Question 1Sorensen Systems Inc. is expected to pay a $2.50 dividend at year end (D1= $2.50), the dividend is expected to grow at a constant rate of 5.50% a year, and the common stock currently sells for $52.50 a share. The before-tax cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of 45% debt and 55% common equity. What is the company’s WACC if all the equity used is from retained earnings?7.07%7.36%7.67%7.98%8.29%2 points Question 2A company’s perpetual preferred stock currently sells for $92.50 per share, and it pays an $8.00 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price. What is the firm’s cost of preferred stock?7.81%8.22%8.65%9.10%9.56%2 points Question 3O’Brien Inc. has the following data: rRF= 5.00%; RPM= 6.00%; and b = 1.05. What is the firm’s cost of common from retained earnings based on the CAPM?11.30%11.64%11.99%12.35%12.72%2 points Question 4Which of the following statements is CORRECT?The WACC as used in capital budgeting is an estimate of a company’s before-tax cost of capital.The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt.The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets.There is an “opportunity cost” associated with using retained earnings, hence they are not “free.”The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year.2 points Question 5Which of the following statements is CORRECT?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.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.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.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.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.2 points Question 6Rivoli Inc. hired you as a consultant to help estimate its cost of common equity. You have been provided with the following data: D0= $0.80; P0= $22.50; and g = 8.00% (constant). Based on the DCF approach, what is the cost of common from retained earnings?10.69%11.25%11.84%12.43%13.05%2 points Question 7A. Butcher Timber Company hired your consulting firm to help them estimate the cost of common equity. The yield on the firm’s bonds is 8.75%, and your firm’s economists believe that the cost of common can be estimated using a risk premium of 3.85% over a firm’s own cost of debt. What is an estimate of the firm’s cost of common from retained earnings?12.60%13.10%13.63%14.17%14.74%2 points Question 8Keys Printing plans to issue a $1,000 par value, 20-year noncallable bond with a 7.00% annual coupon, paid semiannually. The company’s marginal tax rate is 40.00%, but Congress is considering a change in the corporate tax rate to 30.00%. By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted?0.57%0.63%0.70%0.77%0.85%2 points Question 9Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.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.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.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.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.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.2 points Question 10Which of the following statements is CORRECT?A change in a company’s target capital structure cannot affect its WACC.WACC calculations should be based on thebefore-taxcosts of all the individual capital components.Flotation costs associated with issuing new common stock normallyreducethe WACC.If a company’s tax rate increases, then, all else equal, its weighted average cost of capital willdecline.An increase in the risk-free rate will normallylowerthe marginal costs of both debt and equity financing.2 points Question 11Which of the following statements is CORRECT?When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation.All else equal, an increase in a company’s stock price will increase its marginal cost of retained earnings, rs.All else equal, an increase in a company’s stock price will increase its marginal cost of new common equity, re.Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt.If a company’s tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall.2 points Question 12Multi-Part 9-1: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.AssetsCurrent assets$ 38,000,000Net plant, property, and equipment 101,000,000Total assets$139,000,000Liabilities and EquityAccounts payable$ 10,000,000Accruals 9,000,000Current liabilities$ 19,000,000Long-term debt (40,000 bonds, $1,000 par value) 40,000,000Total liabilities$ 59,000,000Common stock (10,000,000 shares)30,000,000Retained earnings 50,000,000Total shareholders’ equity 80,000,000Total liabilities and shareholders’ equity$139,000,000The 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%.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?18.67%19.60%20.58%21.61%22.69%2 points Question 13The MacMillen Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm’s overall WACC is 12%. The CFO believes that this is the correct WACC for the company’s average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though projects
have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO’s position is accepted, what is likely to happen over time?The company will take on too many high-risk projects and reject too many low-risk projects.The company will take on too many low-risk projects and reject too many high-risk projects.Things will generally even out over time, and, therefore, the firm’s risk should remain constant over time.The company’s overall WACC should decrease over time because its stock price should be increasing.The CEO’s recommendation would maximize the firm’s intrinsic value.2 points Question 14You were hired as a consultant to Quigley Company, whose target capital structure is 35% debt, 10% preferred, and 55% common equity. The interest rate on new debt is 6.50%, the yield on the preferred is 6.00%, the cost of common from retained earnings is 11.25%, and the tax rate is 40%. The firm will not be issuing any new common stock. What is Quigley’s WACC?8.15%8.48%8.82%9.17%9.54%2 points Question 15Cranberry Corp. has two divisions of equal size: a computer manufacturing division and a data processing division. Its CFO believes that stand-alone data processor companies typically have a WACC of 8%, while stand-alone computer manufacturers typically have a 12% WACC. He also believes that the data processing and manufacturing divisions have the same risk as their typical peers. Consequently, he estimates that the composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the data processing division and a 12% hurdle rate for the manufacturing division. However, the CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is CORRECT?While the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant’s recommendation, this should not affect the firm’s intrinsic value.The decision not to adjust for risk means, in effect, that it is favoring the data processing division. Therefore, that division is likely to become a larger part of the consolidated company over time.The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division. This will lead to a reduction in the firm’s intrinsic value over time.The decision not to risk-adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business. This will lead to a reduction in its intrinsic value over time.The decision not to risk adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business. This may affect the firm’s capital structure but it will not affect its intrinsic value.