Managerial Finance Problem Review Set Cost of Capital with solutions

1)
If a firm's marginal tax rate is increased, this would, other things held
constant, lower the cost of debt used to calculate its WACC.
a.
b.

True
False

2)
The lower the firm's tax rate, the lower will be its after-tax cost of debt
and WACC, other things held constant.
a.
b.

True
False

3)
If investors' aversion to risk rose, causing the slope of the SML to
increase, this would have a greater impact on the required rate of return on
equity, rs, than on the interest rate on long-term debt, rd, for most firms.
Other things held constant, this would lead to an increase in the use of debt
and a decrease in the use of equity. However, other things would not stay
constant if firms used a lot more debt, as that would increase the riskiness
of both debt and equity and thus limit the shift toward debt.
a.
b.

True
False

4)
Jackson Inc. uses only equity capital, and it has 2 equally-sized divisions.
Division As cost of capital is 10.0%, Division Bs cost is 14.0%, and the
composite WACC is 12.0%. All of Division As projects have the same risk, as
do all of Division B's projects. However, the projects in Division A have
less risk than those in Division B. Which of the following projects should
Jackson accept?
a.
b.
c.
d.
e.

A
A
A
A
A

Division
Division
Division
Division
Division

B
B
A
A
B

project
project
project
project
project

with
with
with
with
with

a 13% return.
a 12% return.
an 11% return.
a 9% return.
an 11% return.

5)
Vang Inc. estimates that its average-risk projects have a WACC of 10%, its
below-average risk projects have a WACC of 8%, and its above-average risk
projects have a WACC of 12%. Which of the following projects (A, B, and C)
should the company accept?
a.
b.
c.
d.
e.

Project B is of below-average risk and has a return of 8.5%.

Project C is of above-average risk and has a return of 11%.
Project A is of average risk and has a return of 9%.
None of the projects should be accepted.
All of the projects should be accepted.
Divisional risk

Answer: c

The correct answer is statement c. Division A should accept only projects with a return greater than 10%,
and Division B should accept only projects with a return greater than 14%. Only statement c meets this
criterion.

6)
Nelson Enterprises, an all-equity firm, has a beta of 2.0. Nelsons chief
financial officer is evaluating a project with an expected return of 21%,
before any risk adjustment. The risk-free rate is 7%, and the market risk
premium is 6%. The project being evaluated is riskier than Nelsons average
project, in terms of both its beta risk and its total risk. Which of the
following statements is CORRECT?
a.
b.
c.
d.
e.

The project should definitely be accepted because its expected return

(before any risk adjustments) is greater than its required return.
The project should definitely be rejected because its expected return
(before risk adjustment) is less than its required return.
Riskier-than-average projects should have their expected returns
increased to reflect their higher risk. Clearly, this would make the
project acceptable regardless of the amount of the adjustment.
The accept/reject decision depends on the firm's risk-adjustment policy.
If Nelson's policy is to increase the required return on a riskier-thanaverage project to 3% over rS, then it should reject the project.
Capital budgeting projects should be evaluated solely on the basis of
their total risk. Thus, insufficient information has been provided to
make the accept/reject decision.
Risk and project selection

Answer: a

Project B has a return greater than its risk-adjusted cost of capital, so it should be accepted.
7)
Which of the following statements is CORRECT?
a.
b.
c.
d.

The WACC is calculated using before-tax costs for all components.

The after-tax cost of debt usually exceeds the after-tax cost of equity.
For a given firm, the after-tax cost of debt is always more expensive
than the after-tax cost of preferred stock.
Retained earnings that were generated in the past and are reflected on
the firms balance sheet are generally available to finance the firms

e.

capital budget during the coming year.

The WACC that should be used in capital budgeting is the firms
marginal, after-tax cost of capital.
Risk and project selection

Answer: d

Statement d is correct. Here is the proof:

rs = 7% + 6%(2.0) = 7% + 12% = 19%.
Required return for risky projects = 19% + 3% = 22%.
Project return = 21% < adjusted rs = 22%. Thus, the project should be rejected.

8)
Assume that you are a consultant to Magee Inc., and you have been provided
with the following data: rRF = 4.00%; RPM = 5.00%; and b = 1.15. What is the
cost of equity from retained earnings based on the CAPM approach?
a.
b.
c.
d.
e.

9.75%
10.04%
10.34%
10.65%
10.97%
Component cost of retained earnings: CAPM
rRF
RPM
b
rs = rRF + (RPM b)

Answer: a

4.00%
5.00%
1.15
9.75%

9)
Lanser Inc. hired you as a consultant to help them estimate its cost of
capital. You have been provided with the following data: D1 = $0.80; P0 =
$22.50; and g = 5.00% (constant). Based on the DCF approach, what is the
cost of equity from retained earnings?
a.
b.
c.
d.
e.

7.34%
7.72%
8.13%
8.56%
8.98%
Component cost of retained earnings: DCF, D1
D1
P0
g
rs = D1/P0 + g

$0.80
$22.50
5.00%
8.56%

Answer: d

10)
You were hired as a consultant to Kroncke Company, whose target capital
structure is 40% debt, 10% preferred, and 50% common equity. The after-tax
cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of
retained earnings is 13.25%. The firm will not be issuing any new stock.
What is its WACC?
a.
b.
c.
d.
e.

9.48%
9.78%
10.07%
10.37%
10.68%
WACC
Debt
Preferred
Common
WACC = wd rd(1 T) + wp rp + wc rs

Answer: b
Weights
40%
10%
50%

Costs
6.00%
7.50%
13.25%
9.78%

11)
To help finance a major expansion, Delano Development Company sold a
noncallable bond several years ago that now has 15 years to maturity. This
bond has a 10.25% annual coupon, paid semiannually, it sells at a price of
$1,025, and it has a par value of $1,000. If Delanos tax rate is 40%, what
component cost of debt should be used in the WACC calculation?
a.
b.
c.
d.
e.

5.11%
5.37%
5.66%
5.96%
6.25%
Component cost of debt
Coupon rate
Periods/year
Maturity (yr)
Bond price
Par value
Tax rate
Calculator inputs:
N = 2 15
PV = Bond's price
PMT = coupon rate * par/2
FV = Par = Maturity value
I/YR
times periods/yr = before-tax cost of debt
= After-tax cost of debt (A-T rd) for use in WACC

Answer: d
10.25%
2
15
$1,025.00
$1,000
40%
30
-$1,025.00
$51.25
$1,000
4.96%
9.93%
5.96%

12)
Chambliss Inc. hired you as a consultant to help estimate its cost of
capital. You have been provided with the following data: D0 = $0.90; P0 =
$27.50; and g = 8.00% (constant). Based on the DCF approach, what is the
cost of equity from retained earnings?
a.
b.
c.
d.
e.

10.41%
10.96%
11.53%
12.11%
12.72%
Component cost of retained earnings: DCF, D0
D0
P0
g
D1 = D0 *(1 + g)
rs = D1/P0 + g

$0.90
$27.50
8.00%
$0.97
11.53%

Answer: c

Intermediate step

13)
You were recently hired by Nast Media Inc. to estimate its cost of capital.
You were provided with the following data: D1 = $2.00; P0 = $55.00; g = 8.00%
(constant); and F = 5.00%. What is the cost of equity raised by selling new
common stock?
a.
b.
c.
d.
e.

11.24%
11.83%
12.42%
13.04%
13.69%
re based on DCF, D1
D1
P0
g
F
re = D1/(P0 (1 F)) + g

Answer: b
$2.00
$55.00
8.00%
5.00%
11.83%

14)
Schadler Systems is expected to pay a $3.50 dividend at year end (D1 = $3.50),
the dividend is expected to grow at a constant rate of 6.50% a year, and the
common stock currently sells for $62.50 a share. The before-tax cost of debt
is 7.50%, and the tax rate is 40%. The target capital structure consists of
40% debt and 60% common equity. What is the companys WACC if all equity is
from retained earnings?
a.
b.
c.
d.
e.

8.35%
8.70%
9.06%
9.42%
9.80%

WACC
D1
P0
g
rd
Tax rate
Weight debt
Weight equity
rd(1 T)
rs = D1/P0 + g
WACC = wd(rd)(1 T) + wc(rs) =

Answer: c
$3.50
$62.50
6.50%
7.50%
40%
40%
60%
4.50%
12.1%
9.06%

15)
Roxie Epoxys balance sheet shows a total of $50 million long-term debt with
a coupon rate of 8.00% and a yield to maturity of 7.00%. This debt currently
has a market value of $55 million. The balance sheet also shows that that
the company has 20 million shares of common stock, and the book value of the
common equity (common stock plus retained earnings) is $65 million. The
current stock price is $8.25 per share; stockholders' required return, rs, is
10.00%; and the firm's tax rate is 40%. Based on market value weights, and
assuming the firm is currently at its target capital structure, what WACC
should Roxie use to evaluate capital budgeting projects?
a.
b.
c.
d.
e.

7.26%
7.56%
7.88%
8.21%
8.55%
WACC based on target capital structure

Answer: e

Weights used in the WACC equation should be based on market values.

P0
Shares outstanding (in millions)
YTM = rd
rs
Tax rate
Market debt value (in millions)
Market equity (in millions) = P0Shares
Total market value of debt and equity
wd
wc
WACC = wd(rd)(1 T) + wc(rs) =

$8.25
20
7.00%
10.00%
40%
$55.00
$165.00
$220.00
25.00%
75.00%
8.55%

Given

Calculated

Book value weights--WRONG!!!

$50.00
43.48%
7.00%
$65.00
56.52% 10.00%
$115.00
100.00%
Book value WACC:7.48%

16)
Assume that you are on the financial staff of Michelson Inc., and you have
collected the following data: (1) The yield on the companys outstanding
bonds is 8.00%, and its tax rate is 40%. (2) The next expected dividend is
$0.65 a share, and the dividend is expected to grow at a constant rate of
6.00% a year. (3) The price of Michelson's stock is $17.50 per share, and
the flotation cost for selling new shares is F = 10%. (4) The target capital
structure is 45% debt and the balance is common equity. What is Michelson's
WACC, assuming it must issue new stock to finance its capital budget?
a.
b.
c.
d.
e.

6.63%
6.98%
7.34%
7.73%
8.12%
WACC, equity from retained earnings, uses DCF
YTM
Tax rate
D1
g
P0
F
Weight debt
Weight equity
A-T cost of debt
re = D1/(P0*(1 F)) + g
WACC = wd(rd)(1 T) + wc(rs) =

Solutions
1)

2)

8.00%
40%
$0.65
6.00%
$17.50
10.0%
45%
55%
4.80%
10.13%
7.73%

Answer: d

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