Chapter 14 Cost of Capital: part 2

33. The subjective approach to project analysis: A. Is used only when a firm has an all-equity capital structure. B. Uses the WACC of Firm X as the basis for the discount rate for a project under consideration by Firm Y. C. Assigns discount rates to projects based on the discretion of the senior managers of a firm. D. Allows managers to randomly adjust the discount rate assigned to a project once the project's beta has been determined. E. Applies a lower discount rate to projects that are financed totally with equity as compared to those that are partially financed with debt.

c

36. The flotation cost for a firm is computed as: A. The arithmetic average of the flotation costs of both debt and equity. B. The weighted average of the flotation costs associated with each form of financing. C. The geometric average of the flotation costs associated with each form of financing. D. One-half of the flotation cost of debt plus one-half of the flotation cost of equity. E. A weighted average based on the book values of the firm's debt and equity.

b

42. The Shoe Outlet has paid annual dividends of $.65, $.70, $.72, and $.75 per share over the last four years, respectively. The stock is currently selling for $9a share. What is this firm's cost of equity? A. 8.74 percent B. 13.65 percent C. 10.38 percent D. 9.53 percent E. 11.79 percent

b

38. Flotation costs for a levered firm should be: A. Ignored when analyzing a project because they are a sunk cost. B. Spread over the life of a project thereby reducing the cash flows for each year of the project. C. Considered only when two projects are mutually exclusive. D. Weighted and included in the initial cash flow. E. Totally ignored when internal equity funding is utilized.

d

39. When computing the adjusted cash flow from assets the tax amount is calculated as: A. EBT TC. B. (EBT - Depreciation) TC. C. (EBIT + Depreciation - Change in NWC - Capital spending) TC. D. EBIT x TC. E. (EBIT - Depreciation - Change in NWC - Capital spending) TC.

d

40. Why does the tax amount need adjusted when valuing a firm using the cash flow from assets approach? A. The tax effect of the dividend payments must be eliminated. B. Only straight-linedepreciation can be used when computing taxes for valuation purposes. C. Taxes must be computed for valuation purposes based solely on the marginal tax rate. D. The tax effect of the interest expense must be removed. E. The taxes must be computed for valuation purposes based on the average tax rate for the past 10 years.

d

77. Deep Mining and Precious Metals are separate firms that are both considering a silver exploration project. Deep Mining is in the actual mining business and has an aftertax cost of capital of 16.7 percent. Precious Metals is in the precious gem retail business and has an aftertax cost of capital of 12.6 percent. The project under consideration has initial costs of $755,000 and anticipated annual cash inflows of $152,000 a year for 10 years. Which firm(s), if either, should accept this project? A. Company A only. B. Company B only. C. Both Company A and Company B. D. Neither Company A nor Company B. E. Cannot be determined without further information.

d

28. Jenner's is a multi division firm that uses its overall WACC as the discount rate for all proposed projects. Each division is in a separate line of business and each presents risks unique to those lines. Given this, a division within the firm will tend to: A. Receive less project funding if its line of business is riskier than that of the other divisions. B. Avoid risky projects so it can receive more project funding. C. Become less risky over time based on the projects that are accepted. D. Have an equal probability with all the other divisions of receiving funding. E. Prefer higher risk projects over lower risk projects.

e

29. The discount rate assigned to an individual project should be based on the: A. Firm's weighted average cost of capital. B. Actual sources of funding used for the project. C. Average of the firm's overall cost of capital for the past five years. D. Current risk level of the overall firm. E. Risks associated with the use of the funds required by the project.

e

44. The common stock of Metal Molds has a negative growth rate of 1.2 percent and a required return of 17.5 percent. The current stock price is $12.20. What was the amount of the last dividend paid? A. $2.07 B. $2.11 C. $2.19 D. $2.22 E. $2.31

e

41. Chelsea Fashions is expected to pay an annual dividend of $1.10 a share next year. The market price of the stock is $21.80 and the growth rate is 4.5 percent. What is the firm's cost of equity? A. 9.77 percent B. 7.91 percent C. 9.24 percent D. 9.55percent E. 10.54 percent

d

43. Sweet Treats common stock is currently priced at $17.15 a share. The company just paid $1.22 per share as its annual dividend. The dividends have been increasing by 2.4 percent annually and are expected to continue doing the same. What is this firm's cost of equity? A. 9.41 percent B. 9.51 percent C. 8.47 percent D. 9.68 percent E. 9.82 percent

d

30. Assigning discount rates to individual projects based on the risk level of each project: A. May cause the firm's overall weighted average cost of capital to either increase or decrease over time. B. Will prevent the firm's overall cost of capital from changing over time. C. Will cause the firm's overall cost of capital to decrease over time. D. Decreases the value of the firm over time. E. Negates the firm's goal of creating the most value for the shareholders.

a

45. Highway Express has paid annual dividends of $1.05, $1.10, $1.12, $1.15, and $1.25 over the past five years, respectively. What is the average dividend growth rate? A. 4.49 percent B. 3.60 percent C. 5.98 percent D. 2.47 percent E. 4.39 percent

a

26. If a firm uses its WACC as the discount rate for all of the projects it undertakes, then the firm will tend to do all of the following except: A. Reject some positive net present value projects. B. Lower the average risk level of the firm over time. C. Increase the firm's overall level of risk over time. D. Accept some negative net present value projects. E. Favor high risk projects over low risk projects.

b

34. Which one of the following statements is correct? A. The subjective approach assesses the risks of each project and assigns an adjustment factor that is unique just for that project. B. Overall, a firm makes better decisions when it uses the subjective approach than when it uses its WACC as the discount rate for all projects. C. Firms will correctly accept or reject every project if they adopt the subjective approach. D. Mandatory projects should only be accepted if they produce a positive NPV when the firm's WACC is used as the discount rate. E. The pure play approach should only be used with low-risk projects.

b

49. Tidewater Fishing has a current beta of 1.08. The market risk premium is 7.9 percent and the risk-free rate of return is 3.2 percent. By how much will the cost of equity increase if the company expands its operations such that the company beta rises to 1.16? A. .88 percent B. .63 percent C. 2.60 percent D. 3.12 percent E. 3.83 percent

b

31. Which one of the following statements is correct? A. Firms should accept low-risk projects prior to funding high-risk projects. B. Making subjective adjustments to a firm's WACC when determining project discount rates unfairly punishes low-risk divisions within a firm. C. A project that is unacceptable today might be acceptable tomorrow given a change in market returns. D. The pure play method is most frequently used for projects involving the expansion of a firm's current operations. E. Firms that elect to use the pure play method for determining a discount rate for a project cannot subjectively adjust the pure play rate.

c

32. Wilderness Adventures specializes in back-country tours and resort management. Travel Excitement specializes in making travel reservations and promoting vacation travel. Wilderness Adventures has an after tax cost of capital of 13 percent and Travel Excitement has an after tax cost of capital of 11 percent. Both firms are considering investing in new web sites that will enhance online reservations. The estimated net present value of such a project is estimated at $87,000 at a discount rate of 11 percent and -$12,500 at a 13 percent discount rate. Which firm or firms, if either, should accept this project? A. Wilderness Adventures only. B. Travel Excitement only. C. Both Wilderness Adventures and Travel Excitement. D. Neither Wilderness Adventures nor Travel Excitement. E. Cannot be determined without further information.

c

46. Southern Home Cooking just paid its annual dividend of $.75 a share. The stock has a market price of $16.80 and a beta of 1.14. The return on the U.S. Treasury bill is 2.7 percent and the market risk premium is 7.1 percent. What is the cost of equity? A. 9.98 percent B. 10.04 percent C. 10.79 percent D. 10.37 percent E. 10.45 percent

c

48. Dee's Fashions has a growth rate of 5.2 percent and is equally as risky as the market while its stock is currently selling for $28 a share. The overall stock market has a return of 12.6 percent and a risk premium of 8.7 percent. What is the expected rate of return on this stock? A. 8.7 percent B. 9.2 percent C. 12.6 percent D. 11.3 percent E. 11.7 percent

c

27. Preston Industries has two separate divisions. Each division is in a separate line of business. Division A is the largest division and represents 70 percent of the firm's overall sales. Division A is also the riskier of the two divisions. Division B is the smaller and least risky of the two. When management is deciding which of the various divisional projects should be accepted, the managers should: A. Allocate more funds to Division A since it is the largest of the two divisions. B. Fund all of Division B's projects first since they tend to be less risky and then allocate the remaining funds to the Division A projects that have the highest net present values. C. Allocate the company's funds to the projects with the highest net present values based on the firm's weighted average cost of capital. D. Assign appropriate, but differing, discount rates to each project and then select the projects with the highest net present values. E. Fund the highest net present value projects from each division based on an allocation of 70 percent of the funds to Division A and 30 percent of the funds to Division B.

d

37. Incorporating flotation costs into the analysis of a project will: A. Cause the project to be improperly evaluated. B. Increase the net present value of the project. C. Increase the project's rate of return. D. Increase the initial cash outflow of the project. E. Have no effect on the present value of the project.

d

35. When a firm has flotation costs equal to 6.8 percent of the funding need, project analysts should: A. Increase the project's discount rate to offset these expenses by multiplying the firm's WACC by 1.068. B. Increase the project's discount rate to offset these expenses by dividing the firm's WACC by (1 - .068). C. Add 6.8 percent to the firm's WACC to determine the discount rate for the project. D. Increase the initial project cost by multiplying that cost by 1.068. E. Increase the initial project cost by dividing that cost by (1 - .068).

e

47. National Home Rentals has a beta of 1.24, a stock price of $22, and recently paid an annual dividend of $.94 a share. The dividend growth rate is 4.5 percent. The market has a 10.6 percent rate of return and a risk premium of 7.5 percent. What is the firm's cost of equity? A. 7.05 percent B. 8.67 percent C. 9.13 percent D. 10.30 percent E. 10.68 percent

e