Question 1

The Market Outlet has a beta of 1.38 and a cost of equity of 14.945 percent. The risk-free rate of return is 4.25 percent. What discount rate should the firm assign to a new project that has a beta of 1.25?

Accepted Answer

R_E = 0.14945 = 0.0425 + (1.38 F1F1F1S1F1F1F10 mrp); mrp = 0.0775R_Project = 0.0425 + (1.25 F1F1F1S1F1F1F10 0.0775) = 13.94 percent

Question 2

The Oil Derrick has an overall cost of equity of 13.6 percent and a beta of 1.28. The firm is financed solely with common stock. The risk-free rate of return is 3.4 percent. What is an appropriate cost of capital for a division within the firm that has an estimated beta of 1.18?

Accepted Answer

0.136 = 0.034 + 1.28mrp; mrp = 0.0796875R_eDivision = 0.034 + 1.18(0.0796875) = 12.80 percent

Question 3

Travis & Sons has a capital structure which is based on 40 percent debt, 5 percent preferred stock, and 55 percent common stock. The pre-tax cost of debt is 7.5 percent, the cost of preferred is 9 percent, and the cost of common stock is 13 percent. The company's tax rate is 39 percent. The company is considering a project that is equally as risky as the overall firm. This project has initial costs of $325,000 and annual cash inflows of $87,000, $279,000, and $116,000 over the next three years, respectively. What is the projected net present value of this project?

Accepted Answer

WACC = (0.55 F1F1F1S1F1F1F10 0.13) + (0.05 F1F1F1S1F1F1F10 0.09) + [0.40 F1F1F1S1F1F1F10 0.075 F1F1F1S1F1F1F10 (1 - 0.39)] =0.0943NPV -$325,000 + ($87,000/1.0943) + ($279,000/1.0943²) + ($116,000/1.0943³) = $76,011.23

Question 4

Kelso's has a debt-equity ratio of 0.55 and a tax rate of 35 percent. The firm does not issue preferred stock. The cost of equity is 14.5 percent and the aftertax cost of debt is 4.8 percent. What is the weighted average cost of capital?

Accepted Answer

WACC = (1/1.55) (0.145) + (0.55/1.55) (0.048) = 11.06 percent

Question 5

Electronics Galore has 950,000 shares of common stock outstanding at a market price of $38 a share. The company also has 40,000 bonds outstanding that are quoted at 106 percent of face value. What weight should be given to the debt when the firm computes its weighted average cost of capital?

Accepted Answer

To calculate the weight of debt in the firm's WACC calculation, we need to first calculate the total market value of the company's equity and debt.

Total market value of equity = Number of shares outstanding * Market price per share = 950,000 * $38 = $36,100,000

Total market value of debt = Number of bonds outstanding * Bond price as a percentage of face value * Face value of each bond = 40,000 * 1.06 * $1,000 = $42,400,000

Total market value of firm = Total market value of equity + Total market value of debt = $36,100,000 + $42,400,000 = $78,500,000

Weight of debt = Total market value of debt / Total market value of firm = $42,400,000 / $78,500,000 = 0.54 or 54%

Therefore, the correct answer is D) 54 percent.

Question 6

Deep Mining and Precious Metals are separate firms that are both considering a silver exploration project. Deep Mining is in the actual mining business and has an aftertax cost of capital of 12.8 percent. Precious Metals is in the precious gem retail business and has an aftertax cost of capital of 10.6 percent. The project under consideration has initial costs of $575,000 and anticipated annual cash inflows of $102,000 a year for ten years. Which firm(s), if either, should accept this project?

Accepted Answer

Neither company should accept this project as the applicable discount rate for both firms is 12.8 percent and the NPV is negative at this discount rate.

Question 7

Central Systems, Inc. desires a weighted average cost of capital of 8 percent. The firm has an aftertax cost of debt of 4.8 percent and a cost of equity of 15.2 percent. What debt-equity ratio is needed for the firm to achieve its targeted weighted average cost of capital?

Accepted Answer

WACC = 0.08 = [W_e F1F1F1S1F1F1F10 0.152] + [(1 - W_e) F1F1F1S1F1F1F10 0.048)]W_e = 0.3077; W_d = 1 - W_e = 0.6923Debt-equity ratio = 0.6923/0.3077 = 2.25

Question 8

Sister Pools sells outdoor swimming pools and currently has an aftertax cost of capital of 11.6 percent. Al's Construction builds and sells water features and fountains and has an aftertax cost of capital of 10.8 percent. Sister Pools is considering building and selling its own water features and fountains. The sales manager of Sister Pools estimates that the water features and fountains would produce 20 percent of the firm's future total sales. The initial cash outlay for this project would be $85,000. The expected net cash inflows are $16,000 a year for 7 years. What is the net present value of the Sister Pools project?

