THE COST OF CAPITAL EXERCISE

THE COST OF CAPITAL CHAPTER 11 (Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard)

Note that there is some overlap between the T/F and the multiple choice questions, as some T/F statements are used in the MC questions. See the preface for information on the AACSB letter indicators (F, M, etc.) on the subject lines. Multiple Choice: True/False (11-1) Capital 1

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F I

Answer: a

EASY

“Capital” is sometimes defined as funds supplied to a firm by investors. a. True b. False

(11-1) Cost of capital 2

.

F I

Answer: a

EASY

The cost of capital used in capital budgeting should reflect the average cost of the various sources of investor-supplied funds a firm uses to acquire assets. a. True b. False

(11-1) Specific capital cost 3

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F I

Answer: b

EASY

Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt. a. True b. False

(11-2) Component capital costs 4

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F I

Answer: a

EASY

The component costs of capital are market-determined variables in the sense that they are based on investors' required returns. a. True b. False

(11-3) Cost of debt 5

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F I

Answer: b

EASY

The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC. a. True b. False

Chapter 11: Cost of Capital

True/False

Page 95

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F I

Answer: b

EASY

The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt. a. True b. False


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F I

Answer: a

EASY

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt. a. True b. False

(11-4) Cost of preferred 8

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F I

Answer: b

EASY

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income. a. True b. False


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F I

Answer: a

EASY

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, are not deductable by the issuing firm. a. True b. False

(11-5) Cost of common 10

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F I

Answer: a

EASY

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock. a. True b. False

(11-5) Cost of retained earnings 11

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F I

Answer: b

EASY

For capital budgeting and cost of capital purposes, the firm should always consider retained earnings as the first source of capital--i.e., use these funds first--because retained earnings have no cost to the firm. a. True b. False

(11-5) Cost of retained earnings 12

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F I

Answer: b

EASY

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost.

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True/False



a. True b. False (11-5) Cost of retained earnings 13

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F I

Answer: b

EASY

The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors. a. True b. False

(11-6) Cost of new common 14

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F I

Answer: b

EASY

The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock. a. True b. False

(11-7) WACC 15

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F I

Answer: a

EASY

For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity. a. True b. False

(Comp.) Flotation and capital 16

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F I

Answer: b

EASY

The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and retained earnings, whose cost is the average return on the assets that are acquired. a. True b. False

(11-1) Specific capital cost 17

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F I

Answer: b

MEDIUM

In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project. a. True b. False

(11-3) After-tax cost of debt 18

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F I

Answer: a

MEDIUM

If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC. a. True


True/False

Page 97


b. False

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True/False



(11-5) Retained earnings 19

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F I

Answer: a

MEDIUM

The reason why retained earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm's common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should pay those earnings out to its investors. Thus, the cost of retained earnings is based on the opportunity cost principle. a. True b. False

(11-5) Cost of equity estimates 20

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F I

Answer: b

MEDIUM

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the DCF method is widely used in practice. a. True b. False


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F I

Answer: b

MEDIUM

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the CAPM method always provides an accurate and reliable estimate. a. True b. False


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F I

Answer: a

MEDIUM

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. Since we cannot be sure that the estimate obtained with any of these methods is correct, it is often appropriate to use all three methods, then consider all three estimates, and end up using a judgmental estimate when calculating the WACC. a. True b. False


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F I

Answer: a

MEDIUM

When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to use long-term or short-term rates for rRF, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and (3) how to measure the market risk premium, RPM. These problems leave us unsure of the true value of rs. a. True b. False


.

F I

Answer: a

MEDIUM

When estimating the cost of equity by use of the DCF method, the single biggest potential problem is to determine the growth rate that investors


True/False

Page 99


use when they estimate a stock's expected future rate of return. problem leaves us unsure of the true value of rs.

This

a. True b. False (11-5) Cost of equity estimates 25

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F I

Answer: a

MEDIUM

When estimating the cost of equity by use of the bond-yield-plus-riskpremium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs. a. True b. False


.

F I

Answer: a

MEDIUM

If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the DCF model, and we don't know what the risk premium is for use in the bond-yield-plus-riskpremium method. All this makes it especially difficult to estimate the cost of equity for a private company. a. True b. False


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F I

Answer: b

MEDIUM

The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: “The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 - F).” a. True b. False


.

F I

Answer: a

MEDIUM

If the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common stock (re) is equal to the cost of equity capital from retaining earnings (rs) divided by one minus the percentage flotation cost required to sell the new stock, (1 - F). If the expected growth rate is not zero, then the cost of external equity must be found using a different formula. a. True b. False

(11-8) Factors affecting WACC 29

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F I

Answer: b

MEDIUM

Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC). a. True

Page 100

True/False



b. False


True/False

Page 101


(11-9) Risk-adjusted capital costs 30

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F I

Answer: a

MEDIUM

Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets. They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects. a. True b. False

(Comp.) WACC 31

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F I

Answer: a

MEDIUM

The cost of debt, rd, is normally less than rs, so rd(1 - T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 - T). a. True b. False

(Comp.) Taxes, rd(1 - T), and WACC 32

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F I

Answer: b

MEDIUM

The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant. a. True b. False

(Comp.) Cost of equity 33

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F I

Answer: b

MEDIUM

Since 70% of the preferred dividends received by a corporation are excluded from taxable income, the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be Cost of equity = rs(0.30)(0.50) + rps(1 - T)(0.70)(0.50). a. True b. False

(Comp.) Inflation effects 34

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F I

Answer: b

MEDIUM

If expectations for long-term inflation rose, but the slope of the SML remained constant, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Therefore, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt. a. True b. False

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True/False



(Comp.) Inflation effects 35

.

F I

Answer: a

MEDIUM

If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity. However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit the shift toward debt. a. True b. False

Multiple Choice: Conceptual (11-2) Capital components 36

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C I

Long-term debt. Accounts payable. Retained earnings. Common stock. Preferred stock.

(11-6) Internal vs. external common .

EASY

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting? a. b. c. d. e.

37

Answer: b

C I

Answer: b

EASY

Bankston Corporation forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Since new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock? a. b. c. d.

Increase the dividend payout ratio for the upcoming year. Increase the percentage of debt in the target capital structure. Increase the proposed capital budget. Reduce the amount of short-term bank debt in order to increase the current ratio. e. Reduce the percentage of debt in the target capital structure. (11-8) Factors affecting WACC 38

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C I

Answer: a

EASY

Schalheim Sisters Inc. has always paid out all of its earnings as dividends, hence the firm has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC? a. The market risk premium declines. b. The flotation costs associated with issuing new common stock increase. c. The company’s beta increases. d. Expected inflation increases.


Conceptual M/C

Page 103


e. The flotation costs associated with issuing preferred stock increase.

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Conceptual M/C



(Comp.) Capital components 39

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C I

rs > re > WACC rd > WACC

re rs > re >

> > re > rd

rd > WACC > rs rs > > rs

WACC. > rd. > rd. WACC. > re.

