Deck 20: Cost of Capital

Question 1

A firm has a capital structure that uses 45 percent equity,20 percent preferred shares,and 35 percent debt.The preferred shares have a current yield of 5.5 percent.The debt has a coupon rate of 10 percent and a current yield to maturity of 6.5 percent.The common shares have a yield of 8 percent.There are no taxes.What is the firm's WACC?
a) 6.575%
b) 6.975%
c) 7.275%
d) 8.200%

Answer 1

b,0.45*8% + .20*5.5% + .35*6.5% = 6.975%

Question 2

A firm's cost of debt can best be estimated:

A) by adding a risk premium to the coupon rate.
B) using the yield-to-maturity on newly issued debt of other firms.
C) using the firm's borrowing rate on short-term loans.
D) using the yield-to-maturity on the firm's outstanding debt.

Answer 2

D

Question 3

A firm has 2 million shares outstanding,which are currently trading at $45 per share and have a dividend yield of 10 percent.The firm also has $40 million of 6 percent bonds outstanding that are currently trading at 110 with a 5-year maturity.There are no preferred shares and no taxes.What is the WACC?
a) 7.70%
b) 7.85%
c) 7.95%
d) 8.77%

Answer 3

c,(.1*90 + .03768*44)/(45*2 + 40*110%)= 7.95%

Question 4

Argus Mining Company is financed by $2 million in debt (yield of 8%)and $1 million in equity (returning a rate of 22%).If we assume no taxes and perpetual cash flows,what level of earnings must Argus Mining Company earn in order to be considered a value-creating company?
a) $0.38 million
b) $0.40 million
c) $0.52 million
d) $0.63 million

Question 5

A firm has a capital structure that uses 45 percent equity,20 percent preferred shares,and 35 percent debt.The preferred shares have a current yield of 5.5 percent.The debt has a coupon rate of 10 percent and a current yield to maturity of 6.5 percent.The common shares have a yield of 8 percent.The tax rate is 25 percent.What is the firm's WACC?
a) 5.231%
b) 6.700%
c) 6.406%
d) 6.975%

Question 6

Use the following statements to answer this question:
I)Without taxes,the benefit of having debt on the WACC largely vanishes.
II)Preferred shares cost the same as common equity financing.

A) I and II are correct.
B) I and II are incorrect.
C) I is correct and II is incorrect.
D) I is incorrect and II is correct.

Question 7

Using the following information,determine the market-to-book ratio for Montreal Computing Power Company.

Montreal Computing Power Company has 1,000 common shares outstanding.The shares were issued 10 years ago at $4 per share and currently trade at a price of $3.
a) 0.667
b) 0.933
c) 1.400
d) 1.500

Question 8

Which of the following is not needed to determine a firm's WACC?

A) The book value of the equity.
B) The market value of the debt.
C) The current share price.
D) The current yield on preferred shares.

Question 9

In the same question above,what would be the WACC if taxes are included at a corporate tax rate of 40%?
a) 10.333%
b) 9.050%
c) 7.825%
d) 6.915%

Question 10

Using the following information,determine the debt-to-equity ratio for Montreal Computing Power Company.

a) 1.400
b) 1.525
c) 1.775
d) 1.950

Question 11

MinMax Corp has the following capital structure: 55% equity (giving a return of 9%),10% preferred shares (with a yield of 6%),and 35% debt (with a coupon rate of 10% and yield to maturity of 6.5%).If there are no taxes,what is the firm's WACC?
a) 10.333%
b) 9.050%
c) 7.825%
d) 6.915%

Question 12

Use the following statements to answer this question:
I)Regulated industries offer their shareholders a limited required rate of return.
II)Regulated industries have a very low level of debt.

A) I and II are correct.
B) I and II are incorrect.
C) I is correct and II is incorrect.
D) I is incorrect and II is correct.

