978-0132757089 Chapter 14 Part 3

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49) 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.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

50) Discuss the primary advantages of the CAPM approach in determining the cost of common

equity.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

51) 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?

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

52) 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?

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

53) 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.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

54) 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?

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

55) 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?

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

56) 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?

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

57) 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?

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

58) 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?

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

1) Based on current market values, Shawhan Supply ‘s capital structure is 30% debt, 20%

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%

Topic: 14.4 Summing Up: Calculating the Firm’s WACC

Keywords: cost of debt

Principles: Principle 2: There Is a Risk-Return Tradeoff

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) All of the above are equally acceptable.

Topic: 14.4 Summing Up: Calculating the Firm’s WACC

Keywords: cost of capital

Principles: Principle 2: There Is a Risk-Return Tradeoff

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.

Topic: 14.4 Summing Up: Calculating the Firm’s WACC

Keywords: cost of capital

Principles: Principle 2: There Is a Risk-Return Tradeoff

4) Reliable Metals plans to issue bonds that will mature in 20 years, will have a semi-annual

coupon rate of 7%., and 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.

Topic: 14.4 Summing Up: Calculating the Firm’s WACC

Keywords: opportunity cost

Principles: Principle 2: There Is a Risk-Return Tradeoff

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.

Topic: 14.4 Summing Up: Calculating the Firm’s WACC

Keywords: cost of capital

Principles: Principle 2: There Is a Risk-Return Tradeoff

6) Metals Corp. has $2,575,000 of debt, $550,000 of preferred stock, and $18,125,000 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%

Topic: 14.4 Summing Up: Calculating the Firm’s WACC

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 2: There Is a Risk-Return Tradeoff

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.

Topic: 14.4 Summing Up: Calculating the Firm’s WACC

Keywords: cost of capital

Principles: Principle 2: There Is a Risk-Return Tradeoff

13%. Autumn Leaves stock pays a $1.00 dividend which is expected to grow at about 4% for the

foreseeable future. We would expect Autumn Leaves stock to sell for approximately:

A) $8.33.

B) $25.00.

C) $11.00.

D) $13.00.

Topic: 14.4 Summing Up: Calculating the Firm’s WACC

Keywords: opportunity cost

Principles: Principle 2: There Is a Risk-Return Tradeoff

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.

Topic: 14.4 Summing Up: Calculating the Firm’s WACC

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 2: There Is a Risk-Return Tradeoff

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.

Topic: 14.4 Summing Up: Calculating the Firm’s WACC

Keywords: opportunity cost

Principles: Principle 2: There Is a Risk-Return Tradeoff

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.

Topic: 14.4 Summing Up: Calculating the Firm’s WACC

Keywords: cost of capital

Principles: Principle 2: There Is a Risk-Return Tradeoff

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.

Topic: 14.4 Summing Up: Calculating the Firm’s WACC

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 2: There Is a Risk-Return Tradeoff

13) Assume the following facts about a firm’s financing in the next year, and calculate the

component cost of debt.

Weighted average cost of capital = 11.3%

Proportion debt financing = 45%

Proportion internal equity financing = 55%

Cost of internal equity = 14.0%

Cost of after-tax debt = ?????

A) 7%

B) 8%

C) 9%

D) 10%

Topic: 14.4 Summing Up: Calculating the Firm’s WACC

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 2: There Is a Risk-Return Tradeoff

14) The cost of capital for a firm which uses 45% debt at an after-tax cost of 10% and 55%

common stock at a 15% cost is:

A) 12.25%.

B) 12.50%.

C) 12.75%.

D) 13.00%.

E) 13.25%.

Topic: 14.4 Summing Up: Calculating the Firm’s WACC

Keywords: cost of capital

Principles: Principle 2: There Is a Risk-Return Tradeoff

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

ratio.

Topic: 14.4 Summing Up: Calculating the Firm’s WACC

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 2: There Is a Risk-Return Tradeoff

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

required rate of return.

Topic: 14.4 Summing Up: Calculating the Firm’s WACC

Keywords: opportunity cost

Principles: Principle 2: There Is a Risk-Return Tradeoff

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

Topic: 14.4 Summing Up: Calculating the Firm’s WACC

Keywords: cost of capital

Principles: Principle 2: There Is a Risk-Return Tradeoff

18) As the corporate tax rate increases, the cost of debt to a corporation increases.

Topic: 14.4 Summing Up: Calculating the Firm’s WACC

Keywords: cost of capital

Principles: Principle 2: There Is a Risk-Return Tradeoff

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.

Topic: 14.4 Summing Up: Calculating the Firm’s WACC

Keywords: cost of capital

Principles: Principle 2: There Is a Risk-Return Tradeoff

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

Topic: 14.4 Summing Up: Calculating the Firm’s WACC

Keywords: cost of capital

Principles: Principle 2: There Is a Risk-Return Tradeoff