Question 1

The Market Outlet is an all-equity financed firm with a beta of 1.08 and a cost of equity of 12.58 percent. The risk-free rate of return is 3.6 percent. What discount rate should the firm assign to a new project that has a beta of 1.22?

Accepted Answer

A)  13.33 percent 
B)  13.58 percent 
C)  13.74 percent 
D)  14.14 percent 
E)  14.36 percent

Question 2

Southern Bakeries just paid its annual dividend of $.48 a share. The stock has a market price of $17.23 and a beta of .93. The return on the U.S. Treasury bill is 3.1 percent and the market risk premium is 7.6 percent. What is the cost of equity?

Accepted Answer

A)  9.98 percent 
B)  10.04 percent 
C)  10.17 percent 
D)  10.30 percent 
E)  10.45 percent

Question 3

The discount rate assigned to an individual project should be based on:

Accepted Answer

A)  the company's overall weighted average cost of capital. 
B)  the actual sources of funding used for the project. 
C)  an average of the company's overall cost of capital for the past five years. 
D)  the current risk level of the overall firm. 
E)  the risks associated with the use of the funds required by the project.

Question 4

Travis & Sons has a capital structure that is based on 45 percent debt, 5 percent preferred stock, and 50 percent common stock. The pretax cost of debt is 8.3 percent, the cost of preferred is 9.2 percent, and the cost of common stock is 15.4 percent. The tax rate is 21 percent. A project is being considered that is equally as risky as the overall company. This project has initial costs of $287,000 and annual cash inflows of $91,000, $248,000, and $145,000 over the next three years, respectively. What is the projected net present value of this project?

Accepted Answer

A)  $116,667 
B)  $121,802 
C)  $99,011 
D)  $104,308 
E)  $101,488

Question 5

Jenner's is a multi-division firm that uses its overall WACC as the discount rate for all proposed projects. Each division is in a separate line of business and each presents risks unique to those lines. Given this, a division within the firm will tend to:

Accepted Answer

A)  receive less project funding if its line of business is riskier than that of the other divisions. 
B)  avoid risky projects so it can receive more project funding. 
C)  become less risky over time based on the projects that are accepted. 
D)  have an equal probability with all the other divisions of receiving funding. 
E)  prefer higher risk projects over lower risk projects.

Question 6

The subjective approach to project analysis:

Accepted Answer

A)  is used only when a firm has an all-equity capital structure. 
B)  uses the WACC of Firm X as the basis for the discount rate for a project under consideration by Firm Y. 
C)  assigns discount rates to projects based on the discretion of the senior managers of a firm. 
D)  allows managers to randomly adjust the discount rate assigned to a project once the project's standard deviation has been determined. 
E)  applies a lower discount rate to projects that are financed totally with equity as compared to those that are partially financed with debt.

Question 7

Dee's Toys has a target debt-equity ratio of .62. Its WACC is 11.3 percent and the tax rate is 21 percent. What is the cost of equity if the aftertax cost of debt is 6.3 percent?

Accepted Answer

A)  15.15 percent 
B)  15.04 percent 
C)  14.68 percent 
D)  14.79 percent 
E)  14.40 percent

Question 8

Jiminy's Cricket Farm issued a 20-year, 7 percent, semiannual bond four years ago. The bond currently sells for 108 percent of its face value. What is the aftertax cost of debt if the company's combined tax rate is 23 percent?

Accepted Answer

A)  4.96 percent 
B)  4.78 percent 
C)  4.15 percent 
D)  4.12 percent 
E)  3.86 percent

Question 9

Theresa's Flower Garden has 650 bonds outstanding that are selling for $1,007 each, 2,100 shares of preferred stock with a market price of $68 a share, and 42,000 shares of common stock valued at $44 a share. What weight should be assigned to the preferred stock when computing the weighted average cost of capital?

Accepted Answer

A)  6.08 percent 
B)  5.40 percent 
C)  6.67 percent 
D)  5.00 percent 
E)  5.75 percent

Question 10

The Well Derrick has 6.3 percent preferred stock outstanding that sells for $57 a share. This stock was originally issued at $45 per share and has a stated value of $100 per share. What is the cost of preferred stock if the relevant combined tax rate is 23 percent?

