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Exam 9: The Cost of Capital

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Question 41

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Which of the following statements is correct?

A) The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity.
B) The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average after-tax cost of all the firm's outstanding debt.
C) The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity.
D) The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm's cost of equity capital.

E) A) and D)
F) All of the above

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Question 42

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What is the best estimate of the WACC for CGT?

A) 9.88%
B) 10.18%
C) 10.50%
D) 11.14%

E) All of the above
F) A) and C)

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Question 43

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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?

Jackson Inc. uses only equity capital, and it has two equally sized divisions. Division A's cost of capital is 10.0%, Division B's cost is 14.0%, and the composite WACC is 12.0%. All of Division A's projects have the same risk, as do all of Division B's projects. However, the projects in Division A have less risk than those in Division B. Which of the following projects should Jackson accept?

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, rs, 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.

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.

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: - rRF = 4.00%; RPM = 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. (5) 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?

When working with the CAPM, which of the following factors can be determined with the most precision?

To help finance a major expansion, Delano Development Company sold a noncallable bond several years ago that now has 15 years to maturity. This bond has a 10.25% annual coupon, paid semiannually, it sells at a price of $1,025, and it has a par value of $1,000. If Delano's tax rate is 40%, what component cost of debt should be used in the WACC calculation?

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.

You were recently hired by Nast Media Inc. to estimate its cost of capital. You were provided with the following data: D1 = $2.00; P0 = $55.00; g = 8.00% (constant) ; and F = 5.00%. What is the cost of equity raised by selling new common stock?

For capital budgeting and cost of capital purposes, the firm should always consider retained earnings as the first source of capital, i.e., use these funds first, because retained earnings have no cost to the firm.

If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.

Suppose you are the president of a small, publicly traded corporation. Since you believe that your firm's share price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. Thus, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt.

Which of the following statements best describes WACC?

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.

Using the CAPM approach, what is the best estimate of the cost of equity for CGT?

Which of the following statements best describes cost of capital?