Question 1

With its current financial policies, Flagstaff Inc. will have to issue new common stock to fund its capital budget. Since new stock has a higher cost than reinvested earnings, Flagstaff would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock?

Accepted Answer

By increasing the percentage of debt in the target capital structure, Flagstaff would be able to raise funds through debt financing instead of equity financing. This would reduce the need to issue new common stock and lower the cost of capital for the company. Increasing the proposed capital budget, reducing short-term bank debt, reducing the percentage of debt in the target capital structure, or increasing the dividend payout ratio would not have a direct impact on the need to issue new common stock.

Question 2

Burnham Brothers Inc. has no retained earnings since it has always paid out all of its earnings as dividends. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, and its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC?

Accepted Answer

The Weighted Average Cost of Capital (WACC) is influenced by the cost of equity, the cost of debt, and the cost of preferred stock. A decline in the market risk premium would reduce the cost of equity calculated using the CAPM (Capital Asset Pricing Model), which in turn would reduce the WACC, assuming other factors remain constant.

Question 3

The Tierney Group has two divisions of equal size: an office furniture manufacturing division and a data processing division. Its CFO believes that stand-alone data processor companies typically have a WACC of 9%, while stand-alone furniture manufacturers typically have a 13% WACC. She also believes that the data processing and manufacturing divisions have the same risk as their typical peers. Consequently, she estimates that the composite, or corporate, WACC is 11%. A consultant has suggested using a 9% hurdle rate for the data processing division and a 13% hurdle rate for the manufacturing division. However, the CFO disagrees, and she has assigned an 11% WACC to all projects in both divisions. Which of the following statements is CORRECT?

Accepted Answer

The answer of The Tierney Group has two divisions of...

Question 4

Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely

Accepted Answer

By using the same WACC for 10 years, Acme Industries is assuming that their risk level and cost of capital will remain constant over time. However, in reality, a company's risk level and cost of capital can change due to various factors such as changes in the industry, economy, and company performance. This means that using the same WACC for 10 years will likely result in incorrect project evaluations and investments. As a result, the company may become more risky and have an increasing WACC, which will not maximize its intrinsic value.

Question 5

Taylor Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?

Accepted Answer

The best choice would be Project B as it has a return of 8.5%, which is above its below-average risk WACC of 8%. Project A has a return of 9%, which is below the average-risk WACC of 10%, and Project C has a return of 11%, which is only slightly above the above-average risk WACC of 12%. Therefore, Project B is the only project that has a return higher than its corresponding WACC and should be accepted.

Question 6

Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets. They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.

Accepted Answer

It is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.

Question 7

Weatherall Enterprises has no debt or preferred stock⎯it is an all-equity firm⎯and has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than an average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT?

Accepted Answer

The accept/reject decision for a project depends on the firm's risk-adjustment policy. Since the project being evaluated is riskier than an average project in terms of both its beta risk and total risk, the required return would be higher than the risk-free rate plus market risk premium. The required return would be calculated as rRF + (rM - rRF) * β + risk premium for total risk. If Weatherall’s policy is to increase the required return on a riskier-than-average project to 3% over r_S, then it should reject the project if the adjusted required return is greater than the expected return.

Question 8

Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.

Accepted Answer

Project A, despite having a higher standard deviation of expected returns, is considered less risky due to its negative correlation with the firm's other assets and the broader market. This diversification effect can reduce the overall risk of the firm's portfolio, justifying a lower cost of capital for evaluating Project A.

Question 9

Careco Company and Audaco Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Careco having a WACC of 10% and Audaco a WACC of 12%. Careco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Careco project. Audaco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Audaco project. Now assume that the two companies merge and form a new company, Careco/Audaco Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is CORRECT?

Accepted Answer

The answer of Careco Company and Audaco Inc are identical...

Question 10

Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

Accepted Answer

The answer of Suppose the debt ratio (D/TA) is 50%,...

Question 11

Bloom and Co. has no debt or preferred stock⎯it uses only equity capital, and has two equally-sized divisions. Division X's cost of capital is 10.0%, Division Y's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division X's projects are equally risky, as are all of Division Y's projects. However, the projects of Division X are less risky than those of Division Y. Which of the following projects should the firm accept?

Accepted Answer

The answer of Bloom and Co. has no debt or...

Question 12

The Anderson Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 12%. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO's position is accepted, what is likely to happen over time?

Accepted Answer

Using a single WACC for projects with different risk profiles means that high-risk projects may appear more attractive (because their expected returns are evaluated against a cost of capital that does not fully account for their risk), while low-risk projects may seem less attractive. Over time, this could lead the company to undertake too many high-risk projects and too few low-risk projects.

Quiz 9: The Cost of Capital

Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely

Taylor Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?

Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.

Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).