the cost of capital exercise

CHAPTER 1

CHAPTER 11THE COST OF CAPITAL(Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard)Note that there is some overlap between the T/F and the multiple choice questions, as some T/F statements are used in the MC questions. See the preface for information on the AACSB letter indicators (F, M, etc.) on the subject lines.Multiple Choice: True/False

(11-1) CapitalF IAnswer: a EASY

.Capital is sometimes defined as funds supplied to a firm by investors.

a.True

b.False

(11-1) Cost of capitalF IAnswer: a EASY

.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.

a.True

b.False

(11-1) Specific capital costF IAnswer: b EASY

.Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt.

a.True

b.False

(11-2) Component capital costsF IAnswer: a EASY

.The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

a.True

b.False

(11-3) Cost of debtF IAnswer: b EASY

.The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC.

a.True

b.False

(11-3) Cost of debtF IAnswer: b EASY

.The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

a.True

b.False

(11-3) Cost of debtF IAnswer: a EASY

.The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.

a.True

b.False

(11-4) Cost of preferredF IAnswer: b EASY

.The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

a.True

b.False

(11-4) Cost of preferredF IAnswer: a EASY

.The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, are not deductable by the issuing firm.

a.True

b.False

(11-5) Cost of commonF IAnswer: a EASY

.The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

a.True

b.False

(11-5) Cost of retained earningsF IAnswer: b EASY

.For capital budgeting and cost of capital purposes, the firm should always consider retained earnings as the first source of capital--i.e., use these funds first--because retained earnings have no cost to the firm.

a.True

b.False


.Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost.

a.True

b.False


.The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.

a.True

b.False

(11-6) Cost of new commonF IAnswer: b EASY

.The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

a.True

b.False

(11-7) WACCF IAnswer: a EASY

.For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity.

a.True

b.False

(Comp.) Flotation and capitalF IAnswer: b EASY

.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.

a.True

b.False

(11-1) Specific capital costF IAnswer: b MEDIUM

.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.

a.True

b.False

(11-3) After-tax cost of debtF IAnswer: a MEDIUM

.If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.

a.True

b.False

(11-5) Retained earningsF IAnswer: a MEDIUM

.The reason why retained earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm's common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should pay those earnings out to its investors. Thus, the cost of retained earnings is based on the opportunity cost principle.

a.True

b.False

(11-5) Cost of equity estimatesF IAnswer: b MEDIUM

.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 DCF method is widely used in practice.

a.True

b.False

(11-5) Cost of equity estimatesF IAnswer: b MEDIUM

.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.

a.True

b.False

(11-5) Cost of equity estimatesF IAnswer: a MEDIUM

.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. Since we cannot be sure that the estimate obtained with any of these methods is correct, it is often appropriate to use all three methods, then consider all three estimates, and end up using a judgmental estimate when calculating the WACC.

a.True

b.False


.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 rRF, (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, RPM. These problems leave us unsure of the true value of rs.

a.True

b.False


.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 rs.

a.True

b.False


.When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs.

a.True

b.False


.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.

a.True

b.False

(11-6) Cost of new commonF IAnswer: b MEDIUM

.The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 - F).a.True

b.False

(11-6) Cost of new commonF IAnswer: a MEDIUM

.If the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common stock (re) is equal to the cost of equity capital from retaining earnings (rs) divided by one minus the percentage flotation cost required to sell the new stock, (1 - F). If the expected growth rate is not zero, then the cost of external equity must be found using a different formula.

a.True

b.False

(11-8) Factors affecting WACCF IAnswer: b MEDIUM

.Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC).

a.True

b.False

(11-9) Risk-adjusted capital costsF IAnswer: a MEDIUM

.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.

a.True

b.False

(Comp.) WACCF IAnswer: a MEDIUM

.The cost of debt, rd, is normally less than rs, so rd(1 - T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 - T).

a.True

b.False

(Comp.) Taxes, rd(1 - T), and WACCF IAnswer: b MEDIUM

.The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant.

a.True

b.False

(Comp.) Cost of equityF IAnswer: b MEDIUM

.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).

a.True

b.False

(Comp.) Inflation effectsF IAnswer: b MEDIUM

.If expectations for long-term inflation rose, but the slope of the SML remained constant, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Therefore, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt.

a.True

b.False(Comp.) Inflation effectsF IAnswer: a MEDIUM

.If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity. However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit the shift toward debt.

a.True

b.FalseMultiple Choice: Conceptual

(11-2) Capital componentsC IAnswer: b EASY

.Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

a.Long-term debt.

b.Accounts payable.

c.Retained earnings.

d.Common stock.

e.Preferred stock.

(11-6) Internal vs. external commonC IAnswer: b EASY

.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.Increase the percentage of debt in the target capital structure.

c.Increase the proposed capital budget.

d.Reduce the amount of short-term bank debt in order to increase the current ratio.

e.Reduce the percentage of debt in the target capital structure.

(11-8) Factors affecting WACCC IAnswer: a EASY

.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 market risk premium declines.

b.The flotation costs associated with issuing new common stock increase.

c.The companys beta increases.

d.Expected inflation increases.

e.The flotation costs associated with issuing preferred stock increase.

(Comp.) Capital componentsC IAnswer: b EASY

.For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure.

a.rs > re > rd > WACC.

b.re > rs > WACC > rd.

c.WACC > re > rs > rd.

d.rd > re > rs > WACC.

e.WACC > rd > rs > re.

(11-5) Cost of equity: CAPMC IAnswer: e MEDIUM

.When working with the CAPM, which of the following factors can be determined with the most precision?

a.The market risk premium (RPM).

b.The beta coefficient, bi, of a relatively safe stock.

c.The most appropriate risk-free rate, rRF.

d.The expected rate of return on the market, rM.

e.The beta coefficient of the market, which is the same as the beta of an average stock.

(11-9) Divisional riskC IAnswer: c MEDIUM

.Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division As cost of capital is 10.0%, Division Bs cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division As 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 a 13% return.

b.A Division B project with a 12% return.

c.A Division A project with an 11% return.

d.A Division A project with a 9% return.e.A Division B project with an 11% return.

(11-9) Risk and projectsC IAnswer: a MEDIUM

.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.Project B, which is of below-average risk and has a return of 8.5%.

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.None of the projects should be accepted.

e.All of the projects should be accepted.

(11-9) Risk and projectsC IAnswer: d MEDIUM

.Norris Enterprises, an all-equity firm, has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than the firms average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT?

a.The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.

b.The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return.

c.Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment.

d.The accept/reject decision depends on the firm's risk-adjustment policy. If Norris' policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project.e.Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision.

(11-9) Risk-adjusted capital costC IAnswer: a MEDIUM

.The MacMillen Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 12%. The CFO believes that this is the correct WACC for the companys average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEOs position is accepted, what is likely to happen over time?

a.The company will take on too many high-risk projects and reject too many low-risk projects.

b.The company will take on too many low-risk projects and reject too many high-risk projects.

c.Things will generally even out over time, and, therefore, the firms risk should remain constant over time.

d.The companys overall WACC should decrease over time because its stock price should be increasing.

e.The CEOs recommendation would maximize the firms intrinsic value.

(11-9) Risk-adjusted capital costC IAnswer: d MEDIUM

.If a typical U.S. company correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely

a.become riskier over time, but its intrinsic value will be maximized.

b.become less risky over time, and this will maximize its intrinsic value.

c.accept too many low-risk projects and too few high-risk projects.

d.become more risky and also have an increasing WACC. Its intrinsic value will not be maximized.

e.continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital.

(Comp.) Capital componentsC IAnswer: e MEDIUM

.Which of the following statements is CORRECT?

a.When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation.

b.All else equal, an increase in a companys stock price will increase its marginal cost of retained earnings, rs.

c.All else equal, an increase in a companys stock price will increase its marginal cost of new common equity, re.

d.Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt.

e.If a companys tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall.

(Comp.) Capital componentsC IAnswer: a MEDIUM


a.When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.

b.When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.

c.Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM.

d.If a companys beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence must issue new stock.

e.Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a companys WACC.

(Comp.) Capital componentsC IAnswer: d MEDIUM


a.In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income.

b.We should use historical measures of the component costs from prior financings that are still outstanding when estimating a companys WACC for capital budgeting purposes.

c.The cost of new equity (re) could possibly be lower than the cost of retained earnings (rs) if the market risk premium, risk-free rate, and the companys beta all decline by a sufficiently large amount.

d.Its cost of retained earnings is the rate of return stockholders require on a firms common stock.

e.The component cost of preferred stock is expressed as rp(1 - T), because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt.

(Comp.) WACCC IAnswer: d MEDIUM


a.The WACC as used in capital budgeting is an estimate of a companys before-tax cost of capital.

b.The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt.

c.The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets.

d.There is an opportunity cost associated with using retained earnings, hence they are not free.e.The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year.

(Comp.) WACCC IAnswer: d MEDIUM


a.A change in a companys target capital structure cannot affect its WACC.b.WACC calculations should be based on the before-tax costs of all the individual capital components.

c.Flotation costs associated with issuing new common stock normally reduce the WACC.

d.If a companys tax rate increases, then, all else equal, its weighted average cost of capital will decline.

e.An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.

(Comp.) WACC and cap. componentsC IAnswer: e MEDIUM


a.The WACC is calculated using before-tax costs for all components.

b.The after-tax cost of debt usually exceeds the after-tax cost of equity.

c.For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock.

d.Retained earnings that were generated in the past and are reported on the firms balance sheet are available to finance the firms capital budget during the coming year.

e.The WACC that should be used in capital budgeting is the firms marginal, after-tax cost of capital.

(Comp.) WACC and cap. componentsC IAnswer: d MEDIUM

.For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is CORRECT?

a.The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet.b.The WACC is calculated on a before-tax basis.

c.The WACC exceeds the cost of equity.

d.The cost of equity is always equal to or greater than the cost of debt.

e.The cost of retained earnings typically exceeds the cost of new common stock.

(Comp.) Cost of capital conceptsC IAnswer: c MEDIUM


a.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.

b.The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes.

c.If a company assigns the same cost of capital to all of its projects regardless of each projects 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.Higher flotation costs tend to reduce the cost of equity capital.

(Comp.) MCC break pointsC IAnswer: d MEDIUM


a.The break point as discussed in the text refers to the point where the firm's tax rate increases.

b.The break point as discussed in the text refers to the point where the firm has raised so much capital that it is simply unable to borrow any more money.

c.The break point as discussed in the text refers to the point where the firm is taking on investments that are so risky the firm is in serious danger of going bankrupt if things do not go exactly as planned.

d.The break point as discussed in the text refers to the point where the firm has raised so much capital that it has exhausted its supply of new retained earnings and thus must raise equity by issuing stock.

e.The break point as discussed in the text refers to the point where the firm has exhausted its supply of new retained earnings and thus must begin to finance with preferred stock.

(11-9) Risk-adjusted capital costC IAnswer: c HARD

.Cranberry Corp. has two divisions of equal size: a computer manufacturing division and a data processing division. Its CFO believes that stand-alone data processor companies typically have a WACC of 8%, while stand-alone computer manufacturers typically have a 12% WACC. He also believes that the data processing and manufacturing divisions have the same risk as their typical peers. Consequently, he estimates that the composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the data processing division and a 12% hurdle rate for the manufacturing division. However, the CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is CORRECT?

a.While the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultants recommendation, this should not affect the firms intrinsic value.

b.The decision not to adjust for risk means, in effect, that it is favoring the data processing division. Therefore, that division is likely to become a larger part of the consolidated company over time.

c.The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division. This will lead to a reduction in the firms intrinsic value over time.

d.The decision not to risk-adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business. This will lead to a reduction in its intrinsic value over time.

e.The decision not to risk adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business. This may affect the firms capital structure but it will not affect its intrinsic value.

(11-9) Div. risk and projectsC IAnswer: a HARD

.Safeco Company and Risco Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Safeco having a WACC of 10% and Risco a WACC of 12%. Safeco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Safeco project. Risco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Risco project.

Now assume that the two companies merge and form a new company, Safeco/Risco Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is CORRECT?

a.If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.

b.If evaluated using the correct post-merger WACC, Project X would have a negative NPV.

c.After the merger, Safeco/Risco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y.

d.Safeco/Riscos WACC, as a result of the merger, would be 10%.

e.After the merger, Safeco/Risco should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%.

(Comp.) Capital componentsC IAnswer: b HARD


a.The component cost of preferred stock is expressed as rp(1 - T). This follows because preferred stock dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes.

b.A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firms stockholders would themselves expect to earn a return on earnings that were paid out rather than retained and reinvested.

c.No cost should be assigned to retained earnings because the firm does not have to pay anything to raise them. They are generated as cash flows by operating assets that were raised in the past, hence they are free.d.Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into the foreseeable future. In this case, the firms before-tax and after-tax costs of debt for purposes of calculating the WACC will both be equal to the interest rate on the firms currently outstanding debt, provided that debt was issued during the past 5 years.

e.If a firm has enough retained earnings to fund its capital budget for the coming year, then there is no need to estimate either a cost of equity or a WACC.

(Comp.) Cost of capitalC IAnswer: d HARD


a.The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity.

b.The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average after-tax cost of all the firms outstanding debt.

c.Suppose some of a publicly-traded firms stockholders are not diversified; they hold only the one firms stock. In this case, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firms intrinsic value.

d.The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity.

e.The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firms cost of equity capital.

(Comp.) Cost of equityC IAnswer: d HARD


a.Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs--beta, the risk-free rate, and the market risk premium--can be estimated with little error.

b.The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the DCF models logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain.

c.The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firms own cost of debt and its risk premium, can be found by using standardized and objective procedures.

d.Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity.

e.The DCF model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield.

(Comp.) CAPM and DCF C IAnswer: c HARD


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 firms 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.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 firms stockholders are well diversified.

d.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.

e.The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach.

(Comp.) WACCC IAnswer: d HARD


a.The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the interest rate on the companys own long-term bonds. The size of the risk premium for bonds with different ratings is published daily in The Wall Street Journal.

b.The WACC is calculated using a before-tax cost for debt that is equal to the interest rate that must be paid on new debt, along with the after-tax costs for common stock and for preferred stock if it is used.

c.An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity.

d.The relevant WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firms target capital structure.

e.Beta measures market risk, which is generally the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. However, this is not true unless all of the firms stockholders are well diversified.

(Comp.) WACCC IAnswer: e HARD


a.Since the costs of internal and external equity are related, an increase in the flotation cost required to sell a new issue of stock will increase the cost of retained earnings.

b.Since its stockholders are not directly responsible for paying a corporations income taxes, corporations should focus on before-tax cash flows when calculating the WACC.

c.An increase in a firms tax rate will increase the component cost of debt, provided the YTM on the firms bonds is not affected by the change in the tax rate.

d.When the WACC is calculated, it should reflect the costs of new common stock, retained earnings, preferred stock, long-term debt, short-term bank loans if the firm normally finances with bank debt, and accounts payable if the firm normally has accounts payable on its balance sheet.

e.If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the after-tax cost of debt.

(Comp.) Beta and project riskC IAnswer: e HARD

.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 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.

b.If a firms 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 projects expected future cash flows.

c.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.

d.Projects with above-average risk typically have higher-than-average expected returns. Therefore, to maximize a firms intrinsic value, its managers should favor high-beta projects over those with lower betas.

e.Project A has a standard deviation of expected returns of 20%, while Project Bs standard deviation is only 10%. As returns are negatively correlated with both the firms other assets and the returns on most stocks in the economy, while Bs returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital.

(Comp.) MCC break pointsC IAnswer: c HARD

.Firm M's earnings and stock price tend to move up and down with other firms in the S&P 500, while Firm W's earnings and stock price move counter cyclically with M and other S&P companies. Both M and W estimate their costs of equity using the CAPM, they have identical market values, their standard deviations of returns are identical, and they both finance only with common equity. Which of the following statements is CORRECT?

a.M should have the lower WACC because it is like most other companies, and investors like that fact.

b.M and W should have identical WACCs because their risks as measured by the standard deviation of returns are identical.

c.If M and W merge, then the merged firm MW should have a WACC that is a simple average of M's and W's WACCs.

d.Without additional information, it is impossible to predict what the merged firm's WACC would be if M and W merged.

e.Since M and W move counter cyclically to one another, if they merged, the merged firm's WACC would be less than the simple average of the two firms' WACCs.

Multiple Choice: Problems(11-4) Cost of preferredC IAnswer: b EASY

.Bosio Inc.'s perpetual preferred stock sells for $97.50 per share, and it pays an $8.50 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is the company's cost of preferred stock for use in calculating the WACC?

a. 8.72%

b. 9.08%

c. 9.44%

d. 9.82%

e.10.22%

(11-4) Cost of preferredC IAnswer: d EASY

.A companys 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%

(11-5) Cost of RE: CAPMC IAnswer: a EASY

.O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of equity from retained earnings based on the CAPM?

a.11.30%

b.11.64%

c.11.99%

d.12.35%

e.12.72%

(11-5) Cost of RE: CAPMC IAnswer: e EASY

.Scanlon Inc.'s CFO hired you as a consultant to help her estimate the cost of capital. You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30. Based on the CAPM approach, what is the cost of equity from retained earnings?

a. 9.67%

b. 9.97%

c.10.28%

d.10.60%

e.10.93%

(11-5) Cost of RE: DCFC IAnswer: c EASY

.Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant). What is the cost of equity from retained earnings based on the DCF approach?

a. 9.42%

b. 9.91%

c.10.44%

d.10.96%

e.11.51%

(11-5) Cost of RE: DCFC IAnswer: d EASY

.Teall Development Company hired you as a consultant to help them estimate its cost of capital. You have been provided with the following data: D1 = $1.45; P0 = $22.50; and g = 6.50% (constant). Based on the DCF approach, what is the cost of equity from retained earnings?

a.11.10%

b.11.68%

c.12.30%

d.12.94%

e.13.59%

(11-5) Bond-yield-plus-risk premiumC IAnswer: a EASY

.A. Butcher Timber Company hired your consulting firm to help them estimate the cost of equity. The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of equity can be estimated using a risk premium of 3.85% over a firm's own cost of debt. What is an estimate of the firm's cost of equity from retained earnings?a.12.60%b.13.10%c.13.63%d.14.17%e.14.74%(11-7) WACCC IAnswer: b EASY

.You were hired as a consultant to Giambono Company, whose target capital structure is 40% debt, 15% preferred, and 45% common equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of retained earnings is 12.75%. The firm will not be issuing any new stock. What is its WACC?

a. 8.98%

b. 9.26%

c. 9.54%

d. 9.83%

e.10.12%

(11-3) Cost of debtC IAnswer: d MEDIUM

.To help finance a major expansion, Castro Chemical Company sold a noncallable bond several years ago that now has 20 years to maturity. This bond has 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 40%, what is the component cost of debt for use in the WACC calculation?

a.4.35%

b.4.58%

c.4.83%

d.5.08%

e.5.33%

(11-3) Cost of debtC IAnswer: c MEDIUM

.Several years ago the Jakob Company sold a $1,000 par value, noncallable bond that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually. The bond currently sells for $925, and the companys tax rate is 40%. What is the component cost of debt for use in the WACC calculation?

a.4.28%

b.4.46%

c.4.65%

d.4.83%

e.5.03%

(11-5) Cost of RE: DCFC IAnswer: d MEDIUM

.Assume that Kish Inc. hired you as a consultant to help estimate its cost of capital. You have obtained the following data: D0 = $0.90; P0 = $27.50; and g = 7.00% (constant). Based on the DCF approach, what is the cost of equity from retained earnings?

a. 9.29%

b. 9.68%

c.10.08%

d.10.50%

e.10.92%

(11-5) Cost of RE: DCFC IAnswer: c MEDIUM

.Rivoli Inc. hired you as a consultant to help estimate its cost of capital. You have been provided with the following data: D0 = $0.80; P0 = $22.50; and g = 8.00% (constant). Based on the DCF approach, what is the cost of equity from retained earnings?

a.10.69%b.11.25%c.11.84%d.12.43%e.13.05%(11-6) re based on DCF, D1C IAnswer: c MEDIUM

.Trahan Lumber Company hired you to help estimate its cost of capital. You obtained the following data: D1 = $1.25; P0 = $27.50; g = 5.00% (constant); and F = 6.00%. What is the cost of equity raised by selling new common stock?

a. 9.06%b. 9.44%c. 9.84%d.10.23%e.10.64%(11-6) re based on DCF, D1C IAnswer: b MEDIUM

.You were recently hired by Scheuer Media Inc. to estimate its cost of capital. You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.00% (constant); and F = 5.00%. What is the cost of equity raised by selling new common stock?

a.10.77%

b.11.33%

c.11.90%

d.12.50%

e.13.12%

(11-6) Cost of new commonC IAnswer: b MEDIUM

.Weaver Chocolate Co. expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, its expected constant dividend growth rate is 6.0%, and its common stock currently sells for $32.50 per share. 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%

(11-7) WACCC IAnswer: c MEDIUM

.Sorensen Systems Inc. is expected to pay a $2.50 dividend at year end (D1 = $2.50), the dividend is expected to grow at a constant rate of 5.50% a year, and the common stock currently sells for $52.50 a share. The before-tax cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of 45% debt and 55% common equity. What is the companys WACC if all the equity used is from retained earnings?

a.7.07%

b.7.36%

c.7.67%

d.7.98%

e.8.29%

(11-7) WACC and target cap. struc.C IAnswer: a MEDIUM

.You were hired as a consultant to Quigley Company, whose 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 retained earnings is 11.25%, and the tax rate is 40%. The firm will not be issuing any new stock. What is Quigley's WACC?

a.8.15%

b.8.48%

c.8.82%

d.9.17%

e.9.54%

(11-3) Taxes and cost of debtC IAnswer: c MEDIUM/HARD

.Keys Printing plans to issue a $1,000 par value, 20-year noncallable bond with a 7.00% annual coupon, paid semiannually. The company's marginal tax rate is 40.00%, but Congress is considering a change in the corporate tax rate to 30.00%. By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted?

a.0.57%

b.0.63%

c.0.70%

d.0.77%

e.0.85%

(11-5) Cost of RE: DCFC IAnswer: c MEDIUM/HARD

.S. Bouchard and Company hired you as a consultant to help estimate its cost of capital. You have obtained the following data: D0 = $0.85; P0 = $22.00; and g = 6.00% (constant). The CEO thinks, however, that the stock price is temporarily depressed, and that it will soon rise to $40.00. Based on the DCF approach, by how much would the cost of equity from retained earnings change if the stock price changes as the CEO expects?

a.-1.49%

b.-1.66%

c.-1.84%

d.-2.03%

e.-2.23%

(11-7) WACC and market cap. struc.C IAnswer: e MEDIUM/HARD

.Sapp Truckings balance sheet shows a total of noncallable $45 million long-term debt with a coupon rate of 7.00% and a yield to maturity of 6.00%. This debt currently has a market value of $50 million. The balance sheet also shows that the company has 10 million shares of common stock, and the book value of the common equity (common stock plus retained earnings) is $65 million. The current stock price is $22.50 per share; stockholders' required return, rs, is 14.00%; and the firm's tax rate is 40%. The CFO thinks the WACC should be based on market value weights, but the president thinks book weights are more appropriate. What is the difference between these two WACCs?

a.1.55%

b.1.72%

c.1.91%

d.2.13%

e.2.36%

(11-5) Risk premium, CAPM, and DCFC IAnswer: b HARD

.The CFO of Lenox Industries hired you as a consultant to help estimate its cost of capital. You have obtained the following data: (1) rd = yield on the firms bonds = 7.00% and the risk premium over its own debt cost = 4.00%. (2) rRF = 5.00%, RPM = 6.00%, and b = 1.25. (3) D1 = $1.20, P0 = $35.00, and g = 8.00% (constant). You were asked to estimate the cost of equity based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates. What is that difference?

a.1.13%

b.1.50%

c.1.88%

d.2.34%

e.2.58%

(11-6) rs vs. reC IAnswer: c HARD

.Eakins Inc.s common stock currently sells for $45.00 per share, the company expects to earn $2.75 per share during the current year, its expected payout ratio is 70%, and its expected constant growth rate is 6.00%. New stock can be sold to the public at the current price, but a flotation cost of 8% would be incurred. By how much would the cost of new stock exceed the cost of retained earnings?

a.0.09%

b.0.19%

c.0.37%

d.0.56%

e.0.84%

(11-7) WACC and capital structureC IAnswer: c HARD

.Bolster Foods (BF) balance sheet shows a total of $25 million long-term debt with a coupon rate of 8.50%. The yield to maturity on this debt is 8.00%, and the debt has a total current market value of $27 million. The balance sheet also shows that the company has 10 million shares of stock, and the stock has a book value per share of $5.00. The current stock price is $20.00 per share, and stockholders' required rate of return, rs, is 12.25%. The company recently decided that its target capital structure should have 35% debt, with the balance being common equity. The tax rate is 40%. Calculate WACCs based on book, market, and target capital structures, and then find the sum of these three WACCs.

a.28.36%

b.29.54%

c.30.77%

d.32.00%

e.33.28%

(11-7) WACC and equity from REC IAnswer: e HARD

.Daves Inc. recently hired you as a consultant to estimate the companys WACC. You have obtained the following information. (1) The firm's noncallable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $1,000, and a market price of $1,050.00. (2) The companys tax rate is 40%. (3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stocks beta is 1.20. (4) The target capital structure consists of 35% debt and the balance is common equity. The firm uses the CAPM to estimate the cost of equity, and it does not expect to issue any new common stock. What is its WACC?

a.7.16%

b.7.54%

c.7.93%

d.8.35%

e.8.79%(11-7) WACC and equity from REC IAnswer: d HARD

.Assume that you are on the financial staff of Vanderheiden Inc., and you have collected the following data: The yield on the companys outstanding bonds is 7.75%, its tax rate is 40%, the next expected dividend is $0.65 a share, the dividend is expected to grow at a constant rate of 6.00% a year, the price of the stock is $15.00 per share, the flotation cost for selling new shares is F = 10%, and the target capital structure is 45% debt and 55% common equity. What is the firm's WACC, assuming it must issue new stock to finance its capital budget?

a.6.89%

b.7.26%

c.7.64%

d.8.04%

e.8.44%(11-9) Project riskC IAnswer: a HARD

.Vang Enterprises, which is debt-free and finances only with equity from retained earnings, is considering 7 equal sized capital budgeting projects. Its CFO hired you to assist in deciding whether none, some, or all of the projects should be accepted. You have the following information: rRF = 4.50%; RPM = 5.50%; and b = 0.92. The company adds or subtracts a specified percentage to the corporate WACC when it evaluates projects that have above- or below-average risk. Data on the 7 projects are shown below. If these are the only projects under consideration, how large should the capital budget be?

RiskExpectedCost

ProjectRiskFactorReturn(Millions)

1Very low-2.00%7.60%$25.0

2Low-1.00%9.15%$25.0

3Average0.00%10.10%$25.0

4High1.00%10.40%$25.0

5Very high2.00%10.80%$25.0

6Very high2.00%10.90%$25.0

7Very high2.00%13.00%$25.0

a.$100

b.$ 75

c.$ 50

d.$ 25

e.$ 0Multiple Part:

(The following information applies to Problems 91, 92, 93, and 94.)

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.

AssetsCurrent assets$ 38,000,000

Net plant, property, and equipment 101,000,000Total assets

$139,000,000Liabilities and EquityAccounts payable$ 10,000,000

Accruals

9,000,000Current liabilities$ 19,000,000

Long-term debt (40,000 bonds, $1,000 par value) 40,000,000Total liabilities$ 59,000,000Common stock (10,000,000 shares)30,000,000

Retained earnings 50,000,000Total shareholders' equity 80,000,000Total liabilities and shareholders' equity$139,000,000The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, 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 40%.(11-2) After-tax cost of debtC IAnswer: c MEDIUM

.What is the best estimate of the after-tax cost of debt?a.4.64%

b.4.88%

c.5.14%

d.5.40%

e.5.67%(11-5) CAPM cost of equityC IAnswer: d MEDIUM

.Based on the CAPM, what is the firm's cost of equity?

a.11.15%

b.11.73%

c.12.35%

d.13.00%

e.13.65%(11-7) Weights for WACCC IAnswer: a MEDIUM

.Which of the following is the best estimate for the weight of debt for use in calculating the WACC?

a.18.67%b.19.60%

c.20.58%

d.21.61%

e.22.69%

(11-7) WACCC IAnswer: c MEDIUM

.What is the best estimate of the firm's WACC?

a.10.85%

b.11.19%

c.11.53%

d.11.88%

e.12.24%

CHAPTER 11ANSWERS AND SOLUTIONS

.(11-1) CapitalF IAnswer: a EASY

.(11-1) Cost of capitalF IAnswer: a EASY

.(11-1) Specific capital costF IAnswer: b EASY

.(11-2) Component capital costsF IAnswer: a EASY

.(11-3) Cost of debtF IAnswer: b EASY

.(11-3) Cost of debtF IAnswer: b EASY

.(11-3) Cost of debtF IAnswer: a EASY

.(11-4) Cost of preferredF IAnswer: b EASY

.(11-4) Cost of preferredF IAnswer: a EASY

.(11-5) Cost of commonF IAnswer: a EASY

.(11-5) Cost of retained earningsF IAnswer: b EASY



.(11-6) Cost of new commonF IAnswer: b EASY

.(11-7) WACCF IAnswer: a EASY

.(Comp.) Flotation and capitalF IAnswer: b EASY

.(11-1) Specific capital costF IAnswer: b MEDIUM

In general, this statement is false, because the firm should be viewed as an ongoing entity, and using debt (or equity) to fund a given project will change the capital structure, and this factor should be recognized by basing the cost of capital for all projects on a target capital structure. Under some special circumstances, where a project is set up as a separate entity, then project financing may be used, and only the project's specific situation is considered. This is a specific situation, however, and not the in general case.

.(11-3) After-tax cost of debtF IAnswer: a MEDIUM

.(11-5) Retained earningsF IAnswer: a MEDIUM

.(11-5) Cost of equity estimatesF IAnswer: b MEDIUM

.(11-5) Cost of equity estimatesF IAnswer: b MEDIUM

None of the methods always provides accurate and reliable estimates. With the CAPM, we don't know the beta that investors are using, we are not totally sure of what rRF to use, and we don't know if the CAPM is truly correct.

.(11-5) Cost of equity estimatesF IAnswer: a MEDIUM

Unfortunately, this is true.








True, but data on comparable publicly owned firms can often be obtained and used as proxies for private firms.

.(11-6) Cost of new commonF IAnswer: b MEDIUM

This statement is true only if the expected growth rate is zero. Here are some illustrative numbers that show that the statement is true if g = 0 but false otherwise.

Positive gZero g

Price$10.00$10.00

Dividend$0.50$0.50

Growth6.00%0.00%

Flotation5.00%5.00%

rs = D1/P0 + g11.00%5.00%

re = D1/P0(1 F) + g11.263%5.263%Equal only if g = zero.

rs/(1 F)11.579%5.263%

.(11-6) Cost of new commonF IAnswer: a MEDIUM

This statement is true. Here are some illustrative numbers to demonstrate this point.

Positive gZero g

Price$10.00$10.00

Dividend$0.50$0.50

Growth6.00%0.00%

Flotation5.00%5.00%

rs = D1/P0 + g11.00%5.00%

re = D1/P0(1 F) + g11.263%5.263%Equal only if g = zero.

rs/(1 F)11.579%5.263%

.(11-8) Factors affecting WACCF IAnswer: b MEDIUM

.(11-9) Risk-adjusted capital costsF IAnswer: a MEDIUM

.(Comp.) WACCF IAnswer: a MEDIUM

.(Comp.) Taxes, rd(1 - T), and WACCF IAnswer: b MEDIUM

.(Comp.) Cost of equityF IAnswer: b MEDIUM

The preferred dividend exclusion is a benefit to the holder of the preferred, not the issuer, hence this statement is not true. It actually is just nonsense anyway!

.(Comp.) Inflation effectsF IAnswer: b MEDIUM

Increased inflation results in a parallel upward shift in the SML, which means equal percentage increases in the required returns on debt and equity.

.(Comp.) Inflation effectsF IAnswer: a MEDIUM

.(11-2) Capital componentsC IAnswer: b EASY

.(11-6) Internal vs. external commonC IAnswer: b EASY

Statement b is correct, because if more debt is used, then less equity will be needed to fund the capital budget, so the need for a stock issue would be reduced.

.(11-8) Factors affecting WACCC IAnswer: a EASY

.(Comp.) Capital componentsC IAnswer: b EASY

.(11-5) Cost of equity: CAPMC IAnswer: e MEDIUM

By definition, both the market and an average stock have betas of 1.0. Since we know this to be the case, we can obviously determine beta for the market or an average stock with precision.

.(11-9) Divisional riskC IAnswer: c MEDIUM

The correct answer is statement c. Division A should accept only projects with returns greater than 10%, and Division B should accept only projects with returns greater than 14%. Only statement c meets this criterion.

.(11-9) Risk and projectsC IAnswer: a MEDIUM

Project B has a return greater than its risk-adjusted cost of capital, so it should be accepted.

.(11-9) Risk and projectsC IAnswer: d MEDIUM

Statement d is correct. Here is the proof:

rs = 5% + 4%(2.0) = 5% + 8% = 13%.

Required return for risky projects = 13% + 3% = 16%.

Project return = 14% < adjusted rs = 16%. Thus, the project should be rejected.

.(11-9) Risk-adjusted capital costC IAnswer: a MEDIUM

Low-risk projects will tend to have low expected returns and vice versa for high-risk projects due to competition in the economy. By not adjusting the cost of capital for project risk, the firm will tend to reject low-risk projects even though they earn higher returns than their risk-adjusted costs of capital, and vice versa for high-risk projects. In addition, as the firm takes on more high-risk projects, its correct WACC will increase over time. Therefore, statement a is correct.

.(11-9) Risk-adjusted capital costC IAnswer: d MEDIUM

Low-risk projects will tend to have low expected returns and vice versa for high-risk projects due to competition in the economy. By not adjusting the cost of capital for project risk, the firm will tend to reject low-risk projects even though they earn higher returns than their risk-adjusted costs of capital, and vice versa for high-risk projects. As the firm takes on more high-risk projects, its true WACC will increase over time. Of course, the true WACC might change over time due to changes in market conditions, but that could cause the true WACC to either rise or decline. Therefore, statement d is correct.

.(Comp.) Capital componentsC IAnswer: e MEDIUM

Statement e is true, because the after-tax cost of debt is rd(1 T). So, if rd remains constant but T increases, rd(1 T) will decline. The other statements are all false.

.(Comp.) Capital componentsC IAnswer: a MEDIUM

Statement a is true, because interest payments on debt are tax deductible. The other statements are false.

.(Comp.) Capital componentsC IAnswer: d MEDIUM

.(Comp.) WACCC IAnswer: d MEDIUM

.(Comp.) WACCC IAnswer: d MEDIUM

Statement d is true, because the cost of debt for WACC purposes = rd(1 T), so if T increases, then rd(1 T) declines.

.(Comp.) WACC and cap. componentsC IAnswer: e MEDIUM

.(Comp.) WACC and cap. componentsC IAnswer: d MEDIUM

Statement d is true, because equity is more risky than debt and hence investors require a higher return on equity. Also, interest on debt is deductible, and this further reduces the cost of debt. The other statements are false.

.(Comp.) Cost of capital conceptsC IAnswer: c MEDIUM

.(Comp.) MCC break pointsC IAnswer: d MEDIUM

.(11-9) Risk-adjusted capital costC IAnswer: c HARD

By not making the risk adjustment, the firm will accept too many projects in the manufacturing division and too few in the data processing division. As a result, the company will become riskier overall, raising its cost of capital. Investors will discount the firm's cash flows at a higher rate, and the firms intrinsic value will fall. Therefore, statement c is true and all other statements are false.

.(11-9) Div. risk and projectsC IAnswer: a HARD

.(Comp.) Capital componentsC IAnswer: b HARD

.(Comp.) Cost of capitalC IAnswer: d HARD

.(Comp.) Cost of equityC IAnswer: d HARD

.(Comp.) CAPM and DCF C IAnswer: c HARD

.(Comp.) WACCC IAnswer: d HARD

Statement d is truethe WACC will increase if the firm raises more funds than can be supported by retained earnings.

.(Comp.) WACCC IAnswer: e HARD

Statement e is true. The firm would get no tax savings on interest, so its cost of debt would not be reduced by the tax factor. However, corporate investors would get to deduct 70% of the preferred dividends they receive, which would make them willing to accept a lower before-tax yield on preferred stock than on bonds. Put another way, the market yield on its preferred could be lower than the interest rate on its debt because of the 70% exclusion, and with a zero tax rate, there is no reduction in the cost of debt.

.(Comp.) Beta and project riskC IAnswer: e HARD

The fact that As returns are negatively correlated means that it serves as a sort of insurance policy to the firm. The fact that its SD is high is actually good, because the negative correlation will cause the projects beta versus the market and also with the firms other assets to be relatively low, denoting a low risk and thus justifying a relatively low cost of capital. This answer is theoretically always true, and it is especially true if the firm is large, has many projects, and Project A is not a bet the company project.

.(Comp.) MCC break pointsC IAnswer: c HARD

Statement c is true. The merged firm would have a beta that is a simple average of M's and W's betas, and that would result in a cost of equity that is an average of the two firms costs of equity. Since they are financed only with equity, their WACCs could also be averaged to find the merged firm's WACC.

.(11-4) Cost of preferredC IAnswer: b EASY

Preferred stock price$97.50

Preferred dividend$8.50

Flotation cost4.00%

rp = Dp/(Pp(1 F))9.08%

.(11-4) Cost of preferredC IAnswer: d EASY

Preferred stock price$92.50

Preferred dividend$8.00

Flotation cost5.00%

rp = Dp/(Pp(1 F))9.10%

.(11-5) Cost of RE: CAPMC IAnswer: a EASY

rRF5.00%

RPM6.00%

b1.05

rs = rRF + b(RPM)11.30%

.(11-5) Cost of RE: CAPMC IAnswer: e EASY

rRF4.10%

RPM5.25%

b1.30

rs = rRF + b(RPM)10.925%

.(11-5) Cost of RE: DCFC IAnswer: c EASY

D1$0.67

P0$27.50

g8.00%

rs = D1/P0 + g10.44%

.(11-5) Cost of RE: DCFC IAnswer: d EASY

D1$1.45

P0$22.50

g6.50%

rs = D1/P0 + g12.94%

.(11-5) Bond-yield-plus-risk premiumC IAnswer: a EASY

Bond yield8.75%

Risk premium3.85%

rs = rd + Risk premium12.60%

.(11-7) WACCC IAnswer: b EASY

WeightsCosts

Debt40%6.00%

Preferred15%7.50%

Common45%12.75%

WACC = wd rd (1 T) + wp rp + wc rs9.26%

.(11-3) Cost of debtC IAnswer: d MEDIUM

Coupon rate9.25%

Periods/year2

Maturity (yr)20

Bond price$1,075.00

Par value$1,000

Tax rate40%

Calculator inputs:

N = 2 2040

PV = Bond's price-$1,075.00

PMT = Coupon rate Par/2$46.25

FV = Par = Maturity value$1,000

Calculator output: I/YR, semiannual rate4.23%

Annual rate = 2 (I/YR) = Before-tax cost of debt8.47%

After-tax cost of debt = rd(1 T)5.08%

.(11-3) Cost of debtC IAnswer: c MEDIUM

Coupon rate7.00%

Periods/year2

Maturity (yr)20

Bond price$925.00

Par value$1,000

Tax rate40%

Calculator inputs:

N = 2 2040

PV = Bond's price-$925.00

PMT = Coupon rate Par/2$35

FV = Par = Maturity value$1,000

I/YR3.87%

Times periods/yr = before-tax cost of debt7.74%


.(11-5) Cost of RE: DCFC IAnswer: d MEDIUM

D0$0.90

P0$27.50

g7.00%

D1 = D0 (1 + g)$0.963

rs = D1/P0 + g10.50%

.(11-5) Cost of RE: DCFC IAnswer: c MEDIUM

D0$0.80

P0$22.50

g8.00%

D1 = D0 (1 + g)$0.864

rs = D1/P0 + g11.84%

.(11-6) re based on DCF, D1C IAnswer: c MEDIUM

D1$1.25

P0$27.50

g5.00%

F6.00%

re = D1/(P0 (1 F)) + g =9.84%

.(11-6) re based on DCF, D1C IAnswer: b MEDIUM

D1$1.75

P0$42.50

g7.00%

F5.00%

re = D1/(P0 (1 F)) + g11.33%

.(11-6) Cost of new commonC IAnswer: b MEDIUM

Expected EPS1$3.50

Payout ratio65%

Expected dividend, D1 = EPS Payout$2.275

Current stock price$32.50

g6.00%

F5.00%

re = D1/(P0 (1 F)) + g13.37%

.(11-7) WACCC IAnswer: c MEDIUM

D1$2.50

g5.50%

P0$52.50

rd7.50%

Tax rate40%

Weight debt45%

Weight equity55%

rd(1 T)4.50%

rs = D1/P0 + g10.26%

WACC = wd(rd)(1 T) + wc(rs) =7.67%

.(11-7) WACC and target cap. struc.C IAnswer: a MEDIUM

Tax rate = 40%

WeightsrdAT Costs

Debt35%6.50%3.90%

Preferred10%6.00%

Common55%11.25%

WACC100%8.15%

.(11-3) Taxes and cost of debtC IAnswer: c MEDIUM/HARD

Tax Rate

Old rate, 40%New rate

Coupon rate7.00%7.00%

Periods/year22

Maturity (yr)2020

Bond price = Par value$1,000.00$1,000.00

Old and New tax rates40%30%

Calculator inputs:

N = 2 204040

PV = Bond's price-$1,000.00-$1,000.00

PMT = Coupon rate Par/2$35.00$35

FV = Par = Maturity value-$1,000-$1,000

I/YR3.50%3.50%

Times periods/yr = before-tax cost of debt7.00%7.00%

After-tax cost of debt = rd(1 T)4.20%4.90%

Difference = Cost at new rate Cost at old rate =0.70%

.(11-5) Cost of RE: DCFC IAnswer: c MEDIUM/HARD

Old PriceNew Price

D0$0.85$0.85

P0$22.00$40.00

g6.00%6.00%

D1 = D0 (1 + g)$0.901$0.901

rs = D1/P0 + g10.10%8.25%

Difference, rs0 rs1-1.84%

.(11-7) WACC and market cap. struc.C IAnswer: e MEDIUM/HARD

P0$22.50Book value weights-WRONG!!!

Shares outstanding (millions)10CapitalWeightsCost ratesProduct

bond coupon rate (not used)7.00%Debt$45.0040.91%3.60%1.47%

YTM = rd6.00%Equity$65.0059.09%14.00%8.27%

rs14.00%Total$110.00100.00%WACC =9.75%

Tax rate40%

BV debt (millions)$45.00Market value weights--RIGHT!!!

BV equity (millions)$65.00CapitalWeightsCost ratesProduct

MV debt (millions)$50.00Debt$50.0018.18%3.60%0.65%

MV equity (millions) = # sh P0 =$225.00Equity$225.0081.82%14.00%11.45%

AT cost of debt = rd(1T)3.60%Total$275.00100.00%WACC =12.11%

Difference =2.36%

.(11-5) Risk premium, CAPM, and DCFC IAnswer: b HARD

Bond yield7.00%

Risk premium4.00%

rs11.00%

rRF5.00%

RPM6.00%

b1.25

rs12.50%

D1$1.20

P0$35.00

g8.00%

rs11.43%

Max12.50%

Min11.00%

Difference1.50%

.(11-6) rs vs. reC IAnswer: c HARD

Expected EPS1$2.75

Payout ratio70%

Current stk price$45.00

g6.00%

F8.00%

D1$1.925

rs = D1/P0 + g10.28%

re = D1/(P0 (1 F)) + g10.65%

Difference = re rs0.37%

.(11-7) WACC and capital structureC IAnswer: c HARD

BOOK VALUE WEIGHTS

CapitalWeightsCost ratesProduct

Debt$25.0033.33%4.80%1.60%

Tax rate40%Equity$50.0066.67%12.25%8.17%

Target wd35.00%Total capital$75.00100.00%WACC =9.77%

Target wce65.00%

Coupon rate8.50%MARKET VALUE WEIGHTS

YTM = rd8.00%CapitalWeightsCost ratesProduct

rd(1 T)4.80%Debt$27.0011.89%4.80%0.57%

rs12.25%Equity$200.0088.11%12.25%10.79%

Number of shares (millions)10Total capital$227.00100.00%WACC =11.36%

Price per share$20.00TARGET WEIGHTS

BV per share$5.00CapitalWeightsCost ratesProduct

Book equity = BV/sh No. Shs$50.00DebtNA35.00%4.80%1.68%

Market equity = P0 No. Shs$200.00EquityNA65.00%12.25%7.96%

Book value of debt (millions)$25.00Total capitalNA100.00%WACC =9.64%

Market value of debt (millions)$27.00

Sum of the 3 WACCS = 30.77%

.(11-7) WACC and equity from REC IAnswer: e HARD

Coupon rate8.00%

Maturity20

Bond price$1,050.00

Par value$1,000

Tax rate40%

rRF4.50%

RPM5.50%

b1.20

Weight debt35%

Weight equity65%

Bond yield7.51%


Cost of equity, rs = rRF + b(RPM)11.10%

WACC = wd(rd)(1 T) + wc(rs) =8.79%

.(11-7) WACC and equity from REC IAnswer: d HARD

YTM7.75%

Tax rate40%

D1$0.65

g6.00%

P0$15.00

F10.0%

Weight debt45%

Weight equity55%


re = D1/(P0 (1 F)) + g 10.81%

WACC = wd(rd)(1 T) + wc(rs) =8.04%

.(11-9) Project riskC IAnswer: a HARD

rRF4.50%

RPM5.50%

b0.92

Cost of equity, rs = rRF + b(RPM)9.56%

Project cost of capital = rs + factorvaries

Projects' cost$25.00

Risk AdderCap cost Exp. returnAmt Invested

A-2.0%7.56%7.60%$25

B-1.0%8.56%9.15%$25

C0.0%9.56%10.10%$25

D1.0%10.56%10.40%$0

E2.0%11.56%10.80%$0

F2.0%11.56%10.90%$0

G2.0%11.56%13.00%$25

Total capital budget:$100

.(11-2) After-tax cost of debtC IAnswer: c MEDIUM

Coupon rate7.25%Calculator inputs:

Periods/year2N = 2 Years =40

Maturity (yr)20PV = -Bond Price =-$875.00

Bond price$875PMT = (Coupon rate Par)/2 =$36.25

Par value$1,000FV = Par value =$1,000

Tax rate40%Yield = I/YR, which we solve for =4.28%

Before-tax cost of debt = rd = yield 2 =8.57%

After-tax cost of debt = rd(1 T) =5.14%

.(11-5) CAPM cost of equityC IAnswer: d MEDIUM

rRF5.50%

Expected rM11.50%

RPM = rM rRF =6.00%

b1.25

rs = rRF + b(RPM)13.00%

.(11-7) Weights for WACCC IAnswer: a MEDIUM

Bond price$875.00

Number of bonds40,000

MV of debt = D$35,000,000

Stock price = P0$15.25

Shares outstanding10,000,000

MV of equity = E$152,500,000

Total MV = D + E$187,500,000

Weight debt = wd = D/Total MV18.67%

.(11-7) WACCC IAnswer: c MEDIUM

wd18.67%

rd(1 T)5.14%

wc = 100.00% wd =81.33%

rs13.00%

WACC = wd(rd)(1 T) + wc(rs) =11.53%

Page 356True/FalseChapter 11: Cost of Capital

2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.Chapter 11: Cost of CapitalTrue/FalsePage 355 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

the cost of capital exercise

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