Question 1

The Tierney Group has two divisions of equal size: an office furniture manufacturing division and a data processing division. Its CFO believes that stand-alone data processor companies typically have a WACC of 9%, while stand-alone furniture manufacturers typically have a 13% WACC. She also believes that the data processing and manufacturing divisions have the same risk as their typical peers. Consequently, she estimates that the composite, or corporate, WACC is 11%. A consultant has suggested using a 9% hurdle rate for the data processing division and a 13% hurdle rate for the manufacturing division. However, the CFO disagrees, and she has assigned an 11% WACC to all projects in both divisions. Which of the following statements is CORRECT?

Accepted Answer

A)  the decision not to adjust for risk means, in effect, that it is favoring the data processing division. therefore, that division is likely to become a larger part of the consolidated company over time. 
B)  the decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division. this will lead to a reduction in the firm's intrinsic value over time. 
C)  the decision not to risk-adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business. this will lead to a reduction in its intrinsic value over time. 
D)  the decision not to risk-adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business. this may affect the firm's capital structure but it will not affect its intrinsic value. 
E)  while the decision to use just one wacc will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant's recommendation, this should not affect the firm's intrinsic value.

Question 2

As the winner of a contest, you are now CFO for the day for Maguire Inc. and your day's job involves raising capital for expansion. Maguire's common stock currently sells for $45.00 per share, the company expects to earn $2.75 per share during the current year, its expected payout ratio is 70%, and its expected constant growth rate is 6.00%. New stock can be sold to the public at the current price, but a flotation cost of 8% would be incurred. By how much would the cost of new stock exceed the cost of common from reinvested earnings?

Accepted Answer

A)  0.09% 
B)  0.19% 
C)  0.37% 
D)  0.56% 
E)  0.84%

Question 3

Collins Group
The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.
 $\begin{array}{l}
\text { Assets }\
\begin{array}{lr}
\text { Current assets } & \$ 38,000,000 \
\text { Net plant, property, and equipment } & 101,000,000\
\text { Total assets }&\$ 139,000,000\
\
\text { Liabilities and Equity }\
\text { Accounts payable } & \$ 10,000,000 \
\text { Accruals } & 9,000,000 \
\text { Current liabilities } & \$ 19,000,000 \
\text { Long-term debt }(40,000 \text { bonds, } \$ 1,000 \text { par value) } & 40,000,000\
\text { Total liabilities }&\$ 59,000,000 \
\text { Common stock ( } 10,000,000 \text { shares) } & 30,000,000 \
\text { Retained earnings } & 50,000,000 \
 \text { Total shareholders' equity } & 80,000,000 \
\text { Total liabilities and shareholders' equity } & \$ 139,000,000
\end{array}
\end{array}$ 
The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%.
-Refer to the data for the Collins Group. 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 4

Which of the following statements is CORRECT?

Accepted Answer

A)  the after-tax cost of debt that should be used as the component cost when calculating the wacc is the average after-tax cost of all the firm's outstanding debt. 
B)  suppose some of a publicly-traded firm's stockholders are not diversified; they hold only the one firm's stock. in this case, the capm approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firm's intrinsic value. 
C)  the cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity. 
D)  the bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm's cost of equity capital. 
E)  the cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity.

Question 5

The CEO of Harding Media Inc. as asked you to help estimate its cost of common equity. You have obtained the following data: D0 = $0.85; P0 = $22.00; and gL = 6.00% (constant). The CEO thinks, however, that the stock price is temporarily depressed, and that it will soon rise to $40.00. Based on the dividend growth model, by how much would the cost of common from reinvested earnings change if the stock price changes as the CEO expects?

Accepted Answer

A) $1.49% 
B)  $1.66% 
C) $1.84% 
D) $2.03% 
E) $2.23%

Question 6

"Capital" is sometimes defined as funds supplied to a firm by investors.

Accepted Answer

A) True 
 B)False

Question 7

To estimate the company's WACC, Marshall Inc. recently hired you as a consultant. 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 common stock, and it does not expect to issue any new shares. What is its WACC?

Accepted Answer

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

Question 8

Collins Group
The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.
 $\begin{array}{l}
\text { Assets }\
\begin{array}{lr}
\text { Current assets } & \$ 38,000,000 \
\text { Net plant, property, and equipment } & 101,000,000\
\text { Total assets }&\$ 139,000,000\
\
\text { Liabilities and Equity }\
\text { Accounts payable } & \$ 10,000,000 \
\text { Accruals } & 9,000,000 \
\text { Current liabilities } & \$ 19,000,000 \
\text { Long-term debt }(40,000 \text { bonds, } \$ 1,000 \text { par value) } & 40,000,000\
\text { Total liabilities }&\$ 59,000,000 \
\text { Common stock ( } 10,000,000 \text { shares) } & 30,000,000 \
\text { Retained earnings } & 50,000,000 \
 \text { Total shareholders' equity } & 80,000,000 \
\text { Total liabilities and shareholders' equity } & \$ 139,000,000
\end{array}
\end{array}$ 
The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%.
-Refer to the data for the Collins Group. Based on the CAPM, what is the firm's cost of common stock?

