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CFA Program Level 1 | Corporate FinancePages
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CFA Level 1 - Corporate Finance Session 11 - Reading 37 (Notes, Practice Questions, Sample Questions) 1. A company is planning a $50 million expansion. The expansion is to be financed by selling $20 million in new debt and $30 million in new commonstock. The before-tax required return on debt is 9% and the required return forequity is 14%. If the company is in the 40% tax bracket, the marginal weightedaverage cost of capital is closest to: A)9.0%.B)10.0% C)10.6%. (Explanation: (0.4)(9%)(1 - 0.4) + (0.6)(14%) = 10.56%) 2. Assume a firm uses a constant WACC to select investment projects rather than adjusting the projects for risk. If so, the firm will tend to: A)reject profitable, low-risk projects and accept unprofitable, high-riskprojects. (Explanation: The firm will reject profitable, low-risk projectsbecause it will use a hurdle rate that is too high. The firm should lower therequired rate of return for lower risk projects. The firm will acceptunprofitable, high-risk projects because the hurdle rate of return used willbe too low relative to the risk of the project. The firm should increase therequired rate of return for high-risk projects) B)accept profitable, low-risk projects and accept unprofitable, high-riskprojects.C)accept profitable, low-risk projects and reject unprofitable, high-risk projects 3. In calculating the weighted average cost of capital (WACC), which of the following statements is least accurate?
A)Different methods for estimating the cost of common equity might producedifferent results.B)The cost of preferred equity capital is the preferred dividend divided by theprice of preferred shares. C)The cost of debt is equal to one minus the marginal tax rate multipliedby the coupon rate on outstanding debt. (Explanation: After-tax cost ofdebt = bond yield − tax savings = kd − kdt = kd(1 − t)) 4. Which of the following events will reduce a company's weighted average cost of capital (WACC)? A)An increase in expected inflation.B)A reduction in the company's bond rating. C)A reduction in the market risk premium. (Explanation: An increase ineither the company’s beta or the market risk premium will cause theWACC to increase using the CAPM approach. A reduction in the marketrisk premium will reduce the cost of equity for WACC) 5. The following data is regarding the Link Company: A target debt/equity ratio of 0.5Bonds are currently yielding 10%Link is a constant growth firm that just paid a dividend of $3.00Stock sells for $31.50 per share, and has a growth rate of 5%Marginal tax rate is 40% What is Link's after-tax cost of capital? A)12.0%. (Explanation: Use the revised form of the constant growth modelto determine the cost of equity. Use algebra to determine the weights for thetarget capital structure realizing that debt is 50% of equity. Substitute 0.5Efor D in the formula below.ks = D1 ÷ P0 + growth = (3)(1.05) ÷ (31.50) +0.05 = 0.15 or 15% V = debt + equity = 0.5 + 1 = 1.5 WACC = (E ÷ V)(ks) +(D ÷ V)(kdebt)(1 − t)WACC = (1 ÷ 1.5)(0.15) + (0.5 ÷ 1.5)(0.10)(1 − 0.4) = 0.1 + 0.02 = 0.12 or12%)
B)10.5%.C)12.5%. 6. Helmut Humm, manager at a large U.S. firm, has just been assigned to the capital budgeting area to replace a person who left suddenly. One of Humm’sfirst tasks is to calculate the company’s weighted average cost of capital(WACC) – and fast! The CEO is scheduled to present to the board in half anhour and needs the WACC – now! Luckily, Humm finds clear notes on thetarget capital component weights. Unfortunately, all he can find for the cost ofcapital components is some handwritten notes. He can make out the numbers,but not the corresponding capital component. As time runs out, he has to guess.Here is what Humm deciphered:Target weights: wd = 30%, wps = 20%, wce = 50%, where wd, wps, and wceare the weights used for debt, preferred stock, and common equity.Cost of components (in no particular order): 6.0%, 15.0%, and 8.5%.The cost of debt is the after-tax cost. If Humm guesses correctly, the WACC is: A)11.0%. (Explanation: If Humm remembers to order the capitalcomponents from cheapest to most expensive, he can calculate WACC. Theorder from cheapest to most expensive is: debt, preferred stock (which actslike a hybrid of debt and equity), and common equity.Then, using the formula for WACC = (wd)(kd) + (wps)(kps) + (wce)(kce)where wd, wps, and we are the weights used for debt, preferred stock, andcommon equity.WACC = (0.30 × 6.0%) + (0.20 × 8.5%) + (0.50 × 15.00%) = 11.0%) B)9.2%.C)9.0%. 7. When calculating the weighted average cost of capital (WACC) an adjustment is made for taxes because: A)equity earns higher return than debt.
