accounting quiz

Multiple Choice:
Conceptual

[i]. Which of
the following is not considered a capital component for the purpose of
calculating the weighted average cost of capital (WACC) as it applies to
capital budgeting?

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a.Long-term
debt.
b.Common
stock.
c.Accounts
payable and accruals.
d.Preferred
stock.

[ii]. For a
typical firm with a given capital structure, which of the following is
correct? (Note: All rates are after
taxes.)

a.kd
> ke > ks > WACC.
b.ks
> ke > kd > WACC.
c.WACC >
ke > ks > kd.
d.ke
> ks > WACC > kd.
e.None of
the statements above is correct.

[iii]. Which of
the following statements is most correct?

a.If a
company’s tax rate increases but the yield to maturity of its noncallable bonds
remains the same, the company’s marginal cost of debt capital used to calculate
its weighted average cost of capital will fall.
b.All else
equal, an increase in a company’s stock price will increase the marginal cost
of retained earnings, ks.
c.All else
equal, an increase in a company’s stock price will increase the marginal cost
of issuing new common equity, ke.
d.Statements
a and b are correct.
e.Statements
b and c are correct.

[iv]. Which of
the following statements is most correct?

a.Since the
money is readily available, the cost of retained earnings is usually a lot
cheaper than the cost of debt financing.
b.When
calculating the cost of preferred stock, a company needs to adjust for taxes,
because preferred stock dividends are tax deductible.
c.When
calculating the cost of debt, a company needs to adjust for taxes, because
interest payments are tax deductible.
d.Statements
a and b are correct.
e.Statements
b and c are correct.

[v]. Which of
the following factors in the discounted cash flow (DCF) approach to estimating
the cost of common equity is the least difficult to estimate?

a.Expected
growth rate, g.
b.Dividend
yield, D1/P0.
c.Required
return, ks.
d.Expected rate of return, .gif”>.
e.All of the
above are equally difficult to estimate.

Answer: d
[vi]. Which of
the following statements is most correct?

a.The WACC
measures the after-tax cost of capital.
b.The WACC
measures the marginal cost of capital.
c.There is
no cost associated with using retained earnings.
d.Statements
a and b are correct.
e.All of the
statements above are correct.

[vii]. Which of
the following statements about the cost of capital is incorrect?

a.A
company’s target capital structure affects its weighted average cost of
capital.
b.Weighted
average cost of capital calculations should be based on the after-tax costs of
all the individual capital components.
c.If a
company’s tax rate increases, then, all else equal, its weighted average cost
of capital will increase.
d.Flotation
costs can increase the weighted average cost of capital.
e.An
increase in the risk-free rate is likely to increase the marginal costs of both
debt and equity financing.

[viii].Campbell
Co. is trying to estimate its weighted average cost of capital (WACC). Which of the following statements is most
correct?

a.The
after-tax cost of debt is generally cheaper than the after-tax cost of
preferred stock.
b.Since
retained earnings are readily available, the cost of retained earnings is generally
lower than the cost of debt.
c.If
the company’s beta increases, this will increase the cost of equity financing,
even if the company is able to rely on only retained earnings for its equity
financing.
d.Statements
a and b are correct.
e.Statements
a and c are correct.

[ix]. Wyden
Brothers has no retained earnings. The
company uses the CAPM to calculate the cost of equity capital. The company’s capital structure consists of
common stock, preferred stock, and debt.
Which of the following events will reduce the company’s WACC?

a.A
reduction in the market risk premium.
b.An
increase in the flotation costs associated with issuing new common stock.
c.An
increase in the company’s beta.
d.An
increase in expected inflation.
e.An
increase in the flotation costs associated with issuing preferred stock.

Answer: c
[x]. Which of
the following statements is most correct?

a.The WACC is a measure of the before-tax cost of
capital.
b.Typically the after-tax cost of debt financing exceeds the after-tax
cost of equity financing.
c.The WACC measures the marginal after-tax cost
of capital.
d.Statements a and b are correct.
e.Statements b and c are correct.

Answer: a
[xi]. A company
has a capital structure that consists of 50 percent debt and 50 percent
equity. Which of the following
statements is most correct?

a.The cost of equity financing is greater than or equal to the cost of
debt financing.
b.The WACC exceeds the cost of equity financing.
c.The WACC is calculated on a before-tax basis.
d.The WACC represents the cost of capital based on historical
averages. In that sense, it does not represent the marginal cost of capital.
e.The cost of retained earnings exceeds the cost of issuing new common
stock.
Answer: e
[xii]. A firm
estimates that its proposed capital budget will force it to issue new common
stock, which has a greater cost than the cost of retained earnings. The firm, however, would like to avoid
issuing costly new common stock. Which
of the following steps would mitigate the firm’s need to raise new common
stock?

a.Increasing the company’s dividend payout ratio
for the upcoming year.
b.Reducing the company’s debt ratio for the
upcoming year.
c.Increasing the company’s proposed capital
budget.
d.All of the statements above are correct.
e.
None of the
statements above is correct.

[xiii].Dick Boe
Enterprises, an all-equity firm, has a corpor­ate beta coefficient of 1.5. The financial manager is evaluating a proj­ect
with an expected return of 21 percent, before any risk adjustment. The risk-free rate is 10 percent, and the
required rate of return on the market is 16 percent. The project being evaluated is risk­ier than
Boe’s average project, in terms of both beta risk and total risk. Which of the following statements is most
correct?

a.The
project should be accepted since its expected return (before risk adjustment)
is greater than its required return.
b.The
project should be rejected since its expected return (before risk adjustment)
is less than its re­quired return.
c.The
accept/reject decision depends on the risk-adjustment policy of the firm. If the firm’s policy were to reduce a
riskier-than-average project’s expected return by 1 percentage point, then the
project should be accepted.
d.Riskier-than-average
projects should have their expected returns increased to reflect their added
riskiness. Clearly, this would make the
project acceptable regardless of the amount of the adjustment.
e.Projects
should be evaluated on the basis of their total risk alone. Thus, there is
insuffi­cient information in the problem to make an accept/reject decision.

[xiv]. A company
estimates that an average-risk project has a WACC of 10 percent, a
below-average risk project has a WACC of 8 percent, and an above-average risk
project has a WACC of 12 percent. Which
of the following independent projects should the company accept?

a.Project A
has average risk and a return of 9 percent.
b.Project B
has below-average risk and a return of 8.5 percent.
c.Project C
has above-average risk and a return of 11 percent.
d.All of the
projects above should be accepted.
e.None of
the projects above should be accepted.

[xv]. Conglomerate
Inc. consists of 2 divisions of equal size, and Conglomerate is 100 percent
equity financed. Division A’s cost of
equity capital is 9.8 percent, while Division B’s cost of equity capital is 14
percent. Conglomerate’s composite WACC
is 11.9 percent. Assume that all
Division A projects have the same risk and that all Division B projects have
the same risk. However, the projects in
Division A are not the same risk as those in Division B. Which of the following projects should
Conglomerate accept?

a.Division A project with an 11 percent return.
b.Division B
project with a 12 percent return.
c.Division B
project with a 13 percent return.
d.Statements
a and c are correct.
e.Statements
b and d are correct.

[xvi]. Which of
the following will increase a company’s retained earnings break point?

a.An
increase in its net income.
b.An
increase in its dividend payout.
c.An increase
in the amount of equity in its capital structure.
d.An
increase in its capital budget.
e.All of the
statements above are correct.

[xvii].Which of
the following actions will increase the retained earnings break point?

a.An
increase in the dividend payout ratio.
b.An
increase in the debt ratio.
c.An
increase in the capital budget.
d.An
increase in flotation costs.
e.All
of the statements above are correct.

[xviii]. Which
of the following statements is most correct?

a.Since debt
capital is riskier than equity capital, the cost of debt is always greater than
the WACC.
b.Because of
the risk of bankruptcy, the cost of debt capital is always higher than the cost
of equity capital.
c.If a
company assigns the same cost of capital to all of its projects regardless of
the project’s risk, then it follows that the company will generally reject too
many safe projects and accept too many risky projects.
d.Because
you are able to avoid flotation costs, the cost of retained earnings is
generally lower than the cost of debt.
e.Higher
flotation costs tend to reduce the cost of equity capital.

