Question #26 of 60

Tony Costa, operations manager of BioChem Inc., is exploring a proposed product line expansion. Costa explains that he
estimates the beta for the project by seeking out a publicly traded firm that is engaged exclusively in the same business as the
proposed BioChem product line expansion. The beta of the proposed project is estimated from the beta of that firm after
appropriate adjustments for capital structure differences. The method that Costa uses is known as the:

A) build-up method.
B) pure-play method.
C) accounting method.

Explanation

The method used by Costa is known as the pure-play method. The method entails selection of the pure-play equity beta,
unlevering it using the pure-play company's capital structure, and re-levering using the subject company's capital structure.

Question #27 of 60

A company primarily engaged in the production of cement has the following characteristics:

Beta = 0.8.
Market value debt = $180 million.
Market value equity = $540 million.
Effective tax rate = 25%.
Marginal tax rate = 34%.

The asset beta that should be used by a company considering entering into cement production is closest to:

A) 0.640.
B) 0.656.
C) 0.725.

Explanation

The unlevered (asset) beta is 0.8{1 / [1 + (1 - 0.34)(180 / 540)]} = 0.656.

Question #28 of 60

A company's outstanding 20-year, annual-pay 6% coupon bonds are selling for $894. At a tax rate of 40%, the company's
after-tax cost of debt capital is closest to:

A) 7.0%
B) 4.2%.
C) 5.1%

Explanation

Pretax cost of debt: N = 20; FV = 1000; PV = 894; PMT = 60; CPT I/Y = 7%

After-tax cost of debt: kd = (7%)(10.4) = 4.2%

Question #29 of 60

An analyst gathered the following data about a company:

Capital Structure Required Rate of Return

30% debt 10% for debt

20% preferred stock 11% for preferred stock

50% common stock 18% for common stock

Assuming a 40% tax rate, what after-tax rate of return must the company earn on its investments?

A) 13.0%.

B) 14.2%.

C) 10.0%.

Explanation

(0.3)(0.1)(1 - 0.4) + (0.2)(0.11) + (0.5)(0.18) = 0.13

Question #30 of 60

Levenworth Industries has the following capital structure on December 31, 2006:

Book Value Market Value

Debt outstanding $8 million $10.5 million

Preferred stock outstanding $2 million $1.5 million

Common stock outstanding $10 million $13.7 million

Total capital $20 million $25.7 million

What is the firm's target debt and preferred stock portion of the capital structure based on existing capital structure?

Debt Preferred Stock

A) 0.40 0.10

B) 0.41 0.06

C) 0.41 0.10

Explanation

The weights in the calculation of WACC should be based on the firm's target capital structure, that is, the proportions (based on
market values) of debt, preferred stock, and equity that the firm expects to achieve over time. Book values should not be used.
As such, the weight of debt is 41% ($10.5 $25.7), the weight of preferred stock is 6% ($1.5 $25.7) and the weight of common
stock is 53% ($13.7 $25.7).
Question #31 of 60

Axle Corporation earned 3.00 per share and paid a dividend of 2.40 on its common stock last year. Its common stock is trading
at 40 per share. Axle is expected to have a return on equity of 15%, an effective tax rate of 34%, and to maintain its historic
payout ratio going forward. In estimating Axle's after-tax cost of capital, an analyst's estimate of Axle's cost of common equity
would be closest to:

A) 9.2%.
B) 8.8%.
C) 9.0%.

Explanation

We can estimate the company's expected growth rate as ROE (1 payout ratio): g = 15% (1 2.40/3.00) = 3%

The expected dividend next period is then 2.40(1.03) = 2.47. Based on dividend discount model pricing, the required return on
equity is 2.47 / 40 + 3% = 9.18%.

Question #32 of 60

A financial analyst is estimating the effect on the cost of capital for a company of a decrease in the marginal tax rate. The
company is financed with debt and common equity. A decrease in the firm's marginal tax rate would:

A) increase the cost of capital because of a higher after-tax cost of debt.

B) decrease the cost of capital because of a lower after-tax cost of debt and equity.
C) increase the cost of capital because of a higher after-tax cost of debt and equity.

