Question 1

A firm has 1,000,000 shares of common stock outstanding, each with a market price of $10.00 per share. It has 15,000 bonds outstanding, each selling for $900 (with a face value of $1,000). The bonds mature in 15 years, have a coupon rate of 10 percent, and pay coupons semi-annually. The firm's equity has a beta of 1.5, and the expected market return is 20 percent. The tax rate is 35 percent and the WACC is 16 percent. What is the risk-free rate?

Accepted Answer

A) 4.8 percent 
B) 11.4 percent 
C) 27.6 percent 
D) 30.0 percent

Question 2

A proxy beta is:

Accepted Answer

A) the average beta of firms that are only engaged in the proposed new line of business. 
B) the industry average beta that is used in lieu of the firm's beta because the firm has not existed long enough to have a beta calculated. 
C) the beta used when the firm has a great deal of business risk. 
D) None of these answers are correct.

Question 3

FlavR Co. stock has a beta of 2.0, the current risk-free rate is 2, and the expected return on the market is 9 percent. What is FlavR Co's cost of equity?

Accepted Answer

A) 11 percent 
B) 13 percent 
C) 16 percent 
D) 20 percent

Question 4

A firm uses only debt and equity in its capital structure. The firm's weight of debt is 45 percent. The firm could issue new bonds at a yield to maturity of 10 percent and the firm has a tax rate of 30 percent. If the firm's WACC is 12 percent, what is the firm's cost of equity?

Accepted Answer

A) 16.09 percent 
B) 15.63 percent 
C) 15.21 percent 
D) 14.57 percent

Question 5

Which of the following is a reason why the divisional cost of capital approach may cause problems if new projects are assigned to the wrong division?

Accepted Answer

A) Managers in different divisions may use different methods to calculate the WACC. 
B) The expected return of the new project may be incorrect. 
C) If projects are assigned to the wrong division, the risk of that division may be significantly different than the risk of the project, implying that the project will be evaluated with a divisional cost of capital that is much different from what a project-specific cost of capital would be. 
D) None of these answers are correct.

Question 6

The ____________ approach to computing a divisional weighted average cost of capital (WACC) requires only that WACCs for "risky" and "relatively safe" divisions be adjusted.

Accepted Answer

A) subjective 
B) objective 
C) firmwide 
D) implicit

Question 7

Which of following is a situation in which you would want to use the CAPM approach for estimating the component cost of equity?

Accepted Answer

A) When you are able to estimate the market risk premium with certainty. 
B) When you are able to estimate the risk-free rate with certainty. 
C) When you are able to estimate the firm's beta with certainty. 
D) When the firm pays a constant dividend.

Question 8

Which of these makes this a true statement? When determining the appropriate weights used in calculating a WACC, it should reflect:

Accepted Answer

A) the relative sizes of the total book capitalizations for each kind of security that the firm issues. 
B) the relative sizes of the total market capitalizations for each kind of security that the firm issues. 
C) only the market after-tax cost of debt. 
D) only the market after-tax cost of equity.

Question 9

An all-equity firm is considering the projects shown as follows. The T-bill rate is 3 percent and the market risk premium is 6 percent. If the firm uses its current WACC of 12 percent to evaluate these projects, which project(s) will be incorrectly rejected? $$\begin{array} { | c | c | c | } 
\hline \text { Project } & \text { Expected Return } & \text { Beta } \
\hline \mathrm { A } & 10.0 \% & 0.9 \
\hline \mathrm { B } & 17.0 \% & 1.1 \
\hline \mathrm { C } & 12.0 \% & 1.4 \
\hline \mathrm { D } & 15.0 \% & 2.2 \
\hline
\end{array}$$

Accepted Answer

A) Project A 
B) Projects B and C 
C) Project D 
D) Project B

Question 10

Suppose your firm has decided to use a divisional WACC approach to analyze projects. The firm currently has four divisions, A through D, with average betas for each division of 0.5, 1.0, 1.3 and 1.6, respectively. If all current and future projects will be financed with half debt and half equity, and if the current cost of equity (based on an average firm beta of 1.0 and a current risk-free rate of 7 percent) is 14 percent and the after-tax yield on the company's bonds is 8 percent, what are the WACCs for divisions A through D?

