accounting problems

[1]. Financial
analysts for Naulls Industries have revealed the following information about
the company:

·
Naulls
Industries currently has a capital structure that consists of 75 percent common
equity and 25 percent debt.
·
The risk-free
rate, kRF, is 5 percent.
·
The market
risk premium , kM – kRF, is 6 percent.
·
Naulls’s
common stock has a beta of 1.2.
·
Naulls has
20-year bonds outstanding with an annual coupon rate of 12 percent and a face
value of $1,000. The bonds sell today
for $1,200.
·
The company’s
tax rate is 40 percent.

What is the company’s current WACC?

a. 7.41%
b. 9.17%
c.10.61%
d.10.99%
e.11.57%

[2]. Grateway
Inc. has a weighted average cost of capital of 11.5 percent. Its target capital
structure is 55 percent equity and 45 percent debt. The company has sufficient
retained earnings to fund the equity portion of its capital budget. The before-tax cost of debt is 9 percent, and
the company’s tax rate is 30 percent. If
the expected dividend next period (D1) is $5 and the current stock
price is $45, what is the company’s growth rate?

a.2.68%
b.3.44%
c.4.64%
d.6.75%
e.8.16%

Answer: e :
[3]. The
managers of Kenforest Grocers are trying to determine the company’s optimal
capital budget for the upcoming year.
Kenforest is considering the following projects:

Rate of
Project Size Return Risk
A $200,000 16% High
B 500,000 14 Average
C 400,000 12 Low
D 300,000 11 High
E 100,000 10 Average
F 200,000 10 Low
G 400,000 7 Low

The company estimates that its WACC is 11
percent. All projects are
independent. The company adjusts for
risk by adding 2 percentage points to the WACC for high-risk projects and
subtracting 2 percentage points from the WACC for low-risk projects. Which of the projects will the company
accept?

a.A, B, C, E, F
b.B, D, F, G
c.A, B, C, E
d,A, B, C, D, E
e.A, B, C, F

[4]. Bradshaw
Steel has a capital structure with 30 percent debt (all long-term bonds) and 70
percent common equity.The
yield to maturity on the company’s long-term bonds is 8 percent, and the firm
estimates that its overall composite WACC is 10 percent.The risk-free rate of interest
is 5.5 percent, the market risk premium is 5 percent, and the company’s tax
rate is 40 percent.Bradshaw
uses the CAPM to determine its cost of equity.What is the beta on Bradshaw’s
stock?

a.1.07
b.1.48
c.1.31
d.0.10
e.1.35

[5]. Arizona
Rock, an all-equity firm, currently has a beta of 1.25. The risk-free rate, kRF, is 7
percent and kM is 14 percent.
Suppose the firm sells 10 percent of its assets with beta equal to 1.25
and purchases the same proportion of new assets with a beta of 1.1. What will be the firm’s new overall required
rate of return, and what rate of return must the new assets produce in order to
leave the stock price unchanged?

a.15.645%;
15.645%
b.15.750%;
14.700%
c.15.645%;
14.700%
d.15.750%;
15.645%
e.14.750%;
15.750%

[6]. Sun
State Mining Inc., an all-equity firm, is considering the formation of a new
division that will increase the assets of the firm by 50 percent. Sun
State currently has a
required rate of return of 18 percent, U.S. Treasury bonds yield 7 percent, and the
market risk premium is 5 percent. If Sun State
wants to reduce its required rate of return to 16 percent, what is the maximum
beta coefficient the new division could have?

a.2.2
b.1.0
c.1.8
d.1.6
e.2.0

[7]. Heavy
Metal Corp. is a steel manufacturer that finances its operations with 40
percent debt, 10 percent preferred stock, and 50 percent equity. The interest
rate on the company’s debt is 11 percent.
The preferred stock pays an annual dividend of $2 and sells for $20 a
share. The company’s common stock trades
at $30 a share, and its current dividend (D0) of $2 a share is
expected to grow at a constant rate of 8 percent per year. The flotation cost of external equity is 15
percent of the dollar amount issued, while the flotation cost on preferred
stock is 10 percent. The company
estimates that its WACC is 12.30 percent.
Assume that the firm will not have enough retained earnings to fund the
equity portion of its capital budget.
What is the company’s tax rate?