(11-5) Cost of equity: CAPM .

C I

C I

A A A A A

Division Division Division Division Division

B B A A B

project project project project project

(11-9) Risk and projects .

Answer: c

MEDIUM

Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A’s cost of capital is 10.0%, Division B’s cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A’s projects are equally risky, as are all of Division B's projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept? a. b. c. d. e.

42

MEDIUM

The market risk premium (RPM). The beta coefficient, bi, of a relatively safe stock. The most appropriate risk-free rate, rRF. The expected rate of return on the market, rM. The beta coefficient of “the market,” which is the same as the beta of an average stock.

(11-9) Divisional risk .

Answer: e

When working with the CAPM, which of the following factors can be determined with the most precision? a. b. c. d. e.

41

EASY

For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure. a. b. c. d. e.

40

Answer: b

with with with with with

a 13% return. a 12% return. an 11% return. a 9% return. an 11% return. C I

Answer: a

MEDIUM

LaPango Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its aboveaverage risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept? a. b. c. d. e.

Project B, which is of below-average risk and has a return of 8.5%. Project C, which is of above-average risk and has a return of 11%. Project A, which is of average risk and has a return of 9%. None of the projects should be accepted. All of the projects should be accepted.


Conceptual M/C

Page 105


(11-9) Risk and projects 43

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C I

Answer: d

MEDIUM

Norris Enterprises, an all-equity firm, has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than the firm’s average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT? a. The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return. b. The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return. c. Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment. d. The accept/reject decision depends on the firm's risk-adjustment policy. If Norris' policy is to increase the required return on a riskier-thanaverage project to 3% over rS, then it should reject the project. e. Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision.

(11-9) Risk-adjusted capital cost 44

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C I

Answer: a

MEDIUM

The MacMillen Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 12%. The CFO believes that this is the correct WACC for the company’s average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO’s position is accepted, what is likely to happen over time? a. The company will take on too many high-risk projects and reject too many low-risk projects. b. The company will take on too many low-risk projects and reject too many high-risk projects. c. Things will generally even out over time, and, therefore, the firm’s risk should remain constant over time. d. The company’s overall WACC should decrease over time because its stock price should be increasing. e. The CEO’s recommendation would maximize the firm’s intrinsic value.


.

C I

Answer: d

MEDIUM

If a typical U.S. company correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely a. become riskier over time, but its intrinsic value will be maximized. b. become less risky over time, and this will maximize its intrinsic value. c. accept too many low-risk projects and too few high-risk projects. d. become more risky and also have an increasing WACC. Its intrinsic value will not be maximized.

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Conceptual M/C



e. continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital. (Comp.) Capital components 46

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C I

Answer: e

MEDIUM

Which of the following statements is CORRECT? a. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation. b. All else equal, an increase in a company’s stock price will increase its marginal cost of retained earnings, rs. c. All else equal, an increase in a company’s stock price will increase its marginal cost of new common equity, re. d. Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt. e. If a company’s tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall.


.

C I

Answer: a

MEDIUM

Which of the following statements is CORRECT? a. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation. b. When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation. c. Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM. d. If a company’s beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence must issue new stock. e. Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company’s WACC.


.

C I

Answer: d

MEDIUM

Which of the following statements is CORRECT? a. In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income. b. We should use historical measures of the component costs from prior financings that are still outstanding when estimating a company’s WACC for capital budgeting purposes. c. The cost of new equity (re) could possibly be lower than the cost of retained earnings (rs) if the market risk premium, risk-free rate, and the company’s beta all decline by a sufficiently large amount. d. Its cost of retained earnings is the rate of return stockholders require on a firm’s common stock.


Conceptual M/C

Page 107


e. The component cost of preferred stock is expressed as rp(1 - T), because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt.

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Conceptual M/C



(Comp.) WACC 49

.

C I

Answer: d

MEDIUM

Which of the following statements is CORRECT? a. The WACC as used in capital budgeting is an estimate of a company’s before-tax cost of capital. b. The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt. c. The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets. d. There is an “opportunity cost” associated with using retained earnings, hence they are not “free.” e. The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year.

(Comp.) WACC 50

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C I

Answer: d

MEDIUM

Which of the following statements is CORRECT? a. A change in a company’s target capital structure cannot affect its WACC. b. WACC calculations should be based on the before-tax costs of all the individual capital components. c. Flotation costs associated with issuing new common stock normally reduce the WACC. d. If a company’s tax rate increases, then, all else equal, its weighted average cost of capital will decline. e. An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.

(Comp.) WACC and cap. components 51

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C I

Answer: e

MEDIUM

Which of the following statements is CORRECT? a. The WACC is calculated using before-tax costs for all components. b. The after-tax cost of debt usually exceeds the after-tax cost of equity. c. For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock. d. Retained earnings that were generated in the past and are reported on the firm’s balance sheet are available to finance the firm’s capital budget during the coming year. e. The WACC that should be used in capital budgeting is the firm’s marginal, after-tax cost of capital.

(Comp.) WACC and cap. components 52

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C I

Answer: d

MEDIUM

For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is CORRECT? a. The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet. b. The WACC is calculated on a before-tax basis. c. The WACC exceeds the cost of equity. d. The cost of equity is always equal to or greater than the cost of debt.


Conceptual M/C

Page 109


e. The cost of retained earnings typically exceeds the cost of new common stock. (Comp.) Cost of capital concepts 53

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C I

Answer: c

MEDIUM

Which of the following statements is CORRECT? a. Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity. b. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes. c. If a company assigns the same cost of capital to all of its projects regardless of each project’s risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject. d. Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt. e. Higher flotation costs tend to reduce the cost of equity capital.

(Comp.) MCC break points 54

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C I

Answer: d

MEDIUM

Which of the following statements is CORRECT? a. The “break point” as discussed in the text refers to the point where the firm's tax rate increases. b. The “break point” as discussed in the text refers to the point where the firm has raised so much capital that it is simply unable to borrow any more money. c. The “break point” as discussed in the text refers to the point where the firm is taking on investments that are so risky the firm is in serious danger of going bankrupt if things do not go exactly as planned. d. The “break point” as discussed in the text refers to the point where the firm has raised so much capital that it has exhausted its supply of new retained earnings and thus must raise equity by issuing stock. e. The “break point” as discussed in the text refers to the point where the firm has exhausted its supply of new retained earnings and thus must begin to finance with preferred stock.

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Conceptual M/C




.

