Principles of Finance, 6e
Besley/Brigham
Chapter 12
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1. Which of the following is not considered a capital component?
a.
Long-term debt.
b.
Common stock.
c.
Short-term debt.
d.
Preferred stock.
e.
All of the above are considered capital components.
ANSWER:
e
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Capital Components
2. Which of the following is not considered a capital component for the purpose of calculating the weighted average cost
of capital as it applies to capital budgeting?
a.
Long-term debt.
b.
Common stock.
c.
Short-term debt.
d.
Preferred stock.
e.
All of the above are considered capital components for WACC and capital budgeting purposes.
ANSWER:
c
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Capital Components
3. Which of the following statements is most correct?
a.
If a company’s tax rate increases but the yield to maturity of its noncallable bonds remains the same, the
company’s marginal cost of debt capital used to calculate its weighted average cost of capital will fall.
b.
All else equal, an increase in a company’s stock price will increase the marginal cost of retained earnings.
c.
All else equal, an increase in a company’s stock price will increase the marginal cost of issuing new common
equity.
d.
Answers a and b are both correct.
e.
Answers b and c are both correct.
ANSWER:
a
RATIONALE:
The debt cost used to calculate a firm’s WACC is rd(1 − T). If rd remains constant but T
increases, then the term (1 − T) decreases and the value of the entire equation, rd(1 − T),
decreases. Statement b is false; if a company’s stock price increases, and all else
Principles of Finance, 6e
Besley/Brigham
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c.
The cost of debt used in calculating the WACC is an average of the after-tax cost of new debt and of
outstanding debt.
d.
The opportunity cost principle implies that if the firm cannot invest retained earnings and earn at least rs, it
should pay these funds to its stockholders and let them invest directly in other assets that do provide this
return.
e.
The cost of new common equity includes an adjustment for flotation costs that is expressed as a fixed
percentage of the current stock price. The flotation percentage is determined jointly by the current price of the
firm’s stock and its growth rate.
ANSWER:
d
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Component Cost of Capital
9. Typically, according to the text, the MCC schedule is either horizontal or rising, which implies that the cost of capital to
a firm increases as it raises larger and larger amounts of capital. The rising section of MCC schedule
a.
Is caused by economies of scale in financing.
b.
Would be eliminated (that is, the MCC schedule would be horizontal) if the firm retained all of its earnings.
c.
Results from a change in the debt-to-assets ratio as the firm expands.
d.
Occurs because the firm must, if it is to expand, be willing to take on riskier and riskier projects, and this
causes an increase in the cost of capital.
e.
Results from flotation costs associated with the sale of new common and preferred stock, along with higher
debt costs, as the firm’s rate of expansion increases.
ANSWER:
e
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
MCC Schedule
10. Which of the following statements is correct?
a.
Because we often need to make comparisons among firms that are in different income tax brackets, it is best to
calculate the WACC on a before-tax basis.
b.
If a firm has been suffering accounting losses and is expected to continue suffering such losses, and therefore
its tax rate is zero, it is possible that its after-tax component cost of preferred stock as used to calculate the
WACC will be less than its after-tax component cost of debt.
c.
Due to the way the MCC is constructed, the first break point in the MCC schedule must be associated with
using up all available retained earnings and having to issue common stock.
d.
Normally, the cost of external equity raised by issuing new common stock is above the cost of retained
Principles of Finance, 6e
Besley/Brigham
Chapter 12
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earnings. Moreover, the higher the growth rate is relative to the dividend yield, the more the cost of external
equity will exceed the cost of retained earnings.
e.
The lower a company’s tax rate, the greater the advantage of using debt in terms of lowering its WACC.
ANSWER:
b
RATIONALE:
Because corporations can exclude dividends for tax purposes, preferred stock often has
a market return that is less than the issuing company’s cost of debt. Then, if the issuer’s
tax rate is zero, its component cost of preferred would be less than its cost of debt.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Capital Components and WACC
11. Which of the following statements is correct?
a.
Although some methods of estimating the cost of capital encounter severe difficulties, the CAPM is a simple
and reliable model that provides great accuracy and consistency in estimating the cost of capital.
b.
The DCF model is preferred over other models to estimate the cost of equity because of the ease with which a
firm’s growth rate is obtained.
c.
The bond-yield-plus-risk-premium approach to estimating the cost of equity is not always accurate but its
advantages are that it is a standardized and objective model.
d.
The tax savings associated with depreciation are an additional source of capital and, in fact, represent the
largest single source of funds for some firms.
e.
None of the above is a correct statement.
ANSWER:
d
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Cost of Equity Estimation
12. Which of the following statements is correct?
a.
Under normal conditions, the CAPM approach to estimating a firm’s cost of retained earnings gives a better
estimate than the DCF approach.
b.
The CAPM approach is typically used to estimate a firm’s flotation cost adjustment factor, and this factor is
added to the DCF cost estimate.
c.
The risk premium used in the bond-yield-plus-risk-premium method is the same as the one used in the CAPM
method.
d.
In practice (as opposed to in theory), the DCF method and the CAPM method usually produce exactly the
same estimate for rs.
e.
The above statements are all false.
Principles of Finance, 6e
Besley/Brigham
Chapter 12
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ANSWER:
e
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
CAPM Cost of Equity Estimation
13. In applying the CAPM to estimate the cost of equity capital, which of the following elements is not subject to dispute
or controversy?
a.
Expected rate of return on the market, rM.
b.
The stock’s beta coefficient, βi.
c.
Risk-free rate, rRF.
d.
Market risk premium (MRP).
e.
All of the above are subject to dispute.
ANSWER:
e
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
CAPM Cost of Equity Estimation
14. Which of the following statements is correct?
a.
The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund
that project.
b.
The cost of debt used to calculate the weighted average cost of capital is based on an average of the cost of
debt already issued by the firm and the cost of new debt.
c.
One problem with the CAPM approach to estimating the cost of equity capital is that if a firm’s stockholders
are, in fact, not well diversified, beta might be a poor measure of the firm’s true investment risk.
d.
The bond-yield-plus-risk-premium approach is the most sophisticated and objective method of estimating a
firm’s cost of equity capital.
e.
The cost of equity capital is generally easier to measure than the cost of debt, which varies daily with interest
rates, or the cost of preferred stock that is issued infrequently.
ANSWER:
c
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
Principles of Finance, 6e
Besley/Brigham
Chapter 12
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distributed with a certain product or service or otherwise on a password-protected website for classroom use.
negative net income.
d.
The weighted average cost of capital will change whenever a break point occurs.
e.
Answers a and b are both false.
ANSWER:
c
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
WACC and Breakpoints
18. Which of the following statements is most correct?
a.
The weighted average cost of capital for a given capital budget level is a weighted average of the marginal cost
of each relevant component that makes up the firm’s target capital structure.
b.
The weighted average cost of capital is calculated on a before-tax basis.
c.
An increase in the risk-free rate is likely to increase the marginal cost of both debt and equity financing.
d.
Answers a and c are both correct.
e.
All of the above answers are correct.
ANSWER:
d
RATIONALE:
Statements a and c are both correct; therefore, statement d is the correct choice.
Statement a recites the definition of the weighted average cost of capital. Statement c is
correct because rd = rRF + LP + MRP + DRP while rs = rRF + (rM − rRF)βs. If rRF increases
then the values for rd and rs will increase.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
WACC
19. Which of the following statements is most correct?
a.
One purpose of calculating the WACC is to have a singular cost of capital measure that can be applied to
evaluate all of the firm’s projects, including those of greater than and lesser than average risks.
b.
A firm facing a steep demand curve (that is, high flotation costs) for new equity would likely also face, at
some point, a steeply upward sloping WACC curve.
c.
A breakpoint is based on the dollar value used of a specific type of capital, and occurs at the point where the
cost of that capital type increases. Thus, if a firm has $100,000 in earnings, and stockholders want $50,000 of
those earnings paid as dividends, then retained earnings will have two breakpoints.
d.
Answers a and b are both correct.
e.
All of the above are false.
ANSWER:
b
Principles of Finance, 6e
Besley/Brigham
Chapter 12
$1,000,000, what is the WACC for the last dollar of capital the company raises?
e.
9.31%; 9.86%
ANSWER:
b
RATIONALE:
Cost of retained earnings: Cost of new common equity:
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Cost of Equity
29. S. Claus & Company is planning a zero coupon bond issue. The bond has a par value of $1,000, matures in 2 years,
and will be sold at a price of $826.45. The firm’s marginal tax rate is 40 percent. What is the annual after-tax cost of debt
to the company on this issue?
a.
4.0%
b.
6.0%
c.
8.0%
d.
10.0%
e.
12.0%
ANSWER:
b
RATIONALE:
Equation solution: First, find the value of rd as the interest rate which will cause $826.45
to grow to $1,000 in 2 years.
rdT = rd(1 − T) = 0.10(0.6) = 0.06 = 6%. Financial calculator solution: Inputs: N = 2; PMT =
0; PV = −826.45; FV = 1,000. Output: I = 10%. rdT = rd(1 − T) = 0.10(0.6) = 0.06 = 6%.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Zero Coupon Bond
30. Your company’s stock sells for $50 per share, its last dividend (D0) was $2.00, its growth rate is a constant 5 percent,
and the company would incur a flotation cost of 15 percent if it sold new common stock. Net income for the coming year
is expected to be $500,000 and the firm’s payout ratio is 60 percent. The firm’s common equity ratio is 30 percent and it
has no preferred stock outstanding. The firm can borrow up to $300,000 at an interest rate of 7 percent; any additional
debt will have an interest rate of 9 percent. Your company’s tax rate is 40 percent. If the firm has a capital budget of
Principles of Finance, 6e
Besley/Brigham
Chapter 12
a.
3.78%
b.
6.76%
c.
9.94%
d.
11.81%
e.
13.25%
ANSWER:
b
RATIONALE:
BPRE = RE/% Equity = $500,000(0.4)/0.3 = $666,667.
Since the capital budget will be $1 million, and because all equity in the WACC beyond
$666,667 will be external equity, the WACC of the last dollar raised will include equity at
a cost of re. In addition, since the capital budget exceeds the debt break point value,
higher-cost debt will also be included in the WACC.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
WACC
31. Heavy Metal Corp. is a steel manufacturer that finances its operations with 40 percent debt, 10 percent preferred stock,
and 50 percent equity. Its net income is $100 million and it has a payout ratio of 35 percent. The interest rate on the
company’s debt is 11 percent. The preferred stock pays an annual dividend of $2 and sells for $20 a share. The company’s
common stock trades at $30 a share and its current dividend (D0) of $2 a share is expected to grow at a constant rate of 8
percent per year. The flotation cost of external equity is 15 percent of the dollar amount issued, while the flotation cost on
preferred stock is 10 percent. The company estimates that its WACC is 12.30 percent. Assume that the company is raising
$150 million in total capital. What is the company’s tax rate?
a.
30.33%
b.
32.87%
c.
35.75%
d.
38.12%
e.
40.98%
ANSWER:
b
RATIONALE:
Capital structure: 40% D, 10% P, 50% E. WACC = 12.30% (given). rd = 11% (given).
Principles of Finance, 6e
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Chapter 12
TOPICS:
Combining MCC and IOS
a.
$32.0 million
b.
$15.9 million
c.
10.46%
d.
11.54%
e.
12.68%
ANSWER:
b
RATIONALE:
We need to find rps at the point where all 4 projects are accepted. In other words, the
capital budget = $2,000 + $3,000 + $5,000 + $3,000 = $13,000. The WACC at that point
is equal to IRRD = 9.5%.
Step 1:
Find the retained earnings break point to determine whether rs or
re is used in the WACC calculation:
Since the capital budget > the retained earnings break point, re is
used in the WACC calculation.
Step 2:
Calculate r e:
Step 3:
Find rps:
9.5%
= 0.4(10%)(0.65) + 0.2(rps) + 0.4(12.80%)
9.5%
= 2.60% + 0.2(rps) + 5.12%
1.78%
= 0.2rps
8.90%
= rps.
POINTS:
1
DIFFICULTY:
Hard
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c.
$23.0 million
d.
$10.6 million
e.
$26.5 million
ANSWER:
e
RATIONALE:
D/TA = 0.60; E/TA = 0.40. Break points:
There are
five breaks, and therefore, six MCCs. After-tax cost of capital components:
WACC
schedule: WACC1 = (0.4)(0.15) + (0.6)(0.056) = 9.36%. WACC2 = (0.4)(0.15) +
(0.6)(0.0595) = 9.57%. WACC3 = (0.4)(0.1556) + (0.6)(0.0595) = 9.79%. WACC4 =
(0.4)(0.1556) + (0.6)(0.063) = 10.00%. WACC5 = (0.4)(0.1588) + (0.6)(0.063) = 10.13%.
WACC6 = (0.4)(0.1625) + (0.6)(0.063) = 10.28%. The IOS curve in this case is horizontal
at r = 10.25%. Therefore, the WACC will cross the IOS at $26.5 million. This is our capital
budget. At any amount of funds greater than $26.5 million, r will increase to 10.28
percent, which exceeds the expected return of 10.25 percent.
POINTS:
1
DIFFICULTY:
Hard
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-b – 10 min.
TOPICS:
MCC and Optimal Capital Budget
Principles of Finance, 6e
Besley/Brigham
Chapter 12
b.
WACC2 = (0.5)(0.11)(1 − 0.3) + (0.5)(0.1167) = 0.09685 = 9.685%.
34. Takeda Enterprises has four investment opportunities with the following costs (all costs are paid at t = 0) and
estimated internal rates of return (IRR):
Project
Cost
IRR
A
$1,000
15.0%
B
2,000
12.0
C
1,000
10.5
D
3,000
10.0
The company wants to maintain a capital structure of 50 percent debt and 50 percent equity. The company anticipates that
it can issue up to $2,000 of debt at an interest rate of 10 percent; if it issues more than $2,000 of debt its interest rate will
increase to 11 percent. The company’s stock price (P0) is currently $90 per share, its expected dividend ( ) is $6, and its
dividend growth rate is 5 percent. The company expects to have $3,000 in retained earnings and its tax rate is 30 percent.
What percentage flotation cost makes the net present value of accepting Project D zero? (Hint: Project D will be selected
only after Projects A, B, and C have been selected.)
a.
18.77%
b.
22.12%
c.
24.10%
d.
27.33%
e.
30.25%
ANSWER:
b
RATIONALE:
rd = 10% or 11%, depending on debt level;
; WACC:
a.
$0 − $4,000:
WACC1 = (0.5)(0.10)(1 − 0.3) + (0.5)(0.1167) = 0.09335 = 9.335%.
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−$7.704F
= −$1.704
F
= 22.12%.
POINTS:
1
DIFFICULTY:
Hard
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-b – 10 min.
TOPICS:
Flotation and WACC
Gulf Electric Company (GEC)
Gulf Electric Company (GEC) uses only debt and equity in its capital structure. It can borrow unlimited amounts at an
interest rate of 10 percent so long as it finances at its target capital structure, which calls for 55 percent debt and 45
percent common equity. Its last dividend was $2.20; its expected constant growth rate is 6 percent; its stock sells on the
NYSE at a price of $35; and new stock would net the company $30 per share after flotation costs. GEC’s tax rate is 40
percent, and it expects to have $100 million of retained earnings this year. GEC has two projects available: Project A has a
cost of $200 million and a rate of return of 13 percent, while Project B has a cost of $125 million and a rate of return of 10
percent. All of the company’s potential projects are equally risky.
35. Refer to Gulf Electric Company. What is GEC’s cost of equity from newly issued stock?
a.
13.77%
b.
12.66%
c.
13.33%
d.
12.29%
e.
10.00%
ANSWER:
a
RATIONALE:
rd = 10%; rd(1 − T) = 10%(0.6) = 6%. D/A = 55%; D0 = $2.20; g = 6%; P0 = $35; NP =
$35; T = 40%. Retained earnings = $100M;
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Cost of Equity
36. Refer to Gulf Electric Company. Assume now that GEC needs to raise $300 million in new capital. What is GEC’s
marginal cost of capital for evaluating the $300 million in capital projects and any others that might arise during the year?
a.
6.00%
b.
13.77%
c.
12.66%