Finance Chapter 13

2) Assume General Motors has a weighted average cost of capital of 9%. GM is considering investing in a new plant that will save the company $20 million over each of the first two years, and then $10 million each year thereafter. If the investment is $100 million, what is the net present value (NPV) of the project?

C) $28.7 million

19) The after-tax cost of equity is ________ the pretax cost of equity.

C) the same as

1) A firm's cost of debt is the rate of interest it would have to pay to refinance its existing debt.

TRUE

1) Financial managers must determine their firm's overall cost of capital based on all sources of financing.

TRUE

16) A firm has outstanding debt with a coupon rate of 8%, seven years maturity, and a price of $1,000. What is the after-tax cost of debt if the marginal tax rate of the firm is 35%?

A) 5.2%

34) A firm has a pre-tax cost of debt of 9.0%. If the firm has a marginal tax rate of 35%, what is its effective cost of debt?

A) 5.9%

33) A firm has a capital structure with $75 million in equity and $75 million of debt. The cost of equity capital is 10% and the pretax cost of debt is 7%. If the marginal tax rate of the firm is 35%, compute the weighted average cost of capital of the firm.

A) 7.3%

12) Assume Ford Motor Company is discussing new ways to recapitalize the firm and raise additional capital. Its current capital structure has a 30% weight in equity, 15% in preferred stock, and 55% in debt. The cost of equity capital is 16%, the cost of preferred stock is 11%, and the pretax cost of debt is 8%. What is the weighted average cost of capital for Ford if its marginal tax rate is 40%?

A) 9.09%

22) An all-equity firm had a dividend expense of $30,000 last year. The market value of the firm is $900,000 and the dividend is expected to increase at 6% each year. What is the cost of equity for this firm?

A) 9.53%

9) A levered firm is one that has ________ outstanding.

A) debt

18) The fact that the after-tax cost of debt is lower than the pretax cost of debt implicitly assumes that interest expense can be ________.

A) expensed

9) Many financial managers use market risk premiums that are closer to 5%, which is lower than historical averages, because ________.

A) the return investors require as compensation for taking on the risk of investing in equity markets has diminished over a period of time

6) A firm's overall cost of capital that is a blend of the costs of the different sources of capital is known as the firm's ________.

A) weighted average cost of capital

15) Holding everything else constant, an increase in cash ________ a firm's net debt.

A) will decrease

19) A firm has $1 million market value and it sells preferred stock with a par value of $100. If the coupon rate on the preferred stock is 5% and the preferred stock trades at $91, what is the cost of preferred stock capital?

D) 5.49%

4) Outstanding debt of Home Depot trades with a yield to maturity of 8%. The tax rate of Home Depot is 30%. What is the effective cost of debt of Home Depot?

D) 5.60%

10) A firm is considering investing in a new project with an upfront cost of $400 million. The project will generate an incremental free cash flow of $50 million in the first year and this cash flow is expected to grow at an annual rate of 3% forever. If the firm's WACC is 12%, what is the value of this project?

A) $155.6 million

16) A firm incurs $35,000 in interest expenses each year. If the tax rate of the firm is 30%, what is the effective after-tax interest rate expense for the firm?

B) $24,500.00

13) Assume Ford Motor Company is discussing new ways to recapitalize the firm and raise additional capital. Its current capital structure has a 10% weight in equity, 20% in preferred stock, and 70% in debt. The cost of equity capital is 16%, the cost of preferred stock is 10%, and the pretax cost of debt is 8%. What is the weighted average cost of capital for Ford if its marginal tax rate is 40%?

B) 6.96%

11) Assume Ford Motor Company is discussing new ways to recapitalize the firm and raise additional capital. Its current capital structure has a 25% weight in equity, 10% in preferred stock, and 65% in debt. The cost of equity capital is 13%, the cost of preferred stock is 9%, and the pretax cost of debt is 8%. What is the weighted average cost of capital for Ford if its marginal tax rate is 40%?

B) 7.27%

17) A firm incurs $70,000 in interest expenses each year. If the tax rate of the firm is 30%, what is the effective after-tax interest rate expense for the firm?

