1.According to the video, the after-tax cost of debt can be stated as ________________ . Plugging in the values for rdrd and (T)T yields an after-tax cost of debt of approximately ___________________ . 2.According to the video, the cost of preferred stock can be stated as __________________ . Plugging in the values for DpDp and PpPp yields a cost of preferred stock of of approximately _______________________ . Hint: Assume no flotation costs. 3.According to the video, the cost of common stock can be stated as ________________ . Plugging in the values for D1D1, P0P0, and gg yields a cost of common stock of approximately ___________________ . Recall that the equation for the weighted average cost of capital (WAAC) can be stated as: WAACWAAC = = (% of debt)×(After-tax cost of debt)% of debt×After-tax cost of debt +(% of preferred stock)×(Cost of preferred stock)+% of preferred stock×Cost of preferred stock +(% of Common equity)×(Cost of common equity)+% of Common equity×Cost of common equity Plugging in the relevant values into the formula for WACC yields a WAAC of approximately __________________ . Suppose that Mullens will only accept projects with an expected rate of return that exceeds the WAAC. Which of the following projects will Mullens accept?
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
Suppose Mullens Corporation is considering three average-risk projects with the following costs and
|
Project |
Cost |
Expected Rate of Return |
|---|---|---|
| 1 | $2,500 | 23.00% |
| 2 | $3,000 | 30.00% |
| 3 | $2,750 | 24.00% |
Mullens estimates that it can issue debt at a rate of rd=20.00%rd=20.00% and a tax rate of T=25.00%T=25.00%. It can issue
Also, its common stock currently sells for P0=$16.00P0=$16.00 per share. The expected dividend payment of the common stock is D1=$4.00D1=$4.00 and the dividend is expected to grow at a constant annual rate of g=5.00%g=5.00% per year.
Mullens’ target capital structure consists of ws=75.00%ws=75.00% common stock, wd=15.00%wd=15.00% debt, and wp=10.00%wp=10.00% preferred stock.
1.According to the video, the after-tax cost of debt can be stated as ________________ . Plugging in the values for rdrd and (T)T yields an after-tax cost of debt of approximately ___________________ .
2.According to the video, the cost of preferred stock can be stated as __________________ . Plugging in the values for DpDp and PpPp yields a cost of preferred stock of of approximately _______________________ .
Hint: Assume no flotation costs.
3.According to the video, the cost of common stock can be stated as ________________ . Plugging in the values for D1D1, P0P0, and gg yields a cost of common stock of approximately ___________________ .
Recall that the equation for the weighted average cost of capital (WAAC) can be stated as:
| WAACWAAC | = = | (% of debt)×(After-tax cost of debt)% of debt×After-tax cost of debt |
| +(% of preferred stock)×(Cost of preferred stock)+% of preferred stock×Cost of preferred stock | ||
| +(% of Common |
Plugging in the relevant values into the formula for WACC yields a WAAC of approximately __________________ .
Suppose that Mullens will only accept projects with an expected rate of return that exceeds the WAAC.
Which of the following projects will Mullens accept? Check all that apply.
Project 1
Project 2
Project 3
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