Finman Chap9

(Difficulty: E = Easy, M = Medium, and T = Tough)
Multiple Choice: Conceptual

Easy:
Capital components Answer: c Diff: E
1
. Which of the following is not considered a capital component for the
purpose of calculating the weighted average cost of capital (WACC) as it
applies to capital budgeting?
a. Long-term debt.
b. Common stoc.
c. Accounts pa!able and accruals.
d. "referred stoc.
Capital components Answer: d Diff: E
#
. $or a t!pical firm with a given capital structure% which of the following
is correct? (&ote' All rates are after ta(es.)
a.
d
)
e
)
s
) WACC.
b.
s
)
e
)
d
) WACC.
c. WACC )
e
)
s
)
d
.
d.
e
)
s
) WACC )
d
.
e. &one of the statements above is correct.
Capital components Answer: a Diff: E
*
. Which of the following statements is most correct?
a. +f a compan!,s ta( rate increases but the !ield to maturit! of its
noncallable bonds remains the same% the compan!,s marginal cost of debt
capital used to calculate its weighted average cost of capital will
fall.
b. All else e-ual% an increase in a compan!,s stoc price will increase
the marginal cost of retained earnings%
s
.
c. All else e-ual% an increase in a compan!,s stoc price will increase
the marginal cost of issuing new common e-uit!%
e
.
d. .tatements a and b are correct.
e. .tatements b and c are correct.
Chapter 9 - Page 1
CHAPTE !
THE C"#T "$ CAP%TA&
Capital components Answer: c Diff: E
/
a. .ince the mone! is readil! available% the cost of retained earnings is
usuall! a lot cheaper than the cost of debt financing.
b. When calculating the cost of preferred stoc% a compan! needs to ad0ust
for ta(es% because preferred stoc dividends are ta( deductible.
c. When calculating the cost of debt% a compan! needs to ad0ust for ta(es%
because interest pa!ments are ta( deductible.
DCF cost of equity estimation Answer: b Diff: E
1
. Which of the following factors in the discounted cash flow (2C$) approach
to estimating the cost of common e-uit! is the least difficult to
estimate?
a. 3(pected growth rate% g.
b. 2ividend !ield% 2
1
4"
5
.
c. 6e-uired return%
s
.
d. 3(pected rate of return%
7
s
.
e. All of the above are e-uall! difficult to estimate.
WACC Answer: d Diff: E
8
a. 9he WACC measures the after-ta( cost of capital.
b. 9he WACC measures the marginal cost of capital.
c. 9here is no cost associated with using retained earnings.
e. All of the statements above are correct.
WACC Answer: c Diff: E
:
. Which of the following statements about the cost of capital is incorrect?
a. A compan!,s target capital structure affects its weighted average cost
of capital.
b. Weighted average cost of capital calculations should be based on the
after-ta( costs of all the individual capital components.
c. +f a compan!,s ta( rate increases% then% all else e-ual% its weighted
average cost of capital will increase.
d. $lotation costs can increase the weighted average cost of capital.
e. An increase in the ris-free rate is liel! to increase the marginal
costs of both debt and e-uit! financing.
Chapter 9 - Page 2
WACC Answer: e Diff: E
;
. Campbell Co. is tr!ing to estimate its weighted average cost of capital
(WACC). Which of the following statements is most correct?
a. 9he after-ta( cost of debt is generall! cheaper than the after-ta( cost
of preferred stoc.
b. .ince retained earnings are readil! available% the cost of retained
earnings is generall! lower than the cost of debt.
c. +f the compan!,s beta increases% this will increase the cost of e-uit!
financing% even if the compan! is able to rel! on onl! retained
earnings for its e-uit! financing.
e. .tatements a and c are correct.
Factors influencing WACC Answer: a Diff: E
<
. W!den =rothers has no retained earnings. 9he compan! uses the CA"> to
calculate the cost of e-uit! capital. 9he compan!,s capital structure
consists of common stoc% preferred stoc% and debt. Which of the
following events will reduce the compan!,s WACC?
a. A reduction in the maret ris premium.
b. An increase in the flotation costs associated with issuing new common
stoc.
c. An increase in the compan!,s beta.
d. An increase in e(pected inflation.
e. An increase in the flotation costs associated with issuing preferred
stoc.
WACC and capital components Answer: c Diff: E
15
a. 9he WACC is a measure of the before-ta( cost of capital.
b. 9!picall! the after-ta( cost of debt financing e(ceeds the after-ta(
cost of e-uit! financing.
c. 9he WACC measures the marginal after-ta( cost of capital.
WACC and capital components Answer: a Diff: E
11
. A compan! has a capital structure that consists of 15 percent debt and 15
percent e-uit!. Which of the following statements is most correct?
a. 9he cost of e-uit! financing is greater than or e-ual to the cost of
debt financing.
b. 9he WACC e(ceeds the cost of e-uit! financing.
c. 9he WACC is calculated on a before-ta( basis.
d. 9he WACC represents the cost of capital based on historical averages.
+n that sense% it does not represent the marginal cost of capital.
e. 9he cost of retained earnings e(ceeds the cost of issuing new common
stoc.
Chapter 9 - Page 3
Internal vs. eternal common equity Answer: e Diff: E
1#
. A firm estimates that its proposed capital budget will force it to issue
new common stoc% which has a greater cost than the cost of retained
earnings. 9he firm% however% would lie to avoid issuing costl! new
common stoc. Which of the following steps would mitigate the firm,s need
to raise new common stoc?
a. +ncreasing the compan!,s dividend pa!out ratio for the upcoming !ear.
b. 6educing the compan!,s debt ratio for the upcoming !ear.
c. +ncreasing the compan!,s proposed capital budget.
d. All of the statements above are correct.
!is" and pro#ect selection Answer: c Diff: E
1*
. 2ic =oe 3nterprises% an all-e-uit! firm% has a corporate beta coefficient
of 1.1. 9he financial manager is evaluating a pro0ect with an e(pected
return of #1 percent% before an! ris ad0ustment. 9he ris-free rate is
15 percent% and the re-uired rate of return on the maret is 18 percent.
9he pro0ect being evaluated is risier than =oe,s average pro0ect% in
terms of both beta ris and total ris. Which of the following statements
is most correct?
a. 9he pro0ect should be accepted since its e(pected return (before ris
ad0ustment) is greater than its re-uired return.
b. 9he pro0ect should be re0ected since its e(pected return (before ris
ad0ustment) is less than its re-uired return.
c. 9he accept4re0ect decision depends on the ris-ad0ustment polic! of the
firm. +f the firm,s polic! were to reduce a risier-than-average
pro0ect,s e(pected return b! 1 percentage point% then the pro0ect
should be accepted.
d. 6isier-than-average pro0ects should have their e(pected returns
increased to reflect their added risiness. Clearl!% this would mae
the pro0ect acceptable regardless of the amount of the ad0ustment.
e. "ro0ects should be evaluated on the basis of their total ris alone.
9hus% there is insufficient information in the problem to mae an
accept4re0ect decision.
!is" and pro#ect selection Answer: b Diff: E
1/
. A compan! estimates that an average-ris pro0ect has a WACC of 15 percent%
a below-average ris pro0ect has a WACC of ; percent% and an above-average
ris pro0ect has a WACC of 1# percent. Which of the following independent
pro0ects should the compan! accept?
a. "ro0ect A has average ris and a return of < percent.
b. "ro0ect = has below-average ris and a return of ;.1 percent.
c. "ro0ect C has above-average ris and a return of 11 percent.
d. All of the pro0ects above should be accepted.
e. &one of the pro0ects above should be accepted.
Chapter 9 - Page 4
Divisional ris" Answer: a Diff: E $
11
. Conglomerate +nc. consists of # divisions of e-ual si?e% and Conglomerate
is 155 percent e-uit! financed. 2ivision A,s cost of e-uit! capital is
<.; percent% while 2ivision =,s cost of e-uit! capital is 1/ percent.
Conglomerate,s composite WACC is 11.< percent. Assume that all 2ivision A
pro0ects have the same ris and that all 2ivision = pro0ects have the same
ris. @owever% the pro0ects in 2ivision A are not the same ris as those
in 2ivision =. Which of the following pro0ects should Conglomerate
accept?
a. 2ivision A pro0ect with an 11 percent return.
b. 2ivision = pro0ect with a 1# percent return.
c. 2ivision = pro0ect with a 1* percent return.
d. .tatements a and c are correct.
e. .tatements b and d are correct.
!etained earnings brea" point Answer: a Diff: E
18
. Which of the following will increase a compan!,s retained earnings brea
point?
a. An increase in its net income.
b. An increase in its dividend pa!out.
c. An increase in the amount of e-uit! in its capital structure.
d. An increase in its capital budget.
!etained earnings brea" point Answer: b Diff: E
1:
. Which of the following actions will increase the retained earnings brea
point?
a. An increase in the dividend pa!out ratio.
b. An increase in the debt ratio.
c. An increase in the capital budget.
d. An increase in flotation costs.
%iscellaneous cost of capital concepts Answer: c Diff: E $
1;
a. .ince debt capital is risier than e-uit! capital% the cost of debt is
alwa!s greater than the WACC.
b. =ecause of the ris of banruptc!% the cost of debt capital is alwa!s
higher than the cost of e-uit! capital.
c. +f a compan! assigns the same cost of capital to all of its pro0ects
regardless of the pro0ect,s ris% then it follows that the compan! will
generall! re0ect too man! safe pro0ects and accept too man! ris!
pro0ects.
d. =ecause !ou are able to avoid flotation costs% the cost of retained
earnings is generall! lower than the cost of debt.
e. @igher flotation costs tend to reduce the cost of e-uit! capital.
Chapter 9 - Page 5
%iscellaneous concepts Answer: e Diff: E
1<
a. @igher flotation costs reduce investor returns% and therefore reduce a
compan!,s WACC.
b. 9he WACC represents the historical cost of capital and is usuall!
calculated on a before-ta( basis.
c. 9he cost of retained earnings is ?ero because retained earnings are
readil! available and do not re-uire the pa!ment of flotation costs.
d. All of the statements above are correct.
Medium:
Capital components Answer: e Diff: %
#5
a. +n the weighted average cost of capital calculation% we must ad0ust the
cost of preferred stoc for the ta( e(clusion of :5 percent of dividend
income.
b. We ideall! would lie to use historical measures of the component costs
from prior financings in estimating the appropriate weighted average
cost of capital.
c. 9he cost of a new e-uit! issuance (
e
) could possibl! be lower than the
cost of retained earnings (
s
) if the maret ris premium and ris-free
rate decline b! a substantial amount.
d. .tatements b and c are correct.
Capital components Answer: a Diff: %
#1
a. 9he cost of retained earnings is the rate of return stocholders
re-uire on a firm,s common stoc.
b. 9he component cost of preferred stoc is e(pressed as
p
(1 - 9)%
because preferred stoc dividends are treated as fi(ed charges% similar
to the treatment of debt interest.
c. 9he bond-!ield-plus-ris-premium approach to estimating a firm,s cost
of common e-uit! involves adding a sub0ectivel! determined ris premium
to the maret ris-free bond rate.
d. 9he higher the firm,s flotation cost for new common stoc% the more
liel! the firm is to use preferred stoc% which has no flotation cost.
Chapter 9 - Page 6
Cost of capital estimation Answer: c Diff: %
##
. Which of the following statements is correct?
a. 9he cost of capital used to evaluate a pro0ect should be the cost of
the specific t!pe of financing used to fund that pro0ect.
b. 9he cost of debt used to calculate the weighted average cost of capital
is based on an average of the cost of debt alread! issued b! the firm
and the cost of new debt.
c. Ane problem with the CA"> approach in estimating the cost of e-uit!
capital is that if a firm,s stocholders are% in fact% not well
diversified% beta ma! be a poor measure of the firm,s true investment
ris.
d. 9he bond-!ield-plus-ris-premium approach is the most sophisticated and
ob0ective method of estimating a firm,s cost of e-uit! capital.
e. 9he cost of e-uit! capital is generall! easier to measure than the cost
of debt% which varies dail! with interest rates% or the cost of
preferred stoc since preferred stoc is issued infre-uentl!.
Cost of equity estimation Answer: d Diff: %
#*
a. Although some methods of estimating the cost of e-uit! capital
encounter severe difficulties% the CA"> is a simple and reliable model
that provides great accurac! and consistenc! in estimating the cost of
e-uit! capital.
b. 9he 2C$ model is preferred over other models to estimate the cost of
e-uit! because of the ease with which a firm,s growth rate is obtained.
c. 9he bond-!ield-plus-ris-premium approach to estimating the cost of
e-uit! is not alwa!s accurate but its advantages are that it is a
standardi?ed and ob0ective model.
d. 2epreciation-generated funds are an additional source of capital and%
in fact% represent the largest single source of funds for some firms.
CA&% cost of equity estimation Answer: e Diff: %
#/
. +n appl!ing the CA"> to estimate the cost of e-uit! capital% which of the
following elements is not sub0ect to dispute or controvers!?
a. 9he e(pected rate of return on the maret%
>
.
b. 9he stoc,s beta coefficient% b
i
.
c. 9he ris-free rate%
6$
.
d. 9he maret ris premium (6"
>
).
e. All of the above are sub0ect to dispute.
Chapter 9 - Page 7
CA&% and DCF estimation Answer: a Diff: %
#1
a. =eta measures maret ris% but if a firm,s stocholders are not well
diversified% beta ma! not accuratel! measure stand-alone ris.
b. +f the calculated beta underestimates the firm,s true investment ris%
then the CA"> method will overestimate
s
.
c. 9he discounted cash flow method of estimating the cost of e-uit! can,t
be used unless the growth component% g% is constant during the anal!sis
period.
d. An advantage shared b! both the 2C$ and CA"> methods of estimating the
cost of e-uit! capital% is that the! !ield precise estimates and
re-uire little or no 0udgement.
WACC Answer: d Diff: %
#8
a. 9he weighted average cost of capital for a given capital budget level
is a weighted average of the marginal cost of each relevant capital
component that maes up the firm,s target capital structure.
b. 9he weighted average cost of capital is calculated on a before-ta(
basis.
c. An increase in the ris-free rate is liel! to increase the marginal
costs of both debt and e-uit! financing.
#:
a. 9he WACC should include onl! after-ta( component costs. 9herefore% the
re-uired rates of return (or Bmaret ratesC) on debt% preferred% and
common e-uit! (
d
%
p
% and
s
) must be ad0usted to an after-ta( basis
before the! are used in the WACC e-uation.
b. 9he cost of retained earnings is generall! higher than the cost of new
common stoc.
c. "referred stoc is risier to investors than is debt. 9herefore% if
someone told !ou that the maret rates showed
d
)

p
for a given
compan!% that person must have made a mistae.
d. +f a compan! with a debt ratio of 15 percent were suddenl! e(empted
from all future income ta(es% then% all other things held constant%
this would cause its WACC to increase.
Chapter 9 - Page 8
WACC Answer: e Diff: %
#;
a. An increase in flotation costs incurred in selling new stoc will
increase the cost of retained earnings.
b. 9he WACC should include onl! after-ta( component costs. 9herefore% the
re-uired rates of return (or Bmaret ratesC) on debt% preferred% and
common e-uit! (
d
%
p
% and
s
) must be ad0usted to an after-ta( basis
before the! are used in the WACC e-uation.
c. An increase in a firm,s corporate ta( rate will increase the firm,s
cost of debt capital% as long as the !ield to maturit! on the compan!,s
bonds remains constant or falls.
d. .tatements b and c are correct.
#<
a. .ince stocholders do not generall! pa! corporate ta(es% corporations
should focus on before-ta( cash flows when calculating the weighted
average cost of capital (WACC).
b. All else e-ual% an increase in flotation costs will increase the cost
of retained earnings.
c. When calculating the weighted average cost of capital% firms should
rel! on historical costs rather than marginal costs of capital.
WACC and capital components Answer: b Diff: %
*5
a. =ecause we often need to mae comparisons among firms that are in
different income ta( bracets% it is best to calculate the WACC on a
before-ta( basis.
b. +f a firm has been suffering accounting losses and is e(pected to
continue suffering such losses% and therefore its ta( rate is ?ero% it
is possible that its after-ta( component cost of preferred stoc as
used to calculate the WACC will be less than its after-ta( component
cost of debt.
c. &ormall!% the cost of e(ternal e-uit! raised b! issuing new common
stoc is above the cost of retained earnings. >oreover% the higher the
growth rate is relative to the dividend !ield% the more the cost of
e(ternal e-uit! will e(ceed the cost of retained earnings.
d. 9he lower a compan!,s ta( rate% the greater the advantage of using debt
in terms of lowering its WACC.
Chapter 9 - Page 9
!is"'ad#usted cost of capital Answer: c Diff: %
*1
. Demp Consolidated has two divisions of e-ual si?e' a computer division and
a restaurant division. .tand-alone restaurant companies t!picall! have a
cost of capital of ; percent% while stand-alone computer companies
t!picall! have a 1# percent cost of capital. Demp,s restaurant division
has the same ris as a t!pical restaurant compan!% and its computer
division has the same ris as a t!pical computer compan!. Conse-uentl!%
Demp estimates that its composite corporate cost of capital is 15 percent.
9he compan!,s consultant has suggested that the! use an ; percent hurdle
rate for the restaurant division and a 1# percent hurdle rate for the
computer division. @owever% Demp has chosen to ignore its consultant% and
instead% chooses to assign a 15 percent cost of capital to all pro0ects in
both divisions. Which of the following statements is most correct?
a. While Demp,s decision to not ris ad0ust its cost of capital will lead
it to accept more pro0ects in its computer division and fewer pro0ects
in its restaurant division% this should not affect the overall value of
the compan!.
b. Demp,s decision to not ris ad0ust means that it is effectivel!
subsidi?ing its restaurant division% which means that its restaurant
division is liel! to become a larger part of the overall compan! over
time.
c. Demp,s decision to not ris ad0ust means that the compan! will accept
too man! pro0ects in the computer business and too few pro0ects in the
restaurant business. 9his will lead to a reduction in the overall
value of the compan!.
!is"'ad#usted cost of capital Answer: b Diff: %
*#
. 9he =arabas Compan! has an e-ual amount of low-ris pro0ects% average-ris
pro0ects% and high-ris pro0ects. =arabas estimates that the overall
compan!,s WACC is 1# percent. 9his is also the correct cost of capital
for the compan!,s average-ris pro0ects. 9he compan!,s C$A argues that%
even though the compan!,s pro0ects have different riss% the cost of
capital for each pro0ect should be the same because the compan! obtains
its capital from the same sources. +f the compan! follows the C$A,s
advice% what is liel! to happen over time?
a. 9he compan! will tae on too man! low-ris pro0ects and re0ect too man!
high-ris pro0ects.
b. 9he compan! will tae on too man! high-ris pro0ects and re0ect too
man! low-ris pro0ects.
c. 9hings will generall! even out over time% and therefore% the ris of
the firm should remain constant over time.
Chapter 9 - Page 10
!is"'ad#usted cost of capital Answer: e Diff: %
**
. +f a compan! uses the same cost of capital for evaluating all pro0ects%
which of the following results is liel!?
a. Accepting poor% high-ris pro0ects.
b. 6e0ecting good% low-ris pro0ects.
c. Accepting onl! good% low-ris pro0ects.
d. Accepting no pro0ects.
e. Answers a and b are correct.
!is"'ad#usted cost of capital Answer: a Diff: %
*/
. +f a t!pical E... compan! uses the same cost of capital to evaluate all
pro0ects% the firm will most liel! become
a. 6isier over time% and its value will decline.
b. 6isier over time% and its value will rise.
c. Less ris! over time% and its value will rise.
d. Less ris! over time% and its value will decline.
e. 9here is no reason to e(pect its ris position or value to change over
time as a result of its use of a single discount rate.
Division WACCs and ris" Answer: e Diff: %
*1
. "earson "lastics has two e-ual-si?ed divisions% 2ivision A and 2ivision =.
9he compan! estimates that if the divisions operated as independent
companies 2ivision A would have a cost of capital of ; percent% while
2ivision = would have a cost of capital of 1# percent. .ince the two
divisions are the same si?e% "earson,s composite weighted average cost of
capital (WACC) is 15 percent. +n the past% "earson has assigned separate
hurdle rates to each division based on their relative ris. &ow% however%
"earson has chosen to use the corporate WACC% which is currentl! 15
percent% for both divisions. Which of the following is liel! to occur as
a result of this change? Assume that this change is liel! to have no
effect on the average ris of each division and maret conditions remain
unchanged.
a. Aver time% the overall ris of the compan! will increase.
b. Aver time% 2ivision = will become a larger part of the overall compan!.
c. Aver time% the compan!,s corporate WACC will increase.
Chapter 9 - Page 11
Divisional ris" and pro#ect selection Answer: e Diff: % $
*8
. .mith 3lectric Co. and $erdinand Water Co. are the same si?e and have the
same capital structure. .mith 3lectric Co. is risier than $erdinand and
has a WACC of 1# percent. $erdinand Water Co. is safer than .mith and has
a WACC of 15 percent. $erdinand Water Co. is considering "ro0ect F.
"ro0ect F has an +66 of 15.1 percent% and has the same ris as a t!pical
pro0ect undertaen b! $erdinand Water Co. .mith 3lectric Co. is
considering "ro0ect G. "ro0ect G has an +66 of 11.1 percent% and has the
same ris as a t!pical pro0ect undertaen b! .mith 3lectric Co.
&ow assume that .mith 3lectric Co. and $erdinand Water Co. merge to form a
new compan!% Leeds Enited Etilities. 9he merger has no impact on the cash
flows or ris of either "ro0ect F or "ro0ect G. Leeds Enited Etilities,
C$A is tr!ing to establish hurdle rates for the new compan!,s pro0ects
that accuratel! reflect the ris of each pro0ect. (9hat is% he is using
ris-ad0usted hurdle rates.) Which of the following statements is most
correct?
a. Leeds Enited Etilities, weighted average cost of capital is 11 percent.
b. "ro0ect F has a positive &"H.
c. After the merger% Leeds Enited Etilities should select "ro0ect F and
re0ect "ro0ect G.
(eta and pro#ect ris" Answer: a Diff: %
*:
a. A relativel! ris! future cash outflow should be evaluated using a
relativel! low discount rate.
b. +f a firm,s managers want to ma(imi?e the value of the stoc% the!
should concentrate e(clusivel! on pro0ects, maret% or beta% ris.
c. +f a firm evaluates all pro0ects using the same cost of capital% then
the risiness of the firm as measured b! its beta will probabl! decline
over time.
d. +f a firm has a beta that is less than 1.5% sa! 5.<% this would suggest
that its assets, returns are negativel! correlated with the returns of
most other firms, assets.
Chapter 9 - Page 12
%iscellaneous concepts Answer: a Diff: %
*;
a. .uppose a firm is losing mone! and thus% is not pa!ing ta(es% and that
this situation is e(pected to persist for a few !ears whether or not
the firm uses debt financing. 9hen the firm,s after-ta( cost of debt
will e-ual its before-ta( cost of debt.
b. 9he component cost of preferred stoc is e(pressed as
p
(1 - 9)%
because preferred stoc dividends are treated as fi(ed charges% similar
to the treatment of debt interest.
c. 9he reason that a cost is assigned to retained earnings is because
these funds are alread! earning a return in the businessI the reason
does not involve the opportunit! cost principle.
d. 9he bond-!ield-plus-ris-premium approach to estimating a firm,s cost
of common e-uit! involves adding a sub0ectivel! determined ris premium
to the maret ris-free bond rate.
Multiple Choice: P'o(lems
Easy:
Cost of new equity Answer: b Diff: E
*<
. Gour compan!,s stoc sells for J15 per share% its last dividend (2
5
) was
J#.55% its growth rate is a constant 1 percent% and the compan! will incur
a flotation cost of 11 percent if it sells new common stoc. What is the
firm,s cost of new e-uit!%
e
?
a. <.#5K
b. <.</K
c. 15.15K
d. 11.:1K
e. 1#.*5K
Cost of new equity Answer: d Diff: E
/5
. =lair =rothers, stoc currentl! has a price of J15 per share and is
e(pected to pa! a !ear-end dividend of J#.15 per share (2
1
L J#.15). 9he
dividend is e(pected to grow at a constant rate of / percent per !ear. 9he
compan! has insufficient retained earnings to fund capital pro0ects and
must% therefore% issue new common stoc. 9he new stoc has an estimated
flotation cost of J* per share. What is the compan!,s cost of e-uit!
capital?
a. 15.1/K
b. <.#1K
c. <./1K
d. <.*#K
e. <.55K
Chapter 9 - Page 13
Cost of retained earnings Answer: d Diff: E
/1
. Allison 3ngines Corporation has established a target capital structure of
/5 percent debt and 85 percent common e-uit!. 9he current maret price of
the firm,s stoc is "
5
L J#;I its last dividend was 2
5
L J#.#5% and its
e(pected dividend growth rate is 8 percent. What will Allison,s marginal
cost of retained earnings%
s
% be?
a. 11.;K
b. 1*.<K
c. :.<K
d. 1/.*K
e. <.:K
WACC Answer: a Diff: E
/#
. An anal!st has collected the following information regarding Christopher Co.'
9he compan!,s capital structure is :5 percent e-uit! and *5 percent
debt.
9he !ield to maturit! on the compan!,s bonds is < percent.
9he compan!,s !ear-end dividend is forecasted to be J5.;5 a share.
9he compan! e(pects that its dividend will grow at a constant rate of <
percent a !ear.
9he compan!,s stoc price is J#1.
9he compan!,s ta( rate is /5 percent.
9he compan! anticipates that it will need to raise new common stoc
this !ear% and total flotation costs will e-ual 15 percent of the
amount issued.
Assume the compan! accounts for flotation costs b! ad0usting the cost of
capital. Miven this information% calculate the compan!,s WACC.
a. 15./1K
b. 1#.18K
c. 15.:;K
d. 1*.11K
e. <.#<K
WACC Answer: a Diff: E
/*
. $lahert! 3lectric has a capital structure that consists of :5 percent
e-uit! and *5 percent debt. 9he compan!,s long-term bonds have a before-
ta( !ield to maturit! of ;./ percent. 9he compan! uses the 2C$ approach to
determine the cost of e-uit!. $lahert!,s common stoc currentl! trades at
J/1 per share. 9he !ear-end dividend (2
1
) is e(pected to be J#.15 per
share% and the dividend is e(pected to grow forever at a constant rate of :
percent a !ear. 9he compan! estimates that it will have to issue new
common stoc to help fund this !ear,s pro0ects. 9he flotation cost on new
common stoc issued is 15 percent% and the compan!,s ta( rate is /5
percent. What is the compan!,s weighted average cost of capital% WACC?
a. 15.:*K
b. 15.*5K
c. 11.*1K
Chapter 9 - Page 14
d. :./;K
e. <.;<K
WACC Answer: b Diff: E
//
. =illic =rothers is estimating its WACC. 9he compan! has collected the
following information'
+ts capital structure consists of /5 percent debt and 85 percent common
e-uit!.
9he compan! has #5-!ear bonds outstanding with a < percent annual
coupon that are trading at par.
9he ris-free rate is 1.1 percent.
9he maret ris premium is 1 percent.
9he stoc,s beta is 1./.
What is the compan!,s WACC?
a. <.:1K
b. <.88K
c. ;.*1K
d. 11.1;K
e. 11.15K
Divisional ris" Answer: c Diff: E
/1
. 2and! "roduct,s overall weighted average re-uired rate of return is 15
percent. +ts !ogurt division is risier than average% its fresh produce
division has average ris% and its institutional foods division has below-
average ris. 2and! ad0usts for both divisional and pro0ect ris b!
adding or subtracting # percentage points. 9hus% the ma(imum ad0ustment
is / percentage points. What is the ris-ad0usted re-uired rate of return
for a low-ris pro0ect in the !ogurt division?
a. 8K
b. ;K
c. 15K
d. 1#K
e. 1/K
!etained earnings brea" point Answer: e Diff: E
/8
. .tephenson N .ons has a capital structure that consists of #5 percent
e-uit! and ;5 percent debt. 9he compan! e(pects to report J* million in
net income this !ear% and 85 percent of the net income will be paid out as
dividends. @ow large must the firm,s capital budget be this !ear without
it having to issue an! new common stoc?
a. J 1.#5 million
b. J1*.55 million
c. J 1.15 million
d. J 5.#/ million
e. J 8.55 million
Chapter 9 - Page 15
Medium:
Cost of retained earnings Answer: d Diff: %
/:
. 9he common stoc of Anthon! .teel has a beta of 1.#5. 9he ris-free rate
is 1 percent and the maret ris premium (
>
-
6$
) is 8 percent. Assume
the firm will be able to use retained earnings to fund the e-uit! portion
of its capital budget. What is the compan!,s cost of retained earnings%
s
?
a. :.5K
b. :.#K
c. 11.5K
d. 1#.#K
e. 1#./K
Cost of eternal equity Answer: d Diff: %
/;
. A compan! 0ust paid a J#.55 per share dividend on its common stoc (2
5
L
J#.55). 9he dividend is e(pected to grow at a constant rate of : percent
per !ear. 9he stoc currentl! sells for J/# a share. +f the compan!
issues additional stoc% it must pa! its investment baner a flotation
cost of J1.55 per share. What is the cost of e(ternal e-uit!%
e
?
a. 11.:8K
b. 11.;;K
c. 11.<;K
d. 1#.##K
e. 1#.*5K
Component cost of debt Answer: b Diff: %
/<
. @amilton Compan!,s ; percent coupon rate% -uarterl! pa!ment% J1%555 par
value bond% which matures in #5 !ears% currentl! sells at a price of
J8;8.;8. 9he compan!,s ta( rate is /5 percent. =ased on the nominal
interest rate% not the 3A6% what is the firm,s component cost of debt for
purposes of calculating the WACC?
a. *.51K
b. :.*#K
c. :.*8K
d. 1#.#5K
e. 1#.#8K
Chapter 9 - Page 16
WACC Answer: e Diff: % $
15
. 9ro0an .ervices, C$A is interested in estimating the compan!,s WACC and
has collected the following information'
9he compan! has bonds outstanding that mature in #8 !ears with an
annual coupon of :.1 percent. 9he bonds have a face value of J1%555
and sell in the maret toda! for J<#5.
9he ris-free rate is 8 percent.
9he stoc,s beta is 1.#.
9he compan!,s target capital structure consists of :5 percent e-uit!
and *5 percent debt.
9he compan! uses the CA"> to estimate the cost of e-uit! and does
not include flotation costs as part of its cost of capital.
What is 9ro0an,s WACC?
a. <.:1K
b. <.*<K
c. 15.;:K
d. <.*5K
e. <.;<K
WACC Answer: a Diff: %
11
. A compan! has determined that its optimal capital structure consists of /5
percent debt and 85 percent e-uit!. Assume the firm will not have enough
retained earnings to fund the e-uit! portion of its capital budget. Also%
assume the firm accounts for flotation costs b! ad0usting the cost of
capital. Miven the following information% calculate the firm,s weighted
average cost of capital.

