QUESTION: 39 Topic 1: Part 2 Sec One (1 to 52)

Assuming the after-tax cost of common stock is 15%, the after-tax weighted marginal cost of capital for Rogers' first financing alternative consisting of bonds, preferred stock, and common stock would be

7.285%
8725%
10.375%
11.700%

Answer(s): C

Explanation:

In the calculation below, the cost of preferred stock equals the preferred dividend divided by the net issuance price. The preferred stock will yield $4,800,000 after subtracting the 4% flotation cost, so it must sell for $5,000,000 ($4,800,000 + .96). The annual dividend on the preferred stock is $300,000 ($5,000,000 x 6%). Consequently, the cost of capital raised by issuing preferred stock is 6.25% ($300,000 dividend + $4,800,000 net issuance price). The flotation cost operates, in effect, as a discount. Thus, the before-tax rate of return must exceed the coupon (nominal) rate of 9%. Assuming that the market rate for instruments with similar risk is 9%, the bonds were issued at par with proceeds at $19.2 million after payment of $800,000 of flotation costs. The before-tax rate of return on the debt is therefore .09375 [($20,000,000 x 9%) ÷ $19,200,000]. The weighted after-tax cost of debt is .0225 [.4 x .09375 x (1.0-- .4)], and the weighted marginal cost of the first financing alternative is 10.375% (2.25% + .625% + 7.5%).

Rogers. lnc operates a chain of restaurants located in the Southeast The company has steadily grown to its present size of 48 restaurants The board of directors recently approved a large-scale remodeling of the restaurant, and the company is now considering two financing alternatives.
o The first alternative would consist of
o Bonds that would have 89% coupon rate and reissued at their base amount would net $19.2 million after a 4% flotation cost
o Preferred stock with a stated rate of 6% that would yield $4.8 million after a 4% flotation cost
o Common stock that would yield $24 million after a 5% flotation cost o The second alternative would consist of a public offering of bonds that would have an 11% market rate and would net $48 million after flotation costs. Rogers' current capital structure, which is considered optimal, consists of 40% long-term debt, 10% preferred stock, and 50% common stock. The current market value of the common stock is $30 per share, and the common stock dividend during the past 12 months was $3 per share. Investors are expecting the growth rate of dividends to equal the historical rate of 6%. Rogers is subject to an effective income tax rate of 40%.

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QUESTION: 40 Topic 1: Part 2 Sec One (1 to 52)

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The after-tax weighted marginal cost of capital for Rogers' second financing alternative consisting solely of bonds would be

5.13%
5.40%
6.27%
6.60%

Answer(s): D

Explanation:

The cost of the bonds equals the interest rate times one minus the tax rate, or 66O% [11% x (100% --40%)]. Rogers. Inc. operates a chain of restaurants located in the Southeast. The company has steadily grown to its present size of 48 restaurants. The board of directors recently approved a large-scale remodeling of the restaurant, and the company is now considering two financing alternatives.
o The first alternative would consist of
o Bonds that would have a 9% coupon rate and reissued at their base amount would net $19.2 million after a 4% flotation cost
o Preferred stock with a stated rate of 6% that would yield $4.8 million after a 4% flotation cost
o Common stock that would yield $24 million after a 5% flotation cost o The second alternative would consist of a public offering of bonds that would have an 11% market rate and would net $48 million after flotation costs. Rogers' current capital structure, which is considered optimal, consists of 40% long-term debt, 10% preferred stock, and 50% common stock. The current market value of the common stock is $30 per share, and the common stock dividend during the past 12 months was $3 per share Investors are expecting the growth rate of dividends to equal the historical rate of 6%. Rogers is subject to an effective income tax rate of 40%.

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QUESTION: 41 Topic 1: Part 2 Sec One (1 to 52)

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The interest rate on the bonds is greater to Rogers. Inc. for the second alternative consisting of pure debt than it is for the first alternative consisting of both debt and equity because the

Diversity of the combination alternative creates greater risk for the investor.
Pure debt alternative would flood the market and be more difficult to sell.
Pure debt alternative carries the risk of increasing the probability of default,
Combination alternative carries the risk of increasing dividend payments.

Answer(s): C

Explanation:

As a larger proportion of an entity's capital is provided by debt, the debt becomes riskier and more expensive. Hence, it requires a higher interest rate

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QUESTION: 42 Topic 1: Part 2 Sec One (1 to 52)

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A firm's optimal capital structure

Minimizes the firm's tax liability.
Minimizes the firm's risk.
Maximizes the firm's degree of financial leverage
Maximizes the price of the firm's stock.

Answer(s): D

Explanation:

Standard financial theory states that the optimal capital structure of a firm is the permanent, long-term financing of the firm represented by long-term debt, preferred stock, and common stock, Capital structure is distinguished from financial structure, which includes short-term debt plus the long-term accounts. The optimal capital structure minimizes the weighted-average cost of capital and thereby maximizes the value of the firm reflected in its stock price.

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QUESTION: 39 Topic 1: Part 2 Sec One (1 to 52)

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