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Exam 14: Cost of Capital

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Question 141

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Given the following information for Jano Corp. find the WACC. Assume the company's tax rate is 35%. Bonds: 10,000 7% coupon bonds outstanding, $1,000 par value, 20 years to maturity, selling for 102 % of par; the bonds make semi-annual payments. Common Shares: 400,000 shares outstanding, selling for $50 per share; the beta is 1.15. Preferred shares: 25,000 shares of 5% preferred stock outstanding, currently selling for $65 per share. 8% market risk premium and 4% risk-free rate.

A) 9.97
B) 10.17%
C) 11.37%
D) 12.57%
E) 13.77%

F) A) and C)
G) A) and D)

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Question 142

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A firm's overall cost of equity is highly dependent upon the growth rate and risk level of a firm.

A) True
B) False

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Question 143

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If a firm uses its WACC as the discount rate for all of the projects it undertakes, then the firm will tend to become riskier over time.

The common stock of a firm is currently priced at $53 a share. The company paid $1.40 in common dividends last year and expects to increase this amount by 3% annually. The stock has a beta of 1.40, which is about equal to its industry average. Given this information, what is the cost of equity financing?

Donaldsen Engines is comprised of three business units, research and development, small motors, and jet engines. The research and development unit has the greatest level of risk while the small motors unit has the lowest level of risk. If Donaldsen applies the firm's WACC to all project proposals, the firm will underfund the _____ division and overfund the _____ division(s) .

The cost of equity is affected by the market risk premium.

The Jamestown Co. has a capital structure which is based on 40 % debt, 15 % preferred stock, and 45 % common stock. The flotation costs are 8 % for common stock, 9 % for preferred stock, and 4 % for debt. What is the weighted average flotation cost?

When a firm uses the subjective approach to assign discount rates to projects, the firm risks rejecting projects which should have been accepted.

Suppose your boss comes to you and asks you to re-evaluate a capital budgeting project. The first evaluation was in error, he explains, because it ignored flotation costs. To correct for this, he asks you to evaluate the project using a higher cost of capital. Is his approach correct? Why or why not?

The cost of debt is affected by investors' risk tolerance level.

Wilson's Clothing has 8 % preferred stock outstanding which is selling for $58 a share. What is Wilson's cost of preferred stock if the tax rate is 34 %?

Green Yards has a capital structure of 50 % common stock, 15 % preferred stock, and 35 % debt. The flotation costs are 3 % for debt, 6 % for preferred stock, and 8 % for common stock. What is the weighted average flotation cost?

Calculation of the weighted average cost of capital requires all of the following EXCEPT:

Mustard Patch Doll Company needs to purchase new plastic molding machines to meet the demand for its product. The cost of the equipment is $100,000. It is estimated that the firm will increase operating cash flow (OCF) by $22,000 annually for the next seven years. The firm is financed with 40% debt and 60% equity, both based on market values. The firm's cost of equity is 16% and its pre-tax cost of debt is 8%. The flotation costs of debt and equity are 2% and 8%, respectively. Assume the firm's tax rate is 34%. (A) What is the firm's WACC? (B) Ignoring flotation costs, what is the NPV of the proposed project? (C) What is the weighted average flotation cost, f_A, for the firm? (D) What is the dollar flotation cost of the proposed financing? (E) After considering flotation costs, what is the NPV of the proposed project?

Which one of the following statements concerning the dividend growth model is correct?

Top-Down, Inc. finances its operations using $1.50 of debt for every $2 of common stock. The pre-tax cost of debt is 7.5 %, the cost of equity is 11 %, and the tax rate is 34 %. Currently, the firm is considering a small project that it considers to be equally as risky as the overall firm. The project has an initial cash outlay of $18,500 and is expected to have a single cash inflow of $25,000 at the end of year two. What is the net present value of this project?

As a means of determining a firm's cost of equity financing for an investment, a weakness in the dividend growth model is that the model can only be used by dividend-paying firms.

An advantage to using the SML approach for calculating the cost of equity it that this approach explicitly accounts for risk.

In which of the following cases would it most likely be appropriate to use the WACC that relates to existing operations?

A firm is considering a project that is virtually risk-free. The company has a beta of 1.3 and a debt-equity ratio of.4. The appropriate discount rate to use in analyzing this project is: