1. Digital Design Corporation has an after-tax cost of debt capital of 7 percent, a cost of preferred stock of 9 percent, a cost of equity capital of 11 percent, and a weighted average cost of capital of 8.5 percent. In raising additional capital, the company intends to maintain its current capital structure.
In order to make a capital – budgeting decision for an average risk project, the relevant cost of capital is:

A. 7 percent.
B. 8.5 percent.
C. 11 percent.


2. RBS Insurance Limited issued to retail investors a fixed-rate perpetual preferred stock four years ago at par value of $10 per share with a $2.85 dividend. If the company had issued the preferred stock today, the yield would be 8.5 percent.
The current value of the stock is:

A. $10.00.
B. $33.53.
C. $43.85.


3. A company issued $20 million in long-term bonds at par value three years ago with a coupon rate of 10 percent. The company has decided to issue an additional $20 million in bonds and expects the new issue to be priced at par value with a coupon rate of 8 percent. There is no other outstanding debt. The applicable tax rate is 35 percent.
The appropriate after-tax cost of debt in order the compute the weighted average cost of capital is closest to:

A. 5.2 percent.
B. 5.8 percent.
C. 6.1 percent.


1. B is correct.
The best estimate of cost of capital for an average-risk project of a company is the weighted average cost of capital using weights derived from the current capital structure.


2. B is correct.
The company can issue preferred stock today at 8.5%.
 P = \frac {\char36 2.85}{0.085} = \char36 33.53


3. A is correct.
The appropriate cost is the marginal cost of debt. The before-tax cost of debt can be calculated by the yield to maturity on a comparable outstanding. After adjusting for tax, the after-tax cost of debt is 8(1 - 0.35) = 8(0.65) = 5.2%.



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