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4a. Question - Chapter 4

The document discusses corporate finance concepts related to cost of capital and valuation. It includes multiple choice questions about how changes in factors like tax rates, bond ratings, and market rates impact the after-tax cost of debt. It also includes short answer questions calculating weighted average cost of capital, cash flows to equity holders, and adjusted present value given financial information about companies and projects.

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176 views

4a. Question - Chapter 4

The document discusses corporate finance concepts related to cost of capital and valuation. It includes multiple choice questions about how changes in factors like tax rates, bond ratings, and market rates impact the after-tax cost of debt. It also includes short answer questions calculating weighted average cost of capital, cash flows to equity holders, and adjusted present value given financial information about companies and projects.

Uploaded by

plinhcoco02
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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CORPORATE FINANCE 2

CHAPTER 4 – COST OF CAPITAL AND VALUATION

I/ MULTIPLE CHOICE

1. All else constant, which one of the following will increase a firm's cost of equity if
the firm computes that cost using the security market line approach? Assume the firm
currently pays an annual dividend of $1 a share and has a beta of 1.2.

A. a reduction in the dividend amount

B. a reduction in the market rate of return

C. a reduction in the firm's beta

D. a reduction in the risk-free rate

2. The aftertax cost of debt generally increases when:

I. a firm's bond rating increases.

II. the market rate of interest increases.

III. tax rates decrease.

IV. bond prices rise.

A. I and III only

B. II and III only

C. I, II, and III only

D. II, III, and IV only

3. Morris Industries has a capital structure of 55 percent common stock, 10 percent


preferred stock, and 45 percent debt. The firm has a 60 percent dividend payout ratio,
a beta of 0.89, and a tax rate of 38 percent. Given this, which one of the following
statements is correct?

A. The aftertax cost of debt will be greater than the current yield-to-maturity on the
firm's bonds.

B. The firm's cost of preferred is most likely less than the firm's actual cost of debt.
C. The firm's cost of equity is unaffected by a change in the firm's tax rate.

D. The cost of equity can only be estimated using the SML approach.

4. The aftertax cost of debt:

A. has a greater effect on a firm's cost of capital when the debt-equity ratio increases.

B. will generally exceed the cost of equity if the relevant tax rate is zero.

C. will generally equal the cost of preferred if the tax rate is zero.

D. is unaffected by changes in the market rate of interest.

5. Which one of the following statements is correct for a firm that uses debt in its
capital structure?

A. The WACC should decrease as the firm's debt-equity ratio increases.

B. When computing the WACC, the weight assigned to the preferred stock is based on
the coupon rate multiplied by the par value of the preferred.

C. The firm's WACC will decrease as the corporate tax rate decreases.

D. The weight of the common stock used in the computation of the WACC is based on the
number of shares outstanding multiplied by the book value per share.

6. Galstone Industries has a return on unlevered equity of 18 percent, a cost of debt of


8 percent, a tax rate of 34 percent, and a debt-equity ratio of .55. What is the levered
return on equity?

A. 17.08 percent

B. 19.61 percent

C. 34.18 percent

D. 21.63 percent

7. A project has an initial cost of $482,000 of which 40 percent will be financed with
debt. The interest rate on the debt is 9 percent. The cash flow from the project to the
equityholders if the firm were unlevered would be $94,000. What is the cash flow to
the equityholders given that the firm is leveraged and has a tax rate of 35 percent?

A. $82,721.20
B. $94,000.00

C. $105,278.80

D. $116,008.12

II/ SHORT ANSWER

1. The Shoe Outlet has paid annual dividends of $0.65, $0.70, $0.72, and $0.75 per share over
the last four years, respectively. The stock is currently selling for $26 a share. What is this
firm's cost of equity?

2. Mangrove Fruit Farms has a $250,000 bond issue outstanding that is selling at 92 percent
of face value. The firm also has 1,500 shares of preferred stock and 15,000 shares of common
stock outstanding. The preferred stock has a market price of $35 a share compared to a price
of $24 a share for the common stock. What is the weight of the preferred stock as it relates
to the firm's weighted average cost of capital?

3. Wayco Industrial Supply has a pre-tax cost of debt of 7.6 percent, a cost of equity of 14.3
percent, and a cost of preferred stock of 8.5 percent. The firm has 220,000 shares of common
stock outstanding at a market price of $27 a share. There are 25,000 shares of preferred
stock outstanding at a market price of $41 a share. The bond issue has a face value of
$550,000 and a market quote of 101.2. The company's tax rate is 37 percent. What is the
firm's weighted average cost of capital?

4. An unlevered firm is considering a new project that has an initial cost of $412,000. The
expected cash flow to the firm's owners from this project is $74,500 given the unlevered
firm's tax rate of 35 percent. Company management is considering the use of $250,000 in
debt at an interest rate of 8.5 percent to finance this project. What will the cash flow be to
the equityholders?
5. Sandler's is considering a project which has an initial cost of $441,000, indefinite annual
cash sales of $525,000, and indefinite annual cash costs of $420,000. The unlevered cost of
capital is 13 percent and the tax rate is 34 percent. What is the adjusted present value of the
project if the firm acquires $200,000 of debt to help finance the project?

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