Question 1

Which of the following statements is CORRECT?

Accepted Answer

A)   Since the costs of internal and external equity are related, an increase in the flotation cost required to sell a new issue of stock will increase the cost of retained earnings.
B)   Since its stockholders are not directly responsible for paying a corporation's income taxes, corporations should focus on before-tax cash flows when calculating the WACC.
C)   An increase in a firm's tax rate will increase the component cost of debt, provided the YTM on the firm's bonds is not affected by the change in the tax rate.
D)   When the WACC is calculated, it should reflect the costs of new common stock, retained earnings, preferred stock, long-term debt, short-term bank loans if the firm normally finances with bank debt, and accounts payable if the firm normally has accounts payable on its balance sheet.
E)   If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the after-tax cost of debt. E

Question 2

Norris Enterprises, an all-equity firm, has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than the firm's average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT?

Accepted Answer

A)   The project should definitely be accepted because its expected return (before any risk adjustments)  is greater than its required return.
B)   The project should definitely be rejected because its expected return (before risk adjustment)  is less than its required return.
C)   Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment.
D)   The accept/reject decision depends on the firm's risk-adjustment policy. If Norris' policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project.
E)   Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision. D

Question 3

Trahan Lumber Company hired you to help estimate its cost of capital. You obtained the following data: D1 = $1.25; P0 = $27.50; g = 5.00% (constant); and F = 6.00%. What is the cost of equity raised by selling new common stock?

Accepted Answer

A)   9.06%
B)   9.44%
C)   9.84%
D)   10.23%
E)   10.64% C

Question 4

Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A's cost of capital is 10.0%, Division B's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A's projects are equally risky, as are all of Division B's projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept?

Accepted Answer

A)   A Division B project with a 13% return.
B)   A Division B project with a 12% return.
C)   A Division A project with an 11% return.
D)   A Division A project with a 9% return.
E)   A Division B project with an 11% return.

Question 5

If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.

Accepted Answer

A) True 
 B)False

Question 6

Assume that you are on the financial staff of Vanderheiden Inc., and you have collected the following data: The yield on the company's outstanding bonds is 7.75%, its tax rate is 40%, the next expected dividend is $0.65 a share, the dividend is expected to grow at a constant rate of 6.00% a year, the price of the stock is $15.00 per share, the flotation cost for selling new shares is F = 10%, and the target capital structure is 45% debt and 55% common equity. What is the firm's WACC, assuming it must issue new stock to finance its capital budget?

Accepted Answer

A)   6.89%
B)   7.26%
C)   7.64%
D)   8.04%
E)   8.44%

Question 7

Which of the following statements is CORRECT?

Accepted Answer

A)   In the WACC calculation, we must adjust the cost of preferred stock (the market yield)  to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income.
B)   We should use historical measures of the component costs from prior financings that are still outstanding when estimating a company's WACC for capital budgeting purposes.
C)   The cost of new equity (re)  could possibly be lower than the cost of retained earnings (rs)  if the market risk premium, risk-free rate, and the company's beta all decline by a sufficiently large amount.
D)   Its cost of retained earnings is the rate of return stockholders require on a firm's common stock.
E)   The component cost of preferred stock is expressed as rp(1 - T) , because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt.

Question 8

Based on the CAPM, what is the firm's cost of equity?

Accepted Answer

A)   11.15%
B)   11.73%
C)   12.35%
D)   13.00%
E)   13.65%

Question 9

Daves Inc. recently hired you as a consultant to estimate the company's WACC. You have obtained the following information. (1) The firm's noncallable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $1,000, and a market price of $1,050.00. (2) The company's tax rate is 40%. (3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock's beta is 1.20. (4) The target capital structure consists of 35% debt and the balance is common equity. The firm uses the CAPM to estimate the cost of equity, and it does not expect to issue any new common stock. What is its WACC?

Accepted Answer

A)   7.16%
B)   7.54%
C)   7.93%
D)   8.35%
E)   8.79%

Question 10

Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.

Accepted Answer

A)   If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms' assets.
B)   If a firm's managers want to maximize the value of the stock, they should, in theory, concentrate on project risk as measured by the standard deviation of the project's expected future cash flows.
C)   If a firm evaluates all projects using the same cost of capital, and the CAPM is used to help determine that cost, then its risk as measured by beta will probably decline over time.
D)   Projects with above-average risk typically have higher-than-average expected returns. Therefore, to maximize a firm's intrinsic value, its managers should favor high-beta projects over those with lower betas.
E)  Project A has a standard deviation of expected returns of 20%, while Project B’s standard deviation is only 10%.  A’s returns are negatively correlated with both the firm’s other assets and the returns on most stocks in the economy, while B’s returns are positively correlated.  Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital.

