a Project A is of average risk and has a return of 9 b Project B is of below

# A project a is of average risk and has a return of 9

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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. e. All of the projects should be accepted.
i . Capital components Answer: c Diff: E ii . WACC Answer: d Diff: M If a firm paid no income taxes, its cost of debt would not be adjusted downward, hence the component cost of debt would be higher than if T were greater than 0. With a higher component cost of debt, the WACC would increase. Of course, the company would have higher earnings, and its cash flows from a given project would be high, so the higher WACC would not impede its investments, that is, its capital budget would be larger than if it were taxed. iii . Component cost of debt Answer: c Diff: M Time line: 0 1 2 3 4 80 Quarters | | | | | • • • | PMT = 20 20 20 20 20 V B = 686.86 FV = 1,000 k d = ? Fin ancial calculator solution: Calculate the nominal YTM of bond: Inputs: N = 40; PV = -686.86; PMT = 40; FV = 1000. Output: I = 6.11% periodic rate. Nominal annual rate = 6.11% × 2 = 12.22%. Calculate k d after-tax: k d,AT = 12.22(1 - T) = 12.22(1 - 0.4) = 7.33%. iv . Cost of retained earnings Answer: d Diff: E Use the dividend growth model to calculate k s : k s = 0 0 P g) (1 D + + g = \$28 ) \$2.20(1.06 + 0.06 = 0.0833 + 0.06 = 0.1433 14.3%. v . Cost of retained earnings Answer: d Diff: M The cost of retained earnings as calculated from the CAPM is k s = k RF + (k M - k RF )b = 5% + (6%)1.2 = 12.2%. vi . Cost of new equity Answer: d Diff: E The firm must issue new equity to fund its capital projects, so we need to find the cost of new equity capital, k e : k e = D 1 /(P 0 - F) + g = \$2.50/(\$50 - \$3) + 4% = \$2.50/\$47 + 4% = 5.32% + 4% = 9.32%. vii . Component cost of preferred stock Answer: c EASY Preferred stock price 90.00 Preferred dividend 7.02 Flotation cost 5.00% rp 8.21% rp = 7.02/[90(1-.05)] = .0821 = 8.21%
viii . Component cost of retained earnings: CAPM Answer: d EASY r RF 5.50% RP M 6.00% b 0.80 r s 10.30% ix . Component cost of retained earnings: CAPM Answer: a EASY r RF 5.00% RP M 5.00% b 1.10 r s 10.50% x . Component cost of retained earnings: DCF, D 1 Answer: d EASY rs = 1.00(1.06)/25 + .06 = .0424 + .06 = .1024 = 10.24% xi . Component cost of retained earnings: DCF, D 1 Answer: e EASY D 1 \$1.30 P 0 \$40.00 g 7.00% r s 10.25% xii . WACC Answer: d EASY Weights Costs Debt 40% 4.00% Preferred 10% 7.50% Common 50% 11.50% WACC 8.10% xiii . Component cost of debt Answer: a MEDIUM
Coupon rate 8.00% Periods/year 4 Maturity (yr) 25 Bond price \$900.90 Par value \$1,000 Tax rate 40% Calculator inputs: N 100 PV -\$900.90 PMT \$20 FV \$1,000 I/YR 2.25% times 4 = 9.0% = Before-tax cost of debt 5.40% = After-tax cost of debt (A-T r d ) for use in WACC xiv . WACC Answer: d MEDIUM/HARD D 1 \$3.00 P 0 \$60.00 g 7.00% r d 8.00% Tax rate 40% Weight debt 60% Weight equity 40% r d (1-t) 4.80% r s 12.0% WACC 7.68% xv . Capital components Answer: e MEDIUM Statement e is true. xvi . WACC Answer: d MEDIUM xvii . Factors influencing WACC Answer: c MEDIUM xviii . Risk and project selection Answer: b MEDIUM The project whose return is greater than its risk-adjusted cost of capital should be selected. Only Project B meets this criterion.

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