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/
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