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Since you incorrectly answered 9 questions, it would be worthwhile to read the explanations for each mistake. That will help you improve your understanding of cost of capital concepts. Also, it is highly recommended that you go to "Practice Mode" where you can get personal, detailed feedback on each problem you complete. -----------------------------Question #1
A company's weighted average cost of capital (WACC) is best described by which of the following statements? A. B. C. D.
The weighted average cost of capital is the return earned and paid on a company's securities in the past. The weighted cost of capital is the minimum acceptable return on any current average risk project under consideration today. The cost of capital is the cost of raising specific sources sources of funds in financial markets today. today. The cost of capital is the required return on new company securities today independent of where the funds are invested.
Correct answer: B Your answer: D Explanation for correct answer The cost of capital (WACC) focuses on the investment side of the balance sheet and seeks to estimate the minimum acceptable return on average risk investments (similar (simi lar to the portfolio of assets already in the company) proposed today. While Whil e the analyst must focus on financial market (financing) data, the use of the WACC will be in evaluating asset investments, probably in a net present value analysis. Explanation for incorrect answers A. The cost of capital concept is concerned with the required return today by suppliers of capital, not in the past. Think of this, "If we had to raise funds today, what return would the capital markets require?" C. While the steps taken in calculating the cost of capital focuses on estimating the current required rates of return on specific sources of funds, the WACC is an important variable used in assessing the acceptability of new investment projects. D. The cost of capital, or required return on new funds raised in securities markets, is directly related to the estimated risk of the investment proposal under consideration.
-----------------------------Question #2
All but one of the following is an estimate of the component cost of equity when calculating the weighted average cost of capital?
A. B. C. D.
CAPM calculating the yield yield to maturity on similar companies' companies' stock the market's equity premium over a long period of time using the constant growth dividend model
Correct answer: B Your answer: C Explanation for correct answer The yield to maturity is an estimated return on a bond held to maturity. All of the other answers are used to estimate the required return on equity. Explanations for incorrect answers A. The Capital Asset Pricing Model is frequently frequentl y used to estimate the required rate of return on common equity. C. Estimating Estimatin g the historic average stock market risk premium over the risk-free rate then adjusted for the company beta is a common method and is part of the CAPM. D. The constant growth dividend model of stock evaluation, solvi ng for the required rate of return on equity, is a common method for estimating the cost of equity for the WACC.
Question #3
If a company's cost of new debt funds raised today is 6%, we can estimate that the cost of equity of the company is ______? A. B. C. D.
greater than the cost of debt funds. less than the cost of debt funds. always 6% higher than debt funds or 12%. equal to the cost of debt funds in low risk companies.
Correct answer: A Your answer: B Explanation for correct answer The required rate of return of common equity investors will be greater than the 6% current debt cost of funds for the same company, due to the higher risk of shareholders. The risk premium over debt funds, required by equity investors, will be determined by the relative risk (beta) of the company. Explanations for incorrect answers B. The risk of shareholders is greater than creditors in terms of claims on income(dividends versus interest) and assets (in case of liquidation) so the required rate of return on equity will be greater than that of lenders at any given time. C. While you are correct that the "cost of equity" or required rate of return on equity will be greater than the cost of debt funds at any given time, one cannot say that every company's risk premium over debt costs is 6%. It will depend on the strength of the creditor's indenture (contract) with the company, and the risk (beta) of the stock. D. Even in low risk companies the required rate of return on equity funds invested will be greater than that company's cost of debt funds at any given time. The creditors' prior and contractual claim on the income flow, and assets if the company is liquidated, places the shareholders in a higher risk position than creditors, even in a low risk company.
-----------------------------Question #4
Akron Corp. has three bond issues outstanding with coupon rates of 7%, 8%, and 10%. What is Akron Corp.'s cost of debt capital if bonds similar to those outstanding are yielding 9%? A. B. C. D.
The average of the three outstanding bond issues. It is impossible to estimate the current cost of debt funds. A good estimate would be the current yield to maturity for similar bonds or 9%. With three bond issues outstanding, the cost of new debt will likely exceed 10%.
