Financial Management (Chapter 14: The Cost of Capital)

14.1   The Cost of Capital: An Overview

1) In order to maximize firm value, management should invest in new assets when cash flows from the assets are discounted at the firm's ________ and result in a positive NPV.

A) cost of capital

B) cost of debt used to finance the project

C) rate of return on equity

D) internal rate of return

2) The investor's required rate of return differs from the firm's cost of capital due to the

A) firm's beta.

B) tax deductible of interest.

C) CAPM.

D) time value of money.

3) The weights used to determine the relative importance of the firm's sources of capital should reflect

A) book values in accord with generally accepted accounting principles.

B) current market values for bonds, common stock, and preferred stock and book values for retained earnings.

C) current market values.

D) subjective adjustments for firm risk.

4) Which of the following best describes a firm's cost of capital?

A) The average yield to maturity on debt

B) The average cost of the firm's assets

C) The rate of return that must be earned on its investments in order to satisfy the firm's investors

D) The coupon rate on preferred stock

5) A firm's capital structure consists of which of the following?

A) Common stock

B) Preferred stock

C) Bonds

D) All of the above

6) Which of the following must be adjusted for the firm's tax rate when estimating the weighted average cost of capital WACC?

A) Cost of common equity

B) Cost of preferred stock

C) Cost of debt

D) All of the above

7) For tax purposes, interest on corporate debt is

A) deductible for the investor, but not for the borrower.

B) deductible for the borrower, but not for the investor.

C) fully taxable for both the borrower and the investor.

D) fully deductible for both the borrower and the investor.

8) Which of the following reasons causes bonds to be a less expensive form of capital for a public firm than the issuance of common stock? Bondholders

A) bear less risk than common stockholders bear.

B) have prior voting rights over common stockholders.

C) receive greater returns than common stockholders.

D) investors pay a lower tax rate on bond interest

9) The cost of capital is

A) the opportunity cost of using funds to invest in new projects.

B) the rate of return the firm must earn on its investments in order to satisfy the required rate of return of the firm's investors.

C) the required rate of return for new capital investments which have typical or average risk.

D) all of the above.

10) Cost of capital is

A) the coupon rate of debt.

B) a minimum rate of return set by the board of directors.

C) the rate of return that must be earned on additional investment if firm value is to remain unchanged.

D) the average cost of the firm's assets.

11) Which of the following is a correct formula for calculating the cost of capital?

A) WACC = weighted after-tax cost of debt + weighted cost of preferred stock + weighted cost of common stock

B) WACC = weighted after-tax cost of debt + weighted after-tax cost of preferred stock + weighted after-tax cost of common stock

C) WACC = (after-tax cost of debt + cost of preferred stock + cost of common stock )/3

D) WACC = weighted cost of debt + weighted cost of preferred stock + weighted cost of common stock

12) The minimum rate of return necessary to attract an investor to purchase or hold a security is called the cost of capital.

Answer:  FALSE

13) The weighted average cost of capital is computed using before-tax costs of each of the sources of financing that a firm uses to finance a project.

Answer:  FALSE

14) When investors increase their required rate of return, the cost of capital increases simultaneously.

Answer:  TRUE

15) The firm should continue to invest in new projects up to the point where the marginal rate of return earned on a new investment equals the marginal cost of new capital.

Answer:  TRUE

16) Business risk reflects the added variability in earnings available to a firm's shareholders.

Answer:  FALSE

17) The after-tax cost of capital is computed by multiplying the before-tax cost of capital by 1 minus the tax rate.

Answer:  FALSE

18) Briefly identify and describe some important uses of a firm's weighted average cost of capital.

Answer:  The WACC is used to establish the value of a firm. If a private equity firm wanted to purchase BJ's Wholesale Club, it would discount BJ's expected cash flows by its estimated cost of capital. The WACC is the starting point for determining the required rate of return on capital expenditures. The WACC is also used in evaluating a firm's performance and determining whether or not it is creating value for its shareholders.

14.2   Determining the Firm's Capital Structure Weights

Use the following information to answer the following question(s).

The following data concerning

Spencer Transgenics' capital structure is available.

$ millions	Book Values	Market Values
Accounts Payable & Accruals	$300
Short-term notes	$150	$150
Long-term debt	$450	$600
Preferred Stock	$75	$150
Common Stock	$600	$1500
Total	$1575	$2400

1) The percentage of common stock in Spencer's weighted average cost of capital is

A) 62.5%.

B) 66.7%.

C) 6.25%.

D) 38.1%.

2) The percentage of debt in Spencer's weighted average cost of capital is

A) 38.1%.

B) 31.25.

C) 25%.

D) 57.14%.

3) The percentage of preferred stock in Spencer's weighted average cost of capital is

A) 5.9%.

B) 62.5%.

C) 4.76%.

D) 6.25%.

Answer:  D

4) The total capital that should be used in computing the weights for Spencer's WACC is

A) $1,275.

B) $2,400.

C) $2,250.

