## Essentials of Corporate Finance Study Set 4

Business

## Quiz 12 :

Cost of Capital

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Q04 Q04 Q04

Farmer's Supply is considering opening a clothing store, which would be a new line of business for the firm.Management has decided to use the cost of capital of a similar clothing store as the discount rate to evaluate this proposed expansion.Which one of the following terms describes this evaluation approach?

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Q05 Q05 Q05

Kate is the CFO of a major firm and has the job of assigning discount rates to each project under consideration.Kate's method of doing this is to assign an incrementally higher rate as the risk level of the project increases and a lower rate as the risk level declines.Kate is applying the ___ approach.

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Q09 Q09 Q09

A firm has a return on equity of 12.4 percent according to the dividend growth model and a return of 18.7 percent according to the capital asset pricing model.The market rate of return is 13.5 percent.What rate should the firm use as the cost of equity when computing the firm's weighted average cost of capital (WACC)?

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Q30 Q30 Q30

Old Town Industries has three divisions.Division X has been in existence the longest and has the most stable sales.Division Y has been in existence for five years and is slightly less risky than the overall firm.Division Z is the research and development side of the business.Given this, the firm should probably:

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Q32 Q32 Q32

Kurt, who is a divisional manager, continually brags that his division's required return for its projects is one percent lower than the return required for any other division of the firm.Which one of the following most likely contributes the most to the lower rate requirement for Kurt's division?

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Q36 Q36 Q36

Boone Brothers remodels homes and replaces windows.Ace Builders constructs new homes.If Boone Brothers considers expanding into new home construction, it should evaluate the expansion project using which one of the following as the required return for the project?

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Q40 Q40 Q40

Kelly's uses the firm's WACC as the required return for some of its projects.For other projects, the firms uses a rate equal to WACC plus one percent, while another set of projects is assigned rates equal to WACC minus some amount.Which one of the following factors should be the key factor the firm uses to determine the amount of the adjustment it will make when assigning a discount rate to a specific project?

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Q45 Q45 Q45

City Equipment announced this morning that its next annual dividend will be decreased to $1.90 a share and that all future dividends will be decreased by an additional 1.9 percent annually.What is the current value per share if the required return is 16.8 percent?

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Q47 Q47 Q47

Mississippi Mud Products would like to issue new equity shares if its cost of equity declines to 9.5 percent.The company pays a constant annual dividend of $4.80 per share.What does the market price of the stock need to be for the firm to issue the new shares?

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Q49 Q49 Q49

Trendsetters has a cost of equity of 14.6 percent.The market risk premium is 8.4 percent and the risk-free rate is 3.9 percent.The company is acquiring a competitor, which will increase the company's beta to 1.4.What effect, if any, will the acquisition have on the firm's cost of equity capital?

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Q51 Q51 Q51

Musical Charts just paid an annual dividend of $1.84 per share.This dividend is expected to increase by 2.1 percent annually.Currently, the firm has a beta of 1.12 and a stock price of $31 a share.The risk-free rate is 4.3 percent and the market rate of return is 13.2 percent.What is the cost of equity capital for this firm?

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Q52 Q52 Q52

Commercial Construction Builders has a beta of 1.34, a dividend growth rate of 2.1 percent for the foreseeable future, a stock price of $15 per share, and an expected annual dividend of $0.45 per share next year.The market rate of return is 12.8 percent and the risk-free rate is 4.2 percent.What is the firm's average cost of equity?

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Q53 Q53 Q53

The market rate of return is 12.65 percent and the risk-free rate is 3.1 percent.Galaxy Co.has 15 percent more systematic risk than the overall market and has a dividend growth rate of 3.75 percent.The firm's stock is currently selling for $53 a share and has a dividend yield of 4.53 percent.What is the firm's average cost of equity?

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Q54 Q54 Q54

Appalachian Mountain Goods has paid increasing dividends of $10, $.12, $.15, and $.20 a share over the past four years, respectively.The firm estimates that future increases in its dividends will be equal to the arithmetic average growth rate over these past four years.The stock is currently selling for $12.50 a share.The risk-free rate is 3.4 percent and the market risk premium is 8.1 percent.What is the cost of equity for this firm if its beta is 1.46?

