Question 1

Unitron Corp.is considering project Z,which costs $50 million and offers an annual after-tax cash flow of $7.5 million in perpetuity.The project is in an industry that has greater market risk than Unitron's typical projects.Unitron's company weighted-average cost of capital,based on its typical projects,is 15%.Should Unitron Corp.accept project Z?

Accepted Answer

Use the equation for a perpetuity to solve for the IRR:
7)5/IRR = 50
IRR = 15%
Since the IRR is 15%,it would have an NPV of zero at a WACC of 15%.However,this project is riskier than the firm's average projects,so the WACC would be higher than 15%,which would make the NPV negative.

Question 2

$\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $FM Foods, Inc.
 $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $Facts and assumptions as of Dec. 31, 2011
$\begin{array}{lr}
\hline \text { Yield to maturity on long-term government bonds } & 4.4 \% \
\text { Yield to maturity on company long-term bonds } & 6.3 \% \
\text { Coupon rate on company long-term bonds } & 7.0 \% \
\text { Historical excess return on common stocks } & 6.5 \% \
\text { Company equity beta } & 1.20 \
\text { Stock price } & \$ 40.00 \
\text { Number of shares outstanding (millions) } & 240 \
\text { Book value of equity (millions) } & \$ 5,240 \
\text { Book value of interest-bearing debt (millions) } & \$ 1,250 \
\text { Tax rate } & 35.0 \% \
\hline
\end{array}$
-Please refer to the information for FM Foods above.FM is contemplating an average-risk investment costing $100 million and promising an annual after-tax cash flow of $15 million in perpetuity.Which of the following statements is/are correct?
i.FM should reject the project because the IRR is greater than the firm's WACC.
II.FM should accept the project because the IRR is greater than the firm's WACC.
III.FM should accept the project because the NPV is greater than zero.
IV.FM should reject the project because the NPV is less than zero.

Accepted Answer

II and III are correct because the project's IRR exceeding the firm's WACC and a positive NPV both indicate that the project is expected to generate returns above the firm's cost of capital, making it a worthwhile investment.

Question 3

The weighted-average cost of capital for a firm is the:

Accepted Answer

The answer of The weighted-average cost of capital for a...

Question 4

Suppose that your company's weighted-average cost of capital is 9 percent.Your company is planning to undertake a project with an internal rate of return of 12%,but you believe that this project is not a good investment for the firm.What logical arguments might you use to convince your boss to forego the project despite its high rate of return? Is it possible that making investments with expected returns higher than your company's cost of capital will destroy value? If so,how?

Accepted Answer

The answer of Suppose that your company's weighted-average cost of...

Question 5

Florida Corp.is calculating the appropriate rate for discounting cash flows on a project valued using the APV method.Florida's target debt ratio (D/(D+E))in market value terms is 50%,and the yield-to-maturity on its outstanding debt is 6%.A comparable firm has an equity beta of 1.4 and a debt ratio (D/(D+E))of 40%.Assume a risk-free rate of 5% and a market risk premium of 8%.Florida's tax rate is 40%.What discount rate should Florida use?

Accepted Answer

Β_A = (E/V)β_E = (0.6)1.4 = 0.84 K_E = 5% + 0.84(8%)= 11.72%

Question 6

Which of the following statements are correct?
i.Using the same risk-adjusted discount rate to discount all future cash flows adjusts for the fact that the more distant cash flows are often more risky than cash flows occurring sooner.II.If you can borrow all of the money you need for a project at 5%,the cost of capital for this project is 5%.III.The best way to obtain the cost of debt capital for a firm is to use the coupon rates on its bonds.IV.A firm's weighted-average cost of capital is NOT the correct discount rate to use for all projects undertaken by the firm.

Accepted Answer

Statement I is correct as using a risk-adjusted discount rate helps in adjusting for the fact that more distant cash flows are often riskier than cash flows occurring sooner. 
Statement II is not entirely correct as the cost of capital is not just the cost of borrowing, it includes the cost of equity as well. 
Statement III is not entirely correct as the coupon rates on bonds may not be the same as the cost of debt capital. A better measure would be the current market interest rate for debt issued by the company. 
Statement IV is correct as the weighted-average cost of capital (WACC) is the discount rate used to evaluate projects that have the same risk as the company's overall operations. However, projects that have different risks than the company's overall operations may require a different discount rate.

