61. Which of the following statements is CORRECT?
a.
Since its stockholders are not directly responsible for paying a corporation’s income taxes,
corporations should focus on before-tax cash flows when calculating the WACC.
b.
An increase in a firm’s tax rate will increase the component cost of debt, provided the
YTM on the firm’s bonds is not affected by the change in the tax rate.
c.
When the WACC is calculated, it should reflect the costs of new common stock,
reinvested earnings, preferred stock, long-term debt, short-term bank loans if the firm
normally finances with bank debt, and accounts payable if the firm normally has accounts
payable on its balance sheet.
d.
If a firm has been suffering accounting losses that are expected to continue into the
foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost
of preferred stock to be less than the after-tax cost of debt.
e.
Since the costs of internal and external equity are related, an increase in the flotation cost
required to sell a new issue of stock will increase the cost of reinvested earnings.
62. Which of the following statements is CORRECT? Assume that the firm is a publicly-owned
corporation and is seeking to maximize shareholder wealth.
a.
If a firm’s managers want to maximize the value of their firm’s stock, they should, in
theory, concentrate on project risk as measured by the standard deviation of the project’s
expected future cash flows.
b.
If a firm evaluates all projects using the same cost of capital, and the CAPM is used to
help determine that cost, then its risk as measured by beta will probably decline over time.
c.
Projects with above-average risk typically have higher than average expected returns.
Therefore, to maximize a firm’s intrinsic value, its managers should favor high-beta
projects over those with lower betas.
d.
Project A has a standard deviation of expected returns of 20%, while Project B’s standard
deviation is only 10%. A’s returns are negatively correlated with both the firm’s other
assets and the returns on most stocks in the economy, while B’s returns are positively
correlated. Therefore, Project A is less risky to a firm and should be evaluated with a
lower cost of capital.
e.
If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected
returns on its assets are negatively correlated with the returns on most other firms’ assets.
63. Firm J’s earnings and stock price tend to move up and down with other firms in the S&P 500, while
Firm F’s earnings and stock price move counter cyclically with J and other S&P companies. Both J and
F estimate their costs of equity using the CAPM, they have identical market values, their standard
deviations of returns are identical, and they both finance only with common equity. Which of the
following statements is CORRECT?
a.
J and F should have identical WACCs because their risks as measured by the standard
deviation of returns are identical.
b.
If J and F merge, then the merged firm MW should have a WACC that is a simple average
of J’s and F’s WACCs.
c.
Without additional information, it is impossible to predict what the merged firm’s WACC
would be if J and F merged.
d.
Since J and F move counter cyclically to one another, if they merged, the merged firm’s
WACC would be less than the simple average of the two firms’ WACCs.
e.
J should have the lower WACC because it is like most other companies, and investors like
that fact.
64. Perpetual preferred stock from Franklin Inc. sells for $97.50 per share, and it pays an $8.50 annual
dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of
the price paid by investors. What is the company’s cost of preferred stock for use in calculating the
WACC?
a.
8.72%
b.
9.08%
c.
9.44%
d.
9.82%
e.
10.22%
65. A company’s perpetual preferred stock currently sells for $92.50 per share, and it pays an $8.00 annual
dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of
the issue price. What is the firm’s cost of preferred stock?
a.
7.81%
b.
8.22%
c.
8.65%
d.
9.10%
e.
9.56%
66. Adams Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm’s cost of
common from reinvested earnings based on the CAPM?
a.
11.30%
b.
11.64%
c.
11.99%
d.
12.35%
e.
12.72%
67. You have been hired as a consultant by Feludi Inc.’s CFO, who wants you to help her estimate the cost
of capital. You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30.
Based on the CAPM approach, what is the cost of common from reinvested earnings?
a.
9.67%
b.
9.97%
c.
10.28%
d.
10.60%
e.
10.93%
68. As a consultant to Basso Inc., you have been provided with the following data: D1 = $0.67; P0 =
$27.50; and g = 8.00% (constant). What is the cost of common from reinvested earnings based on the
DCF approach?
a.
9.42%
b.
9.91%
c.
10.44%
d.
10.96%
e.
11.51%
69. To help them estimate the company’s cost of capital, Smithco has hired you as a consultant. You have
been provided with the following data: D1 = $1.45; P0 = $22.50; and g = 6.50% (constant). Based on
the DCF approach, what is the cost of common from reinvested earnings?
a.
11.10%
b.
11.68%
c.
12.30%
d.
12.94%
e.
13.59%
70. Your consultant firm has been hired by Eco Brothers Inc. to help them estimate the cost of common
equity. The yield on the firm’s bonds is 8.75%, and your firm’s economists believe that the cost of
common can be estimated using a risk premium of 3.85% over a firm’s own cost of debt. What is an
estimate of the firm’s cost of common from reinvested earnings?
a.
12.60%
b.
13.10%
c.
13.63%
d.
14.17%
e.
14.74%
71. Bartlett Company’s target capital structure is 40% debt, 15% preferred, and 45% common equity. The
after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of common using reinvested
earnings is 12.75%. The firm will not be issuing any new stock. You were hired as a consultant to help
determine their cost of capital. What is its WACC?
a.
