FIN 3330 Ch 10-11
Because they are based on investors' required returns, the component costs of capital are market-determined variables. True False
True
If a firm cannot invest retained earnings to earn a rate of return ______________ to the required rate of return on retained earnings, it should return those funds to its stockholders. a) greater than or equal to b) less than
a) greater than or equal to
You were recently hired by Scheuer Media Inc. to estimate its cost of capital. You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.00% (constant); and F = 5.00%. What is the cost of equity raised by selling new common stock? a) 10.77% b) 11.33% c) 12.50% d) 13.12% e) 11.90%
b) 11.33% P0(1-F) = D1/(r-g) $42.50 x (1-5%) = 1.75/(r-7%) r= 11.33%
If the project's cost of capital were to increase, how would that affect the IRR? a) The IRR would increase. b) The IRR would decrease. c) The IRR would not change.
c) The IRR would not change. The IRR is the internal rate of return, or the project's expected return if cash flows earn the same return as the IRR. The IRR is the cost of capital that forces the NPV to equal zero; hence, the calculated IRR is independent of a project's cost of capital.
Avery Co. has $1.1 million of debt, $2.5 million of preferred stock, and $1.2 million of common equity. What would be its weight on debt? a) 0.47 b) 0.25 c) 0.57 d) 0.23
d) 0.23 1.1 + 2.5 + 1.2 = 4.8 1.1 / 4.8 = .23
It is often difficult to estimate the expected future dividend growth rate for use in estimating the cost of existing equity using the DCF or DG approach. In general, there are three available methods to generate such an estimate: •Carry forward a historical realized growth rate, and apply it to the future. •Locate and apply an expected future growth rate prepared and published by security analysts. •Use the retention growth model. Suppose Pierce is currently distributing 55% of its earnings in the form of cash dividends. It has also historically generated an average return on equity (ROE) of 22%. Pierce's estimated growth rate is ____________
9.9% Growth rate = ROE x Retention Ratio (which is 1- current distribution) = 22% x (1-55%) = 9.9%
A project's IRR will (increase / decrease / stay the same) if the project's cash inflows decrease, and everything else is unaffected.
Decrease Calculate a project's IRR by finding the cost of capital that would give the project an NPV of zero ($0). If the amount of a project's cash inflows decrease, and everything else stays the same, the IRR of the project will decrease, because the project has become less profitable
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). True False
False An increase in the debt ratio may increase the interest rate on debt and the current cost of equity. See Section 10.8, Factors that Affect the WACC
As a general rule, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects. After all, most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project. True False
False In general, this statement is false, because the firm should be viewed as an ongoing entity, and using debt (or equity) to fund a given project will change the capital structure, and this factor should be recognized by basing the cost of capital for all projects on a target capital structure. Under some special circumstances, where a project is set up as a separate entity, "project financing" may be used, and only the project's specific situation is considered. This is a specific situation, however, and not the "in general" case.
Because the *before-tax* cost of debt is lower than the *after-tax* cost, it is used as the component cost of debt for purposes of developing the firm's WACC. True False
False The after-tax cost of debt is lower than the before-tax cost.
An increase in a firm's marginal tax rate would lower the cost of debt used to calculate its WACC, other things held constant. True False
True
Sunny Day Manufacturing Company Co.'s addition to earnings for this year is expected to be $420,000. Its target capital structure consists of 50% debt, 5% preferred, and 45% equity. Determine Sunny Day Manufacturing Company's retained earnings breakpoint: a) $933,333 b) $1,166,666 c) $840,000 d) $886,666
a) $933,333 Addition to retained earnings = 420,000 Equity weight in capital structure = 45% Retained earnings breakeven point = Addition to retained earnings / Equity weight in capital structure = 420000 / 45% = *933,333*
O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of equity from retained earnings based on the CAPM? a) 11.30% b) 12.72% c) 12.35% d) 11.64% e) 11.99%
a) 11.30% Cost of equity = Risk Free rate + Beta (Market risk premium) Cost of equity = 5% + 1.05(6%) = *11.3%*
___________ is the interest rate that a firm pays on any new debt financing. a) before-tax cost of debt b) after-tax cost of debt
a) before-tax cost of debt
Helena's Candies Co. (HCC) has a target capital structure of 55% equity and 45% debt to fund its $5 billion in capital. Furthermore, HCC has a WACC of 12.0%. Its before-tax cost of debt is 9%; and its tax rate is 40%. The company's retained earnings are adequate to fund the common equity portion of the capital budget. The firm's expected dividend next year (D1) is $4 and the current stock price is $40. What is the company's expected growth rate? a) 4.50% b) 7.40% c) 6.30% d) 5.25% e) 5.75%
b) 7.40% 1) Cost of common equity: WACC = wd(rd)(1-T)+ wc(rs) 12%= .45(9%)(1-.40) + .55(rs) 9.57% = .55(rs) rs = 17.40% 2) Expected growth rate: rs = D1/P0 + g .1740 = $4/$40 + g g = 7.40%
Water and Power Company (WPC) can borrow funds at an interest rate of 11.10% for a period of eight years. Its marginal federal-plus-state tax rate is 25%. WPC's after-tax cost of debt is ___________ a) 9.57% b) 8.32% c) 7.90% d) 9.15%
b) 8.32% 11.10% x (1-25%) = 8.32%
The director of capital budgeting for See-Saw Inc., manufacturers of playground equipment, is considering a plan to expand production facilities in order to meet an increase in demand. He estimates that this expansion will produce a rate of return of 11%. The firm's target capital structure calls for a debt/equity ratio of 0.8. See-Saw currently has a bond issue outstanding that will mature in 25 years and has a 7% annual coupon rate. The bonds are currently selling for $804. The firm has maintained a constant growth rate of 6%. See-Saw's next expected dividend is $2 (D1), its current stock price is $40, and its tax rate is 40%. Should it undertake the expansion? (Assume that there is no preferred stock outstanding and that any new debt will have a 25-year maturity.) a) No; the expected return is 2.5 percentage points lower than the cost of capital. b) Yes; the expected return is 2.5 percentage points higher than the cost of capital. c) Yes; the expected return is 1.0 percentage point higher than the cost of capital. d) No; the expected return is 1.0 percentage point lower than the cost of capital. e) Yes; the expected return is 0.5 percentage point higher than the cost of capital.
b) Yes; the expected return is 2.5 percentage points higher than the cost of capital.
Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant). What is the cost of equity from retained earnings based on the DCF approach? a) 9.42% b) 9.91% c) 10.96% d) 11.51% e) 10.44%
e) 10.44% re= D1/P0 + g re= $0.67 / $27.50 + 8.00 re= 10.44%
Area Global Goodness Foods has two divisions of equal size: a snack food division and a beverage division. The company's CFO believes that stand-alone snack food companies typically have a WACC of 8%, while stand-alone beverage producers typically have a 12% WACC. He also believes that the snack food and beverage divisions have the same risk as their typical peers; consequently, the CFO estimates that the composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the snack food division and a 12% hurdle rate for the beverage division. However, the CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is CORRECT? a) The decision not to adjust for risk means, in effect, that it is favoring the snack food division. Therefore, that division is likely to become a larger part of the consolidated company over time. b) The decision not to risk adjust means that the company will accept too many projects in the beverage business and too few projects in the snack food business. This may affect the firm's capital structure but it will not affect its intrinsic value. c) While the decision to use just one WACC will result in its accepting more projects in the beverage division and fewer projects in its snack food division than if it followed the consultant's recommendation, this should not affect the firm's intrinsic value. d) The decision not to risk-adjust means that the company will accept too many projects in the snack food business and too few projects in the beverage business. This will lead to a reduction in its intrinsic value over time. e) The decision not to adjust for risk means that the company will accept too many projects in the beverage division and too few in the snack food division. This will lead to a reduction in the firm's intrinsic value over time.
e) The decision not to adjust for risk means that the company will accept too many projects in the beverage division and too few in the snack food division. This will lead to a reduction in the firm's intrinsic value over time. The decision not to adjust for risk means that the company will accept too many projects in the beverage division and too few in the snack food division. This will lead to a reduction in the firm's intrinsic value over time.
