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Exam 9: The Cost of Capital

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Question 41

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Quinlan 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 5.50% a year.The before-tax cost of debt is 7.50%, 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%

F) A) and E)
G) C) and E)

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Question 42

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Which of the following statements is CORRECT?

A) If the calculated beta underestimates the firm's 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 r_s and thus WACC that is too high.
B) 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 firm's stockholders are well diversified.
C) An advantage shared by both the dividend growth model 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.
D) The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach.
E) 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.

F) B) and D)
G) A) and E)

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Question 43

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

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 r_s.

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, is not deductible by the issuing firm.

Which of the following statements is CORRECT? Assume a company's target capital structure is 50% debt and 50% common equity.

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.

Westbrook's Painting Co.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 25%, but Congress is considering a change in the corporate tax rate to 15%.By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted?

Which of the following statements is CORRECT?

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.

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

The Anderson 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 company's 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 CEO's position is accepted, what is likely to happen over time?

Your consultant firm has been hired by Eco Brothers Inc.to help them estimate the cost of common equity.The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of common 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 common from reinvested earnings?

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the dividend growth method, and the bond-yield-plus-risk-premium method.However, only the dividend growth method is widely used in practice.

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 50% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

Assume that you are an intern with the Brayton Company, and you have collected the following data: The yield on the company's outstanding bonds is 7.75%; its tax rate is 25%; 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?

Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.

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.

Collins Group The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below. $\begin{array}{c}\begin{array}{lll}\underline{\text {Assets}}\\ \text {Current assets}\\ \text {Net plant, property, and equipment }\\ \text {Total assets}\\\\\underline{\text {Liabilities and Equity}}\\ \text {Accounts payable}\\ \text {Accruals}\\ \text {Current liabilities}\\ \text {Long-term debt (40,000 bonds, \$ 1,000 par value) }\\ \text { Total liabilities}\\ \text {Common stock \( (10,000,000 \) shares) }\\ \text {Retained earnings}\\ \text {Total shareholders' equity}\\ \text {Total liabilities and shareholders' equity} \end{array}\begin{array}{r}\\\$ 38,000,000 \\\underline{101,000,000 }\\\underline{ \$ 139,000.000} \\\\\\\$ 10,000,000 \\\underline{9,000,000} \\\$ 19,000,000 \\\underline{40,000,000 }\\\underline{ \$ 59,000,000 }\\ 30,000,000 \\\underline{50,000,000 }\\\underline{80,000,000} \\\underline{\$ 139,000,000} \\ \end{array}\end{array}$ The 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 25%. -Refer to the data for the Collins Group.What is the best estimate of the after-tax cost of debt?

Which of the following statements is CORRECT?