Fin 301 module 10

Flotation costs incurred to raise new external capital increase the firm's cost of capital.

True

Flotation costs incurred to raise new external capital reduce the firm's cost of capital.

False

Target weights used in calculating a firm's cost of capital are weights the firm has estimated will provide the maximum cost of capital for the firm.

False Target weights used in calculating a firm's cost of capital are weights the firm has estimated will provide the minimum cost of capital for the firm.

A firm's financial structure is comprised of the total of long-term financing only.

False a firm's financial structure includes both short and long-term financing.

Because of the tax effect, the cost of equity capital is generally lower than the cost of debt capital.

False because of the tax effect, the cost of debt capital is generally lower than the cost of equity capital. Interest is deductible pre-tax, while dividends are paid after-tax.

The minimum rate of return on all long-term capital budgeting projects should be the cost of capital used to finance the project.

False the return on all long-term capital budgeting projects should be the risk-adjusted cost of capital.

A firm's capital structure is comprised of the total of short-term and long-term financing.

False a firm's capital structure is comprised of long-term financing only.

Book value weights used in calculating a firm's cost of capital are preferred to marginal value weights because they represent current costs.

False marginal weights represent current costs.

Retained earnings has a cost of capital which is higher than that of the cost of capital for new issues of common stock because it includes a required return for the lack of dividend payments.

False the cost of retained earnings capital is identical to that for new issues of common stock less flotation costs.

The cost of long-term bond financing is also defined as the bond's yield to maturity.

False the yield to maturity is the return required by investors, the cost of capital for the bonds is determined by finding the after-tax equivalent of the pre-tax yield to maturity adjusted for flotation costs.

A firm's financial structure is comprised of the total of short-term and long-term financing.

True

Flotation costs are generally higher for common stock than for debt financing.

True

Marginal value weights used in calculating a firm's cost of capital are preferred to book value weights because they represent current costs.

True

Target weights used in calculating a firm's cost of capital are weights the firm has estimated will maximize the value of the firm.

True

Target weights used in calculating a firm's cost of capital are weights the firm has estimated will provide the minimum cost of capital for the firm.

True

The cost of capital may also be called a hurdle rate or minimum required rate of return on long-term capital investments.

True

The minimum rate of return on all long-term capital budgeting projects should be the firm's risk-adjusted cost of capital.

True

When the cost of capital is adjusted to a higher minimum required rate of return to account for possible error in forecasting related to capital budgeting projects and the determination of the cost of capital, the new rate and all other adjusted-for-risk rates are called hurdle rates.

True

Because of the tax effect, the cost of debt capital is generally lower than the cost of equity capital.

True because of the tax effect, the cost of debt capital is generally lower than the cost of equity capital. Interest is deductible pre-tax, while dividends are paid after-tax.

Western Electric has 21,000 shares of common stock outstanding at a price per share of $61 and a rate of return of 15.6 percent. The firm has 11,000 shares of $8 preferred stock outstanding at a price of $48 a share. The outstanding debt has a total face value of $275,000 and currently sells for 104 percent of face. The yield to maturity on the debt is 8.81 percent. What is the firm's weighted average cost of capital if the tax rate is 35 percent? (Hint: use market value weights) A. 14.52 percent B. 13.44 percent C. 14.19 percent D. 14.37 percent E. 13.92 percent

a Common stock: 21,000 × $61 = $1,281,000 Preferred stock: 11,000 × $48 = $528,000 Debt: 1.04 × $275,000 = $286,000 Value = $1,281,000 + 528,000 + 286,000 = $2,095,000 WACC = ($1,281,000/$2,095,000)(.156) + ($528,000/$2,095,000)($8/$48) + ($286,000/$2,095,000)(.0881)(1 -.35) = .1452, or 14.52 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? A. 4.82 percent B. 5.12 percent C. 3.76 percent D. 3.59 percent E. 4.40 percent

a Use calculator: N = 24 * 2 = 48; PMT = 7.5%*1000/2 = 37.5 FV = 1000 PV = -1010 Get I/Y = 3.7051 so, RD = 3.7051 * 2 = 7.4102 percent Aftertax cost of debt = 7.4102 percent ×(1 -.35) = 4.82 percent