Accepted Answer

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

Question 9

For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity.

Accepted Answer

A) True 
 B)False

Question 10

The cost of debt, rd, is normally less than rs, so rd(1 σ T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1-T).

Accepted Answer

A) True 
 B)False

Question 11

Which of the following statements is CORRECT?

Accepted Answer

A)  a cost should be assigned to reinvested earnings due to the opportunity cost principle, which refers to the fact that the firm's stockholders would themselves expect to earn a return on earnings that were distributed rather than retained and reinvested. 
B)  no cost should be assigned to reinvested earnings because the firm does not have to pay anything to raise them. they are generated as cash flows by operating assets that were raised in the past; hence, they are "free." 
C)  suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into the foreseeable future. in this case, the firm's before-tax and after-tax costs of debt for purposes of calculating the wacc will both be equal to the interest rate on the firm's currently outstanding debt, provided that debt was issued during the past 5 years. 
D)  if a firm has enough reinvested earnings to fund its capital budget for the coming year, then there is no need to estimate either a cost of equity or a wacc. 
E)  the component cost of preferred stock is expressed as rp(1 σ t). this follows because preferred stock dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes.

Question 12

The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and reinvested earnings, whose cost is the average return on the assets that are acquired.

Accepted Answer

A) True 
 B)False

Question 13

Which of the following statements is CORRECT?

Accepted Answer

A)  the tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes. 
B)  if a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject. 
C)  because no flotation costs are required to obtain capital as reinvested earnings, the cost of reinvested earnings is generally lower than the after-tax cost of debt. 
D)  higher flotation costs tend to reduce the cost of equity capital. 
E)  since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.

Question 14

You have been hired by the CFO of Lugones Industries to help estimate its cost of common equity. You have obtained the following data: (1) rd = yield on the firm's bonds = 7.00% and the risk premium over its own debt cost = 4.00%. (2) rRF = 5.00%, RPM = 6.00%, and b = 1.25. (3) D1 = $1.20, P0 = $35.00, and gL = 8.00% (constant). You were asked to estimate the cost of common based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates. What is that difference?

Accepted Answer

A)  1.13% 
B)  1.50% 
C)  1.88% 
D)  2.34% 
E)  2.58%

Question 15

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

Question 16

Taylor Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?

Accepted Answer

A)  project c, which is of above-average risk and has a return of 11%. 
B)  project a, which is of average risk and has a return of 9%. 
C)  none of the projects should be accepted. 
D)  all of the projects should be accepted. 
E)  project b, which is of below-average risk and has a return of 8.5%.

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 recently hired by Garrett Design, Inc. to estimate its cost of common equity. You obtained the following data: D1 = $1.75; P0 = $42.50; gL = 7.00% (constant); and F = 5.00%. What is the cost of equity raised by selling new common stock?

Accepted Answer

A)  10.77% 
B)  11.33% 
C)  11.90% 
D)  12.50% 
E)  13.12%

Question 19

Trahern Baking Co. common stock sells for $32.50 per share. It expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, and its expected constant dividend growth rate is 6.0%. 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 20

Your consultant firm has been hired by Eco Brothers Inc. to help them estimate the cost of common equity. The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of common can be estimated using a risk premium of 3.85% over a firm's own cost of debt. What is an estimate of the firm's cost of common from reinvested earnings?

Accepted Answer

A)  12.60% 
B)  13.10% 
C)  13.63% 
D)  14.17% 
E)  14.74%

Exam 11: Determining the Cost of Capital

Which of the following statements is CORRECT?

"Capital" is sometimes defined as funds supplied to a firm by investors.

For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity.

The cost of debt, rd, is normally less than rs, so rd(1 σ T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1-T).

Which of the following statements is CORRECT?

The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and reinvested earnings, whose cost is the average return on the assets that are acquired.

Which of the following statements is CORRECT?

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

Taylor Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?

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.

You were recently hired by Garrett Design, Inc. to estimate its cost of common equity. You obtained the following data: D1 = $1.75; P0 = $42.50; gL = 7.00% (constant) ; and F = 5.00%. What is the cost of equity raised by selling new common stock?