1. For a typical firm, which of the following is correct? All rates are after taxes, and assume the firm operates at its target capital structure. (rd= rate on debt; re= rate on equity (ROE), rs= rate on company’s stock, WACC= weighted average cost of capital) (Points : 4) rd > re > rs > WACC. rs > re > rd > WACC. WACC > re > rs > rd. re > rs > WACC > rd. WACC > rd > rs > re. 2. 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? (Points : 4) 7.55% 7.73% 7.94% 8.10% 8.32% = ( 0.4 × 4) + (0.10 × 7.5) + (0.40 × 11.50) = 8.10% 3. Which of the following is not a capital component when calculating the weighted average cost of capital (WACC)? (Points : 4) Long-term debt. Common stock. Retained earnings. Accounts payable. Preferred stock. 4. Assume that you are a consultant to Morton Inc., and you have been provided with the following data: D1 = $1.00; P0 = $25.00; and g = 6% (constant). What is the cost of equity from retained earnings based on the DCF approach? (Points : 4) 9.79% 9.86% 10.00% 10.20% 10.33% 5. To help finance a major expansion, Dimkoff Development Company sold a bond several years ago that now has 20 years to maturity. This bond has a 7% annual coupon, paid quarterly, and it now sells at a price of $1,103.58. The bond cannot be called and has a par value of $1,000. If Dimkoff’s tax rate is 40%, what component cost of debt should be used in the WACC calculation? (Points : 4) 3.03% 3.28% 3.66% 3.85% 4.04% 6. Which of the following statements is CORRECT? (Points : 4) Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock. When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation. If a company’s beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company has does not have enough retained earnings to take care of its equity financing and hence needs to issue new stock. Higher flotation costs reduce investor returns, and that leads to a reduction in a company’s WACC. 7. For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is CORRECT? (Points : 4) The cost of equity is usually greater than or equal to the cost of debt. The WACC exceeds the cost of equity. The WACC is calculated on a before-tax basis. The interest rate used to calculate the WACC is the average cost of all the debt the company has outstanding and shown on its balance sheet. The cost of retained earnings typically exceeds the cost of new common stock. 8. Which of the following statements about the cost of capital is CORRECT? (Points : 4) A change in a company’s target capital structure cannot affect its WACC. WACC calculations should be based on the before-tax costs of all the individual capital components. If a company’s tax rate increases, then, all else equal, its weighted average cost of capital will decrease. Flotation costs associated with issuing new common stock normally lead to a decrease in the WACC. An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing. 9. Which of the following statements is CORRECT? (Points : 4) If a company’s tax rate increases but the YTM of its noncallable bonds remains the same, the after-tax cost of its debt will fall. All else equal, an increase in a company’s stock price will increase its marginal cost of retained earning…
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