Deck 12: Long-Term Financing

Question 1

In an efficient market,a security with a beta of 0.98 will have a rate of return which lies:

A)on the SML just to the left of the market return
B)just below the security market line (SML)and to the left of the market return
C)above the SML just to the right of the market return
D)on the SML just to the right of the market return
E)just below the SML and to the right of the market return

Answer 1

on the SML just to the left of the market return

Question 2

Which one of the following represents the best estimate for a firm's pre-tax cost of debt?

A)the current coupon on the firm's existing debt
B)the firm's historical cost of capital
C)the current yield on the firm's existing debt
D)the current yield-to-maturity on the firm's existing debt
E)twice the rate of return currently offered on risk-free securities

Answer 2

the current yield-to-maturity on the firm's existing debt

Question 3

Horseless Carriages issued twenty-year,7 per cent semi-annual bonds eleven years ago.The bonds currently sell at 101.3 per cent of face value.What is the firm's after tax cost of debt if the tax rate is 34 per cent?

A)4.49 per cent
B)6.71 per cent
C)4.87 per cent
D)6.80 per cent
E)6.83 per cent

Answer 3

4.49 per cent

Question 4

A firm has a cost of equity of 10 per cent,a cost of preferred of 9 per cent,and an after tax cost of debt of 5 per cent.Given this,which one of the following will decrease the firm's cost of capital?

A)exercising the call option on the debt
B)decreasing the firm-specific risk associated with the firm
C)issuing new debt to offset an increase in the dividend payout ratio
D)increasing the systematic risk of the firm
E)decreasing the debt-equity ratio

Question 5

The 7 per cent preferred stock of Winslow and Winslow is selling for $54 a share.What is the firm's cost of preferred shares (face value $100)?

A)12.96 per cent
B)17.56 per cent
C)3.78 per cent
D)7.71 per cent
E)18.52 per cent

Question 6

Rainbow Mining Pty Ltd is concerned that opening a new credit line will affect its share price.Now the company has a risk return on its shares of 17.50%,determined by using a beta factor of 1.50.The risk free rate is 7%.What is the market risk premium based on the information given for Rainbow Mining?

A)11.86%
B)5.50%
C)7.00%
D)17.50%
E)10.50%

Question 7

When the management of a firm evaluates the risk of a proposed project and adjusts the firm's WACC based on that evaluation to ascertain the required return for the project,they are using the _____ approach.

A)pure play
B)insider
C)normative
D)divisional
E)subjective

Question 8

Which one of the following is a correct statement regarding a firm's weighted average cost of capital (WACC)?

A)The WACC will decrease when the tax rate decreases for all firms that utilise debt financing.
B)A reduction in the risk level of a firm will tend to increase the firm's WACC.
C)A 5 per cent increase in a firm's debt-equity ratio will tend to increase the firm's WACC.
D)The WACC can be used as the required return for all new projects with similar risk to that of the existing firm.
E)An increase in the market risk premium will tend to decrease a firm's WACC.

Question 9

When using the pure play approach,a firm is seeking a rate of return which:

A)will cause a project to have a positive net present value
B)is applicable to the risk level of the investment under consideration
C)is lower than its own cost of capital
D)matches the expected internal rate of return of the investment being considered
E)is based on book values rather than market values

Question 10

The proportional cost of equity plus the proportional after tax cost of debt is called the:

A)weighted average cost of capital
B)portfolio weight
C)debt-equity ratio
D)capital structure weight
E)pure play weight

Question 11

The Whitehorse Book Company has 140 million shares outstanding.The market price of one share is currently $2.The company's debentures are publicly traded and their market price is equal to 93% of its face value.The debentures have a total book value of $50 000 000 and the current yield to maturity of corporate debenture is 12% per annum.The risk-free rate is 8.50% and the market risk premium is 5.20%.Market analysts estimated that the Whitehorse Book Company has a beta of 0.90.The corporate tax rate is 30%.What is the company's weighted average cost of capital (WACC)under the classical tax system?

