Deck 14: The Cost of Capital and Taxation Issues in Project Evaluation

Question 1

Calculate the cost of equity capital using CAPM if the risk-free rate of interest is 5 per cent,the return on the market portfolio is 12 per cent,beta is 0.8 and the franking premium is 2 per cent.

A)10.6%
B)14%
C)12.2%
D)12%

Answer 1

12.2%

Question 2

Which of the following statements about the certainty equivalent approach to project evaluation is false?

A)Risk is incorporated into the analysis by adjusting cash flows rather than the discount rate.
B)Risk is incorporated into the analysis by adjusting the discount rate rather than cash flows.
C)Its use is only valid for projects with cash flows considered to be almost certain.
D)Its use is only valid for cash flows such as government bonds.

Answer 2

Risk is incorporated into the analysis by adjusting cash flows rather than the discount rate.

Question 3

The certainty equivalent net cash flow can be defined as:

A)the net cash flow obtained from an equal investment in a government security.
B)the NPV of a project whereby the cost of capital is adjusted by a 'no risk' factor.
C)the NPV of a project whereby cash flows are discounted by the risk-free rate of interest.
D)the smallest certain cash flow that a decision maker would be prepared to accept in exchange for the expected risky cash flow.

Answer 3

the smallest certain cash flow that a decision maker would be prepared to accept in exchange for the expected risky cash flow.

Question 4

Which of the following statements about the risk-adjusted discount rate approach and the certainty equivalent approach to project evaluation is most correct?

A)NPVs will differ under either method according to the 'risk adjustment factor'.
B)NPVs should be the same under either approach.
C)NPVs are generally higher using the 'risk-adjusted discount rate' approach.
D)NPVs are generally lower using the 'risk-adjusted discount rate' approach.

Question 5

If the reducing balance method is used the allowable depreciation rate is generally:

A)two times the straight-line rate.
B)2.5 times the straight-line rate.
C)three times the straight-line rate.
D)1.5 times the straight-line rate.

Question 6

When can the cost of capital for a company as a whole be a valid measure of the cost of capital for a particular project?

A)When market data are available.
B)When it is not practicable to estimate the cost of capital for individual projects.
C)When the risk of a new project is the same as the risk of the company's existing assets.
D)When CAPM is used as an EX POST model.

Question 7

Each project should be evaluated using its own cost of capital because:

A)of the effectiveness of the capital market in providing opportunities for investors to diversify.
B)diversification by a company creates value for companies.
C)risk of cash flows generated from a project depends upon the entire operations of a company.
D)beta values are readily available on a project-by-project basis.

Question 8

Given that a company's net operating cash flows are $2 million in perpetuity and the market value of capital is $10 million,what is the company's cost of capital?

A)20%
B)15%
C)5%
D)25%

Question 9

The shares of ABC Ltd have a market price of $4 and an annual dividend of 17.5 cents per share fully franked at the tax rate of 30 per cent.Calculate the dividend yield after company tax but before personal tax.

A)16%
B)2.56%
C)6.25%
D)Cannot be calculated as not enough information is provided.

Question 10

If a company has on issue debentures paying a coupon rate of 12% p.a.and the market yield on similar securities is 18 per cent,what is the correct cost of debt the company should use when estimating the WACC?

A)None of the given options.
B)15%
C)12%
D)18%

Question 11

The Income Tax Assessment Act allows:

A)three methods of calculating depreciation.
B)four methods of calculating depreciation.
C)two methods of calculating depreciation.
D)many methods of calculating depreciation.

Question 12

Share prices of companies paying franked dividends:

A)should have increased since the introduction of dividend imputation because overseas residents would have sold this type of shares.
B)should have increased since the introduction of dividend imputation because they have become more attractive to Australian investors.
C)have not changed as a result of imputation.
D)should have decreased since the introduction of dividend imputation because overseas residents are unable to use franking credits.

Question 13

The certainty equivalent approach to project valuation may have an advantage over the risk-adjusted discount rate approach when:

A)the certainty equivalent factor does not decrease at a constant rate.
B)the certainty equivalent factor does decrease at a constant rate.
C)valuing investments in government bonds.
D)comparing projects of unequal lives.

