Chapter 14 - Cost of Capital
80. Bleakly Enterprises has a capital structure of 55 percent common stock, 10 percent
preferred stock, and 35 percent debt. The flotation costs are 4.5 percent for debt, 7 percent for preferred stock, and 9.5 percent for common stock. The corporate tax rate is 34 percent. What is the weighted average flotation cost? A. 5.8 percent B. 6.2 percent C. 6.7 percent D. 7.0 percent E. 7.5 percent
Average flotation cost = (0.55 ? 0.095) + (0.10 ? 0.07) + (0.35 ? 0.045) = 7.5 percent
AACSB: Analytic Bloom's: Application Difficulty: Basic
Learning Objective: 14-4 Section: 14.6
Topic: Flotation costs
81. Justice, Inc. has a capital structure which is based on 30 percent debt, 5 percent preferred stock, and 65 percent common stock. The flotation costs are 11 percent for common stock, 10 percent for preferred stock, and 7 percent for debt. The corporate tax rate is 37 percent. What is the weighted average flotation cost? A. 8.97 percent B. 9.48 percent C. 9.62 percent D. 9.75 percent E. 10.00 percent
Average flotation cost = (0.65 ? 0.11) + (0.05 ? 0.10) + (0.30 ? 0.07) = 9.75 percent
AACSB: Analytic Bloom's: Application Difficulty: Basic
Learning Objective: 14-4 Section: 14.6
Topic: Flotation costs
14-45
Chapter 14 - Cost of Capital
82. The Daily Brew has a debt-equity ratio of 0.72. The firm is analyzing a new project which requires an initial cash outlay of $420,000 for equipment. The flotation cost is 9.6 percent for equity and 5.4 percent for debt. What is the initial cost of the project including the flotation costs?
A. $302,400 B. $368,924 C. $455,738 D. $456,400 E. $583,333
Average flotation cost = (1/1.72) (0.096) + (0.72/1.72) (0.054) = 0.0784186 Initial cost = $420,000/(1 - 0.0784186) = $455,738
AACSB: Analytic Bloom's: Application Difficulty: Basic
Learning Objective: 14-4 Section: 14.6
Topic: Project flotation costs
83. You are evaluating a project which requires $230,000 in external financing. The flotation cost of equity is 11.6 percent and the flotation cost of debt is 5.4 percent. What is the initial cost of the project including the flotation costs if you maintain a debt-equity ratio of 0.45? A. $248,494 B. $249,021 C. $254,638 D. $255,551 E. $255,646
Average flotation cost = (1/1.45) (0.116) + (0.45/1.45) (0.054) = 0.0967586 Initial cost = $230,000/(1 - 0.0967586) = $254,638
AACSB: Analytic Bloom's: Application Difficulty: Basic
Learning Objective: 14-4 Section: 14.6
Topic: Flotation costs
14-46
Chapter 14 - Cost of Capital
84. Western Wear is considering a project that requires an initial investment of $274,000. The firm maintains a debt-equity ratio of 0.40 and has a flotation cost of debt of 7 percent and a flotation cost of equity of 10.5 percent. The firm has sufficient internally generated equity to cover the equity portion of this project. What is the initial cost of the project including the flotation costs? A. $279,592 B. $281,406 C. $288,005 D. $297,747 E. $302,762
Average flotation cost = (1/1.40) (0) + (0.40/1.40) (0.07) = 0.02 Initial cost = $274,000/(1 - 0.02) = $279,592
AACSB: Analytic Bloom's: Application Difficulty: Basic
Learning Objective: 14-4 Section: 14.6
Topic: Flotation costs
85. Yesteryear Productions is considering a project with an initial start up cost of $960,000. The firm maintains a debt-equity ratio of 0.50 and has a flotation cost of debt of 6.8 percent and a flotation cost of equity of 11.4 percent. The firm has sufficient internally generated equity to cover the equity cost of this project. What is the initial cost of the project including the flotation costs?
A. $979,417 B. $982,265 C. $992,386 D. $1,038,513 E. $1,065,089
Average flotation cost = (1/1.5) (0.0) + (0.5/1.5) (0.068) = 0.0226667 Initial cost = $960,000/(1 - 0.0226667) = $982,265
AACSB: Analytic Bloom's: Application Difficulty: Basic
Learning Objective: 14-4 Section: 14.6
Topic: Flotation costs
14-47
Chapter 14 - Cost of Capital
Essay Questions
86. What role does the weighted average cost of capital play when determining a project's cost of capital?
Assuming a project is equally as risky as a firm's current operations, WACC will be used as the discount rate when computing the NPV of the project. Therefore, having an accurate WACC is essential to correctly evaluating the project. If a project has a different risk level than the firm's current operations, then the firm's WACC should be adjusted in accordance with the project's risk or in some instances, a different firm's WACC should be applied as the discount rate for the project.
Feedback: Refer to section 14.5
AACSB: Reflective thinking Bloom's: Application Difficulty: Basic
Learning Objective: 14-5 Section: 14.5
Topic: Project cost of capital
87. What are some advantages of the subjective approach to determining the cost of capital and why do you think that approach is utilized?
The subjective approach allows management to adjust a firm's overall cost of capital for individual divisions based upon its evaluation of the risks associated with each division as compared to the overall risk level of the firm. This risk adjustment is based on the wisdom, knowledge, and experiences of the managers. To try and determine a more accurate estimate of the appropriate discount rate might encounter costs that would outweigh any potential benefit. Thus, the subjective approach is useful because it adjusts discount rates in a cost effective and efficient manner.
Feedback: Refer to section 14.5
AACSB: Reflective thinking Bloom's: Application Difficulty: Intermediate Learning Objective: 14-5 Section: 14.5
Topic: Subjective approach
14-48
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