A)13.18%
B)11.10%
C)12.50%
D)14.24%
E)15.00%

Question 12

Calculate the after-tax return to a shareholder assuming a dividend imputation system is used in Australia (if the dividend is fully franked).The shareholder is currently subject to a marginal tax rate of 40% and receives a dividend of $700 per annum.The corporate tax rate is equal to 30%.

A)$350
B)$600
C)$700
D)$420
E)$490

Question 13

Rainbow Mining Pty Ltd is concerned that opening a new credit line will affect its share price.Now the company has a risk return on its shares of 17.50%,determined by using a beta factor of 1.50.The risk free rate is 7%.
What is the risk premium for Rainbow Mining?

A)10.50%
B)5.50%
C)7.00%
D)10.00%
E)16.00%

Question 14

The cost of capital for a project should:

A)be adjusted based on the size of the project
B)remain constant even if a decision on accepting the project is delayed for two years
C)meet or exceed the internal rate of return of the project
D)never exceed the cost of capital for the overall firm
E)be adjusted based on the risk of the project

Question 15

An increase in the market value of a preferred share will _____ the cost of the preferred share.

A)increase
B)not affect
C)either increase or decrease
D)decrease
E)either not affect or increase

Question 16

Using the weighted average cost of capital (WACC)of another firm,one which is focused on the type of project you are considering,rather than using your own firm's WACC is called the:

A)insider's look
B)divisional approach
C)competitor's game
D)pure play approach
E)project divisor

Question 17

The Whitehorse Book Company has 140 million shares outstanding.The market price of one share is currently $2.The company's debentures are publicly traded and their market price is equal to 93% of its face value.The debentures have a total book value of $50 000 000 and the current yield to maturity of corporate debenture is 12% per annum.The risk-free rate is 8.50% and the market risk premium is 5.20%.Market analysts estimated that the Whitehorse Book Company has a beta of 0.90.The corporate tax rate is 30%.What is the company's weighted average cost of capital (WACC)considering the imputation tax system?

A)8.51%
B)9.11%
C)12.15%
D)13.18%
E)7.70%

Question 18

Nesquik and Newton have 75 000 shares outstanding.The stock is currently selling for $57 a share.The firm also has two bond issues outstanding.The first bond issue has a total face value of $500 000 and pays 8 per cent interest annually.This bond is selling at 102.4 per cent of face value.The second bond issue consists of 10 000 bonds which are selling for $990 each.These bonds pay 7 per cent interest annually and mature in 15 years.The cost of debt is 34 per cent.What is the capital structure weight of the firm's common stock?

A)30.30 per cent
B)33.33 per cent
C)31.09 per cent
D)29.11 per cent
E)27.84 per cent

Question 19

Nelson Enterprises just paid an annual dividend of $1.56 per share.This dividend is expected to increase by 3 per cent annually.Currently,the firm has a beta of 1.13 and a stock price of $28 a share.The risk-free rate is 3 per cent and the market rate of return is 10.5 per cent.What is your best estimate of Nelson's cost of equity?

A)10.11 per cent
B)9.38 per cent
C)9.72 per cent
D)11.48 per cent
E)8.74 per cent

Question 20

The PMP Insurance Company preference shares are trading on the ASX at $9 each and a dividend of 63 cents has just been paid.The face value of the issue is $10.What is the cost of preference shares for PMP?

A)6.30%
B)9.00%
C)1.11%
D)14.29%
E)7.00%

Question 21

Fancee Restaurant's cost of equity is 15.3 per cent and its after-tax cost of debt is 6.1 per cent.What is the firm's weighted average cost of capital if its debt-equity ratio is 0.58 and the tax rate is 30 per cent? Assume a classical tax system.

A)11.92 per cent
B)13.01 per cent
C)10.36 per cent
D)12.28 per cent
E)8.94 per cent

Question 22

Which one of the following statements is correct,all else held constant?

A)A decrease in a firm's WACC will increase the attractiveness of the firm's investment options.
B)WACC is only applicable to firms that issue both common and preference shares.
C)Beta is used to compute the return on equity and the standard deviation is used to compute the return on preference shares.
D)If you have both the dividend growth and the security market line's costs of equity,you should use the higher of the two estimates when computing WACC.
E)The after-tax cost of debt increases when the market price of a bond increases.

