ch13 Fin303

Format: True/False
Learning Objective: LO 1
Level of Difficulty: Easy
1. Unique risk is the only risk that investors require compensation for bearing.
A) True
B) False
Ans: A
Format: True/False
2. Utilizing the CAPM to estimate the cost of capital for a project is difficult in practice
because analysts do not have the stock returns from individual projects that are
necessary to use in a regression analysis for estimating a project's beta.
A) True
B) False
Ans: B
Format: True/False
Level of Difficulty: Medium
3. Using the firm's overall cost of capital to evaluate a project's cash flows is problematic
in that the firm is a collection of projects, with the possibility that each project has a
different level of risk than the other projects currently working for the firm.
A) True
B) False
Ans: A
Format: True/False
4. If a firm finances the purchase of an asset with cash, then it has zero financial cost to
the firm.
A) True
B) False
Ans: B
Format: True/False
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5. The finance balance sheet is based on market values, just like the accounting balance
sheet.
A) True
B) False
Ans: B
Format: True/False
6. If the market value of a firm's assets are greater than the book value of a firm's assets
then the book value of the firm's liabilities and equity must be less than the market
value of the firm's liabilities and equity.
A) True
B) False
Ans: A
Format: True/False
7. The beta of the firm is equal to the weighted-average sum of the betas of the individual
projects that the firm is currently operating.
A) True
B) False
Ans: A
Format: True/False
8. Due to the magic of diversification, the risk associated with the assets of the firm must
be less than the risk associated with the financing, or debt and equity, that the firm is
utilizing for its assets.
A) True
B) False
Ans: B
Format: True/False
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9. A firm is currently taking on two projects with an individual cost of capital of 10
percent and 12 percent for each of the projects. That means that the before-tax cost of
capital for the firm must be between 10 and 12 percent.
A) True
B) False
Ans: B
Format: True/False
10. If one observes the market quoted price of a debt security where the expected cash
flows of that security are known, then one can calculate the current cost of that security
to the firm.
A) True
B) False
Ans: A
Format: True/False
11. Estimates of security returns will be reliable in all types of markets, including those
deemed less efficient than others.
A) True
B) False
Ans: B
Format: True/False
12. Long-term debt typically describes debt that will mature in two years or more.
A) True
B) False
Ans: A
Format: True/False
13. Long-term debt is generally viewed as a permanent financing source for the firm.
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A) True
B) False
Ans: A
Format: True/False
14. With respect to the cost of capital, we are generally interested in the cost of a source of
financing on a particular date.
A) True
B) False
Ans: A
Format: True/False
15. If a firm is interested in the current cost of its debt obligations, then it can simply look
at the contractual rate of interest due lenders on those obligations.
A) True
B) False
Ans: B
Format: True/False
16. Milton Corp. issued bonds 10 years ago with a coupon rate of 10 percent at a price of
$1,000. The current price of the bonds is $980. The before-tax cost of the debt to the
firm is still 10 percent.
A) True
B) False
Ans: B
Format: True/False
17. The yield to maturity for a semiannual coupon paying bond will accurately reflect the
actual current annual cost of the debt.
A) True
B) False
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Ans: A
Format: True/False
18. The yield to maturity for an annual coupon paying bond will accurately reflect the
actual current annual pretax cost of the debt.
A) True
B) False
Ans: A
Format: True/False
19. The current cost of bank debt can be determined by asking the firm's banker.
A) True
B) False
Ans: A
Format: True/False
20. The issuance costs of new debt securities can be ignored since those costs will not be
reflected in the yield to maturity of the debt in the future.
A) True
B) False
Ans: B
Format: True/False
21. If a firm is subject to income taxes, then the after-tax cost of debt for the firm will be
less than the before-tax cost of debt.
A) True
B) False
Ans: A
Format: True/False
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22. The cost of equity for the firm must take the cost of preferred stock (if any has been
issued) that the firm has outstanding into account.
A) True
B) False
Ans: A
Format: True/False
23. The correct Treasury rate to use in calculating the cost of equity (when using the
CAPM) for a firm is a short-term rate.
A) True
B) False
Ans: B
Format: True/False
24. When trying to estimate the cost of equity for a firm using the CAPM, it is possible to
find the beta of a comparable, publicly traded firm whose primary business is closely
related to the firm at hand.
A) True
B) False
Ans: A
Format: True/False
25. The market risk premium for the future is always perfectly known, and it is 6.51
percent.
A) True
B) False
Ans: B
Format: True/False
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26. If a firm is currently paying common share dividends to investors and those dividends
are expected to grow at a low but steady rate in the future, then the cost of common
equity for the firm can be determined by also using the current price of the firm's
common shares.
A) True
B) False
Ans: A
Format: True/False
27. The current cost of preferred equity can be found by taking the ratio of the dividend to
the current price of preferred shares.
A) True
B) False
Ans: A
Format: True/False
28. The CAPM can only be used to determine the cost of common equity.
A) True
B) False
Ans: B
Format: True/False
29. The proportions of debt and equity used to determine the weighted average cost of
capital for the firm is based on the market value of debt and equity outstanding.
A) True
B) False
Ans: A
Format: True/False
30. The correctly calculated weighted-average cost of capital for the firm can be used to
discount the cash flows for any new project that the firm may undertake in the future.
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A) True
B) False
Ans: B
Format: True/False
31. The estimated cost of capital financial managers use for efficiency projects tends to be
higher than the cost of capital used to evaluate new projects.
A) True
B) False
Ans: B
Format: True/False
32. When using a single rate, such as the WACC, to discount cash flows for all projects of a
particular company, the discount rate could lead to accepting projects that will actually have
a negative NPV.
A) True
B) False
Ans: A
Format: Multiple Choice
33. Firms have no way to directly estimate the discount rate that reflects the risk of
A) a publicly traded security.
B) its debt securities.
C) the incremental cash flows from a particular project.
D) none of the above.
Ans: C

