ch12
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ch12

Course Number: UNKNOWN unknown, Spring 2012

College/University: Fordham

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ch12 Student: ___________________________________________________________________________ 1. Katie owns 100 shares of ABC stock. Which one of the following terms is used to refer to the return that Katie and the other shareholders require on their investment in ABC? A. Weighted average cost of capital B. Pure play cost C. Cost of equity D. Subjective cost E. Cost of debt 2. Lester lent money to The Corner...

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___________________________________________________________________________ 1. Katie ch12 Student: owns 100 shares of ABC stock. Which one of the following terms is used to refer to the return that Katie and the other shareholders require on their investment in ABC? A. Weighted average cost of capital B. Pure play cost C. Cost of equity D. Subjective cost E. Cost of debt 2. Lester lent money to The Corner Store by purchasing bonds issued by the store. The rate of return that he and the other lenders require is referred to as the: A. pure play cost. B. cost of debt. C. weighted average cost of capital. D. subjective cost. E. cost of equity. 3. The weighted average cost of capital is defined as the weighted average of a firm's: A. return on its investments. B. cost of equity and its aftertax cost of debt. C. pretax cost of debt and equity securities. D. bond coupon rates. E. dividend and capital gains yields. 4. Farmer's Supply, Inc. is considering opening a clothing store, which would be a new line of business for the firm. Management has decided to use the cost of capital of a similar clothing store as the discount rate that should be used to evaluate this proposed expansion. Which one of the following terms is used to describe the approach Farmer's Supply is taking to establish an appropriate discount rate for the project? A. Equity approach B. Aftertax approach C. Subjective approach D. Market play E. Pure play approach 5. Kate is the CFO of a major firm and has the job of assigning discount rates to each project that is under consideration. Kate's method of doing this is to assign an incrementally higher rate as the risk level of the project increases over that of the current firm. Likewise, she assigns lower rates as the risk level declines. Which one of the following approaches is Kate using to assign the discount rates? A. Pure play approach B. Divisional rating C. Subjective approach D. Straight WACC approach E. Equity rating 6. 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? A. Amount of debt used to finance the project B. Use, or lack thereof, of preferred stock to finance the project C. Mix of funds used to finance the project D. Risk level of the project E. Length of the project's life 7. Black Stone Furnaces wants to build a new facility. The cost of capital for this investment is primarily dependent upon which one of the following? A. Firm's overall source of funds B. Source of the funds used to build the facility C. Current tax rate D. The nature of the investment E. Firm's historical average rate of return 8. Which one of the following statements is correct related to the dividend growth model approach to computing the cost of equity? A. The rate of growth must exceed the required rate of return. B. The rate of return must be adjusted for taxes. C. The annual dividend used in the computation must be for year one if you are using today's stock price to compute the return. D. The cost of equity is equal to the return on the stock plus the risk-free rate. E. The cost of equity is equal to the return on the stock multiplied by the stock's beta. 9. A firm has a return on equity of 12.4 percent according to the dividend growth model and a return of 18.7 percent according to the capital asset pricing model. The market rate of return is 13.5 percent. What rate should the firm use as the cost of equity when computing the firm's WACC? A. 12.4 percent because it is lower than 18.7 percent B. 18.7 percent because it is higher than 12.4 percent C. The arithmetic average of 12.4 percent and 18.7 percent D. The arithmetic average of 12.4 percent, 13.5 percent, and 18.7 percent E. 13.5 percent 10. Which of the following features are advantages of the dividend growth model? I. easy to understand II. model simplicity III. constant dividend growth rate IV. model's applicability to all common stocks A. II only B. I and III only C. II and IV only D. I and II only E. I, II, and III only 11. Which of the following are weaknesses of the dividend growth model? I. market risk premium fluctuations II. lack of dividends for some firms III. reliance on historical beta IV. sensitivity of model to dividend growth rate A. II only B. I and II only C. I and III only D. II and IV only E. I, II, III, and IV 12. 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 13. 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 A. II only B. III only C. I and II only D. II and III only E. I and IV only 14. Which one of the following will increase the cost of equity, all else held constant? A. Increase in the dividend growth rate B. Decrease in beta C. Decrease in future dividends D. Increase in stock price E. Decrease in market risk premium 15. All else constant, which of the following will increase the aftertax cost of debt for a firm? I. increase in the yield to maturity of the firm's outstanding debt II. decrease in the yield to maturity of the firm's outstanding debt III. increase in the firm's tax rate IV. decrease in the firm's tax rate A. I only B. I and III only C. I and IV only D. II and III only E. II and IV only 16. Which one of the following is the pre-tax cost of debt? A. Average coupon rate on the firm's outstanding bonds B. Coupon rate on the firm's latest bond issue C. Weighted average yield-to-maturity on the firm's outstanding debt D. Average current yield on the firm's outstanding debt E. Annual interest divided by the market price per bond for the latest bond issue 17. Which one of the following will decrease the aftertax cost of debt for a firm? A. Decrease in the firm's beta B. Increase in tax rates C. Increase in the risk-free rate of return D. Decrease in the market price of the debt E. Decrease in a bond's yield-to-maturity 18. All else constant, an increase in a firm's cost of debt: A. could be caused by an increase in the firm's tax rate. B. will result in an increase in the firm's cost of capital. C. will lower the firm's weighted average cost of capital. D. will lower the firm's cost of equity. E. will increase the firm's capital structure weight of debt. 19. The cost of preferred stock: A. increases when a firm's tax rate decreases. B. is constant over time. C. is unaffected by changes in the market price. D. is equal to the stock's dividend yield. E. increases as the price of the stock increases. 20. Which one of the following statements is correct? A. An increase in the market value of preferred stock will increase a firm's weighted average cost of capital. B. The cost of preferred stock is unaffected by the issuer's tax rate. C. Preferred stock is generally the cheapest source of capital for a firm. D. The cost of preferred stock remains constant from year to year. E. Preferred stock is valued using the capital asset pricing model. 21. Which one of the following will affect the capital structure weights used to compute a firm's weighted average cost of capital? A. Decrease in the book value of a firm's equity B. Decrease in a firm's tax rate C. Increase in the market value of the firm's common stock D. Increase in the market risk premium E. Increase in the firm's beta 22. 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 23. Which one of the following statements is correct concerning capital structure weights? A. Target rates are less relevant to a project than are historical rates. B. The weights are unaffected when a bond issue matures. C. An increase in the debt-equity ratio will increase the weight of the common stock. D. The repurchase of preferred stock will increase the weight of debt. E. The issuance of additional shares of common stock will increase the weight of the preferred stock. 24. Which one of the following statements is correct? Assume the pre-tax cost of debt is less than the cost of equity. A. A firm may change its capital structure if the government changes its tax policies. B. A decrease in the dividend growth rate increases the cost of equity. C. A decrease in the systematic risk of a firm will increase the firm's cost of capital. D. A decrease in a firm's debt-equity ratio will decrease the firm's cost of capital. E. The cost of preferred stock decreases when the tax rate increases. 