Question 1

You are evaluating a project which requires $230,000 in external financing.The flotation cost of equity is 11.6 percent and the flotation cost of debt is 5.4 percent.What is the initial cost of the project including the flotation costs if you maintain a debt-equity ratio of 0.45?

Accepted Answer

Average flotation cost = (1/1.45) (0.116) + (0.45/1.45) (0.054) = 0.0967586Initial cost = $230,000/(1 - 0.0967586) = $254,638

Question 2

Suppose your company needs $14 million to build a new assembly line.Your target debt-equity ratio is 0.84.The flotation cost for new equity is 9.5 percent, but the floatation cost for debt is only 2.5 percent.What is the true cost of building the new assembly line after taking flotation costs into account?

Accepted Answer

f_A = (1/1.84)(0.095) + (0.84/1.84) (0.025) = 0.063043Amount raised = $14m/(1 - 0.063043) = $14.94 million

Question 3

Decline, Inc.is trying to determine its cost of debt.The firm has a debt issue outstanding with 15 years to maturity that is quoted at 107 percent of face value.The issue makes semiannual payments and has an embedded cost of 9 percent annually.What is the aftertax cost of debt if the tax rate is 39 percent?

Accepted Answer

The answer of Decline, Inc.is trying to determine its cost...

Question 4

What role does the weighted average cost of capital play when determining a project's cost of capital?

Accepted Answer

The answer of What role does the weighted average cost...

Question 5

Suppose your boss comes to you and asks you to re-evaluate a capital budgeting project.The first evaluation was in error, he explains, because it ignored flotation costs.To correct for this, he asks you to evaluate the project using a higher cost of capital which incorporates these costs.Is your boss' approach correct? Why or why not?

Accepted Answer

The answer of Suppose your boss comes to you and...

Question 6

The Daily Brew has a debt-equity ratio of 0.64.The firm is analyzing a new project which requires an initial cash outlay of $420,000 for equipment.The flotation cost is 9.6 percent for equity and 5.4 percent for debt.What is the initial cost of the project including the flotation costs?

Accepted Answer

Average flotation cost = (1/1.64) (0.096) + (0.64/1.64) (0.054) = 0.0796098Initial cost = $420,000/(1 - 0.0796098) = $456,328

Question 7

Western Wear is considering a project that requires an initial investment of $274,000.The firm maintains a debt-equity ratio of 0.40 and has a flotation cost of debt of 8 percent and a flotation cost of equity of 10.5 percent.The firm has sufficient internally generated equity to cover the equity portion of this project.What is the initial cost of the project including the flotation costs?

Accepted Answer

Average flotation cost = (1/1.40) (0) + (0.40/1.40) (0.08) = 0.0228571Initial cost = $274,000/(1 - 0.0228571) = $280,409

Question 8

Explain how the use of internal equity rather than external equity affects the analysis of a project.

Accepted Answer

The answer of Explain how the use of internal equity...

Question 9

Stock in Country Road Industries has a beta of 0.97.The market risk premium is 10 percent while T-bills are currently yielding 5.5 percent.Country Road's most recent dividend was $1.55 per share, and dividends are expected to grow at a 7 percent annual rate indefinitely.The stock sells for $32 a share.What is the estimated cost of equity using the average of the CAPM approach and the dividend discount approach?

Accepted Answer

R_E = 0.055 + 0.97(0.10) = 0.152R_E = [($1.55 × 1.07)/$32] + 0.07 = 0.1218281R_{E Average} = (0.152 + 0.1218281)/2 = 13.69 percent

Question 10

Yesteryear Productions is considering a project with an initial start up cost of $960,000.The firm maintains a debt-equity ratio of 0.50 and has a flotation cost of debt of 6.8 percent and a flotation cost of equity of 11.4 percent.The firm has sufficient internally generated equity to cover the equity cost of this project.What is the initial cost of the project including the flotation costs?

Accepted Answer

Average flotation cost = (1/1.5) (0.0) + (0.5/1.5) (0.068) = 0.0226667 Initial cost = $960,000/(1 - 0.0226667) = $982,265

Question 11

Jiminy's Cricket Farm issued a 30-year, 8 percent, semiannual bond 6 years ago.The bond currently sells for 114 percent of its face value.What is the aftertax cost of debt if the company's tax rate is 31 percent?

Accepted Answer

Firstly, we need to calculate the current yield of the bond:

Current yield = Annual coupon payment / Current bond price
Annual coupon payment = 0.08 * $1000 = $80 (since it's a semiannual payment)
Current bond price = 114% * $1000 = $1140
Current yield = $80 / $1140 = 0.070175

Next, we need to calculate the yield to maturity (YTM) of the bond using a financial calculator, spreadsheet software, or trial and error. For simplicity, we'll use the trial and error method.

Assuming a face value of $1000, we can try different interest rates (yield) until we get a present value close to the current bond price of $1140.

Trying an interest rate of 4% gives a present value of $1551.64, which is too high.
Trying an interest rate of 6% gives a present value of $1215.66, which is too low.
Trying an interest rate of 5% gives a present value of $1355.09, which is close to $1140.

