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

Question 1

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%

Answer 1

12.00%

Question 2

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.

Answer 2

Common stock

Question 3

Which of the following statements is incorrect concerning the equity component of the WACC?

A)The value of retained earnings is not included
B)Market values should be used in the calculations
C)Preferred equity has a separate component
D)There is a tax shield such as with debt

Answer 3

There is a tax shield such as with debt

Question 4

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 5

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 6

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 7

What will be the effect of using book value of debt in WACC decisions if interest rates have decreased substantially since a firm's long-term bonds were issued?

A)The debt-to-value ratio will be overstated
B)The debt-to-value ratio will be understated
C)There will be no effect on WACC decisions
D)Cannot be determined without knowing interest rates Example
Market Value of Equity = $5 million
Book Value of Debt = $2 million
Value of Firm = $7 million

Question 8

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 Working backwards:

Question 9

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% after-tax cost of debt = pretax cost x (1 - tax rate)
9% = pretax cost x .65

Question 10

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% WACC = (.35 x (1 - .35).08) + (.1 x .1) + (.55 x .15)
= 1)82% + 1.0% + 8.25%

Question 11

The company cost of capital 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 12

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)15.38%
B)28.6%
C)31.0%
D)33.3% 2 million shares x $3.00 = $6,000,000
$2 million debt x 90% = $1,800,000
Total value = $7,800,000

Question 13

Why is debt financing said to include a tax shield for the company?

A)Taxes are reduced by the amount of the debt
B)Taxes are reduced by the amount of the interest
C)Taxable income is reduced by the amount of the debt
D)Taxable income is reduced by the amount of the interest

Question 14

Should a project be accepted if it offers an annual after-tax cash flow of $1,250,000 indefinitely, costs $10 million, is riskier than the firm's average projects, and the firm uses a 12.5% WACC?

A)Yes, since NPV is positive
B)Yes, since a zero NPV indicates marginal acceptability
C)No, since NPV is zero
D)No, since NPV is negative NPV = -10 million + $1.25 million/.125
= -10 + 10
= 0

Question 15

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 16

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% r_equity =

Question 17

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% Component cost of debt = .45 x (1 - .35).10
= )45 x (.65 x .10)
= )45 x .065

Question 18

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% WACC = (.5 x (.12 x .6)) + (.5 x .2)
= 3)6% + 10%

Question 19

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 20

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 Working backwards:

Question 21

Debt financing is made up of explicit and implicit costs which are:

A)A higher required ROE and the interest rate bondholders demand, respectively
B)The interest rate bondholder's demand and a higher required ROE, respectively
C)The costs of equity and debt, respectively
D)The costs of issuing bonds and the interest rate bondholders demand, respectively

Question 22

With respect to the WACC:

A)It is the proper discount rate for everything the company does
B)It is used to value all new projects
C)This benchmark discount rate is adjusted for the riskiness of the project
D)No adjustments need to be made when using it as the discount rate

Question 23

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 24

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 25

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 9% = Dividend/Price

Question 26

One flaw with using a higher discount rate to account for flotation costs is:

A)It increases the cost of capital
B)It assumes a negative cash outflow for flotation costs
C)Such an adjustment assumes level or constant growth cash flows
D)This discount rate is the rate of return only for projects with lower risk

Question 27

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% r_assets = (.3 x .10) + (.7 x .16)
= )03 + .112

Question 28

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% WACC = .10(600,000/2,000,0000) + .15(1,400,000/2,000,000)
= )10(.3) + .15(.7)

Question 29

For a company that pays no corporate taxes, its WACC will be equal to:

A)The expected return on its assets
B)The expected return on its debt
C)The total value of its assets
D)The expected return on its equity

Question 30

In general, equity is considered a _____ investment than debt, because payments on debt are _______.

A)Safer; lower
B)Safer; less certain
C)Riskier; guaranteed by the company
D)Riskier; guaranteed by the federal government

Question 31

As debt is added to the capital structure, the:

A)WACC will continually decline
B)WACC will continually increase
C)The implied cost of debt can be expected to rise
D)WACC will be unaffected

Question 32

Which of the following statements is correct for a firm that is 55% debt-financed and the value of equity equals $58 million?

A)The firm is valued at approximately $105 million
B)The firm is valued at approximately $129 million
C)The debt is valued at approximately $32 million
D)The debt is valued at approximately $68 million

Question 33

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 Let x = % of debt
Then 3x = % of equity
And 4x = 100% $\rarr$ x = 25.0%

Question 34

What will happen to the required return on assets as a result of changing to a more debt-intensive capital structure?

A)It will decrease
B)It will increase
C)It will remain unchanged although individual investor requirements will shift
D)The required rates of return for assets, debt holders, and equity holders will all remain constant

Question 35

Higher flotation costs will result when:

A)Raising more internal capital
B)A firm does not issue enough stock to cover its costs
C)A firm feels market pressure from selling additional stock
D)Debt is issued versus equity being issued

Question 36

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 Let x = % of debt
Then 2x = % of equity
And 3x = 100% $\rarr$ x = 33.3%

Question 37

An implicit cost of increasing the proportion of debt in a firm's capital structure is that:

A)The firm's asset beta will increase
B)Equity holders will demand a higher rate of return
C)The tax shield will not apply to the added debt
D)The equity-to-value ratio will decrease

Question 38

If a company's cost of capital is less than the required return on equity, then the firm:

A)Is financed with more than 50% debt
B)Is perceived to be safe
C)Has debt in its capital structure
D)Cannot be using any debt

Question 39

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 40

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 41

How would a company's cost of capital calculated from book values be affected if the company's bonds were selling for more than face value?