D) $1,575.

5) Which of the following statements is true?

A) The level of general economic conditions will determine whether a firm should utilize an arithmetic average cost of capital or a weighted average cost of capital.

B) A firm should utilize a weighted average cost of capital for evaluating investment decisions rather than an arithmetic average cost of capital.

C) For an average firm that is capitalized with 65% equity, usage of an arithmetic average cost of capital will usually overstate the true cost of capital.

D) All of the above are true.

E) None of the above is true.

6) A firm's weighted marginal cost of capital increases when internal equity financing is exhausted but is unaffected by an increase in the cost of other financing sources.

Answer:  FALSE

7) Capital structure represents the mix of equity and interest-bearing debt used by a firm.

Answer:  TRUE

8) When computing a firm's cost of capital, book values should be used be used because they are more objective.

Answer:  FALSE

9) The percentage of debt in the firm's capital structure should be adjusted by multiplying by 1 minus the firm's marginal tax rate.

Answer:  FALSE

10) The amount of debt in the firm's capital structure should include all interest-bearing debt, both long-term and short-term.

Answer:  TRUE

11) Why are market values preferred to book (balance sheet) values when computing a firm's weighted average cost of capital.

Answer:  The balance sheet shows the values of bonds, preferred stock, and common stock when they were issued, which might have been years ago under very different market conditions or when the company was at a different stage in its development. 

The current market values of bonds and stocks allows the company to compute an accurate estimate of investors' required rates of return in the present or near future. In practice, however, book values may be used for debt if the debt is not frequently traded and accurate estimates of market value are hard to obtain.

14.3   Estimating the Cost of Individual Sources of Capital

1) PVE, Inc. has $15 million of debt outstanding with a coupon rate of 9%. Currently, the yield to maturity on these bonds is 7%. If the firm's tax rate is 35%, what is the after-tax cost of debt to J & B?

A) 10.76%

B) 5.85%

C) 4.55%

D) 5.4%

2) The expected dividend is $2.50 for a share of stock priced at $25. What is the cost of common equity if the long-term growth in dividends is projected to be 4%?

A) 10%

B) 8%

C) 14%

D) 18%

3) Sonderson Corporation is undertaking a capital budgeting analysis. The firm's beta is 1.5. The rate on six-month T-bills is 5%, and the return on the S&P 500 index is 12%. What is the appropriate cost of common equity in determining the firm's cost of capital?

A) 13.1%

B) 15.5%

C) 17.7%

D) 19.9%

4) Most firms use Treasury securities with maturities of ________ to determine the appropriate risk-free rate to use in the CAPM.

A) 90 days

B) 180 days

C) 10 years

D) 30 years

5) The cost of preferred stock is equal to

A) the preferred stock dividend divided by market price.

B) the preferred stock dividend divided by its par value.

C) (1 - tax rate) times the preferred stock dividend divided by net price.

D) the preferred stock dividend divided by the net market price.

6) The most expensive source of capital is usually

A) preferred stock.

B) new common stock.

C) debt.

D) retained earnings.

7) When calculating the weighted average cost of capital, which of the following has to be adjusted for taxes?

A) Common stock

B) Retained earnings

C) Debt

D) Preferred stock

8) Which of the following is NOT used to calculate the cost of debt?

A) Face value of the debt

B) Market price of the debt

C) Number of years to maturity

D) Risk-free rate

9) Which of the following is a valid issue in implementing the dividend growth model? The model

A) is too complex to be used to estimate value.

B) does not require an accurate estimate of the rate of growth in future dividends.

C) is based upon the assumption that dividends are expected to grow at a constant rate forever.

D) both A and C.

10) An increase in ________ will increase the cost of common equity.

A) the expected growth rate of dividends

B) the risk-free rate

C) the dividend

D) both A and B

11) Bender and Co. is issuing a $1,000 par value bond that pays 9% interest annually. Investors are expected to pay $918 for the 10-year bond. What is the after-tax cost of debt if the firm is in the 34% tax bracket?

A) 6.83%

B) 9.00%

C) 10.35%

D) 15.68%

12) MTD Inc. has a new bond issue that will net the firm $1,603,500. The bonds have a $1,500,000 par value, pay interest annually at a 6% coupon rate, and mature in 10 years. The firm has a marginal tax rate of 34%. The after-tax cost of the debt issue is

A) 5.1%.

B) 3.37%.

C) 5.6%.

D) 6.58%.

13) Alpha has an outstanding bond issue that has a 7.75% semiannual coupon, a current maturity of 20 years, and sells for $967.97. The firm's income tax rate is 40%. What should Alpha use as an after-tax cost of debt for cost of capital purposes?

A) 2.42%

B) 4.04%

C) 4.85%

D) 8.08%

Use the following information to answer the following question(s).

The current market price of an existing debt issue is $1,125. The bonds have a $1,000 par value, pay interest annually at a 12% coupon rate, and mature in 10 years. The firm has a marginal tax rate of 34%.

