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Corporate Finance【Reading 37】Sample

A company is planning a $50 million expansion. The expansion is to be financed by selling $20 million in new debt and $30 million in new common stock. The before-tax required return on debt is 9% and the required return for equity is 14%. If the company is in the 40% tax bracket, the marginal weighted average cost of capital is closest to:
A)
9.0%.
B)
10.0%
C)
10.6%.



(0.4)(9%)(1 - 0.4) + (0.6)(14%) = 10.56%

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.



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.

TOP

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.



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

TOP

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.



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.

TOP

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%.



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%

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