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.
Topic: 14.5 Estimating Project Costs of Capital
Keywords: project cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
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.
Topic: 14.5 Estimating Project Costs of Capital
Keywords: project cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
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.
Topic: 14.5 Estimating Project Costs of Capital
Keywords: project cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
29
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.
Topic: 14.5 Estimating Project Costs of Capital
Keywords: project cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
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.
Topic: 14.5 Estimating Project Costs of Capital
Keywords: project cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
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.
Topic: 14.5 Estimating Project Costs of Capital
Keywords: project cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
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).
Topic: 14.5 Estimating Project Costs of Capital
Keywords: divisional cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
30
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.
Topic: 14.5 Estimating Project Costs of Capital
Keywords: divisional cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
9) Which of the following is NOT a good reason to use divisional costs of capital?
A) Divisional costs of capital require less time and effort to estimate than individual project costs
of capital.
B) Divisional costs of capital reduce the latitude of divisional managers in deciding which
projects to accept.
C) Divisional costs of capital reflect differences in the systematic risk of projects evaluated by
different divisions.
D) Divisional costs of capital may be estimated by comparing divisions to the most similar free
standing companies which may have different capital structures.
Topic: 14.5 Estimating Project Costs of Capital
Keywords: divisional cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
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.
Topic: 14.5 Estimating Project Costs of Capital
Keywords: divisional cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
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.
Topic: 14.5 Estimating Project Costs of Capital
Keywords: cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
31
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.
Topic: 14.5 Estimating Project Costs of Capital
Keywords: cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
13) Using a firm’s overall cost of capital to evaluate divisional projects can lead to the rejection
of good investments in low-risk divisions and the acceptance of poor projects in high-risk
divisions.
Topic: 14.5 Estimating Project Costs of Capital
Keywords: project cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
14) 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.
Topic: 14.5 Estimating Project Costs of Capital
Keywords: divisional cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
32
15) 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.
Topic: 14.5 Estimating Project Costs of Capital
Keywords: divisional cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
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%
Topic: 14.6 Floation Costs and Project NPV
Keywords: flotation costs
Principles: Principle 3: Cash Flows Are the Source of Value
33
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%
Topic: 14.6 Floation Costs and Project NPV
Keywords: project cost of capital
Principles: Principle 3: Cash Flows Are the Source of Value
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
Topic: 14.6 Floation Costs and Project NPV
Keywords: flotation costs
Principles: Principle 3: Cash Flows Are the Source of Value
4) Stonehedge Dairy will expand its organic yogurt production capacity at a cost of $10,000,000.
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
Topic: 14.6 Floation Costs and Project NPV
Keywords: flotation costs
Principles: Principle 3: Cash Flows Are the Source of Value
34
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.
Topic: 14.6 Floation Costs and Project NPV
Keywords: flotation costs
Principles: Principle 3: Cash Flows Are the Source of Value
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
Topic: 14.6 Floation Costs and Project NPV
Keywords: flotation costs
Principles: Principle 3: Cash Flows Are the Source of Value
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
Topic: 14.6 Floation Costs and Project NPV
Keywords: flotation costs
Principles: Principle 3: Cash Flows Are the Source of Value
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
Topic: 14.6 Floation Costs and Project NPV
Keywords: flotation costs
Principles: Principle 3: Cash Flows Are the Source of Value
35
9) Flotation costs increase the amount of funds that must be raised to finance an investment.
Topic: 14.6 Floation Costs and Project NPV
Keywords: flotation costs
Principles: Principle 3: Cash Flows Are the Source of Value
10) Flotation costs are usually ignored when computing the NPV of projects financed with newly
issued securities.
Topic: 14.6 Floation Costs and Project NPV
Keywords: flotation costs
Principles: Principle 3: Cash Flows Are the Source of Value
11) All capital projects incur flotation costs, no matter how they are financed.
Topic: 14.6 Floation Costs and Project NPV
Keywords: flotation costs
Principles: Principle 3: Cash Flows Are the Source of Value
12) 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?
Topic: 14.6 Floation Costs and Project NPV
Keywords: flotation costs
Principles: Principle 3: Cash Flows Are the Source of Value
36