Question 1

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 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?

Accepted Answer

A)   6.89%
B)   7.26%
C)   7.64%
D)   8.04%
E)   8.44%F) A) and B)
G) A) and C)

Question 2

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 firstσbecause reinvested earnings have no cost to the firm.

Accepted Answer

A) True 
 B)False

Question 3

Firm J's earnings and stock price tend to move up and down with other firms in the S&P 500, while Firm F's earnings and stock price move counter cyclically with J and other S&P companies. Both J and F 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?

Accepted Answer

A)   j and f should have identical waccs because their risks as measured by the standard deviation of returns are identical.
B)   if j and f merge, then the merged firm mw should have a wacc that is a simple average of j's and f's waccs.
C)   without additional information, it is impossible to predict what the merged firm's wacc would be if j and f merged.
D)   since j and f 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.
E)   j should have the lower wacc because it is like most other companies, and investors like that fact.F) All of the above
G) None of the above

Question 4

Which of the following statements is CORRECT?

Accepted Answer

A)   the percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt.
B)   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.
C)   there is an "opportunity cost" associated with using reinvested earnings, hence they are not "free."
D)   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.
E)   the wacc as used in capital budgeting is an estimate of a company's before-tax cost of capital.F) None of the above
G) C) and D)

Question 5

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.

Accepted Answer

A) True 
 B)False

Question 6

Which of the following statements is CORRECT?

Accepted Answer

A)   if the calculated beta underestimates the firm's true investment riskσi.e., if the forward-looking beta that investors think exists exceeds the historical betaσthen the capm method based on the historical beta will produce an estimate of rs 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) A) and B)
G) A) and D)

Question 7

To help estimate its cost of common equity, Maxwell and Associates recently hired you. You have obtained the following data: D0 = $0.90; P0 = $27.50; and gL = 7.00% (constant) . Based on the dividend growth model, what is the cost of common from reinvested earnings?

Accepted Answer

A)   9.29%
B)   9.68%
C)   10.08%
D)   10.50%
E)   10.92%F) A) and C)
G) A) and B)

Question 8

Which of the following statements is CORRECT?

Accepted Answer

A)   when calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.
B)   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.
C)   if a company's beta increases, this will increase the cost of equity used to calculate the wacc, but only if the company does not have enough reinvested earnings to take care of its equity financing and hence must issue new stock.
D)   higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's wacc.
E)   when calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.F) A) and B)
G) A) and C)

Question 9

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. 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.

Accepted Answer

A) True 
 B)False

Question 10

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

Accepted Answer

A)   11.30%
B)   11.64%
C)   11.99%
D)   12.35%
E)   12.72%F) C) and E)
G) D) and E)

Question 11

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?

Accepted Answer

A)   the company will take on too many low-risk projects and reject too many high-risk projects.
B)   things will generally even out over time, and, therefore, the firm's risk should remain constant over time.
C)   the company's overall wacc should decrease over time because its stock price should be increasing.
D)   the ceo's recommendation would maximize the firm's intrinsic value.
E)   the company will take on too many high-risk projects and reject too many low-risk projects.F) A) and D)
G) None of the above

Question 12

Avery Corporation's 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 common from reinvested earnings is 11.25%, and the tax rate is 40%. The firm will not be issuing any new common stock. What is Avery's WACC?

Accepted Answer

A)   8.15%
B)   8.48%
C)   8.82%
D)   9.17%
E)   9.54%F) A) and B)
G) A) and C)

Exam 11: Determining the Cost of Capital

Correct Answer
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Correct Answer
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To help estimate its cost of common equity, Maxwell and Associates recently hired you. You have obtained the following data: D0 = $0.90; P0 = $27.50; and gL = 7.00% (constant) . Based on the dividend growth model, what is the cost of common from reinvested earnings?

Correct Answer
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Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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Adams Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of common from reinvested earnings based on the CAPM?

Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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Correct Answer
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Correct Answer
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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 firstσbecause reinvested earnings have no cost to the firm.

Correct Answer
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Exam 11: Determining the Cost of Capital

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

To help estimate its cost of common equity, Maxwell and Associates recently hired you. You have obtained the following data: D0 = $0.90; P0 = $27.50; and gL = 7.00% (constant) . Based on the dividend growth model, what is the cost of common from reinvested earnings?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

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

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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 firstσbecause reinvested earnings have no cost to the firm.

Correct AnswerverifiedShow Answer

Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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