Exam 10: The Cost of Capital and the Capital Structure Decision

Darktree Inc. has $10 million of 10% bonds outstanding that are valued at $9 million. Darktree's corporate tax rate is 15%. What is the cost of debt to Darktree?

Several managers suggested that the company's financial analysts should add 0.5% to the hurdle rate when calculating the IRR of any investment opportunity to provide an added margin of safety and reduce their performance pressure. What would this action do?

When assessing the impact of leverage on capital structure decisions, a company can determine how much confidence it has in its choice of financial options by using the EBIT-EPS indifference chart. How is an EBIT-EPS indifference chart used?

Company A has $45 million worth of common share capital, $3.5 million in retained earnings, $30 million in long-term debt and $2.5 million in preferred shares. Company B has $22.5 million of common share capital, $3 million in retained earnings, $51 million in long-term debt and $4.5 million in preferred shares. If both companies face a tax rate of 32%, cost of common share capital of 11%, cost of debt capital of 8%, cost of preferred share capital of 9.5%, which company is more highly levered?

When determining the value of a share by the Dividend-Based Approach, which of the following provides the best reason for the life time of the business being the relevant timeframe over which to consider the dividend stream?

Bowden Building Supply reported an EBIT of $5,531,500, has a 35% tax rate, pays interest of $480,000 on $9,290,000 of debt and $0.60 to each of its 500,000 common shares outstanding. What is the company experiencing?

Manchester Mechanical Ltd. paid a dividend this year of $6.30 on each of its 450,000 common shares outstanding. Current market price is $56.00. Dividends are expected to grow by 1.5% per year. What is the cost of share capital to the business?

Liquid Shipping Inc. has developed the following data to help in a decision on whether to issue $40 million in bonds or common shares. If bonds are issued the following projections are made: ROE is 19%, EPS is $2.50, Times interest earned is 3, and the leverage ratio is 40%. If shares are issued, ROE is 11%, EPS is $1.30, Times interest earned is 5, and the leverage ratio is 22%. What is the best conclusion to make concerning this data?

The capital structure for a particular project consists of $500,000 of retained earnings, a $2.5 million bank loan with a net after-tax cost of capital of 5.5%, $2.5 million of common shares with a cost of capital of 8.2%.What is the weighted average cost of capital (WACC) for the project?

Which of the following is a limitation to the Weighted Average Cost of Capital approach?

EnerGrowth Industries Ltd. has 3.3 million common shares outstanding with a current market price of $25.50. Now, as in the future, the annual dividend is expected to be $2.50. What is the cost of share capital to the business?

Rekka Resin Moulding Inc. has a 28% tax rate, 3 million common shares outstanding at a price of $18.25 each, pays 7.5% interest on its long-term debt of $55 million and pays $1 million in dividends to preferred shareholders. Last year the company had an EBIT of $15 million. This year the company expects an EBIT of $12 million. What is the company experiencing?

A business has a times-interest-earned ratio of 12, a leverage ratio of 22%, an EPS of $2.23 on a share price of $19.75. Inflation is just below 3.5%, the economy is stable and the rate for government bonds is 5%. The business is in a highly dynamic market and is looking for capital financing which will impact 15% of its capital structure. How should the company finance its new investment opportunity?

Why is the cost of capital is considered an Opportunity Cost?

Which of the following is a disadvantage to a business of using debt to finance its capital projects?

Bellaire Pharma Ltee. refinances its $2.1 million worth of bonds as they come due at an annual rate of 6%. The current market value of the bonds is $920 for each $1000 bond. If the company's tax rate is 25%, what is the cost of capital of the loan to Bellaire?

UPad Wireless needs to raise $10 million to build another factory to meet the strong demand for its latest product. UPad will either issue 12% bonds at par or common shares that they have determined that investors require a 15% return. The fair value of UPad's currently outstanding bonds is $5 million, it shares is $5 million, and its preferred shares is $5 million. UPad's retained earnings is $5 million. The preferred shares also have a 12% dividend. UPad's tax rate is 30%. What is the minimum hurdle rate UPad should set for this investment project?

Light Limited (LL) has assumed its shareholders need a 10% required rate of return. The market return is 15% for next year. Meanwhile, long term government bonds can be purchased with a yield to maturity of 5%. what is the implied beta for LL?

Galhadi Telecommunications Ltd has 15 million 7% preferred shares outstanding with a nominal value of $90, a market price of $80 and a term of five years. Galhadi has a tax rate of 31%. Using trial values of 5% and 10%, what is the company's after-tax cost of preferred share capital?

Why do Modigliani and Miller and the Modernists believe that, when taxes are not being considered, the capital structure is irrelevant?