finance data bank

If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.

a.

True

b.

False

The lower the firm's tax rate, the lower will be its after-tax cost of debt and WACC, other things held constant.

a.

True

b.

False

If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the required rate of return on equity, r_s, than on the interest rate on long-term debt, r_d, for most firms. Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity. However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit the shift toward debt.

a.

True

b.

False

Jackson Inc. uses only equity capital, and it has 2 equally-sized divisions. Division A’s cost of capital is 10.0%, Division B’s cost is 14.0%, and the composite WACC is 12.0%. All of Division A’s projects have the same risk, as do all of Division B's projects. However, the projects in Division A have less risk than those in Division B. Which of the following projects should Jackson accept?

a.

A Division B project with a 13% return.

b.

A Division B project with a 12% return.

c.

A Division A project with an 11% return.

d.

A Division A project with a 9% return.

e.

A Division B project with an 11% return.

Vang Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?

a.

Project B is of below-average risk and has a return of 8.5%.

b.

Project C is of above-average risk and has a return of 11%.

c.

Project A is of average risk and has a return of 9%.

d.

None of the projects should be accepted.

e.

All of the projects should be accepted.

Nelson Enterprises, an all-equity firm, has a beta of 2.0. Nelson’s chief financial officer is evaluating a project with an expected return of 21%, before any risk adjustment. The risk-free rate is 7%, and the market risk premium is 6%. The project being evaluated is riskier than Nelson’s average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT?

a.

The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.

b.

The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return.

c.

Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment.

d.

The accept/reject decision depends on the firm's risk-adjustment policy. If Nelson's policy is to increase the required return on a riskier-than-average project to 3% over r_S, then it should reject the project.

e.

Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision.

Which of the following statements is CORRECT?

a.

The WACC is calculated using before-tax costs for all components.

b.

The after-tax cost of debt usually exceeds the after-tax cost of equity.

c.

For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of preferred stock.

d.

Retained earnings that were generated in the past and are reflected on the firm’s balance sheet are generally available to finance the firm’s capital budget during the coming year.

e.

The WACC that should be used in capital budgeting is the firm’s marginal, after-tax cost of capital.

Assume that you are a consultant to Magee Inc., and you have been provided with the following data: r_RF = 4.00%; RP_M = 5.00%; and b = 1.15. What is the cost of equity from retained earnings based on the CAPM approach?

a.

9.75%

b.

10.04%

c.

10.34%

d.

10.65%

e.

10.97%