C) $49,000.00

7) Assume the market value of Fords' equity, preferred stock and debt are $7 billion, $4 billion and $10 billion respectively. Ford has a beta of 1.4, the market risk premium is 6% and the risk-free rate of interest is 4%. Ford's preferred stock pays a dividend of $3 each year and trades at a price of $25 per share. Ford's debt trades with a yield to maturity of 8.5%. What is Ford's weighted average cost of capital if its tax rate is 35%?

D) 9.05%

11) Which of the following is NOT a step in the WACC valuation method?

D) Determine the mean weighted average cost of capital for the firm's industry.

2) Divisional costs of capital are more appropriate when evaluating a project for a line of business when the types of business in a firm are ________.

D) different

24) As a firm increases its level of debt relative to its level of equity, the firm is ________.

D) increasing its leverage

5) Different divisions with differing lines of business use different costs of capital because their cost of equity is different and also because the ________ could be different.

D) optimal debt-equity ratio

8) A firm raised all its capital via equity rather than debt. Such a firm is also referred to as a(n) ________ firm.

D) unlevered

1) The WACC does not depend on the risk of a company's line of business.

FALSE

1) When a firm is evaluating the purchase of a business that is unrelated to its current business, it is appropriate to use the current WACC of the firm that is purchasing the business.

FALSE

2) Internal financing is more costly than external financing because of issuance costs.

FALSE

2) The fact that the interest paid on debt is a tax-deductible expense increases the cost of debt financing..

FALSE

4) Different divisions with differing lines of business use different costs of capital because their cost of ________ could be different.

C) capital

13) Your estimate of the market risk premium is 7%. The risk-free rate of return is 4% and General Motors has a beta of 1.6. What is General Motors' cost of equity capital?

A) 15.2%

15) Your estimate of the market risk premium is 9%. The risk-free rate of return is 4.1% and General Motors has a beta of 1.8. What is General Motors' cost of equity capital?

A) 20.3%

6) Outstanding debt of Home Depot trades with a yield to maturity of 7%. The tax rate of Home Depot is 35%. What is the effective cost of debt of Home Depot?

A) 4.55%

23) Assume JUP has debt with a book value of $24 million, trading at 120% of par value. The firm has book equity of $28 million, and 2 million shares trading at $20 per share. What weights should JUP use in calculating its WACC?

A) 41.86% for debt, 58.14% for equity

7) Assume SAP Inc. received a $1 million grant under its Small Business Innovation program. SAP invested the grant money and developed a system to remove metal contaminants from storm water in shipyards. The firm estimates that each shipyard spends $500,000 a year on storm water clean-up efforts. If SAP is able to sign up and retain four shipyards from the first year onwards, what is the present value (PV) of the project (net of investment) if the cost of capital for SAP is 20% per year? Assume a cost of operations and other costs for SAP equal 60% of revenue.

A) $3.00 million

6) A firm is considering acquiring a competitor. The firm plans on offering $160 million for the competitor. The firm will need to issue new debt and equity to finance the acquisition. You estimate the issuance costs to be $10 million. The acquisition will generate an incremental free cash flow of $20 million in the first year and this cash flow is expected to grow at an annual rate of 3% forever. If the firm's WACC is 13%, what is the value of this project?

A) $30 million

7) Assume preferred stock of Ford Motors pays a dividend of $4 each year and trades at a price of $35. What is the cost of preferred stock capital for Ford?

A) 11.4%

28) SIROM Scientific Solutions has $10 million of outstanding equity and $5 million of bank debt. The bank debt costs 5% per year. The estimated equity beta is 2. If the market risk premium is 9% and the risk-free rate is 3%, compute the weighted average cost of capital if the firm's tax rate is 30%.

A) 15.17%

4) Assume Ford Motors expects a new hybrid-engine project to produce incremental cash flows of $50 million each year, and expects these to grow at 4% each year. The upfront project costs are $420 million and Ford's weighted average cost of capital is 9%. If the issuance costs for external finances are $20 million, what is the net present value (NPV) of the project?

B) $560 million

20) Epiphany is an all-equity firm with an estimated market value of $400,000. The firm sells $225,000 of debt and uses the proceeds to purchase outstanding equity. Compute the weight in equity and the weight in debt after the proposed financing and repurchase of equity.

B) 0.44, 0.56

14) Assume the total market value of General Motors (GM) is $10 billion. GM has a market value of $6 billion of equity and a face value of $12 billion of debt. What are the weights in equity and debt that are used for calculating the WACC?

B) 0.60, 0.40

8) Assume preferred stock of Ford Motors pays a dividend of $3.50 each year and trades at a price of $30. What is the cost of preferred stock capital for Ford?

B) 11.7%

14) Your estimate of the market risk premium is 6%. The risk-free rate of return is 4% and General Motors has a beta of 1.4. What is General Motors' cost of equity capital?

B) 12.4%

17) A firm has outstanding debt with a coupon rate of 8%, nine years maturity, and a price of $1,000. What is the after-tax cost of debt if the marginal tax rate of the firm is 40%?

B) 4.8%

20) A firm has $2 million market value and it sells preferred stock with a par value of $100. If the coupon rate on the preferred stock is 6% and the preferred stock trades at $98, what is the cost of preferred stock capital?

B) 6.12%

6) Verano Inc. has two business divisions—a software product line and a waste water clean-up product line. The software business has a cost of equity capital of 10% and the waste water clean-up business has a cost of equity capital of 7%. Verano has 50% of its revenue from software and the rest from the waste water business. Verano is considering a purchase of another company in the waste water business using equity financing. What is the appropriate cost of capital to evaluate the business?

B) 7.0%

8) Verano Inc. has two business divisions—a software product line and a waste water clean-up product line. The software business has a cost of equity capital of 10% and the waste water clean-up business has a cost of equity capital of 8%. Verano has 50% of its revenue from software and the rest from the waste water business. Verano is considering a purchase of another company in the waste water business using equity financing. What is the appropriate cost of capital to evaluate the business?

B) 8.0%

4) Assume Time Warner shares have a market capitalization of $65 billion. The company just paid a dividend of $0.40 per share and each share trades for $25. The growth rate in dividends is expected to be 7.00% per year. Also, Time Warner has $10 billion of debt that trades with a yield to maturity of 7%. If the firm's tax rate is 40%, compute the WACC?

B) 8.11%

21) A firm has $3 million market value and it sells preferred stock with a par value of $100. If the coupon rate on the preferred stock is 8% and the preferred stock trades at $92, what is the cost of preferred stock capital?

B) 8.70%

14) Assume JUP has debt with a book value of $20 million, trading at 120% of par value. The bonds have a yield to maturity of 7%. The firm's book value of equity is $16 million, and it has 2 million shares trading at $19 per share. The firm's cost of equity is 12%. What is JUP's WACC if the firm's marginal tax rate is 35%?

B) 9.12%

7) The book value of a firm's equity is $100 million and its market value of equity is $200 million. The face value of its debt is $50 million and its market value of debt is $60 million. What is the market value of assets of the firm?

C) $260 million

5) Assume the market value of Fords' equity, preferred stock, and debt are$6 billion, $2 billion, and $13 billion, respectively. Ford has a beta of 1.7, the market risk premium is 8%, and the risk-free rate of interest is 3%. Ford's preferred stock pays a dividend of $4 each year and trades at a price of $30 per share. Ford's debt trades with a yield to maturity of 8.0%. What is Ford's weighted average cost of capital if its tax rate is 30%?

B) 9.48%

11) For an unlevered firm, the cost of capital can be determined by using the ________.

B) Capital Asset Pricing Model

7) Which of the following statements is FALSE?

B) External equity is less expensive than retained earnings.

3) Anheuser Busch, a manufacturer of beverages, is planning to purchase Six Flags theme parks. Anheuser Busch should use the ________ to evaluate the business of Six Flags.

B) WACC of Six Flags

4) A firm's sources of financing, which usually consists of debt and equity, represent its ________.

B) capital

10) Leverage is the amount of ________ on a firm's balance sheet.

B) debt

6) When we compute the cost of equity capital for a project we assume that the ________ of the project is equivalent to the average market risk of the firm's investments.

B) market risk

30) SIROM Scientific Solutions has $12 million of outstanding equity and $4 million of bank debt. The bank debt costs 4% per year. The estimated equity beta is 1. If the market risk premium is 8% and the risk-free rate is 4%, compute the weighted average cost of capital if the firm's tax rate is 30%.

C) 9.70%

12) Assume IBM just paid a dividend of $4.50 and expects these dividends to grow at 8% a year. The price of IBM is $100 per share. What is IBM's cost of equity capital?

