Question 1

What dividend is paid on preferred stock if investors require a 9% rate of return and the stock has a market value of $54 per share and a book value of $50 per share?

Accepted Answer

0.09 = dividend / $54; Dividend = $4.86

Question 2

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

Accepted Answer

First, we need to calculate the total return required by both equity and debt holders:

Equity: 10% of $13 million = $1.3 million
Debt: 6% of $6 million = $0.36 million

Total return required = $1.3 million + $0.36 million = $1.66 million

Now, we need to adjust for taxes by dividing the total return required by (1-tax rate):

Adjusted return = $1.66 million / (1-0.35) = $2.55 million

Finally, we add back the interest expense on the bonds:

Cash flow before tax and interest = $2.55 million + 0.06*$6 million = $2.91 million

Therefore, the firm will need $2.91 million in cash flow before tax and interest to satisfy debtholders and equityholders. However, this option is not given, and the closest answer is C ($2.36 million), which is the answer we choose.

Question 3

For a company that pays no corporate taxes,its WACC will be equal to:

Accepted Answer

The WACC (Weighted Average Cost of Capital) for a company with no corporate taxes is equal to the expected return on its assets, as it reflects the average rate of return required by all of the company's investors (both debt and equity holders).

Question 4

A firm's WACC:

Accepted Answer

The firm's WACC is a benchmark discount rate that is used as a starting point for determining the required return on a project. However, the riskiness of each project may be different, and therefore the WACC may be adjusted accordingly.

Question 5

Other things equal,which of the following will decrease the WACC of a firm that has both debt and equity in its capital structure?

Accepted Answer

An increase in the tax rate will decrease the cost of debt, resulting in a decrease in the WACC of the firm.

Question 6

Calculate a firm's WACC given that the total value of the firm is $2 million,$600,000 of which is debt,the pre-tax cost of debt is 10%,and the cost of equity is 15%.The firm pays no taxes.

Accepted Answer

WACC = 0.10($600,000 / $2m) + 0.15[($2m − 600,000) / $2m] = 0.135, or 13.5%

Question 7

An implicit cost of increasing the proportion of debt in a firm's capital structure is that:

Accepted Answer

Shareholders will demand a higher rate of return when the proportion of debt in a firm's capital structure increases because they will perceive the increased risk from higher leverage. This is known as the "risk-return tradeoff."

Question 8

A firm has a debt-to-equity ratio of 1/4.The WACC is 18.6%,and the pretax cost of debt is 9.4%.What is the cost of common equity if the tax rate is 34%?

Accepted Answer

D/V = 0.2 and E/V = 0.8; 18.6 = 0.2(9.4)(1 − 0.34) + 0.8(r_e); r_e = 21.70%

Question 9

If a firm earns the WACC on its assets,then:

Accepted Answer

If a firm earns the WACC on its assets, it means it is earning the minimum required rate of return for all investors, including both equityholders and bondholders. Therefore, all investors will be satisfied with their returns. This assumes that the firm's projects are financed in the optimal capital structure and are generating positive NPV.

Question 10

A project requires an investment of $10 million and offers an annual after-tax cash flow of $1,250,000 indefinitely.If the firm's WACC is 12.5% and the project is riskier than the firm's average projects,should it be accepted%?

Accepted Answer

NPV at WACC = −$10m + $1.25m / 0.125 = $0; However, the 12.5% rate does not reflect the projects' greater risk; thus the project's NPV is negative.

Question 11

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%,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

PV = $50,000 / 0.12 = $416,667

Question 12

As debt is added to the capital structure,the:

Accepted Answer

As more debt is added to the capital structure, lenders and investors may consider the increased risk associated with the higher levels of debt and demand a higher cost of borrowing. This would result in an increase in the cost of debt and therefore, an increase in the overall WACC.

Question 13

A firm is 40% financed by debt with a yield-to-maturity of 8.5%.The equity has a beta of 1.3,the market risk premium is 8.4% and the risk-free rate is 3.8%.What is the firm's WACC if the tax rate is 34%?

Accepted Answer

r_e = 3.8% + 1.3(8.4%) = 14.72%WACC = (1 − 0.40)(0.1472) + 0.40(.085)(1 − 0.34) = 0.1108, or 11.08%

Question 14

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

g = 18% − 10 = 8%

Question 15

If a firm has twice as much equity as debt in its capital structure,then the firm is financed with:

Accepted Answer

If the firm has twice as much equity as debt, then we can calculate the proportions of equity and debt in the capital structure using the following formula:

Equity Proportion = Equity / (Equity + Debt)

Debt Proportion = Debt / (Equity + Debt)

Let's assume that the firm has a total of $100 in capital. If the firm has twice as much equity as debt, then the equity amount is $66.67 and the debt amount is $33.33. Therefore, the equity proportion is 66.67% and the debt proportion is 33.33%.

So, the answer is B, which represents 66.7% equity.

Question 16

What would you estimate as the cost of equity if a stock sells for $40,pays a $4.25 dividend,and is expected to grow at a constant rate of 5%?

Accepted Answer

E(R) = $4.25 / $40 + 0.05 = 0.1563, or 15.63%

Question 17

How much will a firm need in cash flow before tax and interest to satisfy debtholders and equityholders 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

First, we need to calculate the amount of return required for the debtholders and equityholders:
Debtholders: $6 million x 0.08 = $480,000
Equityholders: $10 million x 0.12 = $1,200,000

Next, we need to calculate the total cash flow required before tax and interest:
Total CF = ($480,000 + $1,200,000)/ (1-0.4) = $2,480,000

Therefore, the firm will need $2,480,000 in cash flow before tax and interest to satisfy debtholders and equityholders. The best choice is C.

Question 18

Which one of the following statements is incorrect?

Accepted Answer

There is no tax shield on the equity dividends paid, which means that dividends on equity are not tax-deductible expenses for the company. Therefore, statement D is incorrect.

Question 19

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

Accepted Answer

Assume for example that the market value of equity is $5 million, the book value of debt is $2 million, and the value of the firm is $7 million. In the example, the debt-to-value ratio is 0.286. However, if the market value of debt is $2.5 million due to decreased interest rates, the value of the firm is $7.5 million and the debt-to-value ratio is 0.333. The key is that the numerator of the ratio changes proportionately more than the denominator.

Question 20

A firm has 12,000 shares of common stock outstanding with a book value of $20 per share and a market value of $39.There are 5,000 shares of preferred stock with a book value of $22 and a market value of $26.There is a $400,000 face value bond issue outstanding that is selling at 87% of par.What weight should be placed on the preferred stock when computing the firm's WACC?

Accepted Answer

Weight of preferred = (5,000 × $26) / [(12,000 × $39) + (5,000 × $26) + ($400,000 × 0.87)] = 0.1374, or 13.74%

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