Question 1

The following information was obtained about Nashville Bottling. 
EBIT = $6 million
I = $1 million
Taxes rate = 34%
Debt = $2 million
Equity = 8 million
Weighted average cost of capital = 8.75 percent
 Over the reporting period, what is its economic value added?

Accepted Answer

Economic Value Added (EVA) is calculated as NOPAT - (WACC * Capital). NOPAT is EBIT - Taxes, which is $6 million - ($6 million * 34%) = $3.96 million. Capital is Debt + Equity = $2 million + $8 million = $10 million. EVA = $3.96 million - (8.75% * $10 million) = $3.96 million - $0.875 million = $3.085 million.

Question 2

A firm's correctly computed capital structure consists of 20% debt, 10% preferred stock, and 70% equity. If retained earnings of $2 million are expected, at what point will the MCC schedule break upward as retained earnings are replaced with new equity?

Accepted Answer

The break point occurs when retained earnings are fully utilized. The formula to calculate the break point is Retained Earnings / Equity Portion of the Capital Structure. Here, it's $2,000,000 / 0.70 = $2,857,143.

Question 3

Zylon Inc. plans net income of $10 million next year and typically pays 40% of its earnings in dividends. Its capital structure is one third equity and two thirds debt with no preferred stock. Zylon's MCC curve will break at:

Accepted Answer

The answer of Zylon Inc. plans net income of $10...

Question 4

Williamson Manufacturing paid a $2 dividend last year and expects dividends to grow at a constant rate of 7%. The firm's stock is selling at $45 per share and flotation costs on a new issue would be 15%. Calculate Williamson's cost of new equity.

Accepted Answer

First, we need to calculate the expected dividend for the next year:
Expected Dividend = $2 x (1+0.07) = $2.14

Next, we need to calculate the cost of new equity using the dividend growth model:
Cost of New Equity = (Expected Dividend / Current Stock Price) + Growth Rate
Cost of New Equity = ($2.14 / $45) + 0.07 = 0.113 or 11.3%

However, we need to adjust for flotation costs of 15%, which reduces the net proceeds from the new issue:
Net Proceeds = (1 - 0.15) x $45 = $38.25

Using this adjusted stock price, we can recalculate the cost of new equity:
Cost of New Equity = ($2.14 / $38.25) + 0.07 = 0.126 or 12.6%

Therefore, the answer is C (12.6%).

Question 5

Why should the debt portion of the WACC be adjusted for tax?

Accepted Answer

Interest on debt is tax-deductible for the firm, effectively reducing the cost of debt due to the tax shield it provides. This is why the debt portion of the Weighted Average Cost of Capital (WACC) is adjusted for taxes.

Question 6

Suppose two firms are exactly the same except Firm A has no debt in its capital structure and Firm B has 50% debt in its capital structure. Firm A has a WACC of 15%. If Firm B's cost of debt is 10% (after-tax value), what must Firm B's cost of equity be to have the same WACC as Firm A?

Accepted Answer

WACC = (E/V) × Re + (D/V) × Rd × (1-T)
Let V be the total value of the firm and E be the value of equity. Then, D = 0 for Firm A and D = 0.5V for Firm B. Also, since Firm B's tax rate is not given, let's assume it's the same as Firm A's tax rate, which is not affected by the presence of debt in the capital structure.
To find Re for Firm B, we can rearrange the WACC formula as follows:
Re = (WACC - (D/V) × Rd × (1-T)) / (E/V)
Substituting the values, we get:
Re = (0.15 - (0.5/1) × 0.10 × (1-0)) / (1-0.5)
Re = 0.20 or 20%

Question 7

A firm's correctly computed capital structure consists of 20% debt, 10% preferred stock, and 70% equity. If new debt of $3 million can be raised at the current interest rate before a higher yield must be paid to investors, at what point will the MCC break upward because of the cost of debt?

Accepted Answer

The point at which the MCC breaks upward because of the cost of debt is the point at which the weighted average cost of capital (WACC) increases. Since the new debt is being raised at the current interest rate, it will not immediately affect the WACC. However, if the amount of debt raised exceeds a certain point, the cost of debt will likely increase and cause the WACC to rise. This point is where the cost of debt becomes higher than the cost of equity, and is known as the break point.

To calculate the break point, we need to first determine the current weighted average cost of capital (WACC). Let's assume that the current cost of debt is 5%, the cost of preferred stock is 8%, and the cost of equity is 12%. Using the weights given in the question, we can calculate the WACC as follows:

WACC = (0.2 x 0.05) + (0.1 x 0.08) + (0.7 x 0.12) = 0.101 or 10.1%

This means that the company's current WACC is 10.1%.

Next, we need to determine at what point the cost of debt will become higher than the cost of equity, which will cause the WACC to increase. Let's assume that the interest rate on new debt will increase to 7% after $15 million is raised. To calculate the break point, we can use the following formula:

Break Point = (Cost of Preferred Stock + Cost of Equity - Cost of New Debt) / (Weight of Equity x New Debt)

Break Point = (0.08 + 0.12 - 0.07) / (0.7 x 3,000,000) = $15,714,286

This means that if the company raises more than $15,714,286 in new debt, the cost of debt will become higher than the cost of equity, causing the WACC to increase. Therefore, the correct answer is C ($15,000,000), as this is the closest option to the calculated break point.

Question 8

Which is not considered a part of the firm's capital structure?

Accepted Answer

Depreciation expense is not a source of capital and is not a part of the firm's capital structure. It is a non-cash expense that represents the decline in value of an asset over time. The other options, retained earnings, preferred stock, and bank loans, are all sources of capital that make up a firm's capital structure.

Question 9

The following information is available concerning a firm's capital: Debt: Bonds with a face value of $1000 and an initial 20-year term were issued five years ago with a coupon rate of 8% paying semiannually. Today these bonds are selling for $846.30.
Preferred stock: Preferred stock that pays an annual dividend of $9.50 is trading at $79.16.
Common equity: The stock is selling for $22.50 per share. An annual dividend of $1.70 was just paid and is expected to grow indefinitely at 6%.
Target capital structure: The firm's target capital structure is of 30% debt, 20% preferred stock, and 50% equity.
The firm can issue any type of security without paying floatation costs. The combined federal and state tax rate is 40%. Calculate the firm's WACC based on its target capital structure.

Accepted Answer

First, we need to calculate the cost of each type of capital:

Debt: 
PV = $846.30
FV = $1000
n = 15 (20-5)
I/Y = 4% (semi-annual coupon rate of 8%)
PMT = $40 (semi-annual coupon payment of 8%)
Solve for I/Y = 8.44% (semi-annual rate)
Effective annual rate = (1+0.0844/2)^2 - 1 = 8.68%
After-tax cost of debt = 8.68% x (1-40%) = 5.21%

Preferred stock:
Cost of preferred stock = annual dividend / current price
Cost of preferred stock = $9.50 / $79.16 = 12.00%

Common equity:
Cost of common equity = dividend yield + growth rate
Dividend yield = $1.70 / $22.50 = 7.56%
Cost of common equity = 7.56% + 6% = 13.56%

Next, we can calculate the weighted average cost of capital (WACC) based on the target capital structure:

WACC = (wd x kd) + (wp x kp) + (we x ke)
WACC = (0.30 x 5.21%) + (0.20 x 12.00%) + (0.50 x 13.56%)
WACC = 1.563% + 2.400% + 6.780%
WACC = 10.743%

Therefore, the firm's WACC based on its target capital structure is 10.743%. The closest option is B, 11.2%.

Question 10

The firm's capital structure is 20% debt, 30% preferred stock and 50% equity. Debt of $2.5 million is expected to be available at a relatively low cost. Debt beyond that amount will cost substantially more. Where will the MCC break because of an increase in the cost of debt?

Accepted Answer

The answer of The firm's capital structure is 20% debt,...

Question 11

A firm's correctly computed capital structure is 30% debt, 20% preferred stock, and 50% equity. If retained earnings of $1 million are expected, how much capital will have been raised when retained earnings are exhausted and new common equity must be issued?

Accepted Answer

To calculate the amount of new common equity that must be issued, we need to determine the total amount of capital needed when retained earnings are exhausted.

First, we need to determine the amount of total capital that has already been raised:

Total current capital = (Debt / Total capital) + (Preferred stock / Total capital) + (Equity / Total capital)
Total current capital = (0.3) + (0.2) + (0.5)
Total current capital = 1

Next, we can use the total current capital to calculate the amount of new capital needed:

New capital needed = Total capital / (1 - Retained earnings)
New capital needed = 1 / (1 - 1,000,000 / Total capital)

Solving for Total capital, we get:

Total capital = $2,000,000

Finally, we can use the total current capital and total capital to calculate the amount of new common equity needed:

New common equity = Total capital - (Debt + Preferred stock + Retained earnings)
New common equity = $2,000,000 - [(0.3 x $2,000,000) + (0.2 x $2,000,000) + $1,000,000]
New common equity = $2,000,000 - $1,100,000
New common equity = $900,000

Therefore, the amount of capital that will have been raised when retained earnings are exhausted and new common equity must be issued is $2,000,000, and the amount of new common equity needed is $900,000. So, the answer is C.

Question 12

Morrison Movers's optimal capital structure calls for financing seventy percent of new assets with equity. Assuming that Morrison Movers has net income of $5 million, how much can be paid out in the form of a dividend and still have sufficient funds to cover a $6 million capital budget?

Accepted Answer

If Morrison Movers has a capital budget of $6 million and they will finance 70% of the new assets with equity, they will need to raise $4.2 million in equity to cover this budget. If they have net income of $5 million, they can pay out a dividend of $800,000 ($5 million - $4.2 million). Therefore, the best choice is B.

Question 13

Williamson Manufacturing paid a $2 dividend last year and expects dividends to grow at a constant rate of 7%. The firm's stock is selling at $45 per share and flotation costs on a new issue would be 15%. Calculate Williamson's cost of retained earnings.

Accepted Answer

To calculate the cost of retained earnings, we can use the Gordon growth model:

k = (D1 / P0) + g
where:
k = cost of retained earnings
D1 = expected dividend for next year
P0 = current stock price
g = expected growth rate in dividends

First, we need to calculate D1:
D1 = D0 * (1 + g)
where:
D0 = last year's dividend

D1 = $2 * (1 + 0.07) = $2.14

Next, we can plug in the values to calculate k:
k = ($2.14 / $45) + 0.07 = 0.122 = 12.2%

However, the question asks for the cost of retained earnings, which means we need to adjust for flotation costs. If the flotation costs are 15%, this means that the firm can retain 85% of earnings. Therefore, the actual cost of retained earnings is:

k = 12.2% / 0.85 = 14.35%
However, flotation costs only affect new equity issued, not retained earnings. Therefore, the actual cost of retained earnings should be:

k = 12.2%

Out of the answer choices, the closest one is 11.8%, or choice B.

Question 14

Hatter Enterprise paid a dividend of $2 last year, its stock is selling at $45 per share, and a constant growth of 6% is expected. If Hatter's cost of new equity is 11.2%. Calculate the flotation costs associated with a new issue of common stock.

Accepted Answer

First, we need to calculate the expected dividend for the next year:

Expected Dividend = Dividend paid last year x (1 + Growth rate) 
Expected Dividend = $2 x (1 + 0.06) 
Expected Dividend = $2.12

Next, we need to use the dividend discount model to calculate the cost of new equity:

Cost of New Equity = (Expected Dividend / Current Stock Price) + Growth rate 
Cost of New Equity = ($2.12 / $45) + 0.06 
Cost of New Equity = 0.1071 or 10.71%

Finally, we use the formula to calculate the flotation costs:

Flotation Costs = (Cost of New Equity - Dividend Yield) / (1 - Flotation Costs)

Dividend Yield = Dividend / Current Stock Price

Dividend Yield = $2 / $45 
Dividend Yield = 0.0444 or 4.44%

Flotation Costs = (0.1071 - 0.0444) / (1 - Flotation Costs) 
Flotation Costs = 0.0627 / (1 - Flotation Costs)

We can use trial and error or a spreadsheet to solve for Flotation Costs:

Flotation Costs = 9.4%

Question 15

Your company is expected to earn $4.0 million in net income next year of which it will pay out 40% in dividends. If equity represents 50% of your capital, what is the breakpoint on the MCC where new stock will have to be issued?

Accepted Answer

The breakpoint is the level of capital at which the cost of new capital increases.

Total net income = $4.0 million
Dividend payout ratio = 40%
Amount of dividends = $4.0 million * 0.4 = $1.6 million

Retained earnings = $4.0 million - $1.6 million = $2.4 million

Equity represents 50% of capital, so the total capital is:

Total capital = Equity / 0.5

Total capital = $2.4 million / 0.5 = $4.8 million

The breakpoint on the MCC is the level of capital at which the cost of new equity capital will increase. Since the total capital is $4.8 million, any new equity beyond this level will require a higher cost of capital due to increased risk. Therefore, the breakpoint on the MCC is $4.8 million.

Question 16

Calculate the WACC. $\begin{array}{lll}&\text { Value } & \text { Cost } \
\text { Debt } & \$ 50 & 6 \% \
\text { Preferred } & \$ 10 & 9 \% \
\text { Equity } & \$ 90 & 12 \%\&\$150
\end{array}$

Accepted Answer

The WACC is calculated as: $(50/150) \times 6\% + (10/150) \times 9\% + (90/150) \times 12\% = 9.8\%$.

Question 17

Estimate the cost of new equity using the Gordon or dividend growth model, if last year's dividend was $2.00, the anticipated constant growth rate is 5%, the stock's selling price is $30 per share, and flotation costs are estimated to be 10%?

Accepted Answer

The cost of new equity using the Gordon or dividend growth model can be calculated as:

Cost of Equity = (Dividend / Stock Price) + Growth Rate

Since the flotation cost is 10%, the actual amount of money the company receives per share sold is:

Net Proceeds = Selling Price * (1 - Flotation Cost)
Net Proceeds = $30 * (1 - 0.10)
Net Proceeds = $27 per share

Using this value, we can calculate the cost of new equity:

Cost of Equity = ($2.00 / $27) + 5%
Cost of Equity = 0.074 + 0.05
Cost of Equity = 0.124 or 12.4%

Therefore, the best answer is D.

Question 18

Which is incorrect in regard to the firm's cost of capital?

Accepted Answer

The firm's cost of capital is not necessarily the risk-adjusted discount rate appropriate for all projects. Different projects may have different risk profiles and therefore may require different discount rates for their evaluation. The cost of capital serves as a benchmark, but adjustments may be needed based on the specific risk characteristics of each project.

Question 19

A project has an IRR of 16% and is being considered by a firm with $5 million in debt and $15 million in equity. Assuming the debt costs 12% (after-tax value), what is the most equity can cost for the project to be acceptable to the firm? (hint: set the IRR equal to WACC)

Accepted Answer

The Weighted Average Cost of Capital (WACC) is calculated as the weighted sum of the cost of equity and the cost of debt. Given that the IRR (Internal Rate of Return) must equal the WACC for the project to be acceptable, we can set up the equation as follows: $$ WACC = \left(\frac{Equity}{Equity + Debt}\right) \times Cost\_of\_Equity + \left(\frac{Debt}{Equity + Debt}\right) \times Cost\_of\_Debt $$Given:- Equity = $15 million- Debt = $5 million- Cost of Debt = 12%- IRR (which we set equal to WACC) = 16%Substituting the given values:$$ 16\% = \left(\frac{15}{15 + 5}\right) \times Cost\_of\_Equity + \left(\frac{5}{15 + 5}\right) \times 12\% $$$$ 16\% = \left(\frac{15}{20}\right) \times Cost\_of\_Equity + \left(\frac{5}{20}\right) \times 12\% $$$$ 16\% = 0.75 \times Cost\_of\_Equity + 0.25 \times 12\% $$Solving for Cost_of_Equity:$$ 16\% = 0.75 \times Cost\_of\_Equity + 3\% $$$$ 13\% = 0.75 \times Cost\_of\_Equity $$$$ Cost\_of\_Equity = \frac{13\%}{0.75} = 17.33\% $$Therefore, the most equity can cost for the project to be acceptable to the firm is 17.33%.

Question 20

A firm has a previous debt issue on its balance sheet that pays coupons of 8% annually. Newer bonds with equivalent maturity would have 10% annual coupons in order to sell at par value. Based on this information, which statement is true?

Accepted Answer

The answer of A firm has a previous debt issue...

Quiz 13: Cost of Capital

The following information was obtained about Nashville Bottling. EBIT = $6 million I = $1 million Taxes rate = 34% Debt = $2 million Equity = 8 million Weighted average cost of capital = 8.75 percent Over the reporting period, what is its economic value added?