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

Question 1

The returns from Guardian Grocers Ltd. are approximately three-quarters as volatile as that of the market as a whole. If 90-day Treasury bills are trading at 4.2%, the expected return to the market over the next period is 7%, what is the required rate of return by shareholders for Guardian Grocers Ltd.?

A) 4.5
B) 5.2
C) 6.3
D) 7.9
E) 9.1

Answer 1

C

Question 2

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?

A) 2.0%
B) 9.8%
C) 14.5%
D) $8.25 million
E) $84.15 million

Answer 2

B

Question 3

Which of the following is an assumption of the Capital Asset Pricing Model?

A) Very few investors hold fully diversified portfolios.
B) The relationship between beta and expected returns are seldom linear.
C) Returns on specific shares are affected by general market changes only.
D) Beta values tend to be unstable over the long term.
E) Historical data can be used to predict the future.

Answer 3

E

Question 4

I-polo International Inc. has a tax rate of 22% and a capital structure that includes five million common shares outstanding at a rate of $26.50 per share. Its expected dividend for next year is $2.25, the result of a constant rate of dividend growth of 2% per year. It has four million bonds with a face value of $1,000, a coupon rate of 9% and selling at a price of $840. What is the weighted average cost of capital (WACC)?

A) 7.9%%
B) 8.3%
C) 8.5%
D) 9.3%
E) 10.4%

Question 5

Which of the following is a quality that applies to preferred shares but not to bonds?

A) Can be redeemable or irredeemable.
B) Have an agreed rate of return that is fixed over the life of the security.
C) Have a rate of return that cannot be written off against taxes.
D) Can be convertible or non-convertible.
E) Can be traded in the secondary securities markets.

Question 6

Markle Ltd. has issued $7.5 million worth of bonds with an interest rate of 10%, payable annually, and redemption in 10 years. The issue price of the bond is $85 per $100 of nominal value. If Markle's tax rate is 35%, what is the cash flow each year that is associated with this debt?

A) Year 0 has an inflow of $7.5 million. Each of Years 1-19 have an outflow of $637,500 and Year 5 has an outflow of $8.14 million.
B) Year 0 has an inflow of $7.5 million. Year 5 has an outflow of $9.94 million.
C) Year 0 has an inflow of $6.38 million and Year 5 has an outflow of $11.25 million.
D) Year 0 has an inflow of $6.38 million. Each of Years 2-9 has an outflow of $487,500. Year 10 is an outflow of $7.99 million.
E) Year 0 has an inflow of $6.38 million. Each of Years 1-9 has an outflow of $750,000. Year 10 has an outflow of $8.25 million.

Question 7

What is the cost of shares to the business is equivalent to?

A) The average year-over-year percent increase in share price.
B) The NPV of the return to the company from its investments.
C) The bank rate grossed up by a risk premium and the rate of inflation.
D) The IRR used to evaluate the company's investment projects.
E) The NPV of the future share prices.

Question 8

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?

A) 11.3%
B) 11.4%
C) 12.8%
D) $2.88 million
E) $25.2 million

Question 9

Ignoring costs associated with new issues, what is the cost of retained earnings the same as?

A) The cost of debt, as creditors have first call on retained earnings at the company's termination.
B) The weighted average cost of all the company's sources of capital as the company is indifferent as to the use of retained earnings or other sources.
C) The return on total assets as this ratio is equal to the sum of retained earnings plus dividends divided by total assets.
D) The cost of shares as retained earnings represent the undistributed profits belonging to the common shareholders.
E) The return on capital employed as retained earnings represents the opportunity cost of investment.

Question 10

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?

A) It is always recommended that shares be held over the long term.
B) The NPV of the future dividend stream will determine the price of the share whenever it is sold.
C) The inaccuracies inherent in this method are less of a problem than the inaccuracies inherent in other valuation methods.
D) It is easy to estimate the lifetime of a corporation based on historical averages.
E) Individuals planning to hold shares for the short term can adjust the share's value proportionally to the length of time they hold the share.