34. A firm's overall cost of capital is
A) equal to its cost debt.
B) a weighted average of the costs of capital for the collection of individual projects
that the firm is working on.
C) best measured by the cost of capital of the riskiest projects that the firm is
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working on.
Ans: B

35. The finance balance sheet is
A) the same as the accounting balance sheet, but it is based on market values.
B) the same as the accounting balance sheet, but it does not have to balance.
C) based on cash rather than accrual accounting.
D) net income.
Ans: A

36. The value of the cash flows that the assets of the firm are expected to generate must
equal
A) the value of the cash flows claimed by the equity investors.
B) the value of the cash flows claimed by the debt investors.
C) the value of the cash flows claimed by both the equity and debt investors.
D) the revenue produced by the firm.
Ans: C

37. The beta for a firm can be estimated by
A) adding up the betas of the individual projects of the firm.
B) taking the weighted average of the beta for the individual projects of the firm.
C) taking the simple average of the beta for the individual projects of the firm.
D) None of the above.
Ans: B

38. The firm can be viewed as
A) a portfolio of individual projects, each with their own risks, cost of capital, and
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returns.
B) a collection of equity shares comprising it.
C) a collection of debt instruments financing it.
Ans: A

39. In order for a firm to estimate its cost of debt capital by observing the price of its debt
instruments,
A) the firm must depend on markets being reasonably efficient.
B) the debt must be privately held.
C) the beta of the debt must be greater than the beta of the firm's equity.
D) None of the above.
Ans: A

40. If markets are not reasonably efficient, then
A) the estimates of expected returns are not needed.
B) the need for a discount rate to analyze project cash flows is not needed.
C) estimates of expected returns that were based on security prices will not be
reliable.
Ans: C

41. When estimating the cost of debt capital for the firm, we are primarily interested in
A) the cost of short-term debt.
B) the cost of long-term debt.
C) the coupon rate of the debt.
Ans: B

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42. Long-term debt typically describes
A) debt with a maturity greater than one year.
B) only coupon debt.
C) publicly traded debt.
Ans: A

43. Which of the following need to be excluded from the calculation of the firm's amount
of permanent debt?
A) Long-term debt
B) Revolving lines of credit
C) Mortgage debt
D) None of the above
Ans: B

44. When analyzing a firm's cost of debt, we are typically interested in
A) the cost of the debt on the date that the analysis is being completed.
B) the coupon rate on the firm's bonds.
C) the risk-free rate plus half a percent.
Ans: A

45. If a firm has bonds outstanding and the firm would like to calculate the current cost of
debt for the bonds, then the firm would
A) use the coupon rate of the bonds to estimate the cost.
B) use the current yield to maturity of the bonds to estimate the cost.
C) use the current coupon yield of the bonds to estimate the cost.
Ans: B
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46. A bond has a coupon rate of 6 percent and the bond makes semiannual coupon
payments. The dollar amount of coupon interest received every six months is
A) $60.
B) $30.
C) $30 plus or minus the prorate portion of the discount or premium that the bond
was purchased for.
Ans: B

47. Bond issuance costs include
A) investment banking fees.
B) legal fees.
C) accountant fees.
D) all of the above.
Ans: D

48. Income taxes have the effect of
A) increasing the cost of debt.
B) decreasing the cost of debt.
C) decreasing the cost of capital for the firm.
D) both b and c are correct.
Ans: B

49. The appropriate risk-free rate to use when calculating the cost of equity for a firm is
A) a long-term Treasury rate.
B) a short-term Treasury rate.
C) a 50/50 mix of short-term and long-term Treasury rates.
Ans: A
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50. The average risk-premium for the market from 1926 to 2009 was
A) 8.00%.
B) 7.50%.
C) 6.01%.
D) 6.51% + the Treasury rate.
Ans: C

51. The recommended model to estimate the cost of common equity for a firm is
A) a one-stage constant growth model.
B) a multistage growth model.
C) the CAPM.
Ans: C

Level of Difficulty: Hard
52. In order to use the WACC to evaluate a future project's flows, which of the following
must hold?
A) The project will be financed with the same proportion of debt and equity as the
firm.
B) The systematic risk of the project is the same as the overall systematic risk of the
firm.
C) The project must be viable.
D) a and b above.
Ans: D

53. Overall cost of capital: If the market risk premium is currently 6 percent and the risk-
free rate of return is 4 percent, then what is the expected return on a common share with
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a beta equal to 2?
A) 8.0%
B) 10.0%
C) 12.0%
D) 16.0%
Ans: D
Feedback:
E(Ri) = Rrf + bi [E(Rm) – Rrf] = 0.04 + 2.0 [0.06] = 0.04 + 0.12 = 0.16

54. Overall cost of capital: What is the beta of a firm whose equity has an expected return
of 21.3 percent when the risk-free rate of return is 7.0 percent and the expected return
on the market is 18.0 percent?
A) 0.79
B) 1.30
C) 1.57
D) none of the above
Ans: B
Feedback:
E(Ri) = Rrf + bi [E(Rm) – Rrf] ==> 0.213 = 0.07 + bi [0.18 – 0.07] ==> bi= 1.30

55. Overall cost of capital: Stryder, Inc., has 3 million shares outstanding at a current
price of $15 per share. The book value of the shares is $10 per share. The firm also has
$30 million in par value of bonds outstanding. The bonds are selling at a price equal to
101 percent of par. What is the market value of the firm?
A) $30.0 million
B) $45.0 million
C) $75.0 million
D) $75.3 million
Ans: D
Feedback:
MV of assets = MV of liabilities + MV of equity
= (1.01 x $30,000,000) + (3,000,000 x 15)
= $75,300,000
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56. How firms estimate their cost of capital: The Diverse Co. has invested 40 percent of
the firm's assets in a project with a beta of 0.4 and the remaining assets in a project with
a beta of 1.8. What is the beta of the firm?
A) 0.96
B) 1.24
C) 1.28
D) None of the above
Ans: B
Feedback:
2
b n Asset portfolio = �xi bi = 0.4(0.4) + 0.6(1.8) = 1.24
i =1

57. How firms estimate their cost of capital: You are analyzing the cost of capital for a
firm that is financed with 65 percent equity and 35 percent debt. The cost of debt
capital is 8 percent, while the cost of equity capital is 20 percent for the firm. What is
the overall cost of capital for the firm?
A) 12.2%
B) 14.0%
C) 15.8%
D) 20.0%
Ans: C
Feedback:
kFirm = xDebt kDebt + xEquity kEquity = (0.35 x 0.08) + (0.65 x 0.2) = 0.158

