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Piedmont Hotels is an all-equity firm with 48,000 shares of stock outstanding.
The stock has a beta of 1.19 and a standard deviation of 14.8 percent.
The market risk premium is 7.8 percent and the risk-free rate of return is 4.1 percent.
The company is considering a project that it considers riskier than its current operations so has assigned an
adjustment of 1.35 percent to the project's discount rate.
What should the firm set as the required rate of return for the project?
 
17.33 percent
10.92 percent
9.85 percent
15.39 percent
14.73 percent
 
Rate of return = 4.1%+(1.19 * 7.8%) + 1.35% = 14.73%
   
When evaluating a project, the dividend growth model:
 
can only be used by firms that pay increasing dividends.
is only applicable when the growth rate of the project exceeds the dividend growth rate.
is relatively simple to use.
must use the growth rate of the project as the rate of growth in the formula.
must be used by all dividend-paying firms.
   
Kurt, who is a divisional manager, continually brags that his division's required return for its projects is one
percent lower than the return required for any other division of the firm.
Which one of the following most likely contributes the most to the lower rate requirement for Kurt's division?
 
Kurt tends to overestimate the projected cash inflows on his projects.
Kurt's division is less risky than the other divisions
Kurt has the most efficiently managed division.
Kurt's projects are generally financed with debt while the other divisions' projects are financed with equity.
Kurt tends to underestimate the variable costs of his projects.
   
A firm that uses its weighted average cost of capital as the required return for all of its investments will:
 
increase the risk level of the firm over time
accept only the projects that add value to the firm's shareholders.
maintain a constant value for its shareholders.
find that its cost of capital declines over time.
make the best possible accept and reject decisions related to those investments.
   
USA Manufacturing issued 30-year, 7.5 percent semiannual bonds 6 years ago.
The bonds currently sell at 101 percent of face value.
What is the firm's aftertax cost of debt if the tax rate is 35 percent?
 
4.82 percent
3.76 percent
3.59 percent
5.62 percent
4.40 percent
 
$1,010 = [(.075 $1,000) / 2] ({1 - 1 / [1 + (RD / 2)]48} / (RD / 2))+ $1,000 / [1 + (RD/ 2)]48 ; RD = 7.4102 percent ;
After-tax cost of debt = 7.4102 percent (1 -.35) = 4.82 percent
   
Farmer's Supply is considering opening a clothing store, which would be a new line of business for the firm.
Management has decided to use the cost of capital of a similar clothing store as the discount rate to evaluate this proposed expansion.
Which one of the following terms describes this evaluation approach?
 
After-tax approach
Subjective approach
Equity approach
Market play
Pure play approach
   
Assume a firm has a beta of 1.2. All else held constant, the cost of equity for this firm will increase if the:
 
beta decreases.
risk-free rate decreases
market rate of return decreases.
either the risk-free rate or the market rate of return decreases.
market risk premium decreases.
   
City Rentals has 44,000 shares of common stock outstanding at a market price of $32 a share.
The common stock just paid a $1.50 annual dividend and has a dividend growth rate of 2.5 percent.
There are 7,500 shares of $9 preferred stock outstanding at a market price of $72 a share.
The outstanding bonds mature in 11 years, have a total face value of $825,000, a face value per bond of $1,000,
and a market price of $989 each, and a pretax yield to maturity of 8.3 percent. The tax rate is 35 percent.
What is the firm's weighted average cost of capital?
 
8.68 percent
9.97 percent
7.76 percent
9.29 percent
10.30 percent
 
 
   
Electronic Products has 22,500 bonds outstanding that are currently quoted at 101.6.
The bonds mature in 8 years and pay an annual coupon payment of $90.
What is the firm's aftertax cost of debt if the applicable tax rate is 34 percent?
 
5.75 percent
6.67 percent
5.47 percent
4.79 percent
6.98 percent
 
$1,016 = $90 ({1 - [1 / (1 + RD )8]} / RD) + $1,000 / (1 + RD) 8 ; RD = 8.714 percent ;
Aftertax cost of debt = 8.714 percent (1 -.34) = .0575, or 5.75 percent
   
Appalachian Mountain Goods has paid increasing dividends of $.10, $.12, $.15, and $.20 a share over the past four years, respectively.
The firm estimates that future increases in its dividends will be equal to the arithmetic average growth rate over these past four years.
The stock is currently selling for $12.50 a share. The risk-free rate is 3.4 percent and the market risk premium is 8.1 percent.
What is the cost of equity for this firm if its beta is 1.46?
 
16.91 percent
19.78 percent
21.68 percent
18.34 percent
22.03 percent
 
using CAPM
cost of equity = 3.4% + 1.46 * 8.1% = 15.226%
growth rate in year 1 = 0.12 -0.1/0.1 = 20%
growth rate in year 2 = 0.15-0.12/0.12 = 25%
growth rate in year 3 = 0.2-0.15/0.15 = 33.33%
average growth rate = (20%+25%+33.33%)/3 = 26.11%
12.5 = 0.2 * 1.2611/r-26.11%
cost of equity r = 28.13%
cost of equity = (28.13% + 15.226%)/2
= 21.68%
   
The weighted average cost of capital is defined as the weighted average of a firm's:
 
cost of equity, cost of preferred, and its aftertax cost of debt.
   
The amount that an investor is willing to pay for a firm's bonds is inversely related to the firm's cost of preferred stock.
 
False
   
A firm will lose wealth if it invests in projects based on a WACC that is lower than the investors' required rate of return.
 
True
   
The _________ is the interest rate that a firm pays on any new debt financing.
 
before-tax cost of debt
   
If a firm cannot invest retained earnings to earn a rate of return _________________ the required rate of return on retained earnings,
it should return those funds to its stockholders.
 
greater than or equal to
   
Kelly's uses the firm's WACC as the required return for some of its projects. For other projects, the firms uses
a rate equal to WACC plus one percent, while another set of projects is assigned rates equal to WACC minus some amount.
Which one of the following factors should be the key factor the firm uses to determine the amount of the adjustment
it will make when assigning a discount rate to a specific project?
 
the perceived risk level of a project
   
Derek's is a brick-and-mortar toy store. The firm is considering expanding its operations to include Internet sales.
Which one of the following would be the best firm to use in a pure play approach to analyzing this proposed expansion?
 
A toy store that sells online only
   
A firm will never have to take flotation costs into account when calculating the cost of raising capital from ________
 
retained earnings
   
Which one of the following will increase the cost of equity, all else held constant?
Increase in the dividend growth rate
   
The cost of preferred stock:
 
is equal to the stock's dividend yield.
   
Which one of the following is used as the pretax cost of debt?
 
Weighted average yield to maturity on the firm's outstanding debt
   
An increase in a levered firm's tax rate will:
 
decrease the firm's cost of capital.
   
________ is the symbol that represents the cost of raising capital by issuing new stock in the weighted average cost of capital (WACC) equation.
 
Re
   
Kate is the CFO of a major firm and has the job of assigning discount rates to each project under consideration.
Kate's method of doing this is to assign an incrementally higher rate as the risk level of the project increases and a
lower rate as the risk level declines. Kate is applying the ___ approach.
 
Subjective
   
Katie owns 100 shares of ABC stock. Which one of the following terms is used to refer to the return that Katie
and the other shareholders require on their investment in ABC?
 
cost of equity
   
The amount that an investor is willing to pay for a firm's stock is inversely related to the firm's cost of common equity before flotation costs.
 
True
   
When using the pure play approach for a proposed investment, a firm is primarily seeking a rate of return that:
 
best matches the risk level of the proposed investment.
  Judy's Boutique just paid an annual dividend of $1.48 on its common stock and increases its dividend by 2.2 percent annually.
What is the rate of return on this stock if the current stock price is $29.60 a share?
 
.0731, or 7.31 percent
 
Re = [($1.48× 1.022) / $29.60] + .022 = .0731, or 7.31 percent
   
The Green Balloon just paid its first annual dividend of $.87 a share.
The firm plans to increase the dividend by 3.2 percent per year indefinitely.
What is the firm's cost of equity if the current stock price is $4.75 a share?
 
0.2210, or 22.10 percent
 
Re = ($.87× 1.032) / $4.75 + .032 = .2210, or 22.10 percent
   
Tennessee Valley Antiques would like to issue new equity shares if its cost of equity declines to 12.5 percent.
The company pays a constant annual dividend of $2.10 per share.
What does the market price of the stock need to be for the firm to issue the new shares?
 
$16.80
 
P0 = $2.10 /.125 = $16.80
  Trendsetters has a cost of equity of 14.6 percent.
The market risk premium is 8.4 percent and the risk-free rate is 3.9 percent.
The company is acquiring a competitor, which will increase the company's beta to 1.4.
What effect, if any, will the acquisition have on the firm's cost of equity capital?
 
1.06 percent
 
Increase of 1.06 percent; RE = .039 + 1.4(.084) =
.1566, or 15.66 percent Increase in cost of equity =
15.66 percent -14.6 percent = 1.06 percent
  The common stock of Mill Stones has a beta that is 8 percent greater than the overall market beta.
Currently, the market risk premium is 7.65 percent while the U.S. Treasury bill is yielding 4.3 percent.
What is the cost of equity for this firm?
 
.1256, or 12.56 percent
 
RE = .043 + 1.08(.0765) = .1256, or 12.56 percent
  Musical Charts just paid an annual dividend of $1.84 per share.
This dividend is expected to increase by 2.1 percent annually.
Currently, the firm has a beta of 1.12 and a stock price of $31 a share.
The risk-free rate is 4.3 percent and the market rate of return is 13.2 percent.
What is the cost of equity capital for this firm?
 
.1121, or 11.21 percent
 
RE = .043 + 1.12(.132-.043)] = .14268 ; RE = [($1.84× 1.021) / $31] + .021 = .08160 ;
Average RE = (.14268 + .08160)/2 = .1121, or 11.21 percent
   
Donut Delites has a beta of 1.06, a dividend growth rate of 1.2 percent, a stock price of $12a share,
and an expected annual dividend of $.68 per share next year.
The market rate of return is 11.4 percent and the risk-free rate is 3.8 percent.
What is the firm's cost of equity?
 
.0936, or 9.36 percent
 
RE = .038 + 1.06(.114-.038) = .11856 ; RE = ($.68/$12) + .012 = .06867 ;
Average RE = (.11856 + .06867)/2 = .0936, or 9.36 percent
  The market rate of return is 11.8 percent and the risk-free rate is 3.45 percent.
Galaxy Co. has 36 percent more systematic risk than the overall market and has a dividend growth rate of 3.5 percent.
The firm's stock is currently selling for $42 a share and has a dividend yield of 2.8 percent.
What is the firm's cost of equity?
 
.1055, or 10.55 percent
 
RE = .0345 + 1.36(.118 -.0345)] = .14806 ; RE = .028 + .035 = .063 ;
Average RE = (.14806 + .063)/2 = .1055, or 10.55 percent
   
Titans has 7 percent bonds outstanding that mature in 16 years.
The bonds pay interest semiannually and have a face value of $1,000.
Currently, the bonds are selling for $1,015 each.
What is the firm's pretax cost of debt?
 
6.84 percent
 
$1,015 = [(.07 $1,000) / 2] ({1 - 1 / [1 + (RD / 2)]32} / (RD / 2)) + $1,000 / [1 + (RD / 2)]32 ;
RD = 6.84 percent
   
Three years ago, the Morgan Co. issued 15-year, 6.5 percent semiannual coupon bonds at par.
Today, the bonds are quoted at 100.6. What is this firm's pretax cost of debt?
 
6.43 percent
 
$1,006= [(.065 $1,000) / 2] ({1 - 1 / [1 + (RD / 2)]24} / (RD / 2))+ $1,000 / [1 + (RD / 2)]24 ; RD = 6.43 percent
   
Birds of a Feather has bonds outstanding that carry an annual coupon of 6 percent.
The bonds mature in 11 years and are currently priced at 94 percent of face value.
What is the firm's pretax cost of debt?
 
6.79 percent
 
$940= (.06 $1,000) ({1 - [1 / (1 + RD )11]} / RD) + $1,000 / (1 + RD)11 ; RD = 6.79 percent
   
Madison Square Stores has a $20 million bond issue outstanding that currently has a market value of $19.4 million.
The bonds mature in 6.5 years and pay semiannual interest payments of $35 each.
What is the firm's pretax cost of debt?
 
7.59 percent
 
Current bond price = (19.4 /20) $1,000 = $970 ; $970 =
$35 ({1 - 1 / [1 + (RD / 2)]13} / (RD / 2))+ $1,000 / [1 + (RD / 2)]13 ; RD = 7.59 percent
   
Electronic Products has 22,500 bonds outstanding that are currently quoted at 101.6.
The bonds mature in 8 years and pay an annual coupon payment of $90.
What is the firm's aftertax cost of debt if the applicable tax rate is 34 percent?
 
.0575, or 5.75 percent
 
$1,016 = $90 ({1 - [1 / (1 + RD )8]} / RD) + $1,000 / (1 + RD)8 ; RD =
8.714 percent ; Aftertax cost of debt = 8.714 percent (1 -.34) = .0575, or 5.75 percent
   
USA Manufacturing issued 30-year, 7.5 percent semiannual bonds 6 years ago.
The bonds currently sell at 101 percent of face value.
What is the firm's aftertax cost of debt if the tax rate is 35 percent?
 
4.82 percent
 
$1,010 = [(.075 $1,000) / 2] ({1 - 1 / [1 + (RD / 2)]48} / (RD / 2))+ $1,000 / [1 + (RD/ 2)]48 ; RD =
7.4102 percent ; Aftertax cost of debt = 7.4102 percent (1 -.35) = 4.82 percent
   
Appalachian Mountain Goods has paid increasing dividends of $.10, $.12, $.15, and $.20 a share over the past four years, respectively.
The firm estimates that future increases in its dividends will be equal to the arithmetic average growth rate over these past four years.
The stock is currently selling for $12.50 a share. The risk-free rate is 3.4 percent and the market risk premium is 8.1 percent.
What is the cost of equity for this firm if its beta is 1.46?
 
.2168, or 21.68 percent
 
($.12-.10)/$.10 = .20
($.15 -.12)/$.12 = .25
($.20 - $.15)/$.15= .3333
g = (.20+ .25 + .3333)/3 = .2611
RE = [($.20 x 1.2611) / $12.50] + .2611 = .28128
RE =.034 + 1.46(.081) = .15226
Average RE = (.28128 + .15226)/2 = .2168, or 21.68 percent
   
Great Lakes Packing has two bond issues outstanding.
The first issue has a coupon rate of8 percent, matures in 6 years, has a total face value of $5 million,
and is quoted at 101.2 percent of face value. The second issue has a 7.5 percent coupon, matures in 13 years,
has a total face value of $18 million, and is quoted at 99 percent of face value. Both bonds pay interest semiannually.
What is the firm's weighted average aftertax cost of debt if the tax rate is 34 percent?
 
.0505, or 5.05 percent
 
$1,012 = ([(.08 $1,000) / 2] ({1 - 1 / [1 + (RD / 2)]12} / (RD / 2))+ $1,000 / [1 + (RD/ 2)]12
RD =7.7462 percent
$990 = ([(.075 $1,000) / 2] ({1 - 1 / [1 + (RD / 2)]26} / (RD / 2))+ $1,000 / [1 + (RD/ 2)]26
RD = 7.6226 percent
Market values: ($5m 1.012) + ($18m .99) = $5.06 + 17.82m = $22.88m
Aftertax cost of debt = [($5.06/$22.88)(.077462) + ($17.82m /$22.88m)(.076226] (1 -.34) = .0505, or 5.05 percent
   
The 6.5 percent preferred stock of Home Town Brewers is selling for $42 a share.
What is the firm's cost of preferred stock if the tax rate is 35 percent and the par value per share is $100?
 
.1548, or 15.48 percent
 
Rp = (.065 ×$100)/$42 = .1548, or 15.48 percent
   
The 7.5 percent preferred stock of Rock Bottom Floors is selling for $84 a share.
What is the firm's cost of preferred stock if the tax rate is 35 percent and the par value per share is $100?
 
.0893, or 8.93 percent
 
 (.075 × 100) / 84 = .0893, or 8.93 percent
   
The preferred stock of Dolphin Pools pays an annual dividend of $5.25 a share and sells for $48a share.
The tax rate is 35 percent. What is the firm's cost of preferred stock?
 
.1094, or 10.94 percent
 
Rp = $5.25/$48 = .1094, or 10.94 percent
   
K's Bridal Shoppe has 4,000 shares of common stock outstanding at a price of $13 a share.
It also has 500 shares of preferred stock outstanding at a price of $22 a share.
There are 50 bonds outstanding that have a semiannual coupon payment of $25.
The bonds mature in four years, have a face value of $1,000, and sell at 98 percent of par.
What is the capital structure weight of the common stock?
 
.4643, or 46.43 percent
 
Common stock = 4,000 x $13 = $52,000
Preferred stock = 500 x $22 = $11,000
Debt = 50 x (.98 x $1,000) = $49,000
Value = $52,000 + 11,000 + 49,000 = $112,000
Weight of common stock = $52,000/$112,000 = .4643, or 46.43 percent
   
S&W has 21,000 shares of common stock outstanding at a price of $29 a share.
It also has 2,000 shares of preferred stock outstanding at a price of $71 a share.
The firm has 7 percent, 12-year bonds outstanding with a total market value of $386,000.
The bonds are currently quoted at 100.6 percent of face and pay interest semiannually.
What is the capital structure weight of the firm's preferred stock if the tax rate is 34 percent?
 
.1249, or 12.49 percent
 
Common stock = 21,000 x $29 = $609,000
Preferred stock = 2,000 x $71 = $142,000
Debt = $386,000
Value = $609,000 + 142,000 + 386,000 = $1,137,000
Weight of preferred= $142,000/$1,137,000 = .1249, or 12.49 percent
   
Santa Claus Enterprises has 87,000 shares of common stock outstanding at a current price of $39 a share.
The firm also has two bond issues outstanding. The first bond issue has a total face value of $230,000,
pays 7.1 percent interest annually, and currently sells for 103.1 percent of face value.
The second bond issue consists of 5,000 bonds that are selling for $887 each.
These bonds pay 6.5 percent interest annually and mature in eight years. The tax rate is 35 percent.
What is the capital structure weight of the firm's debt?
 
.5793, or 57.93 percent
 
Common stock = 87,000 x $39 = $3,393,000
Debt = (1.031 x $230,000) + (5,000 x $887) = $4,672,130
Weight of debt = $4,672,130/($3,393,000 + 4,672,130) = .5793, or 57.93 percent
   
The Five and Dime Store has a cost of equity of 14.8 percent, a pretax cost of debt of 6.7 percent, and a tax rate of 34 percent.
What is the firm's weighted average cost of capital if the debt-equity ratio is .46?
 
.1153, or 11.53 percent
 
WACC = (1/1.46)(.148) + (.46/1.46)(.067)(1 -.34) = .1153, or 11.53 percent
   
Country Cook's cost of equity is 16.2 percent and its aftertax cost of debt is 5.8 percent.
What is the firm's weighted average cost of capital if its debt-equity ratio is .42 and the tax rate is 34 percent?
 
.1312, or 13.12 percent
 
WACC = (1/1.42)(.162) + [(.42 /1.42)(.058)] = .1312, or 13.12 percent

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