Exam 500304 Cost of Capital

1. What’s the abbreviation for the overall return that a firm must make on its existing assets, used as the required rate of return on any investment that has essentially the same risks as existing operations?
2. Analysts project Microsoft (MSFT) will have an annualized dividend of $1.50 and a long-term growth rate of 10 percent. Currently, the stock price is $60. Using the dividend growth model approach, what’s the implied cost of equity?
A. 12.5 percent
B. 11 percent
C. 10 percent
D. 2.5 percent
3. New Schools expects an EBIT of $87,000 every year, forever. The firm currently has no debt, and its cost of equity is 14.6 percent. The firm can borrow at 7.4 percent, and the corporate tax rate is 34 percent. What will the value of the firm be if it converts to 50 percent debt?
A. $460,146.57
B. $381,796.47
C. $377,407.16
D. $437,552.08
4. Galaxy Products is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 175,000 shares of stock outstanding. Under Plan II, there would be 90,000 shares of stock outstanding and $1.4 million in debt. The interest rate on the debt is 7 percent, and there are no taxes. What’s the break-even EBIT?
A. $201,764.71
B. $341,414.14
C. $351,111.11
D. $287,878.78
5. What’s the concept of using debt to make a return known as?
A. Debt reliance
B. Financial liquidity
C. Debt coverage
D. Financial leverage
6. Because the WACC varies with the use of funds rather than the source of funds, some firms evaluate new projects by sorting projects into risk classes, and add or subtract adjustment factors from the WACC. This approach is called the
A. DuPont approach.
B. divisional approach.
C. pure play approach.
D. subjective approach.
7. According to the static tradeoff theory, what’s the optimal capital structure?
A. A firm should borrow up to the point at which the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress.
B. A firm should borrow up to the point at which the tax benefit from an extra dollar is equal to zero.
C. A firm should have equal parts equity and debt.
D. A firm should borrow up to the point at which the interest is equal to the total tax expense.
8. Which of the following is not a major disadvantage to the SML approach?
A. We rely on the past to predict the future, and economic conditions can change quickly.
B. It requires that we estimate the market risk premium, and if this estimate is poor, the resulting cost of equity will also be poor.
C. It requires that we estimate the beta coefficient of the stock, and if this estimate is poor, the resulting cost of equity will also be poor.
D. It doesn’t explicitly adjust for risk
9. Silo Mills is an all-equity financed firm that has a beta of 1.14 and a cost of equity of 12.8 percent. The risk-free rate of return is 2.8 percent. The firm is currently considering a project that has a beta of 1.03 and a project life of six years. What discount rate should be assigned to this project?
A. 13.62 percent
B. 11.84 percent
C. 13.33 percent
D. 12.09 percent
10. Which of the following is true about a firm with no equity financing?
A. The after-tax cost of debt = WACC
B. The return on equity = WACC
C. The cost of debt = WACC
D. The return on equity = cost of debt
11. A higher debt level usually equates to a
A. larger tax shield and decreased financial risk.
B. smaller tax shield and increased financial risk.
C. larger tax shield but increased financial risk.
D. smaller tax shield and decreased financial risk.
12. Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, how long after a firm files for bankruptcy protection do creditors have to wait before submitting their own reorganization plan to the court?
A. 18 months
B. 45 days
C. 180 days
D. 12 months
13. Alphabet, Inc. (GOOGL) has a 40 percent debt/asset ratio; assume a tax rate of 16 percent. The average yield to maturity on GOOGL’s bonds is 3 percent. Your market analyst estimates that the risk-free rate is 1 percent and that the market risk premium is 7 percent. The firm’s beta coefficient is 0.97. What’s Alphabet’s weighted average cost of capital (WACC)? (Round to the nearest tenth of a percent.)
A. 6 percent
B. 5.7 percent
C. 5.9 percent
D. 7.3 percent
14. The Shoe Outlet has paid annual dividends of $.65, $.70, $.72, and $.75 per share throughout the last four years, respectively. The stock is currently selling for $9 a share. What’s this firm’s cost of equity?
A. 11.79 percent
B. 9.53 percent
C. 13.65 percent
D. 8.74 percent
15. Deep Mines has 14 million shares of common stock outstanding with a beta of 1.15 and a market price of $42 a share. There are 900,000 shares of 9 percent preferred stock outstanding, valued at $80 a share. The 10 percent semiannual bonds have a face value of $1,000 and are selling at 91 percent of par. There are 220,000 bonds outstanding that mature in 17 years. The market risk premium is 11½ percent, T-bills are yielding 7½ percent, and the firm’s tax rate is 32 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. 14.72 percent
B. 13.15 percent
C. 15.54 percent
D. 14.59 percent
16. Hanover Tech is currently an all-equity firm that has 320,000 shares of stock outstanding with a market price of $19 a share. The current cost of equity is 15.4 percent, and the tax rate is 34 percent. The firm is considering adding $1.2 million of debt with a coupon rate of 8 percent to its capital structure. The debt will be sold at par value. What’s the levered value of the equity?
A. $5.209 million
B. $6.708 million
C. $6.512 million
D. $5.288 million
17. Mulberry, Inc. has a weighted average cost of capital (ignoring taxes) of 20 percent. It can borrow at 10 percent. Mulberry has a target ½ debt/equity ratio. Using the M&M Proposition II, what’s the cost of equity?
A. 29 percent
B. 25 percent
C. 31 percent
D. 15 percent
18. Flotation costs are the costs associated with
A. market inefficiencies.
B. reporting.
C. bankruptcy.
D. new stock or bond issues.
19. The dividend growth model is used to calculate
A. the cost of debt by using the equation for a growing perpetuity, plugging in the current price of the bond, the coupon, and the expected growth rate and solving for R(D).
B. the weighted average cost of capital by using the equation for a growing perpetuity, plugging in the current price of the stock, the dividend paid, and the expected growth rate. Then we solve for R(E).
C. the cost of equity by comparing the dividend growth to similar firms.
D. the cost of equity by using the equation for a growing perpetuity, plugging in the current price of the stock, the dividend paid, and the expected growth rate. Then we solve for R(E).
20. Amazon Inc. (AMZN) has 55 percent equity-to-asset ratio. The average yield to maturity on AMZN’s bonds is 3.2 percent; assume a tax rate of 30 percent. The firm’s estimated required rate of return on equity is estimated at about 10.8 percent. What’s Amazon’s weighted average cost of capital (WACC)? (Round to the nearest tenth of a percent.)
A. 6.1 percent
B. 7.3 percent
C. 6.6 percent
D. 6.9 percent

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