FIN 3400 Chapter 11 Assignment Questions and Answers- Florida International University
What does a firm-wide WACC represent?
Multiple choice
... [Show More] question.
A firm's overall cost of financing
A firm's overall rate of return
The current yield on a firm's outstanding debt
A firm's expected return on its investments
A firm funds its operations with $50 of common stock, $30 of preferred stock, and $40 of debt. The
component costs are: common = 12 percent; preferred = 10 percent; pretax debt = 8 percent. Illustrate
the WACC formula at a tax rate of 34 percent.
Multiple choice question.
WACC = ($50/$120)(0.12) + ($30/$120)(0.10) + ($40/$120)(0.08)(0.34)
WACC =($50/$120)(0.12) + ($30/$120)(0.10) + ($40/$120)(0.08)
WACC = ($50/$120)(0.12) + ($30/$120)(0.10) + ($40/$120)(0.08)(1 - 0.34)
WACC = [($50/$120)(0.12) + ($30/$120)(0.10) + ($40/$120)(0.08)][1 - 0.34]
The yield to maturity on a firm's bonds is 8.8 percent. What is the component cost of debt if the tax rate
is 35 percent?
Multiple choice question.
8.8 percent
11.88 percent
5.72 percent
3.08 percent
Reason:
Interest is tax deductible so the component cost is the after-tax cost of debt.
Cost of debt = 0.088 × (1 - 0.35) = 0.0572 = 5.72%
Select all that apply
Which of the following are formulas that can be used to calculate the cost of equity? Select all that apply.
Multiple select question.
iE = [(D1/P0 + g) + (Rf + β(RM - Rf))]/2
iE = D1/P0 + g
iE = [(D1/P0 + g) + (Rf + β(RM - Rf))][1 - TC]/2
iE = Rf + β(RM)
Select all that apply
Which of these are situations which indicate CAPM would be an inappropriate method for computing
the return on equity, iE, based on the firm's historical beta? Select all that apply.
Multiple select question.
A 3-year old firm just announced that it has no plans to pay any dividends for the foreseeable future as
all funds are needed for expansion
A dividend-paying firm just doubled its operations so it can bring an entirely new product to the market
A firm pays a constant dividend but is in the process of terminating operations in its most risky division
A non-dividend paying firm just increased it size to keep up with the demand for its existing products
Which one of these applies to the weighted-average cost of capital (WACC)?
Multiple choice question.
The weights are based on the cost of each component.
WACC is an after-tax cost.
The weights are based on book values.
The tax adjustment applies to every component cost.
ABC Co. was founded a year ago and pays an annual dividend of $0.20. The firm does not expect to
increase this dividend as it is still in a growth stage. Which model should be used to compute the cost of
equity and why?
Multiple choice question.
The average of the CAPM and dividend growth rates
Dividend growth model as there is insufficient company history to compute beta for use in CAPM
Since there is no dividend growth and insufficient data to compute beta, neither method can be used.
CAPM since there is no dividend growth
A firm finances its operations with $500 of common stock and $300 of debt. The cost of equity is 13
percent and the after-tax cost of debt is 5 percent. Illustrate the WACC formula at a tax rate of 15
percent.
Multiple choice question.
WACC = ($500/$800)(0.13) + ($300/$800)(0.05)(1 - 0.15)
WACC = [($500/$800)(0.13) + ($300/$800)(0.05)][1 - 0.15}
WACC = ($500/$800)(0.13) + ($300/$800)(0.05)
WACC cannot be computed as there is no information regarding preferred stock.
Why must the cost of debt be adjusted for taxes?
Multiple choice question.
The cost of debt should not be adjusted for taxes.
Because interest on debt is tax deductible which lowers the firm's total cost of debt financing
All sources of external financing, including the cost of debt, are adjusted for taxes
Because interest payments on bonds are paid with after-tax profits
What are the three sources of external capital for a firm?
Multiple choice question.
Common stock, preferred stock, bonds
Preferred stock, bonds, retained earnings
Paid in surplus, bonds, common stock
Retained earnings, common stock, preferred stock
A 5 percent, $1,000 bond matures in 6 years and sells for $1,023. How is the pretax cost of debt, iD,
computed?
Multiple choice question.
