Question 1

For most healthy firms, the YTM on their bonds is the rate of return investors expect from holding their bonds to maturity.

Accepted Answer

Yield to maturity (YTM) is the expected rate of return that an investor will earn if they hold a bond until its maturity. It takes into account the price paid for the bond, the coupon rate, and the length of time until maturity. For healthy firms, investors typically expect to receive the full value of their investment back, plus interest, upon maturity, which is reflected in the YTM.

Question 2

What is the pretax cost of debt for a firm in the 35% tax bracket that has a 10% aftertax cost of debt?

Accepted Answer

After-tax cost of debt = 0.10/(1 - 0.35) = 0.1538, or 15.38%

Question 3

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 would be:

Accepted Answer

WACC = [0.40 × .08 × (1 - 0.34)] + (0.60 × 0.15) = 0.1111, or 11.11%

Question 4

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

Accepted Answer

This is because interest payments on bonds are tax-deductible expenses for companies. Therefore, the more interest a company pays on its bonds, the lower its taxable income will be, and the less tax it will have to pay. This results in a reduction of the net cost of the interest payments.

Question 5

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 would be:

Accepted Answer

WACC = [0.65 × .08 × (1 - 0.35)] + (0.35 × 0.15) = 0.0863, or 8.63%

Question 6

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

Accepted Answer

Interest expenses on debt reduce a company's taxable income, which in turn reduces the amount of tax the company has to pay. This effect is known as the tax shield of debt financing.

Question 7

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

Accepted Answer

The present value of a business is typically calculated by discounting the firm's future free cash flows at the firm's weighted-average cost of capital (WACC). This is because WACC represents the average cost of the firm's sources of funding (debt and equity), and therefore reflects the opportunity cost of the firm's investors. By discounting free cash flows at the WACC, we can determine the value of the firm to its investors.

Question 8

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

WACC = [0.5 × 0.12 × (1 - 0.40)] + (0.5 × 0.20) = 0.136, or 13.6%

Question 9

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

Accepted Answer

This is because the WACC already takes into account the overall risk of the company, and adjusting the rate further accounts for additional project-specific risks. Riskier projects would have a higher cost of capital and therefore a higher WACC, while safer projects would have a lower cost of capital and a lower WACC.

Question 10

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.

Accepted Answer

The WACC (Weighted Average Cost of Capital) is the rate of return that a company must earn on its investments to satisfy all of its security holders, including shareholders and debt holders, and it reflects the average risk of the company's investments. Therefore, the statement is true.

Question 11

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.

Accepted Answer

The NPV rule states that a project is acceptable if its NPV is positive. NPV is calculated as the present value of cash inflows minus the present value of cash outflows. The discount rate used for calculating the present value is the firm's weighted average cost of capital (WACC). Therefore, if a project has the same risk and financing as the firm, it will have a positive NPV if its rate of return (which is the same as the project's discount rate) is greater than the firm's WACC.

Question 12

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

Debt ratio = $15m/($15m + 35m) = 0.30, or 30%

Question 13

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

Accepted Answer

A change in the capital structure, such as incorporating debt to the capital mix, will alter the cost of capital, which will affect the WACC. The debt component's cost is lower than the equity component's cost, and the new capital mix will reduce the WACC. With the addition of debt, the interest expense will be tax-deductible, resulting in a decrease in taxes paid.

Question 14

Capital structure decisions refer to the:

Accepted Answer

Capital structure decisions refer to the blend of equity and debt used by the firm. This includes determining the appropriate ratio of debt to equity and selecting the types of securities to issue in order to raise capital. Dividend yield, capital gains, and maturity dates are all related to the firm's securities, but are not directly related to capital structure decisions.

Question 15

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 16

One way to check the accuracy of the expected return on bonds is to compare the expected return to the YTM on recently-issued bonds with similar characteristics and risks.

Accepted Answer

Comparing the expected return to the yield to maturity (YTM) on recently issued bonds with similar characteristics and risks provides a reliable way to check the accuracy of the expected return on bonds. By making this comparison, investors can determine whether the expected return is reasonable based on the prevailing market conditions and overall risk profile of the bond in question. If the expected return is significantly higher than the YTM of comparable bonds, for example, this may indicate that the bond is riskier than its peers, or that market conditions have changed in a way that affects the bond's potential return.

Question 17

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.

Accepted Answer

The interest tax shield refers to the tax savings achieved by deducting interest payments, which is related to debt financing, not equity financing. The after-tax cost of equity does not account for an interest tax shield; instead, the after-tax cost of debt in the WACC calculation incorporates the effect of the interest tax shield.

Question 18

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

WACC = (0.55 × 0.15) + (0.1 × 0.1) + [0.35 × .08 × (1 - 0.35)] = 0.1107, or 11.07%

Question 19

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

Component cost of debt = 0.45 × [0.10 × (1 - 0.35)] = 0.0293, or 2.93%

Question 20

Company X has 2 million shares of common stock outstanding at 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 par. What is the weight of debt for WACC purposes?

Accepted Answer

Weight of debt = (0.90 × $2m)/[(2m × $3) + (0.90 × $2m)] = 0.2308, or 23.08%

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