Question 23

A firm has a return on equity of 12.4 per cent according to the dividend growth model and a return of 18.7 per cent according to the capital asset pricing model.The market rate of return is 13.5 per cent.What rate should the firm use as the cost of equity when computing the firm's WACC?

A)13.5 per cent
B)18.7 per cent because it is higher than 12.4 per cent
C)The arithmetic average of 12.4 per cent,13.5 per cent,and 18.7 per cent
D)12.4 per cent because it is lower than 18.7 per cent
E)The arithmetic average of 12.4 per cent and 18.7 per cent

Question 24

The weighted average cost of capital is defined as the weighted average of a firm's:

A)pre-tax cost of debt and equity securities
B)dividend and capital gains yields
C)cost of equity and its after-tax cost of debt
D)bond coupon rates
E)return on its investments

Question 25

Smith and Jones has two separate divisions.Division X produces custom work on a pre-paid basis only for long-term customers and therefore,is subject to less risk than division Y.The company has assigned a discount rate equal to the firm's WACC minus 2 per cent to division X and a rate equal to the firm's WACC plus 3 per cent to division Y.The company has a debt-equity ratio of 0.65 and a tax rate of 35 per cent.The cost of equity is 9 per cent and the after tax cost of debt is 5 per cent.Presently,each division is considering a new project.Division Y's project provides a 9.5 per cent rate of return and division X's project provides a 6.2 per cent return.Which projects,if either,should the company accept? Assume a classical tax system.

A)accept X and reject Y
B)accept both X and Y
C)reject both X and Y
D)the answer cannot be determined without additional information
E)reject X and accept Y

Question 26

A firm has a cost of equity of 13 per cent,a cost of preferred of 11 per cent,and an after-tax cost of debt of 6 per cent.Given this,which one of the following will increase the firm's weighted average cost of capital?

A)redeeming shares of common stock
B)increasing the firm's beta
C)increasing the firm's tax rate
D)increasing the debt-equity ratio
E)issuing new bonds at par

Question 27

Which of the following features are advantages of the dividend growth model?
I.easy to understand
II.model simplicity
III.constant dividend growth rate
IV.model's applicability to all common stocks

A)I and II only
B)I,II and III only
C)II only
D)II and IV only
E)I and III only

Question 28

Katie owns 100 shares of ABC stock.Which one of the following terms is used to refer to the return that Katie and the other shareholders require on their investment in ABC?

A)cost of debt
B)subjective cost
C)weighted average cost of capital
D)pure play cost
E)cost of equity

Question 29

Black Stone Furnaces wants to build a new facility.The cost of capital for this investment is primarily dependent upon which one of the following?

A)source of the funds used to build the facility
B)firm's overall source of funds
C)current tax rate
D)the nature of the investment
E)firm's historical average rate of return

Question 30

Western Electric has 23 000 shares of common stock outstanding at a price per share of $57 and a rate of return of 14.2 per cent.The firm has 6000 shares of 7 per cent preferred stock outstanding at a price of $48 a share.The preferred stock has a par value of $100.The outstanding debt has a total face value of $350 000 and currently sells for 102 per cent of face.The yield-to-maturity on the debt is 8.49 per cent.What is the firm's weighted average cost of capital if the tax rate is 34 per cent? Assume a classical tax system.

A)12.69 per cent
B)14.47 per cent
C)14.92 per cent
D)13.44 per cent
E)14.19 per cent

Question 31

The General Store has a cost of equity of 15.8 per cent,a pre-tax cost of debt of 7.7 per cent,and a tax rate of 32 per cent.What is the firm's weighted average cost of capital if the debt-equity ratio is 0.40,assuming a classical tax system?

A)12.78 per cent
B)10.18 per cent
C)14.93 per cent
D)13.30 per cent
E)11.72 per cent

Question 32

Ted is trying to decide what cost of capital he should assign to a project.Which one of the following should be his primary consideration in this decision?

