fin 125-exam 3

Jamison's has expected earnings before interest and taxes of $11,900. Its unlevered cost of capital is 12.8 percent and its tax rate is 21 percent. The company has debt with both a book and a face value of $12,500. This debt has a coupon rate of 7.6 percent and pays interest annually. What is the weighted average cost of capital?

VU = [$11,900(1 − .21)]/.128 VU = $73,445 VL = $73,445 + .21($12,500) VL = $76,070 VE = $76,070 − 12,500 VE = $63,570 RE = .128 + (.128 − .076)($12,500/$63,570)(1 − .21) RE = .1361 WACC = ($63,570/$76,070)(.1361) + ($12,500/$76,070)(.076)(1 − .21) WACC = .1236, or 12.36% 12.36 percent

An unlevered company has a cost of capital of 14.6 percent and earnings before interest and taxes of $240,090. A levered company with the same operations and assets has a face value of debt of $85,000 with a coupon rate of 7.5 percent that sells at par. The applicable tax rate is 22 percent. What is the value of the levered company?

VU = [$240,090(1 − .22)]/.146 VU = $1,282,673 VL = $1,282,673 + .22($85,000) VL = $1,301,373 $1,301,373

Which form of financing do companies prefer to use last according to the pecking-order theory?

common stock

you have computed the break-even point between a levered and an unlevered capital structure. Ignore taxes. At the break-even level, the

company is earning just enough to pay for the cost of the debt

The optimal capital structure has been achieved when the

debt-equity ratio results in the lowest possible weighted average cost of capital

Pro forma statements for a proposed project should generally do all of the following except

include interest expense

The basic lesson of M&M theory is that the value of a company is dependent upon

the total cash flows of that company

Southwest Sands currently has 22,000 shares of stock outstanding. It is considering issuing $128,000 of debt at an interest rate of 7.5 percent. The break-even level of EBIT between these two capital structure options is $74,000. How many shares of stock will be repurchased if the company undergoes the recapitalization? Ignore taxes.

$74,000/22,000 = [$74,000 − 128,000(.075)]/X X = 19,145.95 shares Shares repurchased = 22,000 − 19,145.95 Shares repurchased = 2,854.05 shares 2,854.05 shares

Saint Nick Enterprises has 17,900 shares of common stock outstanding at a price of $71 per share. The company has two bond issues outstanding. The first issue has 9 years to maturity, a par value of $1,000 per bond, and sells for 102.5 percent of par. The second issue matures in 23 years, has a par value of $2,000 per bond, and sells for 107.5 percent of par. The total face value of the first issue is $270,000, while the total face value of the second issue is $370,000. What is the capital structure weight of debt?

Common stock: 17,900 × $71 = $ 1,270,900 Bond 1: 1.025 × $270,000 = 276,750 Bond 2: 1.075 × $370,000 = 397,750 Total value: $1,945,400 XD = ($276,750 + 397,750)/$1,945,400 XD = .3467 .3467

The operating cash flow for a project should exclude which one of the following?

Interest Expense

Westover Mills reduced its taxes last year by $210 by increasing its interest expense by $1,000. Which one of the following terms is used to describe this tax savings?

Interest tax shield

Which one of the following is a correct method for computing the operating cash flow of a project assuming that the interest expense is equal to zero?

Net income + Depreciation

The option that is forgone so that an asset can be utilized by a specific project is referred to as which one of the following?

Opportunity cost

D. L. Tuckers has $57,000 of debt outstanding that is selling at par and has a coupon rate of 7.15 percent. The tax rate is 21 percent. What is the present value of the tax shield?

PV tax shield = .21($57,000) PV tax shield = $11,970 $11,970

Rossdale Co. stock currently sells for $72.87 per share and has a beta of 1.22. The market risk premium is 7.10 percent and the risk-free rate is 2.90 percent annually. The company just paid a dividend of $4.29 per share, which it has pledged to increase at an annual rate of 3.45 percent indefinitely. What is your best estimate of the company's cost of equity?

RE = .0290 + 1.22(.0710)RE = .1156, or 11.56% RE = $4.29(1.0345)/$72.87 + .0345RE = .0954, or 9.54% RE = (11.56% + 9.54)/2RE = 10.55% 10.55%

Smathers Corp. stock has a beta of 1.18. The market risk premium is 7.50 percent and the risk-free rate is 3.06 percent annually. What is the company's cost of equity?

RE = .0306 + 1.18(.0750) RE = .1191, or 11.91% 11.91%

Ignoring taxes, Pewter & Glass has a weighted average cost of capital of 10.82 percent. The company can borrow at 7.4 percent. What is the cost of equity if the debt-equity ratio is .58?

RE = .1082 + (.1082 − .074)(.58) RE = .1280, or 12.8% 12.8%

The Corner Bakery has a debt-equity ratio of .53. The required return on assets is 13.5 percent and its cost of equity is 15.08 percent. What is the pretax cost of debt based on M&M Proposition II with no taxes?

RE = .1508 = .135 + (.135 − RD)(.53) RD = .1052, or 10.52% 10.52 percent

Piedmont Hotels is an all-equity company. Its stock has a beta of 1.17. The market risk premium is 6.6 percent and the risk-free rate is 2.4 percent. The company is considering a project that it considers riskier than its current operations so it wants to apply an adjustment of 1.6 percent to the project's discount rate. What should the firm set as the required rate of return for the project?

RE = 2.4% + 1.17(6.6%) RE = 10.12% Project's required return = 10.12% + 1.6% Project's required return = 11.72% 11.72%

Judy's Boutique just paid an annual dividend of $2.83 on its common stock. The firm increases its dividend by 3.55 percent annually. What is the company's cost of equity if the current stock price is $40.88 per share?

RE = [($2.83(1.0355)/$40.88] + .0355 RE = 0.1072, or 10.72% 10.72%

Bethesda Water has an issue of preferred stock outstanding with a coupon rate of 4.90 percent that sells for $98.10 per share. If the par value is $100, what is the cost of the company's preferred stock?

RP = $4.90/$98.10 RP = .04995, or 4.995% 4.995%

Which one of the following best illustrates erosion as it relates to a hot dog stand located on the beach?

Selling fewer hot dogs because hamburgers were added to the menu

The fact that a proposed project is analyzed based on the project's incremental cash flows is the assumption behind which one of the following principles?

Stand-alone principle

GL Plastics spent $1,200 last week repairing a machine. This week the company is trying to decide if the machine could be better utilized if they assigned it a proposed project. When analyzing the proposed project, the $1,200 should be treated as which type of cost?

Sunk

Shelton Co. purchased a parcel of land six years ago for $861,500. At that time, the firm invested $133,000 in grading the site so that it would be usable. Since the firm wasn't ready to use the site itself at that time, it decided to lease the land for $48,000 a year. The company is now considering building a warehouse on the site as the rental lease is expiring. The current value of the land is $923,000. What value should be included in the initial cost of the warehouse project for the use of this land?

The opportunity cost of the building is what it could be sold for today, or $923,000 $923,000

Hanover Tech is currently an all-equity company that has 145,000 shares of stock outstanding with a market price of $22 a share. The current cost of equity is 13.9 percent and the tax rate is 21 percent. The company is considering adding $1.5 million of debt with a coupon rate of 7.5 percent to its capital structure. The debt will be sold at par value. What is the levered value of the equity?

VL = 145,000($22) + .21($1,500,000) VL = $3,505,000VE = $3,505,000 − 1,500,000 VE = $2,005,000, or $2.005 million $2.005 million

Lamont Corp. is debt-free and has a weighted average cost of capital of 12.7 percent. The current market value of the equity is $2.8 million and there are no taxes. According to M&M Proposition I, what will be the value of the company if it changes to a debt-equity ratio of .85?

VL = VE = $2,800,000 $2,800,000

SLG Corp. is an all-equity firm with a weighted average cost of capital of 10.02 percent. The current market value of the equity is $13.4 million and the total tax rate is 22 percent. What is EBIT?

VU = $13,400,000 = EBIT(1 − .22)/.1002 EBIT = $1,721,385 $1,721,385

Bruce & Co. expects its EBIT to be $165,000 every year forever. The company currently has no debt but can borrow at 8.6 percent while its cost of equity is 14.7 percent. The tax rate is 21 percent. The company is planning to borrow $55,000 and use the loan proceeds to repurchase shares. What will be the WACC after recapitalization?

VU = $165,000(1 − .21)/.147 VU = $886,735 VL = $886,735 + .21($55,000) VL = $898,285 VE = $898,285 − 55,000 VE = $843,285 RE = .147 + (.147 − .086)($55,000/$843,285)(1 − .21) RE = .1501, or 15.01% WACC = ($843,285/$898,285)(.1501) + ($55,000/$898,285)(.086)(1 − .21) WACC = .1451, or 14.51% 14.51%

Lamey Co. has an unlevered cost of capital of 12.3 percent, a total tax rate of 25 percent, and expected earnings before interest and taxes of $32,840. The company has $60,000 in bonds outstanding that sell at par and have a coupon rate of 7.2 percent. What is the cost of equity?

VU = [$32,840(1 − .25)]/.123 VU = $200,244 VL = $200,244 + .25($60,000) VL = $215,244 VE = $215,244 − 60,000 VE = $155,244 RE = .123 + (.123 − .072)($60,000/$155,244)(1 − .25) RE = .1378 or 13.78% 13.78 percent

L.A. Clothing has expected earnings before interest and taxes of $63,300, an unlevered cost of capital of 14.7 percent, and a combined tax rate of 23 percent. The company also has $11,000 of debt that carries a coupon rate of 7 percent. The debt is selling at par value. What is the value of this company?

VU = [$63,300(1 − .23)]/.147 VU = $331,571VL = $331,571 + .23($11,000) VL = $334,101 The correct answer is: $334,101

The Two Dollar Store has a cost of equity of 12.1 percent, the YTM on the company's bonds is 5.9 percent, and the tax rate is 39 percent. If the company's debt-equity ratio is .56, what is the weighted average cost of capital?

WACC = (1/1.56)(12.1%) + (.56/1.56)(5.9%)(1 − .39) WACC = 9.05% 9.05%

Home Decor has a pretax cost of debt is 6.8 percent and a tax rate of 22 percent. What is the cost of equity if the debt-equity ratio is .65? WACC is 12.05%

WACC = (1/1.65)RE + (.65/1.65)(.068)(1 − .22) RE = .1644, or 16.44% 16.44 percent

Kountry Kitchen has a cost of equity of 12.4 percent, a pretax cost of debt of 5.9 percent, and the tax rate is 40 percent. If the company's WACC is 9.13 percent, what is its debt-equity ratio?

WACC = .0913 = (1 − XD)(.124) + (XD)(.059)(1 − .40) XD = .3691 D/E = .3691/(1 − .3691) D/E = .58 .58

Dyrdek Enterprises has equity with a market value of $12.3 million and the market value of debt is $4.30 million. The company is evaluating a new project that has more risk than the firm. As a result, the company will apply a risk adjustment factor of 1.6 percent. The new project will cost $2.50 million today and provide annual cash flows of $651,000 for the next 6 years. The company's cost of equity is 11.67 percent and the pretax cost of debt is 5.03 percent. The tax rate is 40 percent. What is the project's NPV?

WACC = 11.67%($12,300,000/$16,600,000) + 5.03%($4,300,000/$16,600,000)(1 − 0.4) WACC = 9.43% Project return = 9.43% + 1.6% Project return = 11.03% The correct answer is: $251,702

KN Stitches has debt of $26,000, a leveraged value of $78,400, a pretax cost of debt of 7.05 percent, a cost of equity of 15.3 percent, and a tax rate of 21 percent. What is the weighted average cost of capital?

WACC = [($78,400 − 26,000)/$78,400](.153) + ($26,000/$78,400)(.0705)(1 − .21) WACC = .1207, or 12.07% 12.07 percent

The difference between a company's future cash flows if it accepts a project and the company's future cash flows if it does not accept the project is referred to as the project's

incremental cash flows

M&M Proposition I with taxes is based on the concept that

the value of a taxable company increases as the level of debt increases

Simple Foods has a zero coupon bond issue outstanding that matures in 14 years. The bonds are selling at 65 percent of par value. What is the company's aftertax cost of debt if the combined tax rate is 23 percent? (Use semiannual compounding.)

use calc: N= 28, PV= -650, FV= 1000, I/yr =?? I/yr= 1.5504% R = 1.5504 x 2 = 3.10% Aftertax cost of debt = 3.10%(1 − .23) Aftertax cost of debt = 2.38% 2.38 percent

Which one of the following is an example of a sunk cost?

$1,200 paid to repair a machine last year

Which one of the following states that the value of a company is unrelated to the company's capital structure?

M&M Proposition I, no tax

ABC and XYZ are identical firms in all respects except for their capital structures. ABC is all-equity financed with $530,000 in stock. XYZ has the same total value but uses both stock and perpetual debt; its stock is worth $310,000 and the interest rate on its debt is 7.9 percent. Both firms expect EBIT to be $62,222. Ignore taxes. The cost of equity for ABC is _____ percent and for XYZ it is ______ percent.

ABC: RE = RA = $62,222/$530,000 (use ROA formula which is NI/Total Assets) RE = .1174, or 11.74% XYZ: RE = .1174 + (.1174 − .079)[($530,000 − 310,000)/$310,000] RE = .1447, or 14.47% 11.74; 14.47

The June Bug has a $565,000 bond issue outstanding. These bonds have a coupon rate of 6.65 percent, pay interest semiannually, and sell at 98.7 percent of face value. The tax rate is 21 percent. What is the amount of the annual interest tax shield?

Annual interest tax shield = $565,000(.0665)(.21) Annual interest tax shield = $7,890 $7,890

Georga's Restaurants has 7,000 bonds outstanding with a face value of $1,000 each, a market price of $982, and a coupon rate of 6.95 percent. The interest is paid semiannually. What is the amount of the annual interest tax shield if the tax rate is 23 percent?

Annual interest tax shield = 7,000($1,000)(.0695)(.23) Annual interest tax shield = $111,895 $111,895

Kim's Bridal Shoppe has 11,600 shares of common stock outstanding at a price of $50 per share. It also has 285 shares of preferred stock outstanding at a price of $92 per share. There are 320 bonds outstanding that have a coupon rate of 6.9 percent paid semiannually. The bonds mature in 31 years, have a face value of $2,000, and sell at 109 percent of par. What is the capital structure weight of the common stock?

Common stock: 11,600 × $50 = $580,000 Preferred stock: 285 × $92 = $26,220 Debt: 320 × $2,000 × 1.09 = $697,600 Total value: $1,303,820 XE = $580,000/$1,303,820 XE = .4448 .4448

Charlotte's Crochet Shoppe has 13,100 shares of common stock outstanding at a price per share of $71 and a rate of return of 11.45 percent. The company also has 400 bonds outstanding, with a par value of $1,000 per bond. The pretax cost of debt is 6.05 percent and the bonds sell for 96 percent of par. What is the firm's WACC if the tax rate is 39 percent?

Common stock: 13,100 × $71 = $930,100 Debt: 400 × $1,000 × .960 = 384,000 Total value: $1,314,100 WACC = 11.45%($930,100/$1,314,100) + 6.05%($384,000/$1,314,100)(1 − .39) WACC = 9.18% 9.18%

The concept of homemade leverage is most associated with

M&M Proposition I with no tax

Which one of the following is a project cash inflow? Ignore any tax effects.

Decrease in inventory

Katlin Markets is debating between a levered and an unlevered capital structure. The all-equity capital structure would consist of 60,000 shares of stock. The debt and equity option would consist of 45,000 shares of stock plus $250,000 of debt with an interest rate of 7.35 percent. What is the break-even level of earnings before interest and taxes between these two options? Ignore taxes.

EBIT/60,000 = [EBIT − $250,000(.0735)]/45,000 EBIT = $73,500 $73,500

Ornaments, Inc., is an all-equity firm with a total market value of $542,000 and 20,700 shares of stock outstanding. Management believes the earnings before interest and taxes (EBIT) will be $76,400 if the economy is normal. If there is a recession, EBIT will be 20 percent lower, and if there is a boom, EBIT will be 30 percent higher. The tax rate is 35 percent. What is the EPS in a recession?

EPS = [$76,400(1 − .20) − $76,400(1 − .20)(.35)]/20,700] EPS = $1.92 $1.92

Kelley's Baskets makes handmade baskets and is currently considering making handmade wreaths as well. Which one of the following is the best example of an incremental operating cash flow related to the wreath project?

Hiring additional employees to handle the increased workload should the firm accept the wreath project

Which one of the following makes the capital structure of a company irrelevant?

Homemade leverage

All of the following are related to a proposed project. Which one of these should be included in the cash flow at Time 0?

Initial investment in inventory to support the project

Great Lakes Packing has two bond issues outstanding. The first issue has a coupon rate of 3.58 percent, a par value of $1,000 per bond, matures in 6 years, has a total face value of $4.0 million, and is quoted at 105 percent of face value. The second issue has a coupon rate of 6.26 percent, a par value of $2,000 per bond, matures in 25 years, has a total face value of $8.3 million, and is quoted at 93 percent of face value. Both bonds pay interest semiannually. The company's tax rate is 35 percent. What is the firm's weighted average aftertax cost of debt?

Market value of debt = 1.05($4,000,000) + .93($8,300,000) Market value of debt = $4,200,000 + 7,719,000 Market value of debt = $11,919,000 YTM 1= 2.67% YTM 2= 6.85% Aftertax cost of debt = [2.67%($4,200,000/$11,919,000) + 6.85%($7,719,000/$11,919,000)](1 − .35)Aftertax cost of debt = 3.50% 3.50%

Which one of the following should not be included in the analysis of a new product?

Money already spent for research and development of the new product

You own a house that you rent for $1,400 per month. The maintenance expenses on the house average $260 per month. The house cost $231,000 when you purchased it 4 years ago. A recent appraisal on the house valued it at $263,000. If you sell the house you will incur $20,240 in real estate fees. The annual property taxes are $3,100. You are deciding whether to sell the house or convert it for your own use as a professional office. What value should you place on this house when analyzing the option of using it as a professional office?

Opportunity cost = $263,000 − 20,240 Opportunity cost = $242,760 $242,760

The Greenbriar is an all-equity firm with a total market value of $599,000 and 23,800 shares of stock outstanding. Management is considering issuing $217,000 of debt at an interest rate of 10 percent and using the proceeds on a stock repurchase. Ignore taxes. How many shares will the firm repurchase if it issues the debt securities?

Shares repurchased = $217,000/($599,000/23,800) Shares repurchased = 8,622 shares 8,622 shares

Which one of the following costs was incurred in the past and cannot be recouped?

Sunk

The present value of the interest tax shield is expressed as

TcD

Which one of the following best describes the concept of erosion?

The cash flows of a new project that come at the expense of a firm's existing cash flows

Which one of the following statements is correct in relation to M&M Proposition II, without taxes?

The required return on assets is equal to the weighted average cost of capital

A company's current cost of capital is based on

both the returns currently required by its debtholders and stockholders

The cost of capital for a new project

depends upon how the funds raised for that project are going to be spen

M&M Proposition II with taxes

has the same general implications as M&M Proposition II without taxes

The costs incurred by a business in an effort to avoid bankruptcy are classified as _____ costs

indirect bankruptcy

A firm should select the capital structure that

maximizes the value of the firm

A project's cash flow is equal to the project's operating cash flow

minus both the project's change in net working capital and capital spending

Pro forma financial statements can best be described as financial statements

showing projected values for future time periods

The discount rate assigned to an individual project should be based on

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

Galvatron Metals has a bond outstanding with a coupon rate of 6.5 percent and semiannual payments. The bond currently sells for $951 and matures in 23 years. The par value is $1,000 and the company's tax rate is 35 percent. What is the company's aftertax cost of debt?

use calc: N= 46, PV= -951, PMT= 32.50, FV= 1000 i/yr = ? = 3.46% YTM = 3.460% × 2 YTM = 6.93% RD = 6.93%(1 − .35) RD = 4.50% 4.50%

Which one of the following is the primary determinant of a firm's cost of capital?

use of the funds raised

If a company has the optimal amount of debt, then the

value of the levered company will exceed the value of the unlevered company