## Marginal Cost of Capital Exercises and Problems

Complete these exercises and problems and then check your work.

### Exercises

#### Question 1

Why do we need to convert debt to an after-tax cost when preferred stock and common stock do not take this same conversion?

#### Question 2

Why is the cost of common stock the highest of the three types of financing and the cost of debt the lowest?

#### Question 3

What advantage do we get from using three different methods to calculate the cost of common stock financing?

#### Question 4

Why is the YTM used as the before tax cost of financing rather than the coupon rate?

#### Question 5

Should we use market values to estimate our financing proportions or book values? Why?

#### Question 6

Why is the MCC important? What is it used for?

#### Question 7

To use the MCC as the required return in our capital budgeting analysis, what two conditions must be met?

#### Question 8

If a firm can lower their cost of capital, all else equal, this should result in an increase in the value of the firm. True or False? Explain.

#### Question 9

If debt is the cheapest form of financing, then issuing more debt should automatically lower our cost of capital. True or False? Explain.

#### Problem 1

Assume our company has a bond outstanding with 20-years remaining until maturity. This bond has a 7.5% coupon rate. Our marginal tax rate is 35%. Find our after-tax cost of debt if the bond price is:

1a. $1135 1b.$875

#### Problem 2

If the par value of our preferred stock is $30 and the dividend rate is 5% of par while the current price is$16.50, what is the cost of preferred stock?

#### Problem 3

The price of our common stock is $25. The constant growth rate in dividends is 8% and our current dividend (D0) is$0.75. Also, the risk-free rate of interest is 5% and the expected return on the market is 12%. Beta for this stock is 0.8. Finally, we estimate a risk premium of 5% for stocks relative to bonds and the current YTM on our long-term debt is 9%. Find the estimated cost of capital for common stock under each of the 3 methods.

#### Problem 4

You have the following information about XYZ Corp:

 Asset Book Value Market Value Bonds $20,000,000$24,000,000 Preferred Stock $4,000,000$5,000,000 Common Stock $10,000,000$35,000,000
 Constant growth on common 6.5% YTM on bonds 11% Beta 1.35 Treasury bond yield 5% Price of common stock $34 Tax rate 40% Coupon rate on bonds 10% Risk prem. stocks over bonds 5% Expected market return (km) 12% Expected Common Dividend (D1) 2.75 Number of pref. shares 100,000 Per share dividend on preferred$6.50

4a. What is the marginal cost of capital for this firm?
4b. If you have a capital budgeting project that will generate after tax cash flows of $25,000 per year for the next four years and costs$75,000, should you take it?

#### Problem 5

The following information is available about ACME Inc.
Balance Sheet:

 LT 10% Coupon Bonds (10,000 bonds) $10,000,000 Preferred Stock (40,000 shares) ($50 par with a 10% dividend) 2,000,000 Common Stock (1,000,000 shares) 20,000,000

The market values are $1060 for each$1000 par value bond, $53 for each share of preferred, and$41.25 for each share of common. The bonds are recorded on the balance sheet at their par value and mature in 10 years.

 Beta 1.3 Current Treasury bond rate 6% Risk Premium for stocks over bonds 5% Tax Rate 40% Growth rate in dividends 10% Expected market return 13% Dividend (D0) 2.25

5a. What are the appropriate weights for the opportunity cost of capital?
5b. What are the appropriate costs of debt, preferred, and common (use an average of the 3 methods for common)?
5c. What is the marginal cost of capital?

Source: Kevin Bracker, Fang Lin, Jennifer Pursley, https://businessfinanceessentials.pressbooks.com/chapter/chapter-10-marginal-cost-of-capital-2/