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Q61 Q61 Q61

Great Lakes Packing has two bond issues outstanding.The first issue has a coupon rate of8 percent, matures in 6 years, has a total face value of $5 million, and is quoted at 101.2 percent of face value.The second issue has a 7.5 percent coupon, matures in 13 years, has a total face value of $18 million, and is quoted at 99 percent of face value.Both bonds pay interest semiannually.What is the firm's weighted average aftertax cost of debt if the tax rate is 34 percent?

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Q65 Q65 Q65

Dee's Dress Emporium has 50,000 shares of common stock outstanding at a price of $27 a share.It also has 1000 shares of preferred stock outstanding at a price of $20 a share.There are 800bonds outstanding that have a semiannual coupon payment of $25.The bonds mature in four years, have a face value of $1,000, and sell at 97 percent of par.What is the capital structure weight of the common stock?

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Q66 Q66 Q66

S&W has 21,000 shares of common stock outstanding at a price of $29 a share.It also has 2,000 shares of preferred stock outstanding at a price of $71 a share.The firm has 7 percent, 12-year bonds outstanding with a total market value of $386,000.The bonds are currently quoted at 100.6 percent of face and pay interest semiannually.What is the capital structure weight of the firm's preferred stock if the tax rate is 34 percent?

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Q67 Q67 Q67

Santa Claus Enterprises has 87,000 shares of common stock outstanding at a current price of $39 a share.The firm also has two bond issues outstanding.The first bond issue has a total face value of $230,000, pays 7.1 percent interest annually, and currently sells for 103.1 percent of face value.The second bond issue consists of 5,000 bonds that are selling for $887 each.These bonds pay 6.5 percent interest annually and mature in eight years.The tax rate is 35 percent.What is the capital structure weight of the firm's debt?

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Q68 Q68 Q68

Bermuda Cruises issues only common stock and coupon bonds.The firm has a debt-equity ratio of .45.The cost of equity is 17.6 percent and the pretax cost of debt is 8.9 percent.What is the capital structure weight of the firm's equity if the firm's tax rate is 35 percent?

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Q72 Q72 Q72

The Color Box uses a combination of common stock, preferred stock, and debt financing.The company wants preferred stock to represent 7 percent of the total financing.It also wants to structure the firm in a manner that will produce a weighted average cost of capital of 9.5 percent.The aftertax cost of debt is 4.8 percent, the cost of preferred is 8.9 percent, and the cost of common stock is 14.7 percent.What percentage of the firm's capital funding should be debt financing?

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Q73 Q73 Q73

Gulf Coast Tours currently has a weighted average cost of capital of 12.4 percent based on a combination of debt and equity financing.The firm has no preferred stock.The current debt-equity ratio is .47 and the aftertax cost of debt is 6.1 percent.The company just hired a new president who is considering eliminating all debt financing.All else constant, what will the firm's cost of capital be if the firm switches to an all-equity firm?

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Q75 Q75 Q75

Western Electric has 21,000 shares of common stock outstanding at a price per share of $61 and a rate of return of 15.6 percent.The firm has 11,000 shares of $8 preferred stock outstanding at a price of $48 a share.The outstanding debt has a total face value of $275,000 and currently sells for 104 percent of face.The yield to maturity on the debt is 8.81 percent.What is the firm's weighted average cost of capital if the tax rate is 35 percent?

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Q76 Q76 Q76

City Rentals has 44,000 shares of common stock outstanding at a market price of $32 a share.The common stock just paid a $1.50 annual dividend and has a dividend growth rate of 2.5 percent.There are 7,500 shares of $9 preferred stock outstanding at a market price of $72 a share.The outstanding bonds mature in 11 years, have a total face value of $825,000, a face value per bond of $1,000, and a market price of $989 each, and a pretax yield to maturity of 8.3 percent.The tax rate is 35 percent.What is the firm's weighted average cost of capital?

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Q77 Q77 Q77

Beta Industries is considering a project with an initial cost of $6.9 million.The project will produce cash inflows of $1.52 million a year for seven years.The firm uses the subjective approach to assign discount rates to projects.For this project, the subjective adjustment is +2.2 percent.The firm has a pretax cost of debt of 9.1 percent and a cost of equity of 17.7 percent.The debt-equity ratio is .57 and the tax rate is 34 percent.What is the net present value of the project? (Round the answer to the nearest $100.)