14) The before-tax cost of this debt issue is

A) 12%.

B) 7.92%.

C) 9.97%.

D) 13%.

15) The after-tax cost of this debt issue is

A) 7.92%.

B) 6.58%.

C) 12%.

D) 3.39%.

16) Walker & Son is issuing a 10-year, $1,000 par value bond that pays 9% interest annually. The bond is expected to sell for $885. What is Walker & Son's after-tax cost of debt if the firm is in the 34% tax bracket?

A) 7.23%

B) 8.01%

C) 9.15%

D) 10.35%

17) Dublin International Corporation's marginal tax rate is 40%. It can issue three-year bonds with a coupon rate of 8.5% and par value of $1,000. The bonds can be sold now at a price of $938.90 each. Determine the appropriate after-tax cost of debt for Dublin International to use in a capital budgeting analysis.

A) 11.0%

B) 5.2%

C) 6.6%

D) 7.2%

18) Hill Town Motels has $5 million of debt outstanding with a coupon rate of 12%. Currently, the yield to maturity on these bonds is 14%. If the firm's tax rate is 40%, what is the after-tax cost of debt to Hill Town Motels?

A) 5.43%

B) 11.2%

C) 8.4%

D) 5.6%

19) Verigreen Lawn Care products just paid a dividend of $1.85. This dividend is expected to grow at a constant rate of 3% per year, so the next expected dividend is $1.90. The stock price is currently $12.50. New stock can be sold at this price subject to flotation costs of 15%. The company's marginal tax rate is 40%. Compute the cost of common equity.

A) 18.0%

B) 17.8%

C) 18.2%

D) 15.2%

20) Sola Cola Corporation is undertaking a capital budgeting analysis. The rate on 10-year U.S. Treasury bonds is 3.60%, and the return on the S & P 500 index is 11.6%. If the cost of Sola Cola's common equity is 19.6%, calculate their beta.

A) 1.69

B) 5.4

C) 2.0

D) 1.38

21) Pony Corporation is undertaking a capital budgeting analysis. The firm's beta is 1.5. The rate on 10-year U.S. Treasury bonds is 5%, and the return on the S & P 500 index is 12%. What is the cost of Pony's common equity?

A) 13.3%

B) 15.5%

C) 17.7%

D) 19.9%

22) The last paid dividend is $2 for a share of common stock that is currently selling for $20. What is the cost of common equity if the long-term growth rate in dividends for the firm is expected to be 8%?

A) 10.8%

B) 12.8%

C) 14.8%

D) 16.8%

E) 18.8%

Use the following information to answer the following question(s).

Berlioz Inc. is trying to estimate its cost of common equity, and it has the following information. The firm has a beta of 0.90, the before-tax cost of the firm's debt is 7.75%, and the firm estimates that the risk-free rate is 4% while the current market return is 12%. 

Berlioz stock currently sells for $35.00 per share. The firm pays dividends annually and expects dividends to grow at a constant rate of 5% indefinitely. The most recent dividend per share, paid yesterday, is $2.00. Finally, the firm has a marginal tax rate of 34%.

23) The cost of common equity using the dividend-growth model is

A) 11.00%.

B) 11.32%.

C) 11.50%.

D) 11.72%.

24) The cost of common equity using the CAPM is

A) 11.00%.

B) 11.20%.

C) 11.50%.

D) 11.72%.

25) The best estimate of the cost of new common equity is

A) 11.00%.

B) between 11.0% and 11.2%.

C) 11.50%.

D) between 10% and 12%.

26) XYZ Corporation is trying to determine the appropriate cost of preferred stock to use in determining the firm's cost of capital. This firm's preferred stock is currently selling for $29.89 and pays a perpetual annual dividend of $2.60 per share. Compute the cost of preferred stock for XYZ.

A) 7.2%

B) 6.2%

C) 8.7%

D) 16.7%

27) Many corporate finance professionals favor the CAPM for determining the cost of equity. Which of the following is a reason for this preference?

A) The data is less expensive.

B) The variables in the model that apply to public corporations are readily available from public sources.

C) Because the CAPM gives better treatment to flotation costs.

D) The CAPM uses data from the firm's financial statements.

28) In calculating the cost of capital for an average firm, which of the following statements is true?

A) The cost of a firm's bonds is greater than the cost of its common stock.

B) The cost of a firm's preferred stock is greater than the cost of its common stock.

C) The cost of a firm's retained earnings is less than the cost of its bonds.

D) The cost of a firm's common stock is greater than the cost of its bonds.

29) A firm has an issue of preferred stock that pays an annual dividend of $2.00 per share and currently is selling for $18.50 per share. Finally, the firm's marginal tax rate is 34%. This firm's cost of financing with new preferred stock is

A) 10%.

B) 7.13%.

C) 10.81%.

D) 6.6%.

30) The CAPM approach is used to determine the cost of

A) debt.

B) preferred stock.

C) common equity.

D) long term funds.

31) Given the following information, determine the risk-free rate.

