Question 1

Avery Corporation's target capital structure is 35% debt, 10% preferred, and 55% common equity.The interest rate on new debt is 6.50%, the yield on the preferred is 6.00%, the cost of common from reinvested earnings is 11.25%, and the tax rate is 25%.The firm will not be issuing any new common stock.What is Avery's WACC?

Accepted Answer

A)   8.49%
B)   8.83%
C)   9.19%
D)   9.55%
E)   9.94%

Question 2

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?

Accepted Answer

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.

Question 3

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost.

Accepted Answer

A) True 
 B)False

Question 4

The cost of capital used in capital budgeting should reflect the average after-tax cost of providing required returns to investors.

Accepted Answer

A) True 
 B)False

Question 5

Which of the following statements is CORRECT?

Accepted Answer

A)   When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.
B)   Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM.
C)   If a company's beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough reinvested earnings to take care of its equity financing and hence must issue new stock.
D)   Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC.
E)   When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.

Question 6

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 25%.An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

Accepted Answer

A) True 
 B)False

Question 7

When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to use long-term or short-term rates for rRF, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and (3) how to measure the market risk premium, RPM.These problems leave us unsure of the true value of rs.

Accepted Answer

A) True 
 B)False

Exam 9: The Cost of Capital

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost.

Correct Answer
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Correct Answer
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Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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The cost of capital used in capital budgeting should reflect the average after-tax cost of providing required returns to investors.

Correct Answer
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Correct Answer
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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 25%.An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

Correct Answer
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Exam 9: The Cost of Capital

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

The cost of capital used in capital budgeting should reflect the average after-tax cost of providing required returns to investors.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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 25%.An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

Correct AnswerverifiedShow Answer

Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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