a.30.33%
b.32.86%
c.35.75%
d.38.12%
e.40.98%

[8]. Anderson
Company has four investment opportunities with the following costs (paid at t =
0) and expected returns:

Expected
Project Cost Return
A $2,000
16.0%
B 3,000
14.5
C 5,000
11.5
D 3,000
9.5

The company has a target capital structure that
consists of 40 percent common equity, 40 percent debt, and 20 percent preferred
stock. The company has $1,000 in
retained earnings. The company expects
its year-end dividend to be $3.00 per share (D1 = $3.00). The dividend is expected to grow at a
constant rate of 5 percent a year. The
company’s stock price is currently $42.75.
If the company issues new common stock, the company will pay its
investment bankers a 10 percent flotation cost.

The company can issue corporate bonds with a yield
to maturity of 10 percent. The company
is in the 35 percent tax bracket. How
large can the cost of preferred stock be (including flotation costs) and it
still be profitable for the company to invest in all four projects?

a. 7.75%
b. 8.90%
c.10.46%
d.11.54%
e.12.68%

Multiple
Part:

(The
following information applies to the next three problems.)

The Global Advertising Company has a marginal tax rate of
40 percent. The company can raise debt
at a 12 percent interest rate and the last dividend paid by Global was
$0.90. Global’s common stock is selling
for $8.59 per share, and its expected growth rate in earnings and dividends is
5 percent. If Global issues new common
stock, the flotation cost incurred will be 10 percent. Global plans to finance all capital expenditures
with 30 percent debt and 70 percent equity.

[9]. What is
Global’s cost of retained earnings if it can use retained earnings rather than
issue new common stock?

a.12.22%
b.17.22%
c.10.33%
d. 9.66%
e.16.00%

[10]. What is
the cost of common equity raised by selling new stock?

a.12.22%
b.17.22%
c.10.33%
d. 9.66%
e.16.00%

[11]. What is
the firm’s weighted average cost of capital if the firm has sufficient retained
earnings to fund the equity portion of its capital budget?

a.11.95%
b.12.22%
c.12.88%
d.13.36%
e.14.21%

(The
following information applies to the next two problems.)

Byron Corporation’s present capital structure,
which is also its target capital structure, is 40 percent debt and 60 percent
common equity. Assume that the firm has
no retained earnings. The company’s
earnings and dividends are growing at a constant rate of 5 percent; the last
dividend (D0) was $2.00; and the current equilibrium stock price is
$21.88. Byron can raise all the debt
financing it needs at 14 percent. If
Byron issues new common stock, a 20 percent flotation cost will be incurred. The firm’s marginal tax rate is 40 percent.

[12]. What is
the component cost of the equity raised by selling new common stock?

a.17.0%
b.16.4%
c.15.0%
d.14.6%
e.12.0%

[13]. What is
the firm’s weighted average cost of capital?

a.10.8%
b.13.6%
c.14.2%
d.16.4%
e.18.0%

(The
following information applies to the next six problems.)

Rollins Corporation has a target capital structure
consisting of 20 percent debt, 20 percent preferred stock, and 60 percent
common equity. Assume the firm has
insufficient retained earnings to fund the equity portion of its capital
budget. Its bonds have a 12 percent coupon, paid semiannually, a current
maturity of 20 years, and sell for $1,000.
The firm could sell, at par, $100 preferred stock that pays a 12 percent
annual dividend, but flotation costs of 5 percent would be incurred. Rollins’ beta is 1.2, the risk-free rate is
10 percent, and the market risk premium is 5 percent. Rollins is a constant
growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and
has a growth rate of 8 percent. The
firm’s policy is to use a risk premium of 4 percentage points when using the
bond-yield-plus-risk-premium method to find ks. Flotation costs on new common stock total 10
percent, and the firm’s marginal tax rate is 40 percent.

[14]. What is
Rollins’ component cost of debt?

a.10.0%
b. 9.1%
c. 8.6%
d. 8.0%
e. 7.2%

[15]. What is
Rollins’ cost of preferred stock?

a.10.0%
b.11.0%
c.12.0%
d.12.6%
e.13.2%

[16]. What is
Rollins’ cost of retained earnings using the CAPM approach?

a.13.6%
b.14.1%
c.16.0%
d.16.6%
e.16.9%

[17]. What is
the firm’s cost of retained earnings using the DCF approach?

a.13.6%
b.14.1%
c.16.0%
d.16.6%
e.16.9%

[18]. What is
Rollins’ cost of retained earnings using the bond-yield-plus-risk-premium
approach?

a.13.6%
b.14.1%
c.16.0%
d.16.6%
e.16.9%

[19]. What is
Rollins’ WACC, if the firm has insufficient retained earnings to fund the
equity portion of its capital budget?

a.13.6%
b.14.1%
c.16.0%
d.16.6%
e.16.9%

(The
following information applies to the next two problems.)

The Jackson Company has just paid a dividend of
$3.00 per share on its common stock, and it expects this dividend to grow by 10
percent per year, indefinitely. The firm has a beta of 1.50; the risk-free rate
is 10 percent; and the expected return on the market is 14 percent. The firm’s investment bankers believe that
new issues of common stock would have a flotation cost equal to 5 percent of
the current market price.

[20]. How much
should an investor be willing to pay for this stock today?

a.$62.81
b.$70.00
c.$43.75
d.$55.00
e.$30.00

[21]. What will
be Jackson’s
cost of new common stock if it issues new stock in the marketplace today?

a.15.25%
b.16.32%
c.17.00%
d.12.47%
e. 9.85%

(The
following information applies to the next two problems.)

Becker Glass Corporation expects to have earnings before
interest and taxes during the coming year of $1,000,000, and it expects its
earnings and dividends to grow indefinitely at a constant annual rate of 12.5
percent. The firm has $5,000,000 of debt
outstanding bearing a coupon interest rate of 8 percent, and it has 100,000
shares of common stock outstanding. Historically, Becker has paid 50 percent of
net earnings to common shareholders in the form of dividends. The current price of Becker’s common stock is
$40, but it would incur a 10 percent flotation cost if it were to sell new
stock. The firm’s tax rate is 40
percent.

[22]. What is
the firm’s cost of retained earnings?

a.15.0%
b.15.5%
c.16.0%
d.16.5%
e.17.0%

[23]. What is
Becker’s cost of newly issued stock?

a.16.0%
b.16.5%
c.17.0%
d.17.5%
e.18.0%

(The
following information applies to the next four problems.)

J. Ross and Sons Inc. has a target capital structure
that calls for 40 percent debt, 10 percent preferred stock, and 50 percent
common equity. The firm’s current
after-tax cost of debt is 6 percent, and it can sell as much debt as it wishes
at this rate. The firm’s preferred stock
currently sells for $90 a share and pays a dividend of $10 per share; however,
the firm will net only $80 per share from the sale of new preferred stock. Ross’ common stock currently sells for $40
per share, but the firm will net only $34 per share from the sale of new common
stock. The firm recently paid a dividend
of $2 per share on its common stock, and investors expect the dividend to grow
indefinitely at a constant rate of 10 percent per year. Assume the firm has sufficient retained
earnings to fund the equity portion of its capital budget.

[24]. What is
the firm’s cost of retained earnings?

a.10.0%
b.12.5%
c.15.5%
d.16.5%
e.18.0%

[25]. What is
the firm’s cost of newly issued common stock?

a.10.0%
b.12.5%
c.15.5%
d.16.5%
e.18.0%

[26]. What is
the firm’s cost of newly issued preferred stock?

a.10.0%
b.12.5%
c.15.5%
d.16.5%
e.18.0%

[27]. What is
the firm’s weighted average cost of capital?

a. 9.5%
b.10.3%
c.10.8%
d.11.4%
e.11.9%

(The following information applies
to the next three problems.)

The following information applies to the Coetzer Company:

·
Coetzer has a
target capital structure of 40 percent debt and 60 percent common equity.
·
Coetzer has
$1,000 par value bonds outstanding with a 15-year maturity, a 12 percent annual
coupon, and a current price of $1,150.
·
The risk-free
rate is 5 percent. The market risk
premium (kM – kRF) is also 5 percent.
·
Coetzer’s
common stock has a beta of 1.4.
·
Coetzer’s tax
rate is 40 percent.

[28]. What is
the company’s after-tax cost of debt?

a. 3.6%
b. 6.0%
c. 7.2%
d.10.0%
e.12.0%

[29]. What is
the company’s after-tax cost of common equity?

a. 6.0%
b. 8.4%
c. 9.6%
d.10.0%
e.12.0%

[30]. What is
the company’s WACC?

a. 6.0%
b. 7.4%
c. 9.6%
d.10.8%
e.12.2%

(The
following information applies to the next four problems.)

Viduka Construction’s CFO wants to
estimate the company’s WACC. She has
collected the following information:

·
The company
currently has 20-year bonds outstanding.
The bonds have an 8.5 percent annual coupon, a face value of $1,000, and
they currently sell for $945.
·
The company’s
stock has a beta = 1.20.
·
The market
risk premium, km– kRF,
equals 5 percent.
·
The risk-free
rate is 6 percent.
·
The company
has outstanding preferred stock that pays a $2.00 annual dividend. The preferred
stock sells for $25 a share.
·
The company’s
tax rate is 40 percent.
·
The company’s
capital structure consists of 40 percent long-term debt, 40 percent common
stock, and 20 percent preferred stock.

[31]. What is
the company’s after-tax cost of debt?

a.5.10%
b.5.46%
c.6.46%
d.8.50%
e.9.11%

[32]. What is
the company’s after-tax cost of preferred stock?

a.4.80%
b.5.60%
c.7.10%
d.8.00%
e.8.40%

[33]. What is
the company’s after-tax cost of common equity?

a. 7.20%
b. 7.32%
c. 7.94%
d.12.00%
e.12.20%

[34]. What is
the company’s WACC?

a. 7.95%
b. 8.12%
c. 8.59%
d. 8.67%
e.10.04%

(The following information applies
to the next three problems.)

Burlees Inc.’s
CFO is interested in calculating the cost of capital. In order to calculate the cost of capital,
the company has collected the following information:

·
The company’s
capital structure consists of 40 percent debt and 60 percent common stock.
·
The company
has bonds outstanding with 25 years to maturity. The bonds have a 12 percent annual coupon, a
face value of $1,000, and a current price of $1,252.
·
The company
uses the CAPM to calculate the cost of common stock. Currently, the risk-free rate is 5 percent
and the market risk premium, (kM – kRF), equals 6
percent. The company’s common stock has
a beta of 1.6.
·
The company’s
tax rate is 40 percent.

[35]. What is
the company’s after-tax cost of debt?

a.3.74%
b.4.80%
c.5.62%
d.7.20%
e.8.33%

[36]. What is
the company’s cost of common equity?

a. 9.65%
b.14.00%
c.14.60%
d.17.60%
e.18.91%

[37]. What is
the company’s weighted average cost of capital (WACC)?

a.10.5%
b.11.0%
c.11.5%
d.12.0%
e.12.5%

Web Appendix 9A

Multiple
Choice: Conceptual

9A-[38]. Sunshine Inc. has two divisions. 50 percent of the firm’s capital is invested
in Division A, which has a beta of 0.8.
The other 50 percent of the firm’s capital is invested in Division B,
which has a beta of 1.2. The company has
no debt, and it is 100 percent equity financed. The risk-free rate is 6 percent
and the market risk premium is 5 percent.
Sunshine assigns different hurdle rates to each division, and these
hurdle rates are based on each division’s market risk. Which of the following statements is most
correct?

a.Sunshine’s composite WACC is 11 percent.
b.Division B has a lower weighted average cost of
capital than Division A.
c.If Sunshine assigned the same hurdle rate to
each division, this would lead the firm to select too many projects in Division
A and reject too many projects in Division B.
d.Statements a and b are correct.
e.Statements a and c are correct.

9A-[39]. If the firm is being operated so as to
maximize shareholder wealth, and if our basic assumptions concerning the
relationship between risk and return are true, then which of the following
should be true?

a.If the beta of the asset is larger than the
firm’s beta, then the re-quired return on the asset is less than the required
return on the firm.
b.If the beta of the asset is smaller than the
firm’s beta, then the required return on the asset is greater than the required
return on the firm.
c.If the beta of the asset is greater than the
firm’s beta prior to the addition of that asset, then the firm’s beta after the
purchase of the asset will be smaller than the original firm’s beta.
d.If the beta of an asset is larger than the
firm’s beta prior to the addition of that asset, then the required return on
the firm will be greater after the purchase of that asset than prior to its
purchase.
e.None of the statements above is correct.

9A-[40]. Using the Security Market Line concept in
capital budgeting, which of the following is correct?

a.If the expected rate of return on a given
capital project lies above the SML, the project should be accepted even if its
beta is above the beta of the firm’s average project.
b.If a project’s return lies below the SML, it
should be rejected if it has a beta greater than the firm’s existing beta but
accepted if its beta is below the firm’s beta.
c.If two mutually exclusive projects’ expected
returns are both above the SML, the project with the lower risk should be
accepted.
d.If a project’s expected rate of return is
greater than the expected rate of return on an average project, it should be
accepted.
e.None of the statements above is correct.

Multiple Choice: Problems

9A-[41]. Louisiana Enterprises, an all-equity firm, is
consider­ing a new capital investment.
Analy­sis has indicated that the proposed investment has a beta of 0.5
and will generate an expected return of 7 percent. The firm currently has a required return of
10.75 percent and a beta of 1.25. The
investment, if undertaken, will double the firm’s total assets. If kRF is 7 percent and the market
return is 10 percent, should the firm undertake the invest­ment? (Choose the best answer.)

a.Yes;theexpectedreturnofthe asset(7%)exceedstherequiredreturn (6.5%).
b.Yes; the beta of the asset will reduce the risk
of the firm.
c.No; the expected return of the asset (7%) is
less than the required return (8.5%).
d.No; the risk of the asset (beta) will increase
the firm’s beta.
e.No; the expected return of the asset is less
than the firm’s required return, which is 10.75%.

Medium:

9A-[42]. Assume you are the director of capital
budgeting for an all-equity firm. The firm’s current cost of equity is 16
percent; the risk-free rate is 10 percent; and the market risk premium is 5
percent. You are considering a new
project that has 50 percent more beta risk than your firm’s assets currently
have, that is, its beta is 50 percent larger than the firm’s existing
beta. The expected return on the new
project is 18 percent. Should the
project be accepted if beta risk is the appropriate risk measure? Choose the correct statement.

a.Yes; its expected return is greater than the
firm’s cost of capital.
b.Yes; the project’s risk-adjusted required
return is less than its expected return.
c.No; a 50 percent increase in beta risk gives a
risk-adjusted required return of 24 percent.
d.No; the project’s risk-adjusted required return
is 2 percentage points above its expected return.
e.No; the project’s risk-adjusted required return
is 1 percentage point above its expected return.

Web Appendix 9B

Multiple
Choice: Conceptual

9B-[43]. Which of the following methods involves
calculating an average beta for firms in a similar business and then applying
that beta to determine a project’s beta?

a.Risk premium method.
b.Pure play method.
c.Accounting beta method.
d.CAPM method.
e.Statements b and c are correct.

Multiple
Choice: Problems

9B-[44]. Northern Conglomerate has two divisions,
Division A and Division B. Northern
looks at competing pure-play firms to estimate the betas of each of the two
divisions. After this analysis, Northern
concludesthat Division A has a beta of 0.8 and Division B has a
beta of 1.5. The twodivisions
are the same size. The risk-free rate is
5 percent and the market risk premium, kM – kRF, is 6
percent. Assume that Northern is 100
percent equity financed. What is the overall composite WACC for Northern
Conglomerate?

a. 9.8%
b.10.2%
c.11.9%
d.13.6%
e.14.0%

9B-[45]. Interstate Transport has a target capital
struc­ture of 50 percent debt and 50 percent common equity. The firm is considering a new independent
project that has a return of 13 percent and is not related to
transportation. However, a pure play
proxy firm has been identified that is exclusively engaged in the new line of
busi­ness. The proxy firm has a beta of
1.38. Both firms have a marginal tax
rate of 40 percent, and Interstate’s before-tax cost of debt is 12
percent. The risk-free rate is 10
percent and the market risk premium is 5 percent. The firm should

a.Reject the project; its return is less than the
firm’s required rate of return on the project of 16.9 percent.
b.Accept the project; its return is greater than
the firm’s required rate of return on the project of 12.05 percent.
c.Reject the project; its return is only 13
percent.
d.Accept the project; its return exceeds the
risk-free rate and the before-tax cost of debt.
e.Be indifferent between accepting or rejecting;
the firm’s required rate of return on the project equals its expected return.