C I

Answer: c

HARD

Cranberry Corp. has two divisions of equal size: a computer manufacturing division and a data processing division. Its CFO believes that stand-alone data processor companies typically have a WACC of 8%, while stand-alone computer manufacturers typically have a 12% WACC. He also believes that the data processing and manufacturing divisions have the same risk as their typical peers. Consequently, he estimates that the composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the data processing division and a 12% hurdle rate for the manufacturing division. However, the CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is CORRECT? a. While the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant’s recommendation, this should not affect the firm’s intrinsic value. b. The decision not to adjust for risk means, in effect, that it is favoring the data processing division. Therefore, that division is likely to become a larger part of the consolidated company over time. c. The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division. This will lead to a reduction in the firm’s intrinsic value over time. d. The decision not to risk-adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business. This will lead to a reduction in its intrinsic value over time. e. The decision not to risk adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business. This may affect the firm’s capital structure but it will not affect its intrinsic value.

(11-9) Div. risk and projects 56

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C I

Answer: a

HARD

Safeco Company and Risco Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Safeco having a WACC of 10% and Risco a WACC of 12%. Safeco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Safeco project. Risco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Risco project. Now assume that the two companies merge and form a new company, Safeco/Risco Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is CORRECT? a. If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time. b. If evaluated using the correct post-merger WACC, Project X would have a negative NPV. c. After the merger, Safeco/Risco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y. d. Safeco/Risco’s WACC, as a result of the merger, would be 10%.


Conceptual M/C

Page 111


e. After the merger, Safeco/Risco should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%. (Comp.) Capital components 57

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C I

Answer: b

HARD

Which of the following statements is CORRECT? a. The component cost of preferred stock is expressed as rp(1 - T). This follows because preferred stock dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes. b. A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firm’s stockholders would themselves expect to earn a return on earnings that were paid out rather than retained and reinvested. c. No cost should be assigned to retained earnings because the firm does not have to pay anything to raise them. They are generated as cash flows by operating assets that were raised in the past, hence they are “free.” d. Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into the foreseeable future. In this case, the firm’s before-tax and after-tax costs of debt for purposes of calculating the WACC will both be equal to the interest rate on the firm’s currently outstanding debt, provided that debt was issued during the past 5 years. e. If a firm has enough retained earnings to fund its capital budget for the coming year, then there is no need to estimate either a cost of equity or a WACC.

(Comp.) Cost of capital 58

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C I

Answer: d

HARD

Which of the following statements is CORRECT? a. The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity. b. The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average after-tax cost of all the firm’s outstanding debt. c. Suppose some of a publicly-traded firm’s stockholders are not diversified; they hold only the one firm’s stock. In this case, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firm’s intrinsic value. d. The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity. e. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm’s cost of equity capital.

Page 112

Conceptual M/C



(Comp.) Cost of equity 59

.

C I

Answer: d

HARD

Which of the following statements is CORRECT? a. Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs--beta, the risk-free rate, and the market risk premium--can be estimated with little error. b. The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the DCF model’s logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain. c. The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm’s own cost of debt and its risk premium, can be found by using standardized and objective procedures. d. Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity. e. The DCF model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield.

(Comp.) CAPM and DCF 60

.

C I

Answer: c

HARD

Which of the following statements is CORRECT? a. The discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever. b. If the calculated beta underestimates the firm’s true investment risk--i.e., if the forward-looking beta that investors think exists exceeds the historical beta--then the CAPM method based on the historical beta will produce an estimate of rs and thus WACC that is too high. c. Beta measures market risk, which is, theoretically, the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. This is true even if not all of the firm’s stockholders are well diversified. d. An advantage shared by both the DCF and CAPM methods when they are used to estimate the cost of equity is that they are both “objective” as opposed to “subjective,” hence little or no judgment is required. e. The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach.


Conceptual M/C

Page 113


(Comp.) WACC 61

.

C I

Answer: d

HARD

Which of the following statements is CORRECT? a. The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the interest rate on the company’s own long-term bonds. The size of the risk premium for bonds with different ratings is published daily in The Wall Street Journal. b. The WACC is calculated using a before-tax cost for debt that is equal to the interest rate that must be paid on new debt, along with the after-tax costs for common stock and for preferred stock if it is used. c. An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity. d. The relevant WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm’s target capital structure. e. Beta measures market risk, which is generally the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. However, this is not true unless all of the firm’s stockholders are well diversified.

(Comp.) WACC 62

.

C I

Answer: e

HARD

Which of the following statements is CORRECT? a. Since the costs of internal and external equity are related, an increase in the flotation cost required to sell a new issue of stock will increase the cost of retained earnings. b. Since its stockholders are not directly responsible for paying a corporation’s income taxes, corporations should focus on before-tax cash flows when calculating the WACC. c. An increase in a firm’s tax rate will increase the component cost of debt, provided the YTM on the firm’s bonds is not affected by the change in the tax rate. d. When the WACC is calculated, it should reflect the costs of new common stock, retained earnings, preferred stock, long-term debt, short-term bank loans if the firm normally finances with bank debt, and accounts payable if the firm normally has accounts payable on its balance sheet. e. If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the after-tax cost of debt.

Page 114

Conceptual M/C



(Comp.) Beta and project risk 63

.

C I

Answer: e

HARD

Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth. a. If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms’ assets. b. If a firm’s managers want to maximize the value of the stock, they should, in theory, concentrate on project risk as measured by the standard deviation of the project’s expected future cash flows. c. If a firm evaluates all projects using the same cost of capital, and the CAPM is used to help determine that cost, then its risk as measured by beta will probably decline over time. d. Projects with above-average risk typically have higher-than-average expected returns. Therefore, to maximize a firm’s intrinsic value, its managers should favor high-beta projects over those with lower betas. e. Project A has a standard deviation of expected returns of 20%, while Project B’s standard deviation is only 10%. A’s returns are negatively correlated with both the firm’s other assets and the returns on most stocks in the economy, while B’s returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital.

(Comp.) MCC break points 64

.

C I

Answer: c

HARD

Firm M's earnings and stock price tend to move up and down with other firms in the S&P 500, while Firm W's earnings and stock price move counter cyclically with M and other S&P companies. Both M and W estimate their costs of equity using the CAPM, they have identical market values, their standard deviations of returns are identical, and they both finance only with common equity. Which of the following statements is CORRECT? a. M should have the lower WACC because it is like most other companies, and investors like that fact. b. M and W should have identical WACCs because their risks as measured by the standard deviation of returns are identical. c. If M and W merge, then the merged firm MW should have a WACC that is a simple average of M's and W's WACCs. d. Without additional information, it is impossible to predict what the merged firm's WACC would be if M and W merged. e. Since M and W move counter cyclically to one another, if they merged, the merged firm's WACC would be less than the simple average of the two firms' WACCs.


Conceptual M/C

Page 115


Multiple Choice: Problems (11-4) Cost of preferred 65

.

C I

Answer: b

EASY

Bosio Inc.'s perpetual preferred stock sells for $97.50 per share, and it pays an $8.50 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is the company's cost of preferred stock for use in calculating the WACC? a. 8.72% b. 9.08% c. 9.44% d. 9.82% e. 10.22%


.

Answer: a

EASY

11.30% 11.64% 11.99% 12.35% 12.72%

(11-5) Cost of RE: CAPM .

