Question 1

Peter's Audio Shop has a cost of debt of 7 %, a cost of equity of 11 %, and a cost of preferred stock of 8 %. The firm has 104,000 shares of common stock outstanding at a market price of $20 a share. There are 40,000 shares of preferred stock outstanding at a market price of $34 a share. The bond issue has a total face value of $500,000 and sells at 102 % of face value. The company's tax rate is 34 %. What is the weighted average cost of capital for Peter's Audio Shop?

Accepted Answer

The answer of Peter's Audio Shop has a cost of...

Question 2

In which of the following cases would it most likely be appropriate to use the WACC that relates to existing operations?

Accepted Answer

The WACC (Weighted Average Cost of Capital) related to existing operations is most appropriate for projects that are similar to the current operations of the company. Expanding production capacity to meet increasing demand for the same product (garbage bags) falls directly in line with the company's existing operations, making it the scenario where using the existing WACC is most appropriate.

Question 3

Assume the government just increased corporate tax rates. This change will cause the:

Accepted Answer

The answer of Assume the government just increased corporate tax...

Question 4

McKean, Inc. has a debt-equity ratio of.70 and a tax rate of 34 %. The firm does not issue preferred stock. The cost of equity is 12 % and the after-tax cost of debt is 6 %. What is McKean's weighted average cost of capital?

Accepted Answer

The answer of McKean, Inc. has a debt-equity ratio of.70...

Question 5

Which one of the following statements is correct concerning the weighted average cost of capital (WACC)?

Accepted Answer

The weight of the debt in the WACC calculation is based on the market value of the debt, which can be calculated using the face value of the bond issue(s) multiplied by the quoted price(s) as a percentage of the face value.

Question 6

The _______________ is the firm's cost of debt based on its historic borrowings.

Accepted Answer

The embedded debt cost refers to the interest rate a company pays on its existing debt, which is based on its historical borrowing activities. This cost reflects the actual interest expenses a firm incurs on its outstanding debt obligations.

Question 7

Adapt Electric Cars has two preferred stock offerings. The first consists of 100,000 shares of Class A preferred which yield 9%. The second consists of 200,000 shares of Class B preferred with a yield of 7.8%. The Class A shares are currently selling at $81 a share and the Class B shares are currently selling at $56 a share. What is the weighted average cost of preferred stock?

Accepted Answer

To calculate the weighted average cost of preferred stock, we first determine the annual dividend for each class of shares and then calculate the total value of each class of shares. Finally, we find the weighted average based on the total value of all preferred shares.For Class A preferred:- Dividend per share = 9% of $81 = $7.29- Total value = 100,000 shares * $81 = $8,100,000For Class B preferred:- Dividend per share = 7.8% of $56 = $4.368- Total value = 200,000 shares * $56 = $11,200,000Total value of all preferred stock = $8,100,000 (Class A) + $11,200,000 (Class B) = $19,300,000Weighted average cost = [(100,000 shares * $7.29) + (200,000 shares * $4.368)] / $19,300,000= ($729,000 + $873,600) / $19,300,000= $1,602,600 / $19,300,000= 0.083 or 8.30%

Question 8

RMB, Inc. sold a 20-year bond at par 12 years ago. The bond pays an 8% annual coupon, has a $1,000 face value, and currently sells for $893.30. What is the firm's cost of debt?

Accepted Answer

The answer of RMB, Inc. sold a 20-year bond at...

Question 9

Ponderosa's bonds sell for $846.04. The coupon rate is 8%, the bonds mature in 25 years, and interest is paid semi-annually. The tax rate is 34%. What is Ponderosa's after-tax cost of debt?

Accepted Answer

The after-tax cost of debt is the yield to maturity (YTM) of the bond multiplied by (1 - tax rate). The YTM can be calculated using the following formula:YTM = (C + (FV - PV) / N) / ((FV + PV) / 2)where:C = coupon paymentFV = face value of the bondPV = present value of the bondN = number of periods to maturityIn this case, the coupon payment is $40 (8% of $500), the face value is $500, the present value is $846.04, and the number of periods to maturity is 50 (25 years * 2 semi-annual payments per year).Plugging these values into the formula, we get:YTM = (40 + (500 - 846.04) / 50) / ((500 + 846.04) / 2)YTM = 0.0499 = 4.99%Therefore, the after-tax cost of debt is 4.99% * (1 - 0.34) = 3.18%.

Question 10

The Abco Co. maintains a debt-equity ratio of.70 and has a tax rate of 39 %. The firm does not issue preferred stock. The cost of equity is 12 % and the after-tax cost of debt is 5 %. What is Abco's weighted average cost of capital?