IRR function on calc
irr( initial outlay, L1)
NPV function on calc
npv ( %, initial outlay, L1)
One definition of "capital" is funds supplied to a firm by investors. True False
true
Akita Development, which has an overall WACC of 12%, has equal amounts of low-risk, average-risk, and high-risk projects. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. What is likely to happen over time if the CEO's position is accepted? a) Things will generally even out over time, and, therefore, the firm's risk should remain constant over time. b) The company will take on too many high-risk projects and reject too many low-risk projects. c) The company's overall WACC should decrease over time because its stock price should be increasing. d) The CEO's recommendation would maximize the firm's intrinsic value. e) The company will take on too many low-risk projects and reject too many high-risk projects.
b) The company will take on too many high-risk projects and reject too many low-risk projects. Low-risk projects will tend to have low expected returns and vice versa for high-risk projects due to competition in the economy. By not adjusting the cost of capital for project risk, the firm will tend to reject low-risk projects even though they earn higher returns than their risk-adjusted costs of capital, and vice versa for high-risk projects. In addition, as the firm takes on more high-risk projects, its correct WACC will increase over time. Therefore, statement B is correct.
White Lion Homebuilders has a current stock price of $33.35 per share, and is expected to pay a per-share dividend of $1.36 at the end of the year. The company's earnings' and dividends' growth rate are expected to grow at the constant rate of 8.70% into the foreseeable future. If White Lion expects to incur flotation costs of 6.50% of the value of its newly-raised equity funds, then the flotation-adjusted (net) cost of its new common stock (rounded to two decimal places) should be ___________ a) 11.10% b) 12.78% c) 13.06% d) 10.45%
c) 13.06% Current stock price per share = P = 33.35 Dividend = D1 = 1.36 Constant growth rate = g = 8.70% Flotation costs = f = 6.50% r= new cost of equity r= (D1/ P(1-f)) +g r= (1.36/ 33.35(1-6.50%)) + 8.70% r= 13.06%
At the present time, Water and Power Company (WPC) has 5-year noncallable bonds with a face value of $1,000 that are outstanding. These bonds have a current market price of $1,438.04 per bond, carry a coupon rate of 14%, and distribute annual coupon payments. The company incurs a federal-plus-state tax rate of 25%. If WPC wants to issue new debt, what would be a reasonable estimate for its after-tax cost of debt (rounded to two decimal places)? (Note: Round your YTM rate to two decimal place.) a) 2.48% b) 3.72% c) 3.10% d) 3.57%
c) 3.10% TMV N= 5 I= ? PV= $1438.04 (market price) PMT = 140 (face value x coupon rate) = (1,000 x 14%) FV = 1000 (face value) I= *4.13%* After Tax cost of debt: 4.13% x (1-25%) = *3.097% or 3.10%*
To help finance a major expansion, Castro Chemical Company sold a noncallable bond several years ago that now has 20 years to maturity. This bond has a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000. If the firm's tax rate is 40%, what is the component cost of debt for use in the WACC calculation? a) 4.35% b) 5.33% c) 5.08% d) 4.58% e) 4.83%
c) 5.08% TMV: N=20 I? PV=-1,075 PMT= $92.5 (1000 x .0925) FV=1000 P/Y=1 I= 8.46% Then take Interest x (1- tax rate) .0846 x (1-.4) = *5.08%*
Which of the following statements about the relationship between the IRR and the MIRR is correct? a) A typical firm's IRR will be equal to its MIRR. b) A typical firm's IRR will be less than its MIRR. c) A typical firm's IRR will be greater than its MIRR.
c) A typical firm's IRR will be greater than its MIRR. The IRR method uses the assumption that a project's cash flows can be reinvested at the IRR. This assumption is generally incorrect, which causes the IRR to overstate the project's true return. The MIRR is the discount rate at which the present value of a project's cost is equal to the present value of its terminal value—where the terminal value is found as the sum of the future values of the cash inflows—compounded at the firm's cost of capital. Therefore, a typical firm's IRR will be greater than its MIRR.
