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Problem Set # 8

DATE DUE: 4/24/2013 @ 11:59 am (noon)

Questions for Problem Set #8 come from “Part 9 practice questions” below. Work only the following problems: #14, #15, #20, #21, #23, #25, #27, #32 (solutions for all the remaining problems are provided at the end of the document – see page 16; correct answers are in bold). All problems are based on Chapter 14: “Cost of Capital” of Ross, Westerfield, and Jordan and the lecture slides (Part 9).

Note: Late submissions WILL NOT be accepted and NO MAKEUPS of homework problems will be allowed (see due date/time above). All homework assignments should be submitted electronically in Word of PDF format via the Katalyst website. NO HARD COPIES will be accepted.

NO CREDIT will be given for answers if supporting work is not shown. Partial credit will be given for correct procedures even if the correct answer is not reached. In the event that a problem is done completely on a calculator, briefly explain how (e.g. provide relevant formulae). Your work and answers should be clear and organized. Please box your answer

1.A group of individuals got together and purchased all of the outstanding shares of common stock of DL Smith, Inc. What is the return that these individuals require on this investment called?

A.dividend yield

B.cost of equity

C.capital gains yield

D.cost of capital

E.income return

Page 1 of 34 MGMT310: Part 9 practice questions

2.Textile Mills borrows money at a rate of 13.5 percent. This interest rate is referred to as the:

A.compound rate.

B.current yield.

C.cost of debt.

D.capital gains yield.

E.cost of capital.

3.The average of a firm's cost of equity and aftertax cost of debt that is weighted based on the firm's capital structure is called the:

A.reward to risk ratio.

B.weighted capital gains rate.

C.structured cost of capital.

D.subjective cost of capital.

E.weighted average cost of capital.

4.Which one of the following is the primary determinant of a firm's cost of capital?

A.debt-equity ratio

B.applicable tax rate

C.cost of equity

D.cost of debt

E.use of the funds

Page 2 of 34 MGMT310: Part 9 practice questions

5.Scholastic Toys is considering developing and distributing a new board game for children. The project is similar in risk to the firm's current operations. The firm maintains a debt-equity ratio of 0.40 and retains all profits to fund the firm's rapid growth. How should the firm determine its cost of equity?

A.by adding the market risk premium to the aftertax cost of debt

B.by multiplying the market risk premium by (1 - 0.40)

C.by using the dividend growth model

D.by using the capital asset pricing model

E.by averaging the costs based on the dividend growth model and the capital asset pricing model

6.A firm's cost of equity is:

A.is generally less that the firm's WACC given a leveraged firm.

B.unaffected by changes in the market risk premium.

C.highly dependent upon the risk level of the firm.

D.generally less than the firm's after-tax cost of debt.

E.inversely related to changes in the firm's tax rate.

7.The pre-tax cost of debt:

A.is based on the current yield to maturity of the firm's outstanding bonds.

B.is equal to the coupon rate on the latest bonds issued by a firm.

C.is equivalent to the average current yield on all of a firm's outstanding bonds.

D.is based on the original yield to maturity on the latest bonds issued by a firm.

E.has to be estimated as it cannot be directly observed in the market.

Page 3 of 34 MGMT310: Part 9 practice questions

8.The capital structure weights used in computing the weighted average cost of capital:

A.are based on the book values of total debt and total equity.

B.are based on the market value of the firm's debt and equity securities.

C.are computed using the book value of the long-term debt and the book value of equity.

D.remain constant over time unless the firm issues new securities.

E.are restricted to the firm's debt and common stock.

9.The weighted average cost of capital for a firm is the:

A.discount rate which the firm should apply to all of the projects it undertakes.

B.rate of return a firm must earn on its existing assets to maintain the current value of its stock.

C.coupon rate the firm should expect to pay on its next bond issue.

D.minimum discount rate the firm should require on any new project.

E.rate of return shareholders should expect to earn on their investment in this firm.

10.The discount rate assigned to an individual project should be based on:

A.the firm's weighted average cost of capital.

B.the actual sources of funding used for the project.

C.an average of the firm's overall cost of capital for the past five years.

D.the current risk level of the overall firm.

E.the risks associated with the use of the funds required by the project.

Page 4 of 34 MGMT310: Part 9 practice questions

11.Assigning discount rates to individual projects based on the risk level of each project:

A.may cause the firm's overall weighted average cost of capital to either increase or decrease over time.

B.will prevent the firm's overall cost of capital from changing over time.

