in the interest rate.

D. Two of the above.

E. All of the above.

6. Which of the following statements is (are) true?

A. White, Altman and Weiss estimated the direct costs of financial distress to be about 3% of the firm's market value.

B. Protective covenants can help to reduce agency costs for bondholders.

C. The presence of bankruptcy risk and financial distress costs implies that debt is usually not a good source of capital for most companies.

D. Two of the above.

E. All of the above.

7. The agency cost problem arises from the fact that when debt is present in the capital structure

A. shareholders have an incentive to take large risks in investments.

B. shareholders have an incentive to overinvest in new capital assets.

C. Shareholders have an incentive to pay large dividends or make other large distributions in times of financial distress.

D. Two of the above.

E. All of the above.

8. An examples of typical negative bond covenants include all of the following except:

A. The company must furnish periodic financial statements.

B. The firm may not use additional long-term debt.

C. The firm may not merge with another firm.

D. The firm cannot pledge any of its assets to other lenders.

E. None of the above is an exception.

9. When tax effects and financial distress costs are integrated into the relationship between capital structure and firm value,

A. firm value will rise continuously as the debt/equity ratio rises.

B. the cost of capital will rise continuously as the debt/equity ratio rises.

C. the cost of equity will rise continuously as the debt/equity ration rises.

D. More than one of the above.

E. None of the above.

10. High-growth firms will have lower debt ratios than low-growth firms because

A. low growth firms have lower potential bankruptcy costs.

B. the amount of debt than can be added today is limited by the current ability to pay, not the increases in firm value from greater growth..

C. high growth firms are usually unmanageable and more volatile than low growth firms.

D. the present value of future opportunities is usually greater for the high growth firm.

E. low-growth firms are stodgy and more conservative, resulting in low debt ratios.

11. The "pecking order" theory says that:

A. firms prefer to finance their investments with internal equity (retained earnings)instead of external financing.

B. debt issues are preferred to new equity issues.

C. shareholders are reluctant to accept new equity issues because of asymmetric information.

D. Two of the above.

E. All of the above.

12. Which of the following statements is (are) true?

A. The difference between bank cash and book cash is called float.

B. A decrease in book cash with no immediate change in bank cash is called collection float.

C. The objective in cash collection is to reduce the lag between the time customers pay their bills and the time the checks are collected.

D. Two of the above.

E. All of the above.

13. Which of the following statements is (are) true?

A. The part of the collection and disbursement process where checks are trapped in the postal system is called availability float.

B. In-house processing float is the time it takes the receiver of cash to process payment and deposit it in a bank for collection.

C. The lockbox is the most widely used method to speed up collections of cash.

D. Two of the above.

E. All of the above.

14. Drafts differ from checks because:

A. They are drawn on large money-center banks and thus are very liquid.

B. They are electronic transfers of cash instead of paper vouchers.

C. They clear through the collection system much faster than checks.

D. More than one of the above.

E. None of the above.

15. Money market securities include all of the following except:

A. U.S. Treasury notes and bonds.

B. Commercial paper.

C. Renegotiated mortgages.

D. Repurchase agreements.

E. None of the above is an exception.

16. The most common way of all to finance a temporary cash deficit is the use of

A. factored receivables.

B. call options.

C. commercial paper.

D. banker's acceptances.

E. None of the above.

17. Which of the following statements is (are) true?

A. The components of a firm's credit policy are the terms of sale, the credit analysis, and the collection policy.

B. The fastest and least expensive way to transfer surplus funds from the local deposit bank to the concentration bank is by wire transfer.

C. Trade credit is always free (it carries no interest charge).

D. More than one of the above.

E. None of the above.

18. If a firm grants credit with terms of 3/5 Net 30, the creditor

A. receives a discount of 3% when payment is made within 5 days after the sale.

B. must pay a penalty of 3% when payment is made more than 5 days after the sale.

C. must pay a penalty of 5% when payment is made more than 3 days after the sale.

D. receives a discount of 5% when payment is made within 3 days after the sale.

E. None of the above.

19. The decision to grant credit does not depend on

A. delayed revenues from granting credit.

B. the immediate costs of granting credit.

C. the probability of payment.

D. the appropriate required rate of return for delayed cash flows.

E. All of the above ARE considered in the decision to grant credit.

20. Today is:

A. Monday

B. Tuesday

C. Wednesday

D. More than one of the above.

E. Not enough information to answer.

ANSWERS:

For the cost of capital problem, the following parts of the answer are needed to compute the weighted average cost of capital:

The weights of debt (long term) and equity are .40 and .60, respectively. These weights are obtained from the debt-to-assets ratio. Short term debt is not a component of the cost of capital.

The after-tax cost of debt is 6.27%.

Using the surrogate Beta technique discussed in class (and explained on your handout) the company's estimated beta is 1.545.

Using the adjusted T-Bill method, the constant risk premium method, and the surrogate beta in the CAPM, the estimated cost of equity is 15.05%.

These figures give a weighted average cost of capital of 11.53%.

It will be a good review for you to look up the answers to the multiple choice questions in your book. Many of the answers can be found in the glossary at the end of the book. Others are easily located in the chapters.