Assume that All-American Sporting Goods correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years. The firm will most likely: a) Accept too many low-risk projects and too few high-risk projects. b) Become less risky over time, and this will maximize its intrinsic value. c) Become more risky and also have an increasing WACC. Its intrinsic value will not be maximized. d) Continue as before because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital. e) Become riskier over time, but its intrinsic value will be maximized.
c) Become more risky and also have an increasing WACC. Its intrinsic value will not be maximized. Low-risk projects will tend to have low expected returns and vice versa for high-risk projects due to competition in the economy. By not adjusting the cost of capital for project risk, the firm will tend to reject low-risk projects even though they earn higher returns than their risk-adjusted costs of capital, and vice versa for high-risk projects. As the firm takes on more high-risk projects, its true WACC will increase over time. Of course, the true WACC might change over time due to changes in market conditions, but that could cause the true WACC to either rise or decline. Therefore, statement C is correct.
Area The chief financial officer of Panther Products, which is an all-equity firm with a beta of 2.0, is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than the firm's average project in terms of both its beta risk and its total risk. Which of the following statements is CORRECT? a) Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment. b) Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision. c) The accept/reject decision depends on the firm's risk-adjustment policy. If Panther's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project. d) The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return. e) The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.
c) The accept/reject decision depends on the firm's risk-adjustment policy. If Panther's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project.
Pierce Enterprises's stock is currently selling for $45.56 per share, and the firm expects its per-share dividend to be $2.35 in one year. Analysts project the firm's growth rate to be constant at 5.72%. Estimating the cost of equity using the discounted cash flow (or dividend growth) approach, what is Pierce's cost of internal equity? a) 13.60% b) 11.42% c) 10.34% d) 10.88%
d) 10.88% Cost of Internal Equity = D1/P0 + g = $2.35/$45.56 + .0572 = 10.88%
The Adams Company is closely held and, therefore, cannot generate reliable inputs with which to use the CAPM method for estimating a company's cost of internal equity. Adams's bonds yield 11.52%, and the firm's analysts estimate that the firm's risk premium on its stock over its bonds is 5.89. Based on the bond-yield-plus-risk-premium approach, Adams's cost of internal equity is: a) 20.89% b) 19.15% c) 16.54% d) 17.41%
d) 17.41% Cost of internal Equity= Yield bond + rFP =11.52% + 5.89%
Bosio Inc.'s perpetual preferred stock sells for $97.50 per share, and it pays an $8.50 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is the company's cost of preferred stock for use in calculating the WACC? a) 8.72% b) 10.22% c) 9.82% d) 9.08% e) 9.44%
d) 9.08% Preferred Stock = Dividend / price x (1- flotation) Preferred stock = 8.50 / (97.50 x (1-4%)) Preferred stock = *9.08%*
Which of the following should NOT be included when calculating the weighted average cost of capital (WACC) for use in capital budgeting? a) Retained earnings. b) Long-term debt. c) Common stock. d) Accounts payable. e) Preferred stock.