The common stock of Contemporary Interiors has a beta of 1.13 and a standard deviation of 21.4 percent. The market rate of return is 12.7 percent and the risk-free rate is 4.1 percent. What is the cost of equity for this firm? A. 13.82 percent B. 11.76 percent C. 12.08 percent D. 14.40 percent E. 13.05 percent

a RE= .041 + 1.13 × (.127-.041) = .1382, or 13.82 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? A. 7.31 percent B. 8.37 percent C. 7.88 percent D. 8.19 percent E. 8.33 percent

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

Assume a firm has a beta of 1.2. All else held constant, the cost of equity for this firm will increase if A. market risk premium decreases. B. risk-free rate decreases. C. market rate of return decreases. D. beta decreases. E. either the risk-free rate or the market rate of return decreases.

b

The weighted average cost of capital is defined as the weighted average of a firm's: A. return on all of its investments. B. cost of equity, cost of preferred, and its aftertax cost of debt. C. pretax cost of debt and its preferred and common equity securities. D. bond coupon rates. E. common and preferred stock

b

Which one of the following will decrease the aftertax cost of debt for a firm? A. Decrease in the firm's beta B. Increase in tax rates C. Increase in the risk-free rate of return D. Decrease in the market price of the debt E. Increase in a bond's yield to maturity

b

Which statement is correct, all else held constant? A. Beta is used to compute the return on equity and the standard deviation is used to compute the return on preferred. B. A decrease in a firm's WACC will increase the attractiveness of the firm's investment options. C. The aftertax cost of debt increases when the market price of a bond increases. D. If you have both the dividend growth and the security market line's costs of equity, you should use the higher of the two estimates when computing WACC. E. WACC is applicable only to firms that issue both common and preferred stock

b

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, if the flotation cost is 5%? A. 4.82 percent B. 5.12 percent C. 3.76 percent D. 3.59 percent E. 4.40 percent

b Use calculator N = 24 * 2 = 48; PMT = 7.5%*1000/2 = 37.5; FV = 1000; PV = -1010 * (1-5%) = -959.5 Get I/Y = 3.9391, so RD = 3.9391 * 2 = 7.8782 percent Aftertax cost of debt = 7.8782 percent ×(1 -.35) = 5.12 percent

An increase in a levered firm's tax rate will: A. decrease the cost of preferred stock. B. increase both the cost of preferred stock and debt. C. decrease the firm's cost of capital. D. decrease the cost of equity capital. E. increase the firm's WACC

c

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, and the flotation cost is 10%? A. 7.31 percent B. 8.37 percent C. 7.88 percent D. 8.19 percent E. 8.33 percent

c Re= ($1.48 × 1.022) /[$ 29.60 * (1 - 10%)] + .022 = .0788, or 7.88 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? A. 12.54 percent B. 11.47 percent C. 13.12 percent D. 12.28 percent E. 13.01 percent

c WACC = (1/1.42)(.162) + [(.42 /1.42)(.058)] = .1312, or 13.12 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? A. Increasing the firm's tax rate B. Issuing new bonds at par C. Redeeming shares of common stock D. Increasing the firm's beta E. Increasing the debt-equity ratio

d

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? A. Amount of debt used to finance the project B. Use, or lack, of preferred stock as a financing option C. Mix of funds used to finance the project D. Risk level of the project E. Length of the project's life

d

The results of the dividend growth model: A. vary directly with the market rate of return. B. can only be applied to projects that have a growth rate equal to that of the current firm. C. are highly dependent upon the beta used in the model. D. are sensitive to the rate of dividend growth. E. are most reliable when the growth rate exceeds 10 percent.

d

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? A. Cost of equity B. Pretax cost of debt C. Aftertax cost of debt D. Weighted average cost of capital E. Weighted average cost of preferred and common stock

d

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? A. 9.85 percent B. 10.92 percent C. 15.39 percent D. 14.73 percent E. 17.33 percent

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

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? A. .86 B. .67 C. 1.04 D. .94 E. 1.01

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

Design Interiors has a cost of equity of 14.9 percent and a pretax cost of debt of 8.6 percent. The firm's target weighted average cost of capital is 11 percent and its tax rate is 34 percent. What is the firm's target debt-equity ratio? A. 1.37 B. .87 C. .98 D. 1.02 E. .73

e WACC = .11 = (1 -x)(.149) + (x)(.086)(1 -.34) x = .4228 Debt-equity ratio = .4228 /(1 -.4228) = .73