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# Cost of Capital, Leverage Questions

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41.) A corporation has decided to replace an existing asset with a newer model. The new asset will cost \$70,000. The original asset, when purchased cost \$10,000, was being depreciated under a straight line methodology, using a five-year recovery period, and has been depreciated for four full years. The existing asset can be sold for \$8,000. If the assumed tax rate is 40 percent on ordinary income and capital gains, what is the initial investment?

42.) Cullum Creations produces hand warmers, selling 400,000 warmers a year. Each warmer produced has a variable operating cost of \$0.84 and sells for \$1.00. Fixed operating costs are \$28,000. The firm has annual interest charges of \$6,000, preferred dividends of \$2,000, and a 40% tax rate.

Calculate the operating breakeven point in units
Use the degree of operating leverage (DOL) formula to calculate DOL.
Use the degree of financial leverage (DFL) formula to calculate DFL.
Use the degree of total leverage (DTL) formula to calculate DTL.

43.) Jones Corp uses a cost of capital of 14% to evaluate average risk projects and adds/subtracts 2% points to evaluate projects of greater/lesser risk. Currently two mutually exclusive projects are under consideration. Both have a net cost of \$240,000 and last four years. Project A, which is riskier than average, will produce cash flows of \$97,000 each year. Project B, which is a less-than-average risk, will produce net cash flows of \$196,000 in years 3 and 4 only. What should Jones do?

44.) Ajax, Inc. has common stock outstanding that has a market price of \$48 per share. Last year's dividend was \$2.25 and is expected to grow at a rate of 4% per year, forever. The expected risk-free rate of interest is 2%, and the expected market premium is 5.5%. The company's beta is 1.2.
A) What is the cost of equity for Ajax using the dividend valuation model?
B.) What is the cost of equity for Ajax using the capital asset pricing model (CAPM)?

5.) Alpha, Inc. is expecting to issue new debt at par with a coupon rate of 6%, and to issue new preferred stock with a \$2.00 per share dividend at \$20 a share. Common stock is currently selling for \$25 a share. Alpha expects to pay a dividend of \$2.50 per share next year, and a market analysis indicates dividends will grow at a rate of 3% per year. The marginal tax rate is 40%.

A) What is the cost of debt, cost of preferred stock and cost of common stock?

B) If Alpha raises capital using a capital structure of 40% debt, 10% preferred stock and 50% common stock, what is the cost of capital for Alpha, Inc.?

**PLEASE SHOW ALL CALCULATIONS FOR ALL PROBLEMS

#### Solution Preview

41.) A corporation has decided to replace an existing asset with a newer model. The new asset will cost \$70,000. The original asset, when purchased cost \$10,000, was being depreciated under a straight line methodology, using a five-year recovery period, and has been depreciated for four full years. The existing asset can be sold for \$8,000. If the assumed tax rate is 40 percent on ordinary income and capital gains, what is the initial investment?

Cost of Original asset= \$10,000
Annual Depreciation using straight line method= (Initial Value - Estimated Residual Value)/ Useful life

Initial Value= \$10,000
Estimated Residual Value= \$0 (since no data is given on salvage value, assume it to be zero)
Useful Life= 5 years
Therefore, annual depreciation= \$2,000 =(\$10,000. - \$.) / 5
Total Depreciation for 4 years= \$8,000 =4 x \$2,000.
Therefore Book value of equipment at the end of = 4 years= \$2,000 =\$10,000. - \$8,000.

Sale price of equipment= \$8,000
Book value of equipment= \$2,000
Gain on sale of equipment= \$6,000
Tax rate= 40%
Tax= \$2,400 =40.% x \$6,000
Therefore, After tax cash flow on sale of equipment : \$5,600 =\$8,000.-\$2,400.

Initial Investment:
Purchase of new equipment= \$70,000
After tax cash flow on sale of equipment : \$5,600
Therefore, Initial Investment= \$75,600 =\$70,000. + \$5,600.

42.) Cullum Creations produces hand warmers, selling 400,000 warmers a year. Each warmer produced has a variable operating cost of \$0.84 and sells for \$1.00. Fixed operating costs are \$28,000. The firm has annual interest charges of \$6,000, preferred dividends of \$2,000, and a 40% tax rate.

Calculate the operating breakeven point in units

# of units= 400000
Selling Price= \$1.00 per unit
Variable cost= \$0.84 per unit
Fixed Operating Cost= \$28,000
Interest= \$6,000
Preference Shares Dividends= \$2,000
Tax Rate= 40%

Contribution margin per unit = Selling price per unit - variable cost per unit

Selling Price= \$1.00 per unit
Variable cost= \$0.84 per unit
Therefore Contribution margin per unit= \$0.16 per unit =\$1.-\$.84

Operating Break even units= Fixed Cost / Contribution margin per unit= 175,000 =\$28,000 / ...

