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Exam 14: Cost of Capital

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Question 41

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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) $280,409
B) $281,406
C) $288,005
D) $297,747
E) $302,762

F) A) and E)
G) B) and E)

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Question 42

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Tidewater Fishing has a current beta of 1.21.The market risk premium is 8.9 percent and the risk-free rate of return is 3.2 percent.By how much will the cost of equity increase if the company expands its operations such that the company beta rises to 1.50?

A) 1.88 percent
B) 2.58 percent
C) 2.60 percent
D) 3.10 percent
E) 3.26 percent

F) All of the above
G) A) and C)

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Question 43

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Markley and Stearns is a multi-divisional firm that uses its WACC as the discount rate for all proposed projects.Each division is in a separate line of business and each presents risks unique to those lines.Given this,a division within the firm will tend to:

Silo Mills has a beta of 0.95 and a cost of equity of 11.9 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 6 years.What discount rate should be assigned to this project?

-Decker's is a chain of furniture retail stores.Furniture Fashions is a furniture maker and a supplier to Decker's.Decker's has a beta of 1.38 as compared to Furniture Fashion's beta of 1.12.The risk-free rate of return is 3.5 percent and the market risk premium is 8 percent.What discount rate should Decker's use if it considers a project that involves the manufacturing of furniture?

Phil's is a sit-down restaurant that specializes in home-cooked meals.Theresa's is a walk-in deli that specializes in specialty soups and sandwiches.Both firms are currently considering expanding their operations during the summer months by offering pre-wrapped donuts,sandwiches,and wraps at a local beach.Phil's currently has a WACC of 14 percent while Theresa's WACC is 10 percent.The expansion project has a projected net present value of $12,600 at a 10 percent discount rate and a net present value of -$2,080 at a 14 percent discount rate.Which firm or firms should expand and offer food at the local beach during the summer months?

Give an example of a situation where a firm should adopt the pure play approach for determining the cost of capital for a project.

The Daily Brew has a debt-equity ratio of 0.64.The firm is analyzing a new project which requires an initial cash outlay of $420,000 for equipment.The flotation cost is 9.6 percent for equity and 5.4 percent for debt.What is the initial cost of the project including the flotation costs?

The common stock of Metal Molds has a negative growth rate of 1.5 percent and a required return of 18 percent.The current stock price is $11.40.What was the amount of the last dividend paid?

National Home Rentals has a beta of 1.24,a stock price of $22,and recently paid an annual dividend of $0.94 a share.The dividend growth rate is 4.5 percent.The market has a 10.6 percent rate of return and a risk premium of 7.5 percent.What is the firm's cost of equity?

The cost of preferred stock:

The aftertax cost of debt:

-Phillips Equipment has 80,000 bonds outstanding that are selling at par.Bonds with similar characteristics are yielding 7.5 percent.The company also has 750,000 shares of 7 percent preferred stock and 2.5 million shares of common stock outstanding.The preferred stock sells for $65 a share.The common stock has a beta of 1.34 and sells for $42 a share.The U.S.Treasury bill is yielding 2.8 percent and the return on the market is 11.2 percent.The corporate tax rate is 38 percent.What is the firm's weighted average cost of capital?

If a firm uses its WACC as the discount rate for all of the projects it undertakes then the firm will tend to: I.reject some positive net present value projects. II.accept some negative net present value projects. III.favor high risk projects over low risk projects. IV.increase its overall level of risk over time.

-The Corner Bakery has a bond issue outstanding that matures in 7 years.The bonds pay interest semi-annually.Currently,the bonds are quoted at 101.4 percent of face value and carry a 9 percent coupon.What is the firm's aftertax cost of debt if the tax rate is 30 percent?

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?

When a firm has flotation costs equal to 7 percent of the funding need,project analysts should:

Incorporating flotation costs into the analysis of a project will:

Which one of the following statements is correct?

-Suppose your company needs $14 million to build a new assembly line.Your target debt-equity ratio is 0.84.The flotation cost for new equity is 9.5 percent,but the floatation cost for debt is only 2.5 percent.What is the true cost of building the new assembly line after taking flotation costs into account?