FIN611 Chapter 9 Test Review

Eakins Inc.'s common stock currently sells for $45.00 per share, the company expects to earn $2.75 per share during the current year, its expected payout ratio is 70%, and its expected constant growth rate is 6.00%. New stock can be sold to the public at the current price, but a flotation cost of 8% would be incurred. By how much would the cost of new stock exceed the cost of retained earnings? 0.2% 0.1% 0.6% 0.4% 0.8%

0.4%

Sunrise Canoes Inc. has determined that its optimal capital structure consists of 55% equity and 45% debt. Sunrise must raise additional capital to fund its upcoming expansion. The firm has $0.5 million in retained earnings that has a cost of 11%. Its investment bankers have informed the company that it can issue an additional $3 million of new common equity at a cost of 14%. Furthermore, the firm can raise up to $1.5 million of debt at 10% (before taxes) and an additional $2 million of debt at 12% (before taxes). The firm has estimated that the proposed expansion will require an investment of $2.6 million. The firm's tax rate is 40%. What is the WACC for the funds Sunrise will be raising? 11.85% 10.40% 10.00% 11.20% 11.50%

10.40% WACC = 0.45(10%)(1 - 0.4) + 0.55(14%) = 10.4% If the investment requires $2.6 million, that means that it requires $1.43 million (55%) of equity and $1.17 million (45%) of debt. In this scenario, the firm would exhaust its $0.5 million of retained earnings and be forced to raise new stock at a cost of 14%. Since the firm must raise $1.17 million in debt, it will have a 10% cost (before taxes). (The problem states that the firm can raise up to $1.5 million in debt at a 10% cost—before taxes.) Therefore, its WACC is calculated as follows: WACC = 0.45(10%)(1 - 0.4) + 0.55(14%) = 10.4% #4 in notes

You were recently hired by Scheuer Media Inc. to estimate its cost of capital. You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.0% (constant); and F = 5.0%. What is the cost of equity raised by selling new common stock? 11.3% 11.1% 12.5% 11.9% 13.1%

11.3% Formula is in notes as well as solution as #5

O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of equity from retained earnings based on the CAPM? 11.64% 11.30% 12.35% 11.99% 12.72%

11.30%

Superior Transportation Company has a barge division. Assuming a typical beta of 1.5 for barge operations, a risk-free rate of 4%, and a market risk premium of 5%, what is its divisional cost of capital? 10.5% 9.0% 11.5% 11.0% 12.0%

11.5% rs = rRF + (RPM)b = 4% + (5%)1.5 = 11.5%.

Hodor Manufacturing Co.'s (HMC) common stock currently sells for $50.00 per share. Assume the stock is in a state of constant growth, has an expected dividend yield of 4.5%, and an expected capital gains yield of 6.5%. The current dividend payout ratio is 30% and the firm's return on equity is 9.3%. The firm requires external funds for a new project and anticipates issuing additional shares of common stock at its current price of $50.00. However, the process of issuing this new equity is expected to result in a flotation expense equivalent to 10% of the stock price. If the firm goes ahead with its equity issue, what will be the firm's cost for this new common stock, re? 11.50% 10.75% 12.00% 9.65% 13.25%

11.50% #2 IN NOTES how to work this

Sun Products Company (SPC) uses only debt and equity. It can borrow unlimited amounts at an interest rate of 12% so long as it finances at its target capital structure, which calls for 45% debt and 55% common equity. Its last dividend was $2.40, its expected constant growth rate is 5%, and its stock sells for $24. SPC's tax rate is 40%. Four projects are available: Project A has a cost of $240 million and a rate of return of 13%, Project B has a cost of $125 million and a rate of return of 12%, Project C has a cost of $200 million and a rate of return of 11%, and Project D has a cost of $150 million and a rate of return of 10%. All of the company's potential projects are independent and equally risky. What is SPC's WACC? In other words, what WACC should it use to evaluate capital budgeting projects (these four projects plus any others that might arise during the year, provided the WACC remains constant)? 13.40% 12.05% 12.50% 11.77% 10.61%

11.77% #6 in notes

Apopka Corporation's retention ratio has averaged 40% over the past 15 years, its payout ratio has averaged 60%, and its return on equity has averaged 20%. Using the retention growth model, estimate Apopka's earnings growth rate? 5.6% 5.0% 12.0% 8.0% There is insufficient data to estimate the earnings growth rate.

