Deck 13: The Weighted-Average Cost of Capital and Company Valuation

Question 1

There are two costs of debt finance.The explicit cost of debt is the rate of interest that bondholders demand.But there is also an implicit cost,because higher levels of debt increase the required rate of return to equity.

Answer 1

True

Question 2

Capital structure refers to a firm's mix of long-term debt and equity financing.

Answer 2

True

Question 3

The cost of equity will generally increase for risky firms when the risk-free rate of return increases.

Answer 3

True

Question 4

A firm's weighted-average cost of capital will generally increase if the firm lowers its debt-equity ratio.

Question 5

If the firm decreases its debt ratio,both the debt and the equity will become riskier.The debtholders and equityholders will require a higher return to compensate for the increased risk.

Question 6

The company cost of capital is the minimum acceptable rate of return for any project the firm undertakes.

Question 7

Interest tax shields are available to the firm on debt and preferred stock but not on common equity.

Question 8

Projects that have a zero NPV when the cash flows are discounted at the WACC will provide just sufficient returns to creditors and shareholders.

Question 9

The mix of a company's short-term financing is referred to as its capital structure.

Question 10

A firm's cost of capital should be used as the discount rate for every new project the firm considers.

Question 11

New projects should be undertaken by firms only if they have the same risk as existing assets.

Question 12

If a project has a zero NPV when the expected cash flows are discounted at the weighted-average cost of capital,then the project's cash flows are just sufficient to give debtholders and shareholders the return they require.

Question 13

A firm's cost of capital should be computed using the book weights of each financing source.

Question 14

As a firm increases its debt ratio,debtholders are likely to demand higher rates of return.

Question 15

An increase in a firm's debt ratio will have no effect on the required rate of return for equity holders.

Question 16

The weighted-average cost of capital is the expected rate of return on a portfolio of all the firm's securities,adjusted for the tax savings on interest payments.

Question 17

The weighted-average cost of capital is the return the company needs to earn after tax in order to satisfy all its security holders.

Question 18

Preferred stock should be ignored when computing a firm's weighted-average cost of capital.

Question 19

The company cost of capital is the expected rate of return that investors demand from the company's assets and operations.

Question 20

Both the capital asset pricing model and the dividend discount model can be used to determine the cost of equity financing.

Question 21

The weighted-average cost of capital for a firm with a 65/35 debt/equity split,8% pre-tax cost of debt,15% cost of equity,and a 35% tax rate is:

A) 8.63%.
B) 9.12%.
C) 10.45%.
D) 13.80%.

Question 22

For healthy firms,the expected return on their bonds is close to their yield to maturity.

Question 23

The weighted-average cost of capital for a firm with a 40/60 debt/equity split,8% cost of debt,15% cost of equity,and a 34% tax rate is:

A) 12.20%.
B) 8.63%.
C) 11.11%.
D) 13.80%.

Question 24

What is the WACC for a firm with 50% debt and 50% equity that pays 12% on its debt,20% on its equity,and has a 40% tax rate?

A) 9.6%
B) 12.0%
C) 13.6%
D) 16.0%

Question 25

When using the WACC as a discount rate,it is often adjusted upward for riskier projects and downward for safer projects.

Question 26

One way to estimate the expected return on bonds is to find the yield to maturity on recently-issued bonds with similar characteristics and risks.

Question 27

What is the debt ratio of a firm that has outstanding $15 million in bonds and equity with a market value of $35 million?

A) 15%
B) 30%
C) 35%
D) 43%

Question 28

The WACC is the rate of return that the firm must expect to earn on its average-risk investments in order to provide an acceptable return to its security holders.

Question 29

Company X has 2 million shares of common stock outstanding with a book value of $2 per share.The stock trades for $3 per share.It also has $2 million in face value of debt that trades at 90% of face value.What is the debt ratio that should be used to calculate WACC?

A) 13.91%
B) 23.08%
C) 31.03%
D) 27.67%

Question 30

What is a firm's weighted-average cost of capital for a firm that is financed 45% by debt? The debt has a 10% required return and the equity has a 17% required return.The tax rate is 35%.

A) 13.85%
B) 12.28%
C) 13.50%
D) 9.00%

Question 31

Why is debt financing said to include a tax shield for the company?

