Chapter 11 Part 1

Company A has an outstanding debt of $10,000,000, its interest payments equal $1,500,000 annually, and its marginal tax rate equals 30%. What is the after-tax cost of debt for Company C to be used in its WACC equation?

10.5%

Company A issued all of its outstanding bonds 4 years ago, all maturing in 21 years, with the same terms. The yield to maturity on the bonds was recorded equal to 5.5% 3 years ago, 4% 2 years ago, 4.5% 1 year ago, and 6% earlier today. What pre-tax cost of debt should be used in the WACC equation?

6%

Which of the following is most correct?

An increase in the risk-free rate will increase the cost of equity

Which of the following would likely reduce the weighted average cost of capital for a company?

A higher marginal tax rate faced by the company

When firms use multiple sources of capital, they need to calculate the appropriate discount rate for valuing their firm's cash flows as:

A weighted average of the capital components cost

Which of the statements below is correct? a. Using firm WACC for all projects leads to incorrect acceptance of high risk projects and thus to an increase in the overall company risk b. Using firm WACC for all projects leads to incorrect rejection of low risk projects and thus to an increase in the overall company risk c. In theory (assuming no estimation errors), using divisional WACC does not eliminate the possibility of incorrectly accepting or rejecting a project d. All of the statements are correct

All of the statements are correct

Which of these statements are true? a. The weights of debt and equity should be based on market values because this is the most accurate assessment of the valuation b. An increase in the market risk premium is likely to increase the weighted average cost of capital c. The weighted average cost of capital is calculated on an after-tax basis d. All of these statements are correct

All of these statements are correct

Which of the following makes this a true statement? Ideally, when searching for a beta for a new line of business: a. One would like to find more than one or two pure-play proxies b. two (or even one) proxies might represent a suitable sample if their line of business resembles the proposed new project closely enough c. One could find other firms engaged in the proposed new line of business and use their betas as proxies to estimate the project's risk d. All the answers make this a true statement

All the answers make this a true statement

Using the pure-play approach for estimating a project's beta, to evaluate a new project consisting of opening a new line of business delivering packages across the United States, it would be best to use

An estimate of a beta of a company that specializes in delivering packages, such as FedEx, adjusting properly for financial leverage

Which of the following would likely increase the weighted average cost of capital for a company?

An increase in the market risk premium

Which of the following statements is correct?

An increase in the market risk premium is likely to increase the weighted average cost of capital

Relative to a typical level of risk for Company Z's projects, project A is twice as risky, project B is half as risky, and project C is of about the same risk. Thus firm WACC should be used to discount cash flows for project(s) ______, and project-specific WACC should be used for project(s) _______.

C; A and B

Which of these is an estimated WACC computed using some sort of proxy for the average equity risk of the projects in a particular division?

Divisional WACC

Which of the following is a reason why the divisional cost of capital approach may cause problems if new projects are assigned to the wrong division?

If projects are assigned to the wrong division, the risk of that division may be significantly different than the risk of the project, implying that the project will be evaluated with a divisional cost of capital that is much different from what a project-specific cost of capital would be.

Which of the following statements is true?

If the new project is riskier than the firm's existing projects, then it should be charged a higher cost of capital

When calculating the weighted average cost of capital, weights are based on:

Market values

Which of the statements below is correct?

Most companies use divisional WACC for most projects, while using project WACC for the most important ones

Which of the following statements is true regarding the calculation of component costs for the WACC formula?

Preferred stock represents a special case of the constant growth model, wherein the g equals zero.

What is the correct order of the following component costs of capital, from highest to lowest?

The cost of common equity (highest), the cost of preferred equity, the cost of debt (lowest)

Which of the following statements is correct?

The weights of debt and equity should be based on market values because this is the most accurate assessment of the valuation

Which of these statements are true? a. The weights of debt and equity should be based on market values because this is the most accurate assessment of the valuation b. A decrease in the market risk premium is likely to increase the weighted average cost of capital c. The weighted average cost of capital is calculated on a before-tax basis d. All of these statements are correct

The weights of debt and equity should be based on market values because this is the most accurate assessment of the valuation

Which of the following is a true statement?

To estimate the before-tax cost of debt, it would be best to solve for the Yield to Maturity (YTM) on the firm's existing debt

Which of these statements is true regarding divisional WACC?

Using a simple firmwide WACC to evaluate new projects would give an unfair advantage to projects that present more risk than the firm's average beta

Which of the statements below is correct? a. In theory (assuming no estimation errors), using divisional WACC eliminates the possibility of incorrectly accepting or rejecting a project b. Using firm WACC for all projects leads to incorrect rejection of low risk projects and thus to an increase in the overall company risk c. In theory, using project-specific WACC for all projects leads to incorrect decisions regarding projects with a typical level of risk. d. Using firm WACC for all projects leads to incorrect acceptance of high risk projects and thus to a decrease in the overall company risk

Using firm WACC for all projects leads to incorrect rejection of low risk projects and thus to an increase in the overall company risk

Which of the following is a situation in which you would want to use the constant growth model approach for estimating the component cost of equity?

When the firm's stock is expected to experience constant dividend growth

Which of the following is a situation in which we would most likely use the CAPM approach for estimating the component cost of equity?

When we are able to estimate the firm's beta with a high degree of confidence

A proxy beta is:

the average beta of firms that are only engaged in the proposed new line of business

Which of these makes this a true statement? The WACC formula

uses market values to determine weights