Question 13

An analyst has obtained the following information about Maudite Brewers Co.: Book value of assets $25,000; book value of common equity $10,000; book value of preferred shares $5,000.The company has 4,000 common shares outstanding which are currently trading at $5 per share.The company has 3,000 preferred shares outstanding which are currently trading at $2 per share.The yield on the debt equals the coupon rate.The weights used to determine the weighted average cost of capital are:
Common Equity: Preferred Equity: Debt:
a) 55.56% 16.67% 27.77%
b) 40% 20% 40%
c) 80% 10% 10%
d) Cannot be determined because we need the market value of debt.

Question 14

In estimating a firm's cost of debt,which of the following should be used?

A) The yield to maturity when the bonds were issued.
B) The yield to maturity of the bonds based on current bond prices.
C) The coupon rate payable on the bonds.
D) None of the above.

Question 15

Which of the following statements is incorrect regarding the equity portion of the WACC?

A) Preferred equity is separate from common equity
B) Market values rather than book values should be used
C) Retained earnings is not included
D) Equity has a tax shield as well as debt

Question 16

Greengrocer Foods will pay a dividend of $3.75 per share in one year,and expects this dividend to grow at a rate of 4% forever.If its common shares are currently trading at $50,what is the cost of Greengrocer Foods' equity?
a) 7.50%
b) 11.50%
c) 12.25%
d) 15.75%

Question 17

The required rate of return on Montreal Computing Power's equity is 15 percent and the yield on their debt is 7 percent.There are no taxes and all cash flows are perpetuities.If the value of the debt is $1,000 and value of the equity is $1,000,what level of earnings must Montreal Computing Power earn in order to support the current valuation?
a) $290
b) $300
c) $330
d) $220

Question 18

Which one of the following is true about book and market values?

A) Book-to-market values provide information about the efficient use of assets.
B) A high book to market ratio is well perceived by the market.
C) If the return on equity is lower than the required rate of return, the market-to-book ratio will decrease.
D) Determining prices in regulated industries depends on the market value of assets.

Question 19

Which of the following is the least permanent source of capital for a firm?

A) A 10% coupon bond purchased 3 years ago
B) Preferred shares
C) 10% coupon bonds issued 10 years ago
D) Accounts payable

Question 20

A firm has 2 million shares outstanding,which are currently trading at $45 per share and have a dividend yield of 10 percent.The firm also has $40 million of 6 percent bonds outstanding that are currently trading at 110,with a yield to maturity of 3 percent.There are no preferred shares and no taxes.What is the WACC?
a) 7.70%
b) 7.85%
c) 8.69%
d) 8.77%

Question 21

Toronto Skaters Co.has a return on equity of 8 percent and pays out 20 percent of its earnings in dividends.The expected growth in dividends is:
a) 1.6%
b) 6.4%
c) 8%
d) 20%

Question 22

Use the following statements to answer this question:
I)The source of volatility in operating income is caused by fixed costs.
II)Operating leverage does not necessarily increase with increases in the volatility of net income.

A) I and II are correct.
B) I and II are incorrect.
C) I is correct and II is incorrect.
D) I is incorrect and II is correct.

Question 23

Poutine Company is considering offering long-term contracts to many of its non-contract employees (a switch to fixed labour costs from variable labour costs).What is the impact of this decision?

A) The increase in operating leverage results in greater variability in operating income.
B) The increase in operating leverage results in less variability in operating income.
C) The decrease in operating leverage results in greater variability in operating income.
D) The decrease in operating leverage results in less variability in operating income.

Question 24

According to The Boston Consulting Group,a firm with a low present value of existing operations but a high present value of growth opportunities would be classified as:

A) A dog
B) A cash cow
C) A star
D) A turnaround firm

Question 25

A company with a capital structure having a D/E ratio of 0.5 has:
a) 66.66% debt
b) 66.66% equity
c) 33.33% equity
d) 50.00% debt

Question 26

The return on equity of KillerApps Inc.is 20 percent of which it pays out 30 percent as dividends,and reinvests the rest in the company.The company is expected to pay a dividend of $1.50 next year and the current stock price is $30.The cost of equity of KillerApps is:
a) 15%
b) 17%
c) 19%
d) 21%

Question 27

If a company increases the proportion of debt in a firm's capital structure,then:

A) the increased debt is not covered by the tax shield.
B) holders of common shares will expect a higher rate of return
C) the company's equity beta will decrease
D) the firm's WACC remains unchanged.

Question 28

If a firm's debt-to-equity ratio is 3,what is the weighted average cost of capital for the firm if the required rate of return is 12.4 percent and cost of debt is 8.4 percent?
a) 11.4%
b) 11.06%
c) 9.73%
d) 9.4%

Question 29

Toronto Skaters Company is an all-equity company and is able to fund a $1 million investment using cash.The company has a beta of 1.4,the risk-free rate is 3 percent,and the return on the market is 8 percent.Flotation costs for new equity are 3 percent.The tax rate is zero.The appropriate cost of capital is:

A) 0% as the firm is using cash.
B) 0% as the firm is using funds that have already been raised from the capital markets.
C) The required return on the outstanding equity.
D) The cost of equity taking into account the flotation costs.

Question 30

James Bay Water Park Company's preferred shares pay an annual dividend of $3 per share.What is the cost of preferred stock if the current price is $80 per share and after-tax flotation costs are $6 per share?
a) 4.05%
b) 3.75%
c) 7.50%
d) 7.79%

Question 31

The management of James Bay Water Park is concerned about the volatility of the firm's net income.In order to reduce this volatility,they are planning on issuing new shares to repurchase debt and to enter into more fixed contracts with suppliers.The effect of these actions is likely to be:

A) A reduction of volatility of net income due to the reduction in financial leverage.
B) An increase in volatility of net income due to the reduction in financial leverage.
C) A reduction of volatility of net income due to the reduction in financial leverage and increase in operating leverage.
D) The impact on the volatility of net income is unclear as the effects of the reduction in financial leverage and increase in operating leverage are opposite.

Question 32

Toronto Skaters Company is an all-equity company and is able to fund a $1 million investment using cash.The company has a beta of 1.4,the risk-free rate is 3 percent,and the return on the market is 8 percent.Flotation costs for new equity are 2 percent.The tax rate is 40 percent.What is the WACC of the investment?
a) 14.2%
b) 10%
c) 8%
d) 6.6%

Question 33

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

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

Question 34

Laurentide Union Bank is expected to pay a dividend of $4.20 per share in one year.The dividend is expected to grow at a rate of 5 percent forever.If the current market price for a share of Laurentide Union Bank is $40,what is the cost of equity?
a) 5.00%
b) 9.52%
c) 10.50%
d) 15.50%

Question 35

According to The Boston Consulting Group,a star is characterized by:

A) High present value of operations now and low present value of growth opportunities
B) High present value of operations now and high present value of growth opportunities
C) Low present value of operations now and low present value of growth opportunities
D) Low present value of operations now and high present value of growth opportunities

Question 36

Use the following statements to answer this question:
I)The cost of debt of the firm is always constant.
II)The estimation of the cost of debt using the yield to maturity requires the price of the bonds now.

A) I and II are correct.
B) I and II are incorrect.
C) I is correct and II is incorrect.
D) I is incorrect and II is correct.

Question 37

Which of the following statements is/are true about the marginal cost of capital?

A) It is the weighted average cost of the next dollar of financing raised.
B) For most levels of financing, it equals the weighted average cost of capital.
C) It exceeds the weighted average cost of capital due to flotation costs.
D) All of the above are true.

Question 38

The long-term debt of Laurentide Union Bank is currently selling for 103 percent of its face value.The issue matures in 20 years and pays an annual coupon of 8 percent of face.The corporate tax rate is 40 percent.What is the after-tax cost of debt for Laurentide Union?
a) 3.08%
b) 4.62%
c) 4.80%
d) 7.70%

Question 39

The cost of a security to a company may differ from the security's yield in the capital markets due to:
I)Flotation costs
II)Agency costs
III)Taxes

A) I only
B) I and II only
C) I and III only
D) I and II and III

Question 40

Which of the following is most relevant for estimating a firm's cost of debt?

A) The yield to maturity at issuance.
B) The return bondholders would demand for new debt.
C) The coupon rate on existing debt.
D) None of the above is relevant.

