The Cost of Capital
1. Why is the firm's weighted average cost of capital (WACC) considered a "hurdle rate"?
2. Explain the distinction between the firm's weighted average cost of capital (WACC) and its weighted marginal cost of capital (WMCC)? Are the calculations of the WACC and the WMCC different? Explain. (Two questions here.)
3. Explain how the use of book value weights taken from the balance sheet might render the calculation of a firm's WACC unreliable.
4. Briefly explain the following statement: Models that attempt to estimate the firm's cost of retained earnings are simultaneously measuring the opportunity cost borne by equity investors in the firm (i.e., those that own stock in the firm).
5. Regarding the firm's WACC estimate, list and explain two real-world problems encountered in estimating the firm's cost of equity capital. Be specific.
6. In terms of using the accept/reject criteria in capital budgeting decisions, what might be two outcomes of using the firm's WACC instead of its risk-adjusted WACC (assuming a risk-adjusted WACC is appropriate)?
7. Under typical circumstances the cost of debt is lower than the cost of equity. List two reason why. Do not use flotation costs and taxes on dividends as reasons.
8. Firm X's stock is currently selling for $60 a share. The firm is expected to earn $5.40 per share this year and to pay a year-end dividend of $3.60. Show your work.
A) If investors require a 9% return, what rate of growth must be expected for Firm X?
B) If Firm X reinvests earnings in projects with average returns equal to the stock's expected rate of return, then what will be next year's EPS?