Principles of Finance, 6e
Besley/Brigham
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d.
9.50%
e.
9.00%
ANSWER:
d
RATIONALE:
WACC1 = 0.55(6%) + 0.45(12.66%) = 9.0%. WACC2 = 0.55(6%) + 0.45(13.77%) = 9.5%.
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:
Marginal Cost of Capital
Global Advertising Company
The Global Advertising Company had net income after interest but before taxes of $40,000 this year. The marginal tax
rate is 40 percent, and the dividend payout ratio is 30 percent. The company can raise debt at a 12 percent interest rate for
any amount of debt less than $8,000. If the firm raises $8,000 or more of debt, a 15 percent interest rate will apply to that
new debt. The last dividend paid by Global was $0.90. Global’s common stock is selling for $8.59 per share, and its
expected growth rate in earnings and dividends is 5 percent. If Global issues new common stock, the flotation cost
incurred will be 10 percent. Global plans to finance all capital expenditures with 30 percent debt and 70 percent equity.
37. Refer to Global Advertising Company. What is Global’s cost of retained earnings?
a.
12.22%
b.
17.22%
c.
10.33%
d.
9.66%
e.
16.00%
ANSWER:
e
RATIONALE:
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 Retained Earnings
38. Refer to Global Advertising Company. What is the cost of common equity raised by selling new stock?
a.
12.22%
b.
17.22%
c.
10.33%
d.
9.66%
e.
16.00%
ANSWER:
b
Principles of Finance, 6e
Besley/Brigham
Chapter 12
Principles of Finance, 6e
Besley/Brigham
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b.
14.1%
c.
16.0%
d.
16.6%
e.
16.9%
ANSWER:
c
RATIONALE:
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: DCF
48. Refer to Rollins Corporation. What is Rollins’ cost of retained earnings using the bond-yield-plus-risk-premium
approach?
a.
13.6%
b.
14.1%
c.
16.0%
d.
16.6%
e.
16.9%
ANSWER:
c
RATIONALE:
Cost of retained earnings (Bond yield plus risk premium approach): rs = 12.0% + 4.0% =
16.0%.
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: Risk Premium
49. Refer to Rollins Corporation. What is Rollins’ lowest WACC?
a.
13.6%
b.
14.1%
c.
16.0%
d.
16.6%
e.
16.9%
ANSWER:
a
RATIONALE:
Lowest WACC:
ra
= wd[rd(1 − T)] + wpsrps + wsrs
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= 0.2[(12.0%)(0.6)] + 0.2(12.6%) + 0.6(16.0%)
= 13.56 ≈ 13.6%.
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:
WACC
50. Refer to Rollins Corporation. What is Rollins’ retained earnings break point?
a.
$600,000
b.
$800,000
c.
$1,000,000
d.
$1,200,000
e.
$1,400,000
ANSWER:
c
RATIONALE:
Retained earnings = 0.6($1,000,000) = $600,000. BPRE = $600,000/0.6 = $1 million.
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:
RE Break Point
51. Refer to Rollins Corporation. What is Rollins’ WACC once it starts using new common stock financing?
a.
13.6%
b.
14.1%
c.
16.0%
d.
16.6%
e.
16.9%
ANSWER:
b
RATIONALE:
WACC = ra = 0.2(12.0%)(0.6) +
0.2(12.6%) + 0.6(16.9%) = 14.1%.
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.
Principles of Finance, 6e
Besley/Brigham
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TOPICS:
WACC Above Break Point
Jackson Company
The Jackson Company has just paid a dividend of $3.00 per share on its common stock, and it expects this dividend to
grow by 10 percent per year, indefinitely. The firm has a beta of 1.50; the risk-free rate is 10 percent; and the expected
return on the market is 14 percent. The firm’s investment bankers believe that new issues of common stock would have a
flotation cost equal to 5 percent of the current market price.
52. Refer to Jackson Company. How much should an investor be willing to pay for this stock today?
a.
$62.81
b.
$70.00
c.
$43.75
d.
$55.00
e.
$30.00
ANSWER:
d
RATIONALE:
rs = 10% + 1.5(4%) = 16%.
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:
Price of Stock
53. Refer to Jackson Company. What will be Jackson’s cost of new common stock if it issues new stock in the
marketplace today?
a.
15.25%
b.
16.32%
c.
17.00%
d.
12.47%
e.
9.85%
ANSWER:
b
RATIONALE:
Cost of new common equity:
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 External Equity
Becker Glass Corporation
Principles of Finance, 6e
Besley/Brigham
Chapter 12
Becker Glass Corporation expects to have earnings before interest and taxes during the coming year of $1,000,000, and it
expects its earnings and dividends to grow indefinitely at a constant annual rate of 12.5 percent. The firm has $5,000,000
of debt outstanding bearing a coupon interest rate of 8 percent, and it has 100,000 shares of common stock outstanding.
Historically, Becker has paid 50 percent of net earnings to common shareholders in the form of dividends. The current
price of Becker’s common stock is $40, but it would incur a 10 percent flotation cost if it were to sell new stock. The
firm’s tax rate is 40 percent.
54. Refer to Becker Glass Corporation. What is the firm’s cost of retained earnings?
a.
15.0%
b.
15.5%
c.
16.0%
d.
16.5%
e.
17.0%
ANSWER:
e
RATIONALE:
EBIT
$1,000,000
Interest
(400,000)
EBT
$ 600,000
Taxes (40%)
(240,000)
Net income
$ 360,000
EPS1 = $360,000/100,000 = $3.60. = $3.60(0.5) = $1.80. rs = ($1.80/$40.00) + 0.125
= 17.0%.
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 Retained Earnings
55. Refer to Becker Glass Corporation. What is Becker’s cost of newly issued stock?
a.
16.0%
b.
16.5%
c.
17.0%
d.
17.5%
e.
18.0%
ANSWER:
d
RATIONALE:
Cost of new common equity:
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Principles of Finance, 6e
Besley/Brigham
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TOPICS:
Cost of External Equity
J. Ross and Sons, Inc.
J. Ross and Sons Inc. has a target capital structure that calls for 40 percent debt, 10 percent preferred stock, and 50 percent
common equity. The firm’s current after-tax cost of debt is 6 percent, and it can sell as much debt as it wishes at this rate.
The firm’s preferred stock currently sells for $90 a share and pays a dividend of $10 per share; however, the firm will net
only $80 per share from the sale of new preferred stock. Ross expects to retain $15,000 in earnings over the next year.
Ross’ common stock currently sells for $40 per share, but the firm will net only $34 per share from the sale of new
common stock. The firm recently paid a dividend of $2 per share on its common stock, and investors expect the dividend
to grow indefinitely at a constant rate of 10 percent per year.
56. Refer to J. Ross and Sons. What is the firm’s cost of retained earnings?
a.
10.0%
b.
12.5%
c.
15.5%
d.
16.5%
e.
18.0%
ANSWER:
c
RATIONALE:
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 Retained Earnings
57. Refer to J. Ross and Sons. What is the firm’s cost of newly issued common stock?
a.
10.0%
b.
12.5%
c.
15.5%
d.
16.5%
e.
18.0%
ANSWER:
d
RATIONALE:
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 External Equity
Principles of Finance, 6e
Besley/Brigham
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58. Refer to J. Ross and Sons. What is the firm’s cost of newly issued preferred stock?
a.
10.0%
b.
12.5%
c.
15.5%
d.
16.5%
e.
18.0%
ANSWER:
b
RATIONALE:
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 Preferred Stock
59. Refer to J. Ross and Sons. Where will a break in the WACC curve occur?
a.
$30,000
b.
$20,000
c.
$10,000
d.
$42,000
e.
There will be no breaks in the WACC curve.
ANSWER:
a
RATIONALE:
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:
Breaks in WACC Curve
60. Refer to J. Ross and Sons. What will be the WACC above this break point?
a.
12.5%
b.
8.3%
c.
10.6%
d.
11.9%
e.
14.1%
ANSWER:
d
Principles of Finance, 6e
Besley/Brigham
Chapter 12
Principles of Finance, 6e
Besley/Brigham
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e.
4.00%
ANSWER:
c
RATIONALE:
Financial calculator solution: Solve for the YTM Inputs: N = 3; PV = +727.25; FV =
−1,000. Output: I = 11.20. Before-tax cost debt of this issue = 11.20%. rdT = 11.20%(1 −
T) = 11.2%(0.6) = 6.72%. Alternate solution using cash flows Inputs: CF0 = 727.25; CF1 =
32.58; CF2 = 36.23; CF3 = −959.71. Output: IRR% = 6.72%.
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:
After-Tax Cost of Debt
63. The ____ is the return that must be earned on invested funds to cover the cost of financing such investments
a.
cost of capital
b.
opportunity cost rate
c.
required rate of return
d.
All of the above.
ANSWER:
d
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-3 – Comprehension
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Cost of Capital
64. An increase in total assets can be financed by an increase in which of the following capital components:
a.
debt
b.
preferred stock
c.
common equity
d.
All of the above
ANSWER:
d
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
65. The expected rate of return on a constant growth stock is equal to the ____ plus its ____.
Principles of Finance, 6e
Besley/Brigham
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a.
risk-free rate; inflation premium
b.
risk-free rate; expected growth rate
c.
dividend yield; risk premium
d.
dividend yield; expected growth rate
ANSWER:
a
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:
Cost of Equity
66. When a firm’s stockholders are not well diversified, the firm’s true investment risk will not be measured by beta and
the CAPM procedure will ____ the correct value of rs.
a.
overstate
b.
accurately predict
c.
understate
d.
none of the above.
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:
CAPM Cost of Equity Estimation
67. What is the best data to use for the growth rate estimate for DCF cost of capital estimates?
a.
Growth in the GDP
b.
Inflation
c.
Historical data
d.
Analyst’s forecasts
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:
DCF Cost of Equity Estimation
68. ____ is the portion of net income not paid out in the form of dividends.
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Besley/Brigham
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a.
Par value
b.
Paid in capital
c.
Retained earnings
d.
Common equity
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:
Retained Earnings
69. The ____ is the dollar value of new capital that can be raised before an increase in the firm’s weighted cost of capital.
a.
marginal cost of capital
b.
inflection point
c.
break even quantity
d.
break point
ANSWER:
d
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:
Breaks in MCC Schedule
70. If the MCC includes five break points, then there will be ____ different WACCs.
a.
2
b.
3
c.
4
d.
5
e.
6
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:
Breaks in WACC Curve
71. Capital refers to items on the right-hand side of a firm’s balance sheet.