Accepted Answer

The WACC is calculated using the formula: WACC = (E/V) * Re + (D/V) * Rd * (1-Tc), where E is equity, D is debt, V is total value (E+D), Re is cost of equity, Rd is cost of debt, and Tc is tax rate. With a debt-equity ratio of 0.70, D/E = 0.70, so D/V = 0.70/1.70 and E/V = 1/1.70. Plugging in the values: WACC = (1/1.70) * 12% + (0.70/1.70) * 5% = 9.1%.

Question 11

The relevant cost of debt for use in a WACC computation, which will be used as the required rate of return for a new project, should be the rate that is the:

Accepted Answer

The relevant cost of debt for use in the Weighted Average Cost of Capital (WACC) computation is the after-tax weighted average yield-to-maturity of all outstanding bonds. This measure accurately reflects the current market conditions and the cost of debt for the company, taking into account the tax shield benefits of debt financing.

Question 12

Donnelly and Son pay $8 as the annual dividend on their preferred stock. Currently, this stock is selling for $72 a share. What is Donnelly's cost of preferred stock?

Accepted Answer

The cost of preferred stock is calculated by dividing the annual dividend by the current price per share. So, $8 / $72 = 0.1111 or 11.11%.

Question 13

The common stock of Chelsea, Inc. has a beta of 1.14, a market price of $38.90, and an expected dividend of $.90 next year. The market risk premium is 6% and the risk-free rate of return is 3%. What is the average expected cost of equity for Chelsea, Inc.?

Accepted Answer

The answer of The common stock of Chelsea, Inc. has...

Question 14

Wilson's has 10,000 shares of common stock outstanding at a market price of $35 a share. The firm also has a bond issue outstanding with a total face value of $250,000 which is selling for 102 % of face value. The cost of equity is 11 % while the pre-tax cost of debt is 8 %. The firm has a beta of 1.1 and a tax rate of 34 %. What is Wilson's weighted average cost of capital?

Accepted Answer

The correct answer is A because the weighted average cost of capital is 8.59%.

Question 15

The rate of return which a firm must earn on its existing assets if the firm is to maintain the value of its stock is called the:

Accepted Answer

The weighted average cost of capital (WACC) represents the average rate of return a company must earn on its existing assets to maintain the value of its stock. It reflects the cost of the company's capital, including both debt and equity.

Question 16

A firm has 2,000,000 shares of common stock outstanding with a market price of $2 per share. It has 2,000 bonds outstanding, each selling for $1,200. The bonds mature in 15 years, have a coupon rate of 10%, and pay coupons annually. The firm's beta is 1.2, the risk free rate is 5%, and the market risk premium is 7%. The tax rate is 34%. Calculate the WACC.

Accepted Answer

The answer of A firm has 2,000,000 shares of common...

Question 17

Stock in Globex Corporation has a beta of 0.9. The expected market return is 10%, and T-bills are currently yielding 3.5%. The company's next dividend is expected to be $2 per share, and dividends have been growing at a 4% annual rate. If the stock sells for $25 per share, what is your best estimate of the company's cost of equity?

Accepted Answer

The cost of equity can be estimated using the Capital Asset Pricing Model (CAPM): Cost of Equity = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate). Substituting the given values: 3.5% + 0.9 * (10% - 3.5%) = 9.77%. However, the Dividend Discount Model (DDM) can also be used: Cost of Equity = (Dividend/Price) + Growth Rate = ($2/$25) + 4% = 12%. The average of these two estimates is approximately 10.68%.

Question 18

Hartley, Inc. needs to purchase equipment for its 2,000 drive-ins nationwide. The total cost of the equipment is $2 million. It is estimated that the after-tax cash inflows from the project will be $210,000 annually in perpetuity. Hartley has a market value debt-to-assets ratio of 40%. The firm's cost of equity is 13%, its pre-tax cost of debt is 8%, and the flotation costs of debt and equity are 2% and 8%, respectively. The tax rate is 34%. Assume the project is of similar risk to the firm's existing operations.

What is Hartley's weighted average cost of capital?

Accepted Answer

The answer of Hartley, Inc. needs to purchase equipment for...

Question 19

Toasty Feet makes fur-lined boots for winter wear. The firm has a beta of 1.08 and just paid an annual dividend of $1.50 per share. Based on the security market line approach, which one of the following will increase the firm's cost of equity? Assume a constant market rate of return.

Accepted Answer

A decrease in the risk-free rate of return will increase the firm's cost of equity according to the security market line approach, as it reduces the risk premium.

Question 20

When a firm has flotation costs equal to 6 % of the funding need, it should:

Accepted Answer

Flotation costs should be accounted for by adjusting the initial project cost, not the WACC. Dividing the initial cost by (1 - 0.06) accounts for the 6% flotation cost.

Quiz 14: Cost of Capital