Chapter 12

Delta Foods is an unlevered firm that is equally as risky as the market. U.S. Treasury bills are yielding 2.8 percent and the market risk premium is 8.1 percent. What discount rate should be assigned to a project that has the same risks as Delta Foods? A. 10.9% B. 8.1% C. 2.8% D. 5.3% E. 13.7%

A. 10.9% RS = .028 + .081 = .109, or 10.9%

A firm has a beta of 1.3 and a debt-to-equity ratio of .4. The market rate of return is 11.6 percent, the tax rate is 32 percent, and the risk-free rate is 3.3 percent. The pretax cost of debt is 7.2 percent. What is the firm's WACC? A. 11.46% B. 8.90% C. 10.41% D. 9.96% E. 12.12%

A. 11.46% RS = .033 + 1.3(.116 - .033) = .1409 RWACC = (1/1.4)(.1409) + (.4/1.4)(.072)(1 - .32) = .1146, or 11.46%

CTO Transport has an aftertax cost of debt of 6.8 percent, a cost of equity of 14.2 percent and a cost of preferred stock of 8.5 percent. The firm has 50,000 shares of common stock outstanding at a market price of $43 a share. There are 20,000 shares of preferred stock outstanding at a market price of $46 a share. The bond issue has a total face value of $500,000 and sells at 97 percent of face value. The tax rate is 35 percent. What is WACC? A. 11.72% B. 12.06% C. 12.42% D. 11.39% E. 10.87%

A. 11.72% MVDebt = $500,000 × .97 = $485,000 MVPreferred = 20,000 × $46 = $920,000 MVEquity = 50,000 × $43 = $2,150,000 MVD + E = $485,000 + 920,000 + 2,150,000 = $3,555,000 WACC = ($2,150,000/$3,555,000) × .142 + ($920,000/$3,555,000) × .085 + ($485,000/$3,555,000) × .068 = .1172, or 11.72%

The beta of a firm is more likely to be high under which two conditions? A. High cyclical business activity and high operating leverage B. High cyclical business activity and low operating leverage C. Low cyclical business activity and low financial leverage D. Low cyclical business activity and low operating leverage E. Low operating and financial leverage

A. High cyclical business activity and high operating leverage

The discount rate for a project should equal the: A. cost of equity of the firm. B. expected return on a financial asset of comparable risk. C. discount rate used on the firm's last profitable project. D. firm's weighted average cost of capital. E. market rate of return.

B. expected return on a financial asset of comparable risk.

The weighted average cost of capital for a firm is the: A. discount rate which the firm should apply to all of the projects it undertakes. B. overall rate which the firm must earn on its existing assets to maintain the value of its stock. C. rate the firm should expect to pay on its next bond issue. D. maximum rate which the firm should require on any projects it undertakes. E. rate of return that the firm's preferred stockholders should expect to earn over the long term.

B. overall rate which the firm must earn on its existing assets to maintain the value of its stock.

Zee s Toy Store needs $187,000 for expansion. The firm has a target capital structure of 40 percent debt and 60 percent external equity. The flotation cost of debt is 5.5 percent compared to 9.5 percent for equity. What amount does the firm need to raise? A. $201,773.00 B. $199,716.00 C. $203,040.17 D. $193,333.33 E. $186,111.75

C. $203,040.17 ƒ0 = .6 × .095 + .4 × .055 = .079 Amount raised = $187,000/(1 - .079) = $203,040.17

Southwest Tours needs $80,000 for a new project. The firm has a target capital structure of 25 percent debt and 75 percent equity. The flotation cost of debt is 5 percent compared to 10.25 percent for equity. What amount does the firm need to raise if it generates sufficient internal equity to cover the equity need? A. $87,851.75 B. $76,211.17 C. $81,012.66 D. $69,497.79 E. $79,674.09