N = 12, PV = -1,023, PMT = 25, FV = 1,000, CPT I; Since I will be the semiannual rate, it will need
multiplied by 2.
N = 6, PV = 1,023, PMT = 50, FV - 1,000, CPT I
N = 6, PV = -1,023, PMT = 50, FV = 1,000, CPT I
N = 12, PV = -1,023, PMT = 50, FV = 1,000, CPT I; Since I will be the semiannual rate, it will need
multiplied by 2.
How is the cost of equity, iE, computed if the information is available for both the CAPM and the
dividend growth models?
Multiple choice question.
Use the CAPM value
Use the average of the two costs
Use the higher of the two costs
Use the lower of the two costs
A firm has a capital structure of 40% common stock, 10% preferred stock, and 50% debt. A new project is
being internally funded. What weight should be used for equity in the project WACC?
Multiple choice question.
$30,000/$40,000, of 75%
$30,000/($30,000 + $40,000), or 43%
50%
40%
Select all that apply
Which of these are situations where CAPM would be an inappropriate method of computing the cost of
equity based on a firm's historical beta? Select all that apply.
Multiple select question.
A firm does not pay dividends.
There are insufficient historical observations of beta.
A firm varies its dividends based on current earnings
The risk level of the firm is changing.
A firm has 75,000 shares of common stock outstanding at a price of $42 a share, 10,000 shares of
preferred stock at $50 a share, and 3,000 bonds with a price quote of 101.2. How is the weight of
preferred stock computed for the firm's WACC?
Multiple choice question.
(10,000 × $50)/[(75,000 × $42) + (10,000 × $50) + (3,000 × $1,000 × 101.2)
(10,000 × $50)/[(75,000 × $42) + (10,000 × $50) + (3,000 × $100 × 1.012)
(10,000 × $50)/[(75,000 × $42) + (10,000 × $50) + (3,000 × $1,000 × 101.2%)
(10,000 × $50)/[(75,000 × $42) + (3,000 × $1,000 × 101.2%)
The cost of equity, iE, for a stock is computed accurately using the constant dividend growth model when
their dividends are increasing irregularly.
True false question.
True
False
Select all that apply
Which of these questions need to be answered when determining a project's WACC? Select all that
apply.
Multiple select question.
What is the expected life of the project?
How much will the project cost both to implement and to manage?
How does the risk level of the project compare to the overall risk level of the firm?
Which inputs should be project-specific and which should be firmwide values?
Which of these values represents the pretax cost of debt?
Multiple choice question.
Dividend yield
Yield to maturity
Current yield
Coupon rate
Which of these inputs should be project-specific when computing a project WACC?
Multiple choice question.
Cost of equity
Cost of equity, preferred, and debt
Cost of debt
Cost of preferred
A bond has a coupon rate of 6 percent, a current yield of 6.5 percent, and a yield to maturity of 6.8
percent. How is the after-tax cost of debt computed if the tax rate is 34 percent?
Multiple choice question.
0.068 × (1 - 0.34)
0.06 × (1 - 0.34)
0.068 × 0.34
0.065 × (1 - 0.34)
Cornett Foods has a firm beta of 0.86 and a cost of equity of 11%. The risk-free rate is 4%. A project has a
proxy beta of 1.22. How is the project's cost of equity computed?
Multiple choice question.
Project iE = 0.04 + (1.22 x 0.11)
0.11 = 0.04 + 0.86MRP
Project iE = 0.04 + 1.22MRP
Project iE = 0.04 + (1.22 - 0.86)×(0.11)
A firm has a capital structure of 40 percent common stock, 10 percent preferred stock, and 50 percent
debt. A new project is being funded with $40,000 of debt and $30,000 of common stock. What weight
should be used for equity in the project WACC?
Multiple choice question.
$30,000/($30,000 + $40,000), or 43 percent
40 percent
$30,000/$40,000, of 75 percent
50 percent
A firm currently has taxable income of $87,000. A new project will increase that income by $18,000.
What tax rate should be used in the project's WACC? The tax rate for income between $75,001 and
$100,000 is 34 percent while it is 39 percent for income between $100,001 and $335,000.
Multiple choice question.
