Question 1

Which one of the following statements is incorrect concerning the equity component of the WACC?

Accepted Answer

There is no tax shield on the dividends paid as dividends are not tax deductible. Therefore, statement D is incorrect. The other statements are correct - retained earnings are not included in the equity component, market values should be used, and preferred equity is a separate component of WACC.

Question 2

A firm's WACC:

Accepted Answer

The WACC (weighted average cost of capital) is a benchmark discount rate that represents the average cost of the company's capital. It takes into account the cost of debt and equity of a company and is adjusted for the riskiness of each project. It is recommended to use the WACC as a discount rate for projects with similar risk levels. However, projects with different risk levels may require a different discount rate, and the WACC will only serve as a benchmark. Therefore, option C is the correct answer. Options A, B, and D are not accurate statements.

Question 3

A firm is considering a project that will generate perpetual cash flows of $50,000 per year beginning next year. The project has the same risk as the firm's overall operations. If the firm's WACC is 12%, and its debt-to-equity ratio is 1.33, what is the most it could pay for the project and still earn its required rate of return?

Accepted Answer

PV = $50,000/0.12 = $416,667

Question 4

For a company that pays no corporate taxes, its WACC will be equal to:

Accepted Answer

The Weighted Average Cost of Capital (WACC) for a company that pays no corporate taxes will be equal to the expected return on its assets, as it reflects the overall return the company needs to generate to support its overall capital structure without the tax shield effect on debt.

Question 5

Should a project be accepted if it offers an annual after-tax cash flow of $1,250,000 indefinitely, costs $10 million, is riskier than the firm's average projects, and the firm's WACC is 12.5%?

Accepted Answer

NPV = -$10m + $1.25m/0.125 = $0; However, the 12.5% rate does not reflect the projects' greater risk; thus the project's NPV is negative.

Question 6

What will be the effect of using the book value of debt in WACC decisions if interest rates have decreased substantially since a firm's long-term bonds were issued?

Accepted Answer

Assume for example that the market value of equity is $5 million, the book value of debt is $2 million, and the value of the firm is $7 million. In the example, the debt-to-value ratio is .286. However, if the market value of debt is $2.5 million due to decreased interest rates, the value of the firm is $7.5 million and the debt-to-value ratio is .333. The key is that the numerator of the ratio changes proportionately more than the denominator.

Question 7

As debt is added to the capital structure, the:

Accepted Answer

Adding debt to the capital structure increases financial risk, which typically leads to a higher cost of debt. This in turn increases the WACC as the cost of capital is a weighted average of both the cost of equity and debt. Therefore, the correct option is C.

Question 8

A company's CFO wants to maintain a target debt-to-equity ratio of 1/4. If the WACC is 18.6%, and the pretax cost of debt is 9.4%, what is the cost of common equity assuming a tax rate of 34%?

Accepted Answer

D/V = 1/5 and E/V = 4/5; 0.186 = 1/5(0.094)(1 - 0.34) + 4/5(r_e); r_e = 21.70%

Question 9

If a firm has twice as much equity as debt in its capital structure, then the firm is financed with:

Accepted Answer

If the firm has twice as much equity as debt, then we can calculate the proportions of equity and debt in the capital structure using the following formula:

Equity Proportion = Equity / (Equity + Debt)

Debt Proportion = Debt / (Equity + Debt)

Let's assume that the firm has a total of $100 in capital. If the firm has twice as much equity as debt, then the equity amount is $66.67 and the debt amount is $33.33. Therefore, the equity proportion is 66.67% and the debt proportion is 33.33%.

So, the answer is B, which represents 66.7% equity.

Question 10

An implicit cost of increasing the proportion of debt in a firm's capital structure is that:

Accepted Answer

Shareholders will demand a higher rate of return as they may perceive increased risk due to the higher proportion of debt in the firm's capital structure. This is because debt holders have a higher claim on the firm's assets and profits, and in the event of default, shareholders are last in line to be paid.

Question 11

How much will a firm need in cash flow before tax and interest to satisfy debtholders and equityholders if the tax rate is 35%, there is $13 million in common stock requiring a 10% return, and $6 million in bonds requiring a 6% return?

Accepted Answer

To satisfy the debtholders and equityholders, the firm needs to generate enough cash flow to cover the interest payments on the bonds and the required return on the common stock.

For the common stock: 
10% of $13 million common stock = $1.3 million

For the bonds: 
6% of $6 million bonds = $360,000

Total cash flow required: 
$1.3 million + $360,000 = $1.66 million

To find the amount needed before tax and interest: 
$1.66 million / (1 - 0.35) = $2.553 million

Therefore, the firm needs $2.553 million in cash flow before tax and interest to satisfy debtholders and equityholders.