A)mix of funds used to finance the project
B)length of the project's life
C)use,or lack thereof,of preferred stock to finance the project
D)amount of debt used to finance the project
E)risk level of the project

Question 33

Which one of the following statements is correct related to the dividend growth model approach to computing the cost of equity?

A)The annual dividend used in the computation must be for year one if you are using today's stock price to compute the return.
B)The rate of growth must exceed the required rate of return.
C)The cost of equity is equal to the return on the stock plus the risk-free rate.
D)The cost of equity is equal to the return on the stock multiplied by the stock's beta.
E)The rate of return must be adjusted for taxes.

Question 34

Which one of the following represents the rate of return a firm must earn on its assets if it is to maintain the current value of its securities?

A)debt-equity ratio
B)after-tax cost of debt
C)internal rate of return
D)cost of equity
E)weighted average cost of capital

Question 35

Which one of the following will affect the capital structure weights used to compute a firm's weighted average cost of capital?

A)decrease in a firm's tax rate
B)increase in the market risk premium
C)increase in the market value of the firm's ordinary shares
D)increase in the firm's beta
E)decrease in the book value of a firm's equity

Question 36

Which one of the following statements is correct concerning capital structure weights?

A)The issuance of additional shares of ordinary shares will increase the weight of the preferred shares.
B)An increase in the debt-equity ratio will increase the weight of the ordinary shares.
C)Target rates are less relevant to a project than historical rates are.
D)The repurchase of preferred shares will increase the weight of debt.
E)The weights are unaffected when a bond issue matures.

Question 37

Which one of the following statements is correct? Assume the pre-tax cost of debt is less than the cost of equity.

A)A firm may change its capital structure if the government changes its tax policies.
B)The cost of preferred stock decreases when the tax rate increases.
C)A decrease in the systematic risk of a firm will increase the firm's cost of capital.
D)A decrease in a firm's debt-equity ratio will decrease the firm's cost of capital.
E)A decrease in the dividend growth rate increases the cost of equity.

Question 38

Aaron's Rentals has 58 000 common shares outstanding at a market price of $36 a share.The shares have just paid a $1.64 annual dividend and have a dividend growth rate of 2.8 per cent.There are 12 000 shares with a 6 per cent preference,outstanding at a market price of $51 a share.The preferred shares have a par value of $100.The outstanding bonds mature in 17 years,have a total face value of $750 000,a face value per bond of $1000,and a market price of $1011 each.The bonds pay 8 per cent interest,semi-annually.The tax rate is 34 per cent.What is the firm's weighted average cost of capital assuming a classical tax rate?

A)9.29 per cent
B)7.74 per cent
C)9.97 per cent
D)10.30 per cent
E)8.68 per cent

Question 39

Southwest Tours currently has a weighted average cost of capital of 11.3 per cent based on a combination of debt and equity financing.The firm has no preference shares.The current debt-equity ratio is 0.58 and the after-tax cost of debt is 6.4 per cent.The company just hired a new CEO who is considering eliminating all debt financing.All else constant,what will the firm's cost of capital be if the firm switches to an all-equity firm?

A)12.89 per cent
B)11.45 per cent
C)12.62 per cent
D)14.14 per cent
E)13.37 per cent

Question 40

Musical Charts just paid an annual dividend of $2.45 per share.This dividend is expected to increase by 3.3 per cent annually.Currently,the firm has a beta of 1.09 and a stock price of $36 a share.The risk-free rate is 4.2 per cent and the market rate of return is 12.6 per cent.What is the cost of equity capital for this firm?

A)12.29 per cent
B)11.84 per cent
C)10.28 per cent
D)12.95 per cent
E)13.42 per cent

Question 41

Western Australian Mining Pty Ltd,an Australian listed company,has 5 000 000 ordinary shares outstanding and the current market price per share is $6.50.The required rate of return for the ordinary shares is estimated to be 16%.They have issued bonds with a face value of $15 000 000 but the current market value based on a yield to maturity of 9.5% is $14 950 233.If the corporate tax rate is 30% what is the weighted average cost of capital assuming a classical tax system?

