Question 1

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 is:

Accepted Answer

WACC = [0.65 × 0.08 × (1 − 0.35)] + (0.35 × 0.15) = 0.0863, or 8.63%

Question 2

For healthy firms,the expected return on their bonds is close to their yield to maturity.

Accepted Answer

For healthy firms, the expected return on their bonds is close to their yield to maturity because investors have confidence in the firm's ability to meet its debt obligations, resulting in low default risk. Therefore, the market price of the bond is not significantly affected by changes in interest rates or other market conditions, and the bond's yield to maturity provides an accurate estimate of its expected return.

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 is:

Accepted Answer

WACC = [0.40 × 0.08 × (1 − 0.34)] + (0.60 × 0.15) = 0.1111, or 11.11%

Question 4

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 5

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

Accepted Answer

This statement is true. The WACC (Weighted Average Cost of Capital) is the minimum required rate of return that a company needs to earn on its investments in order to satisfy its investors. This rate takes into account the risk associated with the project or investment. Therefore, riskier projects will have a higher WACC, while safer projects will have a lower WACC.

Question 6

One way to estimate the expected return on bonds is to find the yield to maturity on recently-issued bonds with similar characteristics and risks.

Accepted Answer

Yield to maturity is a common measure of the expected return on bonds, and it takes into account the current market price of the bond, its coupon rate, and its remaining maturity. By comparing the yield to maturity of a recently-issued bond with similar characteristics and risks, investors can estimate the expected return on their own bond investments.

Question 7

What is the debt ratio of a firm that has outstanding $15 million in bonds and equity with a market value of $35 million?

Accepted Answer

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

Question 8

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

This statement accurately describes the definition and purpose of the Weighted Average Cost of Capital (WACC).

Question 9

Company X has 2 million shares of common stock outstanding with 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 face value.What is the debt ratio that should be used to calculate WACC?

Accepted Answer

Debt ratio = (0.90 × $2m) / [(2m × $3) + (0.90 × $2m)] = 0.2308, or 23.08%

Question 10

What is a firm's weighted-average cost of capital for a firm that is financed 45% by debt? The debt has a 10% required return and the equity has a 17% required return.The tax rate is 35%.

Accepted Answer

WACC = 0.45 × [10% × (1 − 0.35)] + 0.55 × 17% = 12.28%

Question 11

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

Accepted Answer

Interest payments on debt are tax-deductible, reducing taxable income and thus providing a tax shield.

Question 12

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 issuing debt or equity, can affect the cost of capital and therefore the WACC. This is because the cost of debt and equity financing is different, and the proportion of each in the capital structure changes the overall WACC. Additionally, a change in the capital structure can affect the amount of interest expenses and other tax-deductible expenses, which can ultimately impact the amount of taxes paid by the company.

Question 13

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 calculated by discounting the firm's future free cash flows at the firm's weighted-average cost of capital (WACC), which reflects the cost of debt and equity financing. This approach takes into account the risk associated with the investment and the cost of obtaining capital to finance the investment. Therefore, choice A is the best answer. The pre-tax cost of debt and after-tax cost of debt only reflect the cost of debt financing, while the cost of equity alone does not account for the cost of debt financing.

Question 14

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 statement is true because interest payments on bonds are tax-deductible expenses, which reduce the company's taxable income and therefore decrease the amount of taxes it has to pay. The tax savings generated by the interest payments can offset some of the costs of borrowing and make the bonds more attractive to investors.

Question 15

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

A project with the same risk and financing as the firm will have a positive NPV if its rate of return is greater than the firm's WACC. This is because the WACC represents the minimum rate of return required to compensate investors for the risk of investing in the firm's assets. Therefore, if the project can generate a rate of return higher than the WACC, it will create value for the firm and its shareholders.

Question 16

If the tax rate is 35%,what is the cost of preferred stock that sells for $10 per share and pays a $1.20 dividend?

Accepted Answer

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

Question 17

Capital structure decisions refer to the:

Accepted Answer

Capital structure decisions refer to the mix of equity and debt a company uses to finance its operations. These decisions can affect the company's risk, cost of capital, and overall value. Dividend yield, capital gains, and maturity date are important factors for investors but do not directly relate to capital structure decisions.

Question 18

A firm is financed 55% by common stock,10% by preferred stock and 35% by debt.The required return is 15% on the common,10% on the preferred,and 8% on the debt.If the tax rate is 35% what is the WACC?

Accepted Answer

WACC = (0.55 × 0.15) + (0.1 × 0.1) + [0.35 × 0.08 × (1 − 0.35)] = 0.1107, or 11.07%

Question 19

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 is related to debt financing, not equity. The after-tax cost of debt, not equity, is used in WACC to account for the tax shield.

Question 20

If the after-tax cost of debt is 10%,what is the pretax cost for a firm in the 35% tax bracket?

Accepted Answer

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

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