Calculating The Cost Of Capital.1

Questions

1     How would you handle calculating the cost of capital if a firm were planning to issue two different classes of common stock?

2     Why don’t we multiply the cost of preferred stock by one minus the tax rate, as we do for debt?

3     Expressing WACC in terms of i_E, i_P, and i_D, what is the theoretical minimum for the WACC?

4     Under what situations would you want to use the CAPM approach for estimating the component cost of equity?  The constant-growth model?

5     Could you calculate the component cost of equity for a stock with nonconstant expected growth rates in dividends if you didn’t have the information necessary to compute the component cost using the CAPM?  Why or why not?

6     Why do we use market-based weights instead of book-value-based weights when computing the WACC?

7     Suppose your firm wanted to expand into a new line of business quickly, and that management anticipated that the new line of business would constitute over 80 percent of your firm’s operations within three years.  If the expansion was going to be financed partially with debt, would it still make sense to use the firm’s existing cost of debt, or should you compute a new rate of return for debt based on the new line of business ?

8     Explain why the divisional cost of capital approach may cause problems if new projects are assigned to the wrong division.

9     When will the subjective approach to forming divisional WACCs be better than using the firm-wide WACC to evaluate all projects?

10   Suppose a new project was going to be financed partially with retained earnings.  What flotation costs should you use for retained earnings?