Business Finance Chapter 9 STUDY TERMS

Which of the following inputs is needed when you use the constant dividend growth model (CDGM) to estimate the cost of equity? Current Stock price
The effective cost of debt is: less than the return paid to debt holders due to tax benefits of interest paid
The cost of retained earnings is equivalent to the cost of __________. common stock
The stock of Canadian Ski Wear is currently trading at $45 a share and the equity beta of the company is estimated to be 1.3. The company is expected to pay a dividend of $1.50 a share next year, and this dividend is expected to grow at a rate of 4% per year. The rate on the 10-year U.S. Treasury bond is 4% and you estimate the market risk premium to be 5%. Using the CDGM, what is the company’s cost of equity? 10.5% The stock of Canadian Ski Wear is currently trading at $45 a share and the equity beta of the company is estimated to be 1.3. The company is expected to pay a dividend of $1.50 a share next year, and this dividend is expected to grow at a rate of 4% per year. The rate on the 10-year U.S. Treasury bond is 4% and you estimate the market risk premium to be 5%. Using the CAPM, the company’s cost of equity is 10.5%. To compute the cost using CAPM you use the following model and inputs: E(Rj) = Rf + Bj(E(Rm) – Rf) where: E(Rj) = required return or expected returnRf = risk-free rateBj = Beta of security jE(Rm) = expected return on the market So, Cost of equity = 4% + 1.3(5%) = 10.5% Additional LearningThe term (E(Rm) – Rf) is the market risk premium. Be careful when making these calculations because the data you have may be an expected market return and a risk-free rate, in which case you would need to compute the market risk premium. In this case the market risk premium (5%) is given to you.
Which of the following should be used as the firm’s cost of debt? the yield to maturity of the existing debt outstandingThe yield to maturity of the existing debt outstanding should be used as the firm’s cost of debt. The YTM is the appropriate rate to use for cost of debt since this is the market determined rate that investors currently demand to hold your company’s bonds. The coupon rate is irrelevant when determining cost of debt since it was set at the time of issue and may bear little resemblance to the current market rate of interest and the risk profile of the firm. The YTM captures all of those elements and represents the true cost of your firm’s debt at this point in time. Additional LearningAt any point in time the current risk-free rate of interest should be embedded or included in the current market rates.
A firm has issued 8% preferred stock, which sold for $100 per share par value. The flotation costs of the stock equaled $3 and the firm’s marginal tax rate is 40%. The cost of the preferred stock is; A firm has issued 8% preferred stock, which sold for $100 per share par value. The flotation costs of the stock equaled $3. The cost of the preferred stock is 8.25%. The cost of the preferred stock is equal to the preferred dividend divided by the proceeds received from the issue. Therefore, Kps = $8/($100 – $3) = $8/$97 = .08247 or 8.25% Additional LearningIf the preferred stock is already outstanding you would use the current market price of the preferred stock as the denominator in the equation.
The __________ is the rate of return a firm must earn on its investment in order to maintain the market value of its stock. he cost of capital is the rate of return a firm must earn on its investment in order to maintain the market value of its stock. The cost of capital is the minimum rate that investors demand the firm earn on each new capital budgeting project. If a firm earns more than this it should increase the value of the firm and if it earns less than the cost of capital the value will fall, other things equal. The internal rate of return for a project is the rate that makes the net present value equal to zero. This rate does not establish a minimum required return but will instead be compared to the cost of capital. If the IRR exceeds the cost of capital the project is expected to generate returns sufficient to warrant investment. The coupon rate determines the amount of interest the company pays to service a specific bond issue. This rate has no bearing on the cost of capital other than its impact on the YTM. Additional LearningKeep in mind that you should use the Yield to Maturity (YTM) as the appropriate pre-tax interest rate on debt since it is the rate that investors demand to hold a specific bond.
The cost of retained earnings is equal to: The cost of retained earnings is equal to the cost of common equity. Retained earnings stem from income that has been reinvested in the firm and are a component of equity. For this reason when you use the market value of equity as the total weight for equity you are incorporating retained earnings in that computation. Therefore the cost of retained earnings is exactly the same as the cost of common equity. The WACC also includes the cost of debt so it is not appropriate to approximate the cost of retained earnings with WACC. And, investors expect to earn a non-zero return on any funds that have been reinvested in the firm and that return is the same as common equity. Additional LearningRetained earnings may not require debt service but they are not free. However, you do not need to compute a separate value for retained earnings since it will be embedded in the overall cost and weight of common equity.
A tax adjustment must be made in determining the cost of: A tax adjustment must be made in determining the cost of long-term debt. Since interest payments on long-term debt can be expensed they reduce the firm’s tax liability and lower the effective cost of long-term debt. There is no such tax benefit from dividends paid so there is no tax adjustment for any equity account such as common stock or retained earnings.
To use the CAPM to estimate the cost of equity you need to know the: The firms equity beta
The firm’s optimal mix of debt and equity is called its: target capital structure
When we use the WACC as the discount rate in capital budgeting, we are assuming: the firm will maintain a constant debt to equity ratio
The cost of common stock equity may be estimated by using the __________. CAPM
Corona Publishing has debt outstanding with a market value of $10 million. The company’s common stock has a book value of $20 million and a market value of $30 million. What weight for equity should Corona use in its WACC calculation? 75%You should always use market values to determine the total value of the firm and then compute the weights as a percentage of market value. In this case Corona’s total value is $10 million debt + $30 million in equity = $40 million. Equity represents $30m/$40m, or 75% of that amount. Additional LearningAlways be consistent and never mix market and book values in a single computation.
The cost of new preferred stock in the WACC is computed as the preferred dividend divided by the __________. NET PROCEEDS from the sale of the preferred
The approximate before-tax cost of debt for a 20-year, 9%, $1,000 par value bond selling for $950 is __________. 9.57%
Net debt equals total debt outstanding minus:
The debt issued by Coastal Construction has a coupon rate of 5% and a yield to maturity of 6.2%. The company is in the 25% tax bracket. Coastal Construction’s effective cost of debt is: 4.65%
The cost of debt used in the WACC is adjusted lower __________. The cost of debt used in the WACC is adjusted lower since there is a tax shield associated with paying interest. The Internal Revenue Code allows interest to be expensed and therefore it creates a tax shield when firms use debt. This effectively lowers the cost of debt to the firm. Dividends are paid with after-tax dollars and interest is expensed so it comes out pre-tax and lowers the firm’s tax burden and therefore lowers the cost of debt.
Net debt equals total debt outstanding minus: Net debt equals total debt outstanding minus any cash balances. Some financial managers now make this adjustment to debt to account for the fact that a cash balance should be earning interest and therefore this interest earned cancels out the interest paid on the same amount of debt. The basic accounting equation still holds and the value of the firm’s assets = total equity + total debt. Additional LearningThe cash balance can be thought of as ‘negative debt.’ Since some firms hold huge cash balances this approach makes sense in theory. However, cash rarely earns as much interest as the firm’s investors demand to hold debt.
The WACC represents the average __________ for the firm. The WACC represents the average COST OF FINANCING for the firm. The weighted average cost of capital contains the cost of both debt and equity financing so it represents an overall financing cost and not just a single component. Additional LearningA typical firm can have several different debt issues that each has a different YTM. When you compute the WACC you will have a separate cost and weight for each debt issue.
The capital structure of Athletic Clothing Corp. is 70% equity and 30% debt. We could say this company is __________. levered
A firm has a beta of 0.90. If market returns are 12% and the risk-free rate is 4%, the estimated cost of equity is __________. 11.2%A firm has a beta of 0.90. If market returns are 12% and the risk-free rate is 4%, the estimated cost of equity is 11.2%. Using the CAPM you can compute the cost of equity with the following formula; Cost of equity = risk-free rate + beta(market return – risk-free rate) So, the cost of equity = 4% + .90(12% – 4%) = 11.2% Additional LearningThe other method you can use to compute the cost of common equity is the Constant Dividend Growth Model (CDGM) which is also known as the Gordon Growth Model. 11.2%
The specific cost of each source of long-term financing is based on __________ costs. AFTER TAX AND CURRENT

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