36.50 percent
36.21 percent
35.95 percent
35.39 percent
Reason:
TC = ($13,000/$18,000) × 0.34 + ($5,000/$18,000) × 0.39 = 0.3539 =
35.39%
Dexter's has 7,500 shares of common stock selling at $54 a share, 1,200 shares of preferred at $84 a
share, and 3,000 bonds priced at $989 each. How is the weight of debt computed?
Multiple choice question.
$989/($54 + $84 + $989)
(3,000 × $989)/[(7,500 × $54) + (1,200 × $84)]
(3,000 × $989)/[(7,500 × $54) + (1,200 × $84) + (3,000 × $989)]
(3,000 × $1,000 × $989)/[(7,500 × $54) + (1,200 × $84) + (3,000 × $1,000 × $989)]
Select all that apply
Which of these statements apply to business risk? Select all that apply.
Multiple select question.
Business risk is the risk of a project arising from the line of business the project is in.
A change in the level of business risk can affect stockholders' required rate of return.
Business risk refers to the capital structure of a firm.
Business risk is related to a firm's mix of new and existing product lines.
What condition must a new project meet if the project is to qualify to use the firm's WACC as the
project's WACC?
Multiple choice question.
The new project must be very similar to the firm's existing projects.
There must be no relationship between the new project and the firm's existing projects.
The new project must be less risky than the firm's existing projects.
The new project must be riskier than the firm's existing projects.
Financial risk refers to which one of these?
Multiple choice question.
Risks arising from a project's line of business
Capital structure decisions
Risk associated with a project's operations
Variability of a firm's cash flows
Assume a firm takes on a new project that is much riskier than the firm's existing projects. Which party
disproportionately bears this new risk?
Multiple choice question.
Preferred stockholders
Bondholders
Parties who financed the new project
Common stockholders
What is the pure-play approach?
Multiple choice question.
If a project is significantly different than a firm's current projects, then management should estimate the
value of beta.
Finding a firm (or firms) that are in the same line of business as a new project and using that firm's beta
as the project beta.
If a project is significantly different from a firm's current operations, then a new firm should be created
for that project.
Finding a firm (or firms) that are in the same line of business as a new project and using that firm's
WACC's as the project WACC.
A new project varies from Wood's operations but is similar to Creekside's operations. Creekside has a
beta of 1.08 while Wood's is 1.36. The market return is 11 percent and the risk-free rate is 4 percent.
How is the cost of equity for Wood's new project computed?
Multiple choice question.
iE = 0.04 + 1.36(0.11 - 0.04)
iE = 0.40 + 1.36(0.11)
iE = 0.04 + 1.08(0.11)
iE = 0.04 + 1.08(0.11 - 0.04)
Deno's has a beta of 0.87 while Leta's has a beta of 1.38. Both firms are considering a new project which
is similar to Deno's current operations. The market rate of return is 11 percent and the risk-free rate is 4
percent. What is the cost of equity for Deno's new project? For Leta's?
Multiple choice question.
13.66 percent; 13.66 percent
11.88 percent; 11.88 percent
10.09 percent; 13.66 percent
10.09 percent; 10.09 percent
Lester's Markets has taxable income of $138,000 which will increase by $109,000 if a new project comes
on line. What tax rate should be used in the WACC for the new project? The tax rate for taxable income
between $75,001 and $100,000 is 34 percent while it is 39 percent for incomes between $100,001 and
$335,000.
Multiple choice question.
37.38 percent
39 percent
34 percent
34.41 percent
True or false: The marginal tax rate of a firm should be used as the value of TC when computing WACC.
True false question.
True
False
How can business risk be defined?
Multiple choice question.
Risk arising from the use of debt
Risk related to financial leverage
Risk related to changes in a firm's capital structure
Variability of a firm's cash flows
A firm has EBIT of $110,000 and interest of $22,000. The tax rate on taxable income between $75,001
and $100,000 is 34 percent while it is 39 percent on income between $100,001 and $335,000. What
value should be assigned to TC in the WACC formula?
Multiple choice question.
TC = Higher marginal rate = 0.39, or 39 percent
TC = ($12,000/$22,000) × 0.34 + ($10,000/$22,000) × 0.39
TC = Lower marginal rate = 0.34, or 34 percent
TC = ($12,000/$22,000) × 0.39 + ($10,000/$22,000) × 0.34
How is financial risk defined?
Multiple choice question.
