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Chapter 14

Cost of Capital

Multiple Choice Questions
1. A group of individuals got together and purchased all of the outstanding
shares of common stock of DL Smith, Inc. What is the return that these
individuals require on this investment called?

A. dividend
yield
B. cost of
equity
C. capital gains
yield
D. cost of
capital
E. income
return
2. Textile Mills borrows money at a rate of 13.5 percent. This interest rate
is referred to as the:

A. compound
rate.
B. current
yield.
C. cost of
debt.
D. capital gains
yield.
E. cost of
capital.

3. The average of a firm's cost of equity and aftertax cost of debt that is
weighted based on the firm's capital structure is called the:

A. reward to risk
ratio.
B. weighted capital gains
rate.
C. structured cost of
capital.
D. subjective cost of
capital.
E. weighted average cost of
capital.
4. When a manager develops a cost of capital for a specific project based
on the cost of capital for another firm which has a similar line of
business as the project, the manager is utilizing the _____ approach.

A. subjective
risk
B. pure
play
C. divisional cost of
capital
D. capital
adjustment
E. security market
line

5. A firm's cost of capital:

A. will decrease as the risk level of the firm
increases.
B. for a specific project is primarily dependent upon the source of the
funds used for the project.
C. is independent of the firm's capital
structure.
D. should be applied as the discount rate for any project considered
by the firm.
E. depends upon how the funds raised are going to
be spent.
6. The weighted average cost of capital for a wholesaler:

A. is equivalent to the aftertax cost of the firm's
liabilities.
B. should be used as the required return when analyzing a potential
acquisition of a retail outlet.
C. is the return investors require on the total assets of
the firm.
D. remains constant when the debt-equity ratio
changes.
E. is unaffected by changes in corporate tax
rates.

by using the dividend growth model D. use of the funds 8. by averaging the costs based on the dividend growth model and the capital asset pricing model . Scholastic Toys is considering developing and distributing a new board game for children.0. Which one of the following is the primary determinant of a firm's cost of capital? A. The firm maintains a debt-equity ratio of 0. debt-equity ratio B.40 and retains all profits to fund the firm's rapid growth. How should the firm determine its cost of equity? A. applicable tax rate C.40) C. by adding the market risk premium to the aftertax cost of debt B. by multiplying the market risk premium by (1 . cost of debt E. by using the capital asset pricing model E. cost of equity D. The project is similar in risk to the firm's current operations.7.

unaffected by changes in the market risk premium. B. highly dependent upon the growth rate and risk level of the firm. C. generally less than the firm's aftertax cost of debt. A. a reduction in the firm's beta E. a reduction in the market rate of return D.9. inversely related to changes in the firm's tax rate. is generally less that the firm's WACC given a leveraged firm. All else constant. a reduction in the dividend amount B. a reduction in the risk-free rate 10 A firm's overall cost of equity is: . an increase in the dividend amount C.2. . A. which one of the following will increase a firm's cost of equity if the firm computes that cost using the security market line approach? Assume the firm currently pays an annual dividend of $1 a share and has a beta of 1. D. E.

equals the firm's pretax weighted average cost of capital. equals the risk-free rate plus the market risk premium. ignores the firm's risks when that cost is based on the dividend growth model. E. I and III only C. 12 The dividend growth model can be used to compute the cost of equity . II and III only D. firms that have a 100 percent retention ratio II. firms that pay a decreasing dividend A. firms that pay an increasing dividend IV. C. firms that pay a constant dividend III. A.11 The cost of equity for a firm: . and III only E. and IV only . increases as the unsystematic risk of the firm increases. II. D. tends to remain static for firms with increasing levels of risk. I. B. III. for a firm in which of the following situations? I. I and II only B. II.

uses beta to measure the systematic risk of a firm. is only as reliable as the estimated rate of growth. can only be used if historical dividend information is available. 14 Which one of the following statements related to the SML approach to . A. D. The model is dependent upon a reliable estimate of the market risk premium. considers the risk that future dividends may vary from their estimated values. . The model applies only to non-dividend paying firms. B. E. C. A. B. This approach generally produces a cost of equity that equals the firm's overall cost of capital. equity valuation is correct? Assume the firm uses debt in its capital structure. The model generally produces the same cost of equity as the dividend growth model. applies only when a firm is currently paying dividends. C.13 The dividend growth model: . D. This model considers a firm's rate of growth. E.

has to be estimated as it cannot be directly observed in the market. I. is based on the current yield to maturity of the firm's outstanding bonds. II. is equivalent to the average current yield on all of a firm's outstanding bonds. D. C. A. E. II and IV only C. I. IV. . A. III. The SML approach can be applied to firms that retain all of their earnings. III and IV only D. and III only E. The SML approach is dependent upon a reliable measure of a firm's unsystematic risk. II. The SML approach assumes a firm's future risks are similar to its past risks. I and III only B. is equal to the coupon rate on the latest bonds issued by a firm. III. The SML approach assumes the reward-to-risk ratio is constant.15 Which of the following statements are correct? . and IV only 16 The pre-tax cost of debt: . B. II. is based on the original yield to maturity on the latest bonds issued by a firm.

and IV only E. B. I. II and III only C. pre-tax cost of debt. C. a firm's bond rating increases. and III only D. and IV 18 The cost of preferred stock is computed the same as the: . II. III. the market rate of interest increases. I and III only B. A. II. bond prices rise. D. III. cost of an irregular growth common stock.17 The aftertax cost of debt generally increases when: . II. III. return on an annuity. E. II. I. . aftertax cost of debt. tax rates decrease. return on a perpetuity. IV. A. I.

decreases when tax rates increase. B. . 20 The capital structure weights used in computing the weighted average . are restricted to the firm's debt and common stock. A. D. B. is equal to the yield to maturity. is equal to the dividend yield.19 The cost of preferred stock: . C. is independent of the stock's price. is highly dependent on the dividend growth rate. are based on the market value of the firm's debt and equity securities. are computed using the book value of the long-term debt and the book value of equity. C. are based on the book values of total debt and total equity. cost of capital: A. E. D. E. remain constant over time unless the firm issues new securities.

. B.89. The firm's weighted average cost of capital will remain constant as long as the capital structure remains constant. a beta of 0. 22 The aftertax cost of debt: . has a greater effect on a firm's cost of capital when the debt-equity ratio increases. Given this. The firm's cost of equity is unaffected by a change in the firm's tax rate. E. is unaffected by changes in the market rate of interest.21 Morris Industries has a capital structure of 55 percent common stock. The cost of equity can only be estimated using the SML approach. 10 percent preferred stock. C. will generally equal the cost of preferred if the tax rate is zero. The firm's cost of preferred is most likely less than the firm's actual cost of debt. and 45 percent debt. C. E. . The firm has a 60 percent dividend payout ratio. varies inversely to changes in market interest rates. will generally exceed the cost of equity if the relevant tax rate is zero. and a tax rate of 38 percent. A. which one of the following statements is correct? A. The aftertax cost of debt will be greater than the current yield-tomaturity on the firm's bonds. D. D. B.

I. III. minimum discount rate the firm should require on any new project. A. I. II. and IV only D. retention ratio. E. coupon rate the firm should expect to pay on its next bond issue. D. B. II and IV only C.23 The weighted average cost of capital for a firm may be dependent upon . and IV only E. the firm's: I. C. II. III. discount rate which the firm should apply to all of the projects it undertakes. . rate of return a firm must earn on its existing assets to maintain the current value of its stock. and IV 24 The weighted average cost of capital for a firm is the: . debt-equity ratio. I and III only B. rate of growth. IV. rate of return shareholders should expect to earn on their investment in this firm. preferred dividend payment. A. I. II. III.

II. favor high risk projects over low risk projects. III and IV only C. When computing the WACC. D. The WACC will remain constant unless a firm retires some of its debt. IV. debt in its capital structure? A. II. undertakes then the firm will tend to: I. II. the weight assigned to the preferred stock is based on the coupon rate multiplied by the par value of the preferred. and IV . B. 26 If a firm uses its WACC as the discount rate for all of the projects it . accept some negative net present value projects. I. II. The weight of the common stock used in the computation of the WACC is based on the number of shares outstanding multiplied by the book value per share. I. I. The firm's WACC will decrease as the corporate tax rate decreases. and III only D. I and III only B. III. reject some positive net present value projects. increase its overall level of risk over time. C.25 Which one of the following statements is correct for a firm that uses . E. and IV only E. III. The WACC should decrease as the firm's debt-equity ratio increases. A.

allocate the company's funds to the projects with the highest net present values based on the firm's weighted average cost of capital. fund all of Division B's projects first since they tend to be less risky and then allocate the remaining funds to the Division A projects that have the highest net present values. . C. prefer higher risk projects over lower risk projects. 28 Markley and Stearns is a multi-divisional firm that uses its WACC as the . E. have equal probability of receiving funding as compared to the other divisions. become less risky over time based on the projects that are accepted. avoid risky projects so it can receive more project funding. allocate more funds to Division A since it is the largest of the two divisions. Division A is the largest division and represents 70 percent of the firm's overall sales. Each division is in a . a division within the firm will tend to: A. E. discount rates to each project and then select the projects with the highest net present values. Division A is also the riskier of the two divisions. Given this. B. D. fund the highest net present value projects from each division based on an allocation of 70 percent of the funds to Division A and 30 percent of the funds to Division B. B.27 Preston Industries has two separate divisions. D. discount rate for all proposed projects. When management is deciding which of the various divisional projects should be accepted. separate line of business. the managers should: A. receive less project funding if its line of business is riskier than that of the other divisions. C. but differing. Each division is in a separate line of business and each presents risks unique to those lines. assign appropriate. Division B is the smaller and least risky of the two.

B. the current risk level of the overall firm. the firm's weighted average cost of capital. A. will prevent the firm's overall cost of capital from changing over time. an average of the firm's overall cost of capital for the past five years. C. the risks associated with the use of the funds required by the project. 30 Assigning discount rates to individual projects based on the risk level of . may cause the firm's overall weighted average cost of capital to either increase or decrease over time. decreases the value of the firm over time.29 The discount rate assigned to an individual project should be based on: . negates the firm's goal of creating the most value for the shareholders. E. each project: A. C. . D. B. E. D. will cause the firm's overall cost of capital to decrease over time. the actual sources of funding used for the project.

Which firm or firms should expand and offer food at the local beach during the summer months? A. Phil's only B. Both firms are currently considering expanding their operations during the summer months by offering pre-wrapped donuts. Firms should accept low risk projects prior to funding high risk projects. Phil's currently has a WACC of 14 percent while Theresa's WACC is 10 percent. sandwiches. cannot be determined from the information provided .31 Which one of the following statements is correct? . 32 Phil's is a sit-down restaurant that specializes in home-cooked meals. D. . and wraps at a local beach. both Phil's and Theresa's D. Making subjective adjustments to a firm's WACC when determining project discount rates unfairly punishes low-risk divisions within a firm. The expansion project has a projected net present value of $12. The pure play method is most frequently used for projects involving the expansion of a firm's current operations.080 at a 14 percent discount rate. B. Theresa's is a walk-in deli that specializes in specialty soups and sandwiches. A project that is unacceptable today might be acceptable tomorrow given a change in market returns. A.600 at a 10 percent discount rate and a net present value of -$2. E. Firms that elect to use the pure play method for determining a discount rate for a project cannot subjectively adjust the pure play rate. neither Phil's nor Theresa's E. C. Theresa's only C.

. is used only when a firm has an all-equity capital structure. A.000 at a discount rate of 11 percent and -$12. Wilderness Adventures has an aftertax cost of capital of 13 percent and Travel Excitement has an aftertax cost of capital of 11 percent. C. E. assigns discount rates to projects based on the discretion of the senior managers of a firm. both Wilderness Adventures and Travel Excitement D. allows managers to randomly adjust the discount rate assigned to a project once the project's beta has been determined. applies a lower discount rate to projects that are financed totally with equity as compared to those that are partially financed with debt.500 at a 13 percent discount rate. should accept this project? A. management. uses the WACC of firm X as the basis for the discount rate for a project under consideration by firm Y.33 Wilderness Adventures specializes in back-country tours and resort . D. Wilderness Adventures only B. The estimated net present value of such a project is estimated at $87. Both firms are considering building wilderness campgrounds complete with man-made lakes and hiking trails. if either. Travel Excitement specializes in making travel reservations and promoting vacation travel. neither Wilderness Adventures nor Travel Excitement E. B. Which firm or firms. cannot be determined without further information 34 The subjective approach to project analysis: . Travel Excitement only C.

