Chapter 14 Flashcards
When evaluating any capital project proposal, the cost of capital:
A. is determined by the overall risk level of the firm.
B. is dependent upon the source of the funds obtained to fund that project.
C. is dependent upon the firm’s overall capital structure.
D. should be applied as the discount rate for all other projects considered by the firm.
E. depends upon how the funds raised for that project are going to be spent.
E. depends upon how the funds raised for that project are going to be spent.
- Judy’s Boutique just paid an annual dividend of $3.43 on its common stock. The firm increases its dividend by 3.65 percent annually. What is the company’s cost of equity if the current stock price is $42.76 per share?
A. 11.35%
B. 11.67%
C. 11.02%
D. 12.38%
E. 11.96%
E. 11.96%
R(e) = D(0) (1+ g)/P(0) + g
D(0) = $3.43
g=.0365
P = 42.76
R(E) = 3.43(1+.0365)/42.76 + .0365 =.1196 or 11.96%
- Countess Corporation is expected to pay an annual dividend of $4.63 on its common stock in one year. The current stock price is $74.11 per share. The company announced that it will increase its dividend by 3.75 percent annually. What is the company’s cost of equity?
A. 10.23%
B. 9.44%
C. 10.00%
D. 9.72%
E. 10.60%
C. 10.00%
R(E) = D(1)/P(0) + g
D(1) = 4.63
P(0) = 74.11
g = .0375
4.63/74.11 + .0375 = 0.0999 = 10%
- Assume a firm utilizes the security market line approach to determine the cost of equity. If the firm currently pays an annual dividend of $2.40 per share and has a beta of 1.42, all else constant, which of the following actions will decrease the firm’s cost of equity?
A. A decrease in the dividend amount
B. An increase in the dividend amount
C. An increase in the market rate of return
D. A decrease in the firm’s beta
E. A decrease in the risk-free rate
D. A decrease in the firm’s beta
- The stock in Bowie Enterprises has a beta of 1.14. The expected return on the market is 12.20 percent and the risk-free rate is 3.33 percent. What is the required return on the company’s stock?
A. 13.07%
B. 12.70%
C. 15.34%
D. 13.44%
E. 17.24%
D. 13.44%
B(E) (R(m)-R(f)) + R(f)
B(E) = 1.14
R(m) = .1220
R(f) = .0333
1.14(.1220-.0333) + .0333
- Which of the following statements regarding a firm’s pretax cost of debt is accurate?
A. It is based on the current yield to maturity of the company’s outstanding bonds.
B. It is equal to the coupon rate on the latest bonds issued by the company.
C. It is equivalent to the average current yield on all of a company’s outstanding bonds.
D. It is based on the original yield to maturity on the latest bonds issued by a company.
E. It must be estimated as it cannot be directly observed in the market.
A. It is based on the current yield to maturity of the company’s outstanding bonds.
- The cost of preferred stock is equivalent to the:
A. pretax cost of debt.
B. rate of return on an annuity.
C. aftertax cost of debt.
D. rate of return on a perpetuity.
E. cost of an irregular growth common stock.
D. rate of return on a perpetuity.
- Bethesda Water has an issue of preferred stock outstanding with a coupon rate of 4.20 percent that sells for $90.86 per share. If the par value is $100, what is the cost of the company’s preferred stock?
A. 4.20%
B. 4.43%
C. 5.01%
D. 4.31%
E. 4.62%
E. 4.62%
R(p) = D/P(0)
D = coupon rate x par value
D = .0420 x 100
P(0) = 90.86
R(p) = 4.20/90.86
- When calculating a firm’s weighted average cost of capital, the capital structure weights:
A. are based on the book values of debt and equity.
B. are based on the market values of the outstanding securities.
C. depend upon the financing obtained to fund each specific project.
D. remain constant over time unless new securities are issued or outstanding securities are redeemed.
E. are restricted to debt and common stock.
B. are based on the market values of the outstanding securities.
- Take It All Away has a cost of equity of 11.08 percent, a pretax cost of debt of 5.38 percent, and a tax rate of 21 percent. The company’s capital structure consists of 68 percent debt on a book value basis, but debt is 34 percent of the company’s value on a market value basis. What is the company’s WACC?
A. 9.75%
B. 8.76%
C. 7.91%
D. 9.14%
E. 12.97%
B. 8.76%
E/V x R(E) + P/V x R(P) + D/V x R(D) x (1-T(C)=WACC
(ignore P/V x R(P) because there is no preferred stock mentioned.
E/V = Weighted value of debt = .66
D/V = Weighted value of equity = .34
R(E) = Cost of Equity = .1108
R(D) = Cost of Debt = .0538
T(C) = tax rate = .21
(.66 x .1108) + [(.34 x .0538) x (1-.21)]
WACC is used to discount ______.
cash flows
news
political unrest
common stock dividends
cash flows
A firm’s overall cost of capital will include both its cost of __________ capital and equity capital.
debt
To apply the dividend growth model to a particular stock, you need to assume that the firm’s ___ will grow at a constant rate.
debts
beta
profitability
dividend
dividend
A firm’s cost of debt can be ___.
obtained by checking yields on publicly traded bonds
obtained by talking to investment bankers
estimated easier than its cost of equity
calculated using the dividend growth model
obtained by checking yields on publicly traded bonds
obtained by talking to investment bankers
estimated easier than its cost of equity
The most appropriate weights to use in the WACC are the ______ weights.
market value
government mandated
book value
salvage value
market value
What does WACC stand for?
Working amount of corporate cost
Weighted average cost of capital
Weighted average company cost
Working amount of corporate cash
Weighted average cost of capital
The WACC is the weighted average of the cost of equity and the _____.
inflation risk premium
before-tax cost of debt
aftertax cost of debt
beta multiplier
aftertax cost of debt
Which of the following are components used in the construction of the WACC?
Cost of accounts payable
Cost of common stock
Cost of preferred stock
Cost of debt
Cost of common stock
Cost of preferred stock
Cost of debt
The formula for calculating the cost of equity capital that is based on the dividend discount model is:
RE = D1/P0 + g
RE = D1/P0 - g
RE = D0/P1 + g
RE = (D1/P0)/g
RE = D1/P0 + g
The cost of ____________ can be observed because it is the interest rate the firm must pay on new loans.
debt
Capital _____________ weights can be interpreted just like portfolio weights.
structure
B = the market value of a firm’s debt
S = the market value of that same firm’s equity
RB = the before-tax yield on the firm’s debt
TC = the corporate tax rate
RS = the cost of equity
Given the definitions above, the weighted average cost of capital formula can be written as:
[S/(S + B)] × RS × (1 − Tc) + [B/(S + B)] × RB
[S/(S + B)] × RS + [B/(S + B)] × RB
[S/(S + B)] × RS + [B/(S + B)] × RB × (1 − Tc)
[S/(S + B)] × RS + [B/(S + B)] × RB × (1 − Tc)
When determining a firm’s cost of capital, the most important determinant is the:
debt-equity ratio of any new funds raised.
marginal tax rate.
pretax cost of equity.
aftertax cost of equity.
use of the funds raised.
use of the funds raised.
Okonjo Economics has a debt-equity ratio of .38. All of the firm’s outstanding shares were purchased by a small number of investors. The return these investors require is called the:
dividend yield.
cost of equity.
capital gains yield.
cost of capital.
income return.
cost of equity.
Wright Market Research is able to borrow money at a rate of 6.8 percent per year. This interest rate is called the:
compound rate.
current yield.
cost of debt.
capital gains yield.
cost of capital.
cost of debt.
A firm’s aftertax cost of debt will increase if there is a(n):
decrease in the company’s debt-equity ratio.
decrease in the company’s tax rate.
increase in the credit rating of the company’s bonds.
increase in the company’s beta.
decrease in the market rate of interest.
decrease in the company’s tax rate.
Which of the following statements regarding the weighted average cost of capital is accurate?
It equals the aftertax cost of the outstanding liabilities.
It should be used as the required return when analyzing any new project.
It is the return investors require on the total assets of the firm.
It remains constant when the debt-equity ratio changes.
It is unaffected by changes in corporate tax rates.
It is the return investors require on the total assets of the firm.
Judy’s Boutique just paid an annual dividend of $2.59 on its common stock. The firm increases its dividend by 3.35 percent annually. What is the company’s cost of equity if the current stock price is $39.40 per share?
9.92%
9.65%
10.14%
10.53%
9.37%
10.14%
Explanation
RE = [($2.59(1.0335))/$39.40] + .0335
RE = .1014, or 10.14%
Countess Corporation is expected to pay an annual dividend of $4.03 on its common stock in one year. The current stock price is $68.91 per share. The company announced that it will increase its dividend by 3.25 percent annually. What is the company’s cost of equity?
9.65%
8.59%
8.85%
9.29%
9.10%
9.10%
Explanation
RE = ($4.03/$68.91) + .0325
RE = .0910, or 9.10%
The stock in Bowie Enterprises has a beta of .93. The expected return on the market is 12.30 percent and the risk-free rate is 3.18 percent. What is the required return on the company’s stock?
13.14%
11.66%
11.34%
14.62%
11.01%
11.66%
Explanation
RE = .0318 + .93(.1230 − .0318)
RE = .1166, or 11.66%
Bethesda Water has an issue of preferred stock outstanding with a coupon rate of 5.60 percent that sells for $95.34 per share. If the par value is $100, what is the cost of the company’s preferred stock?
5.61%
5.60%
5.63%
5.87%
6.36%
5.87%
Explanation
RP = $5.60/$95.34
RP = .0587, or 5.87%
Take It All Away has a cost of equity of 10.48 percent, a pretax cost of debt of 5.23 percent, and a tax rate of 21 percent. The company’s capital structure consists of 66 percent debt on a book value basis, but debt is 26 percent of the company’s value on a market value basis. What is the company’s WACC?
9.72%
12.30%
7.50%
8.83%
9.12%
8.83%
WACC = .74(10.48%) + [.26(5.23%)(1 − .21)]
WACC = 8.83%