C I

O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of equity from retained earnings based on the CAPM? a. b. c. d. e.

68

EASY

7.81% 8.22% 8.65% 9.10% 9.56%

(11-5) Cost of RE: CAPM .

Answer: d

A company’s perpetual preferred stock currently sells for $92.50 per share, and it pays an $8.00 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price. What is the firm's cost of preferred stock? a. b. c. d. e.

67

C I

C I

Answer: e

EASY

Scanlon Inc.'s CFO hired you as a consultant to help her estimate the cost of capital. You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30. Based on the CAPM approach, what is the cost of equity from retained earnings? a. 9.67% b. 9.97% c. 10.28% d. 10.60% e. 10.93%

Page 116

M/C Problems



(11-5) Cost of RE: DCF 69

.

C I

Answer: c

EASY

Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant). What is the cost of equity from retained earnings based on the DCF approach? a. 9.42% b. 9.91% c. 10.44% d. 10.96% e. 11.51%


.

C I

11.10% 11.68% 12.30% 12.94% 13.59%

(11-5) Bond-yield-plus-risk premium .

Answer: a

EASY

12.60% 13.10% 13.63% 14.17% 14.74%

(11-7) WACC .

C I

A. Butcher Timber Company hired your consulting firm to help them estimate the cost of equity. The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of equity can be estimated using a risk premium of 3.85% over a firm's own cost of debt. What is an estimate of the firm's cost of equity from retained earnings? a. b. c. d. e.

72

EASY

Teall Development Company hired you as a consultant to help them estimate its cost of capital. You have been provided with the following data: D1 = $1.45; P0 = $22.50; and g = 6.50% (constant). Based on the DCF approach, what is the cost of equity from retained earnings? a. b. c. d. e.

71

Answer: d

C I

Answer: b

EASY

You were hired as a consultant to Giambono Company, whose target capital structure is 40% debt, 15% preferred, and 45% common equity. The aftertax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of retained earnings is 12.75%. The firm will not be issuing any new stock. What is its WACC? a. 8.98% b. 9.26% c. 9.54% d. 9.83% e. 10.12%


M/C Problems

Page 117



.

Answer: c

MEDIUM

4.28% 4.46% 4.65% 4.83% 5.03%

(11-5) Cost of RE: DCF .

C I

Several years ago the Jakob Company sold a $1,000 par value, noncallable bond that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually. The bond currently sells for $925, and the company’s tax rate is 40%. What is the component cost of debt for use in the WACC calculation? a. b. c. d. e.

75

MEDIUM

4.35% 4.58% 4.83% 5.08% 5.33%

(11-3) Cost of debt .

Answer: d

To help finance a major expansion, Castro Chemical Company sold a noncallable bond several years ago that now has 20 years to maturity. This bond has a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000. If the firm's tax rate is 40%, what is the component cost of debt for use in the WACC calculation? a. b. c. d. e.

74

C I

C I

Answer: d

MEDIUM

Assume that Kish Inc. hired you as a consultant to help estimate its cost of capital. You have obtained the following data: D0 = $0.90; P0 = $27.50; and g = 7.00% (constant). Based on the DCF approach, what is the cost of equity from retained earnings? a. 9.29% b. 9.68% c. 10.08% d. 10.50% e. 10.92%


.

C I

Answer: c

MEDIUM

Rivoli Inc. hired you as a consultant to help estimate its cost of capital. You have been provided with the following data: D0 = $0.80; P0 = $22.50; and g = 8.00% (constant). Based on the DCF approach, what is the cost of equity from retained earnings? a. b. c. d. e.

Page 118

10.69% 11.25% 11.84% 12.43% 13.05%

M/C Problems



(11-6) re based on DCF, D1 77

.

C I

Answer: c

MEDIUM

Trahan Lumber Company hired you to help estimate its cost of capital. You obtained the following data: D1 = $1.25; P0 = $27.50; g = 5.00% (constant); and F = 6.00%. What is the cost of equity raised by selling new common stock? a. 9.06% b. 9.44% c. 9.84% d. 10.23% e. 10.64%

(11-6) re based on DCF, D1 78

.

Answer: b

MEDIUM

12.70% 13.37% 14.04% 14.74% 15.48%

(11-7) WACC .

C I

Weaver Chocolate Co. expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, its expected constant dividend growth rate is 6.0%, and its common stock currently sells for $32.50 per share. New stock can be sold to the public at the current price, but a flotation cost of 5% would be incurred. What would be the cost of equity from new common stock? a. b. c. d. e.

80

MEDIUM

10.77% 11.33% 11.90% 12.50% 13.12%

(11-6) Cost of new common .

Answer: b

You were recently hired by Scheuer Media Inc. to estimate its cost of capital. You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.00% (constant); and F = 5.00%. What is the cost of equity raised by selling new common stock? a. b. c. d. e.

79

C I

C I

Answer: c

MEDIUM

Sorensen Systems Inc. is expected to pay a $2.50 dividend at year end (D1 = $2.50), the dividend is expected to grow at a constant rate of 5.50% a year, and the common stock currently sells for $52.50 a share. The before-tax cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of 45% debt and 55% common equity. What is the company’s WACC if all the equity used is from retained earnings? a. b. c. d. e.

7.07% 7.36% 7.67% 7.98% 8.29%


M/C Problems

Page 119


(11-7) WACC and target cap. struc. 81

.

C I

C I

MEDIUM/HARD

-1.49% -1.66% -1.84% -2.03% -2.23%

(11-7) WACC and market cap. struc. .

Answer: c

S. Bouchard and Company hired you as a consultant to help estimate its cost of capital. You have obtained the following data: D0 = $0.85; P0 = $22.00; and g = 6.00% (constant). The CEO thinks, however, that the stock price is temporarily depressed, and that it will soon rise to $40.00. Based on the DCF approach, by how much would the cost of equity from retained earnings change if the stock price changes as the CEO expects? a. b. c. d. e.

84

MEDIUM/HARD

0.57% 0.63% 0.70% 0.77% 0.85%

(11-5) Cost of RE: DCF .

Answer: c

Keys Printing plans to issue a $1,000 par value, 20-year noncallable bond with a 7.00% annual coupon, paid semiannually. The company's marginal tax rate is 40.00%, but Congress is considering a change in the corporate tax rate to 30.00%. By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted? a. b. c. d. e.

83

MEDIUM

8.15% 8.48% 8.82% 9.17% 9.54%

(11-3) Taxes and cost of debt .

Answer: a

You were hired as a consultant to Quigley Company, whose target capital structure is 35% debt, 10% preferred, and 55% common equity. The interest rate on new debt is 6.50%, the yield on the preferred is 6.00%, the cost of retained earnings is 11.25%, and the tax rate is 40%. The firm will not be issuing any new stock. What is Quigley's WACC? a. b. c. d. e.