B)the interest on debt is tax deductible. (Explanation: Equity and preferredstock are not adjusted for taxes because dividends are not deductible forcorporate taxes. Only interest expense is deductible for corporate taxes) C)equity is risky. 8. company has the following information: A target capital structure of 40% debt and 60% equity.$1,000 par value bonds pay 10% coupon (semi-annual payments), mature in 20years, and sell for $849.54.The company stock beta is 1.2.Risk-free rate is 10%, and market risk premium is 5%.The company's marginal tax rate is 40%.The weighted average cost of capital (WACC) is closest to: A)12.5%. (Explanation: Ks = 0.10 + (0.05)(1.2) = 0.16 or 16%Kd = Solve for i: N = 40, PMT = 50, FV = 1,000, PV = -849.54, CPT I = 6 ×2 = 12%WACC = (0.4)(12)(1 - 0.4) + (0.6)(16)= 2.88 + 9.6 = 12.48) B)13.0%.C)13.5%. 9. Assume that a company has equal amounts of debt, common stock, and preferred stock. An increase in the corporate tax rate of a firm will cause itsweighted average cost of capital (WACC) to: A)fall. (Explanation: Recall the WACC equation:WACC = [wd × kd × (1 − t)] + (wps × kps) + (wce × ks)The increase in the corporate tax rate will result in a lower cost of debt,resulting in a lower WACC for the company) B)rise.C)more information is needed. 10. Ravencroft Supplies is estimating its weighted average cost of capital (WACC). Ravencroft’s optimal capital structure includes 10% preferred stock,
30% debt, and 60% equity. They can sell additional bonds at a rate of 8%. Thecost of issuing new preferred stock is 12%. The firm can issue new shares ofcommon stock at a cost of 14.5%. The firm’s marginal tax rate is 35%.Ravencroft’s WACC is closest to: A)13.3%.B)12.3%. C)11.5%. (Explanation: 0.10(12%) + 0.30(8%)(1 – 0.35) + 0.6(14.5%) =11.46%) 11. Hatch Corporation's target capital structure is 40% debt, 50% common stock, and 10% preferred stock. Information regarding the company's cost ofcapital can be summarized as follows:The company's bonds have a nominal yield to maturity of 7%.The company's preferred stock sells for $40 a share and pays an annual dividendof $4 a share.The company's common stock sells for $25 a share and is expected to pay adividend of $2 a share at the end of the year (i.e., D1 = $2.00). The dividend isexpected to grow at a constant rate of 7% a year.The company has no retained earnings.The company's tax rate is 40%. What is the company's weighted average cost of capital (WACC)? A)10.59%.B)10.03%. C)10.18%. (Explanation: WACC = (wd)(kd)(1 − t) + (wps)(kps) +(wce)(kce)where:wd = 0.40wce = 0.50wps = 0.10kd = 0.07kps = Dps / P = 4.00 / 40.00 = 0.10kce = D1 / P0 + g = 2.00 / 25.00 + 0.07 = 0.08 + 0.07 = 0.15
WACC = (0.4)(0.07)(1 − 0.4) + (0.1)(0.10) + (0.5)(0.15) = 0.0168 + 0.01 +0.075 = 0.1018 or 10.18%) 12. A firm has $100 in equity and $300 in debt. The firm recently issued bonds at the market required rate of 9%. The firm's beta is 1.125, the risk-free rate is6%, and the expected return in the market is 14%. Assume the firm is at theiroptimal capital structure and the firm's tax rate is 40%. What is the firm'sweighted average cost of capital (WACC)? A)8.6%. B)7.8%. (Explanation: CAPM = RE = RF + B(RM − RF) = 0.06 +(1.125)(0.14 − 0.06) = 0.15WACC = (E ÷ V)(RE) + (D ÷ V)(RD)(1 − t)V = 100 + 300 = 400WACC = (1 ÷ 4)(0.15) + (3 ÷ 4)(0.09)(1 − 0.4) = 0.078) C)5.4%. 13. A firm is planning a $25 million expansion project. The project will be financed with $10 million in debt and $15 million in equity stock (equal to thecompany's current capital structure). The before-tax required return on debt is10% and 15% for equity. If the company is in the 35% tax bracket, what cost ofcapital should the firm use to determine the project's net present value (NPV)? A)12.5%.B)9.6%. C)11.6%. (Explanation: WACC = (E / V)(RE) + (D / V)(RD)(1 − TC)WACC = (15 / 25)(0.15) + (10 / 25)(0.10)(1 − 0.35) = 0.09 + 0.026 = 0.116 or11.6%) 14. At a recent Haggerty Semiconductors Board of Directors meeting, Merle Haggerty was asked to discuss the topic of the company’s weighted average costof capital (WACC).At the meeting Haggerty made the following statements about the company’sWACC:
Statement 1: A company creates value by producing a higher return on its assetsthan the cost of financing those assets. As such, the WACC is the cost offinancing a firm’s assets and can be viewed as the firm’s opportunity cost offinancing its assets.Statement 2: Since a firm’s WACC reflects the average risk of the projects thatmake up the firm, it is not appropriate for evaluating all new projects. It shouldbe adjusted upward for projects with greater-than-average risk and downwardfor projects with less-than-average risk.Are Statement 1 and Statement 2, as made by Haggerty CORRECT? Statement 1 Statement 2 A)Correct IncorrectB)Incorrect Correct C)Correct Correct (Explanation: Each statement that Haggerty has madeto the board of directors regarding the weighted average cost of capital iscorrect. New projects should have a return that is higher than the cost tofinance those projects) 15. Hans Klein, CFA, is responsible for capital projects at Vertex Corporation. Klein and his assistant, Karl Schwartz, were discussing various issues aboutcapital budgeting and Schwartz made a comment that Klein believed to beincorrect. Which of the following is most likely the incorrect statement made bySchwartz? A)“The weighted average cost of capital (WACC) should be based on marketvalues for the firm’s outstanding securities.” B)“Net present value (NPV) and internal rate of return (IRR) result in thesame rankings of potential capital projects.” (Explanation: It is possiblethat the NPV and IRR methods will give different rankings. This oftenoccurs when there is a significant difference in the timing of the cash flowsbetween two projects. A firm’s marginal cost of capital, or WACC, is onlyappropriate for computing a project’s NPV if the project has the same riskas the firm) C)“It is not always appropriate to use the firm’s marginal cost of capital whendetermining the net present value of a capital project.”
16. Carlos Rodriquez, CFA, and Regine Davis, CFA, were recently discussing the relationships between capital structure, capital budgets, and net presentvalue (NPV) analysis. Which of the following comments made by these twoindividuals is least accurate? A)“For projects with more risk than the average firm project, NPVcomputations should be based on the marginal cost of capital instead of theweighted average cost of capital.” (Explanation: The marginal cost ofcapital (MCC) and the weighted average cost of capital (WACC) are thesame thing. If a firm’s capital structure remains constant, the MCC(WACC) increases as additional capital is raised) B)“The optimal capital budget is determined by the intersection of a firm’smarginal cost of capital curve and its investment opportunity schedule.”C)“A break point occurs at a level of capital expenditure where one of thecomponent costs of capital increases.” 17. The marginal cost of capital is: A)tied solely to the specific source of financing.B)equal to the firm's weighted cost of funds. C)the cost of the last dollar raised by the firm. (Explanation: The“marginal” cost refers to the last dollar of financing acquired by the firmassuming funds are raised in the same proportion as the target capitalstructure. It is a percentage value based on both the returns required by thelast bondholders and stockholders to provide capital to the firm.Regardless of whether the funding came from bondholders or stockholders,both debt and equity are needed to fund projects) 18. Enamel Manufacturing (EM) is considering investing in a new vehicle. EM finances new projects using retained earnings and bank loans. This new vehicleis expected to have the same level of risk as the typical investment made byEM. Which one of the following should the firm use in making its decision?
