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Chapter 4: Q11-1BP (page 363)

In March 2010, Hertz Pain Relievers bought a massage machine that provided a return of 8 percent. It was financed by debt costing 7 percent. In August, Mr. Hertz came up with a heating compound that would have a return of 14 percent. The chief financial officer, Mr. Smith, told him it was impractical because it would require the issuance of common stock at a cost of 16 percent to finance the purchase. Is the company following a logical approach to using its cost of capital?

Short Answer

Expert verified

No, the company is not following logical approach to using its cost of capital.

Step by step solution

01

Introduction to cost of capital

An organization's cost of capital alludes to the cost that it should pay to raise new capital funds, while its cost of equity measures the returns estimated by investors who are part of the organization's ownership structure.

02

Logical approach

Assume financing a conveyor system having an 9% return with 7% debt and also evaluating a new product having an 12% return but financed with 13% common stock. The project with the higher return would be rejected and the project with the lower return would be accepted if projects and financing are matched in this way.

Actually, if debt and stock are sold in equivalent proportions, the average cost of financing would be 10%(1/2 debt at 7% and 1/2 stock at 13%). With a 10% average cost of capital, we would now reject the 9% conveyor system and accept the 12% new product. This would be a reliable and rational decision.

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Most popular questions from this chapter

Kilgore Natural Gas has a $1,000 par value bond outstanding that pays 9 percent annual interest. The current yield to maturity on such bonds in the market is 12 percent. Compute the price of the bonds for these maturity dates:

a. 30 years.

b. 15 years.

c. 1 year.

If your uncle borrows $60,000 from the bank at 10 percent interest over the seven-year life of the loan, what equal annual payments must be made to discharge the loan, plus pay the bank its required rate of interest (round to the nearest dollar)? How much of his first payment will be applied to interest? To principal? How much of his second payment will be applied to each?

Why is the cost of debt less than the cost of preferred stock if both securities are priced to yield 10 percent in the market? (LO11-3)

Question:Masco Oil and Gas Company is a very large company with common stock listed on the New York Stock Exchange and bonds traded over the counter. As of the current balance sheet, it has three bond issues outstanding:

\(150 million of 10 percent series ....... 2026

\)50 million of 7 percent series ........... 2020

\(75 million of 5 percent series ........... 2016

The vice president of finance is planning to sell \)75 million of bonds next year to replace the debt due to expire in 2016. Present market yields on similar Baa-rated bonds are 12.1 percent. Masco also has \(90 million of 7.5 percent noncallable preferred stock outstanding, and it has no intentions of selling any preferred stock at any time in the future. The preferred stock is currently priced at \)80 per share, and its dividend per share is \(7.80.

The company has had very volatile earnings, but its dividends per share have had a very stable growth rate of 8 percent and this will continue. The expected dividend (D1) is \)1.90 per share, and the common stock is selling for \(40 per share. The company鈥檚 investment banker has quoted the following flotation costs to Masco: \)2.50 per share for preferred stock and $2.20 per share for common stock.

On the advice of its investment banker, Masco has kept its debt at 50 percent of assets and its equity at 50 percent. Masco sees no need to sell either common or preferred stock in the foreseeable future as it has generated enough internal funds for its investment needs when these funds are combined with debt financing. Masco鈥檚 corporate tax rate is 40 percent. Compute the cost of capital for the following:

a. Bond (debt) (Kd).

b. Preferred stock (Kp).

c. Common equity in the form of retained earnings (Ke).

d. New common stock (Kn).

e. Weighted average cost of capital.

Murray Motor Company wants you to calculate its cost of common stock. During the next 12 months, the company expects to pay dividends (D1) of \(2.50 per share, and the current price of its common stock is \)50 per share. The expected growth rate is 8 percent.

a. Compute the cost of retained earnings (Ke). Use Formula 11-5.

b. If a $3 flotation cost is involved, compute the cost of new common stock (Kn). Use Formula 11-6.
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