Question 1

What proportion of a firm is equity financed if the WACC is 14%,the before-tax cost of debt is 10.77%,the tax rate is 35%,and the required return on equity is 18%?

Accepted Answer

0.14 = (1 − x)(10.77%)(1 − 0.35) + x(18%); x = 63.64%

Question 2

A proposed project has a positive NPV if it is financed entirely by equity.If the project can sensibly be financed partly by debt and the firm pays tax,will the project remain acceptable?

Accepted Answer

Using debt financing can increase the NPV of a project due to the tax shield provided by interest payments, which reduces the overall tax burden and increases the project's value.

Question 3

Al's Market plans to close after 3 more years.The firm expects to have free cash flows of $148,000 next year,$128,000 in Year 2,and $65,000 in Year 3 after incurring the costs of closing.The firm's cost of equity is 15.5% and its after-tax cost of debt is 6.2%.What is the present value of the firm if its debt to value ratio is 30%?

Accepted Answer

WACC = 0.3(6.2%) + (1 − 0.3)(15.5%) = 12.71%PV = $148,000 / 1.1271 + $128,000 / 1.1271² + $65,000 / 1.1271³ = $277,467

Question 4

Assume a firm's debt is selling at face value.What is the firm's cost of debt if the debt has a coupon rate of 7.5% and the tax rate is 35%?

Accepted Answer

R_d = 7.5%(1 − 0.35) = 4.88%

Question 5

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

Accepted Answer

If equity is three times debt, then debt is 1 part and equity is 3 parts, making a total of 4 parts. Debt is 1/4 of the total, which is 25%.

Question 6

A firm is considering expanding its current operations and has estimated the internal rate of return on that expansion to be 12.2%.The firm's WACC is 11.8%.Given this,you know that the:

Accepted Answer

Since the project is an expansion project, the risk-level of the project is equal to the risk-level of the current firm. Thus, the project NPV will be positive since the IRR exceeds the required return.

Question 7

What is the WACC for a firm financed with 30% debt if the debt investors require a return of 12.5% and equity investors require a 16% return? The corporate tax rate is 20%.

Accepted Answer

WACC = 0.3(0.8 × 12.5) + (1 − 0.3)(16) = 0.142, or 14.2%

Question 8

Which one of the following changes would tend to increase the WACC for a tax-paying firm?

Accepted Answer

Decreasing the proportion of debt financing would increase the cost of equity financing and increase the WACC.

Question 9

The company cost of capital is the return that is expected on a portfolio of the company's:

Accepted Answer

The company cost of capital is the expected return on a portfolio of the company's existing securities, which includes both equity and debt, reflecting the overall risk and return profile of the company.

Question 10

If a company's WACC is less than the required return on equity,then the firm:

Accepted Answer

This is because WACC takes into account the cost of both debt and equity capital. If the WACC is less than the required return on equity, then it means that the cost of debt is lower than the cost of equity. Hence, the company will have debt in its capital structure as a lower cost of debt reduces the overall cost of capital.

Question 11

A firm has a debt-to-value ratio of 40%,a cost of equity of 14%,and an after-tax cost of debt of 5.5%.It plans to launch a new product that will produce cash flows of $398,000 next year and $211,000 in year 2.If this project is about as risky as the firm's existing assets,what is the present value of the project?

Accepted Answer

WACC = 0.4(5.5%) + (1 − 0.4)(14%) = 10.6%PV = $398,000 / 1.106 + $211,000 / 1.106² = $532,349

Question 12

A tax-paying firm is currently financed with 50% debt and 50% equity.The after-tax cost of debt is 6% and the cost of equity is 12%.If the firm issues some 8% preferred stock at par,then the firm's WACC will:

Accepted Answer

Current WACC = 0.50(0.06) + 0.50(0.12) = 0.09, or 9%; Including some preferred stock at a cost of 8%, will lower the firm's WACC.

Question 13

What proportion of a firm is equity financed if the WACC is 14%,the after-tax cost of debt is 7%,the tax rate is 35%,and the required return on equity is 18%?

Accepted Answer

14% = (1 − x)(7%) + (x)18%; x = 63.64%

Question 14

What is the WACC for a firm with 40% debt,20% preferred stock,and 40% equity if their respective costs are 6% after tax,12%,and 18%? The firm's tax rate is 35%.

Accepted Answer

WACC = (0.4 × 6%) + (0.2 × 12%) + (0.4 × 18%) = 12.00%

Question 15

A firm has 12,500 shares of stock outstanding that sell for $42 each.The book value of equity is $400,000.The firm has also issued $250,000 face value of debt that is currently quoted at 101.2.What value should be used as the weight of equity when computing WACC?

Accepted Answer

W_e = (12,500 × $42) / [(12,500 × $42) + 1.012($250,000)] = 0.6748, or 67.48%

Question 16

What is the WACC for a firm with 40% debt,20% preferred stock,and 40% equity if their respective costs are 9.23% before tax,12%,and 18%? The firm's tax rate is 35%.

Accepted Answer

WACC = [0.4 × ((1 − 0.35) × 9.23%)] + (0.2 × 12%) + (0.4 × 18%) = 12.0%

Question 17

A project will generate a $1 million net cash flow annually in perpetuity.If the project costs $7 million,what is the break-even WACC?

Accepted Answer

$7m = $1m / WACC; WACC = 14.29%

Question 18

What is the after-tax cost of preferred stock that pays a 12% dividend and sells at par if the firm's tax rate is 35%?

Accepted Answer

There is no adjustment for taxes on preferred stock. Therefore, after-tax cost = pretax cost.

Question 19

A firm has just paid its annual dividend of $5.64 a share.Thereafter the dividend is expected to increase at a rate of 2% a year.If the firm's stock currently sells for $60 a share,what is the cost of equity?

Accepted Answer

r_e = ($5.64 × 1.02) / $60 + 0.02 = 0.11588, or 11.59%

Question 20

Which one of the following changes offers the greatest chance of changing a project's NPV from negative to positive?

Accepted Answer

Reducing the risk of the project is the best choice because it has the potential to increase cash flows and decrease the discount rate used to calculate the NPV. This can lead to a significant increase in the project's NPV, potentially changing it from negative to positive. Substituting preferred stock for debt or reducing the maturity of the debt may also have an impact on the project's NPV, but it may not be as significant as reducing the project risk. Selling the debt at less than par value may have a negative impact on the project's finances and is not likely to improve its NPV.

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