chapter 20 - double check answsers

Question 1

1) Which of the following is the least permanent source of capital for a firm?

a) A 10% coupon bond purchased 3 years ago
b) Preferred shares
c) 10% coupon bonds issued 10 years ago
d) Accounts payable

Answer 1

d

Question 2

see sheet

Answer 2

see sheet

Question 3

see sheet

Answer 3

see sheet

Question 4

4) The required rate of return on Montreal Computing Power’s equity is 15 percent and the yield on their debt is 7 percent. There are no taxes and all cash flows are perpetuities. If the value of the debt is $1,000 and value of the equity is $1,000, what level of earnings must Montreal Computing Power earn in order to support the current valuation?

a) $290
b) $300
c) $330
d) $220

Answer 4

Answer: d, 0.071,000 + .151,000 = $220

Question 5

5) Use the following statements to answer this question:
I. Regulated industries offer their shareholders a limited required rate of return
II. Regulated industries have a very low level of debt.

a) I and II are correct
b) I and II are incorrect
c) I is correct and II is incorrect
d) I is incorrect and II is correct

Answer 5

c

Question 6

6) Which one of the following is true about book and market values?

a) Book to market values provide information about the efficient use of assets.
b) A high book to market ratio is well perceived by the market.
c) If the return on equity is lower than the required rate of return, the market to book ratio will decrease.
d) Determining prices in regulated industries depends on the market value of assets.

Answer 6

c

Question 7

7) Which of the following is not needed to determine a firm’s WACC?

a) The value of the book equity.
b) The market value of the debt.
c) The current share price.
d) The current yield on preferred shares.

Answer 7

a

Question 8

8) A firm has a capital structure that uses 45 percent equity, 20 percent preferred shares, and 35 percent debt. The preferred shares have a current yield of 5.5 percent. The debt has a coupon rate of 10 percent and a current yield to maturity of 6.5 percent. The common shares have a yield of 8 percent. There are no taxes. What is the firm’s WACC?

a) 6.575%
b) 6.975%
c) 7.275%
d) 8.200%

Answer 8

b, 0.458% + .205.5% + .35*6.5% = 6.975%

Question 9

9) Use the following statements to answer this question:
I. Without taxes, the benefit of having debt on the WACC largely vanishes.
II. Preferred shares cost the same as common equity financing.

a) I and II are correct
b) I and II are incorrect
c) I is correct and II is incorrect
d) I is incorrect and II is correct

Answer 9

c

Question 10

10) A firm has a capital structure that uses 45 percent equity, 20 percent preferred shares, and 35 percent debt. The preferred shares have a current yield of 5.5 percent. The debt has a coupon rate of 10 percent and a current yield to maturity of 6.5 percent. The common shares have a yield of 8 percent. The tax rate is 25 percent. What is the firm’s WACC?

a) 5.231%
b) 6.700%
c) 6.406%
d) 6.975%

Answer 10

Answer: c, 0.458% + .205.5% + .356.5%(1-.25) = 6.406%

Question 11

11) An analyst has obtained the following information about Maudite Brewers Co.: Book value of assets $25,000; book value of common equity $10,000; book value of preferred shares $5,000. The company has 4,000 common shares outstanding which are currently trading at $5 per share. The company has 3,000 preferred shares outstanding which are currently trading at $2 per share. The yield on the debt equals the coupon rate. The weights used to determine the weighted average cost of capital are:

Common Equity: Preferred Equity: Debt:

a) 55.56% 16.67% 27.77%
b) 40% 20% 40%
c) 80% 10% 10%
d) Cannot be determined, we need the market value of debt.

Answer 11

Answer: a, MV of each component: 4,0005 = $20,000; 3,0002 = $6,000 ; $10,000
A. $20,000/$36,000 = 55.56%; 16.67%; 27.77%

Question 12

12) A firm has 2 million shares outstanding, which are currently trading at $45 per share and have a dividend yield of 10 percent. The firm also has $40 million of 6 percent bonds outstanding that are currently trading at 110, with a yield to maturity of 3 percent. There are no preferred shares and no taxes. What is the WACC?

a) 7.70%
b) 7.85%
c) 8.69%
d) 8.77%

Answer 12

Answer: a, (.190 + .0344)/(452 + 40110%) = 7.70%

Question 13

13) A firm has 2 million shares outstanding, which are currently trading at $45 per share and have a dividend yield of 10 percent. The firm also has $40 million of 6 percent bonds outstanding that are currently trading at 110 with a 5 year maturity. There are no preferred shares and no taxes. What is the WACC?

a) 7.70%
b) 7.85%
c) 7.95%
d) 8.77%

Answer 13

Answer: c, (.190 + .0376844)/(452 + 40110%) = 7.95%

Question 14

14) A firm’s cost of debt can best be estimated:

a) by adding a risk premium to the coupon rate.
b) using the yield-to-maturity on newly issued debt of other firms.
c) using the firm’s borrowing rate on short-term loans.
d) using the yield-to-maturity on the firm’s outstanding debt

Answer 14

d

Question 15

15) Which of the following statements is/are true about the marginal cost of capital?

a) It is the weighted average cost of the next dollar of financing raised.
b) For most levels of financing, it equals the weighted average cost of capital.
c) It exceeds the weighted average cost of capital due to flotation costs.
d) All of the above are true.

Answer 15

d

Question 16

16) Which of the following is most relevant for estimating a firm’s cost of debt?

a) The yield to maturity at issuance.
b) The return bondholders would demand for new debt.
c) The coupon rate on existing debt.
d) None of the above is relevant

Answer 16

b

Question 17

17) Use the following statements to answer this question:
I. The cost of debt of the firm is always constant.
II. The estimation of the cost of debt using the yield to maturity requires the price of the bonds now.

a) I and II are correct
b) I and II are incorrect
c) I is correct and II is incorrect
d) I is incorrect and II is correct

Answer 17

d

Question 18

18) If a firm’s debt-to-equity ratio is 3, what is the weighted average cost of capital for the firm if the required rate of return is 12.4 percent and cost of debt is 8.4 percent?

a) 11.4%
b) 11.06%
c) 9.73
d) 9.4%

Answer 18

d

Question 19

19) When determining the costs of each component of a firm’s capital structure, the firm must evaluate the:

a) marginal cost of new funds
b) total cost of new funds
c) average cost of new funds
d) average cost of old and new funds

Answer 19

a

Question 20

20) The cost of a security to a company may differ from the security’s yield in the capital markets due to:

I. Flotation costs
II. Agency costs
III. Taxes

a) I only
b) I and II only
c) I and III only
d) I and II and III

Answer 20

c

Question 21

21) Toronto Skaters Company is an all-equity company and is able to fund a $1 million investment using cash. The company has a beta of 1.4, the risk-free rate is 3 percent, and the return on the market is 8 percent. Flotation costs for new equity are 3 percent. The tax rate is zero. The appropriate cost of capital is:

a) 0% as the firm is using cash.
b) 0% as the firm is using funds that have already been raised from the capital markets.
c) The required return on the outstanding equity.
d) The cost of equity taking into account the flotation costs.

Answer 21

c

Question 22

22) Toronto Skaters Company is an all-equity company and is able to fund a $1 million investment using cash. The company has a beta of 1.4, the risk-free rate is 3 percent, and the return on the market is 8 percent. Flotation costs for new equity are 2 percent. The tax rate is 40 percent. What is the WACC of the investment?

a) 14.2%
b) 10%
c) 8%
d) 6.6%

Answer 22

Answer: b, (8 – 3)*1.4+3 = 10%

Question 23

23) Laurentide Union Bank is expected to pay a dividend of $4.20 per share in one year. The dividend is expected to grow at a rate of 5 percent forever. If the current market price for a share of Laurentide Union Bank is $40, what is the cost of equity?

a) 5.00%
b) 9.52%
c) 10.50%
d) 15.50%

Answer 23

Answer: d, $40 = 4.20/(k - .05). k = 15.50%

Question 24

24) The long-term debt of Laurentide Union Bank is currently selling for 103 percent of its face value. The issue matures in 20 years and pays an annual coupon of 8 percent of face. The corporate tax rate is 40 percent. What is the after-tax cost of debt for Laurentide Union?

a) 3.08%
b) 4.62%
c) 4.80%
d) 7.70%

Answer 24

Answer: b, YTM * (1-.4) = 4.62%

Question 25

25) The Bay James Water Park Company’s preferred shares pay an annual dividend of $3.00 per share. What is the cost of preferred stock if the current price is $80 per share and after-tax flotation costs are $6 per share?

a) 4.05%
b) 3.75%
c) 7.50%
d) 7.79%

Answer 25

Answer: a, $3/(80-6) = 4.05%

Question 26

26) Poutine Company is considering offering long-term contracts to many of its non-contract employees (a switch to fixed labour costs from variable labour costs). What is the impact of this decision?

a) The increase in operating leverage results in greater variability in operating income.
b) The increase in operating leverage results in less variability in operating income.
c) The decrease in operating leverage results in greater variability in operating income.
d) The decrease in operating leverage results in less variability in operating income.

Answer 26

a

Question 27

27) The management of the Bay James Water Park is concerned about the volatility of the firm’s net income. In order to reduce this volatility, they are planning on issuing new shares to repurchase debt and to enter into more fixed contracts with suppliers. The effect of these actions is likely to be:

a) A reduction of volatility of net income due to the reduction in financial leverage.
b) An increase in volatility of net income due to the reduction in financial leverage.
c) A reduction of volatility of net income due to the reduction in financial leverage and increase in operating leverage.
d) The impact on the volatility of net income is unclear as the effects of the reduction in financial leverage and increase in operating leverage are opposite.

Answer 27

d

Question 28

28) Use the following statements to answer this question:
I. The source of volatility in operating income is caused by fixed costs.
II. Operating leverage does not necessarily increase with increases in the volatility of net income.

a) I and II are correct
b) I and II are incorrect
c) I is correct and II is incorrect
d) I is incorrect and II is correct

Answer 28

a

Question 29

29) Toronto Skaters Co. has a return on equity of 8 percent and pays out 20 percent of its earnings in dividends. The expected growth in dividends is:

a) 1.6%
b) 6.4%
c) 8%
d) 20%

Answer 29

Answer: b, .08 * (1-20%) = 6.4%

Question 30

30) According to the Boston Consulting Group, a firm with a low present value of existing operations but a high present value of growth opportunities would be classified as:

a) A dog
b) A cash cow
c) A star
d) A turnaround firm

Answer 30

d

Question 31

31) According to the Boston Consulting Group, a cash cow is characterized by:

a) High present value of existing operations and low present value of growth opportunities
b) High present value of existing operations and high present value of growth opportunities
c) Low present value of existing operations and low present value of growth opportunities
d) Low present value of existing operations and high present value of growth opportunities

Answer 31

a

Question 32

32) The manager of Montreal Trustco has noticed that as he increases the dividend payout ratio, the value of the firm’s equity declines. This is most likely due to:

a) The firm’s return on equity is lower than the required return on equity
b) The firm’s return on equity is higher than the required return on equity
c) The firm’s return on equity is equal to the required return on equity
d) None of the above is a likely explanation

Answer 32

b

Question 33

33) The manager of Montreal Trustco has noticed that as he increases the dividend payout ratio, the value of the firm’s equity increases. This is most likely due to:

a) The firm’s return on equity is lower than the required return on equity
b) The firm’s return on equity is higher than the required return on equity
c) The firm’s return on equity is equal to the required return on equity
d) None of the above is a likely explanation

Answer 33

a

Question 34

34) Use the following statements to answer this question:
I. A firm’s growth depends on its reinvestment opportunities.
II. Increasing the firm’s retention ratio does not always increase the value of the firm.

a) I and II are correct
b) I and II are incorrect
c) I is correct and II is incorrect
d) I is incorrect and II is correct

Answer 34

a

Question 35

35) Montreal Trustco expects to pay a dividend of $5 next year. Dividends are expected to grow at 3 percent forever and the market requires a rate of return of 7 percent on its stock. Montreal Trustco can issue new stock at $125 per share with flotation costs of $20 per share. The tax rate is zero. The cost of issuing new equity to Montreal Trustco is:

a) 3.00%
b) 7.00%
c) 7.76%
d) 11.76%

Answer 35

Answer: c, k = 5 / (125 - 20) + 3% = 7.76%

Question 36

36) The Third Cup Company has a return on equity of 10 percent and pays out 30 percent of its earnings as dividends. The company is expected to pay a dividend of $2 next year and the current stock price is $20. The cost of equity of The Third Cup Company is:

a) 17%
b) 13%
c) 10%
d) 7%

Answer 36

a

Growth = 10% *(1-30%) = 7%. $20 = 2/(k-.07) k=17%

Question 37

37) The Third Cup Company has just paid a dividend of $3 per share. The dividends are expected to grow at a rate of 4 percent per year forever. The current stock price is $25 per share. The firm faces a tax rate of 40 percent and flotation costs of 5% on new stock issues. The cost of equity for internal funds is:

a) 9.89%
b) 10.12%
c) 16.48%
d) 16.87%

Answer 37

Answer: c, 25 = 3*(1.04)/(k - .04) k = 16.48%

Question 38

38) The Third Cup Company has just paid a dividend of $3 per share. The dividends are expected to grow at a rate of 4 percent per year forever. The current stock price is $25 per share. The firm faces a tax rate of 40 percent and flotation costs of 5 percent on new stock issues. The cost of equity for new funds is:

a) 9.89%
b) 10.12%
c) 16.48%
d) 16.87%

Answer 38

Answer: d, NP = 25 (1-.05(1-.4)) = 24.25, 24.25 = 3*(1.04)/(k-.04), k = 16.87%

Question 39

39) The Montreal Film Festival Company has a book value per share of $10 and a current return on equity of 7 percent. The firm expects to invest $100 next year and earn a return of 10 percent on that investment. The market requires a rate of return of 5 percent on the firm’s equity. The present value of existing opportunities and the present value of growth opportunities are:

a) PVEO = $95.24; PVGO = $14.00
b) PVEO = $14.00; PVGO = $95.24
c) PVEO = $10.00; PVGO = $100.00
d) PVEO = $100.00; PVGO = $10.00

Answer 39

Answer: b, PVEO = 7% * $10/.05 = $14.00; PVGO = ($100/1.05)*(.10-.05)/.05 = $95.24
Type: Calculation

Question 40

40) The Saguenay Tourism Company has a beta of 1.30, the risk-free rate is 3 percent, and the return on the market is 4 percent. The required return on the firm’s equity is:

a) 3.9%
b) 6.5%
c) 4.30%
d) 9.50%

Answer 40

Answer: c, 3% + 1.3*(4% - 3%) = 4.30%
Type: Calculation

Question 41

41) The Saguenay Tourism Company has a beta of .80, the risk-free rate is 4 percent, and the market risk premium is 6 percent. The required return on the firm’s equity is:

a) 4.0%
b) 5.6%
c) 8.8%
d) 6.0%

Answer 41

Answer: c, 4% + .80 * 6% = 8.8%
Type: Calculation

Question 42

42) The Saguenay Tourism Company is an all-equity company and is able to fund a $1 million investment using cash. The company has a beta of 1.4, the risk-free rate is 2 percent, and the return on the market is 8 percent. Flotation costs for new equity are 5 percent. The tax rate is zero. The appropriate cost of capital is:

a) 0.00%
b) 5.00%
c) 10.40%
d) Greater than 10.40%

Answer 42

Answer: c, k = 2% + 1.4*(8% - 2%) = 10.40%

Question 43

43) Use the following statements to answer this question:
I. The WACC is the most appropriate rate to discount future cash flows of average risk.
II. The investment opportunities schedule uses WACC as a threshold for investment.

a) I and II are correct
b) I and II are incorrect
c) I is correct and II is incorrect
d) I is incorrect and II is correct

Answer 43

A