Correct answer: C Your answer: C Explanation for correct answer You have identified an important point associated with the cost of capital concept. The relevant "cost" is the required return if securities were issued today or the yield to maturity of outstanding issues. The key is what return investors require today, not in the past. Explanations for incorrect answers A. The cost of capital concept is a "today" focus. If we had to raise new funds today, what return would investors require before investing with our company? The historical or embedded cost of debt is irrelevant. B. The cost of capital concepts focuses on the current return required by investors, which is provided in the question. D. Three bond issues outstanding do not necessarily make Akron Corp. riskier today. Many large, safe utility companies have over a dozen bond issues outstanding. Now there is a limit, but we cannot assume that Akron Corp. is at the point that would scare investors. We are trying to estimate what coupon rate a new issue of debt would require today.
Question #5
Estimate the current after-tax cost of debt (APR) for a large telecommunications company from a recent $1000 bond quotation: 8.2% coupon(semiannual), matures in 2024; current price = 89.5. Their marginal tax rate is 35%. Today is 2002. A. B. C. D.
8.20% 5.33% 6.07% 9.33%
Correct answer: C Your answer: A Explanation for correct answer The current yield to maturity on the bond is the approximate cost or rate on new debt that the telecom company would pay if it were to issue new bonds in 2002. The bond matures in 2024, 22 x 2 = 44 compounding periods from 2002, pays 8.2% x $1000 = $82/2 = $41 per period, has a present price (PV) of 89.5% of $1000 face value or $895 and will pay $1000 at maturity (FV). Solve for the I x 2 = yield to maturity (APR), then calculate the after-tax return used in the weighted average cost of capital analysis. Solution $82/2 = $41 PMT $1000 FV $895 PV 22 x 2 = 44N I = 4.666 x 2 = 9.33% APR 9.33%(1-MTR) = ATX cost of debt = 9.33%(1 - .35) = 6.07% Explanations for incorrect answers A. The coupon rate of the bond issued years ago would represent the cost of capital only if the bond were selling for $1000. Calculate the yield to maturity then adjust to an after-tax basis. B. The coupon rate adjusted for the marginal tax rate is not the current cost of debt. The coupon rate of the bond issued years ago would represent the cost of capital only if the bond were selling for $1000. Calculate the yield to maturity then adjust to an after-tax basis. D. You have correctly calculated the yield to maturity, but now adjust the figure to an after-tax rate by multiplying the pre-tax rate by (1 marginal tax rate). The marginal tax rate represents the tax deductibility (tax shield) of interest. The remainder is the current ATX cost of debt.
-----------------------------Question #6
West Corporation issued a large preferred stock issue five years ago. The $100 face value preferred pays a $7 annual dividend and currently is priced at $92. What is West's current cost of preferred stock if it has a marginal tax rate of 35%? A. B. C. D.
7% 4.55% 7.6% 4.95%
Correct answer: C Your answer: A Explanation for correct answer The current required yield on preferred stock is $7/$9 2 = 7.6%. At the time the preferred was issued, the going yield was $7 per $100 or 7%, but investors have bid down the price of the preferred to $92, requiring a $7/$92 or 7.6% rate of return. Preferred stock dividends are not tax deductible, so there is no after-tax adjustment. Explanations for incorrect answers A. The current required return (cost) of preferred would be 7% only if the stock were selling at $100 face value. It is currently selling at a discount, so the required yield for new buyers of West's preferred is higher than 7%. B. The current required return (cost) of preferred would be 7% only if the stock were selling at $100 face value. It is currently selling at a discount, so the required yield for new buyers of West's preferred is higher than 7%. In addition, preferred stock dividends are not deductible, so there is no after-tax adjustment. D. You are close, but preferred stock dividends are not tax deductible, so there is no after-tax adjustment. The current required yield on preferred stock is $7/$92 = 7.6%. At the time the preferred was issued, the going yield was $7 per $100 or 7%, but investors have bid down the price of the preferred to $92, requiring a $7/$92 or 7.6% rate of return.
Question #7
Zima Company has grown steadily over the years at an average rate of 6%. Zima paid a common stock dividend of $.85 last year and the stock is currently priced at $9 per share. What is Zima's estimated cost of equity today? The company's marginal tax rate is 35%. A. B. C. D.
10% 16% 15.4% 10.4%
Correct answer: B Your answer: A Explanation for correct answer Zima's information indicates that we might use the constant dividend growth model for estimating the current cost of equity capital for Zima. Rearranging the constant growth model, the required rate of return is the sum of the dividend yield for the coming year, $.85(1.06) = $90/current price of $9 = 10% plus the 6% expected growth rate (stock appreciation). Stock dividends are not tax deductible, so there is no after-tax adjustment. Explanations for incorrect answers A. The dividend yield, next year's expected dividend [$.85 (1.06) = $.90] divided by the current price, $9, is part of the expected return of shareholders, but they expect an appreciation in their stock of 6% as well. The constant dividend growth model, solving the required rate of return, can be used for estimating Zima's current cost of equity. C. You correctly used the constant growth dividend model to estimate the required rate of return, but next year's dividend [$85.(1.06) = $.90], the dividend that a new investor would receive next year, is the correct value, not last year's dividend. D. You are close, but common stock dividends are not tax deductible, so there is no after-tax adjustment. Zima's information indicates that we might use the constant dividend growth model for estimating the current cost of equity capital for Zima. Rearranging the constant growth model, the required rate of return is the sum of the dividend yield for the coming year, $.85(1.06) = $90/current price of $9 = 10% plus the 6% expected growth rate (stock appreciation).
-----------------------------Question #8
TRZ Corporation has issued $10 million in bonds (10,000 bonds) several years ago and the current book value of equity is $25 million (1 million shares). What weights or proportions should TRZ Corporation assign debt and equity as it calculates its weighted average cost of capital (WACC)? Today its bonds are priced at 93 and the stock is selling for $32/share. A. B. C. D.
29% debt; 71% equity 24% debt; 76% equity 22.5% debt; 77.5% equity 27% debt; 73% equity
Correct answer: C Your answer: A Explanation for correct answer The correct weights or proportions should use the market values of debt and equity. The market value of debt is the current price of 93 (93% of face value) or $930/bond x 10,000 bonds or $9.3 million. The market value of equity is the price/share times the number of shares outstanding or $32 x 1 million = $32 million. The sum of the market value of the debt ($9.3 million) and equity ($32 million) is $41.3 million. The market value of debt represents $9.3/$41.3 or 22.5% of the total; equity is $32/$41.3 or 77.5% of the total. Explanation for incorrect answers Use the market value of debt and equity for the weights or proportions when calculating the weighted average cost of capital.
Question #9
Amsted Corp. has asked you to calculate its weighted average cost of capital. It estimates that the pre-tax cost of debt is 7% and 16% for equity. The market value of equity represents about 70% of the capital structure and the marginal tax rate is 40%. Which of the following best estimates the WACC for Amsted Corp? A. B. C. D.
13.30% 10.10% 15.40% 12.46%
Correct answer: D Your answer: A Explanation for correct answer With equity representing 70% of the capital structure, debt is inferred to represent 30%. The after-tax cost of debt is currently 7(1 - .4) = 4.2%. The weighted average cost of capital is: 7%(1 - .4)(.3) + 16%(.7) = 12.46%, the minimum acceptable return on average risk projects made at this time. Explanations for incorrect answers A. Your method is correct except for estimating the cost of debt. Use the after-tax cost of debt. B. You must weight the debt and equity cost components per the proportion of funds in the market value capital structure. C. While you weighted the cost of equity correctly at 70%, you did not weight the after-tax cost of debt at the inferred 30% (100% - 70% = 30%).
-----------------------------Question #10
As a new analyst in a major industrial company, you have just walked out of the office of the Assistant Chief Financial Off icer. You had just interviewed her about estimates for a weighted average cost of capital assignment. You remember that she said the WACC was 12% and the cost of equity is estimated to be 16%, but you cannot remember what she said the pre-tax cost of debt was! If debt makes up 40% of the market value of the company's capital structure and the marginal tax rate is 35%, can you calculate the pre-tax cost of debt from the information you have and not have to go back into her office? A. B. C. D.
It cannot be calculated from the information given. 9.23% 6% 14.35%
Correct answer: B Your answer: A Explanation for correct answer Given all the other variables you correctly have calculated the pre-tax cost of debt. Knowing the WACC, the cost of debt, the capital structure proportions (debt is 40; equity must be 60%), and the marginal tax rate, the pre-tax cost of debt is 9.23%. Solution 12% = (.6)16% + (.4)(1 - .35)x 12% = 9.6% + .26x 2.4%= .26x 9.23% = x Explanations for incorrect answers A. It can be calculated from the information given. The WACC is the sum of the equity-weighted cost of equity plus the product of the after-tax adjustment times the debt-weight times the unknown (x). C. One has to include the after-tax adjustment, a decimal figure, so the answer will be higher than 6%. D. The proportions are 60% equity and 40% debt.
