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

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

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

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

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

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

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

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

Assume that a company has equal amounts of debt, common stock, and preferred stock. An increase in the corporate tax rate of a firm will cause its weighted average cost of capital (WACC) to:

A) fall.

B) rise.

C) more information is needed.

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Recall the WACC equation:

WACC = [wd × kd × (1 − t)] + (wps × kps) + (wce × ks)

The increase in the corporate tax rate will result in a lower cost of debt, resulting in a lower WACC for the company.

prashantsahni

A company has the following capital structure:

• Target weightings: 30% debt, 20% preferred stock, 50% common equity.
• Tax Rate: 35%.
• The firm can issue $1,000 face value, 7% semi-annual coupon debt with a 15-year maturity for a price of $1,047.46.
• A preferred stock issue that pays a dividend of $2.80 has a value of $35 per share.
• The company’s growth rate is estimated at 6%.
• The company's common shares have a value of $40 and a dividend in year 0 of D0 = $3.00.

The company's weighted average cost of capital is closest to:

A) 9.84%.

B) 9.28%.

C) 10.53%.

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Step 1: Determine the after-tax cost of debt:

The after-tax cost of debt [kd (1 – t)] is used to compute the weighted average cost of capital. It is the interest rate on new debt (kd) less the tax savings due to the deductibility of interest (kdt).
Here, we are given the inputs needed to calculate kd: N = 15 × 2 = 30; PMT = (1,000 × 0.07) / 2 = 35; FV = 1,000; PV = -1,047.46; CPT → I = 3.25, multiply by 2 = 6.50%.
Thus, kd (1 – t) = 6.50% × (1 – 0.35) = 4.22%

Step 2: Determine the cost of preferred stock:

Preferred stock is a perpetuity that pays a fixed dividend (Dps) forever. The cost of preferred stock (kps) = Dps / P

where:	Dps = preferred dividends.
	P = price

Here, kps = Dps / P = $2.80 / $35 = 0.08, or 8.0%.

Step 3: Determine the cost of common equity:

kce = (D1 / P0) + g

where:	D1 = Dividend in next year
	P0 = Current stock price
	g = Dividend growth rate

Here, D1 = D0 × (1 + g) = $3.00 × (1 + 0.06) = $3.18.
kce = (3.18 / 40) + 0.06 = 0.1395 or 13.95%.

Step 4: Calculate WACC:

WACC = (wd)(kd) + (wps)(kps) + (wce)(kce)
where wd, wps, and wce are the weights used for debt, preferred stock, and common equity.
Here, WACC = (0.30 × 4.22%) + (0.20 × 8.0%) + (0.50 × 13.95%) = 9.84%.

Note: Your calculation may differ slightly, depending on whether you carry all calculations in your calculator, or round to two decimals and then calculate.