[41] .Bloom and Co. has no debt or preferred stock—it uses only equity capital, and has two equally-

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[41].Bloom and Co. has no debt or preferred stock—it uses only equity capital, and has two equally-sized divisions.  Division X’s cost of capital is 10.0%, Division Y’s cost is 14.0%, and the corporate (composite) WACC is 12.0%.  All of Division X’s projects are equally risky, as are all of Division Y's projects.  However, the projects of Division X are less risky than those of Division Y.  Which of the following projects should the firm accept?

 

a.A Division Y project with a 12% return.

b.A Division X project with an 11% return.

c.A Division X project with a 9% return.

d.A Division Y project with an 11% return.

e.A Division Y project with a 13% return.

 

[42].Taylor 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 C, which is of above-average risk and has a return of 11%.

b.Project A, which is of average risk and has a return of 9%.

c.None of the projects should be accepted.

d.All of the projects should be accepted.

e.Project B, which is of below-average risk and has a return of 8.5%.

 

[43].Weatherall Enterprises has not debt or preferred stock—it is an all-equity firm—and has a beta of 2.0.  The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment.  The risk-free rate is 5%, and the market risk premium is 4%.  The project being evaluated is riskier than an average project, in terms of both its beta risk and its total risk.  Which of the following statements is CORRECT?

 

a.The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return.

b.Riskier-than-average projects should have their expected returns increased to reflect their higher risk.  Clearly, this would make the project acceptable regardless of the amount of the adjustment.

c.The accept/reject decision depends on the firm's risk-adjustment policy.  If Weatherall’s policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project.

d.Capital budgeting projects should be evaluated solely on the basis of their total risk.  Thus, insufficient information has been provided to make the accept/reject decision.

e.The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.

 

[44].The Anderson 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?

 

a.The company will take on too many low-risk projects and reject too many high-risk projects.

b.Things will generally even out over time, and, therefore, the firm’s risk should remain constant over time.

c.The company’s overall WACC should decrease over time because its stock price should be increasing.

d.The CEO’s recommendation would maximize the firm’s intrinsic value.

e.The company will take on too many high-risk projects and reject too many low-risk projects.

 

[45].Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely

 

a.become less risky over time, and this will maximize its intrinsic value.

b.accept too many low-risk projects and too few high-risk projects.

c.become more risky and also have an increasing WACC.  Its intrinsic value will not be maximized.

d.continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital.

e.become riskier over time, but its intrinsic value will be maximized.

 

[46].Which of the following statements is CORRECT?

 

a.All else equal, an increase in a company’s stock price will increase its marginal cost of retained earnings, rs.

b.All else equal, an increase in a company’s stock price will increase its marginal cost of new common equity, re.

c.Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt.

d.If a company’s tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall.

e.When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation.

 

[47].Which of the following statements is CORRECT?

 

a.When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.

b.Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM.

c.If a company’s beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence must issue new stock.

d.Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company’s WACC.

e.When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.

 

[48].Which of the following statements is CORRECT?

 

a.We should use historical measures of the component costs from prior financings that are still outstanding when estimating a company’s WACC for capital budgeting purposes.

b.The cost of new equity (re) could possibly be lower than the cost of retained earnings (rs) if the market risk premium, risk-free rate, and the company’s beta all decline by a sufficiently large amount.

c.A firm’s cost of retained earnings is the rate of return stockholders require on a firm’s common stock.

d.The component cost of preferred stock is expressed as rp(1 – T), because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt.

e.In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income.

 

[49].Which of the following statements is CORRECT?

 

a.The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt.

b.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.

c.There is an “opportunity cost” associated with using retained earnings, hence they are not “free.”

d.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.

e.The WACC as used in capital budgeting is an estimate of a company’s before-tax cost of capital.

 

[50].Which of the following statements is CORRECT?

 

a.WACC calculations should be based on the before-tax costs of all the individual capital components.

b.Flotation costs associated with issuing new common stock normally reduce the WACC.

c.If a company’s tax rate increases, then, all else equal, its weighted average cost of capital will decline.

d.An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.

e.A change in a company’s target capital structure cannot affect its WACC.

 

 

 

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