Question 1

Calculate the cost of preferred stock for Ohio Valley Power Company, which is planning to sell $100 million of $3.25 cumulative preferred stock to the public at a price of $25 per share. Flotation costs are $1.00 per share. Ohio Valley has a marginal income tax rate of 40%.

Accepted Answer

The answer of Calculate the cost of preferred stock for...

Question 2

Allegheny Valley Power Company common stock has a beta of 0.80. If the current risk-free rate is 6.5% and the expected return on the stock market as a whole is 16%, determine the cost of retained earnings for the firm (using the CAPM).

Accepted Answer

The cost of retained earnings can be calculated using the Capital Asset Pricing Model (CAPM) formula: Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate). Plugging in the values: 6.5% + 0.80 * (16% - 6.5%) = 6.5% + 0.80 * 9.5% = 6.5% + 7.6% = 14.1%.

Question 3

The following financial information is available on Simmons Inc.:  Determine the cost of retained earnings using the capital asset pricing model approach. (Compute answer to the nearest 0.1%).

Accepted Answer

The answer of The following financial information is available on...

Question 4

All of the following represent adjustments to the cost of capital components except:

Accepted Answer

The tax effect on equity does not represent an adjustment to the cost of capital components because dividends paid on equity are not tax-deductible, unlike interest on debt which benefits from tax deductibility, reducing the effective cost of debt.

Question 5

Which of the following is false?

Accepted Answer

Breaks in the MCC are not caused by increases in project IRRs, but rather by changes in the cost of capital (WACC) as the amount of financing increases.

Question 6

A firm's WACC for capital budgeting purposes for a planning period is:

Accepted Answer

The weighted average cost of capital (WACC) is the weighted average of the cost of each component of capital (debt, preferred stock, common equity) for a company. The WACC is used as the discount rate to evaluate potential capital projects. It is determined at the point where the marginal cost of capital (MCC) intersects with the investment opportunity schedule (IOS), which represents the expected return on prospective projects of comparable risk. Therefore, the correct choice is B because the WACC is determined at the intersection of the MCC and the IOS.

Question 7

Which of the following is NOT true regarding the marginal cost of capital (MCC)?

Accepted Answer

The marginal cost of capital breaks when the cost of a particular source of capital increases, not specifically when common stock is exhausted.

Question 8

The following financial information is available on the Haverty Company:  Haverty can issue new common stock to net the company $44 per share. Determine the cost of equity raised through selling new stock using the dividend growth model approach. (Compute answer to the nearest .1%).

Accepted Answer

The answer of The following financial information is available on...

Question 9

Determine the (after-tax)component cost of a $50 million debt issue that the Mattingly Corporation is planning to place with a large insurance company. Assume the company is subject to a 40% tax rate. This long-term debt issue will yield 12% to the insurance company.

Accepted Answer

The after-tax component cost of debt can be calculated using the following formula:
After-tax cost of debt = Pre-tax cost of debt x (1 - tax rate)
In this case, the pre-tax cost of debt is 12% and the tax rate is 40%.
After-tax cost of debt = 12% x (1 - 0.40) = 7.2%
Therefore, the after-tax component cost of the $50 million debt issue is 7.2%. The answer is B.

Question 10

Projects with IRRs above the intersection of the IOS and MCC:

Accepted Answer

Projects with IRRs above the intersection of the IOS and MCC have returns greater than the cost of financing and thus should be accepted. The answer is not B because rejecting projects with high IRRs would mean missing out on potential profitable investments. Therefore, the best answer is D.

Question 11

Assume a firm's bonds are currently yielding new investors 6%. The combined federal and state tax rate is 40%. What is the firm's after-tax cost of debt is?

Accepted Answer

The after-tax cost of debt is the yield to investors multiplied by (1 - tax rate). In this case, the after-tax cost of debt is 6% * (1 - 0.40) = 3.6%.

Question 12

The following financial information is available on Rawls Manufacturing Company:  Rawls can issue new common stock to net the company $44 per share. Determine the cost of retained earnings using the dividend growth model approach. (Compute answer to the nearest .1%).

Accepted Answer

The answer of The following financial information is available on...

Question 13

Which of the following statements about the marginal cost of capital (MCC)and the investment opportunity schedule (IOS)is incorrect ?

Accepted Answer

The IOS ranks projects from highest to lowest according to their internal rate of return (IRR), not their individual NPV's.

Question 14

When is a second break in the MCC likely to occur?

Accepted Answer

A second break in the MCC is likely to occur when debt gets more expensive with increasing financial risk. As the initial break took place due to the underlying value of the collateral decreasing, a second break would likely occur if the financial risk associated with the investment further increases, making the cost of borrowing more expensive.

