Question 1

Weatherall Enterprises has no debt or preferred stock⎯it is an all-equity firm⎯and has a beta of 2.0.The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment.The risk-free rate is 5%, and the market risk premium is 4%.The project being evaluated is riskier than an average project, in terms of both its beta risk and its total risk.Which of the following statements is CORRECT?

Accepted Answer

The accept/reject decision in this case depends on the firm's risk-adjustment policy. If the firm's policy is to increase the required return on a riskier-than-average project to 3% over the risk-free rate, then the required return for this project would be 8% (5% + 3%). If the project's expected return is less than 8%, then it should be rejected. Since the project's expected return is 14%, it should be accepted even though it is riskier than an average project.

Question 2

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

Accepted Answer

Project B has a return of 8.5%, which is higher than its below-average risk WACC of 8%. Therefore, it should be accepted. Project A has a return of 9%, which is lower than its average-risk WACC of 10%. Therefore, it should not be accepted. Project C has a return of 11%, which is lower than its above-average risk WACC of 12%. Therefore, it should not be accepted. As a result, only Project B should be accepted.

Question 3

The Anderson Company has equal amounts of low-risk, average-risk, and high-risk projects.The firm's overall WACC is 12%.The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects.The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources.If the CEO's position is accepted, what is likely to happen over time?

Accepted Answer

If the CEO's position is accepted and the same WACC is used for all projects, the company may be more willing to take on higher-risk projects that have a higher potential return but also a higher potential for loss. At the same time, the company may be more likely to reject lower-risk projects that have a lower potential return but also a lower potential for loss. This could lead to the company taking on too many high-risk projects and rejecting too many low-risk projects, which could increase the company's overall risk over time.

Question 4

Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely

Accepted Answer

Using a single cost of capital over a 10-year period assumes that the risk of the firm and the market will remain constant, which is unlikely. As a result, the firm's risk profile is likely to change over time, causing its WACC to increase, and using the same WACC to evaluate projects could result in the acceptance of projects that are not profitable but low in risk, and the rejection of potentially very profitable but high-risk projects. This will decrease the overall intrinsic value of the firm.

Question 5

Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 25%.An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

Accepted Answer

The answer of Suppose the debt ratio (D/TA) is 50%,...

Question 6

With its current financial policies, Flagstaff Inc.will have to issue new common stock to fund its capital budget.Since new stock has a higher cost than reinvested earnings, Flagstaff would like to avoid issuing new stock.Which of the following actions would REDUCE its need to issue new common stock?

Accepted Answer

By increasing the percentage of debt in the target capital structure, Flagstaff can raise funds through debt financing rather than issuing new common stock. This would reduce their need to issue new stock and avoid the higher cost of new equity. Additionally, increasing the proposed capital budget, reducing short-term bank debt, or increasing the dividend payout ratio would all increase the need for funding, potentially leading to the issuance of new stock. Reducing the percentage of debt in the target capital structure would also not be beneficial in reducing the need for new equity financing.

Question 7

Burnham Brothers Inc.has no retained earnings since it has always paid out all of its earnings as dividends.This same situation is expected to persist in the future.The company uses the CAPM to calculate its cost of equity, and its target capital structure consists of common stock, preferred stock, and debt.Which of the following events would REDUCE its WACC?

Accepted Answer

The Weighted Average Cost of Capital (WACC) would decrease if the market risk premium declines because the cost of equity, calculated using the CAPM (Capital Asset Pricing Model), would decrease. The CAPM formula is: Cost of Equity = Risk-Free Rate + Beta * (Market Risk Premium). A lower market risk premium reduces the cost of equity, thereby reducing the WACC, assuming other factors remain constant.

Quiz 9: The Cost of Capital

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

Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely

Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 25%.An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).