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FRL 301 Ch.14 Test Bank Questions And Correct
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A group of individuals got together and purchased all of the outstanding shares of common stock of DL Smith, Inc. What is the return that these individuals require on this investment called? - ANSWER cost of equity
Textile Mills borrows money at a rate of 13.5 percent. This interest rate is referred to as the: - ANSWER cost of debt.
The average of a firm's cost of equity and aftertax cost of debt that is weighted based on the firm's capital structure is called the: - ANSWER weighted average cost of capital
When a manager develops a cost of capital for a specific project based on the cost of capital for another firm which has a similar line of business as the project, the manager is utilizing the _____ approach. - ANSWER pure play
A firm's cost of capital: - ANSWER depends upon how the funds raised are going to be spent.
The weighted average cost of capital for a wholesaler: - ANSWER is the return investors require on the total assets of the firm.
Which one of the following is the primary determinant of a firm's cost of capital? - ANSWER use of the funds
Scholastic Toys is considering developing and distributing a new board game for children. The project is similar in risk to the firm's current operations. The firm maintains a debt-equity ratio of 0.40 and retains all profits to fund the firm's rapid growth. How should the firm determine its cost of equity? - ANSWER by using the capital asset pricing model
All else constant, which one of the following will increase a firm's cost of equity if the firm computes that cost using the security market line approach? Assume the firm currently pays an annual dividend of $1 a share and has a beta of 1.2. - ANSWER a reduction in the risk-free rate
A firm's overall cost of equity is: - ANSWER highly dependent upon the growth rate and risk level of the firm.
The cost of equity for a firm: - ANSWER ignores the firm's risks when that cost is based on the dividend growth model.
The dividend growth model can be used to compute the cost of equity for a firm in which of the following situations?
I. firms that have a 100 percent retention ratio
II. firms that pay a constant dividend
III. firms that pay an increasing dividend
IV. firms that pay a decreasing dividend - ANSWER II, III, and IV only
The dividend growth model: - ANSWER is only as reliable as the estimated rate of growth.
Which one of the following statements related to the SML approach to equity valuation is correct? Assume the firm uses debt in its capital structure. - ANSWER The model is dependent upon a reliable estimate of the market risk premium.
Which of the following statements are correct?
I. The SML approach is dependent upon a reliable measure of a firm's unsystematic risk.
II. The SML approach can be applied to firms that retain all of their earnings.
III. The SML approach assumes a firm's future risks are similar to its past risks.
IV. The SML approach assumes the reward-to-risk ratio is constant. - ANSWER II, III, and
II. debt-equity ratio.
III. preferred dividend payment.
IV. retention ratio. - ANSWER I, II, III, and IV
The weighted average cost of capital for a firm is the: - ANSWER rate of return a firm must earn on its existing assets to maintain the current value of its stock.
Which one of the following statements is correct for a firm that uses debt in its capital structure? - ANSWER The WACC should decrease as the firm's debt-equity ratio increases.
If a firm uses its WACC as the discount rate for all of the projects it undertakes then the firm will tend to:
I. reject some positive net present value projects.
II. accept some negative net present value projects.
III. favor high risk projects over low risk projects.
IV. increase its overall level of risk over time. - ANSWER I, II, III, and IV
Preston Industries has two separate divisions. Each division is in a separate line of business. Division A is the largest division and represents 70 percent of the firm's overall sales. Division A is also the riskier of the two divisions. Division B is the smaller and least risky of the two. When management is deciding which of the various divisional projects should be accepted, the managers should: - ANSWER assign appropriate, but differing, discount rates to each project and then select the projects with the highest net present values.
Markley and Stearns is a multi-divisional firm that uses its WACC as the discount rate for all proposed projects. Each division is in a separate line of business and each presents risks unique to those lines. Given this, a division within the firm will tend to: - ANSWER prefer higher risk projects over lower risk projects.
The discount rate assigned to an individual project should be based on: - ANSWER the risks associated with the use of the funds required by the project.
Assigning discount rates to individual projects based on the risk level of each project: - ANSWER may cause the firm's overall weighted average cost of capital to either increase or decrease over time.
Which one of the following statements is correct?
A. Firms should accept low risk projects prior to funding high risk projects.
B. Making subjective adjustments to a firm's WACC when determining project discount rates unfairly punishes low-risk divisions within a firm.
C. A project that is unacceptable today might be acceptable tomorrow given a change in market returns.
D. The pure play method is most frequently used for projects involving the expansion of a firm's current operations.
E. Firms that elect to use the pure play method for determining a discount rate for a project cannot subjectively adjust the pure play rate. - ANSWER A project that is unacceptable today might be acceptable tomorrow given a change in market returns.
Phil's is a sit-down restaurant that specializes in home-cooked meals. Theresa's is a walk-in deli that specializes in specialty soups and sandwiches. Both firms are currently considering expanding their operations during the summer months by offering pre-wrapped donuts, sandwiches, and wraps at a local beach. Phil's currently has a WACC of 14 percent while Theresa's WACC is 10 percent. The expansion project has a projected net present value of $12,600 at a 10 percent discount rate and a net present value of -$2,080 at a 14 percent discount rate. Which firm or firms should expand and offer food at the local beach during the summer months? - ANSWER both Phil's and Theresa's
Wilderness Adventures specializes in back-country tours and resort management. Travel Excitement specializes in making travel reservations and promoting vacation travel. Wilderness Adventures has an aftertax cost of capital of 13 percent and Travel Excitement has an aftertax cost of capital of 11 percent. Both firms are considering building wilderness campgrounds complete with man-made lakes and hiking trails. The estimated net present value of such a project is estimated at $87,000 at a discount rate of 11 percent and -$12,500 at a 13 percent discount rate. Which firm or firms, if either, should accept this project? - ANSWER neither Wilderness Adventures nor Travel
Chelsea Fashions is expected to pay an annual dividend of $0.80 a share next year. The market price of the stock is $22.40 and the growth rate is 5 percent. What is the firm's cost of equity? - ANSWER 8.57 percent
R(e)= ($0.8/$22.4) + 0.5 = 8.57%
The Shoe Outlet has paid annual dividends of $0.65, $0.70, $0.72, and $0.75 per share over the last four years, respectively. The stock is currently selling for $26 a share. What is this firm's cost of equity? - ANSWER 7.93 percent
g = (0.076923 + 0.028571 + 0.041667)/3 =.
Re = [($0.75 1.049054)/$26] + .049054 = 7.93 percent
Sweet Treats common stock is currently priced at $19.06 a share. The company just paid $1.15 per share as its annual dividend. The dividends have been increasing by 2. percent annually and are expected to continue doing the same. What is this firm's cost of equity? - ANSWER 8.68 percent
e = [($1.15 1.025)/$19.06] + 0.025 = 8.68 percent
The common stock of Metal Molds has a negative growth rate of 1.5 percent and a required return of 18 percent. The current stock price is $11.40. What was the amount of the last dividend paid? - ANSWER $2.
D1 = [(0.18 - (-0.015)) $11.40] = $2.223; D0 = $2.223/(1 - 0.015) = $2.
Highway Express has paid annual dividends of $1.16, $1.20, $1.25, $1.10, and $0. over the past five years respectively. What is the average dividend growth rate? -
ANSWER -4.51 percent
g = (0.034483 + 0.041667 - 0.12 - 0.136364)/4 = -4.51 percent
Southern Home Cookin' just paid its annual dividend of $0.65 a share. The stock has a market price of $13 and a beta of 1.12. The return on the U.S. Treasury bill is 2.5 percent and the market risk premium is 6.8 percent. What is the cost of equity? - ANSWER 10. percent
Re = 0.025 + (1.12 0.068) = 10.12 percent
National Home Rentals has a beta of 1.38, a stock price of $19, and recently paid an annual dividend of $0.94 a share. The dividend growth rate is 4.5 percent. The market has a 10.6 percent rate of return and a risk premium of 7.5 percent. What is the firm's cost of equity? - ANSWER 11.56 percent
Re = (0.106 - 0.075) + (1.38 0.075) = 0.
Re = [($0.94 1.045)/$19] + 0.045 = 0.
Re Average = (0.1345 + 0.0967)/2 = 11.56 percent
Henessey Markets has a growth rate of 4.8 percent and is equally as risky as the market. The stock is currently selling for $17 a share. The overall stock market has a 10.6 percent rate of return and a risk premium of 8.7 percent. What is the expected rate of return on this stock? - ANSWER 10.6 percent
Re = (0.106 - 0.087) + (1.00 0.087) = 10.6 percent
Aftertax R(d)= 0.055597 x (1-0.32) = 3.
Handy Man, Inc. has zero coupon bonds outstanding that mature in 8 years. The bonds have a face value of $1,000 and a current market price of $640. What is the company's pre-tax cost of debt? - ANSWER 5.66 percent
N 8x
IY /
PV -
FV 1000
Solve for IY: 5.
Dog Gone Good Engines has a bond issue outstanding with 17 years to maturity. These bonds have a $1,000 face value, a 9 percent coupon, and pay interest semi-annually. The bonds are currently quoted at 87 percent of face value. What is the company's pre-tax cost of debt if the tax rate is 38 percent? - ANSWER 10.67 percent
N 17x
IY /
PV -
PMT 90/
FV 1000
Solve for IY: 10.
The Corner Bakery has a bond issue outstanding that matures in 7 years. The bonds pay interest semi-annually. Currently, the bonds are quoted at 101.4 percent of face value and carry a 9 percent coupon. What is the firm's aftertax cost of debt if the tax rate is 30 percent? - ANSWER 6.11 percent
N 7x
IY /
PV -
PMT 90/
FV 1000
Solve for IY: 8.
Aftertax R(d)= 0.087285x(1-0.30)=6.11%
The outstanding bonds of Tech Express are priced at $989 and mature in 8 years. These bonds have a 6 percent coupon and pay interest annually. The firm's tax rate is 39 percent. What is the firm's aftertax cost of - ANSWER 3.77 percent
N 8
PV -
PMT 60
FV 1000
Solve for IY: 6.
Aftertax R(d)= 0.061784x(1-0.39)=3.
Simple Foods has a zero coupon bond issue outstanding that matures in 9 years. The bonds are selling at 42 percent of par value. What is the company's aftertax cost of debt if the tax rate is 38 percent? - ANSWER 6.12 percent
N 9x
IY /
PV -
FV 1000
Solve for IY: 9.
Electronics Galore has 950,000 shares of common stock outstanding at a market price of $38 a share. The company also has 40,000 bonds outstanding that are quoted at 106 percent of face value. What weight should be given to the debt when the firm computes its weighted average cost of capital? - ANSWER 54 percent
Debt: 40000 x 1000 x 1.06 = 42.4M
Common: 950000 x 38 = 36.1M
Total: 42.4M + 36.1M = 78.5M
Weight(Debt): 42.4M/78.5M
Phillips Equipment has 80,000 bonds outstanding that are selling at par. Bonds with similar characteristics are yielding 6.75 percent. The company also has 750,000 shares of 7 percent preferred stock and 2.5 million shares of common stock outstanding. The preferred stock sells for $53 a share. The common stock has a beta of 1.34 and sells for $42 a share. The U.S. Treasury bill is yielding 2.8 percent and the return on the market is 11.2 percent. The corporate tax rate is 38 percent. What is the firm's weighted average cost of capital? - ANSWER 10.39 percent
Re = 0.028 + 1.34 (0.112 - 0.028) = 0.
Rp = (0.07 $100)/$53 = 0.
Debt: .028 + 1.34(.112-.028) = 0.
Preferred: 75000 x 53= 39.75m
Common 2.5m x 42= 105m
Total: 224.75m
WACC= (105m/224.75m)(0.14056) = (39.75m/224.75m)(-.13208) + (80m/224.75m)(0.0675)(1-0.38)= 10.39%
Wayco Industrial Supply has a pre-tax cost of debt of 7.6 percent, a cost of equity of 14.
percent, and a cost of preferred stock of 8.5 percent. The firm has 220,000 shares of common stock outstanding at a market price of $27 a share. There are 25,000 shares of preferred stock outstanding at a market price of $41 a share. The bond issue has a face value of $550,000 and a market quote of 101.2. The company's tax rate is 37 percent. What is the firm's weighted average cost of capital? - ANSWER 12.81 percent
Central Systems, Inc. desires a weighted average cost of capital of 8 percent. The firm has an aftertax cost of debt of 4.8 percent and a cost of equity of 15.2 percent. What debt-equity ratio is needed for the firm to achieve its targeted weighted average cost of capital? - ANSWER 2.
WACC = 0.08 = [We 0.152] + [(1 - We) 0.048)]
We = 0.3077; Wd = 1 - We = 0.
Debt-equity ratio = 0.6923/0.3077 = 2.
R.S. Green has 250,000 shares of common stock outstanding at a market price of $28 a share. Next year's annual dividend is expected to be $1.55 a share. The dividend growth rate is 2 percent. The firm also has 7,500 bonds outstanding with a face value of $1, per bond. The bonds carry a 7 percent coupon, pay interest semiannually, and mature in 7.5 years. The bonds are selling at 98 percent of face value. The company's tax rate is 34 percent. What is the firm's weighted average cost of capital? - ANSWER 6.2 percent
Debt: 7500 x .98= 7.35m
Common: 250000 x 28= 7m
Total: 14.35m
R(e)= (1.55/28) + 0.02= 0.
Enter:
N 7.5x
IY /
PV -
Common: 30000 x 17.5= 525000
Debt: 280000 x 0.86= 240000
Total= 756800
The Market Outlet has a beta of 1.38 and a cost of equity of 14.945 percent. The risk-free rate of return is 4.25 percent. What discount rate should the firm assign to a new project that has a beta of 1.25? - ANSWER 13.94 percent.
RE = 0.14945 = 0.0425 + (1.38 mrp); mrp = 0.
RProject = 0.0425 + (1.25 0.0775) = 13.94 percent
Silo Mills has a beta of 0.87 and a cost of equity of 11.9 percent. The risk-free rate of return is 2.8 percent. The firm is currently considering a project that has a beta of 1. and a project life of 6 years. What discount rate should be assigned to this project? - ANSWER 13.57 percent.
RE = 0.119 = 0.028 + (0.87 mrp); mrp = 0.
RProject = 0.028 + (1.03 0.1046) = 13.57 percent
Travis & Sons has a capital structure which is based on 40 percent debt, 5 percent preferred stock, and 55 percent common stock. The pre-tax cost of debt is 7.5 percent, the cost of preferred is 9 percent, and the cost of common stock is 13 percent. The company's tax rate is 39 percent. The company is considering a project that is equally as risky as the overall firm. This project has initial costs of $325,000 and annual cash inflows of $87,000, $279,000, and $116,000 over the next three years, respectively. What is the projected net present value of this project? - ANSWER $76,011.
WACC = (0.55 0.13) + (0.05 0.09) + [0.40 0.075 (1 - 0.39)] =0.
NPV -$325,000 + ($87,000/1.0943) + ($279,000/1.09432) + ($116,000/1.09433) =
Panelli's is analyzing a project with an initial cost of $102,000 and cash inflows of
$65,000 in year one and $74,000 in year two. This project is an extension of the firm's current operations and thus is equally as risky as the current firm. The firm uses only debt and common stock to finance its operations and maintains a debt-equity ratio of 0.45. The aftertax cost of debt is 4.8 percent, the cost of equity is 12.7 percent, and the tax rate is 35 percent. What is the projected net present value of this project? - ANSWER $17,
WACC = (1/1.45) (0.127) + (0.45/1.45) (0.048) = 0.
NPV = -$102,000 + ($65,000/1.102483) + ($74,000/1.1024832) = $17,
Carson Electronics uses 70 percent common stock and 30 percent debt to finance its operations. The aftertax cost of debt is 5.4 percent and the cost of equity is 15. percent. Management is considering a project that will produce a cash inflow of $36, in the first year. The cash inflows will then grow at 3 percent per year forever. What is the maximum amount the firm can initially invest in this project to avoid a negative net present value for the project? - ANSWER $382,
WACC = 0.70(0.154) + 0.30(0.054) = 0.
PV = $36,000/(0.124 - 0.03) = $382,
The Bakery is considering a new project it considers to be a little riskier than its current operations. Thus, management has decided to add an additional 1.5 percent to the company's overall cost of capital when evaluating this project. The project has an initial cash outlay of $62,000 and projected cash inflows of $17,000 in year one, $28,000 in year two, and $30,000 in year three. The firm uses 25 percent debt and 75 percent common stock as its capital structure. The company's cost of equity is 15.5 percent while the aftertax cost of debt for the firm is 6.1 percent. What is the projected net present value of the new project? - ANSWER -$5,
WACCFirm = (0.75 0.155) + (0.25 0.061) = 0.
WACCProject = 0.1315 + 0.015 = 0.
NPV = -$62,000 + ($17,000/1.1465) + ($28,000/1.14652) + ($30,000/1.14653) = -$5,
The Oil Derrick has an overall cost of equity of 13.6 percent and a beta of 1.28. The firm
future total sales. The initial cash outlay for this project would be $85,000. The expected net cash inflows are $16,000 a year for 7 years. What is the net present value of the Sister Pools project? - ANSWER -$9,
Decker's is a chain of furniture retail stores. Furniture Fashions is a furniture maker and a supplier to Decker's. Decker's has a beta of 1.38 as compared to Furniture Fashion's beta of 1.12. The risk-free rate of return is 3.5 percent and the market risk premium is 8 percent. What discount rate should Decker's use if it considers a project that involves the manufacturing of furniture? - ANSWER 12.46 percent
Re = 0.035 + 1.12(0.08) = 12.46 percent
Bleakly Enterprises has a capital structure of 55 percent common stock, 10 percent preferred stock, and 35 percent debt. The flotation costs are 4.5 percent for debt, 7 percent for preferred stock, and 9.5 percent for common stock. The corporate tax rate is 34 percent. What is the weighted average flotation cost? - ANSWER 7.5 percent
Average flotation cost = (0.55 0.095) + (0.10 0.07) + (0.35 0.045) = 7.5 percent
Justice, Inc. has a capital structure which is based on 30 percent debt, 5 percent preferred stock, and 65 percent common stock. The flotation costs are 11 percent for common stock, 10 percent for preferred stock, and 7 percent for debt. The corporate tax rate is 37 percent. What is the weighted average flotation cost? - ANSWER 9. percent
Average flotation cost = (0.65 0.11) + (0.05 0.10) + (0.30 0.07) = 9.75 percent
The Daily Brew has a debt-equity ratio of 0.72. The firm is analyzing a new project which requires an initial cash outlay of $420,000 for equipment. The flotation cost is 9. percent for equity and 5.4 percent for debt. What is the initial cost of the project including the flotation costs? - ANSWER $455,
Average flotation cost = (1/1.72) (0.096) + (0.72/1.72) (0.054) = 0.
Initial cost = $420,000/(1 - 0.0784186) = $455,
You are evaluating a project which requires $230,000 in external financing. The flotation cost of equity is 11.6 percent and the flotation cost of debt is 5.4 percent. What is the initial cost of the project including the flotation costs if you maintain a debt-equity ratio of 0.45? - ANSWER $254,
Average flotation cost = (1/1.45) (0.116) + (0.45/1.45) (0.054) = 0.
Initial cost = $230,000/(1 - 0.0967586) = $254,
Western Wear is considering a project that requires an initial investment of $274,000. The firm maintains a debt-equity ratio of 0.40 and has a flotation cost of debt of 7 percent and a flotation cost of equity of 10.5 percent. The firm has sufficient internally generated equity to cover the equity portion of this project. What is the initial cost of the project including the flotation costs? - ANSWER $279,
Average flotation cost = (1/1.40) (0) + (0.40/1.40) (0.07) = 0.
Initial cost = $274,000/(1 - 0.02) = $279,
Yesteryear Productions is considering a project with an initial start up cost of $960,000. The firm maintains a debt-equity ratio of 0.50 and has a flotation cost of debt of 6. percent and a flotation cost of equity of 11.4 percent. The firm has sufficient internally generated equity to cover the equity cost of this project. What is the initial cost of the project including the flotation costs? - ANSWER $982,
Average flotation cost = (1/1.5) (0.0) + (0.5/1.5) (0.068) = 0.0226667 Initial cost = $960,000/(1 - 0.0226667) = $982,
The City Street Corporation's common stock has a beta of 1.2. The risk-free rate is 3. percent and the expected return on the market is 13 percent. What is the firm's cost of equity? - ANSWER 14.9 percent
RE = 0.035 + 1.2(0.13 - 0.035) = 14.9 percent