C.will cause the firm's overall cost of capital to decrease over time.

D.decreases the value of the firm over time.

E.negates the firm's goal of creating the most value for the shareholders.

12.Phil's is a sit-down restaurant that specializes in home-cooked meals. Theresa's is a walk-in deli that specializes in specialty soups and sandwiches. Both firms are currently considering expanding their operations during the summer months by offering pre- wrapped donuts, sandwiches, and wraps at a local beach. Phil's currently has a WACC of 14 percent while Theresa's WACC is 10 percent. The expansion project has a projected net present value of $12,600 at a 10 percent discount rate and a net present value of -$2,080 at a 14 percent discount rate. Which firm or firms should expand and offer food at the local beach during the summer months?

A.Phil's only

B.Theresa's only

C.both Phil's and Theresa's

D.neither Phil's nor Theresa's

E.cannot be determined from the information provided

Page 5 of 34 MGMT310: Part 9 practice questions

13.Southern Home Cookin' just paid its annual dividend of $0.65 a share. The stock has a market price of $13 and a beta of 1.12. The return on the U.S. Treasury bill is 2.5 percent and the market risk premium is 6.8 percent. What is the cost of equity?

A.9.98 percent

B.10.04 percent

C.10.12 percent

D.10.37 percent

E.10.45 percent

14.Henessey Markets has a growth rate of 4.8 percent and is equally as risky as the market. The stock is currently selling for $17 a share. The overall stock market has a 10.6 percent rate of return and a risk premium of 8.7 percent. What is the expected rate of return on this stock?

A.8.7 percent

B.9.2 percent

C.10.6 percent

D.11.3 percent

E.11.7 percent

Page 6 of 34 MGMT310: Part 9 practice questions

15.Tidewater Fishing has a current beta of 1.21. The market risk premium is 8.9 percent and the risk-free rate of return is 3.2 percent. By how much will the cost of equity increase if the company expands its operations such that the company beta rises to 1.50?

A.1.88 percent

B.2.58 percent

C.2.60 percent

D.3.10 percent

E.3.26 percent

16.Electronics Galore has 950,000 shares of common stock outstanding at a market price of $38 a share. The company also has 40,000 bonds outstanding that are quoted at 106 percent of face value. What weight should be given to the debt when the firm computes its weighted average cost of capital?

A.42 percent

B.46 percent

C.50 percent

D.54 percent

E.58 percent

Page 7 of 34 MGMT310: Part 9 practice questions

17.Kelso's has a debt-equity ratio of 0.6 and a tax rate of 35 percent. The firm does not issue preferred stock. The cost of equity is 14.5 percent and the after-tax cost of debt is 4.8 percent. What is the weighted average cost of capital?

A.10.46 percent

B.10.67 percent

C.10.86 percent

D.11.38 percent

E.11.57 percent

18.Delta Lighting has 30,000 shares of common stock outstanding at a market price of $15.00 a share. This stock was originally issued at $31 per share. The firm also has a bond issue outstanding with a total face value of $280,000 which is selling for 86 percent of par. The cost of equity is 13 percent while the after-tax cost of debt is 6.9 percent. The firm has a beta of 1.48 and a tax rate of 30 percent. What is the weighted average cost of capital?

A.10.07 percent

B.10.87 percent

C.12.36 percent

D.13.29 percent

E.13.47 percent

Page 8 of 34 MGMT310: Part 9 practice questions

19.The Market Outlet has a beta of 1.38 and a cost of equity of 14.945 percent. The risk- free rate of return is 4.25 percent. What discount rate should the firm assign to a new project that has a beta of 1.25?

A.13.54 percent.

B.13.72 percent.

C.13.94 percent.

D.14.14 percent.

E.14.36 percent.

20.Silo Mills has a beta of 0.95 and a cost of equity of 11.9 percent. The risk-free rate of return is 2.8 percent. The firm is currently considering a project that has a beta of 1.03 and a project life of 6 years. What discount rate should be assigned to this project?

A.13.33 percent.

B.12.67 percent.

C.13.62 percent.

D.13.84 percent.

E.14.09 percent.

Page 9 of 34 MGMT310: Part 9 practice questions

21.Panelli's is analyzing a project with an initial cost of $110,000 and cash inflows of $65,000 in year one and $74,000 in year two. This project is an extension of the firm's current operations and thus is equally as risky as the current firm. The firm uses only debt and common stock to finance its operations and maintains a debt-equity ratio of 0.45. The after-tax cost of debt is 4.8 percent, the cost of equity is 12.7 percent, and the tax rate is 35 percent. What is the projected net present value of this project?

