Chapter 10 Sample Problems

Not on test (9*) Heino Inc. hired you as a consultant to help them estimate their cost of capital. You have been provided with the following data: rRF = 5.0%; RPM = 5.0%; and b = 1.1. Based on the CAPM approach, what is the cost of equity from retained earnings? a. 10.50% b. 10.71% c. 10.88% d. 11.03% e. 11.14%

a. 10.50%

(13*) Several years ago the Haverford Company sold a $1,000 par value bond that now has 25 years to maturity and an 8.00% annual coupon that is paid quarterly. The bond currently sells for $900.90, and the company's tax rate is 40%. What is the component cost of debt for use in the WACC calculation? a. 5.40% b. 5.73% c. 5.98% d. 6.09% e. 6.24%

a. 5.40%

(18) Wagner 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 A is of average risk and has a return of 9%. b. Project B is of below-average risk and has a return of 8.5%. c. Project C is of above-average risk and has a return of 11%. d. None of the projects should be accepted. e. All of the projects should be accepted.

b. Project B is of below-average risk and has a return of 8.5%.

(3*) Hamilton Company's 8 percent coupon rate, semiannual payment, $1,000 par value bond, which matures in 20 years, currently sells at a price of $686.86. The company's tax rate is 40 percent. Based on the nominal interest rate, what is the firm's after-tax cost of debt for purposes of calculating the WACC? a. 3.05% b. 6.11% c. 7.33% d. 12.22% e. 12.26%

c. 7.33%

(7*) Klieman Company's perpetual preferred stock sells for $90 per share and pays a $7.02 annual dividend per share. If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the price paid by investors. What is the company's cost of preferred stock? a. 7.50% b. 7.79% c. 8.21% d. 8.57% e. 8.77%

c. 8.21%

(1)Which of the following is not considered a capital component for the purpose of calculating the weighted average cost of capital (WACC) as it applies to capital budgeting? a. Long-term debt. b. Common stock. c. Accounts payable and accruals. d. Preferred stock. e. All of the above are considered capital components.

c. Accounts payable and accruals.

(17) Maese Sisters Inc has been paying out all of its earnings as dividends, and hence has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity. Its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would reducethe WACC? a. The flotation costs associated with issuing new common stock increase. b. The market risk premium increases. c. The company's beta decreases. d. Expected inflation increases. e. The flotation costs associated with issuing preferred stock increase.

c. The company's beta decreases.

(10*) Assume that you are a consultant to Morton Inc., and you have been provided with the following data: D0 = $1.00; P0 = $25.00; and g = 6% (constant). What is the cost of equity from retained earnings based on the DCF approach? a. 9.79% b. 9.86% c. 10.00% d. 10.24% e. 10.33%

d. 10.24%

(8*) Assume that you are a consultant to Thornton Inc., and you have been provided with the following data: rRF = 5.5%; RPM= 6.0%; and b = 0.8. What is the cost of equity from retained earnings based on the CAPM approach? a. 9.65% b. 9.91% c. 10.08% d. 10.30% e. 10.49%

d. 10.30%

(5*) The common stock of Anthony Steel has a beta of 1.20. The risk-free rate is 5 percent and the market risk premium (rM - rRF) is 6 percent. Assume the firm will be able to use retained earnings to fund the equity portion of its capital budget. What is the company's cost of retained earnings, rs? a. 7.0% b. 7.2% c. 11.0% d. 12.2% e. 12.4%

d. 12.2%

(4*) Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent common equity. The current market price of the firm's stock is P0 = $28; its last dividend was D0 = $2.20, and its expected dividend growth rate is 6 percent. What will Allison's marginal cost of retained earnings, rs, be? a. 15.8% b. 13.9% c. 7.9% d. 14.3% e. 9.7%

d. 14.3%

Not on test (14*) Reingaart Systems is expected to pay a $3.00 dividend at year end (D1 = $3.00), the dividend is expected to grow at a constant rate of 7% a year, and the common stock currently sells for $60 a share. The before-tax cost of debt is 8%, and the tax rate is 40%. The target capital structure consists of 60% debt and 40% common equity. What is the company's WACC if all equity is from retained earnings? a. 7.17% b. 7.31% c. 7.45% d. 7.68% e. 7.84%

d. 7.68%

Not on test (12*) You were hired as a consultant to Keys Company, and you were provided with the following data: Target capital structure: 40% debt, 10% preferred, and 50% common equity. The after-tax cost of debt is 4.00%, the cost of preferred is 7.50%, and the cost of retained earnings is 11.50%. The firm will not be issuing any new stock. What is the firm's WACC? a. 7.55% b. 7.73% c. 7.94% d. 8.10% e. 8.32%

d. 8.10%

(6*) Blair Brothers' stock currently has a price of $50 per share and is expected to pay a year-end dividend of $2.50 per share (D1 = $2.50). The dividend is expected to grow at a constant rate of 4 percent per year. The company has insufficient retained earnings to fund capital projects and must, therefore, issue new common stock. The new stock has an estimated flotation cost of $3 per share. What is the company's cost of equity capital? a. 10.14% b. 9.21% c. 9.45% d. 9.32% e. 9.00%

d. 9.32%

(2) Which of the following statements is correct? a. The WACC should include only after-tax component costs. Therefore, the required rates of return (or "market rates") on debt, preferred, and common equity (rd, rp, and rs) must be adjusted to an after-tax basis before they are used in the WACC equation. b. The cost of retained earnings is generally higher than the cost of new common stock. c. Preferred stock is riskier to investors than is debt. Therefore, if someone told you that the market rates showed rd > rp for a given company, that person must have made a mistake. d. If a company with a debt ratio of 50 percent were suddenly exempted from all future income taxes, then, all other things held constant, this would cause its WACC to increase. e. None of the statements above is correct.

d. If a company with a debt ratio of 50 percent were suddenly exempted from all future income taxes, then, all other things held constant, this would cause its WACC to increase.

(16) Which of the following statements is CORRECT? a. The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital. b. There is no cost associated with using retained earnings—they are "free." c. The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets. d. The percentage flotation costs associated with issuing new common equity are typically larger than the flotation costs for new debt. e. The WACC as used in capital budgeting will be the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year.

d. The percentage flotation costs associated with issuing new common equity are typically larger than the flotation costs for new debt.

Not On Test (11*) Rhino Inc. hired you as a consultant to help them estimate their cost of capital. You have been provided with the following data: D1 = $1.30; P0 = $40.00; and g = 7% (constant). Based on the DCF approach, what is the cost of equity from retained earnings? a. 9.66% b. 9.84% c. 9.97% d. 10.08% e. 10.25%

e. 10.25%

(15) Which of the following statements is CORRECT? a. If a company's tax rate increases but the YTM of its noncallable bonds remains the same, the after-tax cost of its debt will increase. b. All else equal, an increase in a company's stock price will increase its marginal cost of retained earnings, rs. c. All else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re. d. Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt. e. When calculating the cost of preferred stock, a company does not need to adjust for taxes, because preferred stock dividends are not tax deductible.

e. When calculating the cost of preferred stock, a company does not need to adjust for taxes, because preferred stock dividends are not tax deductible.