58. How firms estimate their cost of capital: You are analyzing the cost of capital for a
firm that is financed with $300 million of equity and $200 million of debt. The cost of
debt capital for the firm is 9 percent, while the cost of equity capital is 19 percent. What
is the overall cost of capital for the firm?
A) 13.0%
B) 14.0%
C) 15.0%
D) 16.0%
Ans: C
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Feedback:
xDebt = 200/500 = 0.4, xEquity = 300/500 = 0.6
kFirm = xDebt kDebt + xEquity kEquity = (0.4 x 0.09) + (0.6 x 0.19) = 0.15

59. How firms estimate their cost of capital: The WACC for a firm is 19.75 percent. You
know that the firm is financed with $75 million of equity and $25 million of debt. The
cost of debt capital is 7 percent. What is the cost of equity for the firm?
A) 19.75%
B) 24.00%
C) 32.50%
D) 58.00%
Ans: B
Feedback:
xDebt = 25/100 = 0.25, xEquity = 75/100 = 0.75
kFirm = xDebt kDebt + xEquity kEquity ==> .1975 = (0.25 x 0.07) + (0.75 x kEquity) ==>
kEquity = 0.2400

60. How firms estimate their cost of capital: The WACC for a firm is 13.00 percent. You
know that the firm's cost of debt capital is 10 percent and the cost of equity capital is
20%. \ What proportion of the firm is financed with debt?
A) 30%
B) 33%
C) 50%
D) 70%
Ans: D
Feedback:
xDebt = Y, xEquity = (1 – Y)
kFirm = xDebt kDebt + xEquity kEquity ==> 0.13= (Y x 0.1) + ((1 – Y) x 0.20) ==>
Y = 0.7

61. The cost of debt: Bellamee, Inc., has semiannual bonds outstanding with five years to
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maturity and are priced at $920.87. If the bonds have a coupon rate of 7 percent, then
what is the YTM for the bonds?
A) 4.5%
B) 7.0%
C) 9.0%
D) 9.2%
Ans: C
Feedback:
Using the formula for pricing bonds, we have
$920.87 = $35 x PVIFA(YTM / 2,10) + $1, 000 x PVIF (YTM / 2,10)
and after solving for YTM / 2 = 4.5%, we find that YTM = 9.0%.
Note that we assume semi - annual coupons for the bond .

62. The cost of debt: Dynamo Corporation has semiannual bonds outstanding with 12
years to maturity and are currently priced at $1,080.29. If the bonds have a coupon rate
of 8 percent, then what is the equivalent annual return (EAR) to the investor for
purchasing the bonds at the described price?
A) 3.5%
B) 7.00%
C) 7.12%
D) 8.00%
Ans: C
Feedback:
$1, 080.29 = $40 x PVIFA(YTM / 2, 24) + $1, 000 x PVIF (YTM / 2, 24)

0.07 2
Now, we adjust for EAR : (1 + ) - 1 = 0.0712 = 7.12%
2

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63. The cost of debt: Beckham Corporation has semiannual bonds outstanding with 13
years to maturity and are currently priced at $746.16. If the bonds have a coupon rate of
8.5 percent, then what is the after-tax cost of debt for Beckham if its marginal tax rate is
35%? Assume that your calculation is made as on Wall Street.
A) 6.250%
B) 8.125%
C) 12.500%
D) 12.890%
Ans: B
Feedback:
$746.16 = $42.50 x PVIFA(YTM / 2, 26) + $1, 000 x PVIF (YTM / 2, 26)
Now, we adjust taxes :12.50% x (1 - 0.35) = 8.125%

64. The cost of debt: PackMan Corporation has semiannual bonds outstanding with nine
years to maturity and are currently priced at $754.08. If the bonds have a coupon rate of
7.25 percent, then what is the after-tax cost of debt for Beckham if its marginal tax rate
is 30 percent? Complete the calculation as is done on Wall Street.
A) 7.050%
B) 8.225%
C) 11.750%
D) 12.095%
Ans: A
Feedback:
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$754.08 = $36.25 x PVIFA(YTM / 2,18) + $1, 000 x PVIF (YTM / 2,18)
Now, we adjust taxes :11.75% x (1 - 0.3) = 8.225%

