Deck 13: The Weighted-Average Cost of Capital and Company Valuation

Question 1

As a firm changes to a higher debt ratio,debt holders are likely to demand higher rates of return.

Answer 1

True

Question 2

Weighted-average cost of capital is the expected rate of return on a portfolio of all the firm's securities,adjusted for tax savings due to interest payments.

Answer 2

True

Question 3

The riskiness of equity securities typically exceeds that of debt securities for firms.

Answer 3

True

Question 4

Assuming a project has the same risk and financing as the firm,it will have a positive NPV if its rate of return is greater than the firm's WACC.

Question 5

The cost of capital must be based on the securities' book values.

Question 6

The mix of a company's short-term financing is referred to as its capital structure.

Question 7

For most healthy firms,the YTM on their bonds is the rate of return investors expect from holding their bonds.

Question 8

Capital structure in essence is a firm's mix of long-term financing.

Question 9

One way to check the correctness of the expected return on bonds is through the bond discount model.

Question 10

Calculation of company costs of capital should be conducted with market values whenever possible.

Question 11

When using the WACC as a discount rate,it is often adjusted upward for riskier projects and downward for safer projects.

Question 12

The company cost of capital is the expected rate of return that investors demand from the company's assets and operations.

Question 13

An increase in a firm's debt ratio will have no effect on the required rate of return for equity holders.

Question 14

Interest tax shields are available to the firm on debt and preferred stock but not on common equity.

Question 15

The company cost of capital does not make an adjustment for the tax effect.

Question 16

To the company,the cost of interest payments on bonds (issued debt)is reduced by the amount of tax savings.

Question 17

There are two costs of debt finance.The explicit cost of debt is the rate of interest that bondholders demand.But there is also an implicit cost,because over-borrowing increases the required rate of return to equity.

Question 18

There are two costs of debt finance.The explicit cost of debt is the rate of interest that bondholders demand.But there is also an implicit cost,because borrowing decreases the required rate of return to equity.

Question 19

The WACC is the rate of return that the firm must expect to earn on its average-risk investments in order to provide an acceptable return to its security holders.

Question 20

The interest tax shield generated by a project's actual equity financing is accounted for by using the after-tax cost of equity in the WACC.

Question 21

Projects that have a zero NPV when calculated at the WACC will provide sufficient returns to all stakeholders.

Question 22

How much will a firm need in cash flow before tax and interest to satisfy debt holders and equity holders if: the tax rate is 35%,there is $13 million in common stock requiring a 10% return,and $6 million in bonds requiring an 6% return?

A) $1,392,000
B) $1,488,000
C) $2,360,000
D) $2,480,000

Question 23

What is the WACC for a firm with 40% debt,20% preferred stock and 40% equity if the respective costs for these components are 9.23% before-tax,12% after-tax,and 18% before-tax? The firm's tax rate is 35%.

A) 9.48%
B) 11.16%
C) 12.00%
D) 15.60%

Question 24

The weighted-average cost of capital is the return the company needs to earn after tax in order to satisfy all its security holders.

Question 25

The capital structure for the CR Corporation is the following: bonds $5,500,and common stock $11,000.If CR has an after-tax cost of debt of 6%,and a 16% cost of common stock,what is its WACC?

A) 9.33%
B) 12.67%
C) 13.33%
D) 14.67%

Question 26

A change in the company's capital structure will change the amount of taxes paid but will not change the WACC.

Question 27

What coupon rate is being paid on debt for a firm with an after-tax cost of debt of 7.5% and a tax rate of 40%?

A) 10.5%
B) 12.0%
C) 12.5%
D) 18.75%

Question 28

The company cost of capital,after tax,for a firm with a 60/40 debt/equity split,8% cost of debt,15% cost of equity,and a 35% tax rate would be:

A) 7.02%
B) 9.12%
C) 10.80%
D) 13.80%

Question 29

What is the WACC for a firm with 40% debt,20% preferred stock and 40% equity if the respective costs for these components are 6% after-tax,12% after-tax,and 18% before-tax? The firm's tax rate is 35%.

