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Question(s) / Instruction(s):

 1. Schalheim Sisters Inc. has always paid out all of its earnings as dividends; hence, the firm has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, and its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC?

a. The market risk premium declines.

b. The flotation costs associated with issuing new common stock increase.

c. The company's beta increases.

d. Expected inflation increases.

e. The flotation costs associated with issuing preferred stock increase.

 

 2. Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A's cost of capital is 10.0%, Division B's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A's

pr ojects are equally risky, as are all of Division B's projects. However, the projects of Division A are less

risky than those of Division B. Which of the following projects should the firm accept?

a. A Division B project with a 13% return.

b. A Division B project with a 12% return.

c. A Division A project with an 11% return.

d. A Division A project with a 9% return.

e. A Division B project with an 11% return.

 

 3. LaPango 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. Project B, which is of below-average risk and has a return of 8.5%.

b. Project C, which is of above-average risk and has a return of 11%.

c. Project A, which is of average risk and has a return of 9%.

d. None of the projects should be accepted.

e. All of the projects should be accepted.

 

 4. Which of the following statements is CORRECT?

a. Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs¾beta, the risk-free rate, and the market risk premium¾can be estimated with little error.

b. The DCF model is generally preferred by academics and financial executives over other

models for estimating the cost of equity. This is because of the DCF model's logical appeal

and also because accurate estimates for its key inputs, the dividend yield and the growth

rate, are easy to obtain.

c. The bond-yield-plus-risk-premium approach to estimating the cost of equity may not

always be accurate, but it has the advantage that its two key inputs, the firm's own cost of

debt and its risk premium, can be found by using standardized and objective procedures.

d. Surveys indicate that the CAPM is the most widely used method for estimating the cost of

equity. However, other methods are also used because CAPM estimates may be subject to

error, and people like to use different methods as checks on one another. If all of the

methods produce similar results, this increases the decision maker's confidence in the

estimated cost of equity.

e. The DCF model is preferred by academics and finance practitioners over other cost of

capital models because it correctly recognizes that the expected return on a stock consists

of a dividend yield plus an expected capital gains yield.

 

 5. Which of the following statements is CORRECT?

a. Since the costs of internal and external equity are related, an increase in the flotation cost

required to sell a new issue of stock will increase the cost of retained earnings.

b. Since its stockholders are not directly responsible for paying a corporation's income taxes,

corporations should focus on before-tax cash flows when calculating the WACC.

c. An increase in a firm's tax rate will increase the component cost of debt, provided the

YTM on the firm's bonds is not affected by the change in the tax rate.

d. When the WACC is calculated, it should reflect the costs of new common stock, retained

earnings, preferred stock, long-term debt, short-term bank loans if the firm normally

finances with bank debt, and accounts payable if the firm normally has accounts payable

on its balance sheet.

e. If a firm has been suffering accounting losses that are expected to continue into the

foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost

of preferred stock to be less than the after-tax cost of debt.

 

 6. Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and  is seeking to maximize shareholder wealth.

a. If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected

returns on its assets are negatively correlated with the returns on most other firms' assets.

b. If a firm's managers want to maximize the value of their firm's stock, they should, in

theory, concentrate on project risk as measured by the standard deviation of the project's

expected future cash flows.

c. If a firm evaluates all projects using the same cost of capital, and the CAPM is used to

help determine that cost, then its risk as measured by beta will probably decline over time.

d. Projects with above-average risk typically have higher than average expected returns.

Therefore, to maximize a firm's intrinsic value, its managers should favor high-beta

projects over those with lower betas.

e. Project A has a standard deviation of expected returns of 20%, while Project B's standard

deviation is only 10%. A's returns are negatively correlated with both the firm's other

assets and the returns on most stocks in the economy, while B's returns are positively

correlated. Therefore, Project A is less risky to a firm and should be evaluated with a

lower cost of capital.

 

7. S. Bouchard and Company hired you as a consultant to help estimate its cost of common equity. You have obtained the following data: D0 = $0.85; P0 = $22.00; and g = 6.00% (constant). The CEO thinks, however, that the stock price is temporarily depressed, and that it will soon rise to $40.00. Based on the DCF approach, by how much would the cost of common from retained earnings change if the stock price changes as the CEO expects?

a. -1.49%

b. -1.66%

c. -1.84%

d. -2.03%

e. -2.23%

 

8. Eakins Inc.'s common stock currently sells for $45.00 per share, the company expects to earn $2.75 per share during the current year, its expected payout ratio is 70%, and its expected constant growth rate is 6.00%. New stock can be sold to the public at the current price, but a flotation cost of 8% would be incurred. By how much would the cost of new stock exceed the cost of common from retained earnings?

a. 0.09%

b. 0.19%

c. 0.37%

d. 0.56%

e. 0.84%

 

 

Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics,

including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of

capital. The balance sheet and some other information are provided below.

Assets

Current assets $ 38,000,000

Net plant, property, and equipment 101,000,000

Total assets $139,000,000

Liabilities and Equity

Accounts payable $ 10,000,000

Accruals 9,000,000

Current liabilities $ 19,000,000

Long-term debt (40,000 bonds, $1,000 par value) 40,000,000

Total liabilities $ 59,000,000

Common stock (10,000,000 shares) 30,000,000

Retained earnings 50,000,000

Total shareholders' equity 80,000,000

Total liabilities and shareholders' equity $139,000,000

The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%.

 

9. Refer to Multi-Part 9-1. What is the best estimate of the after-tax cost of debt?

a. 4.64%

b. 4.88%

c. 5.14%

d. 5.40%

e. 5.67%

 

10. Refer to Multi-Part 9-1. Which of the following is the best estimate for the weight of debt for use in

calculating the firm's WACC?

a. 18.67%

b. 19.60%

c. 20.58%

d. 21.61%

e. 22.69%

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