What is the cost of equity for a company whose bonds yield 12 percent, if management applies a judgmental risk premium of 4 percent?
Explanation
The bond-yield-plus-risk-premium method estimates the cost of equity by adding a judgmental risk premium (typically 3 to 5 percentage points) to the yield on the company's own long-term debt.
Other questions
What is the primary purpose of calculating the Weighted Average Cost of Capital (WACC)?
Which of the following are considered the three major capital components when calculating the WACC?
A firm has a before-tax cost of debt of 10 percent and a marginal tax rate of 40 percent. What is its after-tax cost of debt?
Why is there no tax adjustment, similar to the one for debt, made for the cost of preferred stock when calculating WACC?
What is the opportunity cost associated with a firm's retained earnings?
Using the Capital Asset Pricing Model (CAPM), what is the estimated cost of equity for Allied Food, given a risk-free rate of 5.6 percent, a market risk premium of 5.0 percent, and a beta of 1.48?
What is the primary assumption of the Discounted Cash Flow (DCF) approach to estimating the cost of equity, also known as the dividend-yield-plus-growth-rate method?
Using the DCF approach, what is the estimated cost of retained earnings for Allied Food, if its stock sells for $23.06, its next expected dividend is $1.25, and its expected growth rate is 8.3 percent?
What is the primary reason that the cost of new common stock, or external equity (re), is higher than the cost of retained earnings (rs)?
A firm's cost of retained earnings (rs) is 13.5 percent. If the firm must issue new stock, it will incur a flotation cost adjustment of 0.6 percent. What is the firm's cost of new common stock (re)?
What does the 'retained earnings breakpoint' represent in capital budgeting?
Allied Food's addition to retained earnings in 2019 is expected to be $66 million, and its target equity fraction is 53 percent. What is Allied's retained earnings breakpoint?
What is the WACC for Allied Food if it uses only retained earnings for its equity component, given a 45 percent target debt weight with a 6 percent after-tax cost, a 2 percent preferred stock weight with a 10.3 percent cost, and a 53 percent common equity weight with a 13.5 percent cost?
Which of the following factors that affect the WACC is generally outside the direct control of a firm's management?
How should a firm generally adjust its composite WACC when evaluating a capital project that has a higher-than-average risk profile?
What is the primary flaw of the regular Internal Rate of Return (IRR) method that the Modified IRR (MIRR) is designed to correct?
A company is using the bond-yield-plus-risk-premium approach to estimate its cost of equity. Its own long-term bonds currently yield 10 percent. What is a reasonable estimate for its cost of equity (rs) based on this method?
When using different approaches to estimate the cost of common equity (CAPM, DCF, bond-yield-plus-risk-premium), what is a common practice if the methods produce different results?
What is the primary reason for a firm to use its target capital structure weights rather than historical book value or current market value weights when calculating the WACC?
A company’s preferred stock sells for $30.00 per share and pays a dividend of $3.30 per share. What is its component cost of preferred stock (rp)?
Which of the following describes the flotation cost adjustment when calculating the cost of new common stock using the DCF approach?
If a firm’s projects differ in risk, what is the recommended approach for determining the discount rate for each project?
Firm A has a target capital structure of 46 percent debt, 3 percent preferred stock, and 51 percent common equity. Its after-tax cost of debt is 4.2 percent, its cost of preferred stock is 7.5 percent, and its cost of common equity (from retained earnings) is 11.5 percent. What is the firm's WACC if it does not issue new stock?
What is the primary reason that established firms like Allied Food rarely issue new common stock?
If a firm's dividend payout ratio is increased, what is the likely immediate effect on its WACC, assuming other factors are held constant?
What is the primary limitation of the bond-yield-plus-risk-premium approach for estimating the cost of common equity?
If a firm plans to finance its capital budget with 46 percent debt, but its current capital structure consists of 50 percent debt, which debt weight should be used in the WACC calculation?
If a firm's tax rate increases, what is the most likely effect on its after-tax cost of debt and its WACC, holding other factors constant?
Which of the following is NOT a common problem or difficulty encountered when estimating the cost of capital?
A firm has a beta of 1.2, the risk-free rate is 7 percent, and the market risk premium is estimated to be 6 percent. What is the firm's estimated cost of common equity using the CAPM?
If a firm uses only retained earnings to fund its equity portion, and its WACC is 10.1 percent, what would happen to the WACC if it had to issue new common stock with flotation costs?
According to the chapter, why do analysts generally use the 10-year Treasury bond rate as the measure of the risk-free rate in the CAPM, rather than the short-term Treasury bill rate?
If a firm's project has a high degree of stand-alone risk, what does this imply about its within-firm risk and market risk?
A firm’s cost of retained earnings (rs) is 10.5 percent. Its next dividend is $1.00, its stock price is $25.00, and its flotation cost for new equity is 10 percent. What is the firm's cost of new common stock (re)?
If investors become more risk-averse, what is the likely impact on the market risk premium (RPM) and the firm's cost of capital?
What is the primary reason for including depreciation-generated funds in a discussion of the cost of capital?
If a firm undertakes an expansion into a new, risky line of business, what is the likely effect on its component costs of debt and equity?
What does it mean if a project's estimated return is higher than its risk-adjusted cost of capital?
A firm with a composite WACC of 10 percent has two divisions, L (low risk) and H (high risk). Division L's cost of capital is 7 percent, and Division H's is 13 percent. If Division L is evaluating a project with a 9 percent return, should it be accepted?
What are the three steps for estimating the cost of common equity using the CAPM approach as outlined in the chapter?
If a firm finances with only debt and common equity, has a target capital structure of 35 percent debt and 65 percent equity, a before-tax cost of debt of 9 percent, a cost of equity of 13.58 percent, and a tax rate of 40 percent, what is its WACC?
Why must the required rate of return (rs) be greater than the long-run growth rate (g) for the constant growth DCF model to be valid?
Midwest Water Works has a WACC of 10.5 percent. It is considering seven independent projects with varying rates of return. Which projects should be accepted?
If a firm changes its capital structure to use more debt, what is the initial, direct effect on the WACC, assuming component costs do not change?
What is the primary reason it's important to use the cost of NEW debt when calculating the WACC?
Which of the three main approaches to estimating the cost of common equity is most widely used by practitioners, according to survey evidence cited in the chapter?
If a company's stock has a beta of 0.8, the risk-free rate is 5.5 percent, and the market risk premium is 6 percent, what is the company's cost of common equity using the CAPM?
A firm's common stock sells for $22.00, its last dividend (D0) was $2.00, and its expected growth rate is 6 percent. What is the firm's cost of common equity (rs) using the DCF approach?
If a firm expects to invest in projects that are much safer than its average existing assets, what adjustment should it make to its composite WACC when evaluating these new projects?