Cost of equity                = 12%

Beta                                  = 1.50

Market risk premium = 6%

A) 6.0%

B) 3.0%

C) 9.0%

D) 6.5%

32) Alpha's beta is 1.06, the present T-bond rate is 6%, and the return on the S & P 500 is 15.25%. What is Alpha's cost of common equity using the CAPM approach?

A) 21.25%

B) 15.81%

C) 9.25%

D) 6.32%

33) Paramount, Inc. just paid a dividend of $2.05 per share, and the firm is expected to experience constant growth of 12.50% over the foreseeable future. The common stock is currently selling for $65.90 per share. What is Paramount's cost of retained earnings using the Dividend Growth Model approach?

A) 12.50%

B) 17.90%

C) 16.00%

D) 14.55%

34) The George Company, Inc., has two issues of debt. Issue A has a maturity value of 8 million dollars, a coupon rate of 8%, paid annually, and is selling at par. Issue B was issued as a 15 year bond 5 years ago. Its coupon rate is 9%, paid annually. Investors demand a pre-tax return of 9.3% on this bond. The maturity value of Issue B is 6 million dollars. The George company has a marginal tax rate of 35%. What is the company's after tax cost of debt?

A) 4.73%

B) 5.56%

C) 7.36%

D) 8.47%

Use the following information to answer the following question(s).

A firm currently has the following capital structure which it intends to maintain. Debt: $3,000,000 par value of 9% bonds outstanding with an annual before-tax yield to maturity of 7.67% on a new issue. The bonds currently sell for $115 per $100 par value. 

Common stock: 46,000 shares outstanding currently selling for $50 per share. The firm expects to pay a $5.50 dividend per share one year from now and is experiencing a 3.67% growth rate in dividends, which it expects to continue indefinitely. The firm's marginal tax rate is 40%. The company has no plans to issue new securities.

35) The current total value of the firm is

A) $6,450,000.

B) $5,750,000.

C) $4,950,000.

D) $3,250,000.

36) The proportion of debt in this firm's capital structure is

A) 40%.

B) 50%.

C) 60%.

D) 70%.

37) The after-tax cost of debt is

A) 6.20%.

B) 5.40%.

C) 4.60%.

D) 3.80%.

38) The after-tax cost of common stock is

A) 14.67%.

B) 13.23%.

C) 12.41%.

D) 11.65%.

39) The firm's weighted average cost of capital is

A) 10.47%.

B) 9.29%.

C) 8.63%.

D) 7.71%.

40) The firm financed completely with equity capital has a cost of capital equal to the required return on common stock.

Answer:  TRUE

41) A bond with a Moody's rating of Aaa and an S&P rating of AAA will have a higher required return than a bond with a Moody's rating of Aa1 and an S&P rating of AA+.

Answer:  FALSE

42) If the before-tax cost of debt is 9% and the firm has a 34% marginal tax rate, the after-tax cost of debt is 5.94%.

Answer:  TRUE

43) No adjustment is made in the cost of preferred stock for taxes since preferred stock dividends are not tax-deductible.

Answer:  TRUE

44) A firm can estimate its cost of debt by finding the yield on bonds issued by other firms with similar ratings and maturities.

Answer:  TRUE

45) The cost of debt is equal to one minus the marginal tax rate times the coupon rate of interest on the firm's outstanding debt.

Answer:  FALSE

46) Assuming an after-tax cost of preferred stock of 12% and a corporate tax rate of 40%, a firm must earn at least $20 before tax on every $100 invested.

Answer:  TRUE

47) The cost of common equity is already on an after-tax basis since dividends paid to common stockholders are not tax-deductible.

Answer:  TRUE

48) Because issuing common equity entails less risk to the firm, it is always less expensive than borrowing.

Answer:  FALSE

49) It is not possible for a firm's after-tax cost of common equity to be lower than its after-tax cost of debt.

Answer:  TRUE

50) Explain why the investor's required return on debt is not equal to the corporation's cost of debt, and explain why the investor's required return on equity is not equal to the corporation's cost of equity.

Answer:  Interest expense is a deduction from the firm's taxable income. The firm can deduct interest expense before taxes, thus reducing the firm's tax burden. If a business is in the 34% tax bracket, taxes are reduced by 34 cents for every dollar of interest expense. A 10% interest rate thus become (10% × (1-.34)) or 6.6% after taxes. This causes the after-tax component of debt in the cost of capital to be less than the required return of the firm's creditors.

51) Discuss the primary advantages of the CAPM approach in determining the cost of common equity.

Answer:  There are two primary advantages of using the CAPM approach to determine the cost of common equity. First, the model is simple to understand and implement. The variables for the model are readily available from public sources. Second, the model can be applied to companies that do not pay dividends.

52) Vipsu Corporation plans to issue 10-year bonds with a par value of $1,000 that will pay $55 every six months. The net amount of capital to the firm from the sale of each bond is $840.68. If Vipsu is in the 25% tax bracket, what is the after-tax cost of debt?