A) 9.48%
B) 11.16%
C) 12.00%
D) 15.60%

Question 30

What is the after-tax cost of preferred stock that pays a 12% dividend and sells at par if the firm's tax rate is 35%?

A) 7.8%
B) 8.5%
C) 12.0%
D) 16.2%

Question 31

A firm's cost of capital can be used in valuation of every new project they encounter,regardless of its risk.

Question 32

What dividend is paid on preferred stock if investors require a 9% rate of return and the stock has a market value of $54.00 per share and a book value of $50.00 per share?

A) $2.92
B) $4.50
C) $4.68
D) $4.86

Question 33

How much will a firm need in cash flow before tax and interest to satisfy debt holders and equity holders if: the tax rate is 40%,there is $10 million in common stock requiring a 12% return,and $6 million in bonds requiring an 8% return?

A) $1,392,000
B) $1,488,000
C) $2,480,000
D) $2,800,000

Question 34

What is the WACC for a firm using 55% equity with a required return of 15%,35% debt with a required return of 8%,10% preferred stock with a required return of 10%,and a tax rate of 35%?

A) 10.72%
B) 11.07%
C) 11.70%
D) 12.05%

Question 35

New projects should only be undertaken by firms if they have the same risk as existing assets.

Question 36

The company cost of capital,pretax for a firm with a 60/40 debt/equity split,8% cost of debt,15% cost of equity,and a 35% tax rate would be:

A) 7.02%
B) 9.12%
C) 10.80%
D) 13.80%

Question 37

What would you estimate to be the required rate of return for equity investors if a stock sells for $40 and will pay a $4.40 dividend that is expected to grow at a constant rate of 5%?

A) 7.6%
B) 12.0%
C) 12.6%
D) 16.0%

Question 38

How much cash flow before tax and interest is necessary to support a project that requires $4 million annually for equity investors and $2 million annually in interest payments if the firm's tax rate is 35%?

A) $7.40 million
B) $8.10 million
C) $8.15 million
D) $8.85 million

Question 39

A firm is considering a project that will generate perpetual cash flows of $50,000 per year beginning next year.The project has the same risk as the firm's overall operations.If the firm's WACC is 12.0%,and its debt-to-equity ratio is 1.33,what is the most it could pay for the project and still earn its required rate of return?

A) $313,283
B) $375,094
C) $416,667
D) $554,167

Question 40

If equity investors require a 20% rate of return,what is the maximum acceptable amount of equity financing for a project with $2 million annual cash flows before tax and interest,$3 million in debt with a 10% coupon,and a 35% tax rate?

A) $5.53 million
B) $5.87 million
C) $8.5 million
D) $9.03 million

Question 41

If a firm has three times as much equity as debt in its capital structure,then the firm has:

A) 25.0% debt
B) 66.7% equity
C) 40.0% debt
D) 33.3% equity

Question 42

What is the WACC for a firm with equal amounts of debt and equity financing,a 17% before-tax company cost of capital,a 35% tax rate,and a 10% coupon rate on its debt that is selling at par value?

A) 10.40%
B) 14.25%
C) 15.25%
D) 16.00%

Question 43

Calculate a firm's WACC given that the total value of the firm is $2,000,000,$600,000 of which is debt,the cost of debt and equity is 10% and 15% respectively,and the firm pays no taxes:

A) 9.0%
B) 11.5%
C) 13.5%
D) 14.4%

Question 44

According to CAPM estimates,what is the cost of equity for a firm with beta of 1.5 when the risk-free interest rate is 6% and the expected return on the market portfolio is 15%?

A) 19.5%
B) 21.0%
C) 22.5%
D) 24.0%

Question 45

A project will generate $1 million net cash flow annually in perpetuity.If the project costs $7 million,what is the lowest WACC shown below that will make the NPV negative?

A) 10%
B) 12%
C) 14%
D) 16%

Question 46

What is the pretax cost of debt for a firm in the 35% tax bracket that has a 9% after-tax cost of debt?

