Description
1. The DEF Company is planning a $64 million expansion. The expansion is to be financed by
selling $25.6 million in new debt and $38.4 million in new common stock. The before-tax
required rate of return on debt is 9 percent and the required rate of return on equity is 14
percent. If the company is in the 35 percent tax bracket, what is the firm’s cost of capital?
a. 8.92%
b. 10.74%
c. 11.50%
d. 9.89%
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Valley Flights, Inc. has a capital structure made up of 40% debt and 60% equity and a tax
rate of 30%. A new issue of $1,000 par bonds maturing in 20 years can be issued with a
coupon of 9% at a price of $1,098.18 with no flotation costs. The firm has no internal equity
available for investment at this time, but can issue new common stock at a price of $45. The
next expected dividend on the stock is $2.70. The dividend for the firm is expected to grow at
constant annual rate of 5% per year indefinitely. Flotation costs on new equity will be $7.00
per share. The company has the following independent investment projects available:
Project Initial Outlay IRR
1 $100,000 10%
2 $10,000 8.5%
3 $50,000 12.5%
2. Which of the above projects should the company take on?
a. Project 3 only
b. Projects 1, 2 and 3
c. Projects 1 and 3
d. Projects 1 and 2
3. PrimaCare has a capital structure that consists of $7 million of debt, $2 million of preferred
stock, and $11 million of common equity, based upon current market values. The firm’s yield
to maturity on its bonds is 7.4%, and investors require an 8% return on the firm’s preferred
stock and a 14% return on PrimaCare’s common stock. If the tax rate is 35%, what is
PrimaCare’s WACC?
a. 7.21%
b. 10.18%
c. 12.25%
d. 8.12%
4. JPR Company is financed 75 percent by equity and 25 percent by debt. If the firm expects
to earn $30 million in net income next year and retain 40% of it, how large can the capital
budget be before common stock must be sold?
a. $15.5 million
b. $7.5 million
c. $16.0 million
d. $12.0 million
5. All else equal, an increase in beta results in:
a. an increase in the cost of retained earnings
b. an increase in the cost of common equity, whether or not the funds come from retained
earnings or newly issued common stock
c. an increase in the cost of newly issued common stock
d. an increase in the after-tax cost of debt
6. Haroldson Inc. common stock is selling for $22 per share. The last dividend was $1.20, and
dividends are expected to grow at a 6% annual rate. Flotation costs on new stock sales are 5%
of the selling price. What is the cost of Haroldson’s retained earnings?
a. 12.09%
b. 11.78%
c. 11.45%
d. 5.73%
7. A company has preferred stock that can be sold for $21 per share. The preferred stock pays
an annual dividend of 3.5% based on a par value of $100. Flotation costs associated with
the sale of preferred stock equal $1.25 per share. The company’s marginal tax rate is 35%.
Therefore, the cost of preferred stock is:
a. 14.26%
b. 12.94%
c. 18.87%
d. 17.72%
8. Which of the following should NOT be considered when calculating a firm’s WACC?
a. after-tax YTM on a firm’s bonds
b. cost of newly issued preferred stock
c. after-tax cost of accounts payable
d. cost of newly issued common stock
9. Your firm is considering an investment that will cost $920,000 today. The investment will
produce cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in
year 5. The discount rate that your firm uses for projects of this type is 11.25%. What is the
investment’s profitability index?
a. 1.26
b. 1.69
c. 1.21
d. 1.43
10. Your firm is considering investing in one of two mutually exclusive projects. Project A requires
an initial outlay of $3,500 with expected future cash flows of $2,000 per year for the next
three years. Project B requires an initial outlay of $2,500 with expected future cash flows of
$1,500 per year for the next two years. The appropriate discount rate for your firm is 12% and
it is not subject to capital rationing. Assuming both projects can be replaced with a similar
investment at the end of their respective lives, compute the NPV of the two chain cycle for
Project A and three chain cycle for Project B.
a. $2,865 and $94
b. $3,528 and $136
c. $5,000 and $1,500
d. $2,232 and $85
11. The capital budgeting manager for XYZ Corporation, a very profitable high technology company,
completed her analysis of Project A assuming 5-year depreciation. Her accountant reviews the
analysis and changes the depreciation method to 3-year depreciation. This change will:
a. increase the present value of the NCFs
b. have no effect on the NCFs because depreciation is a non-cash expense
c. only change the NCFs if the useful life of the depreciable asset is greater than 5 years
d. decrease the present value of the NCFs
12. Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000
and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs
$120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in
year three, and $45,000 in year four. Lithium, Inc.’s required rate of return for these projects
is 10%. The modified internal rate of return for Project B is:
a. 18.52%
b. 22.80%
c. 19.75%
d. 17.84%