Question

1. Firms with riskier projects generally have a lower WACC.

A. True

B. False

2. Which of the following statements is correct?

A. Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity.

B. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes.

C. If a company assigns the same cost of capital to all of its projects regardless of each project’s risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.

D. Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt.

E. Higher flotation costs tend to reduce the cost of equity capital.

3.The sum of weight of debt, weight of preferred stock, and weight of common equity should be A. -1

B. 0

C. 0.5

D. 1

E. 1.5

4. Solar Energy will pay an annual dividend of $2 per share next year. The company just announced that future dividends will be increasing by 2 percent annually. How much are you willing to pay for one share of this stock if you require a rate of return of 12 percent?

A. $20.4

B. $20

C. $14.29

D. $16.67

5. Now a firm has 40% debt, 10% preferred stock, and 50% common equity. The after-tax cost of debt is 5%, cost of preferred stock is 8%, and the cost of common equity is 10%. What is WACC of the firm?

A. 5%

B. 7.4%

C. 7.8%

D. 8%

E. 10%

6. Which of following is correct?

A. Increase of tax rate and increase of cost of preferred stock must result in decrease of WACC. B. Increase of tax rate and decrease of cost of preferred stock must result in decrease of WACC. C. Decrease of tax rate and increase of cost of preferred stock must result in decrease of WACC. D. Decrease of tax rate and decrease of cost of preferred stock must result in decrease of WACC. E. None of above.

7. Which one of the following is an indicator that an investment is acceptable? Assume cash flows are conventional.

A. Modified internal rate of return that is equal to zero

B. Profitability index of zero

C. Internal rate of return that exceeds the required return

D. Payback period that exceeds the required period

E. Negative average accounting return

Answer 1

1) Firms with riskier projects have generally a lower WACC.

Ans: False

Firms with riskier projects will have higher Beta and when beta is higher, WACC will also be higher.

2) ANS: C. If a company assigns the same cost of capital to all of its projects regardless of each project’s risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.

3) The sum of weight of debt, weight of preferred stock, and weight of common equity should be

ANS: D. 1

Capital structure of a firm should be 1 and can't exceed or decrease from 1

4)

= $ 2 / ( 0.12 - 0.02 )

= $ 2 / 0.10

= $ 20

ANS: B. $ 20

5)

= 0.4 * 5 % + 0.1 * 8 % + 0.5 * 10 %

= 2 % + 0.8 % + 5 %

= 7.8 %

ANS. C .7.8 %

6) ANS. B. Increase of tax rate and decrease of cost of preferred stock must result in decrease of WACC

Debt comes with tax shield; as tax rate increases, cost of debt decreases and when both cost of debt and cost of preferred stock will result in decrease of WACC

7) ANS. C. Internal rate of return that exceeds the required return.

It is IRR decision rule.