Chapter 10 Practice Problems(10-1) CapitalF IAnswer: a EASY
1."Capital" is sometimes defined as funds supplied to a firm by
investors.
a.True
b.False
(10-1) Cost of capitalF IAnswer: a EASY
2.The cost of capital used in capital budgeting should reflect
the average cost of the various sources of long-term funds a firm
uses to acquire assets.
a.True
b.False
(10-4) Cost of preferredF IAnswer: b EASY
3.The cost of preferred stock to a firm must be adjusted to an
after-tax figure because 70% of dividends received by a corporation
may be excluded from the receiving corporation's taxable
income.
a.True
b.False
(10-6) Internal vs. external commonC IAnswer: b EASY
4.Bankston Corporation forecasts that if all of its existing
financial policies are followed, its proposed capital budget would
be so large that it would have to issue new common stock. Since new
stock has a higher cost than retained earnings, Bankston would like
to avoid issuing new stock. Which of the following actions would
REDUCE its need to issue new common stock?
a.Increase the dividend payout ratio for the upcoming year.
b.Increase the percentage of debt in the target capital
structure.
c.Increase the proposed capital budget.
d.Reduce the amount of short-term bank debt in order to increase
the current ratio.
e.Reduce the percentage of debt in the target capital
structure.
(10-8) Factors affecting WACCC IAnswer: a EASY
5.Schalheim Sisters Inc. has always paid out all of its earnings
as dividends, hence the firm has no retained earnings. This same
situation is expected to persist in the future. The company uses
the CAPM to calculate its cost of equity, its target capital
structure consists of common stock, preferred stock, and debt.
Which of the following events would REDUCE its WACC?
a.The market risk premium declines.
b.The flotation costs associated with issuing new common stock
increase.
c.The companys beta increases.
d.Expected inflation increases.
e.The flotation costs associated with issuing preferred stock
increase.
(10-9) Risk and projectsC IAnswer: a MEDIUM
6.LaPango 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, which is of below-average risk and has a return of
8.5%.
b.Project C, which is of above-average risk and has a return of
11%.
c.Project A, which 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.
(Comp.) WACCC IAnswer: d MEDIUM
7.Which of the following statements is CORRECT?
a.The WACC as used in capital budgeting is an estimate of a
companys before-tax cost of capital.
b.The percentage flotation cost associated with issuing new
common equity is typically smaller than the flotation cost for new
debt.
c.The WACC as used in capital budgeting is an estimate of the
cost of all the capital a company has raised to acquire its
assets.
d.There is an opportunity cost associated with using retained
earnings, hence they are not free.
e.The WACC as used in capital budgeting would be simply the
after-tax cost of debt if the firm plans to use only debt to
finance its capital budget during the coming year.
(10-4) Cost of preferredC IAnswer: b EASY
8.Bosio Inc.'s perpetual preferred stock sells for $97.50 per
share, and it pays an $8.50 annual dividend. If the company were to
sell a new preferred issue, it would incur a flotation cost of
4.00% of the price paid by investors. What is the company's cost of
preferred stock for use in calculating the WACC?
a.8.72%
b.9.08%
c.9.44%
d.9.82%
e.10.22%
(10-5) Cost of RE: CAPMC IAnswer: e EASY
9.Scanlon Inc.'s CFO hired you as a consultant to help her
estimate the cost of capital. You have been provided with the
following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30. Based on
the CAPM approach, what is the cost of equity from retained
earnings?
a.9.67%
b.9.97%
c.10.28%
d.10.60%
e.10.93%
(10-3) Cost of debtC IAnswer: d MEDIUM
10.To help finance a major expansion, Castro Chemical Company
sold a noncallable bond several years ago that now has 20 years to
maturity. This bond has a 9.25% annual coupon, paid semiannually,
sells at a price of $1,075, and has a par value of $1,000. If the
firm's tax rate is 40%, what is the component cost of debt for use
in the WACC calculation?
a.4.35%
b.4.58%
c.4.83%
d.5.08%
e.5.33%
(10-7) WACCC IAnswer: c MEDIUM
11.Sorensen Systems Inc. is expected to pay a $2.50 dividend at
year end (D1 = $2.50), the dividend is expected to grow at a
constant rate of 5.50% a year, and the common stock currently sells
for $52.50 a share. The before-tax cost of debt is 7.50%, and the
tax rate is 40%. The target capital structure consists of 45% debt
and 55% common equity. What is the companys WACC if all the equity
used is from retained earnings?
a.7.07%
b.7.36%
c.7.67%
d.7.98%
e.8.29%
(10-7) WACC and target cap. struc.C IAnswer: a MEDIUM
12.You were hired as a consultant to Quigley Company, whose
target capital structure is 35% debt, 10% preferred, and 55% common
equity. The interest rate on new debt is 6.50%, the yield on the
preferred is 6.00%, the cost of retained earnings is 11.25%, and
the tax rate is 40%. The firm will not be issuing any new stock.
What is Quigley's WACC?
a.8.15%
b.8.48%
c.8.82%
d.9.17%
e.9.54%