12.0% gL = ROE(Retention ratio) = 20% × 40% ≈ 8%. The answer was 12.0%, but when they worked it out and I did, the answer was 8%

Butcher Timber Company hired your consulting firm to help them estimate the cost of equity. The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of equity can be estimated using a risk premium of 3.85% over a firm's own cost of debt. What is an estimate of the firm's cost of equity from retained earnings? 13.10% 12.60% 14.17% 13.63% 14.74%

12.60% rs = rd + Risk premium = 8.75% + 3.85% = 12.60%

Weaver Chocolate Co. expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65.0%, its expected constant dividend growth rate is 6.0%, and its common stock currently sells for $32.50 per share. New stock can be sold to the public at the current price, but a flotation cost of 5.0% would be incurred. What would be the cost of equity from new common stock? 13.4% 12.7% 14.7% 14.0% 15.5%

13.4% #3 in notes

Roland Corporation's next expected dividend (D1) is $2.50. The firm has maintained a constant payout ratio of 50% during the past 7 years. Seven years ago, its EPS was $1.50. The firm's beta coefficient is 1.2. The estimated market risk premium is 6%, and the risk-free rate is 7%. Roland's A-rated bonds are yielding 10%, and its current stock price is $30. Which of the following values is the most reasonable estimate of Roland's cost of common stock, rs? 12% 10% 20% 14% 26%

14% #1 in notes

For privately owned firms, some analysts use a subjective, ad hoc procedure to estimate a firm's cost of common equity by adding a judgmental risk premium of _____ to the cost of debt. 2% to 4% 1% to 2% 4% to 6% 3% to 5% 5% to 7%

3% to 5%

Zebra Corporation's retention rate has averaged 60% over the past 15 years and its ROE has averaged 14%. Zebra's payout ratio has averaged: 8.4% 5.6% 40.0% 28.6% 42.9%

40.0% The retention ratio is a complement of the payout ratio. If the retention ratio is 60%, then the payout ratio must be 40%.

The projected dividend yield for the next year is 2.56%, the expected constant growth rate in dividends is 5.04%, and the 10-year T-bond yield is 2.00%. The estimated forward-looking market risk premium is: 4.56%. 0.48%. 7.60%. 5.60%. 9.60%.

5.60% 2.56% + 5.04% - 2.00% = 5.60%.

Helena's Candies Co. (HCC) has a target capital structure of 55% equity and 45% debt to fund its $5 billion in capital. Furthermore, HCC has a WACC of 12.0%. Its before-tax cost of debt is 9%; and its tax rate is 40%. The company's retained earnings are adequate to fund the common equity portion of the capital budget. The firm's expected dividend next year (D1) is $4 and the current stock price is $40. What is the company's expected growth rate? 5.25% 4.50% 6.30% 5.75% 7.40%

7.40%

Bosio Inc.'s perpetual preferred stock sells for $97.50 per share, and it pays an $8.50 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is the company's cost of preferred stock for use in calculating the WACC? 9.08% 8.72% 9.82% 9.44% 10.22%

9.08%

Which of the following should NOT be included when calculating the weighted average cost of capital (WACC) for use in capital budgeting? Accounts payable Retained earnings Common stock Preferred stock Long-term debt

Accounts payable

Because the cost of equity for a private company cannot be measured by means of stock market activity, industry-wide averages of traded companies are used. True False

False Most analysts begin by identifying one or more publicly traded firms that are in the same industry and that are approximately the same size as the privately owned firm. The analyst then estimates the betas for these publicly traded firms and uses their average beta as an estimate of the beta of the privately owned firm.