The risk of a project to equity holders stemming from the use of debt
The risk to equity holders if a company executive should steal all of the firm's cash
The risk of a project related to the project's line of business
The risk that a project's beta is incorrectly estimated
Select all that apply
Which of these statements related to a project's WACC formula is correct? Select all that apply.
Multiple select question.
The project's pretax cost of debt is equal to the firm's pretax cost of debt.
The pretax cost of debt is a weighted average of the yields to maturity on all the firm's outstanding
bonds.
The weight of equity is the percentage of equity found in the firm's capital structure.
The cost of preferred is equal to the annual dividend divided by the stock price.
What value is being sought from other firms when the pure-play approach is used for a new project?
Multiple choice question.
Cost of debt
Standard deviation
Beta
WACC
Which variable most needs adjusting when revising a firmwide WACC into a divisional WACC?
Multiple choice question.
Tax rate, TC
Cost of equity, iE
Weights
Cost of debt, iD
A firm has an overall beta of 1.12 and a proxy project beta of 1.49. The risk-free rate is 3 percent and the
firm's cost of equity is 11.96 percent. What is the project's cost of equity?
Multiple choice question.
14.92 percent
11.96 percent
15.36 percent
12.38 percent
Select all that apply
Which of these are pros of using divisional WACCs as compared to applying the firmwide WACC to all
projects? Select all that apply.
Multiple select question.
Divisional WACCS eliminate incorrect accept/reject decisions.
Divisional WACCs adjust for the average risks of the projects in each division.
Divisional WACCs are easier to compute.
Divisional WACCs increase the accuracy of accept/reject decisions.
Which of these explains the tax rate, TC as it applies to the WACC formula?
Multiple choice question.
The tax rate is computed as the tax savings from the interest expense divided by the total taxable
income.
The tax rate is the weighted average of the marginal tax rates that would have been paid on the taxable
income shielded by the interest deduction.
The tax rate is the rate that would apply if a firm earned one additional dollar of taxable income.
The tax rate is the rate computed by dividing the total tax amount by the total taxable income.
Applying the firmwide WACC to all projects results in accepting HIGH -risk projects and rejecting LOW
-risk projects. This will INCREASE the firmwide risk over time.
Lester's has an EBIT of $52,000 and interest of $5,000. The tax rate on taxable income between $0 and
$50,000 is 15 percent while it is 25 percent on taxable income of $50,001 to $75,000. What value should
be assigned to TC in the WACC formula?
Multiple choice question.
0.19, or 19 percent
0.20, or 20 percent
0.25, or 25 percent
0.21, or 21 percent
The adjustments used in the subjective approach are generally based on which of these?
Multiple choice question.
Market reactions to new information
Management's opinion of both a division's level of risk and the risk-reward premium
Divisional geographic locations
Changes in either the market risk premium or the risk-free rate
Which of these variables should be project specific when computing a project's WACC?
Multiple choice question.
Weights, cost of equity, and pretax cost of debt
All variables should be project specific.
Pretax cost of debt, cost of equity, and cost of preferred
Weights, tax rate, and cost of equity
What is the primary advantage of the subjective approach to divisional WACCs?
Multiple choice question.
A firm in a similar line of business as each division is found so divisional proxy betas can be determined
Betas are computed for each division increasing the accuracy of WACC
Ease of implementation with some acknowledgment of risk variations
Incorrect accept/reject decisions are eliminated
When computing a divisional WACC, a proxy value is needed for which one of these?
Multiple choice question.
Market rate of return
Tax rate
Annual dividends
Equity risk
Cal Markets has a firmwide WACC of 12.3 percent. Division A has a beta of 1.42 and has high risk. The
risk-free rate is 3 percent and the market rate of return is 10 percent. Management assigns an
adjustment factor of +2 to high-risk projects. What is the divisional cost of equity using the objective
approach?
Multiple choice question.
12.94 percent
13.68 percent
14.30 percent
17.20 percent
Reason:
iE Division = 0.03 + 1.42(0.10 - 0.03) = 0.1294 = 12.94%
Applying a firmwide WACC to projects of varying levels of risk implies which assumption?
Multiple choice question.
All projects have similar risks once they are implemented.
Firms prefer to accept only low-risk projects.
The rate of return is unaffected by the level of risk.