A.$7,411

B.$7,809

C.$8,333

D.$8,938

E.$9,840

22.Carson Electronics uses 70 percent common stock and 30 percent debt to finance its operations. The after-tax cost of debt is 5.4 percent and the cost of equity is 15.4 percent. Management is considering a project that will produce a cash inflow of $36,000 in the first year. The cash inflows will then grow at 3 percent per year forever. What is the maximum amount the firm can initially invest in this project to avoid a negative net present value for the project?

A.$299,032

B.$382,979

C.$411,406

D.$434,086

E.$441,414

Page 10 of 34 MGMT310: Part 9 practice questions

23.The Bakery is considering a new project it considers to be a little riskier than its current operations. Thus, management has decided to add an additional 1.5 percent to the company's overall cost of capital when evaluating this project. The project has an initial cash outlay of $58,000 and projected cash inflows of $17,000 in year one, $28,000 in year two, and $30,000 in year three. The firm uses 25 percent debt and 75 percent common stock as its capital structure. The company's cost of equity is 15.5 percent while the after-tax cost of debt for the firm is 6.1 percent. What is the projected net present value of the new project?

A.-$6,208

B.-$1,964

C.-$308

D.$1,427

E.$1,573

24.The Oil Derrick has an overall cost of equity of 13.6 percent and a beta of 1.28. The firm is financed solely with common stock. The risk-free rate of return is 3.4 percent. What is an appropriate cost of capital for a division within the firm that has an estimated beta of 1.18?

A.12.37 percent

B.12.41 percent

C.12.54 percent

D.12.67 percent

E.12.80 percent

Page 11 of 34 MGMT310: Part 9 practice questions

25.Miller Sisters has an overall beta of 0.79 and a cost of equity of 11.2 percent for the firm overall. The firm is 100 percent financed with common stock. Division A within the firm has an estimated beta of 1.08 and is the riskiest of all of the firm's operations. What is an appropriate cost of capital for division A if the market risk premium is 9.5 percent?

A.13.12 percent

B.13.96 percent

C.14.63 percent

D.15.77 percent

E.16.01 percent

26.Deep Mining and Precious Metals are separate firms that are both considering a silver exploration project. Deep Mining is in the actual mining business and has an after-tax cost of capital of 12.8 percent. Precious Metals is in the precious gem retail business and has an after-tax cost of capital of 10.6 percent. The project under consideration has initial costs of $575,000 and anticipated annual cash inflows of $102,000 a year for ten years. Which firm(s), if either, should accept this project?

A.Company A only

B.Company B only

C.both Company A and Company B

D.neither Company A or Company B

E.cannot be determined without further information

Page 12 of 34 MGMT310: Part 9 practice questions

27.Sister Pools sells outdoor swimming pools and currently has an after-tax cost of capital of 11.6 percent. Al's Construction builds and sells water features and fountains and has an after-tax cost of capital of 10.3 percent. Sister Pools is considering building and selling its own water features and fountains. The sales manager of Sister Pools estimates that the water features and fountains would produce 20 percent of the firm's future total sales. The initial cash outlay for this project would be $85,000. The expected net cash inflows are $17,000 a year for 7 years. What is the net present value of the Sister Pools project?

A.-$11,044

B.-$3,048

C.-$2,262

D.-$1,508

E.$1,219

28.Decker's is a chain of furniture retail stores. Furniture Fashions is a furniture maker and a supplier to Decker's. Decker's has a beta of 1.38 as compared to Furniture Fashion's beta of 1.12. The risk-free rate of return is 3.5 percent and the market risk premium is 8 percent. What discount rate should Decker's use if it considers a project that involves the manufacturing of furniture?

A.12.46 percent

B.12.92 percent

C.13.50 percent

D.14.08 percent

E.14.54 percent

Page 13 of 34 MGMT310: Part 9 practice questions

29.The City Street Corporation's common stock has a beta of 1.2. The risk-free rate is 3.5 percent and the expected return on the market is 13 percent. What is the firm's cost of equity?

A.11.4 percent

B.12.8 percent

C.14.9 percent

D.17.6 percent

E.19.1 percent

30.Jiminy's Cricket Farm issued a 30-year, 8 percent, semiannual bond 6 years ago. The bond currently sells for 114 percent of its face value. What is the after-tax cost of debt if the company's tax rate is 31 percent?

