978-0133507676 Chapter 13 Part 3

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Explanation: A) 9.0% × (1 – 0.35) = 5.9%

Dif: 1 Var: 50+

Skill: Analytical

AACSB Objective: Analytic Skills

Author: WC

Question Status: Previous Edition

35) The after-tax cost of debt ________ the before-tax cost of debt for a irm that has a

positive marginal tax rate.

A) is always greater than

B) is always equal to

C) is always less than

D) may be greater than or less than

AACSB Objective: Relective Thinking Skills

Author: WC

Question Status: Previous Edition

36) Is it incorrect to use the coupon rate of debt toward cost of debt?

AACSB Objective: Analytic Skills

Author: SS

Question Status: Previous Edition

37) What is the diference between the efective cost of debt and the cost of debt?

AACSB Objective: Analytic Skills

Author: SS

Question Status: Previous Edition

38) Should a irm with high retained earnings have a lower cost of equity?

AACSB Objective: Analytic Skills

Author: SS

Question Status: Previous Edition

39) Among the two models Constant Dividend Growth Model (CDGM) and Capital Asset

Pricing Model (CAPM), which is a better method for computation of the cost of equity?

AACSB Objective: Analytic Skills

Author: SS

Question Status: Previous Edition

40) Which of the three costs—debt, preferred stock and common equity—is most diicult to

estimate?

AACSB Objective: Analytic Skills

Author: SS

Question Status: Previous Edition

13.3 A Second Look at the Weighted Average Cost of Capital

1) The WACC does not depend on the risk of a company’s line of business.

AACSB Objective: Analytic Skills

Author: KB

Question Status: Previous Edition

2) Assume Time Warner shares have a market capitalization of $40 billion. The company is

expected to pay a dividend of $0.25 per share and each share trades for $40. The growth

rate in dividends is expected to be 7% per year. Also, Time Warner has $20 billion of debt

that trades with a yield to maturity of 9%. If the irm’s tax rate is 40%, what is the WACC?

A) 5.85%

B) 6.54%

C) 6.88%

D) 7.57%

AACSB Objective: Analytic Skills

Author: KB

Question Status: Previous Edition

3) Assume Time Warner shares have a market capitalization of $60 billion. The company is

expected to pay a dividend of $0.30 per share and each share trades for $40. The growth

rate in dividends is expected to be 7% per year. Also, Time Warner has $20 billion of debt

that trades with a yield to maturity of 8%. If the irm’s tax rate is 35%, compute the WACC?

A) 6.05%

B) 6.40%

C) 6.76%

D) 7.11%

AACSB Objective: Analytic Skills

Author: KB

Question Status: Previous Edition

4) Assume Time Warner shares have a market capitalization of $65 billion. The company

just paid a dividend of $0.40 per share and each share trades for $25. The growth rate in

dividends is expected to be 7.00% per year. Also, Time Warner has $10 billion of debt that

trades with a yield to maturity of 7%. If the irm’s tax rate is 40%, compute the WACC?

A) 7.70%

B) 8.11%

C) 8.92%

D) 9.33%

AACSB Objective: Analytic Skills

Author: KB

Question Status: Previous Edition

5) Assume the market value of Fords’ equity, preferred stock, and debt are$6 billion, $2

billion, and $13 billion, respectively. Ford has a beta of 1.7, the market risk premium is 8%,

and the risk-free rate of interest is 3%. Ford’s preferred stock pays a dividend of $4 each

year and trades at a price of $30 per share. Ford’s debt trades with a yield to maturity of

8.0%. What is Ford’s weighted average cost of capital if its tax rate is 30%?

A) 9.95%

B) 9.48%

C) 10.43%

D) 11.38%

AACSB Objective: Analytic Skills

Author: KB

Question Status: Previous Edition

6) Assume the market value of Fords’ equity, preferred stock and debt are $6 billion, $3

billion, and $13 billion, respectively. Ford has a beta of 1.7, the market risk premium is 8%,

and the risk-free rate of interest is 3%. Ford’s preferred stock pays a dividend of $2.50 each

year and trades at a price of $30 per share. Ford’s debt trades with a yield to maturity of

9.5%. What is Ford’s weighted average cost of capital if its tax rate is 35%?

A) 9.78%

B) 10.24%

C) 9.31%

D) 11.18%

AACSB Objective: Analytic Skills

Author: KB

Question Status: Previous Edition

7) Assume the market value of Fords’ equity, preferred stock and debt are $7 billion, $4

billion and $10 billion respectively. Ford has a beta of 1.4, the market risk premium is 6%

and the risk-free rate of interest is 4%. Ford’s preferred stock pays a dividend of $3 each

year and trades at a price of $25 per share. Ford’s debt trades with a yield to maturity of

8.5%. What is Ford’s weighted average cost of capital if its tax rate is 35%?

