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Medium pure play method answer b diff m 9b 3

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Medium:Pure play methodAnswer: bDiff: M9B-3.InterstateTransporthasatargetcapitalstructureof50percentdebtand 50 percent common equity.The firm is considering a new independentprojectthathasareturnof13percentandisnotrelatedtotransportation.However, a pure play proxy firm has been identified thatis exclusively engaged in the new line of business.The proxy firm has abetaof1.38.Bothfirmshaveamarginaltaxrateof40percent,andInterstate’sbefore-taxcostofdebtis12percent.Therisk-freerateis 10 percent and the market risk premium is 5 percent. The firm shoulda. Rejecttheproject;itsreturnislessthanthefirm’srequiredrateof return on the project of 16.9 percent.b. Accepttheproject;itsreturnisgreaterthanthefirm’srequiredrate of return on the project of 12.05 percent.c. Reject the project; its return is only 13 percent.d. Accepttheproject;itsreturnexceedstherisk-freerateandthebefore-tax cost of debt.e. Beindifferentbetweenacceptingorrejecting;thefirm’srequiredrate of return on the project equals its expected return.lOMoARcPSD|16538345
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1.Capital componentsAnswer: cDiff: E
Chapter 9 - Page 372.Capital componentsAnswer: dDiff: E3.Capital componentsAnswer: aDiff: EThe debt cost used to calculate a firm’s WACC is kd(1 - T).If kdremainsconstant but T increases, then the term (1 - T) decreases and the value oftheentireequation,kd(1-T),decreases.Statementbisfalse;ifacompany’sstockpriceincreases,andallelseremainsconstant,thenthedividendyielddecreasesandksdecreases.Thiscanbeseenfromtheequationks=D1/P0+g.Statementcisfalseforthesamereason.Thecostofissuingnewcommonstockiske=D1/[P0(1-F)]+g.IfP0increases but there’s no change in the flotation cost, kewill decrease.4.Capital componentsAnswer: cDiff: ERetainedearningsarejustanotherformofequity.Whenthecompanyhasretained earnings, they can do one of two things--reinvest it or pay it outasdividends.Ifthefirmreinveststheearnings,itneedstoearnareturnthatisatleastashighastheksofthestock.Otherwise,investorswouldbehappierreceivingthedividendsandinvestingtheminsomething that will earn ks.Therefore, statement a is false.Some of thepreferredstockdividendsareexcludedfromtaxationwhenanothercompanyownsthem.Itmakesnotaxdifferencetothecompanythatpaysthedividends,sincedividendscomeoutofafter-taxdollars.Therefore,statementbisfalse.Interestpaymentsaretaxdeductible.Therefore,statement c is true.5.DCF cost of equity estimationAnswer: bDiff: E6.WACCAnswer: dDiff: EThecorrectanswerisstatementdbecausestatementsaandbarecorrect.Statementcisfalse.Shareholderscaneitherreceiveadividendortheycan let you reinvest in the company.If they receive a dividend, they caninvestthatmoneyandearnareturnonit.Consequently,ifthecompanykeepsthemoneyasretainedearningsandreinvestsinprojects,ithadbetterearnareturnonthatmoney.Therefore,thereisacostassociatedwith using retained earnings.

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Term
Spring
Professor
N/A
Tags
Corporate Finance, Cost Of Capital, Interest, Dividend yield, Weighted average cost of capital

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