A)The cost of capital would increase
B)The cost of capital would decrease
C)The cost of capital would not be affected
D)The effect depends on the bonds' coupon rate

Question 42

Using market values rather than book values for cost of capital computations insures that the firm:

A)Does not ignore the value of retained earnings
B)Gets the full value of the debt tax shield
C)Uses expected rates of return
D)Will not invest in negative NPV projects

Question 43

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 44

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 45

A proposed project has a positive NPV when evaluated at the company cost of capital.If the firm employs debt in its capital structure, will the project remain acceptable after evaluation with the WACC?

A)Yes, using the WACC will increase the NPV
B)No, using the WACC will decrease the NPV
C)The project may now become unacceptable
D)There will be no change in the project's NPV

Question 46

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 (working up from the bottom)

Question 47

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 48

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 49

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 50

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% 7.50% = before-tax cost x (1 - tax rate)
7)50% = before-tax cost x .60

Question 51

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% 14% = (1 -x)(7%) + (x)18%
14% = 7% = 7% + 18%
7%/11% = 11%x/11%

Question 52

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% r_equity =

Question 53

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% WACC = (.4 x .06) + (.2 x .12) + (.4 x .18)
= )024 + .024 + .072

Question 54

for purposes of computing the WACC, if the book value of equity exceeds the market value of equity, then:

A)The book value of equity should be used
B)The book value of equity less retained earnings should be used
C)The market value of equity should be used
D)The market value of equity less retained earnings should be used

Question 55

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% WACC = (.4 x (1-35%) x .0923) + (.2 x .12) + (.4 x .18)
= )024 + .024 + .072

Question 56

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% Adjustment for tax shield on debt =

Question 57

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% Adjustment for tax shield on debt =

Question 58

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% Expected return on stock = 6% + 1.5(15% - 6%)
= 6 + 13.5

Question 59

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 60

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% $1 million/.16 = $7 million
$6)25 million < $7 million
Therefore, NPV < $0

Question 61

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% D/E = 1/4, then D/D+E = 1/1+4 = 1/5
Therefore: D/V = 1/5 and E/V = 4/5
0)186 = 1/5(0.094)(1 - 0.34) + 4/5(r_e)
0)186 = .0124 + 4/5(re)

Question 62

Which of the following can be used to estimate the firm's cost of equity?

A)The capital asset pricing model (CAPM)
B)The dividend growth model
C)The historic market yield
D)Management approximation

Question 63

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 64

The company cost of capital:

A)Measures what investors want from the company
B)Depends on current profits and cash flows
C)Is measured using security book values
D)Depends on historical profits and cash flows

Question 65

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 66

The difficulty in using the CAPM for determining the cost of equity lies in:

A)The estimation of the firm's beta
B)The estimation of the risk-free rate
C)The estimation of the return on the market
D)All of these

Question 67

Which of the following is NOT true?

A)Flotation costs should be recognized as an incremental cost of undertaking a project
B)The cost of capital depends on interest rates and the riskiness of the project
C)The WACC is used to value new projects of the same risk
D)Flotation costs can be handled by increasing the discount rate

Question 68

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 69

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 70

With respect to issues related to the cost of capital:

A)An increase in the debt ratio will result in greater risk for debt holders but not equity holders
B)The cost of capital is the return a firm must earn before tax to satisfy security holders
C)The WACC is the correct discount rate for average-risk projects
D)The expected return on equity is relevant to capital budgeting decisions

Question 71

A firm has an opportunity to invest in a project that will generate $55,000 per year for the next 10 years and requires an initial investment of $300,000.The firm will need to raise equity to pay for the project, but the flotation costs are 10% of the funds raised.If the firm's discount rate is 11%, should they invest in this project?

A)Yes, since the NPV is approximately $23,900
B)Yes, since the NPV is approximately $9,500
C)No, since the NPV is approximately -$6,100
D)No, since the NPV is approximately -$8,500 NPV = $55,000[1/.11 - (1/.11)(1.11)^-10] - $300,000= $23,908
Flotation costs = .10 x ($300,000) = $30,000

Question 72

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 73

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% r_e = ((1(1 + 0.04))/$15) + 0.04= 10.93%

Question 74

If a firm wishes to undertake a project with a different risk than its own, what is the best method 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 75

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% 0.10 = r_d(1 - 0.35)

Question 76

Which of the following is NOT a cost to the firm of increasing debt financing?

A)Investors will demand a higher interest rate on debt
B)The risk to common stockholders increases
C)Stockholders will demand a higher return
D)The cost of common equity will decrease

Question 77

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 78

Which of the following statements is false regarding flotation costs?

A)It is easier to account for flotation costs by treating them as negative cash flows
B)They increase the required rate of return
C)They are the costs of issuing new securities
D)They involve real money

Question 79

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 80

Which of the following should be expected to occur when a firm significantly increases its proportion of debt financing?

A)The required return on debt will decrease
B)The required return on equity will decrease
C)The company cost of capital will increase
D)The company cost of capital will remain unchanged