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Q78 Q78 Q78

Orchard Farms has a pretax cost of debt of 7.29 percent and a cost of equity of 16.3 percent.The firm uses the subjective approach to determine project discount rates.Currently, the firm is considering a project to which it has assigned an adjustment factor of 1.25 percent.The firm's tax rate is 35 percent and its debt-equity ratio is .48.The project has an initial cost of $3.9 million and produces cash inflows of $1.26 million a year for 5 years.What is the net present value of the project?

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Q79 Q79 Q79

Piedmont Hotels is an all-equity firm with 48,000 shares of stock outstanding.The stock has a beta of 1.19 and a standard deviation of 14.8 percent.The market risk premium is 7.8 percent and the risk-free rate of return is 4.1 percent.The company is considering a project that it considers riskier than its current operations so has assigned an adjustment of 1.35 percent to the project's discount rate.What should the firm set as the required rate of return for the project?

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Q80 Q80 Q80

Cromwell's Interiors is considering a project that is equally as risky as the firm's current operations.The firm has a cost of equity of 15.4 percent and a pretax cost of debt of 8.9 percent.The debt-equity ratio is .46 and the tax rate is 34 percent.What is the cost of capital for this project?

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Q81 Q81 Q81

Swizer Industries has two separate divisions.Division X has less risk so its projects are assigned a discount rate equal to the firm's WACC minus .75 percent.Division Y has more risk and its projects are assigned a rate equal to the firm's WACC plus 1 percent.The company has a debt-equity ratio of .48 and a tax rate of 34 percent.The cost of equity is 15.4 percent and the aftertax cost of debt is 5.4 percent.Presently, each division is considering a new project.Division Y's project provides a return of 12.9percent while Division X's project is expected to earn 11.5 percent.Which project(s), if any, should the company accept?

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Q82 Q82 Q82

Bruceton's is a specialty retailer with multiple brick-and-mortar stores and a cost of capital of 16.4 percent.Specialty Imports is a wholesaler of specialty items and has a cost of capital of 12.6 percent.Both firms are considering opening a new store in downtown Chicago at a cost of $1.1 million.Because this type of store would be trendy, it would have a life of only 8 years and no salvage value.The expected annual net cash flow is $229,000, regardless of which firm opens the store.Which company(ies), if either, should open the Chicago store?

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Q83 Q83 Q83

Lester's is a globally diverse company with multiple divisions and a cost of capital of 15.8 percent.Med, Inc., is a specialty firm in the medical equipment field with a cost of capital of 13.7 percent.With the aging of America, both firms recognize the opportunities that exist in the medical field and are considering expansion in this area.At present, there is an opportunity for multiple firms to be involved in a new medical devices project.Each project will require an initial investment of $8.4 million with annual returns of $2.2 million per year for seven years.Which company(ies), if either, should become involved in the new projects?

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Q84 Q84 Q84

Bob's is a retail chain of specialty hardware stores.The firm has 18,000 shares of stock outstanding that are currently valued at $82 a share and provide a rate of return of 13.2 percent.The firm also has 600 bonds outstanding that have a face value of $1,000, a market price of $1,032, and a coupon rate of 7 percent.These bonds mature in 7 years and pay interest semiannually.The tax rate is 35percent.The firm is considering expanding by building a new superstore.The superstore will require an initial investment of $9.3 million and is expected to produce cash inflows of $1.07 million annually over its 10-year life.The risks associated with the superstore are comparable to the risks of the firm's current operations.The initial investment will be depreciated on a straight line basis to a zero book value over the life of the project.At the end of the 10 years, the firm expects to sell the superstore for an aftertax value of $4.7 million.Should the firm accept or reject the superstore project and why?

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Q85 Q85 Q85

Casper's is analyzing a proposed expansion project that is much riskier than the firm's current operations.Thus, the project will be assigned a discount rate equal to the firm's cost of capital plus 2.5 percent.The proposed project has an initial cost of $18.1 million that will be depreciated on a straight-line basis to a zero book value over 20 years.The project also requires additional inventory of $428,000 over the project's life.Management estimates the facility will generate cash inflows of $2.46 million a year over its 20-year life.After 20 years, the company plans to sell the facility for an aftertax amount of$1.4 million.The company has 58,000 shares of common stock outstanding at a market price of $52 a share.This stock just paid an annual dividend of $2.84 a share.The dividend is expected to increase by 3.6 percent annually.The firm also has 15,000 shares of 9 percent preferred stock with a market value of $87 a share.The preferred stock has a par value of $100.The company has $1.2 million of face value bonds with semiannual payments and a coupon rate of 9 percent.The bonds are currently priced at 102 percent of face value and mature in 13 years.The tax rate is 35 percent.Should the firm pursue the expansion project at this point in time? Why or why not?