A) 7.69%

B) 8.15%

C) 8.60%

D) 9.05%

AACSB Objective: Analytic Skills

Author: KB

Question Status: Previous Edition

8) When calculating the WACC, it is a standard practice to subtract ________ to compute the

net debt outstanding.

A) equity

B) dividends

C) cash and risk-free securities

D) coupons

AACSB Objective: Analytic Skills

Author: KB

Question Status: Previous Edition

9) Many inancial managers use market risk premiums that are closer to 5%, which is lower

than historical averages, because ________.

A) the return investors require as compensation for taking on the risk of investing in equity

markets has diminished over a period of time

B) investors require a higher risk premium for holding risky securities than in the past

C) investors require a supernormal risk premium for holding risky securities as compared

with the past

D) investors require the same premium for holding risky securities as in the past

AACSB Objective: Analytic Skills

Author: KB

Question Status: Revised

10) When corporate tax rates decline, the net cost of debt inancing ________.

A) decreases

B) is unchanged

C) increases

D) doubles

AACSB Objective: Analytic Skills

Author: KB

Question Status: Previous Edition

11) Assume Ford Motor Company is discussing new ways to recapitalize the irm and raise

additional capital. Its current capital structure has a 25% weight in equity, 10% in

preferred stock, and 65% in debt. The cost of equity capital is 13%, the cost of preferred

stock is 9%, and the pretax cost of debt is 8%. What is the weighted average cost of capital

for Ford if its marginal tax rate is 40%?

A) 6.91%

B) 7.27%

C) 8.00%

D) 8.36%

AACSB Objective: Analytic Skills

Author: KB

Question Status: Revised

12) Assume Ford Motor Company is discussing new ways to recapitalize the irm and raise

additional capital. Its current capital structure has a 30% weight in equity, 15% in

preferred stock, and 55% in debt. The cost of equity capital is 16%, the cost of preferred

stock is 11%, and the pretax cost of debt is 8%. What is the weighted average cost of

capital for Ford if its marginal tax rate is 40%?

A) 9.09%

B) 9.54%

C) 10.00%

D) 10.45%

AACSB Objective: Analytic Skills

Author: KB

Question Status: Revised

13) Assume Ford Motor Company is discussing new ways to recapitalize the irm and raise

additional capital. Its current capital structure has a 10% weight in equity, 20% in

preferred stock, and 70% in debt. The cost of equity capital is 16%, the cost of preferred

stock is 10%, and the pretax cost of debt is 8%. What is the weighted average cost of

capital for Ford if its marginal tax rate is 40%?

A) 6.61%

B) 6.96%

C) 7.31%

D) 7.66%

AACSB Objective: Analytic Skills

Author: KB

Question Status: Revised

14) Assume JUP has debt with a book value of $20 million, trading at 120% of par value.

The bonds have a yield to maturity of 7%. The irm’s book value of equity is $16 million,

and it has 2 million shares trading at $19 per share. The irm’s cost of equity is 12%. What

is JUP’s WACC if the irm’s marginal tax rate is 35%?

A) 10.03%

B) 9.12%

C) 9.57%

D) 7.29%

AACSB Objective: Analytic Skills

Author: WC

Question Status: Previous Edition

15) Holding everything else constant, an increase in cash ________ a irm’s net debt.

A) will decrease

B) will have no impact on

C) will increase

D) may increase or decrease

AACSB Objective: Analytic Skills

Author: WC

Question Status: Previous Edition

16) What type of adjustment to debt is in practice?

AACSB Objective: Analytic Skills

Author: SS

Question Status: Previous Edition

13.4 Using the WACC to Value a Project

1) When a irm is evaluating the purchase of a business that is unrelated to its current

business, it is appropriate to use the current WACC of the irm that is purchasing the

business.

AACSB Objective: Analytic Skills

Author: KB

Question Status: Previous Edition

2) Assume General Motors has a weighted average cost of capital of 9%. GM is considering

investing in a new plant that will save the company $20 million over each of the irst two

years, and then $10 million each year thereafter. If the investment is $100 million, what is

the net present value (NPV) of the project?

A) $25.8 million

B) $31.6 million

C) $28.7 million

D) $27.3 million

AACSB Objective: Analytic Skills

Author: KB

Question Status: Previous Edition

3) Assume General Motors has a weighted average cost of capital of 10%. GM is

considering investing in a new plant that will save the company $30 million over each of

the irst two years, and then $15 million each year thereafter. If the investment is $150

million, what is the net present value (NPV) of the project?

A) $18.2 million

B) $20.8 million

C) $23.4 million

D) $26.0 million

AACSB Objective: Analytic Skills

Author: KB

Question Status: Previous Edition