Q: Using the Security Market Line (SML) approach, what is the cost of equity for a company with a beta ($$\beta) of 1.2$$, a risk-free rate ($$R_f) of 6$$%, and a market risk premium ($$E(R_m) - R_f) of 8$$%?

$$R_E = 6\% + 1.2 \times 8\% = 15.6\%$$

Question 1

A firm is evaluating a new project. The project's expected internal rate of return (IRR) is 12%, and the firm's weighted average cost of capital (WACC) is 10%. According to capital budgeting principles, what should the firm do?

Accepted Answer

Accept the project because IRR is greater than WACC.

Question 2

Which formula correctly represents the cost of equity using the Dividend Growth Model (DGM)?

Accepted Answer

$$R_E = \frac{D_1$}{P_0$} + g$$

Question 3

A company has the following capital structure: Market value of equity = $$150 million, market value of preferred stock = 25 $$million, market value of debt = $$75 million. What is the weight of debt (w_D$) in the firm's WACC calculation?

Accepted Answer

$$w_D = \frac{75}{250} = 0.3$$

Question 4

Which of the following is NOT a disadvantage of the Dividend Growth Model for estimating the cost of equity?

Accepted Answer

It adjusts for systematic risk.

Question 5

A firm issues a semiannual bond with a face value of $$1,000, a coupon rate of 7%, and a current price of 960. $$What is the yield to maturity (YTM) on this bond?

Accepted Answer

$$YTM = 7.379\%$$

Question 6

Using the Security Market Line (SML) approach, what is the cost of equity for a company with a beta ($$\beta) of 1.2$$, a risk-free rate ($$R_f) of 6$$%, and a market risk premium ($$E(R_m) - R_f) of 8$$%?

Accepted Answer

$$R_E = 6\% + 1.2 	imes 8\% = 15.6\%$$

Question 7

Why is the after-tax cost of debt used in the WACC calculation?

Accepted Answer

Because interest expense on debt is tax-deductible, reducing the effective cost to the firm.

Question 8

A preferred stock pays a constant annual dividend of $$1.25 and is currently priced at 25.85. $$What is the cost of preferred stock ($$R_p$$)?

Accepted Answer

$$R_p = \frac{1.25}{25.85} = 0.0484 = 4.84\%$$

Question 9

Which of the following best describes the Weighted Average Cost of Capital (WACC)?

Accepted Answer

The average required return on the firm's assets, based on the market's perception of the risk of those assets.

Question 10

If a firm's WACC is 9%, its expected free cash flow ($$CFA^*) is$$ $$120 million, and the expected growth rate (g$) is 5%, what is the estimated value of the company using the perpetuity formula?

Accepted Answer

$$V_0$$ = \frac{120}{0.09 - 0.05} = 3,000$$

Question 11

Which of the following factors would likely increase a company's WACC?

Accepted Answer

An increase in the market risk premium.

Question 12

Why is it generally preferable to use market values rather than book values when calculating capital structure weights for WACC?

Accepted Answer

Market values reflect the current value of the firm's securities as perceived by investors.

Question 13

A firm has a cost of equity of 14%, cost of preferred stock of 9%, cost of debt of 10%, and a tax rate of 40%. The capital structure weights are: equity 60%, preferred stock 10%, debt 30%. What is the firm's WACC?

Accepted Answer

$$WACC = 0.6 	imes 14\% + 0.1 	imes 9\% + 0.3 	imes 10\% 	imes (1 - 0.4) = 8.4\% + 0.9\% + 1.8\% = 11.1\%$$

Question 14

Which method for estimating the cost of equity explicitly adjusts for systematic risk?

Accepted Answer

Security Market Line (SML) or Capital Asset Pricing Model (CAPM)

Question 15

If a project is riskier than the firm's average operations, which discount rate should be used to evaluate it?

Accepted Answer

A rate higher than the firm's WACC.

Question 16

What is a potential pitfall of using the firm's WACC to evaluate all projects regardless of their risk?

Accepted Answer

It may lead to accepting too many high-risk projects and rejecting low-risk ones.

Question 17

Which approach involves finding companies that specialize in a product or service similar to the project being considered, then using their beta to estimate the project's required return?

Accepted Answer

Pure Play Approach

Question 18

A company is expected to pay a dividend of $$2 next year, has a current stock price of 30$$, and analysts estimate a growth rate of 8%. What is the cost of equity using the Dividend Growth Model?

Accepted Answer

$$R_E = \frac{2}{30} + 0.08 = 0.1467 = 14.67\%$$

Question 19

Which of the following is NOT a component cost included in the WACC formula?

Accepted Answer

Cost of inventory

Chapter 12: The Cost of Capital (Essentials of Corporate Finance)

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