25. 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? A. Cost of equity B. Internal rate of return C. Aftertax cost of debt D. Weighted average cost of capital E. Debt-equity ratio 26. Which one of the following statements is accurate for a levered firm? A. WACC should be used as the required return for all proposed investments. B. A firm's WACC will decrease whenever the firm's tax rate decreases. C. An increase in the market risk premium will decrease a firm's WACC. D. The subjective approach totally ignores a firm's own WACC. E. A reduction in the risk level of a firm will tend to decrease the firm's WACC. 27. Which one of the following statements is correct, all else held constant? A. Beta is used to compute the return on equity and the standard deviation is used to compute the return on preferred. B. A decrease in a firm's WACC will increase the attractiveness of the firm's investment options. C. The aftertax cost of debt increases when the market price of a bond increases. D If you have both the dividend growth and the security market line's costs of equity, you should use the . higher of the two estimates when computing WACC. E. WACC is only applicable to firms that issue both common and preferred stock. 28. A firm has a cost of equity of 13 percent, a cost of preferred of 11 percent, and an aftertax cost of debt of 6 percent. Given this, which one of the following will increase the firm's weighted average cost of capital? A. Increasing the firm's tax rate B. Issuing new bonds at par C. Redeeming shares of common stock D. Increasing the firm's beta E. Increasing the debt-equity ratio 29. All else constant, the weighted average cost of capital for a risky, levered firm will decrease if: A. the firm's bonds start selling at a premium rather than at a discount. B. the market risk premium increases. C. the firm replaces some of its debt with preferred stock. D. corporate taxes are eliminated. E. the dividend yield on the common stock increases. 30. A firm that uses its weighted average cost of capital as the required return for all of its investments will: A. maintain a constant value for its shareholders. B. increase the risk level of the firm over time. C. make the best possible accept and reject decisions related to those investments. D. find that its cost of capital declines over time. E. accept only the projects that add value to the firm's shareholders. 31. 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: A. require the highest rate of return from division X since it has been in existence the longest. B. assign the highest cost of capital to division Z because it is most likely the riskiest of the three divisions. C. use the firm's WACC as the cost of capital for division Z as it provides analysis for the entire firm. D use the firm's WACC as the cost of capital for divisions A and B because they are part of the revenue. producing operations of the firm. E. allocate capital funds evenly amongst the divisions to maintain the current capital structure of the firm. 32. 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: A. automatically gives preferential treatment in the allocation of funds to its riskiest division. B. encourages the division managers to only recommend their most conservative projects. C. maintains the current risk level and capital structure of the firm. D. automatically maximizes the total value created for its shareholders. E. allocates capital funds evenly amongst its divisions. 33. Kurt, who is a divisional manager, continually brags that his division's required return for its projects is one percent lower than the return required for any other division of the firm. Which one of the following most likely contributes the most to the lower rate requirement for Kurt's division? A. Kurt tends to overestimate the projected cash inflows on his projects. B. Kurt tends to underestimate the variable costs of his projects. C. Kurt has the most efficiently managed division. D. Kurt's division is less risky than the other divisions. E. Kurt's projects are generally financed with debt while the other divisions' projects are financed with equity. 34. Which one of the following is the primary determinant of an investment's cost of capital? A. Life of investment B. Initial cash outlay C. Level of risk D. Source of funds used for the investment E. Investment's net present value 35. The cost of capital for a project depends primarily on which one of the following? A. Source of funds used for the project B. Division within the firm that undertakes the project C. Project's modified internal rate of return D. How the project uses its funds E. Project's fixed costs 36. Marine Expeditors has three divisions. Division A is the core of the business and represents 80 percent of the firm's operations. Division B is involved only with contractual short-term projects and therefore has about 8 percent less risk than division A. Division C develops and markets new products and is about 12 percent riskier than division A and about equal in size to division B. The manager of division A has suggested that the operations of his division be increased by 10 percent next year. The proposed project should probably be assigned a required return that is equal to _____ percent of the firm's weighted average cost of capital. A. 40 B. 60 C. 80 D. 100 E. 110 37. 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. Management decides to issue new stock to finance the project. B. The initial cash outlay requirement is reduced. C. She learns the project is riskier than previously believed. D. The aftertax cost of debt just decreased. E. The project's life is shortened. 38. Boone Brothers remodels homes and replaces windows. Ace Builders constructs new homes. If Boone Brothers considers expanding into new home construction, it should evaluate the expansion project using which one of the following as the required return for the project? A. Boone Brothers' cost of capital B. Ace Builders' cost of capital C. Average of Boone Brothers' and Ace Builders' cost of capital D. Lower of Boone Brothers' or Ace Builders' cost of capital E. Higher of Boone Brothers' or Ace Builders' cost of capital 39. You need to use the pure play approach to assign a cost of capital to a proposed investment. Which one of the following characteristics should you most concentrate on as you search for an appropriate pure play firm? A. Firm size B. Firm location C. Firm experience D. Firm operations E. Firm management 40. When using the pure play approach for a proposed investment, a firm is primarily seeking a rate of return which: A. is based on the actual source of funds that will be used to fund the project. B. creates a positive net present value for the project. C. reflects the size and life of the project. D. most closely correlates with the proposed investment's internal rate of return. E. best matches the risk level of the proposed investment. 41. Derek's is a brick-and-mortar toy store. The firm is considering expanding its operations to include Internet sales. Which one of the following would be the best firm to use in a pure play approach to analyzing this proposed expansion? A. Another brick-and-mortar store that also sells online B. A wholesale toy distributor C. A toy store that only sells online D. The oldest online retailer of any product E. Derek's own store 42. Kelly's uses the firm's weighted average cost of capital (WACC) as the required return for some of its projects. For other projects, the firms uses a rate equal to WACC plus 1 percent, while another set of projects is assigned rates equal to WACC minus some amount. Which one of the following factors should be the key factor the firm uses to determine the amount of the adjustment it will make when assigning the project a discount rate? A. Firm beta B. Date for project commencement C. Risk level of project D. Division within the firm that will be assigned to manage the project E. Current debt-equity ratio 43. A firm has multiple divisions of similar nature, yet varying degrees of risk. Which one of the following would be the most appropriate, yet relatively easy, means of assigning discount rates to each of its proposed investments? A. Assign every project a rate equal to the firm's cost of equity B. Assign every firm a random rate that varies between the firm's cost of debt and its cost of equity C. Assign every project a rate equal to the firm's WACC plus or minus a subjective adjustment D. Determine the best pure play rate for each project E. Assign every project a rate equal to the market rate of return at the time of the proposal 44. The computation of which one of the following requires assigning every proposed investment to a particular risk class? A. Pure play cost of capital B. Cost of equity C. Aftertax cost of debt D. WACC E. Subjective cost of capital 45. 