Calculating the Cost of Capital

CHAPTER 11 – CALCULATING THE COST OF CAPITAL

Questions

LG1 11-1 How would you handle calculating the cost of capital if a firm were planning two issue two different classes of common stock?

Solution: As the two different classes of common stock are likely to have different component costs, calculate the cost and weight for each separately.

LG2 11-2 Why don’t we multiply the cost of preferred stock by 1 minus the tax rate, as we do for debt?

Solution: Because dividends on preferred stock, unlike interest on debt, are paid out of after-tax income.

LG2 11-3 Expressing WACC in terms of iE, iP, and iD, what is the theoretical minimum for the WACC?

Solution: The theoretical minimum WACC would be that for an all-debt firm: iD × (1-TC)

LG3 11-4 Under what situations would you want to use the CAPM approach for estimating the component cost of equity? The Constant-Growth model?

Solution: You would want to use the CAPM when you can estimate the firm’s beta with a good deal of certainty: you would only want to use the constant-growth model if the firm’s stock is expected to experience constant dividend growth.

LG3 11-5 Could you calculate the component cost of equity for a stock with nonconstant expected growth rate in dividends if you didn’t have the information necessary to compute the component cost using the CAPM? Why or why not?

Solution: You could try and adjust the constant growth model for initial periods of nonconstant growth, but doing so would require estimating the growth rate for all of the nonconstant growth periods.

LG4 11-6 Why do we use market-based weights instead of book-value-based weights when computing the WACC?

Solution: Because we’re interested in determining what the cost of financing the firm’s assets would be given today’s market situation and the component costs the firm currently faces, not what the historic prices would have been.

LG5 11-7 Suppose your firm wanted to expand into a new line of business...