d
L ;K.
&et income L J/5%555.
"a!out ratio L 15K.
9a( rate L /5K.
"
5
L J#1.
Mrowth L 5K.
.hares outstanding L 15%555.
$lotation cost on additional e-uit! L 11K.
a. :.85K
b. ;.51K
c. 11.;1K
d. 1*.8<K
e. 1/.#;K
Chapter 9 - Page 17
WACC Answer: b Diff: %
1#
. @atch Corporation,s target capital structure is /5 percent debt% 15
percent common stoc% and 15 percent preferred stoc. +nformation
regarding the compan!,s cost of capital can be summari?ed as follows'
9he compan!,s bonds have a nominal !ield to maturit! of : percent.
9he compan!,s preferred stoc sells for J/# a share and pa!s an annual
dividend of J/ a share.
9he compan!,s common stoc sells for J#; a share% and is e(pected to
pa! a dividend of J# a share at the end of the !ear (i.e.% 2
1
L J#.55).
9he dividend is e(pected to grow at a constant rate of : percent a
!ear.
9he firm will be able to use retained earnings to fund the e-uit!
portion of its capital budget.
What is the compan!,s weighted average cost of capital (WACC)?
a. <.#1K
b. <.:5K
c. 15.5*K
d. 15.1<K
e. 11.*5K
1*
. @illiard Corp. wants to calculate its weighted average cost of capital
(WACC). 9he compan!,s C$A has collected the following information'
9he compan!,s long-term bonds currentl! offer a !ield to maturit! of ;
percent.
9he compan!,s stoc price is J*# a share ("
5
L J*#).
9he compan! recentl! paid a dividend of J# a share (2
5
L J#.55).
9he dividend is e(pected to grow at a constant rate of 8 percent a !ear
(g L 8K).
9he compan! pa!s a 15 percent flotation cost whenever it issues new
common stoc ($ L 15 percent).
9he compan!,s target capital structure is :1 percent e-uit! and #1
percent debt.
9he firm will be able to use retained earnings to fund the e-uit!
portion of its capital budget.
a. 15.8:K
b. 11.##K
c. 11./:K
d. 1#.5#K
e. 1#.18K
Chapter 9 - Page 18
WACC Answer: c Diff: %
1/
. Oohnson +ndustries finances its pro0ects with /5 percent debt% 15 percent
preferred stoc% and 15 percent common stoc.
9he compan! can issue bonds at a !ield to maturit! of ;./ percent.
9he cost of preferred stoc is < percent.
9he ris-free rate is 8.1: percent.
Oohnson +ndustries, beta is e-ual to 1.*.
Assume that the firm will be able to use retained earnings to fund the
e-uit! portion of its capital budget.
9he compan!,s ta( rate is *5 percent.
a. ;.**K
b. ;.<1K
c. <.:<K
d. 15.<#K
e. 1*.11K
WACC Answer: b Diff: %
11
. @elms Aircraft has a capital structure that consists of 85 percent debt
and /5 percent common stoc. 9he firm will be able to use retained
earnings to fund the e-uit! portion of its capital budget. 9he compan!
recentl! issued bonds with a !ield to maturit! of < percent. 9he ris-
free rate is 8 percent% the maret ris premium is 8 percent% and @elms,
beta is e-ual to 1.1. +f the compan!,s ta( rate is *1 percent% what is
the compan!,s weighted average cost of capital (WACC)?
a. ;.**K
b. <.11K
c. <.<1K
d. 15.<;K
e. 11.;/K
Chapter 9 - Page 19
18
. 2obson 2airies has a capital structure that consists of 85 percent long-
term debt and /5 percent common stoc. 9he compan!,s C$A has obtained the
9he before-ta( !ield to maturit! on the compan!,s bonds is ; percent.
9he compan!,s common stoc is e(pected to pa! a J*.55 dividend at !ear
end (2
1
L J*.55)% and the dividend is e(pected to grow at a constant
rate of : percent a !ear. 9he common stoc currentl! sells for J85 a
share.
Assume the firm will be able to use retained earnings to fund the
e-uit! portion of its capital budget.
a. 1#.55K
b. ;.5*K
c. <.*/K
d. ;.55K
e. :.8;K
1:
. Longstreet Corporation has a target capital structure that consists of *5
percent debt% 15 percent common e-uit!% and #5 percent preferred stoc.
9he ta( rate is *5 percent. 9he compan! has pro0ects in which it would
lie to invest with costs that total J1%155%555. Longstreet will retain
J155%555 of net income this !ear. 9he last dividend was J1% the current
stoc price is J:1% and the growth rate of the compan! is 15 percent. +f
the compan! raises capital through a new e-uit! issuance% the flotation
costs are 15 percent. 9he cost of preferred stoc is
< percent and the cost of debt is : percent. (Assume debt and preferred
stoc have no flotation costs.) What is the weighted average cost of
capital at the firm,s optimal capital budget?
a. 1#.1;K
b. 1;.11K
c. 1#.1;K
d. 1#.*/K
e. 11.</K
Chapter 9 - Page 20
1;
. A stoc anal!st has obtained the following information about O->art% a
large retail chain'
9he compan! has noncallable bonds with #5 !ears maturit! remaining and
a maturit! value of J1%555. 9he bonds have a 1# percent annual coupon
and currentl! sell at a price of J1%#:*.;18/.
Aver the past four !ears% the returns on the maret and on O->art were
as follows'
Gear >aret O->art
1<<< 1#.5K 1/.1K
#555 1:.# ##.#
#551 -*.; -:.1
#55# #5.5 #/.5
9he current ris-free rate is 8.*1 percent% and the e(pected return on
the maret is 11.*1 percent. 9he compan!,s ta( rate is *1 percent. 9he
compan! anticipates that its proposed investment pro0ects will be
financed with :5 percent debt and *5 percent e-uit!.
What is the compan!,s estimated weighted average cost of capital (WACC)?
a. ;.5/K
b. <.55K
c. 15.#1K
d. 1#.**K
e. 1*.1/K
WACC Answer: c Diff: %
1<
. Clar Communications has a capital structure that consists of :5 percent
common stoc and *5 percent long-term debt. +n order to calculate Clar,s
weighted average cost of capital (WACC)% an anal!st has accumulated the
9he compan! currentl! has 11-!ear bonds outstanding with annual
coupon pa!ments of ; percent. 9he bonds have a face value of J1%555
and sell for J1%5:1.
9he maret ris premium is / percent.
9he beta on Clar,s common stoc is 1.1.
9he compan!,s retained earnings are sufficient so that the! do not
have to issue an! new common stoc to fund capital pro0ects.
9he compan!,s ta( rate is *; percent.
Miven this information% what is Clar,s WACC?
a. 1.<*K
b. :./5K
c. :.<1K
d. ;.5:K
e. ;.:*K
Chapter 9 - Page 21
85
. 6eading $oods is interested in calculating its weighted average cost of
capital (WACC). 9he compan!,s C$A has collected the following
information'
9he target capital structure consists of /5 percent debt and 85
percent common stoc.
9he compan! has #5-!ear noncallable bonds with a par value of
J1%555% a < percent annual coupon% and a price of J1%5:1.
3-uit! flotation costs are # percent.
9he compan!,s common stoc has a beta of 5.;.
9he maret ris premium is / percent.
9he compan! plans to use retained earnings to finance the e-uit!
portion of its capital structure% so it does not intend to issue an!
new common stoc.
a. 1*.1*K
b. 8.#/K
c. ;.#1K
d. 8.;<K
e. 8.1:K
WACC Answer: c Diff: % $
81
. $inancial anal!sts for &aulls +ndustries have revealed the following
information about the compan!'
&aulls +ndustries currentl! has a capital structure that consists of :1
percent common e-uit! and #1 percent debt.
9he ris-free rate%
6$
% is 1 percent.
9he maret ris premium %
>
-
6$
% is 8 percent.
&aulls,s common stoc has a beta of 1.#.
&aulls has #5-!ear bonds outstanding with an annual coupon rate of 1#
percent and a face value of J1%555. 9he bonds sell toda! for J1%#55.
What is the compan!,s current WACC?
a. :./1K
b. <.1:K
c. 15.81K
d. 15.<<K
e. 11.1:K
Chapter 9 - Page 22
WACC and dividend growt) rate Answer: c Diff: %
8#
. Mratewa! +nc. has a weighted average cost of capital of 11.1 percent. +ts
target capital structure is 11 percent e-uit! and /1 percent debt. 9he
compan! has sufficient retained earnings to fund the e-uit! portion of its
capital budget. 9he before-ta( cost of debt is < percent% and the
compan!,s ta( rate is *5 percent. +f the e(pected dividend ne(t period (2
1
)
is J1 and the current stoc price is J/1% what is the compan!,s growth
rate?
a. #.8;K
b. *.//K
c. /.8/K
d. 8.:1K
e. ;.18K
WACC and optimal capital budget Answer: e Diff: %
8*
. 9he managers of Denforest Mrocers are tr!ing to determine the compan!,s
optimal capital budget for the upcoming !ear. Denforest is considering
the following pro0ects'
6ate of
"ro0ect .i?e 6eturn 6is
A J#55%555 18K @igh
= 155%555 1/ Average
C /55%555 1# Low
2 *55%555 11 @igh
3 155%555 15 Average
$ #55%555 15 Low
M /55%555 : Low
9he compan! estimates that its WACC is 11 percent. All pro0ects are
independent. 9he compan! ad0usts for ris b! adding # percentage points to
the WACC for high-ris pro0ects and subtracting # percentage points from
the WACC for low-ris pro0ects. Which of the pro0ects will the compan!
accept?
a. A% =% C% 3% $
b. =% 2% $% M
c. A% =% C% 3
d% A% =% C% 2% 3
e. A% =% C% $
CA&%* beta* and WACC Answer: e Diff: %
8/
. =radshaw .teel has a capital structure with *5 percent debt (all long-term
bonds) and :5 percent common e-uit!. 9he !ield to maturit! on the
compan!,s long-term bonds is ; percent% and the firm estimates that its
overall composite WACC is 15 percent. 9he ris-free rate of interest is
1.1 percent% the maret ris premium is 1 percent% and the compan!,s ta(
rate is /5 percent. =radshaw uses the CA"> to determine its cost of
e-uit!. What is the beta on =radshaw,s stoc?
a. 1.5:
b. 1./;
Chapter 9 - Page 23
c. 1.*1
d. 5.15
e. 1.*1
!equired rate of return Answer: c Diff: %
81
. Ari?ona 6oc% an all-e-uit! firm% currentl! has a beta of 1.#1. 9he ris-
free rate%
6$
% is : percent and
>
is 1/ percent. .uppose the firm sells
15 percent of its assets with beta e-ual to 1.#1 and purchases the same
proportion of new assets with a beta of 1.1. What will be the firm,s new
overall re-uired rate of return% and what rate of return must the new
assets produce in order to leave the stoc price unchanged?
a. 11.8/1KI 11.8/1K
b. 11.:15KI 1/.:55K
c. 11.8/1KI 1/.:55K
d. 11.:15KI 11.8/1K
e. 1/.:15KI 11.:15K
(eta ris" Answer: b Diff: %
88
. .un .tate >ining +nc.% an all-e-uit! firm% is considering the formation of
a new division that will increase the assets of the firm b! 15 percent.
.un .tate currentl! has a re-uired rate of return of 1; percent% E...
9reasur! bonds !ield : percent% and the maret ris premium is 1 percent.
+f .un .tate wants to reduce its re-uired rate of return to 18 percent%
what is the ma(imum beta coefficient the new division could have?
a. #.#
b. 1.5
c. 1.;
d. 1.8
e. #.5
Tough:
WACC Answer: b Diff: +
8:
. @eav! >etal Corp. is a steel manufacturer that finances its operations
with /5 percent debt% 15 percent preferred stoc% and 15 percent e-uit!.
9he interest rate on the compan!,s debt is 11 percent. 9he preferred
stoc pa!s an annual dividend of J# and sells for J#5 a share. 9he
compan!,s common stoc trades at J*5 a share% and its current dividend
(2
5
) of J# a share is e(pected to grow at a constant rate of ; percent per
!ear. 9he flotation cost of e(ternal e-uit! is 11 percent of the dollar
amount issued% while the flotation cost on preferred stoc is 15 percent.
9he compan! estimates that its WACC is 1#.*5 percent. Assume that the
firm will not have enough retained earnings to fund the e-uit! portion of
its capital budget. What is the compan!,s ta( rate?
a. *5.**K
b. *#.;8K
c. *1.:1K
d. *;.1#K
e. /5.<;K
Chapter 9 - Page 24
Chapter 9 - Page 25
WACC and cost of preferred stoc" Answer: b Diff: +
8;
. Anderson Compan! has four investment opportunities with the following
costs (paid at t L 5) and e(pected returns'
3(pected
"ro0ect Cost 6eturn
A J#%555 18.5K
= *%555 1/.1
C 1%555 11.1
2 *%555 <.1
9he compan! has a target capital structure that consists of /5 percent
common e-uit!% /5 percent debt% and #5 percent preferred stoc. 9he
compan! has J1%555 in retained earnings. 9he compan! e(pects its !ear-end
dividend to be J*.55 per share (2
1
L J*.55). 9he dividend is e(pected to
grow at a constant rate of 1 percent a !ear. 9he compan!,s stoc price is
currentl! J/#.:1. +f the compan! issues new common stoc% the compan!
will pa! its investment baners a 15 percent flotation cost.
9he compan! can issue corporate bonds with a !ield to maturit! of 15
percent. 9he compan! is in the *1 percent ta( bracet. @ow large can the
cost of preferred stoc be (including flotation costs) and it still be
profitable for the compan! to invest in all four pro0ects?
a. :.:1K
b. ;.<5K
c. 15./8K
d. 11.1/K
e. 1#.8;K
Multiple Part:
(The following information applies to the next three problems.)
9he Mlobal Advertising Compan! has a marginal ta( rate of /5 percent. 9he
compan! can raise debt at a 1# percent interest rate and the last dividend paid
b! Mlobal was J5.<5. Mlobal,s common stoc is selling for J;.1< per share% and
its e(pected growth rate in earnings and dividends is 1 percent. +f Mlobal
issues new common stoc% the flotation cost incurred will be 15 percent. Mlobal
plans to finance all capital e(penditures with *5 percent debt and :5 percent
e-uit!.
Cost of retained earnings Answer: e Diff: E
8<
. What is Mlobal,s cost of retained earnings if it can use retained earnings
rather than issue new common stoc?
a. 1#.##K
b. 1:.##K
c. 15.**K
d. <.88K
e. 18.55K
Chapter 9 - Page 26
Cost of eternal equity Answer: b Diff: E
:5
. What is the cost of common e-uit! raised b! selling new stoc?
a. 1#.##K
b. 1:.##K
c. 15.**K
d. <.88K
e. 18.55K
:1
. What is the firm,s weighted average cost of capital if the firm has
sufficient retained earnings to fund the e-uit! portion of its capital
budget?
a. 11.<1K
b. 1#.##K
c. 1#.;;K
d. 1*.*8K
e. 1/.#1K
(The following information applies to the next two problems.)
=!ron Corporation,s present capital structure% which is also its target capital
structure% is /5 percent debt and 85 percent common e-uit!. Assume that the
firm has no retained earnings. 9he compan!,s earnings and dividends are growing
at a constant rate of 1 percentI the last dividend (2
5
) was J#.55I and the
current e-uilibrium stoc price is J#1.;;. =!ron can raise all the debt
financing it needs at 1/ percent. +f =!ron issues new common stoc% a #5
percent flotation cost will be incurred. 9he firm,s marginal ta( rate is /5
percent.
Cost of eternal equity Answer: a Diff: E
:#
. What is the component cost of the e-uit! raised b! selling new common
stoc?
a. 1:.5K
b. 18./K
c. 11.5K
d. 1/.8K
e. 1#.5K
:*
. What is the firm,s weighted average cost of capital?
a. 15.;K
b. 1*.8K
c. 1/.#K
d. 18./K
e. 1;.5K
Chapter 9 - Page 27
(The following information applies to the next six problems.)
6ollins Corporation has a target capital structure consisting of #5 percent
debt% #5 percent preferred stoc% and 85 percent common e-uit!. Assume the firm
has insufficient retained earnings to fund the e-uit! portion of its capital
budget. +ts bonds have a 1# percent coupon% paid semiannuall!% a current
maturit! of #5 !ears% and sell for J1%555. 9he firm could sell% at par% J155
preferred stoc that pa!s a 1# percent annual dividend% but flotation costs of 1
percent would be incurred. 6ollins, beta is 1.#% the ris-free rate is 15
percent% and the maret ris premium is 1 percent. 6ollins is a constant growth
firm that 0ust paid a dividend of J#.55% sells for J#:.55 per share% and has a
growth rate of ; percent. 9he firm,s polic! is to use a ris premium of /
percentage points when using the bond-!ield-plus-ris-premium method to find
s
.
$lotation costs on new common stoc total 15 percent% and the firm,s marginal
ta( rate is /5 percent.
Cost of debt Answer: e Diff: E
:/
. What is 6ollins, component cost of debt?
a. 15.5K
b. <.1K
c. ;.8K
d. ;.5K
e. :.#K
Cost of preferred stoc" Answer: d Diff: E
:1
. What is 6ollins, cost of preferred stoc?
a. 15.5K
b. 11.5K
c. 1#.5K
d. 1#.8K
e. 1*.#K
Cost of equity: CA&% Answer: c Diff: E
:8
. What is 6ollins, cost of retained earnings using the CA"> approach?
a. 1*.8K
b. 1/.1K
c. 18.5K
d. 18.8K
e. 18.<K
Cost of equity: DCF Answer: c Diff: E
::
. What is the firm,s cost of retained earnings using the 2C$ approach?
a. 1*.8K
b. 1/.1K
c. 18.5K
d. 18.8K
e. 18.<K
Chapter 9 - Page 28
Chapter 9 - Page 29
Cost of equity: ris" premium Answer: c Diff: E
:;
. What is 6ollins, cost of retained earnings using the bond-!ield-plus-ris-
premium approach?
a. 1*.8K
b. 1/.1K
c. 18.5K
d. 18.8K
e. 18.<K
:<
. What is 6ollins, WACC% if the firm has insufficient retained earnings to
fund the e-uit! portion of its capital budget?
a. 1*.8K
b. 1/.1K
c. 18.5K
d. 18.8K
e. 18.<K
9he Oacson Compan! has 0ust paid a dividend of J*.55 per share on its common
stoc% and it e(pects this dividend to grow b! 15 percent per !ear%
indefinitel!. 9he firm has a beta of 1.15I the ris-free rate is 15 percentI and
the e(pected return on the maret is 1/ percent. 9he firm,s investment baners
believe that new issues of common stoc would have a flotation cost e-ual to 1
percent of the current maret price.
,toc" price''constant growt) Answer: d Diff: E
;5
. @ow much should an investor be willing to pa! for this stoc toda!?
a. J8#.;1
b. J:5.55
c. J/*.:1
d. J11.55
e. J*5.55
Cost of eternal equity Answer: b Diff: E
;1
. What will be Oacson,s cost of new common stoc if it issues new stoc in
the maretplace toda!?
a. 11.#1K
b. 18.*#K
c. 1:.55K
d. 1#./:K
e. <.;1K
Chapter 9 - Page 30
=ecer Mlass Corporation e(pects to have earnings before interest and ta(es
during the coming !ear of J1%555%555% and it e(pects its earnings and dividends
to grow indefinitel! at a constant annual rate of 1#.1 percent. 9he firm has
J1%555%555 of debt outstanding bearing a coupon interest rate of ; percent% and
it has 155%555 shares of common stoc outstanding. @istoricall!% =ecer has paid
15 percent of net earnings to common shareholders in the form of dividends. 9he
current price of =ecer,s common stoc is J/5% but it would incur a 15 percent
flotation cost if it were to sell new stoc. 9he firm,s ta( rate is /5 percent.
Cost of retained earnings Answer: e Diff: %
;#
. What is the firm,s cost of retained earnings?
a. 11.5K
b. 11.1K
c. 18.5K
d. 18.1K
e. 1:.5K
Cost of eternal equity Answer: d Diff: E
;*
. What is =ecer,s cost of newl! issued stoc?
a. 18.5K
b. 18.1K
c. 1:.5K
d. 1:.1K
e. 1;.5K
(The following information applies to the next four problems.)
O. 6oss and .ons +nc. has a target capital structure that calls for /5 percent
debt% 15 percent preferred stoc% and 15 percent common e-uit!. 9he firm,s
current after-ta( cost of debt is 8 percent% and it can sell as much debt as it
wishes at this rate. 9he firm,s preferred stoc currentl! sells for J<5 a share
and pa!s a dividend of J15 per shareI however% the firm will net onl! J;5 per
share from the sale of new preferred stoc. 6oss, common stoc currentl! sells
for J/5 per share% but the firm will net onl! J*/ per share from the sale of new
common stoc. 9he firm recentl! paid a dividend of J# per share on its common
stoc% and investors e(pect the dividend to grow indefinitel! at a constant rate
of 15 percent per !ear. Assume the firm has sufficient retained earnings to
fund the e-uit! portion of its capital budget.
Cost of retained earnings Answer: c Diff: E
;/
. What is the firm,s cost of retained earnings?
a. 15.5K
b. 1#.1K
c. 11.1K
d. 18.1K
e. 1;.5K
Chapter 9 - Page 31
Cost of eternal equity Answer: d Diff: E
;1
. What is the firm,s cost of newl! issued common stoc?
a. 15.5K
b. 1#.1K
c. 11.1K
d. 18.1K
e. 1;.5K
Cost of preferred stoc" Answer: b Diff: E
;8
. What is the firm,s cost of newl! issued preferred stoc?
a. 15.5K
b. 1#.1K
c. 11.1K
d. 18.1K
e. 1;.5K
;:
. What is the firm,s weighted average cost of capital?
a. <.1K
b. 15.*K
c. 15.;K
d. 11./K
e. 11.<K
9he following information applies to the Coet?er Compan!'
Coet?er has a target capital structure of /5 percent debt and 85 percent
common e-uit!.
Coet?er has J1%555 par value bonds outstanding with a 11-!ear maturit!% a 1#
percent annual coupon% and a current price of J1%115.
9he ris-free rate is 1 percent. 9he maret ris premium (
>
P
6$
) is also 1
percent.
Coet?er,s common stoc has a beta of 1./.
Coet?er,s ta( rate is /5 percent.
Cost of debt Answer: b Diff: E $
;;
. What is the compan!,s after-ta( cost of debt?
a. *.8K
b. 8.5K
c. :.#K
d. 15.5K
e. 1#.5K
Chapter 9 - Page 32
Cost of common equity: CA&% Answer: e Diff: E $
;<
. What is the compan!,s after-ta( cost of common e-uit!?
a. 8.5K
b. ;./K
c. <.8K
d. 15.5K
e. 1#.5K
WACC Answer: c Diff: E $
<5
. What is the compan!,s WACC?
a. 8.5K
b. :./K
c. <.8K
d. 15.;K
e. 1#.#K
(The following information applies to the next four problems.)
Hidua Construction,s C$A wants to estimate the compan!,s WACC. .he has
collected the following information'
9he compan! currentl! has #5-!ear bonds outstanding. 9he bonds have an ;.1
percent annual coupon% a face value of J1%555% and the! currentl! sell for J</1.
9he compan!,s stoc has a beta L 1.#5.
9he maret ris premium%
>
P
6$
% e-uals 1 percent.
9he compan! has outstanding preferred stoc that pa!s a J#.55 annual
dividend. 9he preferred stoc sells for J#1 a share.
9he compan!,s capital structure consists of /5 percent long-term debt% /5
percent common stoc% and #5 percent preferred stoc.
Cost of debt Answer: b Diff: % $
<1
a. 1.15K
b. 1./8K
c. 8./8K
d. ;.15K
e. <.11K
Cost of preferred stoc" Answer: d Diff: E $
<#
. What is the compan!,s after-ta( cost of preferred stoc?
a. /.;5K
b. 1.85K
c. :.15K
d. ;.55K
e. ;./5K
Chapter 9 - Page 33
Cost of common equity: CA&% Answer: d Diff: E $
<*
. What is the compan!,s after-ta( cost of common e-uit!?
a. :.#5K
b. :.*#K
c. :.</K
d. 1#.55K
e. 1#.#5K
WACC Answer: c Diff: E $
</
. What is the compan!,s WACC?
a. :.<1K
b. ;.1#K
c. ;.1<K
d. ;.8:K
e. 15.5/K
=urlees +nc.,s C$A is interested in calculating the cost of capital. +n order
to calculate the cost of capital% the compan! has collected the following
information'
9he compan!,s capital structure consists of /5 percent debt and 85 percent
common stoc.
9he compan! has bonds outstanding with #1 !ears to maturit!. 9he bonds have
a 1# percent annual coupon% a face value of J1%555% and a current price of
J1%#1#.
9he compan! uses the CA"> to calculate the cost of common stoc. Currentl!%
the ris-free rate is 1 percent and the maret ris premium% (
>
-
6$
)%
e-uals 8 percent. 9he compan!,s common stoc has a beta of 1.8.
After'ta cost of debt Answer: c Diff: E $
<1
a. *.:/K
b. /.;5K
