Medium pure play method answer b diff m 9b 3

Medium:
Pure play method Answer: b Diff: M
9B-3. Interstate Transport has a target capital structure of 50 percent debt
and 50 percent common equity. The firm is considering a new independent
project that has a return of 13 percent and is not related to
transportation. However, a pure play proxy firm has been identified that
is exclusively engaged in the new line of business. The proxy firm has a
beta of 1.38. Both firms have a marginal tax rate of 40 percent, and
Interstate’s before-tax cost of debt is 12 percent. The risk-free rate
is 10 percent and the market risk premium is 5 percent. The firm should
a. Reject the project; its return is less than the firm’s required rate
of return on the project of 16.9 percent.
b. Accept the project; its return is greater than the firm’s required
rate of return on the project of 12.05 percent.
c. Reject the project; its return is only 13 percent.
d. Accept the project; its return exceeds the risk-free rate and the
before-tax cost of debt.
e. Be indifferent between accepting or rejecting; the firm’s required
rate of return on the project equals its expected return.
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1. Capital components Answer: c Diff: E
Chapter 9 - Page 37
2. Capital components Answer: d Diff: E
3. Capital components Answer: a Diff: E
The debt cost used to calculate a firm’s WACC is k
d
(1 - T). If k
d
remains
constant but T increases, then the term (1 - T) decreases and the value of
the entire equation, k
d
(1 - T), decreases. Statement b is false; if a
company’s stock price increases, and all else remains constant, then the
dividend yield decreases and k
s
decreases. This can be seen from the
equation k
s
= D
1
/P
0
+ g. Statement c is false for the same reason. The
cost of issuing new common stock is k
e
= D
1
/[P
0
(1 - F)] + g. If P
0
increases but there’s no change in the flotation cost, k
e
will decrease.
4. Capital components Answer: c Diff: E
Retained earnings are just another form of equity. When the company has
retained earnings, they can do one of two things--reinvest it or pay it out
as dividends. If the firm reinvests the earnings, it needs to earn a
return that is at least as high as the k
s
of the stock. Otherwise,
investors would be happier receiving the dividends and investing them in
something that will earn k
s
. Therefore, statement a is false. Some of the
preferred stock dividends are excluded from taxation when another company
owns them. It makes no tax difference to the company that pays the
dividends, since dividends come out of after-tax dollars. Therefore,
statement b is false. Interest payments are tax deductible. Therefore,
statement c is true.
5. DCF cost of equity estimation Answer: b Diff: E
6. WACC Answer: d Diff: E
The correct answer is statement d because statements a and b are correct.
Statement c is false. Shareholders can either receive a dividend or they
can let you reinvest in the company. If they receive a dividend, they can
invest that money and earn a return on it. Consequently, if the company
keeps the money as retained earnings and reinvests in projects, it had
better earn a return on that money. Therefore, there is a cost associated
with using retained earnings.