CoB (NBS) LOOMBA RISHABH

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AB1201-FINANCIAL MANAGEMENT 2019/2020 Semester 2 Main Content

Lecture 7 - The Cost of Capital Review Test Submission: Lecture 7: Online Assignment

Review Test Submission: Lecture 7: Online Assignment

User CoB (NBS) LOOMBA RISHABH

Course AB1201-FINANCIAL MANAGEMENT 2019/2020 Semester 2 Main
Test Lecture 7: Online Assignment
Started 3/10/20 9:34 AM
Submitted 3/10/20 9:38 AM
Due Date 3/23/20 11:59 PM
Status Completed
Attempt Score 100 out of 100 points  
Time Elapsed 4 minutes
Instructions Answer the questions below to check your understanding of concepts covered
in Lecture 7.

Results All Answers, Submitted Answers, Correct Answers, Feedback, Incorrectly

Displayed Answered Questions

Question 1 10 out of 10 points

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 rm is not completely debt nanced, the weighted
average cost of capital (WACC) will normally be greater than rd(1 - T).

Selected Answer: True

Answers: True
False

Question 2 10 out of 10 points

Weaver Chocolate Co. expects to earn $3.50 per share during the current year, its
expected dividend payout ratio is 65%, its expected constant dividend growth rate
is 6.0%, and its common stock currently sells for $32.50 per share. New stock can
be sold to the public at the current price, but a otation cost of 5% would be
incurred.
What would be the cost of equity from new common stock?

Selected Answer: B. 13.37%

 Answers: A. 12.70%

B. 13.37%

C. 14.04%

D. 14.74%

E. 15.48%

Response Feedback: Expected EPS1     $3.50

Payout ratio   65%
Expected dividend, D1 = EPS x Payout   $2.275
Current stock price   $32.50
g   6.00%
F   5.00%
re = D1/(P0x(1-F)) + g   13.37%

Question 3 10 out of 10 points

Which of the following statements is most CORRECT?

Selected B.
Answer: Managers can change a company’s WACC by adjusting its dividend
policy.

Answers: A.
Increasing the amount of debt in the capital structure will always
reduce the company’s WACC as debt is cheaper than equity.

B.
Managers can change a company’s WACC by adjusting its dividend
policy.

C.
A company should use the composite WACC to evaluate all projects
within the company.

D.
An increase in the company’s stock price will increase its WACC, all
else equals.

E.
A company should calculate its WACC for one year and use this WACC
to evaluate all future projects in the coming 3 years.

Question 4 10 out of 10 points

In general, rms should use their weighted average cost of capital (WACC) to
evaluate capital budgeting projects because most projects are funded with
general corporate funds, which come from a variety of sources. However, if the
 rm plans to use only debt or only equity to fund a particular project, it should
use the after-tax cost of that speci c type of capital to evaluate that project.

Selected Answer: False

Answers: True
False
Response In general, this statement is false, because the rm should be viewed
Feedback: as an ongoing entity, and using debt (or equity) to fund a given
project will change the capital structure, and this factor should be
recognized by basing the cost of capital for all projects on a target
capital structure. Under some special circumstances, where a project
is set up as a separate entity, then “project nancing” may be used,
and only the project's speci c situation is considered. This is a
speci c situation, however, and not the “in general” case.

Question 5 10 out of 10 points

Bosio Inc.'s perpetual preferred stock sells for $97.50 per share, and it pays an
$8.50 annual dividend.
If the company were to sell a new preferred issue, it would incur a otation cost of
4.00% of the price paid by investors.
What is the company's cost of preferred stock for use in calculating the WACC?

Selected Answer: B. 9.08%

Answers: A. 8.72%

B. 9.08%

C. 9.44%

D. 9.82%

E. 10.22%

Response Feedback: Preferred stock price       $97.50

Preferred dividend   $8.50
Flotation cost   4.00%
rp = Dp/(Pp(1-F))   9.08%

Question 6 10 out of 10 points

Sorensen Systems Inc. is expected to pay a $2.50 dividend at year end (D1 =
$2.50), the dividend is expected to grow at a constant rate of 5.50% a year, and
the common stock currently sells for $52.50 a share.
The before-tax cost of debt is 7.50%, and the tax rate is 40%.
The target capital structure consists of 45% debt and 55% common equity.
What is the company’s WACC if all the equity used is from retained earnings?

Selected Answer: C. 7.67%

Answers:
 A. 7.07%

B. 7.36%

C. 7.67%

D. 7.98%

E. 8.29%

Response Feedback: D1     $2.50

g   5.50%
P0   $52.50
rd   7.50%
Tax rate   40%
Weight debt   45%
Weight equity   55%
rd(1-T)   4.50%
rs = D1/P0 + g   10.26%
WACC = wd(rd)(1-T) + wc(rs) =   7.67%

Question 7 10 out of 10 points

Daves Inc. recently hired you as a consultant to estimate the company’s WACC.
You have obtained the following information.
(1) The rm's noncallable bonds mature in 20 years, have an 8.00% annual
coupon, a par value of $1,000, and a market price of $1,050.00.
(2) The company’s tax rate is 40%.
(3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock’s
beta is 1.20.
(4) The target capital structure consists of 35% debt and the balance is common
equity.
The rm uses the CAPM to estimate the cost of equity, and it does not expect to
issue any new common stock.
What is its WACC?

Selected Answer: E. 8.79%

Answers: A. 7.16%

B. 7.54%

C. 7.93%

D. 8.35%

E. 8.79%

Response Feedback: Coupon rate     8.00%

Maturity   20
Bond price    $1,050.00 
Par value    $1,000 
Tax rate    40%
  4.50% 
 rRE 
RPM   5.50% 
b    1.20 
Weight debt    35% 
Weight equity    65% 
Bond yield    7.51% 
After-tax cost of debt = rd(1-T)    4.51% 
Cost of equity, rs = rRE + b(RPM)    11.10% 
WACC = Wd(rd)(1-T) + wc(rs) =     8.79%

Question 8 10 out of 10 points

LaPango 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?

Selected D.
Answer: Project B, which is of below-average risk and has a return of
8.5%.

Answers: A. None of the projects should be accepted.

B. All of the projects should be accepted.

C. Project A, which is of average risk and has a return of 9%.

D.
Project B, which is of below-average risk and has a return of
8.5%.

E.
Project C, which is of above-average risk and has a return of
11%.

Response Project B has a return greater than its risk-adjusted cost of

Feedback: capital, so it should be accepted.

Question 9 10 out of 10 points

Lucky Enterprises, an all-equity rm, has a beta of 2.0.

The chief nancial o cer is evaluating a project with an expected return of 15%,
before any risk adjustment.
The risk-free rate is 5%, and the market risk premium is 4%.
The project being evaluated is riskier than the average project in Lucky
Enterprises, in terms of both its beta risk and its total risk.
Which of the following statements is CORRECT?

Selected B.
Answer:
 The accept/reject decision depends on the rm's risk-adjustment
policy.
If Lucky's policy is to increase the required return on a riskier-than-
average project to 3% over the required return on an average-risk
project, then it should reject the project.

Answers: A.
The project should de nitely be rejected because its expected return
(before risk adjustment) is less than its required return.

B.
The accept/reject decision depends on the rm's risk-adjustment
policy.
If Lucky's policy is to increase the required return on a riskier-than-
average project to 3% over the required return on an average-risk
project, then it should reject the project.

C.
The project should de nitely be accepted because its expected return
(before any risk adjustments) is greater than its required return.

D.
Riskier-than-average projects should have their expected returns
increased to re ect their higher risk.
Clearly, this would make the project acceptable regardless of the
amount of the adjustment.

E.
Capital budgeting projects should be evaluated solely on the basis of
their total risk.
Thus, insu cient information has been provided to make the
accept/reject decision.

Question 10 10 out of 10 points

Which of the following statements is CORRECT?

Selected E.
Answer: If a company’s tax rate increases but the YTM on its noncallable
bonds remains the same, the after-tax cost of its debt will fall.

Answers: A.
When calculating the cost of preferred stock, a company needs to
adjust for taxes, because preferred stock dividends are deductible by
the paying corporation.

B.
All else equal, an increase in a company’s stock price will increase its
marginal cost of retained earnings, rs.

C.
All else equal, an increase in a company’s stock price will increase its
marginal cost of new common equity, re.

D.
Since the money is readily available, the after-tax cost of retained
earnings is usually much lower than the after-tax cost of debt.
 E.
If a company’s tax rate increases but the YTM on its noncallable
bonds remains the same, the after-tax cost of its debt will fall.

Response Statement e is true, because the after-tax cost of debt is rd(1 − T). So,
Feedback: if rd remains constant but T increases, rd(1 − T) will decline. The
other statements are all false.

Tuesday, March 10, 2020 9:38:17 AM SGT

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