Question 1

The Diverse Co. has invested 40 percent of the firm's assets in a project with a beta of 0.4 and the remaining assets in a project with a beta of 1.8. What is the beta of the firm?

Accepted Answer

Given, the weight of the first project (w1) = 0.4 and weight of the second project (w2) = 0.6 (as the remaining assets are in the second project)
The formula to calculate the portfolio beta (βp) is: 
βp = w1 * β1 + w2 *β2 
where β1 and β2 are the beta of the first project and second project respectively.

Substituting the values, 
βp = 0.4 * 0.4 + 0.6 * 1.8 = 1.28

Therefore, the beta of the firm is 1.28. 
Hence, the correct answer is option C.

Question 2

Wally's War Duds has a preferred share issue outstanding with a current price of $26.57. The firm is expected to pay a dividend of $1.86 per share a year from today. What is the firm's cost of preferred equity? Round your final answer to nearest percentage.

Accepted Answer

The cost of preferred equity can be calculated using the formula: 
Cost of preferred equity = Preferred dividend / Current market price of preferred stock 
Therefore, cost of preferred equity = $1.86 / $26.57 = 0.07 or 7% 
Rounding to the nearest percentage, the answer is B, 7.00%.

Question 3

Maloney's, Inc. has found that its cost of common equity capital is 17 percent and its cost of debt capital is 6 percent. The firm is financed with $3,000,000 of common shares (market value) and $2,000,000 of debt. What is the after-tax weighted average cost of capital for Maloney's, if it is subject to a 40 percent marginal tax rate?

Accepted Answer

First, we need to calculate the weight of equity capital and debt capital based on their market value:

Weight of Equity = Market Value of Equity / Total Market Value
                    = 3,000,000 / (3,000,000 + 2,000,000)
                    = 0.6 or 60%

Weight of Debt = Market Value of Debt / Total Market Value
                  = 2,000,000 / (3,000,000 + 2,000,000)
                  = 0.4 or 40%

Then, we can use the following formula to calculate the after-tax weighted average cost of capital:

After-tax WACC = (Weight of Equity x Cost of Equity) + (Weight of Debt x (1 - Tax rate) x Cost of Debt)

Plugging in the numbers, we get:

After-tax WACC = (0.6 x 17%) + (0.4 x (1 - 0.4) x 6%)
                       = 11.64%

Therefore, the right choice is C (11.64%).

Question 4

Oasis, Inc. has common shares with a price of $21.12 per share. The firm is expected to pay a dividend of $1.75 one year from today, and dividends are expected to grow at 10 percent for two years after that and then at 5 percent thereafter. What is the implied cost of common equity capital for Oasis? Round your final answer to nearest percentage.

Accepted Answer

The implied cost of common equity can be calculated using the Gordon Growth Model. The expected dividends for the first three years are $1.75, $1.75*(1+0.10), and $1.75*(1+0.10)^2. After that, dividends grow at 5%. Solving for the discount rate that equates the present value of these dividends to the current share price gives approximately 14%.

Question 5

Melba's Toast has a preferred share issue outstanding with a current price of $19.50. The firm is expected to pay a dividend of $2.34 per share a year from today. What is the firm's
Cost of preferred equity?

Accepted Answer

The cost of preferred equity can be calculated using the formula:
Cost of preferred equity = Dividend per share / Net proceeds per share

Net proceeds per share can be found by subtracting flotation costs from the current market price:
Net proceeds per share = Current market price - Flotation costs

Since no information is given about flotation costs, it is assumed to be zero. Thus, the net proceeds per share is equal to the current market price.

Plugging in the values, we get:

Cost of preferred equity = $2.34 / $19.50 = 0.12 = 12%

Therefore, the best choice is C.

Question 6

Tranquility, Inc. has common shares with a price of $18.37 per share. The firm paid a dividend of $1.50 yesterday, and dividends are expected to grow at 9 percent for three years and then at 2 percent thereafter. What is the implied cost of common equity capital for Tranquility? Round your final percentage answer to 1 decimal place.

Accepted Answer

We can use the dividend discount model to calculate the implied cost of common equity capital (i.e. the required rate of return that investors expect to earn on their investment in Tranquility):

Ke = (D1 / P0) + g

Where:
Ke = implied cost of common equity capital
D1 = expected dividend in one year
P0 = current stock price
g = expected growth rate of dividends

We are given the following information:
P0 = $18.37
D1 = $1.50 * (1 + 0.09) = $1.635
g = 9% for 3 years, and 2% thereafter

Now we can plug in the values and solve for Ke:

Ke = ($1.635 / $18.37) + 0.09 = 0.1775 or 17.75%

Since we were asked to round to one decimal place, the answer is 11.8%, which is closest to choice C (11.5%). Therefore, we choose option C as the best choice.

Question 7

Ronnie's Comics has found that its cost of common equity capital is 15 percent and its cost of debt capital is 12 percent. The firm is financed with $250,000,000 of common shares (market value) and $750,000,000 of debt. What is the after-tax weighted average cost of capital for Ronnie's, if it is subject to a 35 percent marginal tax rate?

Accepted Answer

The after-tax weighted average cost of capital (WACC) is calculated using the formula: WACC = (E/V * Re) + (D/V * Rd * (1-Tc)), where E is the market value of equity, V is the total market value of the firm's financing (equity + debt), Re is the cost of equity, D is the market value of debt, Rd is the cost of debt, and Tc is the tax rate. Plugging in the values: WACC = ($250M/$1,000M * 15%) + ($750M/$1,000M * 12% * (1-0.35)) = 3.75% + 5.85% = 9.6%.

Question 8

In order to use a firm's WACC to evaluate its future project's flows, which of the following must hold?

Accepted Answer

For the WACC to be used to evaluate a project's flows, it is necessary that the project be financed in the same proportion of debt and equity as the firm (choice A) and that the systematic risk of the project is the same as the overall systematic risk of the firm (choice B). Additionally, the project should have conventional cash flows (choice C) for the WACC to be applicable. Therefore, both choice A and choice B must hold.

Question 9

UltraFlex Diving Boards, Inc. just paid a dividend of $1.50. If the firm's growth in dividends is expected to remain at a flat 4 percent forever, then what is the cost of equity capital for Ultra Flex Diving Boards if the price of its common shares is currently $26.00?

Accepted Answer

The answer of UltraFlex Diving Boards, Inc. just paid a...

Question 10

What is the beta of a firm whose equity has an expected return of 21.3 percent when the risk-free rate of return is 7.0 percent and the expected return on the market is 18.0 percent?

Accepted Answer

Using the Capital Asset Pricing Model (CAPM):
Expected return on equity = risk-free rate + beta*(expected return on market - risk-free rate)
21.3% = 7.0% + beta*(18.0% - 7.0%)
Solving for beta: 
beta = (21.3% - 7.0%) / (18.0% - 7.0%) = 1.30
Therefore, the beta of the firm is 1.30.

Question 11

Gangland Water Guns, Inc. is expected to pay a dividend of $2.10 one year from today. If the firm's growth in dividends is expected to remain at a flat 3 percent forever, then what is the cost of equity capital for Gangland if the price of its common shares is currently $17.50?

Accepted Answer

The answer of Gangland Water Guns, Inc. is expected to...

Question 12

If the market risk premium is currently 6 percent and the risk-free rate of return is 4 percent, then what is the expected return on a common share with a beta equal to 2?

Accepted Answer

The expected return on a common share (r) can be calculated using the Capital Asset Pricing Model (CAPM) formula: r = Rf + β*(Rm - Rf), where Rf is the risk-free rate of return, β is the beta coefficient of the stock, and Rm is the market rate of return. Plugging in the given values, we get:
r = 4% + 2*(6%) = 16%
Therefore, the expected return on the common share is 16%, which corresponds to choice D.

Question 13

Swirlpool, Inc. has found that its cost of common equity capital is 18 percent, and its cost of debt capital is 8 percent. The firm is financed with 60 percent common shares and 40 percent debt. What is the after-tax weighted average cost of capital for Swirlpool, if it is subject to a 40 percent marginal tax rate?

Accepted Answer

The after-tax weighted average cost of capital (WACC) can be calculated using the following 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 = Cost of equity
Rd = Cost of debt
T = Marginal tax rate

Given information:
Re = 18%
Rd = 8%
D/V = 40%
E/V = 60%
T = 40%

Using the above formula, we can calculate the WACC as follows:

WACC = (0.6 * 0.18) + (0.4 * 0.08 * (1 - 0.4))
WACC = 0.108 + 0.0192
WACC = 0.1272 or 12.72%

Therefore, the after-tax weighted average cost of capital for Swirlpool is 12.72%. The correct answer is C).

Question 14

The WACC for a firm is 13.00 percent. You know that the firm's cost of debt capital is 10 percent and the cost of equity capital is 20%. What proportion of the firm is financed with debt? Assume the firm pays no tax..

Accepted Answer

The answer of The WACC for a firm is 13.00...

Question 15

The WACC for a firm is 19.75 percent. You know that the firm is financed with $75 million of equity and $25 million of debt. The cost of debt capital is 7 percent. What is the cost of equity for the firm? Assume the firm pays no tax..

Accepted Answer

The Weighted Average Cost of Capital (WACC) is calculated as follows: WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc), where E is the market value of the equity, D is the market value of the debt, V is the total value of financing (E + D), Re is the cost of equity, Rd is the cost of debt, and Tc is the corporate tax rate. Given that the firm pays no tax, the formula simplifies to WACC = (E/V) * Re + (D/V) * Rd.Given: WACC = 19.75%, E = $75 million, D = $25 million, Rd = 7%, and Tc = 0%.First, calculate V: V = E + D = $75 million + $25 million = $100 million.Then, plug the values into the simplified WACC formula and solve for Re (the cost of equity):19.75% = ($75/$100) * Re + ($25/$100) * 7%19.75% = 0.75 * Re + 0.25 * 7%19.75% = 0.75 * Re + 1.75%18% = 0.75 * ReRe = 18% / 0.75 = 24%Therefore, the cost of equity for the firm is 24%.

Question 16

Turquoise Electronics, Inc. paid a dividend of $1.87 last year. If the firm's growth in dividends is expected to be 10 percent next year and then zero thereafter, then what is its cost of equity capital if the price of its common shares is currently $25.71?

Accepted Answer

The answer of Turquoise Electronics, Inc. paid a dividend of...

Question 17

Billy's Goat Coats has a preferred share issue outstanding with a current price of $38.89. The firm last paid a dividend on the issue of $3.50 per share. What is the firm's cost of preferred equity? Round your final answer to nearest percentage.

Accepted Answer

The cost of preferred equity is calculated by dividing the annual dividend by the current price of the preferred shares. Here, $3.50 / $38.89 = 0.0899, which is approximately 9%.

Question 18

The Dedus Shoes, Inc. has common shares with a price of $28.76 per share. The firm paid a dividend of $1.00 yesterday, and dividends are expected to grow at 10 percent for two years and then at 5 percent, thereafter. What is the implied cost of common equity capital for Dedus? Round your final percentage answer to 1 decimal place.

Accepted Answer

The implied cost of common equity capital for Dedus can be calculated using the Dividend Discount Model (DDM) for a stock with dividends growing at different rates. The formula for the price of a stock with a two-stage growth model is:$$ P_0 = \frac{D_1}{(1 + r)^1} + \frac{D_2}{(1 + r)^2} + \frac{D_3}{(r - g_2)(1 + r)^2} $$Given:- $ P_0 = $28.76 $ (current stock price)- $ D_0 = $1.00 $ (dividend paid yesterday)- Growth rates: 10% for two years ($ g_1 = 10\% $) and then 5% indefinitely ($ g_2 = 5\% $)- $ D_1 = D_0 \times (1 + g_1) = $1.00 \times (1 + 0.10) = $1.10 $- $ D_2 = D_1 \times (1 + g_1) = $1.10 \times (1 + 0.10) = $1.21 $- $ D_3 = D_2 \times (1 + g_2) = $1.21 \times (1 + 0.05) = $1.27105 $Plugging these into the formula and solving for $ r $ (the cost of equity) involves iterative calculation or financial calculator, aiming to match the present value of these cash flows to the current stock price. Through calculation or using a financial calculator, you find that the rate $ r $ that equates the present value of these expected dividends to the current stock price is approximately 9.0%. This rate is the implied cost of common equity capital for Dedus.

Question 19

You are analyzing the cost of capital for a firm that is financed with $300 million of equity and $200 million of debt. The cost of debt capital for the firm is 9 percent, while the cost of equity capital is 19 percent. What is the overall cost of capital for the firm? Assume the firm pays no tax.

Accepted Answer

The overall cost of capital is calculated using the weighted average cost of capital (WACC) formula: WACC = (E/V * Re) + (D/V * Rd), where E is equity, D is debt, V is total value (E + D), Re is cost of equity, and Rd is cost of debt. Here, WACC = ($300M/$500M * 19%) + ($200M/$500M * 9%) = 15%.

Question 20

Stryder, Inc. has 3 million shares outstanding at a current price of $15 per share. The book value of the shares is $10 per share. The firm also has $30 million in par value of bonds outstanding. The bonds are selling at a price equal to 101 percent of par. What is the market value of the firm?

Accepted Answer

To calculate the market value of the firm, we need to add the market value of equity (3 million shares × $15 per share = $45 million) to the market value of debt (30 million × 101% = $30.3 million).

Market value of firm = Market value of equity + Market value of debt
Market value of firm = $45 million + $30.3 million
Market value of firm = $75.3 million

Therefore, Choice D is the correct answer.

Quiz 13: The Cost of Capital