Question 15

If a project comes with its own funding offered at a rate lower than the cost of capital, the capital budgeting analysis should be conducted using:

Accepted Answer

The cost of capital represents the minimum return that the firm requires on investments, and it takes into account the cost of all sources of capital, including equity and debt. Therefore, using the offered rate instead of the cost of capital would lead to irrational capital budgeting decisions that do not properly account for the cost of capital. Even if a project comes with its own funding, it still uses the firm's resources and affects the firm's overall cost of capital. Therefore, the cost of capital should be used as the basis for all capital budgeting decisions.

Question 16

The first break in the MCC usually occurs because:

Accepted Answer

The answer of The first break in the MCC usually...

Question 17

Retained earnings are:

Accepted Answer

Retained earnings are the only internally generated capital source as they are profits that a company reinvests in itself rather than distributing to shareholders.

Question 18

Which of the following is a reason why calculating the capital structure based on market prices is considered tedious?

Accepted Answer

The market-based capital structure is constantly changing due to fluctuations in stock prices, making it difficult to accurately calculate and track.

Question 19

A firm pays its bondholders a 12% return. Its cost of retained earnings may be estimated by:

Accepted Answer

The cost of retained earnings for a firm is typically higher than the cost of debt because equity investors demand a higher return for the increased risk they assume compared to bondholders. Adding three to five percentage points to the firm's cost of debt (12% in this case) is a simplified method to estimate the cost of retained earnings, acknowledging the higher risk and return expectation of equity investors.

Question 20

Assume the following information about a firm's capital components:  The firm's WACC is:

Accepted Answer

The WACC is calculated as follows:

WACC = (E/V x Re) + ((D/V x Rd) x (1 - Tc))

where
E = market value of the firm's equity
D = market value of the firm's debt
V = E + D
Re = cost of equity
Rd = cost of debt
Tc = corporate tax rate

Given information:

Total market value of capital = $130,000 + $70,000 = $200,000
Equity = $130,000
Debt = $70,000
Cost of equity (Re) = 16%
Cost of debt (Rd) = 8%
Tax rate (Tc) = 40%

WACC = (130,000/200,000 x 16%) + ((70,000/200,000 x 8%) x (1 - 40%))
WACC = 0.832 x 0.048 x 0.6
WACC = 0.02392 or 2.39%

Therefore, the firm's WACC is 12.20% (rounded to 2 decimal places).

Quiz 13: Cost of Capital

Calculate the cost of preferred stock for Ohio Valley Power Company, which is planning to sell $100 million of $3.25 cumulative preferred stock to the public at a price of $25 per share. Flotation costs are $1.00 per share. Ohio Valley has a marginal income tax rate of 40%.

Allegheny Valley Power Company common stock has a beta of 0.80. If the current risk-free rate is 6.5% and the expected return on the stock market as a whole is 16%, determine the cost of retained earnings for the firm (using the CAPM) .

The following financial information is available on Simmons Inc.: Determine the cost of retained earnings using the capital asset pricing model approach. (Compute answer to the nearest 0.1%) .

All of the following represent adjustments to the cost of capital components except:

Which of the following is false?

A firm's WACC for capital budgeting purposes for a planning period is:

Which of the following is NOT true regarding the marginal cost of capital (MCC) ?

The following financial information is available on the Haverty Company: Haverty can issue new common stock to net the company $44 per share. Determine the cost of equity raised through selling new stock using the dividend growth model approach. (Compute answer to the nearest .1%) .

Determine the (after-tax) component cost of a $50 million debt issue that the Mattingly Corporation is planning to place with a large insurance company. Assume the company is subject to a 40% tax rate. This long-term debt issue will yield 12% to the insurance company.

Projects with IRRs above the intersection of the IOS and MCC:

Assume a firm's bonds are currently yielding new investors 6%. The combined federal and state tax rate is 40%. What is the firm's after-tax cost of debt is?

The following financial information is available on Rawls Manufacturing Company: Rawls can issue new common stock to net the company $44 per share. Determine the cost of retained earnings using the dividend growth model approach. (Compute answer to the nearest .1%) .

Which of the following statements about the marginal cost of capital (MCC) and the investment opportunity schedule (IOS) is incorrect ?

When is a second break in the MCC likely to occur?

If a project comes with its own funding offered at a rate lower than the cost of capital, the capital budgeting analysis should be conducted using:

The first break in the MCC usually occurs because:

Retained earnings are:

Which of the following is a reason why calculating the capital structure based on market prices is considered tedious?

A firm pays its bondholders a 12% return. Its cost of retained earnings may be estimated by:

Assume the following information about a firm's capital components: The firm's WACC is: