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.F) A) and B)
G) A) and C)

Question 2

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 3

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock.No adjustment is needed for taxes because preferred dividends,unlike interest on debt,is not deductible by the issuing firm.

Accepted Answer

A) True 
 B)False

Question 4

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 g = 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 DCF approach,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%F) A) and B)
G) A) and C)

Question 5

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%F) B) and D)
G) B) and C)

Question 6

Exhibit 9.1
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.
  
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 Exhibit 9.1.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%F) A) and B)
G) B) and E)

Question 7

Since 70% of the preferred dividends received by a corporation are excluded from taxable income,the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should,theoretically,be
Cost of equity = rs(0.30) (0.50)+ rps(1 - T) (0.70) (0.50).

Accepted Answer

A) True 
 B)False

Question 8

Which of the following statements is CORRECT?

Accepted Answer

A)   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.
B)   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.
C)   When the WACC is calculated, it should reflect the costs of new common stock, reinvested 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.
D)   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)   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 reinvested earnings.F) B) and E)
G) C) and E)

Question 9

Weatherall Enterprises has no debt or preferred stock - it is an all-equity firm?and 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 an 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 rejected because its expected return (before risk adjustment)  is less than its required return.
B)   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.
C)   The accept/reject decision depends on the firm's risk-adjustment policy. If Weatherall's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project.
D)   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.
E)   The project should definitely be accepted because its expected return (before any risk adjustments)  is greater than its required return.F) A) and D)
G) A) and C)

Question 10

Bloom and Co.has no debt or preferred stock- it uses only equity capital,and has two equally-sized divisions.Division X's cost of capital is 10.0%,Division Y's cost is 14.0%,and the corporate (composite) WACC is 12.0%.All of Division X's projects are equally risky,as are all of Division Y's projects.However,the projects of Division X are less risky than those of Division Y.Which of the following projects should the firm accept?

Accepted Answer

A)   A Division Y project with a 12% return.
B)   A Division X project with an 11% return.
C)   A Division X project with a 9% return.
D)   A Division Y project with an 11% return.
E)   A Division Y project with a 13% return.F) None of the above
G) A) and D) B

Question 11

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

Accepted Answer

A) True 
 B)False

Question 12

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%F) C) and D)
G) A) and B)

Question 13

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 14

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 - 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.F) A) and E)
G) C) and D)

Question 15

Suppose the debt ratio (D/TA)is 50%,the interest rate on new debt is 8%,the current cost of equity is 16%,and the tax rate is 40%.An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

Accepted Answer

A) True 
 B)False  False

Question 16

Quinlan Enterprises stock trades for $52.50 per share.It is expected to pay a $2.50 dividend at year end (D1 = $2.50) ,and the dividend is expected to grow at a constant rate of 5.50% a year.The before-tax cost of debt is 7.50%,and the tax rate is 40%.The target capital structure consists of 45% debt and 55% common equity.What is the company's WACC if all the equity used is from reinvested earnings?

Accepted Answer

A)   7.07%
B)   7.36%
C)   7.67%
D)   7.98%
E)   8.29%F) A) and D)
G) None of the above

Question 17

Firm J's earnings and stock price tend to move up and down with other firms in the S&P 500,while Firm F's earnings and stock price move counter cyclically with J and other S&P companies.Both J and F 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)   J and F should have identical WACCs because their risks as measured by the standard deviation of returns are identical.
B)   If J and F merge, then the merged firm MW should have a WACC that is a simple average of J's and F's WACCs.
C)   Without additional information, it is impossible to predict what the merged firm's WACC would be if J and F merged.
D)   Since J and F 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.
E)   J should have the lower WACC because it is like most other companies, and investors like that fact.F) B) and C)
G) A) and E)

Question 18

Which of the following statements is CORRECT?

Accepted Answer

A)   The after-tax cost of debt usually exceeds the after-tax cost of equity.
B)   For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock.
C)   Retained earnings that were generated in the past and are reported on the firm's balance sheet are available to finance the firm's capital budget during the coming year.
D)   The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital.
E)   The WACC is calculated using before-tax costs for all components.F) C) and D)
G) D) and E) D

Question 19

Which of the following statements is CORRECT?

Accepted Answer

A)   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.
B)   The cost of new equity (re)  could possibly be lower than the cost of reinvested earnings (rs)  if the market risk premium, risk-free rate, and the company's beta all decline by a sufficiently large amount.
C)   A firm's cost of reinvesting earnings is the rate of return stockholders require on a firm's common stock.
D)   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.
E)   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.F) None of the above
G) A) and B)

Question 20

The Lincoln Company sold a $1,000 par value,noncallable bond several years ago 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%F) A) and B)
G) A) and C)

Exam 9: The Cost of Capital

Correct Answer
verified

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 r_s.

Correct Answer
verified

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock.No adjustment is needed for taxes because preferred dividends,unlike interest on debt,is not deductible by the issuing firm.

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Which of the following statements is CORRECT?

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified
B

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

Correct Answer
verified

Correct Answer
verified

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.

Correct Answer
verified

Which of the following statements is CORRECT?

Correct Answer
verified

Suppose the debt ratio (D/TA)is 50%,the interest rate on new debt is 8%,the current cost of equity is 16%,and the tax rate is 40%.An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

Correct Answer
verified
False

Correct Answer
verified

Correct Answer
verified

Which of the following statements is CORRECT?

Correct Answer
verified
D

Which of the following statements is CORRECT?

Correct Answer
verified

The Lincoln Company sold a $1,000 par value,noncallable bond several years ago 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?

Correct Answer
verified

Exam 9: The Cost of Capital

Correct AnswerverifiedShow Answer

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.

Correct AnswerverifiedShow Answer

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock.No adjustment is needed for taxes because preferred dividends,unlike interest on debt,is not deductible by the issuing firm.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedB

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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.

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Suppose the debt ratio (D/TA)is 50%,the interest rate on new debt is 8%,the current cost of equity is 16%,and the tax rate is 40%.An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

Correct AnswerverifiedFalse

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedD

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct Answer
verified

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 r_s.

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified
B

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified
False

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified
D

Correct Answer
verified

Correct Answer
verified