B. E.07. . Firms will correctly accept or reject every project if they adopt the subjective approach. increase the initial project cost by dividing that cost by (1 . E. The subjective approach assesses the risks of each project and assigns an adjustment factor that is unique just for that project.0. 36 When a firm has flotation costs equal to 7 percent of the funding need. increase the project's discount rate to offset these expenses by dividing the firm's WACC by (1 . C. C. B. The pure play approach should only be used with low-risk projects. D.07.07). Mandatory projects should only be accepted if they produce a positive NPV when the firm's WACC is used as the discount rate.07). Overall. add 7 percent to the firm's WACC to get the discount rate for the project.0. A. increase the initial project cost by multiplying that cost by 1. . a firm makes better decisions when it uses the subjective approach than when it uses its WACC as the discount rate for all projects. D.35 Which one of the following statements is correct? . project analysts should: A. increase the project's discount rate to offset these expenses by multiplying the firm's WACC by 1.

C. C. E. cause the project to be improperly evaluated. D. be weighted and included in the initial cash flow. B. a weighted average based on the book values of the firm's debt and equity. 38 Incorporating flotation costs into the analysis of a project will: . 39 Flotation costs for a levered firm should: . be spread over the life of a project thereby reducing the cash flows for each year of the project. E. D. increase the net present value of the project. E. be totally ignored when internal equity funding is utilized. have no effect on the present value of the project. . the geometric average of the flotation costs associated with each form of financing. only be considered when two projects are mutually exclusive. the arithmetic average of the flotation costs of both debt and equity. increase the project's rate of return. increase the initial cash outflow of the project. be ignored when analyzing a project because they are not an actual project cost. A. A.37 The flotation cost for a firm is computed as: . A. C. B. B. one-half of the flotation cost of debt plus one-half of the flotation cost of equity. the weighted average of the flotation costs associated with each form of financing. D.

and .53 percent E.65. 7. 10.56 percent B.00 percent 41 The Shoe Outlet has paid annual dividends of $0.75 per share over the last four years. 8. 10. 7. 7.38 percent D.60 and the growth rate is 5 percent.93 percent C. $0. 7.79 percent .08 percent E.24 percent D.58 percent B.91 percent C.80 a . $0. 10. share next year. The stock is currently selling for $26 a share. What is this firm's cost of equity? A. 9. The market price of the stock is $19. What is the firm's cost of equity? A. 11.72. respectively. $0.70.40 Chelsea Fashions is expected to pay an annual dividend of $0.

2 2 E.41 percent E.40.42 Sweet Treats common stock is currently priced at $18. company just paid $1.5 percent annually and are expected to continue doing the same. $2.25 per share as its annual dividend. The .2 6 .53 a share.18 percent C. 6. What is this firm's cost of equity? A. $2. percent and a required return of 18 percent. $2. 8.0 7 B.47 percent D. $2. 9.82 percent 43 The common stock of Metal Molds has a negative growth rate of 1. 6. 9. $2.1 1 C. What was the amount of the last dividend paid? A. The dividends have been increasing by 2.1 9 D. The current stock price is $11.5 .03 percent B.

What is the average dividend growth rate? A.98 percent B. -3. 10. .37 percent E. What is the cost of equity? A.25. and $0.65 a share. -1.47 percent E. $1.S. The stock has a market price of $13 and a beta of 1. 10.20.04 percent C.95 over the past five years. $1.60 percent C.12 percent D.05. $1.12. 2.45 percent . respectively.15. 9. 10.8 percent. 10. The return on the U.5 percent and the market risk premium is 6. Treasury bill is 2.28 percent D. 4. . 2.74 percent B.39 percent 45 Southern Home Cookin' just paid its annual dividend of $0.44 Highway Express has paid annual dividends of $1.

The dividend growth rate is 4. a stock price of $22. The market has a 10. The overall stock market has a 10.6 percent D. 11.5 percent. 9.7 percent. 8.2 percent C. 10. What is the firm's cost of equity? A.6 percent rate of return and a risk premium of 8.3 percent E.68 percent 47 Henessey Markets has a growth rate of 4.5 percent.46 National Home Rentals has a beta of 1. What is the expected rate of return on this stock? A. 8.94 a share. 10.8 percent and is equally as . and . 11.67 percent C. The stock is currently selling for $17 a share.05 percent B.30 percent E. risky as the market. 9.7 percent . 7.24.7 percent B. recently paid an annual dividend of $0.6 percent rate of return and a risk premium of 7.13 percent D. 10.

3. The face amount of each bond is $1. 4.60 percent D.9 percent and the risk-free rate of return is 3. 3. 2. 2. By how much will the cost of equity increase if the company expands its operations such that the company beta rises to 1. What is the company's pre-tax cost of debt? A.88 percent B. The market risk premium . 1.21.58 percent C. These bonds are currently selling for 114 percent of face value. 5.10 percent E.2 percent.42 percent C. is 8.50? A.71 percent D.98 percent B.36 percent E.26 percent 49 Wind Power Systems has 20-year. 3.55 percent .000. semi-annual bonds outstanding with .48 Tidewater Fishing has a current beta of 1. 4. 5. a 5 percent coupon.

5. have . The bonds have a face value of $1. What is the company's aftertax cost of debt if its tax rate is 32 percent? A.075.24 percent C. 2.31 percent E.53 percent 51 Handy Man. 5.58 percent D. 3.48 percent .000 and a current market price of $1. years. 5. 7. and pay interest annually. has zero coupon bonds outstanding that mature in 8 . What is the company's pre-tax cost of debt? A. a 6 percent coupon.21 percent E.55 percent B. 5. 3.50 Boulder Furniture has bonds outstanding that mature in 15 years. 2.97 percent B. Inc. 7.09 percent C.000 and a current market price of $640. These bonds have a face value of $1.66 percent D.

4.10 percent B.36 percent C. Currently. The bonds pay interest semi-annually. What is the company's pre-tax cost of debt if the tax rate is 38 percent? A. The bonds are currently quoted at 82 percent of face value. maturity.61 percent D. and pay interest semi-annually. the bonds are quoted at 101. 5.000 face value. What is the firm's aftertax cost of debt if the tax rate is 30 percent? A.45 percent D. a 9 percent coupon. 8.4 percent of face value and carry a 9 percent coupon. 6. These bonds have a $1. years. 11.42 percent 53 The Corner Bakery has a bond issue outstanding that matures in 7 .52 Dog Gone Good Engines has a bond issue outstanding with 17 years to .90 percent E. 6.42 percent C. 4. 8.88 percent B. 4. 5.74 percent .11 percent E.

41 percent 55 Simple Foods has a zero coupon bond issue outstanding that matures in . 7. The bonds are selling at 42 percent of par value. 9 years.54 The outstanding bonds of Tech Express are priced at $989 and mature .12 percent D. 4.88 percent . The firm's tax rate is 35 percent.00 percent E. These bonds have a 6 percent coupon and pay interest annually. 4. 5. What is the firm's aftertax cost of debt? A.22 percent C. 6.35 percent D. 3. 3.48 percent B. 3.73 percent C. in 10 years. 5.01 percent B. What is the company's aftertax cost of debt if the tax rate is 38 percent? A.73 percent E. 9.

74 percent . What is the firm's cost of preferred stock? A. 14. this stock has a market value per share of $52 and a book value per share of $38. 13.29 percent C.56 Grill Works and More has 7 percent preferred stock outstanding that is . 13. 19.88 percent C.67 percent D. 14.29 percent E. 13. 7.77 percent B.29 percent E. currently selling for $49 a share. 14.42 percent D.54 percent 57 Samuelson Plastics has 7. 13. What is the cost of preferred stock? A. Currently. The market rate of return is 14 percent and the firm's tax rate is 37 percent.50 percent B. 19. .5 percent preferred stock outstanding.

47.58 New York Deli has 7 percent preferred stock outstanding that sells for . The company also has 2. 55. 13. What is the cost of preferred stock? A.000 shares outstanding. $990 each. 18.45 percent .59 percent E. 54. The common stock is priced at $37 a share and there are 28.16 percent C. 20.29 percent D.80 percent 59 Nelson's Landscaping has 1. 43. What is the weight of the common stock as it relates to the firm's weighted average cost of capital? A. This stock was originally issued at $45 per share. 45.500 shares of preferred stock at a market price of $28 a share.00 percent C. $34 a share.68 percent B. 20.11 percent D. 14.00 percent E.08 percent B.200 bonds outstanding that are selling for .

03 percent E.000 bonds outstanding that are quoted at 106 percent of face value. The company also has 40. 50 percent D. a market price of $38 a share. 6. 7.60 Mangrove Fruit Farms has a $250.17 percent 61 Electronics Galore has 950. What weight should be given to the debt when the firm computes its weighted average cost of capital? A. What is the weight of the preferred stock as it relates to the firm's weighted average cost of capital? A.75 percent B. 7.75 percent D. The preferred stock has a market price of $35 a share compared to a price of $24 a share for the common stock. 46 percent C. 54 percent E. 8. The firm also has 1. 58 percent . selling at 92 percent of face value.000 shares of common stock outstanding. 42 percent B.000 bond issue outstanding that is .20 percent C.500 shares of preferred stock and 15.000 shares of common stock outstanding at . 8.

of equity of 14. Treasury bill is yielding 2. What is the firm's weighted average cost of capital? A. Bonds with similar characteristics are yielding 7. 10.84 percent C. and a cost of preferred stock of 8.000 shares of common stock outstanding at a market price of $27 a share. 10. a cost .8 percent and the return on the market is 11. 11.30 percent E. What is the firm's weighted average cost of capital? A. 11.60 percent E.64 percent C.18 percent D. The common stock has a beta of 1. The bond issue has a face value of $550.000 bonds outstanding that are selling at par. 10. The company's tax rate is 37 percent. The preferred stock sells for $65 a share.2. The firm has 220. 11.S. 11.3 percent.2 percent.000 shares of 7 percent preferred stock and 2. 12.000 and a market quote of 101. 10. . The company also has 750.56 percent 63 Wayco Industrial Supply has a pre-tax cost of debt of 7.18 percent B.15 percent B.5 percent. 12. The U.000 shares of preferred stock outstanding at a market price of $41 a share.32 percent D.81 percent . There are 25.6 percent. The corporate tax rate is 38 percent.62 Phillips Equipment has 80.5 percent.5 million shares of common stock outstanding.34 and sells for $42 a share.

2 percent. The dividend growth rate is 2 percent. The firm also has 7. Inc.S. Green has 250.5 percent D.0 2 D.4 4 C. 5. 8. The firm has an aftertax cost of debt of 5. 9. The bonds are selling at 98 percent of face value. What is the firm's weighted average cost of capital? A. 0.4 percent B.7 7 E. 0. 6.6 3 65 R. 1.000 per bond. 2.5 years.4 percent and a cost of equity of 15. percent.5 percent E. and mature in 7.6 percent . 3. The company's tax rate is 34 percent.3 8 B. Next year's annual dividend is expected to be $1. pay interest semiannually. The bonds carry a 7 percent coupon.64 Central Systems.500 bonds outstanding with a face value of $1.000 shares of common stock outstanding at a . market price of $28 a share. 7.55 a share. What debt-equity ratio is needed for the firm to achieve its targeted weighted average cost of capital? A.2 percent C. desires a weighted average cost of capital of 8 .

What is the weighted average cost of capital? A. firm does not issue preferred stock. This year.65 and has a tax rate .6 and a tax rate of 35 percent.86 percent D. the firm paid an annual dividend of $1. The cost of equity is 14. 9. There are 25.2 and a market price of $19 a share.8 percent. The . 8.44 percent B.67 percent C.000 shares of stock outstanding with a beta of 1.46 percent B. The current market risk premium is 8.66 Kelso's has a debt-equity ratio of 0. Using an average expected cost of equity.96 percent D. 9. The pre-tax cost of debt is 9. of 32 percent.6 percent. The firm does not issue preferred stock. 11. 10.5 percent and the aftertax cost of debt is 4. 11. 10.78 percent C. what is the weighted average cost of capital? A. 8.10 a share and expects to increase that amount by 2 percent each year.38 percent E.57 percent 67 Granite Works maintains a debt-equity ratio of 0.5 percent and the current risk-free rate is 3.20 percent . 8.13 percent E.8 percent. 10.

