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THE COST OF CAPITAL
(Difficulty: E = Easy, M = Medium, and T = Tough)
Multiple Choice: Conceptual
Easy:
Capital components Answer: c Diff: E
. Which of the following is not considered a capital component for the purpose of calculating the weighted average cost of capital (WACC) as it applies to capital budgeting?
a. Longterm debt.
b. Common stock.
c. Accounts payable and accruals.
d. Preferred stock.
Capital components Answer: d Diff: E
. For a typical firm with a given capital structure, which of the following is correct? (Note: All rates are after taxes.)
a. kd > ke > ks > WACC.
b. ks > ke > kd > WACC.
c. WACC > ke > ks > kd.
d. ke > ks > WACC > kd.
e. None of the statements above is correct.
Capital components Answer: a Diff: E
. Which of the following statements is most correct?
a. If a companys tax rate increases but the yield to maturity of its noncallable bonds remains the same, the companys marginal cost of debt capital used to calculate its weighted average cost of capital will fall.
b. All else equal, an increase in a companys stock price will increase the marginal cost of retained earnings, ks.
c. All else equal, an increase in a companys stock price will increase the marginal cost of issuing new common equity, ke.
d. Statements a and b are correct.
e. Statements b and c are correct.
Capital components Answer: c Diff: E
. Which of the following statements is most correct?
a. Since the money is readily available, the cost of retained earnings is usually a lot cheaper than the cost of debt financing.
b. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are tax deductible.
c. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are tax deductible.
d. Statements a and b are correct.
e. Statements b and c are correct.
DCF cost of equity estimation Answer: b Diff: E
. Which of the following factors in the discounted cash flow (DCF) approach to estimating the cost of common equity is the least difficult to estimate?
a. Expected growth rate, g.
b. Dividend yield, D1/P0.
c. Required return, ks.
d. Expected rate of return, EMBED Equation.3.
e. All of the above are equally difficult to estimate.
WACC Answer: d Diff: E
. Which of the following statements is most correct?
a. The WACC measures the aftertax cost of capital.
b. The WACC measures the marginal cost of capital.
c. There is no cost associated with using retained earnings.
d. Statements a and b are correct.
e. All of the statements above are correct.
WACC Answer: c Diff: E
. Which of the following statements about the cost of capital is incorrect?
a. A companys target capital structure affects its weighted average cost of capital.
b. Weighted average cost of capital calculations should be based on the aftertax costs of all the individual capital components.
c. If a companys tax rate increases, then, all else equal, its weighted average cost of capital will increase.
d. Flotation costs can increase the weighted average cost of capital.
e. An increase in the riskfree rate is likely to increase the marginal costs of both debt and equity financing.
WACC Answer: e Diff: E
. Campbell Co. is trying to estimate its weighted average cost of capital (WACC). Which of the following statements is most correct?
a. The aftertax cost of debt is generally cheaper than the aftertax cost of preferred stock.
b. Since retained earnings are readily available, the cost of retained earnings is generally lower than the cost of debt.
c. If the companys beta increases, this will increase the cost of equity financing, even if the company is able to rely on only retained earnings for its equity financing.
d. Statements a and b are correct.
e. Statements a and c are correct.
Factors influencing WACC Answer: a Diff: E
. Wyden Brothers has no retained earnings. The company uses the CAPM to calculate the cost of equity capital. The companys capital structure consists of common stock, preferred stock, and debt. Which of the following events will reduce the companys WACC?
a. A reduction in the market risk premium.
b. An increase in the flotation costs associated with issuing new common stock.
c. An increase in the companys beta.
d. An increase in expected inflation.
e. An increase in the flotation costs associated with issuing preferred stock.
WACC and capital components Answer: c Diff: E
. Which of the following statements is most correct?
a. The WACC is a measure of the beforetax cost of capital.
b. Typically the aftertax cost of debt financing exceeds the aftertax cost of equity financing.
c. The WACC measures the marginal aftertax cost of capital.
d. Statements a and b are correct.
e. Statements b and c are correct.
WACC and capital components Answer: a Diff: E
. A company has a capital structure that consists of 50 percent debt and 50 percent equity. Which of the following statements is most correct?
a. The cost of equity financing is greater than or equal to the cost of debt financing.
b. The WACC exceeds the cost of equity financing.
c. The WACC is calculated on a beforetax basis.
d. The WACC represents the cost of capital based on historical averages. In that sense, it does not represent the marginal cost of capital.
e. The cost of retained earnings exceeds the cost of issuing new common stock.
Internal vs. external common equity Answer: e Diff: E
. A firm estimates that its proposed capital budget will force it to issue new common stock, which has a greater cost than the cost of retained earnings. The firm, however, would like to avoid issuing costly new common stock. Which of the following steps would mitigate the firms need to raise new common stock?
a. Increasing the companys dividend payout ratio for the upcoming year.
b. Reducing the companys debt ratio for the upcoming year.
c. Increasing the companys proposed capital budget.
d. All of the statements above are correct.
None of the statements above is correct.
Risk and project selection Answer: c Diff: E
. Dick Boe Enterprises, an allequity firm, has a corporate beta coefficient of 1.5. The financial manager is evaluating a project with an expected return of 21 percent, before any risk adjustment. The riskfree rate is 10 percent, and the required rate of return on the market is 16 percent. The project being evaluated is riskier than Boes average project, in terms of both beta risk and total risk. Which of the following statements is most correct?
a. The project should be accepted since its expected return (before risk adjustment) is greater than its required return.
b. The project should be rejected since its expected return (before risk adjustment) is less than its required return.
c. The accept/reject decision depends on the riskadjustment policy of the firm. If the firms policy were to reduce a riskierthanaverage projects expected return by 1 percentage point, then the project should be accepted.
d. Riskierthanaverage projects should have their expected returns increased to reflect their added riskiness. Clearly, this would make the project acceptable regardless of the amount of the adjustment.
e. Projects should be evaluated on the basis of their total risk alone. Thus, there is insufficient information in the problem to make an accept/reject decision.
Risk and project selection Answer: b Diff: E
. A company estimates that an averagerisk project has a WACC of 10 percent, a belowaverage risk project has a WACC of 8 percent, and an aboveaverage risk project has a WACC of 12 percent. Which of the following independent projects should the company accept?
a. Project A has average risk and a return of 9 percent.
b. Project B has belowaverage risk and a return of 8.5 percent.
c. Project C has aboveaverage risk and a return of 11 percent.
d. All of the projects above should be accepted.
e. None of the projects above should be accepted.
Divisional risk Answer: a Diff: E N
. Conglomerate Inc. consists of 2 divisions of equal size, and Conglomerate is 100 percent equity financed. Division As cost of equity capital is 9.8 percent, while Division Bs cost of equity capital is 14 percent. Conglomerates composite WACC is 11.9 percent. Assume that all Division A projects have the same risk and that all Division B projects have the same risk. However, the projects in Division A are not the same risk as those in Division B. Which of the following projects should Conglomerate accept?
a. Division A project with an 11 percent return.
b. Division B project with a 12 percent return.
c. Division B project with a 13 percent return.
d. Statements a and c are correct.
e. Statements b and d are correct.
Retained earnings break point Answer: a Diff: E
. Which of the following will increase a companys retained earnings break point?
a. An increase in its net income.
b. An increase in its dividend payout.
c. An increase in the amount of equity in its capital structure.
d. An increase in its capital budget.
e. All of the statements above are correct.
Retained earnings break point Answer: b Diff: E
. Which of the following actions will increase the retained earnings break point?
a. An increase in the dividend payout ratio.
b. An increase in the debt ratio.
c. An increase in the capital budget.
d. An increase in flotation costs.
e. All of the statements above are correct.
Miscellaneous cost of capital concepts Answer: c Diff: E N
. Which of the following statements is most correct?
a. Since debt capital is riskier than equity capital, the cost of debt is always greater than the WACC.
b. Because of the risk of bankruptcy, the cost of debt capital is always higher than the cost of equity capital.
c. If a company assigns the same cost of capital to all of its projects regardless of the projects risk, then it follows that the company will generally reject too many safe projects and accept too many risky projects.
d. Because you are able to avoid flotation costs, the cost of retained earnings is generally lower than the cost of debt.
e. Higher flotation costs tend to reduce the cost of equity capital.
Miscellaneous concepts Answer: e Diff: E
. Which of the following statements is most correct?
a. Higher flotation costs reduce investor returns, and therefore reduce a companys WACC.
b. The WACC represents the historical cost of capital and is usually calculated on a beforetax basis.
c. The cost of retained earnings is zero because retained earnings are readily available and do not require the payment of flotation costs.
d. All of the statements above are correct.
e. None of the statements above is correct.
Medium:
Capital components Answer: e Diff: M
. Which of the following statements is most correct?
a. In the weighted average cost of capital calculation, we must adjust the cost of preferred stock for the tax exclusion of 70 percent of dividend income.
b. We ideally would like to use historical measures of the component costs from prior financings in estimating the appropriate weighted average cost of capital.
c. The cost of a new equity issuance (ke) could possibly be lower than the cost of retained earnings (ks) if the market risk premium and riskfree rate decline by a substantial amount.
d. Statements b and c are correct.
e. None of the statements above is correct.
Capital components Answer: a Diff: M
. Which of the following statements is most correct?
a. The cost of retained earnings is the rate of return stockholders require on a firms common stock.
b. The component cost of preferred stock is expressed as kp(1  T), because preferred stock dividends are treated as fixed charges, similar to the treatment of debt interest.
c. The bondyieldplusriskpremium approach to estimating a firms cost of common equity involves adding a subjectively determined risk premium to the market riskfree bond rate.
d. The higher the firms flotation cost for new common stock, the more likely the firm is to use preferred stock, which has no flotation cost.
e. None of the statements above is correct.
Cost of capital estimation Answer: c Diff: M
. Which of the following statements is correct?
a. The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project.
b. The cost of debt used to calculate the weighted average cost of capital is based on an average of the cost of debt already issued by the firm and the cost of new debt.
c. One problem with the CAPM approach in estimating the cost of equity capital is that if a firms stockholders are, in fact, not well diversified, beta may be a poor measure of the firms true investment risk.
d. The bondyieldplusriskpremium approach is the most sophisticated and objective method of estimating a firms cost of equity capital.
e. The cost of equity capital is generally easier to measure than the cost of debt, which varies daily with interest rates, or the cost of preferred stock since preferred stock is issued infrequently.
Cost of equity estimation Answer: d Diff: M
. Which of the following statements is correct?
a. Although some methods of estimating the cost of equity capital encounter severe difficulties, the CAPM is a simple and reliable model that provides great accuracy and consistency in estimating the cost of equity capital.
b. The DCF model is preferred over other models to estimate the cost of equity because of the ease with which a firms growth rate is obtained.
c. The bondyieldplusriskpremium approach to estimating the cost of equity is not always accurate but its advantages are that it is a standardized and objective model.
d. Depreciationgenerated funds are an additional source of capital and, in fact, represent the largest single source of funds for some firms.
e. None of the statements above is correct.
