Solution to Final Exam - Business Finance | FIR 3410, Exams of Corporate Finance

Download Solution to Final Exam - Business Finance | FIR 3410 and more Exams Corporate Finance in PDF only on Docsity! Capital components Answer: c Diff: E N 1. Which of the following statements is most correct? a. Since the money is readily available, the cost of retained earnings is usually a lot cheaper than the cost of debt financing. b. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are tax deductible. c. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are tax deductible. d. Statements a and b are correct. e. Statements b and c are correct. WACC Answer: e Diff: E N 2. Which of the following statements is most correct? a. The WACC represents the after-tax cost of capital. b. The WACC represents the marginal cost of capital. c. The cost of retained earnings is generally less expensive than the cost of issuing new common stock, due to flotation costs. d. Statements a and b are correct. e. All of the statements above are correct. Factors influencing WACC Answer: a Diff: E 3. Wyden Brothers has no retained earnings. The company uses the CAPM to calculate the cost of equity capital. The company’s capital structure consists of common stock, preferred stock, and debt. Which of the following events will reduce the company’s WACC? a. A reduction in the market risk premium. b. An increase in the flotation costs associated with issuing new common stock. c. An increase in the company’s beta. d. An increase in expected inflation. e. An increase in the flotation costs associated with issuing preferred stock. WACC and capital components Answer: c Diff: E 4. Which of the following statements is most correct? a. The WACC is a measure of the before-tax cost of capital. b. Typically the after-tax cost of debt financing exceeds the after-tax cost of equity financing. Chapter 10 - Page 1 Harcourt, Inc. items and derived items copyright © 2002 by Harcourt, Inc. CHAPTER 9 THE COST OF CAPITAL c. The WACC measures the marginal after-tax cost of capital. d. Statements a and b are correct. e. Statements b and c are correct. Risk-adjusted cost of capital Answer: e Diff: M R 5. If a company uses the same cost of capital for evaluating all projects, which of the following results is likely? a. Accepting poor, high-risk projects. b. Rejecting good, low-risk projects. c. Accepting only good, low-risk projects. d. Accepting no projects. e. Answers a and b are correct. Cost of new equity Answer: d Diff: E N 6. Blair Brothers’ stock currently has a price of $50 per share and is expected to pay a year-end dividend of $2.50 per share (D1 = $2.50). The dividend is expected to grow at a constant rate of 4 percent per year. The company has insufficient retained earnings to fund capital projects and must, therefore, issue new common stock. The new stock has an estimated flotation cost of $3 per share. What is the company’s cost of equity capital? a. 10.14% b. 9.21% c. 9.45% d. 9.32% e. 9.00% Cost of retained earnings Answer: d Diff: E 7. Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent common equity. The current market price of the firm’s stock is P0 = $28; its last dividend was D0 = $2.20, and its expected dividend growth rate is 6 percent. What will Allison’s marginal cost of retained earnings, ks, be? a. 15.8% b. 13.9% c. 7.9% d. 14.3% e. 9.7% WACC Answer: b Diff: E N 8. Billick Brothers is estimating its WACC. The company has collected the following information: Chapter 10 - Page 2 Harcourt, Inc. items and derived items copyright © 2002 by Harcourt, Inc. Chapter 10 - Page 5 Harcourt, Inc. items and derived items copyright © 2002 by Harcourt, Inc. CHAPTER 10 ANSWERS AND SOLUTIONS 1. Capital components Answer: c Diff: E N Retained earnings are just another form of equity. When the company has retained earnings, they can do one of two things--reinvest it or pay it out as dividends. If the firm reinvests the earnings, it needs to earn a return that is at least as high as the ks of the stock. Otherwise, investors would be happier receiving the dividends and investing them in something that will earn ks. Therefore, statement a is false. Some of the preferred stock dividends are excluded from taxation when another company owns them. It makes no tax difference to the company that pays the dividends, since dividends come out of after-tax dollars. Therefore, statement b is false. Interest payments are tax deductible. Therefore, statement c is true. 2. WACC Answer: e Diff: E N 3. Factors influencing WACC Answer: a Diff: E Statement a is true; the other statements are false. If RPM decreases, the cost of equity will be reduced. Answers b through e will all increase the company’s WACC. 4. WACC and capital components Answer: c Diff: E WACC measures the marginal after-tax cost of capital; therefore, statement a is false. The after-tax cost of debt financing is less than the after- tax cost of equity financing; therefore, statement b is false. The correct choice is statement c. 5. Risk-adjusted cost of capital Answer: e Diff: M R 6. Cost of new equity Answer: d Diff: E N The firm must issue new equity to fund its capital projects, so we need to find the cost of new equity capital, ke: ke = D1/(P0 - F) + g = $2.50/($50 - $3) + 4% = $2.50/$47 + 4% = 5.32% + 4% = 9.32%. 7. Cost of retained earnings Answer: d Diff: E Use the dividend growth model to calculate ks: ks = 0 0 P g)(1D  + g = $28 )$2.20(1.06 + 0.06 = 0.0833 + 0.06 = 0.1433  14.3%. 8. WACC Answer: b Diff: E N WACC = wdkd(1 - T) + wcks. ks = kRF + RPM(b) ks = 5.5% + 5%(1.4) ks = 5.5% + 7% = 12.5%. WACC = wdkd(1 - T) + wcks WACC = 0.4(9%)(1 - 0.4) + (0.6)12.5% WACC = 9.66%. 9 . Cost of external equity Answer: d Diff: M D0 = $2; D1 = $2(1.07) = $2.14. ke = D1/[P0(1 - F)] + g = $2.14/($42 - $1) + 7% = 12.22%. 10. WACC Answer: e Diff: M N Data given: kRF = 6%; RPM = 5%; b = 1.2; T = 40%; wd = 0.3; we = 0.7. WACC = wdkd(1 - T) + weks. Step 1: Determine the firm’s costs of debt and equity. Enter the following data as inputs in your calculator: N = 26; PV = -920; PMT = 75; FV = 1,000; and then solve for I = kd = 8.2567%. ks = kRF + (RPM)b = 6% + (5%)1.2 = 12%. Step 2: Given the firm’s component costs of capital, calculate the firm’s WACC. WACC = wdkd(1 - T) + weks = 0.3(8.2567%)(1 - 0.4) + 0.7(12%) = 1.4862% + 8.4% = 9.8862%  9.89%.