A.4.63 percent

B.4.70 percent

C.4.75 percent

D.4.82 percent

E.4.86 percent

31.Cookie Dough Manufacturing has a target debt-equity ratio of 0.5. Its cost of equity is

15 percent, and its cost of debt is 11 percent. What is the firm's WACC given a tax rate of 31 percent?

A.12.53 percent

B.12.78 percent

C.13.11 percent

D.13.48 percent

E.13.67 percent

Page 14 of 34 MGMT310: Part 9 practice questions

32.Fama's Llamas has a weighted average cost of capital of 9.5 percent. The company's cost of equity is 15.5 percent, and its pretax cost of debt is 8.5 percent. The tax rate is 34 percent. What is the company's target debt-equity ratio?

A.0.89

B.0.92

C.0.98

D.1.01

E.1.54

33.Jungle, Inc. has a target debt-equity ratio of 0.72. Its WACC is 11.5 percent and the tax rate is 34 percent. What is the cost of equity if the after-tax cost of debt is 5.5 percent?

A.13.75 percent

B.13.84 percent

C.14.41 percent

D.14.79 percent

E.15.82 percent

Page 15 of 34 MGMT310: Part 9 practice questions

Part 9 practice questions – answer key

See Chapter 14: “Cost of Capital” of Ross, Westerfield, and Jordan and the lecture slides for tips.

1.A group of individuals got together and purchased all of the outstanding shares of common stock of DL Smith, Inc. What is the return that these individuals require on this investment called?

A. dividend yield

B. cost of equity

C.capital gains yield

D.cost of capital

E.income return

Refer to section 14.2

AACSB: Analytic

Blooms: Remember

Difficulty: 1 Easy

Learning Objective: 14-01 How to determine a firm's cost of equity capital.

Section: 14.2

Topic: Cost of equity

Page 16 of 34 MGMT310: Part 9 practice questions

2.Textile Mills borrows money at a rate of 13.5 percent. This interest rate is referred to as the:

A.compound rate.

B.current yield.

C. cost of debt.

D.capital gains yield.

E.cost of capital.

Refer to section 14.3

AACSB: Analytic

Blooms: Remember

Difficulty: 1 Easy

Learning Objective: 14-02 How to determine a firm's cost of debt.

Section: 14.3

Topic: Cost of debt

3.The average of a firm's cost of equity and after-tax cost of debt that is weighted based on the firm's capital structure is called the:

A.reward to risk ratio.

B.weighted capital gains rate.

C.structured cost of capital.

D.subjective cost of capital.

E. weighted average cost of capital.

Refer to section 14.4

AACSB: Analytic

Blooms: Remember

Difficulty: 1 Easy

Learning Objective: 14-03 How to determine a firm's overall cost of capital.

Section: 14.4

Topic: Weighted average cost of capital

Page 17 of 34 MGMT310: Part 9 practice questions

4.Which one of the following is the primary determinant of a firm's cost of capital?

A.debt-equity ratio

B.applicable tax rate

C.cost of equity

D.cost of debt

E. use of the funds

Refer to section 14.1

AACSB: Analytic

Blooms: Remember

Difficulty: 1 Easy

Learning Objective: 14-03 How to determine a firm's overall cost of capital.

Section: 14.1

Topic: Cost of capital

5.Scholastic Toys is considering developing and distributing a new board game for children. The project is similar in risk to the firm's current operations. The firm maintains a debt-equity ratio of 0.40 and retains all profits to fund the firm's rapid growth. How should the firm determine its cost of equity?

A.by adding the market risk premium to the after-tax cost of debt

B.by multiplying the market risk premium by (1 - 0.40)

C.by using the dividend growth model

D. by using the capital asset pricing model

E.by averaging the costs based on the dividend growth model and the capital asset pricing model

Refer to section 14.2

AACSB: Analytic

Blooms: Understand

Difficulty: 1 Easy

Learning Objective: 14-01 How to determine a firm's cost of equity capital.

Section: 14.2

Topic: Cost of equity

Page 18 of 34 MGMT310: Part 9 practice questions

6.A firm's cost of equity is:

A.is generally less that the firm's WACC given a leveraged firm.

B.unaffected by changes in the market risk premium.

C. highly dependent upon the risk level of the firm.

D.generally less than the firm's after-tax cost of debt.

E.inversely related to changes in the firm's tax rate.

