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Chapter 9

Multiple Choice Identify the choice that best completes the statement or answers the question. ____ 1. Schalheim Sisters Inc. has always paid out all of its earnings as dividends; hence, the firm has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, and its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC? a. The market risk premium declines. b. The flotation costs associated with issuing new common stock increase. c. The company's beta increases. d. Expected inflation increases. e. The flotation costs associated with issuing preferred stock increase. 2. Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A's cost of capital is 10.0%, Division B's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A's projects are equally risky, as are all of Division B's projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept? a. A Division B project with a 13% return. b. A Division B project with a 12% return. c. A Division A project with an 11% return. d. A Division A project with a 9% return. e. A Division B project with an 11% return. 3. 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? a. Project B, which is of below-average risk and has a return of 8.5%. b. Project C, which is of above-average risk and has a return of 11%. c. Project A, which is of average risk and has a return of 9%. d. None of the projects should be accepted. e. All of the projects should be accepted. 4. Which of the following statements is CORRECT? a. Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputsbeta, the risk-free rate, and the market risk premiumcan be estimated with little error. b. The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the DCF model's logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain. c. The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm's own cost of debt and its risk premium, can be found by using standardized and objective procedures. d. Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker's confidence in the

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estimated cost of equity. e. The DCF model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield. ____ 5. Which of the following statements is CORRECT? a. Since the costs of internal and external equity are related, an increase in the flotation cost required to sell a new issue of stock will increase the cost of retained earnings. b. Since its stockholders are not directly responsible for paying a corporation's income taxes, corporations should focus on before-tax cash flows when calculating the WACC. c. An increase in a firm's tax rate will increase the component cost of debt, provided the YTM on the firm's bonds is not affected by the change in the tax rate. d. When the WACC is calculated, it should reflect the costs of new common stock, retained earnings, preferred stock, long-term debt, short-term bank loans if the firm normally finances with bank debt, and accounts payable if the firm normally has accounts payable on its balance sheet. e. If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the after-tax cost of debt. 6. 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 their firm's 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. 7. S. Bouchard and Company hired you as a consultant to help estimate its cost of common equity. You have obtained the following data: D0 = $0.85; P0 = $22.00; and g = 6.00% (constant). The CEO thinks, however, that the stock price is temporarily depressed, and that it will soon rise to $40.00. Based on the DCF approach, by how much would the cost of common from retained earnings change if the stock price changes as the CEO expects? a. -1.49% b. -1.66% c. -1.84% d. -2.03% e. -2.23%

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8. Eakins Inc.'s common stock currently sells for $45.00 per share, the company expects to earn $2.75 per share during the current year, its expected payout ratio is 70%, and its expected constant growth rate is 6.00%. New stock can be sold to the public at the current price, but a flotation cost of 8% would be incurred. By how much would the cost of new stock exceed the cost of common from retained earnings? a. 0.09% b. 0.19% c. 0.37% d. 0.56% e. 0.84% Multi-Part 9-1: Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below. Assets Current assets Net plant, property, and equipment Total assets Liabilities and Equity Accounts payable Accruals Current liabilities Long-term debt (40,000 bonds, $1,000 par value) Total liabilities Common stock (10,000,000 shares) Retained earnings Total shareholders' equity Total liabilities and shareholders' equity

$ 38,000,000 101,000,000 $139,000,000

$ 10,000,000 9,000,000 $ 19,000,000 40,000,000 $ 59,000,000 30,000,000 50,000,000 80,000,000 $139,000,000

The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%. ____ 9. Refer to Multi-Part 9-1. What is the best estimate of the after-tax cost of debt? a. 4.64% b. 4.88% c. 5.14% d. 5.40% e. 5.67%

____ 10. Refer to Multi-Part 9-1. Which of the following is the best estimate for the weight of debt for use in calculating the firm's WACC? a. 18.67% b. 19.60% c. 20.58% d. 21.61% e. 22.69%

Chapter 9 Answer Section

MULTIPLE CHOICE 1. ANS: A PTS: 1 DIF: Easy OBJ: 9.12 NAT: AACSB: C; I TOP: Factors affecting WACC MSC: Conceptual 2. ANS: C The correct answer is statement c. Division A should accept only projects with returns greater than 10%, while Division B should accept only projects with returns greater than 14%. Only statement c meets this criterion. PTS: 1 DIF: Medium OBJ: 9.13 NAT: AACSB: C; I TOP: Divisional risk MSC: Conceptual 3. ANS: A Project B has a return greater than its risk-adjusted cost of capital, so it should be accepted. PTS: 1 DIF: Medium OBJ: 9.13 NAT: AACSB: C; I TOP: Risk and projects MSC: Conceptual 4. ANS: D PTS: 1 DIF: Hard OBJ: Comp. NAT: AACSB: C; I TOP: Cost of equity MSC: Conceptual 5. ANS: E Statement e is true. The firm would receive no tax savings on interest, so its cost of debt would not be reduced by the tax factor. However, corporate investors would be able to deduct 70% of the preferred dividends they receive, which would make them willing to accept a lower before-tax yield on preferred stock than on bonds. Put another way, the market yield on this firm's preferred could be lower than the interest rate on its debt because of the 70% exclusion; however, with a zero tax rate there would be no reduction in the firm's cost of debt. PTS: 1 DIF: Hard OBJ: Comp. NAT: AACSB: C; I TOP: WACC MSC: Conceptual 6. ANS: E The fact that A's returns are negatively correlated means that it serves as a sort of insurance policy to the firm. The fact that its SD is high is actually good, because the negative correlation will cause the project's beta versus the market and also with the firm's other assets to be relatively low, denoting a low risk and thus justifying a relatively low cost of capital. This answer is theoretically always true, and it is especially true if the firm is large, has many projects, and Project A is not a "bet the company" project. PTS: 1 DIF: Hard TOP: Beta and project risk 7. ANS: C D0 P0 g D1 = D0 × (1 + g) rs = D1/P0 + g OBJ: Comp. MSC: Conceptual Old Price $0.85 $22.00 6.00% $0.901 10.10% New Price $0.85 $40.00 6.00% $0.901 8.25% NAT: AACSB: C; I

Difference, rs0 - rs1

-1.84%

PTS: 1 DIF: Medium | Hard OBJ: 9.7 NAT: AACSB: C; I TOP: Cost of common: DCF MSC: Problem 8. ANS: C Expected EPS1 $2.75 Payout ratio 70% Current stk price $45.00 g 6.00% F 8.00% D1 $1.925 rs = D1/P0 + g 10.28% 10.65% re = D1/(P0 × (1 - F)) + g 0.37% Difference = re - rs PTS: 1 TOP: r 9. ANS: C Coupon rate Periods/year Maturity (yr) Bond price Par value Tax rate DIF: Hard MSC: Problem OBJ: 9.10 NAT: AACSB: C; I

7.25% 2 20 $875 $1,000 40%

Calculator inputs: N = 2 × Years = PV = -Bond Price = PMT = (Coupon rate × Par)/2 = FV = Par value = Yield = I/YR, which we solve for = Before-tax cost of debt = rd = yield × 2 = After-tax cost of debt for use in WACC = rd(1 - T) = PTS: 1 DIF: Medium TOP: After-tax cost of debt 10. ANS: A Bond price Number of bonds MV of debt = D Stock price = P 0 Shares outstanding MV of equity = E Total MV = D + E Weight debt = wd = D/Total MV PTS: 1 DIF: Medium TOP: Weights for WACC OBJ: 9.3 MSC: Problem $875.00 40,000 $ 35,000,000 $15.25 10,000,000 $152,500,000 $187,500,000 18.67% OBJ: 9.11 MSC: Problem

40 -$875.00 $36.25 $1,000 4.28% 8.57% 5.14% NAT: AACSB: C; I

NAT: AACSB: C; I

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