Accepted Answer

The answer of Sister Pools sells outdoor swimming pools and...

Question 9

The Bakery is considering a new project it considers to be a little riskier than its current operations. Thus, management has decided to add an additional 1.5 percent to the company's overall cost of capital when evaluating this project. The project has an initial cash outlay of $62,000 and projected cash inflows of $17,000 in year one, $28,000 in year two, and $30,000 in year three. The firm uses 25 percent debt and 75 percent common stock as its capital structure. The company's cost of equity is 15.5 percent while the aftertax cost of debt for the firm is 6.1 percent. What is the projected net present value of the new project?

Accepted Answer

WACC_Firm = (0.75 F1F1F1S1F1F1F10 0.155) + (0.25 F1F1F1S1F1F1F10 0.061) = 0.1315WACC_Project = 0.1315 + 0.015 = 0.1465NPV = -$62,000 + ($17,000/1.1465) + ($28,000/1.1465²) + ($30,000/1.1465³) = -$5,964

Question 10

Carson Electronics uses 70 percent common stock and 30 percent debt to finance its operations. The aftertax cost of debt is 5.4 percent and the cost of equity is 15.4 percent. Management is considering a project that will produce a cash inflow of $36,000 in the first year. The cash inflows will then grow at 3 percent per year forever. What is the maximum amount the firm can initially invest in this project to avoid a negative net present value for the project?

Accepted Answer

WACC = 0.70(0.154) + 0.30(0.054) = 0.124PV = $36,000/(0.124 - 0.03) = $382,979

Question 11

Silo Mills has a beta of 0.87 and a cost of equity of 11.9 percent. The risk-free rate of return is 2.8 percent. The firm is currently considering a project that has a beta of 1.03 and a project life of 6 years. What discount rate should be assigned to this project?

Accepted Answer

R_E = 0.119 = 0.028 + (0.87 F1F1F1S1F1F1F10 mrp); mrp = 0.1046R_Project = 0.028 + (1.03 F1F1F1S1F1F1F10 0.1046) = 13.57 percent

Question 12

Panelli's is analyzing a project with an initial cost of $102,000 and cash inflows of $65,000 in year one and $74,000 in year two. This project is an extension of the firm's current operations and thus is equally as risky as the current firm. The firm uses only debt and common stock to finance its operations and maintains a debt-equity ratio of 0.45. The aftertax cost of debt is 4.8 percent, the cost of equity is 12.7 percent, and the tax rate is 35 percent. What is the projected net present value of this project?

Accepted Answer

WACC = (1/1.45) (0.127) + (0.45/1.45) (0.048) = 0.102483NPV = -$102,000 + ($65,000/1.102483) + ($74,000/1.102483²) = $17,840

Question 13

Granite Works maintains a debt-equity ratio of 0.65 and has a tax rate of 32 percent. The firm does not issue preferred stock. The pre-tax cost of debt is 9.8 percent. There are 25,000 shares of stock outstanding with a beta of 1.2 and a market price of $19 a share. The current market risk premium is 8.5 percent and the current risk-free rate is 3.6 percent. This year, the firm paid an annual dividend of $1.10 a share and expects to increase that amount by 2 percent each year. Using an average expected cost of equity, what is the weighted average cost of capital?

Accepted Answer

R_e = 0.036 + 1.2(0.085) = 0.138R_e = [($1.10 F1F1F1S1F1F1F10 1.02)/$19] + 0.02 = 0.0790526R_{e Av}_erage = (0.138 + 0.0790526)/2 = 0.108526WACC = (1/1.65) (0.108526) + (0.65/1.65) (0.098) (1 - 0.32) = 9.20 percent

Question 14

Wayco Industrial Supply has a pre-tax cost of debt of 7.6 percent, a cost of equity of 14.3 percent, and a cost of preferred stock of 8.5 percent. The firm has 220,000 shares of common stock outstanding at a market price of $27 a share. There are 25,000 shares of preferred stock outstanding at a market price of $41 a share. The bond issue has a face value of $550,000 and a market quote of 101.2. The company's tax rate is 37 percent. What is the firm's weighted average cost of capital?

Accepted Answer

WACC = ($5,940,000/$7,521,600) (0.143) + ($1,025,000/$7,521,600) (0.085) + ($556,600/$7,521,600) (0.076) (1 - 0.37) = 12.81 percent

Question 15

Decker's is a chain of furniture retail stores. Furniture Fashions is a furniture maker and a supplier to Decker's. Decker's has a beta of 1.38 as compared to Furniture Fashion's beta of 1.12. The risk-free rate of return is 3.5 percent and the market risk premium is 8 percent. What discount rate should Decker's use if it considers a project that involves the manufacturing of furniture?