Because the before-tax cost of debt is lower than the after-tax cost, it is used as the component cost of debt for purposes of developing the firm's WACC. True False

False The after-tax cost of debt is lower than the before-tax cost.

A firm should base the cost of debt on the coupon rate of the firm's existing debt. True False

False The cost of debt must be based on the interest rate the firm would pay if it issued new debt today.

The WACC is used to find the present value of future cash flows, so it would be inconsistent to use weights based on past history of the company. True False

False The weights should be based on the target capital structure rather than past capital structure.

Modern Fashions, Inc. and New York Accessories Co. are identical in size and capital structure. However, Modern Fashions has a WACC of 10%, and New York Accessories has a WACC of 12%, because the riskiness of their assets and cash flows is somewhat different. New York Accessories is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical New York Accessories project. Modern Fashions is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Modern Fashions project. Now assume that the two companies merge and form a new company, New York Modern, Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is accurate? After the merger, New York Modern would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y. If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time. If evaluated using the correct post-merger WACC, Project X would have a negative NPV. After the merger, New York Modern should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%. New York Modern's WACC, as a result of the merger, would be 10%.

If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.

Red Bird Manufacturing would like to avoid issuing new stock because new stock has a higher cost than retained earnings, but the company forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Which of the following actions would reduce its need to issue new common stock? Increase the dividend payout ratio for the upcoming year. Reduce the percentage of debt in the target capital structure. Increase the proposed capital budget. Increase the percentage of debt in the target capital structure. Reduce the amount of short-term bank debt in order to increase the current ratio.

Increase the percentage of debt in the target capital structure. If more debt is used, then less equity will be needed to fund the capital budget, so the need for a stock issue would be reduced.

Akita Development, which has an overall WACC of 12%, has equal amounts of low-risk, average-risk, and high-risk projects. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. What is likely to happen over time if the CEO's position is accepted? The company will take on too many high-risk projects and reject too many low-risk projects. Things will generally even out over time, and, therefore, the firm's risk should remain constant over time. The company's overall WACC should decrease over time because its stock price should be increasing. The company will take on too many low-risk projects and reject too many high-risk projects. The CEO's recommendation would maximize the firm's intrinsic value.

The company will take on too many high-risk projects and reject too many low-risk projects. Low-risk projects will tend to have low expected returns and vice versa for high-risk projects due to competition in the economy. By not adjusting the cost of capital for project risk, the firm will tend to reject low-risk projects even though they earn higher returns than their risk-adjusted costs of capital, and vice versa for high-risk projects. In addition, as the firm takes on more high-risk projects, its correct WACC will increase over time.

Global Goodness Foods has two divisions of equal size: a snack food division and a beverage division. The company's CFO believes that stand-alone snack food companies typically have a WACC of 8%, while stand-alone beverage producers typically have a 12% WACC. He also believes that the snack food and beverage divisions have the same risk as their typical peers; consequently, the CFO estimates that the composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the snack food division and a 12% hurdle rate for the beverage division. However, the CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is accurate? The decision not to risk-adjust means that the company will accept too many projects in the snack food business and too few projects in the beverage business. This will lead to a reduction in its intrinsic value over time. The decision not to adjust for risk means, in effect, that it is favoring the snack food division. Therefore, that division is likely to become a larger part of the consolidated company over time. While the decision to use just one WACC will result in its accepting more projects in the beverage division and fewer projects in its snack food division than if it followed the consultant's recommendation, this should not affect the firm's intrinsic value. The decision not to adjust for risk means that the company will accept too many projects in the beverage division and too few in the snack food division. This will lead to a reduction in the firm's intrinsic value over time. The decision not to risk adjust means that the company will accept too many projects in the beverage business and too few projects in the snack food business. This may affect the firm's capital structure but it will not affect its intrinsic value.

The decision not to adjust for risk means that the company will accept too many projects in the beverage division and too few in the snack food division. This will lead to a reduction in the firm's intrinsic value over time.

The chief financial officer of Panther Products, which is an all-equity firm with a beta of 2.0, is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than the firm's average project in terms of both its beta risk and its total risk. Which of the following statements is accurate? The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return. Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment. The accept/reject decision depends on the firm's risk-adjustment policy. If Panther's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project. The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return. Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision.

The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return. rs = 5% + 4%(2.0) = 5% + 8% = 13%. Required return for risky projects = 13% + 3% = 16%. Project return = 14% < adjusted rs = 16%. Thus, the project should be rejected.

An increase in a firm's marginal tax rate would lower the cost of debt used to calculate its WACC, other things held constant. True False

True

Because they are based on investors' required returns, the component costs of capital are market-determined variables. True False

True

Retained earnings have a cost equal to rs because investors expect to earn rs on investments with the same risk as the firm's common stock. If the firm cannot earn rs on the earnings that it retains, it should pay those earnings out to its investors. Thus, the cost of retained earnings is based on the opportunity cost principle. True False

True

To find the cost of perpetual preferred stock, divide the preferred stock's annual dividend by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, are not deductible by the issuing firm. True False

True

Funds acquired by the firm through preferred stock have a cost to the firm equal to the preferred dividend divided by the current price of the preferred stock. If significant flotation costs are involved the cost of the preferred should be adjusted upward. True False

True The cost of the preferred stock is equal to the preferred dividend divided by the current price, adjusted for flotation costs.

The director of capital budgeting for See-Saw Inc., manufacturers of playground equipment, is considering a plan to expand production facilities in order to meet an increase in demand. He estimates that this expansion will produce a rate of return of 11%. The firm's target capital structure calls for a debt/equity ratio of 0.8. See-Saw currently has a bond issue outstanding that will mature in 25 years and has a 7% annual coupon rate. The bonds are currently selling for $804. The firm has maintained a constant growth rate of 6%. See-Saw's next expected dividend is $2 (D1), its current stock price is $40, and its tax rate is 40%. Should it undertake the expansion? (Assume that there is no preferred stock outstanding and that any new debt will have a 25-year maturity.) No; the expected return is 1.0 percentage point lower than the cost of capital. No; the expected return is 2.5 percentage points lower than the cost of capital. Yes; the expected return is 1.0 percentage point higher than the cost of capital. Yes; the expected return is 0.5 percentage point higher than the cost of capital. Yes; the expected return is 2.5 percentage points higher than the cost of capital.

Yes; the expected return is 2.5 percentage points higher than the cost of capital.

Betas determined by running a regression of the division's accounting return on assets against the average return on assets for a large sample of companies are called: accounting betas. pure play betas. judgmental risk betas. hurdle betas. stock market betas.

accounting betas.

Assume that All-American Sporting Goods correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years. The firm will most likely: become less risky over time, and this will maximize its intrinsic value. accept too many low-risk projects and too few high-risk projects. become more risky and also have an increasing WACC. Its intrinsic value will not be maximized. become riskier over time, but its intrinsic value will be maximized. continue as before because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital.

become more risky and also have an increasing WACC. Its intrinsic value will not be maximized. Low-risk projects will tend to have low expected returns and vice versa for high-risk projects due to competition in the economy. By not adjusting the cost of capital for project risk, the firm will tend to reject low-risk projects even though they earn higher returns than their risk-adjusted costs of capital, and vice versa for high-risk projects. As the firm takes on more high-risk projects, its true WACC will increase over time. Of course, the true WACC might change over time due to changes in market conditions, but that could cause the true WACC to either rise or decline.

Which of the following factors related to the cost of capital is within a firm's control? credit crisis interest rates dividend policy market risk premiums tax rates

dividend policy A firm can affect its cost of capital through its dividend policy.

The commissions, legal expenses, fees, and other costs that a company incurs when it issues new securities are known as _____ costs: premium sunk flotation discount di minimis

flotation, but it said discount was the correct answer, so watch out

Short-term debt should be included in the capital structure: in all instances. if the company plans to continually renew it. if it exceeds 0.25% of total debt. if its interest rate exceeds the marginal rate. under no circumstances.

if the company plans to continually renew it. Short-term debt should be included in the capital structure only if it is a permanent source of financing in the sense that the company plans to continually repay and refinance the short-term debt.

An increase in the required market risk premium means: investors have become less risk averse, requiring a higher return on stocks, causing stock prices to go down. investors have become more risk averse, requiring a lower return on stocks, causing stock prices to go up. investors have become less risk averse, requiring a higher return on stocks, causing stock prices to go up. investors have become more risk averse, requiring a lower return on stock, causing stock prices to go down. investors have become more risk averse, requiring a higher return on stocks, causing stock prices to go down.

investors have become more risk averse, requiring a higher return on stocks, causing stock prices to go down. An increase in the required premium means that investors have become more risk averse and require a higher return on stocks, but applying a higher discount rate to a stock's future cash flows causes a decline in stock price.

Because a privately held firm is _____ than that of a publicly held firm, investors require a liquidity _____ the firm's cost of equity. less liquid; discount be deducted from less liquid; premium be added to more liquid; discount be deducted from more liquid; premium be added to less liquid; discount be added to

less liquid; premium be added to

Most companies use only two major sources of capital, which are: short-term debt and common stock. short-term debt and preferred stock. long-term debt and common stock. long-term debt and preferred stock. preferred stock and common stock.

long-term debt and common stock.

The required rate of return on new debt is also known as the: discount. marginal rate. constant yield. embedded rate. di minimis rate.

marginal rate

Which of the following factors related to the cost of capital is beyond a firm's control? dividend policy capital structure market risk premium investment policy market risk premium and investment policy

market risk premium

The extra return that investors require to induce them to invest in risky equities over and above the return on a Treasury bond is called the: market risk premium. market risk discount. equity premium. equity risk premium. market risk premium, equity risk premium, or equity premium.

market risk premium, equity risk premium, or equity premium. This extra return is called the market risk premium, the equity risk premium, or just the equity premium.

Accounts payable and accruals arise from _____ decisions. financing operating a combination of operating and financing investing a combination of financing and investing

operating Accounts payable and accruals arise from operating decisions rather than financing decisions, and are therefore excluded from capital structure weights.

Which of the following show how growth is related to reinvestment? retention ratio payout ratio payout growth equation retention growth equation dividend growth equation

retention growth equation

Which of the following is a complement of the payout ratio? retention ratio CAPM payout growth equation retention growth equation dividend growth equation

retention growth equation The retention ratio is a complement of the payout ratio, representing how much of each dollar of earnings the company retains in the business after paying dividends.

Superior Transportation Company has a barge division. Superior found five companies devoted exclusively to operating barges and used the average beta of those firms as an estimate of its barge division's beta. Superior used which method for measuring divisional betas? the accounting beta method the pure play method the judgmental risk method the hurdle method the flotation method

the pure play method In the pure play method, the company tries to find the betas of several publicly held specialized companies in the same line of business as the division being evaluated, and it then averages those betas to determine the cost of capital for its own division.

In the equation for finding the weighted average cost of capital, which of the following variables does NOT represent a target capital structure weight? wstd wd wps wds ws

wds, but cengage said wps so watch out

The correct rate for estimating the present value of a company's (or project's) free cash flows is the: required rate of return on long-term debt. required rate of return on short-term debt. required rate of return on common stock. required rate of return on preferred stock. weighted average of the required rates of return on the various sources of capital.

weighted average of the required rates of return on the various sources of capital.