Question 1

Exhibit 10.1
Assume that you have been hired as a consultant by CGT,a major producer of chemicals and plastics,including plastic grocery bags,styrofoam cups,and fertilizers,to estimate the firm's weighted average cost of capital.The balance sheet and some other information are provided below.
Assets   Current assets $38,000,000 Net plant, property, and equipment $101,000,000 Total assets $139,000,000\begin{array}{lr}	ext { Current assets } & \$ 38,000,000 \	ext { Net plant, property, and equipment } & \$ 101,000,000 \	ext { Total assets } & \$ 139,000,000\end{array} Current assets  Net plant, property, and equipment  Total assets ​$38,000,000$101,000,000$139,000,000​  ​
Liabilities and Equity   Accounts payable $10,000,000 Accruals $9,000,000 Current liabilities $19,000,000 Long-term debt ( 40,000 bonds, $1,000 par value)  $40,000,000 Total liabilities $59,000,000 Common stock ( 10,000,000 shares)  $30,000,000 Retained earnings $50,000,000 Total shareholders’ equity $80,000,000 Total liabilities and sharehol ders’ equity $139,000,000\begin{array}{lr}	ext { Accounts payable } & \$ 10,000,000 \	ext { Accruals } & \$ 9,000,000 \	ext { Current liabilities } & \$ 19,000,000 \	ext { Long-term debt ( } 40,000 	ext { bonds, } \$ 1,000 	ext { par value)  } & \$ 40,000,000 \	ext { Total liabilities } & \$ 59,000,000 \	ext { Common stock ( } 10,000,000 	ext { shares)  } & \$ 30,000,000 \	ext { Retained earnings } & \$ 50,000,000 \	ext { Total shareholders&#x27; equity } & \$ 80,000,000 \	ext { Total liabilities and sharehol ders&#x27; equity } & \$ 139,000,000 \\hline\end{array} Accounts payable  Accruals  Current liabilities  Long-term debt ( 40,000 bonds, $1,000 par value)   Total liabilities  Common stock ( 10,000,000 shares)   Retained earnings  Total shareholders’ equity  Total liabilities and sharehol ders’ equity ​$10,000,000$9,000,000$19,000,000$40,000,000$59,000,000$30,000,000$50,000,000$80,000,000$139,000,000​​  The stock is currently selling for $17.75 per share,and its noncallable $3,319.97 par value,20-year,1.70% bonds with semiannual payments are selling for $881.00.The beta is 1.29,the yield on a 6-month Treasury bill is 3.50%,and the yield on a 20-year Treasury bond is 5.50%.The required return on the stock market is 11.50%,but the market has had an average annual return of 14.50% during the past 5 years.The firm's tax rate is 40%.
-Refer to Exhibit 10.1.What is the best estimate of the after-tax cost of debt?

Accepted Answer

A)   5.62%
B)   6.07%
C)   6.39%
D)   6.77%
E)   7.11% F) A) and B)
G) B) and E)

Question 2

Which of the following statements is CORRECT?

Accepted Answer

A)   The WACC is calculated using before-tax costs for all components.
B)   The after-tax cost of debt usually exceeds the after-tax cost of equity.
C)   For a given firm,the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock.
D)   Retained earnings that were generated in the past and are reported on the firm's balance sheet are available to finance the firm's capital budget during the coming year.
E)   The WACC that should be used in capital budgeting is the firm's marginal,after-tax cost of capital.F) None of the above
G) A) and B)

Question 3

Daves Inc.recently hired you as a consultant to estimate the company's WACC.You have obtained the following information.(1) The firm's noncallable bonds mature in 20 years,have an 8.00% annual coupon,a par value of $1,000,and a market price of $1,225.00.(2) The company's tax rate is 40%.(3) The risk-free rate is 4.50%,the market risk premium is 5.50%,and the stock's beta is 1.20.(4) The target capital structure consists of 35% debt and the balance is common equity.The firm uses the CAPM to estimate the cost of equity,and it does not expect to issue any new common stock.What is its WACC? Do not round your intermediate calculations.

Accepted Answer

A)   8.48%
B)   10.01%
C)   7.80%
D)   6.79%
E)   7.63%F) All of the above
G) A) and C)

Question 4

The cost of external equity capital raised by issuing new common stock (re)is defined as follows,in words: "The cost of external equity equals the cost of equity capital from retaining earnings (rs),divided by one minus the percentage flotation cost required to sell the new stock, (1 - F)."

Accepted Answer

A) True 
 B)False

Question 5

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock.No adjustment is needed for taxes because preferred dividends,unlike interest on debt,are not deductible by the issuing firm.