Explanation

The cost of debt capital is affected by the marginal tax rate because interest costs are tax-deductible. A lower marginal tax rate
decreases the value to the firm of the tax deduction for interest and therefore increases the after-tax cost of debt capital. Cost of
equity capital is not affected by the marginal tax rate.

Question #33 of 60

A firm has $3 million in outstanding 10-year bonds, with a fixed rate of 8% (assume annual payments). The bonds trade at a price
of $92 per $100 par in the open market. The firm's marginal tax rate is 35%. What is the after-tax component cost of debt to be
used in the weighted average cost of capital (WACC) calculations?

A) 9.26%.
B) 6.02%.
C) 5.40%.

Explanation

If the bonds are trading at $92 per $100 par, the required yield is 9.26% (N = 10; PV = -92; FV = 100; PMT = 8; CPT I/Y = 9.26).
The equivalent after-tax cost of this financing is: 9.26% (1 - 0.35) = 6.02%.
Question #34 of 60

When calculating the weighted average cost of capital (WACC) an adjustment is made for taxes because:

A) the interest on debt is tax deductible.

B) equity earns higher return than debt.

C) equity is risky.

Explanation

Equity and preferred stock are not adjusted for taxes because dividends are not deductible for corporate taxes. Only interest expense is
deductible for corporate taxes.

Question #35 of 60

Hanson Aluminum, Inc. is considering whether to build a mill based around a new rolling technology the company has been
developing. Management views this project as being riskier than the average project the company undertakes. Based on their
analysis of the projected cash flows, management determines that the project's internal rate of return is equal to the company's
marginal cost of capital. If the project goes forward, the company will finance it with newly issued debt with an after-tax cost less
than the project's IRR. Should management accept or reject this project?

A) Accept, because the project returns the company's cost of capital.

B) Reject, because the project reduces the value of the company when its risk is taken into account.
C) Accept, because the marginal cost of the new debt is less than the project's internal rate of return.

Explanation

The marginal (or weighted average) cost of capital is the appropriate discount rate for projects that have the same level of risk as
the firm's existing projects. For a project with a higher degree of risk, cash flows should be discounted at a rate higher than the
firm's WACC. Since this project's IRR is equal to the company's WACC, its NPV must be zero if the cash flows are discounted at
the WACC. If the cash flows are discounted at a rate higher than the WACC to account for the project's higher risk, the NPV must
be negative. Therefore, the project would reduce the value of the company, so management should reject it. A company
considers its capital raising and budgeting decisions independently. Each investment decision must be made assuming a WACC
which includes each of the different sources of capital and is based on the long-run target weights.
Question #36 of 60

A company has the following data associated with it:

A target capital structure of 10% preferred stock, 50% common equity and 40% debt.
Outstanding 20-year annual pay 6% coupon bonds selling for $894.
Common stock selling for $45 per share that is expected to grow at 8% and expected to pay a $2 dividend one year from
today.
Their $100 par preferred stock currently sells for $90 and is earning 5%.
The company's tax rate is 40%.

What is the after-tax cost of debt capital and after-tax cost of preferred stock?

Debt capital Preferred stock

A) 4.2% 5.6%

B) 4.5% 3.3%

C) 4.2% 3.3%

Explanation

Debt:
N = 20; FV = 1,000; PMT = 60; PV = -894; CPT I/Y = 7%
kd = (7%)(1 0.4) = 4.2%

Preferred stock:

kps = Dps / P = 5 / 90 = 5.56%

Note that the cost of preferred stock is not adjusted for taxes because preferred dividends are usually not tax-deductible.
Question #37 of 60

Simcox Financial is considering raising additional capital to finance a takeover of one of the firm's major competitors. Reuben
Mellum, an analyst with Simcox, has put together the following schedule of costs related to raising new capital:

Amount of New Debt (in millions) After-tax Cost of Debt Amount of New Equity (in millions) Cost of Equity

$0 to $149 4.2% $0 to $399 7.5%

$150 to $349 5.0% $400 to $799 8.5%

Assuming that Simcox has a target debt to equity ratio of 65% equity and 35% debt, what are the marginal cost of capital
schedule breakpoints for raising additional debt capital and equity capital, respectively?

Breakpoint for new equity

Breakpoint for new debt capital
capital

A) $428.6 million $615.4 million

B) $375.0 million $615.4 million

C) $428.6 million $533.3 million

Explanation

A breakpoint is calculated as the amount of capital where component cost changes / weight of component in the WACC. The
breakpoint for raising new debt capital occurs at ($150 / 0.35) = $428.6 million, and the breakpoint for raising new equity capital
occurs at ($400 / 0.65) = $615.4 million.

Question #38 of 60

The expected annual dividend one year from today is $2.50 for a share of stock priced at $25. What is the cost of equity if the
constant long-term growth in dividends is projected to be 8%?

A) 18%.
B) 19%.
C) 15%.

Explanation

Ks = (D1 / P0) + g = (2.5/25) + 0.08 = 0.18 or 18%.

Question #39 of 60

An analyst gathered the following information for ABC Company, which has a target capital structure of 70% common equity and
30% debt:
 Dividend yield 3.50%
Expected market return 9.00%
Risk-free rate 4.00%
Tax rate 40%
Beta 0.90
Bond yield-to-maturity 8.00%

ABC's weighted-average cost of capital is closest to:

A) 8.4%.
B) 6.9%.

C) 7.4%.

Explanation

The problem must be solved in two steps. First, calculate the cost of equity:
rCE = Rf + (RM - Rf)
= 0.04 + 0.9(0.09 - 0.04)
= 0.085 = 8.5%

Next, calculate the WACC.

WACC = wDrD(1 - t) + wPrP + wCErCE
= (0.30)(0.08)(1 - 0.40) + 0 + (0.70)(0.085)
= 0.0739 or 7.39%

Question #40 of 60

Arlington Machinery currently has assets on its balance sheet of $300 million that is financed with 70% equity and 30% debt. The
executive management team at Arlington is considering a major expansion that would require raising additional capital. Jeffery
Marian, an analyst with Arlington Machinery, has put together the following schedule for the costs of debt and equity:

Amount of New Debt After-tax Amount of New Equity Cost of Equity

(in millions) Cost of Debt (in millions)

$0 to $49 4.0% $0 to $99 7.0%

$50 to $99 4.2% $100 to $199 8.0%

$100 to $149 4.5% $200 to $299 9.0%

In a presentation to Arlington's executive management team, Marian makes the following statements:

Statement 1: If we maintain our target capital structure of 70% equity and 30% debt, the breakpoint at which our cost of equity
will increase to 9.0% is approximately $286 million in new capital.

Statement 2: If we want to finance total assets of $600 million, our weighted average cost of capital (WACC) for the additional
financing needed will be 7.56%.

Marian's statements are:

Statement 1 Statement 2

A) Incorrect Incorrect
 B) Correct Incorrect

C) Correct Correct

Explanation

Marian's first statement is correct. A breakpoint calculated as (amount of capital where component cost changes / weight of
component in the WACC). The component cost of equity for Arlington will increase when the amount of new equity raised is $200
million, which will occur at ($200 million / 0.70) = $285.71 million, or $286 million of new capital.

Marian's second statement is also correct. If Arlington wants to finance $600 million of total assets, the firm will need to raise
$600 $300 = $300 million of additional capital. Using the target capital structure of 70% equity and 30% debt, Arlington will
need to raise $300 0.70 = $210 million in new equity and $300 0.30 = $90 million in new debt. Looking at the capital
schedules, these levels of new financing correspond with rates of 9.0% and 4.2% for costs of equity and debt respectively, and
the WACC is equal to (9.0% 0.70) + (4.2% 0.30) = 7.56%.

Question #41 of 86

A firm has $4 million in outstanding bonds that mature in four years, with a fixed rate of 7.5% (assume annual payments). The
bonds trade at a price of $98 in the open market. The firm's marginal tax rate is 35%. Using the bond-yield plus method, what is
the firm's cost of equity risk assuming an add-on of 4%?

A) 13.34%.
B) 12.11%.
C) 11.50%.

Explanation

If the bonds are trading at $98, the required yield is 8.11%, and the market value of the issue is $3.92 million. To calculate this
rate using a financial calculator (and figuring the rate assuming a $100 face value for each bond), N = 4; PMT = 7.5 = (0.075
100); FV = 100; PV = -98; CPT I/Y = 8.11. By adding the equity risk factor of 4%, we compute the cost of equity as 12.11%.

Question #42 of 86

Which of the following statements is least accurate regarding the marginal cost of capital's role in determining the net present
value (NPV) of a project?

A) The NPVs of potential projects of above-average risk should be calculated using the marginal
cost of capital for the firm.
B) Projects for which the present value of the after-tax cash inflows is greater than the present value of
the after-tax cash outflows should be undertaken by the firm.
C) When using a firm's marginal cost of capital to evaluate a specific project, there is an implicit
assumption that the capital structure of the firm will remain at the target capital structure over the life
of the project.

Explanation

The WACC is the appropriate discount rate for projects that have approximately the same level of risk as the firm's existing
projects. This is because the component costs of capital used to calculate the firm's WACC are based on the existing level of firm
risk. To evaluate a project with above (the firm's) average risk, a discount rate greater than the firm's existing WACC should be
used. Projects with below-average risk should be evaluated using a discount rate less than the firm's WACC. An additional issue
to consider when using a firm's WACC (marginal cost of capital) to evaluate a specific project is that there is an implicit
assumption that the capital structure of the firm will remain at the target capital structure over the life of the project. These
complexities aside, we can still conclude that the NPVs of potential projects of firm-average risk should be calculated using the
marginal cost of capital for the firm. Projects for which the present value of the after-tax cash inflows is greater than the present
value of the after-tax cash outflows should be undertaken by the firm.

Question #43 of 86

The debt of Savanna Equipment, Inc. has an average maturity of ten years and a BBB rating. A market yield to maturity is not
available because the debt is not publicly traded, but the market yield on debt with similar characteristics is 8.33%. Savanna is
planning to issue new ten-year notes that would be subordinate to the firm's existing debt. The company's marginal tax rate is
40%. The most appropriate estimate of the after-tax cost of this new debt is:

A) More than 5.0%.

B) Between 3.3% and 5.0%.

C) 5.0%.

Explanation

The after-tax cost of debt similar to Savanna's existing debt is kd(1 - t) = 8.33%(1 - 0.4) = 5.0%. Because the anticipated new
debt will be subordinated in the company's debt structure, investors will demand a higher yield than the existing debt carries.
Therefore, the appropriate after-tax cost of the new debt is more than 5.0%.

Question #44 of 86

A new project is expected to be less risky than the average risk of existing projects. The appropriate discount rate to use when
evaluating this project is:

A) less than the firm's marginal cost of capital.

B) greater than the firm's marginal cost of capital.
C) the firm's marginal cost of capital.

Explanation

If the new project is less risky than the average risk of existing projects, the MCC should be adjusted downward. A lower discount
rate will increase project's the net present value.

Question #45 of 86

Which of the following statements is most accurate regarding a firm's cost of preferred shares? A firm's cost of preferred stock is:

A) approximately equal to the market price of the firm's debt as a percentage of the market price
of its common shares.
B) the dividend yield on the firm's newly-issued preferred stock.
C) the market price of the preferred shares as a percentage of its issuance price.
Explanation

The newly-issued preferred shares of most companies generally sell at par. As such, the dividend yield on a firm's newly-issued
preferred shares is the market's required rate of return. The yield on a BBB corporate bond reflects a pre-tax cost of debt. Both
remaining choices make no sense.

Question #46 of 86

A $100 par, 8% preferred stock is currently selling for $80. What is the cost of preferred equity?

A) 10.0%.
B) 10.8%.
C) 8.0%.

Explanation

kps = $8 / $80 = 10%

Question #47 of 86

An analyst gathered the following information about a capital budgeting project:

The proposed project cost $10,000.

The project is expected to increase pretax net income and cash flow by $3,000 in each of the next eight years.
The company has 50% of its capital in equity at a cost of 12%.
The pretax cost of debt capital is 6%.
The company's tax rate is 33%.

The project's net present value is closest to:

A) $1,551.
B) $7,240.
C) $6,604.

Explanation

WACC = (wd)(kd)(1 - t) + (wce)(kce)

WACC = (0.5)(6%)(1 - 0.33) + (0.5)(12%) = 8.0%

The increase in after-tax cash flows for each year is 3,000 (1 - 0.33) = $2,010.

I =8; N =8; PMT = $2,010; CPTPV = $11,550.74

NPV = PV income - cost = $11,550.74 - $10,000 = $1,550.74

Question #48 of 86

The following information applies to a corporation:

The company has $200 million of equity and $100 million of debt.
 The company recently issued bonds at 9%.
The corporate tax rate is 30%.
The company's beta is 1.125.

If the risk-free rate is 6% and the expected return on the market portfolio is 14%, the company's after-tax weighted average cost
of capital is closest to:

A) 11.2%.
B) 10.5%.
C) 12.1%.

Explanation

ks = RFR + (Rm RFR)

= 6% + 1.125(14% 6%) = 15%

WACC = [D/(D + E)] kd(1 t) + [E/(D + E)] ks

= (100/300)(9%)(1 0.3) + (200/300)(15%) = 12.1%

Question #49 of 86

Which of the following is least likely to be useful to an analyst who is estimating the pretax cost of a firm's fixed-rate debt?

A) Seniority and any special covenants of the firm's anticipated debt.

B) The yield to maturity of the firm's existing debt.
C) The coupon rate on the firm's existing debt.

Explanation

Ideally, an analyst would use the YTM of a firm's existing debt as the pretax cost of new debt. When a firm's debt is not publicly
traded, however, a market YTM may not be available. In this case, an analyst may use the yield curve for debt with the same
rating and maturity to estimate the market YTM. If the anticipated debt has unique characteristics that affect YTM, these
characteristics should be accounted for when estimating the pretax cost of debt. The cost of debt is the market interest rate
(YTM) on new (marginal) debt, not the coupon rate on the firm's existing debt. If you are provided with both coupon and YTM on
the exam, you should use the YTM.

Question #50 of 86

Which of the following events will reduce a company's weighted average cost of capital (WACC)?

A) A reduction in the market risk premium.

B) A reduction in the company's bond rating.
C) An increase in expected inflation.

Explanation

An increase in either the company's beta or the market risk premium will cause the WACC to increase using the CAPM
approach. A reduction in the market risk premium will reduce the cost of equity for WACC.
Question #51 of 86

Which of the following statements about the role of the marginal cost of capital in determining the net present value of a project is
most accurate? The marginal cost of capital should be used to discount the cash flows:

A) of all projects the firm is considering.

B) if the firm's capital structure is expected to change during the project's life.
C) for potential projects that have a level of risk near that of the firm's average project.

Explanation

Net present values of projects with the average risk for the firm should be determined using the firm's marginal cost of capital.
The discount rate should be adjusted for projects with above-average or below-average risk. Using the marginal cost of capital
assumes the firm's capital structure does not change over the life of the project.

Question #52 of 86

Deighton Industries has 200,000 bonds outstanding. The par value of each corporate bond is $1,000, and the current market
price of the bonds is $965. Deighton also has 6 million common shares outstanding, with a book value of $35 per share and a
market price of $28 per share. At a recent board of directors meeting, Deighton board members decided not to change the
company's capital structure in a material way for the future. To calculate the weighted average cost of Deighton's capital, what
weights should be assigned to debt and to equity?

Debt Equity

A) 56.55% 43.45%

B) 53.46% 46.54%

C) 48.85% 51.15%

Explanation

In order to calculate the weighted average cost of capital (WACC), market value weights should be used.

For the bonds = 200,000 $965 = $193,000,000

For the stocks = 6,000,000 $28 = $168,000,000

$361,000,000

The weight of debt would be: 193,000,000 / 361,000,000 = 0.5346 = 53.46%

The weight of common stock would be: 168,000,000 / 361,000,000 = 0.4654 = 46.54%

Question #53 of 86

If central bank actions caused the risk-free rate to increase, what is the most likely change to cost of debt and equity capital?

A) Both increase.
B) Both decrease.
C) One increase and one decrease.
Explanation

An increase in the risk-free rate will cause the cost of equity to increase. It would also cause the cost of debt to increase. In either
case, the nominal cost of capital is the risk-free rate plus the appropriate premium for risk.

Question #54 of 60

Given the following information about capital structure, compute the WACC. The marginal tax rate is 40%.

Type of Percent of Before-Tax

Capital Capital Structure Component Cost

Bonds 40% 7.5%

Preferred Stock 5% 11.0%

Common Stock 55% 15.0%

A) 10.6%.
B) 13.3%.
C) 7.1%.

Explanation

WACC = (Wd)(Kd (1 t)) + (Wps)(Kps) + (Wce)(Ks)

WACC = 0.4(7.5%)(1 0.4) + 0.05(11%) + 0.55(15%) = 10.6%.

Question #55 of 60

Which of the following is least likely to be useful to an analyst when estimating the cost of raising capital through the issuance of
non-callable, nonconvertible preferred stock?

A) The firm's corporate tax rate.

B) The preferred stock's dividend rate.
C) The stated par value of the preferred issue.

Explanation

The corporate tax rate is not a relevant factor when calculating the cost of preferred stock.

The cost of preferred stock, kps is expressed as:

kps = Dps / P

where:
Dps = divided per share = dividend rate stated par value
P = market price

Question #56 of 60
The following information applies to World Turn Company:

10% rate of interest on newly issued bonds.

7% growth rate in earnings and dividends.
The last dividend paid was $0.93.
Shares sell for $16.
Stock's beta is 1.5.
Market risk premium is 6%.
Risk-free rate of interest is 5%.
The firm is in a 40% marginal tax bracket.

If the appropriate risk premium relative to the bond yield is 4%, World Turn's equity cost of capital using the dividend discount
model is closest to:

A) 13.2%.
B) 12.8%.

C) 14.0%.

Explanation

Question #57 of 60

Assume a firm uses a constant WACC to select investment projects rather than adjusting the projects for risk. If so, the firm will tend to:

A) reject profitable, low-risk projects and accept unprofitable, high-risk projects.

B) accept profitable, low-risk projects and accept unprofitable, high-risk projects.

C) accept profitable, low-risk projects and reject unprofitable, high-risk projects.

Explanation

The firm will reject profitable, low-risk projects because it will use a hurdle rate that is too high. The firm should lower the required rate of
return for lower risk projects. The firm will accept unprofitable, high-risk projects because the hurdle rate of return used will be too low
relative to the risk of the project. The firm should increase the required rate of return for high-risk projects.

Question #58 of 60

The cost of preferred stock is equal to the preferred stock dividend:

A) divided by its par value.

B) divided by the market price.

C) multiplied by the market price.

Explanation

The cost of preferred stock, kps, is Dps price.

Question #59 of 60

A company has a target capital structure of 40% debt and 60% equity. The company is a constant growth firm that just paid a
dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8%.

The company's bonds pay 10% coupon (semi-annual payout), mature in 20 years, and sell for $849.54.
The company's stock beta is 1.2.
The company's marginal tax rate is 40%.
The risk-free rate is 10%.
The market risk premium is 5%.

The cost of equity using the capital asset pricing model (CAPM) approach and the discounted cash flow approach is:

CAPM Discounted cash flow

A) 16.0% 16.0%

B) 16.6% 15.4%

C) 16.0% 15.4%

Explanation

CAPM approach:
10 + (5)(1.2) = 16%.

Discounted cash flow approach:

Next-period dividend = 2(1.08) = 2.16
(2.16 / 27) + 0.08 = 16%

Question #60 of 60

A publicly traded company has a beta of 1.2, a debt/equity ratio of 1.5, ROE of 8.1%, and a marginal tax rate of 40%. The
unlevered beta for this company is closest to:

A) 1.071.
B) 0.632.
C) 0.832.

Explanation

The unlevered beta for this company is calculated as: