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

Question 1

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 overborrowing increases the required rate of return to equity.

Answer 1

True

Question 2

If a project has 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.

Answer 2

True

Question 3

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

Answer 3

False

Question 4

The company cost of capital is always at least as large as the weighted-average cost of capital for the same firm.

Question 5

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

Question 6

The company cost of capital equals the weighted-average cost of capital (WACC)as long as the tax rate is non-zero.

Question 7

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

Question 8

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

Question 9

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

Question 10

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

Question 11

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

Question 12

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

Question 13

McDonald's weighted-average cost of capital is lower than that of Walmart.

Question 14

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

Question 15

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

Question 16

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

Question 17

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.

Question 18

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

Question 19

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 20

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 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 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 23

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 24

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 25

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

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

Question 26

The company cost of capital for a firm with a 65/35 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) 10.45%.
D) 13.80%.

Question 27

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 28

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

Question 29

Company X has 2 million shares of common stock outstanding at a book value of $2.00 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) 13.9%
B) 23.1%
C) 31.0%
D) 76.9%

Question 30

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 31

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) 70.00%

Question 32

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 33

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

A) 7.02%.
B) 8.63%.
C) 10.80%.
D) 13.80%.

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

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

Question 36

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

Question 37

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

Question 38

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

Question 39

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 40

What is the after-tax cost of preferred stock that sells for $10.00 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 41

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 42

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.

Question 43

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 44

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 45

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 46

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 47

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.

Question 48

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 49

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 50

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 51

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 52

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 53

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) It cannot be determined without knowing interest rates.

Question 54

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 equity-to-value ratio will decrease.

Question 55

What would you estimate to be the required rate of return for equity investors if a stock sells for $40.00 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 56

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 57

Debt financing is made up of explicit and implicit costs that refer to:

A) a higher required ROE and the interest rate bondholders demand, respectively.
B) the interest rate bondholders 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 58

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 59

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.

Question 60

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 61

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 62

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 63

If the debt is trading at face value,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 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 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 66

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 67

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 68

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 69

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) Reducing project risk
D) Decreasing the marginal tax rate

Question 70

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 71

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 72

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 73

Using market values rather than book values for cost of capital computations ensures 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 positive NPV projects.

Question 74

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 75

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 76

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 77

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 78

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 79

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 80

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.