FINC CHP 10

Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A's cost of capital is 10.0%, Division B's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A's projects are equally risky, as are all of Division B's projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept? a. A Division B project with an 11% return. b. A Division A project with a 9% return. c. A Division A project with an 11% return. d. A Division B project with a 12% return. e. A Division B project with a 13% return.

C

Which of the following statements is CORRECT? a.Higher flotation costs tend to reduce the cost of equity capital.b.Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.c.If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.d.Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt.e.The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes.

C

Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth. a.If a firm evaluates all projects using the same cost of capital, and the CAPM is used to help determine that cost, then its risk as measured by beta will probably decline over time.b.Projects with above-average risk typically have higher-than-average expected returns. Therefore, to maximize a firm's intrinsic value, its managers should favor high-beta projects over those with lower betas.c.Project A has a standard deviation of expected returns of 20%, while Project B's standard deviation is only 10%. A's returns are negatively correlated with both the firm's other assets and the returns on most stocks in the economy, while B's returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital.d.If a firm's managers want to maximize the value of the stock, they should, in theory, concentrate on project risk as measured by the standard deviation of the project's expected future cash flows.e.If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms' assets.

C

Bankston Corporation 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. Since new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock? a.Increase the dividend payout ratio for the upcoming year.b.Reduce the amount of short-term bank debt in order to increase the current ratio.c.Increase the proposed capital budget.d.Increase the percentage of debt in the target capital structure.e.Reduce the percentage of debt in the target capital structure.

D

LaPango Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept? a.None of the projects should be accepted.b.Project C, which is of above-average risk and has a return of 11%.c.Project A, which is of average risk and has a return of 9%.d.Project B, which is of below-average risk and has a return of 8.5%.e.All of the projects should be accepted.

D

Which of the following statements is CORRECT? a.The discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever.b.If the calculated beta underestimates the firm's true investment risk—i.e., if the forward-looking beta that investors think exists exceeds the historical beta—then the CAPM method based on the historical beta will produce an estimate of rs and thus WACC that is too high.c.The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach.d.Beta measures market risk, which is, theoretically, the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. This is true even if not all of the firm's stockholders are well diversified.e.An advantage shared by both the DCF and CAPM methods when they are used to estimate the cost of equity is that they are both "objective" as opposed to "subjective," hence little or no judgment is required.

D

Schalheim Sisters Inc. has always paid out all of its earnings as dividends, hence the firm has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC? a.The flotation costs associated with issuing new common stock increase.b.The company's beta increases.c.Expected inflation increases.d.The market risk premium declines.e.The flotation costs associated with issuing preferred stock increase.

D market risk premium declines

Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below. Assets Current assets................... $38,000,000 Net plant, property, and equipment................... $101,000,000 Total assets................. $139,000,000 Liabilities and Equity Accounts payable.................... $10,000,000 Accruals................... $9,000,000 Current liabilities................... $19,000,000 Long-term debt (40,000 bonds, $1,000 par value).......... $40,000,000 Total liabilities............................. $59,000,000 Common stock (10,000,000 shares)................... $30,000,000 Retained earnings................. $50,000,000 Total shareholders' equity................... $80,000,000 Total liabilities and shareholders' equity................... $139,000,000 The stock is currently selling for $15.25 per share, and its noncallable $1,000.00 par value, 20-year, 9.00% bonds with semiannual payments are selling for $930.41. The beta is 1.22, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 25%. Refer to Exhibit 10.1. Which of the following is the best estimate for the weight of debt for use in calculating the WACC? Do not round your intermediate calculations.

It is best to use the market weight for the debt when calculating Weighted Average Cost of Capital. What is the market value of debt? This can be found as: = Number of bonds x Price of bonds = 40,000 x 930.41 = $37,216,400 What is the market value of Common stock? = Number of outstanding stock x Price of stock = 10,000,000 x 15.25 = $152,500,000 What is the weight of debt? = Amount of debt / (Value of debt + Value of stock) = 37,216,400 / (37,216,400 + 152,500,000) =37,216,400 / 189,716,400 =0.196168597 =19.62%

In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project.

false

Since 70% of the preferred dividends received by a corporation are excluded from taxable income, the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be ​ Cost of equity = rs(0.30)(0.50) + rps(1 - T)(0.70)(0.50).

false

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 50% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

false

The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and retained earnings, whose cost is the average return on the assets that are acquired.

false

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the CAPM method always provides an accurate and reliable estimate.

false

Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets. They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.

true

If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the DCF model, and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method. All this makes it especially difficult to estimate the cost of equity for a private company.

true

The cost of capital used in capital budgeting should reflect the average cost of the various sources of investor-supplied funds a firm uses to acquire assets.

true

When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to use long-term or short-term rates for r RF, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and (3) how to measure the market risk premium, RP M. These problems leave us unsure of the true value of r s.

true

When estimating the cost of equity by use of the DCF method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return. This problem leaves us unsure of the true value of r s.

true