Chapter 01

2
The Weighted Average Cost of Capital and Company Valuation
13
-
3
22.
The interest tax shield generated by a project's actual equity financing is
accou
nted for by
using the after
-
tax cost of equity in the WACC.
FALSE
23.
Assuming a project has the same risk and financing as the firm, it will have
a positive NPV
if its rate of return is greater than the firm's WACC.
TRUE
24.
For most healthy firms, the
YTM on their bonds is the rate of return investors expect from
holding their bonds.
TRUE
25.
One way to check the correctness of the expected return on bonds is
through the bond
discount model.
FALSE
26.
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.
TRUE
27.
When using the WACC as a discount rate, it is often adjusted upward for
riskier projects
and downward for safer projects.
TRUE
28.
A change in the company's capital structure will change the amount of
taxes paid but will
not change the WACC.
FALSE
Multiple Choice Questions
Chapter 01
2
The Weighted Average Cost of Capital and Company Valuation
13
-
4
29.
Capital structure decisions refer to the:
A.
dividend yield of the firm's stock.
B.
blend of equity and
debt used by the firm.
C.
capital gains available on the firm's stock.
D.
maturity date for the firm's securities.
30.
What appears to be the targeted debt ratio of a firm that issues $15 million
in bonds and $35
million in equity to finance its new capit
al projects?
A.
15.00%
B.
30.00%
C.
35.00%
D.
60.00%
31.
Proposed assets can be evaluated using the company cost of capital
providing that the:
A.
firm does not pay taxes.
B.
firm is all
equity financed.
C.
cost of debt is less than the cost of equity.
D.
new assets have the same risk as existing assets.
32.
The company cost of capital for a firm with a 6
5/35 debt/equity split, 8% cost of debt, 15%
cost of equity, and a 35% tax rate would be:
A.
7.02%
B.
9.12%
C.
10.45%
D.
13.80%
0.65x 8% + 0.35 x 15% = 10.45%
33.
The company cost of capital, after tax, for a firm with a 65/35 d
ebt/equity split, 8% cost of
debt, 15% cost of equity, and a 35% tax rate would be:
A.
7.02%
B.
8.63%
C.
10.80%
D.
13.80%
0.65x (1
-
35%) x 8% + 0.35 x 15% = 8.63%
34.
Why is debt financing said to include a tax shield for the company?
A.
Taxes are reduced
by the amount of the debt.
B.
Taxes are reduced by the amount of the interest.
C.
Taxable income is reduced by the amount of the debt.
D.
Taxable income is reduced by the amount of the interest.
Chapter 01
2
The Weighted Average Cost of Capital and Company Valuation
13
-
5
35.
What is the pretax cost of debt for a firm in the 35%
tax bracket that has a 10% after
-
tax cost
of debt?
A.
5.85%
B.
12.15%
C.
15.38%
D.
25.71%
after
-
tax cost of debt = pretax cost x (1
-
tax rate)
10% = pretax cost x .65
15.38% = pretax cost of debt
36.
How much is added to a firm's weighted average cost o
f capital for 45% debt financing with
a required rate of return of 10% and a tax rate of 35%?
A.
1.29%
B.
2.93%
C.
3.50%
D.
4.50%
Chapter 01
2
The Weighted Average Cost of Capital and Company Valuation
13
-
6
Component cost of debt = .45 x (1
-
.35).10
= .45 x (.65 x .10)
= .45 x .065
= 2.925%
37.
What is the WACC for a firm with 50
% debt and 50% equity that pays 12% on its debt, 20%
on its equity, and has a 40% tax rate?
A.
9.6%
B.
12.0%
C.
13.6%
D.
16.0%
WACC = (.5 x (.12 x .6)) + (.5 x .2)
= 3.6% + 10% = 13.60%
38.
Company X has 2 million shares of common stock outstanding at a b
ook value of $2 per
share. The stock trades for $3.00 per share. It also has $2 million in face
value of debt that trades
at 90% of par. What is its ratio of debt to value for WACC purposes?
A.
15.38%
B.
28.6%
C.
31.0%
D.
33.3%
2 million shares x $3.00 =
$6,000,000
$2 million debt x 90% = $1,800,000
Total value = $7,800,000
$1.2 million/$7.8 million = 15.38%
39.
What is the after
-
tax cost of preferred stock that sells for $10 per share and offers a $1.20
dividend when the tax rate is 35%?
A.
4.20%
B.
7.80
%
C.
8.33%
D.
12.00%
$1.20/$10.00 = 12%
40.
What is the WACC for a firm using 55% equity with a required return of
15%, 35% debt
with a required return of 8%, 10% preferred stock with a required return of
10%, and a tax rate
of 35%?
A.
10.72%
B.
11.07%
C.
11.70%
D.
12.05%
Chapter 01
2
The Weighted Average Cost of Capital and Company Valuation
13
-
7
WACC = (.35 x (1
-
.35).08) + (.1 x .1) + (.55 x .15)
= 1.82% + 1.0% + 8.25%
= 11.07%
41.
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 av
erage projects, and the firm uses a
12.5% WACC?
A.
Yes, since NPV is positive.
B.
Yes, since a zero NPV indicates marginal acceptability.
C.
No, since NPV is zero.
D.
No, since NPV is negative.
NPV =
-
10 million + $2 million/.20 =
-
10 + 10 = 0
However, th
e 20% rate does not reflect the projects' greater risk; thus NPV is negative.
42.
How much will a firm need in cash flow before tax and interest to satisfy
debtholders and
equityholders if: the tax rate is 40%, there is $10 million in common stock
requirin
g a 12%
return, and $6 million in bonds requiring an 8% return?
A.
$1,392,000
B.
$1,488,000
C.
$2,480,000
D.
$2,800,000
43.
How much will a firm need in cash flow before tax and interest
to satisfy debtholders and
equityholders if: the tax rate is 35%, there is $13 million in common stock
requiring a 10%
return, and $6 million in bonds requiring an 6% return?
A.
$1,392,000
B.
$1,488,000
C.
$2,360,000
D.
$2,480,000
Chapter 01
2
The Weighted Average Cost of Capital and Company Valuation
13
-
8
44.
Which of the following statements is incorrect concerning the equity
component of the
WACC?
A.
The value of retained earnings is not included.
B.
Market values should be used in the calculations.
C.
Prefer
red equity has a separate component.
D.
There is a tax shield such as with debt.
Chapter 01
2
The Weighted Average Cost of Capital and Company Valuation
13
-
9
45.
What will be the effect of using book value of debt in WACC decisions if
interest rates have
decreased substantially since a firm's long
-
term bonds were issued?
A.
The debt
-
to
-
value ratio will be overstated.
B.
The debt
-
to
-
value ratio will be understated.
C.
There will be no effect on WACC decisions.
D.
Cannot be determined without knowing interest rates.
Thus, the debt
-
to
-
value ratio is .286. However, if the market value of debt is $2.5 million due
to
increased interest rates, the value of the firm is $7.5 million and the debt
-
to
-
value ratio is .333.
The key is that the numerator of the ratio changes
proportionately more than the denominator.
46.
Which component is more likely to be biased if book values are used in the
calculation of
WACC rather than market values?
A.
Debt
B.
Preferred stock
C.
Common stock
D.
All categories should be equally biased.
47.
What would you estimate to be the required rate of return for equity
investors if a stock sells
for $40 and will pay a $4.40 dividend that is expected to grow at a constant
rate of 5%?
A.
7.6%
B.
12.0%
C.
12.6%
D.
16.0%