FIN 321 SB 13

Martin Co. has issued preferred stock with an annual dividend of $6.00. The current market price per share of this preferred stock is $47.00. What is the expected return on the Martin preferred stock?

$6.00/$47.00 = 12.8%.

SkiFree Incorporated has $20 million of debt and $80 million of equity outstanding. The market cost of debt is 6% and the cost of equity is 12%. The firm has a 35% corporate tax rate. What is SkiFree's WACC?

(0.2)(0.65)6 + (0.8)12 = 10.38%.

Which of the following statements regarding the company's cost of capital are true?

- It is an opportunity cost. - It is used to value new assets that have the same risk as the existing ones. - It is the minimum rate of return that the firm must earn on its average-risk investments.

Vandalay Industries has $30 million of debt and $70 million of equity outstanding. The market cost of debt is 8% and the cost of equity is 14%. The firm has a 35% corporate tax rate. What is Vandalay's WACC?

11.36%; (0.3)(0.65)8.0 + (0.7)14.0 = 11.36%.

Spock Enterprises has a market value of $100 million in debt outstanding. They also have a market value of equity of $400 million. Shareholders require a 12% return on their shares and creditors require a 7% before-tax return on their investment. The weighted average return required by investors in Spock Enterprises is ___%

11; (0.2 × 0.07) + (0.8 × 0.12) = 11.0.

Little LampLighter Inc has a book value of $10 million in debt; its bonds are trading at $900 and there are 11,000 outstanding. It also has a market value of equity of $25 million. Shareholders require a 14% return on their shares and creditors require an 8% before-tax return on their investment. The weighted average return required by investors in Spock Enterprises is ______%.

12.3; (0.28 × 0.08) + (0.72 × 0.14) = 12.3.

Spock Enterprises has a market value of $100 million in debt outstanding. They also have a market value of equity of $400 million. Spock's capital structure is ______% debt and =______% equity.

20; 80

Spock Enterprises has a market value of $100 million in debt outstanding. They also have a market value of equity of $400 million. Spock's total market value is ______ million.

500 million

A project requires a $12 million initial investment and has expected after-tax cash flows of $2 million in perpetuity. The weighted-average cost of capital is 15%. What is the project's net present value (NPV)?

93.33 million

The firm's cost of equity is usually calculated using the ______ equation.

CAPM

Potter National Bank has a beta of 1.8. The risk-free rate is currently quoted at 1.5% and the expected market risk premium is 7.5%. What is Potter's cost of equity?

Cost of equity = risk-free rate + beta (expected market risk premium) = 1.5 + 1.8(7.5) = 15%

True or false: It is acceptable to use book values of debt and equity to calculate the weights of debt and equity for the company's cost of capital calculation.

False

True or false: The market value and book value of debt are often very similar, so many financial managers use book value in WACC calculations.

False

A project requires a $1 million initial investment and has an expected after-tax cash flow of $2.4 million per year in perpetuity. The weighted-average cost of capital (WACC) is 13%. What is the net present value (NPV) of the project?

NPV = −$1 million + ($2.4 million/0.13) = $17.46 million

What is one necessary condition to use WACC to value an entire business?

The debt ratio will stay the same over time.

Vandalay Industries has $30 million of debt, $10 million of preferred stock, and $60 million of common stock outstanding. The market cost of debt is 8%, the cost of preferred is 9%, and the cost of common equity is 14%. The firm has a 35% corporate tax rate. What is Vandalay's WACC?

WACC = [$30/$100 × (1 − 0.35) × 8%] + ($10/$100 × 9%) + ($60/$100 × 14%) = (0.3)(0.65)0.08+ (0.1)0.09 + (0.6)0.14 = 10.86%.

The WACC is the return the company needs to earn after-tax in order to satisfy

all its security holders

The weighted average cost of capital is the expected rate of return investors would demand on a portfolio of

all the firm's outstanding securities

The WACC is the appropriate discount rate for use with ______ projects but should be adjusted ______ for lower risk ones.

average; downward

On a large and healthy firm, the use of yield to maturity as the cost of debt when calculating WACC is appropriate because

bankruptcy is sufficiently low

To determine the equity value of an entire business, discount the firm's ______ using the ______ as the discount rate, then subtract the value of the firm's ______.

cash flows; WACC; debt

If the corporate tax rate is not zero, increasing the proportion of debt in the capital structure causes the WACC to

change

Order the following three components of the firm's capital structure from riskiest to least risky.

common stock, preferred stock, debt

Another name for the WACC is the

company cost of capital

The company cost of capital is calculated as a weighted average of the firm's ______ and ______.

debt; equity

Preferred stock is valued like perpetuity. The price of preferred stock is therefore equal to

dividend/rpreferred

There are two costs of debt finance, the ______ cost and the ______ cost.

explicit; implicit

The cash flow available to distribute to investors after paying for new investments or additions to working capital is a firm's

free cash flow

The ______ cost of debt is the increase in the required return on common equity as the amount of debt borrowed increases. Multiple choice question.

implicit; The implicit cost of debt is the increase in the required return on common equity as the amount of debt borrowed increases.

When a project's cash flows are discounted at the WACC and the NPV is exactly zero, then those cash flows are ______ to give debtholders and shareholders the returns they require.

just enough

The cost of capital used by firms should be based on ___values of the firm's securities.

market

Increasing the amount of debt makes debt ______ risky and equity ______ risky.

more, more

Free cash flow is often ______ in the beginning years of a firm due to heavy initial investing.

negative

If a firm uses its book value of debt instead of its market value of debt to calculate its WACC, then its WACC will likely be Blank

only slightly off

The ___ is usually accepted as a firm's cost of debt capital for WACC calculations

promised yield to maturity on the firm's existing bonds

If the corporate tax rate is zero, then increasing the proportion of debt in a firm's capital structure causes the WACC to

remain unchanged

Which of the following best describes the firm's capital structure?

the firm's mix of debt and equity financing

The market value of a firm is equal to

the market value of debt + the market value of equity