Which of the following statements is CORRECT? Answer The WACC is calculated using before-tax costs for all components. The after-tax cost of debt usually exceeds the after-tax cost of equity. For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock. Retained earnings that were generated in the past and are reported on the firm's balance sheet are available to finance the firm's capital budget during the coming year. The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital. 2 points Question 8 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? Answer 4.35% 4.58% 4.83% 5.08% 5.33% 2 points Question 9 The MacMillen Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 12%. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO's position is accepted, what is likely to happen over time? Answer The company will take on too many high-risk projects and reject too many low-risk projects. The company will take on too many low-risk projects and reject too many high-risk projects. Things will generally even out over time, and, therefore, the firm's risk should remain constant over time. The company's overall WACC should decrease over time because its stock price should be increasing. The CEO's recommendation would maximize the firm's intrinsic value. 2 points Question 10 Which of the following statements is CORRECT? Answer Since the costs of internal and external equity are related, an increase in the flotation cost required to sell a new issue of stock will increase the cost of retained earnings. Since its stockholders are not directly responsible for paying a corporation's income taxes, corporations should focus on before-tax cash flows when calculating the WACC. An increase in a firm's tax rate will increase the component cost of debt, provided the YTM on the firm's bonds is not affected by the change in the tax rate. When the WACC is calculated, it should reflect the costs of new common stock, retained earnings, preferred stock, long-term debt, short-term bank loans if the firm normally finances with bank debt, and accounts payable if the firm normally has accounts payable on its balance sheet. If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the after-tax cost of debt. 2 points Question 11 Teall Development Company hired you as a consultant to help them estimate its cost of capital. You have been provided with the following data: D1 = $1.45;P0 = $22.50;and g = 6.50% (constant). Based on the DCF approach, what is the cost of common from retained earnings? Answer 11.10% 11.68% 12.30% 12.94% 13.59% 2 points Question 12 Multi-Part 9-1:Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below. Assets Current assets $ 38,000,000 Net plant, property, and equipment 101,000,000 Total assets $139,000,000 Liabilities and Equity Accounts payable $ 10,000,000 Accruals 9,000,000 Current liabilities $ 19,000,000 Long-term debt (40,000 bonds, $1,000 par value) 40,000,000 Total liabilities $ 59,000,000 Common stock (10,000,000 shares) 30,000,000 Retained earnings 50,000,000 Total shareholders' equity 80,000,000 Total liabilities and shareholders' equity $139,000,000 The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%. Refer to Multi-Part 9-1. What is the best estimate of the firm's WACC? Answer 10.85% 11.19% 11.53% 11.88% 12.24%
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