Question 1

What is the weighted average cost of capital after taxes if the desired capital structure is 40% debt and 60% equity,investors require a 10% pre-tax return from debt and 25% from equity,and the tax rate is 30%?

Accepted Answer

WACC = W_dK_d 11ea7fdb_fc74_f4c6_a768_3dd371890a16_TB2902_11 + W_pK_p + W_eK_e WACC = (0.40 × 0.10)(1 - 0.30) + (0.60 × 0.25) = 18%

Question 2

Which one of the following statements is correct concerning the weighted average cost of capital (WACC)?

Accepted Answer

The weight of the debt can be based on the face value of the bond issue(s) outstanding multiplied by the quoted price(s) when expressed as a percentage of the face value.

Question 3

Doing a single corporate WACC is always the best way to evaluate a project.

Accepted Answer

Companies with multiple divisions should not use a single corporate WACC to evaluate projects.

Question 4

The proportions of the market value of the firm's assets financed via debt,common stock,and preferred stock are called the firm's:

Accepted Answer

The weights represent the proportion that each source of capital represents in the firm's capital structure.

Question 5

Swanson & Sons has two separate divisions.Each division is in a separate line of business.Division A is the largest division and represents 65 percent of the firm's overall sales.Division A is also the riskier of the two divisions.Division B is the smaller and least risky of the two.When the company is deciding which of the various divisional projects should be accepted they should:

Accepted Answer

When a company is deciding various divisional projects should be accepted, they should assign different discount rates to each project and then select the projects with the highest net present values.

Question 6

The pre-tax cost of debt is 11%,preferred stock costs 14%,and equity costs 15%.What is the weighted average cost of capital assuming a tax rate of 40% and a target capital structure of 40% debt,20% preferred stock,and 40% equity?

Accepted Answer

WACC = W_dK_d 11ea7fdb_fc74_f4c5_a768_1ff2f6ad1dd8_TB2902_11 + W_pK_p + W_eK_e WACC = (0.40 × 0.11)(1 - 0.40) + (0.20 × 0.14) + (0.40 × 0.15) = 11.4%

Question 7

What is the weighted average cost of capital after taxes for Moss Diet Centers if the target weights are 25% equity and 75% debt,and the costs of equity and after-tax debt are 15% and 12%,respectively? Assume the relevant tax rate is 20%.

Accepted Answer

WACC = W_dK_d 11ea7fdb_fc74_cdb4_a768_6718eabd7b37_TB2902_11 + W_pK_p + W_eK_e WACC = (0.25 × 0.15) + (0.75 × 0.12) = 12.8%

Question 8

Your firm uses both preferred and common stock as well as long-term debt to finance its operations.Which one of the following will increase the capital structure weight of the debt,all else equal?

Accepted Answer

An increase in the quoted price of a firm's bonds as a percentage of face value would increase the capital structure weight of the debt.

Question 9

Peter's Audio Shop has a cost of debt of 7 percent,a cost of equity of 11 percent,and a cost of preferred stock of 8 percent.The firm has 104,000 shares of common stock outstanding at a market price of $20 a share.There are 40,000 shares of preferred stock outstanding at a market price of $34 a share.The bond issue has a total face value of $500,000 and sells at 102 percent of face value.The company's tax rate is 34 percent.What is the weighted average cost of capital for Peter's Audio Shop?

Accepted Answer

Step 1 - Calculate the value of the firm's securities. V = E + D + P E = 20 × 104,000 = 2,080,000D = 1.02 × 500,000 = 510,000P = 34 × 40,000 = 1,360,000V = 3,950,000 Step 2 - Calculate the weight of each component of the firm's capital. W_d = 510,000 / 3,950,000 = 12.91% W_e = 2,080,000 / 3,950,000 = 52.66% W_p = 1,360,000 / 3,950,000 = 34.43% Step 3 - Compute the WACC. WACC = W_dK_d 11ea7fdb_fc74_5882_a768_2770c3d3c1aa_TB2902_11 + W_pK_p + W_eK_e WACC = (.1291 × .07 (1 - .34)) + (.3443 × .08) + (.5266 × .11) WACC = 9.14%

Question 10

Wilson's has 10,000 shares of common stock outstanding at a market price of $35 a share.The firm also has a bond issue outstanding with a total face value of $250,000 which is selling for 102 percent of face value.The cost of equity is 11 percent while the pre-tax cost of debt is 8 percent.The firm has a beta of 1.1 and a tax rate of 34 percent.What is Wilson's weighted average cost of capital?

Accepted Answer

Step 1 - Calculate the value of the firm's securities. V = E + D + P E = 35 × 10,000 = 350,000D = 1.02 × 250,000 = 255,000P = 0V = 605,000 Step 2 - Calculate the weight of each component of the firm's capital. W_d = 255,000 / 605,000 = 42.15% W_e = 350,000 / 605,000 = 57.85% Step 3 - Compute the WACC. WACC = W_dK_d 11ea7fdb_fc74_7f93_a768_a13e22e739dc_TB2902_11 + W_pK_p + W_eK_e WACC = (.4215 × .08 (1 - .34)) + (.5785 × .11) WACC = 8.59%

Question 11

Benson's,Inc.has an overall cost of equity of 10.24 percent and a beta of 1.2.The firm is financed 100 percent with common stock.The risk-free rate of return is 4 percent.What is an appropriate cost of capital for a division within the firm that has an estimated beta of 1.5?

Accepted Answer

Step 1 - Use CAPM to solve for the return of the market. k_e = k_F + β(k_M - k_F) .1024 = .04 + 1.2 11ea7fdb_fc75_b817_a768_75b6cb54b60e_TB2902_11 .052 = 11ea7fdb_fc75_b818_a768_a96050a5cb65_TB2902_11 k_M = 9.2% Step 2 - Use the return of the market with the new Beta to solve for the cost of capital. k_e = k_F + β(k_M - k_F) k_e = .04 + 1.5(.092 - .04) k_e = 11.8%

Question 12

Bob's Tractor and Party Supply has two separate divisions: party supplies,and tractor supplies and services.The party supply division has a beta of 1.2 and is financed by 25% debt.The tractor supply and service division has a beta of 0.8 and is financed by 60% debt.The cost of debt for each division is 5%.The risk free rate and market rate are 5% and 10% respectively.A project has recently become available for each division with an expected return of 10%.Which division(s)should take on the project?

Accepted Answer

k_e = k_F + β(k_M - k_F) Party Supplies = 0.05 + 1.2(0.10 - 0.05) = 11%. 11% > 10%, so reject Tractor Supply and Services = 0.05 + 0.80(0.10 - 0.05) = 9%. 9% < 10%, so accept

Question 13

If a firm applies its overall cost of capital to all its proposed projects,then the divisions within the firm will tend to:

Accepted Answer

If a firm applies its overall cost of capital to all its proposed projects, then the divisions within the firm will tend to receive more funding if they represent the riskiest operations of the firm.

Question 14

For a firm with multiple business units,the cost of capital developed for each unit is called a:

Accepted Answer

The divisional cost of capital is the cost of capital developed for each business unit within a firm.

Question 15

The capital structure weights used in computing the weighted average cost of capital are:

Accepted Answer

The capital structure weight used in computing the weighted average cost of capital are based on the market value of the firm's debt and equity securities.

Quiz 11: Cost of Capital