d) Accounts Payable Long-term debt, retained earnings, common stock, and preferred stock are components of WACC
Eakins Inc.'s common stock currently sells for $45.00 per share, the company expects to earn $2.75 per share during the current year, its expected payout ratio is 70%, and its expected constant growth rate is 6.00%. New stock can be sold to the public at the current price, but a flotation cost of 8% would be incurred. By how much would the cost of new stock exceed the cost of retained earnings? a) 0.09% b) 0.19% c) 0.56% d) 0.84% e) 0.37%
e) 0.37% We have: Po = $45 D1 = EPS x payout ratio D1= $2.75 x 70% D1= $1.925 G= 6% F= 8% Cost of retained earnings = D1 / Po + g = $1.925 / 45 + 0.06 = 10.28% Cost of new equity = D1 / Po(1-F) + g = $1.925 / 45(1-0.08) + 0.06 = 0.0465+0.06 = 10.65% Excess of cost of new equity over cost of retained earnings = 10.65%-10.28% *= 0.37%*
Sun Products Company (SPC) uses only debt and equity. It can borrow unlimited amounts at an interest rate of 12% so long as it finances at its target capital structure, which calls for 45% debt and 55% common equity. Its last dividend was $2.40, its expected constant growth rate is 5%, and its stock sells for $24. SPC's tax rate is 40%. Four projects are available: Project A has a cost of $240 million and a rate of return of 13%, Project B has a cost of $125 million and a rate of return of 12%, Project C has a cost of $200 million and a rate of return of 11%, and Project D has a cost of $150 million and a rate of return of 10%. All of the company's potential projects are independent and equally risky. What is SPC's WACC? In other words, what WACC should it use to evaluate capital budgeting projects (these four projects plus any others that might arise during the year, provided the WACC remains constant)? a) 12.05% b) 13.40% c) 12.50% d) 10.61% e) 11.77%
e) 11.77% 1) rd rd = 12%; rd(1-T) = 12%(.6) = *7.2%* 2) rs rs= [$2.40(1.05)]/$24 + 5% = *15.50%* 3) WACC WACC = .45(7.2%) + .55(15.50%) = *11.77%*
Roland Corporation's next expected dividend (D1) is $2.50. The firm has maintained a constant payout ratio of 50% during the past 7 years. Seven years ago its EPS was $1.50. The firm's beta coefficient is 1.2. The estimated market risk premium is 6%, and the risk-free rate is 7%. Roland's A-rated bonds are yielding 10%, and its current stock price is $30. Which of the following values is the most reasonable estimate of Roland's cost of retained earnings, rs? a) 10% b) 26% c) 20% d) 12% e) 14%
e) 14% CAPM: rs = rRF + (RPM)b = 7% + (6%)1.2 = 14.2% Risk Premium: rs = Bond yield + Risk premium = 10% + 4% = 14%
Which of the following statements could be true concerning the costs of debt and equity? a) The cost of debt for Firm A is greater than the cost of equity for Firm A. b)The cost of debt for Firm A is greater than the cost of equity for Firm B. c) The cost of retained earnings for Firm A is less than its cost of new outside equity. d) The cost of retained earnings for Firm A is less than its cost of debt. e) Both statements b and c could be true.
e) Both statements b and c could be true. If Firm A has more business risk than Firm B, Firm A's cost of debt could be greater than Firm B's cost of equity. Also, the cost of retained earnings is less than the cost of new outside equity due to flotation costs. See 10.7, Composite, or Weighted Average, Cost of Capital, WACC.
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 proposed capital budget. d) Reduce the amount of short-term bank debt in order to increase the current ratio. e) Increase the percentage of debt in the target capital structure.
e) Increase the percentage of debt in the target capital structure. Increase the percentage of debt in the target capital structure is correct, because 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.
Year 1 = 2,400,000 Year 2= 4,500,000 Year 3= 4,500,000 Year 4= 4,500,000 IRR= 13.2% WACC = 9% What is the NPV
*$1,177,569* NPV ( 9, -11474565, L1) L1 is the cash flows NPV = $1,177,569
Turnbull Co. is considering a project that requires an initial investment of $570,000. The firm will raise the $570,000 in capital by issuing $230,000 of debt at a before-tax cost of 9.6%, $20,000 of preferred stock at a cost of 10.7%, and $320,000 of equity at a cost of 13.5%. The firm faces a tax rate of 25%. What will be the WACC for this project?
