Managerial Finance Problem Review Set Cost of Capital with Solutions

Managerial Finance – Problem Review Set – Cost of Capital – with solutions

If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.
a. / True
b. / False

The lower the firm's tax rate, the lower will be its after-tax cost of debt and WACC, other things held constant.
a. / True
b. / False

If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity. However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit the shift toward debt.
a. / True
b. / False

Jackson Inc. uses only equity capital, and it has 2 equally-sized divisions. Division A’s cost of capital is 10.0%, Division B’s cost is 14.0%, and the composite WACC is 12.0%. All of Division A’s projects have the same risk, as do all of Division B's projects. However, the projects in Division A have less risk than those in Division B. Which of the following projects should Jackson accept?
a. / A Division B project with a 13% return.
b. / A Division B project with a 12% return.
c. / A Division A project with an 11% return.
d. / A Division A project with a 9% return.
e. / A Division B project with an 11% return.

Vang Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?
a. / Project B is of below-average risk and has a return of 8.5%.
b. / Project C is of above-average risk and has a return of 11%.
c. / Project A is of average risk and has a return of 9%.
d. / None of the projects should be accepted.
e. / All of the projects should be accepted.

Divisional risk Answer: c

The correct answer is statement c. Division A should accept only projects with a return greater than 10%, and Division B should accept only projects with a return greater than 14%. Only statement c meets this criterion.

Nelson Enterprises, an all-equity firm, has a beta of 2.0. Nelson’s chief financial officer is evaluating a project with an expected return of 21%, before any risk adjustment. The risk-free rate is 7%, and the market risk premium is 6%. The project being evaluated is riskier than Nelson’s average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT?
a. / The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.
b. / The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return.
c. / Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment.
d. / The accept/reject decision depends on the firm's risk-adjustment policy. If Nelson's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project.
e. / Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision.

Risk and project selection Answer: a

Project B has a return greater than its risk-adjusted cost of capital, so it should be accepted.

Which of the following statements is CORRECT?
a. / The WACC is calculated using before-tax costs for all components.
b. / The after-tax cost of debt usually exceeds the after-tax cost of equity.
c. / For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of preferred stock.
d. / Retained earnings that were generated in the past and are reflected on the firm’s balance sheet are generally available to finance the firm’s capital budget during the coming year.
e. / The WACC that should be used in capital budgeting is the firm’s marginal, after-tax cost of capital.

Risk and project selection Answer: d

Statement d is correct. Here is the proof:

rs = 7% + 6%(2.0) = 7% + 12% = 19%.

Required return for risky projects = 19% + 3% = 22%.

Project return = 21% adjusted rs = 22%. Thus, the project should be rejected.

Assume that you are a consultant to Magee Inc., and you have been provided with the following data: rRF = 4.00%; RPM = 5.00%; and b = 1.15. What is the cost of equity from retained earnings based on the CAPM approach?
a. / 9.75%
b. / 10.04%
c. / 10.34%
d. / 10.65%
e. / 10.97%

Component cost of retained earnings: CAPM Answer: a

rRF 4.00%

RPM 5.00%

b 1.15

rs = rRF + (RPM ´ b) 9.75%

Lanser Inc. hired you as a consultant to help them estimate its cost of capital. You have been provided with the following data: D1 = $0.80; P0 = $22.50; and g = 5.00% (constant). Based on the DCF approach, what is the cost of equity from retained earnings?
a. / 7.34%
b. / 7.72%
c. / 8.13%
d. / 8.56%
e. / 8.98%

Component cost of retained earnings: DCF, D1 Answer: d

D1 $0.80

P0 $22.50

g 5.00%

rs = D1/P0 + g 8.56%

10)

You were hired as a consultant to Kroncke Company, whose target capital structure is 40% debt, 10% preferred, and 50% common equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of retained earnings is 13.25%. The firm will not be issuing any new stock. What is its WACC?
a. / 9.48%
b. / 9.78%
c. / 10.07%
d. / 10.37%
e. / 10.68%

WACC Answer: b

Weights Costs

Debt 40% 6.00%

Preferred 10% 7.50%

Common 50% 13.25%

WACC = wd ´ rd(1 – T) + wp × rp + wc × rs 9.78%

11)

To help finance a major expansion, Delano Development Company sold a noncallable bond several years ago that now has 15 years to maturity. This bond has a 10.25% annual coupon, paid semiannually, it sells at a price of $1,025, and it has a par value of $1,000. If Delano’s tax rate is 40%, what component cost of debt should be used in the WACC calculation?
a. / 5.11%
b. / 5.37%
c. / 5.66%
d. / 5.96%
e. / 6.25%

Component cost of debt Answer: d

Coupon rate 10.25%

Periods/year 2

Maturity (yr) 15

Bond price $1,025.00

Par value $1,000

Tax rate 40%

Calculator inputs:

N = 2 ´ 15 30

PV = Bond's price -$1,025.00

PMT = coupon rate * par/2 $51.25

FV = Par = Maturity value $1,000

I/YR 4.96%

times periods/yr = before-tax cost of debt 9.93%

= After-tax cost of debt (A-T rd) for use in WACC 5.96%

12)

Chambliss Inc. hired you as a consultant to help estimate its cost of capital. You have been provided with the following data: D0 = $0.90; P0 = $27.50; and g = 8.00% (constant). Based on the DCF approach, what is the cost of equity from retained earnings?
a. / 10.41%
b. / 10.96%
c. / 11.53%
d. / 12.11%
e. / 12.72%

Component cost of retained earnings: DCF, D0 Answer: c

D0 $0.90

P0 $27.50

g 8.00%

D1 = D0 *(1 + g) $0.97 Intermediate step

rs = D1/P0 + g 11.53%

13)

You were recently hired by Nast Media Inc. to estimate its cost of capital. You were provided with the following data: D1 = $2.00; P0 = $55.00; g = 8.00% (constant); and F = 5.00%. What is the cost of equity raised by selling new common stock?
a. / 11.24%
b. / 11.83%
c. / 12.42%
d. / 13.04%
e. / 13.69%

re based on DCF, D1 Answer: b

D1 $2.00

P0 $55.00

g 8.00%

F 5.00%

re = D1/(P0 × (1 – F)) + g 11.83%

14)

Schadler Systems is expected to pay a $3.50 dividend at year end (D1 = $3.50), the dividend is expected to grow at a constant rate of 6.50% a year, and the common stock currently sells for $62.50 a share. The before-tax cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of 40% debt and 60% common equity. What is the company’s WACC if all equity is from retained earnings?
a. / 8.35%
b. / 8.70%
c. / 9.06%
d. / 9.42%
e. / 9.80%

WACC Answer: c

D1 $3.50

P0 $62.50

g 6.50%

rd 7.50%

Tax rate 40%

Weight debt 40%

Weight equity 60%

rd(1 – T) 4.50%

rs = D1/P0 + g 12.1%

WACC = wd(rd)(1 – T) + wc(rs) = 9.06%

15)

Roxie Epoxy’s balance sheet shows a total of $50 million long-term debt with a coupon rate of 8.00% and a yield to maturity of 7.00%. This debt currently has a market value of $55 million. The balance sheet also shows that that the company has 20 million shares of common stock, and the book value of the common equity (common stock plus retained earnings) is $65 million. The current stock price is $8.25 per share; stockholders' required return, rs, is 10.00%; and the firm's tax rate is 40%. Based on market value weights, and assuming the firm is currently at its target capital structure, what WACC should Roxie use to evaluate capital budgeting projects?
a. / 7.26%
b. / 7.56%
c. / 7.88%
d. / 8.21%
e. / 8.55%

WACC based on target capital structure Answer: e

Weights used in the WACC equation should be based on market values.

P0 $8.25

Shares outstanding (in millions) 20

YTM = rd 7.00%

rs 10.00% Given

Tax rate 40%

Market debt value (in millions) $55.00

Market equity (in millions) = P0×Shares $165.00 Book value weights--WRONG!!!

Total market value of debt and equity $220.00 $50.00 43.48% 7.00%

wd 25.00% $65.00 56.52% 10.00%

wc 75.00% Calculated $115.00 100.00%

WACC = wd(rd)(1 – T) + wc(rs) = 8.55% Book value WACC: 7.48%

16)

Assume that you are on the financial staff of Michelson Inc., and you have collected the following data: (1) The yield on the company’s outstanding bonds is 8.00%, and its tax rate is 40%. (2) The next expected dividend is $0.65 a share, and the dividend is expected to grow at a constant rate of 6.00% a year. (3) The price of Michelson's stock is $17.50 per share, and the flotation cost for selling new shares is F = 10%. (4) The target capital structure is 45% debt and the balance is common equity. What is Michelson's WACC, assuming it must issue new stock to finance its capital budget?
a. / 6.63%
b. / 6.98%
c. / 7.34%
d. / 7.73%
e. / 8.12%

WACC, equity from retained earnings, uses DCF Answer: d

YTM 8.00%

Tax rate 40%

D1 $0.65

g 6.00%

P0 $17.50

F 10.0%

Weight debt 45%

Weight equity 55%

A-T cost of debt 4.80%

re = D1/(P0*(1 – F)) + g 10.13%

WACC = wd(rd)(1 – T) + wc(rs) = 7.73%

Solutions

1) a

2) b

3) a

4) c

5) a

6) d

7) e

8) a

9) d

10) b

11) d

12) c

13) b

14) c

15) e

16) d