65. The cost of equity: Jacque Ewing Drilling, Inc., has a beta of 1.3 and is trying to
calculate its cost of equity capital. If the risk-free rate of return is 8 percent and the
expected return on the market is 12 percent, then what is the firm's after-tax cost of
equity capital if the firm's marginal tax rate is 40 percent?
A) 7.92%
B) 13.20%
C) 15.57%
D) 23.60%
Ans: B
Feedback:
The equation for the CAPM is : E ( Ri ) = Rrf + bi � �E ( Rm ) - Rrf �
.
�
If b i = 1.3, Rrf = 0.08, and E ( Rm ) = 0.12, then we have
E ( Ri ) = 0.08 + 1.3 [ 0.08 - 0.12] = 0.132 = 13.20%

66. The cost of equity: TeleNyckel, Inc., has a beta of 1.4 and is trying to calculate its cost
of equity capital. If the risk-free rate of return is 9 percent and the market risk premium
is 5 percent, then what is the firm's after-tax cost of equity capital if the firm's marginal
tax rate is 30 percent?
A) 11.20%
B) 10.60%
C) 15.14%
D) 16.00%
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Ans: D
Feedback:
The equation for the CAPM is : E ( Ri ) = Rrf + bi �
E ( Rm ) - Rrf �
� .
�
If b i = 1.4, Rrf = 0.09, and E ( Rm ) - Rrf = 0.05, then we have
E ( Ri ) = 0.09 + 1.4 [ 0.05] = 0.16 = 16.00%

67. The cost of equity: RadicalVenOil, Inc., has a cost of equity capital equal to 22.8
percent. If the risk-free rate of return is 10 percent and the expected return on the
market is 18 percent, then what is the firm's beta if the firm's marginal tax rate is 35
percent?
A) 1.0
B) 1.28
C) 1.60
D) 4.10
Ans: C
Feedback:
The equation for the CAPM is : E ( Ri ) = Rrf + bi � � E ( Rm ) - Rrf �
.
�
If E ( Ri ) = 0.228, Rrf = 0.10, and E ( Rm ) = 0.18, then we have
0.228 = 0.10 + bi [ 0.18 - 0.10] ===> bi = 1.60

68. The cost of equity: Gangland Water Guns, Inc., is expected to pay a dividend of $2.10
one year from today. If the firm's growth in dividends is expected to remain at a flat 3
percent forever, then what is the cost of equity capital for Gangland if the price of its
common shares is currently $17.50?
A) 12.00%
B) 14.65%
C) 15.00%
D) 15.36%
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Ans: C
Feedback:
Since the price of common shares is given as well as the exp ected growth in dividends
and the next exp ected dividend , we can use the following :
D $2.10
kcs = 1 + g = + 0.03 = 0.15 = 15%
P0 $17.50

69. The cost of equity: UltraFlex Diving Boards, Inc., is just paid a dividend of $1.50. If
the firm's growth in dividends is expected to remain at a flat 4 percent forever, then
what is the cost of equity capital for Ultra Flex Diving Boards if the price of its
A) 5.77%
B) 6.00%
C) 9.77%
D) 10.00%
Ans: D
Feedback:
and the last paid dividend , we can use the following :
D D �(1 + g ) $1.50 �1.04
kcs = 1 + g = 0 +g= + 0.04 = 0.10 = 10%
P0 P0 $26.00

70. The cost of equity: Rubber Chicken, Inc., was paid a dividend of $1.87 last year. If the
firm's growth in dividends is expected to be 10 percent next year and then zero
thereafter, then what is the cost of equity capital for Rubber Chicken if the price of its
A) 7.27%
B) 8.00%
C) 18.00%
D) The problem is not solvable with the information that is given.
Ans: B
Feedback:
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and the last paid dividend , we can use the following :
D D �(1 + g ) $1.87 �1.1
kcs = 1 + g = 0 +g= + 0 = 0.08 = 8%
P0 P0 $25.71

71. The cost of equity: The Dedus Shoes, Inc., has common shares with a price of $28.76
per share. The firm paid a dividend of $1.00 yesterday, and dividends are expected to
grow at 10 percent for two years and then at 5 percent thereafter. What is the implied
cost of common equity capital for Dedus?
A) 7.00%
B) 8.00%
C) 9.00%
D) 10.00%
Ans: C
Feedback:
We can use the common stock pricing equation to solve for the cos t of
common equity capital :
$1.00 ( 1.1) ( 1.05 )

2
$1.00(1.1) $1.00(1.1)2
$28.76 = + + ; Trial and error gives us kcs = 0.09
( 1 + kcs ) ( 1 + kcs )
2
( kcs - 0.05) ( 1 + kcs )
2

72. The cost of equity: Tranquility, Inc., has common shares with a price of $18.37 per
share. The firm paid a dividend of $1.50 yesterday, and dividends are expected to grow
at 9 percent for three years and then at 2 percent thereafter. What is the implied cost of
common equity capital for Tranquility?
A) 9%
B) 10%
C) 11%
D) 12%
Ans: D
Feedback:
We can use the common stock pricing equation to solve for the cost of common equity
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capital:

73. The cost of equity: Oasis, Inc., has common shares with a price of $21.12 per share.
The firm is expected to pay a dividend of $1.75 one year from today, and dividends are
expected to grow at 10 percent for two years after that and then at 5 percent thereafter.
What is the implied cost of common equity capital for Oasis?
A) 13%
B) 14%
C) 15%
D) 16%
Ans: B
Feedback:
We can use the common stock pricing equation to solve for the cos t of
common equity capital :
$1.75 $1.75(1.10) $1.75(1.10) 2 $1.75 ( 1.10 ) ( 1.05 )

2
$21.12 = + + + ;
( 1 + kcs ) ( 1 + kcs ) 2 ( 1 + kcs )
3
( kcs - 0.05) ( 1 + kcs )
3
Trial and error gives us kcs = 0.14

74. The cost of preferred equity: Billy's Goat Coats has a preferred share issue
outstanding with a current price of $38.89. The firm last paid a dividend on the issue of
$3.50 per share. What is the firm's cost of preferred equity?
A) 7%
B) 8%
C) 9%
D) 10%
Ans: C
Feedback:
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We start with the pricing equation for preferred shares and rearrange to solve for
the cos t of preferred equity :
D $3.50
k ps = = = 0.09
P0 $38.89

75. The cost of equity: Wally's War Duds has a preferred share issue outstanding with a
current price of $26.57. The firm is expected to pay a dividend of $1.86 per share a year
from today. What is the firm's cost of preferred equity?
A) 6.50%
B) 7.00%
C) 7.50%
D) 8.00%
Ans: B
Feedback:
D $1.86
k ps = = = 0.07
P0 $26.57

76. The cost of equity: Melba's Toast has a preferred share issue outstanding with a current
price of $19.50. The firm is expected to pay a dividend of $2.34 per share a year from
today. What is the firm's cost of preferred equity?
A) 11.50%
B) 11.75%
C) 12.00%
D) 12.25%
Ans: C
Feedback:
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D $2.34
k ps = = = 0.12
P0 $19.50

77. Using the WACC in practice: Swirlpool, Inc., has found that its cost of common
equity capital is 18 percent, and its cost of debt capital is 8 percent. If the firm is
financed with 60 percent common shares and 40 percent debt, then what is the after-tax
weighted average cost of capital for Swirlpool if it is subject to a 40 percent marginal
tax rate?
A) 10.37%
B) 12.00%
C) 12.72%
D) 14.00%
Ans: C
Feedback:
The formula for WACC is :
WACC = xDebt k Debt pretax (1 - t ) + x ps kcs = 0.4 �0.08 �(1 - 0.4) + 0.6 �0.18 = 0.1272

78. Using the WACC in practice: Maloney's, Inc., has found that its cost of common
equity capital is 17 percent and its cost of debt capital is 6 percent. If the firm is
financed with $3,000,000 of common shares (market value) and $2,000,000 of debt,
then what is the after-tax weighted average cost of capital for Maloney's if it is subject
to a 40 percent marginal tax rate?
A) 8.96%
B) 11.16%
C) 11.64%
D) 12.60%
Ans: C
Feedback:
Page 25
Noting that the proportion of debt and equity is
xDebt = $2, 000, 000 /($3,000,000 + $2, 000, 000) = 0.4, xcs = $3, 000, 000 /($3, 000, 000 + $2, 000, 000) = 0.6

