Question 1

Appalachian Mountain Goods has paid increasing dividends of $.0.12, $0.18, $0.20, and $0.25 a share over the past four years, respectively. The firm estimates that future increases in its dividends will be equal to the arithmetic average growth rate over these past four years. The stock is currently selling for $12.60 a share. The risk-free rate is 3.2 percent and the market risk premium is 9.1 percent. What is the cost of equity for this firm if its beta is 1.26?

Accepted Answer

($0.18 - $0.12)/$0.12 = 0.50($0.20 - $0.18)/$0.18 = 0.111111($0.25 - $0.20)/$0.20 = 0.25g = (0.50 + 0.111111 + 0.25)/3 = 0.287037R_E = 0.032 + 1.26(0.091) = 0.14666 Average R_E = (0.14666 + 0.312573)/2 = 22.96 percent

Question 2

Hi Tech Products has 35,000 bonds outstanding that are currently quoted at 102.3. The bonds mature in 11 years and carry a 9 percent annual coupon. What is the firm's aftertax cost of debt if the applicable tax rate is 35 percent?

Accepted Answer

The aftertax cost of debt is calculated using the formula: Aftertax cost of debt = (Annual coupon payment / Current bond price) * (1 - Tax rate). The annual coupon payment is 9% of the face value (assumed to be $1,000), so $90. The current bond price is 102.3% of the face value, so $1,023. The aftertax cost of debt is ($90 / $1,023) * (1 - 0.35) = 5.63%.

Question 3

The market rate of return is 14.8 percent and the risk-free rate is 4.45 percent. Galaxy Co. has 54 percent more systematic risk than the overall market and has a dividend growth rate of 5.5 percent. The firm's stock is currently selling for $39 a share and has a dividend yield of 3.6 percent. What is the firm's cost of equity?

Accepted Answer

The correct answer is A.The firm's cost of equity can be calculated using the CAPM model:Cost of equity = Risk-free rate + Beta * (Market rate of return - Risk-free rate) + Dividend growth rateBeta = 1 + 54% = 1.54Cost of equity = 4.45% + 1.54 * (14.8% - 4.45%) + 5.5%= 4.45% + 1.54 * 10.35% + 5.5%= 4.45% + 15.93% + 5.5%= 25.88%

Question 4

Catnip Stores has a $20 million bond issue outstanding that currently has a market value of $18.6 million. The bonds mature in 6.5 years and pay semiannual interest payments of $30 each. What is the firm's pre-tax cost of debt?

Accepted Answer

The answer of Catnip Stores has a $20 million bond...

Question 5

The Green Balloon just paid its first annual dividend of $0.12 a share. The firm plans to increase the dividend by 3.5 percent per year indefinitely. What is the firm's cost of equity if the current stock price is $6.50 a share?

Accepted Answer

We can use the constant growth model to solve this problem:

Cost of Equity = (Dividend / Current Stock Price) + Growth Rate

Dividend = $0.12
Current Stock Price = $6.50
Growth Rate = 3.5% or 0.035

Cost of Equity = ($0.12 / $6.50) + 0.035 = 0.0554 or 5.54%

Therefore, the closest answer choice is B (5.41%), so that is the best choice.

Question 6

Kelly's uses the firm's weighted average cost of capital (WACC) as the required return for some of its projects. For other projects, the firms uses a rate equal to WACC plus 1 percent, while another set of projects is assigned rates equal to WACC minus some amount. Which one of the following factors should be the key factor the firm uses to determine the amount of the adjustment it will make when assigning the project a discount rate?

Accepted Answer

The key factor that the firm should use to determine the amount of adjustment to its discount rate when assigning projects is the risk level of the project. Projects with higher risk levels should have discount rates that are higher than the WACC, while projects with lower risk levels should have discount rates that are lower than the WACC. The other factors listed may be relevant to determining the appropriate discount rate for a specific project, but they are not the key factor that should be used to determine the amount of the adjustment to the discount rate.

