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Exam 12: Cost of Capital

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Question 1

Multiple Choice

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The aftertax cost of which of the following are affected by a change in a firm's tax rate? I. preferred stock II) debt III) equity IV) capital

A) I and III only
B) II and IV only
C) I, II, and IV only
D) II, III, and IV only
E) I, II, III, and IV

F) B) and D)
G) B) and E)

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Question 2

Multiple Choice

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In an efficient market, the cost of equity for a risky firm does which one of the following according to the security market line?

A) Produces a return that will be less than the market rate but higher than the risk-free rate
B) Equals the market rate of return for all stocks
C) Has a maximum cost equal to the market rate of return
D) Decreases as the beta of the firm's stock increases
E) Increases in direct relation to the stock's systematic risk

F) A) and B)
G) B) and D)

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E

Question 3

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Assume the federal government decides to permanently eliminate corporate income taxes as a means of encouraging economic development and job growth. What effect, if any, would this change have on the evaluation of a proposed project?

The Color Box uses a combination of common stock, preferred stock, and debt financing. The company wants preferred stock to represent 8 percent of the total financing. It also wants to structure the firm in a manner that will produce a weighted average cost of capital of 10.25 percent. The aftertax cost of debt is 5.1 percent, the cost of preferred is 9.3 percent, and the cost of common stock is 15.6 percent. What percentage of the firm's capital funding should be debt financing?

Alpha Industries is considering a project with an initial cost of $7.4 million. The project will produce cash inflows of $1.54 million a year for 7 years. The firm uses the subjective approach to assign discount rates to projects. For this project, the subjective adjustment is +1.5 percent. The firm has a pre-tax cost of debt of 8.6 percent and a cost of equity of 13.7 percent. The debt-equity ratio is .0.65 and the tax rate is 35 percent. What is the net present value of the project?

Southwest Tours currently has a weighted average cost of capital of 11.3 percent based on a combination of debt and equity financing. The firm has no preferred stock. The current debt-equity ratio is 0.58 and the aftertax cost of debt is 6.4 percent. The company just hired a new president who is considering eliminating all debt financing. All else constant, what will the firm's cost of capital be if the firm switches to an all-equity firm?

Which one of the following represents the rate of return a firm must earn on its assets if it is to maintain the current value of its securities?

The Green Balloon just paid its first annual dividend of $0.12 a share. The firm plans to increase the dividend by 3.5 percent per year indefinitely. What is the firm's cost of equity if the current stock price is $6.50 a share?

Old Town Industries has three divisions. Division X has been in existence the longest and has the most stable sales. Division Y has been in existence for five years and is slightly less risky than the overall firm. Division Z is the research and development side of the business. When allocating funds, the firm should probably:

Which one of the following is most apt to cause a wise manager to increase a project's cost of capital? Assume the firm is levered.

A firm uses its weighted average cost of capital to evaluate the proposed projects for all of its varying divisions. By doing so, the firm:

Ted is trying to decide what cost of capital he should assign to a project. Which one of the following should be his primary consideration in this decision?

All else constant, the weighted average cost of capital for a risky, levered firm will decrease if:

A firm that uses its weighted average cost of capital as the required return for all of its investments will:

Fancee Restaurant's cost of equity is 15.3 percent and its aftertax cost of debt is 6.1 percent. What is the firm's weighted average cost of capital if its debt-equity ratio is 0.58 and the tax rate is 30 percent?

Beverly's is a retail chain selling the latest fashions through its outlets located in various neighborhood malls. Clothing Galore is a wholesaler that buys from textile mills and sells to retail outlets. Beverly's has a cost of capital of 13.6 percent, while Clothing Galore's cost of capital is 17.8 percent. Both firms are considering opening a retail outlet in a gigantic new mall. Both proposals are quite similar in design and have basically the following financial features: an initial cash outlay of $2.7 million, a projected 5-year life with no salvage value, and cash inflows of $845,000 a year for the life of the project. Which firm or firms, if either, should open a retail outlet in the new mall?

Which of the following will increase the cost of equity for a firm with a beta of 1.1? I. decrease in the security's beta II) decrease in the market risk premium III) decrease in the risk-free rate IV) increase in the risk-free rate

Which one of the following statements is correct related to the dividend growth model approach to computing the cost of equity?

Which one of the following will increase the cost of equity, all else held constant?

Judy's Boutique just paid an annual dividend of $1.65 on its common stock. The firm increases its dividend by 2.5 percent annually. What is the rate of return on this stock if the current stock price is $38.20 a share?