prashantsahni

A company has the following information:

• A target capital structure of 40% debt and 60% equity.
• $1,000 par value bonds pay 10% coupon (semi-annual payments), mature in 20 years, and sell for $849.54.
• The company stock beta is 1.2.
• Risk-free rate is 10%, and market risk premium is 5%.
• The company's marginal tax rate is 40%.

The weighted average cost of capital (WACC) is closest to:

A) 12.5%.

B) 13.0%.

C) 13.5%.

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Ks = 0.10 + (0.05)(1.2) = 0.16 or 16%
Kd = Solve for i: N = 40, PMT = 50, FV = 1,000, PV = -849.54, CPT I = 6 × 2 = 12%
WACC = (0.4)(12)(1 - 0.4) + (0.6)(16)= 2.88 + 9.6 = 12.48

prashantsahni

When calculating the weighted average cost of capital (WACC) an adjustment is made for taxes because:

A) equity earns higher return than debt.

B) the interest on debt is tax deductible.

C) equity is risky.

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Equity and preferred stock are not adjusted for taxes because dividends are not deductible for corporate taxes. Only interest expense is deductible for corporate taxes.

prashantsahni

Helmut Humm, manager at a large U.S. firm, has just been assigned to the capital budgeting area to replace a person who left suddenly. One of Humm’s first tasks is to calculate the company’s weighted average cost of capital (WACC) – and fast! The CEO is scheduled to present to the board in half an hour and needs the WACC – now! Luckily, Humm finds clear notes on the target capital component weights. Unfortunately, all he can find for the cost of capital components is some handwritten notes. He can make out the numbers, but not the corresponding capital component.  As time runs out, he has to guess.
Here is what Humm deciphered:

• Target weights: wd = 30%, wps = 20%, wce = 50%, where wd, wps, and wce are the weights used for debt, preferred stock, and common equity.
• Cost of components (in no particular order): 6.0%, 15.0%, and 8.5%.
• The cost of debt is the after-tax cost.

If Humm guesses correctly, the WACC is:

A) 11.0%.

B) 9.2%.

C) 9.0%.

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If Humm remembers to order the capital components from cheapest to most expensive, he can calculate WACC. The order from cheapest to most expensive is: debt, preferred stock (which acts like a hybrid of debt and equity), and common equity.
Then, using the formula for WACC = (wd)(kd) + (wps)(kps) + (wce)(kce)

where wd, wps, and we are the weights used for debt, preferred stock, and common equity.

WACC = (0.30 × 6.0%) + (0.20 × 8.5%) + (0.50 × 15.00%) = 11.0%.

hinsafdar

The following data is regarding the Link Company:

• A target debt/equity ratio of 0.5
• Bonds are currently yielding 10%
• Link is a constant growth firm that just paid a dividend of $3.00
• Stock sells for $31.50 per share, and has a growth rate of 5%
• Marginal tax rate is 40%

What is Link's after-tax cost of capital?

A) 12.0%.

B) 10.5%.

C) 12.5%.

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Use the revised form of the constant growth model to determine the cost of equity. Use algebra to determine the weights for the target capital structure realizing that debt is 50% of equity. Substitute 0.5E for D in the formula below.ks = D1 ÷ P0 + growth = (3)(1.05) ÷ (31.50) + 0.05 = 0.15 or 15% V = debt + equity = 0.5 + 1 = 1.5 WACC = (E ÷ V)(ks) + (D ÷ V)(kdebt)(1 − t)
WACC = (1 ÷ 1.5)(0.15) + (0.5 ÷ 1.5)(0.10)(1 − 0.4) = 0.1 + 0.02 = 0.12 or 12%

hinsafdar

Which of the following events will reduce a company's weighted average cost of capital (WACC)?

A) An increase in expected inflation.

B) A reduction in the company's bond rating.

C) A reduction in the market risk premium.

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An increase in either the company’s beta or the market risk premium will cause the WACC to increase using the CAPM approach. A reduction in the market risk premium will reduce the cost of equity for WACC.

hinsafdar

In calculating the weighted average cost of capital (WACC), which of the following statements is least accurate?

A) Different methods for estimating the cost of common equity might produce different results.

B) The cost of preferred equity capital is the preferred dividend divided by the price of preferred shares.

C) The cost of debt is equal to one minus the marginal tax rate multiplied by the coupon rate on outstanding debt.

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After-tax cost of debt = bond yield − tax savings = kd − kdt = kd(1 − t)

hinsafdar

Assume a firm uses a constant WACC to select investment projects rather than adjusting the projects for risk. If so, the firm will tend to:

A) reject profitable, low-risk projects and accept unprofitable, high-risk projects.

B) accept profitable, low-risk projects and accept unprofitable, high-risk projects.

C) accept profitable, low-risk projects and reject unprofitable, high-risk projects.

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The firm will reject profitable, low-risk projects because it will use a hurdle rate that is too high. The firm should lower the required rate of return for lower risk projects. The firm will accept unprofitable, high-risk projects because the hurdle rate of return used will be too low relative to the risk of the project. The firm should increase the required rate of return for high-risk projects.