Question

Which of the following statementsis CORRECT?

a.   Cost of preferred stock is the rate of return investors require on the firm’s preferred stock it is calculated as the common stock dividend divided by the current price.

b.   When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.

c.   Because of tax effects, an increase in the risk-free ratewill have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM.

d.   Cost of new common stock is based on the cost of retained earnings, but decreased for flotation costs necessary to issue new common stock.

Cost of external equity (selling common stocks) is greater than the cost of internal equity (retained earnings) because

a.   of high inflation rate

b.   of high interest rate

c.   of high dividends payment

d.   of the flotation costs

The River Valley Power Company common stock has a beta of 1.20. If the current risk-free rate is 3% and the expected return on the stock market is 15%, determine the cost of equity capital for the firm using the Capital Assets Pricing Model (CAPM). Show All Work

            a.   17.4%                    b. 15.8%                      c. 18.9%                      d. 14.4%

Answer 1

QUESTION 1 - Statement b is correct

Cost of debt is reduced by the tax amount, as the interest expenses made on debt are tax deductible and hence lower the tax liability of the company. Cost of preferred stock is dividends on preferred stock divided by price of dividend (so statement a is incorrect). An increase in risk free rate will have a greater effect on cost of equity since cost of equity is calculated by CAPM equation, where cost of equity is directly proportional to risk free rate (so staement c is incorrect). Cost of new common stock is based on the cost of retained earnings, but incresed for flotation costs necessary to issue new common stock (so statement d is incorrect).

QUESTION 2 - Statement d is correct

Cost of external equity is greater than the cost of equity because of floatation cost. Flotation costs are incurred by a publicly traded company when it issues new securities, and includesexpenses such as underwriting fees, legal fees and registration fees. Other terms affect the retianed earnings equally to both external and internal equity financing.

QUESTION 3 - Statement a is correct

According to CAPM equation,

Expected return on stock = Risk free rate + Beta * (Expected market return - risk free rate)

Expected return on stock = 3% + 1.2 * (15% - 3%) = 17.4%