Question 11

Weaver Chocolate Co. expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, its expected constant dividend growth rate is 6.0%, and its common stock currently sells for $32.50 per share. New stock can be sold to the public at the current price, but a flotation cost of 5% would be incurred. What would be the cost of equity from new common stock?

Accepted Answer

A)   12.70%
B)   13.37%
C)   14.04%
D)   14.74%
E)   15.48%

Question 12

Bolster Foods' (BF) balance sheet shows a total of $25 million long-term debt with a coupon rate of 8.50%. The yield to maturity on this debt is 8.00%, and the debt has a total current market value of $27 million. The balance sheet also shows that the company has 10 million shares of stock, and the stock has a book value per share of $5.00. The current stock price is $20.00 per share, and stockholders' required rate of return, rs, is 12.25%. The company recently decided that its target capital structure should have 35% debt, with the balance being common equity. The tax rate is 40%. Calculate WACCs based on book, market, and target capital structures, and then find the sum of these three WACCs.

Accepted Answer

A)   28.36%
B)   29.54%
C)   30.77%
D)   32.00%
E)   33.28%

Question 13

Several years ago the Jakob Company sold a $1,000 par value, noncallable bond that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually. The bond currently sells for $925, and the company's tax rate is 40%. What is the component cost of debt for use in the WACC calculation?

Accepted Answer

A)   4.28%
B)   4.46%
C)   4.65%
D)   4.83%
E)   5.03%

Question 14

What is the best estimate of the firm's WACC?

Accepted Answer

A)   10.85%
B)   11.19%
C)   11.53%
D)   11.88%
E)   12.24%

Question 15

Keys Printing plans to issue a $1,000 par value, 20-year noncallable bond with a 7.00% annual coupon, paid semiannually. The company's marginal tax rate is 40.00%, but Congress is considering a change in the corporate tax rate to 30.00%. By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted?

Accepted Answer

A)   0.57%
B)   0.63%
C)   0.70%
D)   0.77%
E)   0.85%

Question 16

Firm M's earnings and stock price tend to move up and down with other firms in the S&P 500, while Firm W's earnings and stock price move counter cyclically with M and other S&P companies. Both M and W estimate their costs of equity using the CAPM, they have identical market values, their standard deviations of returns are identical, and they both finance only with common equity. Which of the following statements is CORRECT?

Accepted Answer

A)   M should have the lower WACC because it is like most other companies, and investors like that fact.
B)   M and W should have identical WACCs because their risks as measured by the standard deviation of returns are identical.
C)   If M and W merge, then the merged firm MW should have a WACC that is a simple average of M's and W's WACCs.
D)   Without additional information, it is impossible to predict what the merged firm's WACC would be if M and W merged.
E)   Since M and W move counter cyclically to one another, if they merged, the merged firm's WACC would be less than the simple average of the two firms' WACCs.

Question 17

When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs.

Accepted Answer

A) True 
 B)False

Question 18

You were hired as a consultant to Quigley Company, whose target capital structure is 35% debt, 10% preferred, and 55% common equity. The interest rate on new debt is 6.50%, the yield on the preferred is 6.00%, the cost of retained earnings is 11.25%, and the tax rate is 40%. The firm will not be issuing any new stock. What is Quigley's WACC?

Accepted Answer

A)   8.15%
B)   8.48%
C)   8.82%
D)   9.17%
E)   9.54%

Question 19

Bosio Inc.'s perpetual preferred stock sells for $97.50 per share, and it pays an $8.50 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is the company's cost of preferred stock for use in calculating the WACC?

Accepted Answer

A)   8.72%
B)   9.08%
C)   9.44%
D)   9.82%
E)   10.22%

Question 20

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.

Accepted Answer

A) True 
 B)False

Exam 11: Cost of Capital

Which of the following statements is CORRECT?

Trahan Lumber Company hired you to help estimate its cost of capital. You obtained the following data: D1 = $1.25; P0 = $27.50; g = 5.00% (constant) ; and F = 6.00%. What is the cost of equity raised by selling new common stock?

If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.

Which of the following statements is CORRECT?

Based on the CAPM, what is the firm's cost of equity?

Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.

What is the best estimate of the firm's WACC?

When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs.

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.