Ch 09 The Cost of Capital
60. 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.
b.
c.
d.
e.
False
WACC
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Ch 09 The Cost of Capital
61. 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%
c
Multiple Choice
False
FMTP.EHRH.17.09.08 – LO: 9-8
United States – BUSPROG: Analytic
United States – OH – Default City – TBA
WACC
TYPE: Multiple Choice: Problem
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62. 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?
Ch 09 The Cost of Capital
a.
8.15%
b.
8.48%
c.
8.82%
d.
9.17%
e.
9.54%
a
False
capital
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63. 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%
e
Ch 09 The Cost of Capital
64. 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
Difficulty: Challenging
Multiple Choice
FMTP.EHRH.17.09.08 – LO: 9-8
United States – BUSPROG: Analytic
United States – OH – Default City – TBA
WACC and market cap. struc.
TYPE: Multiple Choice: Problem
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Ch 09 The Cost of Capital
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.
b.
c.
d.
e.
c
Ch 09 The Cost of Capital
False
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65. 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%
e
Ch 09 The Cost of Capital
False
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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%
Ch 09 The Cost of Capital
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%
Min
False
False
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Ch 09 The Cost of Capital
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.
b.
c.
d.
e.
a
Bond price
Number of bonds
Shares outstanding
United States – OH – Default City – TBA
Risk premium, CAPM, and dividend growth model (discounted cash flow, DCF)
TYPE: Multiple Choice: Problem
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Ch 09 The Cost of Capital
69. Refer to the data for the Collins Group. What is the best estimate of the firm’s WACC?
a.
b.
c.
d.
e.
c
False
False
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GCID-3c40b4d2540c-a67a-f1e4-5168-6ba5ad08
Ch 09 The Cost of Capital
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
False
False
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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
WACC
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Ch 09 The Cost of Capital
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
True
False
False
capital
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Ch 09 The Cost of Capital
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
the CAPM method always provides an accurate and reliable estimate.
a.
True
b.
False
False
False
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capital
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Ch 09 The Cost of Capital
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
True
Unfortunately, this is true.
False
United States – AK – DISC: Capital budgeting and cost – DISC: Capital budgeting and cost of
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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
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.