Accepted Answer

A) True 
 B)False

Question 6

If a firm is privately owned,and its stock is not traded in public markets,then we cannot measure its beta for use in the CAPM model,we cannot observe its stock price for use in the DCF model,and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method.All this makes it especially difficult to estimate the cost of equity for a private company.

Accepted Answer

A) True 
 B)False

Question 7

For a company whose target capital structure calls for 50% debt and 50% common equity,which of the following statements is CORRECT?

Accepted Answer

A)   The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet.
B)   The WACC is calculated on a before-tax basis.
C)   The WACC exceeds the cost of equity.
D)   The cost of equity is always equal to or greater than the cost of debt.
E)   The cost of retained earnings typically exceeds the cost of new common stock.F) B) and D)
G) C) and D) D

Question 8

Suppose the debt ratio is 50%,the interest rate on new debt is 8%,the current cost of equity is 16%,and the tax rate is 40%.An increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC).

Accepted Answer

A) True 
 B)False

Question 9

"Capital" is sometimes defined as funds supplied to a firm by investors.

Accepted Answer

A) True 
 B)False

Question 10

The reason why retained earnings have a cost equal to rs is because investors think they can (i.e. ,expect to)earn rs on investments with the same risk as the firm's common stock,and if the firm does not think that it can earn rs on the earnings that it retains,it should pay those earnings out to its investors.Thus,the cost of retained earnings is based on the opportunity cost principle.

Accepted Answer

A) True 
 B)False

Question 11

Which of the following statements is CORRECT?

Accepted Answer

A)   When calculating the cost of debt,a company needs to adjust for taxes,because interest payments are deductible by the paying corporation.
B)   When calculating the cost of preferred stock,companies must adjust for taxes,because dividends paid on preferred stock are deductible by the paying corporation.
C)   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.
D)   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 retained earnings to take care of its equity financing and hence must issue new stock.
E)   Higher flotation costs reduce investors' expected returns,and that leads to a reduction in a company's WACC.F) A) and D)
G) A) and B)

Question 12

Safeco Company and Risco Inc are identical in size and capital structure.However,the riskiness of their assets and cash flows are somewhat different,resulting in Safeco having a WACC of 10% and Risco a WACC of 12%.Safeco is considering Project X,which has an IRR of 10.5% and is of the same risk as a typical Safeco project.Risco is considering Project Y,which has an IRR of 11.5% and is of the same risk as a typical Risco project.
Now assume that the two companies merge and form a new company,Safeco/Risco Inc.Moreover,the new company's market risk is an average of the pre-merger companies' market risks,and the merger has no impact on either the cash flows or the risks of Projects X and Y.Which of the following statements is CORRECT?

Accepted Answer

A)   If the firm evaluates these projects and all other projects at the new overall corporate WACC,it will probably become riskier over time.
B)   If evaluated using the correct post-merger WACC,Project X would have a negative NPV.
C)   After the merger,Safeco/Risco would have a corporate WACC of 11%.Therefore,it should reject Project X but accept Project Y.
D)   Safeco/Risco's WACC,as a result of the merger,would be 10%.
E)   After the merger,Safeco/Risco should select Project Y but reject Project X.If the firm does this,its corporate WACC will fall to 10.5%.F) A) and E)
G) A) and B)

Question 13

Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets.They then provide funds to their different divisions for investment in capital projects.The divisions may vary in risk,and the projects within the divisions may also vary in risk.Therefore,it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.

Accepted Answer

A) True 
 B)False

Question 14

The CFO of Lenox Industries hired you as a consultant to help estimate its cost of capital.You have obtained the following data: (1) rd = yield on the firm's bonds = 7.00% and the risk premium over its own debt cost = 4.00%.(2) rRF = 5.00%,RPM = 6.00%,and b = 1.50.(3) D1 = $1.20,P0 = $35.00,and g = 8.00% (constant) .You were asked to estimate the cost of equity based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates.What is that difference?

Accepted Answer

A)   3.00%
B)   3.54%
C)   2.61%
D)   3.72%
E)   2.67%F) B) and C)
G) A) and B) A

Question 15

When estimating the cost of equity by use of the DCF method,the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return.This problem leaves us unsure of the true value of rs.

Accepted Answer

A) True 
 B)False

Question 16

Which of the following statements is CORRECT?

Accepted Answer

A)   When calculating the cost of preferred stock,a company needs to adjust for taxes,because preferred stock dividends are deductible by the paying corporation.
B)   All else equal,an increase in a company's stock price will increase its marginal cost of retained earnings,rs.
C)   All else equal,an increase in a company's stock price will increase its marginal cost of new common equity,re.
D)   Since the money is readily available,the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt.
E)   If a company's tax rate increases but the YTM on its noncallable bonds remains the same,the after-tax cost of its debt will fall.F) A) and B)
G) D) and E)

Question 17

The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

Accepted Answer

A) True 
 B)False  False

Question 18

When estimating the cost of equity by use of the CAPM,three potential problems are (1)whether to use long-term or short-term rates for rRF, (2)whether or not the historical beta is the beta that investors use when evaluating the stock,and (3)how to measure the market risk premium,RPM.These problems leave us unsure of the true value of rs.

Accepted Answer

A) True 
 B)False

Question 19

You were recently hired by Scheuer Media Inc.to estimate its cost of capital.You obtained the following data: D1 = $1.75;P0 = $115.00;g = 7.00% (constant) ;and F = 5.00%.What is the cost of equity raised by selling new common stock?

Accepted Answer

A)   9.98%
B)   10.49%
C)   8.52%
D)   8.60%
E)   7.05%F) A) and B)
G) A) and C)

Question 20

You were hired as a consultant to Giambono Company,whose target capital structure is 40% debt,15% preferred,and 45% 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 12.00%.The firm will not be issuing any new stock.What is its WACC?

Accepted Answer

A)   8.93%
B)   7.59%
C)   6.96%
D)   7.68%
E)   6.69%F) A) and D)
G) C) and D)

Exam 10: The Cost of Capital

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Which of the following statements is CORRECT?

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The cost of external equity capital raised by issuing new common stock (r_e)is defined as follows,in words: "The cost of external equity equals the cost of equity capital from retaining earnings (r_s),divided by one minus the percentage flotation cost required to sell the new stock, (1 - F)."

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The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock.No adjustment is needed for taxes because preferred dividends,unlike interest on debt,are not deductible by the issuing firm.

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For a company whose target capital structure calls for 50% debt and 50% common equity,which of the following statements is CORRECT?

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D

Suppose the debt ratio is 50%,the interest rate on new debt is 8%,the current cost of equity is 16%,and the tax rate is 40%.An increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC).

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"Capital" is sometimes defined as funds supplied to a firm by investors.

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Which of the following statements is CORRECT?

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A

When estimating the cost of equity by use of the DCF method,the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return.This problem leaves us unsure of the true value of r_s.

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Which of the following statements is CORRECT?

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The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

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False

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You were recently hired by Scheuer Media Inc.to estimate its cost of capital.You obtained the following data: D₁ = $1.75;P₀ = $115.00;g = 7.00% (constant) ;and F = 5.00%.What is the cost of equity raised by selling new common stock?

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Exam 10: The Cost of Capital

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

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The cost of external equity capital raised by issuing new common stock (re)is defined as follows,in words: "The cost of external equity equals the cost of equity capital from retaining earnings (rs),divided by one minus the percentage flotation cost required to sell the new stock, (1 - F)."

Correct AnswerverifiedShow Answer

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock.No adjustment is needed for taxes because preferred dividends,unlike interest on debt,are not deductible by the issuing firm.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

For a company whose target capital structure calls for 50% debt and 50% common equity,which of the following statements is CORRECT?

Correct AnswerverifiedD

Suppose the debt ratio is 50%,the interest rate on new debt is 8%,the current cost of equity is 16%,and the tax rate is 40%.An increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC).

Correct AnswerverifiedShow Answer

"Capital" is sometimes defined as funds supplied to a firm by investors.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedA

When estimating the cost of equity by use of the DCF method,the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return.This problem leaves us unsure of the true value of rs.

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

Correct AnswerverifiedFalse

Correct AnswerverifiedShow Answer

You were recently hired by Scheuer Media Inc.to estimate its cost of capital.You obtained the following data: D1 = $1.75;P0 = $115.00;g = 7.00% (constant) ;and F = 5.00%.What is the cost of equity raised by selling new common stock?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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The cost of external equity capital raised by issuing new common stock (r_e)is defined as follows,in words: "The cost of external equity equals the cost of equity capital from retaining earnings (r_s),divided by one minus the percentage flotation cost required to sell the new stock, (1 - F)."

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D

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A

When estimating the cost of equity by use of the DCF method,the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return.This problem leaves us unsure of the true value of r_s.

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False

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You were recently hired by Scheuer Media Inc.to estimate its cost of capital.You obtained the following data: D₁ = $1.75;P₀ = $115.00;g = 7.00% (constant) ;and F = 5.00%.What is the cost of equity raised by selling new common stock?

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