A) Taxes are reduced by the amount of the debt.
B) Taxes are reduced by the amount of the interest.
C) Taxable income is reduced by the amount of the debt.
D) Taxable income is reduced by the amount of the interest.

Question 32

A change in the company's capital structure will change the amount of taxes paid but will not change the WACC.

Question 33

To calculate the present value of a business,the firm's free cash flows should be discounted at the firm's:

A) weighted-average cost of capital.
B) pre-tax cost of debt.
C) after-tax cost of debt.
D) cost of equity.

Question 34

To a company,the cost of interest payments on its bonds is reduced by the amount of tax savings generated by that interest.

Question 35

Assuming a project has the same risk and financing as the firm,it will have a positive NPV if its rate of return is greater than the firm's WACC.

Question 36

If the tax rate is 35%,what is the cost of preferred stock that sells for $10 per share and pays a $1.20 dividend?

A) 4.20%
B) 7.80%
C) 8.33%
D) 12.00%

Question 37

Capital structure decisions refer to the:

A) dividend yield of the firm's stock.
B) blend of equity and debt used by the firm.
C) capital gains available on the firm's stock.
D) maturity date for the firm's securities.

Question 38

A firm is financed 55% by common stock,10% by preferred stock and 35% by debt.The required return is 15% on the common,10% on the preferred,and 8% on the debt.If the tax rate is 35% what is the WACC?

A) 10.72%
B) 11.07%
C) 11.70%
D) 12.05%

Question 39

The interest tax shield generated by a project's actual equity financing is accounted for by using the after-tax cost of equity in the WACC.

Question 40

If the after-tax cost of debt is 10%,what is the pretax cost for a firm in the 35% tax bracket?

A) 5.85%
B) 12.15%
C) 15.38%
D) 25.71%

Question 41

What dividend is paid on preferred stock if investors require a 9% rate of return and the stock has a market value of $54 per share and a book value of $50 per share?

A) $2.92
B) $4.50
C) $4.68
D) $4.86

Question 42

How much will a firm need in cash flow before tax and interest to satisfy debtholders and equityholders if the tax rate is 35%,there is $13 million in common stock requiring a 10% return,and $6 million in bonds requiring a 6% return?

A) $1,392,000
B) $1,488,000
C) $2,360,000
D) $2,480,000

Question 43

For a company that pays no corporate taxes,its WACC will be equal to:

A) the expected return on its assets.
B) the expected return on its debt.
C) the total value of its assets.
D) the expected return on its equity.

Question 44

A firm's WACC:

A) is the proper discount rate for every project the firm undertakes.
B) is used to value all of the firm's existing projects.
C) is a benchmark discount rate that may be adjusted for the riskiness of each project.
D) is for informational value only and should never be used as a discount rate.

Question 45

Other things equal,which of the following will decrease the WACC of a firm that has both debt and equity in its capital structure?

A) An increase in the stock's beta
B) An increase in the expected market return
C) An increase in the tax rate
D) An increase in the yield on preferred stock

Question 46

Calculate a firm's WACC given that the total value of the firm is $2 million,$600,000 of which is debt,the pre-tax cost of debt is 10%,and the cost of equity is 15%.The firm pays no taxes.

A) 9.0%
B) 11.5%
C) 13.5%
D) 14.4%

Question 47

An implicit cost of increasing the proportion of debt in a firm's capital structure is that:

A) the firm's asset beta will increase.
B) shareholders will demand a higher rate of return.
C) the tax shield will not apply to the added debt.
D) the cost of equity will decrease.

Question 48

A firm has a debt-to-equity ratio of 1/4.The WACC is 18.6%,and the pretax cost of debt is 9.4%.What is the cost of common equity if the tax rate is 34%?

A) 19.90%
B) 20.90%
C) 21.70%
D) 22.73%

Question 49

If a firm earns the WACC on its assets,then:

A) equityholders will be satisfied, but bondholders will not.
B) bondholders will be satisfied, but equityholders will not.
C) all investors will earn their minimum required rate of return.
D) the firm is investing in only positive NPV projects.

Question 50

A project requires an investment of $10 million and offers an annual after-tax cash flow of $1,250,000 indefinitely.If the firm's WACC is 12.5% and the project is riskier than the firm's average projects,should it be accepted%?