C. $81,012.66 ƒ0 = .75 × 0 + .25 × .05 = .0125 Amount raised = $80,000/(1 - .0125) = $81,012.66

A stock is comprised of 40 percent Stock A, 30 percent Stock B, and the remainder is invested in Stock C. The security betas are 1.32. .97, and 1.28 for Stocks A, B, and C, respectively. What is the portfolio beta? A. 1.190 B. 1.196 C. 1.203 D. 1.211 E. 1.219

C. 1.203 ΒP = .4 × 1.32 + .3 × .97 + (1 - .4 - .3) × 1.28 = 1.203

ABC stock has a beta that is 20 percent higher than the overall market beta. The risk-free rate is 2.7 percent and the market rate of return is 13.6 percent. What is the cost of equity? A. 16.27% B. 15.91% C. 15.78% D. 16.32% E. 16.08%

C. 15.78% Rs = .027 + 1.2(.136 - .027) = .1578, or 15.78%

The S&P 500 has a dividend yield of 2.4 percent. Analysts expect overall dividends to grow at a 5.2 percent annually. Treasury bills yield 3.2 percent. The expected market rate of return is ____ percent and the market risk premium is ____ percent. A. 10.8; 7.6 B. 4.4; 1.2 C. 7.6; 4.4 D. 10.8; 4.4 E. 10.8; 5.2

C. 7.6; 4.4 RM = .024 + .052 = .076, or 7.6% RM - RF = .076 - .032 = .044, or 4.4%

NuPress Valet has a proposed investment with an initial cost of $62 million and cash flows of $12.5 million for five years. Debt represents 50 percent of the capital structure. The cost of equity is 12 percent, the pretax cost of debt is 8.5 percent, and the tax rate is 34 percent. What is the firm's WACC? A. 6.15% B. 9.12% C. 8.81% D. 10.25% E. 9.75%

C. 8.81% WACC = .5 × .12 + .5 × .085 × (1 - .34) = .0881, or 8.81%

Finally There! has 1,600 bonds outstanding with a $1,000 par value, a 6 percent coupon, 8 years to maturity, semiannual interest payments, and a market price equal to 97 percent of par. The firm also has 60,000 shares of common stock outstanding at a price per share of $32 and a beta of 1.15. The risk-free rate is 5 percent, the market risk premium is 7 percent, and the tax rate is 35 percent. What is the firm's WACC? (When computing WACC, round your cost of debt to 4 decimal places when expressed as a decimal value.) A. 9.58% B. 10.34% C. 9.10% D. 9.19% E. 10.12%

C. 9.10% MVDebt = 1,600 × $1,000 × .97 = $1,552,000 MVEquity = 60,000 × $32 = $1,920,000 MVD + E = $1,552,000 + 1,920,000 = $3,472,000 RS = .05 + 1.15 × .07 = .1305, or 13.05% Bond value = ($1,000 × .97) = [(.06 × $1,000)/2]({1 - 1/[1 + (RB/2)](8 × 2)}/(RB/2)) + $1,000/[1 + (RB/2)](8 × 2) Using a financial calculator, RB = 6.49% WACC = ($1,920,000/$3,472,000) × .1305 + ($1,552,000/$3,472,000) × .0649 × (1 - .35) = .0910, or 9.10%

Which of these may occur if a firm uses its overall cost of capital as the discount rate for all projects? I. Profitable low-risk projects may be incorrectly rejected. II. Only projects with risks similar to the current firm will be accepted. III. Too many high-risk projects may be accepted. IV. Only low-risk projects will be accepted. A. II only B. II and IV only C. I and III only D. I and IV only E. I, II, and III only

C. I and III only

When computing the weights to be used in a project's WACC equation, you should use the: A. proportions of debt and equity that will finance the project. B. current market values of debt and equity. C. average market weights of debt and equity that are expected over the project's life. D. average book weights of debt and equity that are expected over the project's life. E. current book values of debt and equity.

C. average market weights of debt and equity that are expected over the project's life.

The cost of preferred stock: A. increases as the beta of the firm increases. B. is equal to the annual dividend divided by the par value of the stock. C. is equal to the annual dividend divided by the present value of all the stock's dividend payments. D. varies as tax rates vary. E. is generally computed using the CAPM.

C. is equal to the annual dividend divided by the present value of all the stock's dividend payments.

A firm s cost of debt will decrease when: A. market interest rates increase. B. the coupon rate on the firm's bonds increase. C. tax rates increase. D. inflation rates increase E. interest is paid semiannually versus annually.

C. tax rates increase.

Upper Roads is an all-equity financed firm. The beta is .75, the market risk premium is 8 percent, and the tax rate is 35 percent. The firm just issued its annual dividend of $1.42 per share and announced that future dividends will increase by 5 percent annually. The stock sells for $27 a share. What is the cost of equity? A. 10.26% B. 9.38% C. 11.19% D. 10.52% E. 11.78%

D. 10.52% RS = ($1.42 × 1.05)/$27 + .05 = .1052, or 10.52%

An all-equity firm has a beta of .98. The firm is evaluating a project that will increase the output of the firm's existing product. The market risk premium is 7.3 percent and the risk-free rate is 3.4 percent. What discount rate should be assigned to this expansion project? A. 8.39% B. 7.22% C. 7.15% D. 10.55% E. 11.37%

D. 10.55% RS = .034 + .98 × .073 = .1055, or 10.55%

The terminal value of a firm is based on which one of these assumptions? A. The growth rate of the future cash flows will exceed the firm's WACC. B. All future cash flows will be constant. C. The cash flows after Time T will diminish on an annual basis. D. The cash flows will increase in the future at a constant perpetual rate. E. The firm will be sold at Time T for the stated terminal value.

D. The cash flows will increase in the future at a constant perpetual rate.

Which one of these statements related to beta is correct? A. A firm with a given sales cyclicality can reduce its beta by replacing variable production costs with fixed costs. B. The beta of debt is generally assumed to equal the market beta. C. Highly cyclical stocks tend to have low betas. D. The levered beta of equity exceeds the asset beta. E. Stocks with a high variance must have a high beta.

D. The levered beta of equity exceeds the asset beta.

In a changing interest rate environment, the cost of new debt: A. is assumed to be zero for a levered firm. B. is equal to the embedded cost of old debt. C. generally exceeds the cost of equity on a pretax basis. D. is equal to the cost of borrowing. E. increases when taxes are considered.

D. is equal to the cost of borrowing.

The Red Hen currently has a debt-to-equity ratio of .45, its cost of equity is 13.6 percent, and its beta is 1.49. The pretax cost of debt is 7.8 percent, the tax rate is 35 percent, and the risk-free rate is 3.1 percent. The firm's target debt-to-equity ratio is .5. What discount rate should be assigned to a new project the firm is considering if the project is equally as risky as the overall firm and will be financed solely with debt? A. 7.80% B. 9.76% C. 5.07% D. 9.34% E. 10.76%

E. 10.76% WACC = (1/1.5)(.136) + (.5/1.5)(.078)(1 - .35) = .1076, or 10.76%

Taylor s has a beta of .78 and a debt-to-equity ratio of .2. The market rate of return is 10.6 percent, the tax rate is 34 percent, and the risk-free rate is 1.4 percent. The pretax cost of debt is 6.1 percent. What is the firm's WACC? A. 8.08% B. 7.67% C. 8.16% D. 9.96% E. 7.82%

E. 7.82% RS = .014 + .78(.106 - .014) = .08576 RWACC = (1/1.2)(.08576) + (.2/1.2)(.061)(1 - .34) = .0782, or 7.82%

Diversified Industries is a multi-product firm operating in a number of industries. Assume the firm is analyzing a new project that has risks unrelated to those of the current firm's product. When computing the net present value of the new project the cash flows should be discounted using: A. a rate based on a beta of one since the firm is well diversified. B. a rate based on the firm's current beta. C. the risk-free rate of return. D. the market rate of return. E. a rate commensurate with the risk level of the project

E. a rate commensurate with the risk level of the project.