chpt 14

Highway Express has paid annual dividends of $1.16, $1.20, $1.25, $1.10, and $0.95 over the past five years respectively. What is the average dividend growth rate?

($1.20 - $1.16)/$1.16 = 0.034483 ($1.25 - $1.20)/$1.20 = 0.041667 ($1.10 - $1.25)/$1.25 = -0.12 ($0.95 - $1.10)/$1.10 = -0.136364 g = (0.034483 + 0.041667 - 0.12 - 0.136364)/4 = -4.51%

The dividend growth model

. is only as reliable as the estimated rate of growth

The City Street Corporation's common stock has a beta of 1.2. The risk-free rate is 3.5 percent and the expected return on the market is 13 percent. What is the firm's cost of equity

RE = 0.035 + 1.2(0.13 - 0.035) = 14.9 percent

Phillips Equipment has 80,000 bonds outstanding that are selling at par. Bonds with similar characteristics are yielding 6.75 percent. The company also has 750,000 shares of 7 percent preferred stock and 2.5 million shares of common stock outstanding. The preferred stock sells for $53 a share. The common stock has a beta of 1.34 and sells for $42 a share. The U.S. Treasury bill is yielding 2.8 percent and the return on the market is 11.2 percent. The corporate tax rate is 38 percent. What is the firm's weighted average cost of capital?

Re = 0.028 + 1.34 (0.112 - 0.028) = 0.14056 Rp = (0.07 X $100)/$53 = 0.13208 Total D + E = 224.75 WACC = ($105m/$224.75m) (0.14056) + ($39.75m/$224.75m) (0.13208) + ($80m/$224.75m) (0.0675) (1 - 0.38) = 10.39 percent

Decker's is a chain of furniture retail stores. Furniture Fashions is a furniture maker and a supplier to Decker's. Decker's has a beta of 1.38 as compared to Furniture Fashion's beta of 1.12. The risk-free rate of return is 3.5 percent and the market risk premium is 8 percent. What discount rate should Decker's use if it considers a project that involves the manufacturing of furniture?

Re = 0.035 + 1.12(0.08)= 12.46%

The capital structure weights used in computing the weighted average cost of capital

are based on the market value of the firm's debt and equity securities.

. Flotation costs for a levered firm should:

be weighted and included in the initial cash flow

A firm's overall cost of equity is

highly dependent upon the growth rate and risk level of the firm

When a manager develops a cost of capital for a specific project based on the cost of capital for another firm which has a similar line of business as the project, the manager is utilizing the ___ approach

pure play

. The cost of equity for a firm

ignores the firm's risks when that cost is based on the dividend growth model.

The pre-tax cost of debt

is based on the current yield to maturity of the firm's outstanding bonds

The cost of preferred stock

is equal to the dividend yield

The discount rate assigned to an individual project should be based on:

the risks associated with the use of the funds required by the project.

The average of a firm's cost of equity and aftertax cost of debt that is weighted based on the firm's capital structure is called the

weighted average cost of capital

The weighted average cost of capital for a wholesaler

. is the return investors require on the total assets of the firm

Chelsea Fashions is expected to pay an annual dividend of $0.80 a share next year. The market price of the stock is $22.40 and the growth rate is 5 percent. What is the firm's cost of equity?

8.57 percent (.80/22.40) + .5 = 8.57

Which one of the following statements is correct

A project that is unacceptable today might be acceptable tomorrow given a change in market returns.

The weighted average cost of capital for a firm may be dependent upon the firm's

I. rate of growth. II. debt-equity ratio. III. preferred dividend payment. IV. retention ratio.

If a firm uses its WACC as the discount rate for all of the projects it undertakes then the firm will tend to

I. reject some positive net present value projects. II. accept some negative net present value projects. III. favor high risk projects over low risk projects. IV. increase its overall level of risk over time.

. The dividend growth model can be used to compute the cost of equity for a firm in which of the following situations?

II. firms that pay a constant dividend III. firms that pay an increasing dividend IV. firms that pay a decreasing dividend

Boulder Furniture has bonds outstanding that mature in 13 years, have a 6 percent coupon, and pay interest annually. These bonds have a face value of $1,000 and a current market price of $1,040. What is the company's aftertax cost of debt if its tax rate is 32 percent?

N- 13 5.5597= I/Y PV- (-1040) PMT- 60 FV- 1000 Aftertax Rd= .055597x(1-.032)= 3.78%

Wind Power Systems has 20-year, semi-annual bonds outstanding with a 5 percent coupon. The face amount of each bond is $1,000. These bonds are currently selling for 114 percent of face value. What is the company's pre-tax cost of debt?