82

C I

C I

Answer: e

MEDIUM/HARD

Sapp Trucking’s balance sheet shows a total of noncallable $45 million long-term debt with a coupon rate of 7.00% and a yield to maturity of 6.00%. This debt currently has a market value of $50 million. The balance sheet also shows that the company has 10 million shares of common stock, and the book value of the common equity (common stock plus retained earnings) is $65 million. The current stock price is $22.50 per share; stockholders' required return, rs, is 14.00%; and the firm's tax rate is 40%. The CFO thinks the WACC should be based on market value weights, but the president thinks book weights are more appropriate. What is the difference between these two WACCs? a. 1.55%

Page 120

M/C Problems



b. c. d. e.

1.72% 1.91% 2.13% 2.36%

(11-5) Risk premium, CAPM, and DCF 85

.

Answer: c

HARD

0.09% 0.19% 0.37% 0.56% 0.84%

(11-7) WACC and capital structure .

C I

Eakins Inc.’s common stock currently sells for $45.00 per share, the company expects to earn $2.75 per share during the current year, its expected payout ratio is 70%, and its expected constant growth rate is 6.00%. New stock can be sold to the public at the current price, but a flotation cost of 8% would be incurred. By how much would the cost of new stock exceed the cost of retained earnings? a. b. c. d. e.

87

HARD

1.13% 1.50% 1.88% 2.34% 2.58%

(11-6) rs vs. re .

Answer: b

The CFO of Lenox Industries hired you as a consultant to help estimate its cost of capital. You have obtained the following data: (1) rd = yield on the firm’s bonds = 7.00% and the risk premium over its own debt cost = 4.00%. (2) rRF = 5.00%, RPM = 6.00%, and b = 1.25. (3) D1 = $1.20, P0 = $35.00, and g = 8.00% (constant). You were asked to estimate the cost of equity based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates. What is that difference? a. b. c. d. e.

86

C I

C I

Answer: c

HARD

Bolster Foods’ (BF) balance sheet shows a total of $25 million long-term debt with a coupon rate of 8.50%. The yield to maturity on this debt is 8.00%, and the debt has a total current market value of $27 million. The balance sheet also shows that the company has 10 million shares of stock, and the stock has a book value per share of $5.00. The current stock price is $20.00 per share, and stockholders' required rate of return, rs, is 12.25%. The company recently decided that its target capital structure should have 35% debt, with the balance being common equity. The tax rate is 40%. Calculate WACCs based on book, market, and target capital structures, and then find the sum of these three WACCs. a. b. c. d. e.

28.36% 29.54% 30.77% 32.00% 33.28%


M/C Problems

Page 121


(11-7) WACC and equity from RE 88

.

C I

7.16% 7.54% 7.93% 8.35% 8.79%

(11-7) WACC and equity from RE .

C I

HARD

6.89% 7.26% 7.64% 8.04% 8.44%

(11-9) Project risk .

Answer: d

Assume that you are on the financial staff of Vanderheiden Inc., and you have collected the following data: The yield on the company’s outstanding bonds is 7.75%, its tax rate is 40%, the next expected dividend is $0.65 a share, the dividend is expected to grow at a constant rate of 6.00% a year, the price of the stock is $15.00 per share, the flotation cost for selling new shares is F = 10%, and the target capital structure is 45% debt and 55% common equity. What is the firm's WACC, assuming it must issue new stock to finance its capital budget? a. b. c. d. e.

90

HARD

Daves Inc. recently hired you as a consultant to estimate the company’s WACC. You have obtained the following information. (1) The firm's noncallable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $1,000, and a market price of $1,050.00. (2) The company’s tax rate is 40%. (3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock’s beta is 1.20. (4) The target capital structure consists of 35% debt and the balance is common equity. The firm uses the CAPM to estimate the cost of equity, and it does not expect to issue any new common stock. What is its WACC? a. b. c. d. e.

89

Answer: e

C I

Answer: a

HARD

Vang Enterprises, which is debt-free and finances only with equity from retained earnings, is considering 7 equal sized capital budgeting projects. Its CFO hired you to assist in deciding whether none, some, or all of the projects should be accepted. You have the following information: rRF = 4.50%; RPM = 5.50%; and b = 0.92. The company adds or subtracts a specified percentage to the corporate WACC when it evaluates projects that have above- or below-average risk. Data on the 7 projects are shown below. If these are the only projects under consideration, how large should the capital budget be? Project 1 2 3 4 5 6 7

Page 122

Risk Very low Low Average High Very high Very high Very high

Risk Factor -2.00% -1.00% 0.00% 1.00% 2.00% 2.00% 2.00%

Expected Return 7.60% 9.15% 10.10% 10.40% 10.80% 10.90% 13.00%

M/C Problems

Cost (Millions)

$25.0 $25.0 $25.0 $25.0 $25.0 $25.0 $25.0 Chapter 11: Cost of Capital


a. b. c. d. e.

$100 $ 75 $ 50 $ 25 $ 0

Multiple Part: (The following information applies to Problems 91, 92, 93, and 94.) Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below. Assets Current assets Net plant, property, and equipment Total assets

$ 38,000,000 101,000,000 $139,000,000

Liabilities and Equity Accounts payable Accruals Current liabilities Long-term debt (40,000 bonds, $1,000 par value) Total liabilities Common stock (10,000,000 shares) Retained earnings Total shareholders' equity Total liabilities and shareholders' equity

$ 10,000,000 9,000,000 $ 19,000,000 40,000,000 $ 59,000,000 30,000,000 50,000,000 80,000,000 $139,000,000

The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%. (11-2) After-tax cost of debt 91

.

MEDIUM

4.64% 4.88% 5.14% 5.40% 5.67%

(11-5) CAPM cost of equity .

Answer: c

What is the best estimate of the after-tax cost of debt? a. b. c. d. e.

92

C I

C I

Answer: d

MEDIUM

Based on the CAPM, what is the firm's cost of equity? a. b. c. d.

11.15% 11.73% 12.35% 13.00%


M/C Problems

Page 123


e. 13.65% (11-7) Weights for WACC 93

.

MEDIUM

18.67% 19.60% 20.58% 21.61% 22.69%

(11-7) WACC .

Answer: a

Which of the following is the best estimate for the weight of debt for use in calculating the WACC? a. b. c. d. e.

94

C I

C I

Answer: c

MEDIUM

What is the best estimate of the firm's WACC? a. b. c. d. e.

Page 124

10.85% 11.19% 11.53% 11.88% 12.24%

M/C Problems



ANSWERS AND SOLUTIONS CHAPTER 11


Answers

Page 125


1.

(11-1) Capital

F I

Answer: a

EASY

2.

(11-1) Cost of capital

F I

Answer: a

EASY

3.

(11-1) Specific capital cost

F I

Answer: b

EASY

4.

(11-2) Component capital costs

F I

Answer: a

EASY

5.

(11-3) Cost of debt

F I

Answer: b

EASY

6.

(11-3) Cost of debt

F I

Answer: b

EASY

7.

