Module 3 Quiz Questions PDF

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Module 3 1. A company has a risk-free rate of 3% and a risk premium of 6%. Its tax rate is 35%. What is the company's cost of debt? Select one: pg. 87 states, “Estimation of cost of equity using CAPM (Capital Asset Pricing Model) involves estimation of risk-free rate, beta and market risk premium”. Cost of Equity = Risk-Free Rate + Equity Beta * Market Risk Premium; (0.03+0.06) x (1 - .35) = .0585 * the last piece of the formula is (1-t). The tax rate in this problem is 35%, so 1-0.35= 0.058. Pg. 95 states, “Bondholders would have set the interest rate at the time of issue after assessing the default risk. If the default risk increases later on, the required rate of return (or yield or YTM or cost of debt) also increases. In sum, the cost of debt is in the denominator and not in the numerator. This is the pre-tax cost of debt. Since, interest payments are tax deductible, the post-tax cost of debt is kd(1 – T), where T is the marginal tax rate.* a. 2.10% b. 3.90% c. 3.15% d. 5.85%

2. A company is thinking of issuing more common stock. Its stock's current market price is $50 a share with an expected dividend annual one year from today of $3 a share. Dividends are expected to grow 5% per year and there are no flotation costs. What is the company cost of new common stock? Select one: Pg. 93; DCF Approach or the Gordon Growth model or the constant growth model. Po = D1/(k-g), where D1 is the dividend one year from now, g is the constant growth rate of dividends, and Po is the current market price of the share. The letter k is the cost of equity that you need to solve for to answer the question. OR! Equation is: k = (D1 / P0) + g K= cost of equity D1 = dividend in one year P0 = current market price g = dividend growth rate =3/50 + 0.05 =0.06 + 0.05 =0.11 or 11% a. 12.58% b. 11.00% c. 13.65% d. 65% 3. A company has retained earnings of $1.5 million and net income of $8 million. What is the retention ratio (expressed as a decimal)? Select one: Pg. 94 It's called the retention ratio because it's the fraction of net income that is retained. So the retention ratio = retained earnings/net income Step 1: 8- 1.5 = 6.5 Step 2: 8 – 6.5 = 1.5 Step 3: 1.5 / 8 = .1875 *Retained earnings might not be given on the test so you will need to find the paid out dividend first, which in this case is step 2*

a. 0.08125 b. 0.01875 c. 0.8125 d. 0.1875

4. A company makes an initial $10,000 investment in a project. This project is projected to earn $8,000 in year one, $10,000 in year 2, $12,000 in year 3, and $20,000 in year 4. If the WACC is 5%, what is the project's present value? Select one: *(1+.05)=1.05* PV = Co + c1/ (1+ r) + c2/ (1+ r^2) + c3/ (1+ r^3) + c4/ (1+ r^4) PV = -10,000 + (8,000/1.05) + (10,000/1.05^2) + (12,000/1.05^3) + (20,000/1.05^4) a. $43,509 b. $33,509 c. $40,000 d. $37,619

5. MV Corporation has debt with market value of $100 million, common equity with a book value of $104 million, and preferred stock worth $17 million outstanding. Its common equity trades at $55 per share, and the firm has 6.1 million shares outstanding. What weights should MV Corporation use in its WACC? *View pg. 8 of formula sheet* Select one: Value of debt: $100 million Value of preferred stock: $17 million Market value of common equity: $55 per shares X 6.1 million shares = $335.5 million Total market value of firm: $100 + 17 + 335.5 = $452.5 million Weights for WACC calculation: Debt: 100/452.5= 22.08% Preferred Stock: 17/452.5= 03.75% Common Equity: 335.5/452.5= 74.14% *Do not round up* a. Weight for debt: 22.08%; weight for preferred stock: 3.75%; weight for common equity: 74.17%. b. There is not enough information to answer this question. c. Weight for debt: 12.51%; weight for preferred stock: 2.45%; weight for common equity: 71.47%. d. Weight for debt: 20.18%; weight for preferred stock: 5.76%; weight for common equity: 64.17%.

6. Book Co. has 1.9 million shares of common equity with a par (book) value of $1.05, retained earnings of $30.4 million, and its shares have a market value of $51.61 per share. It also has debt with a par value of $21.5 million that is trading at 101% of par. What is the market value of its equity? What is the market value of its debt? Select one: *View pg. 8 of formula sheet* Market value of common equity=Price of common stock X # of common stock shares outstanding MV=1.9 mill X 51.61

MV=98.06 mill MV of deb=21.5 mill X .101 / .100 MV=21.72 a. MV of equity: $97.68 million; MV of debt: $21.72 million b. MV of equity: $98.06 million; MV of debt: $21.72 million c. MV of equity: $98.06 million; MV of debt: $23.84 million d. MV of equity: $51.61 million million; MV of debt: $21.50 million

7. Laurel, Inc., has debt outstanding with a coupon rate of 5.9% and a yield to maturity of 6.9%. Its tax rate is 35%. What is Laurel's effective (after-tax) cost of debt? NOTE: Assume that the debt has annual coupons. Select one: Pg. 96; Pg. 10 Formula sheet; Let ATCD be after-tax cost of debt, YTM be yield to maturity and TR be the Tax Rate ATCD = YTM (1 - TR) ATCD = 6.9(1 - 0.35) ATCD = 6.9(.65) ATCD = 4.485 ATCD = 4.49% a. 1.0% b. 6.9% c. 4.49% d. 5.9%

