CHAPTER 12

        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?

        A)        $138,000

        B)        $156,000

        C)        $164,000

        D)        $182,000

        E)        $199,000

        3.        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, and III

        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.

        A)    True

        B)    False

        5.        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

        6.        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 a whole

        7.     To use the _________ approach, we place projects into risk classes in order to assign discount rates.

        A)        subjective

        B)        capital analysis

        C)    pure play

        D)    SML

        E)     yield play

        8.     For a profitable firm, an increase in its marginal tax rate will increase its weighted average cost of capital.

        A)    True

        B)    False

        9.        Given the following information, what is the value of XYZ Corporation?

                Common Stock:        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

        A)        $697.52 million

        B)        $874.82 million

        C)        $987.24 million

        D)        $1,049.43 million

        E)        $1,155.75 million

        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

        E)     A 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 manger should

        A)    deny the request since it was computed in error

        B)        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

        D)        approve the request if neither of the other two divisions have any capital budgeting projects with positive NPVs

        E)        subjectively reduce the NPV to reflect the difference in risk and then accept the project if NPV is still positive

        12.        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?

        A)        3.2%

        B)        3.7%

        C)        4.0%

        D)        4.7%

        E)        31.3%

        13.        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 III

Use the following to answer question 14:

Kottinger's 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.

        14.        What is the NPV of the proposed project?

        A)        $6,297

        B)        $7,899

        C)        $9,156

        D)        $13,436

        E)        $15,984

        15.        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 III

        16.   The cost of capital

                I. is an opportunity cost that depends on the use of the funds, not the source

                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 are true

        B)    I, II, and IV are true

        C)    II, III, and IV are true

        D)    I, III, and IV are true

        E)     I, II, III, and IV are all true

Use the following to answer question 17:

Hartley 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%.

        17.        What is Hartley's weighted average cost of capital?

        A)        6.09%

        B)        8.73%

        C)        8.95%

        D)        9.05%

        E)        9.91%

        18.        Given the following information, what is JHM Corporation's WACC?

                Common Stock:      2 million shares outstanding

                        $30 per share, $1 par value

                        b = .5

                Bonds:        80,000 bonds outstanding

                        $1,000 face value for each bond

                        7% annual coupon

                        10 years to maturity

                        Selling at 108.25% of face

                Market risk premium:        7%

                Risk free rate:   5%

                Tax rate:  34%

        A)        5.77%

        B)        6.54%

        C)        7.90%

        D)        7.97%

        E)        9.61%

        19.   In general, for the purpose of estimating the cost of preferred stock, one can ignore the current level of common stock dividends.

        A)    True

        B)    False

        20.        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

Answer Key

        1.     This 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.

        2.     B     

        3.     D    

        4.     A    

        5.     A    

        6.     A    

        7.     A    

        8.     B     

        9.     E     

        10.   E     

        11.   C    

        12.   A    

        13.   B     

        14.   B     

        15.   D    

        16.   E     

        17.   E     

        18.   A    

        19.   A