Chapter 10 Sample Problems i . Which of the following is not considered a capital component for the purpose of calculating the weighted average cost of capital (WACC) as it applies to capital budgeting? a. Long-term debt. b. Common stock. c. Accounts payable and accruals. d. Preferred stock. e. All of the above are considered capital components. ii . Which of the following statements is correct? a. The WACC should include only after-tax component costs. Therefore, the required rates of return (or “market rates”) on debt, preferred, and common equity (k d , k p , and k s ) must be adjusted to an after-tax basis before they are used in the WACC equation. b. The cost of retained earnings is generally higher than the cost of new common stock. c. Preferred stock is riskier to investors than is debt. Therefore, if someone told you that the market rates showed k d > k p for a given company, that person must have made a mistake. d. If a company with a debt ratio of 50 percent were suddenly exempted from all future income taxes, then, all other things held constant, this would cause its WACC to increase. e. None of the statements above is correct. iii . Hamilton Company’s 8 percent coupon rate, semiannual payment, $1,000 par value bond, which matures in 20 years, currently sells at a price of $686.86. The company’s tax rate is 40 percent. Based on the nominal interest rate, what is the firm’s after-tax cost of debt for purposes of calculating the WACC? a. 3.05% b. 6.11% c. 7.33% d. 12.22% e. 12.26% iv . Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent common equity. The current market price of the firm’s stock is P 0 = $28; its last dividend was D 0 = $2.20, and its expected dividend growth rate is 6 percent. What will Allison’s marginal cost of retained earnings, k s , be? a. 15.8% b. 13.9% c. 7.9% d. 14.3% e. 9.7%
v . The common stock of Anthony Steel has a beta of 1.20. The risk-free rate is 5 percent and the market risk premium (k M - k RF ) is 6 percent. Assume the firm will be able to use retained earnings to fund the equity portion of its capital budget. What is the company’s cost of retained earnings, k s ? a. 7.0% b. 7.2% c. 11.0% d. 12.2% e. 12.4% vi . Blair Brothers’ stock currently has a price of $50 per share and is expected to pay a year-end dividend of $2.50 per share (D 1 = $2.50). The dividend is expected to grow at a constant rate of 4 percent per year. The company has insufficient retained earnings to fund capital projects and must, therefore, issue new common stock. The new stock has an estimated flotation cost of $3 per share.
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