8. Dewyco has preferred stock trading at $49 per share. The next preferred dividend of $5 is due in one year. What is Dewyco's cost of capital for preferred stock? Select one: Pg. 10 formula sheet; Pg. 96 Cost of preferred stock capital = Preferred dividend / Preferred stock price 5/49 = .1020 = 10.2% a. 5.0% b. 0.098% c. 9.8% d. 10.2%

9. Steady Company's stock has a beta of 0.25. If the risk-free rate is 5.9% and the market risk premium is 7.2%, what is an estimate of Steady Company's cost of equity? Select one: Pg. 99; Pg. 10 on Formula sheet; Cost of Equity = Risk-Free Rate + Equity Beta * Market Risk Premium 5.9 + .25 (7.2%) = 7.7% a. 4.3% b. 15.1% c. 7.7% d. 8.0%

10. CoffeeCarts has a cost of equity of 15.4%, has an effective (aka after-tax) cost of debt of 3.5%, and is financed 70% with equity and 30% with debt. What is this firm's WACC? Select one: Pg. 9 on Formula sheet; Pg. 99 Weighted Average Cost of Capital (Pre-Tax) = (Financed by Equity)(Equity cost of capital) + (Financed by debt)(debt cost of capital) = (.70) (15.4) +(.30) (3.5) = 11.83 a. 13.6% b. 11.8% c. 5.1% d. 9.4%

11. Pfd Company has debt with a yield to maturity of 7.8%, a cost of equity of 12.9%, and a cost of preferred stock of 8.9%. The market values of its debt, preferred stock, and equity are $10.4 million, $3.3 million, and $16.2 million, respectively, and its tax rate is 38%. What is this firm's after-tax WACC? Select one: Pg. 98-99 a) Get the weights of common stock/equity, preferred stock, and debt by dividing market value of each by sum of all three market values. *10.4+3.3+16.2= 29.9 weight of equity: 16.2/29.9 = .5418 weight of preferred stock: 3.3/29.9 = .1104 weight of debt: 10.4/29.9 = .3478 b) Get the sum of (weight of e X cost of e) + (weight of ps X cost of ps) + (weight of debt X debt yield to maturity)(1 - tax rate) = (.5418)(12.9) + (.1104)(8.9) + (.3478)(7.8)(.62)* *(1 - .38 = .62) = 6.9892 + .9826 + 1.682 = 9.65% a. 15.8% b. 11.36% c. 9.65% d. 6.89%

12. A company has issued preferred stock that are valued at $75 a share. The preferred dividend is $5. The company's growth rate is 5%. What is the cost of the company's preferred stock? Select one: Use The cost of preferred stock capital formula and the cost of equity formula because there was growth. Formula pg. 10 Rp = D (dividend)/ P0 (price) Rp = 5 / 75 = .066 % Second part below: Rp (growth rate) = D (dividend)/ P0 (price) + Growth rate Rp = 5 / 75 + .05 = .1166

a. 11.67% b. 6.67% c. 1.67% d. 5%

13. A company is considering investing in a project that requires the company to take on risks outside of the company's current scope. As a result, which of the following things will happen? Select one: a. The company does not have to recalculate its WACC to evaluate the project. b. All of these things. c. The project would decrease the company's cost of equity. d. The company's stock value would drop unless the project increase the company's expected returns.

14. A company issues common equity and has a beta of 1.5. The risk free return is 3% and the market return is 7%. What is the company's cost of common equity? Select one: Pg. 87; Pg. 8 on the Formula sheet; CAPM formulas. The market return is given instead of the market risk premium. Market risk premium = market return - risk free return = 3 + 1.5 (7-3) =9

a. 13.50% b. 9% c. 7% d. 6%

15. A company's cost of capital is used as a tool in relation to which aspect of financial policy? Select one: a. Hedging a company's investments. b. Evaluating a company's capital structure. c. Valuing projects by discounting cash flows, and then selecting projects with the highest return. d. Diversifying a company's portfolio

16. In the capital asset pricing model (CAPM), you derive a stock's: Select one: a. Expected return (or cost of capital) b. Beta c. Equity Premium d. Beta, expected return (or cost of capital), and equity premium

17. Suppose that a company has total financing where 10% comes from bonds, 10% from a loan, and 80% from shareholders equity. The bonds pay on average a 10% interest rate, the loan has a 10% interest rate, and shareholders require a 10% return. What is the weighted average cost of capital (WACC) equal to?" Select one: a. 0.1 b. 0.3 c. 0.3333 d. 0.0333

18. The weighted average cost of capital weighting is based on _____. Select one: a. the market value of the company's debt and equity. b. the company's returns on equity and debt. c. the company's tax rate. d. the book value of the company's debt and equity.

19. Which of the following correctly explains how a specific factor can influence a company's weighted average cost of capital? Select one: a. If a company increases it dividends, it leads to an increase in its WACC. b. Increased fixed costs will decrease a company's WACC. c. All of these answers. d. Increasing the amount of debt generally improves performance and increases return on equity.

20. Which of the following interpretations of data related to a Security Market Line (SML) is correct? Select one: a. If an asset is priced at a point above the SML it is overvalued. b. If an asset's value lies on the SML, it is correctly priced. c. All of these answers. d. If an asset is priced at a point below the SML, it is undervalued....