A)13.06%
B)9.77%
C)8.93%
D)12.75%
E)11.33%

Question 42

Kate is the CFO of a major firm and has the job of assigning discount rates to each project that is under consideration.Kate's method of doing this is to assign an incrementally higher rate as the risk level of the project increases over that of the current firm.Likewise,she assigns lower rates as the risk level declines.Which one of the following approaches is Kate using to assign the discount rates?

A)subjective approach
B)straight WACC approach
C)divisional rating
D)pure play approach
E)equity rating

Question 43

Pacific Coast Mining Pty Ltd,an Australian listed company,has 1 000 000 ordinary shares outstanding and the current market price per share is $13.The required rate of return for the ordinary shares is estimated to be 12%.They have issued bonds with a face value of $8 000 000 but the current market value based on a yield to maturity of 7.5% is $7 750 250.If the corporate tax rate is 30% what is the weighted average cost of capital assuming a classical tax system?

A)6.83%
B)7.22%
C)9.75%
D)9.48%
E)10.32%

Question 44

All else constant,the weighted average cost of capital for a risky,levered firm will decrease if:

A)the dividend yield on the ordinary shares increases
B)corporate taxes are eliminated
C)the firm replaces some of its debt with preferred shares
D)the firm's bonds start selling at a premium rather than at a discount
E)the market risk premium increases

Question 45

Pacific Coast Mining Pty Ltd,an Australian listed company,has 1 000 000 ordinary shares outstanding and the current market price per share is $13.The required rate of return for the ordinary shares is estimated to be 12%.They have issued bonds with a face value of $8 000 000 but the current market value based on a yield to maturity of 7.5% is $7 750 250.If the corporate tax rate is 30% what is the weighted average cost of capital assuming an imputation tax system? Assume all registered shareholders are Australian residents and all dividends are fully franked.

A)7.22%
B)10.32%
C)9.48%
D)6.83%
E)9.75%

Question 46

Which one of the following statements is accurate for a levered firm?

A)A firm's WACC will decrease whenever the firm's tax rate decreases.
B)The subjective approach totally ignores a firm's own WACC.
C)WACC should be used as the required return for all proposed investments.
D)An increase in the market risk premium will decrease a firm's WACC.
E)A reduction in the risk level of a firm will tend to decrease the firm's WACC.

Question 47

Western Australian Mining Pty Ltd,an Australian listed company,has 5 000 000 ordinary shares outstanding and the current market price per share is $6.50.The required rate of return for the ordinary shares is estimated to be 16%.They have issued bonds with a face value of $15 000 000 but the current market value based on a yield to maturity of 9.5% is $14 950 233.If the corporate tax rate is 30% what is the weighted average cost of capital assuming an imputation tax system? Assume all registered shareholders are Australian residents and all dividends are fully franked.

A)13.06%
B)12.75%
C)8.93%
D)11.33%
E)9.77%

Question 48

A firm that uses its weighted average cost of capital as the required return for all of its investments will:

A)maintain a constant value for its shareholders
B)increase the risk level of the firm over time
C)make the best possible accept and reject decisions related to those investments
D)find that its cost of capital declines over time
E)accept only the projects that add value to the firm's shareholders

Question 49

A firm uses its weighted average cost of capital to evaluate the proposed projects for all of its varying divisions.By doing so,the firm:

A)automatically maximises the total value created for its shareholders
B)allocates capital funds evenly amongst its divisions
C)encourages the division managers to only recommend their most conservative projects
D)maintains the current risk level and capital structure of the firm
E)automatically gives preferential treatment in the allocation of funds to its riskiest division

Question 50

Pacific Coast Fishing and Camping Stores Pty Ltd is considering opening a clothing store,which would be a new line of business for the company.Management has decided to use the cost of capital of a similar clothing store as the discount rate that should be used to evaluate this proposed expansion.Which one of the following terms is used to describe the approach Pacific Coast is taking to establish an appropriate discount rate for the project?

A)subjective approach
B)equity approach
C)market play
D)pure play approach
E)after-tax approach