Question 7

The standard deviation of returns on Wildcat Oil Drilling is very high.Does this necessarily imply that Wildcat Oil Drilling is a high-risk investment when investors hold diversified portfolios? Explain why or why not.

Accepted Answer

The answer of The standard deviation of returns on Wildcat...

Question 8

$\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $FM Foods, Inc.
 $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $Facts and assumptions as of Dec. 31, 2011
$\begin{array}{lr}
\hline \text { Yield to maturity on long-term government bonds } & 4.4 \% \
\text { Yield to maturity on company long-term bonds } & 6.3 \% \
\text { Coupon rate on company long-term bonds } & 7.0 \% \
\text { Historical excess return on common stocks } & 6.5 \% \
\text { Company equity beta } & 1.20 \
\text { Stock price } & \$ 40.00 \
\text { Number of shares outstanding (millions) } & 240 \
\text { Book value of equity (millions) } & \$ 5,240 \
\text { Book value of interest-bearing debt (millions) } & \$ 1,250 \
\text { Tax rate } & 35.0 \% \
\hline
\end{array}$
-Please refer to the information for FM Foods above.Estimate FM's after-tax cost of equity capital.

Accepted Answer

The after-tax cost of equity capital can be estimated using the Capital Asset Pricing Model (CAPM): Cost of Equity = Risk-Free Rate + Beta * Market Risk Premium. Here, the risk-free rate is the yield on long-term government bonds (4.4%), the beta is 1.20, and the market risk premium is the historical excess return on common stocks (6.5%). Thus, Cost of Equity = 4.4% + 1.20 * 6.5% = 12.20%.

Question 9

Explain the difference between systematic and unsystematic risk,and why one of these types of risks is rewarded with a risk premium while the other type is not.

Accepted Answer

The answer of Explain the difference between systematic and unsystematic...

Question 10

Honest Abe's is a chain of furniture retail stores.Integral Designs is a furniture maker and a supplier to Honest Abe's.Honest Abe's has a beta of 1.38 as compared to Integral Designs' beta of 1.12.Both firms carry no debt,i.e. ,are 100% equity-financed.The risk-free rate of return is 3.5 percent and the market risk premium is 8 percent.What discount rate should Honest Abe's use if it considers a project that involves the manufacturing of furniture?

Accepted Answer

The correct discount rate for Honest Abe's is 12.46%. This is calculated using the Capital Asset Pricing Model (CAPM), which states that the expected return on an asset is equal to the risk-free rate plus a risk premium. The risk premium is determined by multiplying the beta of the asset by the market risk premium. In this case, the beta of Honest Abe's is 1.38, the risk-free rate is 3.5%, and the market risk premium is 8%. Therefore, the expected return on Honest Abe's is 3.5% + (1.38 * 8%) = 12.46%.

Question 11

$\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $FM Foods, Inc.
 $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $Facts and assumptions as of Dec. 31, 2011
$\begin{array}{lr}
\hline \text { Yield to maturity on long-term government bonds } & 4.4 \% \
\text { Yield to maturity on company long-term bonds } & 6.3 \% \
\text { Coupon rate on company long-term bonds } & 7.0 \% \
\text { Historical excess return on common stocks } & 6.5 \% \
\text { Company equity beta } & 1.20 \
\text { Stock price } & \$ 40.00 \
\text { Number of shares outstanding (millions) } & 240 \
\text { Book value of equity (millions) } & \$ 5,240 \
\text { Book value of interest-bearing debt (millions) } & \$ 1,250 \
\text { Tax rate } & 35.0 \% \
\hline
\end{array}$
-Please refer to the information for FM Foods above.Estimate FM's after-tax cost of debt capital.

Accepted Answer

The after-tax cost of debt capital is calculated as the yield to maturity on the company's long-term bonds multiplied by (1 - tax rate). Using the given yield to maturity of 6.3% and a tax rate of 35%, the calculation is 6.3% * (1 - 0.35) = 4.095%, which rounds to 4.10%.

Question 12

$\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $FM Foods, Inc.
 $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $Facts and assumptions as of Dec. 31, 2011
$\begin{array}{lr}
\hline \text { Yield to maturity on long-term government bonds } & 4.4 \% \
\text { Yield to maturity on company long-term bonds } & 6.3 \% \
\text { Coupon rate on company long-term bonds } & 7.0 \% \
\text { Historical excess return on common stocks } & 6.5 \% \
\text { Company equity beta } & 1.20 \
\text { Stock price } & \$ 40.00 \
\text { Number of shares outstanding (millions) } & 240 \
\text { Book value of equity (millions) } & \$ 5,240 \
\text { Book value of interest-bearing debt (millions) } & \$ 1,250 \
\text { Tax rate } & 35.0 \% \
\hline
\end{array}$
-Please refer to the information for FM Foods above.Estimate the appropriate weight of equity to be used when calculating FM's weighted-average cost of capital.

Accepted Answer

The weight of equity in the weighted-average cost of capital (WACC) formula is calculated by dividing the book value of equity by the sum of the book value of equity and interest-bearing debt.

Weight of Equity = Book Value of Equity / (Book Value of Equity + Book Value of Interest-Bearing Debt)

= $5,240 million / ($5,240 million + $1,250 million)

= 0.807

Therefore, the appropriate weight of equity to be used when calculating FM's WACC is 80.7%, which is closest to option D: 88.5%.

Question 13

Company X has 2 million shares of common stock outstanding at a book value of $2 per share.The stock trades for $3.00 per share.It also has $2 million in face value of debt that trades at 90% of par.What is the appropriate debt ratio (D/(D+E))to use for calculating Company X's weighted-average cost of capital?

Accepted Answer

D = 0.9 × $2 million = $1.8 million
E = $3 × 2 million = $6 million
D/(D+E)= 1.8/(1.8 + 6)= 0.231

Question 14

$\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $FM Foods, Inc.
 $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $Facts and assumptions as of Dec. 31, 2011
$\begin{array}{lr}
\hline \text { Yield to maturity on long-term government bonds } & 4.4 \% \
\text { Yield to maturity on company long-term bonds } & 6.3 \% \
\text { Coupon rate on company long-term bonds } & 7.0 \% \
\text { Historical excess return on common stocks } & 6.5 \% \
\text { Company equity beta } & 1.20 \
\text { Stock price } & \$ 40.00 \
\text { Number of shares outstanding (millions) } & 240 \
\text { Book value of equity (millions) } & \$ 5,240 \
\text { Book value of interest-bearing debt (millions) } & \$ 1,250 \
\text { Tax rate } & 35.0 \% \
\hline
\end{array}$
-Please refer to the information for FM Foods above.Estimate FM's weighted-average cost of capital.

Accepted Answer

The answer of  $\quad $ $\quad $ $\quad $...

Question 15

JKL Corporation,a company devoted primarily to paper products,is estimating the cost of equity appropriate for a vegetable processing plant it is planning to build.JKL Corp.has an equity beta of 1.0 and a debt ratio (D/(D+E))of 0.3.A comparable (vegetable processing)firm has an equity beta of 0.8 and a debt ratio of 0.2.Assume a risk-free rate of 5% and a market risk premium of 8%.What cost of equity should JKL use in this situation?

Accepted Answer

Unlever the comparable firm's beta: β_A = (E/V)β_E = (0.8)0.8 = 0.64 Then relever at JKL's debt ratio: β_E = β_A/(E/V)= 0.64/(0.7)= 0.91 Cost of Equity: K_E = 5% + 0.91(8%)= 12.3%

Question 16

$\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $FM Foods, Inc.
 $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $ $\quad $Facts and assumptions as of Dec. 31, 2011
$\begin{array}{lr}
\hline \text { Yield to maturity on long-term government bonds } & 4.4 \% \
\text { Yield to maturity on company long-term bonds } & 6.3 \% \
\text { Coupon rate on company long-term bonds } & 7.0 \% \
\text { Historical excess return on common stocks } & 6.5 \% \
\text { Company equity beta } & 1.20 \
\text { Stock price } & \$ 40.00 \
\text { Number of shares outstanding (millions) } & 240 \
\text { Book value of equity (millions) } & \$ 5,240 \
\text { Book value of interest-bearing debt (millions) } & \$ 1,250 \
\text { Tax rate } & 35.0 \% \
\hline
\end{array}$
-Please refer to the information for FM Foods above.Estimate the appropriate weight of debt to be used when calculating FM's weighted-average cost of capital.