79. Using the WACC in practice: Ronnie's Comics has found that its cost of common
equity capital is 15 percent and its cost of debt capital is 12 percent. If the firm is
financed with $250,000,000 of common shares (market value) and $750,000,000 of
debt, then what is the after-tax weighted average cost of capital for Ronnie's if it is
subject to a 35 percent marginal tax rate?
A) 6.05%
B) 9.6%
C) 8.75%
D) 13.65%
Ans: B
Feedback:
Noting that the proportion of debt and equity is:
The formula for WACC is:

Level of D ifficulty: Hard
80. Using the WACC in practice: Poly's Parrot Shops has found that its cost of common
equity capital is 17 percent. It has 7-year maturity semiannual bonds outstanding with a
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price of $767.03 that have a coupon rate of 7 percent. If the firm is financed with
$120,000,000 of common shares (market value) and $80,000,000 of debt, then what is
the after-tax weighted average cost of capital for Poly's if it is subject to a 35 percent
marginal tax rate?
A) 10.20%
B) 11.76%
C) 11.88%
D) 13.32%
Ans: D
Feedback:
xDebt = $80, 000, 000 /($120, 000, 000 + $80, 000, 000) = 0.4,
xcs = $120, 000, 000 /($120, 000, 000 + $80, 000, 000) = 0.6
The price of the bonds can be used to find the YTM :
$767.63 = $35 �PVIFA ( YTM / 2,14 ) + $1, 000 �PVIF ( YTM / 2,14 ) �
YTM / 2 = 6% � YTM = 12% = k Debt pretax

81. Using the WACC in practice: Marley's Pipe Shops has found that its common equity
capital shares have a beta equal to 1.5 while the risk-free return is 8 percent and the
expected return on the market is 14 percent. Its cost of debt financing is 12 percent. If
the firm is financed with $120,000,000 of common shares (market value) and
$80,000,000 of debt, then what is the after-tax weighted average cost of capital for
Marley's if it is subject to a 35 percent marginal tax rate?
A) 10.20%
B) 11.76%
C) 11.88%
D) 13.32%
Ans: D
Feedback:
Page 27
xDebt = $80, 000, 000 /($120, 000, 000 + $80, 000, 000) = 0.4,
xcs = $120, 000, 000 /($120, 000, 000 + $80, 000, 000) = 0.6
The return on common shares can be found with the CAPM :

E ( Rm ) - Rrf �
� ��
E ( Ri ) = 0.08 + 1.5 �[ 0.14 - 0.08] = 0.17

82. Using the WACC in practice: Droz's Hiking Gear, Inc., has found that its common
equity capital shares have a beta equal to 1.5 while the risk-free return is 8 percent and
the expected return on the market is 14 percent. It has 7-year semiannual maturity
bonds outstanding with a price of $767.03 that have a coupon rate of 7 percent.. If the
firm is financed with $120,000,000 of common shares (market value) and $80,000,000
of debt, then what is the after-tax weighted average cost of capital for Droz's if it is
subject to a 35 percent marginal tax rate? Calculate the cost of debt as it would be done
on Wall Street.
A) 10.20%
B) 11.76%
C) 11.88%
D) 13.32%
Ans: D
Feedback:
Page 28
xDebt = $80, 000, 000 /($120, 000, 000 + $80, 000, 000) = 0.4,
xcs = $120, 000, 000 /($120, 000, 000 + $80, 000, 000) = 0.6
The return on common shares can be found with the CAPM :

E ( Rm ) - Rrf �
� ��
E ( Ri ) = 0.08 + 1.5 �[ 0.14 - 0.08] = 0.17
The price of the bonds can be used to find the YTM :
$767.63 = $35 �PVIFA ( YTM / 2,14 ) + $1, 000 �PVIF ( YTM / 2,14 ) �
YTM / 2 = 6% � YTM = 12% = k Debt pretax

83. Which type of project do financial managers typically use the highest cost of capital
when evaluating?
A) Extension projects
B) New product projects
C) Efficiency projects
D) Market expansion projects
Ans: B

