HIGGINS Chapter 8

Please refer to the information for FM Foods above. Estimate the appropriate weight of debt to be used when calculating FM's weighted-average cost of capital. A. 11.5% B. 19.3% C. 80.7% D. 88.5% E. 100.0% F. None of the above.

A. 11.5% Market value of equity = $40 × 240 million = $9,600 million. Weight of debt = 1,250/(9,600 + 1,250) = 0.1152 or 11.5%.

Honest Abe's is a chain of furniture retail stores. Integral Designs is a furniture maker and a supplier to Honest Abe's. Honest Abe's has a beta of 1.38 as compared to Integral Designs' beta of 1.12. Both firms carry no debt, i.e., are 100% equity-financed. The risk-free rate of return is 3.5 percent and the market risk premium is 8 percent. What discount rate should Honest Abe's use if it considers a project that involves the manufacturing of furniture? A. 12.46% B. 12.92% C. 13.50% D. 14.08% E. 14.54% F. None of the above.

A. 12.46% KE = gov't borrowing rate + equity beta × market risk premium = 0.035 + 1.12(0.08) = 0.1246 or 12.46%

Company X has 2 million shares of common stock outstanding at a book value of $2 per share. The stock trades for $3.00 per share. It also has $2 million in face value of debt that trades at 90% of par. What is the appropriate debt ratio (D/(D+E)) to use for calculating Company X's weighted-average cost of capital? A. 23.1% B. 25.0% C. 31.0% D. 33.3%

A. 23.1% D = 0.9 × $2 million = $1.8 million E = $3 × 2 million = $6 million D/(D+E) = 1.8/(1.8 + 6) = 0.231

Which of the following statements concerning risk are correct? I. Systematic risk is measured by beta. II. The risk premium increases as unsystematic risk increases. III. Systematic risk is the only part of total risk that should affect asset prices and returns. IV. Diversifiable risks are market risks you cannot avoid. A. I and III only B. II and IV only C. I and II only D. III and IV only E. I, II, and III only F. None of the above.

A. I and III only

Which one of the following is an example of systematic risk? A. The Federal Reserve unexpectedly announces an increase in target interest rates. B. A flood washes away a firm's warehouse. C. A city imposes an additional one percent sales tax on all products. D. A toymaker has to recall its top-selling toy. E. Corn prices increase due to increased demand for alternative fuels. F. None of the above.

A. The Federal Reserve unexpectedly announces an increase in target interest rates.

Unsystematic risk: A. can be effectively eliminated by portfolio diversification. B. is compensated for by the risk premium. C. is measured by beta. D. is measured by standard deviation. E. is related to the overall economy. F. None of the above.

A. can be effectively eliminated by portfolio diversification.

The pre-tax cost of debt: A. is based on the current yield to maturity of the firm's outstanding bonds. B. is equal to the coupon rate on the latest bonds issued by a firm. C. is equivalent to the average current yield on all of a firm's outstanding bonds. D. is based on the original yield to maturity on the latest bonds issued by a firm. E. has to be estimated as it cannot be directly observed in the market. F. None of the above.

A. is based on the current yield to maturity of the firm's outstanding bonds

Please refer to the information for FM Foods above. Estimate FM's after-tax cost of debt capital. A. 2.21% B. 4.10% C. 4.55% D. 6.30% E. 7.00% F. None of the above.

B. 4.10% The correct approach is to use the YTM on the firm's bonds for the before-tax cost. Thus, after-tax cost = 6.3% × (1 - 0.35) = 4.10%.

The after-tax cost of debt generally increases when: I. a firm's bond rating improves. II. the market-required rate of interest for the company's bonds increases. III. tax rates decrease. IV. bond prices rise. A. I and III only B. II and III only C. I, II, and III only D. II, III, and IV only E. I, II, III, and IV F. None of the above.

B. II and III only

The capital structure weights used in computing the weighted-average cost of capital: A. are based on the book values of total debt and total equity. B. are based on the market value of the firm's debt and equity securities. C. are computed using the book value of the long-term debt and the book value of equity. D. remain constant over time unless the firm issues new securities. E. are restricted to the firm's debt and common stock. F. None of the above.

B. are based on the market value of the firm's debt and equity securities.

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. rate of return a firm must earn on its existing assets to maintain the current value of its stock. C. coupon rate the firm should expect to pay on its next bond issue. D. minimum discount rate the firm should require on any new project. E. rate of return shareholders should expect to earn on their investment in this firm. F. None of the above.

