Question

My question is Q 8 , cost of capital , parts b and c go on to another page , thank you !

final 12) 5. so the weighted average cost is Luty lo tance is perw we vrst need the Dost. As in the previous problem, the percentage of equity 15 20 3. so EN XS+ (Din. 1/3 X 16% + 1/3 x 20 anxo L33% If War leeds $30. $30 miton/(1- 20 million after flotation costs, then the true cost of the rest is 11-f) 530 million/8867 - $33.83 million VIEW AND CRITICAL THINKING QUESTIONS CONCEPT EVIEW A 1. WACCO3] On the this mean? On the most basic level, if a firm's WACC is 12 percent, what does Book Values versus Market Vol. to use book values for either debt Market Values ILO3) In calculating the WACC, if you had for either debt or equity, which would you choose? Why? ILO5] If you can borrow all the money you need for a project at it follow that 6 percent is your cost of capital for the project! Taxes (LO3] Why do we use an aftertax figure for cost of debt but not 3. Project Risk (L05) 6 percent, doesn't it follow the 4 WACC and Taxes (LO31 for cost of equity? 5. DCF Cost of Equity Est model for determini fFquity Estimation (LO1] What are the advantages of using the DCF determining the cost of equity capital? What are the disadvantages? What ecific piece of information do you need to find the cost of equity What are some of the ways in which you could get this estimate? Cast of Equity Estimation [LO1] What are the advantages of usine the SML approach to finding the cost of equity capital? What are the disadvantage cific pieces of information are needed to use this method? Are all of these variables observable, or do they need to be estimated? What are some of the ways in which you 6 SML Cost of Equity Estimatie could get these estimates? 1. Cost of Debt Estimation (LO2] How do you determine the appropriate cost of debt for a company? Does it make a difference if the company's debt is privately placed as opposed to being publicly traded? How would you estimate the cost of debt for a firm whose only debt issues are privately held by institutional investors? Cost of Capital (LO5] Suppose Tom O'Bedlam, president of Bedlam Products, has hired you to determine the firm's cost of debt and cost of equity capital. ck currently sells for $50 per share, and the dividend per share will be about $5. Tom argues. "It will cost us $5 per share to use the stock- a. The stock currently sells probably be about $5. Tom holders' money this ye vey this year, so the cost of equity is equal to 10 percent (= $5/50)." What's wrong with this conclusion?

Answer 1

8. B. This conclusion is wrong as cost of debt has a tax shield associated with it so, the rate of 12.5 percent has to be readjusted with the tax rate . Let's say if tax rate is 20 percent , then effective cost of debt will be

12.5*(1-.20)= 10 percent so Tom conclusion is wrong completely.

C. Cost of equity has a tax component and cost of debt has protection from tax component ac tax shield. So cost of equity and cost of debt can only be compared in absolute terms after readjusted for income tax rates. So Tom statement is again wrong.