A)Marginal cost of capital. (Explanation: The marginal cost of capitalrepresents the cost of raising an additional dollar of capital. The cost ofretained earnings would only be appropriate if the company avoidedcreditor-supplied financing or the issuance of new common or preferredstock (and preferred stock financing). The after-tax cost of debt is neversufficient, because a business, regardless of their size, always has a residualowner, and hence a cost of equity) B)Cost of retained earnings.C)After-tax cost of debt. 19. Which of the following statements is least accurate regarding the marginal cost of capital’s role in determining the net present value (NPV) of a project? A)Projects for which the present value of the after-tax cash inflows is greaterthan the present value of the after-tax cash outflows should be undertaken by thefirm. B)The NPVs of potential projects of above-average risk should becalculated using the marginal cost of capital for the firm. (Explanation:The WACC is the appropriate discount rate for projects that haveapproximately the same level of risk as the firm’s existing projects. This isbecause the component costs of capital used to calculate the firm’s WACCare based on the existing level of firm risk. To evaluate a project with above(the firm’s) average risk, a discount rate greater than the firm’s existingWACC should be used. Projects with below-average risk should beevaluated using a discount rate less than the firm’s WACC. An additionalissue to consider when using a firm’s WACC (marginal cost of capital) toevaluate a specific project is that there is an implicit assumption that thecapital structure of the firm will remain at the target capital structure overthe life of the project. These complexities aside, we can still conclude thatthe NPVs of potential projects of firm-average risk should be calculatedusing the marginal cost of capital for the firm. Projects for which thepresent value of the after-tax cash inflows is greater than the present valueof the after-tax cash outflows should be undertaken by the firm) C)When using a firm’s marginal cost of capital to evaluate a specific project,there is an implicit assumption that the capital structure of the firm will remainat the target capital structure over the life of the project
20. Which of the following statements about the role of the marginal cost of capital in determining the net present value of a project is most accurate? Themarginal cost of capital should be used to discount the cash flows: A)of all projects the firm is considering.B)if the firm’s capital structure is expected to change during the project’s life. C)for potential projects that have a level of risk near that of the firm’saverage project (Explanation: Net present values of projects with theaverage risk for the firm should be determined using the firm’s marginalcost of capital. The discount rate should be adjusted for projects withabove-average or below-average risk. Using the marginal cost of capitalassumes the firm’s capital structure does not change over the life of theproject) 21. Which of the following is most accurate regarding the component costs and component weights in a firm’s weighted average cost of capital (WACC)? A)The appropriate pre-tax cost of a firm’s new debt is the average coupon rateon the firm’s existing debt.B)The weights in the WACC should be based on the book values of theindividual capital components. C)Taxes reduce the cost of debt for firms in countries in which interestpayments are tax deductible (Explanation: The after-tax cost of debt = kd(1– t) = kd – kd(t), where kd is the pretax cost of debt and t is the effectivecorporate tax rate. So the tax savings from the tax treatment of debt iskd(t). Capital component weights should be based on market weights, notbook values. And, the appropriate pre-tax cost of debt is the yield tomaturity on the firm’s existing debt) 22. Ferryville Radar Technologies has five-year, 7.5% notes outstanding that trade at a yield to maturity of 6.8%. The company’s marginal tax rate is 35%.Ferryville plans to issue new five-year notes to finance an expansion.Ferryville’s cost of debt capital is closest to:
A)4.4%. (Explanation: Ferryville’s cost of debt capital is kd(1 - t) = 6.8% ×(1 - 0.35) = 4.42%. Note that the before-tax cost of debt is the yield tomaturity on the company’s outstanding notes, not their coupon rate. If theexpected yield on new par debt were known, we would use that. Since it isnot, the yield to maturity on existing debt is the best approximation) B)4.9%.C)2.4%. 23. The 6% semiannual coupon, 7-year notes of Woodbine Transportation, Inc. trade for a price of $94.54. What is the company’s after-tax cost of debt capitalif its marginal tax rate is 30%? A)2.1%.B)4.2%. C)4.9% (Explanation: To determine Woodbine’s before-tax cost of debt,find the yield to maturity on its outstanding notes:PV = -94.54; FV = 100; PMT = 6 / 2 = 3; N = 14; CPT → I/Y = 3.50 × 2 =7%Woodbine’s after-tax cost of debt is kd(1 - t) = 7%(1 - 0.3) = 4.9%) 24. The debt of Savanna Equipment, Inc. has an average maturity of ten years and a BBB rating. A market yield to maturity is not available because the debt isnot publicly traded, but the market yield on debt with similar characteristics is8.33%. Savanna is planning to issue new ten-year notes that would besubordinate to the firm’s existing debt. The company’s marginal tax rate is 40%.The most appropriate estimate of the after-tax cost of this new debt is: A)5.0%.B)Between 3.3% and 5.0%. C)More than 5.0% (Explanation: The after-tax cost of debt similar toSavanna’s existing debt is kd(1 - t) = 8.33%(1 - 0.4) = 5.0%. Because theanticipated new debt will be subordinated in the company’s debt structure,investors will demand a higher yield than the existing debt carries.
