ch. 10 finance

Which of the following is NOT a method used to calculate the cost of retained earnings? a. DCF approach b. Averaging the alternative estimates c. CAPM method d. Bond yield plus risk premium approach e. Net earnings minus risk premium approach

E

Which of the following is a factor affecting the WACC that a firm can control? a. Rising interest rates in the economy b. General level of stock prices c. Changes in tax rates d. Altering the schedule of accounts payable e. Changing dividend payout ratios

E

Which of the following statements is NOT true in regard to problems with cost of capital estimates? a. There is not a reliable way to measure the cost of equity for privately owned firms. b. Depreciation cash flows can either be reinvested or returned to investors. c. It is often difficult to measure the cost of a project's risk. d. The accuracy of estimated costs is uncertain due to difficulties in measuring cost of equity. e. Depreciation generated funds are generally a minimal source for a company's capital.

E

Which of the two components of the DCF formula, the dividend yield or the growth rate, do you think is more difficult to estimate? Why?

G because not always table; investors use historic growth rate if it is stable or a security analyst forecast if it is not stable

How can the yield to maturity on a firm's outstanding debt be used to estimate its before-tax cost of debt?

YTM on outstanding debt (which reflects current market conditions) is a better measure of the cost of debt than the coupon rate; debt is used to raise money for long term projects

When calculating WACC, what capital is excluded and why?

accounts payable and accruals do not come directly from investors (these arise when capital budgeting projects are undertaken)

Why might the weights of capital be different depending on whether book values, market values, or target values are used?

because values are according to different things; book value depends on accounting principles, market on value the market ascribes to it, and target is what firm wants it to be in the future

Red Bird Manufacturing would like to avoid issuing new stock because new stock has a higher cost than retained earnings, but the company forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Which of the following actions would REDUCE its need to issue new common stock? a.Reduce the percentage of debt in the target capital structure. b.Increase the dividend payout ratio for the upcoming year. c.Increase the percentage of debt in the target capital structure. d.Increase the proposed capital budget. e.Reduce the amount of short-term bank debt in order to increase the current ratio.

c; if more debt is used, then less equity will be needed to fund the capital budget, so the need for a stock issue would be reduced

Suppose interest rates in the economy increase. How would such a change affect the costs of both debt and common equity based on the CAPM?

cost of debt increases because firm must pay bondholders more when it borrows; if stock prices increase, the cost of equity will fall

Identify the firm's three major capital structure components, and give their respective component cost and weight symbols.

debt; preferred stock; common equity (internal and external as well as retained earnings)

Identify some problem areas in cost of capital analysis. Do these problems invalidate the cost of capital procedures discussed in this chapter? Explain.

depreciation-generated funds, privately owned firms, measurement problems, cost of capital for projects of differing risk, capital structure weights no, our methods are sufficiently accurate

What three approaches are used to estimate the cost of common equity? Which approach is most commonly used in practice?

1. CAPM 2. bond-yield-plus-risk-premium approach 3. DCF (dividend-yield-plus-growth-rate, discounted cash flow) one used by companies depends on the company but often CAPM is most common

What are the two approaches that can be used to adjust for flotation costs?

1. ad flotation costs to a projects cost 2. increase the cost of capital

If a firm now has a debt ratio of 50% but plans to finance with only 40% debt in the future, what should it use as wd when it calculates its WACC? Explain.

40% if using target capital structure

Eurydome Company has a preferred stock with a par value of $50 and an $4 annual coupon payment. The current market price of the stock is $75. What is Eurydome's cost of preferred stock? a. 5.3% b. 6.4% c. 8% d. 12.5% e. 16%

A

Thorstein Company has a targeted capital structure of 45% debt, 5% preferred stock, and 50% common equity. The company's cost of debt is 8.5%, preferred stock 7% and common equity 11%. They have a marginal tax rate of 25%. Which of the following most closely approximates Thorstein's WACC? a. 8.7% b. 9.4% c. 11.9% d. 12.2% e. 19.9%

A

Which of the following statements is NOT true about adjusting the cost of capital for risk? a. The hurdle rate is the same for every new project taken on by a firm. b. The cost of capital should never exceed the expected return on a project c. Investors require a higher return for riskier projects. d. Failing to adjust for risk can result in a firm taking on too many risky projects. e. Failing to adjust for risk can result in rejecting too many safe projects.

A

Modern Fashions, Inc. and New York Accessories Co. are identical in size and capital structure. However, Modern Fashions has a WACC of 10% and New York Accessories a WACC of 12%, because the riskiness of their assets and cash flows somewhat different. New York Accessories is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical New York Accessories project. Modern Fashions is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Modern Fashions project.Now assume that the two companies merge and form a new company, New York Modern, 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 the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time. b.After the merger, New York Modern would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y. c.After the merger, New York Modern should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%. d.If evaluated using the correct post-merger WACC, Project X would have a negative NPV. e.New York Modern's WACC, as a result of the merger, would be 10%.

A; If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.

Why must a cost be assigned to retained earnings?

Although it is true that no direct costs are associated with retained earnings, this capital still has an opportunity cost for investors; cost of retained earnings is the rate of return required by stockholders on a firm's common stock

A company borrows funds at an interest rate of 6% and has a marginal federal tax rate of 22%. What is the company's after-tax cost of debt? a. 1.3% b. 4.7% c. 16% d. 20.7% e. 28%

B

Mateo Company's stock sells for $19.25 and expects to pay an annual dividend of 1.14. The company has a growth rate of 4.8% and floatation costs of 8%. What is the cost for Mateo Company to add new common stock? a. 10.7% b. 11.2% c. 12.8% d. 13.9% e. 17.7%

B

The target capital structure of a company a. is based on book value numbers. b. is based on a company's intentions for obtaining capital to fund future projects. c. is optimal when debt and equity are equal. d. must be in equal proportions of debt, preferred stock, and common equity. e. does not include preferred stock.

B

What is a notable problem when it comes to determining the cost of capital for a privately owned firm? a. Investors see return rates as too risky in a private firm. b. It is difficult to obtain any data to measure the cost of equity. c. Stockholders demand higher return rates from preferred stock. d. Tax structures are constantly changing. e. Inflation rates make a more significant impact on private firms.

B

When calculating the WACC, why is it that only debt has an adjustment factor (1-T)? a. Because debt is offset by equity from investors. b. Because the interest on debt is tax deductible. c. Because dividends aren't paid on debt. d. Because debt is discounted as a cost of capital. e. Because companies pay more taxes on debt used to acquire capital.

B

Capstone Company has a preferred stock with a $9 annual dividend and current market price of $118. What is Capstone's cost of preferred stock? a. 1.1% b. 7.6% c. 10.6% d. 11.8% e. 13.1%

B; D/P

What is one way that rising interest rates in the economy would impact a company's WACC? a. Rising interest rates lead to inflation making the company's overall costs rise. b. Rising interest rates help to raise the price of stock for the company, increasing the company's value. c. Rising interest rates increase the cost of debt because bondholders must be paid more. d. Rising interest rates deter investors and companies subsequently suffer loss of equity. e. Rising interest rates have no impact on a company's WACC.

C

Which of the following is CORRECT about the cost of new common stock? a. Adding new common stock is a better financial option than utilizing retained earnings. b. Flotation costs are generally minimal and can be ignored when issuing new common stock. c. The flotation cost is the percentage cost of adding new common stock. d. The retained earnings breakpoint is also the end of new common stock issuance. e. Only the CAPM method works to calculate the cost of new common stock.

C

Why is the after-tax cost of debt used to calculate the WACC? a. Using the after-tax cost of debt makes the debt appear to be less than the actual amount. b. This method maximizes stock value and decreases the dividend payouts. c. Stock prices depend on after-tax cash flows and the goal is to maximize stock value. d. After tax costs prioritizes a company's assets over its debt. e. It provides validation that a company is paying its taxes.

C

A company has outstanding bonds with a 10-year maturity date and a face value of $1,000. The bonds have an annual coupon payment of $80 and current market price of $1,155. If the company has a marginal tax rate of 22%, what would be a reasonable estimate of their after-tax cost of debt? a. 1.7% b. 1.8% c. 4.6% d. 5.1% e. 5.4%

C; TVM problem

Oleg Corporation has a beta of 1.2. The market risk premium is 4.7% and the risk-free rate is 4.2%. Using the CAPM approach, what is Oleg's cost of retained earnings? a. 5.3% b. 8.9% c. 9.7% d. 9.8% e. 10.7%

D

Which of the following best describes the hurdle rate? a. The minimum rate of return investors will accept to purchase new common stock b. The breakeven point of retained earnings at the end of a high-risk project c. The rate at which a project's risk becomes acceptable at any cost d. The minimum expected rate of return required for a new project to exceed the cost of capital and be accepted e. The hurdle rate is the point when a new project shows a risk factor above 0

D

Which of the following components of capital is excluded when calculating a firm's WACC? a. Interest bearing debt b. Preferred stock c. Inventory d. Accounts payable e. Cash

D

Which of the following is NOT a component cost used to calculate the WACC? a. Internal equity b. Debt c. Preferred stock d. Accruals e. External equity

D

What are three factors under the firm's control that can affect its cost of capital?

factors firm can control 1. changing its capital structure changing dividend payout ratio altering capital budgeting decision rules to accept projects with more or less risk

Name three factors that affect the cost of capital and are beyond the firm's control.

factors firm cannot control: 1. interest rates in the economy 2. general level of stock prices 3. tax rates

If the debt ratio is 50%, the interest rate on new debt is 8%, the tax rate is 40%, and the current cost of equity is 16%, then an increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC).

false; An increase in the debt ratio may increase the interest rate on debt and the current cost of equity

Would a firm that has many good investment opportunities be likely to have a higher or a lower dividend payout ratio than a firm with few good investment opportunities? Explain.

firms with many good investment opportunities would have a high retention ratio and thus a lower dividend payout ratio; firm with good investment ops. will invest profits back into business to pursue many good investment opportunities and not any dividends

Identify some potential problems with the CAPM.

hard to obtain accurate estimates of CAPM inputs because... 1. controversy over whether to use long-term or short-term treasury yield for rRF 2. hard to estimate beta that investors expect the company to have in the future 3. its difficult to estimate the proper market risk premium

How should firms evaluate projects with different risks?

if estimated returns > cost of capital, then project should be accepted

Is a tax adjustment made to the cost of preferred stock? Why or why not?

no because dividends are not tax deductible

Should all divisions within the same firm use the firm's composite WACC for evaluating all capital budgeting projects? Explain.

no, each project's hurdle rate should reflect the risk of the project, not the risk associated with the firm's average project as reflected in the composite WACC

Why is the after-tax cost of debt rather than the before-tax cost used to calculate the WACC?

payments on debt are tax deductible so the acquisition of debt financing can lower a company's total tax burden; we are interested in maximizing the value of the firm's stock, and the stock price depends on after-tax cash flows

Why is the cost of capital sometimes referred to as a "hurdle rate"?

project's expected rate of return must "jump the hurdle" for it to be accepted

Why might there be two different component costs for common equity? Which one is generally relevant, and for what type of firm is the second one likely to be relevant?

rs = internal equity or equity raised by retained earnings; rate of return investors require on firm's common stock; cost of new equity re = external equity, common equity raised by issuing new stock; only relevant for consideration in young, rapidly growing firms; demonstrates cost of issuing new stock

When calculating a company's WACC, should book value, market value, or target weights be used? Explain.

target weights because they are the optimal mix of capital structure (debt, preferred stock, com stock) that company plans to use to raise funds for future projects

Funds acquired by the firm through preferred stock have a cost to the firm equal to the preferred dividend divided by the current price of the preferred stock. If significant flotation costs are involved the cost of the preferred should be adjusted upward.

true; The cost of the preferred stock is equal to the preferred dividend divided by the current price, adjusted for flotation costs

What's the logic behind the bond-yield-plus-risk-premium approach?

used if inputs of CAPM are too difficult to obtain

Why is the relevant cost of debt the interest rate on new debt, not that on already outstanding, or old, debt?

we are interested in the cost of new debt because our primary concern with the cost of capital is its use in capital budgeting decisions; therefore, the rate at which the firm has borrowed in the past is irrelevant because we need to know the cost of new capital; historical debt doesn't reflect current market positions