FIN Chapter 13

All else held constant, which one of these is most apt to increase the WACC of a leveraged firm? A. an increase in the weight of debt B. a decrease in a firm's equity beta C. a decrease in the dividend growth rate D. a decrease in the tax rate E. an increase in the risk-free rate when the equity beta > 1

a decrease in the tax rate

The problem that results from using the overall firm's beta in discounting projects of differing risk levels is the:

acceptance of too many high-risk projects and rejection of too many low risk projects.

When computing WACC, you should use the: A. pretax cost of debt because most corporations pay taxes at the same tax rate. B. pretax cost of debt because it is the actual rate the firm is paying bondholders. C. current yield because it is based on the current market price of debt. D. aftertax cost of debt because interest is tax deductible. E. pretax yield to maturity because it considers the current market price of debt.

aftertax cost of debt because interest is tax deductible.

Internal equity is: A. assumed to be cost-free. B. assumed to have a beta of 1. C. assigned a cost equal to the aftertax cost of equity. D. assigned the same cost as common stock. E. assigned a cost equal to the risk-free rate.

assumed to be cost-free

When computing the weighted average cost of capital, which of these are adjusted for taxes?

cost of debt

If the CAPM is used to estimate the cost of equity capital, the expected excess market return is equal to the:

difference between the return on the market and the risk-free rate.

Assume a leveraged firm plans to raise new capital to finance a project. To properly account for the flotation costs, the firm should: A. subtract the pretax flotation cost from the project's NPV. B. deduct the amount of the flotation cost from the cash flows for Year 1 of the project. C. add the percentage of the flotation cost to the WACC when discounting the cash flows. D. divide the amount of project capital needed by (1 - Weighted average flotation cost). E. increase the target weights of both debt and equity to account for the flotation percentage.

divide the amount of project capital needed by (1 - Weighted average flotation cost).

When estimating the cost of equity using the DDM, which one of these is most apt to add error to this estimate? A. next year's dividend B. firm's tax rate C. beta D. dividend growth rate E. current stock price

dividend growth rate

The CAPM has an advantage over DDM because the CAPM:

explicitly adjusts for risk.

When calculating the weighted average flotation cost, the weights should be based on the: A. mix of debt and equity that will be used to finance the specific project. B. firm's target capital structure. C. percentages of internal and external financing that will be used for the project. D. firm's current mix of debt and equity. E. average amounts of external capital raised during the past twelve months.

firm's target capital structure.

Comparing two otherwise equivalent firms, the beta of the common stock of a levered firm is _______ the beta of the common stock of an unlevered firm

greater than

For a leveraged firm the equity beta is __________ the asset beta.

greater than

A firm's WACC can be correctly used to discount the expected cash flows of a new project when that project:

has the same level of risk as the firm's current operations.

Companies will generally have a: A. low beta if their sales are directly related to the market cycle. B. high beta if their sales are highly dependent on the market cycle. C. high beta if sales are independent of the market cycle. D. high beta if their sales are highly variable but unrelated to the market cycle. E. low beta is their sales are highly cyclical.

high beta if their sales are highly dependent on the market cycle.

The beta of a firm is more likely to be high under which two conditions?

high cyclical business activity and high operating leverage

A firm with high operating leverage has: A. low fixed costs in its production process. B. high variable costs in its production process. C. high fixed costs in its production process. D. high costs per unit. E. low costs per unit.

high fixed costs in its production process.

The terminal value of a firm is also commonly referred to as the:

horizon value.

The use of leverage: A. increases both the asset and the equity betas. B. decreases both the asset and the equity betas. C. decreases the equity beta and increases the asset beta. D. increases the equity beta but does not affect the asset beta. E. decreases the equity beta but does not affect the asset beta.

increases the equity beta but does not affect the asset beta

The cost of preferred stock: A. should be adjusted for taxes when computing WACC. B. is ignored by all firms when computing WACC. C. is generally calculated using the overall firm's beta. D. is equal to the stock's dividend yield. E. is set equal to the pretax cost of debt since it is a fixed income security.

is equal to the stock's dividend yield.

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 its value. 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.

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

For a multi-product firm, if a project's level of risk differs from that of the overall firm, then the: A. CAPM can no longer be used to estimate the cost of equity as beta no longer applies. B. project should be discounted using the overall firm's beta. C. project should be discounted using a beta commensurate with the project's risks. D. project should be discounted at the market rate. E. project should be discounted at the T-bill rate.

project should be discounted using a beta commensurate with the project's risks.

If the risk of an investment project differs from the overall firm's risk then the: A. market rate of return should be used as the project's discount rate. B. project's discount rate must be adjusted based on the risks of the project's cash flows. C. project's discount rate must be adjusted based on the sources of project financing. D. average rate used for all prior projects should be used as the new project's discount rate. E. project's initial cost should be increased/decreased to account for the increase/decrease in risk.

project's discount rate must be adjusted based on the risks of the project's cash flows.

A firm with cyclical earnings is characterized by A. revenue patterns that vary with the business cycle. B. high levels of debt in its capital structure. C. high fixed costs. D. high costs per unit. E. low contribution margins.

revenue patterns that vary with the business cycle.

An industry is likely to have a low beta if the: A. stream of revenues within that industry is less volatile than the market. B. economy is in a recessionary period. C. market for its goods is highly affected by the market cycle. D. number of firms within the industry is fairly constant. E. industry tends to use a lot of debt financing.

stream of revenues within that industry is less volatile than the market.

The beta of the stock of an individual firm is primarily affected by:

the operating and financial leverage of the firm as well as the cyclical nature of the firm's revenues.

Assume LK Metals is similar to its industry with one exception, it has low fixed costs relative to all other firms in that industry. Given this, you should expect LK Metals:

to have a lower beta than its industry.

The beta of debt is commonly considered to be:

zero.

Norris Co. has developed an improved version of its most popular product. To get this improvement to the market, will cost $48 million and will return an additional $13.5 million for 5 years in net cash flows. The firm's debt-equity ratio is .25, the cost of equity is 13 percent, the pretax cost of debt is 9 percent, and the tax rate is 30 percent. What is the net present value of this proposed project? A. $1,306,411 B. $1,102,459 C. $1,077,180 D. $1,214,318 E. $989,760

$1,077,180

Tin Roof's net cash flows for the next three years are projected at $72,000, $78,000, and $84,000, respectively. After that the cash flows are expected to increase by 3.2 percent annually. The aftertax cost of debt is 6.2 percent and the cost of equity is 11.4 percent. What is the value of the firm if it is financed with 40 percent debt and 60 percent equity? A. $1,215,650 B. $1,328,141 C. $1,461,439 D. $1,575,941 E. $1,279,623

$1,279,623

ABC is considering acquiring XYZ and has compiled this information on XYZ: Year 1 2 3 EBIT 318,000 364,000 392,000 CS 46,500 28,000 36,200 NWC 5,500 6,500 1,200 Dep 34,000 32,100 28,700 The applicable tax rate is 30 percent and the terminal value of XYZ as of Year 3 is $2.5 million. What is PV0 of this acquisition if the discount rate is 7.1 percent? A. $2,138,316 B. $3,309,482 C. $2,499,003 D. $3,106,048 E. $2,662,398

$2,662,398

Hu's has 25,000 shares of common stock outstanding with a beta of 1.4, a market price of $32 a share, and a dividend yield of 5.7 percent. Dividends increase by 4.2 percent annually. The firm also has $450,000 of debt outstanding that is selling at 102 percent of par that has a yield to maturity of 6.8 percent. The tax rate is 35 percent. The firm is considering a project that has the same risk level as the firm's current operations, an initial cost of $328,000 and cash inflows of $52,500, $155,000, and $225,000 for Years 1 to 3, respectively. What is the NPV of the project? A. $48,515 B. $61,492 C. $46,511 D. $57,006 E. $32,899

$32,899

The net cash flows of Advantage Leasing for the next three years are $42,000, $49,000, and $64,000, respectively, after which the growth rate will be a constant 2 percent with an RWACC of 8 percent. What is the present value of the terminal value? A. $881,822 B. $863,689 C. $959,259 D. $910,444 E. $828,406

$863,689

When valuing a firm financed with debt and equity, the cash flows should be discounted using: A. the market rate of return. B. the average of the DDM and CAPM costs of equity. C. (1 + WACC)T. D. (1 + CAPM)T. E. (r - g).

(1 + WACC)T.

The cost of equity for RJ Corporation is 8.4 percent and the debt-equity ratio is .6. The expected return on the market is 10.4 percent and the risk-free rate is 3.8 percent. Using the common assumption for the debt beta, what is the asset beta? A. .70 B. .44 C. .62 D. .67 E. .59

.44

BG's cost of equity is 9.4 percent, expected return on the market is 13.6 percent, and the risk-free rate is 3.8 percent. What is the firm's debt-equity ratio if its asset beta is .36? Assume there is no preferred stock. A. .52 B. .59 C. .82 D. .77 E. .63

.59

A firm has an equity beta of 1.2, the risk-free rate of return is 3.4 percent, the market return is 15.7 percent, and the pretax cost of debt is 9.4 percent. The debt-equity ratio is .47. If you apply the common beta assumptions, what is the firm's asset beta? A. .816 B. .609 C. .667 D. .582 E. .646

.816

Barges' has an asset beta of .57, the risk-free rate is 4.3 percent, and the market risk premium is 7.7 percent. What is the equity beta if the firm has a debt-equity ratio of .56? A. .46 B. .89 C. .74 D. .37 E. .32

.89

Phil's Carvings wants to have a weighted average cost of capital of 9.5 percent. The firm has an aftertax cost of debt of 6.5 percent and a cost of equity of 12.75 percent. What debt-equity ratio is needed for the firm to achieve its targeted weighted average cost of capital? A. .84 B. .92 C. 1.08 D. .76 E. .67

1.08

HNT is an all-equity firm with a beta of .88. What will the firm's equity beta be if the firm switches to a debt-equity ratio of .35? A. .880 B. 8.567 C. .972 D. 1.188 E. 1.204

1.188

Jack's Construction Co. has 80,000 bonds outstanding that are selling at par value. Bonds with similar characteristics are yielding 8.6 percent. The company also has 4 million shares of common stock outstanding. The stock has a beta of 1.1 and sells for $40 a share. The U.S. Treasury bill is yielding 4 percent and the market risk premium is 8 percent. Jack's tax rate is 34 percent. What is Jack's weighted average cost of capital? A. 10.10% B. 11.39% C. 10.43% D. 10.65% E. 11.47%

10.43% Debt Number of bond = 80,000 Face value = $1,000 Market value of long term debt = ($1,000 × 80,000) = $80,000,000 YTM of Bond = 8.60%. Tax rate is 34%. So, cost of after tax is calculated below: After tax cost per debt = 8.60% × (1 - 34%) = 5.676% After tax cost of debt is 5.676%. EQUITY Number of share outstanding = 4,000,000 Price of stock = $40 Market value of equity = $40 × 4,000,000 = $160,000,000 Risk free rate = 4.00% Market return = 8.00% Beta = 1.10 Cost of common Equity is calculated below using CAPM formula: Cost of common Equity = Risk free rate + Risk Premium× Beta = 4.00% + 8.00% × 1.1 = 4.00% + 8.80% = 12.80% Cost of common Equity is 12.80%. Value of total capital = $80 million + $160 million = $240 million Weight of debt = 33.33% Weight of equity = 66.67% Now WACC is calculated below: WACC = (66.67% × 12.80%) + (33.33% × 5.676%) = 8.53% + 1.892% = 10.43 WACC of company is 10.43%.

Suppose the Simmons Co's common stock has a beta of 1.37, the risk-free rate is 3.4 percent, and the market risk premium is 8.2 percent. The yield to maturity in the firm's bonds is 7.6 percent and the debt-equity ratio is .45. What is the RWACC if the tax rate is 34 percent? A. 14.07% B. 10.94% C. 12.60% D. 10.59% E. 11.65%

11.65%

What is the cost of equity for a firm that has a beta of 1.2 if the risk-free rate of return is 2.9 percent and the expected market return is 11.4 percent? A. 13.1% B. 10.8% C. 12.8% D. 14.4% E. 13.6%

13.1%

Sound Systems (SS) has 200,000 shares of common stock outstanding at a market price of $37 a share. SS recently paid an annual dividend in the amount of $1.20 per share. The dividend growth rate is 4 percent. SS also has 4,500 bonds outstanding with a face value of $1,000 per bond that are selling at 99 percent of par. The bonds have a 6 percent coupon and a 6.7 percent yield to maturity. If the tax rate is 34 percent, what is the weighted average cost of capital? A. 5.33% B. 5.87% C. 6.49% D. 6.26% E. 7.28%

6.26%

The Upper Tier has a current debt-equity ratio of .52 and a target debt-equity ratio of .45. The cost of floating equity is 9.5 percent and the flotation cost of debt is 6.6 percent. What should the firm use as their weighted average flotation cost? A. 8.01% B. 8.52% C. 8.33% D. 7.76% E. 8.60%

8.60%

Peter's Audio has a yield to maturity on its debt of 7.8 percent, a cost of equity of 12.4 percent, and a cost of preferred stock of 8 percent. The firm has 105,000 shares of common stock outstanding at a market price of $22 a share. There are 25,000 shares of preferred stock outstanding at a market price of $45 a share. The bond issue has a total face value of $1.5 million and sells at 98 percent of face value. If the tax rate is 34 percent, what is the weighted average cost of capital? A. 9.04% B. 8.54% C. 8.69% D. 9.22% E. 9.45%

9.22%

The Consolidated Transfer Co. is an all-equity financed firm. The beta is .75, the market risk premium is 7.78 percent and the risk-free rate is 3.84 percent. What is the expected return on Consolidated stock? A. 6.80% B. 8.22% C. 9.54% D. 9.68% E. 8.46%

9.68%

The beta of a security is calculated as: (_____ of a security's return with the return on the market portfolio / _______).

Covariance; Variance of the market return

A firm's net cash flow is calculated as: A. EBIT - Taxes + Depreciation - Capital spending - Increases in net working capital. B. EBIT + Taxes + Depreciation - Capital spending - Increases in net working capital. C. EBIT - Taxes - Depreciation - Capital spending + Increases in net working capital. D. EBIT - Taxes - Depreciation + Capital spending - Increases in net working capital. E. EBIT + Taxes + Depreciation - Capital spending + Increases in net working capital.v

EBIT - Taxes + Depreciation - Capital spending - Increases in net working capital.

Which one of these ratios is commonly used to compute the horizon value of a firm? A. PE B. Price/Sales C. EV/EBITDA D. Book equity/ROE E. Market value of equity/ROE

EV/EBITDA

JR's is preparing to start a new project in an industry that differs significantly from its current operations. JR's has searched and found the beta of a firm that is a good fit as a good pure play for this new project. Given this good fit, why might JR's assign a higher beta to the project than the beta of the pure play? A. The generally accepted practice would be to assign a beta to the project that is based on the average of the firm's beta and the pure play's beta. B. The revenues of the project may be expected to be less cyclical than those of the pure play. C. The firm may use less debt in its operations than does the pure play. D. The new project may be more responsive to the economy than the pure play and thus represent a higher risk. E. The project may incur flotation costs so a higher beta is warranted to offset the additional cost.

The new project may be more responsive to the economy than the pure play and thus represent a higher risk.

Which one of these statements related to beta is correct? A. Firm betas have less error than industry betas. B. Firms should always rely on their own beta rather than their industry beta. C. Beta is unaffected by a firm's capital structure. D. The sample size used to compute beta may be too small to yield a reliable result. E. Firm betas rarely vary over time.

The sample size used to compute beta may be too small to yield a reliable result