Chapter 12 - Cost of Capital
99. You are given the following information concerning Around Town Tours:
Debt: 8,500, 7.1 percent coupon bonds outstanding, with 14 years to maturity and a quoted price of 102.6. These bonds pay interest semiannually.
Common stock: 265,000 shares of common stock selling for $76 per share. The stock has a beta of 0.92 and will pay a dividend of $2.48 next year. The dividend is expected to grow by 4 percent per year indefinitely.
Preferred stock: 7,500 shares of 6 percent preferred stock selling at $88 per share.
Market: A 13.2 percent expected return, a 4.5 percent risk-free rate, and a 34 percent tax rate. Calculate the WACC for this firm. A. 8.22 percent B. 8.67 percent C. 9.29 percent D. 9.57 percent E. 10.08 percent
100. Stewart's is considering a new project. The company has a debt-equity ratio of 0.72. The company's cost of equity is 15.1 percent, and the aftertax cost of debt is 7.2 percent. The firm feels that the project is riskier than the company as a whole and that it should use an adjustment factor of +2 percent. What is the WACC it should use for the project? A. 12.53 percent B. 12.98 percent C. 13.79 percent D. 14.14 percent E. 14.68 percent
Chapter 12 Cost of Capital Answer Key
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Chapter 12 - Cost of Capital
Multiple Choice Questions
1. Katie owns 100 shares of ABC stock. Which one of the following terms is used to refer to the return that Katie and the other shareholders require on their investment in ABC? A. Weighted average cost of capital B. Pure play cost C. Cost of equity D. Subjective cost E. Cost of debt Refer to section 12.2.
Bloom's: Knowledge Difficulty: Basic
Learning Objective: 12-01 Determine a firm's cost of equity capital Section: 12.2
Topic: Cost of equity
2. Lester lent money to The Corner Store by purchasing bonds issued by the store. The rate of return that he and the other lenders require is referred to as the: A. pure play cost. B. cost of debt.
C. weighted average cost of capital. D. subjective cost. E. cost of equity. Refer to section 12.3.
Bloom's: Knowledge Difficulty: Basic
Learning Objective: 12-02 Determine a firm's cost of debt Section: 12.3
Topic: Cost of debt
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Chapter 12 - Cost of Capital
3. The weighted average cost of capital is defined as the weighted average of a firm's: A. return on its investments.
B. cost of equity and its aftertax cost of debt. C. pretax cost of debt and equity securities. D. bond coupon rates.
E. dividend and capital gains yields. Refer to section 12.4.
Bloom's: Knowledge Difficulty: Basic
Learning Objective: 12-03 Determine a firm's overall cost of capital Section: 12.4
Topic: Weighted average cost of capital
4. Farmer's Supply, Inc. is considering opening a clothing store, which would be a new line of business for the firm. Management has decided to use the cost of capital of a similar clothing store as the discount rate that should be used to evaluate this proposed expansion. Which one of the following terms is used to describe the approach Farmer's Supply is taking to establish an appropriate discount rate for the project? A. Equity approach B. Aftertax approach C. Subjective approach D. Market play
E. Pure play approach Refer to section 12.5.
Bloom's: Knowledge Difficulty: Basic
Learning Objective: 12-04 Identify some of the pitfalls associated with a firm's overall cost of capital and what to do about them Section: 12.5
Topic: Pure play approach
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Chapter 12 - Cost of Capital
5. Kate is the CFO of a major firm and has the job of assigning discount rates to each project that is under consideration. Kate's method of doing this is to assign an incrementally higher rate as the risk level of the project increases over that of the current firm. Likewise, she assigns lower rates as the risk level declines. Which one of the following approaches is Kate using to assign the discount rates? A. Pure play approach B. Divisional rating C. Subjective approach
D. Straight WACC approach E. Equity rating Refer to section 12.5.
Bloom's: Knowledge Difficulty: Basic
Learning Objective: 12-04 Identify some of the pitfalls associated with a firm's overall cost of capital and what to do about them Section: 12.5
Topic: Subjective approach
6. Ted is trying to decide what cost of capital he should assign to a project. Which one of the following should be his primary consideration in this decision? A. Amount of debt used to finance the project
B. Use, or lack thereof, of preferred stock to finance the project C. Mix of funds used to finance the project D. Risk level of the project E. Length of the project's life Refer to section 12.1.
Bloom's: Knowledge Difficulty: Basic
Learning Objective: 12-01 Determine a firm's cost of equity capital Section: 12.1
Topic: Cost of capital
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Chapter 12 - Cost of Capital
7. Black Stone Furnaces wants to build a new facility. The cost of capital for this investment is primarily dependent upon which one of the following? A. Firm's overall source of funds
B. Source of the funds used to build the facility C. Current tax rate
D. The nature of the investment
E. Firm's historical average rate of return Refer to section 12.1
Bloom's: Knowledge Difficulty: Basic
Learning Objective: 12-01 Determine a firm's cost of equity capital Section: 12.1
Topic: Cost of capital
8. Which one of the following statements is correct related to the dividend growth model approach to computing the cost of equity?
A. The rate of growth must exceed the required rate of return. B. The rate of return must be adjusted for taxes.
C. The annual dividend used in the computation must be for year one if you are using today's stock price to compute the return.
D. The cost of equity is equal to the return on the stock plus the risk-free rate.
E. The cost of equity is equal to the return on the stock multiplied by the stock's beta. Refer to section 12.2.
Bloom's: Comprehension Difficulty: Basic
Learning Objective: 12-01 Determine a firm's cost of equity capital Section: 12.2
Topic: Cost of equity
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