CAPM cost of equity estimation Answer: e Diff: M
. In applying the CAPM to estimate the cost of equity capital, which of the following elements is not subject to dispute or controversy?
a. The expected rate of return on the market, kM.
b. The stocks beta coefficient, bi.
c. The riskfree rate, kRF.
d. The market risk premium (RPM).
e. All of the above are subject to dispute.
CAPM and DCF estimation Answer: a Diff: M
. Which of the following statements is most correct?
a. Beta measures market risk, but if a firms stockholders are not well diversified, beta may not accurately measure standalone risk.
b. If the calculated beta underestimates the firms true investment risk, then the CAPM method will overestimate ks.
c. The discounted cash flow method of estimating the cost of equity cant be used unless the growth component, g, is constant during the analysis period.
d. An advantage shared by both the DCF and CAPM methods of estimating the cost of equity capital, is that they yield precise estimates and require little or no judgement.
e. None of the statements above is correct.
WACC Answer: d Diff: M
. Which of the following statements is most correct?
a. The weighted average cost of capital for a given capital budget level is a weighted average of the marginal cost of each relevant capital component that makes up the firms target capital structure.
b. The weighted average cost of capital is calculated on a beforetax basis.
c. An increase in the riskfree rate is likely to increase the marginal costs of both debt and equity financing.
d. Statements a and c are correct.
e. All of the statements above are correct.
WACC Answer: d Diff: M
. Which of the following statements is correct?
a. The WACC should include only aftertax component costs. Therefore, the required rates of return (or market rates) on debt, preferred, and common equity (kd, kp, and ks) must be adjusted to an aftertax basis before they are used in the WACC equation.
b. The cost of retained earnings is generally higher than the cost of new common stock.
c. Preferred stock is riskier to investors than is debt. Therefore, if someone told you that the market rates showed kd > kp for a given company, that person must have made a mistake.
d. If a company with a debt ratio of 50 percent were suddenly exempted from all future income taxes, then, all other things held constant, this would cause its WACC to increase.
e. None of the statements above is correct.
WACC Answer: e Diff: M
. Which of the following statements is most correct?
a. An increase in flotation costs incurred in selling new stock will increase the cost of retained earnings.
b. The WACC should include only aftertax component costs. Therefore, the required rates of return (or market rates) on debt, preferred, and common equity (kd, kp, and ks) must be adjusted to an aftertax basis before they are used in the WACC equation.
c. An increase in a firms corporate tax rate will increase the firms cost of debt capital, as long as the yield to maturity on the companys bonds remains constant or falls.
d. Statements b and c are correct.
e. None of the statements above is correct.
WACC Answer: e Diff: M
. Which of the following statements is most correct?
a. Since stockholders do not generally pay corporate taxes, corporations should focus on beforetax cash flows when calculating the weighted average cost of capital (WACC).
b. All else equal, an increase in flotation costs will increase the cost of retained earnings.
c. When calculating the weighted average cost of capital, firms should rely on historical costs rather than marginal costs of capital.
d. Statements a and b are correct.
e. None of the statements above is correct.
WACC and capital components Answer: b Diff: M
. Which of the following statements is correct?
a. Because we often need to make comparisons among firms that are in different income tax brackets, it is best to calculate the WACC on a beforetax basis.
b. If a firm has been suffering accounting losses and is expected to continue suffering such losses, and therefore its tax rate is zero, it is possible that its aftertax component cost of preferred stock as used to calculate the WACC will be less than its aftertax component cost of debt.
c. Normally, the cost of external equity raised by issuing new common stock is above the cost of retained earnings. Moreover, the higher the growth rate is relative to the dividend yield, the more the cost of external equity will exceed the cost of retained earnings.
d. The lower a companys tax rate, the greater the advantage of using debt in terms of lowering its WACC.
e. None of the statements above is correct.
Riskadjusted cost of capital Answer: c Diff: M
. Kemp Consolidated has two divisions of equal size: a computer division and a restaurant division. Standalone restaurant companies typically have a cost of capital of 8 percent, while standalone computer companies typically have a 12 percent cost of capital. Kemps restaurant division has the same risk as a typical restaurant company, and its computer division has the same risk as a typical computer company. Consequently, Kemp estimates that its composite corporate cost of capital is 10 percent. The companys consultant has suggested that they use an 8 percent hurdle rate for the restaurant division and a 12 percent hurdle rate for the computer division. However, Kemp has chosen to ignore its consultant, and instead, chooses to assign a 10 percent cost of capital to all projects in both divisions. Which of the following statements is most correct?
a. While Kemps decision to not risk adjust its cost of capital will lead it to accept more projects in its computer division and fewer projects in its restaurant division, this should not affect the overall value of the company.
b. Kemps decision to not risk adjust means that it is effectively subsidizing its restaurant division, which means that its restaurant division is likely to become a larger part of the overall company over time.
c. Kemps decision to not risk adjust means that the company will accept too many projects in the computer business and too few projects in the restaurant business. This will lead to a reduction in the overall value of the company.
d. Statements a and b are correct.
e. Statements b and c are correct.
Riskadjusted cost of capital Answer: b Diff: M
. The Barabas Company has an equal amount of lowrisk projects, averagerisk projects, and highrisk projects. Barabas estimates that the overall companys WACC is 12 percent. This is also the correct cost of capital for the companys averagerisk projects. The companys CFO argues that, even though the companys projects have different risks, the cost of capital for each project should be the same because the company obtains its capital from the same sources. If the company follows the CFOs advice, what is likely to happen over time?
a. The company will take on too many lowrisk projects and reject too many highrisk projects.
b. The company will take on too many highrisk projects and reject too many lowrisk projects.
c. Things will generally even out over time, and therefore, the risk of the firm should remain constant over time.
d. Statements a and c are correct.
e. Statements b and c are correct.
Riskadjusted cost of capital Answer: e Diff: M
. If a company uses the same cost of capital for evaluating all projects, which of the following results is likely?
a. Accepting poor, highrisk projects.
b. Rejecting good, lowrisk projects.
c. Accepting only good, lowrisk projects.
d. Accepting no projects.
e. Answers a and b are correct.
Riskadjusted cost of capital Answer: a Diff: M
. If a typical U.S. company uses the same cost of capital to evaluate all projects, the firm will most likely become
a. Riskier over time, and its value will decline.
b. Riskier over time, and its value will rise.
c. Less risky over time, and its value will rise.
d. Less risky over time, and its value will decline.
e. There is no reason to expect its risk position or value to change over time as a result of its use of a single discount rate.
Division WACCs and risk Answer: e Diff: M
. Pearson Plastics has two equalsized divisions, Division A and Division B. The company estimates that if the divisions operated as independent companies Division A would have a cost of capital of 8 percent, while Division B would have a cost of capital of 12 percent. Since the two divisions are the same size, Pearsons composite weighted average cost of capital (WACC) is 10 percent. In the past, Pearson has assigned separate hurdle rates to each division based on their relative risk. Now, however, Pearson has chosen to use the corporate WACC, which is currently 10 percent, for both divisions. Which of the following is likely to occur as a result of this change? Assume that this change is likely to have no effect on the average risk of each division and market conditions remain unchanged.
a. Over time, the overall risk of the company will increase.
b. Over time, Division B will become a larger part of the overall company.
c. Over time, the companys corporate WACC will increase.
d. Statements a and c are correct.
e. All of the statements above are correct.
Divisional risk and project selection Answer: e Diff: M N
. Smith Electric Co. and Ferdinand Water Co. are the same size and have the same capital structure. Smith Electric Co. is riskier than Ferdinand and has a WACC of 12 percent. Ferdinand Water Co. is safer than Smith and has a WACC of 10 percent. Ferdinand Water Co. is considering Project X. Project X has an IRR of 10.5 percent, and has the same risk as a typical project undertaken by Ferdinand Water Co. Smith Electric Co. is considering Project Y. Project Y has an IRR of 11.5 percent, and has the same risk as a typical project undertaken by Smith Electric Co.
Now assume that Smith Electric Co. and Ferdinand Water Co. merge to form a new company, Leeds United Utilities. The merger has no impact on the cash flows or risk of either Project X or Project Y. Leeds United Utilities CFO is trying to establish hurdle rates for the new companys projects that accurately reflect the risk of each project. (That is, he is using riskadjusted hurdle rates.) Which of the following statements is most correct?
a. Leeds United Utilities weighted average cost of capital is 11 percent.
b. Project X has a positive NPV.
c. After the merger, Leeds United Utilities should select Project X and reject Project Y.
d. Statements a and b are correct.
e. All of the statements above are correct.
Beta and project risk Answer: a Diff: M
. Which of the following statements is correct?
a. A relatively risky future cash outflow should be evaluated using a relatively low discount rate.
b. If a firms managers want to maximize the value of the stock, they should concentrate exclusively on projects market, or beta, risk.
c. If a firm evaluates all projects using the same cost of capital, then the riskiness of the firm as measured by its beta will probably decline over time.
d. If a firm has a beta that is less than 1.0, say 0.9, this would suggest that its assets returns are negatively correlated with the returns of most other firms assets.
e. None of the statements above is correct.
Miscellaneous concepts Answer: a Diff: M
. Which of the following statements is most correct?
a. Suppose a firm is losing money and thus, is not paying taxes, and that this situation is expected to persist for a few years whether or not the firm uses debt financing. Then the firms aftertax cost of debt will equal its beforetax cost of debt.
b. The component cost of preferred stock is expressed as kp(1  T), because preferred stock dividends are treated as fixed charges, similar to the treatment of debt interest.
c. The reason that a cost is assigned to retained earnings is because these funds are already earning a return in the business; the reason does not involve the opportunity cost principle.
d. The bondyieldplusriskpremium approach to estimating a firms cost of common equity involves adding a subjectively determined risk premium to the market riskfree bond rate.
e. None of the statements above is correct.
Multiple Choice: Problems
Easy:
Cost of new equity Answer: b Diff: E
. Your companys stock sells for $50 per share, its last dividend (D0) was $2.00, its growth rate is a constant 5 percent, and the company will incur a flotation cost of 15 percent if it sells new common stock. What is the firms cost of new equity, ke?
a. 9.20%
b. 9.94%
c. 10.50%
d. 11.75%
e. 12.30%
Cost of new equity Answer: d Diff: E
. Blair Brothers stock currently has a price of $50 per share and is expected to pay a yearend dividend of $2.50 per share (D1 = $2.50). The dividend is expected to grow at a constant rate of 4 percent per year. The company has insufficient retained earnings to fund capital projects and must, therefore, issue new common stock. The new stock has an estimated flotation cost of $3 per share. What is the companys cost of equity capital?
a. 10.14%
b. 9.21%
c. 9.45%
d. 9.32%
e. 9.00%
Cost of retained earnings Answer: d Diff: E
. Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent common equity. The current market price of the firms stock is P0 = $28; its last dividend was D0 = $2.20, and its expected dividend growth rate is 6 percent. What will Allisons marginal cost of retained earnings, ks, be?
a. 15.8%
b. 13.9%
c. 7.9%
d. 14.3%
e. 9.7%
WACC Answer: a Diff: E
. An analyst has collected the following information regarding Christopher Co.:
The companys capital structure is 70 percent equity and 30 percent debt.
The yield to maturity on the companys bonds is 9 percent.
The companys yearend dividend is forecasted to be $0.80 a share.
The company expects that its dividend will grow at a constant rate of 9 percent a year.
The companys stock price is $25.
The companys tax rate is 40 percent.
The company anticipates that it will need to raise new common stock this year, and total flotation costs will equal 10 percent of the amount issued.
Assume the company accounts for flotation costs by adjusting the cost of capital. Given this information, calculate the companys WACC.
a. 10.41%
b. 12.56%
c. 10.78%
d. 13.55%
e. 9.29%
WACC Answer: a Diff: E
. Flaherty Electric has a capital structure that consists of 70 percent equity and 30 percent debt. The companys longterm bonds have a beforetax yield to maturity of 8.4 percent. The company uses the DCF approach to determine the cost of equity. Flahertys common stock currently trades at $45 per share. The yearend dividend (D1) is expected to be $2.50 per share, and the dividend is expected to grow forever at a constant rate of 7 percent a year. The company estimates that it will have to issue new common stock to help fund this years projects. The flotation cost on new common stock issued is 10 percent, and the companys tax rate is 40 percent. What is the companys weighted average cost of capital, WACC?
a. 10.73%
b. 10.30%
c. 11.31%
d. 7.48%
e. 9.89%
WACC Answer: b Diff: E
. Billick Brothers is estimating its WACC. The company has collected the following information:
Its capital structure consists of 40 percent debt and 60 percent common equity.
The company has 20year bonds outstanding with a 9 percent annual coupon that are trading at par.
The companys tax rate is 40 percent.
The riskfree rate is 5.5 percent.
The market risk premium is 5 percent.
The stocks beta is 1.4.
What is the companys WACC?
a. 9.71%
b. 9.66%
c. 8.31%
d. 11.18%
e. 11.10%
Divisional risk Answer: c Diff: E
. Dandy Products overall weighted average required rate of return is 10 percent. Its yogurt division is riskier than average, its fresh produce division has average risk, and its institutional foods division has belowaverage risk. Dandy adjusts for both divisional and project risk by adding or subtracting 2 percentage points. Thus, the maximum adjustment is 4 percentage points. What is the riskadjusted required rate of return for a lowrisk project in the yogurt division?
a. 6%
b. 8%
c. 10%
d. 12%
e. 14%
Retained earnings break point Answer: e Diff: E
. Stephenson & Sons has a capital structure that consists of 20 percent equity and 80 percent debt. The company expects to report $3 million in net income this year, and 60 percent of the net income will be paid out as dividends. How large must the firms capital budget be this year without it having to issue any new common stock?
a. $ 1.20 million
b. $13.00 million
c. $ 1.50 million
d. $ 0.24 million
e. $ 6.00 million
Medium:
Cost of retained earnings Answer: d Diff: M
. The common stock of Anthony Steel has a beta of 1.20. The riskfree rate is 5 percent and the market risk premium (kM  kRF) is 6 percent. Assume the firm will be able to use retained earnings to fund the equity portion of its capital budget. What is the companys cost of retained earnings, ks?
a. 7.0%
b. 7.2%
c. 11.0%
d. 12.2%
e. 12.4%
Cost of external equity Answer: d Diff: M
. A company just paid a $2.00 per share dividend on its common stock (D0 = $2.00). The dividend is expected to grow at a constant rate of 7 percent per year. The stock currently sells for $42 a share. If the company issues additional stock, it must pay its investment banker a flotation cost of $1.00 per share. What is the cost of external equity, ke?
a. 11.76%
b. 11.88%
c. 11.98%
d. 12.22%
e. 12.30%
Component cost of debt Answer: b Diff: M
. Hamilton Companys 8 percent coupon rate, quarterly payment, $1,000 par value bond, which matures in 20 years, currently sells at a price of $686.86. The companys tax rate is 40 percent. Based on the nominal interest rate, not the EAR, what is the firms component cost of debt for purposes of calculating the WACC?
a. 3.05%
b. 7.32%
c. 7.36%
d. 12.20%
e. 12.26%
WACC Answer: e Diff: M N
. Trojan Services CFO is interested in estimating the companys WACC and has collected the following information:
The company has bonds outstanding that mature in 26 years with an annual coupon of 7.5 percent. The bonds have a face value of $1,000 and sell in the market today for $920.
The riskfree rate is 6 percent.
The market risk premium is 5 percent.
The stocks beta is 1.2.
The companys tax rate is 40 percent.
The companys target capital structure consists of 70 percent equity and 30 percent debt.
The company uses the CAPM to estimate the cost of equity and does not include flotation costs as part of its cost of capital.
What is Trojans WACC?
a. 9.75%
b. 9.39%
c. 10.87%
d. 9.30%
e. 9.89%
WACC Answer: a Diff: M
. A company has determined that its optimal capital structure consists of 40 percent debt and 60 percent equity. Assume the firm will not have enough retained earnings to fund the equity portion of its capital budget. Also, assume the firm accounts for flotation costs by adjusting the cost of capital. Given the following information, calculate the firms weighted average cost of capital.
kd = 8%.
Net income = $40,000.
Payout ratio = 50%.
Tax rate = 40%.
P0 = $25.
Growth = 0%.
Shares outstanding = 10,000.
Flotation cost on additional equity = 15%.
a. 7.60%
b. 8.05%
c. 11.81%
d. 13.69%
e. 14.28%
WACC Answer: b Diff: M
. Hatch Corporations target capital structure is 40 percent debt, 50 percent common stock, and 10 percent preferred stock. Information regarding the companys cost of capital can be summarized as follows:
The companys bonds have a nominal yield to maturity of 7 percent.
The companys preferred stock sells for $42 a share and pays an annual dividend of $4 a share.
The companys common stock sells for $28 a share, and is expected to pay a dividend of $2 a share at the end of the year (i.e., D1 = $2.00). The dividend is expected to grow at a constant rate of 7 percent a year.
The firm will be able to use retained earnings to fund the equity portion of its capital budget.
The companys tax rate is 40 percent.
What is the companys weighted average cost of capital (WACC)?
a. 9.25%
b. 9.70%
c. 10.03%
d. 10.59%
e. 11.30%
WACC Answer: a Diff: M
. Hilliard Corp. wants to calculate its weighted average cost of capital (WACC). The companys CFO has collected the following information:
The companys longterm bonds currently offer a yield to maturity of 8 percent.
The companys stock price is $32 a share (P0 = $32).
The company recently paid a dividend of $2 a share (D0 = $2.00).
The dividend is expected to grow at a constant rate of 6 percent a year (g = 6%).
The company pays a 10 percent flotation cost whenever it issues new common stock (F = 10 percent).
The companys target capital structure is 75 percent equity and 25 percent debt.
The companys tax rate is 40 percent.
The firm will be able to use retained earnings to fund the equity portion of its capital budget.
What is the companys WACC?
a. 10.67%
b. 11.22%
c. 11.47%
d. 12.02%
e. 12.56%
WACC Answer: c Diff: M
. Johnson Industries finances its projects with 40 percent debt, 10 percent preferred stock, and 50 percent common stock.
The company can issue bonds at a yield to maturity of 8.4 percent.
The cost of preferred stock is 9 percent.
The riskfree rate is 6.57 percent.
The market risk premium is 5 percent.
Johnson Industries beta is equal to 1.3.
Assume that the firm will be able to use retained earnings to fund the equity portion of its capital budget.
The companys tax rate is 30 percent.
What is the companys weighted average cost of capital (WACC)?
a. 8.33%
b. 8.95%
c. 9.79%
d. 10.92%
e. 13.15%
WACC Answer: b Diff: M
. Helms Aircraft has a capital structure that consists of 60 percent debt and 40 percent common stock. The firm will be able to use retained earnings to fund the equity portion of its capital budget. The company recently issued bonds with a yield to maturity of 9 percent. The riskfree rate is 6 percent, the market risk premium is 6 percent, and Helms beta is equal to 1.5. If the companys tax rate is 35 percent, what is the companys weighted average cost of capital (WACC)?
a. 8.33%
b. 9.51%
c. 9.95%
d. 10.98%
e. 11.84%
WACC Answer: e Diff: M
. Dobson Dairies has a capital structure that consists of 60 percent longterm debt and 40 percent common stock. The companys CFO has obtained the following information:
The beforetax yield to maturity on the companys bonds is 8 percent.
The companys common stock is expected to pay a $3.00 dividend at year end (D1 = $3.00), and the dividend is expected to grow at a constant rate of 7 percent a year. The common stock currently sells for $60 a share.
Assume the firm will be able to use retained earnings to fund the equity portion of its capital budget.
The companys tax rate is 40 percent.
What is the companys weighted average cost of capital (WACC)?
a. 12.00%
b. 8.03%
c. 9.34%
d. 8.00%
e. 7.68%
WACC Answer: d Diff: M
. Longstreet Corporation has a target capital structure that consists of 30 percent debt, 50 percent common equity, and 20 percent preferred stock. The tax rate is 30 percent. The company has projects in which it would like to invest with costs that total $1,500,000. Longstreet will retain $500,000 of net income this year. The last dividend was $5, the current stock price is $75, and the growth rate of the company is 10 percent. If the company raises capital through a new equity issuance, the flotation costs are 10 percent. The cost of preferred stock is 9 percent and the cost of debt is 7 percent. (Assume debt and preferred stock have no flotation costs.) What is the weighted average cost of capital at the firms optimal capital budget?
a. 12.58%
b. 18.15%
c. 12.18%
d. 12.34%
e. 11.94%
WACC Answer: a Diff: M
. A stock analyst has obtained the following information about JMart, a large retail chain:
The company has noncallable bonds with 20 years maturity remaining and a maturity value of $1,000. The bonds have a 12 percent annual coupon and currently sell at a price of $1,273.8564.
Over the past four years, the returns on the market and on JMart were as follows:
Year Market JMart
1999 12.0% 14.5%
2000 17.2 22.2
2001 3.8 7.5
2002 20.0 24.0
The current riskfree rate is 6.35 percent, and the expected return on the market is 11.35 percent. The companys tax rate is 35 percent. The company anticipates that its proposed investment projects will be financed with 70 percent debt and 30 percent equity.
What is the companys estimated weighted average cost of capital (WACC)?
a. 8.04%
b. 9.00%
c. 10.25%
d. 12.33%
e. 13.14%
WACC Answer: c Diff: M
. Clark Communications has a capital structure that consists of 70 percent common stock and 30 percent longterm debt. In order to calculate Clarks weighted average cost of capital (WACC), an analyst has accumulated the following information:
The company currently has 15year bonds outstanding with annual coupon payments of 8 percent. The bonds have a face value of $1,000 and sell for $1,075.
The riskfree rate is 5 percent.
The market risk premium is 4 percent.
The beta on Clarks common stock is 1.1.
The companys retained earnings are sufficient so that they do not have to issue any new common stock to fund capital projects.
The companys tax rate is 38 percent.
Given this information, what is Clarks WACC?
a. 5.93%
b. 7.40%
c. 7.91%
d. 8.07%
e. 8.73%
WACC Answer: d Diff: M
. Reading Foods is interested in calculating its weighted average cost of capital (WACC). The companys CFO has collected the following information:
The target capital structure consists of 40 percent debt and 60 percent common stock.