N- 20*2 (I/Y)/2= 3.98 PV- (-1140) PMT - 50/2 FV- 1000

. Handy Man, Inc. has zero coupon bonds outstanding that mature in 8 years. The bonds have a face value of $1,000 and a current market price of $640. What is the company's pre-tax cost of debt?

N- 8x2 I/Y)/2= 5.66 PV- (-640) PMT- 0 FV- 1000

Which one of the following statements is correct?

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

Morris Industries has a capital structure of 55 percent common stock, 10 percent preferred stock, and 45 percent debt. The firm has a 60 percent dividend payout ratio, a beta of 0.89, and a tax rate of 38 percent. Given this, which one of the following statements is correct?

The firm's cost of equity is unaffected by a change in the firm's tax rate

Which one of the following statements related to the SML approach to equity valuation is correct? Assume the firm uses debt in its capital structure.

The model is dependent upon a reliable estimate of the market risk premium

All else constant, which one of the following will increase a firm's cost of equity if the firm computes that cost using the security market line approach? Assume the firm currently pays an annual dividend of $1 a share and has a beta of 1.2.

a reduction in the risk-free rate

The subjective approach to project analysis

assigns discount rates to projects based on the discretion of the senior managers of a firm.

Nelson's Landscaping has 1,200 bonds outstanding that are selling for $990 each. The company also has 2,500 shares of preferred stock at a market price of $28 a share. The common stock is priced at $37 a share and there are 28,000 shares outstanding. What is the weight of the common stock as it relates to the firm's weighted average cost of capital?

debt= 1,200*990= 1188000 pref; 2500*28 = 70,000 comm; 28000*37= 1,036,00 sum= 2,294,000 wght; 1,036/2294= 45.16%

Suppose your company needs $14 million to build a new assembly line. Your target debt-equity ratio is 0.84. The flotation cost for new equity is 9.5 percent, but the floatation cost for debt is only 2.5 percent. What is the true cost of building the new assembly line after taking flotation costs into account?

fA = (1/1.84)(0.095) + (0.84/1.84) (0.025) = 0.063043 Amount raised = $14m/(1 - 0.063043) = $14.94 million

. The aftertax cost of debt

has a greater effect on a firm's cost of capital when the debt-equity ratio increases

Incorporating flotation costs into the analysis of a project will

increase the initial cash outflow of the project.

When a firm has flotation costs equal to 7 percent of the funding need, project analysts should:

increase the initial project cost by dividing that cost by (1 - 0.07).

Assigning discount rates to individual projects based on the risk level of each project:

may cause the firm's overall weighted average cost of capital to either increase or decrease over time.

The weighted average cost of capital for a firm is the:

rate of return a firm must earn on its existing assets to maintain the current value of its stock

18. The cost of preferred stock is computed the same as the

return on a perpetuity

Bleakly Enterprises has a capital structure of 55 percent common stock, 10 percent preferred stock, and 35 percent debt. The flotation costs are 4.5 percent for debt, 7 percent for preferred stock, and 9.5 percent for common stock. The corporate tax rate is 34 percent. What is the weighted average flotation cost?

Average flotation cost = (0.55 X 0.095) + (0.10 X 0.07) + (0.35 X 0.045) = 7.5 percent

. Sister Pools sells outdoor swimming pools and currently has an aftertax cost of capital of 11.6 percent. Al's Construction builds and sells water features and fountains and has an aftertax cost of capital of 10.8 percent. Sister Pools is considering building and selling its own water features and fountains. The sales manager of Sister Pools estimates that the water features and fountains would produce 20 percent of the firm's future total sales. The initial cash outlay for this project would be $85,000. The expected net cash inflows are $16,000 a year for 7 years. What is the net present value of the Sister Pools project?

B. -$9,115

Mangrove Fruit Farms has a $200,000 bond issue outstanding that is selling at 92 percent of face value. The firm also has 1,500 shares of preferred stock and 15,000 shares of common stock outstanding. The preferred stock has a market price of $35 a share compared to a price of $24 a share for the common stock. What is the weight of the preferred stock as it relates to the firm's weighted average cost of capital?

D- 184,000 P- 52,500 C- 360,000 total= 596500 wght; 52,500/596500 =8.8%

Electronics Galore has 950,000 shares of common stock outstanding at a market price of $38 a share. The company also has 40,000 bonds outstanding that are quoted at 106 percent of face value. What weight should be given to the debt when the firm computes its weighted average cost of capital?

D- 42.4m C- 36.1m total= 78.5 m wght; 42.4/78.5 = 54%

The aftertax cost of debt generally increases when:

II. the market rate of interest increases. III. tax rates decrease

Granite Works maintains a debt-equity ratio of 0.65 and has a tax rate of 32 percent. The firm does not issue preferred stock. The pre-tax cost of debt is 9.8 percent. There are 25,000 shares of stock outstanding with a beta of 1.2 and a market price of $19 a share. The current market risk premium is 8.5 percent and the current risk-free rate is 3.6 percent. This year, the firm paid an annual dividend of $1.10 a share and expects to increase that amount by 2 percent each year. Using an average expected cost of equity, what is the weighted average cost of capital?

Re = 0.036 + 1.2(0.085) = 0.138 Re = [($1.10 X 1.02)/$19] + 0.02 = 0.0790526 Re Average = (0.138 + 0.0790526)/2 = 0.108526 WACC = (1/1.65) (0.108526) + (0.65/1.65) (0.098) (1 - 0.32) = 9.20 percent

New York Deli's has 7 percent preferred stock outstanding that sells for $36 a share. This stock was originally issued at $50 per share. What is the cost of preferred stock?

Rp = (0.07 X $100)/$36 = 19.44 percent

Samuelson Plastics has 7.5 percent preferred stock outstanding. Currently, this stock has a market value per share of $52 and a book value per share of $38. What is the cost of preferred stock?

Rp = (0.075 X $100)/$52 = 14.42 percent

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:

assign appropriate, but differing, discount rates to each project and then select the projects with the highest net present values

Scholastic Toys is considering developing and distributing a new board game for children. The project is similar in risk to the firm's current operations. The firm maintains a debt-equity ratio of 0.40 and retains all profits to fund the firm's rapid growth. How should the firm determine its cost of equity?

by using the capital asset pricing model

Textile Mills borrows money at a rate of 13.5 percent. This interest rate is referred to as the:

cost of debt

. A group of individuals got together and purchased all of the outstanding shares of common stock of DL Smith, Inc. What is the return that these individuals require on this investment called

cost of equity

A firm's cost of capital

depends upon how the funds raised are going to be spent.

42. Sweet Treats common stock is currently priced at $19.06 a share. The company just paid $1.15 per share as its annual dividend. The dividends have been increasing by 2.5 percent annually and are expected to continue doing the same. What is this firm's cost of equity?

e = [($1.15 X 1.025)/$19.06] + 0.025 = 8.68 percent

The flotation cost for a firm is computed as

the weighted average of the flotation costs associated with each form of financing

The Shoe Outlet has paid annual dividends of $0.65, $0.70, $0.72, and $0.75 per share over the last four years, respectively. The stock is currently selling for $26 a share. What is this firm's cost of equity?

($0.70 - $0.65)/$0.65 = 0.076923 ($0.72 - $0.70)/$0.70 = 0.028571 ($0.75 - $0.72)/$0.72 = 0.041667 g = (0.076923 + 0.028571 + 0.041667)/3 = .049054 Re = [($0.75 X 1.049054)/$26] + .049054 = 7.93 percent

Phil's is a sit-down restaurant that specializes in home-cooked meals. Theresa's is a walk-in deli that specializes in specialty soups and sandwiches. Both firms are currently considering expanding their operations during the summer months by offering pre-wrapped donuts, sandwiches, and wraps at a local beach. Phil's currently has a WACC of 14 percent while Theresa's WACC is 10 percent. The expansion project has a projected net present value of $12,600 at a 10 percent discount rate and a net present value of -$2,080 at a 14 percent discount rate. Which firm or firms should expand and offer food at the local beach during the summer months?

. both Phil's and Theresa's

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 aftertax cost of capital of 13 percent and Travel Excitement has an aftertax cost of capital of 11 percent. Both firms are considering building wilderness campgrounds complete with man-made lakes and hiking trails. 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?

. neither Wilderness Adventures nor Travel Excitement

Markley and Stearns is a multi-divisional firm that uses its 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:

. prefer higher risk projects over lower risk projects.

Which one of the following is the primary determinant of a firm's cost of capital?

. use of the funds

The common stock of Metal Molds has a negative growth rate of 1.5 percent and a required return of 18 percent. The current stock price is $11.40. What was the amount of the last dividend paid?

D1 = [(0.18 - (-0.015)) X $11.40] = $2.223; D0 = $2.223/(1 - 0.015) = $2.26

Which of the following statements are correct?

II. The SML approach can be applied to firms that retain all of their earnings. III. The SML approach assumes a firm's future risks are similar to its past risks. IV. The SML approach assumes the reward-to-risk ratio is constant.

Tidewater Fishing has a current beta of 1.48. The market risk premium is 8.9 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 1.60?

Increase in cost of equity = (1.60 - 1.48) X 0.089 = 1.07 percent

Dog Gone Good Engines has a bond issue outstanding with 17 years to maturity. These bonds have a $1,000 face value, a 9 percent coupon, and pay interest semi-annually. The bonds are currently quoted at 87 percent of face value. What is the company's pre-tax cost of debt if the tax rate is 38 percent?

N- 17x2 I/Y)/2= 10.67 PV- (-870) PMT- 90/2 FV- 1000

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 12.8 percent. Precious Metals is in the precious gem retail business and has an aftertax cost of capital of 10.6 percent. The project under consideration has initial costs of $575,000 and anticipated annual cash inflows of $102,000 a year for ten years. Which firm(s), if either, should accept this project?

Neither company should accept this project as the applicable discount rate for both firms is 12.8 percent and the NPV is negative at this discount rate.

Titan Mining Corporation has 14 million shares of common stock outstanding, 900,000 shares of 9 percent preferred stock outstanding and 210,000 ten percent semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $34 per share and has a beta of 1.15, the preferred stock currently sells for $80 per share, and the bonds have 17 years to maturity and sell for 91 percent of par. The market risk premium is 11.5 percent, T-bills are yielding 7.5 percent, and the firm's tax rate is 32 percent. What discount rate should the firm apply to a new project's cash flows if the project has the same risk as the firm's typical project?

RD Aftertax = 0.1119514 (1 - 0.32) = 0.076127 WACC = 0.644027(0.20725) + 0.097416 (0.1125) + 0.258558 (0.076127) = 16.41 percent

Stock in Country Road Industries has a beta of 0.97. The market risk premium is 10 percent while T-bills are currently yielding 5.5 percent. Country Road's most recent dividend was $1.70 per share, and dividends are expected to grow at a 7 percent annual rate indefinitely. The stock sells for $32 a share. What is the estimated cost of equity using the average of the CAPM approach and the dividend discount approach?

RE = 0.055 + 0.97(0.10) = 0.152 RE = [($1.70 1.07)/$32] + 0.07 = 0.12684375 RE Average = (0.152 + 0.12684375)/2 = 13.94 percent

Holdup Bank has an issue of preferred stock with a $5 stated dividend that just sold for $92 per share. What is the bank's cost of preferred?

RP = $5/$92 = 5.43 percent

National Home Rentals has a beta of 1.38, a stock price of $19, and recently paid an annual dividend of $0.94 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?

Re = (0.106 - 0.075) + (1.38 X 0.075) = 0.1345 Re = [($0.94 X 1.045)/$19] + 0.045 = 0.0967 Re Average = (0.1345 + 0.0967)/2 = 11.56 percent

Henessey Markets has a growth rate of 4.8 percent and is equally as risky as the market. The stock is currently selling for $17 a share. The overall stock market has a 10.6 percent rate of return and a risk premium of 8.7 percent. What is the expected rate of return on this stock?

Re = (0.106 - 0.087) + (1.00 X 0.087) = 10.6 percent

Southern Home Cookin' just paid its annual dividend of $0.65 a share. The stock has a market price of $13 and a beta of 1.12. The return on the U.S. Treasury bill is 2.5 percent and the market risk premium is 6.8 percent. What is the cost of equity?

Re = 0.025 + (1.12 X 0.068) = 10.12 percent

Which one of the following statements is correct for a firm that uses debt in its capital structure

The WACC should decrease as the firm's debt-equity ratio increases

Cookie Dough Manufacturing has a target debt-equity ratio of 0.5. Its cost of equity is 15 percent, and its cost of debt is 11 percent. What is the firm's WACC given a tax rate of 31 percent?

WACC = (1/1.5)(0.15) + (0.5/1.5)(0.11)(1 - 0.31) = 12.53 percent

Kelso's has a debt-equity ratio of 0.55 and a tax rate of 35 percent. The firm does not issue preferred stock. The cost of equity is 14.5 percent and the aftertax cost of debt is 4.8 percent. What is the weighted average cost of capital?

WACC = (1/1.55) (0.145) + (0.55/1.55) (0.048) = 11.06%

Central Systems, Inc. desires a weighted average cost of capital of 8 percent. The firm has an aftertax cost of debt of 4.8 percent and a cost of equity of 15.2 percent. What debt-equity ratio is needed for the firm to achieve its targeted weighted average cost of capital?

WACC = 0.08 = [We X 0.152] + [(1 - We) X 0.048)] We = 0.3077; Wd = 1 - We = 0.6923 Debt-equity ratio = 0.6923/0.3077 = 2.25

Fama's Llamas has a weighted average cost of capital of 10.5 percent. The company's cost of equity is 15.5 percent, and its pretax cost of debt is 8.5 percent. The tax rate is 34 percent. What is the company's target debt-equity ratio?

WACC = 0.105 = 0.155(E/V) + (0.085) (D/V) (1 - 0.34) 0.105(V/E) = 0.155 + 0.085(0.66) (D/E) .105(1 + D/E)=.155 + .0561(D/E) D/E = 1.02