[xix]. Which of the
following statements is most correct?

a.Higher
flotation costs reduce investor returns, and therefore reduce a company’s WACC.
b.The WACC
represents the historical cost of capital and is usually calculated on a
before-tax basis.
c.The cost
of retained earnings is zero because retained earnings are readily available
and do not require the payment of flotation costs.
d.All of the
statements above are correct.
e.None of
the statements above is correct.

[xx]. Which of
the following statements is most correct?

a.In the
weighted average cost of capital calculation, we must adjust the cost of
preferred stock for the tax exclusion of 70 percent of dividend income.
b.We ideally
would like to use historical measures of the component costs from prior
financings in estimating the appropriate weighted average cost of capital.
c.The cost
of a new equity issuance (ke) could possibly be lower than the cost
of retained earnings (ks) if the market risk premium and risk-free
rate decline by a substantial amount.
d.Statements
b and c are correct.
e.None of
the statements above is correct.

[xxi]. Which of
the following statements is most correct?

a.The cost
of retained earnings is the rate of return stockholders require on a firm’s
common stock.
b.The
component cost of preferred stock is expressed as kp(1 – T), because
preferred stock dividends are treated as fixed charges, similar to the
treatment of debt interest.
c.The
bond-yield-plus-risk-premium approach to estimating a firm’s cost of common
equity involves adding a subjectively determined risk premium to the market
risk-free bond rate.
d.The higher
the firm’s flotation cost for new common stock, the more likely the firm is to
use preferred stock, which has no flotation cost.
e.None of
the statements above is correct.

[xxii].Which of
the following statements is correct?

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.
b.The cost
of debt used to calculate the weighted average cost of capital is based on an
average of the cost of debt already issued by the firm and the cost of new
debt.
c.One
problem with the CAPM approach in estimating the cost of equity capital is that
if a firm’s stockholders are, in fact, not well diversified, beta may be a poor
measure of the firm’s true investment risk.
d.The
bond-yield-plus-risk-premium approach is the most sophisticated and objective
method of estimating a firm’s cost of equity capital.
e.The cost
of equity capital is generally easier to measure than the cost of debt, which
varies daily with interest rates, or the cost of preferred stock since
preferred stock is issued infrequently.

[xxiii]. Which of
the following statements is correct?

a.Although
some methods of estimating the cost of equity capital encounter severe
difficulties, the CAPM is a simple and reliable model that provides great
accuracy and consistency in estimating the cost of equity capital.
b.The DCF
model is preferred over other models to estimate the cost of equity because of
the ease with which a firm’s growth rate is obtained.
c.The
bond-yield-plus-risk-premium approach to estimating the cost of equity is not
always accurate but its advantages are that it is a standardized and objective
model.
d.Depreciation-generated
funds are an additional source of capital and, in fact, represent the largest
single source of funds for some firms.
e.None of
the statements above is correct.

[xxiv].In applying
the CAPM to estimate the cost of equity capital, which of the following
elements is not subject to dispute or controversy?

a.The
expected rate of return on the market, kM.
b.The
stock’s beta coefficient, bi.
c.The
risk-free rate, kRF.
d.The market
risk premium (RPM).
e.All of the
above are subject to dispute.

[xxv]. Which of
the following statements is most correct?

a.Beta
measures market risk, but if a firm’s stockholders are not well diversified,
beta may not accurately measure stand-alone risk.
b.If the
calculated beta underestimates the firm’s true investment risk, then the CAPM
method will overestimate ks.
c.The
discounted cash flow method of estimating the cost of equity can’t be used
unless the growth component, g, is constant during the analysis period.
d.An
advantage shared by both the DCF and CAPM methods of estimating the cost of
equity capital, is that they yield precise estimates and require little or no
judgement.
e.None of
the statements above is correct.

[xxvi].Which of
the following statements is most correct?

a.The
weighted average cost of capital for a given capital budget level is a weighted
average of the marginal cost of each relevant capital component that makes up
the firm’s target capital structure.
b.The
weighted average cost of capital is calculated on a before-tax basis.
c.An
increase in the risk-free rate is likely to increase the marginal costs of both
debt and equity financing.
d.Statements
a and c are correct.
e.All of the
statements above are correct.

[xxvii]. Which of
the following statements is correct?

a.The WACC
should include only after-tax component costs.
Therefore, the required rates of return (or “market rates”) on debt,
preferred, and common equity (kd, kp, and ks)
must be adjusted to an after-tax basis before they are used in the WACC
equation.
b.The cost
of retained earnings is generally higher than the cost of new common stock.
c.Preferred
stock is riskier to investors than is debt. Therefore, if someone told you that
the market rates showed kd>kp for a given
company, that person must have made a mistake.
d.If a
company with a debt ratio of 50 percent were suddenly exempted from all future
income taxes, then, all other things held constant, this would cause its WACC to
increase.
e.None of
the statements above is correct.

[xxviii]. Which of
the following statements is most correct?

a.An
increase in flotation costs incurred in selling new stock will increase the
cost of retained earnings.
b.The WACC
should include only after-tax component costs.
Therefore, the required rates of return (or “market rates”) on debt,
preferred, and common equity (kd, kp, and ks)
must be adjusted to an after-tax basis before they are used in the WACC
equation.
c.An
increase in a firm’s corporate tax rate will increase the firm’s cost of debt
capital, as long as the yield to maturity on the company’s bonds remains
constant or falls.
d.Statements
b and c are correct.
e.None of
the statements above is correct.

[xxix].Which of
the following statements is most correct?

a.Since
stockholders do not generally pay corporate taxes, corporations should focus on
before-tax cash flows when calculating the weighted average cost of capital
(WACC).
b.All else
equal, an increase in flotation costs will increase the cost of retained
earnings.
c.When
calculating the weighted average cost of capital, firms should rely on
historical costs rather than marginal costs of capital.
d.Statements
a and b are correct.
e.None of
the statements above is correct.

[xxx]. Which of
the following statements is correct?

a.Because we
often need to make comparisons among firms that are in different income tax
brackets, it is best to calculate the WACC on a before-tax basis.
b.If a firm
has been suffering accounting losses and is expected to continue suffering such
losses, and therefore its tax rate is zero, it is possible that its after-tax
component cost of preferred stock as used to calculate the WACC will be less
than its after-tax component cost of debt.
c.Normally,
the cost of external equity raised by issuing new common stock is above the
cost of retained earnings. Moreover, the
higher the growth rate is relative to the dividend yield, the more the cost of
external equity will exceed the cost of retained earnings.
d.The lower
a company’s tax rate, the greater the advantage of using debt in terms of
lowering its WACC.
e.None of
the statements above is correct.

[xxxi].Kemp
Consolidated has two divisions of equal size: a computer division and a
restaurant division. Stand-alone restaurant companies typically
have a cost of capital of 8 percent, while stand-alone computer companies
typically have a 12 percent cost of capital.Kemp’s restaurant division has
the same risk as a typical restaurant company, and its computer division has
the same risk as a typical computer company.Consequently, Kemp estimates
that its composite corporate cost of capital is 10 percent. The company’s
consultant has suggested that they use an 8 percent hurdle rate for the
restaurant division and a 12 percent hurdle rate for the computer division.However, Kemp has chosen to
ignore its consultant, and instead, chooses to assign a 10 percent cost of
capital to all projects in both divisions.
Which of the following statements is most correct?

a.While
Kemp’s decision to not risk adjust its cost of capital will lead it to accept
more projects in its computer division and fewer projects in its restaurant
division, this should not affect the overall value of the company.
b.Kemp’s
decision to not risk adjust means that it is effectively subsidizing its
restaurant division, which means that its restaurant division is likely to
become a larger part of the overall company over time.
c.Kemp’s
decision to not risk adjust means that the company will accept too many
projects in the computer business and too few projects in the restaurant
business. This will lead to a reduction
in the overall value of the company.
d.Statements
a and b are correct.
e.Statements
b and c are correct.

al
[xxxii]. The
Barabas Company has an equal amount of low-risk projects, average-risk
projects, and high-risk projects.
Barabas estimates that the overall company’s WACC is 12 percent. This is also the correct cost of capital for
the company’s average-risk projects. The
company’s CFO argues that, even though the company’s projects have different
risks, the cost of capital for each project should be the same because the
company obtains its capital from the same sources. If the company follows the CFO’s advice, what
is likely to happen over time?

a.The
company will take on too many low-risk projects and reject too many high-risk
projects.
b.The
company will take on too many high-risk projects and reject too many low-risk
projects.
c.Things
will generally even out over time, and therefore, the risk of the firm should
remain constant over time.
d.Statements
a and c are correct.
e.Statements
b and c are correct.

[xxxiii]. If a
company uses the same cost of capital for evaluating all projects, which of the
following results is likely?

a.Accepting
poor, high-risk projects.
b.Rejecting
good, low-risk projects.
c.Accepting
only good, low-risk projects.
d.Accepting
no projects.
e.Answers a
and b are corre
[xxxiv]. If a
typical U.S.
company uses the same cost of capital to evaluate all projects, the firm will
most likely become

a.Riskier
over time, and its value will decline.
b.Riskier
over time, and its value will rise.
c.Less risky
over time, and its value will rise.
d.Less risky
over time, and its value will decline.
e.There is
no reason to expect its risk position or value to change over time as a result
of its use of a single discount rate.

[xxxv].Pearson
Plastics has two equal-sized divisions, Division A and Division B. The company
estimates that if the divisions operated as independent companies Division A
would have a cost of capital of 8 percent, while Division B would have a cost
of capital of 12 percent. Since the two
divisions are the same size, Pearson’s composite weighted average cost of
capital (WACC) is 10 percent. In the
past, Pearson has assigned separate hurdle rates to each division based on
their relative risk. Now, however,
Pearson has chosen to use the corporate WACC, which is currently 10 percent,
for both divisions. Which of the
following is likely to occur as a result of this change? Assume that this change is likely to have no
effect on the average risk of each division and market conditions remain
unchanged.

a.Over time,
the overall risk of the company will increase.
b.Over time,
Division B will become a larger part of the overall company.
c.Over time,
the company’s corporate WACC will increase.
d.Statements
a and c are correct.
e.All of the
statements above are correct.

Answer: e
[xxxvi]. Smith
Electric Co. and Ferdinand Water Co. are the same size and have the same
capital structure. Smith Electric Co. is
riskier than Ferdinand and has a WACC of 12 percent. Ferdinand Water Co. is safer than Smith and
has a WACC of 10 percent. Ferdinand
Water Co. is considering Project X. Project X has an IRR of 10.5 percent, and
has the same risk as a typical project undertaken by Ferdinand Water Co. Smith Electric Co. is considering Project
Y. Project Y has an IRR of 11.5 percent,
and has the same risk as a typical project undertaken by Smith Electric Co.

Now assume that Smith Electric Co. and Ferdinand
Water Co. merge to form a new company, Leeds United Utilities. The merger has no impact on the cash flows or
risk of either Project X or Project Y.
Leeds United Utilities’ CFO is trying to establish hurdle rates for the
new company’s projects that accurately reflect the risk of each project. (That
is, he is using risk-adjusted hurdle rates.)
Which of the following statements is most correct?

a.Leeds United Utilities’ weighted average cost
of capital is 11 percent.
b.Project
X has a positive NPV.
c.After
the merger, Leeds United Utilities should select Project X and reject Project
Y.
d.Statements
a and b are correct.
e.All
of the statements above are correct.

[xxxvii]. Which of
the following statements is correct?

a.A
relatively risky future cash outflow should be evaluated using a relatively low
discount rate.
b.If a
firm’s managers want to maximize the value of the stock, they should
concentrate exclusively on projects’ market, or beta, risk.
c.If a firm
evaluates all projects using the same cost of capital, then the riskiness of
the firm as measured by its beta will probably decline over time.
d.If a firm
has a beta that is less than 1.0, say 0.9, this would suggest that its assets’
returns are negatively correlated with the returns of most other firms’ assets.
e.None of
the statements above is correct.

[xxxviii].Which of
the following statements is most correct?

a.Suppose a
firm is losing money and thus, is not paying taxes, and that this situation is
expected to persist for a few years whether or not the firm uses debt
financing. Then the firm’s after-tax
cost of debt will equal its before-tax cost of debt.
b.The
component cost of preferred stock is expressed as kp(1 – T), because
preferred stock dividends are treated as fixed charges, similar to the
treatment of debt interest.
c.The reason
that a cost is assigned to retained earnings is because these funds are already
earning a return in the business; the reason does not
involve the opportunity cost principle.
d.The
bond-yield-plus-risk-premium approach to estimating a firm’s cost of common
equity involves adding a subjectively determined risk premium to the market
risk-free bond rate.
e.None of
the statements above is correct.

Multiple Choice:
Problems

[xxxix]. Your
company’s stock sells for $50 per share, its last dividend (D0) was
$2.00, its growth rate is a constant 5 percent, and the company will incur a
flotation cost of 15 percent if it sells new common stock. What is the firm’s cost of new equity, ke?

a. 9.20%
b. 9.94%
c.10.50%
d.11.75%
e.12.30%

[xl]. Blair
Brothers’ stock currently has a price of $50 per share and is expected to pay a
year-end dividend of $2.50 per share (D1 = $2.50). The dividend is expected to grow at a constant
rate of 4 percent per year. The company has insufficient retained earnings to
fund capital projects and must, therefore, issue new common stock. The new stock has an estimated flotation cost
of $3 per share. What is the company’s
cost of equity capital?

a.10.14%
b. 9.21%
c. 9.45%
d. 9.32%
e. 9.00%

[xli]. Allison
Engines Corporation has established a target capital structure of 40 percent
debt and 60 percent common equity. The
current market price of the firm’s stock is P0 = $28; its last dividend
was D0 = $2.20, and its expected dividend growth rate is 6
percent. What will Allison’s marginal
cost of retained earnings, ks, be?

a.15.8%
b.13.9%
c. 7.9%
d.14.3%
e. 9.7%

Answer: a
[xlii].Ananalysthas collected the following information regarding Christopher Co.:

·
The company’s
capital structure is 70 percent equity and 30 percent debt.
·
The yield to
maturity on the company’s bonds is 9 percent.
·
The company’s
year-end dividend is forecasted to be $0.80 a share.
·
The company
expects that its dividend will grow at a constant rate of 9 percent a year.
·
The company’s
stock price is $25.
·
The company’s
tax rate is 40 percent.
·
The company
anticipates that it will need to raise new common stock this year, and total
flotation costs will equal 10 percent of the amount issued.

Assume the
company accounts for flotation costs by adjusting the cost of capital. Given this information, calculate the
company’s WACC.

a.10.41%
b.12.56%
c.10.78%
d.13.55%
e. 9.29%

[xliii]. Flaherty
Electric has a capital structure that consists of 70 percent equity and 30
percent debt. The company’s long-term
bonds have a before-tax yield to maturity of 8.4 percent. The company uses the DCF approach to
determine the cost of equity. Flaherty’s
common stock currently trades at $45 per share.
The year-end dividend (D1) is expected to be $2.50 per share,
and the dividend is expected to grow forever at a constant rate of 7 percent a
year. The company estimates that it will
have to issue new common stock to help fund this year’s projects. The flotation cost on new common stock issued
is 10 percent, and the company’s tax rate is 40 percent. What is the company’s weighted average cost
of capital, WACC?

a.10.73%
b.10.30%
c.11.31%
d. 7.48%
e. 9.89%

[xliv].Billick
Brothers is estimating its WACC. The
company has collected the following information:

·
Its capital
structure consists of 40 percent debt and 60 percent common equity.
·
The company
has 20-year bonds outstanding with a 9 percent annual coupon that are trading
at par.
·
The company’s
tax rate is 40 percent.
·
The risk-free
rate is 5.5 percent.
·
The market
risk premium is 5 percent.
·
The stock’s
beta is 1.4.

What is the company’s WACC?

a. 9.71%
b. 9.66%
c. 8.31%
d.11.18%
e.11.10%

[xlv]. Dandy
Product’s overall weighted average required rate of return is 10 percent. Its yogurt division is riskier than average,
its fresh produce division has average risk, and its institutional foods
division has below-average risk. Dandy
adjusts for both divisional and project risk by adding or subtracting 2
percentage points. Thus, the maximum
adjustment is 4 percentage points. What
is the risk-adjusted required rate of return for a low-risk project in the
yogurt division?

a. 6%
b. 8%
c.10%
d.12%
e.14%

[xlvi].Stephenson
& Sons has a capital structure that consists of 20 percent equity and 80
percent debt. The company expects to
report $3 million in net income this year, and 60 percent of the net income
will be paid out as dividends. How large
must the firm’s capital budget be this year without it having to issue any new
common stock?

a.$ 1.20
million
b.$13.00
million
c.$ 1.50
million
d.$ 0.24
million
e.$ 6.00
million

Medium:

[xlvii]. The
common stock of Anthony Steel has a beta of 1.20. The risk-free rate is 5 percent and the market
risk premium (kM – kRF) is 6 percent. Assume the firm will be able to use retained
earnings to fund the equity portion of its capital budget. What is the company’s cost of retained
earnings, ks?

a. 7.0%
b. 7.2%
c.11.0%
d.12.2%
e.12.4%

[xlviii]. A company
just paid a $2.00 per share dividend on its common stock (D0 =
$2.00). The dividend is expected to grow
at a constant rate of 7 percent per year.
The stock currently sells for $42 a share. If the company issues additional stock, it
must pay its investment banker a flotation cost of $1.00 per share. What is the cost of external equity, ke?

a.11.76%
b.11.88%
c.11.98%
d.12.22%
e.12.30%

[xlix].Hamilton
Company’s 8 percent coupon rate, quarterly payment, $1,000 par value bond,
which matures in 20 years, currently sells at a price of $686.86. The company’s tax rate is 40 percent. Based on the nominal interest rate, not the
EAR, what is the firm’s component cost of debt for purposes of calculating the
WACC?

a. 3.05%
b. 7.32%
c. 7.36%
d.12.20%
e.12.26%

Answer: e

[l]. Trojan
Services’ CFO is interested in estimating the company’s WACC and has collected
the following information:

·
The company
has bonds outstanding that mature in 26 years with an annual coupon of 7.5
percent. The bonds have a face value of
$1,000 and sell in the market today for $920.
·
The risk-free
rate is 6 percent.
·
The market
risk premium is 5 percent.
·
The stock’s
beta is 1.2.
·
The company’s
tax rate is 40 percent.
·
The company’s
target capital structure consists of 70 percent equity and 30 percent debt.
·
The company
uses the CAPM to estimate the cost of equity and does not include flotation
costs as part of its cost of capital.

What is
Trojan’s WACC?

a. 9.75%
b. 9.39%
c.10.87%
d. 9.30%
e. 9.89%

[li]. A company
has determined that its optimal capital structure consists of 40 percent debt
and 60 percent equity. Assume the firm
will not have enough retained earnings to fund the equity portion of its
capital budget. Also, assume the firm
accounts for flotation costs by adjusting the cost of capital. Given the following information, calculate
the firm’s weighted average cost of capital.

·
kd
= 8%.
·
Net income =
$40,000.
·
Payout ratio
= 50%.
·
Tax rate =
40%.
·
P0
= $25.
·
Growth = 0%.
·
Shares
outstanding = 10,000.
·
Flotation
cost on additional equity = 15%.

a. 7.60%
b. 8.05%
c.11.81%
d.13.69%
e.14.28%

[lii]. Hatch
Corporation’s target capital structure is 40 percent debt, 50 percent common
stock, and 10 percent preferred stock.
Information regarding the company’s cost of capital can be summarized as
follows:

·
The company’s
bonds have a nominal yield to maturity of 7 percent.
·
The company’s
preferred stock sells for $42 a share and pays an annual dividend of $4 a
share.
·
The company’s
common stock sells for $28 a share, and is expected to pay a dividend of $2 a
share at the end of the year (i.e., D1 = $2.00). The dividend is
expected to grow at a constant rate of 7 percent a year.
·
The firm will
be able to use retained earnings to fund the equity portion of its capital
budget.
·
The company’s
ta

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