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Chapter 11: Determining the Cost of Capital
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POINTS:
1
66. 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%
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POINTS:
1
67. 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 gL = 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%
Collins Group
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%.
68. Refer to the data for the Collins Group. 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%
ANSWER:
a
Chapter 11: Determining the Cost of Capital
69. Refer to the data for the Collins Group. 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%
POINTS:
1
70. The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which
has no flotation cost, and reinvested earnings, whose cost is the average return on the assets that are acquired.
a.
True
b.
False
ANSWER:
False
71. The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: "The cost
of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage
flotation cost required to sell the new stock, (1 − F)."
a.
True
b.
False
POINTS:
1
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72. If the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common
stock (re) is equal to the cost of equity capital from retaining earnings (rs) divided by one minus the percentage flotation
cost required to sell the new stock, (1 − F). If the expected growth rate is not zero, then the cost of external equity must be
found using a different formula.
a.
True
b.
False
POINTS:
1
73. The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued
stock): the CAPM method, the dividend growth method, and the bond-yield-plus-risk-premium method. However, only
Chapter 11: Determining the Cost of Capital
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the CAPM method always provides an accurate and reliable estimate.
a.
True
b.
False
ANSWER:
False
74. The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued
stock): the CAPM method, the dividend growth method, and the bond-yield-plus-risk-premium method. Since we cannot
be sure that the estimate obtained with any of these methods is correct, it is often appropriate to use all three methods,
then consider all three estimates, and end up using a judgmental estimate when calculating the WACC.
a.
True
b.
False
ANSWER:
True
75. Which of the following statements is CORRECT?
a.
All else equal, an increase in a company's stock price will increase its marginal cost of reinvested earnings (not
Chapter 11: Determining the Cost of Capital
newly issued stock), rs.
b.
All else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re.
c.
Since the money is readily available, the after-tax cost of reinvested earnings (not newly issued stock) is
usually much lower than the after-tax cost of debt.
d.
If a company's tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of
its debt will fall.
e.
When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock
dividends are deductible by the paying corporation.
ANSWER:
d
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%
POINTS:
1
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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; gL = 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%
POINTS:
1
78. You were recently hired by Garrett Design, Inc. to estimate its cost of common equity. You obtained the following
Chapter 11: Determining the Cost of Capital
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data: D1 = $1.75; P0 = $42.50; gL = 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%
POINTS:
1
79. 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%
Chapter 11: Determining the Cost of Capital
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80. If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in
the CAPM model, we cannot observe its stock price for use in the dividend growth model, and we don't know what the
risk premium is for use in the bond-yield-plus-risk-premium method. All this makes it especially difficult to estimate the
cost of equity for a private company.
a.
True
b.
False
ANSWER:
True
81. Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the
tax rate is 40%. An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).
Chapter 11: Determining the Cost of Capital
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a.
True
b.
False
ANSWER:
False
82. Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets.
They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and
the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted
costs of capital for different capital budgeting projects.
a.
True
b.
False
ANSWER:
True
83. With its current financial policies, Flagstaff Inc. will have to issue new common stock to fund its capital budget. Since
new stock has a higher cost than reinvested earnings, Flagstaff would like to avoid issuing new stock. Which of the
following actions would REDUCE its need to issue new common stock?
a.
Increase the percentage of debt in the target capital structure.
b.
Increase the proposed capital budget.
c.
Reduce the amount of short-term bank debt in order to increase the current ratio.
d.
Reduce the percentage of debt in the target capital structure.
Chapter 11: Determining the Cost of Capital
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e.
Increase the dividend payout ratio for the upcoming year.
ANSWER:
a
84. Burnham Brothers Inc. has no retained earnings since it has always paid out all of its earnings as dividends. This same
situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, and its target
capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its
WACC?
a.
The flotation costs associated with issuing new common stock increase.
b.
The company's beta increases.
c.
Expected inflation increases.
d.
The flotation costs associated with issuing preferred stock increase.
e.
The market risk premium declines.
ANSWER:
e
85. Bloom and Co. has no debt or preferred stock⎯it uses only equity capital, and has two equally-sized divisions.
Chapter 11: Determining the Cost of Capital
Division X's cost of capital is 10.0%, Division Y's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of
Division X's projects are equally risky, as are all of Division Y's projects. However, the projects of Division X are less
risky than those of Division Y. Which of the following projects should the firm accept?
a.
A Division Y project with a 12% return.
b.
A Division X project with an 11% return.
c.
A Division X project with a 9% return.
d.
A Division Y project with an 11% return.
e.
A Division Y project with a 13% return.
ANSWER:
b
86. Taylor Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a
WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C)
should the company accept?
a.
Project C, which is of above-average risk and has a return of 11%.
b.