36 percent D. 14. E.25? A.000 shares of common stock outstanding at a . The firm also has a bond issue outstanding with a total face value of $280.47 percent 69 The Market Outlet has a beta of 1.38 and a cost of equity of 14.00 a share.68 Delta Lighting has 30.94 percent.54 percent.87 percent C.72 percent.000 which is selling for 86 percent of par. 14. What is the weighted average cost of capital? A. 12. What discount rate should the firm assign to a new project that has a beta of 1. C. The cost of equity is 13 percent while the aftertax cost of debt is 6. D. The firm has a beta of 1. 10. 13. B.9 percent.14 percent. 13.945 . 10.29 percent E. 13. 13. market price of $15. percent. 13. .25 percent. The risk-free rate of return is 4.48 and a tax rate of 30 percent. This stock was originally issued at $31 per share.36 percent.07 percent B.

97 C.03 and a project life of 6 years. 08 D. and the cost of common stock is 13 percent.011. risk-free rate of return is 2. 13.95 and a cost of equity of 11.000 over the next three years. 14. This project has initial costs of $325.9 percent.5 percent.70 Silo Mills has a beta of 0.62 percent.000. What is the projected net present value of this project? A. the cost of preferred is 9 percent. and 55 percent common stock. The firm is currently considering a project that has a beta of 1.09 percent.208. $68. E.84 percent. 04 B. 23 . and $116. 13. $76. D. B. $279. The .211. 5 percent preferred stock. The company is considering a project that is equally as risky as the overall firm. The company's tax rate is 39 percent.67 percent. 13. C. respectively.361. $74.33 percent. .000. The pre-tax cost of debt is 7. 18 E. 12.879.000 and annual cash inflows of $87.8 percent. 71 Travis & Sons has a capital structure which is based on 40 percent debt. What discount rate should be assigned to this project? A. $68. $69.

inflows of $65. $7.97 9 C.4 percent. $299. This project is an extension of the firm's current operations and thus is equally as risky as the current firm. $8.93 8 E. $7.08 6 E.84 0 73 Carson Electronics uses 70 percent common stock and 30 percent debt . The aftertax cost of debt is 5. What is the maximum amount the firm can initially invest in this project to avoid a negative net present value for the project? A. to finance its operations.72 Panelli's is analyzing a project with an initial cost of $110. $382. The aftertax cost of debt is 4.41 1 B. the cost of equity is 12. $9.000 in the first year.7 percent. What is the projected net present value of this project? A. The cash inflows will then grow at 3 percent per year forever.45.40 6 D. $411.33 3 D. Management is considering a project that will produce a cash inflow of $36. $441.8 percent. $434.80 9 C.41 4 .000 and cash .000 in year one and $74.4 percent and the cost of equity is 15. $8.000 in year two.03 2 B. The firm uses only debt and common stock to finance its operations and maintains a debt-equity ratio of 0. and the tax rate is 35 percent.

000 and projected cash inflows of $17.96 4 C.42 7 E. and $30. $1.80 percent . than its current operations. of 1. $1. 12. The firm uses 25 percent debt and 75 percent common stock as its capital structure.54 percent D.4 percent.18? A.41 percent C.28.000 in year three. $308 D. The project has an initial cash outlay of $58. What is an appropriate cost of capital for a division within the firm that has an estimated beta of 1.000 in year two.6 percent and a beta . Thus.5 percent while the aftertax cost of debt for the firm is 6.000 in year one. What is the projected net present value of the new project? A.57 3 75 The Oil Derrick has an overall cost of equity of 13.1 percent.67 percent E. The company's cost of equity is 15.74 The Bakery is considering a new project it considers to be a little riskier . $1. The risk-free rate of return is 3. $28.37 percent B. management has decided to add an additional 1. 12. 12. The firm is financed solely with common stock.20 8 B. 12. $6.5 percent to the company's overall cost of capital when evaluating this project. 12.

79 and a cost of equity of 11. The firm is 100 percent financed with common stock.6 percent. should accept this project? A. percent for the firm overall. The project under consideration has initial costs of $575. 13. 13. both Company A and Company B D. neither Company A or Company B E. What is an appropriate cost of capital for division A if the market risk premium is 9.2 .5 percent? A.12 percent B. Precious Metals is in the precious gem retail business and has an aftertax cost of capital of 10. Company A only B.01 percent 77 Deep Mining and Precious Metals are separate firms that are both .8 percent. 16. 15.76 Miller Sisters has an overall beta of 0. considering a silver exploration project.77 percent E. if either. Deep Mining is in the actual mining business and has an aftertax cost of capital of 12.000 and anticipated annual cash inflows of $102. Division A within the firm has an estimated beta of 1. cannot be determined without further information .08 and is the riskiest of all of the firm's operations. 14.96 percent C. Which firm(s).63 percent D.000 a year for ten years. Company B only C.

21 9 . The sales manager of Sister Pools estimates that the water features and fountains would produce 20 percent of the firm's future total sales. $11.000 a year for 7 years. The initial cash outlay for this project would be $85.50 8 E.000. Al's Construction builds and sells water features and fountains and has an aftertax cost of capital of 10. Sister Pools is considering building and selling its own water features and fountains.3 percent.26 2 D. The expected net cash inflows are $17. $2. cost of capital of 11.04 4 B. $1. $3.6 percent. What is the net present value of the Sister Pools project? A.04 8 C. $1.78 Sister Pools sells outdoor swimming pools and currently has an aftertax .

6. . 12. 6.2 percent C. 10 percent preferred stock. What discount rate should Decker's use if it considers a project that involves the manufacturing of furniture? A. The risk-free rate of return is 3. 6. 7 percent for preferred stock.92 percent C. Decker's has a beta of 1. 5. and 50 percent debt. and 9. The flotation costs are 4. 14.38 as compared to Furniture Fashion's beta of 1.5 percent and the market risk premium is 8 percent.8 percent B.54 percent 80 Bleakly Enterprises has a capital structure of 40 percent common stock.50 percent D. 14.46 percent B.8 percent .12.5 percent for common stock. What is the weighted average flotation cost? A. furniture maker and a supplier to Decker's. The corporate tax rate is 34 percent.4 percent D.6 percent E.5 percent for debt.08 percent E. 13. Furniture Fashions is a .79 Decker's is a chain of furniture retail stores. 12. 6.

The corporate tax rate is 37 percent. 9.75 percent E.64.97 percent B.92 4 C.62 percent D. 9. $456. $583.4 percent for debt. The flotation cost is 9.000 for equipment. 10. What is the weighted average flotation cost? A.48 percent C.81 Justice.00 percent 82 The Daily Brew has a debt-equity ratio of 0. 5 .6 percent for equity and 5.33 3 . 9. What is the initial cost of the project including the flotation costs? A. and 7 percent for debt.32 8 D.40 0 B. percent preferred stock. The firm is analyzing a . $368. has a capital structure which is based on 30 percent debt.70 0 E. new project which requires an initial cash outlay of $420. Inc. and 65 percent common stock. 10 percent for preferred stock. 8. $456. $302. The flotation costs are 11 percent for common stock.

000 in external . $280.63 8 D.5 percent.00 5 D. $254. $288.02 1 C.4 percent. What is the initial cost of the project including the flotation costs? A.64 6 84 Western Wear is considering a project that requires an initial investment .83 You are evaluating a project which requires $230. $297.74 7 E. $248.6 percent and the flotation cost of debt is 5. $255.76 2 . $302. $255. The firm maintains a debt-equity ratio of 0.45? A.40 9 B. $281. What is the initial cost of the project including the flotation costs if you maintain a debt-equity ratio of 0.40 6 C.49 4 B. financing.55 1 E. of $274. The firm has sufficient internally generated equity to cover the equity portion of this project. $249.000.40 and has a flotation cost of debt of 8 percent and a flotation cost of equity of 10. The flotation cost of equity is 11.

065.26 5 C. 19.038. cost of $960. free rate is 3. The firm has sufficient internally generated equity to cover the equity cost of this project.5 13 E.0 89 86 The City Street Corporation's common stock has a beta of 1.9 percent D. $979. 14. 17.000.8 percent C.2.41 7 B.38 6 D. What is the initial cost of the project including the flotation costs? A.50 and has a flotation cost of debt of 6. 11.5 percent and the expected return on the market is 13 percent.85 Yesteryear Productions is considering a project with an initial start up . $1. 12.4 percent.1 percent . $982. What is the firm's cost of equity? A.4 percent B.8 percent and a flotation cost of equity of 11.6 percent E. $1. $992. The firm maintains a debt-equity ratio of 0. The risk.

What is the estimated cost of equity using the average of the CAPM approach and the dividend discount approach? A. that just sold for $92 per share. What is the bank's cost of preferred? A.69 percent B. 14. Country Road's most recent dividend was $1. The stock sells for $32 a share. The market risk .5 percent. 14.60 percent B.55 per share.97.43 percent E. 4.64 percent C. and dividends are expected to grow at a 7 percent annual rate indefinitely. premium is 10 percent while T-bills are currently yielding 5.06 percent C.87 Stock in Country Road Industries has a beta of 0.38 percent E. 13. 5.21 percent D. 14. 5. 4.39 percent D.54 percent .50 percent 88 Holdup Bank has an issue of preferred stock with a $5 stated dividend . 14. 5.

years ago. 4. semiannual bond 6 . 6. 7.89 Decline. 4. The issue makes semiannual payments and has an embedded cost of 9 percent annually.75 percent D. 5.70 percent C. The bond currently sells for 114 percent of its face value.82 percent E. What is the aftertax cost of debt if the company's tax rate is 31 percent? A.99 percent B. Inc. 4. 4.90 percent C.86 percent . is trying to determine its cost of debt.63 percent B. issue outstanding with 15 years to maturity that is quoted at 107 percent of face value. 7. What is the aftertax cost of debt if the tax rate is 39 percent? A.17 percent D. 8 percent.37 percent E. The firm has a debt . 4.42 percent 90 Jiminy's Cricket Farm issued a 30-year. 4.

38 percent E. What is the firm's WACC given a tax rate of 31 percent? A.53 percent B.91 Mullineaux Corporation has a target capital structure of 41 percent . 15.5 percent. and its cost of debt is 11 percent.87 percent B. 13.11 percent D. 13. 4 percent preferred stock. common stock.5 percent. 9.78 percent C. Its cost of equity is 18 percent.67 percent . and the pre-tax cost of debt is 8.43 percent C. 10. 12. 13. Its .5. 13. cost of equity is 15 percent. and 55 percent debt. 10. What is the firm's WACC given a tax rate of 39 percent? A. 12.49 percent D.48 percent E. the cost of preferred stock is 6.17 percent 92 Cookie Dough Manufacturing has a target debt-equity ratio of 0.

93 Fama's Llamas has a weighted average cost of capital of 9. 14. Its WACC is 11.5 .79 percent E.5 percent. 14. 15.75 percent B. .9 2 C. 0. has a target debt-equity ratio of 0. 13.8 9 B.82 percent .41 percent D. What is the company's target debt-equity ratio? A.5 percent.5 percent? A. 0.5 percent.72. 1. What is the cost of equity if the aftertax cost of debt is 5. Inc. The company's cost of equity is 15. and its pretax cost of debt is 8.84 percent C.0 1 E.5 4 94 Jungle. percent and the tax rate is 34 percent. The tax rate is 34 percent.9 8 D. 0. 1. 13.

15. 15. and the firm's tax rate is 32 percent.59 percent B.07 million D.12 million E. 15.94 million C. and the bonds have 17 years to maturity and sell for 91 percent of par. the preferred stock currently sells for $80 per share. 14.5 percent.5 percent.82 million B. but the floatation cost for debt is only 2. 14. The flotation cost for new equity is 9.88 percent 96 Suppose your company needs $14 million to build a new assembly line.000 shares of 9 percent preferred stock outstanding and 220. outstanding. .95 Titan Mining Corporation has 14 million shares of common stock .15. 900. T-bills are yielding 7.000 ten percent semiannual bonds outstanding. The common stock currently sells for $42 per share and has a beta of 1. par value $1.84.5 percent. Your target debt-equity ratio is 0. 15. What is the true cost of building the new assembly line after taking flotation costs into account? A.17 percent D. What discount rate should the firm apply to a new project's cash flows if the project has the same risk as the firm's typical project? A.54 percent E.23 million . 14. 16. The market risk premium is 11.72 percent C. 14. 15.5 percent.000 each.

Essay Questions 97 What role does the weighted average cost of capital play when . . the cost of capital and why do you think that approach is utilized? 99 Give an example of a situation where a firm should adopt the pure play . determining a project's cost of capital? 98 What are some advantages of the subjective approach to determining . approach for determining the cost of capital for a project.

he asks you to evaluate the project using a higher cost of capital which incorporates these costs. because it ignored flotation costs. Is your boss' approach correct? Why or why not? 101 Explain how the use of internal equity rather than external equity . affects the analysis of a project. .100 Suppose your boss comes to you and asks you to re-evaluate a capital . he explains. The first evaluation was in error. budgeting project. To correct for this.

Inc. A group of individuals got together and purchased all of the outstanding shares of common stock of DL Smith. What is the return that these individuals require on this investment called? A. capital gains yield D. dividend yield B.2 Topic: Cost of equity . cost of capital E.Chapter 14 Cost of Capital Answer Key Multiple Choice Questions 1. cost of equity C.2 AACSB: Analytic Blooms: Remember Difficulty: 1 Easy Learning Objective: 14-01 How to determine a firm's cost of equity capital. Section: 14. income return Refer to section 14.

The average of a firm's cost of equity and aftertax cost of debt that is weighted based on the firm's capital structure is called the: A.3 Topic: Cost of debt 3. compound rate. E. B. C. C. cost of capital. subjective cost of capital.2.5 percent.4 AACSB: Analytic . E. D. Refer to section 14. cost of debt. structured cost of capital. weighted average cost of capital. Refer to section 14. reward to risk ratio. capital gains yield.3 AACSB: Analytic Blooms: Remember Difficulty: 1 Easy Learning Objective: 14-02 How to determine a firm's cost of debt. weighted capital gains rate. current yield. Textile Mills borrows money at a rate of 13. D. Section: 14. This interest rate is referred to as the: A. B.

5 AACSB: Analytic Blooms: Remember Difficulty: 1 Easy Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them. A. When a manager develops a cost of capital for a specific project based on the cost of capital for another firm which has a similar line of business as the project. Section: 14. capital adjustment E. Section: 14.Blooms: Remember Difficulty: 1 Easy Learning Objective: 14-03 How to determine a firm's overall cost of capital.4 Topic: Weighted average cost of capital 4. divisional cost of capital D. pure play C. security market line Refer to section 14.5 Topic: Pure Play . the manager is utilizing the _____ approach. subjective risk B.

. is unaffected by changes in corporate tax rates. should be applied as the discount rate for any project considered by the firm. E. D. C.1 AACSB: Analytic Blooms: Understand Difficulty: 1 Easy Learning Objective: 14-03 How to determine a firm's overall cost of capital. The weighted average cost of capital for a wholesaler: A. is independent of the firm's capital structure. B. Refer to section 14. B. D. should be used as the required return when analyzing a potential acquisition of a retail outlet.1 AACSB: Analytic Blooms: Understand Difficulty: 1 Easy Learning Objective: 14-03 How to determine a firm's overall cost of capital.1 Topic: Cost of capital 6. A firm's cost of capital: A. E. remains constant when the debt-equity ratio changes.5. for a specific project is primarily dependent upon the source of the funds used for the project. Section: 14. C. is equivalent to the aftertax cost of the firm's liabilities. Refer to section 14. will decrease as the risk level of the firm increases. depends upon how the funds raised are going to be spent. is the return investors require on the total assets of the firm.

1 Topic: Cost of capital . use of the funds Refer to section 14. cost of equity D. debt-equity ratio B.Section: 14. cost of debt E. applicable tax rate C.1 Topic: WACC 7. Which one of the following is the primary determinant of a firm's cost of capital? A.1 AACSB: Analytic Blooms: Remember Difficulty: 1 Easy Learning Objective: 14-03 How to determine a firm's overall cost of capital. Section: 14.

The project is similar in risk to the firm's current operations.40 and retains all profits to fund the firm's rapid growth.2 AACSB: Analytic Blooms: Understand Difficulty: 1 Easy Learning Objective: 14-01 How to determine a firm's cost of equity capital. How should the firm determine its cost of equity? A. by using the capital asset pricing model E. The firm maintains a debt-equity ratio of 0. by multiplying the market risk premium by (1 .0. Section: 14. by using the dividend growth model D.8.40) C. Scholastic Toys is considering developing and distributing a new board game for children. by averaging the costs based on the dividend growth model and the capital asset pricing model Refer to section 14. by adding the market risk premium to the aftertax cost of debt B.2 Topic: Cost of equity .

a reduction in the risk-free rate Refer to section 14. a reduction in the market rate of return D. All else constant.2 Topic: CAPM . a reduction in the dividend amount B. A. which one of the following will increase a firm's cost of equity if the firm computes that cost using the security market line approach? Assume the firm currently pays an annual dividend of $1 a share and has a beta of 1. a reduction in the firm's beta E.9. an increase in the dividend amount C.2 AACSB: Analytic Blooms: Understand Difficulty: 2 Medium Learning Objective: 14-01 How to determine a firm's cost of equity capital. Section: 14.2.

A firm's overall cost of equity is: A. highly dependent upon the growth rate and risk level of the firm. B.10. ignores the firm's risks when that cost is based on the dividend growth model. D.2 Topic: Cost of equity 11. Section: 14. E. unaffected by changes in the market risk premium.2 AACSB: Analytic Blooms: Understand Difficulty: 1 Easy Learning Objective: 14-01 How to determine a firm's cost of equity capital. inversely related to changes in the firm's tax rate. D. equals the firm's pretax weighted average cost of capital. . is generally less that the firm's WACC given a leveraged firm. Refer to section 14. C. C. equals the risk-free rate plus the market risk premium. generally less than the firm's aftertax cost of debt.2 AACSB: Analytic Blooms: Understand Difficulty: 1 Easy Learning Objective: 14-01 How to determine a firm's cost of equity capital. tends to remain static for firms with increasing levels of risk. Refer to section 14. increases as the unsystematic risk of the firm increases. The cost of equity for a firm: A. E. B.

Section: 14. I. and III only E. III.2 AACSB: Analytic Blooms: Understand Difficulty: 1 Easy Learning Objective: 14-01 How to determine a firm's cost of equity capital. firms that pay a constant dividend III. The dividend growth model can be used to compute the cost of equity for a firm in which of the following situations? I. firms that pay a decreasing dividend A. firms that have a 100 percent retention ratio II. II. firms that pay an increasing dividend IV. II. I and II only B. Section: 14. I and III only C. II and III only D.2 Topic: Cost of equity 12. and IV only Refer to section 14.2 Topic: Dividend growth model .

This approach generally produces a cost of equity that equals the firm's overall cost of capital. D.2 AACSB: Analytic .13. A. Refer to section 14. C. Which one of the following statements related to the SML approach to equity valuation is correct? Assume the firm uses debt in its capital structure. D. uses beta to measure the systematic risk of a firm. The model applies only to non-dividend paying firms.2 AACSB: Analytic Blooms: Understand Difficulty: 1 Easy Learning Objective: 14-01 How to determine a firm's cost of equity capital. B. is only as reliable as the estimated rate of growth. E. The model is dependent upon a reliable estimate of the market risk premium. The model generally produces the same cost of equity as the dividend growth model. Section: 14. can only be used if historical dividend information is available. considers the risk that future dividends may vary from their estimated values. Refer to section 14. B. This model considers a firm's rate of growth. applies only when a firm is currently paying dividends. C.2 Topic: Dividend growth model 14. The dividend growth model: A. E.

III. I and III only B. and III only E.2 Topic: SML approach . A. Which of the following statements are correct? I. Section: 14.Blooms: Understand Difficulty: 1 Easy Learning Objective: 14-01 How to determine a firm's cost of equity capital.2 AACSB: Analytic Blooms: Understand Difficulty: 2 Medium Learning Objective: 14-01 How to determine a firm's cost of equity capital. IV.2 Topic: SML approach 15. I. and IV only Refer to section 14. II. II and IV only C. The SML approach assumes a firm's future risks are similar to its past risks. The SML approach assumes the reward-to-risk ratio is constant. II. Section: 14. The SML approach is dependent upon a reliable measure of a firm's unsystematic risk. II. The SML approach can be applied to firms that retain all of their earnings. III. III and IV only D.

is equal to the coupon rate on the latest bonds issued by a firm. The pre-tax cost of debt: A. is based on the original yield to maturity on the latest bonds issued by a firm. Refer to section 14.3 Topic: Cost of debt . D. has to be estimated as it cannot be directly observed in the market.3 AACSB: Analytic Blooms: Understand Difficulty: 1 Easy Learning Objective: 14-02 How to determine a firm's cost of debt. is based on the current yield to maturity of the firm's outstanding bonds. is equivalent to the average current yield on all of a firm's outstanding bonds. C. E.16. B. Section: 14.

and III only D. and IV only E.3 Topic: Cost of debt . II. I and III only B. Section: 14. tax rates decrease. IV.17. II.3 AACSB: Analytic Blooms: Understand Difficulty: 2 Medium Learning Objective: 14-02 How to determine a firm's cost of debt. the market rate of interest increases. I. III. a firm's bond rating increases. bond prices rise. II. III. I. II. II and III only C. A. The aftertax cost of debt generally increases when: I. III. and IV Refer to section 14.

C. B.3 Topic: Cost of preferred 19. C. D.3 AACSB: Analytic Blooms: Remember Difficulty: 1 Easy Learning Objective: 14-01 How to determine a firm's cost of equity capital. return on a perpetuity. B. D.3 AACSB: Analytic Blooms: Understand Difficulty: 1 Easy Learning Objective: 14-01 How to determine a firm's cost of equity capital. is independent of the stock's price. aftertax cost of debt. The cost of preferred stock: A.18. pre-tax cost of debt. decreases when tax rates increase. The cost of preferred stock is computed the same as the: A. is equal to the dividend yield. Refer to section 14. is highly dependent on the dividend growth rate. E. Refer to section 14. Section: 14. return on an annuity. E. cost of an irregular growth common stock. . is equal to the yield to maturity.

4 AACSB: Analytic Blooms: Remember Difficulty: 1 Easy Learning Objective: 14-03 How to determine a firm's overall cost of capital. C. The capital structure weights used in computing the weighted average cost of capital: A. are based on the book values of total debt and total equity. Refer to section 14.Section: 14. E. are based on the market value of the firm's debt and equity securities. remain constant over time unless the firm issues new securities. Section: 14.4 Topic: WACC . D. are restricted to the firm's debt and common stock. B.3 Topic: Cost of preferred 20. are computed using the book value of the long-term debt and the book value of equity.

The firm's cost of equity is unaffected by a change in the firm's tax rate. The firm's cost of preferred is most likely less than the firm's actual cost of debt. Refer to section 14. C. B. Section: 14.4 AACSB: Analytic Blooms: Understand Difficulty: 2 Medium Learning Objective: 14-03 How to determine a firm's overall cost of capital. The firm's weighted average cost of capital will remain constant as long as the capital structure remains constant. Given this. The cost of equity can only be estimated using the SML approach. 10 percent preferred stock. and a tax rate of 38 percent. and 45 percent debt.21. Morris Industries has a capital structure of 55 percent common stock. E. a beta of 0. D.89. which one of the following statements is correct? A.4 Topic: WACC . The firm has a 60 percent dividend payout ratio. The aftertax cost of debt will be greater than the current yield-tomaturity on the firm's bonds.

3 Topic: Cost of debt . Refer to section 14. varies inversely to changes in market interest rates. will generally equal the cost of preferred if the tax rate is zero.3 AACSB: Analytic Blooms: Understand Difficulty: 2 Medium Learning Objective: 14-02 How to determine a firm's cost of debt. C.22. Section: 14. E. B. The aftertax cost of debt: A. D. is unaffected by changes in the market rate of interest. will generally exceed the cost of equity if the relevant tax rate is zero. has a greater effect on a firm's cost of capital when the debtequity ratio increases.