The company has 20year noncallable bonds with a par value of $1,000, a 9 percent annual coupon, and a price of $1,075.
Equity flotation costs are 2 percent.
The companys common stock has a beta of 0.8.
The riskfree rate is 5 percent.
The market risk premium is 4 percent.
The companys tax rate is 40 percent.
The company plans to use retained earnings to finance the equity portion of its capital structure, so it does not intend to issue any new common stock.
What is the companys WACC?
a. 13.13%
b. 6.24%
c. 8.21%
d. 6.89%
e. 6.57%
WACC Answer: c Diff: M N
. Financial analysts for Naulls Industries have revealed the following information about the company:
Naulls Industries currently has a capital structure that consists of 75 percent common equity and 25 percent debt.
The riskfree rate, kRF, is 5 percent.
The market risk premium , kM  kRF, is 6 percent.
Naullss common stock has a beta of 1.2.
Naulls has 20year bonds outstanding with an annual coupon rate of 12 percent and a face value of $1,000. The bonds sell today for $1,200.
The companys tax rate is 40 percent.
What is the companys current WACC?
a. 7.41%
b. 9.17%
c. 10.61%
d. 10.99%
e. 11.57%
WACC and dividend growth rate Answer: c Diff: M
. Grateway Inc. has a weighted average cost of capital of 11.5 percent. Its target capital structure is 55 percent equity and 45 percent debt. The company has sufficient retained earnings to fund the equity portion of its capital budget. The beforetax cost of debt is 9 percent, and the companys tax rate is 30 percent. If the expected dividend next period (D1) is $5 and the current stock price is $45, what is the companys growth rate?
a. 2.68%
b. 3.44%
c. 4.64%
d. 6.75%
e. 8.16%
WACC and optimal capital budget Answer: e Diff: M
. The managers of Kenforest Grocers are trying to determine the companys optimal capital budget for the upcoming year. Kenforest is considering the following projects:
Rate of
Project Size Return Risk
A $200,000 16% High
B 500,000 14 Average
C 400,000 12 Low
D 300,000 11 High
E 100,000 10 Average
F 200,000 10 Low
G 400,000 7 Low
The company estimates that its WACC is 11 percent. All projects are independent. The company adjusts for risk by adding 2 percentage points to the WACC for highrisk projects and subtracting 2 percentage points from the WACC for lowrisk projects. Which of the projects will the company accept?
a. A, B, C, E, F
b. B, D, F, G
c. A, B, C, E
d, A, B, C, D, E
e. A, B, C, F
CAPM, beta, and WACC Answer: e Diff: M
. Bradshaw Steel has a capital structure with 30 percent debt (all longterm bonds) and 70 percent common equity. The yield to maturity on the companys longterm bonds is 8 percent, and the firm estimates that its overall composite WACC is 10 percent. The riskfree rate of interest is 5.5 percent, the market risk premium is 5 percent, and the companys tax rate is 40 percent. Bradshaw uses the CAPM to determine its cost of equity. What is the beta on Bradshaws stock?
a. 1.07
b. 1.48
c. 1.31
d. 0.10
e. 1.35
Required rate of return Answer: c Diff: M
. Arizona Rock, an allequity firm, currently has a beta of 1.25. The riskfree rate, kRF, is 7 percent and kM is 14 percent. Suppose the firm sells 10 percent of its assets with beta equal to 1.25 and purchases the same proportion of new assets with a beta of 1.1. What will be the firms new overall required rate of return, and what rate of return must the new assets produce in order to leave the stock price unchanged?
a. 15.645%; 15.645%
b. 15.750%; 14.700%
c. 15.645%; 14.700%
d. 15.750%; 15.645%
e. 14.750%; 15.750%
Beta risk Answer: b Diff: M
. Sun State Mining Inc., an allequity firm, is considering the formation of a new division that will increase the assets of the firm by 50 percent. Sun State currently has a required rate of return of 18 percent, U.S. Treasury bonds yield 7 percent, and the market risk premium is 5 percent. If Sun State wants to reduce its required rate of return to 16 percent, what is the maximum beta coefficient the new division could have?
a. 2.2
b. 1.0
c. 1.8
d. 1.6
e. 2.0
Tough:
WACC Answer: b Diff: T
. Heavy Metal Corp. is a steel manufacturer that finances its operations with 40 percent debt, 10 percent preferred stock, and 50 percent equity. The interest rate on the companys debt is 11 percent. The preferred stock pays an annual dividend of $2 and sells for $20 a share. The companys common stock trades at $30 a share, and its current dividend (D0) of $2 a share is expected to grow at a constant rate of 8 percent per year. The flotation cost of external equity is 15 percent of the dollar amount issued, while the flotation cost on preferred stock is 10 percent. The company estimates that its WACC is 12.30 percent. Assume that the firm will not have enough retained earnings to fund the equity portion of its capital budget. What is the companys tax rate?
a. 30.33%
b. 32.86%
c. 35.75%
d. 38.12%
e. 40.98%
WACC and cost of preferred stock Answer: b Diff: T
. Anderson Company has four investment opportunities with the following costs (paid at t = 0) and expected returns:
Expected
Project Cost Return
A $2,000 16.0%
B 3,000 14.5
C 5,000 11.5
D 3,000 9.5
The company has a target capital structure that consists of 40 percent common equity, 40 percent debt, and 20 percent preferred stock. The company has $1,000 in retained earnings. The company expects its yearend dividend to be $3.00 per share (D1 = $3.00). The dividend is expected to grow at a constant rate of 5 percent a year. The companys stock price is currently $42.75. If the company issues new common stock, the company will pay its investment bankers a 10 percent flotation cost.
The company can issue corporate bonds with a yield to maturity of 10 percent. The company is in the 35 percent tax bracket. How large can the cost of preferred stock be (including flotation costs) and it still be profitable for the company to invest in all four projects?
a. 7.75%
b. 8.90%
c. 10.46%
d. 11.54%
e. 12.68%
Multiple Part:
(The following information applies to the next three problems.)
The Global Advertising Company has a marginal tax rate of 40 percent. The company can raise debt at a 12 percent interest rate and the last dividend paid by Global was $0.90. Globals common stock is selling for $8.59 per share, and its expected growth rate in earnings and dividends is 5 percent. If Global issues new common stock, the flotation cost incurred will be 10 percent. Global plans to finance all capital expenditures with 30 percent debt and 70 percent equity.
Cost of retained earnings Answer: e Diff: E
. What is Globals cost of retained earnings if it can use retained earnings rather than issue new common stock?
a. 12.22%
b. 17.22%
c. 10.33%
d. 9.66%
e. 16.00%
Cost of external equity Answer: b Diff: E
. What is the cost of common equity raised by selling new stock?
a. 12.22%
b. 17.22%
c. 10.33%
d. 9.66%
e. 16.00%
WACC Answer: d Diff: E
. What is the firms weighted average cost of capital if the firm has sufficient retained earnings to fund the equity portion of its capital budget?
a. 11.95%
b. 12.22%
c. 12.88%
d. 13.36%
e. 14.21%
(The following information applies to the next two problems.)
Byron Corporations present capital structure, which is also its target capital structure, is 40 percent debt and 60 percent common equity. Assume that the firm has no retained earnings. The companys earnings and dividends are growing at a constant rate of 5 percent; the last dividend (D0) was $2.00; and the current equilibrium stock price is $21.88. Byron can raise all the debt financing it needs at 14 percent. If Byron issues new common stock, a 20 percent flotation cost will be incurred. The firms marginal tax rate is 40 percent.
Cost of external equity Answer: a Diff: E
. What is the component cost of the equity raised by selling new common stock?
a. 17.0%
b. 16.4%
c. 15.0%
d. 14.6%
e. 12.0%
WACC Answer: b Diff: E
. What is the firms weighted average cost of capital?
a. 10.8%
b. 13.6%
c. 14.2%
d. 16.4%
e. 18.0%
(The following information applies to the next six problems.)
Rollins Corporation has a target capital structure consisting of 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Assume the firm has insufficient retained earnings to fund the equity portion of its capital budget. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock that pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins beta is 1.2, the riskfree rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firms policy is to use a risk premium of 4 percentage points when using the bondyieldplusriskpremium method to find ks. Flotation costs on new common stock total 10 percent, and the firms marginal tax rate is 40 percent.
Cost of debt Answer: e Diff: E
. What is Rollins component cost of debt?
a. 10.0%
b. 9.1%
c. 8.6%
d. 8.0%
e. 7.2%
Cost of preferred stock Answer: d Diff: E
. What is Rollins cost of preferred stock?
a. 10.0%
b. 11.0%
c. 12.0%
d. 12.6%
e. 13.2%
Cost of equity: CAPM Answer: c Diff: E
. What is Rollins cost of retained earnings using the CAPM approach?
a. 13.6%
b. 14.1%
c. 16.0%
d. 16.6%
e. 16.9%
Cost of equity: DCF Answer: c Diff: E
. What is the firms cost of retained earnings using the DCF approach?
a. 13.6%
b. 14.1%
c. 16.0%
d. 16.6%
e. 16.9%
Cost of equity: risk premium Answer: c Diff: E
. What is Rollins cost of retained earnings using the bondyieldplusriskpremium approach?
a. 13.6%
b. 14.1%
c. 16.0%
d. 16.6%
e. 16.9%
WACC Answer: b Diff: E
. What is Rollins WACC, if the firm has insufficient retained earnings to fund the equity portion of its capital budget?
a. 13.6%
b. 14.1%
c. 16.0%
d. 16.6%
e. 16.9%
(The following information applies to the next two problems.)
The Jackson Company has just paid a dividend of $3.00 per share on its common stock, and it expects this dividend to grow by 10 percent per year, indefinitely. The firm has a beta of 1.50; the riskfree rate is 10 percent; and the expected return on the market is 14 percent. The firms investment bankers believe that new issues of common stock would have a flotation cost equal to 5 percent of the current market price.
Stock priceconstant growth Answer: d Diff: E
. How much should an investor be willing to pay for this stock today?
a. $62.81
b. $70.00
c. $43.75
d. $55.00
e. $30.00
Cost of external equity Answer: b Diff: E
. What will be Jacksons cost of new common stock if it issues new stock in the marketplace today?
a. 15.25%
b. 16.32%
c. 17.00%
d. 12.47%
e. 9.85%
(The following information applies to the next two problems.)
Becker Glass Corporation expects to have earnings before interest and taxes during the coming year of $1,000,000, and it expects its earnings and dividends to grow indefinitely at a constant annual rate of 12.5 percent. The firm has $5,000,000 of debt outstanding bearing a coupon interest rate of 8 percent, and it has 100,000 shares of common stock outstanding. Historically, Becker has paid 50 percent of net earnings to common shareholders in the form of dividends. The current price of Beckers common stock is $40, but it would incur a 10 percent flotation cost if it were to sell new stock. The firms tax rate is 40 percent.
