Question 1

The Shoe Box pays an annual dividend of $3.80 on its preferred stock.What is the cost of preferred if the stock currently sells for $42.70 a share and the tax rate is 21 percent?

Accepted Answer

The answer of The Shoe Box pays an annual dividend...

Question 2

Southern Imports is an all-equity firm with a beta of 1.32.The firm is considering a new project that entails less risk than its current operations and thus management feels that the firm's beta should be lowered by .18 when assigning a discount rate to this project.The market rate of return is 9.4 percent and the risk-free rate is 2.8 percent.What discount rate should be assigned to this project?

Accepted Answer

The project's beta is 1.32 - 0.18 = 1.14. Using the CAPM formula: Discount Rate = Risk-free rate + Beta * (Market rate of return - Risk-free rate) = 2.8% + 1.14 * (9.4% - 2.8%) = 10.32%.

Question 3

Winslow and Sons is expected to pay an annual dividend of $1.35 per share one year from now with future increases of 2.5 percent annually.The stock currently sells for $14.70 a share.What is the cost of equity?

Accepted Answer

The answer of Winslow and Sons is expected to pay...

Question 4

Peter's Audio has a yield to maturity on its debt of 7.8 percent,a cost of equity of 12.4 percent,and a cost of preferred stock of 8 percent.The firm has 105 shares of common stock outstanding at a market price of $22 a share.There are 25 shares of preferred stock outstanding at a market price of $45 a share.The bond issue has a total face value of $1,500 and sells at 98 percent of face value.If the tax rate is 21 percent,what is the weighted average cost of capital assuming all interest is tax deductible?

Accepted Answer

The answer of Peter's Audio has a yield to maturity...

Question 5

Clancy's just paid its annual dividend of $1.48 per share.Analysts expect the stock price to increase by 2.1 percent annually and value the stock at $14.65 per share currently.What is the cost of equity for this firm?

Accepted Answer

The cost of equity can be calculated using the dividend discount model: Cost of Equity = (Dividend per share / Current stock price) + Growth rate. Here, it is ($1.48 / $14.65) + 0.021 = 0.1241 or 12.41 percent.

Question 6

Sound Systems has 200 shares of common stock outstanding at a market price of $37 a share.The firm recently paid an annual dividend in the amount of $1.20 per share and has a dividend growth rate of 4 percent.The firm also has 5 bonds outstanding with a face value of $1,000 per bond that are selling at 99 percent of par.The bonds have a coupon rate of 6 percent and a yield to maturity of 6.7 percent.All interest is tax deductible.If the tax rate is 21 percent,what is the weighted average cost of capital?

Accepted Answer

The weighted average cost of capital (WACC) is calculated using the cost of equity and the after-tax cost of debt. The cost of equity can be estimated using the Gordon Growth Model: Cost of Equity = (Dividend per share / Current stock price) + Growth rate = ($1.20 / $37) + 0.04 = 0.0724 or 7.24%. The cost of debt is the yield to maturity adjusted for taxes: After-tax cost of debt = Yield to maturity * (1 - Tax rate) = 0.067 * (1 - 0.21) = 0.0529 or 5.29%. The market value of equity is 200 shares * $37 = $7,400. The market value of debt is 5 bonds * $1,000 * 0.99 = $4,950. The WACC is calculated as: WACC = (Equity / Total value) * Cost of equity + (Debt / Total value) * After-tax cost of debt = ($7,400 / $12,350) * 0.0724 + ($4,950 / $12,350) * 0.0529 = 0.0654 or 6.54%.

Question 7

Jack's Construction Co.has 80 bonds outstanding that are selling at their par value of $1,000 each.Bonds with similar characteristics are yielding a pretax 8.6 percent.The firm also has 4,000 shares of common stock outstanding.The stock has a beta of 1.1 and sells for $40 a share.The U.S.T-bill is yielding 4 percent,the market risk premium is 8 percent,and the firm's tax rate is 21 percent.What is the firm's weighted average cost of capital assuming its earnings are sufficient to classify all interest as a tax-deductible expense?

Accepted Answer

First, we need to calculate the cost of debt:

Cost of debt = Yield to maturity * (1 - tax rate)
Cost of debt = 8.6% * (1 - 0.21)
Cost of debt = 6.794%

Then, we need to calculate the cost of equity:

Cost of equity = Risk-free rate + Beta * Market risk premium
Cost of equity = 4% + 1.1 * 8%
Cost of equity = 12.4%

Next, we need to calculate the weights of debt and equity:

Weight of debt = (Number of bonds * Face value of each bond) / Total capital
Weight of debt = (80 * $1,000) / ($1,000 * 80 + $40 * 4,000)
Weight of debt = 16%

Weight of equity = (Number of shares * Market price per share) / Total capital
Weight of equity = (4,000 * $40) / ($1,000 * 80 + $40 * 4,000)
Weight of equity = 84%

Finally, we can calculate the weighted average cost of capital (WACC):

WACC = Weight of debt * Cost of debt + Weight of equity * Cost of equity
WACC = 16% * 6.794% + 84% * 12.4%
WACC = 1.08704% + 10.416%
WACC = 11.50304%
WACC ≈ 10.80%

Therefore, the best answer is C, 10.80 percent.

