978-0134083285 Chapter 9 Part 3

Unlock access to all the studying documents.

View Full Document

68) The cost of common equity financing is more difficult to estimate than the costs of debt and preferred

equity. Explain why.

Keywords: Cost of Capital, Required Rate of Return

Learning Obj.: L.O. 9.2

AACSB: Reflective Thinking

69) What practical problems are encountered in using the CAPM to estimate common equity capital cost?

Keywords: CAPM

Learning Obj.: L.O. 9.2

AACSB: Reflective Thinking

70) When a privately owned company decides to distribute its shares to the general public, it goes

through a process known as an initial public offering (IPO). List and describe at least three advantages

and three disadvantages to having a firm’s shares traded in the public equity market.

Keywords: Initial Public Offering (IPO)

Learning Obj.: L.O. 9.2

AACSB: Reflective Thinking

Learning Objective 9.3

1) A company‘s cost of capital is equal to a weighted average of its investors’ required returns.

Keywords: Cost of Capital, Investors’ Required Returns

Learning Obj.: L.O. 9.3

AACSB: Reflective Thinking

2) A corporation may lower its cost of capital by shifting a portion of its total financing from a higher cost

source of capital, such as common equity, to a lower cost source of capital, such as debt.

Keywords: Weighted Average Cost of Capital

Learning Obj.: L.O. 9.3

AACSB: Reflective Thinking

3) The best financial structure is determined by finding the debt and equity mix that maximizes the firm’s

cost of capital.

Keywords: Optimal Capital Structure, Cost of Capital

Learning Obj.: L.O. 9.3

AACSB: Reflective Thinking

4) If a firm‘s tax rate increases, then its weighted average cost of capital increases also.

Keywords: Cost of Capital, Tax Rate

Learning Obj.: L.O. 9.3

AACSB: Analytical Thinking

5) The average cost of capital is the appropriate rate to use when evaluating new investments, even

though the new investments may be in a higher risk class.

Keywords: Average Cost of Capital, Risk

Learning Obj.: L.O. 9.3

AACSB: Reflective Thinking

6) Once the weighted average cost of capital (WACC) is determined, then all projects of average risk will

be compared to the original WACC regardless of the size of the capital budget.

Keywords: Weighted Average Cost of Capital

Learning Obj.: L.O. 9.3

AACSB: Reflective Thinking

7) The mixture of financing sources used by a firm will vary from year to year, so many firms use target

capital structure proportions when calculating the firm‘s weighted average cost of capital.

Keywords: Weighted Cost of Capital

Learning Obj.: L.O. 9.3

AACSB: Reflective Thinking

8) Using the weighted cost of capital as a cutoff rate assumes that the riskiness of the project being

evaluated is similar to the riskiness of the company‘s existing assets.

Keywords: Weighted Cost of Capital

Learning Obj.: L.O. 9.3

AACSB: Reflective Thinking

9) Using the weighted cost of capital as a cutoff rate assumes that future investments will be financed so

as to maintain the firm’s target degree of financial leverage.

Keywords: Weighted Cost of Capital, Target Capital Structure

Learning Obj.: L.O. 9.3

AACSB: Reflective Thinking

10) The market value weights are preferred when calculating a firm‘s weighted average cost of capital.

Keywords: Market Value Weights, Weighted Average Cost of Capital

Learning Obj.: L.O. 9.3

AACSB: Reflective Thinking

11) A firm‘s weighted average cost of capital is a function of (1) the individual costs of capital, (2) the

capital structure mix, and (3) the level of financing necessary to make the investment.

Keywords: Weighted Average Cost of Capital

Learning Obj.: L.O. 9.3

AACSB: Reflective Thinking

12) A company‘s capital structure mix is based on the proportion of fixed versus variable costs in its

optimal production process.

Keywords: Capital Structure

Learning Obj.: L.O. 9.3

AACSB: Reflective Thinking

13) The firm’s best financial structure is determined by finding the capital structure that minimizes the

firm’s cost of capital.

Keywords: Capital Structure, Cost of Capital

Learning Obj.: L.O. 9.3

AACSB: Reflective Thinking

14) A firm‘s weighted average cost of capital is determined using all of the following inputs EXCEPT

A) the firm’s capital structure.

B) the amount of capital necessary to make the investment.

C) the firm’s after-tax cost of debt.

D) the probability distribution of expected returns.

Keywords: Weighted Average Cost of Capital

Learning Obj.: L.O. 9.3

AACSB: Reflective Thinking

15) Cost of capital is commonly used interchangeably with all of the following terms EXCEPT

A) the firm’s required rate of return.

B) the hurdle rate for new investments.

C) the internal rate of return for new investments.

D) the firm‘s opportunity cost of funds.

Keywords: Cost of Capital, Required Rate of Return, Hurdle Rate, Opportunity Cost of Funds

Learning Obj.: L.O. 9.3

AACSB: Reflective Thinking

16) Baxter Inc. has a target capital structure of 30% debt, 15% preferred stock, and 55% common equity.

The company‘s after-tax cost of debt is 7%, its cost of preferred stock is 11%, its cost of retained earnings is

15%, and its cost of new common stock is 16%. The company stock has a beta of 1.5 and the company‘s

marginal tax rate is 35%. What is the company‘s weighted average cost of capital if retained earnings are

used to fund the common equity portion?

A) 11.20%

B) 12.00%

C) 13.80%

D) 14.45%

Keywords: Weighted Average Cost of Capital

Learning Obj.: L.O. 9.3

AACSB: Analytical Thinking

17) GHJ Inc. is investing in a major capital budgeting project that will require the expenditure of $16

million. The money will be raised by issuing $2 million of bonds, $4 million of preferred stock, and $10

million of new common stock. The company estimates is after-tax cost of debt to be 7%, its cost of

preferred stock to be 9%, the cost of retained earnings to be 14%, and the cost of new common stock to be

17%. What is the weighted average cost of capital for this project?

A) 12.20%

B) 13.12%

C) 13.75%

D) 14.23%

Keywords: Weighted Average Cost of Capital

Learning Obj.: L.O. 9.3

AACSB: Analytical Thinking

18) Coyote Inc. operates three divisions. One division involves significant research and development, and

thus has a high-risk cost of capital of 15%. The second division operates in business segments related to

Coyote’s core business, and this division has a cost of capital of 10% based upon its risk. Coyote’s core

business is the least risky segment, with a cost of capital of 8%. The firm’s overall weighted average cost

of capital of 11% has been used to evaluate capital budgeting projects for all three divisions. This

approach will

A) favor projects in the core business division because that division is the least risky.

B) favor projects in the related businesses division because the cost of capital for this division is the

closest to the firm’s weighted average cost of capital.

C) favor projects in the research and development division because the higher risk projects look more

favorable if a lower cost of capital is used to evaluate them.

D) not favor any division over the other because they all use the same company-wide weighted average

cost of capital.

Keywords: Weighted Average Cost of Capital, Risk-Return Tradeoff

Learning Obj.: L.O. 9.3

AACSB: Analytical Thinking

19) WineCellars Inc. currently has a weighted average cost of capital of 12%. WineCellars has been

growing rapidly over the past several years, selling common stock in each year to finance its growth.

However, due to difficult economic times this year, WineCellars decides to cut its dividend and increase

its retained earnings so that the common equity portion of its capital structure will include only retained

earnings and no new common stock will be sold. WineCellars’ weighted average cost of capital this year

should be

A) zero, since no new stock will be sold.

B) less than 12%.

C) equal to 12%.

D) greater than 12%.

Keywords: Weighted Average Cost of Capital

Learning Obj.: L.O. 9.3

AACSB: Analytical Thinking

20) Beauty Inc. plans to maintain its optimal capital structure of 40 percent debt, 10 percent preferred

stock, and 50 percent common equity indefinitely. The required return on each component source of

capital is as follows: debt—8 percent; preferred stock—12 percent; common equity—16 percent.

Assuming a 40 percent marginal tax rate, what after-tax rate of return must the firm earn on its

investments if the value of the firm is to remain unchanged?

A) 12.40 percent

B) 12.00 percent

C) 11.12 percent

D) 10.64 percent

Keywords: Weighted Average Cost of Capital

Learning Obj.: L.O. 9.3

AACSB: Analytical Thinking

21) The DEF Company is planning a $64 million expansion. The expansion is to be financed by selling

$25.6 million in new debt and $38.4 million in new common stock. The before-tax required rate of return

on debt is 9 percent and the required rate of return on equity is 14 percent. If the company is in the 35

percent tax bracket, what is the firm’s cost of capital?