Therefore, the appropriate after-tax cost of the new debt is more than5.0%) 25. Which of the following is least likely to be useful to an analyst who is estimating the pretax cost of a firm’s fixed-rate debt? A)The yield to maturity of the firm’s existing debt. B)The coupon rate on the firm’s existing debt. (Explanation: Ideally, ananalyst would use the YTM of a firm’s existing debt as the pretax cost ofnew debt. When a firm’s debt is not publicly traded, however, a marketYTM may not be available. In this case, an analyst may use the yield curvefor debt with the same rating and maturity to estimate the market YTM. Ifthe anticipated debt has unique characteristics that affect YTM, thesecharacteristics should be accounted for when estimating the pretax cost ofdebt. The cost of debt is the market interest rate (YTM) on new (marginal)debt, not the coupon rate on the firm’s existing debt. If you are providedwith both coupon and YTM on the exam, you should use the YTM) C)Seniority and any special covenants of the firm’s anticipated debt. 26. Which of the following is least likely to be useful to an analyst when estimating the cost of raising capital through the issuance of non-callable,nonconvertible preferred stock? A)The stated par value of the preferred issue. B)The firm’s corporate tax rate. (Explanation: The corporate tax rate isnot a relevant factor when calculating the cost of preferred stock.The cost of preferred stock, kps is expressed as:kps = Dps / Pwhere:Dps = divided per share = dividend rate × stated par valueP = market price) C)The preferred stock’s dividend rate.
27. The after-tax cost of preferred stock is always: A)equal to the before-tax cost of preferred stock. (Explanation: Theafter-tax cost of preferred stock is equal to the before-tax cost of preferredstock, because preferred stock dividends are not tax deductible. The cost ofpreferred shares is usually higher than the cost of debt, but less than thecost of common shares) B)less than the before-tax cost of preferred stock.C)higher than the cost of common shares. 28. Justin Lopez, CFA, is the Chief Financial Officer of Waterbury Corporation. Lopez has just been informed that the U.S. Internal Revenue Code may berevised such that the maximum marginal corporate tax rate will be increased.Since Waterbury’s taxable income is routinely in the highest marginal taxbracket, Lopez is concerned about the potential impact of the proposed change.Assuming that Waterbury maintains its target capital structure, which of thefollowing is least likely to be affected by the proposed tax change? A)Waterbury’s after-tax cost of noncallable, nonconvertible preferredstock. (Explanation: Corporate taxes do not affect the cost of preferredstock to the issuing firm. Waterbury’s after-tax cost of debt, andconsequently, its weighted average cost of capital will decrease because thetax savings on interest will increase. Also, since taxes impact net income,Waterbury’s ROE will be affected by the change) B)Waterbury’s return on equity (ROE).C)Waterbury’s after-tax cost of corporate debt. 29. Which of the following statements is most accurate regarding a firm’s cost of preferred shares? A firm’s cost of preferred stock is: A)the dividend yield on the firm’s newly-issued preferred stock.(Explanation: The newly-issued preferred shares of most companiesgenerally sell at par. As such, the dividend yield on a firm’s newly-issuedpreferred shares is the market’s required rate of return. The yield on a
BBB corporate bond reflects a pre-tax cost of debt. Both remaining choicesmake no sense) B)the market price of the preferred shares as a percentage of its issuance price.C)approximately equal to the market price of the firm’s debt as a percentage ofthe market price of its common shares. 30. Axle Corporation earned £3.00 per share and paid a dividend of £2.40 on its common stock last year. Its common stock is trading at £40 per share. Axle isexpected to have a return on equity of 15%, an effective tax rate of 34%, and tomaintain its historic payout ratio going forward. In estimating Axle’s after-taxcost of capital, an analyst’s estimate of Axle’s cost of common equity would beclosest to: A)8.8%.B)9.0%. C)9.2%. (Explanation: We can estimate the company’s expected growthrate as ROE × (1 − payout ratio): g = 15% × (1 − 2.40/3.00) = 3%The expected dividend next period is then £2.40(1.03) = £2.47. Based ondividend discount model pricing, the required return on equity is 2.47 / 40+ 3% = 9.18%) 31. A $100 par, 8% preferred stock is currently selling for $80. What is the cost of preferred equity? A)10.0%. (Explanation: kps = $8 / $80 = 10%) B)10.8%.C)8.0%. 32. The expected dividend one year from today is $2.50 for a share of stock priced at $22.50. The long-term growth in dividends is projected at 8%. Thecost of common equity is closest to: A)15.6%.B)18.0%.
C)19.1%. (Explanation: Kce = ( D1 / P0) + g)Kce = [ 2.50 / 22.50 ] + 0.08 = 0.19111, or 19.1%) 33. The cost of preferred stock is equal to the preferred stock dividend: A)divided by the market price. (Explanation: The cost of preferred stock,kps, is Dps ÷ price.) B)divided by its par value.C)multiplied by the market price. 34. The expected annual dividend one year from today is $2.50 for a share of stock priced at $25. What is the cost of equity if the constant long-term growthin dividends is projected to be 8%? A)18%. (Explanation: Ks = (D1 / P0) + g = (2.5/25) + 0.08 = 0.18 or 18%.) B)19%.C)15%. 35. A company has $5 million in debt outstanding with a coupon rate of 12%. Currently the YTM on these bonds is 14%. If the tax rate is 40%, what is theafter tax cost of debt? A)7.2%.B)5.6%. C)8.4%. (Explanation: (0.14)(1 - 0.4)) 36. A firm has $4 million in outstanding bonds that mature in four years, with a fixed rate of 7.5% (assume annual payments). The bonds trade at a price of $98in the open market. The firm’s marginal tax rate is 35%. Using the bond-yieldplus method, what is the firm’s cost of equity risk assuming an add-on of 4%? A)12.11%. (Explanation: If the bonds are trading at $98, the required yieldis 8.11%, and the market value of the issue is $3.92 million. To calculate this
rate using a financial calculator (and figuring the rate assuming a $100 facevalue for each bond), N = 4; PMT = 7.5 = (0.075 × 100); FV = 100; PV =-98; CPT → I/Y = 8.11. By adding the equity risk factor of 4%, we computethe cost of equity as 12.11%) B)11.50%.C)13.34%. 37. Which of the following statements about the cost of capital is CORRECT? A)Ideally, historical measures of the component costs from prior financingshould be used in estimating the appropriate weighted average cost of capital.B)The cost of issuing new equity could possibly be lower than the cost ofretained earnings if the market risk premium and risk-free rate decline by asubstantial amount. C)In the weighted average cost of capital calculation, the cost of preferredstock must be adjusted for the cost to issue new preferred stock.(Explanation: The marginal cost of capital will increase or stay the same asmore capital is raised. Marginal costs of capital, not historical costs, shouldbe used in estimating the weighted average cost of capital) 38. A firm has $3 million in outstanding 10-year bonds, with a fixed rate of 8% (assume annual payments). The bonds trade at a price of $92 per $100 par in theopen market. The firm’s marginal tax rate is 35%. What is the after-taxcomponent cost of debt to be used in the weighted average cost of capital(WACC) calculations? A)6.02%. (Explanation: If the bonds are trading at $92 per $100 par, therequired yield is 9.26%, and the market value of the issue is $2.76 million.The equivalent after-tax cost of this financing is: 9.26% (1 – 0.35) = 6.02%) B)9.26%.C)5.40%.
39. Julius, Inc., is in a 40% marginal tax bracket. The firm can raise as much capital as needed in the bond market at a cost of 10%. The preferred stock has afixed dividend of $4.00. The price of preferred stock is $31.50. The after-taxcosts of debt and preferred stock are closest to: Debt Preferred stock A)10.0% 7.6% B)6.0% 12.7% (Explanation: After-tax cost of debt = 10% × (1 – 0.4) = 6%.Cost of preferred stock = $4 / $31.50 = 12.7%) C)6.0% 7.6% 40. If central bank actions caused the risk-free rate to increase, what is the most likely change to cost of debt and equity capital? A)Both decrease.B)One increase and one decrease. C)Both increase. (Explanation: An increase in the risk-free rate will causethe cost of equity to increase. It would also cause the cost of debt toincrease. In either case, the nominal cost of capital is the risk-free rate plusthe appropriate premium for risk) 41. A company’s outstanding 20-year, annual-pay 6% coupon bonds are selling for $894. At a tax rate of 40%, the company’s after-tax cost of debt capital isclosest to: A)4.2%. (Explanation: Pretax cost of debt: N = 20; FV = 1000; PV = −894;PMT = 60; CPT → I/Y = 7%After-tax cost of debt: kd = (7%)(1−0.4) = 4.2%) B)5.1%C)7.0% 42. Tony Costa, operations manager of BioChem Inc., is exploring a proposed product line expansion. Costa explains that he estimates the beta for the project
by seeking out a publicly traded firm that is engaged exclusively in the samebusiness as the proposed BioChem product line expansion. The beta of theproposed project is estimated from the beta of that firm after appropriateadjustments for capital structure differences. The method that Costa uses isknown as the: A)build-up method. B)pure-play method. (Explanation: The method used by Costa is known asthe pure-play method. The method entails selection of the pure-play equitybeta, unlevering it using the pure-play company’s capital structure, andre-levering using the subject company’s capital structure) C)accounting method. 43. Jamal Winfield is an analyst with Stolzenbach Technologies, a major computer services company based in the U.S. Stolzenbach’s management teamis considering opening new stores in Mexico, and wants to estimate the cost ofequity capital for Stolzenbach’s investment in Mexico. Winfield has researchedbond yields in Mexico and found that the yield on a Mexican government10-year bond is 7.7%. A similar maturity U.S. Treasury bond has a yield of4.6%. In the most recent year, the standard deviation of Mexico's All ShareIndex stock index and the S&P 500 index was 38% and 20% respectively. Theannualized standard deviation of the Mexican dollar-denominated 10-yeargovernment bond over the last year was 26%. Winfield has also determined thatthe appropriate beta to use for the project is 1.25, and the market risk premiumis 6%. The risk free interest rate is 4.2%. What is the appropriate country riskpremium for Mexico and what is the cost of equity that Winfield should use inhis analysis? Country Risk Premium for Mexico Cost of Equity for Project A)4.53% 17.36% (Explanation: CRP = Sovereign Yield Spread(Annualizedstandard deviation of equity index ÷ Annualized standard deviation ofsovereign bond market in terms of the developed market currency) = (0.077– 0.046)(0.38 ÷ 0.26) = 0.0453, or 4.53%
Cost of equity = RF + β[E(RMKT) – RF + CRP] = 0.042 + 1.25[0.06 +0.0453] = 0.1736 = 17.36% Note that you are given the market riskpremium, which equals E(RMKT) – RF) B)5.89% 17.36%C)4.53% 19.06% 44. Jeffery Marian, an analyst with Arlington Machinery, is estimating a country risk premium to include in his estimate of the cost of equity for a projectArlington is starting in India. Marian has compiled the following informationfor his analysis:Indian 10-year government bond yield = 7.20%10-year U.S. Treasury bond yield = 4.60%Annualized standard deviation of the Bombay Sensex stock index = 40%.Annualized standard deviation of Indian dollar denominated 10-yeargovernment bond = 24%Annualized standard deviation of the S&P 500 Index = 18%. The estimated country risk premium for India based on Marian’s research isclosest to: A)2.6%. B)4.3%. (Explanation: CRP = Sovereign Yield Spread(Annualizedstandard deviation of equity index ÷ Annualized standard deviation ofsovereign bond market in terms of the developed market currency) = (0.072– 0.046)(0.40/0.24) = 0.043, or 4.3%) C)5.8%. 45. In order to more accurately estimate the cost of equity for a company situated in a developing market, an analyst should: A)use the yield on the sovereign debt of the developing country instead of therisk free rate when using the capital asset pricing model (CAPM). B)add a country risk premium to the market risk premium when using thecapital asset pricing model (CAPM). (Explanation: In order to reflect the
increased risk when investing in a developing country, a country riskpremium is added to the market risk premium when using the CAPM) C)add a country risk premium to the risk-free rate when using the capital assetpricing model (CAPM). 46. Which one of the following statements about the marginal cost of capital (MCC) is most accurate? A)The MCC is the cost of the last dollar obtained from bondholders. B)A breakpoint on the MCC curve occurs when one of the components inthe weighted average cost of capital changes in cost. (Explanation: Abreakpoint is calculated by dividing the amount of capital at which acomponent's cost of capital changes by the weight of that component in thecapital structure.The marginal cost of capital (MCC) is defined as the weighted average costof the last dollar raised by the company. Typically, the marginal cost ofcapital will increase as more capital is raised by the firm. The marginal costof capital is the weighted average rate across all sources of long-termfinancings—bonds, preferred stock, and common stock—when the finaldollar was obtained, regardless of its specific source) C)The MCC falls as more and more capital is raised in a given period. 47. A North American investment society held a panel discussion on the topics of capital costs and capital budgeting. Which of the following comments madeduring this discussion is the least accurate? A)An increase in the after-tax cost of debt may occur at a break point. B)A project’s internal rate of return decreases when a breakpoint isreached. (Explanation: The internal rate of return is independent of thefirm’s cost of capital. It is a function of the amount and timing of aproject’s cash flows) C)Any given project’s NPV will decline when a breakpoint is reached.
48. Which of the following is used to illustrate a firm’s weighted average cost of capital (WACC) at different levels of capital? A)Schedule of marginal capital break points.B)Cost of capital component schedule. C)Marginal cost of capital schedule. (Explanation: The marginal cost ofcapital schedule shows the WACC at different levels of capital investment.It is usually upward sloping and is a function of a firm’s capital structureand its cost of capital at different levels of total capital investment) 49. The most accurate way to account for flotation costs when issuing new equity to finance a project is to: A)increase the cost of equity capital by dividing it by (1 – flotation cost). B)adjust cash flows in the computation of the project NPV by the dollaramount of the flotation costs. (Explanation: Adjusting the cost of equity forflotation costs is incorrect because doing so entails adjusting the presentvalue of cash flows by a fixed percentage over the life of the project. Inreality, flotation costs are a cash outflow that occurs at the initiation of aproject. Therefore, the correct way to account for flotation costs is to adjustthe cash flows in the computation of project NPV, not the cost of equity.The dollar amount of the flotation cost should be considered an additionalcash outflow at initiation of the project) C)increase the cost of equity capital by multiplying it by (1 + flotation cost) 50. Meredith Suresh, an analyst with Torch Electric, is evaluating two capital projects. Project 1 has an initial cost of $200,000 and is expected to producecash flows of $55,000 per year for the next eight years. Project 2 has an initialcost of $100,000 and is expected to produce cash flows of $40,000 per year forthe next four years. Both projects should be financed at Torch’s weightedaverage cost of capital. Torch’s current stock price is $40 per share, and nextyear’s expected dividend is $1.80. The firm’s growth rate is 5%, the current taxrate is 30%, and the pre-tax cost of debt is 8%. Torch has a target capitalstructure of 50% equity and 50% debt. If Torch takes on either project, it will
need to be financed with externally generated equity which has flotation costs of4%.Suresh is aware that there are two common methods for accounting for flotationcosts. The first method, commonly used in textbooks, is to incorporate flotationcosts directly into the cost of equity. The second, and more correct approach, isto subtract the dollar value of the flotation costs from the project NPV. If Sureshuses the cost of equity adjustment approach to account for flotation costs ratherthan the correct cash flow adjustment approach, will the NPV for each projectbe overstated or understated? Project 1 NPV Project 2 NPV A)Understated OverstatedB)Understated Understated C)Overstated Overstated (Explanation: The incorrect method ofaccounting for flotation costs spreads the flotation cost out over the life ofthe project by a fixed percentage that does not necessarily reflect thepresent value of the flotation costs. The impact on project evaluationdepends on the length of the project and magnitude of the flotation costs,however, for most projects that are shorter, the incorrect method willoverstate NPV, and that is exactly what we see in this problem.Correct method of accounting for flotation costs:After-tax cost of debt = 8.0% (1-0.30) = 5.60%Cost of equity = ($1.80 / $40.00) + 0.05 = 0.045 + 0.05 = 9.50%WACC = 0.50(5.60%) + 0.50(9.50%) = 7.55%Flotation costs Project 1 = $200,000 × 0.5 × 0.04 = $4,000Flotation costs Project 2 = $100,000 × 0.5 × 0.04 = $2,000NPV Project 1 = -$200,000 - $4,000 + (N = 8, I = 7.55%, PMT = $55,000, FV= 0 →CPT PV = $321,535) = $117,535NPV Project 2 = -$100,000 - $2,000 + (N = 4, I = 7.55%, PMT = $40,000, FV= 0 →CPT PV = $133,823) = $31,823Incorrect Adjustment for cost of equity method for accounting for flotationcosts:After-tax cost of debt = 8.0% (1-0.30) = 5.60%Cost of equity = [$1.80 / $40.00(1-0.04)] + 0.05 = 0.0469 + 0.05 = 9.69%WACC = 0.50(5.60%) + 0.50(9.69%) = 7.65%
NPV Project 1 = -$200,000 + (N = 8, I = 7.65%, PMT = $55,000, FV = 0→CPT PV = $320,327) = $120,327NPV Project 2 = -$100,000+ (N = 4, I = 7.65%, PMT = $40,000, FV = 0→CPT PV = $133,523) = $33,523) 51. Nippon Post Corporation (NPC), a Japanese software development firm, has a capital structure that is comprised of 60% common equity and 40% debt. Inorder to finance several capital projects, NPC will raise USD1.6 million byissuing common equity and debt in proportion to its current capital structure.The debt will be issued at par with a 9% coupon and flotation costs on theequity issue will be 3.5%. NPC’s common stock is currently selling forUSD21.40 per share, and its last dividend was USD1.80 and is expected to growat 7% forever. The company’s tax rate is 40%. NPC’s WACC based on the costof new capital is closest to: A)9.6%.B)13.1%. C)11.8%. (Explanation: kd = 0.09(1 – 0.4) = 0.054 = 5.4%kce = [(1.80 × 1.07) / 21.40] + 0.07 = 0.16 = 16.0%WACC = 0.6(16.0%) + 0.4(5.4%) = 11.76%Flotation costs, treated correctly, have no effect on the cost of equitycomponent of the WACC)
CFA Level 1 - Corporate Finance Session 11 - Reading 37
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