978-0134083285 Chapter 9 Part 4

Unlock access to all the studying documents.

View Full Document

29) Office Clean Corporation has a capital structure consisting of 30 percent debt and 70 percent common

equity. Assuming the capital structure is optimal, what amount of total investment can be financed by a

$35 million addition to retained earnings without selling new common stock?

Keywords: Optimal Capital Structure, Total Capital Budget

Learning Obj.: L.O. 9.3

AACSB: Analytical Thinking

30) Last year Gator Getters, Inc. had $50 million in total assets. Management desires to increase its plant

and equipment during the coming year by $12 million. The company plans to finance 40 percent of the

expansion with debt and the remaining 60 percent with equity capital. Bond financing will be at a 9

percent rate and will be sold at its par value. Common stock is currently selling for $50 per share, and

flotation costs for new common stock will amount to $5 per share. The expected dividend next year for

Gator is $2.50. Furthermore, dividends are expected to grow at a 6 percent rate far into the future. The

marginal corporate tax rate is 34 percent. Internal funding available from additions to retained earnings is

$4,000,000.

a. What amount of new common stock must be sold if the existing capital structure is to be maintained?

b. Calculate the weighted marginal cost of capital at an investment level of $12 million.

Keywords: After-tax Cost of Debt, Cost of New Common Stock, Marginal Cost of Capital

Learning Obj.: L.O. 9.3

AACSB: Analytical Thinking

31) A firm‘s capital structure and its target capital structure proportions are important determinants of a

firm’s weighted average cost of capital. Explain.

Keywords: Capital Structure, Cost of Capital

Learning Obj.: L.O. 9.3

AACSB: Reflective Thinking

Learning Objective 9.4

1) Calculating the cost of capital for divisions within a company is not recommended because the data is

too fragmented and all divisions are part of the same company in any case.

Keywords: Divisional Costs of Capital

Learning Obj.: L.O. 9.4

AACSB: Reflective Thinking

2) The after-tax cost of debt is equal to one minus the marginal tax rate times the yield to maturity on the

firm’s outstanding debt.

Keywords: After-tax Cost of Debt, Yield to Maturity

Learning Obj.: L.O. 9.4

AACSB: Reflective Thinking

3) If the before-tax cost of debt is 7% and the firm has a 40% marginal tax rate, the after–tax cost of debt is

2.8%.

Keywords: After-tax Cost of Debt

Learning Obj.: L.O. 9.4

AACSB: Analytical Thinking

4) A firm‘s cost of capital is the required rate of return on the firm‘s average project.

Keywords: Cost of Capital, Required Return

Learning Obj.: L.O. 9.4

AACSB: Reflective Thinking

5) A corporate bond has a face value of $1,000 and a coupon rate of 5%. The bond matures in 15 years and

has a current market price of $925. If the corporation sells more bonds, it will incur flotation costs of $25

per bond. If the corporate tax rate is 35%, what is the after-tax cost of debt capital?

A) 3.74%

B) 4.45%

C) 5.29%

D) 6.78%

Keywords: After-tax Cost of Debt, Flotation Costs, Bond Valuation

Learning Obj.: L.O. 9.4

AACSB: Analytical Thinking

6) A corporate bond has a face value of $1,000 and a coupon rate of 9%. The bond matures in 14 years and

has a current market price of $946. If the corporation sells more bonds, it will incur flotation costs of $26

per bond. If the corporate tax rate is 35%, what is the after-tax cost of debt capital?

A) 5.57%

B) 6.56%

C) 8.18%

D) 7.31%

Keywords: After-tax Cost of Debt, Flotation Costs, Bond Valuation

Learning Obj.: L.O. 9.4

AACSB: Analytical Thinking

7) TC, Inc. has $15 million of outstanding bonds with a coupon rate of 10 percent. The yield to maturity

on these bonds is 12.5 percent. If the firm’s tax rate is 30 percent, what is relevant cost of debt financing to

TC, Inc.?

A) 13.75 percent

B) 8.75 percent

C) 7.00 percent

D) 3.75 percent

Keywords: After-tax Cost of Debt, Yield to Maturity

Learning Obj.: L.O. 9.4

AACSB: Analytical Thinking

8) XRT, Inc. is issuing a $1,000 par value bond that pays 8.5% interest annually. Investors are expected to

pay $1,100 for the 12-year bond. The firm will pay $50 per bond in flotation costs. What is the after-tax

cost of new debt if the firm is in the 35% tax bracket?

A) 8.23%

B) 4.55%

C) 4.70%

D) 7.45%

Keywords: After-tax Cost of Debt, Flotation Costs

Learning Obj.: L.O. 9.4

AACSB: Analytical Thinking

9) All the following variables are used in computing the cost of debt EXCEPT

A) maturity value of the debt.

B) market price of the debt.

C) number of years to maturity.

D) risk-free rate.

Keywords: After-tax Cost of Debt

Learning Obj.: L.O. 9.4

AACSB: Reflective Thinking

10) Blammo, Inc. has a target capital structure of 30% debt and 70% equity. The firm is planning to invest

in a project that will necessitate raising new capital. New debt will be issued at a before-tax yield of 14%,

with a coupon rate of 10%. The equity will be provided by internally generated funds so no new outside

equity will be issued. If the required rate of return on the firm‘s stock is 22% and its marginal tax rate is

35%, compute the firm’s cost of capital.

A) 18.00%

B) 18.13%

C) 19.68%

D) 15.55%

Keywords: Weighted Average Cost of Capital, After-tax Cost of Debt

Learning Obj.: L.O. 9.4

AACSB: Analytical Thinking

11) Donner, Inc. will finance a proposed investment by issuing new securities while maintaining its

optimal capital structure of 60% debt and 40% equity. The firm can issue bonds at a price of $950.00

before $15 flotation costs. The 10-year bonds will have an annual coupon rate of 8% and a face value of

$1,000. The company can issue new equity at a before-tax cost of 16% and its marginal tax rate is 34%.

What is the appropriate cost of capital to use in analyzing this project?

A) 3.63%

B) 8.77%

C) 9.97%

D) 11.81%

Keywords: After-tax Cost of Debt, Cost of New Common Stock, Weighted Average Cost of Capital

Learning Obj.: L.O. 9.4

AACSB: Analytical Thinking

12) QRM, Inc.‘s marginal tax rate is 35%. It can issue 10-year bonds with an annual coupon rate of 7% and

a par value of $1,000. After $12 per bond flotation costs, new bonds will net the company $966 in

proceeds. Determine the appropriate after-tax cost of new debt for the firm to use in a capital budgeting

analysis.

A) 2.62%

B) 4.87%

C) 7.50%

D) 7.8%

Keywords: After-tax Cost of Debt, Flotation Costs

Learning Obj.: L.O. 9.4

AACSB: Analytical Thinking

13) Valley Flights, Inc. has a capital structure made up of 40% debt and 60% equity and a tax rate of 30%.

A new issue of $1,000 par bonds maturing in 20 years can be issued with a coupon of 9% at a price of

$1,098.18 with no flotation costs. The firm has no internal equity available for investment at this time, but

can issue new common stock at a price of $45. The next expected dividend on the stock is $2.70. The

dividend for the firm is expected to grow at a constant annual rate of 5% per year indefinitely. Flotation

costs on new equity will be $7.00 per share. The company has the following independent investment

projects available:

Project

Initial Outlay

IRR

$100,000

10%

$10,00

8.5%

$50,000

12.5%

Which of the above projects should the company take on?

A) Project 3 only

B) Projects 1 and 2

C) Projects 1 and 3

D) Projects 1, 2 and 3

Keywords: Optimal Capital Budget, After-tax Cost of Debt, Cost of New Common Stock

Learning Obj.: L.O. 9.4

AACSB: Analytical Thinking

14) Mountain Retreat and Resort is undergoing a major expansion. The expansion will be financed by

issuing new 15-year, $1,000 par, 9% annual coupon bonds. The market price of the bonds is $1,070 each.

The firm’s flotation expense on the new bonds will be $50 per bond. The firm’s marginal tax rate is 35%.

What is the relevant cost of the new bonds for capital budgeting purposes?

A) 5.14%

B) 5.69%

C) 8.45%

D) 4.82%

Keywords: After-tax Cost of Debt

Learning Obj.: L.O. 9.4

AACSB: Analytical Thinking

15) Using the weighted average cost of capital as the required rate of return for every project will

A) cause a firm to reject projects that should have been accepted.

B) cause a firm to accept projects that were too risky.

C) result in maximization of shareholder wealth.

D) A and B above

Keywords: Weighted Average Cost of Capital, Accept/Reject Decision

Learning Obj.: L.O. 9.4

AACSB: Analytical Thinking

16) Why should firms that own and operate multiple businesses that have different risk characteristics

use business-specific, or divisional costs of capital?

A) Not all divisions have equal risk and the firm might accept projects whose returns are higher than are

deemed appropriate.

B) Not all business divisions have equal risk and the firm will likely become less risky in the future.

C) Not all lines of business have equal risk and it is likely that the firm will accept projects whose returns

are unacceptably low in relation to the risk involved.

D) Use of the same weighted average cost of capital for all divisions may result in too much money being

allocated to the least risky division.

Keywords: Divisional Costs of Capital, Weighted Average Cost of Capital

Learning Obj.: L.O. 9.4

AACSB: Reflective Thinking

17) Texas Transport has five possible investment projects for the coming year. Each project is indivisible.

They are:

Project

Investment (million)

IRR

18%

$10

15%

20%

12%

24%

The firm’s weighted marginal cost of capital schedule is 12 percent for up to $6 million of investment; 16

percent for between $6 million and $18 million of investment; and above $18 million the weighted cost of

capital is 18 percent. The optimal capital budget is

A) $12 million.

B) $18 million.

C) $23 million.

D) $28 million.

Keywords: Weighted Average Cost of Capital, Optimal Capital Budget

Learning Obj.: L.O. 9.4

AACSB: Analytical Thinking

18) What are the implications for a firm’s capital investment decisions of using a company-wide cost of

capital when the firm has multiple operating divisions that have unique risk attributes and capital costs?

Keywords: Divisional Costs of Capital, Weighted Average Cost of Capital

Learning Obj.: L.O. 9.4

AACSB: Reflective Thinking

19) If a firm has decided to move from a situation in which it uses a company-wide cost of capital to

divisional costs of capital, what problems is it likely to encounter?

Keywords: Divisional Costs of Capital, Weighted Average Cost of Capital

Learning Obj.: L.O. 9.4

AACSB: Reflective Thinking