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WACC, cost of debt, which project to accept, cost of equity,

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1. You were hired as a consultant to Keys Company, and you were provided with the following data: Target capital structure: 40% debt, 10% preferred, and 50% common equity. The after-tax cost of debt is 4.00%, the cost of preferred is 7.50%, and the cost of retained earnings is 11.50%. The firm will not be issuing any new stock. What is the firm's WACC?
7.55%
7.73%
7.94%
8.10%
8.32%

2. Several years ago the Haverford Company sold a $1,000 par value bond that now has 25 years to maturity and an 8.00% annual coupon that is paid quarterly. The bond currently sells for $900.90, and the company's tax rate is 40%. What is the component cost of debt for use in the WACC calculation?

5.40%
5.73%
5.98%
6.09%
6.24%

3. Tapley Inc. recently hired you as a consultant to estimate the company's WACC. You have obtained the following information. (1) Tapley's bonds mature in 25 years, have a 7.5% annual coupon, a par value of $1,000, and a market price of $936.49. (2) The company's tax rate is 40%. (3) The risk-free rate is 6.0%, the market risk premium is 5.0%, and the stock's beta is 1.5. (4) The target capital structure consists of 30% debt and 70% equity. Tapley uses the CAPM to estimate the cost of equity, and it does not expect to have to issue any new common stock. What is its WACC?
9.89%
10.01%
10.35
10.64%
10.91%

4. Wagner Inc estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?
Project A is of average risk and has a return of 9%.
Project B is of below-average risk and has a return of 8.5%.
Project C is of above-average risk and has a return of 11%.
None of the projects should be accepted.
All of the projects should be accepted.

5. The Nunnally Company has equal amounts of low-risk, average-risk, and high-risk projects. Nunnally estimates that its overall WACC is 12%. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower risk projects and a higher rate for higher risk projects. However, the CEO argues that, even though the company's projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO's opinion is followed, what is likely to happen over time?
The company will take on too many low-risk projects and reject too many high-risk projects.
The company will take on too many high-risk projects and reject too many low-risk projects.
Things will generally even out over time, and, therefore, the firm's risk should remain constant over time.
The company's overall WACC should decrease over time because its stock price should be increasing.
The CEO's recommendation would maximize the firm's intrinsic value.

6. Percy Motors has a target capital structure of 40 percent debt and 60 percent common equity, with no preferred stock. The yield to maturity on the company's outstanding bonds is 9 percent, and its tax rate is 40 percent. Percy's CFO estimates that the company's WACC is 9.96 percent. What is Percy's cost of common equity?

7. The earnings, dividends, and common stock price of Carpetto Technologies Inc. are expected to grow at 7 percent per year in the future. Carpetto's common stock sells for $23 per share, its last dividend was $2.00, and it will pay a dividend of $2.14 at the end of the current year.
Using the DCF approach, what is the cost of common equity?

8. The earnings, dividends, and common stock price of Carpetto Technologies Inc. are expected to grow at 7 percent per year in the future. Carpetto's common stock sells for $23 per share, its last dividend was $2.00, and it will pay a dividend of $2.14 at the end of the current year.
If the firm's beta is 1.6, the risk-free rate is 9 percent, and the average return on the market is 13 percent, what will be the firm's cost of common equity using the CAPM approach?

9. The earnings, dividends, and common stock price of Carpetto Technologies Inc. are expected to grow at 7 percent per year in the future. Carpetto's common stock sells for $23 per share, its last dividend was $2.00, and it will pay a dividend of $2.14 at the end of the current year.
If the firm's bonds earn a return of 12 percent, what will rs be based on the bond-yield-plus-risk-premium approach, using the midpoint of the risk premium range?

10. The earnings, dividends, and common stock price of Carpetto Technologies Inc. are expected to grow at 7 percent per year in the future. Carpetto's common stock sells for $23 per share, its last dividend was $2.00, and it will pay a dividend of $2.14 at the end of the current year.

Assuming you have equal confidence in the inputs used for the three approaches, what is your estimate of Carpetto's cost of common equity?

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Solution Preview

1. You were hired as a consultant to Keys Company, and you were provided with the following data: Target capital structure: 40% debt, 10% preferred, and 50% common equity. The after-tax cost of debt is 4.00%, the cost of preferred is 7.50%, and the cost of retained earnings is 11.50%. The firm will not be issuing any new stock. What is the firm's WACC?

WACC=Cost of debt *Proportion of debt + Cost of Preferred *Proportion of Preferred+Cost of common equity *Proportion of common equity
=4%*0.4+7.5%*0.1+11.5%*0.5
= 8.10%

2. Several years ago the Haverford Company sold a $1,000 par value bond that now has 25 years to maturity and an 8.00% annual coupon that is paid quarterly. The bond currently sells for $900.90, and the company's tax rate is 40%. What is the component cost of debt for use in the WACC calculation?

The cash flow is as below:
-900.9
80
80
80
80
80
80
80
80
80
80
80
80
80
80
80
80
80
80
80
80
80
80
80
80
1080
YTM=9.01%
Cost of Debt =9.01*(1-40%)=5.41%
Answer:5.40%

3. Tapley Inc. recently hired you as a consultant to estimate the company's WACC. You have obtained the following information. (1) Tapley's bonds mature in 25 years, have a 7.5% annual coupon, a par value of $1,000, and a market price of $936.49. (2) The company's tax rate is 40%. (3) The risk-free rate is 6.0%, the market risk premium is 5.0%, and the stock's beta is 1.5. (4) ...

Solution Summary

This post solves 10 questions related to various concepts such as WACC, cost of debt, which project to accept, cost of equity, CAPM, DCF. Can be used as a very good practice for exams.

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Cost of capital

1. Bankston Corporation forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Since new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock?
a. Increase the dividend payout ratio for the upcoming year.
b. Increase the percentage of debt in the target capital structure.
c. Increase the proposed capital budget.
d. Reduce the amount of short-term bank debt in order to increase the current ratio.
e. Reduce the percentage of debt in the target capital structure.

2. LaPango Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?

a. Project B, which is of below-average risk and has a return of 8.5%.
b. Project C, which is of above-average risk and has a return of 11%.
c. Project A, which is of average risk and has a return of 9%.
d. None of the projects should be accepted.
e. All of the projects should be accepted.

3. Which of the following statements is CORRECT?
a. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation.
b. All else equal, an increase in a company's stock price will increase its marginal cost of retained earnings, rs.
c. All else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re.
d. Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt.
e. If a company's tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall. 4. 4) Which of the following statements is CORRECT?
a. Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.
b. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes.
c. If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.
d. Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt.
e. Higher flotation costs tend to reduce the cost of equity capital.

5. Cranberry Corp. has two divisions of equal size: a computer manufacturing division and a data processing division. Its CFO believes that stand-alone data processor companies typically have a WACC of 8%, while stand-alone computer manufacturers typically have a 12% WACC. He also believes that the data processing and manufacturing divisions have the same risk as their typical peers. Consequently, he estimates that the composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the data processing division and a 12% hurdle rate for the manufacturing division. However, the CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is CORRECT?
a. While the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant's recommendation, this should not affect the firm's intrinsic value.
b. The decision not to adjust for risk means, in effect, that it is favoring the data processing division. Therefore, that division is likely to become a larger part of the consolidated company over time.
c. The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division. This will lead to a reduction in the firm's intrinsic value over time.
d. The decision not to risk-adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business. This will lead to a reduction in its intrinsic value over time.
e. The decision not to risk adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business. This may affect the firm's capital structure but it will not affect its intrinsic value.

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