Accepted Answer

R_e = 0.035 + 1.12(0.08) = 12.46 percent

Question 16

Delta Lighting has 30,000 shares of common stock outstanding at a market price of $17.50 a share. This stock was originally issued at $31 per share. The firm also has a bond issue outstanding with a total face value of $280,000 which is selling for 86 percent of par. The cost of equity is 16 percent while the aftertax cost of debt is 6.9 percent. The firm has a beta of 1.48 and a tax rate of 30 percent. What is the weighted average cost of capital?

Accepted Answer

Step 1: Calculate the market value of equity
Market value of equity = 30,000 x $17.50 = $525,000
Step 2: Calculate the market value of debt
Market value of debt = $280,000 x 0.86 = $240,800
Step 3: Calculate the total market value of the firm
Total market value = $525,000 + $240,800 = $765,800
Step 4: Calculate the weight of equity
Weight of equity = $525,000 / $765,800 = 0.6852
Step 5: Calculate the weight of debt
Weight of debt = $240,800 / $765,800 = 0.3148
Step 6: Calculate the cost of equity using CAPM
Cost of equity = risk-free rate + beta x (market return - risk-free rate)
Cost of equity = 0.069 + 1.48 x (0.16 - 0.069)
Cost of equity = 0.2024 or 20.24%
Step 7: Calculate the aftertax cost of debt
Aftertax cost of debt = 0.069 x (1 - 0.3)
Aftertax cost of debt = 0.0483 or 4.83%
Step 8: Calculate the weighted average cost of capital
WACC = (weight of equity x cost of equity) + (weight of debt x aftertax cost of debt)
WACC = (0.6852 x 0.2024) + (0.3148 x 0.0483)
WACC = 0.1393 or 13.93%
Therefore, the best choice is B, the weighted average cost of capital is 13.14 percent.

Question 17

Bleakly Enterprises has a capital structure of 55 percent common stock, 10 percent preferred stock, and 35 percent debt. The flotation costs are 4.5 percent for debt, 7 percent for preferred stock, and 9.5 percent for common stock. The corporate tax rate is 34 percent. What is the weighted average flotation cost?

Accepted Answer

7.5 percentAverage flotation cost = (0.55 F1F1F1S1F1F1F10 0.095) + (0.10 F1F1F1S1F1F1F10 0.07) + (0.35 F1F1F1S1F1F1F10 0.045) = 7.5 percent

Question 18

Miller Sisters has an overall beta of 0.64 and a cost of equity of 11.2 percent for the firm overall. The firm is 100 percent financed with common stock. Division A within the firm has an estimated beta of 1.08 and is the riskiest of all of the firm's operations. What is an appropriate cost of capital for division A if the market risk premium is 9.5 percent?

Accepted Answer

0.112 = r_f + 0.64(0.095); r_f = 0.0512R_eDivision = 0.0512 + 1.08(0.095) = 15.38 percent

Question 19

R.S. Green has 250,000 shares of common stock outstanding at a market price of $28 a share. Next year's annual dividend is expected to be $1.55 a share. The dividend growth rate is 2 percent. The firm also has 7,500 bonds outstanding with a face value of $1,000 per bond. The bonds carry a 7 percent coupon, pay interest semiannually, and mature in 7.5 years. The bonds are selling at 98 percent of face value. The company's tax rate is 34 percent. What is the firm's weighted average cost of capital?

Accepted Answer

The answer of R.S. Green has 250,000 shares of common...

Question 20

Phillips Equipment has 80,000 bonds outstanding that are selling at par. Bonds with similar characteristics are yielding 6.75 percent. The company also has 750,000 shares of 7 percent preferred stock and 2.5 million shares of common stock outstanding. The preferred stock sells for $53 a share. The common stock has a beta of 1.34 and sells for $42 a share. The U.S. Treasury bill is yielding 2.8 percent and the return on the market is 11.2 percent. The corporate tax rate is 38 percent. What is the firm's weighted average cost of capital?

Accepted Answer

R_e = 0.028 + 1.34 (0.112 - 0.028) = 0.14056R_p = (0.07 F1F1F1S1F1F1F10 $100)/$53 = 0.13208 WACC = ($105m/$224.75m) (0.14056) + ($39.75m/$224.75m) (0.13208) + ($80m/$224.75m) (0.0675) (1 - 0.38) = 10.39 percent

Quiz 14: Cost of Capital