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Exam 9: The Cost of Capital

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Question 21

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Careco Company and Audaco Inc are identical in size and capital structure.However,the riskiness of their assets and cash flows are somewhat different,resulting in Careco having a WACC of 10% and Audaco a WACC of 12%.Careco is considering Project X,which has an IRR of 10.5% and is of the same risk as a typical Careco project.Audaco is considering Project Y,which has an IRR of 11.5% and is of the same risk as a typical Audaco project. Now assume that the two companies merge and form a new company,Careco/Audaco Inc.Moreover,the new company's market risk is an average of the pre-merger companies' market risks,and the merger has no impact on either the cash flows or the risks of Projects X and Y.Which of the following statements is CORRECT?

A) If evaluated using the correct post-merger WACC,Project X would have a negative NPV.
B) After the merger,Careco/Audaco would have a corporate WACC of 11%.Therefore,it should reject Project X but accept Project Y.
C) Careco/Audaco's WACC,as a result of the merger,would be 10%.
D) After the merger,Careco/Audaco should select Project Y but reject Project X.If the firm does this,its corporate WACC will fall to 10.5%.
E) If the firm evaluates these projects and all other projects at the new overall corporate WACC,it will probably become riskier over time.

F) B) and D)
G) C) and E)

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Question 22

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The Tierney Group has two divisions of equal size: an office furniture manufacturing division and a data processing division.Its CFO believes that stand-alone data processor companies typically have a WACC of 9%,while stand-alone furniture manufacturers typically have a 13% WACC.She also believes that the data processing and manufacturing divisions have the same risk as their typical peers.Consequently,she estimates that the composite,or corporate,WACC is 11%.A consultant has suggested using a 9% hurdle rate for the data processing division and a 13% hurdle rate for the manufacturing division.However,the CFO disagrees,and she has assigned an 11% WACC to all projects in both divisions.Which of the following statements is CORRECT?

A) The decision not to adjust for risk means,in effect,that it is favoring the data processing division.Therefore,that division is likely to become a larger part of the consolidated company over time.
B) The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division.This will lead to a reduction in the firm's intrinsic value over time.
C) The decision not to risk-adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business.This will lead to a reduction in its intrinsic value over time.
D) The decision not to risk-adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business.This may affect the firm's capital structure but it will not affect its intrinsic value.
E) While the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant's recommendation,this should not affect the firm's intrinsic value.

F) A) and E)
G) B) and C)

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Question 23

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Since 70% of the preferred dividends received by a corporation are excluded from taxable income,the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should,theoretically,be Cost of equity = r_s(0.30)(0.50)+ r_ps(1 − T)(0.70)(0.50).

Bartlett Company's target capital structure is 40% debt,15% preferred,and 45% common equity.The after-tax cost of debt is 6.00%,the cost of preferred is 7.50%,and the cost of common using reinvested earnings is 12.75%.The firm will not be issuing any new stock.You were hired as a consultant to help determine their cost of capital.What is its WACC?

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

Quinlan Enterprises stock trades for $52.50 per share.It is expected to pay a $2.50 dividend at year end (D₁ = $2.50) ,and the dividend is expected to grow at a constant rate of 5.50% a year.The before-tax cost of debt is 7.50%,and the tax rate is 40%.The target capital structure consists of 45% debt and 55% common equity.What is the company's WACC if all the equity used is from reinvested earnings?

If the expected dividend growth rate is zero,then the cost of external equity capital raised by issuing new common stock (r_e)is equal to the cost of equity capital from retaining earnings (r_s)divided by one minus the percentage flotation cost required to sell the new stock, (1 − F).If the expected growth rate is not zero,then the cost of external equity must be found using a different formula.

In general,firms should use their weighted average cost of capital (WACC)to evaluate capital budgeting projects because most projects are funded with general corporate funds,which come from a variety of sources.However,if the firm plans to use only debt or only equity to fund a particular project,it should use the after-tax cost of that specific type of capital to evaluate that project.

To help estimate its cost of common equity,Maxwell and Associates recently hired you.You have obtained the following data: D₀ = $0.90;P₀ = $27.50;and g_L = 7.00% (constant) .Based on the dividend growth model,what is the cost of common from reinvested earnings?

For capital budgeting and cost of capital purposes,the firm should always consider reinvested earnings as the first source of capital⎯i.e. ,use these funds first⎯because reinvested earnings have no cost to the firm.

Your consultant firm has been hired by Eco Brothers Inc.to help them estimate the cost of common equity.The yield on the firm's bonds is 8.75%,and your firm's economists believe that the cost of common can be estimated using a risk premium of 3.85% over a firm's own cost of debt.What is an estimate of the firm's cost of common from reinvested earnings?

Granby Foods' (GF) balance sheet shows a total of $25 million long-term debt with a coupon rate of 8.50%.The yield to maturity on this debt is 8.00%,and the debt has a total current market value of $27 million.The company has 10 million shares of stock,and the stock has a book value per share of $5.00.The current stock price is $20.00 per share,and stockholders' required rate of return,r_s,is 12.25%.The company recently decided that its target capital structure should have 35% debt,with the balance being common equity.The tax rate is 40%.Calculate WACCs based on book,market,and target capital structures.What is the sum of these three WACCs?

The Anderson Company has equal amounts of low-risk,average-risk,and high-risk projects.The firm's overall WACC is 12%.The CFO believes that this is the correct WACC for the company's average-risk projects,but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects.The CEO disagrees,on the grounds that even though projects have different risks,the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources.If the CEO's position is accepted,what is likely to happen over time?

The Lincoln Company sold a $1,000 par value,noncallable bond several years ago that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually.The bond currently sells for $925 and the company's tax rate is 40%.What is the component cost of debt for use in the WACC calculation?

The cost of equity raised by retaining earnings can be less than,equal to,or greater than the cost of external equity raised by selling new issues of common stock,depending on tax rates,flotation costs,the attitude of investors,and other factors.

Suppose the debt ratio (D/TA)is 50%,the interest rate on new debt is 8%,the current cost of equity is 16%,and the tax rate is 40%.An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

Kenny Electric Company's noncallable bonds were issued several years ago and now have 20 years to maturity.These bonds have a 9.25% annual coupon,paid semiannually,sells at a price of $1,075,and has a par value of $1,000.If the firm's tax rate is 40%,what is the component cost of debt for use in the WACC calculation?

Which of the following statements is CORRECT?

The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

To help them estimate the company's cost of capital,Smithco has hired you as a consultant.You have been provided with the following data: D₁ = $1.45;P₀ = $22.50;and g_L = 6.50% (constant) .Based on the dividend growth approach,what is the cost of common from reinvested earnings?