Accepted Answer

The answer of  $\quad $ $\quad $ $\quad $...

Question 17

Key facts and assumptions concerning Costco Company,at December 31,2011,appear below.Use the above information to answer the following questions.a.Estimate Costco's cost of equity capital.b.Estimate Costco's weighted-average cost of capital.

Accepted Answer

The answer of Key facts and assumptions concerning Costco Company,at...

Question 18

The capital structure weights used in computing the weighted-average cost of capital:

Accepted Answer

The capital structure weights used in computing the weighted-average cost of capital are based on the market value of the firm's debt and equity securities, not the book values. The market value reflects the actual value of the securities in the current market, and these values are used to determine the proportions of debt and equity in the firm's capital structure. This is because the market value represents the true cost of replacing or repurchasing the securities in the market, while the book value only reflects the historic cost of obtaining the securities.

Question 19

The discount rate assigned to an individual project should be based on:

Accepted Answer

The discount rate assigned for a project should reflect the risks associated with the project's funding. The risks may not be the same as the overall firm's risks. Therefore, the best choice is E, which emphasizes the risks associated with the project's use of funds.

Question 20

A firm is considering an average-risk project with an IRR of 6%.The firm's cost of debt (K_D)is 5%,its cost of equity (K_E)is 12%,and its tax rate (t)is 20%.The target debt ratio (D/(D+E))for the project,in market values,is 0.5.The firm should:

Accepted Answer

The project's IRR is lower than the weighted average cost of capital (WACC), indicating it will not generate a return above the firm's cost of capital.

Quiz 8: Risk Analysis in Investment Decisions

The weighted-average cost of capital for a firm is the:

The standard deviation of returns on Wildcat Oil Drilling is very high.Does this necessarily imply that Wildcat Oil Drilling is a high-risk investment when investors hold diversified portfolios? Explain why or why not.

Explain the difference between systematic and unsystematic risk,and why one of these types of risks is rewarded with a risk premium while the other type is not.

Key facts and assumptions concerning Costco Company,at December 31,2011,appear below.Use the above information to answer the following questions.a.Estimate Costco's cost of equity capital.b.Estimate Costco's weighted-average cost of capital.

The capital structure weights used in computing the weighted-average cost of capital:

The discount rate assigned to an individual project should be based on:

A firm is considering an average-risk project with an IRR of 6%.The firm's cost of debt (K_D) is 5%,its cost of equity (K_E) is 12%,and its tax rate (t) is 20%.The target debt ratio (D/(D+E) ) for the project,in market values,is 0.5.The firm should:

Quiz 8: Risk Analysis in Investment Decisions

The weighted-average cost of capital for a firm is the:

The standard deviation of returns on Wildcat Oil Drilling is very high.Does this necessarily imply that Wildcat Oil Drilling is a high-risk investment when investors hold diversified portfolios? Explain why or why not.

Explain the difference between systematic and unsystematic risk,and why one of these types of risks is rewarded with a risk premium while the other type is not.

Key facts and assumptions concerning Costco Company,at December 31,2011,appear below.Use the above information to answer the following questions.a.Estimate Costco's cost of equity capital.b.Estimate Costco's weighted-average cost of capital.

The capital structure weights used in computing the weighted-average cost of capital:

The discount rate assigned to an individual project should be based on:

A firm is considering an average-risk project with an IRR of 6%.The firm's cost of debt (KD) is 5%,its cost of equity (KE) is 12%,and its tax rate (t) is 20%.The target debt ratio (D/(D+E) ) for the project,in market values,is 0.5.The firm should:

A firm is considering an average-risk project with an IRR of 6%.The firm's cost of debt (K_D) is 5%,its cost of equity (K_E) is 12%,and its tax rate (t) is 20%.The target debt ratio (D/(D+E) ) for the project,in market values,is 0.5.The firm should: