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Exam 9: The Cost of Capital

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Question 41

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The component costs of capital are based on embedded costs.

A) True
B) False

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Question 42

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When working with the CAPM, which factor can be determined with the most precision?

A) the market risk premium (RP_M)
B) the beta coefficient, b_i, of a relatively safe stock
C) the most appropriate risk-free rate, r_RF
D) the beta coefficient of "the market," which is the same as the beta of an average stock

E) A) and B)
F) C) and D)

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Question 43

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In general, firms should use their 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.

Which of the following is the best estimate for the weights to be used when calculating the WACC?

Which of the following statements is correct?

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.

P. Lange Inc. hired your consulting firm to help the company estimate the cost of equity. The yield on Lange's bonds is 7.25%, and your firm's economists believe that the cost of equity can be estimated using a risk premium of 3.50% over a firm's own cost of debt. What is an estimate of Lange's cost of equity from retained earnings?

Suppose a company's target capital structure calls for 50% debt and 50% common equity. Which of the following statements is correct?

You have the following data: D₁ = $0.80; P₀ = $22.50; and g = 5.00% (constant) . Based on the DCF approach, what is the cost of equity from retained earnings?

Bruner Breakfast Foods' (BBF) balance sheet shows a total of $20 million long-term debt with a coupon rate of 8.00%. The yield to maturity on this debt is 10.00%, and the debt has a total current market value of $18 million. The balance sheet also shows that that the company has 10 million shares of stock, and total of common equity (common stock plus retained earnings) is $30 million. The current stock price is $4.50 per share, and stockholders' required rate of return, r_s, is 12.25%. The company recently decided that its target capital structure should have 50% debt, with the balance being common equity. The tax rate is 40%. Calculate WACCs based on target, book, and market value capital structures, and then find the sum of these three WACCs.

Suppose the debt ratio (D/TA) is 10%, the current cost of debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 20% would have to decrease the WACC.

The cost of capital should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets.

Malitz Inc. recently hired you as a consultant to estimate the company's WACC. You have obtained the following information. - Malitz's noncallable bonds mature in 25 years, have an 8.00% annual coupon, a par value of $1,000, and a market price of $1,075.00. - The company's tax rate is 40%. - The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock's beta is 1.20. - The target capital structure consists of 35% debt and the balance as common equity. Malitz uses the CAPM to estimate the cost of equity, and it does not expect to issue any new common stock. What is its WACC?

Schalheim Sisters Inc. has always paid out all of its earnings as dividends, and hence 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 circumstance would reduce the WACC?

A company's perpetual preferred stock currently trades at $87.50 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?

Which of the following statements is correct?

The McCue Company has equal amounts of low-risk, average-risk, and high-risk projects. McCue estimates that its 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?

Durst Enterprises, which is debt-free and finances only with equity from retained earnings, is considering five large capital budgeting projects. Its CFO hired you to assist in deciding whether none, one, two, three, four, or five projects should be accepted. You have the following information: - r_RF = 4.00%; RP_M = 5.50%; and b = 1.00. - The company adds 5%, 3%, 1%, 0%, or -1% to the corporate WACC when it evaluates projects that differ in risk. - Project A is in the -1% category, B is in the 0% group, C is in the +1% group, D is in the +3% group, and E is in the most risky +5% group. - Each project has a cost of $25,000. - The projects' expected returns are as follows: A = 8.7%, B = 9.60%, C = 10.30%, D = 13.80%, and E = 14.70%. If these are the only projects under consideration, how large should Durst's capital budget be?

Assume that Considine Inc. hired you as a consultant to help estimate its cost of capital. You have been provided with the following data: D₀ = $0.90; P₀ = $22.50; and g = 7.00% (constant) . Based on the DCF approach, what is Considine's cost of equity from retained earnings?

You were hired as a consultant to Kroncke Company, whose target capital structure is 40% debt, 10% preferred, and 50% 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 13.25%. The firm will not be issuing any new stock. What is its WACC?