Question 41

Montreal Trustco expects to pay a dividend of $5 next year.Dividends are expected to grow at 3 percent forever and the market requires a rate of return of 7 percent on its stock.Montreal Trustco can issue new stock at $125 per share with flotation costs of $20 per share.The tax rate is zero.The cost of issuing new equity to Montreal Trustco is:
a) 3.00%
b) 7.00%
c) 7.76%
d) 11.76%

Question 42

The Third Cup Company has a return on equity of 10 percent and pays out 30 percent of its earnings as dividends.The company is expected to pay a dividend of $2 next year and the current stock price is $20.The cost of equity of The Third Cup Company is:
a) 17%
b) 13%
c) 10%
d) 7%

Question 43

The manager of Montreal Trustco has noticed that as he increases the dividend payout ratio,the value of the firm's equity increases.This is most likely due to:

A) The firm's return on equity is lower than the required return on equity
B) The firm's return on equity is higher than the required return on equity
C) The firm's return on equity is equal to the required return on equity
D) None of the above is a likely explanation.

Question 44

Activa Sports Gyms is considering a project that is virtually risk-free.It has a beta of 1.5 and a D/E ratio of 0.6.The appropriate discount rate to use in analyzing this project is:

A) The cost of equity computed from its beta.
B) The adjusted WACC based on a beta of 1.0.
C) The WACC based on market values.
D) The Treasury-bill rate.

Question 45

Use the following statements to answer this question:
I)A firm's growth depends on its reinvestment opportunities.
II)Increasing the firm's retention ratio does not always increase the value of the firm.

A) I and II are correct.
B) I and II are incorrect.
C) I is correct and II is incorrect.
D) I is incorrect and II is correct.

Question 46

The Third Cup Company has just paid a dividend of $3 per share.The dividends are expected to grow at a rate of 4 percent per year forever.The current stock price is $25 per share.The firm faces a tax rate of 40 percent and flotation costs of 5 percent on new stock issues.The cost of equity for internal funds is:
a) 9.89%
b) 10.12%
c) 16.48%
d) 16.87%

Question 47

Laurentide Resort has just paid a dividend of $3.The current stock price is $25.The beta of the company is 1.3,the risk-free rate is 2 percent,and the market risk premium is 6 percent.The firm earns a return on equity of 10%.Is this a growth firm?

Question 48

The CFO of Cynergy Inc.decides to recalculate the company's WACC based on higher growth expectations for the firm,thus making the new WACC:

A) Lower than the previous WACC because the cost of debt decreases.
B) Lower than the previous WACC because the cost of equity decreases.
C) Higher than the previous WACC because the cost of debt increases.
D) Higher than the previous WACC because the cost of equity increases.

Question 49

The Third Cup Company has just paid a dividend of $3 per share.The dividends are expected to grow at a rate of 4 percent per year forever.The current stock price is $25 per share.The firm faces a tax rate of 40 percent and flotation costs of 5 percent on new stock issues.The cost of equity for new funds is:
a) 9.89%
b) 10.12%
c) 16.48%
d) 16.87%

Question 50

According to The Boston Consulting Group,a cash cow is characterized by:

A) High present value of existing operations and low present value of growth opportunities
B) High present value of existing operations and high present value of growth opportunities
C) Low present value of existing operations and low present value of growth opportunities
D) Low present value of existing operations and high present value of growth opportunities

Question 51

The Saguenay Tourism Company has a beta of .80,the risk-free rate is 4 percent,and the market risk premium is 6 percent.The required return on the firm's equity is:
a) 4.0%
b) 5.6%
c) 8.8%
d) 6.0%

Question 52

Toronto Skaters Company has a D/E ratio of 1.5.The company has 1,000 shares outstanding and a beta of 1.2.The risk-free rate is 3 percent and the market risk premium is 5 percent.The company has 10-year debt with a face value of $1 million and annual coupons of 4 percent.The debt is currently trading at 105.The tax rate is 35 percent.Calculate the weighted average cost of capital for Toronto Skaters Company.

