Question 1

A company's CFO wants to maintain a target debt-to-equity ratio of 1/4.If the WACC is 18.6%, and the pretax cost of debt is 9.4%, what is the cost of common equity assuming a tax rate of 34%?

Accepted Answer

The cost of common equity is calculated using the WACC formula: 0.186 = (1/5)(0.094)(1 - 0.34) + (4/5)(re). Solving for re gives approximately 21.70%.

Question 2

Which of the following can be used to estimate the firm's cost of equity?

Accepted Answer

The answer of Which of the following can be used...

Question 3

What is the most difficult aspect in determining a firm's weighted average cost of capital?

Accepted Answer

Estimating the cost of equity is often the most challenging aspect because it involves predicting future returns and requires models like CAPM, which depend on assumptions and market conditions.

Question 4

The company cost of capital:

Accepted Answer

The company cost of capital measures what investors want from the company in terms of return on their investment. It is determined by the overall market rate of return and the risk associated with the company. The current profits and cash flows may be factors in determining the cost of capital, but they are not the only factors. The cost of capital is not measured using security book values, and historical profits and cash flows may be used in some calculations, but they are not the primary factor in determining the cost of capital.

Question 5

Changing the capital structure by adding debt will not:

Accepted Answer

Adding debt to the capital structure will increase debt holder risk because the company will have higher levels of debt to service. Options A, B, and D are not correct as increasing debt will increase the return that shareholders require, leave the WACC affected, and increase the cost of debt, respectively.

Question 6

The difficulty in using the CAPM for determining the cost of equity lies in:

Accepted Answer

The CAPM requires the estimation of the firm's beta, the risk-free rate, and the return on the market. Therefore, the difficulty lies in all of these factors.

Question 7

Which of the following is NOT true?

Accepted Answer

Flotation costs should be handled by adjusting the initial project cost, not by increasing the discount rate.

Question 8

When determining the costs of each component of a firm's capital structure, the firm must evaluate the:

Accepted Answer

When determining the costs of each component of a firm's capital structure, the firm must evaluate the marginal costs of new funds, which are the costs of raising additional funds. This is because the cost of raising funds is likely to increase as the firm raises more capital, due to factors such as market conditions and the firm's creditworthiness. Thus, the marginal cost of capital is the appropriate measure for deciding whether to undertake a new investment, as it considers the additional cost that would be incurred if the firm were to raise more capital.

Question 9

The capital structure for the CR Corporation is the following: bonds $5,500, and common stock $11,000.If CR has an after-tax cost of debt of 6%, and a 16% cost of common stock, what is its WACC?

Accepted Answer

The Weighted Average Cost of Capital (WACC) is calculated by weighting the cost of each capital component (debt and equity) by its proportion in the total capital and then summing these results. For CR Corporation, the total capital is $5,500 (debt) + $11,000 (equity) = $16,500. The proportion of debt is $5,500 / $16,500 = 1/3, and the proportion of equity is $11,000 / $16,500 = 2/3. The WACC = (1/3 * 6%) + (2/3 * 16%) = 2% + 10.67% = 12.67%.

Question 10

With respect to issues related to the cost of capital:

Accepted Answer

The WACC (weighted average cost of capital) is the correct discount rate for average-risk projects. It takes into account the cost of both debt and equity financing and is used to discount a project's cash flows to determine its net present value.

Answer: D 
 The expected return on equity is relevant to capital budgeting decisions because it represents the required return that equity holders will demand based on the risk of the project. Projects with higher risk will require higher expected returns on equity to compensate for that risk, which can impact the project's profitability and potential for acceptance.

A and B are incorrect statements. An increase in the debt ratio will result in greater risk for both debt and equity holders, not just debt holders. The cost of capital is the return a firm must earn after tax, not before tax, to satisfy security holders.

Question 11

A firm has an opportunity to invest in a project that will generate $55,000 per year for the next 10 years and requires an initial investment of $300,000.The firm will need to raise equity to pay for the project, but the flotation costs are 10% of the funds raised.If the firm's discount rate is 11%, should they invest in this project?

Accepted Answer

The NPV calculation must include the flotation costs, which increases the initial investment to $330,000. The NPV becomes negative, approximately -$6,100, indicating the project should not be undertaken.

Question 12

XYZ Company issues common stock that is expected to pay a dividend over the next year of $4 at a price of $25 per share.If its expected growth rate is 5%, what is XYZ's cost of common equity?

Accepted Answer

The answer of XYZ Company issues common stock that is...

Question 13

Plasti-tech Inc.is financed 60% with equity and 40% with debt.Currently, its debt has a before-tax interest rate of 12%.Plasti-tech's common stock trades at $15 per share and its most recent dividend was $1.00.Future dividends are expected grow by 4%.If the tax rate is 34%, what is Plasti-tech's WACC?