Cost of retained earnings Answer: e Diff: M
. What is the firms cost of retained earnings?
a. 15.0%
b. 15.5%
c. 16.0%
d. 16.5%
e. 17.0%
Cost of external equity Answer: d Diff: E
. What is Beckers cost of newly issued stock?
a. 16.0%
b. 16.5%
c. 17.0%
d. 17.5%
e. 18.0%
(The following information applies to the next four problems.)
J. Ross and Sons Inc. has a target capital structure that calls for 40 percent debt, 10 percent preferred stock, and 50 percent common equity. The firms current aftertax cost of debt is 6 percent, and it can sell as much debt as it wishes at this rate. The firms preferred stock currently sells for $90 a share and pays a dividend of $10 per share; however, the firm will net only $80 per share from the sale of new preferred stock. Ross common stock currently sells for $40 per share, but the firm will net only $34 per share from the sale of new common stock. The firm recently paid a dividend of $2 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year. Assume the firm has sufficient retained earnings to fund the equity portion of its capital budget.
Cost of retained earnings Answer: c Diff: E
. What is the firms cost of retained earnings?
a. 10.0%
b. 12.5%
c. 15.5%
d. 16.5%
e. 18.0%
Cost of external equity Answer: d Diff: E
. What is the firms cost of newly issued common stock?
a. 10.0%
b. 12.5%
c. 15.5%
d. 16.5%
e. 18.0%
Cost of preferred stock Answer: b Diff: E
. What is the firms cost of newly issued preferred stock?
a. 10.0%
b. 12.5%
c. 15.5%
d. 16.5%
e. 18.0%
WACC Answer: d Diff: E
. What is the firms weighted average cost of capital?
a. 9.5%
b. 10.3%
c. 10.8%
d. 11.4%
e. 11.9%
(The following information applies to the next three problems.)
The following information applies to the Coetzer Company:
Coetzer has a target capital structure of 40 percent debt and 60 percent common equity.
Coetzer has $1,000 par value bonds outstanding with a 15year maturity, a 12 percent annual coupon, and a current price of $1,150.
The riskfree rate is 5 percent. The market risk premium (kM kRF) is also 5 percent.
Coetzers common stock has a beta of 1.4.
Coetzers tax rate is 40 percent.
Cost of debt Answer: b Diff: E N
. What is the companys aftertax cost of debt?
a. 3.6%
b. 6.0%
c. 7.2%
d. 10.0%
e. 12.0%
Cost of common equity: CAPM Answer: e Diff: E N
. What is the companys aftertax cost of common equity?
a. 6.0%
b. 8.4%
c. 9.6%
d. 10.0%
e. 12.0%
WACC Answer: c Diff: E N
. What is the companys WACC?
a. 6.0%
b. 7.4%
c. 9.6%
d. 10.8%
e. 12.2%
(The following information applies to the next four problems.)
Viduka Constructions CFO wants to estimate the companys WACC. She has collected the following information:
The company currently has 20year bonds outstanding. The bonds have an 8.5 percent annual coupon, a face value of $1,000, and they currently sell for $945.
The companys stock has a beta = 1.20.
The market risk premium, km kRF, equals 5 percent.
The riskfree rate is 6 percent.
The company has outstanding preferred stock that pays a $2.00 annual dividend. The preferred stock sells for $25 a share.
The companys tax rate is 40 percent.
The companys capital structure consists of 40 percent longterm debt, 40 percent common stock, and 20 percent preferred stock.
Cost of debt Answer: b Diff: M N
. What is the companys aftertax cost of debt?
a. 5.10%
b. 5.46%
c. 6.46%
d. 8.50%
e. 9.11%
Cost of preferred stock Answer: d Diff: E N
. What is the companys aftertax cost of preferred stock?
a. 4.80%
b. 5.60%
c. 7.10%
d. 8.00%
e. 8.40%
Cost of common equity: CAPM Answer: d Diff: E N
. What is the companys aftertax cost of common equity?
a. 7.20%
b. 7.32%
c. 7.94%
d. 12.00%
e. 12.20%
WACC Answer: c Diff: E N
. What is the companys WACC?
a. 7.95%
b. 8.12%
c. 8.59%
d. 8.67%
e. 10.04%
(The following information applies to the next three problems.)
Burlees Inc.s CFO is interested in calculating the cost of capital. In order to calculate the cost of capital, the company has collected the following information:
The companys capital structure consists of 40 percent debt and 60 percent common stock.
The company has bonds outstanding with 25 years to maturity. The bonds have a 12 percent annual coupon, a face value of $1,000, and a current price of $1,252.
The company uses the CAPM to calculate the cost of common stock. Currently, the riskfree rate is 5 percent and the market risk premium, (kM  kRF), equals 6 percent. The companys common stock has a beta of 1.6.
The companys tax rate is 40 percent.
Aftertax cost of debt Answer: c Diff: E N
. What is the companys aftertax cost of debt?
a. 3.74%
b. 4.80%
c. 5.62%
d. 7.20%
e. 8.33%
Cost of common equity: CAPM Answer: c Diff: E N
. What is the companys cost of common equity?
a. 9.65%
b. 14.00%
c. 14.60%
d. 17.60%
e. 18.91%
WACC Answer: b Diff: E N
. What is the companys weighted average cost of capital (WACC)?
a. 10.5%
b. 11.0%
c. 11.5%
d. 12.0%
e. 12.5%
Web Appendix 9A
Multiple Choice: Conceptual
Easy:
Risk and divisional costs of capital Answer: a Diff: E N
9A. Sunshine Inc. has two divisions. 50 percent of the firms capital is invested in Division A, which has a beta of 0.8. The other 50 percent of the firms capital is invested in Division B, which has a beta of 1.2. The company has no debt, and it is 100 percent equity financed. The riskfree rate is 6 percent and the market risk premium is 5 percent. Sunshine assigns different hurdle rates to each division, and these hurdle rates are based on each divisions market risk. Which of the following statements is most correct?
a. Sunshines composite WACC is 11 percent.
b. Division B has a lower weighted average cost of capital than Division A.
c. If Sunshine assigned the same hurdle rate to each division, this would lead the firm to select too many projects in Division A and reject too many projects in Division B.
d. Statements a and b are correct.
e. Statements a and c are correct.
Medium:
Risk and project betas Answer: d Diff: M
9A. If the firm is being operated so as to maximize shareholder wealth, and if our basic assumptions concerning the relationship between risk and return are true, then which of the following should be true?
a. If the beta of the asset is larger than the firms beta, then the required return on the asset is less than the required return on the firm.
b. If the beta of the asset is smaller than the firms beta, then the required return on the asset is greater than the required return on the firm.
c. If the beta of the asset is greater than the firms beta prior to the addition of that asset, then the firms beta after the purchase of the asset will be smaller than the original firms beta.
d. If the beta of an asset is larger than the firms beta prior to the addition of that asset, then the required return on the firm will be greater after the purchase of that asset than prior to its purchase.
e. None of the statements above is correct.
SML and capital budgeting Answer: a Diff: M
9A. Using the Security Market Line concept in capital budgeting, which of the following is correct?
a. If the expected rate of return on a given capital project lies above the SML, the project should be accepted even if its beta is above the beta of the firms average project.
b. If a projects return lies below the SML, it should be rejected if it has a beta greater than the firms existing beta but accepted if its beta is below the firms beta.
c. If two mutually exclusive projects expected returns are both above the SML, the project with the lower risk should be accepted.
d. If a projects expected rate of return is greater than the expected rate of return on an average project, it should be accepted.
e. None of the statements above is correct.
Multiple Choice: Problems
Easy:
Project cost of capital Answer: c Diff: E
9A. Louisiana Enterprises, an allequity firm, is considering a new capital investment. Analysis has indicated that the proposed investment has a beta of 0.5 and will generate an expected return of 7 percent. The firm currently has a required return of 10.75 percent and a beta of 1.25. The investment, if undertaken, will double the firms total assets. If kRF is 7 percent and the market return is 10 percent, should the firm undertake the investment? (Choose the best answer.)
a. Yes; the expected return of the asset (7%) exceeds the required return (6.5%).
b. Yes; the beta of the asset will reduce the risk of the firm.
c. No; the expected return of the asset (7%) is less than the required return (8.5%).
d. No; the risk of the asset (beta) will increase the firms beta.
e. No; the expected return of the asset is less than the firms required return, which is 10.75%.
Medium:
Project cost of capital Answer: e Diff: M
9A. Assume you are the director of capital budgeting for an allequity firm. The firms current cost of equity is 16 percent; the riskfree rate is 10 percent; and the market risk premium is 5 percent. You are considering a new project that has 50 percent more beta risk than your firms assets currently have, that is, its beta is 50 percent larger than the firms existing beta. The expected return on the new project is 18 percent. Should the project be accepted if beta risk is the appropriate risk measure? Choose the correct statement.
a. Yes; its expected return is greater than the firms cost of capital.
b. Yes; the projects riskadjusted required return is less than its expected return.
c. No; a 50 percent increase in beta risk gives a riskadjusted required return of 24 percent.
d. No; the projects riskadjusted required return is 2 percentage points above its expected return.
e. No; the projects riskadjusted required return is 1 percentage point above its expected return.
Web Appendix 9B
Multiple Choice: Conceptual
Medium:
Pure play method Answer: b Diff: M
9B. Which of the following methods involves calculating an average beta for firms in a similar business and then applying that beta to determine a projects beta?
a. Risk premium method.
b. Pure play method.
c. Accounting beta method.
d. CAPM method.
e. Statements b and c are correct.
Multiple Choice: Problems
Easy:
Corporate WACC for firm with divisions Answer: c Diff: E N
9B. Northern Conglomerate has two divisions, Division A and Division B. Northern looks at competing pureplay firms to estimate the betas of each of the two divisions. After this analysis, Northern concludes that Division A has a beta of 0.8 and Division B has a beta of 1.5. The two divisions are the same size. The riskfree rate is 5 percent and the market risk premium, kM  kRF, is 6 percent. Assume that Northern is 100 percent equity financed. What is the overall composite WACC for Northern Conglomerate?
a. 9.8%
b. 10.2%
c. 11.9%
d. 13.6%
e. 14.0%
Medium:
Pure play method Answer: b Diff: M
9B. Interstate Transport has a target capital structure of 50 percent debt and 50 percent common equity. The firm is considering a new independent project that has a return of 13 percent and is not related to transportation. However, a pure play proxy firm has been identified that is exclusively engaged in the new line of business. The proxy firm has a beta of 1.38. Both firms have a marginal tax rate of 40 percent, and Interstates beforetax cost of debt is 12 percent. The riskfree rate is 10 percent and the market risk premium is 5 percent. The firm should
a. Reject the project; its return is less than the firms required rate of return on the project of 16.9 percent.
b. Accept the project; its return is greater than the firms required rate of return on the project of 12.05 percent.
c. Reject the project; its return is only 13 percent.
d. Accept the project; its return exceeds the riskfree rate and the beforetax cost of debt.
e. Be indifferent between accepting or rejecting; the firms required rate of return on the project equals its expected return.
