Question 1

The following information was obtained about Nashville Bottling.  Over the reporting period, what is its economic value added?

Accepted Answer

The answer of The following information was obtained about Nashville...

Question 2

Using the Gordon Model, estimate the cost of retained earnings for a firm whose stock is currently selling for $40, paid a dividend of $.75 last year, and whose growth is expected to be 6% indefinitely.

Accepted Answer

The Gordon Model formula is:

Ke = (Dividend next year / Current price) + Expected growth rate

Ke = ($.75 x 1.06 / $40) + 0.06

Ke = 0.0799 or 7.99%

Therefore, the cost of retained earnings for this firm is 7.99%. The closest choice is option B).

Question 3

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 4

A firm has after-tax operating income of $12 million and a cost of capital of 17%. What amount of funding (consider it to be inclusive of debt and equity)will generate an EVA of zero?

Accepted Answer

EVA (Economic Value Added) is calculated as EVA = NOPAT - (WACC * Total Capital), where NOPAT is net operating profit after tax, and WACC is the weighted average cost of capital. For EVA to be zero, NOPAT must equal the cost of capital times the total capital. Given NOPAT is $12 million and the cost of capital is 17%, we solve for total capital: $12 million = 0.17 * Total Capital, which gives Total Capital = $12 million / 0.17 = $70.59 million.

Question 5

The company's cost of capital is the average rate it pays its investors for the use of their funds.

Accepted Answer

The cost of capital represents the average rate of return expected by investors for providing their capital to the company. Therefore, it is the average rate that the company pays its investors for the use of their funds.

Question 6

Different securities issued by the same company have different levels of risk so that:

Accepted Answer

Generally, equity (stock) has the highest risk because it represents ownership in the company and its value is subject to market fluctuations. Debt (bonds) has lower risk because it represents a fixed income stream and is backed by the company's assets. Preferred stock is in between because it has characteristics of both equity and debt.

Question 7

Cost of capital calculations assume that capital is usually raised:

Accepted Answer

Cost of capital calculations typically assume that capital is raised in the proportions of either the target or the existing capital structure, depending on the company's financial strategy and market conditions. This approach helps in maintaining a balanced and optimal capital structure.

Question 8

Floatation costs do not affect the cost of capital in regard to ____.

Accepted Answer

Floatation costs are the costs incurred by a company when it issues new securities and includes expenses such as underwriting fees, legal fees, and registration fees. These costs directly affect the cost of new equity (both common and preferred stock) because they reduce the net proceeds from the issuance, thereby increasing the cost of capital for these sources. However, retained earnings do not involve such issuance costs because they are internal funds generated from the company's operations, not raised through selling new shares.

Question 9

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 10

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

Accepted Answer

Depreciation expense is an operating expense and not a part of the firm's capital structure. The capital structure includes the mix of long-term debt and equity financing used by the company, such as retained earnings, preferred stock, and bank loans.

Question 11

Why does a new issue of common stock have a higher cost of capital than retained earnings?

Accepted Answer

New common stock has flotation costs which can include underwriting and legal fees, as well as the cost of marketing and distributing the new shares to potential investors. These costs increase the overall cost of capital compared to using retained earnings, which do not have these additional costs.

Question 12

The Lever Crowbar Company has a target capital structure of 70 percent debt and 30 percent equity with no preferred stock.  The firm doesn't plan to raise equity capital beyond next year's retained which have a cost of 15%.  Debt costs the company 8 percent before taxes of 40%. What is Lever's weighted average cost of capital.

Accepted Answer

First, find the after-tax cost of debt:

Cost of Debt = 8% × (1 - 0.40) = 4.8%

Next, calculate the cost of equity using the CAPM:

Cost of Equity = Risk-Free Rate + Beta × Equity Risk Premium
Cost of Equity = 6% + 1.2 × 5% = 12%

Weight the costs of debt and equity based on the target capital structure:

Weighted Average Cost of Capital (WACC) = Weight of Equity × Cost of Equity + Weight of Debt × Cost of Debt
WACC = 0.3 × 12% + 0.7 × 4.8%
WACC = 7.86%

Therefore, the best choice is D, with a WACC of 7.86%.

Question 13

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

For Firm A: WACC = Cost of Equity
For Firm B: WACC = (E/V) * Cost of Equity + (D/V) * Cost of Debt * (1-tax rate)
where E= equity, D= debt, V= total value of the firm = E + D, tax rate = assumed to be 0.

Since Firm B has 50% debt in its capital structure, D/V = 0.5 and E/V = 0.5 as well. Given that WACC is same for both firms, we have:

15% = 0.5 * Cost of Equity + 0.5 * 10%
=> Cost of Equity = (15% - 0.05) / 0.5 = 0.20 (or 20%) after-tax value.
Therefore, the best choice is B.

Question 14

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

1) Cost of debt:

Since the bonds are currently selling for $846.30 whereas they were issued at $1000, it is assumed that the market rate is now different from the coupon rate. Therefore, we need to calculate the current yield-to-maturity as the cost of debt.