Question 14

If the preference shares are redeemable on a predetermined date,the calculation of the cost of preference shares is the same as the calculation of the:

A)effective interest rate on debt.
B)marginal interest rate on debt.
C)average interest rate on debt.
D)cost of short-term debt.

Question 15

The shares of ABC Ltd have a market price of $4 and an annual dividend of 17.5 cents per share fully franked at the tax rate of 30 per cent.Calculate the dividend yield on the shares of ABC that would be reported in the financial press.

A)22.85%
B)4.375%
C)1.312%
D)Cannot be calculated as not enough information is provided.

Question 16

Which approach incorporates risk by adjusting the cash flows rather than the discount rate?

A)The RADR approach.
B)The Capital equivalent approach.
C)The certainty approach.
D)The certainty equivalent approach.

Question 17

The cost of capital of a project:

A)depends on the characteristics of the company undertaking the project.
B)depends on the characteristics of the investors.
C)is considered on a project-by-project basis.
D)depends on the correlation of the proposed project's cash flows with the existing cash flows of the company.

Question 18

How are company taxes treated in estimating cash flows for a project?

A)They are ignored.
B)They are treated as cash inflows.
C)They are treated as cash outflows.
D)None of the given options.

Question 19

A problem with estimating the cost of capital for a project using the CAPM derived from market data is that:

A)the estimate for standard deviation is not obtainable.
B)a value for the risk-free rate of interest is not available.
C)it is not possible to estimate systematic risk from market data.
D)individual investment projects are not traded on a stock exchange.

Question 20

If the cost of equity capital is 15% p.a. ,the market value of equity is $5 million,the company tax rate is 30%,the cost of debt is 12% p.a.and
=0)60,what is the cost of capital?

A)11.9%
B)11.7%
C)12.8%
D)12.6%

Question 21

From the estimates,calculate the return on equity (after tax)if Rf = 5%,E(Rm)= 13%,franking premium = 3%,beta = 1.5 and the corporate tax rate is 30 per cent.

A)15.05%
B)21.5%
C)18.8%
D)15%

Question 22

A problem with the dividend growth model is:

A)that it is difficult to estimate the value of any tax credits.
B)that it is difficult to obtain market prices for shares listed on the stock exchange.
C)that it is extremely sensitive to estimates of the future growth rate in dividends.
D)none of the given options.

Question 23

The ____________________ requires that the definition of cash flows in the numerator should match the definition of the discount rate in the denominator of a NPV calculation.

Question 24

Assume that Expansion Ltd is a diversified company that is considering an expansion project in a mining division.The company has a target debt-equity ratio of 1:2 and this ratio will not be affected by the new project.The company's manager has identified Dig-it-out Ltd as a company with the same business risk as the new project (equity beta of 1.5).Dig-it-out has a debt-equity ratio of 1:3.Estimate the project's cost of equity for Expansion if the risk-free rate of interest is 7 per cent and the risk premium of the market portfolio is 10 per cent.

A)18.25%
B)22.0%
C)24.5%
D)23.88%

Question 25

What is the effective annual interest rate for a bank overdraft with an interest rate of 15% p.a.paid twice a year?

A)15%
B)7.5%
C)16.4%
D)15.6%

Question 26

Given that shares have an expected dividend stream of 10 cents in perpetuity and that the current market price of the shares is $2.40,calculate the cost of equity capital of these shares.

A)8%
B)12%
C)10%
D)4.2%

Question 27

When using the CAPM to estimate the cost of equity for evaluation of investment proposals,the appropriate substitute for the risk-free rate of interest is:

A)the yield on 10-year government bonds.
B)the yield on three-year government bonds.
C)the yield on 90-day treasury notes.
D)the yield on a government security whose term to maturity matches the life of the proposed project.

Question 28

During the year,Success Ltd shares have increased from $8 to $9 and shareholders received a final dividend of 50 cents per share,fully franked at the company tax rate of 30 per cent.Using the information above,calculate the dividend yield after company tax but before personal tax (using the beginning of the year share price)on Success shares.

A)13.89%
B)7.94%
C)6.25%
D)8.93%

Question 29

Which of the following statements describes a limitation of the WACC approach?

A)The WACC approach can give misleading results if it is used to analyse investment decisions rather than financing decisions.
B)There is no consensus on the taxation issues surrounding the inclusion of strategic options in the WACC approach,which can lead to incorrect inferences.
C)Has no practical application.
D)Can only be used directly for the whole company and to evaluate new projects that are identical to the company's existing operations.

Question 30

Under what conditions can a company's current capital structure be used to calculate the weights for each source of funds?

A)When implementing a new project will alter a company's capital structure.
B)When implementing a new project is not expected to alter a company's capital structure.
C)When reliable market weights can be obtained.
D)Only when preference shares are not included in the measure for WACC.

Question 31

The _____________________ approach is considered the superior method of risk adjustment where the risk per unit of time is not constant.

Question 32

Calculate the weighted average cost of preference shares and ordinary shares if there are: 1 million preference shares with market value of $2.50 each and an opportunity cost of 10.8%;10 million ordinary shares with market value of $4.50 each and an opportunity cost of 16.5%.

A)15.4%
B)16.9%
C)16.2%
D)None of the given options.

Question 33

Under which of the following conditions is it appropriate to estimate a project's cost of capital using the company's cost of capital?

A)When a company is a diversified conglomerate.
B)When the systematic risk of a project is similar to that of some other divisions.
C)When a company operates in a sole industry.
D)When a company operates in more than one industry but less than five.

Question 34

In the calculation of WACC,each of the debt and equity securities is weighted according to its ___________ values.

Question 35

The cost of capital is an ____________ because capital suppliers require a projects rate of return to be at least as high as the return they can obtain on other investments of equivalent risk.

Question 36

Assume that Expansion Ltd is a diversified company that is considering an expansion project in a mining division.The company has a target debt-equity ratio of 1:2 and this ratio will not be affected by the new project.The company's manager has identified Dig-it-out Ltd as a company with the same business risk as the new project (equity beta of 1.5).Dig-it-out has a debt-equity ratio of 1:3.What is the beta estimate of Expansion Ltd?

A)1.69
B)1.12
C)1.5
D)1.75

Question 37

From the following information,calculate the weighted average cost of debt:

A)7.2%
B)5.6%
C)16.5%
D)8.8%

Question 38

A consequence for a company that uses a single discount rate to evaluate projects is that:

A)high systematic risk divisions will find it hard to have their projects accepted.
B)low systematic risk divisions will find it easy to have their projects accepted.
C)high systematic risk divisions are likely to stagnate and even close down.
D)the systematic risk of the company will drift upward over time.

Question 39

During the year,Success Ltd shares have increased from $8 to $9 and shareholders received a final dividend of 50 cents per share,fully franked at the company tax rate of 30 per cent.Calculate the dividend yield after personal taxes for shareholders with a tax rate of 47 per cent (using the beginning of the year share price)on Success shares.

A)6.25%
B)4.7%
C)5%
D)6.7%

Question 40

During the year,Success Ltd shares have increased from $8 to $9 and shareholders received a final dividend of 50 cents per share,fully franked at the company tax rate of 30 per cent.Calculate first the conventional rate of return and second,the dividend yield (using the beginning of the year share price)on Success shares.

A)18.75% and 6.25%.
B)15.18% and 5.5%.
C)18.75% and 5.5%.
D)15.18% and 6.25%.

Question 41

A _________ is a company that operates almost entirely in only one industry or line of business.

Question 42

The direct use of the CAPM is the best method to estimate the cost of capital.

Question 43

The weighted average cost of capital is calculated as: k' = ke [E/V] + kd (1 - te)[D/V]

Question 44

The cost of capital of a project should never be estimated based on another listed company,even if that company's sole operations are of the same systematic risk as the project being assessed.

Question 45

Issue costs should be included in the calculation of cost of capital.

Question 46

Bank overdraft is not included in the calculation of the WACC.

Question 47

For a diversified company,the use of the WACC is likely to result in incorrect investment decisions.