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? A. 6.93 percent B. 7.37 percent C. 7.54 percent D. 8.19 percent E. 8.33 percent 46. Farm Equipment, Inc. announced this morning that its next annual dividend will be decreased to $1.80 a share and that all future dividends will be decreased by an additional 1.5 percent annually. What is the current value per share of this stock if the required return is 16.5 percent? A. $8 B. $10 C. $12 D. $14 E. $16 47. 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? A. 5.35 percent B. 5.41 percent C. 14.42 percent D. 18.79 percent E. 19.98 percent 48. High Valley Antiques would like to issue new equity shares if its cost of equity declines to 10.5 percent. The company pays a constant annual dividend of $1.60 per share. What does the market price of the stock need to be for the firm to issue the new shares? A. $14.48 B. $14.83 C. $15.24 D. $15.92 E. $16.80 49. The common stock of Modern Interiors has a beta of 1.61 and a standard deviation of 27.4 percent. The market rate of return is 13.2 percent and the risk-free rate is 4.8 percent. What is the cost of equity for this firm? A. 18.32 percent B. 19.97 percent C. 21.08 percent D. 24.40 percent E. 26.05 percent 50. Jet Setters has a cost of equity of 17.8 percent. The market risk premium is 10.2 percent and the risk-free rate is 4.4 percent. The company is acquiring a competitor, which will increase the company's beta to 1.6. What effect, if any, will the acquisition have on the firm's cost of equity capital? A. No effect B. Decrease of 3.39 percent C. Decrease of 0.84 percent D. Increase of 2.92 percent E. Increase of 4.13 percent 51. The common stock of Yanderloft and Sons has a beta that is 25 percent larger than the overall market beta. Currently, the market risk premium is 9.2 percent while the U.S. Treasury bill is yielding 4.7 percent. What is the cost of equity for this firm? A. 13.76 percent B. 14.96 percent C. 15.80 percent D. 16.20 percent E. 17.85 percent 52. Musical Charts just paid an annual dividend of $2.45 per share. This dividend is expected to increase by 3.3 percent annually. Currently, the firm has a beta of 1.09 and a stock price of $36 a share. The risk-free rate is 4.2 percent and the market rate of return is 12.6 percent. What is the cost of equity capital for this firm? A. 10.28 percent B. 11.84 percent C. 12.29 percent D. 12.95 percent E. 13.42 percent 53. The Cracker Mill has a beta of 0.97, a dividend growth rate of 3.2 percent, a stock price of $33 a share, and an expected annual dividend of $1.06 per share next year. The market rate of return is 11.2 percent and the risk-free rate is 3.7 percent. What is the firm's cost of equity? A. 7.74 percent B. 8.69 percent C. 9.30 percent D. 9.72 percent E. 10.01 percent 54. The market rate of return is 14.8 percent and the risk-free rate is 4.45 percent. Galaxy Co. has 54 percent more systematic risk than the overall market and has a dividend growth rate of 5.5 percent. The firm's stock is currently selling for $39 a share and has a dividend yield of 3.6 percent. What is the firm's cost of equity? A. 14.73 percent B. 15.31 percent C. 15.82 percent D. 16.28 percent E. 16.73 percent 55. Appalachian Mountain Goods has paid increasing dividends of $.0.12, $0.18, $0.20, and $0.25 a share over the past four years, respectively. The firm estimates that future increases in its dividends will be equal to the arithmetic average growth rate over these past four years. The stock is currently selling for $12.60 a share. The risk-free rate is 3.2 percent and the market risk premium is 9.1 percent. What is the cost of equity for this firm if its beta is 1.26? A. 14.34 percent B. 16.91 percent C. 19.78 percent D. 22.96 percent E. 24.03 percent 56. Winter Wear, Inc. has 6 percent bonds outstanding that mature in 13 years. The bonds pay interest semiannually and have a face value of $1,000. Currently, the bonds are selling for $993 each. What is the firm's pre-tax cost of debt? A. 5.97 percent B. 6.08 percent C. 6.14 percent D. 6.31 percent E. 6.40 percent 57. Four years ago, the Moore Co. issued 15-year, 7.5 percent semiannual coupon bonds at par. Today, the bonds are quoted at 101.6. What is this firm's pre-tax cost of debt? A. 6.97 percent B. 7.08 percent C. 7.29 percent D. 7.33 percent E. 7.39 percent 58. Birds and Yards has 10-year bonds outstanding that carry an annual coupon of 8 percent. The bonds mature in 7 years and are currently priced at 108.4 percent of face value. What is the firm's pre-tax cost of debt? A. 6.47 percent B. 6.82 percent C. 7.34 percent D. 7.70 percent E. 8.23 percent 59. Catnip Stores has a $20 million bond issue outstanding that currently has a market value of $18.6 million. The bonds mature in 6.5 years and pay semiannual interest payments of $30 each. What is the firm's pretax cost of debt? A. 6.99 percent B. 7.37 percent C. 7.58 percent D. 7.74 percent E. 7.80 percent 60. Hi Tech Products has 35,000 bonds outstanding that are currently quoted at 102.3. The bonds mature in 11 years and carry a 9 percent annual coupon. What is the firm's aftertax cost of debt if the applicable tax rate is 35 percent? A. 4.47 percent B. 4.79 percent C. 5.63 percent D. 5.98 percent E. 6.31 percent 61. Major Manufacturing issued 30-year, 8.5 percent semiannual bonds 6 years ago. The bonds currently sell at 101 percent of face value. What is the firm's aftertax cost of debt if the tax rate is 35 percent? A. 5.46 percent B. 5.62 percent C. 5.76 percent D. 6.59 percent E. 6.83 percent 62. Great Lakes Packing has two bond issues outstanding. The first issue has a coupon rate of 9 percent, matures in 3 years, has a total face value of $6 million, and is quoted at 108 percent of face value. The second issue has a 7.5 percent coupon, matures in 16 years, has a total face value of $18 million, and is quoted at 97 percent of face value. Both bonds pay interest semiannually. What is the firm's weighted average aftertax cost of debt if the tax rate is 35 percent? A. 4.78 percent B. 5.12 percent C. 5.63 percent D. 5.95 percent E. 6.08 percent 63. The 7.5 percent preferred stock of Home Town Brews is selling for $43 a share. What is the firm's cost of preferred stock if the tax rate is 34 percent and the par value per share is $100? A. 14.47 percent B. 15.92 percent C. 16.17 percent D. 16.52 percent E. 17.44 percent 64. The 7.5 percent preferred stock of Tanners Floors is selling for $57 a share. What is the firm's cost of preferred stock if the tax rate is 35 percent and the par value per share is $100? A. 11.69 percent B. 12.81 percent C. 13.16 percent D. 13.79 percent E. 14.14 percent 65. The preferred stock of Pollard's Pools pays an annual dividend of $5.50 a share and sells for $42 a share. The tax rate is 34 percent. What is the firm's cost of preferred stock? A. 12.28 percent B. 13.10 percent C. 15.07 percent D. 15.59 percent E. 16.47 percent 66. Christie's Train Shoppe has 15,000 shares of common stock outstanding at a price of $11 a share. It also has 2,000 shares of preferred stock outstanding at a price of $34 a share. There are 50 bonds outstanding that have a 7.5 percent semiannual coupon. The bonds mature in 6 years, have a face value of $1,000, and sell at 96 percent of par. What is the capital structure weight of the preferred stock? A. 20.50 percent B. 21.68 percent C. 23.15 percent D. 24.20 percent E. 26.23 percent 67. Chesterfield and Weston has 55,000 shares of common stock outstanding at a price of $31 a share. It also has 3,000 shares of preferred stock outstanding at a price of $62 a share. The firm has 8 percent, 12-year bonds outstanding with a total face value of $400,000. The bonds are currently quoted at 101.2 percent of face and pay interest semiannually. What is the capital structure weight of the firm's debt if the tax rate is 35 percent? A. 14.49 percent B. 15.20 percent C. 15.67 percent D. 16.84 percent E. 17.63 percent 68. Claus Enterprises has 174,000 shares of common stock outstanding at a current price of $46 a share. The firm also has two bond issues outstanding. The first bond issue has a total face value of $250,000, pays 7.7 percent interest annually, and currently sells for 102.5 percent of face value. The second bond issue consists of 5,000 bonds that are selling for $993 each. These bonds pay 6.5 percent interest annually and mature in 8 years. The tax rate is 34 percent. What is the capital structure weight of the firm's common stock? A. 47.78 percent B. 51.39 percent C. 55.50 percent D. 60.52 percent E. 71.86 percent 69. Sunshine Cruises issues only common stock and coupon bonds. The firm has a debt-equity ratio of 0.55. The cost of equity is 16.3 percent and the pre-tax cost of debt is 9.9 percent. What is the capital structure weight of the firm's equity if the firm's tax rate is 34 percent? A. 46.75 percent B. 49.97 percent C. 52.93 percent D. 61.08 percent E. 64.52 percent 70. The General Store has a cost of equity of 15.8 percent, a pre-tax cost of debt of 7.7 percent, and a tax rate of 32 percent. What is the firm's weighted average cost of capital if the debt-equity ratio is 0.40? A. 10.18 percent B. 11.72 percent C. 12.78 percent D. 13.30 percent E. 14.93 percent 71. 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? A. 8.94 percent B. 10.36 percent C. 11.92 percent D. 12.28 percent E. 13.01 percent 72. A firm wants to create a weighted average cost of capital (WACC) of 10.4 percent. The firm's cost of equity is 14.5 percent and its pre-tax cost of debt is 8.5 percent. The tax rate is 34 percent. What does the debt-equity ratio need to be for the firm to achieve its target WACC? A. 0.51 B. 0.57 C. 0.62 D. 0.70 E. 0.86 73. 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? A. 46.12 percent B. 52.03 percent C. 54.15 percent D. 58.78 percent E. 63.21 percent 74. 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? A. 11.45 percent B. 12.62 percent C. 12.89 percent D. 13.37 percent E. 14.14 percent 75. Dallas Interiors has a cost of equity of 18.6 percent and a pre-tax cost of debt of 9.7 percent. The firm's target weighted average cost of capital is 10.8 percent and its tax rate is 35 percent. What is the firm's target debt-equity ratio? A. 0.81 B. 0.87 C. 1.18 D. 1.32 E. 1.74 76. Western Electric has 23,000 shares of common stock outstanding at a price per share of $57 and a rate of return of 14.2 percent. The firm has 6,000 shares of 7 percent preferred stock outstanding at a price of $48 a share. The preferred stock has a par value of $100. The outstanding debt has a total face value of $350,000 and currently sells for 102 percent of face. The yield-to-maturity on the debt is 8.49 percent. What is the firm's weighted average cost of capital if the tax rate is 34 percent? A. 12.69 percent B. 13.44 percent C. 14.19 percent D. 14.47 percent E. 14.92 percent 77. Aaron's Rentals has 58,000 shares of common stock outstanding at a market price of $36 a share. The common stock just paid a $1.64 annual dividend and has a dividend growth rate of 2.8 percent. There are 12,000 shares of 6 percent preferred stock outstanding at a market price of $51 a share. The preferred stock has a par value of $100. The outstanding bonds mature in 17 years, have a total face value of $750,000, a face value per bond of $1,000, and a market price of $1,011 each. The bonds pay 8 percent interest, semiannually. The tax rate is 34 percent. What is the firm's weighted average cost of capital? A. 7.74 percent B. 8.68 percent C. 9.29 percent D. 9.97 percent E. 10.30 percent 78. 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? A. -$372,951 B. -$187,016 C. $48,209 D. $133,333 E. $269,480 79. Orchard Farms has a pre-tax cost of debt of 7.68 percent and a cost of equity of 15.2 percent. The firm uses the subjective approach to determine project discount rates. Currently, the firm is considering a project to which it has assigned an adjustment factor of -0.5 percent. The firm's tax rate is 34 percent and its debt-equity ratio is 0.45. The project has an initial cost of $4.3 million and produces cash inflows of $1.27 million a year for 5 years. What is the net present value of the project? A. $121,619 B. $328,895 C. $514,370 D. $561,027 E. $628,721 80. Bruceton Hotels is an all-equity firm with 60,000 shares of stock outstanding. The stock has a beta of 1.27 and a standard deviation of 13.8 percent. The market risk premium is 9.1 percent and the risk-free rate of return is 4.2 percent. The company is considering a project that it considers riskier than its current operations so it wants to apply an adjustment of 1 percent to the project's discount rate. What should the firm set as the required rate of return for the project? A. 12.54 percent B. 13.92 percent C. 15.39 percent D. 16.76 percent E. 17.03 percent 81. Brewster's is considering a project that is equally as risky as the firm's current operations. The firm has a cost of equity of 13.7 percent and a pre-tax cost of debt of 8.4 percent. The debt-equity ratio is .65 and the tax rate is 36 percent. What is the cost of capital for this project? A. 9.97 percent B. 10.42 percent C. 11.38 percent D. 11.62 percent E. 13.30 percent 82. Global Exchange has three divisions: A, B, and C. Division A has the least risk and division C has the most risk. The firm has an aftertax cost of debt of 6.1 percent and a cost of equity of 14.3 percent. The firm is financed with 35 percent debt and 65 percent equity. Division A's projects are assigned a discount rate that is 2 percent less than the firm's weighted average cost of capital. What is the discount rate applicable to division A? A. 7.98 percent B. 8.27 percent C. 9.43 percent D. 11.48 percent E. 13.43 percent 83. Swizer Industries has two separate divisions. Division X has less risk so its projects are assigned a discount rate equal to the firm's WACC minus 0.5 percent. Division Y has more risk and its projects are assigned a rate equal to the firm's WACC plus 1 percent. The company has a debt-equity ratio of .45 and a tax rate of 35 percent. The cost of equity is 14.7 percent and the aftertax cost of debt is 5.1 percent. Presently, each division is considering a new project. Division Y's project provides a 12.3 percent rate of return and division X's project provides an 11.64 percent return. Which projects, if any, should the company accept? A. Accept both X and Y B. Accept X and reject Y C. Reject X and accept Y D. Reject both X and Y E. The answer cannot be determined based on the information provided. 84. 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? A. Beverly's only B. Clothing Galore only C. Both Beverly's and Clothing Galore D. Neither Beverly's nor Clothing Galore E. The answer cannot be determined based on the information provided. 85. Lester's is a globally diverse company with multiple divisions and a cost of capital of 15.8 percent. Med, Inc. is a specialty firm in the medical equipment field with a cost of capital of 13.7 percent. With the aging of America, both firms recognize the opportunities that exist in the medical field and are considering expansion in this area. At present, there is an opportunity for multiple firms to be involved in a new medical devices project. Each project will require an initial investment of $8.4 million with annual returns of $2.2 million per year for 7 years. Which firm or firms, if either, should become involved in the new projects? A. Lester's only B. Med, Inc. only C. Both Lester's and Med, Inc. D. Neither Lester's nor Med, Inc. E. The answer cannot be determined based on the information provided. 86. Bob's is a retail chain of specialty hardware stores. The firm has 21,000 shares of stock outstanding that are currently valued at $68 a share and provide a 13.2 percent rate of return. The firm also has 500 bonds outstanding that have a face value of $1,000, a market price of $1,068, and a 7 percent coupon. These bonds mature in 6 years and pay interest semiannually. The tax rate is 35 percent. The firm is considering expanding by building a new superstore. The superstore will require an initial investment of $12.3 million and is expected to produce cash inflows of $1.1 million annually over its 10-year life. The risks associated with the superstore are comparable to the risks of the firm's current operations. The initial investment will be depreciated on a straight line basis over the life of the project. At the end of the 10 years, the firm expects to sell the superstore for $6.7 million. Should the firm accept or reject the superstore project and why? A. Accept; The project's NPV is $1.27 million. B. Accept; The NPV is $4.89 million. C. Reject; The NPV is $1.06 million D. Reject; The NPV -$3.27 million. E. Reject; The NPV is -$5.71 million. 87. Casper's is analyzing a proposed expansion project is that much riskier than the firm's current operations. Thus, the project will be assigned a discount rate equal to the firm's cost of capital plus 3 percent. The proposed project has an initial cost of $17.2 million dollars that will be depreciated on a straight-line basis over 20 years. The project also requires additional inventory of $687,000 over the project's life. Management estimates the facility will generate cash inflows of $2.78 million a year over its 20-year life. After 20 years, the company plans to sell the facility for an estimated $1.3 million. The company has 60,000 shares of common stock outstanding at a market price of $49 a share. This stock just paid an annual dividend of $1.84 a share. The dividend is expected to increase by 3.5 percent annually. The firm also has 10,000 shares of 12 percent preferred stock with a market value of $98 a share. The preferred stock has a par value of $100. The company has a 9 percent, semiannual coupon bond issue outstanding with a total face value of $1.1 million. The bonds are currently priced at 102 percent of face value and mature in 16 years. The tax rate is 33 percent. Should the firm pursue the expansion project at this point in time? Why or why not? A. Accept; The NPV is $2.648 million. B. Accept; The NPV is $4.507 million. C. Reject; The NPV is -$3.241 million. D. Reject; The NPV is -$3.027 million. E. Reject; The NPV is -$1.040 million. 88. Explain the concept of the subjective approach to assigning a required return to a project. 89. Assume a firm follows a policy of using its weighted average cost of capital as the required return for all of its proposed projects. Evaluate this policy. How will this policy affect the overall risk level of the firm over time? 90. 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? 91. Assume the federal government mandates that all retail stores in the northern states install heated sidewalks to help minimize the number of injuries that occur from people falling as a result of snow and ice buildup on those sidewalks. How should a firm determine the cost of capital for a project such as is? 92. Gray's Tools just issued a dividend of $1.60 per share on its common stock. The company is expected to maintain a constant 4 percent growth rate in its dividends indefinitely. If the stock sells for $31 a share, what is the company's cost of equity? A. 8.81 percent B. 9.37 percent C. 9.94 percent D. 10.32 percent E. 11.46 percent 93. Stock in ABC Enterprises has a beta of 1.06. The market risk premium is 6.8 percent, and T-bills are currently yielding 3.2 percent. ABC's most recent dividend was $1.56 per share, and dividends are expected to grow at a 4 percent annual rate indefinitely. If the stock sells for $43 a share, what is your best estimate of ABC's cost of equity? A. 7.78 percent B. 8.82 percent C. 9.09 percent D. 9.41 percent E. 9.69 percent 94. Upstate Bank has an issue of preferred stock with a $4.80 stated dividend that just sold for $86 a share. What is the bank's cost of preferred stock? A. 4.91 percent B. 5.58 percent C. 6.23 percent D. 6.47 percent E. 7.32 percent 95. Raceway Motors issued a 20-year, 8 percent semiannual bond 3 years ago. The bond currently sells for 98.6 percent of its face value. The company's tax rate is 34 percent. What is the aftertax cost of debt? A. 5.38 percent B. 5.54 percent C. 5.69 percent D. 5.72 percent E. 5.99 percent 96. Healthy Foods has a target capital structure of 55 percent common stock, 5 percent preferred stock, and 40 percent debt. Its cost of equity is 14.3 percent, the cost of preferred stock is 8.9 percent, and the pretax cost of debt is 8.1 percent. What is the company's WACC if the applicable tax rate is 34 percent? A. 9.29 percent B. 9.61 percent C. 10.02 percent D. 10.45 percent E. 10.83 percent 97. Precision Engineering has a target debt-equity ratio of 0.55. Its cost of equity is 15.4 percent, and its pretax cost of debt is 7.8 percent. If the tax rate is 34 percent, what is the company's WACC? A. 10.20 percent B. 10.72 percent C. 10.91 percent D. 11.48 percent E. 11.76 percent 98. Given the following information for Electric Transport, find the WACC. Assume the company's tax rate is 34 percent. Debt: 7,500, 8.4 percent coupon bonds outstanding. $1,000 par value, 22 years to maturity, selling for 103 percent of par, the bonds make semiannual payments. Common stock: 195,000 shares outstanding, selling for $78 per share, beta is 1.21 Preferred stock: 11,000 shares of 6.35 percent preferred stock outstanding, currently selling for $76 per share. Market: 8 percent market risk premium and 5.1 percent risk-free rate. A. 11.49 percent B. 12.07 percent C. 12.42 percent D. 13.33 percent E. 13.80 percent 99. You are given the following information concerning Around Town Tours: Debt: 8,500, 7.1 percent coupon bonds outstanding, with 14 years to maturity and a quoted price of 102.6. These bonds pay interest semiannually. Common stock: 265,000 shares of common stock selling for $76 per share. The stock has a beta of 0.92 and will pay a dividend of $2.48 next year. The dividend is expected to grow by 4 percent per year indefinitely. Preferred stock: 7,500 shares of 6 percent preferred stock selling at $88 per share. Market: A 13.2 percent expected return, a 4.5 percent risk-free rate, and a 34 percent tax rate. Calculate the WACC for this firm. A. 8.22 percent B. 8.67 percent C. 9.29 percent D. 9.57 percent E. 10.08 percent 100.Stewart's is considering a new project. The company has a debt-equity ratio of 0.72. The company's cost of equity is 15.1 percent, and the aftertax cost of debt is 7.2 percent. The firm feels that the project is riskier than the company as a whole and that it should use an adjustment factor of +2 percent. What is the WACC it should use for the project? A. 12.53 percent B. 12.98 percent C. 13.79 percent D. 14.14 percent E. 14.68 percent ch12 Key 1. Katie owns 100 shares of ABC stock. Which one of the following terms is used to refer to the return that Katie and the other shareholders require on their investment in ABC? A. Weighted average cost of capital B. Pure play cost C. Cost of equity D. Subjective cost E. Cost of debt Refer to section 12.2. Blooms: Knowledge Difficulty: Basic Learning Objective: 12-01 Determine a firms cost of equity capital Ross - Chapter 12 #1 Section: 12.2 Topic: Cost of equity 2. Lester lent money to The Corner Store by purchasing bonds issued by the store. The rate of return that he and the other lenders require is referred to as the: A. pure play cost. B. cost of debt. C. weighted average cost of capital. D. subjective cost. E. cost of equity. Refer to section 12.3. Blooms: Knowledge Difficulty: Basic Learning Objective: 12-02 Determine a firms cost of debt Ross - Chapter 12 #2 Section: 12.3 Topic: Cost of debt 3. The weighted average cost of capital is defined as the weighted average of a firm's: A. return on its investments. B. cost of equity and its aftertax cost of debt. C. pretax cost of debt and equity securities. D. bond coupon rates. E. dividend and capital gains yields. Refer to section 12.4. Blooms: Knowledge Difficulty: Basic Learning Objective: 12-03 Determine a firms overall cost of capital Ross - Chapter 12 #3 Section: 12.4 Topic: Weighted average cost of capital 4. Farmer's Supply, Inc. is considering opening a clothing store, which would be a new line of business for the firm. Management has decided to use the cost of capital of a similar clothing store as the discount rate that should be used to evaluate this proposed expansion. Which one of the following terms is used to describe the approach Farmer's Supply is taking to establish an appropriate discount rate for the project? A. Equity approach B. Aftertax approach C. Subjective approach D. Market play E. Pure play approach Refer to section 12.5. Blooms: Knowledge Difficulty: Basic Learning Objective: 12-04 Identify some of the pitfalls associated with a firms overall cost of capital and what to do about them Ross - Chapter 12 #4 Section: 12.5 Topic: Pure play approach 5. Kate is the CFO of a major firm and has the job of assigning discount rates to each project that is under consideration. Kate's method of doing this is to assign an incrementally higher rate as the risk level of the project increases over that of the current firm. Likewise, she assigns lower rates as the risk level declines. Which one of the following approaches is Kate using to assign the discount rates? A. Pure play approach B. Divisional rating C. Subjective approach D. Straight WACC approach E. Equity rating Refer to section 12.5. Blooms: Knowledge Difficulty: Basic Learning Objective: 12-04 Identify some of the pitfalls associated with a firms overall cost of capital and what to do about them Ross - Chapter 12 #5 Section: 12.5 Topic: Subjective approach 6. 