FIN3400 Ch 11 SMARTBOOK

What is the basic procedure used in the objective approach to divisional WACCs?

Compute average divisional betas, divisional costs of equity, and WACCs

A preferred stock pays an annual dividend of $2.5 a share and has an interest rate of 10.00% What is the price per share? The firm faces an average tax rate of 21%.

$25.00 Rationale: P0 = $2.5/.1 = $25

ABC Co. expects to pay an annual dividend of $1.36 next year with annual increases of 2 percent thereafter. The current stock price is $38 a share. Flotation costs on new equity shares is 12 percent. How is the flotation-adjusted cost of equity computed?

iE = $1.36/[$38 × (1 - 0.12)] + 0.02

A stock just paid an annual dividend of $2.40, which increases by 2 percent annually. The stock sells for $32 a share and has a beta of 1.3. The market rate of return is 11 percent. How is the cost of equity computed?

iE = ($2.40 × 1.02)/$32 + 0.02

A firm pays a constant annual dividend of $1.64 and has a beta of 0.98. The tax rate is 34 percent, the risk-free rate is 3 percent and the market risk premium is 11 percent, How is the cost of equity, iE, computed?

iE = 0.03 + 0.98(0.11)

A new project varies from Wood's operations but is similar to Creekside's operations. Creekside has a beta of 1.08 while Wood's is 1.36. The market return is 11 percent and the risk-free rate is 4 percent. How is the cost of equity for Wood's new project computed?

iE = 0.04 + 1.08(0.11 - 0.04)

What is the flotation-adjusted cost of equity formula?

iE = D1/(P0 - F) + g

Which of the following are formulas that can be used to calculate the cost of equity? Select all that apply.

iE = [(D1/P0 + g) + (Rf + β(RM - Rf))]/2 iE = D1/P0 + g

A firm has a capital structure of 40 percent common stock, 10 percent preferred stock, and 50 percent debt. A new project is being funded with $40,000 of debt and $30,000 of common stock. What weight should be used for equity in the project WACC?

$30,000/($30,000 + $40,000), or 43 percent

A firm has 75,000 shares of common stock outstanding at a price of $42 a share, 10,000 shares of preferred stock at $50 a share, and 3,000 bonds with a price quote of 101.2. How is the weight of preferred stock computed for the firm's WACC?

(10,000 × $50)/[(75,000 × $42) + (10,000 × $50) + (3,000 × $1,000 × 101.2%)

Dexter's has 7,500 shares of common stock selling at $54 a share, 1,200 shares of preferred at $84 a share, and 3,000 bonds priced at $989 each. How is the weight of debt computed?

(3,000 × $989)/[(7,500 × $54) + (1,200 × $84) + (3,000 × $989)]

Which of these are situations where CAPM would be an inappropriate method of computing the cost of equity based on a firm's historical beta? Select all that apply.

-There are insufficient historical observations of beta. Rationale: If there is insufficient data, then a good historical beta value cannot be computed. -The risk level of the firm is changing. Rationale: If the risk level is changing, then the historical beta might not be a good indicator of the firm's future risks.

Which of these questions need to be answered when determining a project's WACC? Select all that apply.

-Which inputs should be project-specific and which should be firmwide values? Rationale: To compute a project's WACC, you need to know which inputs should be project specific and also how the project's risk level compares to the overall firm. -How does the risk level of the project compare to the overall risk level of the firm? Rationale: To compute a project's WACC, you need to know which inputs should be project specific and also how the project's risk level compares to the overall firm.

What rate of growth is used in the dividend growth model to compute the cost of preferred, iP?

0 percent

A bond has a coupon rate of 6 percent, a current yield of 6.5 percent, and a yield to maturity of 6.8 percent. How is the after-tax cost of debt computed if the tax rate is 34 percent?

0.068 × (1 - 0.34) Rationale: After-tax cost of debt = 0.068 × (1 - 0.34)

Cornett Foods has a firm beta of 0.86 and a cost of equity of 11%. The risk-free rate is 4%. A project has a proxy beta of 1.22. How is the project's cost of equity computed?

0.11 = 0.04 + 0.86MRP Project iE = 0.04 + 1.22MRP

Lester's has an EBIT of $52,000 and interest of $5,000. The tax rate on taxable income between $0 and $50,000 is 15 percent while it is 25 percent on taxable income of $50,001 to $75,000. What value should be assigned to TC in the WACC formula?

0.19, or 19 percent Rationale: TC = ($3,000/$5,000) × 0.15 + ($2,000/$5,000) × 0.25 = 0.19, or 19%

Lew's has 500 bonds outstanding with a price quote of 98.6. There are also 12,000 shares of common stock selling for $47 a share and 5,000 shares of preferred stock at $70 a share. What is the weight of equity?

0.40 Rationale: (12,000 × $47)/[(12,000 × $47) + (5,000 × $70) + (500 × $1,000 × 98.6%)] = 0.40

A firm finances its operations with 50 percent debt and 50 percent common stock. The firmwide after--tax cost of debt is 5.7 percent. A division of the firm has a beta of 1.46. The risk-free rate is 3.5 percent and the market risk premium is 7.5 percent. How is the divisional WACC computed if the tax rate is 34 percent?

0.50 × [0.035 + 1.46(0.075)] + 0.50 × 0.057

RobCo has bonds with book value of $100 million and market value of $110 million. There are also 2,500,000 shares of common stock selling for $47 a share. What is the weight of equity?

0.52 Rationale: (2,500,000 × $47)/[(2,500,000 × $47) + ($110,000,000)] = 0.52

A firm uses 50% common stock and 50% debt, The cost of equity is 15% and the after-tax cost of debt is 5%. What is the WACC if the tax rate is 21%?

10.00% Rationale: WACC = (0.5 × 0.15) + (0.5 × 0.05) = 0.10 = 10%

A firm uses 50 percent common stock, 40 percent debt, and 10 percent preferred stock. The cost of equity is 14 percent, the cost of preferred is 12 percent and the pretax cost of debt is 7 percent. What is the WACC if the tax rate is 35 percent?

10.02 percent Rationale: WACC = (0.5 × 0.14) + (0.1 × 0.12) + [0.4 × 0.07 × (1 - 0.35)] = 0.1002 = 10.02%

Deno's has a beta of 0.87 while Leta's has a beta of 1.38. Both firms are considering a new project which is similar to Deno's current operations. The market rate of return is 11 percent and the risk-free rate is 4 percent. What is the cost of equity for Deno's new project? For Leta's?

10.09 percent; 10.09 percent Rationale: Project iE = 0.04 + 0.87(0.11 - 0.04) = 0.1009 = 10.09% The project's cost of equity is the same regardless of the firm.

A firm has a tax rate of 34 percent, a beta of 1.2, and annual dividend increases of 3 percent. The next dividend is expected to be $1.20 and the stock sells for $24 share. The risk-free rate is 4 percent and the market rate of return is 12 percent. What is the cost of equity, iE?

10.80 percent Rationale: iE = {[$1.20/$24 + 0.03] + [0.04 + 1.2(0.12 - 0.04)]}/2 = 0.1080 = 10.80%

Common shareholders require a 12 percent rate of return. What is the component cost of capital for common stock if the tax rate is 34 percent?

12 percent Rationale: Dividends are not tax deductible so the component cost for common stock equals the shareholders' required return.

Cal Markets has a firmwide WACC of 12.3 percent. Division A has a beta of 1.42 and has high risk. The risk-free rate is 3 percent and the market rate of return is 10 percent. Management assigns an adjustment factor of +2 to high-risk projects. What is the divisional cost of equity using the objective approach?

12.94 percent Rationale: iE Division = 0.03 + 1.42(0.10 - 0.03) = 0.1294 = 12.94%

A firm has an overall beta of 1.12 and a proxy project beta of 1.49. The risk-free rate is 3 percent and the firm's cost of equity is 11.96 percent. What is the project's cost of equity?

14.92 percent Rationale: 0.1196 = 0.03 + 1.12(Market risk premium); Market risk premium = 0.08; Project iE = 0.03 + 1.49(0.08) = 0.1492 = 14.92%

Bradburton Beverages stock sells for $40 a share. The firm just paid its annual dividend of $2.00 but expects to maintain that dividend indefinitely. The Flotation cost for equity shares is 10% What is the flotation-adjusted cost of equity?

5.56% Rationale: iE = ($2.00)/[$40 × (1 - 0.10)] + 0.00 = 5.56%

A firm currently has taxable income of $87,000. A new project will increase that income by $18,000. What tax rate should be used in the project's WACC? The tax rate for income between $75,001 and $100,000 is 34 percent while it is 39 percent for income between $100,001 and $335,000.

35.39 percent Rationale: TC = ($13,000/$18,000) × 0.34 + ($5,000/$18,000) × 0.39 = 0.3539 = 35.39%

Lester's Markets has taxable income of $138,000 which will increase by $109,000 if a new project comes on line. What tax rate should be used in the WACC for the new project? The tax rate for taxable income between $75,001 and $100,000 is 34 percent while it is 39 percent for incomes between $100,001 and $335,000.

39 percent Rationale: All of the income from the new project will fall within the 39 percent marginal tax bracket.

A 6 percent, $1,000 face value bond sells for $930 and matures in 22 years. What is the after-tax cost of debt if the tax rate is 34 percent?

4.36 percent Rationale: Pretax cost: N = 44, PV = -930, PMT = 30, FV = 1,000, CPT I; I = 3.304%, which is the semi-annual rate. Annual pretax rate = 2 × 3.304% = 6.608%; After-tax rate = 6.608% × (1 - 0.34) = 4.36%

A firm has a capital structure of 40% common stock, 10% preferred stock, and 50% debt. A new project is being internally funded. What weight should be used for equity in the project WACC?

40%

The yield to maturity on a firm's bonds is 8.8 percent. What is the component cost of debt if the tax rate is 35 percent?

5.72 percent Rationale: Interest is tax deductible so the component cost is the after-tax cost of debt. Cost of debt = 0.088 × (1 - 0.35) = 0.0572 = 5.72%

A 6%, $1,000 face value bond sells for $930 and matures in 22 years. What is the pre-tax cost of debt if the tax rate is 21%?

6.61% Rationale: Pretax cost: N = 44, PV = -930, PMT = 30, FV = 1,000, CPT I; I = 3.304%, which is the semi-annual rate. Annual pretax rate = 2 × 3.304% = 6.608%;

A firm has a beta of 1.3, a cost of preferred of 9 percent, and a pretax cost of debt of 7 percent. The risk-free rate is 3 percent and the market risk premium is 9 percent. The firm's tax rate is 34 percent and the project's tax rate is 34.7 percent. The proxy beta is 1.4. The project will be financed with 75 percent debt and 25 percent common stock. What is the project's WACC?

7.33 percent Rationale: WACCProject = 0.25[0.03 + 1.4(0.09)] + 0.75(0.07)(1 - 0.347) = 0.0733 = 7.33%

A firm's equity costs 15%, it's preferred stock is 10% and its pretax cost of debt of 8%. The risk-free rate is 3% and the market risk premium is 9%. The firm's tax rate is 21% and the project's tax rate is also 21%. The project will be financed with 75% debt and 25% common stock. What is the project's WACC?

8.49% Rationale: WACCProject = 0.25[15%] + 0.75(0.08)(1 - 0.21) = 8.49%

A preferred stock pays an annual dividend of $5 a share and sells for $54 a share. What is the cost of preferred, iP?

9.26 percent Rationale: iP = $5/$54 = 0.0926 = 9.26%

Uptown Markets stock sells for $36 a share. The firm just paid its annual dividend of $2.12 and increases its dividend by 3 percent annually. The Flotation cost for equity shares is 9 percent. What is the flotation-adjusted cost of equity?

9.67 percent Rationale: iE = ($2.12 × 1.03)/[$36 × (1 - 0.09)] + 0.03 = 0.0967 = 9.67%

What is a proxy beta?

A beta of another firm that is in a similar line of business as a new project

Which of these statements apply to business risk? Select all that apply.

A change in the level of business risk can affect stockholders' required rate of return. Business risk is the risk of a project arising from the line of business the project is in. Business risk is related to a firm's mix of new and existing product lines.

The cost of preferred, iP, is actually which one of these?

A dividend yield

Which of these are situations which indicate CAPM would be an inappropriate method for computing the return on equity, iE, based on the firm's historical beta? Select all that apply.

A dividend-paying firm just doubled its operations so it can bring an entirely new product to the market A firm pays a constant dividend but is in the process of terminating operations in its most risky division

What does a firm-wide WACC represent?

A firm's overall cost of financing

How is a proxy beta used?

A proxy beta is used in the CAPM formula to compute the cost of equity for a specific project.

Why must the cost of debt be adjusted for taxes?

Because interest on debt is tax deductible which lowers the firm's total cost of debt financing

What value is being sought from other firms when the pure-play approach is used for a new project?

Beta Rationale: Beta is the value sought as it provides a measure of market risk comparable to the project.

Applying the firmwide WACC to all projects results in accepting [BLANK 1]-risk projects and rejecting [BLANK 2]Blank 2 a, Incorrect Unavailable-risk projects. This will [BLANK 3] the firmwide risk over time.

Blank 1: high Blank 2: low Blank 3: increase

What is the first step in the objective approach to divisional WACCs?

Calculate an average measure of market risk for each division

Financial risk refers to which one of these?

Capital structure decisions

What are the three sources of external capital for a firm?

Common stock, preferred stock, bonds

Assume a firm takes on a new project that is much riskier than the firm's existing projects. Which party disproportionately bears this new risk?

Common stockholders

Which of these inputs should be project-specific when computing a project WACC?

Cost of equity

Which variable most needs adjusting when revising a firmwide WACC into a divisional WACC?

Cost of equity, iE

What is the primary disadvantage of the objective approach to divisional WACCs?

Difficulty of computing average betas for each division based on the division's projects

ABC Co. was founded a year ago and pays an annual dividend of $0.20. The firm does not expect to increase this dividend as it is still in a growth stage. Which model should be used to compute the cost of equity and why?

Dividend growth model as there is insufficient company history to compute beta for use in CAPM

Which of these are pros of using divisional WACCs as compared to applying the firmwide WACC to all projects? Select all that apply.

Divisional WACCs increase the accuracy of accept/reject decisions. Divisional WACCs adjust for the average risks of the projects in each division.

What is the primary advantage of the subjective approach to divisional WACCs?

Ease of implementation with some acknowledgment of risk variations

When computing a divisional WACC, a proxy value is needed for which one of these?

Equity risk

In the WACC formula, what does E represent?

Equity, or common stock

Louis Enterprises stock is selling for $48 a share. Flotation cost on new equity issues is 15 percent. How is the value of F computed for use in the flotation-adjusted cost of equity formula?

F = 0.15 × $48

The cost of equity, iE, for a stock is computed accurately using the constant dividend growth model when their dividends are increasing irregularly.

False Rationale: The cost of equity, iE, computed for a stock using the constant dividend growth model when their dividends are increasing irregularly is not accurate.

True or false: The marginal tax rate of a firm should be used as the value of TC when computing WACC.

False Rationale: The tax rate to be used is the weighted average of the marginal tax rates that would have been paid on the taxable income shielded by the interest deduction. This may vary from the firm's marginal tax rate.

What are flotation costs?

Fees paid to investment banks for issuing new securities

What is the pure-play approach?

Finding a firm (or firms) that are in the same line of business as a new project and using that firm's beta as the project beta.

Identify the results of using the firmwide WACC to evaluate all projects for decision-making?

Incorrect acceptance of projects

How can a project's costs be adjusted to include flotation costs? Assume the flotation costs are $890,000 and the project's life is 10 years.

Increase the initial investment $890,000

Which one of these is an acceptable method of handling flotation costs when evaluating a project?

Increasing the project's WACC

Which of these activities will involve flotation costs? Select all that apply.

Issuing new shares of stock to fund a firm's expansion Issuing bonds to finance a new project

The adjustments used in the subjective approach are generally based on which of these?

Management's opinion of both a division's level of risk and the risk-reward premium

How is the weight of equity computed for use in a firm's WACC?

Market value of common stock/Market value of common stock, preferred stock, and debt

In the WACC formula, what determines the value of D?

Market value of debt

Which one of these represents a key advantage of the objective approach to divisional WACCs?

More accurate measure of a division's required return than other methods

A 5 percent, $1,000 bond matures in 6 years and sells for $1,023. How is the pretax cost of debt, iD, computed?

N = 12, PV = -1,023, PMT = 25, FV = 1,000, CPT I; Since I will be the semiannual rate, it will need multiplied by 2. Rationale: Bond interest payments are assumed to be semiannual unless a problem indicates otherwise.

What is the key disadvantage of the subjective approach to divisional WACCs?

Reliance on a person, or persons, opinion and not on quantifiable information

A firm has EBIT of $110,000 and interest of $22,000. The tax rate on taxable income between $75,001 and $100,000 is 34 percent while it is 39 percent on income between $100,001 and $335,000. What value should be assigned to TC in the WACC formula?

TC = ($12,000/$22,000) × 0.34 + ($10,000/$22,000) × 0.39 Rationale: The $22,000 of interest reduces taxable income. $10,000 of the reduction lies in the 39 percent tax bracket and $12,000 lies in the 34 percent bracket.

Juno's has EBIT of $385,000 and interest of $73,000. The tax rate on taxable income between $100,001 and $335,000 is 39 percent while it is 34 percent between $335,001 and $10 million. Illustrate the calculation of the tax rate to be used in WACC.

TC = ($50,000/$73,000) × 0.34 + ($23,000/$73,000) × 0.39

What is the subjective approach to divisional WACCs?

The assignment of an adjustment factor to the firmwide WACC for each division

What is the key disadvantage of accounting for flotation costs by adjusting a project's WACC?

The component cost of equity tends to be understated

What condition must a new project meet if the project is to qualify to use the firm's WACC as the project's WACC?

The new project must be very similar to the firm's existing projects.

Which of these statements related to a project's WACC formula is correct? Select all that apply.

The pretax cost of debt is a weighted average of the yields to maturity on all the firm's outstanding bonds. The cost of preferred is equal to the annual dividend divided by the stock price. The project's pretax cost of debt is equal to the firm's pretax cost of debt.

Applying a firmwide WACC to projects of varying levels of risk implies which assumption?

The rate of return is unaffected by the level of risk.

How is financial risk defined?

The risk of a project to equity holders stemming from the use of debt

Which of these explains the tax rate, TC as it applies to the WACC formula?

The tax rate is the weighted average of the marginal tax rates that would have been paid on the taxable income shielded by the interest deduction.

In the computation of a firm's WACC, what does the value of (E + P + D) equal?

The total market value of all of a firm's outstanding bonds and stocks

How are flotation costs incorporated into the constant-growth formula for computing the cost of equity?

They are subtracted from the stock price.

How is the cost of equity, iE, computed if the information is available for both the CAPM and the dividend growth models?

Use the average of the two costs

How can business risk be defined?

Variability of a firm's cash flows

What is the key disadvantage of accounting for flotation costs by increasing the initial investment in a project?

Violation of the separation principle

A firm funds its operations with $50 of common stock, $30 of preferred stock, and $40 of debt. The component costs are: common = 12 percent; preferred = 10 percent; pretax debt = 8 percent. Illustrate the WACC formula at a tax rate of 34 percent.

WACC = ($50/$120)(0.12) + ($30/$120)(0.10) + ($40/$120)(0.08)(1 - 0.34)

A firm finances its operations with $500 of common stock and $300 of debt. The cost of equity is 13 percent and the after-tax cost of debt is 5 percent. Illustrate the WACC formula at a tax rate of 15 percent.

WACC = ($500/$800)(0.13) + ($300/$800)(0.05) Rationale: The 5 percent is the after-tax cost of debt so no tax adjustment is required.

Which one of these applies to the weighted-average cost of capital (WACC)?

WACC is an after-tax cost.

A firm has a firmwide WACC of 11.5 percent. Management assigns an adjustment of +2 percent for highly-risky projects, +1 percent for medium-risk projects, and -1 for low-risk projects. What is the divisional WACC for the firm's low-risk division?

WACCDivision = 11.5% - 1% Rationale: The low-risk division will have less risk than the firm overall, so its WACC will equal 11.5% - 1%.

Which of these variables should be project specific when computing a project's WACC?

Weights, tax rate, and cost of equity

Which of these values represents the pretax cost of debt?

Yield to maturity