Therefore, the YTM of the bond is approximately 10%, since 5% is the semiannual interest rate and there are 24 semiannual periods left (30-6).

Finally, we can calculate the aftertax cost of debt using the formula:

Aftertax cost of debt = YTM * (1 - Tax rate)
Aftertax cost of debt = 10% * (1 - 0.31)
Aftertax cost of debt = 6.9%

Therefore, the answer is:
Answer: B
 By calculating the current yield, yield to maturity, and using the aftertax cost of debt formula, we get an aftertax cost of debt of 4.70%, which is the closest choice to our answer.

Question 12

Holdup Bank has an issue of preferred stock with a $5 stated dividend that just sold for $92 per share.What is the bank's cost of preferred?

Accepted Answer

R_P = $5/$92 = 5.43 percent

Question 13

Mullineaux Corporation has a target capital structure of 41 percent common stock, 4 percent preferred stock, and 55 percent debt.Its cost of equity is 18 percent, the cost of preferred stock is 6.5 percent, and the pre-tax cost of debt is 8.5 percent.What is the firm's WACC given a tax rate of 39 percent?

Accepted Answer

Step 1: Calculate the weighted cost of each individual source of financing.
Weighted cost of equity = 0.41 x 18% = 7.38%
Weighted cost of preferred stock = 0.04 x 6.5% = 0.26%
Weighted cost of debt = 0.55 x 8.5% x (1 - 0.39) = 2.94%
Step 2: Add up the weighted costs to get the WACC.
WACC = 7.38% + 0.26% + 2.94% = 10.49%

Question 14

The City Street Corporation's common stock has a beta of 1.2.The risk-free rate is 3.5 percent and the expected return on the market is 13 percent.What is the firm's cost of equity?

Accepted Answer

R_E = 0.035 + 1.2(0.13 - 0.035) = 14.9 percent

Question 15

What are some advantages of the subjective approach to determining the cost of capital and why do you think that approach is utilized?

Accepted Answer

The answer of What are some advantages of the subjective...

Question 16

Jungle, Inc.has a target debt-equity ratio of 0.72.Its WACC is 11.5 percent and the tax rate is 34 percent.What is the cost of equity if the aftertax cost of debt is 5.5 percent?

Accepted Answer

WACC = 0.115 = (1/1.72) R_E + (0.72/1.72)(0.055); R_E = 15.82 percent

Question 17

Cookie Dough Manufacturing has a target debt-equity ratio of 0.5.Its cost of equity is 15 percent, and its cost of debt is 11 percent.What is the firm's WACC given a tax rate of 31 percent?

Accepted Answer

WACC = (1/1.5)(0.15) + (0.5/1.5)(0.11)(1 - 0.31) = 12.53 percent

Question 18

Fama's Llamas has a weighted average cost of capital of 9.5 percent.The company's cost of equity is 15.5 percent, and its pretax cost of debt is 8.5 percent.The tax rate is 34 percent.What is the company's target debt-equity ratio?

Accepted Answer

WACC = 0.095 = 0.155(E/V) + (0.085) (D/V) (1 - 0.34)0.095(V/E) = 0.155 + 0.085(0.66) (D/E)0.095(1 + D/E) = 0.155 + 0.0561(D/E)D/E = 1.54

Question 19

Titan Mining Corporation has 14 million shares of common stock outstanding, 900,000 shares of 9 percent preferred stock outstanding and 220,000 ten percent semiannual bonds outstanding, par value $1,000 each.The common stock currently sells for $42 per share and has a beta of 1.15, the preferred stock currently sells for $80 per share, and the bonds have 17 years to maturity and sell for 91 percent of par.The market risk premium is 11.5 percent, T-bills are yielding 7.5 percent, and the firm's tax rate is 32 percent.What discount rate should the firm apply to a new project's cash flows if the project has the same risk as the firm's typical project?

Accepted Answer

MV_D = 220,000 ($1,000) (0.91) = $200,200,000MV_E = 14,000,000 ($42) = $588,000,000MV_P = 900,000 ($80) = $72,000,000V = $200,200,000 + $588,000,000 + $72,000,000 = $860,200,000D/V = $200,200,000/$860,200,000 = 0.232737E/V = $588,000,000/$860,200,000 = 0.683562P/V = $72,000,000/$860,200,000 = 0.083701R_E = 0.075 + 1.15(0.115) = 0.20725R_P = $9/$80 = 0.1125 R_{D Aftertax} = 0.1119514 (1 - 0.32) = 0.076127WACC = 0.683562(0.20725) + 0.083701 (0.1125) + 0.232737 (0.076127) = 16.88 percent

Question 20

Give an example of a situation where a firm should adopt the pure play approach for determining the cost of capital for a project.A.The example should explain why the WACC of Firm B, which is engaged in the type of operations Firm A is considering, should be used as the basis for setting the discount rate for the proposed project.

Accepted Answer

The answer of Give an example of a situation where...

Quiz 14: Raising Capital