Business Finance Final 12-14

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? WACC = (1/1.42)(.162) + [(.42 /1.42)(.058)] = A. 12.54 percent B. 11.47 percent C. 13.12 percent D. 12.28 percent E. 13.01 percent

c

Electronic Products has 22,500 bonds outstanding that are currently quoted at 101.6. The bonds mature in 8 years and pay an annual coupon payment of $90. What is the firm's aftertax cost of debt if the applicable tax rate is 34 percent? $1,016 = $90 ({1 - [1 / (1 + RD )8 ]} / RD) + $1,000 / (1 + RD) 8 RD = 8.714 percent Aftertax cost of debt = 8.714 percent x (1 -.34) = A. 5.47 percent B. 4.79 percent C. 5.75 percent D. 6.98 percent E. 6.67 percent

c

Kate is the CFO of a major firm and has the job of assigning discount rates to each project under consideration. Kate's method of doing this is to assign an incrementally higher rate as the risk level of the project increases and a lower rate as the risk level declines. Kate is applying the ___ approach. A. pure play B. divisional rating C. subjective D. straight WACC E. equity rating

c

Which one of the following is the equity risk arising from the capital structure selected by a firm? A. Strategic risk B. Financial risk C. Liquidity risk D. Industry risk E. Business risk

b

A firm has a return on equity of 12.4 percent according to the dividend growth model and a return of 18.7 percent according to the capital asset pricing model. The market rate of return is 13.5 percent. What rate should the firm use as the cost of equity when computing the firm's weighted average cost of capital (WACC)? A. 12.4 percent because it is lower than 18.7 percent B. 18.7 percent because it is higher than 12.4 percent C. The arithmetic average of 12.4 percent and 18.7 percent D. The arithmetic average of 12.4 percent, 13.5 percent, and 18.7 percent E. 13.5 percent

c

Which one of the following is minimized when the value of a firm is maximized? A. Return on equity B. WACC C. Debt D. Taxes E. Bankruptcy costs

b

. Domino's is evaluating an extra dividend versus a share repurchase. In either case, $10,000 would be spent. Current earnings are $2.10 per share, and the stock currently sells for $52 per share. There are 2,000 shares outstanding. Ignore taxes and other imperfections. The PE ratio will be ____ if the firm issues the dividend as compared to ____ if the firm does the share repurchase. If the firm issues the dividend: Dividends per share = $10,000/2,000 shares = $5.00 P/E = ($52-5.00)/$2.10 = If the firm does the share repurchase: Shares repurchased = $10,000/$52 = 192.31 EPS after repurchase = ($2.10 ×2,000) /(2,000 -192.31) = $2.3234 P/E= $52 / $2.3234 = A. 22.38; 22.38 B. 24.87; 22.38 C. 20.23; 24.87 D. 22.38; 20.23 E. 20.23; 22.38

a

Beta Industries is considering a project with an initial cost of $6.9 million. The project will produce cash inflows of $1.52 million a year for seven years. The firm uses the subjective approach to assign discount rates to projects. For this project, the subjective adjustment is +2.2 percent. The firm has a pretax cost of debt of 9.1 percent and a cost of equity of 17.7 percent. The debt-equity ratio is .57 and the tax rate is 34 percent. What is the net present value of the project? (Round the answer to the nearest $100.) WACC = (1/1.57)(.177) + (.57 /1.57)(.091)(1 -.34) = .134544 Project WACC = .134544 + .022 = .156544, or 15.6544 percent NPV = -$6.9m + ($1.52m)(PVIFA7, 15.6544%) = A. -$698,400 B. -$187,100 C. $48,200 D. $333,300 E. $2,500

a

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? Common stock: 21,000 x $61 = $1,281,000 Preferred stock: 11,000 x $48 = $528,000 Debt: 1.04 x $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) = A. 14.52 percent B. 13.44 percent C. 14.19 percent D. 14.37 percent E. 13.92 percent

a

Which one of the following terms applies to the costs incurred by a firm that is trying to avoid filing for bankruptcy? A. Indirect bankruptcy costs B. Direct bankruptcy costs C. Static theory cost D. Optimal capital structure cost E. Reorganization costs

a

Which one of the following terms is inclusive of both direct and indirect bankruptcy costs? A. Financial distress costs B. Capital structure costs C. Financial leverage D. Homemade leverage E. Cost of capital

a

All else constant, an increase in a firm's cost of debt: A. could be caused by an increase in the firm's tax rate. B. will result in an increase in the firm's cost of capital. C. will lower the firm's weighted average cost of capital. D. will lower the firm's cost of equity. E. will increase the firm's capital structure weight of debt.

b

Assume a firm has a beta of 1.2. All else held constant, the cost of equity for this firm will increase if the: 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

Donut Delites has a beta of 1.06, a dividend growth rate of 1.2 percent, a stock price of $12a share, and an expected annual dividend of $.68 per share next year. The market rate of return is 11.4 percent and the risk-free rate is 3.8 percent. What is the firm's cost of equity? RE = .038 + 1.06(.114-.038) = .11856 RE = ($.68/$12) + .012 = .06867 Average RE = (.11856 + .06867)/2 = A. 7.74 percent B. 9.36 percent C. 9.30 percent D. 9.72 percent E. 7.46 percent

b

The Green Balloon just paid its first annual dividend of $.87 a share. The firm plans to increase the dividend by 3.2 percent per year indefinitely. What is the firm's cost of equity if the current stock price is $4.75 a share? Re = ($.87× 1.032) / $4.75 + .032 = A. 20.35 percent B. 22.10 percent C. 24.42 percent D. 18.79 percent E. 19.98 percent

b

Lester's is a globally diverse company with multiple divisions and a cost of capital of 15.8 percent. Med, Inc., is a specialty firm in the medical equipment field with a cost of capital of 13.7 percent. With the aging of America, both firms recognize the opportunities that exist in the medical field and are considering expansion in this area. At present, there is an opportunity for multiple firms to be involved in a new medical devices project. Each project will require an initial investment of $8.4 million with annual returns of $2.2 million per year for seven years. Which company(ies), if either, should become involved in the new projects? A. Lester's only B. Med, Inc., only C. Both Lester's and Med, Inc. D. Neither Lester's nor Med, Inc. E. The answer cannot be determined based on the information provided.

c

Sharpie's Co. has a market value balance sheet as shown below. The firm currently has 2,200 shares of stock outstanding and net income of $10,500. Market Value Book Sheet Excess Cash: $14,300 Debt: $84,600 Other Assets: 215,460 Equity: 145,160 Total = $229,760 $229,760 The firm has decided to spend $6,500 on new equipment and use the remaining excess cash to pay an extra cash dividend. What will the firm's PE ratio be after this dividend is paid, all else held constant? Ignore taxes. EPS = $10,500/2,200 = $4.7727 Ex-dividend price per share = [$145,160 - ($14,300 - 6,500)] / 2,200 = $62.4364 PE ratio = $62.4364/$4.7727 = A. 14.20 B. 16.67 C. 13.08 D. 11.22 E. 14.57

c

Tennessee Valley Antiques would like to issue new equity shares if its cost of equity declines to 12.5 percent. The company pays a constant annual dividend of $2.10 per share. What does the market price of the stock need to be for the firm to issue the new shares? P0 = $2.10 /.125 = A. $15.60 B. $15.10 C. $16.80 D. $17.90 E. $18.40

c

The 7.5 percent preferred stock of Rock Bottom Floors is selling for $84 a share. What is the firm's cost of preferred stock if the tax rate is 35 percent and the par value per share is $100? Rp = (.075 ×$100)/$84 = A. 7.50 percent B. 8.13 percent C. 8.93 percent D. 10.79 percent E. 9.14 percent

c

Three years ago, the Morgan Co. issued 15-year, 6.5 percent semiannual coupon bonds at par. Today, the bonds are quoted at 100.6. What is this firm's pretax cost of debt? $1,006= [(.065 $1,000) / 2] ({1 - 1 / [1 + (RD / 2)]24} / (RD / 2))+ $1,000 / [1 + (RD / 2)]24 RD = A. 6.27 percent B. 6.08 percent C. 6.43 percent D. 6.83 percent E. 6.29 percent

c

Which one of the following best defines legal bankruptcy? A. Negotiating new payment terms with a firm's creditors B. A temporary technical insolvency C. A legal proceeding for liquidating or reorganizing a business D. The internal process of revising the capital structure of a firm E. The failure of a firm to meet its financial obligations in a timely manner

c

Which one of the following is used as the pretax cost of debt? A. Average coupon rate on the firm's outstanding bonds B. Coupon rate on the firm's latest bond issue C. Weighted average yield to maturity on the firm's outstanding debt D. Average current yield on the firm's outstanding debt E. Annual interest divided by the market price per bond for the latest bond issue

c

Which one of these will affect the capital structure weights used to compute a firm's weighted average cost of capital? A. Decrease in the book value of a firm's equity B. Decrease in a firm's tax rate C. Increase in the market value of the firm's common stock D. Increase in the market risk premium E. Increase in the firm's beta

c

You are comparing two possible capital structures for a firm. The first option is an all-equity firm. The second option involves the use of $3.8 million of debt. The break-even point between these two financing options occurs when the earnings before interest and taxes (EBIT) are $428,000. Given this, you know that leverage is beneficial to the firm: A. whenever EBIT is less than $428,000. B. only when EBIT is $428,000. C. whenever EBIT exceeds $428,000. D. only if the debt is decreased by $428,000. E. only if the debt is increased by $428,000.

c

. K's Bridal Shoppe has 4,000 shares of common stock outstanding at a price of $13 a share. It also has 500 shares of preferred stock outstanding at a price of $22 a share. There are 50 bonds outstanding that have a semiannual coupon payment of $25. The bonds mature in four years, have a face value of $1,000, and sell at 98 percent of par. What is the capital structure weight of the common stock? Common stock = 4,000 x $13 = $52,000 Preferred stock = 500 x $22 = $11,000 Debt = 50 x (.98 x $1,000) = $49,000 Value = $52,000 + 11,000 + 49,000 = $112,000 Weight of common stock = $52,000/$112,000 = A. 48.20 percent B. 49.68 percent C. 48.15 percent D. 46.43 percent E. 50.08 percent

d

Black Stone Furnaces wants to build a new facility. The cost of capital for this investment is primarily dependent on which one of the following? A. The firm's overall source of funds B. Source of the funds used to build the facility C. Current tax rate D. The nature of the investment E. Firm's historical average rate of return

d

Jericho Snacks is an all-equity firm with estimated earnings before interest and taxes of $624,000 annually forever. Currently, the firm has no debt but is considering borrowing $725,000 at 6.75 percent interest. The tax rate is 35 percent and the current cost of equity is 15.2 percent. What is the value of the levered firm? Vu = [$624,000 ×(1 -.35)]/.152 = $2,668,421.05 VL = $2,668,421.05 + (.35 ×$725,000) = $2,922,171 A. $3,187,271 B. $2,769,535 C. $3,307,271 D. $2,922,171 E. $3,506,418

d

T.L.C. Enterprises just revised its capital structure from a debt-equity ratio of .37 to a debt-equity ratio of .48. The firm's shareholders who prefer the old capital structure should: A. sell some shares and hold the sale proceeds in cash. B. sell all of their shares and loan out the entire sale proceeds. C. do nothing. D. sell some shares and loan out the sale proceeds. E. borrow funds and purchase more shares.

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

Trendsetters has a cost of equity of 14.6 percent. The market risk premium is 8.4 percent and the risk-free rate is 3.9 percent. The company is acquiring a competitor, which will increase the company's beta to 1.4. What effect, if any, will the acquisition have on the firm's cost of equity capital? RE = .039 + 1.4(.084) = .1566, or 15.66 percent Increase in cost of equity = 15.66 % -14.6 % = A. No effect B. Decrease of .62 percent C. Decrease of .84 percent D. Increase of 1.06 percent E. Increase of .13 percent

d

Which one of the following statements concerning capital structure weights is correct? A. Target capital structure rates for a firm are irrelevant to individual projects. B. The weights are unaffected when a bond issue matures. C. An increase in the debt-equity ratio will increase the weight of the common stock. D. The repurchase of preferred stock will increase the weight of debt. E. The issuance of additional shares of common stock will increase the weight of both the common and preferred stock.

d

Which one of the following statements concerning financial leverage is correct? A. The benefits of leverage are unaffected by the amount of a firm's earnings. B. The use of leverage will always increase a firm's earnings per share. C. The shareholders of a firm are exposed to less risk anytime a firm uses financial leverage. D. Changes in the capital structure of a firm will generally change the firm's earnings per share. E. Financial leverage is beneficial to a firm only when the firm has negative earnings.

d

Assume you are comparing two firms that are identical in every aspect, except one is levered and one is unlevered. Which one of the following statements is correct regarding these two firms? A. The levered firm has higher EPS (earnings per share) than the unlevered firm at the break-even point. B. The levered firm will have higher EPS than the unlevered firm at all levels of EBIT. C. The unlevered firm will have higher EPS than the levered firm at relatively high levels of EBIT. D. The EPS for the unlevered firm will always exceed those of the levered firm. E. The unlevered firm will have higher EPS at relatively low levels of EBIT.

e

In an efficient market, the cost of equity for a highly risky firm: A. will be less than the market rate but higher than the risk-free rate. B. must equal the market rate of return. C. changes by 1 percent for every 1 percent change in the risk-free rate. D. decreases as the beta of the firm's stock increases. E. increases in direct relation to the stock's systematic risk.

e

The Fruit Mart is an all-equity firm with a current cost of equity of 17.4 percent. The estimated earnings before interest and taxes are $169,500 annually forever. Currently, the firm has no debt but is in the process of borrowing $400,000 at 9.5 percent interest. The tax rate is 35 percent. What is the value of the unlevered firm? Vu = [$169,500 ×(1 -.35)]/.174 = $633,190 A. $649,207 B. $753,571 C. $656,411 D. $719,307 E. $633,190

e

Triangle Enterprises has no debt but can borrow at 8 percent. The firm's WACC is currently 13.2 percent, and there is no corporate tax. If the firm converts to 30 percent debt, what will its cost of equity be? WACC = .132 = .70 RE + .30(.08) RE = A. 16.67 percent B. 12.95 percent C. 14.47 percent D. 16.39 percent E. 15.43 percent

e

Which one of the following is the equity risk arising from the daily operations of a firm? A. Strategic risk B. Financial risk C. Liquidity risk D. Industry risk E. Business risk

e