978-0133423822 Chapter 14 Part 3

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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%

Question Status: Revised

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

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%

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

33) Paramount, Inc. just paid a dividend of $2.05 per share, and the irm 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%

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

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%

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

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

A irm 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 irm 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 indeinitely. The irm’s marginal tax rate is 40%.

The company has no plans to issue new securities.

35) The current total value of the irm is

A) $6,450,000.

B) $5,750,000.

C) $4,950,000.

D) $3,250,000.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: irm value

Principles: Principle 1: Money Has a Time Value

36) The proportion of debt in this irm’s capital structure is

A) 40%.

B) 50%.

C) 60%.

D) 70%.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 1: Money Has a Time Value

37) The after-tax cost of debt is

A) 6.20%.

B) 5.40%.

C) 4.60%.

D) 3.80%.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

38) The after-tax cost of common stock is

A) 14.67%.

B) 13.23%.

C) 12.41%.

D) 11.65%.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

39) The irm’s weighted average cost of capital is

A) 10.47%.

B) 9.29%.

C) 8.63%.

D) 7.71%.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 1: Money Has a Time Value

40) The irm inanced completely with equity capital has a cost of capital equal to the

required return on common stock.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of capital

Principles: Principle 1: Money Has a Time Value

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+.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

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

tax cost of debt is 5.94%.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

43) No adjustment is made in the cost of preferred stock for taxes since preferred stock

dividends are not tax-deductible.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

44) A irm can estimate its cost of debt by inding the yield on bonds issued by other irms

with similar ratings and maturities.

Question Status: New question

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

45) The cost of debt is equal to one minus the marginal tax rate times the coupon rate of

interest on the irm’s outstanding debt.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

46) Assuming an after-tax cost of preferred stock of 12% and a corporate tax rate of 40%, a

irm must earn at least $20 before tax on every $100 invested.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

47) The cost of common equity is already on an after-tax basis since dividends paid to

common stockholders are not tax-deductible.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

48) Because issuing common equity entails less risk to the irm, it is always less expensive

than borrowing.

Question Status: New question

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

49) It is not possible for a irm’s after-tax cost of common equity to be lower than its after-

tax cost of debt.

Question Status: New question

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

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.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

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

common equity.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

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 irm 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?

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

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 inancing?

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

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.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

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?

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

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?

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

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?

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

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?

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

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?

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

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 irm is to remain unchanged?

A) 18.0%

B) 13.0%

C) 10.0%

D) 14.3%

Question Status: Previous edition

Objective: 14.4 Calculate a irm’s weighted average cost of capital.

Keywords: cost of debt

Principles: Principle 2: There Is a Risk–Return Tradeof

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

A) Consider the cost of a speciic source of inancing that will be used for a irm’s new

projects; i.e., the marginal cost of capital.

B) Calculate the weighted average cost of new capital to be utilized in inancing a irm’s

projects.

C) Calculate the irm’s weighted average CAPM to be utilized in inancing a irm’s projects.

D) Calculate the irm’s cost of capital using the historical cost of components.

Question Status: Revised

Objective: 14.4 Calculate a irm’s weighted average cost of capital.

Keywords: cost of capital

Principles: Principle 2: There Is a Risk–Return Tradeof

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 afect 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.

Question Status: Previous edition

Objective: 14.4 Calculate a irm’s weighted average cost of capital.

Keywords: cost of capital

Principles: Principle 2: There Is a Risk–Return Tradeof

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.

Question Status: Previous edition

Objective: 14.4 Calculate a irm’s weighted average cost of capital.

Keywords: opportunity cost

Principles: Principle 2: There Is a Risk–Return Tradeof

5) Tropical Fruit Drinks issued $10,000,000 in bonds to expand its production facilities.

After issuing the bonds, the company was 60% debt inanced and 40% common equity

inanced. 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 ive years, then increase rapidly.

Question Status: Previous edition

Objective: 14.4 Calculate a irm’s weighted average cost of capital.

Keywords: cost of capital

Principles: Principle 2: There Is a Risk–Return Tradeof

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%

Question Status: Previous edition

Objective: 14.4 Calculate a irm’s weighted average cost of capital.

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 2: There Is a Risk–Return Tradeof