Question 7

The common stock of Yanderloft and Sons has a beta that is 25 percent larger than the overall market beta. Currently, the market risk premium is 9.2 percent while the U.S. Treasury bill is yielding 4.7 percent. What is the cost of equity for this firm?

Accepted Answer

The cost of equity can be calculated using the Capital Asset Pricing Model (CAPM): Cost of Equity = Risk-Free Rate + Beta * Market Risk Premium. Given that the market beta is 1, Yanderloft's beta is 1.25. Thus, Cost of Equity = 4.7% + 1.25 * 9.2% = 16.20%.

Question 8

High Valley Antiques would like to issue new equity shares if its cost of equity declines to 10.5 percent. The company pays a constant annual dividend of $1.60 per share. What does the market price of the stock need to be for the firm to issue the new shares?

Accepted Answer

The market price of the stock needs to be such that the dividend yield equals the cost of equity. Using the formula for dividend yield: Dividend/Price = Cost of Equity, we have $1.60/Price = 0.105. Solving for Price gives $1.60/0.105 = $15.24.

Question 9

Winter Wear, Inc. has 6 percent bonds outstanding that mature in 13 years. The bonds pay interest semiannually and have a face value of $1,000. Currently, the bonds are selling for $993 each. What is the firm's pre-tax cost of debt?

Accepted Answer

To calculate the pre-tax cost of debt, we need to find the yield to maturity (YTM) of the bond. Using a financial calculator or spreadsheet, we can solve for YTM to be 6.08%. Therefore, the pre-tax cost of debt is also 6.08%. Option B is the closest to this value.

Question 10

The computation of which one of the following requires assigning every proposed investment to a particular risk class?

Accepted Answer

The computation of the subjective cost of capital requires assigning every proposed investment to a particular risk class based on the analyst's subjective judgment of the investment's risk level. This cannot be determined by a formula or objective criteria, unlike the pure play cost of capital, cost of equity, aftertax cost of debt, and WACC.

Question 11

Derek's is a brick-and-mortar toy store. The firm is considering expanding its operations to include Internet sales. Which one of the following would be the best firm to use in a pure play approach to analyzing this proposed expansion?

Accepted Answer

To analyze the proposed expansion of Derek's toy store into Internet sales, the best firm to use would be a toy store that only sells online, also known as a pure play online retailer. This firm would have experience and expertise in online sales and could provide valuable insights and strategies for Derek's to consider in their own online sales expansion. Choosing another brick-and-mortar store or a wholesale toy distributor would not provide relevant information on online sales strategies. The oldest online retailer of any product may not necessarily have experience in the toy industry or in the specific challenges and opportunities of online toy sales. Finally, Derek's own store would not provide the perspective of an online-only business.

Question 12

The Cracker Mill has a beta of 0.97, a dividend growth rate of 3.2 percent, a stock price of $33 a share, and an expected annual dividend of $1.06 per share next year. The market rate of return is 11.2 percent and the risk-free rate is 3.7 percent. What is the firm's cost of equity?

Accepted Answer

The answer of The Cracker Mill has a beta of...

Question 13

Four years ago, the Moore Co. issued 15-year, 7.5 percent semiannual coupon bonds at par. Today, the bonds are quoted at 101.6. What is this firm's pre-tax cost of debt?

Accepted Answer

When the bonds were issued, they were sold at par, which means the coupon rate of 7.5% matched the yield to maturity (YTM) of the bonds. Since the bonds are now trading at 101.6, which is a premium to par, we can assume that the current YTM is lower than 7.5%. We can use the bond pricing formula to calculate the current YTM:

PV = (C / r) x [1 - 1 / (1 + r)^n] + F / (1 + r)^n

Where:
PV = present value of the bond = 1016
C = semiannual coupon payment = 0.075 x 1000 / 2 = 37.5
r = YTM (in decimal)
n = number of semiannual periods = 15 x 2 = 30
F = face value of the bond = 1000

Rearranging the equation and solving for r gives:

r = 7.29%

This is the pre-tax cost of debt for Moore Co.

