Order The Cost of Capital Discussion

Order The Cost of Capital Discussion
Order The Cost of Capital Discussion
Concept Questions
1. Cost of capital What is meant by the cost of capital? How does the concept
apply to the financial operations of a firm, and why is it so important?
2. Required returns Discuss the relationship between costs of capital and
required returns. Who cares about which and how do they relate to each
other, both qualitatively and quantitatively?
3. Equity Your boss comes to you and says “why don’t we just use all our retained
earnings for the project. That’s the company’s money, not the shareholders.”
What is the fallacy of this statement, and how does your boss indicate his
misunderstanding of the way a publicly traded firm operates.
Order The Cost of Capital Discussion
 
4. Growth rates Why is estimating the growth rate of a firm so important?
Discuss from both the shareholder and firm perspective.
5. Cost of equity What are the strengths and weaknesses of using both the DGM
and CAPM methods of estimating the cost of equity?
6. Debt sources List at least three sources of debt capital. What are the characteristics of each?
7. WACC Describe in a sentence what the WACC tells the firm. Where does it
come from?
8. WACC Discuss both the qualitative and quantitative implications and design
of WACC.
9. Cost of debt How do taxes influence the cost of debt? Why? Can you create a
personal financial analogy to extend the answer?
10. Capital structure theories Briefly describe the primary findings of the capital
structure theories discussed in the text. How do we incorporate those findings
into capital structure policies?
11. Financial distress Bob from accounting just barged into your office and
screams “We’re about to go bankrupt! Do something!” Why is Bob so upset?
Why is financial distress such a concern for a firm? What does Bob want you to
“do” about it?
Order The Cost of Capital Discussion
12. Source of funds Evaluate the statement “the cost of funds depends upon the use
of the funds.” What does that mean? Assume you are talking to your supervisor
in relation to a project you are planning that has a very high level of risk.
Problems
1. Cost of equity Kelly’s Tiki Hut has experienced growth of 11 % per year over
the past 15 years and expects this to continue indefinitely. Three years ago, they
began paying dividends. The first dividend was $.90. The current price per
share of Kelly’s stock is $35.99. What would you estimate Kelly’s current cost
of equity to be?
280 8 This Is So WACC!
2. Cost of equity Suppose ABC company has stock currently selling at $21.00 per
share that just paid dividends of $1.75. They have a required rate of return of
12 %. We have the following data for their historical dividends. Calculate the
cost of equity using the DGM approach.
Year Dividends
1 1.10
2 1.20
3 1.35
4 1.55
5 1.75
3. Cost of equity You have just taken a position as chief financial officer of a
large, multinational firm. Your first task is to find an appropriate cost of capital
to apply to capital budgeting. Historically, dividend growth has averaged
3.12 % and the last dividend paid was $1.02. The current stock price is
$12.25. The stock currently has a beta of .82 and the market risk premium is
9.8 %. The current T-bill rate is 3.2 %.
1. What is the estimated cost of equity using the CAPM approach?
2. What is the estimated cost of equity using the DGM approach?

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