Chapter 11

Discussion Questions

11-1. Why do we use the overall cost of capital for investment decisions even when only one source of capital will be used (e.g., debt)?   Though an investment financed by low-cost debt might appear acceptable at first glance, the use of debt could increase the overall risk of the firm and eventually make all forms of financing more expensive. Each project must be measured against the overall cost of funds to the firm.
11-2. How does the cost of a source of capital relate to the valuation concepts presented previously in Chapter 10?   The cost of a source of financing directly relates to the required rate of return for that means of financing. Of course, the required rate of return is used to establish valuation.
11-3. In computing the cost of capital, do we use the historical costs of existing debt and equity or the current costs as determined in the market? Why?   In computing the cost of capital, we use the current costs for the various sources of financing rather than the historical costs. We must consider what these funds will cost us to finance projects in the future rather than their past costs.
11-4. Why is the cost of debt less than the cost of preferred stock if both securities are priced to yield 10 percent in the market?   Even though debt and preferred stock may be both priced to yield 10 percent in the market, the cost of debt is less because the interest on debt is a tax-deductible expense. A 10 percent market rate of interest on debt will only cost a firm in a
35 percent tax bracket an aftertax rate of 6.5 percent. The answer is the yield multiplied by the difference of (one minus the tax rate).

What are the two sources of equity (ownership) capital for the firm?   The two sources of equity capital are retained earnings and new common stock.
11-6. Explain why retained earnings have an opportunity cost associated?   Retained earnings belong to the existing common stockholders. If the funds are paid out instead of reinvested, the stockholders could earn a return on them. Thus, we say retaining funds for reinvestment carries an opportunity cost.
11-7. Why is the cost of retained earnings the equivalent of the firm’s own required rate of return on common stock (Ke)?   Because stockholders can earn a return at least equal to their present investment. For this reason, the firm’s rate of return (Ke) serves as a means of approximating the opportunities for alternate investments.
11-8. Why is the cost of issuing new common stock (Kn) higher than the cost of retained earnings (Ke)?   In issuing new common stock, we must earn a slightly higher return than the normal cost of common equity in order to cover the distribution costs of the new security. In the case of the Baker Corporation, the cost of new common stock was six percent higher.
11-9. How are the weights determined to arrive at the optimal weighted average cost of capital?   The weights are determined by examining different capital structures and using that mix which gives the minimum cost of capital. We must solve a multidimensional problem to determine the proper weights.
11-10. Explain the traditional, U-shaped approach to the cost of capital.   The logic of the U-shaped approach to cost of capital can be explained through Figure 11-1. It is assumed that as we initially increase the
debt-to-equity mix the cost of capital will go down. After we reach an optimum point, the increased use of debt will increase the overall cost of financing to the firm. Thus we say the weighted average cost of capital curve is U-shaped.
11-11. It has often been said that if the company can’t earn a rate of return greater than the cost of capital it should not make investments. Explain.   If the firm cannot earn the overall cost of financing on a given project, the investment will have a negative impact on the firm’s operations and will lower the overall wealth of the shareholders.   Clearly, it is undesirable to invest in a project yielding 8 percent if the financing cost is 10 percent.
11-12. What effect would inflation have on a company’s cost of capital? (Hint: Think about how inflation influences interest rates, stock prices, corporate profits, and growth.)   Inflation can only have a negative impact on a firm’s cost of capital-forcing it to go up. This is true because inflation tends to increase interest rates and lower stock prices, thus raising the cost of debt and equity directly and the cost of preferred stock indirectly.
11-13. What is the concept of marginal cost of capital?   The marginal cost of capital is the cost of incremental funds. After a firm reaches a given level of financing, capital costs will go up because the firm must tap more expensive sources. For example, new common stock may be needed to replace retained earnings as a source of equity capital.  
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