Question 14

A firm has multiple divisions of similar nature, yet varying degrees of risk. Which one of the following would be the most appropriate, yet relatively easy, means of assigning discount rates to each of its proposed investments?

Accepted Answer

The answer of A firm has multiple divisions of similar...

Question 15

Farm Equipment, Inc. announced this morning that its next annual dividend will be decreased to $1.80 a share and that all future dividends will be decreased by an additional 1.5 percent annually. What is the current value per share of this stock if the required return is 16.5 percent?

Accepted Answer

Using the constant growth model:

P0 = D1 / (r - g)

where: 
D1 = next year's dividend = $1.80 
r = required return = 16.5% or 0.165 
g = growth rate = -1.5% or -0.015 (since the dividend is decreasing)

Plugging in the values:

P0 = $1.80 / (0.165 - (-0.015)) 
P0 = $1.80 / 0.18 
P0 = $10

Therefore, the current value per share of this stock is $10. Choice B is the correct answer.

Question 16

Musical Charts just paid an annual dividend of $2.45 per share. This dividend is expected to increase by 3.3 percent annually. Currently, the firm has a beta of 1.09 and a stock price of $36 a share. The risk-free rate is 4.2 percent and the market rate of return is 12.6 percent. What is the cost of equity capital for this firm?

Accepted Answer

R_E = 0.042 + 1.09(0.126 - 0.042)] = 0.13356 Average R_E = (0.13356 + 0.103301)/2 = 11.84 percent

Question 17

Birds and Yards has 10-year bonds outstanding that carry an annual coupon of 8 percent. The bonds mature in 7 years and are currently priced at 108.4 percent of face value. What is the firm's pre-tax cost of debt?

Accepted Answer

The correct answer is A because the pre-tax cost of debt is 6.47 percent. This is calculated using the following formula:Pre-tax cost of debt = (Coupon payment / Current bond price) + ((Face value - Current bond price) / (Current bond price * Years to maturity))= (0.08 * 1000) / (108.4 * 1000) + ((1000 - 108.4 * 1000) / (108.4 * 1000 * 7))= 0.0738 + 0.0064= 0.0802 or 8.02%

Question 18

Jet Setters has a cost of equity of 17.8 percent. The market risk premium is 10.2 percent and the risk-free rate is 4.4 percent. The company is acquiring a competitor, which will increase the company's beta to 1.6. What effect, if any, will the acquisition have on the firm's cost of equity capital?

Accepted Answer

The acquisition will increase the company's beta, which will increase the company's cost of equity capital. The new cost of equity capital can be calculated using the CAPM:Cost of equity = Risk-free rate + Beta * Market risk premiumCost of equity = 4.4% + 1.6 * 10.2%Cost of equity = 20.72%The acquisition will increase the company's cost of equity capital by 2.92%.

Question 19

Judy's Boutique just paid an annual dividend of $1.65 on its common stock. The firm increases its dividend by 2.5 percent annually. What is the rate of return on this stock if the current stock price is $38.20 a share?

Accepted Answer

The answer of Judy's Boutique just paid an annual dividend...

Question 20

The common stock of Modern Interiors has a beta of 1.61 and a standard deviation of 27.4 percent. The market rate of return is 13.2 percent and the risk-free rate is 4.8 percent. What is the cost of equity for this firm?

Accepted Answer

The correct answer is A because the cost of equity for this firm is 18.32 percent. This can be calculated using the Capital Asset Pricing Model (CAPM), which states that the expected return on a stock is equal to the risk-free rate plus a risk premium. The risk premium is determined by the beta of the stock, which measures the stock's volatility relative to the market. In this case, the beta of Modern Interiors is 1.61, which means that it is 61% more volatile than the market. The market rate of return is 13.2 percent and the risk-free rate is 4.8 percent, so the cost of equity for Modern Interiors is 4.8% + (1.61 * (13.2% - 4.8%)) = 18.32%.

Quiz 12: Cost of Capital