Question 11

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?

A) Improve shareholder wealth by reducing the risk associated with the outcomes of those projects that were accepted.
B) Reduce shareholder wealth by rejecting otherwise acceptable projects.
C) Reduce shareholder wealth by accepting otherwise unacceptable projects.
D) Improve shareholder wealth by increasing the percent return of projects undertaken.
E) Improve shareholders' wealth by reflecting the added risk perceived by the company's managers.

Question 12

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?

A) 4.5
B) 5.6
C) 6.4
D) 7.0
E) 7.3

Question 13

Omaro Ltd. has $34 million worth of bonds outstanding with an interest rate of 8% and redemption in 4 years. The issue price of the bond is $90 per $100 of nominal value. The company's tax rate is 24%. Using trial values of 8% and 12%, what is the company's after tax cost of capital for the bonds?

A) 7.8%
B) 8.6%
C) 9.3%
D) 11.3%
E) 12.0%

Question 14

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?

A) 5.2%
B) 7.5%
C) 8.0%
D) 9.9%
E) 12.8%

Question 15

McDuffs' Moving and Storage has a capital structure which includes 1.5 million common shares selling at $15.00 per share with a dividend of $1.70 and a growth in dividends of 1.1% per year. Its newly issued 300,000 preferred shares have an issue and market price of $50, a term of 5 years and a fixed dividend of $4.50. McDuffs' nominal $40 million debt is perpetual with a interest rate of 7% and selling at $92 per $100 of nominal value. The company's tax rate is 28%. Using trial values of 6% and 12%, what is the company's weighted average cost of capital?

A) 7.8
B) 8.3
C) 8.4
D) 9.0
E) 9.3

Question 16

Which of the following is an internal source of long-term capital?

A) Retained Earnings.
B) Common Shares
C) Preferred Shares
D) Bonds
E) Loans

Question 17

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

A) The interest is an expense that allows for the opportunity of undertaking the project.
B) The value of the capital invested in the business is the cost to the business of not undertaking a different project of similar risk.
C) The returns to the business represent the opportunity for which the capital invested is the cost.
D) The business is indifferent to investing in any project that provides similar returns for a similar level of risk.
E) The returns to investors supplying the capital must equal to or greater than that which could be had from other projects of similar risk.

Question 18

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?

A) 0.5%
B) 1.6%
C) 4.9%
D) 6.5%
E) 13.0%

Question 19

A company has 1.5 million 5% preferred shares with a nominal value of $50 and a market capitalization of $91.5 million. What is the cost of capital for the preferred shares?

A) 4.1%
B) 7.5%
C) 8.2%
D) 10.0%
E) 13.7%

Question 20

If the risk co-efficient, beta, for McDonald's Corporation is .9, what can be said about the fluctuation of the company's returns?

A) They are similar to, but not as volatile, as the returns from the market as a whole.
B) They are nearly non-existent.
C) They cannot be calculated without a beta value for the market as a whole.
D) They are significantly more volatile than the returns from the market a whole.
E) They are similar to, but more volatile, than the returns from the market as a whole.

Question 21

Intelligent Corp. (IC) pays an annual dividend of $2.00 per share. IC announced it will start to grow the dividend by 15% per year from now on. If IC's shareholders require a 20% return on common shares, what should one share of IC stock sell for?

A) $10.00
B) $11.50
C) $15.33
D) $40.00
E) $46.00

Question 22

Intelligent Corp. (IC) has paid an annual dividend of $2.00 per share ever since it was formed ten years ago. Today IC announced it will start to grow the dividend by 15% per year from now on. If IC's shareholders require a 20% return on common shares, by what percentage should IC's share price jump according to the dividend-based approach to share valuation?

A) 60%
B) 120%
C) 180%
D) 360%
E) 480%

Question 23

What is one strategy that a hedge fund uses to maximize shareholder wealth?

A) Investing exclusively in select exchange traded funds (ETFs).
B) Using correlation coefficients to create perfectly diversified portfolios.
C) Investing in low yield, government securities.
D) Investing exclusively in market indexes.
E) Levering itself by selling short (shares it does not yet own).

