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Chapter 10 Practice Problems

(10-1) Capital 1. FI Answer: a EASY "Capital" is sometimes defined as funds supplied to a firm by investors. a. True b. False (10-1) Cost of capital 2. FI Answer: a EASY

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 preferred 3.

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Answer: b EASY

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 common 4.

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Answer: b EASY

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 WACC 5.

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Answer: a EASY

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 projects 6.

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Answer: a MEDIUM

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.) WACC 7.

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Answer: d MEDIUM

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 preferred 8.

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Answer: b EASY

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: CAPM 9.

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Answer: e EASY

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 debt 10.

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Answer: d MEDIUM

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) WACC 11.

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Answer: c MEDIUM

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. 12.

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Answer: a MEDIUM

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%