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

Question 1

If the firm decreases its debt ratio, both the debt and the equity will become riskier. The debtholders and equity holders will require a higher return to compensate for the increased risk.

Answer 1

False

Question 2

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

Answer 2

True

Question 3

A firm's cost of capital will generally increase if the firm lowers its debt-equity ratio.

Answer 3

True

Question 4

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

Question 5

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

Question 6

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 higher levels of debt increase the required rate of return to equity.

Question 7

Capital structure refers to a firm's mix of long-term debt and equity financing.

Question 8

Projects that have a zero NPV when calculated at the WACC will provide sufficient returns to creditors and shareholders.

Question 9

The cost of equity will generally increase for risky firms when the risk-free rate of return increases.

Question 10

A firm's cost of capital should be computed using the book weights of each financing source.

Question 11

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 12

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

Question 13

If a project has a zero NPV when the expected cash flows are discounted at the weighted-average cost of capital, then the project's cash flows are just sufficient to give debtholders and shareholders the return they require.

Question 14

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

Question 15

Preferred stock should be ignored when computing a firm's weighted-average cost of capital.

Question 16

As a firm increases its debt ratio, debtholders are likely to demand higher rates of return.

Question 17

Both the capital asset pricing model and the dividend discount model can be used to determine the cost of equity financing.

Question 18

The company cost of capital is the minimum acceptable rate of return for any project the firm undertakes.

Question 19

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

Question 20

A firm's cost of capital should be used as the discount rate for every new project the firm considers.

Question 21

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

Question 22

What is the pretax cost of debt for a firm in the 35% tax bracket that has a 10% aftertax cost of debt?

A) 5.85%
B) 12.15%
C) 15.38%
D)25.71%

Question 23

The weighted-average cost of capital for a firm with a 40/60 debt/equity split, 8% cost of debt, 15% cost of equity, and a 34% tax rate would be:

A) 12.20%.
B) 8.63%.
C) 11.11%.
D)13.80%.

Question 24

To a company, the cost of interest payments on its bonds is reduced by the amount of tax savings generated by that interest.

Question 25

The weighted-average cost of capital for a firm with a 65/35 debt/equity split, 8% pre-tax cost of debt, 15% cost of equity, and a 35% tax rate would be:

A) 8.63%.
B) 9.12%.
C) 10.45%.
D)13.80%.

Question 26

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 27

To calculate the present value of a business, the firm's free cash flows should be discounted at the firm's:

A) weighted-average cost of capital.
B) pre-tax cost of debt.
C) aftertax cost of debt.
D)cost of equity.

Question 28

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 29

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

Question 30

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 31

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 32

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%
B) 30%
C) 35%
D)43%

Question 33

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

Question 34

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 35

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 36

One way to check the accuracy of the expected return on bonds is to compare the expected return to the YTM on recently-issued bonds with similar characteristics and risks.

Question 37

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 38

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 39

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 40

Company X has 2 million shares of common stock outstanding at a book value of $2 per share. The stock trades for $3 per share. It also has $2 million in face value of debt that trades at 90% of par. What is the weight of debt for WACC purposes?

A) 13.91%
B) 23.08%
C) 31.03%
D)27.67%

Question 41

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

A) The value of retained earnings is excluded.
B) Market values should be used in the calculations.
C) Preferred equity is a separate component of WACC.
D)There is a tax shield on the dividends paid.

Question 42

A firm's WACC:

A) is the proper discount rate for every project the firm undertakes.
B) is used to value all of the firm's existing projects.
C) is a benchmark discount rate that is adjusted for the riskiness of each project.
D)is an informational value only and should never be used as a discount rate.

Question 43

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%, 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 44

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

A) the expected return on it assets.
B) the expected return on its debt.
C) the total value of its assets.
D)the expected return on its equity.

Question 45

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's WACC is 12.5%?

A) Yes, since the project's NPV is positive.
B) Yes, since a zero NPV indicates marginal acceptability.
C) No, since the project's NPV is zero.
D)No, since the project's NPV is negative.

Question 46

What will be the effect of using the 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)It cannot be determined without knowing interest rates.

Question 47

As debt is added to the capital structure, the:

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

Question 48

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 49

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

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

Question 50

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) shareholders will demand a higher rate of return.
C) the tax shield will not apply to the added debt.
D)the cost of equity will decrease.

Question 51

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

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

Question 52

What would you estimate as the cost of equity if a stock sells for $40, pays a $4.25 dividend, and is expected to grow at a constant rate of 5%?

A) 17.46%
B) 14.52%
C) 12.69%
D)15.63%

Question 53

An increase in which one of the following is most apt to decrease the WACC of a firm that has both debt and equity in its capital structure?