B. rate of return a firm must earn on its existing assets to maintain the current value of its stock.

The excess return earned by a risky asset, for example with a beta of 1.4, over that earned by a risk-free asset is referred to as a: A. market risk premium. B. risk premium. C. systematic return. D. total return. E. real rate of return. F. None of the above.

B. risk premium.

Please refer to the information for FM Foods above. Estimate FM's weighted-average cost of capital. A. 6.46% B. 6.58% C. 11.27% D. 11.32% E. 11.52% F. None of the above.

C. 11.27%

Florida Corp. is calculating the appropriate rate for discounting cash flows on a project valued using the APV method. Florida's target debt ratio (D/(D+E)) in market value terms is 50%, and the yield-to-maturity on its outstanding debt is 6%. A comparable firm has an equity beta of 1.4 and a debt ratio (D/(D+E)) of 40%. Assume a risk-free rate of 5% and a market risk premium of 8%. Florida's tax rate is 40%. What discount rate should Florida use? A. 7.66% B. 11.02% C. 11.72% D. 18.44%

C. 11.72% βA = (E/V)βE = (0.6)1.4 = 0.84 KE = 5% + 0.84(8%) = 11.72%

JKL Corporation, a company devoted primarily to paper products, is estimating the cost of equity appropriate for a vegetable processing plant it is planning to build. JKL Corp. has an equity beta of 1.0 and a debt ratio (D/(D+E)) of 0.3. A comparable (vegetable processing) firm has an equity beta of 0.8 and a debt ratio of 0.2. Assume a risk-free rate of 5% and a market risk premium of 8%. What cost of equity should JKL use in this situation? A. 7.7% B. 11.4% C. 12.3% D. 13.0%

C. 12.3% Unlever the comparable firm's beta: βA = (E/V)βE = (0.8)0.8 = 0.64 Then relever at JKL's debt ratio: βE = βA/(E/V) = 0.64/(0.7) = 0.91 Cost of Equity: KE = 5% + 0.91(8%) = 12.3%

The dividend growth model can be used to compute the cost of equity for a firm in which of the following situations? I. Firms that have a 100 percent retention ratio II. Firms that pay an unchanging dividend III. Firms that pay a constantly increasing dividend IV. Firms that pay an erratically growing dividend A. I and II only B. I and IV only C. II and III only D. I, II, and III only E. I, III, and IV only F. None of the above.

C. II and III only

The cost of equity for a firm: A. tends to remain static for firms with increasing levels of risk. B. increases as the unsystematic risk of the firm increases. C. can be estimated from the capital asset pricing model or the dividend growth model. D. equals the risk-free rate plus the market risk premium. E. equals the firm's pre-tax weighted-average cost of capital. F. None of the above.

C. can be estimated from the capital asset pricing model or the dividend growth model.

Please refer to the information for FM Foods above. Estimate FM's after-tax cost of equity capital. A. 4.50% B. 6.92% C. 7.93% D. 12.20% E. 17.48% F. None of the above.

D. 12.20% KE = gov't borrowing rate + equity beta × market risk premium = 0.044 + 1.2 × 0.065 = 0.122

Please refer to the information for FM Foods above. Estimate the appropriate weight of equity to be used when calculating FM's weighted-average cost of capital. A. 11.5% B. 19.3% C. 80.7% D. 88.5% E. 100.0% F. None of the above

D. 88.5% Market value of equity = $40 × 240 million = $9,600 million. Weight of equity = 9,600/(9,600 + 1,250) = 0.8848 or 88.5%.

Which of the following are examples of diversifiable risk? I. An earthquake damages Oakland, California. II. The federal government imposes an additional $1,000 fee on all business entities. III. Employment taxes increase nationally. IV. Toymakers are required to improve their safety standards. A. I and III only B. II and IV only C. II and III only D. I and IV only E. I, III, and IV only F. None of the above.

D. I and IV only

Which of the following statements are correct? I. Using the same risk-adjusted discount rate to discount all future cash flows adjusts for the fact that the more distant cash flows are often more risky than cash flows occurring sooner. II. If you can borrow all of the money you need for a project at 5%, the cost of capital for this project is 5%. III. The best way to obtain the cost of debt capital for a firm is to use the coupon rates on its bonds. IV. A firm's weighted-average cost of capital is NOT the correct discount rate to use for all projects undertaken by the firm. A. I and III only B. II and IV only C. I and II only D. I and IV only E. I, II, and III only F. None of the above

D. I and IV only

Which of the following statements are correct concerning diversifiable, or unsystematic, risks? I. Diversifiable risks can be largely eliminated by investing in 50 unrelated securities. II. There is no reward for accepting diversifiable risks. III. Diversifiable risks are generally associated with an individual firm or industry. IV. Beta measures diversifiable risk. A. I and III only B. II and IV only C. I and IV only D. I, II, and III only E. I, II, III, and IV F. None of the above.

D. I, II, and III only

Unitron Corp. is considering project Z, which costs $50 million and offers an annual after-tax cash flow of $7.5 million in perpetuity. The project is in an industry that has greater market risk than Unitron's typical projects. Unitron's company weighted-average cost of capital, based on its typical projects, is 15%. Should Unitron Corp. accept project Z? A. Yes, because the NPV of the project is positive. B. Yes, because a zero-NPV project is marginally acceptable. C. No, because a zero-NPV project is a waste of resources. D. No, because the NPV of the project is negative.

D. No, because the NPV of the project is negative. Use the equation for a perpetuity to solve for the IRR: 7.5/IRR = 50 IRR = 15% Since the IRR is 15%, it would have an NPV of zero at a WACC of 15%. However, this project is riskier than the firm's average projects, so the WACC would be higher than 15%, which would make the NPV negative.

A firm is considering an average-risk project with an IRR of 6%. The firm's cost of debt (KD) is 5%, its cost of equity (KE) is 12%, and its tax rate (t) is 20%. The target debt ratio (D/(D+E)) for the project, in market values, is 0.5. The firm should: A. accept the project only if it can be completely financed with equity B. accept the project only if it can be completely financed with debt C. accept the project regardless of the financing method D. reject the project regardless of the financing method

D. reject the project regardless of the financing method The project should be rejected because the IRR of 6% does not meet the hurdle of 8%.

Total risk is measured by _____ and systematic risk is measured by ____. A. beta; alpha B. beta; standard deviation C. WACC; beta D. standard deviation; beta E. standard deviation; variance F. None of the above.

D. standard deviation; beta

Please refer to the information for FM Foods above. FM is contemplating an average-risk investment costing $100 million and promising an annual after-tax cash flow of $15 million in perpetuity. Which of the following statements is/are correct? I. FM should reject the project because the IRR is greater than the firm's WACC. II. FM should accept the project because the IRR is greater than the firm's WACC. III. FM should accept the project because the NPV is greater than zero. IV. FM should reject the project because the NPV is less than zero. A. I only B. II only C. IV only D. I and IV only E. II and III only F. None of the above

E. II and III only The IRR of the investment is 15/100 = 15%. FM's WACC of 11.27% is shown in the calculations below. The NPV of the investment at the WACC = -100 + 15/0.1127 = $33.1 million.

When investment returns are less than perfectly positively correlated, the resulting diversification effect means that: A. making an investment in two or three large stocks will eliminate all of the unsystematic risk. B. making an investment in three companies all within the same industry will greatly reduce the systematic risk. C. spreading an investment across five diverse companies will not lower the total risk. D. spreading an investment across many diverse assets will eliminate all of the systematic risk. E. spreading an investment across many diverse assets will eliminate some of the total risk. F. None of the above.

E. spreading an investment across many diverse assets will eliminate some of the total risk.

The discount rate assigned to an individual project should be based on: A. the firm's weighted-average cost of capital. B. the actual sources of funding used for the project. C. an average of the firm's overall cost of capital for the past five years. D. the current risk level of the overall firm. E. the risks associated with the use of the funds required by the project. F. None of the above.

E. the risks associated with the use of the funds required by the project.

A beta greater than 1 is indicative of an above-average level of diversifiable (unsystematic) risk.

False

All else equal, if two competing firms in industry X are valuing the same plant in industry Y for a potential acquisition, the firm with the more volatile stock should arrive at a lower valuation for the plant.

False

Asset betas measure financial risk and business risk.

False

Failing to include real options in a project valuation could cause the NPV of the project to be overestimated.

False

In reality, the cost of equity is always less than the cost of debt because firms are not obligated to pay out cash to shareholders.

False

The adjusted present value (APV) method of valuation is superior to the standard WACC method of valuation because the WACC method makes no adjustment for interest tax shields

False

An average-risk project that has an NPV of zero when its cash flows are discounted at the weighted-average cost of capital will provide sufficient returns to satisfy both stockholders and bondholders.

True

When projected cash flows are in nominal dollars, they should be discounted with a nominal discount rate.

True