prashantsahni

Ravencroft Supplies is estimating its weighted average cost of capital (WACC). Ravencroft’s optimal capital structure includes 10% preferred stock, 30% debt, and 60% equity. They can sell additional bonds at a rate of 8%. The cost of issuing new preferred stock is 12%. The firm can issue new shares of common stock at a cost of 14.5%. The firm’s marginal tax rate is 35%. Ravencroft’s WACC is closest to:

A) 13.3%.

B) 12.3%.

C) 11.5%.

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0.10(12%) + 0.30(8%)(1 – 0.35) + 0.6(14.5%) = 11.46%.

prashantsahni

Hatch Corporation's target capital structure is 40% debt, 50% common stock, and 10% preferred stock. Information regarding the company's cost of capital can be summarized as follows:

• The company's bonds have a nominal yield to maturity of 7%.
• The company's preferred stock sells for $40 a share and pays an annual dividend of $4 a share.
• The company's common stock sells for $25 a share and is expected to pay a dividend of $2 a share at the end of the year (i.e., D1 = $2.00). The dividend is expected to grow at a constant rate of 7% a year.
• The company has no retained earnings.
• The company's tax rate is 40%.

What is the company's weighted average cost of capital (WACC)?

A) 10.59%.

B) 10.03%.

C) 10.18%.

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WACC = (wd)(kd)(1 − t) + (wps)(kps) + (wce)(kce)
where:
wd = 0.40
wce = 0.50
wps = 0.10
kd = 0.07
kps = Dps / P = 4.00 / 40.00 = 0.10
kce = D1 / P0 + g = 2.00 / 25.00 + 0.07 = 0.08 + 0.07 = 0.15
WACC = (0.4)(0.07)(1 − 0.4) + (0.1)(0.10) + (0.5)(0.15) = 0.0168 + 0.01 + 0.075 = 0.1018 or 10.18%

prashantsahni

A firm has $100 in equity and $300 in debt. The firm recently issued bonds at the market required rate of 9%. The firm's beta is 1.125, the risk-free rate is 6%, and the expected return in the market is 14%. Assume the firm is at their optimal capital structure and the firm's tax rate is 40%. What is the firm's weighted average cost of capital (WACC)?

A) 8.6%.

B) 7.8%.

C) 5.4%.

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CAPM = RE = RF + B(RM − RF) = 0.06 + (1.125)(0.14 − 0.06) = 0.15
WACC = (E ÷ V)(RE) + (D ÷ V)(RD)(1 − t)
V = 100 + 300 = 400
WACC = (1 ÷ 4)(0.15) + (3 ÷ 4)(0.09)(1 − 0.4) = 0.078

prashantsahni

A firm is planning a $25 million expansion project. The project will be financed with $10 million in debt and $15 million in equity stock (equal to the company's current capital structure). The before-tax required return on debt is 10% and 15% for equity. If the company is in the 35% tax bracket, what cost of capital should the firm use to determine the project's net present value (NPV)?

A) 12.5%.

B) 9.6%.

C) 11.6%.

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WACC = (E / V)(RE) + (D / V)(RD)(1 − TC)
WACC = (15 / 25)(0.15) + (10 / 25)(0.10)(1 − 0.35) = 0.09 + 0.026 = 0.116 or 11.6%

prashantsahni

Which of the following choices best describes the role of taxes on the after-tax cost of capital in the U.S. from the different capital sources?

Common equity

Preferred equity

Debt

A) No effect Decrease Decrease

B) Decrease Decrease No effect

C) No effect No effect Decrease

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In the U.S., interest paid on corporate debt is tax deductible, so the after-tax cost of debt capital is less than the before-tax cost of debt capital. Dividend payments are not tax deductible, so taxes do not decrease the cost of common or preferred equity.

prashantsahni

At a recent Haggerty Semiconductors Board of Directors meeting, Merle Haggerty was asked to discuss the topic of the company’s weighted average cost of capital (WACC).
At the meeting Haggerty made the following statements about the company’s WACC:
Statement 1: A company creates value by producing a higher return on its assets than the cost of financing those assets. As such, the WACC is the cost of financing a firm’s assets and can be viewed as the firm’s opportunity cost of financing its assets.
Statement 2: Since a firm’s WACC reflects the average risk of the projects that make up the firm, it is not appropriate for evaluating all new projects. It should be adjusted upward for projects with greater-than-average risk and downward for projects with less-than-average risk.
Are Statement 1 and Statement 2, as made by Haggerty CORRECT?

Statement 1

Statement 2

A) Correct Incorrect

B) Incorrect Correct

C) Correct Correct

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Each statement that Haggerty has made to the board of directors regarding the weighted average cost of capital is correct. New projects should have a return that is higher than the cost to finance those projects.

prashantsahni

Deighton Industries has 200,000 bonds outstanding. The par value of each corporate bond is $1,000, and the current market price of the bonds is $965. Deighton also has 6 million common shares outstanding, with a book value of $35 per share and a market price of $28 per share. At a recent board of directors meeting, Deighton board members decided not to change the company’s capital structure in a material way for the future. To calculate the weighted average cost of Deighton’s capital, what weights should be assigned to debt and to equity?

Debt

Equity

A) 53.46% 46.54%

B) 48.85% 51.15%

C) 56.55% 43.45%

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In order to calculate the weighted average cost of capital (WACC), market value weights should be used.

For the bonds	=	200,000 × $965	=	$193,000,000
For the stocks	=	6,000,000 × $28	=	$168,000,000
				$361,000,000

The weight of debt would be: 193,000,000 / 361,000,000 = 0.5346 = 53.46%
The weight of common stock would be: 168,000,000 / 361,000,000 = 0.4654 = 46.54%

prashantsahni

Hans Klein, CFA, is responsible for capital projects at Vertex Corporation. Klein and his assistant, Karl Schwartz, were discussing various issues about capital budgeting and Schwartz made a comment that Klein believed to be incorrect. Which of the following is most likely the incorrect statement made by Schwartz?

A) “The weighted average cost of capital (WACC) should be based on market values for the firm’s outstanding securities.”

B) “Net present value (NPV) and internal rate of return (IRR) result in the same rankings of potential capital projects.”

C) “It is not always appropriate to use the firm’s marginal cost of capital when determining the net present value of a capital project.”

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It is possible that the NPV and IRR methods will give different rankings. This often occurs when there is a significant difference in the timing of the cash flows between two projects. A firm’s marginal cost of capital, or WACC, is only appropriate for computing a project’s NPV if the project has the same risk as the firm.

prashantsahni

Carlos Rodriquez, CFA, and Regine Davis, CFA, were recently discussing the relationships between capital structure, capital budgets, and net present value (NPV) analysis. Which of the following comments made by these two individuals is least accurate?

A) “For projects with more risk than the average firm project, NPV computations should be based on the marginal cost of capital instead of the weighted average cost of capital.”

B) “The optimal capital budget is determined by the intersection of a firm’s marginal cost of capital curve and its investment opportunity schedule.”

C) “A break point occurs at a level of capital expenditure where one of the component costs of capital increases.”

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The marginal cost of capital (MCC) and the weighted average cost of capital (WACC) are the same thing. If a firm’s capital structure remains constant, the MCC (WACC) increases as additional capital is raised.

prashantsahni

The marginal cost of capital is:

A) tied solely to the specific source of financing.

B) equal to the firm's weighted cost of funds.

C) the cost of the last dollar raised by the firm.

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The “marginal” cost refers to the last dollar of financing acquired by the firm assuming funds are raised in the same proportion as the target capital structure. It is a percentage value based on both the returns required by the last bondholders and stockholders to provide capital to the firm. Regardless of whether the funding came from bondholders or stockholders, both debt and equity are needed to fund projects.