Accepted Answer

A)  11.22 percent 
B)  10.94 percent 
C)  10.45 percent 
D)  11.05 percent 
E)  11.37 percent

Question 11

Decline Inc. is trying to determine its cost of debt. The firm has a debt issue outstanding with 13 years to maturity that is quoted at 105.2 percent of face value. The issue makes semiannual payments and has an embedded cost of 6 percent annually. What is the aftertax cost of debt if the tax rate is 21 percent?

Accepted Answer

A)  4.30 percent 
B)  4.92 percent 
C)  4.17 percent 
D)  5.43 percent 
E)  5.58 percent

Question 12

A company's overall cost of equity is:

Accepted Answer

A)  generally less than its WACC given a debt-equity ratio of .5. 
B)  unaffected by changes in the market risk premium. 
C)  directly related to the risk level of the firm. 
D)  generally less than the firm's aftertax cost of debt. 
E)  inversely related to changes in the level of inflation.

Question 13

Delta Lighting has 24,500 shares of common stock outstanding at a market price of $19 a share. This stock was originally issued at $21 per share. The firm also has a bond issue outstanding with a total face value of $250,000 which is selling for 94 percent of par. The cost of equity is 12.6 percent while the aftertax cost of debt is 5.8 percent. The firm has a beta of 1.33 and a tax rate of 23 percent. What is the weighted average cost of capital?

Accepted Answer

A)  10.07 percent 
B)  10.32 percent 
C)  12.36 percent 
D)  11.29 percent 
E)  11.47 percent

Question 14

Which one of the following statements related to WACC is correct for a company that uses debt in its capital structure?

Accepted Answer

A)  The WACC would most likely decrease if the firm replaced its preferred stock with debt. 
B)  The weight assigned to preferred stock decreases as the market value of the preferred stock increases. 
C)  The WACC will decrease as the corporate tax rate decreases. 
D)  The weight of equity is based on the number of shares outstanding and the book value per share. 
E)  The WACC will remain constant unless a company retires some of its debt.

Question 15

Which one of the following is the primary determinant of a firm's cost of capital?

Accepted Answer

A)  Debt-equity ratio of any new funds raised 
B)  Marginal tax rate 
C)  Pretax cost of equity 
D)  Aftertax cost of equity 
E)  Use of the funds raised

Question 16

AZ Products has 140,000 shares of common stock outstanding at a market price of $27 a share. Next year's annual dividend is expected to be $1.43 a share and the dividend growth rate is 2 percent. The company also has 2,500 bonds outstanding with a face value of $1,000 per bond. The bonds have a pretax yield of 7.35 percent and sell at 98.2 percent of face value. The company's tax rate is 21 percent. What is the weighted average cost of capital?

Accepted Answer

A)  8.41 percent 
B)  6.71 percent 
C)  7.52 percent 
D)  6.58 percent 
E)  6.59 percent

Question 17

The cost of preferred stock:

Accepted Answer

A)  is equal to the dividend yield. 
B)  is equal to the yield to maturity. 
C)  is highly dependent on the dividend growth rate. 
D)  is independent of the stock's price. 
E)  decreases when tax rates increase.

Question 18

All else constant, which one of the following will increase a company's cost of equity if the company computes that cost using the security market line approach? Assume the firm currently pays an annual dividend of $1 a share and has a beta of 1.2.

Accepted Answer

A)  A reduction in the dividend amount 
B)  An increase in the dividend amount 
C)  A reduction in the market rate of return 
D)  A reduction in the firm's beta 
E)  A reduction in the risk-free rate

Question 19

Holdup Bank has an issue of preferred stock with a stated dividend of $7 that just sold for $87 per share. What is the bank's cost of preferred?

Accepted Answer

A)  7.00 percent 
B)  7.64 percent 
C)  8.39 percent 
D)  8.05 percent 
E)  7.54 percent

Question 20

Mullineaux Corporation has a target capital structure of 46 percent common stock, 5 percent preferred stock, and the balance in debt. Its cost of equity is 15.8 percent, the cost of preferred stock is 8.3 percent, and the aftertax cost of debt is 6.8 percent. What is the WACC given a tax rate of 23 percent?

Accepted Answer

A)  9.89 percent 
B)  10.43 percent 
C)  11.02 percent 
D)  11.38 percent 
E)  12.17 percent

Exam 14: Cost of Capital