Chapter 12 - Cost of Capital
85. Lester's is a globally diverse company with multiple divisions and a cost of capital of 15.8 percent. Med, Inc. is a specialty firm in the medical equipment field with a cost of capital of 13.7 percent. With the aging of America, both firms recognize the opportunities that exist in the medical field and are considering expansion in this area. At present, there is an opportunity for multiple firms to be involved in a new medical devices project. Each project will require an initial investment of $8.4 million with annual returns of $2.2 million per year for 7 years. Which firm or firms, if either, should become involved in the new projects? A. Lester's only B. Med, Inc. only
C. Both Lester's and Med, Inc. D. Neither Lester's nor Med, Inc.
E. The answer cannot be determined based on the information provided.
86. Bob's is a retail chain of specialty hardware stores. The firm has 21,000 shares of stock outstanding that are currently valued at $68 a share and provide a 13.2 percent rate of return. The firm also has 500 bonds outstanding that have a face value of $1,000, a market price of $1,068, and a 7 percent coupon. These bonds mature in 6 years and pay interest semiannually. The tax rate is 35 percent. The firm is considering expanding by building a new superstore. The superstore will require an initial investment of $12.3 million and is expected to produce cash inflows of $1.1 million annually over its 10-year life. The risks associated with the superstore are comparable to the risks of the firm's current operations. The initial investment will be depreciated on a straight line basis over the life of the project. At the end of the 10 years, the firm expects to sell the superstore for $6.7 million. Should the firm accept or reject the superstore project and why?
A. Accept; The project's NPV is $1.27 million. B. Accept; The NPV is $4.89 million. C. Reject; The NPV is $1.06 million D. Reject; The NPV -$3.27 million. E. Reject; The NPV is -$5.71 million.
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Chapter 12 - Cost of Capital
87. Casper's is analyzing a proposed expansion project that is much riskier than the firm's current operations. Thus, the project will be assigned a discount rate equal to the firm's cost of capital plus 3 percent. The proposed project has an initial cost of $17.2 million dollars that will be depreciated on a straight-line basis over 20 years. The project also requires additional inventory of $687,000 over the project's life. Management estimates the facility will generate cash inflows of $2.78 million a year over its 20-year life. After 20 years, the company plans to sell the facility for an estimated $1.3 million. The company has 60,000 shares of common stock outstanding at a market price of $49 a share. This stock just paid an annual dividend of $1.84 a share. The dividend is expected to increase by 3.5 percent annually. The firm also has 10,000 shares of 12 percent preferred stock with a market value of $98 a share. The preferred stock has a par value of $100. The company has a 9 percent, semiannual coupon bond issue outstanding with a total face value of $1.1 million. The bonds are currently priced at 102 percent of face value and mature in 16 years. The tax rate is 33 percent. Should the firm pursue the expansion project at this point in time? Why or why not? A. Accept; The NPV is $2.648 million. B. Accept; The NPV is $4.507 million. C. Reject; The NPV is -$3.241 million. D. Reject; The NPV is -$3.027 million. E. Reject; The NPV is -$1.040 million.
Essay Questions
88. Explain the concept of the subjective approach to assigning a required return to a project.
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Chapter 12 - Cost of Capital
89. Assume a firm follows a policy of using its weighted average cost of capital as the required return for all of its proposed projects. Evaluate this policy. How will this policy affect the overall risk level of the firm over time?
90. Assume the federal government decides to permanently eliminate corporate income taxes as a means of encouraging economic development and job growth. What effect, if any, would this change have on the evaluation of a proposed project?
91. Assume the federal government mandates that all retail stores in the northern states install heated sidewalks to help minimize the number of injuries that occur from people falling as a result of snow and ice buildup on those sidewalks. How should a firm determine the cost of capital for a project such as is?
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Chapter 12 - Cost of Capital
Multiple Choice Questions
92. Gray's Tools just issued a dividend of $1.60 per share on its common stock. The company is expected to maintain a constant 4 percent growth rate in its dividends indefinitely. If the stock sells for $31 a share, what is the company's cost of equity? A. 8.81 percent B. 9.37 percent C. 9.94 percent D. 10.32 percent E. 11.46 percent
93. Stock in ABC Enterprises has a beta of 1.06. The market risk premium is 6.8 percent, and T-bills are currently yielding 3.2 percent. ABC's most recent dividend was $1.56 per share, and dividends are expected to grow at a 4 percent annual rate indefinitely. If the stock sells for $43 a share, what is your best estimate of ABC's cost of equity? A. 7.78 percent B. 8.82 percent C. 9.09 percent D. 9.41 percent E. 9.69 percent
94. Upstate Bank has an issue of preferred stock with a $4.80 stated dividend that just sold for $86 a share. What is the bank's cost of preferred stock? A. 4.91 percent B. 5.58 percent C. 6.23 percent D. 6.47 percent E. 7.32 percent
95. Raceway Motors issued a 20-year, 8 percent semiannual bond 3 years ago. The bond
currently sells for 98.6 percent of its face value. The company's tax rate is 34 percent. What is the aftertax cost of debt? A. 5.38 percent B. 5.54 percent C. 5.69 percent D. 5.72 percent E. 5.99 percent
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Chapter 12 - Cost of Capital
96. Healthy Foods has a target capital structure of 55 percent common stock, 5 percent
preferred stock, and 40 percent debt. Its cost of equity is 14.3 percent, the cost of preferred stock is 8.9 percent, and the pre-tax cost of debt is 8.1 percent. What is the company's WACC if the applicable tax rate is 34 percent? A. 9.29 percent B. 9.61 percent C. 10.02 percent D. 10.45 percent E. 10.83 percent
97. Precision Engineering has a target debt-equity ratio of 0.55. Its cost of equity is 15.4 percent, and its pre-tax cost of debt is 7.8 percent. If the tax rate is 34 percent, what is the company's WACC?
A. 10.20 percent B. 10.72 percent C. 10.91 percent D. 11.48 percent E. 11.76 percent
98. Given the following information for Electric Transport, find the WACC. Assume the company's tax rate is 34 percent.
Debt: 7,500, 8.4 percent coupon bonds outstanding. $1,000 par value, 22 years to maturity, selling for 103 percent of par, the bonds make semiannual payments.
Common stock: 195,000 shares outstanding, selling for $78 per share, beta is 1.21
Preferred stock: 11,000 shares of 6.35 percent preferred stock outstanding, currently selling for $76 per share.
Market: 8 percent market risk premium and 5.1 percent risk-free rate. A. 11.49 percent B. 12.07 percent C. 12.42 percent D. 13.33 percent E. 13.80 percent
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