A) Firm's beta
B) Market rate of return
C) Tax rate
D)Yield on preferred stock

Question 54

What dividend is paid on preferred stock if investors require a 9% rate of return and the stock has a market value of $54 per share and a book value of $50 per share?

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

Question 55

A firm has 12,000 shares of common stock outstanding with a book value of $20 per share and a market value of $39. There are 5,000 shares of preferred stock with a book value of $10 and a market value of $26. There is a $400,000 face value bond issue outstanding that is selling at 87% of par. What weight should be placed on the preferred stock when computing the firm's WACC?

A) 7.25%
B) 13.74%
C) 11.48%
D)15.09%

Question 56

The yield-to-maturity of a firm's bond is 8.5%. The firm has a beta of 1.3 and a tax rate of 34%. The market risk premium is 8.4% and the risk-free rate is 3.8%. What is the firm's WACC if the firm has a capital structure that is 40% debt financed?

A) 10.74%
B) 11.08%
C) 11.61%
D)11.38%

Question 57

Calculate a firm's WACC given that the total value of the firm is $2 million, $600,000 of which is debt, the pre-tax cost of debt is 10%, and the cost of equity is 15%. The firm pays no taxes.

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

Question 58

How much will a firm need in cash flow before tax and interest to satisfy debtholders and equityholders 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 59

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

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

Question 60

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 61

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 62

What is the WACC for a firm financed with 30% debt if the debt requires an after-tax return of 10% and equity requires a 16% return?

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

Question 63

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)is all equity financed.

Question 64

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 65

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 66

What proportion of a firm is equity financed if the WACC is 14%, the before-tax cost of debt is 10.77%, 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 67

A firm has 12,500 shares of stock outstanding that sell for $42 each. The book value of equity is $400,000. The firm has also issued $250,000 face value of debt that is currently quoted at 101.2. What value should be used as the weight of equity when computing WACC?

A) 67.48%
B) 72.09%
C) 61.54%
D)69.74%

Question 68

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

A) 25.0% debt.
B) 90.0% equity.
C) 40.0% debt.
D)33.3% debt.

Question 69

Which one of the following changes would tend to increase the WACC 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 70

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 71

Al's Market plans to close after 3 more years. The firm expects to have free cash flows of $148,000 next year, $128,000 in Year 2, and $65,000 in Year 3 after incurring the costs of closing. The firm's cost of equity is 15.5% and its cost of debt is 6.2%. What is the present value of the firm if its debt to value ratio is 30%?

A) $312,020
B) $248,915
C) $277,467
D)$301,004

Question 72

Assume a tax-paying firm is currently financed with 50% debt and 50% equity. The after-tax cost of debt is 6% and the cost of equity is 12%. If the firm issues some 8% preferred stock at par, then the firm's WACC will:

A) increase.
B) decrease.
C) either increase or decrease depending upon the amount of stock issued.
D)not be affected.

Question 73

A firm sells a product that it realizes is short-lived and thus the firm plans to close after 2 more years. The firm expects to have free cash flows of $398,000 next year and $211,000 in Year 2 after incurring the costs of closing. The firm's cost of equity is 14% and its cost of debt is 5.5%. What is the present value of the firm if its debt to value ratio is 40%?

A) $458,008
B) $481,707
C) $500,614
D)$532,349

Question 74

Which one of the following changes offers 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) Reducing the risk level of the project
D)Decreasing the marginal tax rate

Question 75

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 76

A firm is considering expanding its current operations and has determined the internal rate of return on that expansion is 12.2%. The firm's WACC is 11.8%. Given this, you know the:

A) project will have a lower debt-equity ratio than the firm's current operations.
B) appropriate discount rate for the project is between 11.8% and 12.2%.
C) project has slightly more risk than the firm's current operations.
D)expansion should be undertaken as it has a positive net present value.

Question 77

What proportion of a firm is equity financed if the WACC is 14%, the after-tax cost of debt is 7%, 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 78

A firm with a beta of 1.22 just paid its annual dividend of $5.64 a share. The dividends increase at a rate of 2% annually. The risk-free rate is 3.5%, the market rate of return is 12.4%, and the dividend discount rate is 11.6%. What is the best estimate of the firm's cost of equity if the firm's stock currently sells for $60 a share using an average of methods?

A) 12.97%
B) 14.33%
C) 11.60%
D)13.38%

Question 79

A project will generate a $1 million net cash flow annually in perpetuity. If the project costs $7 million, what is the break-even WACC?

A) 13.33%
B) 12.08%
C) 14.29%
D)16.67%

Question 80

Assume a firm's debt is selling at face value. What is the firm's cost of debt if the debt has a coupon rate of 7.5% and the tax rate is 35%?

A) 4.88%
B) 4.97%
C) 5.21%
D)5.35%