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? A. Amount of debt used to finance the project B. Use, or lack thereof, of preferred stock to finance the project C. Mix of funds used to finance the project D. Risk level of the project E. Length of the project's life Refer to section 12.1. Blooms: Knowledge Difficulty: Basic Learning Objective: 12-01 Determine a firms cost of equity capital Ross - Chapter 12 #6 Section: 12.1 Topic: Cost of capital 7. Black Stone Furnaces wants to build a new facility. The cost of capital for this investment is primarily dependent upon which one of the following? A. Firm's overall source of funds B. Source of the funds used to build the facility C. Current tax rate D. The nature of the investment E. Firm's historical average rate of return Refer to section 12.1 Blooms: Knowledge Difficulty: Basic Learning Objective: 12-01 Determine a firms cost of equity capital Ross - Chapter 12 #7 Section: 12.1 Topic: Cost of capital 8. Which one of the following statements is correct related to the dividend growth model approach to computing the cost of equity? A. The rate of growth must exceed the required rate of return. B. The rate of return must be adjusted for taxes. C. The annual dividend used in the computation must be for year one if you are using today's stock price to compute the return. D. The cost of equity is equal to the return on the stock plus the risk-free rate. E. The cost of equity is equal to the return on the stock multiplied by the stock's beta. Refer to section 12.2. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-01 Determine a firms cost of equity capital Ross - Chapter 12 #8 Section: 12.2 Topic: Cost of equity 9. A firm has a return on equity of 12.4 percent according to the dividend growth model and a return of 18.7 percent according to the capital asset pricing model. The market rate of return is 13.5 percent. What rate should the firm use as the cost of equity when computing the firm's WACC? A. 12.4 percent because it is lower than 18.7 percent B. 18.7 percent because it is higher than 12.4 percent C. The arithmetic average of 12.4 percent and 18.7 percent D. The arithmetic average of 12.4 percent, 13.5 percent, and 18.7 percent E. 13.5 percent Refer to section 12.2. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-01 Determine a firms cost of equity capital Ross - Chapter 12 #9 Section: 12.2 Topic: Cost of equity 10. Which of the following features are advantages of the dividend growth model? I. easy to understand II. model simplicity III. constant dividend growth rate IV. model's applicability to all common stocks A. II only B. I and III only C. II and IV only D. I and II only E. I, II, and III only Refer to section 12.2. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-01 Determine a firms cost of equity capital Ross - Chapter 12 #10 Section: 12.2 Topic: Dividend growth model 11. Which of the following are weaknesses of the dividend growth model? I. market risk premium fluctuations II. lack of dividends for some firms III. reliance on historical beta IV. sensitivity of model to dividend growth rate A. II only B. I and II only C. I and III only D. II and IV only E. I, II, III, and IV Refer to section 12.2. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-01 Determine a firms cost of equity capital Ross - Chapter 12 #11 Section: 12.2 Topic: Dividend growth model 12. 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 Refer to section 12.2. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-01 Determine a firms cost of equity capital Ross - Chapter 12 #12 Section: 12.2 Topic: Security market line 13. 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 A. II only B. III only C. I and II only D. II and III only E. I and IV only Refer to section 12.2. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-01 Determine a firms cost of equity capital Ross - Chapter 12 #13 Section: 12.2 Topic: Cost of equity 14. Which one of the following will increase the cost of equity, all else held constant? A. Increase in the dividend growth rate B. Decrease in beta C. Decrease in future dividends D. Increase in stock price E. Decrease in market risk premium Refer to section 12.2 Blooms: Comprehension Difficulty: Basic Learning Objective: 12-01 Determine a firms cost of equity capital Ross - Chapter 12 #14 Section: 12.2 Topic: Cost of equity 15. All else constant, which of the following will increase the aftertax cost of debt for a firm? I. increase in the yield to maturity of the firm's outstanding debt II. decrease in the yield to maturity of the firm's outstanding debt III. increase in the firm's tax rate IV. decrease in the firm's tax rate A. I only B. I and III only C. I and IV only D. II and III only E. II and IV only Refer to section 12.3. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-02 Determine a firms cost of debt Ross - Chapter 12 #15 Section: 12.3 Topic: Aftertax cost of debt 16. Which one of the following is the pre-tax cost of debt? A. Average coupon rate on the firm's outstanding bonds B. Coupon rate on the firm's latest bond issue C. Weighted average yield-to-maturity on the firm's outstanding debt D. Average current yield on the firm's outstanding debt E. Annual interest divided by the market price per bond for the latest bond issue Refer to section 12.3. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-02 Determine a firms cost of debt Ross - Chapter 12 #16 Section: 12.3 Topic: Cost of debt 17. Which one of the following will decrease the aftertax cost of debt for a firm? A. Decrease in the firm's beta B. Increase in tax rates C. Increase in the risk-free rate of return D. Decrease in the market price of the debt E. Decrease in a bond's yield-to-maturity Refer to section 12.3. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-02 Determine a firms cost of debt Ross - Chapter 12 #17 Section: 12.3 Topic: Aftertax cost of debt 18. All else constant, an increase in a firm's cost of debt: A. could be caused by an increase in the firm's tax rate. B. will result in an increase in the firm's cost of capital. C. will lower the firm's weighted average cost of capital. D. will lower the firm's cost of equity. E. will increase the firm's capital structure weight of debt. Refer to sections 12.3 and 12.4 Blooms: Comprehension Difficulty: Basic Learning Objective: 12-03 Determine a firms overall cost of capital Ross - Chapter 12 #18 Section: 12.3 and 12.4 Topic: WACC 19. The cost of preferred stock: A. increases when a firm's tax rate decreases. B. is constant over time. C. is unaffected by changes in the market price. D. is equal to the stock's dividend yield. E. increases as the price of the stock increases. Refer to section 12.3. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-02 Determine a firms cost of debt Ross - Chapter 12 #19 Section: 12.3 Topic: Preferred stock 20. Which one of the following statements is correct? A. An increase in the market value of preferred stock will increase a firm's weighted average cost of capital. B. The cost of preferred stock is unaffected by the issuer's tax rate. C. Preferred stock is generally the cheapest source of capital for a firm. D. The cost of preferred stock remains constant from year to year. E. Preferred stock is valued using the capital asset pricing model. Refer to section 12.3. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-02 Determine a firms cost of debt Ross - Chapter 12 #20 Section: 12.3 Topic: Preferred stock 21. Which one of the following will affect the capital structure weights used to compute a firm's weighted average cost of capital? A. Decrease in the book value of a firm's equity B. Decrease in a firm's tax rate C. Increase in the market value of the firm's common stock D. Increase in the market risk premium E. Increase in the firm's beta Refer to section 12.4. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-03 Determine a firms overall cost of capital Ross - Chapter 12 #21 Section: 12.4 Topic: WACC 22. 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 Refer to section 12.4. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-03 Determine a firms overall cost of capital Ross - Chapter 12 #22 Section: 12.4 Topic: WACC 23. Which one of the following statements is correct concerning capital structure weights? A. Target rates are less relevant to a project than are historical rates. B. The weights are unaffected when a bond issue matures. C. An increase in the debt-equity ratio will increase the weight of the common stock. D. The repurchase of preferred stock will increase the weight of debt. E. The issuance of additional shares of common stock will increase the weight of the preferred stock. Refer to section 12.4. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-03 Determine a firms overall cost of capital Ross - Chapter 12 #23 Section: 12.4 Topic: Capital structure weights 24. Which one of the following statements is correct? Assume the pre-tax cost of debt is less than the cost of equity. A. A firm may change its capital structure if the government changes its tax policies. B. A decrease in the dividend growth rate increases the cost of equity. C. A decrease in the systematic risk of a firm will increase the firm's cost of capital. D. A decrease in a firm's debt-equity ratio will decrease the firm's cost of capital. E. The cost of preferred stock decreases when the tax rate increases. Refer to section 12.4. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-03 Determine a firms overall cost of capital Ross - Chapter 12 #24 Section: 12.4 Topic: WACC 25. 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? A. Cost of equity B. Internal rate of return C. Aftertax cost of debt D. Weighted average cost of capital E. Debt-equity ratio Refer to section 12.4. Blooms: Knowledge Difficulty: Basic Learning Objective: 12-03 Determine a firms overall cost of capital Ross - Chapter 12 #25 Section: 12.4 Topic: WACC 26. Which one of the following statements is accurate for a levered firm? A. WACC should be used as the required return for all proposed investments. B. A firm's WACC will decrease whenever the firm's tax rate decreases. C. An increase in the market risk premium will decrease a firm's WACC. D. The subjective approach totally ignores a firm's own WACC. E. A reduction in the risk level of a firm will tend to decrease the firm's WACC. Refer to section 12.5. Blooms: Comprehension Difficulty: Intermediate Learning Objective: 12-04 Identify some of the pitfalls associated with a firms overall cost of capital and what to do about them Ross - Chapter 12 #26 Section: 12.5 Topic: WACC 27. Which one of the following statements is correct, all else held constant? A. Beta is used to compute the return on equity and the standard deviation is used to compute the return on preferred. B. A decrease in a firm's WACC will increase the attractiveness of the firm's investment options. C. The aftertax cost of debt increases when the market price of a bond increases. D If you have both the dividend growth and the security market line's costs of equity, you should use . the higher of the two estimates when computing WACC. E. WACC is only applicable to firms that issue both common and preferred stock. Refer to section 12.4. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-03 Determine a firms overall cost of capital Ross - Chapter 12 #27 Section: 12.4 Topic: WACC 28. A firm has a cost of equity of 13 percent, a cost of preferred of 11 percent, and an aftertax cost of debt of 6 percent. Given this, which one of the following will increase the firm's weighted average cost of capital? A. Increasing the firm's tax rate B. Issuing new bonds at par C. Redeeming shares of common stock D. Increasing the firm's beta E. Increasing the debt-equity ratio Refer to section 12.4. Blooms: Analysis Difficulty: Intermediate Learning Objective: 12-03 Determine a firms overall cost of capital Ross - Chapter 12 #28 Section: 12.4 Topic: WACC 29. All else constant, the weighted average cost of capital for a risky, levered firm will decrease if: A. the firm's bonds start selling at a premium rather than at a discount. B. the market risk premium increases. C. the firm replaces some of its debt with preferred stock. D. corporate taxes are eliminated. E. the dividend yield on the common stock increases. Refer to section 12.4. Blooms: Analysis Difficulty: Intermediate Learning Objective: 12-03 Determine a firms overall cost of capital Ross - Chapter 12 #29 Section: 12.4 Topic: WACC 30. A firm that uses its weighted average cost of capital as the required return for all of its investments will: A. maintain a constant value for its shareholders. B. increase the risk level of the firm over time. C. make the best possible accept and reject decisions related to those investments. D. find that its cost of capital declines over time. E. accept only the projects that add value to the firm's shareholders. Refer to section 12.5. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-04 Identify some of the pitfalls associated with a firms overall cost of capital and what to do about them Ross - Chapter 12 #30 Section: 12.5 Topic: Project return 31. 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: A. require the highest rate of return from division X since it has been in existence the longest. B. assign the highest cost of capital to division Z because it is most likely the riskiest of the three divisions. C. use the firm's WACC as the cost of capital for division Z as it provides analysis for the entire firm. D use the firm's WACC as the cost of capital for divisions A and B because they are part of the . revenue-producing operations of the firm. E. allocate capital funds evenly amongst the divisions to maintain the current capital structure of the firm. Refer to section 12.5. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-04 Identify some of the pitfalls associated with a firms overall cost of capital and what to do about them Ross - Chapter 12 #31 Section: 12.5 Topic: Applying WACC 32. 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: A. automatically gives preferential treatment in the allocation of funds to its riskiest division. B. encourages the division managers to only recommend their most conservative projects. C. maintains the current risk level and capital structure of the firm. D. automatically maximizes the total value created for its shareholders. E. allocates capital funds evenly amongst its divisions. Refer to section 12.5. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-04 Identify some of the pitfalls associated with a firms overall cost of capital and what to do about them Ross - Chapter 12 #32 Section: 12.5 Topic: Project cost of capital 33. Kurt, who is a divisional manager, continually brags that his division's required return for its projects is one percent lower than the return required for any other division of the firm. Which one of the following most likely contributes the most to the lower rate requirement for Kurt's division? A. Kurt tends to overestimate the projected cash inflows on his projects. B. Kurt tends to underestimate the variable costs of his projects. C. Kurt has the most efficiently managed division. D. Kurt's division is less risky than the other divisions. E. Kurt's projects are generally financed with debt while the other divisions' projects are financed with equity. Refer to section 12.5. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-04 Identify some of the pitfalls associated with a firms overall cost of capital and what to do about them Ross - Chapter 12 #33 Section: 12.5 Topic: Project cost of capital 34. Which one of the following is the primary determinant of an investment's cost of capital? A. Life of investment B. Initial cash outlay C. Level of risk D. Source of funds used for the investment E. Investment's net present value Refer to section 12.5. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-04 Identify some of the pitfalls associated with a firms overall cost of capital and what to do about them Ross - Chapter 12 #34 Section: 12.5 Topic: Project cost of capital 35. The cost of capital for a project depends primarily on which one of the following? A. Source of funds used for the project B. Division within the firm that undertakes the project C. Project's modified internal rate of return D. How the project uses its funds E. Project's fixed costs Refer to section 12.5 Blooms: Comprehension Difficulty: Basic Learning Objective: 12-04 Identify some of the pitfalls associated with a firms overall cost of capital and what to do about them Ross - Chapter 12 #35 Section: 12.5 Topic: Project cost of capital 36. Marine Expeditors has three divisions. Division A is the core of the business and represents 80 percent of the firm's operations. Division B is involved only with contractual short-term projects and therefore has about 8 percent less risk than division A. Division C develops and markets new products and is about 12 percent riskier than division A and about equal in size to division B. The manager of division A has suggested that the operations of his division be increased by 10 percent next year. The proposed project should probably be assigned a required return that is equal to _____ percent of the firm's weighted average cost of capital. A. 40 B. 60 C. 80 D. 100 E. 110 Refer to section 12.5. Blooms: Analysis Difficulty: Basic Learning Objective: 12-04 Identify some of the pitfalls associated with a firms overall cost of capital and what to do about them Ross - Chapter 12 #36 Section: 12.5 Topic: Project cost of capital 37. 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. Management decides to issue new stock to finance the project. B. The initial cash outlay requirement is reduced. C. She learns the project is riskier than previously believed. D. The aftertax cost of debt just decreased. E. The project's life is shortened. Refer to section 12.5. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-04 Identify some of the pitfalls associated with a firms overall cost of capital and what to do about them Ross - Chapter 12 #37 Section: 12.5 Topic: Project cost of capital 38. Boone Brothers remodels homes and replaces windows. Ace Builders constructs new homes. If Boone Brothers considers expanding into new home construction, it should evaluate the expansion project using which one of the following as the required return for the project? A. Boone Brothers' cost of capital B. Ace Builders' cost of capital C. Average of Boone Brothers' and Ace Builders' cost of capital D. Lower of Boone Brothers' or Ace Builders' cost of capital E. Higher of Boone Brothers' or Ace Builders' cost of capital Refer to section 12.5. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-04 Identify some of the pitfalls associated with a firms overall cost of capital and what to do about them Ross - Chapter 12 #38 Section: 12.5 Topic: Pure play 39. You need to use the pure play approach to assign a cost of capital to a proposed investment. Which one of the following characteristics should you most concentrate on as you search for an appropriate pure play firm? A. Firm size B. Firm location C. Firm experience D. Firm operations E. Firm management Refer to section 12.5. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-04 Identify some of the pitfalls associated with a firms overall cost of capital and what to do about them Ross - Chapter 12 #39 Section: 12.5 Topic: Pure play 40. When using the pure play approach for a proposed investment, a firm is primarily seeking a rate of return which: A. is based on the actual source of funds that will be used to fund the project. B. creates a positive net present value for the project. C. reflects the size and life of the project. D. most closely correlates with the proposed investment's internal rate of return. E. best matches the risk level of the proposed investment. Refer to section 12.5. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-04 Identify some of the pitfalls associated with a firms overall cost of capital and what to do about them Ross - Chapter 12 #40 Section: 12.5 Topic: Pure play 41. Derek's is a brick-and-mortar toy store. The firm is considering expanding its operations to include Internet sales. Which one of the following would be the best firm to use in a pure play approach to analyzing this proposed expansion? A. Another brick-and-mortar store that also sells online B. A wholesale toy distributor C. A toy store that only sells online D. The oldest online retailer of any product E. Derek's own store Refer to section 12.5. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-04 Identify some of the pitfalls associated with a firms overall cost of capital and what to do about them Ross - Chapter 12 #41 Section: 12.5 Topic: Pure play 42. Kelly's uses the firm's weighted average cost of capital (WACC) as the required return for some of its projects. For other projects, the firms uses a rate equal to WACC plus 1 percent, while another set of projects is assigned rates equal to WACC minus some amount. Which one of the following factors should be the key factor the firm uses to determine the amount of the adjustment it will make when assigning the project a discount rate? A. Firm beta B. Date for project commencement C. Risk level of project D. Division within the firm that will be assigned to manage the project E. Current debt-equity ratio Refer to section 12.5. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-04 Identify some of the pitfalls associated with a firms overall cost of capital and what to do about them Ross - Chapter 12 #42 Section: 12.5 Topic: Subjective approach 43. A firm has multiple divisions of similar nature, yet varying degrees of risk. Which one of the following would be the most appropriate, yet relatively easy, means of assigning discount rates to each of its proposed investments? A. Assign every project a rate equal to the firm's cost of equity B. Assign every firm a random rate that varies between the firm's cost of debt and its cost of equity C. Assign every project a rate equal to the firm's WACC plus or minus a subjective adjustment D. Determine the best pure play rate for each project E. Assign every project a rate equal to the market rate of return at the time of the proposal Refer to section 12.5. Blooms: Comprehension Difficulty: Basic Learning Objective: 12-04 Identify some of the pitfalls associated with a firms overall cost of capital and what to do about them Ross - Chapter 12 #43 Section: 12.5 Topic: Subjective approach 44. The computation of which one of the following requires assigning every proposed investment to a particular risk class? A. Pure play cost of capital B. Cost of equity C. Aftertax cost of debt D. WACC E. Subjective cost of capital Refer to section 12.5 Blooms: Knowledge Difficulty: Basic Learning Objective: 12-04 Identify some of the pitfalls associated with a firms overall cost of capital and what to do about them Ross - Chapter 12 #44 Section: 12.5 Topic: Subjective approach 45. 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? A. 6.93 percent B. 7.37 percent C. 7.54 percent D. 8.19 percent E. 8.33 percent AACSB: Analytic Blooms: Analysis Difficulty: Basic Learning Objective: 12-01 Determine a firms cost of equity capital Ross - Chapter 12 #45 Section: 12.2 Topic: Cost of equity 46. Farm Equipment, Inc. announced this morning that its next annual dividend will be decreased to $1.80 a share and that all future dividends will be decreased by an additional 1.5 percent annually. What is the current value per share of this stock if the required return is 16.5 percent? A. $8 B. $10 C. $12 D. $14 E. $16 AACSB: Analytic Blooms: Analysis Difficulty: Basic Learning Objective: 12-01 Determine a firms cost of equity capital Ross - Chapter 12 #46 Section: 12.1 Topic: Cost of equity 47. 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? A. 5.35 percent B. 5.41 percent C. 14.42 percent D. 18.79 percent E. 19.98 percent AACSB: Analytic Blooms: Analysis Difficulty: Basic Learning Objective: 12-01 Determine a firms cost of equity capital Ross - Chapter 12 #47 Section: 12.2 Topic: Cost of equity 48. High Valley Antiques would like to issue new equity shares if its cost of equity declines to 10.5 percent. The company pays a constant annual dividend of $1.60 per share. What does the market price of the stock need to be for the firm to issue the new shares? A. $14.48 B. $14.83 C. $15.24 D. $15.92 E. $16.80 P0 = $1.60/0.105 = $15.24 AACSB: Analytic Blooms: Analysis Difficulty: Basic Learning Objective: 12-01 Determine a firms cost of equity capital Ross - Chapter 12 #48 Section: 12.2 Topic: Cost of equity 49. The common stock of Modern Interiors has a beta of 1.61 and a standard deviation of 27.4 percent. The market rate of return is 13.2 percent and the risk-free rate is 4.8 percent. What is the cost of equity for this firm? A. 18.32 percent B. 19.97 percent C. 21.08 percent D. 24.40 percent E. 26.05 percent Re = 0.048 + 1.61(0.132 - 0.048) = 18.32 percent AACSB: Analytic Blooms: Analysis Difficulty: Basic Learning Objective: 12-01 Determine a firms cost of equity capital Ross - Chapter 12 #49 Section: 12.2 Topic: Cost of equity 50. Jet Setters has a cost of equity of 17.8 percent. The market risk premium is 10.2 percent and the riskfree rate is 4.4 percent. The company is acquiring a competitor, which will increase the company's beta to 1.6. What effect, if any, will the acquisition have on the firm's cost of equity capital? A. No effect B. Decrease of 3.39 percent C. Decrease of 0.84 percent D. Increase of 2.92 percent E. Increase of 4.13 percent Re = 0.044 + 1.6(0.102) = 20.72 percent Increase in cost of equity = 20.72 percent - 17.8 percent = 2.92 percent AACSB: Analytic Blooms: Analysis Difficulty: Basic Learning Objective: 12-01 Determine a firms cost of equity capital Ross - Chapter 12 #50 Section: 12.2 Topic: Cost of equity 51. The common stock of Yanderloft and Sons has a beta that is 25 percent larger than the overall market beta. Currently, the market risk premium is 9.2 percent while the U.S. Treasury bill is yielding 4.7 percent. What is the cost of equity for this firm? A. 13.76 percent B. 14.96 percent C. 15.80 percent D. 16.20 percent E. 17.85 percent Re = 0.047 + 1.25(0.092) = 16.20 percent AACSB: Analytic Blooms: Analysis Difficulty: Basic Learning Objective: 12-01 Determine a firms cost of equity capital Ross - Chapter 12 #51 Section: 12.2 Topic: Cost of equity

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