Answer:  Find the present value factors that equate

$840.67 = $55(PVIFA, 20, r/2) + $1,000(PVIF, 20, r/2)

r = 0.14

kd = 14(1 - 0.25) = .105 = 10.5%

In this answer the six month rate has been doubled to get 14%. If the investor demands a 6 month rate of 7%, the investor will demand (l.07 squared) - 1 or 14.5%.

53) Moore Financing Corporation has preferred stock in its capital structure paying a dividend of $3.75 and selling for $25.00. If the marginal tax rate for Moore is 34%, what is the after-tax cost of preferred financing?

Answer:  After-tax cost of preferred = $3.75/$25.00 = .15

54) Hoak Company's common stock is currently selling for $50. Last year's dividend was $1.83 per share. Investors expect dividends to grow at an annual rate of 9% into the future.

a.   What is Hoak's cost of common equity?

b.   Selling new common stock is expected to decrease the price of the stock by $5.00. What is the cost of new common stock? Dividends will remain the same.

Answer: 
a.   Kr = [$1.83(1.09)/$50] + 0.09 = 0.13

b.   Ks = [$1.83(1.09)/$50 - $5] + 0.09 = 0.134

55) Toto and Associates' preferred stock is selling for $18.40. The stock pays an annual dividend of $2.21 per share. What is the cost of preferred stock to the company?

Answer:  Kp = $2.21/$18.40 = 12%

56) Sutter Corporation's common stock is selling for $16.80 a share. Last year, Sutter paid a dividend of $.80. Investors are expecting Sutter's dividends to grow at a rate of 5% per year. What is the cost of common equity?

Answer:  Kc = (D1/Po) + 6 = [$80(1.05)/16.80] + .05 = 10%

Alternatively, 16.80 = (.80 × 1.05)/r - .05), so 16.80r - .84 = .84, after we multiply each side of the equation by (r - .05). Adding .84 to each side, we see that 16.80r = 1.68, so r = .10

57) Gibson Industries is issuing a $1,000 par value bond with an 8% semi-annual interest coupon rate and that matures in 11 years. Investors are willing to pay $972 for these bonds. Gibson is in the 34% tax bracket. What will be the after-tax cost of debt of the bond?

Answer:  Using a financial calculator, N = 11 × 2, PV = -972, PMT = 80/2, FV = 1000. Solving for i, we get 4.197% or an annual yield of 8.39%.

After-tax cost of debt = 8.39(1 - .34)

After-tax cost of debt = 5.54%

58) The preferred stock of Wells Co. sells for $15.30 and pays a $1.75 dividend. What is the cost of capital for preferred stock?

Answer: 

Cost of preferred stock = 1.75/15.30

Cost of preferred stock = 11.44%

59) Caribe's common stock sells for $41, and dividends paid last year were $1.18. The dividends and earnings per share are predicted to have a 5% growth rate. What is the cost of common equity for Caribe?

Answer: 

Cost of internal equity = ((1.18(1 .05)/41) + .05

Cost of internal equity = 8.02%

14.4   Summing Up: Calculating the Firm's WACC

1) Based on current market values, Shawhan Supply 's capital structure is 30% debt, 20% preferred stock, and 50% common stock. When using book values, capital structure is 25% debt, 10% preferred stock, and 65% common stock. The required return on each component is: debt—10%; preferred stock—11%; and common stock—18%. The marginal tax rate is 40%. What rate of return must Shawhan Supply earn on its investments if the value of the firm is to remain unchanged?

A) 18.0%

B) 13.0%

C) 10.0%

D) 14.3%

2) Which of the following is the preferred method in estimating a firm's cost of capital?

A) Consider the cost of a specific source of financing that will be used for a firm's new projects; i.e., the marginal cost of capital.

B) Calculate the weighted average cost of new capital to be utilized in financing a firm's projects.

C) Calculate the firm's weighted average CAPM to be utilized in financing a firm's projects.

D) Calculate the firm's cost of capital using the historical cost of components.

3) Capital budgeting analyses typically assume a constant cost of capital, even though the analysts know it will change. One reason for this practice is that

A) the changes are too small to affect the decision.

B) a constant cost of capital is the most conservative assumption.

C) the changes are unpredictable.

D) NPV calculations do not allow more than one discount rate.

4) Reliable Metals plans to issue bonds that will mature in 20 years, will have a semi-annual coupon rate of 7%, and will have a Moody's rating of Aa2. Bonds of other metals companies with similar maturities and ratings currently yield an average of 6.3%.

A) Reliable's bonds will sell at a price to yield about 6.3% because that is the investors' opportunity cost.

B) Reliable's bonds should be priced to yield a rate close to the coupon rate.

C) Reliable's bonds should yield more than 6.3% because they are new.

D) Reliable's bonds should yield less than 6.3% because they are new.

5) Tropical Fruit Drinks issued $10,000,000 in bonds to expand its production facilities. After issuing the bonds, the company was 60% debt financed and 40% common equity financed. Tropical intends to retire 20% of the bonds each year for the next 5 years and not to issue any new debt.

A) All things equal, we would expect Tropical Fruit Drinks cost of capital to decrease gradually over the next 5 years.

B) All things equal, we would expect Tropical Fruit Drinks cost of capital to increase gradually over the next 5 years.

C) All things equal, we would expect Tropical Fruit Drinks cost of capital to stay the same for the next 5 years, then decrease rapidly.

D) All things equal, we would expect Tropical Fruit Drinks cost of capital to stay the same for the next five years, then increase rapidly.

6) Metals Corp. has $2,575,000 of debt, $550,000 of preferred stock, and $18,125,000 of common equity. Metals Corp.'s after-tax cost of debt is 5.25%, preferred stock has a cost of 6.35%, and newly issued common stock has a cost of 14.05%. What is Metals Corp.'s weighted average cost of capital?

A) 12.78%

B) 10.84%

C) 8.32%

D) 6.56%

7) How frequently do most firms update their cost of capital?

A) Rarely, if ever

B) At least once a year

C) Daily

D) Only when there are major changes in the firm's capital structure

8) The highest cost of capital at which a project can reach break-even NPV is the project's

A) component cost of capital.

B) cost of common equity.

C) project-specific cost of capital.

D) internal rate of return.

9) The WACC should be computed using

A) balance sheet weights and target yields.

B) weights based on the firm's ideal capital structure and target yields on debt and equity.

C) market weights and opportunity costs to the firm.

D) market weights and opportunity costs to investors.

10) The opportunity cost of securities issued by a firm is determined by

A) the rate of return investors could earn on riskless securities.

B) the rate of return on the firm's next best investment opportunity.

C) the rate of return investors could obtain on similar securities.

D) the weighted average rate of return on all securities issued by the firm.

11) Which of the following statements regarding calculating a firm's cost of capital is correct?

A) The after-tax cost of debt is generally more expensive than the after-tax cost of preferred stock.

B) Since retained earnings are readily available, the cost of retained earnings is generally lower than the cost of debt.

C) If a company's beta increases, this will increase the cost of capital.

D) The level of general economic conditions will determine whether a firm should utilize an arithmetic average cost of capital or a weighted average cost of capital.

12) A company has a capital structure that consists of 50% debt and 50% equity. Which of the following is generally true?

A) The weighted average cost of capital is less than the cost of equity financing.

B) The cost of equity financing is greater than the cost of debt financing.

C) The weighted average cost of capital is calculated on a before-tax basis.

D) Both A and B.

13) Which of the following circumstances would invalidate the constant cost of capital assumption?

A) the project will be financed entirely with debt.

B) The firm know that it's marginal tax rate will change from 25% to 34% next year.

C) the project will be financed entirely from retained earnings.

D) the price of the company's stock is extremely volatile.

14) A strong stock market and reasonably good earnings have caused the price of the firm's common stock to increase by 25%.

A) This will have no effect on the firm's cost of capital.

B) All thing's equal, this will increase the firm's cost of capital.

C) All thing's equal, this will lower the firm's cost of capital.

D) This will only affect the cost of capital if the firm uses CAPM to compute the cost of equity.

15) The weighted cost of capital assumes that the company maintains a constant debt to equity ratio.

Answer:  TRUE

16) In most instances, as the amount of debt rises, the common stockholders will decrease their required rate of return.

Answer:  FALSE

17) All things equal, as the tax rate increases, the incentive to use more debt financing increases.

Answer:  TRUE

18) As long as the firm issues no new debt, changes in interest rates will have no effect on the cost of capital.

Answer:  FALSE

19) National Gridlock's capital structure consisted of $125 million of debt and $250 million of equity before it issued bonds to borrow an additional $125 million. The new funds will be used to finance infrastructure improvements and expansion. The company believes that the project will generate enough cash to retire 1/5 of the bonds each year. How do the borrowing and the repayment plan affect the discount rate(s) that should be used to evaluate this project?

Answer:  Such a large borrowing will definitely impact National Gridlock's WACC and the discount rate it will use. Increasing the amount of debt from 33% to 50% should, all things equal, lower the company's WACC because of the tax shelter provided by the additional interest expense. Because the company plans to retire the debt over such a short period of time, the WACC should gradually return to about its previous level. 

National Gridlock could discount cash flows from the project at different rates, reflecting its changing cost of capital, or it could use the higher rate based on a capital structure of 1/3 debt and 2/3 equity. Using the higher rate would be conservative and somewhat understate the project's NPV.

20) Why is it important to use market-based weights rather than balance sheet weights when estimating a company's weighted average cost of capital

Answer:  The WACC is supposed to represent the opportunity cost of funds to the investors. A company may have issued bonds years ago when interest rates were either higher or lower. Common stocks also may have been first issued when the company was new and risky and market conditions were very different. These "embedded" costs are irrelevant to the investor who decides to buy or keep the company's bonds and stocks. These investors will be looking only at the rate of return that could be earned on investments of similar risk available today.

14.5   Estimating Project Costs of Capital

1) Pilgrim's WACC is 12%. It has one opportunity to invest in a high risk project with an expected rate of return of 25%. It has another opportunity to lease a building to a government agency. The expected rate of return on the lease is 10%.

A) Pilgrim should definitely accept the high risk project and reject the leasing arrangement.

B) Ideally, Pilgrim would discount the cash flows from each project at a rate appropriate to its risk.

C) Pilgrim should definitely accept both projects.

D) Pilgrim should finance the lease with all debt and the high risk project with all equity.

2) Plimoth Plantation's overall WACC is 11%. It has an opportunity to accept a project that involves nearly riskless cash flows, but will earn only 7%. This project will require a significant portion of the firm's capital. If Plimoth accepts this project

A) the value of the company will fall because it's WACC will fall.

B) the value of the company will fall because it's average rate of return on investments will fall.

C) the value of the company will rise because its WACC will fall.

D) both it's average rate of return and its WACC should fall.

Answer:  D

3) Alio e Olio has restaurants throughout the United States, Canada, and Western Europe. It is considering a proposal to open several restaurants in major cities of India and China.

A) Alio e Olio should use the company's overall WACC to evaluate all proposals.

B) Alio e Olio should use a lower discount rate for new ventures to be sure it does not miss out on opportunities.

C) Alio e Olio should evaluate projects in different regions at discount rates that reflect the risk inherent in those projects.

D) Alio e Olio should adjust the discount rate for specific regions to reflect the specific sources of funding used.

4) In theory using the same discount rate to evaluate all projects can lead to

A) rejection of low risk projects that should be accepted.

B) acceptance of high risk projects that should be rejected.

C) control of efforts by employees with a vested interested in a project to manipulate the discount rate.

D) all of the above.

5) Lott Bros Developers evaluates a great many small to medium size projects each year. Some are riskier than others. Lott Bros should probably

A) allow individual project managers to estimate their own discount rates.

B) try to identify the specific funding sources for each project.

C) use the company's overall WACC for all projects.

D) spend a great deal of time and money to estimate discount rates for each project.

6) Survey literature indicates that separate project costs of capital

A) are used by less than half of major companies.

B) are used by more than 75% of major companies.

C) are used by nearly all major companies.

D) are almost never used by major companies.

7) Estimating a divisional cost of capital by comparing the division to a similar free-standing company is known as

A) Divisional Average Cost of Capital approach (DACC).

B) Segmental Capital Structure approach. (SCS).

C) the "pure play" approach.

D) Project Specific Approach (PSA).

8) The "pure play" approach to estimating a divisions WACC involves

A) computing the value of the division if it were to be spun off as a separate company.

B) comparisons to free standing firms with businesses similar to the division.

C) "deleveraging" the division so that only the cost of equity is considered.

D) using the company's WACC to estimate the value added by the division.

9) Which of the following is a good reason to use divisional costs of capital?

A) Division managers have no vested interest in underestimating the capital costs associated with their division.

B) Divisional costs of capital reduce are relatively easy to estimate.

C) Comparison firms are often engaged in various lines of business.

D) The divisions of a company represent well-defined lines of business with different risk characteristics, for example oil and gas exploration and distribution through pipelines.

10) Large firms are most likely to adjust for differences in the risk levels of investments taken on by different parts of the firm

A) by subjectively adjusting the company's WACC up or down.

B) by estimating individual costs of capital for each individual project.

C) by estimating individual costs of capital for each division or unit of the company.

D) by identifying the specific sources of funding used by each division or unit.

11) The average cost of capital is the appropriate rate to use when evaluating new investments, even though the new investments might be in a higher risk class.

Answer:  FALSE

12) The weighted average cost of capital is the minimum required return that must be earned on additional investment if firm value is to remain unchanged.

Answer:  TRUE

13) Using separate cost of capital estimates for individual projects is not appropriate when the projects are relatively few in number and large in scale.

Answer:  FALSE

14) Using a firm's overall cost of capital to evaluate individual projects creates an incentive for managers to avoid high risk projects with potentially high returns.

Answer:  FALSE

15) Most large firms use individual costs of capital to evaluate all projects.

Answer:  FALSE

16) Tantasqua Paper Products is composed of 3 divisions: industrial paper products, commercial paper products, and a forestry division which grows trees for wood pulp used in the paper-making process. Each of these divisions takes on a large number of projects with differing risk characteristics. Tantasqua now uses a single discount rate based on the company's WACC to evaluate all capital budgeting proposals. Discuss the advantages and disadvantages of this approach.

Answer:  The single discount rate approach minimizes time and effort spent in estimating the required rate of return for projects and divisions. The single rate may be perceived as fair by the division managers and project managers. This approach minimizes the problem of managers attempting to manipulate the discount rate to have their projects accepted.

The biggest disadvantage to this approach is that it may cause Tantasqua to accept projects whose returns are not high enough to justify their risk or on the contrary, reject attractive low risk projects whose returns are below the WACC.

17) Tantasqua Paper Products is composed of 3 divisions: industrial paper products, commercial paper products, and a forestry division which grows trees for wood pulp used in the paper-making process. 

Each of these divisions takes on a large number of projects with differing risk characteristics. Tantasqua now uses a single discount rate based on the company's WACC to evaluate all capital budgeting proposals. Discuss the advantages and disadvantages of switching to an approach based on separate discount rates for each division or even the risk level of each project.

Answer:  Switching to multiple discount rates may lead to better capital budgeting decisions because it matches the discount rate used to the unique risk characteristics of each project or division. Tantasqua would then be less likely to reject good projects that offered relatively low rates of return but with very little risk or to accept projects with too much risk for the rate of return implied by the discount rate.

On the other hand, trying to match discount rates to each individual project might be time consuming and often somewhat subjective. The benefits of such an attempt might not be commensurate with the costs. Using a WACC tailored to each of the three divisions is a more practical approach, but also not without its problems. In particular, it might be difficult to find good free-standing comparable companies needed to implement the "pure play" approach.

14.6   Flotation Costs and Project NPV

1) Jen and Barry's Ice Cream needs $20 million in new capital to expand its production facilities. It will use 40% debt and 60% equity. The company's after-tax cost of debt is 5% and the cost of equity is 12.5%. Flotation costs will be 3% for debt and 9% for equity. Compute Jen and Barry's weighted average flotation cost.

A) 6.6%

B) 6.0%

C) 9.5%

D) 16.1%

2) Jen and Barry's Ice Cream needs $20 million in new capital to expand its production facilities. It will use 40% debt and 60% equity. The company's after-tax cost of debt is 5% and the cost of equity is 12.5%. Flotation costs will be 3% for debt and 9% for equity. What rate should be used to discount the cash flows from the expansion project?

A) 6.6%

B) 6.0%

C) 9.5%

D) 16.1%

3) Jen and Barry's Ice Cream needs $20 million in new capital to expand its production facilities. It will use 40% debt and 60% equity. The company's after-tax cost of debt is 5% and the cost of equity is 12.5%. Flotation costs will be 3% for debt and 9% for equity. What is the total amount of capital that will need to be raised to finance the expansion project?

A) $22,386,000

B) $20,000,000

C) $21,200.000

D) $21,413,276

4) Stonehedge Dairy will expand its organic yogurt production capacity at a cost of $10,000,000. The expansion will increase after-tax operating cash by $1.4 million dollars per year for the next 20 years. Stonehedge's WACC is 10%. To raise the $10,000,000 Stonehedge will need to issue new securities at a weighted average flotation cost of 10%. What is the NPV of the expansion?

A) $918,989

B) $807,878

C) $11,918,989

D) $1,918,989

5) When new capital must be raised for an expansion project, flotation costs should

A) be deducted from the operating cash flows.

B) increase the initial investment outlay.

C) be considered in recomputing the firm's overall WACC.

D) be ignored.

6) Larger issues of new common stock can cause ________ to increase.

A) flotation costs

B) the investor's required rate of return

C) the stock price

D) the tax rate

7) As the size of a financing issue increases, the ________ usually decreases on a percentage basis.

A) cost of equity

B) flotation cost of the issue

C) effective tax rate

D) both A and B

8) The cost of newly issued common stock is greater than the current cost common equity because of

A) capital gains taxes on retained earnings.

B) flotation costs on newly issued common stock.

C) capital gains taxes on newly issued common stock.

D) all of the above

9) Flotation costs

A) have no effect on the project's NPV.

B) increase the firm's cost of capital, but only for the life of the project.

C) increase the initial investment in a project.

D) permanently increase the firm's cost of capital.

10) Flotation costs increase the amount of funds that must be raised to finance an investment.

Answer:  TRUE

11) Flotation costs are usually ignored when computing the NPV of projects financed with newly issued securities.

Answer:  FALSE

12) All capital projects incur flotation costs, no matter how they are financed.

Answer:  FALSE

13) Flotation costs are higher for debt than for equity because debt creates more risk to the issuer.

Answer:  FALSE

14) A project with a positive NPV may have a negative NPV when flotation costs are considered.

Answer:  TRUE

15) Sprite Communications will erect 20 new transmission towers at a total cost of $15,000,000. The expansion will increase after-tax operating cash flows by $2.3 million dollars per year for the next 20 years. Sprite's WACC is 12%. To raise the $15,000,000, Sprite will need to issue new securities at a weighted average flotation cost of 12%. What is the NPV of the expansion?

Answer:  In order to raise $15 million after flotation costs, Sprite will need to raise $15,000,000/(1-.12) = $17,045,455. Using a financial calculator, the PV of the incremental cash flows is N=20, i=12, PMT=2,300,000 and PV=17,179,720. The project's NPV is $17,179,720 - $17,045,455 = $134,265.