Question 1

How would a company's cost of capital calculated from book values be affected if the company's bonds were selling for more than face value?

Accepted Answer

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Question 2

Using market values rather than book values for cost of capital computations insures that the firm:

Accepted Answer

Market values reflect current investor expectations and required rates of return, which are more relevant for cost of capital computations than historical book values.

Question 3

If equity investors require a 20% rate of return, what is the maximum acceptable amount of equity financing for a project with $2 million annual cash flows before tax and interest, $3 million in debt with a 10% coupon, and a 35% tax rate?

Accepted Answer

Maximum equity = $1,105,000/0.20 = $5,525,000, or $5.53 million

Question 4

What%age of value should be allocated to equity in WACC computations for a firm with $50 million in debt selling at 85% of par, $50 million in book value of equity, and $65 million in market value of equity?

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Question 5

A proposed project has a positive NPV when evaluated at the company cost of capital.If the firm employs debt in its capital structure, will the project remain acceptable after evaluation with the WACC?

Accepted Answer

When a proposed project has a positive NPV at the company cost of capital, it means that the project generates more cash flows than the cost of funds used to finance it. However, when debt is introduced in the capital structure, the weighted average cost of capital (WACC) is used to evaluate the project. The WACC is calculated by taking into account the cost of equity and debt, which reflects the company's overall cost of capital. Since debt has a lower cost of funds than equity, using the WACC will lower the overall cost of capital. This, in turn, increases the NPV of the proposed project, making it more acceptable. Therefore, the best choice is A, using the WACC will increase the NPV.

Question 6

How much cash flow before tax and interest is necessary to support a project that requires $4 million annually for equity investors and $2 million annually in interest payments if the firm's tax rate is 35%?

Accepted Answer

Total cash outflows for equity investors and interest payments = $4 million + $2 million = $6 million
Let X be the necessary cash flow before tax and interest
After-tax cash flow = X - 0.35X = 0.65X
0.65X = $6 million
X = $9.23 million
Therefore, the necessary cash flow before tax and interest is $9.23 million, which is higher than option A, B, and D. Only option C ($8.15 million) is lower than the calculated amount, making it the best choice.

Question 7

What decision should be made on a project of above-average risk if the project's IRR exceeds the WACC?

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Question 8

Why is it important to include the tax effect into cost of capital computations for firms with debt financing?

Accepted Answer

The tax effect needs to be included in cost of capital computations for firms with debt financing because the interest paid on debt is tax deductible, which reduces the taxable income for the firm. This ultimately affects the cost of debt financing and the overall cost of capital for the firm.

Question 9

Which of the following changes offer the greatest chance of changing a project's NPV from negative to positive?

Accepted Answer

A reduction in project risk will decrease the discount rate used to calculate the NPV, leading to a potential increase in the NPV. Substituting preferred stock for debt or selling debt at less than par value may lower the cost of capital, but it does not necessarily change the NPV from negative to positive. Decreasing the marginal tax rate may increase cash flows, but unless it is significant enough, it may not change the NPV from negative to positive.

Question 10

What coupon rate is being paid on debt for a firm with an after-tax cost of debt of 7.5% and a tax rate of 40%?

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Question 11

What proportion of a firm is equity financed if the WACC is 14%, the after-tax cost of debt is 7.0%, the tax rate is 35%, and the required return on equity is 18%?

Accepted Answer

Using the WACC formula:
WACC = (E/V)*Re + (D/V)*Rd*(1-T)
where:
E = market value of equity
D = market value of debt
V = total value of the firm (E + D)
Re = required return on equity
Rd = before-tax cost of debt
T = tax rate

We can rearrange the formula to solve for the proportion of equity financing (E/V):
E/V = (WACC - Rd*(1-T))/(Re - Rd*(1-T))
Plugging in the given values:
E/V = (0.14 - 0.07*(1-0.35))/(0.18 - 0.07*(1-0.35))
E/V = 0.6364 or 63.64%
Therefore, choice B is the correct answer.

Question 12

What return on equity do investors seem to expect for a firm with a $55 share price, an expected dividend of $5.50, a beta of .9 and a constant growth rate of 5.5%?

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Question 13

What is the WACC for a firm with 40% debt, 20% preferred stock and 40% equity if the respective costs for these components are 6% after-tax, 12% after-tax, and 18% before-tax? The firm's tax rate is 35%.

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Question 14

for purposes of computing the WACC, if the book value of equity exceeds the market value of equity, then:

Accepted Answer

The market value of equity should be used in the WACC calculation because it reflects the current market value of the company's equity and provides a more accurate measure of the shareholders' required return on investment. The book value of equity may be outdated and might not reflect the company's current financial situation or future growth prospects.

Question 15

What is the WACC for a firm with 40% debt, 20% preferred stock and 40% equity if the respective costs for these components are 9.23% before-tax, 12% after-tax, and 18% before-tax? The firm's tax rate is 35%.

Accepted Answer

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Question 16

What is the WACC for a firm with equal amounts of debt and equity financing, a 16% before-tax company cost of capital, a 35% tax rate, and a 10% coupon rate on its debt that is selling at par value?

Accepted Answer

The WACC is calculated by taking the weighted average of the cost of equity and the after-tax cost of debt. Since the firm has equal amounts of debt and equity, each has a weight of 0.5. The cost of equity is 16%. The after-tax cost of debt is 10% * (1 - 0.35) = 6.5%. Therefore, WACC = 0.5 * 16% + 0.5 * 6.5% = 14.25%.

Question 17

What is the WACC for a firm with equal amounts of debt and equity financing, a 17% before-tax company cost of capital, a 35% tax rate, and a 10% coupon rate on its debt that is selling at par value?

Accepted Answer

WACC = (Cost of Equity * % Equity) + (After-Tax Cost of Debt * % Debt)

% Equity = 0.5
% Debt = 0.5

Cost of Equity = 17%

After-Tax Cost of Debt = Coupon Rate * (1 - Tax Rate) 
                      = 10% * (1 - 0.35) 
                      = 6.5%

WACC = (0.17 * 0.5) + (0.065 * 0.5) 
     = 0.085 + 0.0325 
     = 0.1175 or 11.75%

Therefore, the answer is C) 15.25%.

Question 18

According to CAPM estimates, what is the cost of equity for a firm with beta of 1.5 when the risk-free interest rate is 6% and the expected return on the market portfolio is 15%?

Accepted Answer

Expected return on stock = 6% + 1.5(15% - 6%)= 6 + 13.5= 19.5%

Question 19

What is the after-tax cost of preferred stock that pays a 12% dividend and sells at par if the firm's tax rate is 35%?

Accepted Answer

There is no adjustment for taxes on preferred stock. Therefore, after-tax cost = pretax cost.

Question 20

A project will generate $1 million net cash flow annually in perpetuity.If the project costs $7 million, what is the lowest WACC shown below that will make the NPV negative?

Accepted Answer

The NPV is negative when the WACC is greater than the project's IRR, which is 14.29%.

Quiz 13: The Weighted-Average Cost of Capital and Company Valuation