CHAPTER 9
ANSWERS AND SOLUTIONS
Chapter 9  Page PAGE 54
Chapter 9  Page PAGE 55
. Capital components Answer: c Diff: E
. Capital components Answer: d Diff: E
. Capital components Answer: a Diff: E
The debt cost used to calculate a firms WACC is kd(1  T). If kd remains constant but T increases, then the term (1  T) decreases and the value of the entire equation, kd(1  T), decreases. Statement b is false; if a companys stock price increases, and all else remains constant, then the dividend yield decreases and ks decreases. This can be seen from the equation ks = D1/P0 + g. Statement c is false for the same reason. The cost of issuing new common stock is ke = D1/[P0(1  F)] + g. If P0 increases but theres no change in the flotation cost, ke will decrease.
. Capital components Answer: c Diff: E
Retained earnings are just another form of equity. When the company has retained earnings, they can do one of two thingsreinvest it or pay it out as dividends. If the firm reinvests the earnings, it needs to earn a return that is at least as high as the ks of the stock. Otherwise, investors would be happier receiving the dividends and investing them in something that will earn ks. Therefore, statement a is false. Some of the preferred stock dividends are excluded from taxation when another company owns them. It makes no tax difference to the company that pays the dividends, since dividends come out of aftertax dollars. Therefore, statement b is false. Interest payments are tax deductible. Therefore, statement c is true.
. DCF cost of equity estimation Answer: b Diff: E
. WACC Answer: d Diff: E
The correct answer is statement d because statements a and b are correct. Statement c is false. Shareholders can either receive a dividend or they can let you reinvest in the company. If they receive a dividend, they can invest that money and earn a return on it. Consequently, if the company keeps the money as retained earnings and reinvests in projects, it had better earn a return on that money. Therefore, there is a cost associated with using retained earnings.
. WACC Answer: c Diff: E
Statement c is the correct choice. A tax rate increase would lead to a decrease in the aftertax cost of debt and, consequently, the firms WACC would decrease.
. WACC Answer: e Diff: E
The preferred stock dividend is not tax deductible like the interest payment on debt. Therefore, there is no tax benefit from preferred stock. Statement a is true. Retained earnings are equity, and equity will have a higher cost than debt. Therefore, statement b is false. If the beta increases, investors will require a higher rate of return to hold or buy the stock. Therefore, the cost of equity will go up, and statement c is true. Because statements a and c are true, the correct choice is statement e.
. Factors influencing WACC Answer: a Diff: E
Statement a is true; the other statements are false. If RPM decreases, the cost of equity will be reduced. Answers b through e will all increase the companys WACC.
. WACC and capital components Answer: c Diff: E
WACC measures the marginal aftertax cost of capital; therefore, statement a is false. The aftertax cost of debt financing is less than the aftertax cost of equity financing; therefore, statement b is false. The correct choice is statement c.
. WACC and capital components Answer: a Diff: E
Statement a is true; the other statements are false. Statement b is false; WACC is an average of debt and equity financing. Since debt financing is cheaper and is adjusted downward for taxes, it should, when averaged with equity, cause the WACC to be less than the cost of equity financing. Statement c is false; WACC is calculated on an aftertax basis. Statement d is false; the WACC is based on marginal, not embedded, costs. Statement e is false; the cost of issuing new common stock is greater than the cost of retained earnings.
. Internal vs. external common equity Answer: e Diff: E
Statements a through c will increase the need to raise new common stock; therefore, statement e is the correct answer.
. Risk and project selection Answer: c Diff: E
ks = 10% + (16%  10%)1.5 = 10% + 9% = 19%.
Expected return = 21%. 21%  Risk adjustment 1% = 20%.
Riskadjusted return = 20% > ks = 19%. Thus, the project should be selected.
. Risk and project selection Answer: b Diff: E
The project whose return is greater than its riskadjusted cost of capital should be selected. Only Project B meets this criteria.
. Divisional risk Answer: a Diff: E N
The correct answer is statement a. Division A should accept only projects with a return greater than 9.8 percent, and Division B should accept only projects with a return greater than 14 percent. Only statement a fits this criteria. The companys composite WACC is irrelevant in the decision.
. Retained earnings break point Answer: a Diff: E
Statement a is true; an increase in net income will increase the retained earnings break point. Statements b and c will serve to lower the break point. Statement b will result in less earnings being retained, so the retained earnings break point will be reduced. Statement c will result in more earnings being needed, so the retained earnings break point will be reduced. Statement d will have no effect on the retained earnings break point.
. Retained earnings break point Answer: b Diff: E
Statement a is false; increasing the dividend payout will result in the firm running out of retained earnings earlier. Statement b is true; a higher debt ratio means that retained earnings are a smaller portion of the funding mix and, therefore, retained earnings will go further. Statement c will have no effect on the retained earnings break point, as is the case for statement d.
. Miscellaneous cost of capital concepts Answer: c Diff: E N
The correct answer is statement c. Debt is usually safer than equity because it has promised payments over the life of the debt. So, the cost of debt is typically below the WACC. So, statement a is incorrect. If bankruptcy occurs, debt holders may get something. Equity holders will get nothing! So, the cost of debt is again typically below the cost of equity. So, statement b is incorrect. Statement c is correct. Statement d is incorrect. The cost of retained earnings is generally equal to the required return on equity, which exceeds the cost of debt. Higher flotation costs increase the cost of equity. So statement e is incorrect.
. Miscellaneous concepts Answer: e Diff: E
Flotation costs do not reduce investor returns; they reduce the amount of the companys proceeds. This drives the companys cost of equity, and thus its WACC, higher. Therefore, statement a is false. The WACC is based on marginal costs and incorporates taxes. Consequently, statement b is false. Retained earnings have no flotation costs but the company still must earn a return on them, so they are not without a cost. Investors expect a required rate of return, and if they dont receive it, they would prefer that the company pay out retained earnings as dividends, so that they can then invest in something that does give them their expected return. Thus, retained earnings have a cost. Therefore, statement c is false. Since statements a, b, and c are false, the correct choice is statement e.
. Capital components Answer: e Diff: M
Statement e is the correct answer. Unlike interest expense on debt, preferred dividends are not deductible, hence there are no tax savings associated with the use of preferred stock. The component costs of WACC should reflect the costs of new financing, not historical measures. The cost of issuing new equity is always greater than the cost of retained earnings.
. Capital components Answer: a Diff: M
Statement a is true; the other statements are false. Preferred stock dividends are not tax deductible; therefore, the cost of preferred stock is only kp. The risk premium in the bondyieldplusrisk premium approach would be added to the firms cost of debt, not the riskfree rate. Preferred stock also has flotation costs.
. Cost of capital estimation Answer: c Diff: M
. Cost of equity estimation Answer: d Diff: M
. CAPM cost of equity estimation Answer: e Diff: M
. CAPM and DCF estimation Answer: a Diff: M
. WACC Answer: d Diff: M
Both statements a and c are true; therefore, statement d is the correct choice. Statement a recites the definition of the weighted average cost of capital. Statement c is correct because kd = kRF + LP + MRP + DRP while ks = kRF + (kM  kRF)b. If kRF increases then the values for kd and ks will increase.
. WACC Answer: d Diff: M
If a firm paid no income taxes, its cost of debt would not be adjusted downward, hence the component cost of debt would be higher than if T were greater than 0. With a higher component cost of debt, the WACC would increase. Of course, the company would have higher earnings, and its cash flows from a given project would be high, so the higher WACC would not impede its investments, that is, its capital budget would be larger than if it were taxed.
. WACC Answer: e Diff: M
Statement e is the correct answer. An increase in flotation costs has no effect on the cost of retained earnings. Since interest is tax deductible, while preferred and common dividends are not, only the cost of debt used in the WACC equation must be adjusted by multiplying by (1  T). An increase in the firms corporate tax rate reduces the aftertax component cost of debt.
. WACC Answer: e Diff: M
Statement e is the correct answer. Aftertax cash flows must be considered in order to account for the tax deductibility of interest payments on corporate debt. An increase in flotation costs will leave the cost of retained earnings unchanged, but will raise the cost of new equity issues. The marginal, not the embedded, cost of capital is the relevant cost of capital.
. WACC and capital components Answer: b Diff: M
Because corporations can exclude dividends for tax purposes, preferred stock often has a beforetax market return that is less than the issuing companys beforetax cost of debt. Then, if the issuers tax rate is zero, its component cost of preferred would be less than its aftertax cost of debt.
. Riskadjusted cost of capital Answer: c Diff: M
By Kemp not making the risk adjustment, it is true that the company will accept more projects in the computer division, and fewer projects in the restaurant division. However, this will make the company riskier overall, raising its cost of equity. Investors will discount their cash flows at a higher rate, and the companys value will fall. In addition, some of the computer projects might not exceed the appropriate riskadjusted hurdle rate, and will actually be negative NPV projects, further destroying value. Therefore, statement a is false. Because fewer of the restaurant projects will be accepted, the restaurant division will become a smaller part of the overall company. Therefore, statement b is false. As explained above, statement c is true.
. Riskadjusted cost of capital Answer: b Diff: M
By not risk adjusting the cost of capital, the firm will tend to reject lowrisk projects since their returns will be lower than the average cost of capital, and it will take on highrisk projects since their returns will be higher than the average cost of capital.
. Riskadjusted cost of capital Answer: e Diff: M
. Riskadjusted cost of capital Answer: a Diff: M
. Division WACCs and risk Answer: e Diff: M
If the company uses the 10 percent WACC, it will turn down all projects with a return of less than 10 percent but more than 8 percent. Thus, these safer projects will no longer be taken, and the company will increase the proportion of risky projects it undertakes. Therefore, statement a is true. If Division As projects have lower returns than Division Bs because they have less risk, fewer and fewer projects will be accepted from Division A and more projects will be accepted from Division B. Therefore, Division B will grow and Division A will shrink. Therefore, statement b is true. If the company becomes riskier, then its cost of equity will increase causing WACC to increase. Therefore, statement c is true. Because all of the statements are true, the correct choice is statement e.
. Divisional risk and project selection Answer: e Diff: M N
The correct answer is statement e. Statement a is correct; the firms have the same size and capital structure, so the WACC of the merged company is just a simple average of their separate WACCs. Statement b is correct; Project X has an IRR of 10.5% and its appropriate cost of capital is 10%, therefore, the project has a positive net present value. Statement c is also correct; Project X should be accepted because of the previous argument. Project Y should be rejected because it has an 11.5% return and its appropriate cost of capital is 12%. Therefore, statement e is the correct choice.
. Beta and project risk Answer: a Diff: M
. Miscellaneous concepts Answer: a Diff: M
. Cost of new equity Answer: b Diff: E
ke = EMBED Equation.2 + 5% = 9.94%.
. Cost of new equity Answer: d Diff: E
The firm must issue new equity to fund its capital projects, so we need to find the cost of new equity capital, ke:
ke = D1/(P0  F) + g
= $2.50/($50  $3) + 4%
= $2.50/$47 + 4%
= 5.32% + 4%
= 9.32%.
. Cost of retained earnings Answer: d Diff: E
Use the dividend growth model to calculate ks:
ks = EMBED Equation.2 + g = EMBED Equation.2 + 0.06
= 0.0833 + 0.06 = 0.1433 14.3%.
. WACC Answer: a Diff: E
WACC = wdkd(1  T) + wcke. kd is given = 9%. Find ke:
ke = D1/[P0(1  F)] + g
= $0.8/[$25(1  0.1)] + 0.09
= 0.125556.