(11-3) Cost of debt

F I

Answer: a

EASY

8.

(11-4) Cost of preferred

F I

Answer: b

EASY

9.

(11-4) Cost of preferred

F I

Answer: a

EASY

10.

(11-5) Cost of common

F I

Answer: a

EASY

11.

(11-5) Cost of retained earnings

F I

Answer: b

EASY

12.


F I

Answer: b

EASY

13.


F I

Answer: b

EASY

14.

(11-6) Cost of new common

F I

Answer: b

EASY

15.

(11-7) WACC

F I

Answer: a

EASY

16.

(Comp.) Flotation and capital

F I

Answer: b

EASY

17.

(11-1) Specific capital cost

F I

Answer: b

MEDIUM

In general, this statement is false, because the firm should be viewed as an ongoing entity, and using debt (or equity) to fund a given project will change the capital structure, and this factor should be recognized by basing the cost of capital for all projects on a target capital structure. Under some special circumstances, where a project is set up as a separate entity, then “project financing” may be used, and only the project's specific situation is considered. This is a specific situation, however, and not the “in general” case. 18.

(11-3) After-tax cost of debt

F I

Answer: a

MEDIUM

19.

(11-5) Retained earnings

F I

Answer: a

MEDIUM

20.

(11-5) Cost of equity estimates

F I

Answer: b

MEDIUM

21.


F I

Answer: b

MEDIUM

None of the methods always provides accurate and reliable estimates. With the CAPM, we don't know the beta that investors are using, we are not totally sure of what r RF to use, and we don't know if the CAPM is truly correct. 22.


F I

Answer: a

MEDIUM

F I

Answer: a

MEDIUM

Unfortunately, this is true. 23.

(11-5) Cost of equity estimates Unfortunately, this is true.

24.


F I

Answer: a

MEDIUM

F I

Answer: a

MEDIUM

F I

Answer: a

MEDIUM

Unfortunately, this is true. 25.

(11-5) Cost of equity estimates Unfortunately, this is true.

26.


True, but data on comparable publicly owned firms can often be obtained and used as proxies for private firms. 27.


F I

Answer: b

MEDIUM

This statement is true only if the expected growth rate is zero. Here are some illustrative numbers that show that the statement is true if g = 0 but false otherwise. Price Dividend Growth Flotation rs = D1/P0 + g re = D1/P0(1 − F) + g rs/(1 − F) 28.

Positive g $10.00 $0.50 6.00% 5.00% 11.00% 11.263% 11.579%


Zero g $10.00 $0.50 0.00% 5.00% 5.00% 5.263% 5.263% F I

Equal only if g = zero. Answer: a

MEDIUM

This statement is true. Here are some illustrative numbers to demonstrate this point. Price Dividend Growth Flotation rs = D1/P0 + g re = D1/P0(1 − F) + g rs/(1 − F)

Positive g $10.00 $0.50 6.00% 5.00% 11.00% 11.263% 11.579%

Zero g $10.00 $0.50 0.00% 5.00% 5.00% 5.263% 5.263%

Equal only if g = zero.

29.

(11-8) Factors affecting WACC

F I

Answer: b

MEDIUM

30.

(11-9) Risk-adjusted capital costs F I

Answer: a

MEDIUM

31.

(Comp.) WACC

F I

Answer: a

MEDIUM

32.

(Comp.) Taxes, rd(1 - T), and WACC

F I

Answer: b

MEDIUM

33.

(Comp.) Cost of equity

F I

Answer: b

MEDIUM

The preferred dividend exclusion is a benefit to the holder of the preferred, not the issuer, hence this statement is not true. It actually is just nonsense anyway! 34.

(Comp.) Inflation effects

F I

Answer: b

MEDIUM

Increased inflation results in a parallel upward shift in the SML, which means equal percentage increases in the required returns on debt and equity. 35.

(Comp.) Inflation effects

F I

Answer: a

MEDIUM

36.

(11-2) Capital components

C I

Answer: b

EASY

37.

(11-6) Internal vs. external common

C I

Answer: b

EASY

Statement b is correct, because if more debt is used, then less equity will be needed to fund the capital budget, so the need for a stock issue would be reduced. 38.

(11-8) Factors affecting WACC

C I

Answer: a

EASY

39.

(Comp.) Capital components

C I

Answer: b

EASY

40.

(11-5) Cost of equity: CAPM

C I

Answer: e

MEDIUM

By definition, both the market and an average stock have betas of 1.0. Since we know this to be the case, we can obviously determine beta for the market or an average stock with precision. 41.

(11-9) Divisional risk

C I

Answer: c

MEDIUM

The correct answer is statement c. Division A should accept only projects with returns greater than 10%, and Division B should accept only projects with returns greater than 14%. Only statement c meets this criterion. 42.

(11-9) Risk and projects

C I

Answer: a

MEDIUM

Project B has a return greater than its risk-adjusted cost of capital, so it should be accepted. 43.

(11-9) Risk and projects

C I

Answer: d

MEDIUM

Answer: a

MEDIUM

Statement d is correct. Here is the proof: rs = 5% + 4%(2.0) = 5% + 8% = 13%. Required return for risky projects = 13% + 3% = 16%. Project return = 14% < adjusted r s = 16%. Thus, the project should be rejected. 44.

(11-9) Risk-adjusted capital cost C I

Low-risk projects will tend to have low expected returns and vice versa for high-risk projects due to competition in the economy. By not adjusting the cost of capital for project risk, the firm will tend to reject low-risk projects even though they earn higher returns than their risk-adjusted costs of capital, and vice versa for high-risk projects. In addition, as the firm takes on more high-risk projects, its correct WACC will increase over time. Therefore, statement a is correct.

45.


Answer: d

MEDIUM

Low-risk projects will tend to have low expected returns and vice versa for high-risk projects due to competition in the economy. By not adjusting the cost of capital for project risk, the firm will tend to reject low-risk projects even though they earn higher returns than their risk-adjusted costs of capital, and vice versa for high-risk projects. As the firm takes on more high-risk projects, its true WACC will increase over time. Of course, the true WACC might change over time due to changes in market conditions, but that could cause the true WACC to either rise or decline. Therefore, statement d is correct. 46.


C I

Answer: e

MEDIUM

Statement e is true, because the after-tax cost of debt is r d(1 − T). So, if r d remains constant but T increases, r d(1 − T) will decline. The other statements are all false. 47.


C I

Answer: a

MEDIUM

Statement a is true, because interest payments on debt are tax deductible. The other statements are false. 48.


C I

Answer: d

MEDIUM

49.

(Comp.) WACC

C I

Answer: d

MEDIUM

50.

(Comp.) WACC

C I

Answer: d

MEDIUM

Statement d is true, because the cost of debt for WACC purposes = r d(1 − T), so if T increases, then rd(1 − T) declines. 51.

(Comp.) WACC and cap. components

C I

Answer: e

MEDIUM

52.