*10.86%* Investment = 570,000 Debt = 230,000 Debt weight = 40.351% Debt Cost = 9.6% Weight average = (.40351 x .096) = 3.874% x (1-25%) = *2.906%* Preferred stock = 20,000 PS weight= 3.509% PS cost = 10.7% PS weighted average = (.0351 x .107) = *0.375%* Common stock = 320,000 CS weight = 56.140% CS cost = 13.5% CS weighted average= (.56140 x .135) = *7.579%* WACC= 2.906% + 0.375% + 7.579% WACC= *10.86%*
Kuhn Co. is considering a new project that will require an initial investment of $20 million. It has a target capital structure of 45% debt, 4% preferred stock, and 51% common equity. Kuhn has noncallable bonds outstanding that mature in 15 years with a face value of $1,000, an annual coupon rate of 11%, and a market price of $1555.38. The yield on the company's current bonds is a good approximation of the yield on any new bonds that it issues. The company can sell shares of preferred stock that pay an annual dividend of $9 at a price of $95.70 per share. Kuhn does not have any retained earnings available to finance this project, so the firm will have to issue new common stock to help fund it. Its common stock is currently selling for $33.35 per share, and it is expected to pay a dividend of $2.78 at the end of next year. Flotation costs will represent 8% of the funds raised by issuing new common stock. The company is projected to grow at a constant rate of 8.7%, and they face a tax rate of 25%. What will be the WACC for this project?
*11.23%* TMV N= 15 I= ? PMT = 110 (11% x 1000) PV = -1555.38 (market price) FV = 1000 *I= 5.48%* Cost of Debt = 5.48% Weight of Debt= 45% WACC= .45 x (5.48% x (1- 25%) WACC= 1.85% Cost of P.S. = Annual preferred dividend / price Cost of P.S. = (9/95.70) Cost of P.S. = 9.40% Weight of PS= 4% WACC= (9.40 x 4) = .38% Cost of Equity = Dividend / (stock price x (1 - flotation cost)) Cost of E = 2.78 / (33.35 x (1-8%) + .087 Cost of E = 17.65% Weight of E= 51% WACC= (.51 x .1765) = 9.00% WACC = 1.85% + .38% + 9.00% = *11.23*
Debt or Equity 1. Has a par, or face, value. 2. No tax adjustments are made when calculating the cost of preferred stock.
1. Debt 2. Equity
Sunrise Canoes Inc. has determined that its optimal capital structure consists of 55% equity and 45% debt. Sunrise must raise additional capital to fund its upcoming expansion. The firm has $0.5 million in retained earnings that has a cost of 11%. Its investment bankers have informed the company that it can issue an additional $3 million of new common equity at a cost of 14%. Furthermore, the firm can raise up to $1.5 million of debt at 10% (before taxes) and an additional $2 million of debt at 12% (before taxes). The firm has estimated that the proposed expansion will require an investment of $2.6 million. The firm's tax rate is 40%. What is the WACC for the funds Sunrise will be raising? 10.40% 11.50% 10.00% 10.75% 11.20%
10.40% WACC=0.45(10)(1-.4)+0.55(14)=10.4%
he current risk-free rate of return (rRF) is 4.67% while the market risk premium is 5.75%. The Allen Company has a beta of 1.56. Using the capital asset pricing model (CAPM) approach, Allen's cost of equity is __________
13.64% COST OF EQUITY = Rf + BETA * RISK PREMIUM = 4.67% + (1.56 x 5.75%) = 13.64%
Year 1 = 2,400,000 Year 2= 4,500,000 Year 3= 4,500,000 Year 4= 4,500,000 IRR= 13.2% WACC = 9% Given the data and hints, Project Gamma's initial investment is ___________________.