#### Solution Summary

Answers questions on Capital Budgeting, Leverage, Cost of Capital.

\$2.19

## Finance MC questions: optimal capital, risk types, leverage, NPV, 'real option', ROI

Question 1

The optimal capital structure is that structure which:

reduces overall leverage

reduces or eliminates only financial leverage

gives the highest stock price

provides the best risk versus return scenario for investors

carries extra options for timing and future events.

Question 2

Select the best combination below of risk as it relates to a company's sales and a company's profits.

foreign exchange risk / interest rate risk.

business risk / interest rate risk.

interest rate risk / investment risk.

Question 3

Operating leverage targets

the percent of costs that are fixed

the usage of labor.

outsourcing

variable costs

Question 4

Fill in the blank. Considering one industry, all firms must have _________ capital structures to be optimal.

identical

similar

dissimilar

any number of combinations of

Question 5

Capital rationing is:

the allocation of available capital to projects best suited to be undertaken, at the present time.

Applying an even distribution of capital; all departments get the same funding.

Applying a distribution of capital based on the % of profits generated by each department.

borrowing conservatively.

none of the above.

Question 6

As operating leverage increases, all things being equal,

the lower the break even point will be

variable costs per unit will decrease

the higher the sales volume needed to break even.

variable costs per unit will increse

all of the above.

Question 7

If the analytical results of projects "N" and "M" are:
M: NPV = \$450, IRR 12%
N: NPV = \$500, IRR = 12%
Which of the following would be correct?

Your company has an historical return for its shareholders at 15%; therefore, both projects are rejected.

If they are mutually exclusive, you would reject "N".

If they are not mutually exclusive, you can accept both because they have a positive NPV.

Reject both because there is no way both can have the same IRR with different NPV's.

"A" and "C" are correct answers.

Question 8

Which of the following is not considered a "real option"?.

flexibility

growth

timing

replacement

abandonment

Question 9

The concept of sunk costs is most associated with which of the following:

Baywatch

abandonment costs or options to abandon if you decide to do something else.

Working capital needed to start a business

Net after tax but before interest and principal payments.

none of these!

Question 10

Which of the following is not an example of a real option?

Quitting a job

Paying off a debt obligation early

dropping one quiz grade in this course

Question 11

What is the after-tax cost of debt for a firm in the 35% tax bracket that pays 15% on its debt?

5.25%

9.75%

12.17%

20.25%

Question 12

A project has the following projected outcomes in dollars: \$250, \$350, and \$500. The probabilities of their outcomes are 25%, 50%, and 25% respectively. What is the expected value of these outcomes?

\$362.5

\$89.4

\$94.5

\$178.3

Question 13

Financial risk refers to the:

risk of owning equity securities.

risk faced by equity holders when debt is used.

general business risk of the firm.

possibility that interest rates will increase.

Question 14

A firm's capital structure is represented by its mix of:

assets.

liabilities and equity.

assets and liabilities.

assets, liabilities and equity.

Question 15

Risk is usually measured as the :

potential loss.

variability of outcomes around some expected value.

probability of expected values.

potential expected loss.

Question 16

What is the return on equity for a firm with 15% return on assets, 10% return on debt, and a .75 debt/equity ratio?

18.75%

20.00%

23.75%

26.25%

Question 17

An increase in a firm's financial leverage will:

increase the variability in earnings per share.

reduce the operating risk of the firm.

increase the value of the firm in a non-MM world.

increase the WACC.

Question 18

Which of the following could SIGNAL to investors that the future prospects of the company are bright?

Borrow significantly more money (increase financial leverage).

Sell new equity shares in the open market.

Sell stock the company had listed as Treasury Stock.

Pay down debt.

all of the above.

Question 19

Trade off theory of leverage relates

returns to stock holders as bond leverage increases

returns to both owners and debt holders as leverage increases

operating versus financial aspects of leverage

tax benefits of debt versus increase chance of defaulting on debt.

Question 20

Which of the following is an example of restructuring the firm?

Dividends are increased from \$1 to \$2 per share.

A new investment increases the firm's business risk.

New equity is issued and the proceeds repay debt.

A new Board of Directors is elected to the firm.

Question 21

The stability of a firm's operating income is the focus of:

financial leverage.

weighted-average cost of capital.

capital structure.

Question 22

The capital asset pricing model (CAPM.:

uses the risk free rate

relates risk versus return

all of the above

none of the above

Question 23

Optimal Capital structure is:

easily attained; just plug in variables to the formula.

achieved through trial and error by leveraging financial assets.

static once the optimal point is reached.

a great academic discussion but cannot be determined in dynamic financial markets for any given period of time.

constant, but each industry, as defined by NAICS, has its own debt/equity mix.

Question 24

Asymmetric information occurs when:

all parties have complete information

one party has less information than the other.

all analysts agree about future earning predictions

No one has any information

none of the above

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