Question 24

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?

A) By calculating the slope of the line at the indifference point.
B) By observing the position of the indifference point relative to EPS.
C) By calculating the slope of the line of the chosen financial option.
D) By observing the size of the margin of safety triangle that appears between and below the lines formed by the financial options.
E) By determining the distance between the indifference point and the expected level of earnings before interest and taxes.

Question 25

JY Electronics has EBIT of $35 million, interest expense of $4.5 million, a tax rate of 24% and 15 million common shares outstanding. It is looking for $22 million in long-term capital to finance a project that will provide an increase to EBIT of $3.5 million each year. It could fund the project by issuing bonds with a coupon rate of 9.1% or issuing 2.2 million shares at $10 each. Ignoring issuing expense, at what level of EBIT is JY Electronics indifferent as to the financing option?

A) $0.64 million
B) $20.14 million
C) $35.64 million
D) $55.15 million
E) $107.02 million

Question 26

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?

A) 0.33
B) 0.50
C) 1.00
D) 1.50
E) 3.00

Question 27

How can dividends over the entire future life of a business be relevant to a short term investor?

A) The share price when the investor sells should reflect the present value of all future earnings streams of the company.
B) The share price when the investor sells should reflect the present value of all future dividends of the company.
C) The share price when the investor sells should reflect the present value of all future earnings per share of the company.
D) The share price when the investor sells should reflect the after-tax present value of all future earnings of the company.
E) The share price when the investor sells should reflect after-tax the present value of all future dividends of the company.

Question 28

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

A) Contributes to the dilution of management control.
B) Takes longer to acquire than equity financing.
C) By making the business riskier, contributes to a higher weighted average cost of capital.
D) Is more expensive than equity financing because of tax considerations.
E) Reduces the positive impact of leverage in a company with growing earnings.

Question 29

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

A) The price of a business's shares are derived as much from rational decisions based on the returns to a company as from irrational ones.
B) Shareholders will always demand risk compensation equal to the increased returns from borrowing.
C) Investors, using borrowed funds to purchase shares in unlevered companies, will equalize the value of levered and unlevered companies.
D) Capital structure is a closed system where companies push to increase debt, and, lenders and shareholders push to reduce it resulting in a predetermined equilibrium.
E) There will always be sufficient risk adverse, risk neutral and risk seeking investors to invest in a company regardless of the proportion of debt in its capital structure.

Question 30

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?

A) 8.4% if UPad issues bonds to finance the factory.
B) 11.7% if UPad issues preferred shares to finance the factory.
C) 12.0% if UPad issues bonds or preferred shares to finance the factory.
D) 12.6% if UPad issues bonds or preferred shares or common shares to finance the factory.
E) 15.0% if UPad issues common shares to finance the factory.

Question 31

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?

A) 8.5%
B) 9.0%
C) 9.4%
D) 10.3%
E) 11.1%

Question 32

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

A) Later projects may be rejected as not meeting the hurdle rate because cheaper funding was used up on an earlier project.
B) Capital structures and interest rates are highly dynamic, always creating inconsistency in determining an overall cost of capital.
C) The approach assumes that there will be more than one form of capital in the structure thereby being inapplicable to companies funded solely by common shares.
D) Different investment decisions have different levels of risk and this is not taken into account in the model.
E) An insufficient number of companies use this method of evaluating their capital structure to trust in its reliability.

Question 33

What would be an important consequence if the CEO of a company required the Finance Department to use a cost of capital rate 2% lower than the true value?

A) The company would accept investment projects that would reduce shareholder wealth.
B) The company would reject investment projects that would increase shareholder wealth.
C) The company would accept investment projects that have a positive net present value.
D) The company would reject investment projects that have a negative net present value.
E) The company would accept investment projects with a higher internal rate of return.

Question 34

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?