Refer to section 14.2

AACSB: Analytic

Blooms: Understand

Difficulty: 1 Easy

Learning Objective: 14-01 How to determine a firm's cost of equity capital.

Section: 14.2

Topic: Cost of equity

7.The pre-tax cost of debt:

A.is based on the current yield to maturity of the firm's outstanding bonds.

B.is equal to the coupon rate on the latest bonds issued by a firm.

C.is equivalent to the average current yield on all of a firm's outstanding bonds.

D.is based on the original yield to maturity on the latest bonds issued by a firm.

E.has to be estimated as it cannot be directly observed in the market.

Refer to section 14.3

AACSB: Analytic

Blooms: Understand

Difficulty: 1 Easy

Learning Objective: 14-02 How to determine a firm's cost of debt.

Section: 14.3

Topic: Cost of debt

Page 19 of 34 MGMT310: Part 9 practice questions

8.The capital structure weights used in computing the weighted average cost of capital:

A. are based on the book values of total debt and total equity.

B. are based on the market value of the firm's debt and equity securities.

C.are computed using the book value of the long-term debt and the book value of equity.

D.remain constant over time unless the firm issues new securities.

E.are restricted to the firm's debt and common stock.

Refer to section 14.4

AACSB: Analytic

Blooms: Remember

Difficulty: 1 Easy

Learning Objective: 14-03 How to determine a firm's overall cost of capital.

Section: 14.4

Topic: WACC

9.The weighted average cost of capital for a firm is the:

A. discount rate which the firm should apply to all of the projects it undertakes.

B. rate of return a firm must earn on its existing assets to maintain the current value of its stock.

C.coupon rate the firm should expect to pay on its next bond issue.

D.minimum discount rate the firm should require on any new project.

E.rate of return shareholders should expect to earn on their investment in this firm.

Refer to section 14.4

AACSB: Analytic

Blooms: Understand

Difficulty: 1 Easy

Learning Objective: 14-03 How to determine a firm's overall cost of capital.

Section: 14.4

Topic: WACC

Page 20 of 34 MGMT310: Part 9 practice questions

10.The discount rate assigned to an individual project should be based on:

A.the firm's weighted average cost of capital.

B.the actual sources of funding used for the project.

C.an average of the firm's overall cost of capital for the past five years.

D.the current risk level of the overall firm.

E. the risks associated with the use of the funds required by the project.

Refer to section 14.5

AACSB: Analytic Blooms: Remember Difficulty: 1 Easy

Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them. Section: 14.5 Topic: Divisional cost of capital

11.Assigning discount rates to individual projects based on the risk level of each project:

A.may cause the firm's overall weighted average cost of capital to either increase or decrease over time.

B.will prevent the firm's overall cost of capital from changing over time.

C.will cause the firm's overall cost of capital to decrease over time.

D.decreases the value of the firm over time.

E.negates the firm's goal of creating the most value for the shareholders.

Refer to section 14.5

AACSB: Analytic Blooms: Understand Difficulty: 1 Easy

Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them. Section: 14.5 Topic: Project cost of capital

Page 21 of 34 MGMT310: Part 9 practice questions

12.Phil's is a sit-down restaurant that specializes in home-cooked meals. Theresa's is a walk-in deli that specializes in specialty soups and sandwiches. Both firms are currently considering expanding their operations during the summer months by offering pre-wrapped donuts, sandwiches, and wraps at a local beach. Phil's currently has a WACC of 14 percent while Theresa's WACC is 10 percent. The expansion project has a projected net present value of $12,600 at a 10 percent discount rate and a net present value of -$2,080 at a 14 percent discount rate. Which firm or firms should expand and offer food at the local beach during the summer months?

A.Phil's only

B.Theresa's only

C. both Phil's and Theresa's

D.neither Phil's nor Theresa's

E.cannot be determined from the information provided

Refer to section 14.5

AACSB: Analytic Blooms: Understand Difficulty: 1 Easy

Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them. Section: 14.5 Topic: Project cost of capital

Page 22 of 34 MGMT310: Part 9 practice questions

13.Southern Home Cooking just paid its annual dividend of $0.65 a share. The stock has a market price of $13 and a beta of 1.12. The return on the U.S. Treasury bill is 2.5 percent and the market risk premium is 6.8 percent. What is the cost of equity?

A.9.98 percent

B.10.04 percent

C.10.12 percent

D.10.37 percent

E.10.45 percent

E[R] = 0.025 + 1.12 × 0.068 = 10.12 percent

AACSB: Analytic

Blooms: Apply

Difficulty: 1 Easy

Learning Objective: 14-01 How to determine a firm's cost of equity capital.