Project A, which is of average risk and has a return of 9%.
c.
None of the projects should be accepted.
d.
All of the projects should be accepted.
e.
Project B, which is of below-average risk and has a return of 8.5%.
ANSWER:
e
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87. Weatherall Enterprises has no debt or preferred stock⎯it is an all-equity firm⎯and has a beta of 2.0. The chief financial
officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the
market risk premium is 4%. The project being evaluated is riskier than an average project, in terms of both its beta risk
and its total risk. Which of the following statements is CORRECT?
a.
The project should definitely be rejected because its expected return (before risk adjustment) is less than its
required return.
b.
Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly,
this would make the project acceptable regardless of the amount of the adjustment.
c.
The accept/reject decision depends on the firm's risk-adjustment policy. If Weatherall's policy is to increase
the required return on a riskier-than-average project to 3% over rS, then it should reject the project.
d.
Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient
information has been provided to make the accept/reject decision.
e.
The project should definitely be accepted because its expected return (before any risk adjustments) is greater
than its required return.
ANSWER:
c
88. The Anderson Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall
WACC is 12%. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower
rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds
that even though projects have different risks, the WACC used to evaluate each project should be the same because the
company obtains capital for all projects from the same sources. If the CEO's position is accepted, what is likely to happen
over time?
Chapter 11: Determining the Cost of Capital
a.
The company will take on too many low-risk projects and reject too many high-risk projects.
b.
Things will generally even out over time, and, therefore, the firm's risk should remain constant over time.
c.
The company's overall WACC should decrease over time because its stock price should be increasing.
d.
The CEO's recommendation would maximize the firm's intrinsic value.
e.
The company will take on too many high-risk projects and reject too many low-risk projects.
ANSWER:
e
89. Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital
to evaluate all projects for the next 10 years, then the firm will most likely
a.
become less risky over time, and this will maximize its intrinsic value.
b.
accept too many low-risk projects and too few high-risk projects.
c.
become more risky and also have an increasing WACC. Its intrinsic value will not be maximized.
d.
continue as before, because there is no reason to expect its risk position or value to change over time as a
result of its use of a single cost of capital.
e.
become riskier over time, but its intrinsic value will be maximized.
ANSWER:
c
90. The Tierney Group has two divisions of equal size: an office furniture manufacturing division and a data processing
division. Its CFO believes that stand-alone data processor companies typically have a WACC of 9%, while stand-alone
furniture manufacturers typically have a 13% WACC. She also believes that the data processing and manufacturing
divisions have the same risk as their typical peers. Consequently, she estimates that the composite, or corporate, WACC is
11%. A consultant has suggested using a 9% hurdle rate for the data processing division and a 13% hurdle rate for the
manufacturing division. However, the CFO disagrees, and she has assigned an 11% WACC to all projects in both
divisions. Which of the following statements is CORRECT?
a.
The decision not to adjust for risk means, in effect, that it is favoring the data processing division. Therefore,
that division is likely to become a larger part of the consolidated company over time.
b.
The decision not to adjust for risk means that the company will accept too many projects in the manufacturing
division and too few in the data processing division. This will lead to a reduction in the firm's intrinsic value
over time.
c.
The decision not to risk-adjust means that the company will accept too many projects in the data processing
business and too few projects in the manufacturing business. This will lead to a reduction in its intrinsic value
over time.
d.
The decision not to risk-adjust means that the company will accept too many projects in the manufacturing
business and too few projects in the data processing business. This may affect the firm's capital structure but it
will not affect its intrinsic value.
e.
While the decision to use just one WACC will result in its accepting more projects in the manufacturing
division and fewer projects in its data processing division than if it followed the consultant's recommendation,
this should not affect the firm's intrinsic value.
ANSWER:
b
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91. Careco Company and Audaco Inc are identical in size and capital structure. However, the riskiness of their assets and
cash flows are somewhat different, resulting in Careco having a WACC of 10% and Audaco a WACC of 12%. Careco is
considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Careco project. Audaco is
considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Audaco project.
Now assume that the two companies merge and form a new company, Careco/Audaco Inc. Moreover, the new company's
market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash
flows or the risks of Projects X and Y. Which of the following statements is CORRECT?
a.
If evaluated using the correct post-merger WACC, Project X would have a negative NPV.
b.
After the merger, Careco/Audaco would have a corporate WACC of 11%. Therefore, it should reject Project X
but accept Project Y.
c.
Careco/Audaco's WACC, as a result of the merger, would be 10%.
d.
After the merger, Careco/Audaco should select Project Y but reject Project X. If the firm does this, its
corporate WACC will fall to 10.5%.
e.
If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably
become riskier over time.
ANSWER:
e
92. 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
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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.
ANSWER:
d