Now you can calculate WACC:
WACC = (0.3)(0.09)(0.6) + (0.7)(0.125556) = 10.41%.
. WACC Answer: a Diff: E
WACC = [0.3 ( 0.084 ( (1  0.4)] + [0.7 ( ($2.5/($45 ( (1  0.1)) + 0.07)]
= 10.73%.
. WACC Answer: b Diff: E
WACC = wdkd(1  T) + wcks.
ks = kRF + RPM(b)
ks = 5.5% + 5%(1.4)
ks = 5.5% + 7% = 12.5%.
WACC = wdkd(1  T) + wcks
WACC = 0.4(9%)(1  0.4) + (0.6)12.5%
WACC = 9.66%.
. Divisional risk Answer: c Diff: E
kYD = 10% + 2% = 12%.
However, for a lowrisk project, Dandy Product subtracts 2 percentage points. Therefore, the required rate of return is 10 percent.
kYD,Lowrisk project = 10% + 2%  2% = 10%.
. Retained earnings break point Answer: e Diff: E
Additions to retained earnings will be: $3.0 million ( 0.4 = $1.2 million. The retained earnings breakpoint is $1.2 million/0.2 = $6 million.
. Cost of retained earnings Answer: d Diff: M
The cost of retained earnings as calculated from the CAPM is
ks = kRF + (kM  kRF)b
= 5% + (6%)1.2
= 12.2%.
. Cost of external equity Answer: d Diff: M
D0 = $2; D1 = $2(1.07) = $2.14.
ke = D1/[P0(1  F)] + g
= $2.14/($42  $1) + 7% = 12.22%.
. Component cost of debt Answer: b Diff: M
EMBED Word.Document.6 \s Financial calculator solution:
Calculate the nominal YTM of bond:
Inputs: N = 80; PV = 686.86; PMT = 20; FV = 1000.
Output: I = 3.05% periodic rate.
Nominal annual rate = 3.05% 4 = 12.20%.
Calculate kd aftertax: kd,AT = 12.20(1  T) = 12.20(1  0.4) = 7.32%.
. WACC Answer: e Diff: M N
Data given:
kRF = 6%; RPM = 5%; b = 1.2; T = 40%; wd = 0.3; wc = 0.7.
WACC = wdkd(1  T) + wcks.
Step 1: Determine the firm s costs of debt and equity:
Enter the following data as inputs in your calculator:
N = 26; PV = 920; PMT = 75; FV = 1000; and then solve for I = kd = 8.2567%.
ks = kRF + (RPM)b
= 6% + (5%)1.2
= 12%.
Step 2: Given the firms component costs of capital, calculate the firms WACC:
WACC = wdkd(1  T) + wcks
= 0.3(8.2567%)(1  0.4) + 0.7(12%)
= 1.4862% + 8.4%
= 9.8862% ( 9.89%.
. WACC Answer: a Diff: M
Find the dividend, D1 = [(0.5)$40,000]/# of Shares = $20,000/10,000 = $2.00.
Since the firm will not have enough retained earnings to fund the equity portion of its capital budget, the firm will have to issue new common stock.
Find the cost of new common stock:
ke = D1/[P0(1  F)] + g = $2.00/[$25(1  0.15)] + 0% = 0.0941 = 9.41%.
Finally, calculate WACC, using ke = 0.0941, and kd = 0.08, so
WACC = (D/A)(1  Tax rate)kd + (E/A)ke
= 0.4(0.08)(1  0.4) + 0.6(0.0941) = 0.0757 ( 7.6%.
. WACC Answer: b Diff: M
AT cost of debt = 0.07(1  0.40) = 0.042 = 4.2%.
Cost of preferred stock = $4/$42 = 0.0952 = 9.52%.
Cost of retained earnings = $2/$28 + 0.07 = 0.1414 = 14.14%.
WACC = 0.40(0.042) + 0.10(0.0952) + 0.50(0.1414) = 0.0970 = 9.70%.
. WACC Answer: a Diff: M
AT cost of debt = 0.08(1  0.40) = 0.048 = 4.80%.
Cost of retained earnings = $2.12/$32 + 0.06 = 0.1263 = 12.63%.
WACC = 0.75(0.1263) + 0.25(0.048) = 10.67%.
. WACC Answer: c Diff: M
Cost of debt = 0.084(1  0.30) = 0.0588 = 5.88%.
Cost of preferred stock = 0.09 = 9%.
Cost of retained earnings = kRF + (RPM)b = 6.57% + (5%)1.3 = 13.07%.
WACC = 0.4(0.0588) + 0.10(0.09) + 0.50(0.1307) = 9.79%.
. WACC Answer: b Diff: M
Cost of debt = 0.09(1  0.35) = 0.0585 = 5.85%.
Cost of retained earnings = kRF + (RPM)b = 6% + 6%(1.5) = 15%.
WACC = 0.60(0.0585) + 0.40(0.1500) = 0.0951 = 9.51%.
. WACC Answer: e Diff: M
The firm will not be issuing new equity because there are adequate retained earnings available to fund available projects. Therefore, WACC should be calculated using ks rather than ke.
ks = D1/P0 + g
= $3.00/$60.00 + 0.07
= 0.12 = 12%.
WACC = wdkd(1  T) + wcks
= (0.6)(0.08)(1  0.4) + (0.4)(0.12)
= 0.0768 = 7.68%.
. WACC Answer: d Diff: M
AT cost of debt = 7%(1  0.3) = 4.9%.
Retained earnings breakpoint = $500,000/0.5 = $1,000,000.
Thus, to finance its optimal capital budget, Longstreet must issue some new equity and flotation costs of 10% will be incurred.
Cost of new equity = [$5(1.10)/$75(1  0.1)] + 10% = 8.15% + 10% = 18.15%.
WACC = 4.9%(0.3) + 9%(0.2) + 18.15%(0.5) = 12.34%.
. WACC Answer: a Diff: M
WACC = [(0.7)(kd)(1  T)] + [(0.3)(ks)].
Use bond information to solve for kd:
N = 20; PV = 1273.8564; PMT = 120; FV = 1000; and then solve for kd = 9%.
To solve for ks, we can use the SML equation, but we need to find beta. Using Market and JMart return information and a calculators regression feature we find b = 1.3585.
ks = 0.0635 + (0.1135  0.0635)(1.3585) = 0.1314 = 13.14%.
Plug these values into the WACC equation and solve:
WACC = [(0.7)(0.09)(1  0.35)] + [(0.3)(0.1314)] = 0.0804 = 8.04%.
. WACC Answer: c Diff: M
Step 1: Find the cost of debt:
Enter the following input data in the calculator:
N = 15; PV = 1075; PMT = 80; FV = 1000; and then solve for I = kd = 7.1678%.
Step 2: Find the cost of equity:
ks = kRF + (kM  kRF)b
= 5% + 4%(1.1)
= 5% + 4.4%
= 9.4%.
Step 3: Calculate the firms WACC:
WACC = wdkd(1  T) + wcks
= (0.3)(7.1678%)(1  0.38) + (0.7)(9.4%)
= 1.3332% + 6.58%
= 7.9132% ( 7.91%.
. WACC Answer: d Diff: M
wd = 0.4; wc = 0.6.
Step 1: Calculate kd:
Use the information about the companys existing bonds to enter the following input data in the calculator:
N = 20; PV = 1075; PMT = 90; FV = 1000; and then solve for I = 8.2234%.
Step 2: Calculate ks:
kRF = 5%; kM  kRF = 4%; b = 0.8.
ks = kRF + (kM  kRF)b
= 5% + (4%)0.8
= 8.2%.
Step 3: Calculate WACC:
WACC = wdkd(1  T) + wcks
= (0.4)(8.2234%)(1  0.4) + (0.6)(8.2%)
= 6.89%.
. WACC Answer: c Diff: M N
WACC = wdkd(1  T) + wcks.
Step 1: Calculate the cost of common equity using the CAPM equation:
ks = 5% + (6%)1.2 = 12.20%.
Step 2: Calculate the cost of debt using a financial calculator by entering the following input data:
N = 20; PV = 1200; PMT = 120; FV = 1000; and then solve for I = kd = 9.7%.
Step 3: Calculate the firms WACC by substituting the values calculated above in the WACC equation:
WACC = (0.25)9.7%(1  0.40) + (0.75)12.20% = 10.61%.
. WACC and dividend growth rate Answer: c Diff: M
Solve for ks: WACC = wdkd(1  T) + wcks
11.5% = 0.45(0.09)(0.70) + 0.55ks
ks = 15.75%.
Solve for g: 15.75% = D1/P0 + g
15.75% = $5/$45 + g
ADVANCE \r2 g = 4.64%.
. WACC and optimal capital budget Answer: e Diff: M
Rate of RiskAdjusted
Project Return Cost of Capital
A 16% 13%
B 14 11
C 12 9
D 11 13
E 10 11
F 10 9
G 7 9
Projects A, B, and C are profitable because their returns surpass their riskadjusted costs of capital. D is not profitable because its return (11%) is less than its riskadjusted cost of capital (13%). E is not acceptable for the same reason: Its return (10%) is less than its riskadjusted cost of capital (11%). F is accepted since it is low risk and its return (10%) surpasses the riskadjusted cost of capital of 9%. G is rejected because its return (7%) is less than the riskadjusted cost of capital (9%).
. CAPM, beta, and WACC Answer: e Diff: M
Data given: wd = 0.3; wc = 0.7; kd = 8%; WACC = 10%; T = 40%; kRF = 5.5%, kM  kRF = 5%.
Step 1: Determine the firms cost of equity using the WACC equation:
WACC = wdkd(1  T) + wcks
10% = (0.3)(8%)(1  0.4) + (0.7)ks
8.56% = (0.7)ks
ks = 12.2286%.
Step 2: Calculate the firms beta using the CAPM equation:
ks = kRF + (kM  kRF)b
12.2286% = 5.5% + (5%)b
6.7286% = 5%b
b = 1.3457 ( 1.35.
. Required rate of return Answer: c Diff: M
bOld, firm = 1.25.
kOld, firm = 0.07 + (0.14 0.07)1.25 = 15.75%.
bNew, firm = 0.9(1.25) + 0.1(1.1) = 1.235.
kNew, firm = 0.07 + 1.235(0.07) = 15.645%.
kNew, assets = 0.07 + 1.1(0.07) = 14.7%.
. Beta risk Answer: b Diff: M
Old assets = 1.0. New assets = 0.5. Total assets = 1.5.
Old required rate: New required rate:
18% = 7% + (5%)b 16% = 7% + (5%)b
beta = 2.2. beta = 1.8.
New b must not be greater than 1.8, therefore
EMBED Equation.3(2.2) + EMBED Equation.3(b) = 1.8
ADVANCE \r0 0.3333(b) = 0.3333
ADVANCE \r0b = 1.0.
Therefore, beta of the new division cannot exceed 1.0.
. WACC Answer: b Diff: T
Capital structure: 40% D, 10% P, 50% E.
WACC = 12.30% (given).
kd = 11% (given).
