Question 1

There are two costs of debt finance. The explicit cost of debt is the rate of interest that bondholders demand. But there is also an implicit cost, because higher levels of debt increase the required rate of return to equity.

Accepted Answer

A) True 
 B)False

Question 2

Preferred stock should be ignored when computing a firm's weighted-average cost of capital.

Accepted Answer

A) True 
 B)False

Question 3

The weighted-average cost of capital for a firm with a 65/35 debt/equity split, 8% pre-tax cost of debt, 15% cost of equity, and a 35% tax rate would be:

Accepted Answer

A)  8.63%. 
B)  9.12%. 
C)  10.45%. 
D) 13.80%.

Question 4

How should the weighted-average cost of capital be applied to projects that are not average-risk projects?

Accepted Answer

The answer of How should the weighted-average cost of capital...

Question 5

The WACC is the rate of return that the firm must expect to earn on its average-risk investments in order to provide an acceptable return to its security holders.

Accepted Answer

A) True 
 B)False

Question 6

A firm's WACC:

Accepted Answer

A)  is the proper discount rate for every project the firm undertakes. 
B)  is used to value all of the firm's existing projects. 
C)  is a benchmark discount rate that is adjusted for the riskiness of each project. 
D) is an informational value only and should never be used as a discount rate.

Question 7

What is the WACC for a firm with 40% debt, 20% preferred stock, and 40% equity if the respective costs for these components are 6% after tax, 12% after tax, and 18% before tax? The firm's tax rate is 35%.

Accepted Answer

A)  9.48% 
B)  11.16% 
C)  12.00% 
D) 15.60%

Question 8

One way to check the accuracy of the expected return on bonds is to compare the expected return to the YTM on recently-issued bonds with similar characteristics and risks.

Accepted Answer

A) True 
 B)False

Question 9

A firm's cost of capital will generally increase if the firm lowers its debt-equity ratio.

Accepted Answer

A) True 
 B)False

Question 10

What percentage of value should be allocated to equity in WACC computations for a firm with $50 million in debt selling at 85% of par, $50 million in book value of equity, and $65 million in market value of equity?

Accepted Answer

A)  50.00% 
B)  54.18% 
C)  56.55% 
D) 60.47%

Question 11

A firm has issued $20 million in long-term bonds that now have 10 years remaining until maturity. The bonds carry an 8% annual coupon but are selling in the market for $877.10. The firm also has $45 million in market value of common stock. For cost of capital purposes, what portion of the firm is debt financed and what is the after-tax cost of debt, if the tax rate is 35%?

Accepted Answer

The answer of A firm has issued $20 million in...

Question 12

As a firm increases its debt ratio, debtholders are likely to demand higher rates of return.

Accepted Answer

A) True 
 B)False

Question 13

How do firms compute the weighted-average cost of capital?

Accepted Answer

The answer of How do firms compute the weighted-average cost...

Question 14

If a firm earns the WACC as an average return on its average-risk assets, then:

Accepted Answer

A)  equityholders will be satisfied, but bondholders will not. 
B)  bondholders will be satisfied, but equityholders will not. 
C)  all investors will earn their minimum required rate of return. 
D) the firm is investing in only positive NPV projects.

Question 15

If equity investors require a 20% rate of return, what is the maximum acceptable amount of equity financing for a project with $2 million annual cash flows before tax and interest, $3 million in debt with a 10% coupon, and a 35% tax rate?

Accepted Answer

A)  $5.53 million 
B)  $5.87 million 
C)  $8.5 million 
D) $9.03 million

Question 16

How are the costs of debt and equity calculated?

Accepted Answer

The answer of How are the costs of debt and...

Question 17

For most healthy firms, the YTM on their bonds is the rate of return investors expect from holding their bonds to maturity.

Accepted Answer

A) True 
 B)False

Question 18

Why can faulty decisions be made when all capital budgeting proposals are evaluated at the firm's current weighted average cost of capital?

Accepted Answer

The answer of Why can faulty decisions be made when...

Question 19

Should a project be accepted if it offers an annual after-tax cash flow of $1,250,000 indefinitely, costs $10 million, is riskier than the firm's average projects, and the firm's WACC is 12.5%?

Accepted Answer

A)  Yes, since the project's NPV is positive. 
B)  Yes, since a zero NPV indicates marginal acceptability. 
C)  No, since the project's NPV is zero. 
D) No, since the project's NPV is negative.

Question 20

Plasti-tech Inc. is financed 60% with equity and 40% with debt. Currently, its debt has a pretax interest rate of 12%. Plasti-tech's common stock trades at $15.00 per share and its most recent dividend was $1.00. Future dividends are expected grow by 4%. If the tax rate is 34%, what is Plasti-tech's WACC?

Accepted Answer

A)  7.39% 
B)  9.57% 
C)  9.73% 
D) 11.20%

Exam 13: The Weighted-Average Cost of Capital and Company Valuation

There are two costs of debt finance. The explicit cost of debt is the rate of interest that bondholders demand. But there is also an implicit cost, because higher levels of debt increase the required rate of return to equity.

Preferred stock should be ignored when computing a firm's weighted-average cost of capital.

The weighted-average cost of capital for a firm with a 65/35 debt/equity split, 8% pre-tax cost of debt, 15% cost of equity, and a 35% tax rate would be:

How should the weighted-average cost of capital be applied to projects that are not average-risk projects?

The WACC is the rate of return that the firm must expect to earn on its average-risk investments in order to provide an acceptable return to its security holders.

A firm's WACC:

What is the WACC for a firm with 40% debt, 20% preferred stock, and 40% equity if the respective costs for these components are 6% after tax, 12% after tax, and 18% before tax? The firm's tax rate is 35%.

One way to check the accuracy of the expected return on bonds is to compare the expected return to the YTM on recently-issued bonds with similar characteristics and risks.

A firm's cost of capital will generally increase if the firm lowers its debt-equity ratio.

What percentage of value should be allocated to equity in WACC computations for a firm with $50 million in debt selling at 85% of par, $50 million in book value of equity, and $65 million in market value of equity?

As a firm increases its debt ratio, debtholders are likely to demand higher rates of return.

How do firms compute the weighted-average cost of capital?

If a firm earns the WACC as an average return on its average-risk assets, then:

If equity investors require a 20% rate of return, what is the maximum acceptable amount of equity financing for a project with $2 million annual cash flows before tax and interest, $3 million in debt with a 10% coupon, and a 35% tax rate?

How are the costs of debt and equity calculated?

For most healthy firms, the YTM on their bonds is the rate of return investors expect from holding their bonds to maturity.

Why can faulty decisions be made when all capital budgeting proposals are evaluated at the firm's current weighted average cost of capital?

Should a project be accepted if it offers an annual after-tax cash flow of $1,250,000 indefinitely, costs $10 million, is riskier than the firm's average projects, and the firm's WACC is 12.5%?