II and IV only C. I. I. III. II. III. The weighted average cost of capital for a firm may be dependent upon the firm's: I. IV. II. I. II.23. I and III only B. rate of growth. A.4 AACSB: Analytic Blooms: Understand Difficulty: 2 Medium Learning Objective: 14-03 How to determine a firm's overall cost of capital. Section: 14. retention ratio.4 Topic: WACC . and IV only E. preferred dividend payment. debt-equity ratio. and IV Refer to section 14. and IV only D. III.

rate of return shareholders should expect to earn on their investment in this firm. Refer to section 14. B. coupon rate the firm should expect to pay on its next bond issue.4 AACSB: Analytic Blooms: Understand Difficulty: 1 Easy Learning Objective: 14-03 How to determine a firm's overall cost of capital. Section: 14.24. E. rate of return a firm must earn on its existing assets to maintain the current value of its stock. D. The weighted average cost of capital for a firm is the: A. discount rate which the firm should apply to all of the projects it undertakes. C. minimum discount rate the firm should require on any new project.4 Topic: WACC .

25. C. the weight assigned to the preferred stock is based on the coupon rate multiplied by the par value of the preferred. The weight of the common stock used in the computation of the WACC is based on the number of shares outstanding multiplied by the book value per share.4 Topic: WACC . D. When computing the WACC. The firm's WACC will decrease as the corporate tax rate decreases. Which one of the following statements is correct for a firm that uses debt in its capital structure? A. B. E.4 AACSB: Analytic Blooms: Understand Difficulty: 2 Medium Learning Objective: 14-03 How to determine a firm's overall cost of capital. Refer to section 14. Section: 14. The WACC should decrease as the firm's debt-equity ratio increases. The WACC will remain constant unless a firm retires some of its debt.

26. II. II. Section: 14. increase its overall level of risk over time. I and III only B. III and IV only C. and IV only E. reject some positive net present value projects. III. III. and III only D. IV. A. II. I. I.5 AACSB: Analytic Blooms: Understand Difficulty: 1 Easy Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them.5 Topic: WACC . accept some negative net present value projects. II. If a firm uses its WACC as the discount rate for all of the projects it undertakes then the firm will tend to: I. and IV Refer to section 14. I. favor high risk projects over low risk projects.

Division B is the smaller and least risky of the two. allocate more funds to Division A since it is the largest of the two divisions. assign appropriate. C. Each division is in a separate line of business. fund the highest net present value projects from each division based on an allocation of 70 percent of the funds to Division A and 30 percent of the funds to Division B.5 AACSB: Analytic Blooms: Understand Difficulty: 1 Easy Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them. Section: 14.27. the managers should: A. B. fund all of Division B's projects first since they tend to be less risky and then allocate the remaining funds to the Division A projects that have the highest net present values. allocate the company's funds to the projects with the highest net present values based on the firm's weighted average cost of capital. but differing. Preston Industries has two separate divisions. Division A is also the riskier of the two divisions. D. Refer to section 14. E.5 Topic: Divisional cost of capital . When management is deciding which of the various divisional projects should be accepted. Division A is the largest division and represents 70 percent of the firm's overall sales. discount rates to each project and then select the projects with the highest net present values.

E.5 AACSB: Analytic Blooms: Understand Difficulty: 1 Easy Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them. Given this.5 Topic: Divisional cost of capital . have equal probability of receiving funding as compared to the other divisions. receive less project funding if its line of business is riskier than that of the other divisions. Each division is in a separate line of business and each presents risks unique to those lines. Refer to section 14. C. Markley and Stearns is a multi-divisional firm that uses its WACC as the discount rate for all proposed projects. a division within the firm will tend to: A.28. become less risky over time based on the projects that are accepted. D. prefer higher risk projects over lower risk projects. B. avoid risky projects so it can receive more project funding. Section: 14.

The discount rate assigned to an individual project should be based on: A. C. the risks associated with the use of the funds required by the project. Section: 14.5 AACSB: Analytic Blooms: Remember Difficulty: 1 Easy Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them. B. the firm's weighted average cost of capital. Refer to section 14. the actual sources of funding used for the project.29. the current risk level of the overall firm. an average of the firm's overall cost of capital for the past five years. E.5 Topic: Divisional cost of capital . D.

Assigning discount rates to individual projects based on the risk level of each project: A. will prevent the firm's overall cost of capital from changing over time. C. decreases the value of the firm over time.30. B. Refer to section 14.5 AACSB: Analytic Blooms: Understand Difficulty: 1 Easy Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them. E.5 Topic: Project cost of capital . D. will cause the firm's overall cost of capital to decrease over time. may cause the firm's overall weighted average cost of capital to either increase or decrease over time. Section: 14. negates the firm's goal of creating the most value for the shareholders.

The pure play method is most frequently used for projects involving the expansion of a firm's current operations. A project that is unacceptable today might be acceptable tomorrow given a change in market returns.31. Refer to section 14. C. E. Section: 14. B. Which one of the following statements is correct? A. Making subjective adjustments to a firm's WACC when determining project discount rates unfairly punishes low-risk divisions within a firm.5 AACSB: Analytic Blooms: Understand Difficulty: 2 Medium Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them. Firms that elect to use the pure play method for determining a discount rate for a project cannot subjectively adjust the pure play rate. Firms should accept low risk projects prior to funding high risk projects. D.5 Topic: Cost of capital .

both Phil's and Theresa's D.600 at a 10 percent discount rate and a net present value of -$2. cannot be determined from the information provided Refer to section 14. Phil's is a sit-down restaurant that specializes in home-cooked meals.5 AACSB: Analytic Blooms: Understand Difficulty: 1 Easy Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them. The expansion project has a projected net present value of $12. Phil's only B.080 at a 14 percent discount rate. Phil's currently has a WACC of 14 percent while Theresa's WACC is 10 percent. neither Phil's nor Theresa's E. Theresa's is a walk-in deli that specializes in specialty soups and sandwiches. Section: 14. Both firms are currently considering expanding their operations during the summer months by offering pre-wrapped donuts.32. Which firm or firms should expand and offer food at the local beach during the summer months? A. and wraps at a local beach. Theresa's only C. sandwiches.5 Topic: Project cost of capital .

cannot be determined without further information Refer to section 14. Both firms are considering building wilderness campgrounds complete with manmade lakes and hiking trails.5 Topic: Project cost of capital . Section: 14.33. The estimated net present value of such a project is estimated at $87. Travel Excitement specializes in making travel reservations and promoting vacation travel. should accept this project? A. neither Wilderness Adventures nor Travel Excitement E. Wilderness Adventures specializes in back-country tours and resort management. Wilderness Adventures only B. Which firm or firms. Travel Excitement only C. Wilderness Adventures has an aftertax cost of capital of 13 percent and Travel Excitement has an aftertax cost of capital of 11 percent.5 AACSB: Analytic Blooms: Understand Difficulty: 1 Easy Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them.000 at a discount rate of 11 percent and -$12. both Wilderness Adventures and Travel Excitement D.500 at a 13 percent discount rate. if either.

allows managers to randomly adjust the discount rate assigned to a project once the project's beta has been determined. Refer to section 14. E. C. uses the WACC of firm X as the basis for the discount rate for a project under consideration by firm Y. applies a lower discount rate to projects that are financed totally with equity as compared to those that are partially financed with debt. The subjective approach to project analysis: A. is used only when a firm has an all-equity capital structure. Section: 14. assigns discount rates to projects based on the discretion of the senior managers of a firm. B.5 AACSB: Analytic Blooms: Remember Difficulty: 1 Easy Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them. D.5 Topic: Project cost of capital .34.

E.5 Topic: Subjective approach . Refer to section 14.5 AACSB: Analytic Blooms: Understand Difficulty: 1 Easy Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them. D. Which one of the following statements is correct? A. Mandatory projects should only be accepted if they produce a positive NPV when the firm's WACC is used as the discount rate.35. Overall. Section: 14. B. The pure play approach should only be used with low-risk projects. Firms will correctly accept or reject every project if they adopt the subjective approach. The subjective approach assesses the risks of each project and assigns an adjustment factor that is unique just for that project. a firm makes better decisions when it uses the subjective approach than when it uses its WACC as the discount rate for all projects. C.

the arithmetic average of the flotation costs of both debt and equity. Refer to section 14. B.6 AACSB: Analytic Blooms: Remember Difficulty: 1 Easy .07.0. D.36. E. increase the project's discount rate to offset these expenses by dividing the firm's WACC by (1 .07). increase the initial project cost by dividing that cost by (1 . the weighted average of the flotation costs associated with each form of financing. increase the project's discount rate to offset these expenses by multiplying the firm's WACC by 1. a weighted average based on the book values of the firm's debt and equity.6 Topic: Flotation costs 37.07. increase the initial project cost by multiplying that cost by 1. The flotation cost for a firm is computed as: A. project analysts should: A. D. B. C. C. When a firm has flotation costs equal to 7 percent of the funding need.07).0. add 7 percent to the firm's WACC to get the discount rate for the project. Section: 14. E.6 AACSB: Analytic Blooms: Remember Difficulty: 1 Easy Learning Objective: 14-04 How to correctly include flotation costs in capital budgeting projects. one-half of the flotation cost of debt plus one-half of the flotation cost of equity. the geometric average of the flotation costs associated with each form of financing. Refer to section 14.

Section: 14. cause the project to be improperly evaluated. Refer to section 14. Incorporating flotation costs into the analysis of a project will: A. have no effect on the present value of the project. B.6 AACSB: Analytic Blooms: Understand Difficulty: 1 Easy Learning Objective: 14-04 How to correctly include flotation costs in capital budgeting projects. E.Learning Objective: 14-04 How to correctly include flotation costs in capital budgeting projects.6 Topic: Flotation costs 38. C. Section: 14. increase the initial cash outflow of the project. increase the project's rate of return. D.6 Topic: Flotation costs . increase the net present value of the project.

7. Flotation costs for a levered firm should: A. be ignored when analyzing a project because they are not an actual project cost.80/19. 8. E. 10.91 percent C. B.24 percent D. D. Section: 14. C.08 percent E. 9.60 and the growth rate is 5 percent.58 percent B.6 AACSB: Analytic Blooms: Understand Difficulty: 1 Easy Learning Objective: 14-04 How to correctly include flotation costs in capital budgeting projects. 7. Refer to section 14. What is the firm's cost of equity? A. be weighted and included in the initial cash flow.39. be spread over the life of a project thereby reducing the cash flows for each year of the project.00 percent R = (.05 = 9.80 a share next year. only be considered when two projects are mutually exclusive.60) + . Chelsea Fashions is expected to pay an annual dividend of $0.6 Topic: Flotation costs 40. be totally ignored when internal equity funding is utilized.08 percent AACSB: Analytic . The market price of the stock is $19.

$0.2 Topic: Cost of equity 41.65)/$0.$0.028571 + 0. What is this firm's cost of equity? A.049054)/$26] + . Section: 14.79 percent ($0.028571 ($0.72)/$0.70 .2 Topic: Cost of equity . and $0.65.75 × 1. respectively.70. 11.076923 + 0.53 percent E.$0.Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-01 How to determine a firm's cost of equity capital.70 = 0.049054 Re = [($0. Section: 14.041667)/3 = . $0. 7.70)/$0.041667 g = (0.75 .38 percent D.72.93 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-01 How to determine a firm's cost of equity capital. The Shoe Outlet has paid annual dividends of $0.56 percent B.93 percent C. The stock is currently selling for $26 a share.$0. 10.72 .75 per share over the last four years.65 = 0.72 = 0. 10.049054 = 7.076923 ($0. 7.

47 percent D. 6.5 percent annually and are expected to continue doing the same. The dividends have been increasing by 2.25 × 1.025)/$18. Sweet Treats common stock is currently priced at $18.2 Topic: Cost of equity . 9.18 percent C.42. What is this firm's cost of equity? A. The company just paid $1. 9.82 percent e = [($1.03 percent B. 6.53 a share. Section: 14.41 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-01 How to determine a firm's cost of equity capital.025 = 9.41 percent E.25 per share as its annual dividend. 8.53] + 0.

Section: 14.40] = $2.223/(1 .1 1 C. $2.18 . The common stock of Metal Molds has a negative growth rate of 1.2 Topic: Dividend growth . $2.2 6 D1 = [(0.1 9 D.40. $2.(-0.223.0 7 B.5 percent and a required return of 18 percent. D0 = $2. $2.43.2 2 E. The current stock price is $11.015)) × $11.015) = $2.26 AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-01 How to determine a firm's cost of equity capital.0. What was the amount of the last dividend paid? A. $2.