D) 12.86%

5) Assume Ford Motors expects a new hybrid-engine project to produce incremental cash flows of $45 million each year, and expects these to grow at 3% each year. The upfront project costs are $380 million and Ford's weighted average cost of capital is 9%. If the issuance costs for external finances are $10 million, what is the net present value (NPV) of the project?

C) $360 million

8) Assume SAP Inc. received a $2 million grant under its Small Business Innovation program. SAP invested the grant money and developed a system to remove metal contaminants from storm water in shipyards. The firm estimates that each shipyard spends $600,000 a year on storm water clean-up efforts. If SAP is able to sign up and retain four shipyards from the first year onwards, what is the present value (PV) of the project (net of investment) if the cost of capital for SAP is 14% per year? Assume a cost of operations and other costs for SAP equal 60% of revenue.

C) $4.86 million

12) Assume Lavender Corporation has a market value of $4 billion of equity and a market value of $19.8 billion of debt. What are the weights in equity and debt that are used for calculating the WACC?

C) 0.168, 0.832

21) Epiphany is an all-equity firm with an estimated market value of $300,000. The firm sells $250,000 of debt and uses the proceeds to purchase outstanding equity. Compute the weight in equity and the weight in debt after the proposed financing and repurchase of equity.

C) 0.17, 0.83

29) SIROM Scientific Solutions has $5 million of outstanding equity and $5 million of bank debt. The bank debt costs 4% per year. The estimated equity beta is 2. If the market risk premium is 8% and the risk-free rate is 4%, compute the weighted average cost of capital if the firm's tax rate is 35%.

C) 11.30%

24) An all-equity firm had a dividend expense of $45,000 last year. The market value of the firm is $800,000 and the dividend is expected to increase at 7% each year. What is the cost of equity for this firm?

C) 13.02%

9) Assume preferred stock of Ford Motors pays a dividend of $3.00 each year and trades at a price of $20. What is the cost of preferred stock capital for Ford?

C) 15.0%

18) A firm has outstanding debt with a coupon rate of 5%, ten years maturity, and a price of $1,000. What is the after-tax cost of debt if the marginal tax rate of the firm is 35%?

C) 3.3%

7) Verano Inc. has two business divisions—a software product line and a waste water clean-up product line. The software business has a cost of equity capital of 11% and the waste water clean-up business has a cost of equity capital of 4%. Verano has 50% of its revenue from software and the rest from the waste water business. Verano is considering a purchase of another company in the waste water business using equity financing. What is the appropriate cost of capital to evaluate the business?

C) 4.0%

31) A firm has a capital structure with $50 million in equity and $100 million of debt. The cost of equity capital is 11% and the pretax cost of debt is 5%. If the marginal tax rate of the firm is 40%, compute the weighted average cost of capital of the firm.

C) 5.67%

2) Assume Time Warner shares have a market capitalization of $40 billion. The company is expected to pay a dividend of $0.25 per share and each share trades for $40. The growth rate in dividends is expected to be 7% per year. Also, Time Warner has $20 billion of debt that trades with a yield to maturity of 9%. If the firm's tax rate is 40%, what is the WACC?

C) 6.88%

26) The outstanding debt of Berstin Corp. has five years to maturity, a current yield of 6%, and a price of $95. What is the pretax cost of debt if the tax rate is 30%.

C) 6.9%

32) A firm has a capital structure with $75 million in equity and $45 million of debt. The cost of equity capital is 10% and the pretax cost of debt is 7%. If the marginal tax rate of the firm is 40%, compute the weighted average cost of capital of the firm.

C) 7.8%

27) The outstanding debt of Berstin Corp. has eight years to maturity, a current yield of 7%, and a price of $85. What is the pretax cost of debt if the tax rate is 40%?

C) 8.5%

23) An all-equity firm had a dividend expense of $20,000 last year. The market value of the firm is $600,000 and the dividend is expected to increase at 5% each year. What is the cost of equity for this firm?

C) 8.50%

6) Assume the market value of Fords' equity, preferred stock and debt are $6 billion, $3 billion, and $13 billion, respectively. Ford has a beta of 1.7, the market risk premium is 8%, and the risk-free rate of interest is 3%. Ford's preferred stock pays a dividend of $2.50 each year and trades at a price of $30 per share. Ford's debt trades with a yield to maturity of 9.5%. What is Ford's weighted average cost of capital if its tax rate is 35%?

C) 9.31%

5) Outstanding debt of Home Depot trades with a yield to maturity of 5%. The tax rate of Home Depot is 40%. What is the effective cost of debt of Home Depot?

D) 3.00%

5) The relative proportion of debt, equity, and other securities that a firm has outstanding constitute its ________.

C) capital structure

8) When calculating the WACC, it is a standard practice to subtract ________ to compute the net debt outstanding.

C) cash and risk-free securities

5) When we use the WACC to assess a project, we assume that the ________ ratio does not change.

C) debt to equity

10) When corporate tax rates decline, the net cost of debt financing ________.

C) increases

35) The after-tax cost of debt ________ the before-tax cost of debt for a firm that has a positive marginal tax rate.

C) is always less than

3) The ________ of a firm's debt can be used as the firm's current cost of debt.

C) yield to maturity

4) Assume General Motors has a weighted average cost of capital of 10%. GM is considering investing in a new plant that will save the company $30 million over each of the first two years, and then $25 million each year thereafter. If the investment is $150 million, what is the net present value (NPV) of the project?

D) $108.7 million

13) Assume Bismuth Electronics has a book value of $6 billion of equity and a face value of $19.7 billion of debt. The market values of equity and debt are $2.5 billion and $18.5 billion. A Wall Street financial analyst determines values of equity and debt as $3 billion and $20 billion. Which of the following values should be used for calculating the firm's WACC?

D) $2.5 billion of equity and $18.5 billion of debt

3) Assume General Motors has a weighted average cost of capital of 10%. GM is considering investing in a new plant that will save the company $30 million over each of the first two years, and then $15 million each year thereafter. If the investment is $150 million, what is the net present value (NPV) of the project?

D) $26.0 million

15) A firm incurs $40,000 in interest expenses each year. If the tax rate of the firm is 30%, what is the effective after-tax interest rate expense for the firm?

D) $28,000.00

9) SAP Inc. received a $1.5 million grant under its Small Business Innovation program. SAP invested the grant money and developed a system to remove metal contaminants from storm water in shipyards. The firm estimates that each shipyard spends $500,000 a year on storm water clean-up efforts. If SAP is able to sign up and retain four shipyards in the first year onwards, what is the present value (PV) of the project (net of investment) if the cost of capital for SAP is 14% per year? Assume a cost of operations and other costs for SAP equal 50% of revenue.

D) $5.64 million

3) Assume Ford Motors expects a new hybrid-engine project to produce incremental cash flows of $90 million each year and expects these to grow at 3% each year. The upfront project costs are $900 million and Ford's weighted average cost of capital is 9%. If the issuance costs for external finances are $20 million, what is the net present value (NPV) of the project?

D) $580 million

22) Epiphany is an all-equity firm with an estimated market value of $500,000. The firm sells $150,000 of debt and uses the proceeds to purchase outstanding equity. Compute the weight in equity and the weight in debt after the proposed financing and repurchase of equity.

D) 0.70, 0.30

10) IBM expects to pay a dividend of $2 next year and expects these dividends to grow at 9% a year. The price of IBM is $80 per share. What is IBM's cost of equity capital?

D) 11.50%

11) IBM expects to pay a dividend of $5 next year and expects these dividends to grow at 7% a year. The price of IBM is $90 per share. What is IBM's cost of equity capital?

D) 12.56%

3) Assume Time Warner shares have a market capitalization of $60 billion. The company is expected to pay a dividend of $0.30 per share and each share trades for $40. The growth rate in dividends is expected to be 7% per year. Also, Time Warner has $20 billion of debt that trades with a yield to maturity of 8%. If the firm's tax rate is 35%, compute the WACC?

D) 7.11%

25) The outstanding debt of Berstin Corp. has ten years to maturity, a current yield of 7%, and a price of $95. What is the pretax cost of debt if the tax rate is 30%.

D) 7.37%

3) One should use accounting-based book values rather than market values of debt and equity to determine the weights for the different sources of capital.

FALSE

1) Firms that have many divisions with different lines of business do not use a companywide WACC to evaluate projects.

TRUE

1) The costs of external financing must be deducted from the net present value (NPV) of a project to evaluate if it is worth undertaking.

TRUE

2) To attract capital from outside investors, a firm must offer potential investors an expected return that is commensurate with the level of risk that they can bear.

TRUE