A) 5.85%
B) 12.15%
C) 13.85%
D) 25.71%

Question 47

What is the yield to maturity on Dotte Inc.'s bonds if its after-tax cost of debt is 10% and its tax rate is 35%?

A) 6.50%
B) 13.50%
C) 15.38%
D) 16.42%

Question 48

What is the WACC for a firm with equal amounts of debt and equity financing,a 16% before-tax company cost of capital,a 35% tax rate,and a 10% coupon rate on its debt that is selling at par value?

A) 10.40%
B) 14.25%
C) 15.13%
D) 16.00%

Question 49

What appears to be the targeted debt ratio of a firm that issues $15 million in bonds and $35 million in equity to finance its new capital projects?

A) 15.00%
B) 30.00%
C) 35.00%
D) 60.00%

Question 50

What % age of value should be allocated to equity in WACC computations for a firm with $50 million in debt selling at 85% of par,$50 million in book value of equity,and $65 million in market value of equity?

A) 50.0%
B) 54.1%
C) 56.5%
D) 60.5%

Question 51

XYZ Company issues common stock that is expected to pay a dividend over the next year of $4 at a price of $25 per share.If its expected growth rate is 5%,what is XYZ's cost of common equity?

A) 9.0%
B) 11.0%
C) 16.0%
D) 21.0%

Question 52

What is the WACC for a firm with 50% debt and 50% equity that pays 12% on its debt,20% on its equity,and has a 40% tax rate?

A) 9.6%
B) 12.0%
C) 13.6%
D) 16.0%

Question 53

How much is added to a firm's weighted average cost of capital for 45% debt financing with a required rate of return of 10% and a tax rate of 35%?

A) 1.29%
B) 2.93%
C) 3.50%
D) 4.50%

Question 54

Find the required rate of return for equity investors of a firm with a beta of 1.3 when the risk free rate is 5%,the market risk premium is 5%,and the return on the market is 10%.

A) 11.5%
B) 13.0%
C) 16.5%
D) 18.0%

Question 55

Company X has 2 million shares of common stock outstanding at a book value of $2 per share.The stock trades for $3.00 per share.It also has $2 million in face value of debt that trades at 90% of par.What is its ratio of debt to value for WACC purposes?

A) 23.08%
B) 28.6%
C) 31.0%
D) 33.3%

Question 56

If a firm has twice as much equity as debt in its capital structure,then the firm has:

A) 75.0% debt
B) 66.7% equity
C) 40.0% debt
D) 33.3% equity

Question 57

What proportion of a firm is equity financed if the WACC is 14%,the after-tax cost of debt is 7.0%,the tax rate is 35%,and the required return on equity is 18%?

A) 54.00%
B) 63.64%
C) 70.26%
D) 77.78%

Question 58

What is the company cost of capital for a firm financed with 30% debt if the debt requires a 10% return and equity requires a 16% return?

A) 11.8%
B) 13.3%
C) 14.2%
D) 14.8%

Question 59

What return on equity do investors seem to expect for a firm with a $55 share price,an expected dividend of $5.50,a beta of .9 and a constant growth rate of 5.5%?

A) 9.00%
B) 10.00%
C) 13.95%
D) 15.50%

Question 60

A company's CFO wants to maintain a target debt-to-equity ratio of 1/4.If the WACC is 18.6%,and the pretax cost of debt is 9.4%,what is the cost of common equity assuming a tax rate of 34%?

A) 19.90%
B) 20.90%
C) 21.70%
D) 22.73%

Question 61

Which of the following changes would tend to increase the company cost of capital for a traditional firm?

A) decrease the proportion of equity financing.
B) increase the market value of the debt.
C) decrease the proportion of debt financing.
D) Decrease the market value of the equity.

Question 62

Capital structure decisions refer to the:

A) dividend yield of the firm's stock.
B) blend of equity and debt used by the firm.
C) capital gains available on the firm's stock.
D) maturity date for the firm's securities.

Question 63

If a firm wishes to undertake a project with a different risk than its own,what is the best way by which to estimate the project's beta?

A) a company in the same business as the firm.
B) a risk adjustment made to the firm's beta.
C) a company in the same business as the project.
D) management approximation.

