The theory underlying the cost of capital is primarily concerned with the cost of
Answer(s): C
The theory underlying the cost of capital is based primarily on the cost of long-term funds and the acquisition of new funds.. The reason is that long-term funds are used to finance long-term investments. For an investment alternative to be viable, the return on the investment must be greater than the cost of the funds used. The objective in short- term borrowing is different. Short-term loans are used to meet working capital needs and not to finance long-term investments.
When calculating the cost of capital, the cost assigned to retained earnings should be
Answer(s): B
Newly issued or external common equity is more costly than retained earnings. The company incurs issuance costs when raising new, outside funds.
A preferred stock is sold for $101 per share, has a face value of $100 per share, underwriting fees of $5 per share, and annual dividends of $10 per share If the tax rate is 40%, me cost of funds (capital) for the preferred stocks
Answer(s): D
Because the dividends on preferred stock are not deductible for tax purposes, the effect of income taxes is ignored. Thus, the relevant calculation is to divide the $10 annual dividend by the quantity of funds received at the time the stock is issued. In this case, the funds received equal $96 ($101 selling price -- $5 underwriting fee). Thus, the cost of capital is 10.4% ($10 + $96)
Osgood Products has announced that it plans to finance future investments so that the firm will achieve an optimum capital structure. Which one of the following corporate objectives is consistent with this announcement?
Financial structure is the composition of the financing sources of the assets of a firm. Traditionally, the financial structure consists of current liabilities, Long-term debt, retained earnings, and stock For most firms, the optimum structure includes a combination of debt and equity. Debt is cheaper than equity, but excessive use of debt increases the firm's risk and drives up the weighted-average cost of capital.
In referring to the graph of a firm's cost of capital, if e is the current position, which one of the following statements best explains the saucer or U-shaped curve'?
The U-shaped curve indicates that the cost of capital is quite high when the debt-to-equity ratio is quite low. As debt increases, the cost of capital declines as long as the cost of debt is less than that of equity. Eventually, the decline in the cost of capital levels off because the cost of debt ultimately rises as more debt is used. Additional increases in debt (relative to equity) will then increase the cost of capital. The implication is that some debt is present in the optimal capital structure because the cost of capital initially declines when debt is added However, a point is reached at which debt becomes excessive and the cost of capital begins to rise. The FLF Corporation is preparing to evaluate capital expenditure proposals for the coming year. Because the firm employs discounted cash flow methods, the cost of capital for the firm must be estimated. The following information for FLF Corporation is provided:· The market price of common stock is $60 per share. · The dividend next year is expected to be $3 per share. · Expected growth in dividends is a constant 10%. · New bonds can be issued at face value with a 10% coupon rate.· The current capital structure of 40% long-term debt and 60% equity is considered to be optimal.· Anticipated earnings to be retained in the coming year are $3 million.· The firm has a 40% marginal tax rate.
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