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Exam 10: The Cost of Capital

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Question 51

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Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.

A) If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms' assets.
B) If a firm's managers want to maximize the value of the stock, they should, in theory, concentrate on project risk as measured by the standard deviation of the project's expected future cash flows.
C) If a firm evaluates all projects using the same cost of capital, and the CAPM is used to help determine that cost, then its risk as measured by beta will probably decline over time.
D) Projects with above-average risk typically have higher-than-average expected returns. Therefore, to maximize a firm's intrinsic value, its managers should favor high-beta projects over those with lower betas.
E) Project A has a standard deviation of expected returns of 20%, while Project B's standard deviation is only 10%. A's returns are negatively correlated with both the firm's other assets and the returns on most stocks in the economy, while B's returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital.

F) All of the above
G) D) and E)

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Question 52

Multiple Choice

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If a typical U.S. company correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely

A) become riskier over time, but its intrinsic value will be maximized.
B) become less risky over time, and this will maximize its intrinsic value.
C) accept too many low-risk projects and too few high-risk projects.
D) become more risky and also have an increasing WACC. Its intrinsic value will not be maximized.
E) continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital.

F) A) and B)
G) A) and C)

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Question 53

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When working with the CAPM, which of the following factors can be determined with the most precision?

The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and retained earnings, whose cost is the average return on the assets that are acquired.

The cost of debt, rd, is normally less than rs, so rd(1 − T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 − T).

Bolster Foods' (BF) balance sheet shows a total of $25 million long-term debt with a coupon rate of 8.50%. The yield to maturity on this debt is 8.00%, and the debt has a total current market value of $27 million. The balance sheet also shows that the company has 10 million shares of stock, and the stock has a book value per share of $5.00. The current stock price is $20.00 per share, and stockholders' required rate of return, rs, is 12.25%. The company recently decided that its target capital structure should have 35% debt, with the balance being common equity. The tax rate is 40%. Calculate WACCs based on book, market, and target capital structures, and then find the sum of these three WACCs.

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.

Which of the following statements is CORRECT?

Suppose the debt ratio is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC).

Vang Enterprises, which is debt-free and finances only with equity from retained earnings, is considering 7 equal- sized capital budgeting projects. Its CFO hired you to assist in deciding whether none, some, or all of the projects should be accepted. You have the following information: rRF = 4.50%; RPM = 5.50%; and b = 0.92. The company adds or subtracts a specified percentage to the corporate WACC when it evaluates projects that have above- or below-average risk. Data on the 7 projects are shown below. If these are the only projects under consideration, how large should the capital budget be? $\begin{array}{lcccc}&&\text { Risk } & \text { Expected} & \text {Cost }\\ \underline{\text { Project }} & \underline{\text { Risk }} & \underline{\text { Factor }} &\underline{ \text { Return }} & \underline{\text { (Millions) }} \\1 & \text { Very low } & -2.00 \% & 7.60 \% & \$ 25.0 \\2 & \text { Low } & -1.00 \% & 9.15 \% & \$ 25.0 \\3 & \text { Average } & 0.00 \% & 10.10 \% & \$ 25.0 \\4 & \text { High } & 1.00 \% & 10.40 \% & \$ 25.0 \\5 & \text { Very high } & 2.00 \% & 10.80 \% & \$ 25.0 \\6 & \text { Very high } & 2.00 \% & 10.90 \% & \$ 25.0 \\7 & \text { Very high } & 2.00 \% & 13.00 \% & \$ 25.0\end{array}$

Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt.

The CFO of Lenox Industries hired you as a consultant to help estimate its cost of capital. You have obtained the following data: (1) rd = yield on the firm's bonds = 7.00% and the risk premium over its own debt cost = 4.00%. (2) rRF = 5.00%, RPM = 6.00%, and b = 1.25. (3) D1 = $1.20, P0 = $35.00, and g = 8.00% (constant) . You were asked to estimate the cost of equity based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates. What is that difference?

Refer to Exhibit 10.1. What is the best estimate of the after-tax cost of debt?

Which of the following statements is CORRECT?