(Comp.) WACC and cap. components

C I

Answer: d

MEDIUM

Statement d is true, because equity is more risky than debt and hence investors require a higher return on equity. Also, interest on debt is deductible, and this further reduces the cost of debt. The other statements are false. 53.

(Comp.) Cost of capital concepts

C I

Answer: c

MEDIUM

54.

(Comp.) MCC break points

C I

Answer: d

MEDIUM

55.


Answer: c

HARD

By not making the risk adjustment, the firm will accept too many projects in the manufacturing division and too few in the data processing division. As a result, the company will become riskier overall, raising its cost of capital. Investors will discount the firm's cash flows at a higher rate, and the firm’s intrinsic value will fall. Therefore, statement c is true and all other statements are false. 56.

(11-9) Div. risk and projects

C I

Answer: a

HARD

57.


C I

Answer: b

HARD

58.

(Comp.) Cost of capital

C I

Answer: d

HARD

59.

(Comp.) Cost of equity

C I

Answer: d

HARD

60.

(Comp.) CAPM and DCF

C I

Answer: c

HARD

61.

(Comp.) WACC

C I

Answer: d

HARD

Statement d is true—the WACC will increase if the firm raises more funds than can be supported by retained earnings. 62.

(Comp.) WACC

C I

Answer: e

HARD

Statement e is true. The firm would get no tax savings on interest, so its cost of debt would not be reduced by the tax factor. However, corporate investors would get to deduct 70% of the preferred dividends they receive, which would make them willing to accept a lower before-tax yield on preferred stock than on bonds. Put another way, the market yield on its preferred could be lower than the interest rate on its debt because of the 70% exclusion, and with a zero tax rate, there is no reduction in the cost of debt. 63.

(Comp.) Beta and project risk

C I

Answer: e

HARD

The fact that A’s returns are negatively correlated means that it serves as a sort of insurance policy to the firm. The fact that its SD is high is actually good, because the negative correlation will cause the project’s beta versus the market and also with the firm’s other assets to be relatively low, denoting a low risk and thus justifying a

relatively low cost of capital. This answer is theoretically always true, and it is especially true if the firm is large, has many projects, and Project A is not a “bet the company” project. 64.

(Comp.) MCC break points

C I

Answer: c

HARD

Statement c is true. The merged firm would have a beta that is a simple average of M's and W's betas, and that would result in a cost of equity that is an average of the two firms’ costs of equity. Since they are financed only with equity, their WACCs could also be averaged to find the merged firm's WACC. 65.

(11-4) Cost of preferred Preferred stock price Preferred dividend Flotation cost rp = Dp/(Pp(1 − F))

66.

67.

68.

69.

70.

71.

72.

(11-7) WACC

C I

Answer: a

EASY

C I

Answer: e

EASY

C I

Answer: c

EASY

C I

Answer: d

EASY

C I

Answer: a

EASY

C I

Answer: b

EASY

$1.45 $22.50 6.50% 12.94%

(11-5) Bond-yield-plus-risk premium Bond yield Risk premium rs = rd + Risk premium

EASY

$0.67 $27.50 8.00% 10.44%

(11-5) Cost of RE: DCF D1 P0 g rs = D1/P0 + g

Answer: d

4.10% 5.25% 1.30 10.925%

(11-5) Cost of RE: DCF D1 P0 g rs = D1/P0 + g

C I

5.00% 6.00% 1.05 11.30%

(11-5) Cost of RE: CAPM rRF RPM b rs = rRF + b(RPM)

EASY

$92.50 $8.00 5.00% 9.10%

(11-5) Cost of RE: CAPM rRF RPM b rs = rRF + b(RPM)

Answer: b

$97.50 $8.50 4.00% 9.08%

(11-4) Cost of preferred Preferred stock price Preferred dividend Flotation cost rp = Dp/(Pp(1 − F))

C I

8.75% 3.85% 12.60%

Debt Preferred Common WACC = wd × rd × (1 − T) + wp × rp + wc × r s 73.

(11-3) Cost of debt

Weights 40% 15% 45% C I

Coupon rate Periods/year Maturity (yr) Bond price Par value Tax rate

Costs 6.00% 7.50% 12.75% 9.26% Answer: d

MEDIUM

Answer: c

MEDIUM

Answer: d

MEDIUM

9.25% 2 20 $1,075.00 $1,000 40%

Calculator inputs: N = 2 × 20 40 PV = Bond's price -$1,075.00 PMT = Coupon rate × Par/2 $46.25 FV = Par = Maturity value $1,000 Calculator output: I/YR, semiannual rate 4.23% Annual rate = 2 × (I/YR) = Before-tax cost of debt 8.47% After-tax cost of debt = r d(1 – T) 5.08%

74.

(11-3) Cost of debt

C I

Coupon rate Periods/year Maturity (yr) Bond price Par value Tax rate

7.00% 2 20 $925.00 $1,000 40%

Calculator inputs: N = 2 × 20 PV = Bond's price PMT = Coupon rate × Par/2 FV = Par = Maturity value I/YR Times periods/yr = before-tax cost of debt After-tax cost of debt = r d(1 – T) 75.

(11-5) Cost of RE: DCF D0 P0 g D1 = D0 × (1 + g) rs = D1/P0 + g

40 -$925.00 $35 $1,000 3.87% 7.74% 4.65% C I

$0.90 $27.50 7.00% $0.963 10.50%

76.

(11-5) Cost of RE: DCF D0 P0 g D1 = D0 × (1 + g) rs = D1/P0 + g

77.

(11-6) re based on DCF, D1


(11-7) WACC

Answer: c

MEDIUM

C I

Answer: b

MEDIUM

C I

Answer: b

MEDIUM

Answer: c

MEDIUM

Answer: a

MEDIUM

$3.50 65% $2.275 $32.50 6.00% 5.00% 13.37% C I

D1 g P0 rd Tax rate Weight debt Weight equity rd(1 − T) rs = D1/P0 + g WACC = wd(rd)(1 − T) + wc(rs) = 81.

C I

$1.75 $42.50 7.00% 5.00% 11.33%

Expected EPS1 Payout ratio Expected dividend, D1 = EPS × Payout Current stock price g F re = D1/(P0 × (1 − F)) + g 80.

MEDIUM

$1.25 $27.50 5.00% 6.00% 9.84%

(11-6) re based on DCF, D1 D1 P0 g F re = D1/(P0 × (1 − F)) + g

79.

Answer: c

$0.80 $22.50 8.00% $0.864 11.84%

D1 P0 g F re = D1/(P0 × (1 − F)) + g = 78.

C I

$2.50 5.50% $52.50 7.50% 40% 45% 55% 4.50% 10.26% 7.67%

(11-7) WACC and target cap. struc.

C I

Tax rate = 40% Debt

Weights 35%

rd 6.50%

AT Costs 3.90%

Preferred Common WACC 82.

10% 55% 100%

6.00% 11.25% 8.15%

(11-3) Taxes and cost of debt

C I

Calculator inputs: N = 2 × 20 PV = Bond's price PMT = Coupon rate × Par/2 FV = Par = Maturity value I/YR Times periods/yr = before-tax cost of debt After-tax cost of debt = r d(1 – T) Difference = Cost at new rate − Cost at old rate =

(11-5) Cost of RE: DCF D0 P0 g D1 = D0 × (1 + g) rs = D1/P0 + g Difference, rs0 − rs1

84.

85.

MEDIUM/HARD

Tax Rate Old rate, 40% New rate 7.00% 7.00% 2 2 20 20 $1,000.00 $1,000.00 40% 30%

Coupon rate Periods/year Maturity (yr) Bond price = Par value Old and New tax rates

83.

Answer: c

40 -$1,000.00 $35.00 -$1,000 3.50% 7.00% 4.20% 0.70%

C I Old Price $0.85 $22.00 6.00% $0.901 10.10% -1.84%

40 -$1,000.00 $35 -$1,000 3.50% 7.00% 4.90%

Answer: c

MEDIUM/HARD

Answer: e

MEDIUM/HARD

New Price $0.85 $40.00 6.00% $0.901 8.25%

(11-7) WACC and market cap. struc.

C I

P0 Shares outstanding (millions) bond coupon rate (not used) YTM = r d rs Tax rate BV debt (millions) BV equity (millions) MV debt (millions) MV equity (millions) = # sh × P0 = AT cost of debt = r d(1−T)

Book value weights-WRONG!!! Capital Weights Cost rates Product Debt $45.00 40.91% 3.60% 1.47% Equity $65.00 59.09% 14.00% 8.27% Total $110.00 100.00% WACC = 9.75%

$22.50 10 7.00% 6.00% 14.00% 40% $45.00 $65.00 $50.00 $225.00 3.60%

(11-5) Risk premium, CAPM, and DCF Bond yield Risk premium rs rRF

7.00% 4.00% 11.00% 5.00%

Market value weights--RIGHT!!! Capital Weights Cost rates Product Debt $50.00 18.18% 3.60% 0.65% Equity $225.00 81.82% 14.00% 11.45% Total $275.00 100.00% WACC = 12.11% Difference = 2.36% C I

Answer: b

HARD

RPM b rs

6.00% 1.25 12.50%

D1 P0 g rs

$1.20 $35.00 8.00% 11.43%

Max Min Difference

12.50% 11.00% 1.50%

86.

(11-6) rs vs. re

C I

Answer: c

HARD

87.

Expected EPS1 $2.75 Payout ratio 70% Current stk price $45.00 g 6.00% F 8.00% D1 $1.925 rs = D1/P0 + g 10.28% re = D1/(P0 × (1 − F)) + g 10.65% Difference = r e – rs 0.37% (11-7) WACC and capital structure

C I

Answer: c

HARD

Tax rate Target wd Target wce Coupon rate YTM = r d rd(1 – T) rs Number of shares (millions) Price per share BV per share Book equity = BV/sh × No. Shs Market equity = P0 × No. Shs Book value of debt (millions) Market value of debt (millions) 88.

BOOK VALUE WEIGHTS Capital Weights Cost rates Debt $25.00 33.33% 4.80% 40% Equity $50.00 66.67% 12.25% 35.00% Total capital $75.00 100.00% WACC = 65.00% 8.50% MARKET VALUE WEIGHTS 8.00% Capital Weights Cost rates 4.80% Debt $27.00 11.89% 4.80% 12.25% Equity $200.00 88.11% 12.25% 10 Total capital $227.00 100.00% WACC = $20.00 TARGET WEIGHTS $5.00 Capital Weights Cost rates $50.00 Debt NA 35.00% 4.80% $200.00 Equity NA 65.00% 12.25% $25.00 Total capital NA 100.00% WACC = $27.00 Sum of the 3 WACCS =

(11-7) WACC and equity from RE Coupon rate Maturity Bond price Par value Tax rate rRF RPM b Weight debt Weight equity Bond yield After-tax cost of debt = r d(1 – T)

C I

8.00% 20 $1,050.00 $1,000 40% 4.50% 5.50% 1.20 35% 65% 7.51% 4.51%

Answer: e

Product 1.60% 8.17% 9.77% Product 0.57% 10.79% 11.36%

Product 1.68% 7.96% 9.64% 30.77% HARD

Cost of equity, r s = rRF + b(RPM) WACC = wd(rd)(1 – T) + wc(rs) = 89.

11.10% 8.79%

(11-7) WACC and equity from RE YTM Tax rate D1 g P0 F Weight debt Weight equity

C I

rRF RPM b Cost of equity, r s = rRF + b(RPM) Project cost of capital = r s + factor Projects' cost

91.

Risk Adder -2.0% -1.0% 0.0% 1.0% 2.0% 2.0% 2.0%

92.

Cap cost 7.56% 8.56% 9.56% 10.56% 11.56% 11.56% 11.56%

7.25% 2 20 $875 $1,000 40%

(11-5) CAPM cost of equity rRF Expected r M RPM = rM − rRF = b rs = r RF + b(RPM)

93.

Answer: a

HARD

4.50% 5.50% 0.92 9.56% varies $25.00 Exp. return Amt Invested 7.60% $25 9.15% $25 10.10% $25 10.40% $0 10.80% $0 10.90% $0 13.00% $25 Total capital budget: $100

(11-2) After-tax cost of debt Coupon rate Periods/year Maturity (yr) Bond price Par value Tax rate

HARD

4.65% 10.81% 8.04%

(11-9) Project risk

A B C D E F G

Answer: d

7.75% 40% $0.65 6.00% $15.00 10.0% 45% 55%

After-tax cost of debt = r d(1 – T) re = D1/(P0 × (1 − F)) + g WACC = wd(rd)(1 – T) + wc(rs) =

90.

C I

(11-7) Weights for WACC

C I

Answer: c

Calculator inputs: N = 2 × Years = PV = -Bond Price = PMT = (Coupon rate × Par)/2 = FV = Par value = Yield = I/YR, which we solve for = Before-tax cost of debt = r d = yield × 2 = After-tax cost of debt = r d(1 − T) = C I

MEDIUM 40 -$875.00 $36.25 $1,000 4.28% 8.57% 5.14%

Answer: d

MEDIUM

Answer: a

MEDIUM

5.50% 11.50% 6.00% 1.25 13.00% C I

Bond price Number of bonds MV of debt = D Stock price = P0 Shares outstanding MV of equity = E Total MV = D + E Weight debt = wd = D/Total MV 94.

(11-7) WACC wd rd(1 – T) wc = 100.00% – wd = rs WACC = wd(rd)(1 – T) + wc(rs) =

$875.00 40,000 $35,000,000 $15.25 10,000,000 $152,500,000 $187,500,000 18.67% C I 18.67% 5.14% 81.33% 13.00% 11.53%

Answer: c

MEDIUM

THE COST OF CAPITAL EXERCISE

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