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Cost of capital, business structure

1. Which of the following statements is most correct?

a.Suppose a firm is losing money and thus, is not paying taxes, and that this situation is expected to persist for a few years whether or not the firm uses debt financing. Then the firm's after-tax cost of debt will equal its before-tax cost of debt.
b.The component cost of preferred stock is expressed as kps(1 - T), because preferred stock dividends are treated as fixed charges, similar to the treatment of debt interest.
c.The reason that a cost is assigned to retained earnings is because these funds are already earning a return in the business; the reason does not involve the opportunity cost principle.
d.The bond-yield-plus-risk-premium approach to estimating a firm's cost of common equity involves adding a subjectively determined risk-premium to the market risk-free bond rate.
e.All of the statements above are false

2. Which of the following statements about a not-for-profit firm=s cost of capital estimate is most correct?

a.Since a not-for-profit firm has no shareholders, its WACC estimate does not include a cost of equity (fund capital) estimate.
b.The capital structure weights for a not-for-profit firm are set at 50/50, because such firms can raise $1 of debt financing for each dollar of retained earnings.
c.The cost of tax-exempt debt issued by not-for-profit firms is increased (Agrossed up@) by 1 - T in the WACC estimate to reflect the fact that such firms do not pay taxes.
d.Equity (fund) capital has a cost that is roughly equivalent to the cost of retained earnings to similar investor-owned companies.
e.None of the above statements is correct.

3. A company forecasts free cash flow in one year to be -$10 million and free cash flow in two years to be $20 million. After the second year, free cash flow will grow at a constant rate of 4 percent per year forever. If the overall cost of capital is 14 percent, what is the current value of operations, to the nearest million?

a. $150 million
b. $167 million
c. $200 million
d. $208 million
e. $228 million

Solution Preview

1. Which of the following statements is most correct?

a.Suppose a firm is losing money and thus, is not paying taxes, and that this situation is expected to persist for a few years whether or not the firm uses debt financing. Then the firm's after-tax cost of debt will equal its before-tax cost of debt.

This is correct, without tax benefit, the after tax cost ands the before tax cost are the same

b.The component cost of preferred stock is expressed as kps(1 - T), because preferred stock dividends are treated as fixed charges, similar to the treatment of debt interest.

This is false as preferred stock dividends are paid from net income and there is no tax benefit

c.The reason that a cost is assigned to retained earnings is because these funds are already earning a return in the business; the reason does not involve ...

Solution Summary

The solution has explanations for questions relating to cost of capital, business structure and free cash flows

$2.19