Question 53

The current T-Bill rate is 3%,and the market risk premium is 9%.If Arabica Coffee Company has a beta of 1.75,its required return on equity is:
a) 9.0%
b) 13.50%
c) 15.75%
d) 18.75%

Question 54

The Saguenay Tourism Company has a beta of 1.30,the risk-free rate is 3 percent,and the return on the market is 4 percent.The required return on the firm's equity is:
a) 3.9%
b) 6.5%
c) 4.30%
d) 9.50%

Question 55

The manager of Montreal Trustco has noticed that as he increases the dividend payout ratio,the value of the firm's equity declines.This is most likely due to:

A) The firm's return on equity is lower than the required return on equity
B) The firm's return on equity is higher than the required return on equity
C) The firm's return on equity is equal to the required return on equity
D) None of the above is a likely explanation

Question 56

A firm is going to finance a new project 100 percent with debt,through a new bond issue.Since the firm is only using debt to finance the project,the NPV of the project should be calculated using the cost of debt as the discount rate.Is this statement true,false,or uncertain? Explain.

Question 57

The Saguenay Tourism Company is an all-equity company and is able to fund a $1 million investment using cash.The company has a beta of 1.4,the risk-free rate is 2 percent,and the return on the market is 8 percent.Flotation costs for new equity are 5 percent.The tax rate is zero.The appropriate cost of capital is:
a) 0.00%
b) 5.00%
c) 10.40%
d) Greater than 10.40%

Question 58

Use the following statements to answer this question:
I)The WACC is the most appropriate rate to discount future cash flows of average risk.
II)The investment opportunities schedule uses WACC as a threshold for investment.

A) I and II are correct.
B) I and II are incorrect.
C) I is correct and II is incorrect.
D) I is incorrect and II is correct.

Question 59

The Montreal Film Festival Company has a book value per share of $10 and a current return on equity of 7 percent.The firm expects to invest $100 next year and earn a return of 10 percent on that investment.The market requires a rate of return of 5 percent on the firm's equity.The present value of existing opportunities and the present value of growth opportunities are:
a) PVEO = $95.24; PVGO = $14.00
b) PVEO = $14.00; PVGO = $95.24
c) PVEO = $10.00; PVGO = $100.00
d) PVEO = $100.00; PVGO = $10.00

Question 60

Cynergy Inc.currently has a debt-equity ratio of 0.70,an after-tax cost of debt of 7.5%,and a cost of equity of 14%.If the firm changes its debt-equity ratio to 0.40,it will:

A) Decrease the firm's WACC.
B) Increase the firm's total debt.
C) Cause the NPV of projects under consideration to decrease.
D) Not have an effect on the firm's capital budgeting decisions.

Question 61

What is the cost of internally generated funds?

Question 62

Pataty Patata Company is considering a project that costs $1 million.The project will generate constant perpetual earnings.The firm has just paid a dividend of $5 and dividends are expected to be constant forever.The current value of one share is $25.The firm has 100,000 shares outstanding.The firm also has perpetual debt with a market value of $3 million and annual coupons of $300,000.The firm pays taxes at the rate of 35%.The firm will not need to issue new securities to finance the project.Determine the minimum annual cash flows that must be generated by the project in order for the project to be undertaken.Demonstrate that the project will satisfy the requirements of the capital providers.

Question 63

Multiplex Entertainment has 9 million shares outstanding,250,000 shares of 6% preferred stock,and 105,000 semi-annual bonds at 7.5% (with par value of $1000 each).Common stock sells at $34/share (beta 1.25),preferred stock at $91/share,and the bonds at 93% of par with 15 years to maturity.The market risk premium is 8.5%,T-Bills are yielding 5%,and the corporate tax rate is 35%.What is the Multiplex Entertainment's WACC?
If Multiplex Entertainment is evaluating a new investment project with the same risk as the firm's typical projects,what should the firm use to discount the project's cash flows?

Question 64

Explain the reasoning behind the Fed's stock valuation model and how it estimates the overvaluation or undervaluation of the stock market.