Chapter 9 The Cost of Capital

19) Coyote Inc. operates three divisions. One division involves significant research and development, and thus has a high-risk cost of capital of 15%. The second division operates in business segments related to Coyote's core business, and this division has a cost of capital of 10% based upon its risk. Coyote's core business is the least risky segment, with a cost of capital of 8%. The firm's overall weighted average cost of capital of 11% has been used to evaluate capital budgeting projects for all three divisions. This approach will

A) favor projects in the core business division because that division is the least risky.

B) favor projects in the related businesses division because the cost of capital for this division is the closest to the firm's weighted average cost of capital.

C) favor projects in the research and development division because the higher risk projects look more favorable if a lower cost of capital is used to evaluate them.

D) not favor any division over the other because they all use the same company-wide weighted average cost of capital.

20) WineCellars Inc. currently has a weighted average cost of capital of 12%. WineCellars has been growing rapidly over the past several years, selling common stock in each year to finance its growth. However, due to difficult economic times this year, WineCellars decides to cut its dividend and increase its retained earnings so that the common equity portion of its capital structure will include only retained earnings and no new common stock will be sold. WineCellars weighted average cost of capital this year should be

A) zero, since no new stock will be sold.

B) less than 12%.

C) equal to 12%.

D) greater than 12%.

21) Beauty Inc. plans to maintain its optimal capital structure of 40 percent debt, 10 percent preferred stock, and 50 percent common equity indefinitely. The required return on each component source of capital is as follows: debt--8 percent; preferred stock--12 percent; common equity--16 percent. Assuming a 40 percent marginal tax rate, what after-tax rate of return must the firm earn on its investments if the value of the firm is to remain unchanged?

A) 12.40 percent

B) 12.00 percent

C) 11.12 percent

D) 10.64 percent

22) Texas Transport has five possible investment projects for the coming year. Each project is indivisible. They are:

Project Investment (million) IRR

A $ 6 18%

B $10 15%

C $ 9 20%

D $ 4 12%

E $ 3 24%

The firm's weighted marginal cost of capital schedule is 12 percent for up to $6 million of investment; 16 percent for between $6 million and $18 million of investment; and above $18 million the weighted cost of capital is 18 percent. The optimal capital budget is

A) $12 million.

B) $18 million.

C) $23 million.

D) $28 million.

23) The DEF Company is planning a $64 million expansion. The expansion is to be financed by selling $25.6 million in new debt and $38.4 million in new common stock. The before-tax required rate of return on debt is 9 percent and the required rate of return on equity is 14 percent. If the company is in the 35 percent tax bracket, what is the firm's cost of capital?

A) 8.92%

B) 9.89%

C) 11.50%

D) 10.74%

24) CrochetCo is considering an investment in a project which would require an initial outlay of $350,000 and produce expected cash flows in years 1-5 of $95,450 per year. You have determined that the current after-tax cost of the firm's capital (required rate of return) for each source of financing is as follows:

Cost of Long-Term Debt 7%

Cost of Preferred Stock 11%

Cost of Common Stock 15%

long-term debt currently makes up 25% of the capital structure, preferred stock 15%, and common stock 60%. What is the net present value of this project?

A) -$9,306

B) $2,149

C) $5,983

D) $11,568

25) For a typical corporation, which of the following capital structures will result in the lowest weighted average cost of capital?

A) 40% debt, 20% preferred stock, 40% common equity

B) 50% debt, 10% preferred stock, 40% common equity

C) 60% debt, 10% preferred stock, 30% common equity

D) 60% debt, 15% preferred stock, 25% common equity

26) Given the following information on S & G Inc.'s capital structure, compute the company's weighted average cost of capital.

Type of Percent of Before-Tax

Capital Capital Structure Component Cost

Bonds 40% 7.5%

Preferred Stock 5% 11%

Common Stock (Internal Only) 55% 15%

The company's marginal tax rate is 40%.

A) 13.3%

B) 7.1%

C) 10.6%

D) 10%

27) Which of the following causes a firm's cost of capital (WACC) to differ from an investor's required rate of return on the company's common stock?

A) the fact that the risk free rate of interest has increased

B) the incurrence of flotation costs when new securities are issued

C) The market risk premium exceeds 12%.

D) None of the above — the WACC and required return are the same.

28) Which of the following should NOT be considered when calculating a firm's WACC?

A) cost of preferred stock

B) after-tax cost of bonds

C) cost of common stock

D) cost of carrying inventory