A) 8.92%

B) 9.89%

C) 11.50%

D) 10.74%

Keywords: Weighted Average Cost of Capital

Learning Obj.: L.O. 9.3

AACSB: Analytical Thinking

22) CrochetCo is considering an investment in a project which would require an initial outlay of $350,000

and produce expected cash flows in years 1-5 of $95,450 per year. You have determined that the current

after-tax cost of the firm’s capital (required rate of return) for each source of financing is as follows:

Cost of Long-Term Debt

Cost of Preferred Stock

11%

Cost of CommonStock

15%

Long-term debt currently makes up 25% of the capital structure, preferred stock 15%, and common stock

60%. What is the net present value of this project?

A) -$9,306

B) $2,149

C) $5,983

D) $11,568

Keywords: Net Present Value, Weighted Average Cost of Capital

Learning Obj.: L.O. 9.3

AACSB: Analytical Thinking

23) For a typical corporation, which of the following capital structures will result in the lowest weighted

average cost of capital?

A) 40% debt, 20% preferred stock, 40% common equity

B) 50% debt, 10% preferred stock, 40% common equity

C) 60% debt, 10% preferred stock, 30% common equity

D) 60% debt, 15% preferred stock, 25% common equity

Keywords: Capital Structure, Weighted Average Cost of Capital

Learning Obj.: L.O. 9.3

AACSB: Analytical Thinking

24) Given the following information on S & G Inc.’s capital structure, compute the company‘s weighted

average cost of capital.

Type of Capital

Percent of Capital

Structure

Before-Tax

Component Cost

Bonds

40%

7.5%

Preferred Stock

11%

Common Stock (Internal Only)

55%

15%

The company‘s marginal tax rate is 40%.

A) 13.3%

B) 7.1%

C) 10.6%

D) 10%

Keywords: Weighted Average Cost of Capital

Learning Obj.: L.O. 9.3

AACSB: Analytical Thinking

25) Kokapeli, Inc. has a target capital structure of 40% debt and 60% common equity, and has a 40%

marginal tax rate. If the firm’s yield to maturity on bonds is 7.5% and investors require a 15% return on

the firm’s common stock, what is the firm’s weighted average cost of capital?

A) 7.20%

B) 10.80%

C) 12.00%

D) 12.25%

Keywords: Weighted Average Cost of Capital

Learning Obj.: L.O. 9.3

AACSB: Analytical Thinking

26) PrimaCare has a capital structure that consists of $7 million of debt, $2 million of preferred stock, and

$11 million of common equity, based upon current market values. The firm’s yield to maturity on its

bonds is 7.4%, and investors require an 8% return on the firm’s preferred and a 14% return on

PrimaCare’s common stock. If the tax rate is 35%, what is PrimaCare’s WACC?

A) 7.21%

B) 8.12%

C) 10.18%

D) 12.25%

Keywords: Weighted Average Cost of Capital, Capital Structure

Learning Obj.: L.O. 9.3

AACSB: Analytical Thinking

27) The average cost associated with each additional dollar of financing for investment projects is

A) the incremental return.

B) the marginal cost of capital.

C) CAPM required return.

D) the component cost of capital.

Keywords: Marginal Cost of Capital

Learning Obj.: L.O. 9.3

AACSB: Reflective Thinking

28) Meacham Corp. wants to issue bonds with a 9% coupon rate, a face value of $1,000, and 12 years to

maturity. Meacham estimates that the bonds will sell for $1,090 and that flotation costs will equal $15 per

bond. Meacham Corp. common stock currently sells for $30 per share. Meacham can sell additional

shares by incurring flotation costs of $3 per share. Meacham paid a dividend yesterday of $4.00 per share

and expects the dividend to grow at a constant rate of 5% per year. Meacham also expects to have $12

million of retained earnings available for use in capital budgeting projects during the coming year.

Meacham’s capital structure is 40% debt and 60% common equity. Meacham’s marginal tax rate is 35%.

a. Calculate the after-tax cost of debt assuming Meacham‘s bonds are its only debt.

b. Calculate the cost of retained earnings.

c. Calculate the cost of new common stock.

d. Calculate the weighted average cost of capital assuming Meacham‘s total capital budget is $30

million.

Keywords: Weighted Average Cost of Capital, Cost of Debt, Cost of Retained Earnings, Cost of New Common Stock,

Capital Structure

Learning Obj.: L.O. 9.3

AACSB: Analytical Thinking