BCOR 340 CH 12

Birds of a Feather has bonds outstanding that carry an annual coupon of 6 percent. The bonds mature in 11 years and are currently priced at 94 percent of face value. What is the firm's pretax cost of debt?

$940= (.06 $1,000) ({1 - [1 / (1 + RD )11]} / RD) + $1,000 / (1 + RD)11 ; RD = 6.79 percent

Judy's Boutique just paid an annual dividend of $1.48 on its common stock and increases its dividend by 2.2 percent annually. What is the rate of return on this stock if the current stock price is $29.60 a share?

Re = [($1.48× 1.022) / $29.60] + .022 = .0731, or 7.31 percent

Beta Industries is considering a project with an initial cost of $6.9 million. The project will produce cash inflows of $1.52 million a year for seven years. The firm uses the subjective approach to assign discount rates to projects. For this project, the subjective adjustment is +2.2 percent. The firm has a pretax cost of debt of 9.1 percent and a cost of equity of 17.7 percent. The debt-equity ratio is .57 and the tax rate is 34 percent. What is the net present value of the project? (Round the answer to the nearest $100.)

WACC = (1/1.57)(.177) + (.57 /1.57)(.091)(1 -.34) = .134544 Project WACC = .134544 + .022 = .156544, or 15.6544 percent NPV = -$6.9m + ($1.52m)(PVIFA7, 15.6544%) = -$698,400

A firm wants to create a WACC of 11.2 percent. The firm's cost of equity is 16.8 percent and its pretax cost of debt is 8.7 percent. The tax rate is 35 percent. What does the debt-equity ratio need to be for the firm to achieve its target WACC?

WACC = .112 = (1 -x)(.168) + (x)(.087)(1 -.35)] x = .5025 Debt-equity ratio = .5025 /(1 -.5025) = 1.01

Which one of the following represents the minimum rate of return a firm must earn on its assets if it is to maintain the current value of its securities?

Weighted average cost of capital

The results of the dividend growth model:

are sensitive to the rate of dividend growth.

A firm uses its weighted average cost of capital to evaluate the proposed projects for all of its varying divisions. By doing so, the firm:

automatically gives preferential treatment in the allocation of funds to its riskiest division.

Three years ago, the Morgan Co. issued 15-year, 6.5 percent semiannual coupon bonds at par. Today, the bonds are quoted at 100.6. What is this firm's pretax cost of debt?

$1,006= [(.065 $1,000) / 2] ({1 - 1 / [1 + (RD / 2)]24} / (RD / 2))+ $1,000 / [1 + (RD / 2)]24 ; RD = 6.43 percent

USA Manufacturing issued 30-year, 7.5 percent semiannual bonds 6 years ago. The bonds currently sell at 101 percent of face value. What is the firm's aftertax cost of debt if the tax rate is 35 percent?

$1,010 = [(.075 $1,000) / 2] ({1 - 1 / [1 + (RD / 2)]48} / (RD / 2))+ $1,000 / [1 + (RD/ 2)]48 ; RD = 7.4102 percent ; Aftertax cost of debt = 7.4102 percent (1 -.35) = 4.82 percent

Black Stone Furnaces wants to build a new facility. The cost of capital for this investment is primarily dependent on which one of the following?

The nature of the investment

A firm that uses its weighted average cost of capital as the required return for all of its investments will:

increase the risk level of the firm over time.

In an efficient market, the cost of equity for a highly risky firm:

increases in direct relation to the stock's systematic risk.

The cost of preferred stock:

is equal to the stock's dividend yield.

Great Lakes Packing has two bond issues outstanding. The first issue has a coupon rate of8 percent, matures in 6 years, has a total face value of $5 million, and is quoted at 101.2 percent of face value. The second issue has a 7.5 percent coupon, matures in 13 years, has a total face value of $18 million, and is quoted at 99 percent of face value. Both bonds pay interest semiannually. What is the firm's weighted average aftertax cost of debt if the tax rate is 34 percent?

$1,012 = ([(.08 $1,000) / 2] ({1 - 1 / [1 + (RD / 2)]12} / (RD / 2))+ $1,000 / [1 + (RD/ 2)]12 RD =7.7462 percent $990 = ([(.075 $1,000) / 2] ({1 - 1 / [1 + (RD / 2)]26} / (RD / 2))+ $1,000 / [1 + (RD/ 2)]26 RD = 7.6226 percent Market values: ($5m 1.012) + ($18m .99) = $5.06 + 17.82m = $22.88m Aftertax cost of debt = [($5.06/$22.88)(.077462) + ($17.82m /$22.88m)(.076226] (1 -.34) = .0505, or 5.05 percent

Titans has 7 percent bonds outstanding that mature in 16 years. The bonds pay interest semiannually and have a face value of $1,000. Currently, the bonds are selling for $1,015 each. What is the firm's pretax cost of debt?

$1,015 = [(.07 $1,000) / 2] ({1 - 1 / [1 + (RD / 2)]32} / (RD / 2)) + $1,000 / [1 + (RD / 2)]32 ; RD = 6.84 percent

Electronic Products has 22,500 bonds outstanding that are currently quoted at 101.6. The bonds mature in 8 years and pay an annual coupon payment of $90. What is the firm's aftertax cost of debt if the applicable tax rate is 34 percent?

$1,016 = $90 ({1 - [1 / (1 + RD )8]} / RD) + $1,000 / (1 + RD)8 ; RD = 8.714 percent ; Aftertax cost of debt = 8.714 percent (1 -.34) = .0575, or 5.75 percent

Rockingham Motors issued a 30-year, 8 percent semiannual bond 3 years ago. The bond currently sells for 103.1 percent of its face value. The company's tax rate is 34 percent. What is the aftertax cost of debt?

$1,031 = [(.08 $1,000) / 2] ({1 - 1 / [1 + (r/ 2)]54} / (r / 2)) + $1,000 / [1 + (r / 2)]54 r = 7.725 percent Aftertax cost of debt = .07725 (1 -.34) = .0510, or 5.10 percent

Appalachian Mountain Goods has paid increasing dividends of $.10, $.12, $.15, and $.20 a share over the past four years, respectively. The firm estimates that future increases in its dividends will be equal to the arithmetic average growth rate over these past four years. The stock is currently selling for $12.50 a share. The risk-free rate is 3.4 percent and the market risk premium is 8.1 percent. What is the cost of equity for this firm if its beta is 1.46?

($.12-.10)/$.10 = .20 ($.15 -.12)/$.12 = .25 ($.20 - $.15)/$.15= .3333 g = (.20+ .25 + .3333)/3 = .2611 RE = [($.20 x 1.2611) / $12.50] + .2611 = .28128 RE =.034 + 1.46(.081) = .15226 Average RE = (.28128 + .15226)/2 = .2168, or 21.68 percent

Which one of the following statements is correct? Assume the pretax cost of debt is less than the cost of equity.

A firm may change its capital structure if the government changes its tax policies.

Lester's is a globally diverse company with multiple divisions and a cost of capital of 15.8 percent. Med, Inc., is a specialty firm in the medical equipment field with a cost of capital of 13.7 percent. With the aging of America, both firms recognize the opportunities that exist in the medical field and are considering expansion in this area. At present, there is an opportunity for multiple firms to be involved in a new medical devices project. Each project will require an initial investment of $8.4 million with annual returns of $2.2 million per year for seven years. Which company(ies), if either, should become involved in the new projects?

Both Lester's and Med, Inc. NPV = -$8.4m + $2.2m(PVIFA7, 13.7%) = $1,121,389 Both firms should use Med, Inc.'s, cost of capital. Since the project has a positive NPV at 13.7 percent, both firms should accept the new project.

S&W has 21,000 shares of common stock outstanding at a price of $29 a share. It also has 2,000 shares of preferred stock outstanding at a price of $71 a share. The firm has 7 percent, 12-year bonds outstanding with a total market value of $386,000. The bonds are currently quoted at 100.6 percent of face and pay interest semiannually. What is the capital structure weight of the firm's preferred stock if the tax rate is 34 percent?

Common stock = 21,000 x $29 = $609,000 Preferred stock = 2,000 x $71 = $142,000 Debt = $386,000 Value = $609,000 + 142,000 + 386,000 = $1,137,000 Weight of preferred= $142,000/$1,137,000 = .1249, or 12.49 percent

Madison Square Stores has a $20 million bond issue outstanding that currently has a market value of $19.4 million. The bonds mature in 6.5 years and pay semiannual interest payments of $35 each. What is the firm's pretax cost of debt?

Current bond price = (19.4 /20) $1,000 = $970 ; $970 = $35 ({1 - 1 / [1 + (RD / 2)]13} / (RD / 2))+ $1,000 / [1 + (RD / 2)]13 ; RD = 7.59 percent

K's Bridal Shoppe has 4,000 shares of common stock outstanding at a price of $13 a share. It also has 500 shares of preferred stock outstanding at a price of $22 a share. There are 50 bonds outstanding that have a semiannual coupon payment of $25. The bonds mature in four years, have a face value of $1,000, and sell at 98 percent of par. What is the capital structure weight of the common stock?

Common stock = 4,000 x $13 = $52,000 Preferred stock = 500 x $22 = $11,000 Debt = 50 x (.98 x $1,000) = $49,000 Value = $52,000 + 11,000 + 49,000 = $112,000 Weight of common stock = $52,000/$112,000 = .4643, or 46.43 percent

Santa Claus Enterprises has 87,000 shares of common stock outstanding at a current price of $39 a share. The firm also has two bond issues outstanding. The first bond issue has a total face value of $230,000, pays 7.1 percent interest annually, and currently sells for 103.1 percent of face value. The second bond issue consists of 5,000 bonds that are selling for $887 each. These bonds pay 6.5 percent interest annually and mature in eight years. The tax rate is 35 percent. What is the capital structure weight of the firm's debt?

Common stock = 87,000 x $39 = $3,393,000 Debt = (1.031 x $230,000) + (5,000 x $887) = $4,672,130 Weight of debt = $4,672,130/($3,393,000 + 4,672,130) = .5793, or 57.93 percent

City Rentals has 44,000 shares of common stock outstanding at a market price of $32 a share. The common stock just paid a $1.50 annual dividend and has a dividend growth rate of 2.5 percent. There are 7,500 shares of $9 preferred stock outstanding at a market price of $72 a share. The outstanding bonds mature in 11 years, have a total face value of $825,000, a face value per bond of $1,000, and a market price of $989 each, and a pretax yield to maturity of 8.3 percent. The tax rate is 35 percent. What is the firm's weighted average cost of capital?

Common stock:44,000 $32 = $1,408,000 Preferred stock:7,500 $72 = $540,000 Debt:$989 / $1,000 $825,000 = $815,925 Value = $1,408,000 + 540,000 + 815,925 = $2,763,925 RE = [($1.50 1.025)/$32] + .025 = .073047 Rp = $9/$72= .125 WACC = ($1,408,000/$2,763,925)(.073047) + ($540,000/$2,763,925)(.125) + ($815,925/$2,763,925)(.083)(1 -.35) = .0776, or 7.76 percent

Given the following information for Electric Transport, find the WACC. Assume the company's tax rate is 35 percent. Debt:8,100, 6.9 percent coupon bonds outstanding. $1,000 par value, 17 years to maturity, selling for 101 percent of par, the bonds make semiannual payments. Common stock: 175,000 shares outstanding, selling for $77 per share, beta is 1.32. Preferred stock:9,000 shares of $7.50 preferred stock outstanding, currently selling for $73 per share. Market: 7.9 percent market risk premium and 3.6 percent risk-free rate.

Common: 175,000 $77 = $13,475,000 Preferred: 9,000 $73 = $657,000 Debt: 8,100 1.01 $1,000 = $8,181,000 Value = $13,475,000 + 657,000 + 8,181,000 = $22,313,000 RE = .036 + 1.32(.079) = .1403 RP = $7.50 /$73= .1027 $1,010 = [(.069 $1,000) / 2] ({1- 1 / [1 + (r/ 2)]34} / (r / 2)) + $1,000 / [1 + (r / 2)]34 r = 6.80 percent WACC = ($13,475,000/$22,313,000)(.1403) + ($657,000/$22,313,000)(.1027) + ($8,181,000/$22,313,000)(.0680)(1 -.35) = .104, or 10.4 percent

Katie owns 100 shares of ABC stock. Which one of the following terms is used to refer to the return that Katie and the other shareholders require on their investment in ABC?

Cost of equity

Trendsetters has a cost of equity of 14.6 percent. The market risk premium is 8.4 percent and the risk-free rate is 3.9 percent. The company is acquiring a competitor, which will increase the company's beta to 1.4. What effect, if any, will the acquisition have on the firm's cost of equity capital?

Increase of 1.06 percent; RE = .039 + 1.4(.084) = .1566, or 15.66 percent Increase in cost of equity = 15.66 percent -14.6 percent = 1.06 percent

A firm has a cost of equity of 13 percent, a cost of preferred of 11 percent, an aftertax cost of debt of 5.2 percent, and a tax rate of 35 percent. Given this, which one of the following will increase the firm's weighted average cost of capital?

Increasing the firm's beta

Bruceton's is a specialty retailer with multiple brick-and-mortar stores and a cost of capital of 16.4 percent. Specialty Imports is a wholesaler of specialty items and has a cost of capital of 12.6 percent. Both firms are considering opening a new store in downtown Chicago at a cost of $1.1 million. Because this type of store would be trendy, it would have a life of only 8 years and no salvage value. The expected annual net cash flow is $229,000, regardless of which firm opens the store. Which company(ies), if either, should open the Chicago store?

Neither company NPV = -$1.1m + $229,000(PVIFA8, 16.4%) = -$118,008.96 Both firms should use Bruceton's cost of capital of 16.4 percent as the project cost of capital since that rate is most applicable to the project's level of risk. At 16.4 percent, the NPV is negative, so neither company should open a Chicago store.

Farm Equipment announced this morning that its next annual dividend will be decreased to $1.67 a share and that all future dividends will be decreased by an additional 1.3 percent annually. What is the current value per share if the required return is 15.7 percent?

P0 = $1.67 / [.157 - (-.013)] = $9.82

Tennessee Valley Antiques would like to issue new equity shares if its cost of equity declines to 12.5 percent. The company pays a constant annual dividend of $2.10 per share. What does the market price of the stock need to be for the firm to issue the new shares?

P0 = $2.10 /.125 = $16.80

Cromwell's Interiors is considering a project that is equally as risky as the firm's current operations. The firm has a cost of equity of 15.4 percent and a pretax cost of debt of 8.9 percent. The debt-equity ratio is .46 and the tax rate is 34 percent. What is the cost of capital for this project?

Project cost of capital = (1/1.46)(.154) + (.46 /1.46)(.089)(1 -.34) = .1240, or 12.40 percent

Lawler's is considering a new project. The company has a debt-equity ratio of .64. The company's cost of equity is 14.9 percent, and the aftertax cost of debt is 5.3 percent. The firm feels that the project is riskier than the company as a whole and that it should use an adjustment factor of +1.8 percent. What is the project cost of capital if the tax rate is 34 percent?

Project cost of capital = (1/1.64)(.149) + (.64 /1.64)(.053) + .018 = .1295, or 12.95 percent

Piedmont Hotels is an all-equity firm with 48,000 shares of stock outstanding. The stock has a beta of 1.19 and a standard deviation of 14.8 percent. The market risk premium is 7.8 percent and the risk-free rate of return is 4.1 percent. The company is considering a project that it considers riskier than its current operations so has assigned an adjustment of 1.35 percent to the project's discount rate. What should the firm set as the required rate of return for the project?

Project cost of capital = .041 + 1.19(.078) + .0135 = .1473, or 14.73 percent

Orchard Farms has a pretax cost of debt of 7.29 percent and a cost of equity of 16.3 percent. The firm uses the subjective approach to determine project discount rates. Currently, the firm is considering a project to which it has assigned an adjustment factor of 1.25 percent. The firm's tax rate is 35 percent and its debt-equity ratio is .48. The project has an initial cost of $3.9 million and produces cash inflows of $1.26 million a year for 5 years. What is the net present value of the project?

Project cost of capital = [(1/1.48)(.163) + (.48 /1.48)(.0729)(1 -.35)] + .0125 = .1380, or 13.80 percent NPV = -$3.9m + $1.26m(PVIFA5, 13.80%) = $446,556

Farmer's Supply is considering opening a clothing store, which would be a new line of business for the firm. Management has decided to use the cost of capital of a similar clothing store as the discount rate to evaluate this proposed expansion. Which one of the following terms describes this evaluation approach?

Pure play approach

The market rate of return is 11.8 percent and the risk-free rate is 3.45 percent. Galaxy Co. has 36 percent more systematic risk than the overall market and has a dividend growth rate of 3.5 percent. The firm's stock is currently selling for $42 a share and has a dividend yield of 2.8 percent. What is the firm's cost of equity?

RE = .0345 + 1.36(.118 -.0345)] = .14806 ; RE = .028 + .035 = .063 ; Average RE = (.14806 + .063)/2 = .1055, or 10.55 percent

Donut Delites has a beta of 1.06, a dividend growth rate of 1.2 percent, a stock price of $12a share, and an expected annual dividend of $.68 per share next year. The market rate of return is 11.4 percent and the risk-free rate is 3.8 percent. What is the firm's cost of equity?

RE = .038 + 1.06(.114-.038) = .11856 ; RE = ($.68/$12) + .012 = .06867 ; Average RE = (.11856 + .06867)/2 = .0936, or 9.36 percent

The common stock of Mill Stones has a beta that is 8 percent greater than the overall market beta. Currently, the market risk premium is 7.65 percent while the U.S. Treasury bill is yielding 4.3 percent. What is the cost of equity for this firm?

RE = .043 + 1.08(.0765) = .1256, or 12.56 percent

Musical Charts just paid an annual dividend of $1.84 per share. This dividend is expected to increase by 2.1 percent annually. Currently, the firm has a beta of 1.12 and a stock price of $31 a share. The risk-free rate is 4.3 percent and the market rate of return is 13.2 percent. What is the cost of equity capital for this firm?

RE = .043 + 1.12(.132-.043)] = .14268 ; RE = [($1.84× 1.021) / $31] + .021 = .08160 ; Average RE = (.14268 + .08160)/2 = .1121, or 11.21 percent

The Green Balloon just paid its first annual dividend of $.87 a share. The firm plans to increase the dividend by 3.2 percent per year indefinitely. What is the firm's cost of equity if the current stock price is $4.75 a share?

Re = ($.87× 1.032) / $4.75 + .032 = .2210, or 22.10 percent

Bob's is a retail chain of specialty hardware stores. The firm has 18,000 shares of stock outstanding that are currently valued at $82 a share and provide a rate of return of 13.2 percent. The firm also has 600 bonds outstanding that have a face value of $1,000, a market price of $1,032, and a coupon rate of 7 percent. These bonds mature in 7 years and pay interest semiannually. The tax rate is 35percent. The firm is considering expanding by building a new superstore. The superstore will require an initial investment of $9.3 million and is expected to produce cash inflows of $1.07 million annually over its 10-year life. The risks associated with the superstore are comparable to the risks of the firm's current operations. The initial investment will be depreciated on a straight line basis to a zero book value over the life of the project. At the end of the 10 years, the firm expects to sell the superstore for an aftertax value of $4.7 million. Should the firm accept or reject the superstore project and why?

Reject; The NPV -$1.15 million. Stock: 18,000 $82 = $1,476,000 Bonds: 600 $1,032 = $619,200 Value = $1,476,000 + 619,200 = $2,095,200 $1,032 = [(.07 $1,000) / 2] ({1 / [1 + (r/ 2)]14} / (r / 2)) + $1,000 / [1 + (r / 2)]14 r = 6.43 percent WACC = ($1,476,000/$2,095,200)(.132) + ($619,200 /$2,095,200)(.0643)(1 - .35) = .1053, or 10.53 percent NPV = -$9.3m + $1.07m(PVIFA10, 10.53%) + $4.7m/1.105310 = -$1.15 million The project should be rejected because the NPV is negative at the firm's cost of capital.

Ted is trying to decide what cost of capital he should assign to a project. Which one of the following should be his primary consideration in this decision?

Risk level of the project

The preferred stock of Dolphin Pools pays an annual dividend of $5.25 a share and sells for $48a share. The tax rate is 35 percent. What is the firm's cost of preferred stock?

Rp = $5.25/$48 = .1094, or 10.94 percent

The 6.5 percent preferred stock of Home Town Brewers is selling for $42 a share. What is the firm's cost of preferred stock if the tax rate is 35 percent and the par value per share is $100?

Rp = (.065 ×$100)/$42 = .1548, or 15.48 percent

The 7.5 percent preferred stock of Rock Bottom Floors is selling for $84 a share. What is the firm's cost of preferred stock if the tax rate is 35 percent and the par value per share is $100?

Rp = (.075 ×$100)/$84 = .0893, or 8.93 percent

Which one of the following statements is correct related to the dividend growth model approach to computing the cost of equity?

The annual dividend used in the computation must be for Year 1 if you are Time 0's stock price to compute the return.

A firm has a return on equity of 12.4 percent according to the dividend growth model and a return of 18.7 percent according to the capital asset pricing model. The market rate of return is 13.5 percent. What rate should the firm use as the cost of equity when computing the firm's weighted average cost of capital (WACC)?

The arithmetic average of 12.4 percent and 18.7 percent

Country Cook's cost of equity is 16.2 percent and its aftertax cost of debt is 5.8 percent. What is the firm's weighted average cost of capital if its debt-equity ratio is .42 and the tax rate is 34 percent?

WACC = (1/1.42)(.162) + [(.42 /1.42)(.058)] = .1312, or 13.12 percent

The Five and Dime Store has a cost of equity of 14.8 percent, a pretax cost of debt of 6.7 percent, and a tax rate of 34 percent. What is the firm's weighted average cost of capital if the debt-equity ratio is .46?

WACC = (1/1.46)(.148) + (.46/1.46)(.067)(1 -.34) = .1153, or 11.53 percent

Precision Cuts has a target debt-equity ratio of .48. Its cost of equity is 16.4 percent, and its pretax cost of debt is 8.2 percent. If the tax rate is 34 percent, what is the company's WACC?

WACC = (1/1.48)(.164) + (.48 /1.48)(.082)(1 -.34) = .1284 or 12.84 percent

Healthy Snacks has a target capital structure of 60 percent common stock, 3 percent preferred stock, and 37 percent debt. Its cost of equity is 16.8 percent, the cost of preferred stock is 11.4 percent, and the pretax cost of debt is 8.3 percent. What is the company's WACC if the applicable tax rate is 34 percent?

WACC = .60(.168) + .03(.114) + .37(.083)(1 -.34) = .1245, or 12.45 percent

Lester lent money to The Corner Store by purchasing bonds issued by the store. The rate of return that he and the other lenders require is referred to as the:

cost of debt.

The weighted average cost of capital is defined as the weighted average of a firm's:

cost of equity, cost of preferred, and its aftertax cost of debt.

Assume a firm has a beta of 1.2. All else held constant, the cost of equity for this firm will increase if the:

risk-free rate decreases.

Kate is the CFO of a major firm and has the job of assigning discount rates to each project under consideration. Kate's method of doing this is to assign an incrementally higher rate as the risk level of the project increases and a lower rate as the risk level declines. Kate is applying the ___ approach.

subjective

All else constant, the weighted average cost of capital for a risky, levered firm will decrease if:

the firm's bonds start selling at a premium rather than at a discount.

All else constant, an increase in a firm's cost of debt:

will result in an increase in the firm's cost of capital.