1. Your firm
is about to issue new, AA-rated bonds to finance an expansion project. This new
issue would double the amount of AA-rated publicly traded bonds the firm has
outstanding. Explain each of the ways might use to determine the cost of debt
for the project.
2. A firm is
considering a project that will generate perpetual cash flows of $15,000 per
year beginning next year. The project has the same risk as the firm's overall
operations and must be financed externally. Equity costs 14% and debt costs 4%
after-tax. The firm's debt/equity ratio is .8. What is the most the firm could
pay for the project and still earn its required return?
Advantages of using the SML approach as opposed to the dividend growth
approach to estimate the cost of equity include:
I. We must estimate the firm's equity beta
II. We can adjust for differences in risk
III. A firm need not maintain a constant growth rate in dividends
A) I only
B) II only
C) I and III only
D) II and III only
E) I, II,
4. For the
purpose of estimating the firm's cost of capital, one cannot look only at the
coupon rate on the firm's existing debt.
Which of the following is generally true about a firm's cost of debt?
A) It is easier to
calculate than the cost of equity
B) It is the
return creditors require on existing borrowing
C) It normally
cannot be observed directly, or indirectly, in the marketplace
D) It is greater
than the average coupon payments on outstanding debt
E) The cost
of debt based on its new borrowing is known as its embedded debt cost
Which of the following is NOT correct?
A) The WACC is
equal to the firm's embedded debt cost times (1 - the tax rate)
B) The WACC
requires the cost of debt be decreased by 1-tc
C) The WACC is not
directly observable in financial markets
D) The WACC is the
required return on any investments a firm makes that have a level of risk equal
to that of present operations
E) The WACC
represents the risk and target capital structure of a firm's existing assets as
7. To use
the _________ approach, we place projects into risk classes in order to assign
C) pure play
8. For a
profitable firm, an increase in its marginal tax rate will increase its weighted
average cost of capital.
Given the following information, what is the value of XYZ Corporation?
14,200,000 shares outstanding; price is $35 per share
Bond Issue 1:
$500,000,000 total face value; Selling for 102% of face value
Bond Issue 2:
$175,000,000 total face value; Selling for $850 per bond
10. In which of the
following cases would it most likely be appropriate to use the WACC that relates
to existing operations?
A) A pizza
delivery service is planning to expand by adding a sit-down pizza restaurant
B) A grocery store
owner is considering adding a bakery and a delicatessen to his store
C) A gas tank
manufacturer is contemplating switching to manufacturing tie-outs for dogs
D) A gas station
owner is considering adding a convenience store
manufacturer of garbage bags is considering expanding production capacity to
meet increasing demand
11. A firm has three
divisions. A capital budgeting request has just come through for Division C
showing a positive NPV at the firm's overall WACC. The financial manager of the
firm knows that Division C is the riskiest of the three divisions. The financial
A) deny the
request since it was computed in error
approve the request since it has a positive NPV
C) ask that the
NPV be recomputed at a cost of capital appropriate for the division
approve the request if neither of the other two divisions have any
capital budgeting projects with positive NPVs
subjectively reduce the NPV to reflect the difference in risk and then
accept the project if NPV is still positive
Topstone Industries' preferred stock pays an annual dividend of $4.00 per
share. When issued, the shares sold for their par value of $100 per share. What
is the cost of preferred stock if the current price is $125 per share?
Ignoring taxes, if a firm issues debt at par, then
I. the cost of the debt is equal to its coupon rate
II. the cost of the debt is equal to its yield-to-maturity
III. the cost of the debt differs from its current yield
A) I only
B) I and II only
C) II only
D) I and III only
E) I, II and
the following to answer question 14:
Kamp Supplies is considering an investment in new manufacturing equipment. The
equipment costs $220,000 and will provide annual after-tax inflows of $50,000 at
the end of each of the next 7 years. The firm's debt-to-equity (all market
values) ratio is 25%, its cost of equity is 14% and its pre-tax cost of debt is
7%. The firm's combined marginal federal and state tax rate is 40%. Assume the
project is of approximately the same risk as the firm.
What is the NPV of the proposed project?
Which of the following will always decrease a firm's cost of equity, as
computed using the SML approach?
I. A decrease in the pure time value of money
II. A decrease in the amount of systematic risk
III. A decrease in the reward for bearing systematic risk
A) I only
B) III only
C) II only
D) II and III only
E) I, II and
16. The cost of capital
I. is an opportunity cost that depends on the use of the funds, not the
II. is the same thing as the required rate of return
III. is the same as the WACC for projects with the same risk as the firm
as a whole
IV. is also known as the appropriate discount rate
A) I, II, and III
B) I, II, and IV
C) II, III, and IV
D) I, III, and IV
E) I, II,
III, and IV are all true
the following to answer question 17:
Psychiatric, Inc. needs to purchase office equipment for its 2000 drive-in
therapy centers nationwide. The total cost of the equipment is $2,000,000. It is
estimated that the after-tax cash inflows from the project will be $210,000
annually forever. Hartley has a debt-to-value (both market values) ratio of 40%.
The firm's cost of equity is 13% and its pre-tax cost of debt is 8%. Assume the
firm's tax rate is 34%.
What is Hartley's weighted average cost of capital?
Given the following information, what is JHM Corporation's WACC?
2 million shares outstanding
per share, $1 par value
80,000 bonds outstanding
face value for each bond
years to maturity
at 108.25% of face
Market risk premium:
Risk free rate: 5%
Tax rate: 34%
19. In general, for the
purpose of estimating the cost of preferred stock, one can ignore the current
level of common stock dividends.
Which of the following is NOT true regarding a firm's cost of debt?
A) The cost of
debt is the return the firm's creditors demand on new borrowing
B) The firm's cost
of debt based on its past borrowing is known as its embedded debt cost
C) It is possible
to determine a firm's cost of debt by using the SML
D) The coupon rate
on outstanding debt is not necessarily the firm's current cost of debt
E) A firm's
cost of equity is generally easier to calculate than the firm's cost of debt
question requires a simple recitation of the basics presented in section 12.3.
In brief, the firm can compute the yield on its already publicly traded debt or
it can observe the yields on recently issued bonds that have a similar rating to
those that are to be issued.