142857 ($1.$1. 2.44.74 percent B.05.041667 . What is the average dividend growth rate? A.20. 4.95 .08 .39 percent ($1. -1. Section: 14.2 Topic: Dividend growth .$1.15.0.142857 + 0. respectively. $1.$1.25 = -0.20 .15 .28 percent D.17391)/4 = -1.47 percent E. $1.05)/$1.0.15)/$1. Highway Express has paid annual dividends of $1. $1.25)/$1.74 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-01 How to determine a firm's cost of equity capital. and $0.08 ($0.05 = 0.25 .25. 2.95 over the past five years. -3.041667 ($1.$1.17391 g = (0.20 = 0.60 percent C.15 = -0.20)/$1.

45. The return on the U.98 percent B.068) = 10.S. 9. 10.025 + (1. The stock has a market price of $13 and a beta of 1.37 percent E.12 × 0.12 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-01 How to determine a firm's cost of equity capital. Section: 14. 10. 10.04 percent C.65 a share.12 percent D. What is the cost of equity? A.5 percent and the market risk premium is 6. 10.8 percent.12.2 Topic: Cost of equity .45 percent Re = 0. Treasury bill is 2. Southern Home Cookin' just paid its annual dividend of $0.

075) = 0.5 percent. The dividend growth rate is 4.67 percent C.2 Topic: Cost of equity .30 percent E.0. The market has a 10.94 × 1.68 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-01 How to determine a firm's cost of equity capital. 10. Section: 14.075) + (1.5 percent.68 percent Re = (0.124 + 0.08965 Re Average = (0.46.124 Re = [($0. 9.6 percent rate of return and a risk premium of 7.045)/$22] + 0.045 = 0. and recently paid an annual dividend of $0.05 percent B. 10. a stock price of $22.24 × 0.08965)/2 = 10. 8.106 . National Home Rentals has a beta of 1. What is the firm's cost of equity? A.94 a share.24.13 percent D. 7.

10.6 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-01 How to determine a firm's cost of equity capital.7 percent B. 11. Henessey Markets has a growth rate of 4.6 percent D.47. The overall stock market has a 10.087) = 10. 9. The stock is currently selling for $17 a share.2 Topic: Cost of equity .106 .087) + (1.7 percent Re = (0.00 × 0. 8. Section: 14.3 percent E. What is the expected rate of return on this stock? A. 11.6 percent rate of return and a risk premium of 8.2 percent C.0.7 percent.8 percent and is equally as risky as the market.

2.58 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-01 How to determine a firm's cost of equity capital. The market risk premium is 8.21) × 0.2 percent. 1. By how much will the cost of equity increase if the company expands its operations such that the company beta rises to 1. 2. 3.50 .48.26 percent Increase in cost of equity = (1.58 percent C. Tidewater Fishing has a current beta of 1.1.50? A.88 percent B.60 percent D. 3. Section: 14.2 Topic: Cost of equity .10 percent E.21.089 = 2.9 percent and the risk-free rate of return is 3.

Section: 14.3 Topic: Cost of debt .000. The face amount of each bond is $1.49. semi-annual bonds outstanding with a 5 percent coupon.36 percent E.71 percent D.55 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-02 How to determine a firm's cost of debt. These bonds are currently selling for 114 percent of face value. Wind Power Systems has 20-year. 4.42 percent C. 5. 4. 3.98 percent B. 5. What is the company's pre-tax cost of debt? A.

Section: 14. 3. These bonds have a face value of $1. 3.97 percent B.24 percent C. have a 6 percent coupon. 5.53 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-02 How to determine a firm's cost of debt.075.3 Topic: Cost of debt .000 and a current market price of $1. What is the company's aftertax cost of debt if its tax rate is 32 percent? A.21 percent E. 2.58 percent D. and pay interest annually.50. 5. Boulder Furniture has bonds outstanding that mature in 15 years.

5.09 percent C.66 percent D.55 percent B.000 and a current market price of $640. Inc. 7. The bonds have a face value of $1. 2.31 percent E. Handy Man. Section: 14. What is the company's pre-tax cost of debt? A. 5.48 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-02 How to determine a firm's cost of debt. 7.51.3 Topic: Cost of debt . has zero coupon bonds outstanding that mature in 8 years.

The bonds are currently quoted at 82 percent of face value. 8. 4. Dog Gone Good Engines has a bond issue outstanding with 17 years to maturity. Section: 14.000 face value.42 percent C.90 percent E. 6. 4. and pay interest semi-annually. a 9 percent coupon. These bonds have a $1. What is the company's pre-tax cost of debt if the tax rate is 38 percent? A.52. 11.10 percent B.42 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-02 How to determine a firm's cost of debt.61 percent D.3 Topic: Cost of debt .

88 percent B. The Corner Bakery has a bond issue outstanding that matures in 7 years. What is the firm's aftertax cost of debt if the tax rate is 30 percent? A. Currently.45 percent D.36 percent C.53. The bonds pay interest semi-annually.74 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-02 How to determine a firm's cost of debt. Section: 14. 5. 8. 6.3 Topic: Cost of debt .11 percent E. 5.4 percent of face value and carry a 9 percent coupon. 4. the bonds are quoted at 101.

Section: 14. 4.54.01 percent B.22 percent C.00 percent E. The outstanding bonds of Tech Express are priced at $989 and mature in 10 years. 3.41 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-02 How to determine a firm's cost of debt. 4.35 percent D.3 Topic: Cost of debt . 3. These bonds have a 6 percent coupon and pay interest annually. The firm's tax rate is 35 percent. What is the firm's aftertax cost of debt? A. 3.

3 Topic: Cost of debt . Simple Foods has a zero coupon bond issue outstanding that matures in 9 years. 7.73 percent C. 5. What is the company's aftertax cost of debt if the tax rate is 38 percent? A.48 percent B.88 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-02 How to determine a firm's cost of debt.73 percent E. 9.12 percent D. Section: 14. The bonds are selling at 42 percent of par value. 6.55. 5.

13.54 percent Rp = (0.77 percent B.67 percent D. 14.07 × $100)/$49 = 14. 14. The market rate of return is 14 percent and the firm's tax rate is 37 percent. 13. Grill Works and More has 7 percent preferred stock outstanding that is currently selling for $49 a share.56. What is the firm's cost of preferred stock? A. 13. Section: 14.3 Topic: Cost of preferred .29 percent C.29 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-02 How to determine a firm's cost of debt.29 percent E.

19. Section: 14. What is the cost of preferred stock? A. Currently. this stock has a market value per share of $52 and a book value per share of $38.42 percent D.075 × $100)/$52 = 14. 19.50 percent B.3 Topic: Cost of preferred . 7. 13.74 percent Rp = (0.57.29 percent E. Samuelson Plastics has 7.5 percent preferred stock outstanding.88 percent C.42 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-02 How to determine a firm's cost of debt. 14.

58.29 percent D.59 percent E. 20. 13. Section: 14.59 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-02 How to determine a firm's cost of debt. This stock was originally issued at $45 per share.68 percent B. What is the cost of preferred stock? A.00 percent C.07 × $100)/$34 = 20.80 percent Rp = (0. 20. 14. New York Deli has 7 percent preferred stock outstanding that sells for $34 a share.3 Topic: Cost of preferred . 18.

00 percent E. What is the weight of the common stock as it relates to the firm's weighted average cost of capital? A.45 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-03 How to determine a firm's overall cost of capital. The common stock is priced at $37 a share and there are 28.11 percent D.000 shares outstanding. The company also has 2.500 shares of preferred stock at a market price of $28 a share. 45. Section: 14. 43.200 bonds outstanding that are selling for $990 each. 55. Nelson's Landscaping has 1.16 percent C. 47.59.08 percent B.4 Topic: Weighted average . 54.

17 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-03 How to determine a firm's overall cost of capital.03 percent E.60. The firm also has 1. 6. 7.75 percent D. What is the weight of the preferred stock as it relates to the firm's weighted average cost of capital? A. The preferred stock has a market price of $35 a share compared to a price of $24 a share for the common stock. 8. 7.000 bond issue outstanding that is selling at 92 percent of face value. Section: 14. Mangrove Fruit Farms has a $250.000 shares of common stock outstanding.500 shares of preferred stock and 15.20 percent C.4 Topic: Weight of preferred .75 percent B. 8.

Section: 14. 46 percent C. 54 percent E. 50 percent D. 58 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-03 How to determine a firm's overall cost of capital. 42 percent B.4 Topic: Weight of debt .000 shares of common stock outstanding at a market price of $38 a share.61. Electronics Galore has 950.000 bonds outstanding that are quoted at 106 percent of face value. The company also has 40. What weight should be given to the debt when the firm computes its weighted average cost of capital? A.

112 .75m) (0.75m/$233. Section: 14.18 percent D.10769 WACC = ($105m/$233. The corporate tax rate is 38 percent. The U.15 percent AACSB: Analytic Blooms: Analyze Difficulty: 1 Easy Learning Objective: 14-03 How to determine a firm's overall cost of capital.64 percent C. Bonds with similar characteristics are yielding 7.07 × $100)/$65 = 0.34 (0. The company also has 750. What is the firm's weighted average cost of capital? A. 11.000 shares of 7 percent preferred stock and 2.56 percent Re = 0.075) (1 .75m) (0. Phillips Equipment has 80.75m) (0. 10.14056) + ($48.0.5 million shares of common stock outstanding.30 percent E.2 percent.0. 10. The preferred stock sells for $65 a share.S.000 bonds outstanding that are selling at par.10769) + ($80m/$233. 11. 11.5 percent.028 + 1. Treasury bill is yielding 2.14056 Rp = (0.34 and sells for $42 a share.38) = 10. The common stock has a beta of 1.8 percent and the return on the market is 11.4 Topic: WACC .028) = 0.62.15 percent B.

18 percent B.940.025.143) + ($1. 10. and a cost of preferred stock of 8.81 percent WACC = ($5.600) (0. What is the firm's weighted average cost of capital? A.84 percent C.60 percent E.000 shares of common stock outstanding at a market price of $27 a share. 11. The firm has 220. Section: 14.076) (1 . There are 25.521.6 percent.600) (0.085) + ($556.521. a cost of equity of 14.37) = 12.000/$7. The company's tax rate is 37 percent. 12. 10.000 shares of preferred stock outstanding at a market price of $41 a share. Wayco Industrial Supply has a pre-tax cost of debt of 7.000 and a market quote of 101.600/$7.5 percent.0.63.32 percent D.3 percent. The bond issue has a face value of $550.81 percent AACSB: Analytic Blooms: Analyze Difficulty: 1 Easy Learning Objective: 14-03 How to determine a firm's overall cost of capital.521.4 Topic: WACC .000/$7.2. 12.600) (0.

64.

Central Systems, Inc. desires a weighted average cost of capital of 8
percent. The firm has an aftertax cost of debt of 5.4 percent and a
cost of equity of 15.2 percent. What debt-equity ratio is needed for
the firm to achieve its targeted weighted average cost of capital?

A. 0.3
8
B. 0.4
4
C. 1.0
2
D. 2.7
7
E. 3.6
3
WACC = 0.08 = [We × 0.152] + [(1 - We) × 0.054)]
We = 0.2653; Wd = 1 - We = 0.7347
Debt-equity ratio = 0.7347/0.2653 = 2.77
AACSB: Analytic
Blooms: Analyze
Difficulty: 1 Easy
Learning Objective: 14-03 How to determine a firm's overall cost of capital.
Section: 14.4
Topic: Debt-equity ratio

65.

R.S. Green has 250,000 shares of common stock outstanding at a
market price of $28 a share. Next year's annual dividend is expected
to be $1.55 a share. The dividend growth rate is 2 percent. The firm
also has 7,500 bonds outstanding with a face value of $1,000 per
bond. The bonds carry a 7 percent coupon, pay interest
semiannually, and mature in 7.5 years. The bonds are selling at 98
percent of face value. The company's tax rate is 34 percent. What is
the firm's weighted average cost of capital?

A. 5.4
percent
B. 6.2
percent
C. 7.5
percent
D. 8.5
percent
E. 9.6
percent

AACSB: Analytic
Blooms: Analyze
Difficulty: 1 Easy
Learning Objective: 14-03 How to determine a firm's overall cost of capital.
Section: 14.4
Topic: WACC

66.

Kelso's has a debt-equity ratio of 0.6 and a tax rate of 35 percent.
The firm does not issue preferred stock. The cost of equity is 14.5
percent and the aftertax cost of debt is 4.8 percent. What is the
weighted average cost of capital?