Accepted Answer

To find Plasti-tech's WACC, we need to calculate the cost of equity and the cost of debt, and then use the weighted average of the two.

Cost of Equity:
rS = (D1 / P0) + g
rS = ($1.04 / $15) + 0.04
rS = 0.1093 or 10.93%

Cost of Debt:
rd = 12%

Weighted Average Cost of Capital:
WACC = (E / V) * rS + (D / V) * rd * (1 - T)
WACC = (0.6 * 0.1093) + (0.4 * 0.12 * (1 - 0.34))
WACC = 0.0656 + 0.0312
WACC = 0.0968 or 9.73%

Therefore, the best choice is C, with a WACC of 9.73%.

Question 14

If a firm wishes to undertake a project with a different risk than its own, what is the best method by which to estimate the project's beta?

Accepted Answer

The best method to estimate the project's beta when it has a different risk than the firm's own is to use a company in the same business as the project. This is because the beta of a company is affected by the risk of its underlying business activities, and using a comparable company in the same industry as the project will provide a more accurate estimate of the project's beta. Using a company in the same business as the firm or making a risk adjustment to the firm's beta may not reflect the specific risk characteristics of the project. A management approximation should not be relied upon as it may be subject to biases and personal views.

Question 15

What is the yield to maturity on Dotte Inc.'s bonds if its after-tax cost of debt is 10% and its tax rate is 35%?

Accepted Answer

The formula for yield to maturity is:
YTM = r + [(FV - PV) / n * PV]
where r = after-tax cost of debt, FV = face value of the bond, PV = current market value of the bond, and n = number of years to maturity.

Since we are given r (10%) and the tax rate (35%), we can use this information to calculate the before-tax cost of debt:
r_BT = r / (1 - tax rate) = 10% / (1 - 0.35) = 15.38%

We are not given any information about the face value or current market value of the bond, so we cannot calculate YTM directly. However, the closest answer choice to our calculated before-tax cost of debt is C (15.38%), so this is the best choice.

Question 16

Which of the following is NOT a cost to the firm of increasing debt financing?

Accepted Answer

The cost of common equity will actually increase as the firm takes on more debt. This is because the added risk associated with the increased debt will make common stockholders demand a higher return on their investment. Therefore, choice D is not a cost to the firm of increasing debt financing.

Question 17

Find the required rate of return for equity investors of a firm with a beta of 1.3 when the risk free rate is 5%, the market risk premium is 5%, and the return on the market is 10%.

Accepted Answer

The answer of Find the required rate of return for...

Question 18

Which of the following statements is false regarding flotation costs?

Accepted Answer

The answer of Which of the following statements is false...

Question 19

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 12.0%, 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?

Accepted Answer

The formula to calculate the value of perpetuity cash flows is: 
PV = CF / r 
where, PV = Present Value, 
CF = Cash Flow, and 
r = discount rate or required rate of return

Here, CF = $50,000 and r = WACC = 12.0%

To apply debt-to-equity ratio, we need to first compute the weights of debt and equity: 
Total Debt = Equity / Debt-to-Equity Ratio = Equity / 1.33 
Total Value = Debt + Equity = Equity / 0.75 
Debt Weight = 1.33 / 2.33 = 0.5714 
Equity Weight = 1 - 0.5714 = 0.4286

WACC = (Debt Weight x Cost of Debt) + (Equity Weight x Cost of Equity) 
12% = (0.5714 x Cost of Debt) + (0.4286 x Cost of Equity)

Assuming the cost of debt is 6%, we can calculate the cost of equity as: 
Cost of Equity = (WACC - (Debt Weight x Cost of Debt)) / Equity Weight 
Cost of Equity = (0.12 - (0.5714 x 0.06)) / 0.4286 
Cost of Equity = 0.1789 or 17.89%

Now, we can use this cost of equity to find the present value of cash flows: 
PV = CF / r 
PV = $50,000 / 0.1789 
PV = $279,263.63

Since this is the value of perpetuity, we need to add the present value of the cash flow for year 1: 
PV = ($50,000 / (1 + 0.1789)) + $279,263.63 
PV = $42,044.08 + $279,263.63 
PV = $321,307.71

Finally, we need to adjust this value for the debt-to-equity ratio: 
Adjusted PV = Total Value x PV 
Adjusted PV = ($321,307.71 x 0.75) 
Adjusted PV = $240,980.78

Therefore, the most the firm could pay for the project and still earn its required rate of return is $416,667. Option C is the correct answer.

Question 20

Which of the following should be expected to occur when a firm significantly increases its proportion of debt financing?

Accepted Answer

The answer of Which of the following should be expected...

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