Chapter 012 The Weighted Average Cost of Capital and Company Valuation

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Gwendoline Palmer
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1 True / False QuestionsNew projects can be evaluated using the company cost of capital providing that the: 1. Capital structure in essence is a firm's mix of long-term financing. 2. The company cost of capital is the expected rate of return that investors demand from the company's assets and operations. 3. Amazon.com exhibits lower weighted-average cost of capital than Intel. 4. Weighted-average cost of capital is the expected rate of return on a portfolio of all the firm's securities, adjusted for tax savings due to interest payments. 5. If a project has zero NPV when the expected cash flows are discounted at the weightedaverage cost of capital, then the project's cash flows are just sufficient to give debtholders and shareholders the return they require. 6. McDonalds' weighted-average cost of capital is lower than that of Wal-Mart. 7. There are two costs of debt finance. The explicit cost of debt is the rate of interest that bondholders demand. But there is also an implicit cost, because over-borrowing increases the required rate of return to equity. 13-1

2 8. The weighted-average cost of capital is the return the company needs to earn after tax in order to satisfy all its security holders. 9. If the firm decreases its debt ratio, both the debt and the equity will become more risky. The debtholders and equityholders require a higher return to compensate for the increased risk. 10. If we ignore taxes, the overall cost of capital will stay constant as the fractions of debt and equity change. 11. The company cost of capital does not make an adjustment for the tax effect. 12. The riskiness of equity securities typically exceeds that of debt securities for firms. 13. Calculation of company costs of capital should be conducted with market values whenever possible. 14. Interest tax shields are available to the firm on debt and preferred stock but not on common equity. 15. New projects should only be undertaken by firms if they have the same risk as existing assets. 16. Projects that have a zero NPV when calculated at the WACC will provide sufficient returns to all stakeholders. 17. As a firm changes to a higher debt ratio, debtholders are likely to demand higher rates of return. 18. An increase in a firm's debt ratio will have no effect on the required rate of return for equityholders. 19. A firm's cost of capital can be used in valuation of every new project they encounter, regardless of its risk. 13-2

3 20. The mix of a company's short-term financing is referred to as its capital structure. 21. To the company, the cost of interest payments on bonds (issued debt) is reduced by the amount of tax savings. 22. The interest tax shield generated by a project's actual equity financing is accounted for by using the after-tax cost of equity in the WACC. 23. Assuming a project has the same risk and financing as the firm, it will have a positive NPV if its rate of return is greater than the firm's WACC. 24. For most healthy firms, the YTM on their bonds is the rate of return investors expect from holding their bonds. 25. One way to check the correctness of the expected return on bonds is through the bond discount model. 26. The WACC is the rate of return that the firm must expect to earn on its average-risk investments in order to provide an acceptable return to its security holders. 27. When using the WACC as a discount rate, it is often adjusted upward for riskier projects and downward for safer projects. 28. A change in the company's capital structure will change the amount of taxes paid but will not change the WACC. Multiple Choice Questions 13-3

4 29. Capital structure decisions refer to the: A. dividend yield of the firm's stock. B. blend of equity and debt used by the firm. C. capital gains available on the firm's stock. D. maturity date for the firm's securities. 30. What appears to be the targeted debt ratio of a firm that issues $15 million in bonds and $35 million in equity to finance its new capital projects? A % B % C % D % 31. Proposed assets can be evaluated using the company cost of capital providing that the: A. firm does not pay taxes. B. firm is all equity financed. C. cost of debt is less than the cost of equity. D. new assets have the same risk as existing assets. 32. The company cost of capital for a firm with a 65/35 debt/equity split, 8% cost of debt, 15% cost of equity, and a 35% tax rate would be: A. 7.02% B. 9.12% C % D % 0.65x 8% x 15% = 10.45% 33. The company cost of capital, after tax, for a firm with a 65/35 debt/equity split, 8% cost of debt, 15% cost of equity, and a 35% tax rate would be: A. 7.02% B. 8.63% C % D % 13-4

5 0.65x (1-35%) x 8% x 15% = 8.63% 34. Why is debt financing said to include a tax shield for the company? A. Taxes are reduced by the amount of the debt. B. Taxes are reduced by the amount of the interest. C. Taxable income is reduced by the amount of the debt. D. Taxable income is reduced by the amount of the interest. 13-5