Accepted Answer

A) 9.00 percent; 10.25 percent; 12.95 percent; 13.15 percent 
B) 9.75 percent; 12.00 percent; 12.65 percent; 13.75 percent 
C) 9.25 percent; 11.00 percent; 12.05 percent; 13.10 percent 
D) 8.95 percent; 10.15 percent; 12.50 percent; 13.45 percent

Question 11

A firm has 4,000,000 shares of common stock outstanding, each with a market price of $12.00 per share. It has 25,000 bonds outstanding, each selling for $980. The bonds mature in 20 years, have a coupon rate of 9 percent, and pay coupons semi-annually. The firm's equity has a beta of 1.5, and the expected market return is 15 percent. The tax rate is 30 percent and the WACC is 15 percent. What is the risk-free rate?

Accepted Answer

A) 6.28 percent 
B) 8.00 percent 
C) 9.22 percent 
D) 19.36 percent

Question 12

When we adjust the WACC to reflect flotation costs, this approach:

Accepted Answer

A) raises each capital source's effective cost. 
B) raises only the cost of external equity. 
C) reduces the cost of debt. 
D) reduces each capital source's effective cost.

Question 13

KatyDid Clothes has a $150 million ($1,000 face value) 15-year bond issue selling for 86 percent of par that carries a coupon rate of 8 percent, paid semi-annually. What would be KatyDid's before-tax component cost of debt?

Accepted Answer

A) 4.90 percent 
B) 8.13 percent 
C) 9.80 percent 
D) 7.09 percent

Question 14

A firm has 5,000,000 shares of common stock outstanding, each with a market price of $8.00 per share. It has 25,000 bonds outstanding, each selling for $1,100 with a $1,000 face value. The bonds mature in 12 years, have a coupon rate of 9 percent, and pay coupons semi-annually. The firm's equity has a beta of 1.4, and the expected market return is 15 percent. The tax rate is 35 percent and the WACC is 14 percent. Calculate the risk-free rate.

Accepted Answer

A) 2.05 percent 
B) 15.27 percent 
C) 20.18 percent 
D) 1.19 percent

Question 15

Which of the following will impact the cost of equity component in the weighted average cost of capital?

Accepted Answer

A) The risk-free rate 
B) Beta 
C) Expected return on the market 
D) All of these

Question 16

Fern has preferred stock selling for 95 percent of par that pays an 8 percent annual coupon. What would be Fern's component cost of preferred stock?

Accepted Answer

A) 7.60 percent 
B) 8.00 percent 
C) 8.42 percent 
D) 9.00 percent

Question 17

Town Crier has 10 million shares of common stock outstanding, 2 million shares of preferred stock outstanding, and 10 thousand bonds. If the common shares are selling for $28 per share, the preferred shares are selling for $15.50 per share, and the bonds are selling for 97 percent of par, what would be the weight used for debt in the computation of Town Crier's WACC?

Accepted Answer

A) 3.02 percent 
B) 3.12 percent 
C) 3.20 percent 
D) 3.33 percent

Question 18

FarCry Industries, a maker of telecommunications equipment, has 26 million shares of common stock outstanding, 1 million shares of preferred stock outstanding, and 10 thousand bonds. If the common shares sell for $12 per share, the preferred shares sell for $114.50 per share, and the bonds sell for 98 percent of par ($1,000), what weight should you use for preferred stock in the computation of FarCry's WACC?

Accepted Answer

A) 28.52 percent 
B) 27.51 percent 
C) 26.24 percent 
D) 25.01 percent

Question 19

KatyDid Clothes has a $150 million ($1,000 face value) 15-year bond issue selling for 106 percent of par that carries a coupon rate of 8 percent, paid semi-annually. What would be KatyDid's before-tax component cost of debt?

Accepted Answer

A) 3.67 percent 
B) 7.34 percent 
C) 8.12 percent 
D) 7.09 percent

Question 20

Which of the following statements is correct?

Accepted Answer

A) The weighted average cost of capital is calculated on a before-tax basis. 
B) An increase in the market risk premium is likely to increase the weighted average cost of capital. 
C) The weights of debt and equity should be based on the balance sheet because this is the most accurate assessment of the valuation. 
D) All of these statements are correct.

Exam 11: Calculating the Cost of Capital