Chapter 9: WACC

Appalachian Inc. has the following data: risk free rate= 5%, market risk premium= 6% and beta= 1.05. What is the firm's cost of common stock from reinvested earnings based on CAPM? a. 11.30% b. 11.64% c. 11.99% d. 12.35% e. 12.72%

a

Avery Corporation's target capital structure is 35% debt, 10% preferred, and 55% common equity. The interest rate on new debt is 6.50%, the yield on the preferred is 6.00%, the cost of common from reinvested earnings is 11.25%, and the tax rate is 25%. The firm will not be issuing any new common stock. What is Avery's WACC? a. 8.49% b. 8.83% c. 9.19% d. 9.55% e. 9.94%

a

Which of the following is not a capital component when calculating the weighted average cost of capital for use in capital budgeting? a. accounts payable b. common stock raised by reinvested earnings c. common stock raised by new issues d. preferred stock e. long term debt

a

Which of the following statements is most correct? a. If Congress raised the corporate tax rate, this would lower the effective cost of debt but probably would also reduce the amount of earnings available to reinvest, so the effect on the marginal cost of capital is uncertain. b. For corporate investors, 70 percent of the dividends received on both common and preferred stocks is exempt from taxes. However, neither preferred nor common dividends may be deducted by the issuing company. Therefore, the dividend exclusion has no effect on a company's cost of capital, so its WACC would probably not change at all if the dividend exclusion rule were rescinded by Congress. c. The calculation for a firm's WACC includes an adjustment to the cost of debt for taxes, since interest is deductible, and includes the cost of short-term debt. d. Each of the above statements is true. e. Each of the above statements is false.

a

If the expected rate of return on a given capital project lies _______ the SML, the expected rate of return on the project is more than enough to compensate for its risk, and the project should be accepted.

above

Appstate Company's target capital structure is 40% debt, 15% preferred, and 45% common equity. The after tax cost of debt is 6%, the cost of preferred is 7.5%, and the cost of common using reinvested earnings is 12.75%. The firm will not be issuing any new stock. You were hired as a consultant to help determine their cost of capital. What is their WACC? a. 8.98% b. 9.26% c. 9.54% d. 9.83% e. 10.12%

b

Trahern Baking Co. common stock sells for $32.50 per share. It expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, and its expected constant dividend growth rate is 6.0%. New stock can be sold to the public at the current price, but a flotation cost of 5% would be incurred. What would be the cost of equity from new common stock? a. 12.70% b. 13.37% c. 14.04% d. 14.74% e. 15.48%

b

As a consultant to Basso Inc., you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant). What is the cost of common from reinvested earnings based on the dividend growth approach? a. 9.42% b. 9.91% c. 10.44% d. 10.96% e. 11.51%

c

Quilan enterprises stock trades for $52.50 per share. It is expected to pay a $2.50 dividend at year end (D1=2.50), and the dividend is expected to grow at a constant rate of 5.5% a year. The before tax cost of debt is 7.5% and the tax rate is 25%. The target capital structure consists of 45% debt and 55% common equity. What is the company's WACC if all the equity used is from reinvested earnings? a. 7.53% b. 7.85% c. 8.18% d. 8.50% e. 8.84%

c

The Appstate Company sold a $1000 par value non callable bond several years ago that now has 20 years to maturity and a 7% coupon paid semiannually. The bond currently sells for $925 and the company's tax rate is 25%. What is the component cost of debt for use in the WACC calculation? a. 5.35% b. 5.58% c. 5.81% d. 6.04% e. 6.28%

c

_________ ___________ analysis is a similar process to the corporate valuation model, except that it focuses on proposed new projects rather than on the firm's existing assets.

capital budgeting

Most firms employ several types of capital, called _________ ____________, with common and preferred stock, along with debt, being the three most frequently used types.

capital components

A firm can affect its cost of capital through its _________ ___________ policy, its __________ policy, and its ____________ (capital budgeting) policy.

capital structure; dividend; investment

A company's perpetual preferred stock currently sells for $92.50 per share, and it pays an $8.00 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price. What is the firm's cost of preferred stock? a. 7.81% b. 8.22% c. 8.65% d. 9.10% e. 9.56%

d

Kenny Electric Company's noncallable bonds were issued several years ago and now have 20 years to maturity. These bonds have a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000. If the firm's tax rate is 25%, what is the component cost of debt for use in the WACC calculation? a. 5.44% b. 5.73% c. 6.03% d. 6.35% e. 6.67%

d

The proportions of ______, ___________ _______, and ________ ________ in the target capital structure should be used to calculate the __________ _________ cost of capital.

debt; preferred stock; common equity; weighted average

For many firms, ______________ is the largest source of funds as shown in their statement of cash flows and is available to support the capital budget.

depreciation

The required rate of return on common equity may also be estimated as the expected __________ _______ on the common stock plus the expected future ________ ______ of the dividends.

dividend yield; growth rate

Which of the following statements could be true concerning the costs of debt and equity? a. The cost of debt for Firm A is greater than the cost of equity for Firm A. b. The cost of debt for Firm A is greater than the cost of equity for Firm B. c. The cost of reinvested earnings for Firm A is less than its cost of new equity. d. The cost of reinvested earnings for Firm A is less than its cost of debt. e. Statements b and c could both be true.

e

Companies must earn more than rs on new shares because they incur ___________ ______ to issue new stock.

floatation costs

The combined effects of ___________ _______ and _______ __________ inhibit companies from issuing additional common stock.

floatation costs; price pressure

The cost of capital is sometimes referred to as the ________ rate because projects must jump over it to be accepted.

hurdle

The two most important factors that affect the cost of capital and which are beyond the firm's direct control are the level of __________ rates and _______.

interest;taxes

Companies can raise common equity in two ways; (1) by _________ _______ shares and (2) by ___________ ___________.

issuing new; retaining earnings

rd is the __________ cost of new debt to be raised during the planning period.

marginal

Of the three risk measures, ________ risk is theoretically the most relevant measure because of its direct effect on stock prices.

market

Assigning a cost to reinvested earnings is based on the _____________ ______ principle.

opportunity cost

The component cost of preferred stock is calculated as the ___________ ___________ divided by the _____ _________ _______ of preferred stock.

preferred dividends; net issuing price

Two approaches have been developed for estimating project betas: the ______ ______ and the ____________ ______ methods.

pure play; accounting beta

One method for estimating g involves multiplying the ___________ ______ by the company's expected future rate of return on equity (ROE).

retention rate

The cost of common equity may also be found by adding a(n) ______ _________ to the interest rate on the firm's own long-term debt.

risk premium

Projects are classified into subjective risk categories and then ______-__________ _______ ____ _________ are developed for each category using the composite WACC as a starting point.

risk-adjusted costs of capital

Using the Capital Asset Pricing Model (CAPM), the required rate of return on common stock is found as a function of the ______-______ ______, the firm's ______ _____________, and the required rate of return on an average _______.

risk-free rate; beta coefficient; stock

The hurdle rate for each project should reflect the ______ of the project itself, not necessarily those associated with the firm's _________ project as reflected in the firm's composite WACC.

risk; average

_______-_______ risk is the risk an asset would have if it were a firm's only asset.

stand-alone

Three separate and distinct types of risk can be identified: _______-_______ risk, ___________ risk, and ________ risk.

stand-alone; corporate (within-firm); market (beta)

The correct weights to use in the WACC calculation are those based on the firm's ________ capital structure, since this is the best estimate of how the firm will, on average, raise money in the future.

target

There are _______ methods that can be used to determine the cost of common equity.

three

Funds acquired by the firm through preferred stock have a cost to the firm equal to the preferred dividend divided by the net issuing price, Pn, the price the firm receives on preferred after deducting flotation costs. a. True b. False

true

The firm should calculate its cost of capital as a(n) __________ _________ of the after‑tax costs of the various types of funds it uses.

weighted average

The opportunity cost of depreciation is the __________ _________ ______ ____ _________.

weighted average cost of capital