Question 8

What is the cost of equity for a firm that has a beta of 1.2 if the risk-free rate of return is 2.9 percent and the expected market return is 11.4 percent?

Accepted Answer

The cost of equity can be calculated using the Capital Asset Pricing Model (CAPM) formula: Cost of Equity = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate). Plugging in the given values: Cost of Equity = 2.9% + 1.2 * (11.4% - 2.9%) = 2.9% + 1.2 * 8.5% = 2.9% + 10.2% = 13.1%.

Question 9

Albert's recently paid its annual dividend of $1.98 per share.At that time,the firm announced that all future dividends will be increased by 2.2 percent annually.What is the firm's cost of equity if the stock is currently selling for $28.40 a share?

Accepted Answer

The correct answer is A because the cost of equity is calculated as the dividend yield plus the expected growth rate. The dividend yield is $1.98/$28.40 = 0.0697, and the expected growth rate is 2.2%, so the cost of equity is 0.0697 + 0.022 = 0.0933, or 9.33%.

Question 10

High Road Tours has an aftertax cost of debt of 5.1 percent at its current tax rate of 34 percent.What will its aftertax cost of debt be if the tax rate drops to 21 percent? Assume all interest is tax deductible.

Accepted Answer

Using the formula for aftertax cost of debt:
Aftertax Cost of Debt = (1 - Tax Rate) x Cost of Debt
At a tax rate of 34%, the aftertax cost of debt is:
Aftertax Cost of Debt = (1 - 0.34) x 0.051 = 0.03366 or 3.366%
At a tax rate of 21%, the aftertax cost of debt is:
Aftertax Cost of Debt = (1 - 0.21) x 0.051 = 0.04029 or 4.029%
Therefore, the aftertax cost of debt increases to 6.10% if the tax rate drops to 21%. Thus, the answer is A.

Question 11

Phil's Carvings wants to have a weighted average cost of capital of 9.5 percent.The firm has an aftertax cost of debt of 6.5 percent and a cost of equity of 12.75 percent.What debt-equity ratio is needed for the firm to achieve its targeted weighted average cost of capital?

Accepted Answer

The weighted average cost of capital (WACC) is calculated as WACC = E/V * Re + D/V * Rd * (1 - Tc), where E is the market value of the equity, D is the market value of the debt, V = E + D is the total market value of the firm's financing (equity and debt), Re is the cost of equity, Rd is the cost of debt, and Tc is the corporate tax rate. However, in this question, the after-tax cost of debt is already given, so we don't need to adjust for taxes.Given that the firm wants a WACC of 9.5%, the after-tax cost of debt is 6.5%, and the cost of equity is 12.75%, we can set up the equation for WACC and solve for the debt-equity ratio (D/E).Let E = equity, D = debt, then D/E = debt-equity ratio.WACC = (E/(D+E)) * Re + (D/(D+E)) * RdGiven WACC = 9.5%, Rd = 6.5%, and Re = 12.75%, we need to find D/E.Rearranging the equation to solve for D/E, we get:9.5 = (1/(1+D/E)) * 12.75 + (D/E/(1+D/E)) * 6.5Solving this equation for D/E gives us the debt-equity ratio required to achieve the targeted WACC. The correct answer is the ratio that satisfies this equation, which is approximately 1.08. This means the firm needs a debt-equity ratio of about 1.08 to achieve its targeted WACC of 9.5%.

Question 12

HNT is an all-equity firm with a beta of .88.What will the firm's equity beta be if the firm switches to a debt-equity ratio of .35?

Accepted Answer

The correct answer is D.The equity beta of a firm with a debt-equity ratio of .35 can be calculated using the following formula:Equity beta = Unlevered beta / (1 + (1 - Tax rate) * Debt-equity ratio)Assuming a tax rate of 40%, we get:Equity beta = 0.88 / (1 + (1 - 0.4) * 0.35) = 1.19

Question 13

Barges has an asset beta of .57,the risk-free rate is 4.3 percent,and the market risk premium is 7.7 percent.What is the equity beta if the firm has a debt-equity ratio of .56?

Accepted Answer

The equity beta ($\beta_{equity}$) can be calculated using the formula: $\beta_{equity} = \beta_{asset} (1 + (1 - tax rate) \times debt/equity ratio)$. Since the tax rate is not provided, we assume it to be 0 for simplicity, making the formula: $\beta_{equity} = \beta_{asset} (1 + debt/equity ratio)$. Plugging in the given values: $\beta_{equity} = 0.57 \times (1 + 0.56) = 0.57 \times 1.56 = 0.8892$, which rounds to 0.89.

Question 14

Ladder Works has debt outstanding with a coupon rate of 6 percent and a yield to maturity of 6.8 percent.What is the aftertax cost of debt if the tax rate is 21 percent? Assume all interest is tax deductible.

Accepted Answer

The aftertax cost of debt is the yield to maturity multiplied by (1 - tax rate). In this case, the aftertax cost of debt is 6.8% * (1 - 21%) = 5.37%.

Question 15

LR Engines stock is selling for $42.39 a share,has an ROE of 14.3 percent,and a dividend payout ratio of 35 percent.The next expected dividend is $1.62 a share.What is the cost of equity for this firm?

Accepted Answer

The cost of equity can be calculated using the Gordon Growth Model: Cost of Equity = (D1 / P0) + g, where D1 is the next expected dividend, P0 is the current stock price, and g is the growth rate. The growth rate (g) can be calculated as ROE * (1 - payout ratio). Here, g = 14.3% * (1 - 0.35) = 9.295%. Thus, Cost of Equity = ($1.62 / $42.39) + 9.295% = 13.12%.

Question 16

Consolidated Transfer is an all-equity financed firm.The beta is .75,the market risk premium is 7.78 percent,and the risk-free rate is 3.84 percent.What is the expected rate of return on this stock?

Accepted Answer

The answer of Consolidated Transfer is an all-equity financed firm.The...

Question 17

The cost of equity for RJ Corporation is 8.4 percent and the debt-equity ratio is .6.The expected return on the market is 10.4 percent and the risk-free rate is 3.8 percent.Using the common assumption for the debt beta,what is the asset beta?

Accepted Answer

The answer of The cost of equity for RJ Corporation...

Question 18

APL has an overall cost of capital of 11.6 percent and a beta of 1.31.The firm is contemplating a new project that is unrelated to the firm's current operations.SKL is a firm that operates similarly to the new project and SKL has a cost of capital of 10.7 percent.APL knows that it will be less efficient than SKL and thus feels that an adjustment of +1 percent should be added to the project's discount rate to allow for this inefficiency.What discount rate should be assigned to the new project?

Accepted Answer

To calculate the discount rate for the new project, we need to add a premium to SKL's cost of capital because APL expects to be less efficient than SKL in operating the new project. The premium is given as +1 percent, so we need to add this to SKL's cost of capital of 10.7 percent.

Discount rate for the new project = SKL's cost of capital + premium 
Discount rate for the new project = 10.7% + 1% 
Discount rate for the new project = 11.7%

Therefore, the best choice is C) 11.7 percent.

Question 19

BG's cost of equity is 9.4 percent,the expected return on the market is 13.6 percent,and the risk-free rate is 3.8 percent.What is the firm's debt-equity ratio if its asset beta is .36? Assume there is no preferred stock.

Accepted Answer

First, we need to use the asset beta to find the unlevered beta of the firm. 
Unlevered Beta = Asset Beta / (1 + (1 - Tax Rate) x (Debt/Equity)) 
Since the tax rate and total debt are not given, we can assume a tax rate of 35% (typical for US companies) and solve for the debt/equity ratio. 
0.36 = 0.4 / (1 + (1 - 0.35) x Debt/Equity)
Debt/Equity = 0.59 
Therefore, the best choice is B.

Question 20

A firm has an equity beta of 1.2,the risk-free rate is 3.4 percent,the market return is 15.7 percent,and the pretax cost of debt is 9.4 percent.The debt-equity ratio is .47.If you apply the common beta assumptions,what is the firm's asset beta?

Accepted Answer

The asset beta ($\beta_A$) can be calculated using the formula $\beta_A = \frac{\beta_E}{1 + ((1 - T) \times D/E)}$, where $\beta_E$ is the equity beta, $T$ is the tax rate (which is not provided, so we assume taxes are not considered in this calculation), and $D/E$ is the debt-to-equity ratio. Given $\beta_E = 1.2$ and $D/E = 0.47$, the calculation is $\beta_A = \frac{1.2}{1 + (1 \times 0.47)} = \frac{1.2}{1.47} \approx 0.82$.

Quiz 13: Risk, cost of Capital, and Valuation