8.98%
b.
9.26%
c.
9.54%
d.
9.83%
e.
10.12%
72. Kenny Electric Company’s noncallable bonds were issued several years ago and now have 20 years to
maturity. These bonds have a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and
has a par value of $1,000. If the firm’s tax rate is 40%, what is the component cost of debt for use in
the WACC calculation?
a.
4.35%
b.
4.58%
c.
4.83%
d.
5.08%
e.
5.33%
73. The Lincoln Company sold a $1,000 par value, noncallable bond several years ago that now has 20
years to maturity and a 7.00% annual coupon that is paid semiannually. The bond currently sells for
$925 and the company’s tax rate is 40%. What is the component cost of debt for use in the WACC
calculation?
a.
4.28%
b.
4.46%
c.
4.65%
d.
4.83%
e.
5.03%
74. To help estimate its cost of common equity, Maxwell and Associates recently hired you. You have
obtained the following data: D0 = $0.90; P0 = $27.50; and g = 7.00% (constant). Based on the DCF
approach, what is the cost of common from reinvested earnings?
a.
9.29%
b.
9.68%
c.
10.08%
d.
10.50%
e.
10.92%
75. As the assistant to the CFO of Johnstone Inc., you must estimate its cost of common equity. You have
been provided with the following data: D0 = $0.80; P0 = $22.50; and g = 8.00% (constant). Based on
the DCF approach, what is the cost of common from reinvested earnings?
a.
10.69%
b.
11.25%
c.
11.84%
d.
12.43%
e.
13.05%
76. Trahern Baking Co. common stock sells for $32.50 per share. It expects to earn $3.50 per share during
the current year, its expected dividend payout ratio is 65%, and its expected constant dividend growth
rate is 6.0%. New stock can be sold to the public at the current price, but a flotation cost of 5% would
be incurred. What would be the cost of equity from new common stock?
a.
12.70%
b.
13.37%
c.
14.04%
d.
14.74%
e.
15.48%
77. You are a finance intern at Chambers and Sons and they have asked you to help estimate the
company’s cost of common equity. You obtained the following data: D1 = $1.25; P0 = $27.50; g =
5.00% (constant); and F = 6.00%. What is the cost of equity raised by selling new common stock?
a.
9.06%
b.
9.44%
c.
9.84%
d.
10.23%
e.
10.64%
78. You were recently hired by Garrett Design, Inc. to estimate its cost of common equity. You obtained
the following data: D1 = $1.75; P0 = $42.50; g = 7.00% (constant); and F = 5.00%. What is the cost of
equity raised by selling new common stock?
a.
10.77%
b.
11.33%
c.
11.90%
d.
12.50%
e.
13.12%
79. Quinlan Enterprises stock trades for $52.50 per share. It is expected to pay a $2.50 dividend at year
end (D1 = $2.50), and the dividend is expected to grow at a constant rate of 5.50% a year. The before-
tax cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of 45% debt and
55% common equity. What is the company’s WACC if all the equity used is from reinvested earnings?
a.
7.07%
b.
7.36%
c.
7.67%
d.
7.98%
e.
8.29%
80. Avery Corporation’s target capital structure is 35% debt, 10% preferred, and 55% common equity. The
interest rate on new debt is 6.50%, the yield on the preferred is 6.00%, the cost of common from
reinvested earnings is 11.25%, and the tax rate is 40%. The firm will not be issuing any new common
stock. What is Avery’s WACC?
a.
8.15%
b.
8.48%
c.
8.82%
d.
9.17%
e.
9.54%
81. Westbrook’s Painting Co. plans to issue a $1,000 par value, 20-year noncallable bond with a 7.00%
annual coupon, paid semiannually. The company’s marginal tax rate is 40.00%, but Congress is
considering a change in the corporate tax rate to 30.00%. By how much would the component cost of
debt used to calculate the WACC change if the new tax rate was adopted?
a.
0.57%
b.
0.63%
c.
0.70%
d.
0.77%
e.
0.85%
82. The CEO of Harding Media Inc. as asked you to help estimate its cost of common equity. You have
obtained the following data: D0 = $0.85; P0 = $22.00; and g = 6.00% (constant). The CEO thinks,
however, that the stock price is temporarily depressed, and that it will soon rise to $40.00. Based on
the DCF approach, by how much would the cost of common from reinvested earnings change if the
stock price changes as the CEO expects?
a.
−1.49%
b.
−1.66%
c.
−1.84%
d.
−2.03%
e.
−2.23%
83. The president and CFO of Spellman Transportation are having a disagreement about whether to use
market value or book value weights in calculating the WACC. Spellman’s balance sheet shows a total
of noncallable $45 million long-term debt with a coupon rate of 7.00% and a yield to maturity of
6.00%. This debt currently has a market value of $50 million. The company has 10 million shares of
common stock, and the book value of the common equity (common stock plus retained earnings) is
$65 million. The current stock price is $22.50 per share; stockholders’ required return, rs, is 14.00%;
and the firm’s tax rate is 40%. The CFO thinks the WACC should be based on market value weights,
but the president thinks book weights are more appropriate. What is the difference between these two
WACCs?
a.
1.55%
b.
1.72%
c.
1.91%
d.
2.13%
e.
2.36%
84. As the winner of a contest, you are now CFO for the day for Maguire Inc. and your day’s job involves
raising capital for expansion. Maguire’s common stock currently sells for $45.00 per share, the
company expects to earn $2.75 per share during the current year, its expected payout ratio is 70%, and
its expected constant growth rate is 6.00%. New stock can be sold to the public at the current price, but
a flotation cost of 8% would be incurred. By how much would the cost of new stock exceed the cost of
common from reinvested earnings?
a.
0.09%
b.
0.19%
c.
0.37%
d.
0.56%
e.
0.84%
85. Granby Foods’ (GF) balance sheet shows a total of $25 million long-term debt with a coupon rate of
8.50%. The yield to maturity on this debt is 8.00%, and the debt has a total current market value of $27
million. The company has 10 million shares of stock, and the stock has a book value per share of
$5.00. The current stock price is $20.00 per share, and stockholders’ required rate of return, rs, is
12.25%. The company recently decided that its target capital structure should have 35% debt, with the
balance being common equity. The tax rate is 40%. Calculate WACCs based on book, market, and
target capital structures. What is the sum of these three WACCs?
a.
28.36%
b.
29.54%
c.
30.77%
d.
32.00%
e.
33.28%
86. To estimate the company’s WACC, Marshall Inc. recently hired you as a consultant. You have
obtained the following information. (1) The firm’s noncallable bonds mature in 20 years, have an
8.00% annual coupon, a par value of $1,000, and a market price of $1,050.00. (2) The company’s tax
rate is 40%. (3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock’s beta is
1.20. (4) The target capital structure consists of 35% debt and the balance is common equity. The firm
uses the CAPM to estimate the cost of common stock, and it does not expect to issue any new shares.
What is its WACC?
a.
7.16%
b.
7.54%
c.
7.93%
d.
8.35%
e.
8.79%
87. Assume that you are an intern with the Brayton Company, and you have collected the following data:
The yield on the company’s outstanding bonds is 7.75%; its tax rate is 40%; the next expected dividend
is $0.65 a share; the dividend is expected to grow at a constant rate of 6.00% a year; the price of the
stock is $15.00 per share; the flotation cost for selling new shares is F = 10%; and the target capital
structure is 45% debt and 55% common equity. What is the firm’s WACC, assuming it must issue new
stock to finance its capital budget?
a.
6.89%
b.
7.26%
c.
7.64%
d.
8.04%
e.
8.44%
88. You have been hired by the CFO of Lugones Industries to help estimate its cost of common equity.
You have obtained the following data: (1) rd = yield on the firm’s bonds = 7.00% and the risk premium
over its own debt cost = 4.00%. (2) rRF = 5.00%, RPM = 6.00%, and b = 1.25. (3) D1 = $1.20, P0 =
$35.00, and g = 8.00% (constant). You were asked to estimate the cost of common based on the three
most commonly used methods and then to indicate the difference between the highest and lowest of
these estimates. What is that difference?
a.
1.13%
b.
1.50%
c.
1.88%
d.
2.34%
e.
2.58%
Exhibit 9.1
The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the
firm’s weighted average cost of capital. The balance sheet and some other information are provided
below.
Assets
Current assets
$ 38,000,000
Net plant, property, and equipment
101,000,000
Total assets
$139,000,000
Liabilities and Equity
Accounts payable
$ 10,000,000
Accruals
9,000,000
Current liabilities
$ 19,000,000
Long-term debt (40,000 bonds, $1,000 par value)
40,000,000
Total liabilities
$ 59,000,000
Common stock (10,000,000 shares)
30,000,000
Retained earnings
50,000,000
Total shareholders’ equity
80,000,000
Total liabilities and shareholders’ equity
$139,000,000
The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year,
7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-
month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return
on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the
past 5 years. The firm’s tax rate is 40%.
89. Refer to Exhibit 9.1. What is the best estimate of the after-tax cost of debt?
a.
4.64%
b.
4.88%
c.
5.14%
d.
5.40%
e.
5.67%
90. Refer to Exhibit 9.1. Based on the CAPM, what is the firm’s cost of common stock?
a.
11.15%
Coupon rate
Periods/year
Maturity (yr)
Bond price
Par value
Tax rate
Calculator inputs:
N = 2 Years =
PV = −Bond Price =
PMT = (Coupon rate Par)/2 =
FV = Par value =
Before-tax cost of debt = rd = yield 2 =
After-tax cost of debt for use in WACC = rd(1 − T) =
b.
11.73%
c.
12.35%
d.
13.00%
e.
13.65%
91. Refer to Exhibit 9.1. Which of the following is the best estimate for the weight of debt for use in
calculating the firm’s WACC?
a.
18.67%
b.
19.60%
c.
20.58%
d.
21.61%
e.
22.69%
92. Refer to Exhibit 9.1. What is the best estimate of the firm’s WACC?
a.
10.85%
b.
11.19%
c.
11.53%
d.
11.88%
e.
12.24%