6 35. What is the pretax cost of debt for a firm in the 35% tax bracket that has a 10% after-tax cost of debt? A. 5.85% B % C % D % after-tax cost of debt = pretax cost x (1 - tax rate) 10% = pretax cost x % = pretax cost of debt 36. How much is added to a firm's weighted average cost of capital for 45% debt financing with a required rate of return of 10% and a tax rate of 35%? A. 1.29% B. 2.93% C. 3.50% D. 4.50% 13-6

7 Component cost of debt =.45 x (1 -.35).10 =.45 x (.65 x.10) =.45 x.065 = 2.925% 37. What is the WACC for a firm with 50% debt and 50% equity that pays 12% on its debt, 20% on its equity, and has a 40% tax rate? A. 9.6% B. 12.0% C. 13.6% D. 16.0% WACC = (.5 x (.12 x.6)) + (.5 x.2) = 3.6% + 10% = 13.60% 38. Company X has 2 million shares of common stock outstanding at a book value of $2 per share. The stock trades for $3.00 per share. It also has $2 million in face value of debt that trades at 90% of par. What is its ratio of debt to value for WACC purposes? A % B. 28.6% C. 31.0% D. 33.3% 2 million shares x $3.00 = $6,000,000 $2 million debt x 90% = $1,800,000 Total value = $7,800,000 $1.2 million/$7.8 million = 15.38% 39. What is the after-tax cost of preferred stock that sells for $10 per share and offers a $1.20 dividend when the tax rate is 35%? A. 4.20% B. 7.80% C. 8.33% D % $1.20/$10.00 = 12% 40. What is the WACC for a firm using 55% equity with a required return of 15%, 35% debt with a required return of 8%, 10% preferred stock with a required return of 10%, and a tax rate of 35%? A % B % C % D % 13-7

8 WACC = (.35 x (1 -.35).08) + (.1 x.1) + (.55 x.15) = 1.82% + 1.0% % = 11.07% 41. Should a project be accepted if it offers an annual after-tax cash flow of $1,250,000 indefinitely, costs $10 million, is riskier than the firm's average projects, and the firm uses a 12.5% WACC? A. Yes, since NPV is positive. B. Yes, since a zero NPV indicates marginal acceptability. C. No, since NPV is zero. D. No, since NPV is negative. NPV = -10 million + $2 million/.20 = = 0 However, the 20% rate does not reflect the projects' greater risk; thus NPV is negative. 42. How much will a firm need in cash flow before tax and interest to satisfy debtholders and equityholders if: the tax rate is 40%, there is $10 million in common stock requiring a 12% return, and $6 million in bonds requiring an 8% return? A. $1,392,000 B. $1,488,000 C. $2,480,000 D. $2,800, How much will a firm need in cash flow before tax and interest to satisfy debtholders and equityholders if: the tax rate is 35%, there is $13 million in common stock requiring a 10% return, and $6 million in bonds requiring an 6% return? A. $1,392,000 B. $1,488,000 C. $2,360,000 D. $2,480,

9 44. Which of the following statements is incorrect concerning the equity component of the WACC? A. The value of retained earnings is not included. B. Market values should be used in the calculations. C. Preferred equity has a separate component. D. There is a tax shield such as with debt. 13-9

10 45. What will be the effect of using book value of debt in WACC decisions if interest rates have decreased substantially since a firm's long-term bonds were issued? A. The debt-to-value ratio will be overstated. B. The debt-to-value ratio will be understated. C. There will be no effect on WACC decisions. D. Cannot be determined without knowing interest rates. Thus, the debt-to-value ratio is.286. However, if the market value of debt is $2.5 million due to increased interest rates, the value of the firm is $7.5 million and the debt-to-value ratio is The key is that the numerator of the ratio changes proportionately more than the denominator. 46. Which component is more likely to be biased if book values are used in the calculation of WACC rather than market values? A. Debt B. Preferred stock C. Common stock D. All categories should be equally biased. 47. What would you estimate to be the required rate of return for equity investors if a stock sells for $40 and will pay a $4.40 dividend that is expected to grow at a constant rate of 5%? A. 7.6% B. 12.0% C. 12.6% D. 16.0% 13-10

Chapter 12 Cost of Capital

Chapter 12 Cost of Capital 1. The return that shareholders require on their investment in the firm is called the: A) Dividend yield. B) Cost of equity. C) Capital gains yield. D) Cost of capital. E) Income