Section: 14.2

Topic: Cost of equity

14.Henessey Markets has a growth rate of 4.8 percent and is equally as risky as the market. The stock is currently selling for $17 a share. The overall stock market has a 10.6 percent rate of return and a risk premium of 8.7 percent. What is the expected rate of return on this stock?

AACSB: Analytic

Blooms: Apply

Difficulty: 1 Easy

Learning Objective: 14-01 How to determine a firm's cost of equity capital.

Section: 14.2

Topic: Cost of equity

15.Tidewater Fishing has a current beta of 1.21. The market risk premium is 8.9 percent and the risk-free rate of return is 3.2 percent. By how much will the cost of equity increase if the company expands its operations such that the company beta rises to 1.50?

AACSB: Analytic

Blooms: Apply

Difficulty: 1 Easy

Learning Objective: 14-01 How to determine a firm's cost of equity capital.

Section: 14.2

Topic: Cost of equity

Page 23 of 34 MGMT310: Part 9 practice questions

16.Electronics Galore has 950,000 shares of common stock outstanding at a market price of $38 a share. The company also has 40,000 bonds outstanding that are quoted at 106 percent of face value. What weight should be given to the debt when the firm computes its weighted average cost of capital?

A.42 percent

B.46 percent

C.50 percent

D. 54 percent

E. 58 percent

AACSB: Analytic

Blooms: Apply

Difficulty: 1 Easy

Learning Objective: 14-03 How to determine a firm's overall cost of capital.

Section: 14.4

Topic: Weight of debt

17.Kelso's has a debt-equity ratio of 0.6 and a tax rate of 35 percent. The firm does not issue preferred stock. The cost of equity is 14.5 percent and the after-tax cost of debt is 4.8 percent. What is the weighted average cost of capital?

A.10.46 percent

B.10.67 percent

C. 10.86 percent

D.11.38 percent

E.11.57 percent

WACC = (1/1.6) (0.145) + (0.6/1.6) (0.048) = 10.86 percent

AACSB: Analytic

Page 24 of 34 MGMT310: Part 9 practice questions

Blooms: Apply

Difficulty: 1 Easy

Learning Objective: 14-03 How to determine a firm's overall cost of capital.

Section: 14.4

Topic: WACC

18.Delta Lighting has 30,000 shares of common stock outstanding at a market price of $15.00 a share. This stock was originally issued at $31 per share. The firm also has a bond issue outstanding with a total face value of $280,000 which is selling for 86 percent of par. The cost of equity is 13 percent while the aftertax cost of debt is 6.9 percent. The firm has a beta of 1.48 and a tax rate of 30 percent. What is the weighted average cost of capital?

A. 10.07 percent

B. 10.87 percent

C.12.36 percent

D.13.29 percent

E.13.47 percent

WACC = (450,000/690,800 * .13) + (240,800/690,800 * .069) = 10.87 percent

AACSB: Analytic

Blooms: Apply

Difficulty: 1 Easy

Learning Objective: 14-03 How to determine a firm's overall cost of capital.

Section: 14.4

Topic: WACC

Page 25 of 34 MGMT310: Part 9 practice questions

19.The Market Outlet has a beta of 1.38 and a cost of equity of 14.945 percent. The risk-free rate of return is 4.25 percent. What discount rate should the firm assign to a new project that has a beta of 1.25?

A.13.54 percent.

B.13.72 percent.

C. 13.94 percent.

D.14.14 percent.

E.14.36 percent.

E[R] = 0.14945 = 0.0425 + (1.38 × MRP); MRP = 0.0775

RProject = 0.0425 + (1.25 × 0.0775) = 13.94 percent

AACSB: Analytic

Blooms: Apply

Difficulty: 1 Easy

Learning Objective: 14-01 How to determine a firm's cost of equity capital.

Section: 14.5

Topic: Discount rate

20.Silo Mills has a beta of 0.95 and a cost of equity of 11.9 percent. The risk-free rate of return is 2.8 percent. The firm is currently considering a project that has a beta of 1.03 and a project life of 6 years. What discount rate should be assigned to this project?

AACSB: Analytic

Blooms: Apply

Difficulty: 1 Easy

Learning Objective: 14-01 How to determine a firm's cost of equity capital.

Section: 14.5

Topic: Discount rate

Page 26 of 34 MGMT310: Part 9 practice questions

21.Panelli's is analyzing a project with an initial cost of $110,000 and cash inflows of $65,000 in year one and $74,000 in year two. This project is an extension of the firm's current operations and thus is equally as risky as the current firm. The firm uses only debt and common stock to finance its operations and maintains a debt- equity ratio of 0.45. The after-tax cost of debt is 4.8 percent, the cost of equity is 12.7 percent, and the tax rate is 35 percent. What is the projected net present value of this project?

AACSB: Analytic

Blooms: Analyze

Difficulty: 1 Easy

Learning Objective: 14-03 How to determine a firm's overall cost of capital.

Section: 14.5

Topic: Project NPV

22.Carson Electronics uses 70 percent common stock and 30 percent debt to finance its operations. The aftertax cost of debt is 5.4 percent and the cost of equity is 15.4 percent. Management is considering a project that will produce a cash inflow of $36,000 in the first year. The cash inflows will then grow at 3 percent per year forever. What is the maximum amount the firm can initially invest in this project to avoid a negative net present value for the project?

A. $299,032

B. $382,979

C.$411,406

D.$434,086

E.$441,414

WACC = 0.70(0.154) + 0.30(0.054) = 0.124

PV = $36,000/(0.124 - 0.03) = $382,979

AACSB: Analytic

Blooms: Apply

Difficulty: 1 Easy

Learning Objective: 14-03 How to determine a firm's overall cost of capital.

Section: 14.5

Topic: Project NPV

Page 27 of 34 MGMT310: Part 9 practice questions

23.The Bakery is considering a new project it considers to be a little riskier than its current operations. Thus, management has decided to add an additional 1.5 percent to the company's overall cost of capital when evaluating this project. The project has an initial cash outlay of $58,000 and projected cash inflows of $17,000 in year one, $28,000 in year two, and $30,000 in year three. The firm uses 25 percent debt and 75 percent common stock as its capital structure. The company's cost of equity is 15.5 percent while the after-tax cost of debt for the firm is 6.1 percent. What is the projected net present value of the new project?

AACSB: Analytic

Blooms: Analyze

Difficulty: 1 Easy Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them.

Section: 14.5 Topic: Project NPV

24.The Oil Derrick has an overall cost of equity of 13.6 percent and a beta of 1.28. The firm is financed solely with common stock. The risk-free rate of return is 3.4 percent. What is an appropriate cost of capital for a division within the firm that has an estimated beta of 1.18?

A.12.37 percent

B.12.41 percent

C.12.54 percent

D.12.67 percent

E. 12.80 percent

0.136 = 0.034 + 1.28MRP; MRP = 0.0796875 E[R]Division = 0.034 + 1.18(0.0796875) = 12.80 percent

AACSB: Analytic

Blooms: Analyze

Difficulty: 1 Easy Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them.

Section: 14.5 Topic: Divisional cost of capital

Page 28 of 34 MGMT310: Part 9 practice questions

25.Miller Sisters has an overall beta of 0.79 and a cost of equity of 11.2 percent for the firm overall. The firm is 100 percent financed with common stock. Division A within the firm has an estimated beta of 1.08 and is the riskiest of all of the firm's operations. What is an appropriate cost of capital for division A if the market risk premium is 9.5 percent?

AACSB: Analytic

Blooms: Analyze

Difficulty: 1 Easy Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them.

Section: 14.5 Topic: Divisional cost of capital

Page 29 of 34 MGMT310: Part 9 practice questions

26.Deep Mining and Precious Metals are separate firms that are both considering a silver exploration project. Deep Mining is in the actual mining business and has an after-tax cost of capital of 12.8 percent. Precious Metals is in the precious gem retail business and has an after-tax cost of capital of 10.6 percent. The project under consideration has initial costs of $575,000 and anticipated annual cash inflows of $102,000 a year for ten years. Which firm(s), if either, should accept this project?

A.Company A only

B.Company B only

C.both Company A and Company B

D. neither Company A or Company B

E. cannot be determined without further information

Neither company should accept this project as the applicable discount rate for both firms is 12.8 percent (i.e. due to the nature of this project the cost of capital for Deep Mining should be used) and the NPV is negative at this discount rate.

AACSB: Analytic

Blooms: Apply

Difficulty: 1 Easy Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them.

Section: 14.5 Topic: Pure Play

Page 30 of 34 MGMT310: Part 9 practice questions

27.Sister Pools sells outdoor swimming pools and currently has an after-tax cost of capital of 11.6 percent. Al's Construction builds and sells water features and fountains and has an after-tax cost of capital of 10.3 percent. Sister Pools is considering building and selling its own water features and fountains. The sales manager of Sister Pools estimates that the water features and fountains would

produce 20 percent of the firm's future total sales. The initial cash outlay for this project would be $85,000. The expected net cash inflows are $17,000 a year for 7 years. What is the net present value of the Sister Pools project?

AACSB: Analytic

Blooms: Apply

Difficulty: 1 Easy Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them.

Section: 14.5 Topic: Pure Play

28.Decker's is a chain of furniture retail stores. Furniture Fashions is a furniture maker and a supplier to Decker's. Decker's has a beta of 1.38 as compared to Furniture Fashion's beta of 1.12. The risk-free rate of return is 3.5 percent and the market risk premium is 8 percent. What discount rate should Decker's use if it considers a project that involves the manufacturing of furniture?

A.12.46 percent

B.12.92 percent

C.13.50 percent

D.14.08 percent

E.14.54 percent

E[R] = 0.035 + 1.12(0.08) = 12.46 percent

AACSB: Analytic

Blooms: Apply

Difficulty: 1 Easy Learning Objective: 14-05 Some of the pitfalls associated with a firm's overall cost of capital and what to do about them.

Section: 14.5 Topic: Pure Play

Page 31 of 34 MGMT310: Part 9 practice questions

29.The City Street Corporation's common stock has a beta of 1.2. The risk-free rate is

3.5 percent and the expected return on the market is 13 percent. What is the firm's cost of equity?

A.11.4 percent

B.12.8 percent

C.14.9 percent

D.17.6 percent

E.19.1 percent

E[R] = 0.035 + 1.2(0.13 - 0.035) = 14.9 percent

AACSB: Analytic

Blooms: Apply

Difficulty: 1 Easy

EOC: 14-2

Learning Objective: 14-01 How to determine a firm's cost of equity capital.

Section: 14.2

30.Jiminy's Cricket Farm issued a 30-year, 8 percent, semiannual bond 6 years ago. The bond currently sells for 114 percent of its face value. What is the after-tax cost of debt if the company's tax rate is 31 percent?

A. 4.63 percent

B. 4.70 percent

C.4.75 percent

D.4.82 percent

E.4.86 percent

AACSB: Analytic

Blooms: Apply

Difficulty: 1 Easy

Page 32 of 34 MGMT310: Part 9 practice questions

EOC: 14-7

Learning Objective: 14-02 How to determine a firm's cost of debt.

Section: 14.3

Topic: Cost of debt

31.Cookie Dough Manufacturing has a target debt-equity ratio of 0.5. Its cost of equity is 15 percent, and its cost of debt is 11 percent. What is the firm's WACC given a tax rate of 31 percent?

A.12.53 percent

B.12.78 percent

C.13.11 percent

D.13.48 percent

E.13.67 percent

WACC = (1/1.5)(0.15) + (0.5/1.5)(0.11)(1 - 0.31) = 12.53 percent

AACSB: Analytic

Blooms: Apply

Difficulty: 1 Easy

EOC: 14-10

Learning Objective: 14-03 How to determine a firm's overall cost of capital.

Section: 14.4

Topic: WACC

32.Fama's Llamas has a weighted average cost of capital of 9.5 percent. The company's cost of equity is 15.5 percent, and its pretax cost of debt is 8.5 percent. The tax rate is 34 percent. What is the company's target debt-equity ratio?

AACSB: Analytic

Blooms: Analyze

Difficulty: 1 Easy

EOC: 14-11

Learning Objective: 14-03 How to determine a firm's overall cost of capital.

Section: 14.4

Topic: Target capital structure

Page 33 of 34 MGMT310: Part 9 practice questions

33.Jungle, Inc. has a target debt-equity ratio of 0.72. Its WACC is 11.5 percent and the tax rate is 34 percent. What is the cost of equity if the after-tax cost of debt is 5.5 percent?

A.13.75 percent

B.13.84 percent

C.14.41 percent

D.14.79 percent

E. 15.82 percent

WACC = 0.115 = (1/1.72) E[R] + (0.72/1.72)(0.055); E[R] = 15.82 percent

AACSB: Analytic

Blooms: Apply

Difficulty: 1 Easy

EOC: 14-14

Learning Objective: 14-03 How to determine a firm's overall cost of capital.

Section: 14.4

Topic: WACC

Page 34 of 34 MGMT310: Part 9 practice questions