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Q87 Q87 Q87

Stock in ABC Enterprises has a beta of 1.28.The market risk premium is 7.4 percent, and T-bills are currently yielding 3.6 percent.ABC's most recently paid dividend was $1.62 per share, and dividends are expected to grow at an annual rate of 2 percent indefinitely.If the stock sells for $38 a share, what is your best estimate of ABC's cost of equity?

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Q90 Q90 Q90

Healthy Snacks has a target capital structure of 60 percent common stock, 3 percent preferred stock, and 37 percent debt.Its cost of equity is 16.8 percent, the cost of preferred stock is 11.4 percent, and the pretax cost of debt is 8.3 percent.What is the company's WACC if the applicable tax rate is 34 percent?

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Q92 Q92 Q92

Given the following information for Electric Transport, find the WACC.Assume the company's tax rate is 35 percent.
Debt:8,100, 6.9 percent coupon bonds outstanding.$1,000 par value, 17 years to maturity, selling for 101 percent of par, the bonds make semiannual payments.
Common stock: 175,000 shares outstanding, selling for $77 per share, beta is 1.32.
Preferred stock:9,000 shares of $7.50 preferred stock outstanding, currently selling for $73 per share.
Market: 7.9 percent market risk premium and 3.6 percent risk-free rate.

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Q93 Q93 Q93

You are given the following information concerning Around Town Tours:
Debt:7,500, 6.8 percent coupon bonds outstanding, with 11 years to maturity and a quoted price of 97.9.These bonds pay interest semiannually.
Common stock: 284,000 shares of common stock selling for $68 per share.The stock has a beta of 1.04 and will pay a dividend of $2.62 next year.The dividend is expected to grow by 2.5 percent per year indefinitely.
Preferred stock:9,000 shares of $8 preferred stock selling at $88 per share.
Market: 14.6 percent expected return, 4.1 percent risk-free rate
Company:34 percent tax rate.
Calculate the WACC for this firm.

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Q94 Q94 Q94

Lawler's is considering a new project.The company has a debt-equity ratio of .64.The company's cost of equity is 14.9 percent, and the aftertax cost of debt is 5.3 percent.The firm feels that the project is riskier than the company as a whole and that it should use an adjustment factor of +1.8 percent.What is the project cost of capital if the tax rate is 34 percent?

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Q95 Q95 Q95

Country Markets has an EBIT of $42,650, an increase in net working capital of $2,615, interest expense of $4,300, net capital spending of $3,620, and a tax rate of 34 percent.The firm's WACC is 11.2 percent and its growth rate is 3.1 percent.What is the adjusted value of the firm?

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Q96 Q96 Q96

Big Tree Inn has an EBIT of $121,318, a decrease in net working capital of $1,204, interest expense of $5,200, net capital spending of $5,200, and a tax rate of 35 percent.The firm's WACC is 12.6 percent and its growth rate is 2.7 percent.What is the adjusted value of the firm?

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Q98 Q98 Q98

Muttly Engineering announced this morning that its next annual dividend will be decreased to $2.45 a share and that all future dividends will be decreased by an additional 1.45 percent annually.What is the current value per share if the required return is 19.5 percent?

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Q100 Q100 Q100

Bluff City Sushi Distributors would like to issue new equity shares if its cost of equity declines to 16.5 percent.The company pays a constant annual dividend of $2.11 per share.What does the market price of the stock need to be for the firm to issue the new shares?

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Q103 Q103 Q103

Regulation Insurance has a beta of 0.90, a dividend growth rate of 2.5 percent for the foreseeable future, a stock price of $47 per share, and an expected annual dividend of $0.60 per share next year.The market rate of return is 13.9 percent and the risk-free rate is 3.4 percent.What is the firm's average cost of equity?

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Q106 Q106 Q106

Empire Plumbing Supply has 100,000 shares of common stock outstanding at a price of $37 a share.It also has 6,000 shares of preferred stock outstanding at a price of $30 a share.There are 5,000 bonds outstanding that have a semiannual coupon payment of $25.The bonds mature in four years, have a face value of $1,000, and sell at 110 percent of par.What is the capital structure weight of the common stock?

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