A) Yes, since the project's NPV is positive.
B) Yes, since a zero NPV indicates marginal acceptability.
C) No, since the project's NPV is zero.
D) No, since the project's NPV is negative.

Question 51

A firm is considering a project that will generate perpetual cash flows of $50,000 per year beginning next year.The project has the same risk as the firm's overall operations.If the firm's WACC is 12%,and its debt-to-equity ratio is 1.33,what is the most it could pay for the project and still earn its required rate of return?

A) $313,283
B) $375,094
C) $416,667
D) $554,167

Question 52

As debt is added to the capital structure,the:

A) WACC will continually decline.
B) WACC will continually increase.
C) cost of debt can be expected to rise.
D) WACC will be unaffected.

Question 53

A firm is 40% financed by debt with a yield-to-maturity of 8.5%.The equity has a beta of 1.3,the market risk premium is 8.4% and the risk-free rate is 3.8%.What is the firm's WACC if the tax rate is 34%?

A) 10.74%
B) 11.08%
C) 11.61%
D) 11.38%

Question 54

What is the expected growth rate in dividends for a firm in which shareholders require an 18% rate of return and the dividend yield is 10%?

A) 1.8%
B) 5.2%
C) 8.0%
D) 28.0%

Question 55

If a firm has twice as much equity as debt in its capital structure,then the firm is financed with:

A) 75.0% debt.
B) 66.7% equity.
C) 40.0% debt.
D) 33.3% equity.

Question 56

What would you estimate as the cost of equity if a stock sells for $40,pays a $4.25 dividend,and is expected to grow at a constant rate of 5%?

A) 17.46%
B) 14.52%
C) 12.69%
D) 15.63%

Question 57

How much will a firm need in cash flow before tax and interest to satisfy debtholders and equityholders if the tax rate is 40%,there is $10 million in common stock requiring a 12% return,and $6 million in bonds requiring an 8% return?

A) $1,392,000
B) $1,488,000
C) $2,480,000
D) $2,800,000

Question 58

Which one of the following statements is incorrect?

A) The equity component of WACC reflects the return expected by the company's shareholders.
B) Market values should be used in calculating WACC.
C) Preferred equity is a separate component of WACC.
D) There is a tax shield on the equity dividends paid.

Question 59

What will be the effect of using the book value of debt in WACC decisions if interest rates have decreased substantially since a firm's long-term bonds were issued?

A) The debt-to-value ratio will be overstated.
B) The debt-to-value ratio will be understated.
C) There will be no effect on WACC decisions.
D) It cannot be determined without knowing interest rates.

Question 60

A firm has 12,000 shares of common stock outstanding with a book value of $20 per share and a market value of $39.There are 5,000 shares of preferred stock with a book value of $22 and a market value of $26.There is a $400,000 face value bond issue outstanding that is selling at 87% of par.What weight should be placed on the preferred stock when computing the firm's WACC?

A) 7.25%
B) 13.74%
C) 11.48%
D) 15.09%

Question 61

What proportion of a firm is equity financed if the WACC is 14%,the before-tax cost of debt is 10.77%,the tax rate is 35%,and the required return on equity is 18%?

A) 54.00%
B) 63.64%
C) 70.26%
D) 77.78%

Question 62

A proposed project has a positive NPV if it is financed entirely by equity.If the project can sensibly be financed partly by debt and the firm pays tax,will the project remain acceptable?

A) Yes, using debt will increase the NPV.
B) No, using debt will decrease the NPV.
C) The project may now become unacceptable.
D) There will be no change in the project's NPV.

Question 63

Al's Market plans to close after 3 more years.The firm expects to have free cash flows of $148,000 next year,$128,000 in Year 2,and $65,000 in Year 3 after incurring the costs of closing.The firm's cost of equity is 15.5% and its after-tax cost of debt is 6.2%.What is the present value of the firm if its debt to value ratio is 30%?

A) $312,020
B) $248,915
C) $277,467
D) $301,004

Question 64

Assume a firm's debt is selling at face value.What is the firm's cost of debt if the debt has a coupon rate of 7.5% and the tax rate is 35%?