IRR is the rate of return that makes initial investment equal to present value of cash inflows Initial investment = 2,400,000 / (1 + 0.132)1 + 4,500,000 / (1 + 0.132)2 + 4,500,000 / (1 + 0.132)3 + 4,500,000 / (1 + 0.132)4 Initial investment = $11,474,565
Use Exhibit 10.1 to determine the best estimate of the after-tax cost of debt: The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%. a) 4.64% b) 4.88% c) 5.40% d) 5.67% e) 5.14%
TVM: N= 20 I = ? PV = -875 PMT = 72.5 (1000 x 7.25%) FV = 1000 P/Y =1 I= 8.57% Then take I (8.57%) and multiply it by 1 - the tax rate 8.57% x (1 - 40%) = 0.0857% x .6 = *5.14%*
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 False
True
In capital budgeting, the cost of capital should reflect the average cost of the various sources of investor-supplied funds a firm uses to acquire assets. True False
True
In theory, capital budgeting decisions should depend solely on forecasted cash flows and the opportunity cost of capital. Managers' tastes, choice of accounting method, or the profitability of other independent projects should not be considered. True False
True
Retained earnings have a cost equal to rs because investors expect to earn rs on investments with the same risk as the firm's common stock. If the firm cannot earn rs on the earnings that it retains, it should pay those earnings out to its investors. Thus, the cost of retained earnings is based on the opportunity cost principle. True False
True
To find the cost of perpetual preferred stock, divide the preferred's annual dividend by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, are not deductible by the issuing firm. True False
True
A. Butcher Timber Company hired your consulting firm to help them estimate the cost of equity. The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of equity can be estimated using a risk premium of 3.85% over a firm's own cost of debt. What is an estimate of the firm's cost of equity from retained earnings? a) 12.60% b) 14.74% c) 14.17% d) 13.10% e) 13.63%
a) 12.60% Risk premium 3.85% + Cost of debt 8.75% = 12.60% estimated cost of common
Sunny Day Manufacturing Company is considering investing in a one-year project that requires an initial investment of $500,000. To do so, it will have to issue new common stock and will incur a flotation cost of 2.00%. At the end of the year, the project is expected to produce a cash inflow of $550,000. The rate of return that Sunny Day expects to earn on its project (net of its flotation costs) is ____________ a) 7.84% b) 7.06% c) 4.70% d) 5.10%
a) 7.84% Stock issued = initial investment = 500000 Flotation costs = 2% of stock issued = 2% of 500000 = *10000* Initial Cash outflow = CF0 = Initial investment + Flotation costs = 500000 + 10000 = 510000 Cash Inflow at the end of year = CF1 = 550000 Let r be the rate of return earned on the project, then CF0 = CF1 / (1 + r) 510000 = 550000 / (1+r) r = (550000/510000) -1 r = 1.078431 - 1 = 0.078431 = 7.8431% = 7.84%
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) If evaluated using the correct post-merger WACC, Project X would have a negative NPV. d) New York Modern's WACC, as a result of the merger, would be 10%. e) 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%.
a) If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.
Which of the following statements best explains what it means when a project has an NPV of $0? a) When a project has an NPV of $0, the project is earning a rate of return equal to the project's weighted average cost of capital. It's OK to accept a project with an NPV of $0, because the project is earning the required minimum rate of return. b) When a project has an NPV of $0, the project is earning a profit of $0. A firm should reject any project with an NPV of $0, because the project is not profitable. c) When a project has an NPV of $0, the project is earning a rate of return less than the project's weighted average cost of capital. It's OK to accept the project, as long as the project's profit is positive.
a) When a project has an NPV of $0, the project is earning a rate of return equal to the project's weighted average cost of capital. It's OK to accept a project with an NPV of $0, because the project is earning the required minimum rate of return.
Which of the following sequences is CORRECT for a typical firm? All rates are after taxes, and assume that the firm operates at its target capital structure. a) re > rs > WACC > rd. b) WACC > re > rs > rd. c) WACC > rd > rs > re. d) rs > re > rd > WACC. e) rd > re > rs > WACC.
a) re > rs > WACC > rd. The cost of new common stock is greater than the cost of retained earnings, which is greater than the cost of debt, meaning that WACC is greater than the cost of debt
Turnbull Co. has a target capital structure of 58% debt, 6% preferred stock, and 36% common equity. It has a before-tax cost of debt of 11.1%, and its cost of preferred stock is 12.2%. If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 14.7%. However, if it is necessary to raise new common equity, it will carry a cost of 16.8%. If its current tax rate is 25%, how much higher will Turnbull's weighted average cost of capital (WACC) be if it has to raise additional common equity capital by issuing new common stock instead of raising the funds through retained earnings? (Note: Round your intermediate calculations to two decimal places.) a) 0.87% b) 0.76% c) 0.84% d) 0.95%
b) 0.76% WACC = WeRe+ WpRp+Wd[Rd x (1-T)] = (36% x 14.7%) + (6% x 12.2%) + (58% x [11.1% x (1-25%]) = (.05292) + (.00732) + (.0482585) = 10.85% WACC = WeRe+ WpRp+Wd[Rd x (1-T)] = (36% x 16.8%) + (6% x 12.2%) + (58% x [11.1% x (1-25%]) = (.06048) + (.00732) + (.0482585) = 11.61% Difference in WACC = 11.61% - 10.85% = .76%
Hodor Manufacturing Co.'s (HMC) common stock currently sells for $50.00 per share. Assume the stock is in a state of constant growth, has an expected dividend yield of 4.5%, and an expected capital gains yield of 6.5%. The current dividend payout ratio is 30% and the firm's return on equity is 9.3%. The firm requires external funds for a new project and anticipates issuing additional shares of common stock at its current price of $50.00. However, the process of issuing this new equity is expected to result in a flotation expense equivalent to 10% of the stock price. If the firm goes ahead with its equity issue, what will be the firm's cost for this new common stock, re? a) 10.75% b) 11.50% c) 12.00% d) 13.25% e) 9.65%
b) 11.50% Dividend yield = D1/P0 4.5% = D1/$50.00 D1 = $2.25 re = D1/[P0(1 - F)] + g = $2.25/[$50.00(1 - 0.10)] + 0.065 = 11.50%
At the present time, Turnbull Enterprises does not have any preferred stock outstanding but is looking to include preferred stock in its capital structure in the future. Turnbull has found some institutional investors that are willing to purchase its preferred stock issue provided that it pays a perpetual dividend of $12 per share. If the investors pay $98.90 per share for their investment, then Turnbull's cost of preferred stock (rounded to four decimal places) will be ________ a) 9.7068% b) 12.1335% c) 13.9539% d) 10.9202%
b) 12.1335% Preferred stock= perpetual dividend / price of investment 12 / 98.90 = 12.1335%
Weaver Chocolate Co. expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, its expected constant dividend growth rate is 6.0%, and its common stock currently sells for $32.50 per share. New stock can be sold to the public at the current price, but a flotation cost of 5% would be incurred. What would be the cost of equity from new common stock? a) 12.70% b) 13.37% c) 14.74% d) 15.48% e) 14.04%
b) 13.37% - Expected Dividend = $3.50 x 65% = $2.276 - Common stock PV = $32.50 per share - Growth rate = 6% - Flotation cost = 5% Value of stock flotation cost = Expected divided / (cost of common equity - growth rate) $32.50 x (1-5%) = $2.227 / (cost of common equity - 6%) (Cost of common equity - 6%) = $2.275 / 30.875 Cost of common equity - 6% = .073684 *Cost of common equity = 13.37%*
The cost of issuing new common stock is calculated the same way as the cost of raising equity capital from retained earnings. a) True: The cost of retained earnings and the cost of new common stock are calculated in the same manner, except that the cost of retained earnings is based on the firm's existing common equity, while the cost of new common stock is based on the value of the firm's share price net of its flotation cost. b) False: Flotation costs need to be taken into account when calculating the cost of issuing new common stock, but they do not need to be taken into account when raising capital from retained earnings.
b) False: Flotation costs need to be taken into account when calculating the cost of issuing new common stock, but they do not need to be taken into account when raising capital from retained earnings.
Mountaineer Manufacturing is considering two normal, equally risky, mutually exclusive, but not repeatable projects. The two projects have the same investment costs, but Project A has an IRR of 15%, while Project B has an IRR of 20%. Mountaineer has a WACC of 10%. Assuming the projects' NPV profiles cross in the upper right quadrant, which of the following statements is CORRECT? a) As the projects are mutually exclusive, the firm should always select Project B. b) If the crossover rate is 8%, Project B will have the higher NPV. c) Only one project has a positive NPV. d) If the crossover rate is 8%, Project A will have the higher NPV. e) Each project must have a negative NPV.
b) If the crossover rate is 8%, Project B will have the higher NPV.
Which of the following statements about IRR and NPV is CORRECT? a) The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate. b) The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR. c) The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR. d) The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period. e) The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
b) The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method
