1.The firm\'s tax rate is 40%. 2.The current price of the 12% coupon, semiannual
ID: 2687836 • Letter: 1
Question
1.The firm's tax rate is 40%. 2.The current price of the 12% coupon, semiannual payment, non-callable bonds with 15 years to maturity is $1,153.72. New bonds could be issued with no flotation costs. 3.The current price of the firm's 10% $100 par value, quarterly dividend, perpetual preferred stock is $116.95. The flotation costs on a new issue would be 5% of the proceeds. 4.The current price of the common stock is $50 per share. The last dividend was $4.19, and dividends are expected to grow at a constant rate of 5%. The firm's beta is 1.2, the yield on T-bonds is 7%, and the market risk premium is 6%. 5.The target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.Explanation / Answer
The WACC is used primarily for making long-term capital investment decisions, i.e., for capital budgeting. Thus, the WACC should include the types of capital used to
pay for long-term assets, and this is typically long-term debt, preferred stock (if used), and common stock.
Short-term sources of capital consist of (1) spontaneous, noninterest-bearing liabilities such as accounts payable and accrued liabilities and (2) short-term interest-bearing debt, such as notes payable. If the firm uses shortterm interest-bearing debt to acquire fixed assets rather than just to finance working capital needs, then the WACC should include a shortterm debt component. Noninterest-bearing debt is generally not included in the cost of capital estimate because these funds are netted out when determining investment needs, that is, net operating rather than gross operating working capital is included in capital expenditures.
Stockholders are concerned primarily with those corporate cash flows that are available for their use, namely,those cash flows available to pay dividends or for reinvestment.
Since dividends are paid from and reinvestment is made with aftertax dollars, all cash flow and rate of return calculations should be done on an after-tax basis.
In financial management, the cost of capital is used primarily to make decisions that involve raising new
capital. Thus, the relevant component costs are today’s marginal costs rather than historical costs
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