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Exam 12: Cost of Capital

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Question 1

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Which one of the following statements is correct?

A) An increase in the market value of preferred stock will increase a firm's weighted average cost of capital.
B) The cost of preferred stock is unaffected by the issuer's tax rate.
C) Preferred stock is generally the cheapest source of capital for a firm.
D) The cost of preferred stock remains constant from year to year.
E) Preferred stock is valued using the capital asset pricing model.

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

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Question 2

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A firm has a cost of equity of 13 percent,a cost of preferred of 11 percent,and an aftertax cost of debt of 6 percent.Given this,which one of the following will increase the firm's weighted average cost of capital?

A) Increasing the firm's tax rate
B) Issuing new bonds at par
C) Redeeming shares of common stock
D) Increasing the firm's beta
E) Increasing the debt-equity ratio

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

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D

Question 3

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The market rate of return is 14.8 percent and the risk-free rate is 4.45 percent.Galaxy Co.has 54 percent more systematic risk than the overall market and has a dividend growth rate of 5.5 percent.The firm's stock is currently selling for $39 a share and has a dividend yield of 3.6 percent.What is the firm's cost of equity?

Old Town Industries has three divisions.Division X has been in existence the longest and has the most stable sales.Division Y has been in existence for five years and is slightly less risky than the overall firm.Division Z is the research and development side of the business.When allocating funds,the firm should probably:

Casper's is analyzing a proposed expansion project that is much riskier than the firm's current operations.Thus,the project will be assigned a discount rate equal to the firm's cost of capital plus 3 percent.The proposed project has an initial cost of $17.2 million that will be depreciated on a straight-line basis over 20 years.The project also requires additional inventory of $687,000 over the project's life.Management estimates the facility will generate cash inflows of $2.78 million a year over its 20-year life.After 20 years,the company plans to sell the facility for an estimated $1.3 million.The company has 60,000 shares of common stock outstanding at a market price of $49 a share.This stock just paid an annual dividend of $1.84 a share.The dividend is expected to increase by 3.5 percent annually.The firm also has 10,000 shares of 12 percent preferred stock with a market value of $98 a share.The preferred stock has a par value of $100.The company has a 9 percent,semiannual coupon bond issue outstanding with a total face value of $1.1 million.The bonds are currently priced at 102 percent of face value and mature in 16 years.The tax rate is 33 percent.Should the firm pursue the expansion project at this point in time? Why or why not?

Assume a firm follows a policy of using its weighted average cost of capital as the required return for all of its proposed projects.Evaluate this policy.How will this policy affect the overall risk level of the firm over time?

Lester's is a globally diverse company with multiple divisions and a cost of capital of 15.8 percent.Med,Inc.is a specialty firm in the medical equipment field with a cost of capital of 13.7 percent.With the aging of America,both firms recognize the opportunities that exist in the medical field and are considering expansion in this area.At present,there is an opportunity for multiple firms to be involved in a new medical devices project.Each project will require an initial investment of $8.4 million with annual returns of $2.2 million per year for seven years.Which firm or firms,if either,should become involved in the new projects?

A firm uses its weighted average cost of capital to evaluate the proposed projects for all of its varying divisions.By doing so,the firm:

Titans,Inc.has 6 percent bonds outstanding that mature in 14 years.The bonds pay interest semiannually and have a face value of $1,000.Currently,the bonds are selling for $993 each.What is the firm's pretax cost of debt?

When using the pure play approach for a proposed investment,a firm is primarily seeking a rate of return that:

Trendsetters has a cost of equity of 18.1 percent.The market risk premium is 10.2 percent and the risk-free rate is 4.4 percent.The company is acquiring a competitor,which will increase the company's beta to 1.6.What effect,if any,will the acquisition have on the firm's cost of equity capital?

A firm that uses its weighted average cost of capital as the required return for all of its investments will:

Which one of the following will decrease the aftertax cost of debt for a firm?

Orchard Farms has a pretax cost of debt of 7.68 percent and a cost of equity of 15.2 percent.The firm uses the subjective approach to determine project discount rates.Currently,the firm is considering a project to which it has assigned an adjustment factor of -0.5 percent.The firm's tax rate is 34 percent and its debt-equity ratio is 0.45.The project has an initial cost of $4.3 million and produces cash inflows of $1.27 million a year for 5 years.What is the net present value of the project?

Beverly's is a retail chain selling the latest fashions through its outlets located in various neighborhood malls.Clothing Galore is a wholesaler that buys from textile mills and sells to retail outlets.Beverly's has a cost of capital of 13.6 percent,while Clothing Galore's cost of capital is 17.8 percent.Both firms are considering opening a retail outlet in a gigantic new mall.Both proposals are quite similar in design and have basically the following financial features: an initial cash outlay of $2.7 million,a projected five-year life with no salvage value,and cash inflows of $845,000 a year for the life of the project.Which firm or firms,if either,should open a retail outlet in the new mall?

Which one of the following represents the rate of return a firm must earn on its assets if it is to maintain the current value of its securities?

The computation of which one of the following requires assigning every proposed investment to a particular risk class?

A firm has multiple divisions of similar nature,yet varying degrees of risk.Which one of the following would be the most appropriate,yet relatively easy,means of assigning discount rates to each of its proposed investments?

Tim's Tools just issued a dividend of $1.80 per share on its common stock.The company is expected to maintain a constant 4 percent growth rate in its dividends indefinitely.If the stock sells for $31 a share,what is the company's cost of equity?

The common stock of Wiley and Sons has a beta that is 25 percent larger than the overall market beta.Currently,the market risk premium is 9.5 percent while the U.S.Treasury bill is yielding 4.7 percent.What is the cost of equity for this firm?