e. The after-tax cost of debt is generally more expensive than the after- tax cost of preferred stock. WACC and capital components Answer: a MEDIUM 31 . For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is CORRECT? a. The cost of equity is usually greater than or equal to the cost of debt. b. The WACC exceeds the cost of equity. c. The WACC is calculated on a before-tax basis. d. The interest rate used to calculate the WACC is the average cost of all the debt the company has outstanding and shown on its balance sheet. e. The cost of retained earnings typically exceeds the cost of new common stock. Factors influencing WACC Answer: b MEDIUM 32 . Maese Sisters Inc has been paying out all of its earnings as dividends, and hence has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity. Its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would reduce the WACC? a. The flotation costs associated with issuing new common stock increase. b. The market risk premium declines. c. The company’s beta increases. d. Expected inflation increases. e. The flotation costs associated with issuing preferred stock increase. Risk and project selection Answer: b MEDIUM 33 . Wagner Inc estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept? a. Project A is of average risk and has a return of 9%. b. Project B is of below-average risk and has a return of 8.5%. c. Project C is of above-average risk and has a return of 11%. d. None of the projects should be accepted. Page 64 Chapter 10: The Cost of Capital
e. All of the projects should be accepted. Divisional risk Answer: a MEDIUM 34 . Basu Inc. uses only equity capital, and it has two equally-sized divisions. Division A’s cost of capital is 10.0%, Division B’s cost is 14.0%, and the composite WACC is 12.0%. All of Division A’s projects have the same risk, and all Division B projects are also equally risky. However, the projects in Division A do not have the same risk as those in Division B. Which of the following projects should Basu accept? a. A Division A project with an 11% return. b. A Division B project with a 12% return. c. A Division B project with a 13% return. d. A Division A project with a 9% return. e. A Division B project with an 11% return. Miscellaneous cost of capital concepts Answer: c MEDIUM 35 . Which of the following statements is CORRECT? a. Since debt capital is riskier than equity capital, the after-tax cost of debt is always greater than the WACC.
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