Cost of Capital and Financial Policy
Questions 1 to 20: Select the best answer to each question. Note that a question and its answers may be split across a page
break, so be sure that you have seen the entire question and all the answers before choosing an answer.
1. The Shoe Outlet has paid annual dividends of $.65, $.70, $.72, and $.75 per share throughout the last four years, respectively. The stock is currently selling for $9 a share. What's this firm's cost of equity?
A. 11.79 percent
B. 13.65 percent
C. 8.74 percent
D. 9.53 percent
2. Key Motors has a cost of equity of 11.29 percent and an unlevered cost of capital of 10.4 percent. The company has $22,000 in debt that's selling at par value. The levered value of the firm is $64,000, and the tax rate is 34 percent. What's the pretax cost of debt?
A. 7.82 percent
B. 6.59 percent
C. 6.18 percent
D. 5.73 percent
3. Mulberry, Inc. has a weighted average cost of capital (ignoring taxes) of 20 percent. It can borrow at 10 percent. Mulberry has a target ½ debt/equity ratio. Using the M&M Proposition II, what's the cost of equity?
A. 15 percent
B. 29 percent
C. 25 percent
D. 31 percent
4. Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, how long after a firm files for bankruptcy protection do creditors have to wait before submitting their own reorganization plan to the court?
A. 45 days
B. 12 months
C. 180 days
D. 18 months
5. A friend approaches you with an investment opportunity-a property in an area of rapidly appreciating property values. You can get a loan for $1 million with a $60,000 down payment. Your friend estimates that you'll be able to sell the property in one year for $1.1 million, which means you could make $100,000 in a year, a very large annual return. Why should you be skeptical?
A. The rate of return is too high.
B. The rate of return is too low.
C. Banks can't be trusted.
D. A highly leveraged investment, such as this one, is risky.
6. What's the relationship between the WACC and the structure of the firm?
A. The lower the WACC, the higher the value of the firm to a certain point; then the relationship reverses.
B. The lower the WACC, the higher the value of the firm.
C. The lower the WACC, the lower the value of the firm.
D. There's no relationship between WACC and the value of the firm.
7. Deep Mines has 14 million shares of common stock outstanding with a beta of 1.15 and a market price of $42 a share. There are 900,000 shares of 9 percent preferred stock outstanding, valued at $80 a share. The 10 percent semiannual bonds have a face value of $1,000 and are selling at 91 percent of par. There are 220,000 bonds outstanding that mature in 17 years. The market risk premium is 11½ percent, T-bills are yielding 7½ percent, and the firm's tax rate is 32 percent. What discount rate should the firm apply to a new project's cash flows if the project has the same risk as the firm's typical project?
A. 14.59 percent
B. 14.72 percent
C. 15.54 percent
D. 13.15 percent
8. What are the two risk components that determine a firm's cost of equity?
A. Interest rate risk and the risk inherent in a firm's operations
B. The risk inherent in a firm's operations, plus financial structure risk
C. Management risk and financial structure risk
D. Financial structure risk and interest rate risk
9. Deep Mining and Precious Metals are separate firms that are both considering a silver exploration project. Deep Mining is in the actual mining business and has an aftertax cost of capital of 16.7 percent. Precious Metals is in the precious gem retail business and has an aftertax cost of capital of 12.6 percent. The project under consideration has initial costs of $755,000 and anticipated annual cash inflows of
$152,000 a year for 10 years. Which firm(s), if either, should accept this project?
A. Both Deep Mining and Precious Metals
B. Deep Mining only
C. Precious Metals only
D. Neither Deep Mining nor Precious Metals
10. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005
A. prevents firms from filing for bankruptcy protection more than once.
B. permits key employee retention plans, only if an employee has another job offer.
C. prevents creditors from submitting any reorganization plans.
D. permits creditors to file a prepack immediately after a firm files for bankruptcy protection.
11. D. L. Tuckers has $48,000 of debt outstanding that's selling at par and has a coupon rate of 6.75 percent. The tax rate is 35 percent. What's the present value of the tax shield?
A. $2,106
B. $16,800
C. $16,200
D. $3,240
12. Because the WACC varies with the use of funds rather than the source of funds, some firms evaluate new projects based on the WACC of companies in similar lines of business. This approach is called the
A. pure play approach.
B. DuPont approach.
C. divisional approach.
D. subjective approach.
13. Which one of these actions generally occurs first in a bankruptcy reorganization?
A. Dividing creditors into classes
B. Filing proofs of claim
C. Confirming the reorganization plan
D. Submitting a reorganization plan
14. Dagwood, Inc. has a weighted average cost of capital (ignoring taxes) of 16 percent. It can borrow at 6 percent. Dagwood has a target capital structure of 40 percent equity and 60 percent debt. Using the M&M Proposition II, what's the cost of equity?
A. 15 percent
B. 31 percent
C. 29 percent
D. 21 percent
15. Analysts project Microsoft (MSFT) will have an annualized dividend of $1.50 and a long-term growth rate of 10 percent. Currently, the stock price is $60. Using the dividend growth model approach, what's the implied cost of equity?
A. 11 percent
B. 12.5 percent
C. 2.5 percent
D. 10 percent
16. Galaxy Products is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 175,000 shares of stock outstanding. Under Plan II, there would be 90,000 shares of stock outstanding and $1.4 million in debt. The interest rate on the debt is 7 percent, and there are no taxes. What's the break-even EBIT?
A. $341,414.14
B. $287,878.78
C. $351,111.11
D. $201,764.71
17. Which of the following is not a problem when using the dividend growth model?
A. It's complicated and difficult to implement.
B. It doesn't explicitly consider risk.
C. It's very sensitive to the estimated growth rate and assumes dividends grow at a constant rate.
D. It's only applicable to companies that pay dividends.
18. What's the process by which a firm is no longer considered a "going concern" and involves selling off all firm assets?
A. Reorganization
B. Capital structuring
C. Liquidation
D. Bankruptcy
19. What's the concept of using debt to make a return known as?
A. Financial liquidity
B. Debt coverage
C. Financial leverage
D. Debt reliance
20. The unlevered cost of capital refers to the cost of capital for
A. a corporate shareholder.
B. a privately owned entity.
C. an all-equity firm.
D. a governmental entity.