Finance : As the company’s risk rises, its cost of capital

Subject: Business / Finance
Question
1. ( T or F ) As the company’s risk rises, its cost of capital
declines.
2. ( T or F ) Since interest payment is tax-deductible, the
after-tax cost of debt is, in general, higher than
the before-tax cost of debt. (The following information applies to the next five questions)
Ink Inc. has decided that the capital it is raising will consist
of 10% preferred stock, 20% common stock, 30% retained earnings,
and 40% debt. Ink has outstanding 20 year semi-annual, 6% coupon
bonds selling for $950. The par value of the bonds is $1,000.
Ink’s common stock sells for $50 per share. Ink expects that it
will pay a $2 dividend next year and that its dividend will grow
at 5% a year. If Ink sells new common it must pay a $5 per share
flotation fee. Ink’s preferred stock currently sells for $54, and
its annual dividend is $5 per share. If Ink were to sell new
preferred stock, it would pay $3 per share as flotation cost.
Ink’s tax rate is 40%.
3. What is Ink’s after tax cost of debt capital?
4. What is Ink’s cost of preferred stock capital?
5. What is Ink’s cost of common stock?
6. What is Ink’s cost of retained earnings?
7. What is Ink’s cost of capital? (The following information applies to next three questions.)
A firm has $2 million of capital needs. The firm has noticed that
the current yield to maturity on its bonds is 9.5%, and its stock
beta is 1.2. Currently, the expected return on the S&P 500 stocks
is 12%, and the 90-day T-bill rate is 5%. The firm’s target
capital structure is 40% debt and 60% equity. The firm’s marginal
tax rate is 28%. 8. What is the cost of debt?
9. What is the cost of equity?
10. What is the cost of capital for the $2 million?

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