Question 1

What equity proportion should be used when calculating WACC for a firm with $50 million in debt selling at 85% of par,$50 million in book value of equity,and $65 million in market value of equity?

Accepted Answer

W_e = $65m / [($50m × 0.85) + $65m] = 0.6047, or 60.47%

Question 2

XYZ Company issues common stock at a price of $25 a share.The firm expects to pay a dividend of $2.20 a share next year.If the dividend is expected to grow at 2.5% annually,what is XYZ's cost of common equity?

Accepted Answer

r_e = $1.20 / $25 + 0.025 = 0.113, or 11.3%

Question 3

How much cash flow before tax and interest is necessary to support a project if $2 million is used to pay interest,the tax rate is 35%,and equity investors require annual income of $4 million?

Accepted Answer

The answer of How much cash flow before tax and...

Question 4

What return on equity do investors expect for a firm with a $55 share price,an expected dividend of $4.60,a beta of 0.9,and a constant growth rate of 3.5%?

Accepted Answer

R_e = $4.60 / $55 + 0.035 = 0.1186, or 11.86%

Question 5

The capital structure for the CR Corporation includes bonds valued at $5,500 and common stock valued at $11,000.If CR has an after-tax cost of debt of 6%,and a cost of common stock of 16%,what is its WACC?

Accepted Answer

WACC = [($5,500 / $16,500) × 6%] + [($11,000 / $16,500) × 16%] = 12.67%

Question 6

What is the yield to maturity on Dotte Inc.'s bonds if its after-tax cost of debt is 10% and its tax rate is 35%?

Accepted Answer

0.10 = r_d(1 − 0.35); r_d = 15.38%

Question 7

What decision should be made on a project with above-average market risk?

Accepted Answer

With above-average market risk, using a higher discount rate than the WACC to reflect the project's risk is appropriate. This is because the project has higher risk and requires a higher return to compensate for that risk. Accept the project only if the NPV is positive at this higher discount rate.

Question 8

Increasing debt financing will do all of the following except:

Accepted Answer

Increasing debt financing can lead to a higher interest rate on debt (A), increased risk for common stockholders (B), and higher return demands from stockholders (C). However, it does not have any direct effect on decreasing the firm's cost of common equity (D). In fact, taking on too much debt can increase the perceived risk of the company and lead to higher cost of equity as well.

Question 9

Suppose an analyst estimates that free cash flow will be $2.43 million in year 5.What is the present value of this free cash flow if the company cost of capital is 12%,the WACC is 10%,and the equity cost of capital is 15%?

Accepted Answer

PV = $2.43m / 1.10⁵ = $1,508,839

Question 10

If equity investors require a 20% rate of return,what is the maximum acceptable amount of equity financing for a project with cash flows of $2 million a year in perpetuity before tax and interest? The project supports debt of $3 million with a 10% coupon,and the tax rate is 35%.

Accepted Answer

Maximum equity = $1,105,000 / 0.20 = $5,525,000, or $5.53 million

Question 11

Find the required rate of return for equity investors of a firm with a beta of 1.3 when the risk free rate is 5% and the return on the market is 13.6%.

Accepted Answer

r_r = 0.05 + 1.3(0.136 − 0.05) = 0.1618, or 16.18%

Question 12

For purposes of computing the WACC,if the book value of equity exceeds the market value of equity,then:

Accepted Answer

The WACC is based on the market value of equity. This is because the market value reflects the current value of the company and how investors value the equity, whereas the book value is based on historical accounting figures and may not accurately reflect the current market value. Therefore, if the market value of equity is available, it should be used for WACC calculations regardless of whether it is higher or lower than the book value of equity.

Question 13

The company cost of capital:

Accepted Answer

The company cost of capital measures the return that investors require from the company. It is a reflection of the risk associated with the company's operations and the market's expectation of future returns. Current and historical profits and cash flows may be used to estimate the cost of capital, but it is ultimately determined by the market. Security book values are not relevant to measuring the cost of capital.

Question 14

According to CAPM estimates,what is the cost of equity for a firm with a beta of 1.5 when the risk-free interest rate is 6% and the expected return on the market portfolio is 15%?

Accepted Answer

R_e = 6% + 1.5(15% − 6) = 19.5%

Question 15

Plasti-tech Inc.is financed 60% with equity and 40% with debt.Currently,its debt has a pretax interest rate of 12%.Plasti-tech's common stock trades at $15.00 per share and its most recent dividend was $1.00.Future dividends are expected grow by 4%.If the tax rate is 34%,what is Plasti-tech's WACC?

Accepted Answer

r_e = [($1 × 1.04) / $15] + 0.04 = 0.1093, or 10.93%WACC = 0.4[0.12(1 − 0.34)] + 0.6(0.1093) = 0.0973, or 9.73%

Question 16

Changing the capital structure by adding debt will:

Accepted Answer

Adding debt increases the financial risk for debtholders, as they are now more exposed to the company's ability to meet its debt obligations.

Question 17

WACC can be used to determine the value of a firm by discounting the firm's:

Accepted Answer

WACC is the weighted average cost of capital, which takes into account the cost of both debt and equity financing for a company. To determine the value of a firm, it is necessary to discount the expected future cash flows generated by the company. These cash flows can be represented by a company's free cash flows, which account for all cash inflows and outflows from operating activities, capital expenditures, dividend payments, and other financing activities. Therefore, using WACC to discount a company's free cash flows is the most appropriate method to determine its value.

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