Chapter 14
Panelli's is analyzing a project with an initial cost of $102,000 and cash inflows of $65,000 in year one and $74,000 in year two. This project is an extension of the firm's current operations and thus is equally as risky as the current firm. The firm uses only debt and common stock to finance its operations and maintains a debt-equity ratio of 0.45. The aftertax cost of debt is 4.8 percent, the cost of equity is 12.7 percent, and the tax rate is 35 percent. What is the projected net present value of this project? A. $15,411 B. $15,809 C. $16,333 D. $16,938 E. $17,840
$17,840
You are evaluating a project which requires $230,000 in external financing. The flotation cost of equity is 11.6 percent and the flotation cost of debt is 5.4 percent. What is the initial cost of the project including the flotation costs if you maintain a debt-equity ratio of 0.45? A. $248,494 B. $249,021 C. $254,638 D. $255,551 E. $255,646
$254,638
Western Wear is considering a project that requires an initial investment of $274,000. The firm maintains a debt-equity ratio of 0.40 and has a flotation cost of debt of 7 percent and a flotation cost of equity of 10.5 percent. The firm has sufficient internally generated equity to cover the equity portion of this project. What is the initial cost of the project including the flotation costs? A. $279,592 B. $281,406 C. $288,005 D. $297,747 E. $302,762
$279,592
Carson Electronics uses 70 percent common stock and 30 percent debt to finance its operations. The aftertax cost of debt is 5.4 percent and the cost of equity is 15.4 percent. Management is considering a project that will produce a cash inflow of $36,000 in the first year. The cash inflows will then grow at 3 percent per year forever. What is the maximum amount the firm can initially invest in this project to avoid a negative net present value for the project? A. $299,032 B. $382,979 C. $411,406 D. $434,086 E. $441,414
$382,979
The Daily Brew has a debt-equity ratio of 0.72. The firm is analyzing a new project which requires an initial cash outlay of $420,000 for equipment. The flotation cost is 9.6 percent for equity and 5.4 percent for debt. What is the initial cost of the project including the flotation costs? A. $302,400 B. $368,924 C. $455,738 D. $456,400 E. $583,333
$455,738
Travis & Sons has a capital structure which is based on 40 percent debt, 5 percent preferred stock, and 55 percent common stock. The pre-tax cost of debt is 7.5 percent, the cost of preferred is 9 percent, and the cost of common stock is 13 percent. The company's tax rate is 39 percent. The company is considering a project that is equally as risky as the overall firm. This project has initial costs of $325,000 and annual cash inflows of $87,000, $279,000, and $116,000 over the next three years, respectively. What is the projected net present value of this project? A. $68,211.04 B. $68,879.97 C. $69,361.08 D. $74,208.18 E. $76,011.23
$76,011.23
Yesteryear Productions is considering a project with an initial start up cost of $960,000. The firm maintains a debt-equity ratio of 0.50 and has a flotation cost of debt of 6.8 percent and a flotation cost of equity of 11.4 percent. The firm has sufficient internally generated equity to cover the equity cost of this project. What is the initial cost of the project including the flotation costs? A. $979,417 B. $982,265 C. $992,386 D. $1,038,513 E. $1,065,089
$982,265
The Bakery is considering a new project it considers to be a little riskier than its current operations. Thus, management has decided to add an additional 1.5 percent to the company's overall cost of capital when evaluating this project. The project has an initial cash outlay of $62,000 and projected cash inflows of $17,000 in year one, $28,000 in year two, and $30,000 in year three. The firm uses 25 percent debt and 75 percent common stock as its capital structure. The company's cost of equity is 15.5 percent while the aftertax cost of debt for the firm is 6.1 percent. What is the projected net present value of the new project? A. -$6,208 B. -$5,964 C. -$2,308 D. $1,427 E. $1,573
-$5,964
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? A. -$11,044 B. -$9,115 C. -$7,262 D. -$4,508 E. $1,219
-$9,115
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? A. 10.39 percent B. 10.64 percent C. 11.18 percent D. 11.30 percent E. 11.56 percent
10.39 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? A. 10.46 percent B. 10.67 percent C. 11.06 percent D. 11.38 percent E. 11.57 percent
11.06 WACC = (1/1.55) (0.145) + (0.55/1.55) (0.048) = 11.06 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? A. 12.46 percent B. 12.92 percent C. 13.50 percent D. 14.08 percent E. 14.54 percent
12.46
Wayco Industrial Supply has a pre-tax cost of debt of 7.6 percent, a cost of equity of 14.3 percent, and a cost of preferred stock of 8.5 percent. The firm has 220,000 shares of common stock outstanding at a market price of $27 a share. There are 25,000 shares of preferred stock outstanding at a market price of $41 a share. The bond issue has a face value of $550,000 and a market quote of 101.2. The company's tax rate is 37 percent. What is the firm's weighted average cost of capital? A. 10.18 percent B. 10.84 percent C. 11.32 percent D. 12.60 percent E. 12.81 percent
12.81 percent
Delta Lighting has 30,000 shares of common stock outstanding at a market price of $17.50 a share. This stock was originally issued at $31 per share. The firm also has a bond issue outstanding with a total face value of $280,000 which is selling for 86 percent of par. The cost of equity is 16 percent while the aftertax cost of debt is 6.9 percent. The firm has a beta of 1.48 and a tax rate of 30 percent. What is the weighted average cost of capital? A. 11.07 percent B. 13.14 percent C. 14.36 percent D. 15.29 percent E. 15.47 percent
13.14
Delta Lighting has 30,000 shares of common stock outstanding at a market price of $17.50 a share. This stock was originally issued at $31 per share. The firm also has a bond issue outstanding with a total face value of $280,000 which is selling for 86 percent of par. The cost of equity is 16 percent while the aftertax cost of debt is 6.9 percent. The firm has a beta of 1.48 and a tax rate of 30 percent. What is the weighted average cost of capital? A. 11.07 percent B. 13.14 percent C. 14.36 percent D. 15.29 percent E. 15.47 percent
13.14 percent
Silo Mills has a beta of 0.87 and a cost of equity of 11.9 percent. The risk-free rate of return is 2.8 percent. The firm is currently considering a project that has a beta of 1.03 and a project life of 6 years. What discount rate should be assigned to this project? A. 13.33 percent. B. 13.57 percent. C. 13.62 percent. D. 13.84 percent. E. 14.09 percent.
13.57 percent
The Market Outlet has a beta of 1.38 and a cost of equity of 14.945 percent. The risk-free rate of return is 4.25 percent. What discount rate should the firm assign to a new project that has a beta of 1.25? A. 13.54 percent. B. 13.72 percent. C. 13.94 percent. D. 14.14 percent. E. 14.36 percent.
13.94 percent
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? A. 14.82 million B. 14.94 million C. 15.07 million D. 15.12 million E. 15.23 million
14.94 million
Jiminy's Cricket Farm issued a 30-year, 8 percent, semiannual bond 6 years ago. The bond currently sells for 114 percent of its face value. What is the aftertax cost of debt if the company's tax rate is 31 percent? A. 4.63 percent B. 4.70 percent C. 4.75 percent D. 4.82 percent E. 4.86 percent
4.70 percent
Grill Works and More has 8 percent preferred stock outstanding that is currently selling for $49 a share. The market rate of return is 14 percent and the firm's tax rate is 37 percent. What is the firm's cost of preferred stock? A. 14.77 percent B. 15.29 percent C. 15.67 percent D. 16.33 percent E. 16.54 percent
16.33 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? A. 13.68 percent B. 14.00 percent C. 14.29 percent D. 19.44 percent E. 19.80 percent
19.44 percent
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? A. 0.38 B. 0.44 C. 1.02 D. 2.25 E. 2.63
2.25
The outstanding bonds of Tech Express are priced at $989 and mature in 8 years. These bonds have a 6 percent coupon and pay interest annually. The firm's tax rate is 39 percent. What is the firm's aftertax cost of debt? A. 3.01 percent B. 3.22 percent C. 3.35 percent D. 3.77 percent E. 4.41 percent
3.77 percent
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? A. 2.97 percent B. 3.24 percent C. 3.78 percent D. 5.21 percent E. 5.53 percent
3.78 percent
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? A. 3.98 percent B. 4.42 percent C. 4.71 percent D. 5.36 percent E. 5.55 percent
3.98 percent
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? A. 43.08 percent B. 45.16 percent C. 47.11 percent D. 54.00 percent E. 55.45 percent
45.16 percent
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? A. 2.55 percent B. 5.09 percent C. 5.66 percent D. 7.31 percent E. 7.48 percent
5.66 percent
The Corner Bakery has a bond issue outstanding that matures in 7 years. The bonds pay interest semi-annually. Currently, the bonds are quoted at 101.4 percent of face value and carry a 9 percent coupon. What is the firm's aftertax cost of debt if the tax rate is 30 percent? A. 4.88 percent B. 5.36 percent C. 5.45 percent D. 6.11 percent E. 8.74 percent
6.11 percent
Simple Foods has a zero coupon bond issue outstanding that matures in 9 years. The bonds are selling at 42 percent of par value. What is the company's aftertax cost of debt if the tax rate is 38 percent? A. 5.48 percent B. 5.73 percent C. 6.12 percent D. 7.73 percent E. 9.88 percent
6.12 percent
R.S. Green has 250,000 shares of common stock outstanding at a market price of $28 a share. Next year's annual dividend is expected to be $1.55 a share. The dividend growth rate is 2 percent. The firm also has 7,500 bonds outstanding with a face value of $1,000 per bond. The bonds carry a 7 percent coupon, pay interest semiannually, and mature in 7.5 years. The bonds are selling at 98 percent of face value. The company's tax rate is 34 percent. What is the firm's weighted average cost of capital? A. 5.4 percent B. 6.2 percent C. 7.5 percent D. 8.5 percent E. 9.6 percent
6.2 percent
Decline, Inc. is trying to determine its cost of debt. The firm has a debt issue outstanding with 15 years to maturity that is quoted at 107 percent of face value. The issue makes semiannual payments and has an embedded cost of 11 percent annually. What is the aftertax cost of debt if the tax rate is 33 percent? A. 6.76 percent B. 6.90 percent C. 7.17 percent D. 7.37 percent E. 7.42 percent
6.76 percent
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? A. 5.8 percent B. 6.2 percent C. 6.7 percent D. 7.0 percent E. 7.5 percent
7.5 percent
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? A. 6.75 percent B. 7.20 percent C. 7.75 percent D. 8.30 percent E. 8.80 percent
8.80 percent
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? A. 8.44 percent B. 8.78 percent C. 8.96 percent D. 9.13 percent E. 9.20 percent
9.20 percent
Justice, Inc. has a capital structure which is based on 30 percent debt, 5 percent preferred stock, and 65 percent common stock. The flotation costs are 11 percent for common stock, 10 percent for preferred stock, and 7 percent for debt. The corporate tax rate is 37 percent. What is the weighted average flotation cost? A. 8.97 percent B. 9.48 percent C. 9.62 percent D. 9.75 percent E. 10.00 percent
9.75 percent
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. A. I and III only B. III and IV only C. I, II, and III only D. I, II, and IV only E. I, II, III, and IV
I, II, III, and IV
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. A. I and III only B. II and IV only C. I, II, and IV only D. I, III, and IV only E. I, II, III, and IV
I, II, III, and IV
The aftertax cost of debt generally increases when: I. a firm's bond rating increases. II. the market rate of interest increases. III. tax rates decrease. IV. bond prices rise. A. I and III only B. II and III only C. I, II, and III only D. II, III, and IV only E. I, II, III, and IV
II and III only
The dividend growth model can be used to compute the cost of equity for a firm in which of the following situations? I. firms that have a 100 percent retention ratio II. firms that pay a constant dividend III. firms that pay an increasing dividend IV. firms that pay a decreasing dividend A. I and II only B. I and III only C. II and III only D. I, II, and III only E. II, III, and IV only
II, III, and IV only
Which of the following statements are correct? I. The SML approach is dependent upon a reliable measure of a firm's unsystematic risk. 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. A. I and III only B. II and IV only C. III and IV only D. I, II, and III only E. II, III, and IV only
II, III, and IV only
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. A. This model considers a firm's rate of growth. B. The model applies only to non-dividend paying firms. C. The model is dependent upon a reliable estimate of the market risk premium. D. The model generally produces the same cost of equity as the dividend growth model. E. This approach generally produces a cost of equity that equals the firm's overall cost of capital.
The model is dependent upon a reliable estimate of the market risk premium
The capital structure weights used in computing the weighted average cost of capital: A. are based on the book values of total debt and total equity. B. are based on the market value of the firm's debt and equity securities. C. are computed using the book value of the long-term debt and the book value of equity. D. remain constant over time unless the firm issues new securities. E. are restricted to the firm's debt and common stock.
are based on the market value of the firm's debt and equity securities
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.
Flotation costs for a levered firm should: A. be ignored when analyzing a project because they are not an actual project cost. B. be spread over the life of a project thereby reducing the cash flows for each year of the project. C. only be considered when two projects are mutually exclusive. D. be weighted and included in the initial cash flow. E. be totally ignored when internal equity funding is utilized.
be weighted and included in the initial cash flow
Textile Mills borrows money at a rate of 13.5 percent. This interest rate is referred to as the: A. compound rate. B. current yield. C. cost of debt. D. capital gains yield. E. cost of capital.
cost of debt
The aftertax cost of debt: A. varies inversely to changes in market interest rates. B. will generally exceed the cost of equity if the relevant tax rate is zero. C. will generally equal the cost of preferred if the tax rate is zero. D. is unaffected by changes in the market rate of interest. E. has a greater effect on a firm's cost of capital when the debt-equity ratio increases.
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: A. cause the project to be improperly evaluated. B. increase the net present value of the project. C. increase the project's rate of return. D. increase the initial cash outflow of the project. E. have no effect on the present value of the project.
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: A. increase the project's discount rate to offset these expenses by multiplying the firm's WACC by 1.07. B. increase the project's discount rate to offset these expenses by dividing the firm's WACC by (1 - 0.07). C. add 7 percent to the firm's WACC to get the discount rate for the project. D. increase the initial project cost by multiplying that cost by 1.07. E. increase the initial project cost by dividing that cost by (1 - 0.07).
increase the initial project cost by dividing that cost by (1 - 0.07)
The pre-tax cost of debt: A. is based on the current yield to maturity of the firm's outstanding bonds. B. is equal to the coupon rate on the latest bonds issued by a firm. C. is equivalent to the average current yield on all of a firm's outstanding bonds. D. is based on the original yield to maturity on the latest bonds issued by a firm. E. has to be estimated as it cannot be directly observed in the market.
is based on the current yield to maturity of the firm's outstanding bonds
The cost of preferred stock: A. is equal to the dividend yield. B. is equal to the yield to maturity. C. is highly dependent on the dividend growth rate. D. is independent of the stock's price. E. decreases when tax rates increase.
is equal to the dividend yield
The dividend growth model: A. is only as reliable as the estimated rate of growth. B. can only be used if historical dividend information is available. C. considers the risk that future dividends may vary from their estimated values. D. applies only when a firm is currently paying dividends. E. uses beta to measure the systematic risk of a firm.
is only as reliable as the estimated rate of growth
The weighted average cost of capital for a wholesaler: A. is equivalent to the aftertax cost of the firm's liabilities. B. should be used as the required return when analyzing a potential acquisition of a retail outlet. C. is the return investors require on the total assets of the firm. D. remains constant when the debt-equity ratio changes. E. is unaffected by changes in corporate tax rates.
is the return investors require on the total assets of the firm.
The cost of preferred stock is computed the same as the: A. pre-tax cost of debt. B. return on an annuity. C. aftertax cost of debt. D. return on a perpetuity. E. cost of an irregular growth common stock.
return on a perpetuity
Assigning discount rates to individual projects based on the risk level of each project: A. may cause the firm's overall weighted average cost of capital to either increase or decrease over time. B. will prevent the firm's overall cost of capital from changing over time. C. will cause the firm's overall cost of capital to decrease over time. D. decreases the value of the firm over time. E. negates the firm's goal of creating the most value for the shareholders.
may cause the firm's overall weighted average cost of capital to either increase or decrease
Assigning discount rates to individual projects based on the risk level of each project: A. may cause the firm;s overall weighted average cost of capital to either increase or decrease over time. B. will prevent the firm's overall cost of capital from changing over time. C. will cause the firm's overall cost of capital to decrease over time. D. decreases the value of the firm over time. E. negates the firm's goal of creating the most value for the shareholders. Refer to section 14.5
may cause the firm;s overall weighted average cost of capital to either increase or decrease
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. rate of return a firm must earn on its existing assets to maintain the current value of its stock. C. coupon rate the firm should expect to pay on its next bond issue. D. minimum discount rate the firm should require on any new project. E. rate of return shareholders should expect to earn on their investment in this firm.
rate of return a firm must earn on its existing assets to maintain the current value of its stock.
The discount rate assigned to an individual project should be based on: A. the firm's weighted average cost of capital. B. the actual sources of funding used for the project. C. an average of the firm's overall cost of capital for the past five years. D. the current risk level of the overall firm. E. the risks associated with the use of the funds required by the project.
the risks associated with the use of the funds required by the project.
The flotation cost for a firm is computed as: A. the arithmetic average of the flotation costs of both debt and equity. B. the weighted average of the flotation costs associated with each form of financing. C. the geometric average of the flotation costs associated with each form of financing. D. one-half of the flotation cost of debt plus one-half of the flotation cost of equity. E. a weighted average based on the book values of the firm's debt and equity.
the weighted average of the flotation costs associated with each form of financing
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: A. reward to risk ratio. B. weighted capital gains rate. C. structured cost of capital. D. subjective cost of capital. E. weighted average cost of capital.
weighted average cost of capital