Question 64

The weighted average cost of capital should be used on projects of similar risk that are funded through:

A) debt issues.
B) retained earnings.
C) Depreciation.
D) any external financing.

Question 65

Which of the following changes offer the greatest chance of changing a project's NPV from negative to positive?

A) Substituting preferred stock for debt.
B) Selling the debt at less than par value.
C) A reduction in project risk.
D) A decrease in the marginal tax rate.

Question 66

What is the expected growth rate in dividends for a firm in which shareholders require an 18% rate of return and the dividend yield is 10%?

A) 1.8%
B) 5.2%
C) 8.0%
D) 28.0%

Question 67

Free cash flow is defined as:

A) debt at zero percent interest..
B) cash flow that is not required for investing in fixed assets only.
C) cash flow that is not required for investing in working capital only.
D) cash flow that is not required for investing in either fixed assets or working capital.

Question 68

What is the most difficult aspect in determining a firm's weighted average cost of capital?

A) estimating the cost of equity.
B) estimating the cost of preferred stock.
C) estimating the cost of debt.
D) deriving weights for each cost.

Question 69

If a firm earns the WACC as an average return on its average-risk assets,then:

A) equity holders will be satisfied, but bondholders will not.
B) bondholders will be satisfied, but equity holders will not.
C) all investors will earn their minimum required rate of return.
D) the firm is investing only in positive NPV projects.

Question 70

What decision should be made on a project of above-average risk if the project's IRR exceeds the WACC?

A) accept the project; NPV is positive.
B) reject the project; NPV is negative.
C) decide after discounting at the IRR.
D) decide after discounting at an appropriate rate.

Question 71

When determining the cost of capital for a new project,the firm should consider the:

A) discounted rate that makes the NPV equal to zero.
B) IRR of the investment.
C) cost of capital of a project of similar risk.
D) cost of capital facing the firm.

Question 72

Changing the capital structure by adding debt will not:

A) increase the return that shareholders require.
B) leave the WACC unaffected.
C) decrease debt holder risk.
D) increase the cost of debt.

Question 73

The company cost of capital is the return that is expected on a portfolio of the company's:

A) existing securities.
B) equity securities.
C) debt securities.
D) proposed securities.

Question 74

What is the after-tax cost of preferred stock that sells for $10 per share and offers a $1.20 dividend when the tax rate is 35%?

A) 4.20%
B) 7.80%
C) 8.33%
D) 12.00%

Question 75

Why is it important to include the tax effect into cost of capital computations for firms with debt financing?

A) firms pay taxes on the outstanding principal amount of the debt.
B) taxable income is reduced by the amount of the interest expense.
C) comparisons with equity financing would otherwise not be possible.
D) taxes are paid on interest but not on dividends.

Question 76

For a firm that pays no corporate taxes,changing its capital structure will:

A) change the total cash it pays out to investors.
B) change the risk of the cash flows.
C) change both the cash flows and the risk of the cash flows.
D) not affect the cash flows nor the risk of the cash flows.

Question 77

Plasti-tech Inc.is financed 60% with equity and 40% with debt.Currently,its debt has a before-tax interest rate of 12%.Plasti-tech's common stock trades at $15 per share and its most recent dividend was $1.00.Future dividends are expected grow by 4%.If the tax rate is 34%,what is Plasti-tech's WACC?

A) 7.39%
B) 9.57%
C) 9.73%
D) 11.20%

Question 78

When determining the costs of each component of a firm's capital structure,the firm must evaluate the:

A) marginal costs of new funds.
B) total costs of new funds.
C) average costs of new funds.
D) average costs of old and new funds.

Question 79

Proposed assets can be evaluated using the company cost of capital providing that the:

A) firm does not pay taxes.
B) firm is all equity financed.
C) cost of debt is less than the cost of equity.
D) new assets have the same risk as existing assets.

Question 80

Which component is more likely to be biased if book values are used in the calculation of WACC rather than market values?

A) debt.
B) preferred stock.
C) common stock.
D) all categories should be equally biased.