Answer choice C ($2.360 million) is the closest option to this amount.

Question 12

What would you estimate as the cost of equity if a stock sells for $40, pays a $4.25 dividend, and is expected to grow at a constant rate of 5%?

Accepted Answer

E(R) = $4.25/$40 + 0.05 = 0.1563, or 15.63%

Question 13

An increase in which one of the following is most apt to decrease the WACC of a firm that has both debt and equity in its capital structure?

Accepted Answer

A higher tax rate reduces the after-tax cost of debt, which is a component of the WACC. This reduction in cost of debt decreases the overall WACC of the firm. Increases in the other options (A, B, and D) would increase the WACC.

Question 14

What dividend is paid on preferred stock if investors require a 9% rate of return and the stock has a market value of $54 per share and a book value of $50 per share?

Accepted Answer

0.09 = dividend/$54; Dividend = $4.86

Question 15

A firm has 12,000 shares of common stock outstanding with a book value of $20 per share and a market value of $39. There are 5,000 shares of preferred stock with a book value of $10 and a market value of $26. There is a $400,000 face value bond issue outstanding that is selling at 87% of par. What weight should be placed on the preferred stock when computing the firm's WACC?

Accepted Answer

Weight of preferred = (5,000 × $26)/[(12,000 × $39) + (5,000 × $26) + ($400,000 × 0.87)] = 0.1374, or 13.74%

Question 16

The yield-to-maturity of a firm's bond is 8.5%. The firm has a beta of 1.3 and a tax rate of 34%. The market risk premium is 8.4% and the risk-free rate is 3.8%. What is the firm's WACC if the firm has a capital structure that is 40% debt financed?

Accepted Answer

r_e = 3.8% + 1.3(8.4%) = 14.72%WACC = (1 - 0.40)(0.1472) + 0.40(.085)(1 - 0.34) = 0.1108, or 11.08%

Question 17

Calculate a firm's WACC given that the total value of the firm is $2 million, $600,000 of which is debt, the pre-tax cost of debt is 10%, and the cost of equity is 15%. The firm pays no taxes.

Accepted Answer

WACC = 0.10($600,000/$2m) + 0.15[($2m - 600,000)/$2m] = 0.135, or 13.5%

Question 18

How much will a firm need in cash flow before tax and interest to satisfy debtholders and equityholders if the tax rate is 40%, there is $10 million in common stock requiring a 12% return, and $6 million in bonds requiring an 8% return?

Accepted Answer

To satisfy both debtholders and equityholders, the firm needs to generate enough cash flow to cover interest payments on the bonds and the required return on equity. The interest payment on the bonds is $6 million * 8% = $480,000. The required return on equity is $10 million * 12% = $1,200,000. The total cash flow needed before tax is the sum of these two amounts, which is $480,000 + $1,200,000 = $1,680,000. However, because interest is tax-deductible, we need to adjust this amount for taxes. The effective cash flow needed is $1,680,000 / (1 - 0.40) = $2,800,000. However, this calculation does not correctly account for the tax shield on the interest payment. The correct calculation should consider the after-tax cost of the interest, which is $480,000 * (1 - 0.40) = $288,000 for the bonds. Adding this to the required return on equity gives $288,000 + $1,200,000 = $1,488,000, which does not match any of the provided options exactly as per the correct calculation method. The correct approach to find the total cash flow before tax and interest is to calculate the pre-tax amounts needed to satisfy both the interest on the debt and the return on equity without adjusting the interest for taxes in the final sum, leading to a misunderstanding in the explanation. The correct calculation directly sums the required returns without adjusting for taxes on the interest expense, which was the initial mistake in the explanation. The correct answer should reflect the total cash flow needed before taxes to cover both the interest and the equity return without the tax adjustment error. Given the misunderstanding in the explanation, the correct answer should be based on the total pre-tax returns required by both debtholders and equityholders.

Question 19

If a firm earns the WACC as an average return on its average-risk assets, then:

Accepted Answer

The WACC represents the minimum rate of return that all investors, including both equity and bond holders, require to invest in the firm. Therefore, if the firm earns the WACC as an average return on its average-risk assets, all investors will be earning their minimum required rate of return.

Question 20

What is the expected growth rate in dividends for a firm in which shareholders require an 18% rate of return and the dividend yield is 10%?

Accepted Answer

g = 18% - 10 = 8%

Quiz 13: The Weighted-Average Cost of Capital and Company Valuation