c. 1.8#K
d. :.#5K
e. ;.**K
Cost of common equity: CA&% Answer: c Diff: E $
<8
. What is the compan!,s cost of common e-uit!?
a. <.81K
b. 1/.55K
c. 1/.85K
d. 1:.85K
e. 1;.<1K
Chapter 9 - Page 34
Chapter 9 - Page 35
WACC Answer: b Diff: E $
<:
. What is the compan!,s weighted average cost of capital (WACC)?
a. 15.1K
b. 11.5K
c. 11.1K
d. 1#.5K
e. 1#.1K
)e( Appendi* !A
Easy:
!is" and divisional costs of capital Answer: a Diff: E $
<A-
<;
. .unshine +nc. has two divisions. 15 percent of the firm,s capital is
invested in 2ivision A% which has a beta of 5.;. 9he other 15 percent
of the firm,s capital is invested in 2ivision =% which has a beta of
1.#. 9he compan! has no debt% and it is 155 percent e-uit! financed.
9he ris-free rate is 8 percent and the maret ris premium is 1
percent. .unshine assigns different hurdle rates to each division% and
these hurdle rates are based on each division,s maret ris. Which of
the following statements is most correct?
a. .unshine,s composite WACC is 11 percent.
b. 2ivision = has a lower weighted average cost of capital than 2ivision A.
c. +f .unshine assigned the same hurdle rate to each division% this
would lead the firm to select too man! pro0ects in 2ivision A and
re0ect too man! pro0ects in 2ivision =.
e. .tatements a and c are correct.
Medium:
!is" and pro#ect betas Answer: d Diff: %
<A-
<<
. +f the firm is being operated so as to ma(imi?e shareholder wealth% and
if our basic assumptions concerning the relationship between ris and
return are true% then which of the following should be true?
a. +f the beta of the asset is larger than the firm,s beta% then the re-
-uired return on the asset is less than the re-uired return on the firm.
b. +f the beta of the asset is smaller than the firm,s beta% then the
re-uired return on the asset is greater than the re-uired return on the
firm.
c. +f the beta of the asset is greater than the firm,s beta prior to the
addition of that asset% then the firm,s beta after the purchase of
the asset will be smaller than the original firm,s beta.
d. +f the beta of an asset is larger than the firm,s beta prior to the
addition of that asset% then the re-uired return on the firm will be
greater after the purchase of that asset than prior to its purchase.
Chapter 9 - Page 36
,%- and capital budgeting Answer: a Diff: %
<A-
155
. Esing the .ecurit! >aret Line concept in capital budgeting% which of
the following is correct?
a. +f the e(pected rate of return on a given capital pro0ect lies above
the .>L% the pro0ect should be accepted even if its beta is above the
beta of the firm,s average pro0ect.
b. +f a pro0ect,s return lies below the .>L% it should be re0ected if it
has a beta greater than the firm,s e(isting beta but accepted if its
beta is below the firm,s beta.
c. +f two mutuall! e(clusive pro0ects, e(pected returns are both above
the .>L% the pro0ect with the lower ris should be accepted.
d. +f a pro0ect,s e(pected rate of return is greater than the e(pected
rate of return on an average pro0ect% it should be accepted.
Easy:
&ro#ect cost of capital Answer: c Diff: E
<A-
151
. Louisiana 3nterprises% an all-e-uit! firm% is considering a new capital
investment. Anal!sis has indicated that the proposed investment has a
beta of 5.1 and will generate an e(pected return of : percent. 9he firm
currentl! has a re-uired return of 15.:1 percent and a beta of 1.#1.
9he investment% if undertaen% will double the firm,s total assets. +f
6$
is : percent and the maret return is 15 percent% should the firm
undertae the investment? (Choose the best answer.)
a. GesI the e(pected return of the asset (:K) e(ceeds the re-uired return
(8.1K).
b. GesI the beta of the asset will reduce the ris of the firm.
c. &oI the e(pected return of the asset (:K) is less than the re-uired
return (;.1K).
d. &oI the ris of the asset (beta) will increase the firm,s beta.
e. &oI the e(pected return of the asset is less than the firm,s re-uired
return% which is 15.:1K.
Chapter 9 - Page 37
Medium:
&ro#ect cost of capital Answer: e Diff: %
<A-
15#
. Assume !ou are the director of capital budgeting for an all-e-uit! firm.
9he firm,s current cost of e-uit! is 18 percentI the ris-free rate is
15 percentI and the maret ris premium is 1 percent. Gou are
considering a new pro0ect that has 15 percent more beta ris than !our
firm,s assets currentl! have% that is% its beta is 15 percent larger
than the firm,s e(isting beta. 9he e(pected return on the new pro0ect
is 1; percent. .hould the pro0ect be accepted if beta ris is the
appropriate ris measure? Choose the correct statement.
a. GesI its e(pected return is greater than the firm,s cost of capital.
b. GesI the pro0ect,s ris-ad0usted re-uired return is less than its
e(pected return.
c. &oI a 15 percent increase in beta ris gives a ris-ad0usted re-uired
return of #/ percent.
d. &oI the pro0ect,s ris-ad0usted re-uired return is # percentage
points above its e(pected return.
e. &oI the pro0ect,s ris-ad0usted re-uired return is 1 percentage point
above its e(pected return.
)e( Appendi* !+
Medium:
&ure play met)od Answer: b Diff: %
<=-
15*
. Which of the following methods involves calculating an average beta for
firms in a similar business and then appl!ing that beta to determine a
pro0ect,s beta?
a. 6is premium method.
b. "ure pla! method.
c. Accounting beta method.
d. CA"> method.
Chapter 9 - Page 38
Easy:
Corporate WACC for firm wit) divisions Answer: c Diff: E $
<=-
15/
. &orthern Conglomerate has two divisions% 2ivision A and 2ivision =.
&orthern loos at competing pure-pla! firms to estimate the betas of each
of the two divisions. After this anal!sis% &orthern concludes that
2ivision A has a beta of 5.; and 2ivision = has a beta of 1.1. 9he two
divisions are the same si?e. 9he ris-free rate is 1 percent and the
maret ris premium%
>
-
6$
% is 8 percent. Assume that &orthern is 155
percent e-uit! financed. What is the overall composite WACC for &orthern
Conglomerate?
a. <.;K
b. 15.#K
c. 11.<K
d. 1*.8K
e. 1/.5K
Medium:
&ure play met)od Answer: b Diff: %
<=-
151
. +nterstate 9ransport has a target capital structure of 15 percent debt
and 15 percent common e-uit!. 9he firm is considering a new independent
pro0ect that has a return of 1* percent and is not related to
transportation. @owever% a pure pla! pro(! firm has been identified
that is e(clusivel! engaged in the new line of business. 9he pro(! firm
has a beta of 1.*;. =oth firms have a marginal ta( rate of /5 percent%
and +nterstate,s before-ta( cost of debt is 1# percent. 9he ris-free
rate is 15 percent and the maret ris premium is 1 percent. 9he firm
should
a. 6e0ect the pro0ectI its return is less than the firm,s re-uired rate
of return on the pro0ect of 18.< percent.
b. Accept the pro0ectI its return is greater than the firm,s re-uired
rate of return on the pro0ect of 1#.51 percent.
c. 6e0ect the pro0ectI its return is onl! 1* percent.
d. Accept the pro0ectI its return e(ceeds the ris-free rate and the
before-ta( cost of debt.
e. =e indifferent between accepting or re0ectingI the firm,s re-uired
rate of return on the pro0ect e-uals its e(pected return.
Chapter 9 - Page 39
CHAPTE !
A,#)E# A,D #"&-T%",#
1. Capital components Answer: c Diff: E
#. Capital components Answer: d Diff: E
*. Capital components Answer: a Diff: E
9he debt cost used to calculate a firm,s WACC is
d
(1 - 9). +f
d
remains
constant but 9 increases% then the term (1 - 9) decreases and the value of the
entire e-uation%
d
(1 - 9)% decreases. .tatement b is falseI if a compan!,s
stoc price increases% and all else remains constant% then the dividend !ield
decreases and
s
decreases. 9his can be seen from the e-uation
s
L 2
1
4"
5
Q g.
.tatement c is false for the same reason. 9he cost of issuing new common stoc
is
e
L 2
1
4R"
5
(1 - $)S Q g. +f "
5
increases but there,s no change in the
flotation cost%
e
will decrease.
/. Capital components Answer: c Diff: E
6etained earnings are 0ust another form of e-uit!. When the compan! has
retained earnings% the! can do one of two things--reinvest it or pa! it out as
dividends. +f the firm reinvests the earnings% it needs to earn a return that
is at least as high as the
s
of the stoc. Atherwise% investors would be
happier receiving the dividends and investing them in something that will earn
s
. 9herefore% statement a is false. .ome of the preferred stoc dividends are
e(cluded from ta(ation when another compan! owns them. +t maes no ta(
difference to the compan! that pa!s the dividends% since dividends come out of
after-ta( dollars. 9herefore% statement b is false. +nterest pa!ments are ta(
deductible. 9herefore% statement c is true.
1
. DCF cost of equity estimation Answer: b Diff: E
8. WACC Answer: d Diff: E
9he correct answer is statement d because statements a and b are correct.
.tatement c is false. .hareholders can either receive a dividend or the! can
let !ou reinvest in the compan!. +f the! receive a dividend% the! can invest
that mone! and earn a return on it. Conse-uentl!% if the compan! eeps the
mone! as retained earnings and reinvests in pro0ects% it had better earn a
return on that mone!. 9herefore% there is a cost associated with using retained
earnings.
:. WACC Answer: c Diff: E
.tatement c is the correct choice. A ta( rate increase would lead to a
decrease in the after-ta( cost of debt and% conse-uentl!% the firm,s WACC would
decrease.
;. WACC Answer: e Diff: E
9he preferred stoc dividend is not ta( deductible lie the interest pa!ment on
debt. 9herefore% there is no ta( benefit from preferred stoc.
.tatement a is true. 6etained earnings are e-uit!% and e-uit! will have a higher
cost than debt. 9herefore% statement b is false. +f the beta increases%
investors will re-uire a higher rate of return to hold or bu! the stoc.
9herefore% the cost of e-uit! will go up% and statement c is true. =ecause
statements a and c are true% the correct choice is statement e.
<. Factors influencing WACC Answer: a Diff: E
.tatement a is trueI the other statements are false. +f 6"
>
decreases% the cost
of e-uit! will be reduced. Answers b through e will all increase the compan!,s
WACC.
15. WACC and capital components Answer: c Diff: E
WACC measures the marginal after-ta( cost of capitalI therefore% statement a is
false. 9he after-ta( cost of debt financing is less than the after-ta( cost of
e-uit! financingI therefore% statement b is false. 9he correct choice is
statement c.
11. WACC and capital components Answer: a Diff: E
.tatement a is trueI the other statements are false. .tatement b is falseI
WACC is an average of debt and e-uit! financing. .ince debt financing is
cheaper and is ad0usted downward for ta(es% it should% when averaged with
e-uit!% cause the WACC to be less than the cost of e-uit! financing. .tatement
c is falseI WACC is calculated on an after-ta( basis. .tatement d is falseI
the WACC is based on marginal% not embedded% costs. .tatement e is falseI the
cost of issuing new common stoc is greater than the cost of retained earnings.
1#. Internal vs. eternal common equity Answer: e Diff: E
.tatements a through c will increase the need to raise new common stocI
therefore% statement e is the correct answer.
1*. !is" and pro#ect selection Answer: c Diff: E
s
L 15K Q (18K - 15K)1.1 L 15K Q <K L 1<K.
3(pected return L #1K. #1K - 6is ad0ustment 1K L #5K.
6is-ad0usted return L #5K )
s
L 1<K. 9hus% the pro0ect should be selected.
1/. !is" and pro#ect selection Answer: b Diff: E
9he pro0ect whose return is greater than its ris-ad0usted cost of capital
should be selected. Anl! "ro0ect = meets this criteria.
11. Divisional ris" Answer: a Diff: E $
9he correct answer is statement a. 2ivision A should accept onl! pro0ects with
a return greater than <.; percent% and 2ivision = should accept onl! pro0ects
with a return greater than 1/ percent. Anl! statement a fits this criteria.
9he compan!,s composite WACC is irrelevant in the decision.
18. !etained earnings brea" point Answer: a Diff: E
.tatement a is trueI an increase in net income will increase the retained
earnings brea point. .tatements b and c will serve to lower the brea point.
.tatement b will result in less earnings being retained% so the retained
earnings brea point will be reduced. .tatement c will result in more earnings
being needed% so the retained earnings brea point will be reduced. .tatement
d will have no effect on the retained earnings brea point.
1:. !etained earnings brea" point Answer: b Diff: E
.tatement a is falseI increasing the dividend pa!out will result in the firm
running out of retained earnings earlier. .tatement b is trueI a higher debt
ratio means that retained earnings are a smaller portion of the funding mi(
and% therefore% retained earnings will go further. .tatement c will have no
effect on the retained earnings brea point% as is the case for statement d.
1;. %iscellaneous cost of capital concepts Answer: c Diff: E $
9he correct answer is statement c. 2ebt is usuall! safer than e-uit! because
it has promised pa!ments over the life of the debt. .o% the cost of debt is
t!picall! below the WACC. .o% statement a is incorrect. +f banruptc! occurs%
debt holders ma! get something. 3-uit! holders will get nothingT .o% the cost
of debt is again t!picall! below the cost of e-uit!. .o% statement b is
incorrect. .tatement c is correct. .tatement d is incorrect. 9he cost of
retained earnings is generall! e-ual to the re-uired return on e-uit!% which
e(ceeds the cost of debt. @igher flotation costs increase the cost of e-uit!.
.o statement e is incorrect.
1<. %iscellaneous concepts Answer: e Diff: E
$lotation costs do not reduce investor returnsI the! reduce the amount of the
compan!,s proceeds. 9his drives the compan!,s cost of e-uit!% and thus its
WACC% higher. 9herefore% statement a is false. 9he WACC is based on marginal
costs and incorporates ta(es. Conse-uentl!% statement b is false. 6etained
earnings have no flotation costs but the compan! still must earn a return on
them% so the! are not without a cost. +nvestors e(pect a re-uired rate of
return% and if the! don,t receive it% the! would prefer that the compan! pa!
out retained earnings as dividends% so that the! can then invest in something
that does give them their e(pected return. 9hus% retained earnings have a
cost. 9herefore% statement c is false. .ince statements a% b% and c are false%
the correct choice is statement e.
#5. Capital components Answer: e Diff: %
.tatement e is the correct answer. Enlie interest e(pense on debt% preferred
dividends are not deductible% hence there are no ta( savings associated with
the use of preferred stoc. 9he component costs of WACC should reflect the
costs of new financing% not historical measures. 9he cost of issuing new
e-uit! is alwa!s greater than the cost of retained earnings.
#1. Capital components Answer: a Diff: %
.tatement a is trueI the other statements are false. "referred stoc dividends
are not ta( deductibleI therefore% the cost of preferred stoc is onl!
p
. 9he
ris premium in the bond-!ield-plus-ris premium approach would be added to the
firm,s cost of debt% not the ris-free rate. "referred stoc also has
flotation costs.
##. Cost of capital estimation Answer: c Diff: %
#*. Cost of equity estimation Answer: d Diff: %
#/. CA&% cost of equity estimation Answer: e Diff: %
#1. CA&% and DCF estimation Answer: a Diff: %
#8. WACC Answer: d Diff: %
=oth statements a and c are trueI therefore% statement d is the correct choice.
.tatement a recites the definition of the weighted average cost of capital.
.tatement c is correct because
d
L
6$
Q L" Q >6" Q 26" while
s
L
6$
Q (
>
-
6$
)b. +f
6$
increases then the values for
d
and
s
will
increase.
#:. WACC Answer: d Diff: %
+f a firm paid no income ta(es% its cost of debt would not be ad0usted
downward% hence the component cost of debt would be higher than if 9 were
greater than 5. With a higher component cost of debt% the WACC would increase.
Af course% the compan! would have higher earnings% and its cash flows from a
given pro0ect would be high% so the higher WACC would not impede its
investments% that is% its capital budget would be larger than if it were ta(ed.
#;. WACC Answer: e Diff: %
.tatement e is the correct answer. An increase in flotation costs has no
effect on the cost of retained earnings. .ince interest is ta( deductible%
while preferred and common dividends are not% onl! the cost of debt used in the
WACC e-uation must be ad0usted b! multipl!ing b! (1 - 9). An increase in the
firm,s corporate ta( rate reduces the after-ta( component cost of debt.
#<. WACC Answer: e Diff: %
.tatement e is the correct answer. After-ta( cash flows must be considered in
order to account for the ta( deductibilit! of interest pa!ments on cor-porate
debt. An increase in flotation costs will leave the cost of retained earnings
unchanged% but will raise the cost of new e-uit! issues. 9he marginal% not the
embedded% cost of capital is the relevant cost of capital.
*5. WACC and capital components Answer: b Diff: %
=ecause corporations can e(clude dividends for ta( purposes% preferred stoc
often has a before-ta( maret return that is less than the issuing compan!,s
before-ta( cost of debt. 9hen% if the issuer,s ta( rate is ?ero% its component
cost of preferred would be less than its after-ta( cost of debt.
*1. !is"'ad#usted cost of capital Answer: c Diff: %
=! Demp not maing the ris ad0ustment% it is true that the compan! will accept
more pro0ects in the computer division% and fewer pro0ects in the restaurant
division. @owever% this will mae the compan! risier overall% raising its
cost of e-uit!. +nvestors will discount their cash flows at a higher rate% and
the compan!,s value will fall. +n addition% some of the computer pro0ects
might not e(ceed the appropriate ris-ad0usted hurdle rate% and will actuall!
be negative &"H pro0ects% further destro!ing value. 9herefore% statement a is
false. =ecause fewer of the restaurant pro0ects will be accepted% the
restaurant division will become a smaller part of the overall compan!.
9herefore% statement b is false. As e(plained above% statement c is true.
*#. !is"'ad#usted cost of capital Answer: b Diff: %
=! not ris ad0usting the cost of capital% the firm will tend to re0ect low-
ris pro0ects since their returns will be lower than the average cost of
capital% and it will tae on high-ris pro0ects since their returns will be
higher than the average cost of capital.
**. !is"'ad#usted cost of capital Answer: e Diff: %
*/. !is"'ad#usted cost of capital Answer: a Diff: %
*1. Division WACCs and ris" Answer: e Diff: %
+f the compan! uses the 15 percent WACC% it will turn down all pro0ects with a
return of less than 15 percent but more than ; percent. 9hus% these BsaferC
pro0ects will no longer be taen% and the compan! will increase the proportion
of ris! pro0ects it undertaes. 9herefore% statement a is true. +f 2ivision
A,s pro0ects have lower returns than 2ivision =,s because the! have less ris%
fewer and fewer pro0ects will be accepted from 2ivision A and more pro0ects
will be accepted from 2ivision =. 9herefore% 2ivision = will grow and 2ivision
A will shrin. 9herefore% statement b is true. +f the compan! becomes risier%
then its cost of e-uit! will increase causing WACC to increase. 9herefore%
statement c is true. =ecause all of the statements are true% the correct
choice is statement e.
*8. Divisional ris" and pro#ect selection Answer: e Diff: % $
9he correct answer is statement e. .tatement a is correctI the firms have the
same si?e and capital structure% so the WACC of the merged compan! is 0ust a
simple average of their separate WACCs. .tatement b is correctI "ro0ect F has
an +66 of 15.1K and its appropriate cost of capital is 15K% therefore% the
pro0ect has a positive net present value. .tatement c is also correctI "ro0ect
F should be accepted because of the previous argument. "ro0ect G should be
re0ected because it has an 11.1K return and its appropriate cost of capital is
1#K. 9herefore% statement e is the correct choice.
*:. (eta and pro#ect ris" Answer: a Diff: %
*;. %iscellaneous concepts Answer: a Diff: %
*<. Cost of new equity Answer: b Diff: E
e
L
5.11) - J15(1
) J#.55(1.51
Q 1K L <.</K.
/5. Cost of new equity Answer: d Diff: E
9he firm must issue new e-uit! to fund its capital pro0ects% so we need to find
the cost of new e-uit! capital%
e
'
e
L 2
1
4("
5
- $) Q g
L J#.154(J15 - J*) Q /K
L J#.154J/: Q /K
L 1.*#K Q /K
L <.*#K.
/1. Cost of retained earnings Answer: d Diff: E
Ese the dividend growth model to calculate
s
'
s
L
5
5
"
g) (1 2 +
Q g L
J#;
) J#.#5(1.58
Q 5.58
L 5.5;** Q 5.58 L 5.1/** 1/.*K.
/#. WACC Answer: a Diff: E
WACC L w
d
d
(1 - 9) Q w
c
e
.
d
is given L <K. $ind
e
'
e
L 2
1
4R"
5
(1 - $)S Q g
L J5.;4RJ#1(1 - 5.1)S Q 5.5<
L 5.1#1118.
&ow !ou can calculate WACC'
WACC L (5.*)(5.5<)(5.8) Q (5.:)(5.1#1118) L 15./1K.
/*. WACC Answer: a Diff: E
WACC L R5.* 5.5;/ (1 - 5./)S Q R5.: (J#.14(J/1 (1 - 5.1)) Q 5.5:)S
L 15.:*K.
//. WACC Answer: b Diff: E
WACC L w
d
d
(1 - 9) Q w
c
s
.
s
L
6$
Q 6"
>
(b)
s
L 1.1K Q 1K(1./)
s
L 1.1K Q :K L 1#.1K.
WACC L w
d
d
(1 - 9) Q w
c
s
WACC L 5./(<K)(1 - 5./) Q (5.8)1#.1K
WACC L <.88K.
/1. Divisional ris" Answer: c Diff: E
G2
L 15K Q #K L 1#K.
@owever% for a low-ris pro0ect% 2and! "roduct subtracts # percentage points.
9herefore% the re-uired rate of return is 15 percent.
G2%Low-ris pro0ect
L 15K Q #K - #K L 15K.
/8
. !etained earnings brea" point Answer: e Diff: E
Additions to retained earnings will be' J*.5 million 5./ L J1.# million. 9he
retained earnings breapoint is J1.# million45.# L J8 million.
/:. Cost of retained earnings Answer: d Diff: %
9he cost of retained earnings as calculated from the CA"> is
s
L
6$
Q (
>
-
6$
)b
L 1K Q (8K)1.#
L 1#.#K.
/;
. Cost of eternal equity Answer: d Diff: %
2
5
L J#I 2
1
L J#(1.5:) L J#.1/.
e
L 2
1
4R"
5
(1 - $)S Q g
L J#.1/4(J/# - J1) Q :K L 1#.##K.
/<. Component cost of debt Answer: b Diff: %
9ime line'

5 1 # * /

;5 Uuarters

V V V V V W W W V

">9 L #5 #5 #5 #5 #5
H
=
L 8;8.;8 $H L 1%555

d L ?
$in
ancial calculator solution'
Calculate the nominal G9> of bond'
+nputs' & L ;5I "H L -8;8.;8I ">9 L #5I $H L 1555.
Autput' + L *.51K periodic rate.
&ominal annual rate L *.51K / L 1#.#5K.
Calculate
d
after-ta('
d%A9
L 1#.#5(1 - 9) L 1#.#5(1 - 5./) L :.*#K.
15. WACC Answer: e Diff: % $
2ata given'
6$
L 8KI 6"
>
L 1KI b L 1.#I 9 L /5KI w
d
L 5.*I w
c
L 5.:.
WACC L w
d
d
(1 - 9) Q w
c
s
.
.tep 1' 2etermine the firm,s costs of debt and e-uit!'
3nter the following data as inputs in !our calculator'
& L #8I "H L -<#5I ">9 L :1I $H L 1555I and then solve for + L
d
L
;.#18:K.
s
L
6$
Q (6"
>
)b
L 8K Q (1K)1.#
L 1#K.
.tep #' Miven the firm,s component costs of capital% calculate the firm,s
WACC'
WACC L w
d
d
(1 - 9) Q w
c
s
L 5.*(;.#18:K)(1 - 5./) Q 5.:(1#K)
L 1./;8#K Q ;./K
L <.;;8#K <.;<K.
11. WACC Answer: a Diff: %
$ind the dividend% 2
1
L R(5.1)J/5%555S4X of .hares L J#5%555415%555 L J#.55.
.ince the firm will not have enough retained earnings to fund the e-uit!
portion of its capital budget% the firm will have to issue new common stoc.
$ind the cost of new common stoc'
e
L 2
1
4R"
5
(1 - $)S Q g L J#.554RJ#1(1 - 5.11)S Q 5K L 5.5</1 L <./1K.
$inall!% calculate WACC% using
e
L 5.5</1% and
d
L 5.5;% so
WACC L (24A)(1 - 9a( rate)
d
Q (34A)
e
L 5./(5.5;)(1 - 5./) Q 5.8(5.5</1) L 5.5:1: :.8K.
1#. WACC Answer: b Diff: %
A9 cost of debt L 5.5:(1 - 5./5) L 5.5/# L /.#K.
Cost of preferred stoc L J/4J/# L 5.5<1# L <.1#K.
Cost of retained earnings L J#4J#; Q 5.5: L 5.1/1/ L 1/.1/K.
WACC L 5./5(5.5/#) Q 5.15(5.5<1#) Q 5.15(5.1/1/) L 5.5<:5 L <.:5K.
1*. WACC Answer: a Diff: %
A9 cost of debt L 5.5;(1 - 5./5) L 5.5/; L /.;5K.
Cost of retained earnings L J#.1#4J*# Q 5.58 L 5.1#8* L 1#.8*K.
WACC L 5.:1(5.1#8*) Q 5.#1(5.5/;) L 15.8:K.
1/
. WACC Answer: c Diff: %
Cost of debt L 5.5;/(1 - 5.*5) L 5.51;; L 1.;;K.
Cost of preferred stoc L 5.5< L <K.
Cost of retained earnings L
6$
Q (6"
>
)b L 8.1:K Q (1K)1.* L 1*.5:K.
WACC L 5./(5.51;;) Q 5.15(5.5<) Q 5.15(5.1*5:) L <.:<K.
11. WACC Answer: b Diff: %
Cost of debt L 5.5<(1 - 5.*1) L 5.51;1 L 1.;1K.
Cost of retained earnings L
6$
Q (6"
>
)b L 8K Q 8K(1.1) L 11K.
WACC L 5.85(5.51;1) Q 5./5(5.1155) L 5.5<11 L <.11K.
18. WACC Answer: e Diff: %
9he firm will not be issuing new e-uit! because there are ade-uate retained
earnings available to fund available pro0ects. 9herefore% WACC should be
calculated using
s
rather than
e
.
s
L 2
1
4"
5
Q g
L J*.554J85.55 Q 5.5:
L 5.1# L 1#K.
WACC L w
d
d
(1 - 9) Q w
c
s
L (5.8)(5.5;)(1 - 5./) Q (5./)(5.1#)
L 5.5:8; L :.8;K.
1:. WACC Answer: d Diff: %
A9 cost of debt L :K(1 - 5.*) L /.<K.
6etained earnings breapoint L J155%55545.1 L J1%555%555.
9hus% to finance its optimal capital budget% Longstreet must issue some new
e-uit! and flotation costs of 15K will be incurred.
Cost of new e-uit! L RJ1(1.15)4J:1(1 - 5.1)S Q 15K L ;.11K Q 15K L 1;.11K.
WACC L /.<K(5.*) Q <K(5.#) Q 1;.11K(5.1) L 1#.*/K.
1;
. WACC Answer: a Diff: %
WACC L R(5.:)(
d
)(1 - 9)S Q R(5.*)(
s
)S.
Ese bond information to solve for
d
'
& L #5I "H L -1#:*.;18/I ">9 L 1#5I $H L 1555I and then solve for
d
L <K.
9o solve for
s
% we can use the .>L e-uation% but we need to find beta. Esing
>aret and O->art return information and a calculator,s regression feature we
find b L 1.*1;1.
s
L 5.58*1 Q (5.11*1 - 5.58*1)(1.*1;1) L 5.1*1/ L 1*.1/K.
"lug these values into the WACC e-uation and solve'
WACC L R(5.:)(5.5<)(1 - 5.*1)S Q R(5.*)(5.1*1/)S L 5.5;5/ L ;.5/K.
1<. WACC Answer: c Diff: %
.tep 1' $ind the cost of debt'
3nter the following input data in the calculator'
& L 11I "H L -15:1I ">9 L ;5I $H L 1555I and then solve for + L
d
L
:.18:;K.
.tep #' $ind the cost of e-uit!'
s
L
6$
Q (
>
-
6$
)b
L 1K Q /K(1.1)
L 1K Q /./K
L <./K.
.tep *' Calculate the firm,s WACC'
WACC L w
d
d
(1 - 9) Q w
c
s
L (5.*)(:.18:;K)(1 - 5.*;) Q (5.:)(<./K)
L 1.***#K Q 8.1;K
L :.<1*#K :.<1K.
85. WACC Answer: d Diff: %
w
d
L 5./I w
c
L 5.8.
.tep 1' Calculate
d
'
Ese the information about the compan!,s e(isting bonds to enter the
following input data in the calculator'
& L #5I "H L -15:1I ">9 L <5I $H L 1555I and then solve for + L ;.##*/K.
.tep #' Calculate
s
'
6$
L 1KI
>
-
6$
L /KI b L 5.;.
s
L
6$
Q (
>
-
6$
)b
L 1K Q (/K)5.;
L ;.#K.
.tep *' Calculate WACC'
WACC L w
d
d
(1 - 9) Q w
c
s
L (5./)(;.##*/K)(1 - 5./) Q (5.8)(;.#K)
L 8.;<K.
81. WACC Answer: c Diff: % $
WACC L w
d
d
(1 - 9) Q w
c
s
.
.tep 1' Calculate the cost of common e-uit! using the CA"> e-uation'
s
L 1K Q (8K)1.# L 1#.#5K.
.tep #' Calculate the cost of debt using a financial calculator b! entering
the following input data'
& L #5I "H L -1#55I ">9 L 1#5I $H L 1555I and then solve for + L
d
L
<.:K.
.tep *' Calculate the firm,s WACC b! substituting the values calculated above
in the WACC e-uation'
WACC L (5.#1)<.:K(1 - 5./5) Q (5.:1)1#.#5K L 15.81K.
8#. WACC and dividend growt) rate Answer: c Diff: %
.olve for
s
' WACC L w
d
d
(1 - 9) Q w
c
s
11.1K L 5./1(5.5<)(5.:5) Q 5.11
s

s
L 11.:1K.
.olve for g' 11.:1K L 2
1
4"
5
Q g
11.:1K L J14J/1 Q g
g L /.8/K.
8*. WACC and optimal capital budget Answer: e Diff: %
6ate of 6is-Ad0usted
"ro0ect 6eturn Cost of Capital
A 18K 1*K
= 1/ 11
C 1# <
2 11 1*
3 15 11
$ 15 <
M : <
"ro0ects A% =% and C are profitable because their returns surpass their ris-
ad0usted costs of capital. 2 is not profitable because its return (11K) is
less than its ris-ad0usted cost of capital (1*K). 3 is not acceptable for the
same reason' +ts return (15K) is less than its ris-ad0usted cost of capital
(11K). $ is accepted since it is low ris and its return (15K) surpasses the
ris-ad0usted cost of capital of <K. M is re0ected because its return (:K) is
less than the ris-ad0usted cost of capital (<K).
8/. CA&%* beta* and WACC Answer: e Diff: %
2ata given' w
d
L 5.*I w
c
L 5.:I
d
L ;KI WACC L 15KI 9 L /5KI
6$
L 1.1K%
>
-
6$
L 1K.
.tep 1' 2etermine the firm,s cost of e-uit! using the WACC e-uation'
WACC L w
d
d
(1 - 9) Q w
c
s
15K L (5.*)(;K)(1 - 5./) Q (5.:)
s
;.18K L (5.:)
s
s
L 1#.##;8K.
.tep #' Calculate the firm,s beta using the CA"> e-uation'
s
L
6$
Q (
>
-
6$
)b
1#.##;8K L 1.1K Q (1K)b
8.:#;8K L 1Kb
b L 1.*/1: 1.*1.
81. !equired rate of return Answer: c Diff: %
b
Ald% firm
L 1.#1.
Ald% firm
L 5.5: Q (5.1/ P 5.5:)1.#1 L 11.:1K.
b
&ew% firm
L 5.<(1.#1) Q 5.1(1.1) L 1.#*1.
&ew% firm
L 5.5: Q 1.#*1(5.5:) L 11.8/1K.
&ew% assets
L 5.5: Q 1.1(5.5:) L 1/.:K.
88. (eta ris" Answer: b Diff: %
Ald assets L 1.5. &ew assets L 5.1. 9otal assets L 1.1.
Ald re-uired rate' &ew re-uired rate'
1;K L :K Q (1K)b 18K L :K Q (1K)b
beta L #.#. beta L 1.;.
&ew b must not be greater than 1.;% therefore
1.1
1
(#.#) Q
1.1
5.1
(b) L 1.;

5.****(b) L 5.****

b L 1.5.
9herefore% beta of the new division cannot e(ceed 1.5.
8:. WACC Answer: b Diff: +
Capital structure' /5K 2% 15K "% 15K 3.
WACC L 1#.*5K (given).
d
L 11K (given).
WACC L 5./(
d
)(1 - 9) Q 5.1(
p
) Q 5.1(
e
).
=ecause the firm has insufficient retained earnings to fund the e-uit! portion
of the firm,s capital budget% use
e
in the WACC calculation.
a. Calculate
e
'
e
L
J*5(5.;1)
J#(1.5;)
Q ;K L ;./:K Q ;K L 18./:K.
b. Calculate
p
'
p
L
p
p
"
2
L
J#5(5.<)
J#
L 11.11K.
c. $ind 9 b! substituting values for
d
%
p
% and
e
in the WACC e-uation'
5.1#*5 L 5./(5.11)(1 - 9) Q 5.1(5.1111) Q 5.1(5.18/:)
5.1#*5 L 5.5//(1 - 9) Q 5.5111 Q 5.5;#*1
5.5#<1/ L 5.5//(1 - 9)
5.8:1*8/ L 1 - 9
5.*#;8*8 L 9.
8;. WACC and cost of preferred stoc" Answer: b Diff: +
We need to find
p
at the point where all / pro0ects are accepted. +n other
words% the capital budget L J#%555 Q J*%555 Q J1%555 Q J*%555 L J1*%555. 9he
WACC at that point is e-ual to +66
2
L <.1K.
.tep 1' $ind the retained earnings brea point to determine whether
s
or
e
is
used in the WACC calculation'
="
63
L
5./
J1%555
L J#%155.
.ince the capital budget ) the retained earnings brea point%
e
is
used in the WACC calculation.
.tep #' Calculate
e
'
e
L
) J/#.:1(5.<
J*.55
Q 1K L 1#.;5K.
.tep *' $ind
p
'
<.1K L 5./(15K)(5.81) Q 5.#(
p
) Q 5./(1#.;5K)
<.1K L #.85K Q 5.#(
p
) Q 1.1#K
1.:;K L 5.#
p
;.<5K L
p
.
8<. Cost of retained earnings Answer: e Diff: E
s
L
J;.1<
) J5.<5(1.51
Q 5.51 L 5.1855 L 18.55K.
:5
. Cost of eternal equity Answer: b Diff: E
e
L
5.15) - J;.1<(1
) J5.<5(1.51
Q 5.51 L 5.1:## L 1:.##K.
:1
. WACC Answer: d Diff: E
.ince the firm can fund the e-uit! portion of its capital budget with retained
earnings% use
s
in WACC.
WACC L w
d
d
(1 - 9) Q w
c
s
L 5.*(5.1#)(1 - 5./) Q 5.:(5.18)
L 5.5#18 Q 5.11#
L 5.1**8 L 1*.*8K.
:#
. Cost of eternal equity Answer: a Diff: E
e
L
5.#) - J#1.;;(1
) J#.55(1.51
Q 5.51 L 1:K.
:*
. WACC Answer: b Diff: E
WACC L 5./(5.1/)(1 - 5./) Q 5.8(5.1:) L 5.1*18 L 1*.18K 1*.8K.
:/. Cost of debt Answer: e Diff: E
9ime line'

5 1 # * /

/5 8-month

V V V V V W W W V "eriods

">9 L 85 85 85 85 85
H
=
L 1%555 $H L 1%555
d4# L ?
.ince the bond sells at par of J1%555% its G9> and coupon rate (1# percent) are
e-ual. 9hus% the before-ta( cost of debt to 6ollins is 1#.5 percent. 9he
after-ta( cost of debt e-uals'
d%After-ta(
L 1#.5K(1 - 5./5) L :.#K.
$inancial calculator solution'
+nputs' & L /5I "H L -1555I ">9 L 85I $H L 1555I
Autput' + L 8.5K L
d
4#.
d
L 8.5K # L 1#K.
d
(1 - 9) L 1#.5K(5.8) L :.#K.
:1. Cost of preferred stoc" Answer: d Diff: E
Cost of preferred stoc'
p
L J1#4J155(5.<1) L 1#.8K.
:8
. Cost of equity: CA&% Answer: c Diff: E
Cost of retained earnings (CA"> approach)'
s
L 15K Q (1K)1.# L 18.5K.
::. Cost of equity: DCF Answer: c Diff: E
Cost of retained earnings (2C$ approach)'
s
L
J#:
) J#.55(1.5;
Q ;K L 18.5K.
:;
. Cost of equity: ris" premium Answer: c Diff: E
Cost of retained earnings (bond !ield-plus-ris-premium approach)'
s
L 1#.5K Q /.5K L 18.5K.
:<
. WACC Answer: b Diff: E
Calculate
e
'
e
L
5.1) J#:(1
) J#.55(1.5;
Q ;K L 18.;<K.
WACC L w
d
d
(1 - 9) Q w
p
p
Q w
c
e
L 5.#(1#.5K)(5.8) Q 5.#(1#.8K) Q 5.8(18.;<K) L 1/.5< 1/.1K.
;5
. ,toc" price''constant growt) Answer: d Diff: E
s
L 15K Q (/K)1.1 L 18K.
"
5
L
5.15 - 5.18
) J*.55(1.15
L J11.55.
;1. Cost of eternal equity Answer: b Diff: E
Cost of new common e-uit!'
e
L
1) J11.55(5.<
J*.*5
Q 5.15 L 18.*#K.
;#
. Cost of retained earnings Answer: e Diff: %
3=+9 J1%555%555
+nterest /55%555
3=9 J 855%555
9a(es (/5K) #/5%555
&et income J *85%555
3".
1
L J*85%5554155%555 L J*.85.
2
1
L J*.85(5.1) L J1.;5.
s
L (J1.;54J/5.55) Q 5.1#1 L 1:.5K.
;*
. Cost of eternal equity Answer: d Diff: E
e
L
) (J/5)(5.<5
J1.;5
Q 5.1#1 L 1:.1K.
;/
. Cost of retained earnings Answer: c Diff: E
s
L
J/5.55
) J#.55(1.15
Q 5.15 L 11.1K.
;1. Cost of eternal equity Answer: d Diff: E
e
L
J*/.55
J#.#5
Q 5.15 L 5.18/: 18.1K.
;8
. Cost of preferred stoc" Answer: b Diff: E
p
L
J;5
J15
L 1#.1K.
;:
. WACC Answer: d Diff: E
.ince the firm has sufficient retained earnings to fund the e-uit! portion of
its capital budget% use
s
in WACC e-uation.
WACC L w
d
d
(1 - 9) Q w
p
p
Q w
c
s
L 5./(8K) Q 5.1(1#.1K) Q 5.1(11.1K)
L 11./K.
;; . Cost of debt
Answer: b Diff: E $
9o determine the cost of debt% use maret values and the bond information
given. 3nter the following data as inputs into !our calculator as follows'
& L 11I "H L -1115I ">9 L 1#5I $H L 1555I and then solve for + L
d
L 15.5*K.
9he after-ta( cost of debt is 15.5*K(1 - 9a( rate) L 15.5*K(5.8) L 8.5#K 8K.
;< . Cost of common equity: CA&%
Answer: e Diff: E $
Esing the CA"> e-uation'
s
L
6$
Q (
>
P
6$
)b

s
L 1K Q (1K)1./

s
L 1#K.
.ince e-uit! costs are not ta(-deductible% this is also the after-ta( cost of
e-uit!.
<5. WACC Answer: c Diff: E $
Ese the target debt and e-uit! ratios and the WACC e-uation as follows'
WACC L w
d
d
(1 P 9) Q w
c
s
L (5./5)(5.58) Q (5.85)(5.1#)
L 5.5<8% or <.8K.
<1. Cost of debt Answer: b Diff: % $
9he after-ta( cost of debt is found b! using the firm,s bond information to
solve for the G9> on bonds outstanding. 9hen% the G9> needs to be converted to
an after-ta( !ield.
& L #5I "H L -</1I ">9 L ;1I $H L 1555I and then solve for
d
L + L <.11K.
A9
d
L <.11K(1 - 5./) L 1./8K.
<#. Cost of preferred stoc" Answer: d Diff: E $
9he after-ta( cost of preferred stoc can be derived b! simpl! dividing the
preferred dividend paid b! the price of preferred stoc.
p
L
p
p
"
2
p
L J#4J#1
p
L ;.5K.
<*. Cost of common equity: CA&% Answer: d Diff: E $
9he cost of common e-uit! can be found in a variet! of wa!s. +n this case% we
have been given information about the maret ris premium and beta. 9herefore%
we can use the CA"> to value the cost of common e-uit!.
s
L
6$
Q (
>
P
6$
)b
s
L 8K Q (1K)1.#
s
L 1#.5K.
</. WACC Answer: c Diff: E $
9he WACC is merel! a weighted-average of the capital component costs.
WACC L w
d
d
(1 P 9) Q w
p
p
Q w
c
s
WACC L 5./(<.11K)(1 - 5./) Q 5.#(;K)Q 5./(1#K)
WACC L ;.1<K.
<1. After'ta cost of debt Answer: c Diff: E $
9o find the cost of debt% enter the following data into !our calculator'
& L #1I "H L -1#1#I ">9 L 1#5I $H L 1555I and then solve for + L <.*1</K% which
is the before-ta( cost of debt.
9o calculate the after-ta( cost of debt% multipl! b! (1 P 9) as follows'
(1 - 5./5) <.*1</K L 1.8118K 1.8#K.
<8. Cost of common equity: CA&% Answer: c Diff: E $
s
L 1K Q (8K)1.8 L 1/.8K.
<:. WACC Answer: b Diff: E $
WACC L (5./5)(1.8118K) Q (5.85)(1/.8K) L 11.558#K 11.5K.
<;.A'. !is" and divisional costs of capital Answer: a Diff: E $
9he correct answer is statement a. 9he composite WACC will be the average of
the two divisional WACCs. .ince there is no debt% the WACC L
s
. 9here is no
cost of e-uit! given% but it can be calculated from the beta% the ris-free
rate% and the maret ris premium using CA">. 9he beta of the entire compan!
is the weighted average of the two divisions, betas (5.1 5.; Q 5.1 1.# L
1.5). 9he firm,s cost of e-uit! will be e-ual to 11K (
s
L
6$
Q (6"
>
)b L 8K Q
1K 1.5 L 11K). 9herefore% the WACC is 11K% and statement a is correct.
2ivision = has a higher beta% therefore its cost of capital will be higher
than A,s. 9herefore% statement b is false. +f both divisions were assigned
the same hurdle rate% this rate would reflect the re-uired return on pro0ects
with a beta of 1.5. .ince 2ivision A,s average pro0ects have a beta of 5.;%
the! would tend to have a lower return. 9herefore% fewer of them would meet
the hurdle rate of 11K% and the compan! would choose too few of them.
Conversel!% the compan! would choose too man! pro0ects in 2ivision =.
9herefore% statement c is false.
<<.A'. !is" and pro#ect betas Answer: d Diff: %
155.A'. ,%- and capital budgeting Answer: a Diff: %
151.A'. &ro#ect cost of capital Answer: c Diff: E
Calculate the re-uired return%
s
% and compare to the e(pected return%
s
7
.
s
7
L :K.
)E+ APPE,D%. !A #"&-T%",#
s
L
6$
Q (
>
-
6$
)b L :K Q (15K - :K)5.1 L ;.1K.
s
)
s
7
I ;.1K ) :.5KI re0ect the investment.
15#.A'. &ro#ect cost of capital Answer: e Diff: %
Calculate the beta of the firm% and use to calculate pro0ect beta'
s
L 5.18 L 5.15 Q (5.51)b
$irm
. b
$irm
L 1.#.
b
"ro0ect
L (b
$irm
)1.1. (b
"ro0ect
is 15K greater than current b
$irm
)
b
"ro0ect
L (1.#)1.1 L 1.;.
Calculate re-uired return on pro0ect% "ro0ect% and compare to e(pected
return'
"ro0ect'
"ro0ect
L 5.15 Q (5.51)1.; L 5.1< L 1<K. 3(pected return L 5.1; L
1;K. .ince the re-uired return is one percentage point greater than the
e(pected return% the firm should not accept the new pro0ect.
15*.('. &ure play met)od Answer: b Diff: %
15/.('. Corporate WACC for firm wit) divisions Answer: c Diff: E $
$or 2ivision A'
A
L
6$
Q (
>
P
6$
)b
A

A
L 1K Q (8K)5.;

A
L <.;K.
$or 2ivision ='
=
L
6$
Q (
>
P
6$
)b
=

=
L 1K Q (8K)1.1

=
L 1/K.
WACC L w
A
A
Q w
=
=
L (5.15)(5.5<;) Q (5.15)(5.1/)
L 5.11<% or 11.<K.
151.('. &ure play met)od Answer: b Diff: %
Calculate the re-uired return%
s
% and use to calculate the WACC'
s
L 15K Q 1.*;(1K) L 18.<K.
WACC L 5.1(1#.5K)(5.8) Q 5.1(18.<K) L 1#.51K.
Compare e(pected pro0ect return%
"ro0ect
7
% to WACC'
=ut
"ro0ect
7
L 1*.5K.
Accept the pro0ect since WACC
7
"ro0ect
> ' 1*.5K ) 1#.51K.
)E+ APPE,D%. !+ #"&-T%",#

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Multiple Choice: Conceptual

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