Question

In: Finance

1A. An investment project is accepted if its NPV is less than its WACC. True False...

1A. An investment project is accepted if its NPV is less than its WACC.

True

False

1B. An investment project provides all positive cash flows in its economic its life (In this project, first cash flow is negative and rest of the cash flows are positive). However, this project can only be accepted if its IRR is greater than its WACC.

True

False

1C. A company has financed an investment entirely by issuing a bond. Then, which component of the bond represents the cost of capital for the firm?

YTM

Dividend Rate

Sunk Costs

None

1D. A company is raising $1,750,000 by selling preferred stock. The face value of the preferred stock is $1000, and the annual dividend rate is 0.5%. A single share of this company's preferred stock is selling for $40, with a floatation cost of $2 per share. What is the cost of capital?

13.16 %

8.72 %

15.43 %

12.98 %

1E. Another company issues additional common stocks to raise $325,700,000 to finance its new project. That company's common stocks' current price is $18 per share. The company's dividend's annual growth rate is 2% and the last dividend that the company has paid is $1 per share. The new shares will be issued with a floatation cost of 4%. What is the cost of capital for this company?

10.9 %

7.90 %

3.98%

30.98 %

Solutions

Expert Solution

Answer : 1A : False

Reason :

An investment project is not accepted if its NPV or IRR is less than its WACC. A project is undertaken when its IRR is greater than WACC.

Answer : 1B True :

Reason :

An investment project is accepted if its IRR is greater than its WACC. Even though it generates positive cash flows but it is acceptable only when its IRR is more than WACC.

Answer : 1C : Correct Option is YTM.

Reason :

YTM is the cost of debt and component of the bond that represents the cost of capital for the firm.

Answer : 1D Correct Option is 13.16%

Reason :

Cost of Preferred Stock = Annual Dividend / [Current Price - Flotation Cost]

= [1000 * 0.5%] / [40 - 2]

= 5 / 38

= 0.13157894736 or 13.16%

Answer : 1E Correct Option is 7.90%

Reason :

Cost of capital = {Expected Dividend / (Current Price - Flotation cost)} + growth rate

= {[1 * (1 + 0.02)] / [18 - (18 * 4%)]} + 0.02

= {1.02 / 17.28} + 0.02

= 0.0790277777 or 7.90%


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