A. 10.46
percent
B. 10.67
percent
C. 10.86
percent
D. 11.38
percent
E. 11.57
percent
WACC = (1/1.6) (0.145) + (0.6/1.6) (0.048) = 10.86 percent
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 14-03 How to determine a firm's overall cost of capital.
Section: 14.4
Topic: WACC

The pretax cost of debt is 9. This year.10 × 1.2 and a market price of $19 a share. The current market risk premium is 8.4 Topic: WACC .10 a share and expects to increase that amount by 2 percent each year.65) (0. 8.67.6 percent.138 + 0. Granite Works maintains a debt-equity ratio of 0. 8.8 percent.20 percent Re = 0.2(0.000 shares of stock outstanding with a beta of 1. 8.32) = 9. what is the weighted average cost of capital? A.108526 WACC = (1/1. the firm paid an annual dividend of $1.65/1.20 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-03 How to determine a firm's overall cost of capital.65) (0.02 = 0. Section: 14.0790526 Re Average = (0. Using an average expected cost of equity.0.108526) + (0. There are 25. 9.96 percent D.78 percent C.13 percent E.0790526)/2 = 0.098) (1 .65 and has a tax rate of 32 percent.138 Re = [($1. The firm does not issue preferred stock. 9.036 + 1.5 percent and the current risk-free rate is 3.085) = 0.44 percent B.02)/$19] + 0.

The firm also has a bond issue outstanding with a total face value of $280.36 percent D.13) + (240.800/690.4 Topic: WACC .000 shares of common stock outstanding at a market price of $15. 10. The cost of equity is 13 percent while the aftertax cost of debt is 6.47 percent WACC = (450. Section: 14.48 and a tax rate of 30 percent. This stock was originally issued at $31 per share. What is the weighted average cost of capital? A. Delta Lighting has 30. The firm has a beta of 1.000/690.000 which is selling for 86 percent of par.069) = 10.800 * .800 * . 12. 13. 13.87 percent C. 10.87 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-03 How to determine a firm's overall cost of capital.68.07 percent B.29 percent E.00 a share.9 percent.

14 percent.0775 RProject = 0.54 percent. 13.36 percent.94 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-01 How to determine a firm's cost of equity capital.38 and a cost of equity of 14.0425 + (1.25 × 0. What discount rate should the firm assign to a new project that has a beta of 1. C.945 percent. mrp = 0. The risk-free rate of return is 4. 13. RE = 0. B.38 × mrp).5 Topic: Discount rate . 14. 14. D.69.0425 + (1.25 percent. 13. The Market Outlet has a beta of 1.14945 = 0. E. Section: 14.72 percent.0775) = 13.94 percent.25? A.

13. 12.67 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-01 How to determine a firm's cost of equity capital.03 and a project life of 6 years. Section: 14. mrp = 0.62 percent. E.67 percent. Silo Mills has a beta of 0.0958 RProject = 0.84 percent. 13. RE = 0. The firm is currently considering a project that has a beta of 1.5 Topic: Discount rate .33 percent. C. The risk-free rate of return is 2.95 and a cost of equity of 11.95 × mrp). 14. What discount rate should be assigned to this project? A. 13. D. B.03 × 0.8 percent.028 + (1.70.9 percent.119 = 0.09 percent.028 + (0.0958) = 12.

$68.0943) + ($279.09432) + ($116.011.000.361.000.211. and the cost of common stock is 13 percent. 5 percent preferred stock. the cost of preferred is 9 percent. $279.71. 08 D. 18 E.000 over the next three years. The company is considering a project that is equally as risky as the overall firm. $69.13) + (0. $68. and 55 percent common stock. $74.55 × 0.39)] =0.879.000/1.09433) = $76. What is the projected net present value of this project? A.05 × 0.075 × (1 .208.000/1. The company's tax rate is 39 percent. Travis & Sons has a capital structure which is based on 40 percent debt.5 percent.011.09) + [0. and $116.5 Topic: Project NPV . The pre-tax cost of debt is 7.0. Section: 14.0943 NPV -$325. This project has initial costs of $325. respectively. 97 C.000 + ($87.000 and annual cash inflows of $87.23 AACSB: Analytic Blooms: Analyze Difficulty: 1 Easy Learning Objective: 14-03 How to determine a firm's overall cost of capital. 04 B.40 × 0. $76.000/1. 23 WACC = (0.

5 Topic: Project NPV .000/1.93 8 E. The aftertax cost of debt is 4.72. $7.45) (0. $8. This project is an extension of the firm's current operations and thus is equally as risky as the current firm. The firm uses only debt and common stock to finance its operations and maintains a debt-equity ratio of 0. the cost of equity is 12. $9.000/1.7 percent. What is the projected net present value of this project? A.000 in year one and $74.8 percent. Panelli's is analyzing a project with an initial cost of $110.000 in year two.1024832) = $9.41 1 B.102483) + ($74.102483 NPV = -$110.840 AACSB: Analytic Blooms: Analyze Difficulty: 1 Easy Learning Objective: 14-03 How to determine a firm's overall cost of capital. $7. Section: 14. and the tax rate is 35 percent.45/1. $8.048) = 0.45) (0.33 3 D.84 0 WACC = (1/1.127) + (0.45.000 + ($65.80 9 C.000 and cash inflows of $65.

Carson Electronics uses 70 percent common stock and 30 percent debt to finance its operations.4 percent. What is the maximum amount the firm can initially invest in this project to avoid a negative net present value for the project? A.03 2 B. $299.000 in the first year.979 AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-03 How to determine a firm's overall cost of capital.0.41 4 WACC = 0.40 6 D. Section: 14.124 PV = $36.03) = $382.4 percent and the cost of equity is 15.5 Topic: Project NPV .30(0.124 .000/(0. Management is considering a project that will produce a cash inflow of $36.154) + 0. The aftertax cost of debt is 5.70(0.054) = 0. The cash inflows will then grow at 3 percent per year forever.97 9 C. $441. $434. $411.73.08 6 E. $382.

5 percent while the aftertax cost of debt for the firm is 6.000/1.5 percent to the company's overall cost of capital when evaluating this project.75 × 0.155) + (0. $28.42 7 E. Thus.74.1315 WACCProject = 0.1315 + 0.96 4 C.20 8 B. The company's cost of equity is 15.000 and projected cash inflows of $17. The project has an initial cash outlay of $58.000 + ($17. $1.000 in year three.000/1. $1. $308 D.5 Topic: Project NPV .015 = 0. management has decided to add an additional 1. What is the projected net present value of the new project? A. The firm uses 25 percent debt and 75 percent common stock as its capital structure.1465) + ($28.964 AACSB: Analytic Blooms: Analyze Difficulty: 1 Easy Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them.1465 NPV = -$58.000 in year one. $6.1 percent.14653) = -$1.1465 2) + ($30.25 × 0. Section: 14.000/1.061) = 0.57 3 WACCFirm = (0. The Bakery is considering a new project it considers to be a little riskier than its current operations. and $30.000 in year two. $1.

0796875) = 12.41 percent C.034 + 1. Section: 14. 12.37 percent B. 12.034 + 1.54 percent D. The firm is financed solely with common stock.80 percent 0. 12.0796875 ReDivision = 0. The riskfree rate of return is 3.4 percent.28. 12. The Oil Derrick has an overall cost of equity of 13.18? A. 12.5 Topic: Divisional cost of capital . mrp = 0.6 percent and a beta of 1.18(0.28mrp.136 = 0. What is an appropriate cost of capital for a division within the firm that has an estimated beta of 1.75.80 percent AACSB: Analytic Blooms: Analyze Difficulty: 1 Easy Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them.67 percent E.

13.5 percent? A.12 percent B.79 and a cost of equity of 11.96 percent AACSB: Analytic Blooms: Analyze Difficulty: 1 Easy Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them. rf = 0. 14.095). Division A within the firm has an estimated beta of 1. 16. 13.96 percent C.03695 ReDivision = 0.79(0.63 percent D.03695 + 1.01 percent 0.76. What is an appropriate cost of capital for division A if the market risk premium is 9.112 = rf + 0.2 percent for the firm overall.08(0.08 and is the riskiest of all of the firm's operations. Section: 14. Miller Sisters has an overall beta of 0.5 Topic: Divisional cost of capital .77 percent E. 15. The firm is 100 percent financed with common stock.095) = 13.

Section: 14.6 percent. should accept this project? A.5 Topic: Pure Play . Precious Metals is in the precious gem retail business and has an aftertax cost of capital of 10. Deep Mining and Precious Metals are separate firms that are both considering a silver exploration project. Deep Mining is in the actual mining business and has an aftertax cost of capital of 12. cannot be determined without further information Neither company should accept this project as the applicable discount rate for both firms is 12.8 percent and the NPV is negative at this discount rate.8 percent. The project under consideration has initial costs of $575. Company A only B. AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them.77.000 and anticipated annual cash inflows of $102. if either. both Company A and Company B D. neither Company A or Company B E. Which firm(s).000 a year for ten years. Company B only C.

26 2 D.5 Topic: Pure Play .78.04 8 C.000.04 4 B. What is the net present value of the Sister Pools project? A.000 a year for 7 years. The initial cash outlay for this project would be $85.21 9 AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them.3 percent. The sales manager of Sister Pools estimates that the water features and fountains would produce 20 percent of the firm's future total sales. $1. Section: 14. The expected net cash inflows are $17. $11. $3. Sister Pools sells outdoor swimming pools and currently has an aftertax cost of capital of 11. Sister Pools is considering building and selling its own water features and fountains. $1.6 percent. $2.50 8 E. Al's Construction builds and sells water features and fountains and has an aftertax cost of capital of 10.

035 + 1. Section: 14. 12.79.46 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them.92 percent C.12(0. The risk-free rate of return is 3. 14.5 percent and the market risk premium is 8 percent.46 percent B. What discount rate should Decker's use if it considers a project that involves the manufacturing of furniture? A. 14.08) = 12. 12.54 percent Re = 0. 13. Decker's has a beta of 1.38 as compared to Furniture Fashion's beta of 1. Furniture Fashions is a furniture maker and a supplier to Decker's.5 Topic: Pure Play .08 percent E.50 percent D. Decker's is a chain of furniture retail stores.12.

5 percent for debt.07) + (0. The flotation costs are 4. 10 percent preferred stock. 6.8 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-04 How to correctly include flotation costs in capital budgeting projects. 6.6 Topic: Flotation costs . and 9.045) = 6. 7 percent for preferred stock.80.10 × 0. Section: 14.8 percent B. 6. and 50 percent debt. Bleakly Enterprises has a capital structure of 40 percent common stock.40 × 0. What is the weighted average flotation cost? A.2 percent C. 6.5 percent for common stock.6 percent E.4 percent D.8 percent Average flotation cost = (0.50 × 0. 5.095) + (0. The corporate tax rate is 34 percent.

6 Topic: Flotation costs . The corporate tax rate is 37 percent. Inc.81. Section: 14. The flotation costs are 11 percent for common stock.97 percent B. and 7 percent for debt.48 percent C.05 × 0. What is the weighted average flotation cost? A. 10 percent for preferred stock.00 percent Average flotation cost = (0. has a capital structure which is based on 30 percent debt.62 percent D. 8.65 × 0.10) + (0.75 percent E. 10. and 65 percent common stock. 9.30 × 0.11) + (0. Justice. 9. 5 percent preferred stock.07) = 9.75 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-04 How to correctly include flotation costs in capital budgeting projects. 9.

70 0 E. What is the initial cost of the project including the flotation costs? A. $302.000/(1 .82. Section: 14.64/1.6 percent for equity and 5. The flotation cost is 9. The firm is analyzing a new project which requires an initial cash outlay of $420.64) (0.328 AACSB: Analytic Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-04 How to correctly include flotation costs in capital budgeting projects.64. $456. $368.054) = 0.0796098) = $456.0796098 Initial cost = $420.40 0 B.0.4 percent for debt.33 3 Average flotation cost = (1/1.32 8 D. $583.096) + (0. The Daily Brew has a debt-equity ratio of 0.000 for equipment.64) (0. $456.92 4 C.6 Topic: Project flotation costs .

83.

You are evaluating a project which requires $230,000 in external
financing. The flotation cost of equity is 11.6 percent and the
flotation cost of debt is 5.4 percent. What is the initial cost of the
project including the flotation costs if you maintain a debt-equity
ratio of 0.45?

A. $248,49
4
B. $249,02
1
C. $254,63
8
D. $255,55
1
E. $255,64
6
Average flotation cost = (1/1.45) (0.116) + (0.45/1.45) (0.054) =
0.0967586
Initial cost = $230,000/(1 - 0.0967586) = $254,638
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 14-04 How to correctly include flotation costs in capital budgeting projects.
Section: 14.6
Topic: Flotation costs

84.

Western Wear is considering a project that requires an initial
investment of $274,000. The firm maintains a debt-equity ratio of
0.40 and has a flotation cost of debt of 8 percent and a flotation cost
of equity of 10.5 percent. The firm has sufficient internally generated
equity to cover the equity portion of this project. What is the initial
cost of the project including the flotation costs?

A. $280,40
9
B. $281,40
6
C. $288,00
5
D. $297,74
7
E. $302,76
2
Average flotation cost = (1/1.40) (0) + (0.40/1.40) (0.08) =
0.0228571
Initial cost = $274,000/(1 - 0.0228571) = $280,409
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 14-04 How to correctly include flotation costs in capital budgeting projects.
Section: 14.6
Topic: Flotation costs

85.

Yesteryear Productions is considering a project with an initial start up
cost of $960,000. The firm maintains a debt-equity ratio of 0.50 and
has a flotation cost of debt of 6.8 percent and a flotation cost of
equity of 11.4 percent. The firm has sufficient internally generated
equity to cover the equity cost of this project. What is the initial cost
of the project including the flotation costs?

A. $979,41
7
B. $982,26
5
C. $992,38
6
D. $1,038,5
13
E. $1,065,0
89
Average flotation cost = (1/1.5) (0.0) + (0.5/1.5) (0.068) = 0.0226667
Initial cost = $960,000/(1 - 0.0226667) = $982,265
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 14-04 How to correctly include flotation costs in capital budgeting projects.
Section: 14.6
Topic: Flotation costs

17.9 percent D.13 . Section: 14.5 percent and the expected return on the market is 13 percent.6 percent E.86.035 + 1. 11.2(0.0. The risk-free rate is 3.2.8 percent C.9 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy EOC: 14-2 Learning Objective: 14-01 How to determine a firm's cost of equity capital.4 percent B. 12.035) = 14. What is the firm's cost of equity? A. 19. 14.2 Topic: Cost of equity . The City Street Corporation's common stock has a beta of 1.1 percent RE = 0.

5 percent. 14.152 RE = [($1.055 + 0. 14. 13.10) = 0.07 = 0. The market risk premium is 10 percent while T-bills are currently yielding 5.87.69 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy EOC: 14-3 Learning Objective: 14-01 How to determine a firm's cost of equity capital. and dividends are expected to grow at a 7 percent annual rate indefinitely.152 + 0. Stock in Country Road Industries has a beta of 0.55 × 1.21 percent D.06 percent C.1218281)/2 = 13.50 percent RE = 0. 14.55 per share. Country Road's most recent dividend was $1.38 percent E.97(0.69 percent B. The stock sells for $32 a share. 14. Section: 14.07)/$32] + 0.2 Topic: Cost of equity .1218281 RE Average = (0.97. What is the estimated cost of equity using the average of the CAPM approach and the dividend discount approach? A.

54 percent RP = $5/$92 = 5. Holdup Bank has an issue of preferred stock with a $5 stated dividend that just sold for $92 per share. 4.60 percent B.64 percent C. 5.3 Topic: Cost of preferred . What is the bank's cost of preferred? A.39 percent D. 4. 5.43 percent E. Section: 14.88. 5.43 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy EOC: 14-5 Learning Objective: 14-01 How to determine a firm's cost of equity capital.

3 Topic: Cost of debt .89. Section: 14. 6. 4. Inc.42 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy EOC: 14-6 Learning Objective: 14-02 How to determine a firm's cost of debt.37 percent E.17 percent D.90 percent C. The firm has a debt issue outstanding with 15 years to maturity that is quoted at 107 percent of face value. What is the aftertax cost of debt if the tax rate is 39 percent? A. Decline. The issue makes semiannual payments and has an embedded cost of 9 percent annually. 7. 5.99 percent B. is trying to determine its cost of debt. 7.

75 percent D. What is the aftertax cost of debt if the company's tax rate is 31 percent? A. 4. Section: 14. 4.90. The bond currently sells for 114 percent of its face value.70 percent C. 4. 8 percent.82 percent E.3 Topic: Cost of debt . 4. semiannual bond 6 years ago.86 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy EOC: 14-7 Learning Objective: 14-02 How to determine a firm's cost of debt.63 percent B. 4. Jiminy's Cricket Farm issued a 30-year.

085)(1 .38 percent E.5 percent. 10.39) = 10.04)(.87 percent B.5 percent.55)(. 4 percent preferred stock.41(0.18) + (0.49 percent AACSB: Analytic Blooms: Apply Difficulty: 1 Easy EOC: 14-9 Learning Objective: 14-03 How to determine a firm's overall cost of capital. 15. What is the firm's WACC given a tax rate of 39 percent? A. 9.065) + (0. Section: 14. Mullineaux Corporation has a target capital structure of 41 percent common stock.43 percent C.49 percent D. 13.91.0.4 Topic: WACC . and 55 percent debt. Its cost of equity is 18 percent. 10.17 percent WACC = 0. the cost of preferred stock is 6. and the pre-tax cost of debt is 8.

92.

Cookie Dough Manufacturing has a target debt-equity ratio of 0.5. Its
cost of equity is 15 percent, and its cost of debt is 11 percent. What
is the firm's WACC given a tax rate of 31 percent?

A. 12.53
percent
B. 12.78
percent
C. 13.11
percent
D. 13.48
percent
E. 13.67
percent
WACC = (1/1.5)(0.15) + (0.5/1.5)(0.11)(1 - 0.31) = 12.53 percent
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
EOC: 14-10
Learning Objective: 14-03 How to determine a firm's overall cost of capital.
Section: 14.4
Topic: WACC

93.

Fama's Llamas has a weighted average cost of capital of 9.5 percent.
The company's cost of equity is 15.5 percent, and its pretax cost of
debt is 8.5 percent. The tax rate is 34 percent. What is the company's
target debt-equity ratio?

A. 0.8
9
B. 0.9
2
C. 0.9
8
D. 1.0
1
E. 1.5
4
WACC = 0.095 = 0.155(E/V) + (0.085) (D/V) (1 - 0.34)
0.095(V/E) = 0.155 + 0.085(0.66) (D/E)
0.095(1 + D/E) = 0.155 + 0.0561(D/E)
D/E = 1.54
AACSB: Analytic
Blooms: Analyze
Difficulty: 1 Easy
EOC: 14-11
Learning Objective: 14-03 How to determine a firm's overall cost of capital.
Section: 14.4
Topic: Target capital structure

94.

Jungle, Inc. has a target debt-equity ratio of 0.72. Its WACC is 11.5
percent and the tax rate is 34 percent. What is the cost of equity if
the aftertax cost of debt is 5.5 percent?

A. 13.75
percent
B. 13.84
percent
C. 14.41
percent
D. 14.79
percent
E. 15.82
percent
WACC = 0.115 = (1/1.72) RE + (0.72/1.72)(0.055); RE = 15.82 percent
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
EOC: 14-14
Learning Objective: 14-03 How to determine a firm's overall cost of capital.
Section: 14.4
Topic: WACC

.

000 ten percent semiannual bonds outstanding.232737 E/V = $588.000 ($42) = $588.200.000) (0.200. 15.000 ($80) = $72.200.000.000.000 each.1125 RD Aftertax = 0. 14.000.115) = 0. the preferred stock currently sells for $80 per share.54 percent E.000 = $860. Titan Mining Corporation has 14 million shares of common stock outstanding.5 percent. What discount rate should the firm apply to a new project's cash flows if the project has the same risk as the firm's typical project? A.200.200.000 MVE = 14.000.20725 RP = $9/$80 = 0. 15. 900. T-bills are yielding 7.95.075 + 1. 14.000 ($1.000 + $72.000/$860.200.15(0.000 V = $200. and the bonds have 17 years to maturity and sell for 91 percent of par. 16.000.32) = 0.683562 P/V = $72.000 + $588.000.59 percent B.17 percent D.083701 RE = 0.0.000.15.000 D/V = $200.000 = 0. The market risk premium is 11.5 percent.000 MVP = 900.000/$860. The common stock currently sells for $42 per share and has a beta of 1.88 percent MVD = 220.000 = 0.000 = 0.72 percent C.91) = $200.000/$860.076127 .1119514 (1 .000 shares of 9 percent preferred stock outstanding and 220. par value $1. and the firm's tax rate is 32 percent.200.

5 percent.0.683562(0.4 Topic: WACC 96. Suppose your company needs $14 million to build a new assembly line.083701 (0.095) + (0.063043 Amount raised = $14m/(1 .94 million C.076127) = 16.1125) + 0. 15.063043) = $14. The flotation cost for new equity is 9.82 million B.23 million fA = (1/1. 15.5 percent.84)(0.232737 (0.84/1. Section: 14.88 percent AACSB: Analytic Blooms: Analyze Difficulty: 1 Easy EOC: 14-16 Learning Objective: 14-03 How to determine a firm's overall cost of capital. What is the true cost of building the new assembly line after taking flotation costs into account? A.6 Topic: Flotation costs .84.84) (0. Your target debt-equity ratio is 0. 14. 14.07 million D.12 million E. Section: 14.20725) + 0. 15.94 million AACSB: Analytic Blooms: Analyze Difficulty: 1 Easy EOC: 14-18 Learning Objective: 14-04 How to correctly include flotation costs in capital budgeting projects.025) = 0. but the floatation cost for debt is only 2.WACC = 0.

What role does the weighted average cost of capital play when determining a project's cost of capital? Assuming a project is equally as risky as a firm's current operations. a different firm's WACC should be applied as the discount rate for the project. Feedback: Refer to section 14. then the firm's WACC should be adjusted in accordance with the project's risk or in some instances. Section: 14. If a project has a different risk level than the firm's current operations. having an accurate WACC is essential to correctly evaluating the project.Essay Questions 97.5 Topic: Project cost of capital . WACC will be used as the discount rate when computing the NPV of the project.5 AACSB: Reflective Thinking Blooms: Apply Difficulty: 1 Easy Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them. Therefore.

which is engaged in the type of operations Firm A is considering. Give an example of a situation where a firm should adopt the pure play approach for determining the cost of capital for a project. knowledge. This risk adjustment is based on the wisdom. The example should explain why the WACC of Firm B. Section: 14. To try and determine a more accurate estimate of the appropriate discount rate might encounter costs that would outweigh any potential benefit. Feedback: Refer to section 14. should be used as the basis for setting the discount rate for the proposed project. What are some advantages of the subjective approach to determining the cost of capital and why do you think that approach is utilized? The subjective approach allows management to adjust a firm's overall cost of capital for individual divisions based upon its evaluation of the risks associated with each division as compared to the overall risk level of the firm. Student examples will vary but should illustrate a project that is unrelated to the current operations of Firm A. and experiences of the managers. Feedback: Refer to section 14. Thus.5 AACSB: Reflective Thinking Blooms: Apply Difficulty: 2 Medium Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them.5 AACSB: Reflective Thinking Blooms: Create Difficulty: 2 Medium Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do . the subjective approach is useful because it adjusts discount rates in a cost effective and efficient manner.5 Topic: Subjective approach 99.98.

Internal equity avoids the flotation costs associated with raising external equity. Section: 14. the initial cost of the project is decreased.6 Topic: Flotation costs 101. Section: 14. by utilizing internal equity rather than external equity.6 .6 AACSB: Reflective Thinking Blooms: Analyze Difficulty: 2 Medium Learning Objective: 14-04 How to correctly include flotation costs in capital budgeting projects. Flotation costs should be included in the initial cash flow of a project and not in the cost of capital. Decreasing the initial cost increases the NPV of the project.6 AACSB: Reflective Thinking Blooms: Analyze Difficulty: 2 Medium Learning Objective: 14-04 How to correctly include flotation costs in capital budgeting projects. Section: 14. To correct for this. Feedback: Refer to section 14.5 Topic: Pure Play 100. Feedback: Refer to section 14.about them. Explain how the use of internal equity rather than external equity affects the analysis of a project. he asks you to evaluate the project using a higher cost of capital which incorporates these costs. The first evaluation was in error. Suppose your boss comes to you and asks you to re-evaluate a capital budgeting project. that determines the cost of capital. and not the source of funds. Therefore. because it ignored flotation costs. he explains. Is your boss' approach correct? Why or why not? Your boss is confused since it is the use of funds.

Topic: Flotation costs .