The risk level of the firm will decrease over time using this method.
What is the primary disadvantage of the objective approach to divisional WACCs?
Multiple choice question.
Difficulties in allocating tax rates at the divisional level
Difficulty of computing average betas for each division based on the division's projects
Difficulties encountered in determining divisional costs of debt
Increased number of incorrect accept/reject decisions as compared to applying the firmwide WACC
Identify the results of using the firmwide WACC to evaluate all projects for decision-making?
Multiple choice question.
Incorrect acceptance of projects
Incorrect rejection of projects
Firmwide investment decisions will be most accurate
Firmwide risk may vary but maximum profit will be earned
Select all that apply
Which of these activities will involve flotation costs? Select all that apply.
Multiple select question.
Funding a project with retained earnings
Issuing new shares of stock to fund a firm's expansion
Issuing bonds to finance a new project
Redeeming bonds prior to maturity
What is the subjective approach to divisional WACCs?
Multiple choice question.
Accepting all projects with high expected rates of return and rejecting all projects with low expected
rates of return
The computation of divisional WACCs based on the average betas of each division
The assignment of an adjustment factor to the firmwide WACC for each division
Accepting all projects from low-risk divisions while rejecting all projects from high-risk divisions
How can a project's costs be adjusted to include flotation costs? Assume the flotation costs are $890,000
and the project's life is 10 years.
Multiple choice question.
Decrease annual costs by $89,000
Increase annual costs by $89,000
Decrease the initial investment by $890,000
Increase the initial investment $890,000
What is the key disadvantage of the subjective approach to divisional WACCs?
Multiple choice question.
More incorrect accept/reject decisions occur than when the firmwide WACC is applied
Reliance on a person, or persons, opinion and not on quantifiable information
The costs of preparing the WACCs tend to be higher than the benefits
Time required to gather necessary data
Louis Enterprises stock is selling for $48 a share. Flotation cost on new equity issues is 15 percent. How is
the value of F computed for use in the flotation-adjusted cost of equity formula?
Multiple choice question.
F = $48/(1 + 0.15)
F = (1 - 0.15) × $48
F = 0.15 × $48
F = 1.15 × $48
What is the basic procedure used in the objective approach to divisional WACCs?
Multiple choice question.
Compute average divisional betas, divisional costs of equity, and WACCs
Apply the firmwide beta to all divisions and projects
Compute an adjustment to the firmwide WACC for each division
Find firms in the same line of business as each division and use their betas as divisional proxy betas
What is the flotation-adjusted cost of equity formula?
Multiple choice question.
iE = (D1/P0 + g) × (1 + F)
iE = D1/(P0 - F) + g
iE = (D1 + F)/P0 + g
iE = D1/P0 + g + F
Which one of these represents a key advantage of the objective approach to divisional WACCs?
Multiple choice question.
Automatically-adjusted WACC as divisional projects change
Easier to implement than other methods
Use of standard deviation, rather then beta, which is a better measure of risk
More accurate measure of a division's required return than other methods
What are flotation costs?
Multiple choice question.
Costs associated with computing divisional betas
Fees paid to investment banks for issuing new securities
Interest paid on new debt securities
Costs incurred when new projects are funded with retained earnings
Which one of these is an acceptable method of handling flotation costs when evaluating a project?
Multiple choice question.
Ignoring the costs as they are financing costs
Decreasing the project's WACC
Increasing the project's WACC
Increasing the tax rate by an offsetting amount
How are flotation costs incorporated into the constant-growth formula for computing the cost of equity?
Multiple choice question.
They are subtracted from the stock price.
They are subtracted from the dividend amount.
They are added to the unadjusted cost of equity, iE.
They are added to the growth rate.
ABC Co. expects to pay an annual dividend of $1.36 next year with annual increases of 2 percent
thereafter. The current stock price is $38 a share. Flotation costs on new equity shares is 12 percent.
How is the flotation-adjusted cost of equity computed?
Multiple choice question.
iE = $1.36/[$38 × (1 - 0.12)] + 0.02
iE = [$1.36/$38 + 0.02] × (1 + 0.12)
iE = [$1.36 + (0.12 × $38)]/$38 + 0.02
iE = $1.36/$38 + 0.02 + (0.12 × $38) [Show Less]