WACC = 0.4(kd)(1  T) + 0.1(kp) + 0.5(ke).
Because the firm has insufficient retained earnings to fund the equity portion of the firms capital budget, use ke in the WACC calculation.
a. Calculate ke:
ke = EMBED Equation.2 + 8% = 8.47% + 8% = 16.47%.
b. Calculate kp:
kp = EMBED Equation.3 = EMBED Equation.2 = 11.11%.
c. Find T by substituting values for kd, kp, and ke in the WACC equation:
0.1230 = 0.4(0.11)(1  T) + 0.1(0.1111) + 0.5(0.1647)
0.1230 = 0.044(1  T) + 0.0111 + 0.08235
0.02954 = 0.044(1  T)
0.671364 = 1  T
0.328636 = T.
. WACC and cost of preferred stock Answer: b Diff: T
We need to find kp at the point where all 4 projects are accepted. In other words, the capital budget = $2,000 + $3,000 + $5,000 + $3,000 = $13,000. The WACC at that point is equal to IRRD = 9.5%.
Step 1: Find the retained earnings break point to determine whether ks or ke is used in the WACC calculation:
BPRE = EMBED Equation.3 = $2,500.
Since the capital budget > the retained earnings break point, ke is used in the WACC calculation.
Step 2: Calculate ke:
ke = EMBED Equation.3 + 5% = 12.80%.
Step 3: Find kp:
9.5% = 0.4(10%)(0.65) + 0.2(kp) + 0.4(12.80%)
9.5% = 2.60% + 0.2(kp) + 5.12%
1.78% = 0.2kp
8.90% = kp.
. Cost of retained earnings Answer: e Diff: E
ks = EMBED Equation.2 + 0.05 = 0.1600 = 16.00%.
. Cost of external equity Answer: b Diff: E
ke = EMBED Equation.2 + 0.05 = 0.1722 = 17.22%.
. WACC Answer: d Diff: E
Since the firm can fund the equity portion of its capital budget with retained earnings, use ks in WACC.
WACC = wdkd(1  T) + wcks
= 0.3(0.12)(1  0.4) + 0.7(0.16)
= 0.0216 + 0.112
= 0.1336 = 13.36%.
. Cost of external equity Answer: a Diff: E
ke = EMBED Equation.2 + 0.05 = 17%.
. WACC Answer: b Diff: E
WACC = 0.4(0.14)(1  0.4) + 0.6(0.17) = 0.1356 = 13.56% ( 13.6%.
. Cost of debt Answer: e Diff: E
EMBED Word.Document.6 \s
Since the bond sells at par of $1,000, its YTM and coupon rate (12 percent) are equal. Thus, the beforetax cost of debt to Rollins is 12.0 percent. The aftertax cost of debt equals:
kd,Aftertax = 12.0%(1  0.40) = 7.2%.
Financial calculator solution:
Inputs: N = 40; PV = 1000; PMT = 60; FV = 1000;
Output: I = 6.0% = kd/2.
kd = 6.0% 2 = 12%.
kd(1  T) = 12.0%(0.6) = 7.2%.
. Cost of preferred stock Answer: d Diff: E
Cost of preferred stock: kp = $12/$100(0.95) = 12.6%.
. Cost of equity: CAPM Answer: c Diff: E
Cost of retained earnings (CAPM approach):
ks = 10% + (5%)1.2 = 16.0%.
. Cost of equity: DCF Answer: c Diff: E
Cost of retained earnings (DCF approach):
ks = EMBED Equation.2 + 8% = 16.0%.
. Cost of equity: risk premium Answer: c Diff: E
Cost of retained earnings (bond yieldplusriskpremium approach):
ks = 12.0% + 4.0% = 16.0%.
. WACC Answer: b Diff: E
Calculate ke: ke = EMBED Equation.2 + 8% = 16.89%.
WACC = wdkd(1  T) + wpkp + wcke
= 0.2(12.0%)(0.6) + 0.2(12.6%) + 0.6(16.89%) = 14.09 14.1%.
. Stock priceconstant growth Answer: d Diff: E
ks = 10% + (4%)1.5 = 16%.
P0 = EMBED Equation.2 = $55.00.
. Cost of external equity Answer: b Diff: E
Cost of new common equity:
ke = EMBED Equation.2 + 0.10 = 16.32%.
. Cost of retained earnings Answer: e Diff: M
EBIT $1,000,000
Interest 400,000
EBT $ 600,000
Taxes (40%) 240,000
Net income $ 360,000
EPS1 = $360,000/100,000 = $3.60.
D1 = $3.60(0.5) = $1.80.
ks = ($1.80/$40.00) + 0.125 = 17.0%.
. Cost of external equity Answer: d Diff: E
Cost of new common equity:
ke = EMBED Equation.2 + 0.125 = 17.5%.
. Cost of retained earnings Answer: c Diff: E
ks = EMBED Equation.2 + 0.10 = 15.5%.
. Cost of external equity Answer: d Diff: E
Cost of new common equity:
ke = EMBED Equation.2 + 0.10 = 0.1647 16.5%.
. Cost of preferred stock Answer: b Diff: E
kp = EMBED Equation.2 = 12.5%.
. WACC Answer: d Diff: E
Since the firm has sufficient retained earnings to fund the equity portion of its capital budget, use ks in WACC equation.
WACC = wdkd(1  T) + wpkp + wcks
= 0.4(6%) + 0.1(12.5%) + 0.5(15.5%)
= 11.4%.
. Cost of debt Answer: b Diff: E N
To determine the cost of debt, use market values and the bond information given. Enter the following data as inputs into your calculator as follows:
N = 15; PV = 1150; PMT = 120; FV = 1000; and then solve for I = kd = 10.03%. The aftertax cost of debt is 10.03%(1  Tax rate) = 10.03%(0.6) = 6.02% ( 6%.
. Cost of common equity: CAPM Answer: e Diff: E N
Using the CAPM equation: ks = kRF + (kM kRF)b
ks = 5% + (5%)1.4
ks = 12%.
Since equity costs are not taxdeductible, this is also the aftertax cost of equity.
. WACC Answer: c Diff: E N
Use the target debt and equity ratios and the WACC equation as follows:
WACC = wdkd(1 T) + wcks
= (0.40)(0.06) + (0.60)(0.12)
= 0.096, or 9.6%.
. Cost of debt Answer: b Diff: M N
The aftertax cost of debt is found by using the firms bond information to solve for the YTM on bonds outstanding. Then, the YTM needs to be converted to an aftertax yield.
N = 20; PV = 945; PMT = 85; FV = 1000; and then solve for kd = I = 9.11%.
AT kd = 9.11%(1  0.4) = 5.46%.
. Cost of preferred stock Answer: d Diff: E N
The aftertax cost of preferred stock can be derived by simply dividing the preferred dividend paid by the price of preferred stock.
kp = EMBED Equation.3
kp = $2/$25
kp = 8.0%.
. Cost of common equity: CAPM Answer: d Diff: E N
The cost of common equity can be found in a variety of ways. In this case, we have been given information about the market risk premium and beta. Therefore, we can use the CAPM to value the cost of common equity.
ks = kRF + (kM kRF)b
ks = 6% + (5%)1.2
ks = 12.0%.
. WACC Answer: c Diff: E N
The WACC is merely a weightedaverage of the capital component costs.
WACC = wdkd(1 T) + wpkp + wcks
WACC = 0.4(9.11%)(1  0.4) + 0.2(8%)+ 0.4(12%)
WACC = 8.59%.
. Aftertax cost of debt Answer: c Diff: E N
To find the cost of debt, enter the following data into your calculator:
N = 25; PV = 1252; PMT = 120; FV = 1000; and then solve for I = 9.3594%, which is the beforetax cost of debt.
To calculate the aftertax cost of debt, multiply by (1 T) as follows:
(1  0.40) ( 9.3594% = 5.6156% ( 5.62%.
. Cost of common equity: CAPM Answer: c Diff: E N
ks = 5% + (6%)1.6 = 14.6%.
. WACC Answer: b Diff: E N
WACC = (0.40)(5.6156%) + (0.60)(14.6%) = 11.0062% ( 11.0%.
WEB APPENDIX 9A SOLUTIONS
9A. Risk and divisional costs of capital Answer: a Diff: E N
The correct answer is statement a. The composite WACC will be the average of the two divisional WACCs. Since there is no debt, the WACC = ks. There is no cost of equity given, but it can be calculated from the beta, the riskfree rate, and the market risk premium using CAPM. The beta of the entire company is the weighted average of the two divisions betas (0.5 ( 0.8 + 0.5 ( 1.2 = 1.0). The firms cost of equity will be equal to 11% (ks = kRF + (RPM)b = 6% + 5% ( 1.0 = 11%). Therefore, the WACC is 11%, and statement a is correct. Division B has a higher beta, therefore its cost of capital will be higher than As. Therefore, statement b is false. If both divisions were assigned the same hurdle rate, this rate would reflect the required return on projects with a beta of 1.0. Since Division As average projects have a beta of 0.8, they would tend to have a lower return. Therefore, fewer of them would meet the hurdle rate of 11%, and the company would choose too few of them. Conversely, the company would choose too many projects in Division B. Therefore, statement c is false.
9A. Risk and project betas Answer: d Diff: M
9A. SML and capital budgeting Answer: a Diff: M
9A. Project cost of capital Answer: c Diff: E
Calculate the required return, ks, and compare to the expected return, EMBED Equation.3 .
EMBED Equation.3 = 7%.
ks = kRF + (kM  kRF)b = 7% + (10%  7%)0.5 = 8.5%.
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9A. Project cost of capital Answer: e Diff: M
Calculate the beta of the firm, and use to calculate project beta:
ks = 0.16 ADVANCE \l6= 0.10 + (0.05)bFirm. bFirm = 1.2.
bProject = (bFirm)1.5. (bProject is 50% greater than current bFirm)
bProject = (1.2)1.5 = 1.8.
Calculate required return on project, kProject, and compare to expected return:
Project: kProject = 0.10 + (0.05)1.8 = 0.19 = 19%. Expected return ADVANCE \l1= 0.18 = 18%. Since the required return is one percentage point greater than the expected return, the firm should not accept the new project.
WEB APPENDIX 9B SOLUTIONS
9B. Pure play method Answer: b Diff: M
9B. Corporate WACC for firm with divisions Answer: c Diff: E N
For Division A: kA = kRF + (kM kRF)bA
kA = 5% + (6%)0.8
kA = 9.8%.
For Division B: kB = kRF + (kM kRF)bB
kB = 5% + (6%)1.5
kB = 14%.
WACC = wAkA + wBkB
= (0.50)(0.098) + (0.50)(0.14)
= 0.119, or 11.9%.
9B. Pure play method Answer: b Diff: M
Calculate the required return, ks, and use to calculate the WACC:
ks = 10% + 1.38(5%) = 16.9%.
WACC = 0.5(12.0%)(0.6) + 0.5(16.9%) = 12.05%.
Compare expected project return, EMBED Equation.3 , to WACC:
But EMBED Equation.3 = 13.0%.
Accept the project since EMBED Equation.3 : 13.0% > 12.05%.
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CHAPTER 9Rob Clayton Susan Whitman`
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