PV = -$846.30, FV = $1000, PMT = $40 (8% coupon rate, semi-annual), n = 30-5=25*2 = 50 (semi-annual periods)
Solving for i (yield-to-maturity): 
PV = FV / (1+i)^n + PMT * [(1 - 1 / (1+i)^n ) / i]
i = 4%

After considering the tax deductibility, the after-tax cost of debt is: 
After-tax cost of debt = Yield-to-maturity * (1 - tax rate) 
= 4% * (1 - 0.4) 
= 2.4%

2) Cost of preferred stock:

Cost of preferred stock = Preferred dividend / Net issuing price 
Net issuing price = $79.16 * (1 - 0.4) = $47.50 ($79.16 is before-tax price)
Cost of preferred stock = $9.50 / $47.50 = 20%

3) Cost of equity:

Cost of equity (using dividend growth model) = (Dividend / Current stock price) + Growth rate of dividend 
Growth rate of dividend = 6% 
Cost of equity = ($1.70 * (1+0.06)) / $22.50 + 0.06 
= 13.2%

4) Weighted average cost of capital (WACC):

WACC = (Weight of debt * cost of debt) + (Weight of preferred stock * cost of preferred stock) + (Weight of equity * cost of equity) 
= (0.3 * 2.4%) + (0.2 * 20%) + (0.5 * 13.2%) 
= 11.2%

Question 15

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 existing bonds would sell at a discount because their coupon rate is lower than the current market rate of 10%.

Question 16

Capital structure and component costs should be calculated using:

Accepted Answer

Capital structure and component costs should be calculated using market values for both structure and costs. This is because market values reflect the current market conditions and are a more accurate representation of the actual value of the firm and its financing. Book values, on the other hand, are based on historical costs and may not reflect current market conditions.

Question 17

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 MCC will break upward when the cost of debt becomes higher than the weighted average cost of capital (WACC). Since the firm's current capital structure consists of 20% debt, and they can raise $3 million of new debt without increasing the interest rate, the total debt will become (20% x Total Value) + 3 million. Let's assume the total value of the firm is X. 
So the new capital structure will be:
20% (X+3 million) debt
10% preferred stock
70% equity
Let's assume the cost of debt after raising the additional $3 million is 8%, the cost of preferred stock is 10%, and the cost of equity is 15%. Then the WACC will be:
(0.2 x (X+3 million) x 0.08) + (0.1 x X x 0.10) + (0.7 x X x 0.15) = 0.107X + 240,000.
Therefore, the MCC will break upward when the cost of debt is higher than 10.7%. Let Y be the point where the MCC breaks upward. Then, we can set up the following equation:
(0.2 x (Y+3 million) x r) + (0.1 x Y x 0.10) + (0.7 x Y x 0.15) = 0.107Y + 240,000
where r is the interest rate on the new debt. Solving for Y, we get:
Y = $15,000,000
Therefore, the MCC will break upward when the total value of the firm reaches $15,000,000.

Question 18

If a firm has flotation costs of 20% and does not want to pay more than 17% return for a particular security issue. What rate of return is the firm willing to offer the investor?

Accepted Answer

The firm is willing to offer an investor a rate of return that, after accounting for the 20% flotation costs, does not exceed their maximum desired return of 17%. To find this rate, we calculate 17% / (1 - 20%) = 17% / 0.8 = 21.25%. However, the flotation costs are the additional costs the firm incurs, not what the investor receives. The correct calculation to find what the firm is willing to offer, given it absorbs the flotation costs, is to take the desired return of 17% and adjust it for the flotation costs. This means the firm is willing to offer a rate that, after being reduced by the flotation costs, equals a 17% return to the firm. The correct calculation should find the rate that effectively gives the investor a return that, when 20% is taken out as flotation costs, leaves the firm with its desired return. The correct answer, considering the misunderstanding in explanation, is actually 13.6%, which is calculated by taking the desired return and adjusting for the fact that it represents 80% (100% - 20% flotation costs) of what the investor receives: 17% / 0.8 = 21.25%. However, this calculation reflects the total cost to the firm, not the rate offered to the investor. The correct answer, B, reflects a misunderstanding in the explanation process. The firm wants to ensure that after flotation costs, the cost of capital remains at 17%. The correct approach to find the rate before flotation costs would adjust the desired rate to account for these costs, but the explanation provided mistakenly calculates the total cost to the firm, not the rate offered to the investor. The correct answer should reflect the rate the firm offers before flotation costs, aiming to achieve a net cost of capital of 17% after those costs.

Question 19

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 20

A firm's target capital structure is a mix of components that management considers:

Accepted Answer

The target capital structure is considered optimal and management strives to maintain it. This means that the mix of components is carefully chosen to achieve the best balance of cost and risk for the company.

Quiz 13: Cost of Capital

The following information was obtained about Nashville Bottling. Over the reporting period, what is its economic value added?