84. After-tax cost of debt financing A recent leveraged buyout was financed with $50M. This
amount comprised of partner’s equity capital of $12M, $20M unsecured debt borrowed at 7%
Page 29
from one bank and the remainder from another bank at 8.5%. What is the overall after-tax cost
of the debt financing if you expect the firm’s tax rate to be 33%?
A) 2.55%
B) 3.34%
C) 5.17%
D) 7.71%
Ans: C
Feedback:
20M @ 7% and 50M – 12M – 20M = 18M @ 8.5%
Weighted average pretax cost of debt = 7(20/38) + 8.5(18/38) = 7.71%
After-tax cost of debt = 7.71% (1-.33) = 5.17%

85. If a company's weighted average cost of capital is less than the required return on equity, then
the firm:
A) Is financed with more than 50% debt.

B) Is perceived to be safe
C) Has debt in its capital structure
D) Must have preferred stock in its capital structure
Ans: C
Format: Essay
86. Briefly explain why the book value of debt might not reflect the current cost of debt for
the firm, with respect to a single issuance of debt?
Ans: The book value of debt (or bonds) will be reflective of the market and firm risks
at the time the bonds were issued. If market or firm conditions have changed
materially since that time, then the market price of the bonds will reflect the
current cost of debt equity for the firm rather than the book value of that debt.
Format: Essay
87. Explain the conditions under which the constant-growth dividend formula for the cost
of common stock can be used to find the cost of common equity capital for the firm.
Ans: The first condition that must hold is that the growth rate in dividends must be
constant for the foreseeable future of the firm. This condition does not generally
hold for growing or contracting firms. The second condition is that the growth
rate in dividends must be less than the cost of equity capital for the firm.
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Format: Essay
88. Discuss the two major conditions for when the firm may use its current weighted
average cost of capital to evaluate a new project's cash flows.
Ans: The first condition is that the proportions of capital (debt, common shares,
preferred shares) that the firm is relying on to finance the firm must also be
utilized to finance the new project. Any material deviation from that mix will
alter the individual cost of each type of financing. The second condition is that
the level of systematic risk inherent in the overall portfolio of projects the firm is
currently taking on must be the same as the level of systematic risk for the new
project.
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Format: Multiple Choice

Format: Multiple Choice

Format: Multiple Choice

Format: Multiple Choice

Format: Multiple Choice

Note that we assume semi - annual coupons for the bond .

Format: Multiple Choice

Note that we assume semi - annual coupons for the bond .

Format: Multiple Choice

Note that we assume semi - annual coupons for the bond .

Now, we adjust taxes :12.50% x (1 - 0.35) = 8.125%

Format: Multiple Choice

Note that we assume semi - annual coupons for the bond .

Now, we adjust taxes :11.75% x (1 - 0.3) = 8.225%

Format: Multiple Choice

If b i = 1.3, Rrf = 0.08, and E ( Rm ) = 0.12, then we have

E ( Ri ) = 0.08 + 1.3 [ 0.08 - 0.12] = 0.132 = 13.20%

Format: Multiple Choice

If b i = 1.4, Rrf = 0.09, and E ( Rm ) - Rrf = 0.05, then we have

E ( Ri ) = 0.09 + 1.4 [ 0.05] = 0.16 = 16.00%

Format: Multiple Choice

If E ( Ri ) = 0.228, Rrf = 0.10, and E ( Rm ) = 0.18, then we have

0.228 = 0.10 + bi [ 0.18 - 0.10] ===> bi = 1.60

Format: Multiple Choice

Format: Multiple Choice

Format: Multiple Choice

Format: Multiple Choice

$1.00 ( 1.1) ( 1.05 )

Format: Multiple Choice

Format: Multiple Choice

$1.75 $1.75(1.10) $1.75(1.10) 2 $1.75 ( 1.10 ) ( 1.05 )

Trial and error gives us kcs = 0.14

Format: Multiple Choice

Format: Multiple Choice

Format: Multiple Choice

Format: Multiple Choice

Format: Multiple Choice

The formula for WACC is :

Format: Multiple Choice

Noting that the proportion of debt and equity is:

The formula for WACC is: