Question

1. In general, it is not possible for Re, the cost of new equity, to be lower than Rs, the cost of retained earnings. However, an exception to this rule occurs when the stock price increases just prior to the firm issuing new equity such that it more than offsets the flotation costs and thus, Re becomes less than Rs.

a. True                               b. False

2. Bouchard Company's stock sells for $20 per share, its last dividend was $1.00, its growth rate is a constant 6 percent, and the company would incur a flotation cost of 20 percent if it sold new common stock. If Bouchard has a capital budget of $2,000,000, what component cost of common equity will be built into the WACC for the last dollar of capital the company raises?

a. 11.30%      b. 11.45%

c. 11.80%      d. 12.15%

e. 12.63%

3. Santorum Co. has a capital structure that consists of 50 percent debt, 30 percent common stock, and 20 percent preferred stock. The company just reported net income to be $1,000,000. The company pays out 40 percent of its net income as dividends. How large can the company capital budget be without having to issue additional common stock or change its capital structure?

a. $ 180,000 b. $ 200,000

c. $ 600,000 d. $1,200,000

e. $2,000,000

4. Byron Corporation's present capital structure, which is also its target capital structure, is 40 percent debt and 60 percent common equity. Byron’s debt financing costs 14 percent. The firm's marginal tax rate is 40 percent. Assuming that the component cost of equity is 18 percent, what is the weighted average cost of capital?

a. 10.8%                  b. 13.6%

c. 14.2%                  d. 16.4%

e. 18.0%

Answer 1

1.False

2.Bouchard Company

BP RE = R.E./% Equity = $1,000,000/0.6 = $1,666,667.

Since the capital budget will be $2 million, and because all equity in the WACC beyond

$1,666,667 will be external equity, the WACC of the last dollar raised will include equity at a

cost of k e :

k e = $1(1.06)/$20(1 - 0.2) + 0.06 = 0.0663 + 0.06 = 0.1263 = 12.63%.

3. Santorum Co - e.$2000000

The retained earnings break point indicates the size of the capital budget when not issuing additional common stock. BP(RE) = ($1,000,000(1 - 0.4))/0.30 = $2,000,000.

BP = break point; RE = retained earnings

4. Byron Corporation's

WACC = Cost of equity x weight of equity + Cost of debt x ( 1 - tax rate ) x weight of debt

WACC = 18% x 0.60 + 14% x ( 1 - 0.40 ) x 0.40 = 10.8% + 3.36% = 14.2%