Fabozzi Frank, Peterson Pamela. Financial Management and Analysis Workbook

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100 QUESTIONS AND PROBLEMS

c. What do these measures tell an investor?

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CHAPTER

101

The Cost of Capital

FILL IN THE BLANKS

Refer to Chapter 11, pages 307–347 in Financial Manage-

ment and Analysis.

1. The ______________ of ______________ is the return that

must be provided for the use of an investor’s

______________. If the funds are ______________, the

______________ is related to the ______________ that must

be paid on the loan. If the funds are ______________, the

______________ is the ______________ that investors

expect, both from the stock’s price ______________ and

______________. The cost of ______________ is the same

as the ______________ rate of ______________.

2. Capital ______________ is the mix of ______________,

______________ stock, and ______________ stock. It is the

goal of the financial manager to estimate the ______________

of each in order for the firm to issue new ______________.

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102 QUESTIONS AND PROBLEMS

3. The ______________ of ______________, which is the rais-

ing of one more ______________ by issuing debt, is directly

affected by the ______________ tax ______________,

which provides the ______________ rate on the next dollar

of ______________ income. Because ______________ paid is

deducted from ______________ income, the ______________

cost of debt is ______________ than the stated cost.

4. When ______________ securities and ______________ are

issued, ______________ costs must be considered. These costs

are ______________ to ______________, ______________,

and investment ______________ who assist the firm in the

issue. Also called ______________ of debt, it drives

______________ the cost of the issue.

5. The ______________ of ______________ stock is the cost

associated with raising one more ______________ of capi-

tal by ______________ shares of ______________ stock.

______________ stock may or may not have a(n)

______________. If it does not have a(n) ______________,

then it is called ______________ stock.

6. The ______________ of ______________ stock is the cost

of raising one more dollar of ______________ equity

capital, either ______________ or ______________.

______________ generated capital comes from

______________ earnings whereas ______________ gen-

erated capital comes from issuing new ______________

of ______________ stock.

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The Cost of Capital 103

7. The ______________ Model (______________) for valuing

______________ stock states the ______________ of a

share of ______________ is the ______________ value of

all its ______________ cash ______________ that are

______________ at the ______________ rate of

______________ on ______________. It is based on the

assumption that ______________ grow at a(n)

______________ rate into the ______________.

8. The ______________ Model (______________) assumes

investors hold ______________ portfolios that are only

subject to ______________ risk. Investors are

______________ for the ______________ value of

______________ and for the ______________ they assume.

The ______________ for the ______________ value of

______________ is represented by the market

______________ and the riskiness of the ______________

is represented by ______________.

9. The ______________ budget implies that in order to

______________ shareholder wealth, ______________ in

projects must be made until the ______________ cost of

______________ is ______________ to its marginal

______________. In other words, the ______________ is

the capital ______________ where the ______________

cost of ______________ intersects the ______________

rate of return, also known as the marginal

______________ of capital.

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104 QUESTIONS AND PROBLEMS

SHORT ANSWER QUESTIONS

Refer to Chapter 11, pages 307–347 in Financial Manage-

ment and Analysis.

1. Explain what is meant when it is said that the cost of cap-

ital and the required rate of return are marginal concepts.

2. How is the cost of capital determined?

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The Cost of Capital 105

3. Under what financial conditions is it appropriate to use

the DVM? The CAPM?

PROBLEMS

Refer to Chapter 11, pages 307–347 in Financial Manage-

ment and Analysis.

1. Tallahassee Trucking and Towing (TTT) wants to issue

additional debt. Using the yield on their current debt as a

guide for the cost of new debt, what is TTT’s after-tax

cost of debt? They currently have a 7% coupon bond pay-

ing interest semiannually that matures in ﬁve years and it

has a current market price of $90 or $900 per $1,000 face

value bond.

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106 QUESTIONS AND PROBLEMS

2. H&H, Inc., estimates they can sell an issue of $35 par

value preferred stock that has a dividend rate of 3% to be

paid at the end of each year. What is the all-in-cost of pre-

ferred stock if they sell the issue at par value with no flota-

tion costs? With flotation costs of 1% of par value?

3. Rose Flower Company is considering issuing new stock.

The current stock price is $65 per share and the corre-

sponding current dividend of $3.12 per share and the divi-

dends are expected to grow at a rate of 5% per year. Using

the Dividend Valuation Model, what is the cost of com-

mon stock?

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The Cost of Capital 107

4. ABC Company is considering issuing new stock and is

evaluating its cost of equity capital. If the risk-free rate of

interest is 4% and the return on the market is 11%, what

is the cost of common stock using the Capital Asset Pric-

ing Model, assuming ABC has a beta of 1.35?

5. Sutton, Inc., is evaluating its cost of capital under alterna-

tive financing arrangements. It expects to be able to issue

new debt at par with a coupon rate of 8% and to issue

new preferred stock with a $2.00 per share dividend at

$30 a share. The common stock is currently selling for $25

a share. It expects to pay a dividend of $1.50 per share

next year. Sutton expects dividends to grow at a rate of

5% per year and Sutton’s marginal tax rate is 40%. Con-

sider the two arrangements that follow to answer this

question: What is the cost of capital to Sutton, Inc., under

each financing arrangement?

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108 QUESTIONS AND PROBLEMS

Financing

Arrangement

Percentage of New Capital Raised

Debt Preferred Stock Common Stock

1 30% 10% 60%

2 50% 25% 25%

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CHAPTER

109

Capital Budgeting: Cash Flows

FILL IN THE BLANKS

Refer to Chapter 12, pages 355–392 in Financial Manage-

ment and Analysis.

1. The ﬁnancial manager’s ______________ is to maximize

owners’ ______________. To accomplish this, the man-

ager must evaluate ______________ opportunities and

determine which ones will add ______________ to the

ﬁrm. Firms continually ______________ funds in

______________ and ______________ assets and these

assets produce ______________ and ______________

ﬂows that the ﬁrm can then either ______________ in

more assets or ______________ to the owners.

2. ______________ investment is the firm’s investment in its

______________ through the use of ______________,

______________, ______________, and ______________

financing. The firm’s ______________ investment decision

may be comprised of a number of distinct

______________. Managers must evaluate a number of

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