Question 1

What is the after-tax cost of preferred stock that sells for $10 per share and offers a $1.20 dividend when the tax rate is 35%?

Accepted Answer

Cost of preferred = $1.20/$10.00 = 0.12, or 12%

Question 2

Which component is more likely to be biased if book values are used in the calculation of WACC rather than market values?

Accepted Answer

Common stock is the component that is more likely to be biased if book values are used instead of market values. This is because the book value of common stock might not reflect its current market value due to factors such as changes in industry conditions, company performance, or market sentiment. In contrast, debt and preferred stock typically have fixed values that are less affected by market fluctuations, making them less likely to be biased if book values are used in the WACC calculation.

Question 3

Which of the following statements is incorrect concerning the equity component of the WACC?

Accepted Answer

The equity component of the WACC does not have a tax shield like debt.

Question 4

The company cost of capital, after tax, for a firm with a 60/40 debt/equity split, 8% cost of debt, 15% cost of equity, and a 35% tax rate would be:

Accepted Answer

The company's cost of capital can be calculated using the weighted average cost of capital (WACC) formula: WACC = (E/V * Re) + [(D/V * Rd) * (1 - Tc)], where E = market value of the equity, D = market value of the debt, V = E + D (total market value of the firm's financing), Re = cost of equity, Rd = cost of debt, and Tc = corporate tax rate. Plugging in the given values: WACC = (0.4 * 15%) + [(0.6 * 8%) * (1 - 0.35)] = 6% + 3.12% = 9.12%.

Question 5

What appears to be the targeted debt ratio of a firm that issues $15 million in bonds and $35 million in equity to finance its new capital projects?

Accepted Answer

The targeted debt ratio is the percentage of debt in the firm's capital structure. In this case, the total capital raised is $50 million ($15 million in bonds and $35 million in equity). To find the debt ratio, we divide the amount of debt by the total capital raised: $15 million / $50 million = 0.30 or 30%. Therefore, the targeted debt ratio is 30.00%.

Question 6

Capital structure decisions refer to the:

Accepted Answer

Capital structure decisions refer to the specific blend of equity and debt that a firm uses to finance its operations and investments. This mix has important implications for the risk profile of the company, as well as for the cost of financing and the value of the firm. Dividend yield, capital gains, and maturity dates are all important considerations for investors, but they do not directly relate to capital structure decisions.

Question 7

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

Accepted Answer

When interest rates decrease, the market value of existing debt increases. Using the book value of debt, which does not reflect this increase, will understate the debt-to-value ratio.

Question 8

How much will a firm need in cash flow before tax and interest to satisfy debt holders and equity holders 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?

Accepted Answer

To calculate the required cash flow before tax and interest, we need to find the total amount of return required by both debt holders and equity holders.

For bonds, the return required is $6 million x 8% = $480,000

For common stock, the return required is $10 million x 12% = $1,200,000

Total return required = $480,000 + $1,200,000 = $1,680,000

However, this is before tax and interest. If we apply the tax rate of 40%, we get:

Required cash flow before tax and interest = $1,680,000 / (1 - 0.4) = $2,800,000

Question 9

What is the pretax cost of debt for a firm in the 35% tax bracket that has a 9% after-tax cost of debt?

Accepted Answer

To find the pretax cost of debt, we can use the formula: 
pre-tax cost of debt = after-tax cost of debt / (1 - tax rate)
Substituting the given values: 
pre-tax cost of debt = 9% / (1 - 0.35) = 13.85% 
Therefore, the answer is choice C.

Question 10

What is the WACC for a firm using 55% equity with a required return of 15%, 35% debt with a required return of 8%, 10% preferred stock with a required return of 10%, and a tax rate of 35%?

Accepted Answer

Using the given values, we can calculate the WACC as follows:

WACC = (.35 x (1 - .35).08) + (.1 x .1) + (.55 x .15)
     = 0.0552 + 0.01 + 0.0825
     = 0.1477 
     = 14.77%

Therefore, the best choice is B, which is closest to this value.

Question 11

The company cost of capital for a firm with a 60/40 debt/equity split, 8% cost of debt, 15% cost of equity, and a 35% tax rate would be:

Accepted Answer

To calculate the cost of capital, we use the weighted average cost of capital (WACC) formula:
WACC = (E/V) × Re + (D/V) × Rd × (1 - Tc)
Where:
E/V = percentage of equity
Re = cost of equity
D/V = percentage of debt
Rd = cost of debt
Tc = corporate tax rate

Plugging in the numbers, we get:
WACC = (0.4 × 0.15) + (0.6 × 0.08) × (1 - 0.35)
WACC = 0.06 + 0.0312
WACC = 0.0912 or 9.12%
Therefore, the answer is choice B.

Question 12

Company X has 2 million shares of common stock outstanding at a book value of $2 per share.The stock trades for $3.00 per share.It also has $2 million in face value of debt that trades at 90% of par.What is its ratio of debt to value for WACC purposes?

Accepted Answer

The answer of Company X has 2 million shares of...

Question 13

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

Accepted Answer

The answer of Why is debt financing said to include...

Question 14

Should a project be accepted if it offers an annual after-tax cash flow of $1,250,000 indefinitely, costs $10 million, is riskier than the firm's average projects, and the firm uses a 12.5% WACC?

Accepted Answer

The answer of Should a project be accepted if it...

Question 15

Proposed assets can be evaluated using the company cost of capital providing that the:

Accepted Answer

In order to use the company cost of capital to evaluate proposed assets, it is necessary to assume that the new assets have the same risk as the existing assets. This assumption ensures that the cost of capital represents the required return for the level of risk involved in the investment. If the new assets have a different risk profile, then the cost of capital would need to be adjusted accordingly. Therefore, option D is the best choice. The other options are incorrect because they are not necessary conditions for using the cost of capital to evaluate proposed assets.

Question 16

What would you estimate to be the required rate of return for equity investors if a stock sells for $40 and will pay a $4.40 dividend that is expected to grow at a constant rate of 5%?

Accepted Answer

The answer of What would you estimate to be the...

Question 17

How much is added to a firm's weighted average cost of capital for 45% debt financing with a required rate of return of 10% and a tax rate of 35%?

Accepted Answer

The component cost of debt is calculated as 0.45 x (1 - 0.35) x 0.10 = 0.45 x 0.065 = 0.02925 or 2.93%.

Question 18

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?

Accepted Answer

The WACC is calculated as follows: WACC = (.5 x (.12 x .6)) + (.5 x .2) = 0.036 + 0.1 = 0.136 or 13.6%. Therefore, the correct answer is C.

Question 19

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%?

Accepted Answer

The formula for calculating the expected growth rate in dividends is (required rate of return - dividend yield). Using the given values, the expected growth rate in dividends would be 8% [(18% - 10%) = 8%]. Therefore, the best choice is C.

Question 20

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

Accepted Answer

First, we need to calculate the amount of return required for the equity and bond holders:
- Common stock requires a 10% return on $13 million, which is $1.3 million.
- Bonds require a 6% return on $6 million, which is $360,000.
Next, we add these two amounts together to get the total cash flow required before tax and interest:
$1.3 million + $360,000 = $1.66 million
Finally, we need to adjust for the tax rate by dividing by (1 - tax rate):
$1.66 million / (1 - 0.35) = $2.56 million
Therefore, the firm needs $2.56 million in cash flow before tax and interest to satisfy debt holders and equity holders.

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