A) Company A with a leverage ratio that equals 40.1%
B) Company B with a leverage ratio that equals 68.5%
C) Company A with a leverage ratio that equals 8.9%
D) Company B with a leverage ratio that equals 7.4%
E) Company B with a leverage ratio that equals 71.2%

Question 35

In the fifth year of operations both Sea Ltd. and Air Inc. had EBIT of $6 million. At the end of the year, the degree of financial leverage for Sea had decreased by 10% and for Air by 50%. What conclusion can be drawn from this?

A) EBIT grew more quickly at Sea than at Air.
B) Air has relatively more capital payments than Sea.
C) EPS decreased more rapidly at Sea.
D) EBIT did not change by much at Air.
E) EPS remained at 90% of EBIt at Sea.

Question 36

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) A degree of financial leverage of 0.7.
B) No degree of financial leverage of 0.9.
C) No degree of financial leverage of 1.3.
D) A degree of financial leverage 1.6.
E) A degree of financial leverage of 2.1.

Question 37

In the Traditional view, at what level of borrowing does the Optimal Capital Structure occur?

A) Shareholders' marginal demand for risk compensation due to borrowing is just equal to the increased returns from borrowing.
B) The cost of common share capital is equal to the cost of borrowing.
C) The benefits arising from tax relief due to borrowing are offset by the potential cost of bankruptcy.
D) Shareholders are no longer indifferent to the risks associated with borrowing.
E) There is any borrowing as shareholders always demand risk compensation equal to the increased returns from borrowing.

Question 38

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?

A) No presence of financial leverage as indicated by a ratio of 0.6.
B) No presence of financial leverage as indicated by a ratio of 1.0.
C) No presence of financial leverage as indicated by a ratio of 1.3.
D) The presence of financial leverage as indicated by a ratio of 1.1.
E) The presence of financial leverage as indicated by a ratio of 1.8.

Question 39

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?

A) Debt.
B) Common shares.
C) Retained earnings.
D) Preferred shares.
E) 50% debt and 50% equity.

Question 40

Last year Monaco Hotels distributed $26.25 million in dividends to its seven million common shareholders. Monaco Hotels is planning a $75 million resort hotel in Tobago. The expected income before income taxes is $20 million of which 25% will be distributed to the 7 million common shareholders over and above the amount of dividends equivalent to those distributed last year. Common shares trade for $42 per share. 1.3 million Class A cumulative preferred shares trade for $16.40 and carry a dividend of $1.23 per share. The company can fund the project through an issue of a new class of irredeemable cumulative preferred shares priced at $14 a share with a return rate similar to that of the Class A shares. Alternatively, it can issue of bonds with a face value of $1,000 and an interest rate of 6.8%. Applying a tax rate of 24% and ignoring issuing costs, which option will provide the highest incremental EPS from the project?

A) The bond option providing an incremental EPS of 0.40
B) The equity option providing an incremental EPS of $1.42
C) The bond option providing an incremental EPS of $1.62
D) The equity option providing an incremental EPS of $2.17
E) The bond option providing an incremental EPS of $6.07

Question 41

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?

A) The company should issue some bonds and some shares because the returns are large enough to outweigh the risk.
B) The company should issue shares because the returns are large enough to outweigh the risk.
C) The company should issue bonds because the returns are large enough to outweigh the risk.
D) The company should not issue bonds because the returns are too small to outweigh the risk.
E) The company should issue neither bonds nor shares because the returns are too small to outweigh the risk.

Question 42

An EBIT-EPS indifference chart for Rail Shipping Inc. indicates a breakeven point occurs at EBIT of $100 million. If the company issues shares to finance an expansion, EBIT will be $20 million below the indifference point. If bonds are issued, EBIt will be $30 million below the indifference point. What is the most appropriate conclusion to draw from this data?

A) EBIT would have to increase 20% before issuing shares is a better alternative.
B) EBIT would have to increase 25% before issuing bonds is a better alternative.
C) EBIT would have to increase 30% before issuing shares is a better alternative.
D) EBIT would have to increase 43% before issuing bonds is a better alternative.
E) EBIT would have to increase 50% before issuing shares is a better alternative.