A) 4.88%
B) 4.97%
C) 5.21%
D) 5.35%

Question 65

If a firm has three times as much equity as debt in its capital structure,then the firm is financed with:

A) 25.0% debt.
B) 90.0% equity.
C) 40.0% debt.
D) 33.3% debt.

Question 66

A firm is considering expanding its current operations and has estimated the internal rate of return on that expansion to be 12.2%.The firm's WACC is 11.8%.Given this,you know that the:

A) project will have a lower debt-equity ratio than the firm's current operations.
B) appropriate discount rate for the project is between 11.8% and 12.2%.
C) project has slightly more risk than the firm's current operations.
D) expansion should be undertaken as it has a positive net present value.

Question 67

What is the WACC for a firm financed with 30% debt if the debt investors require a return of 12.5% and equity investors require a 16% return? The corporate tax rate is 20%.

A) 11.8%
B) 13.3%
C) 14.2%
D) 14.8%

Question 68

Which one of the following changes would tend to increase the WACC for a tax-paying firm?

A) Decrease the proportion of equity financing
B) Increase the market value of the debt
C) Decrease the proportion of debt financing
D) Decrease the market value of the equity

Question 69

The company cost of capital is the return that is expected on a portfolio of the company's:

A) existing securities.
B) equity securities.
C) debt securities.
D) proposed securities.

Question 70

If a company's WACC is less than the required return on equity,then the firm:

A) is financed with more than 50% debt.
B) is perceived to be safe.
C) has debt in its capital structure.
D) is all equity financed.

Question 71

A firm has a debt-to-value ratio of 40%,a cost of equity of 14%,and an after-tax cost of debt of 5.5%.It plans to launch a new product that will produce cash flows of $398,000 next year and $211,000 in year 2.If this project is about as risky as the firm's existing assets,what is the present value of the project?

A) $458,008
B) $481,707
C) $500,614
D) $532,349

Question 72

A tax-paying firm is currently financed with 50% debt and 50% equity.The after-tax cost of debt is 6% and the cost of equity is 12%.If the firm issues some 8% preferred stock at par,then the firm's WACC will:

A) increase.
B) decrease.
C) either increase or decrease depending upon the amount of stock issued.
D) not be affected.

Question 73

What proportion of a firm is equity financed if the WACC is 14%,the after-tax cost of debt is 7%,the tax rate is 35%,and the required return on equity is 18%?

A) 54.00%
B) 63.64%
C) 70.26%
D) 77.78%

Question 74

What is the WACC for a firm with 40% debt,20% preferred stock,and 40% equity if their respective costs are 6% after tax,12%,and 18%? The firm's tax rate is 35%.

A) 9.48%
B) 11.16%
C) 12.00%
D) 15.60%

Question 75

A firm has 12,500 shares of stock outstanding that sell for $42 each.The book value of equity is $400,000.The firm has also issued $250,000 face value of debt that is currently quoted at 101.2.What value should be used as the weight of equity when computing WACC?

A) 67.48%
B) 72.09%
C) 61.54%
D) 69.74%

Question 76

What is the WACC for a firm with 40% debt,20% preferred stock,and 40% equity if their respective costs are 9.23% before tax,12%,and 18%? The firm's tax rate is 35%.

A) 9.48%
B) 11.16%
C) 12.00%
D) 15.60%

Question 77

A project will generate a $1 million net cash flow annually in perpetuity.If the project costs $7 million,what is the break-even WACC?

A) 13.33%
B) 12.08%
C) 14.29%
D) 16.67%

Question 78

What is the after-tax cost of preferred stock that pays a 12% dividend and sells at par if the firm's tax rate is 35%?

A) 7.8%
B) 8.5%
C) 12.0%
D) 16.2%

Question 79

A firm has just paid its annual dividend of $5.64 a share.Thereafter the dividend is expected to increase at a rate of 2% a year.If the firm's stock currently sells for $60 a share,what is the cost of equity?

A) 11.59%
B) 14.33%
C) 11.40%
D) 9.40%

Question 80

Which one of the following changes offers the greatest chance of changing a project's NPV from negative to positive?

A) Substituting preferred stock for debt
B) Selling the debt at less than par value
C) Reducing the risk of the project
D) Reducing the maturity of the debt