Question 1

Assume JUP has debt with a book value of $20 million,trading at 120% of par value.The firm has book equity of $20 million,and 2 million shares trading at $18 per share.What weights should JUP use in calculating its WACC?

Accepted Answer

The answer of Assume JUP has debt with a book...

Question 2

Portentious Door Company has outstanding corporate debt paying a 5% semiannual coupon,with a current yield to maturity of 6%.If the firm's tax rate is 15%,what is its effective cost of debt?

Accepted Answer

The effective cost of debt takes into account the tax savings from the interest expense deduction. The calculation is: 
Effective cost of debt = Yield to maturity x (1 - tax rate)
Effective cost of debt = 0.06 x (1 - 0.15)
Effective cost of debt = 0.051 or 5.1%
Therefore, the best choice is C) 5.1%.

Question 3

Manitou Inc has preferred stock paying an annual dividend of $2.25,and common stock paying an annual dividend of $0.85.If the current preferred stock price is $18.75,what is Manitou's cost of preferred stock capital?

Accepted Answer

The cost of preferred stock is calculated as the dividend payment divided by the current market price of the stock.

Dividend payment = $2.25 
Current market price = $18.75

Cost of preferred stock capital = $2.25/$18.75 = 0.12 or 12%

Therefore, the best choice is B) 12% as it is the calculated cost of preferred stock capital.

Question 4

A firm incurs $50,000 in interest expenses each year.If the tax rate of the firm is 30%,what is the effective after-tax interest rate expense for the firm?

Accepted Answer

The answer of A firm incurs $50,000 in interest expenses...

Question 5

A firm incurs $70,000 in interest expenses each year.If the tax rate of the firm is 20%,what is the effective after-tax interest rate expense for the firm?

Accepted Answer

To find the effective after-tax interest rate expense, we need to first calculate the amount of taxes saved due to the interest expense.

Tax savings = Interest expense x Tax rate 
Tax savings = $70,000 x 0.20 = $14,000

Then, we can subtract the tax savings from the interest expense to find the effective after-tax interest rate expense.

Effective after-tax interest rate expense = Interest expense - Tax savings 
Effective after-tax interest rate expense = $70,000 - $14,000 = $56,000

Therefore, the answer is (C) $56,000.

Question 6

The ________ of a firm's debt can be used as the firm's current cost of debt.

Accepted Answer

The yield to maturity (YTM) of a bond represents the total return that an investor can expect to earn on a bond if the investor holds the bond until it matures and is paid in full. YTM takes into account not only the coupon rate but also the market price of the bond, any premium or discount, and the time to maturity. Therefore, YTM is a more accurate measure of a firm's current cost of debt than the coupon rate, which is the annual interest rate stated on the bond, or current yield, which is the annual interest payment divided by the current market price of the bond. Discount yield is the annual percentage rate of return earned by an investor who buys a discounted bond and holds it to maturity, while amount is not relevant to the cost of debt calculation.

Question 7

The fact that the interest paid on debt is a tax-deductible expense increases the cost of debt financing.

Accepted Answer

The tax deductibility of interest expense actually decreases the after-tax cost of debt financing, making it cheaper for companies to borrow.

Question 8

As a firm increases its level of debt relative to its level of equity,the firm is:

Accepted Answer

Increasing the level of debt relative to equity increases the firm's leverage, which is the use of borrowed funds to increase the potential return of an investment. This is because debt is considered a form of leverage, as it allows a firm to invest more with less money down.

Question 9

Outstanding debt of Home Depot trades with a yield to maturity of 7%.The tax rate of Home Depot is 30%.What is the effective cost of debt of Home Depot?

Accepted Answer

The answer of Outstanding debt of Home Depot trades with...

Question 10

A firm incurs $40,000 in interest expenses each year.If the tax rate of the firm is 40%,what is the effective after-tax interest rate expense for the firm?

Accepted Answer

The effective after-tax interest rate expense for the firm can be calculated as follows:

1. Calculate the amount of taxes saved due to interest expense:

Tax savings = Interest expense x Tax rate 
Tax savings = $40,000 x 0.40 
Tax savings = $16,000

2. Calculate the after-tax interest expense:

After-tax interest expense = Interest expense - Tax savings 
After-tax interest expense = $40,000 - $16,000 
After-tax interest expense = $24,000

Therefore, the effective after-tax interest rate expense for the firm is $24,000. Option B is the correct choice.

Question 11

Preferred stock of Ford Motors pays a dividend of $4 each year and trades at a price of $30.What is the cost of preferred stock capital for Ford?

Accepted Answer

The cost of preferred stock capital is calculated by dividing the annual dividend by the current price of the stock. So, $4 / $30 = 0.1333 or 13.3%.

Question 12

Why do we use market values rather than book values in calculation of WACC?

Accepted Answer

The answer of Why do we use market values rather...

Question 13

Garwood Garages will pay a dividend of $2.55 next year,and expects its dividends to grow at 3% per year.The current price of Garwood stock is $18.25 per share.What is Garwood's cost of equity?

Accepted Answer

The cost of equity can be calculated using the dividend discount model (DDM) formula for a perpetuity, which is: Cost of Equity = (Dividend per Share / Current Price per Share) + Growth Rate. Plugging in the given values: Cost of Equity = ($2.55 / $18.25) + 3% = 0.1397 + 0.03 = 0.1697 or 16.97%, which rounds to 17%.

Question 14

Why do we use leverage if it increases the risk of a firm?

Accepted Answer

The answer of Why do we use leverage if it...

Question 15

A firm's cost of debt is the rate of interest it would have to pay to refinance its existing debt.

Accepted Answer

The cost of debt is the rate of interest a company would have to pay on new debt to replace its existing debt. It is not the rate to refinance its existing debt.

Question 16

Xcom Industries will pay a dividend of $0.44 next year,and expects its dividends to grow at 8% per year.The current price of Xom stock is $6.45 per share.What is Xom's cost of equity?

Accepted Answer

We can use the dividend discount model (DDM) to calculate the cost of equity:

Cost of Equity = (Next Year's Dividend / Current Stock Price) + Dividend Growth Rate

Cost of Equity = ($0.44 / $6.45) + 0.08 = 0.14 or 14.8%

Therefore, the correct answer is B, 14.8%.

Question 17

Starling Capital has outstanding corporate debt paying a 10% coupon,with a current yield to maturity of 8%.If Starling's tax rate is 35%,what is the firm's effective cost of debt?

Accepted Answer

The answer of Starling Capital has outstanding corporate debt paying...

Question 18

Your estimate of the market risk premium is 6%.The risk-free rate of return is 5% and General Motors has a beta of 1.2.What is General Motors' cost of equity capital?

Accepted Answer

The cost of equity capital can be calculated using the Capital Asset Pricing Model (CAPM), which is given by the formula: Cost of Equity = Risk-Free Rate + Beta * (Market Risk Premium). Plugging in the given values: Cost of Equity = 5% + 1.2 * 6% = 5% + 7.2% = 12.2%.

Question 19

IBM expects to pay a dividend of $4 next year and expects these dividends to grow at 7% a year.The price of IBM is $90 per share.What is IBM's cost of equity capital?

Accepted Answer

The answer of IBM expects to pay a dividend of...

Question 20

The fact that the after-tax cost of debt is lower than the pretax cost of debt implicitly assumes that interest expense can be:

Accepted Answer

The fact that the after-tax cost of debt is lower than the pretax cost of debt assumes that interest expense can be deducted from taxable income, which reduces the amount of income subject to tax. Therefore, the after-tax cost of debt is lower than the pretax cost of debt.

Quiz 12: Determining the Cost of Capital