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 interest tax shield is a key reason why
A. the net cost of debt to a firm is generally less than the cost of equity.
B. the value of an unlevered firm is equal to the value of a levered firm.
C. the cost of debt is equal to the cost of equity for a levered firm.
D. firms prefer equity financing over debt financing.
2. The unlevered cost of capital refers to the cost of capital for
A. a privately owned entity.
B. a corporate shareholder.
C. a governmental entity.
D. an all-equity firm.
3. 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. 14.72 percent
B. 15.54 percent
C. 13.15 percent
D. 14.59 percent
4. River Walk Tours is expected to have an EBIT of $354,000 next year. Depreciation, the increase in net working capital, and capital spending, are expected to be $24,000, $2,000, and $33,000, respectively. All are expected to grow at 7 percent per year for three years. After year four, the adjusted cash flow from assets is expected to grow at 3.2 percent indefinitely. The company's WACC is 9.2 percent, and the tax rate is 34 percent. What's the terminal value of the firm's cash flows?
A. $4,008,051
B. $3,711,052
C. $4,691,189
D. $3,992,419
5. Hanover Tech is currently an all-equity firm that has 320,000 shares of stock outstanding with a market price of $19 a share. The current cost of equity is 15.4 percent, and the tax rate is 34 percent. The firm is considering adding $1.2 million of debt with a coupon rate of 8 percent to its capital structure. The debt will be sold at par value. What's the levered value of the equity?
A. $5.209 million
B. $6.708 million
C. $6.512 million
D. $5.288 million
6. What does the pecking order theory postulate?
A. The optimal capital structure is dependent upon the effective tax rate.
B. The optimal capital structure is a highly leveraged firm because of the tax shield.
C. There's no optimal debt-equity ratio; instead, a firm's capital structure is determined by its need for external financing.
D. The optimal capital structure is the point at which the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress.
7. Alphabet, Inc. (GOOGL) has a 40 percent debt/asset ratio; assume a tax rate of 16 percent. The average yield to maturity on GOOGL's bonds is 3 percent. Your market analyst estimates that the risk-free rate is 1 percent and that the market risk premium is 7 percent. The firm's beta coefficient is 0.97. What's Alphabet's weighted average cost of capital (WACC)? (Round to the nearest tenth of a percent.)
A. 7.3 percent
B. 5.9 percent
C. 5.7 percent
D. 6 percent
8. What does the absolute priority rule establish?
A. Priority of cash dividends
B. Priority of suppliers
C. Priority of control of key stakeholders
D. Priority of claims in liquidation
9. Which of the following is not a problem when using the dividend growth model?
A. It's very sensitive to the estimated growth rate and assumes dividends grow at a constant rate.
B. It's complicated and difficult to implement.
C. It's only applicable to companies that pay dividends.
D. It doesn't explicitly consider risk.
10. Jiminy's Cricket Farm issued a 30-year, 8 percent, semiannual bond six years ago. The bond currently sells for 114 percent of its face value. What's the aftertax cost of debt if the company's tax rate is 31 percent?
A. 4.82 percent
B. 4.70 percent
C. 4.63 percent
D. 4.75 percent
11. Silo Mills is an all-equity financed firm that has a beta of 1.14 and a cost of equity of 12.8 percent. The risk-free rate of return is 2.8 percent. The firm is currently considering a project that has a beta of 1.03 and a project life of six years. What discount rate should be assigned to this project?
A. 11.84 percent
B. 13.62 percent
C. 12.09 percent
D. 13.33 percent
12. According to the static tradeoff theory, what's the optimal capital structure?
A. A firm should have equal parts equity and debt.
B. A firm should borrow up to the point at which the tax benefit from an extra dollar is equal to zero.
C. A firm should borrow up to the point at which the interest is equal to the total tax expense.
D. A firm should borrow up to the point at which the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress.
13. 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. $16,200
B. $2,106
C. $3,240
D. $16,800
14. 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. 18 months
C. 12 months
D. 180 days
15. Fama's Llamas has a weighted average cost of capital of 9½ percent. The company's cost of equity is 15½ percent, and its pretax cost of debt is 8½ percent. The tax rate is 34 percent. What's the company's target debt-equity ratio?
A. 1.54
B. 1.01
C. 0.92
D. 0.89
16. Which of the following is true about a firm with no debt financing?
A. Cost of debt = WACC
B. Return on equity = WACC
C. Cost of Equity = coupon rate
D. Return on equity = cost of debt
17. 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. DuPont approach.
B. subjective approach.
C. divisional approach.
D. pure play approach.
18. SLG Corp. is an all-equity firm with a weighted average cost of capital of 9.68 percent. The current market value of the equity is $27½ million, and the tax rate is 35 percent. What is EBIT?
A. $1,730,300
B. $6,180,000
C. $4,095,385
D. $2,821,194
19. U.S. Treasury bills are paying about 0.2 percent, and the estimated market risk premium (based on large common stocks) is about 8 percent. Apple (AAPL) has an estimated beta of 1.44. Using the SML approach, what's the return on equity of Apple stock?
A. 11 percent
B. 11.32 percent
C. 10.32 percent
D. 11.72 percent
20. What's the concept of using debt to make a return known as?
A. Financial leverage
B. Debt coverage
C. Debt reliance
D. Financial liquidity