Assignment # 5 Ch 10

True/False
Indicate whether the statement is true or false.

____ 1. "Capital" is sometimes defined as the funds supplied by investors.

____ 2. The component costs of capital are market-determined variables in the sense that they are based on investors'
required returns.
____ 3. The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all
outstanding debt.
____ 4. For capital budgeting and cost of capital purposes, the firm should always consider retained earnings as the
first source of capital, i.e., use these funds first, because retained earnings have no cost to the firm.
____ 5. The cost of debt, rd, is normally less than rs, so rd(1  T) will normally be less than rs. Therefore, as long as the
firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater
than rd(1  T).

Multiple Choice
Identify the choice that best completes the statement or answers the question.

____ 6. Which of the following is NOT a capital component when calculating the weighted average cost of capital
(WACC)?
a. Long-term debt.
b. Accounts payable.
c. Retained earnings.
d. Common stock.
e. Preferred stock.
____ 7. For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume the
firm operates at its target capital structure.
a. re > rs > WACC > rd.
b. rs > re > rd > WACC.
c. WACC > re > rs > rd.
d. rd > re > rs > WACC.
e. WACC > rd > rs > re.
____ 8. Hettenhouse Company's perpetual preferred stock sells for $102.50 per share, and it pays a $9.50 annual
dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the
price paid by investors. What is the company's cost of preferred stock for use in calculating the WACC?
a. 9.27%
b. 9.65%
c. 10.04%
d. 10.44%
e. 10.86%
____ 9. Assume that you are a consultant to Magee Inc., and you have been provided with the following data: r RF =
4.00%; RPM = 5.00%; and b = 1.15. What is the cost of equity from retained earnings based on the CAPM
approach?
a. 9.75%
b. 10.04%
 c. 10.34%
d. 10.65%
e. 10.97%
____ 10. Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D 1 =
$1.30; P0 = $42.50; and g = 7.00% (constant). What is the cost of equity from retained earnings based on the
DCF approach?
a. 9.08%
b. 9.56%
c. 10.06%
d. 10.56%
e. 11.09%
____ 11. P. Lange Inc. hired your consulting firm to help them estimate the cost of equity. The yield on Lange's bonds
is 7.25%, and your firm's economists believe that the cost of equity can be estimated using a risk premium of
3.50% over a firm's own cost of debt. What is an estimate of Lange's cost of equity from retained earnings?
a. 10.75%
b. 11.18%
c. 11.63%
d. 12.09%
e. 12.58%
____ 12. You were hired as a consultant to Kroncke Company, whose target capital structure is 40% debt, 10%
preferred, and 50% common equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and
the cost of retained earnings is 13.25%. The firm will not be issuing any new stock. What is its WACC?
a. 9.48%
b. 9.78%
c. 10.07%
d. 10.37%
e. 10.68%
____ 13. To help finance a major expansion, Delano Development Company sold a noncallable bond several years ago
that now has 15 years to maturity. This bond has a 10.25% annual coupon, paid semiannually, it sells at a
price of $1,025, and it has a par value of $1,000. If Delano's tax rate is 40%, what component cost of debt
should be used in the WACC calculation?
a. 5.11%
b. 5.37%
c. 5.66%
d. 5.96%
e. 6.25%
____ 14. Schadler Systems is expected to pay a $3.50 dividend at year end (D 1 = $3.50), the dividend is expected to
grow at a constant rate of 6.50% a year, and the common stock currently sells for $62.50 a share. The before-
tax cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of 40% debt and 60%
common equity. What is the company's WACC if all equity is from retained earnings?
a. 8.35%
b. 8.70%
c. 9.06%
d. 9.42%
e. 9.80%
____ 15. Roxie Epoxy's balance sheet shows a total of $50 million long-term debt with a coupon rate of 8.00% and a
yield to maturity of 7.00%. This debt currently has a market value of $55 million. The balance sheet also
shows that that the company has 20 million shares of common stock, and the book value of the common
equity (common stock plus retained earnings) is $65 million. The current stock price is $8.25 per share;
stockholders' required return, rs, is 10.00%; and the firm's tax rate is 40%. Based on market value weights, and
assuming the firm is currently at its target capital structure, what WACC should Roxie use to evaluate capital
budgeting projects?
a. 7.26%
b. 7.56%
c. 7.88%
d. 8.21%
e. 8.55%
____ 16. Grunewald Co.'s common stock currently sells for $60.00 per share, the company expects to earn $3.00 per
share during the current year, its expected payout ratio is 40%, and its expected constant growth rate is 7.00%.
New stock can be sold to the public at the current price, but a flotation cost of 9% would be incurred. By how
much would the cost of new stock exceed the cost of retained earnings?
a. 0.05%
b. 0.10%
c. 0.20%
d. 0.30%
e. 0.45%
____ 17. Bruner Breakfast Foods' (BBF) balance sheet shows a total of $20 million long-term debt with a coupon rate
of 8.00%. The yield to maturity on this debt is 10.00%, and the debt has a total current market value of $18
million. The balance sheet also shows that that the company has 10 million shares of stock, and total of
common equity (common stock plus retained earnings) is $30 million. The current stock price is $4.50 per
share, and stockholders' required rate of return, rs, is 12.25%. The company recently decided that its target
capital structure should have 50% debt, with the balance being common equity. The tax rate is 40%. Calculate
WACCs based on target, book, and market value capital structures, and then find the sum of these three
WACCs.
a. 27.04%
b. 28.17%
c. 29.34%
d. 30.51%
e. 31.73%
____ 18. Assume that you are on the financial staff of Michelson Inc., and you have collected the following data: (1)
The yield on the company's outstanding bonds is 8.00%, and its tax rate is 40%. (2) The next expected
dividend is $0.65 a share, and the dividend is expected to grow at a constant rate of 6.00% a year. (3) The
price of Michelson's stock is $17.50 per share, and the flotation cost for selling new shares is F = 10%. (4)
The target capital structure is 45% debt and the balance is common equity. What is Michelson's WACC,
assuming it must issue new stock to finance its capital budget?
a. 6.63%
b. 6.98%
c. 7.34%
d. 7.73%
e. 8.12%

Exhibit 10-1
(The following data apply to the problem(s) below.)
You are employed by CGT, a Fortune 500 firm that is a major producer of chemicals and plastics, including
plastic grocery bags, styrofoam cups, and fertilizers. You are on the corporate staff as an assistant to the CFO.
This is a position with high visibility and the opportunity for rapid advancement, providing you make the
right decisions. Your boss has asked you to estimate the weighted average cost of capital for the company.
The balance sheet and some other information about CGT follows below.

Assets
Current assets $ 38,000,000
Net plant, property, and equipment 101,000,000
Total assets $139,000,000

Liabilities and equity

Accounts payable $ 10,000,000
Accruals 9,000,000
Current liabilities $ 19,000,000
Long term debt (40,000 bonds, $1,000 par value) 40,000,000
Total liabilities 59,000,000
Common stock (10,000,000 shares) 30,000,000
Retained earnings 50,000,000
Total shareholders equity 80,000,000
Total liabilities and shareholders equity $139,000,000

You check The Wall Street Journal and see that CGT stock is currently selling for $7.50 per share and that
CGT bonds are selling for $875.00 per bond. The bonds have a S1,000 par value, a 7.25% annual coupon rate,
semiannual payments, are not callable, and a 20-year maturity. CGT's beta is 1.25, the yield on a 6-month
Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The expected return on the stock
market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. CGT is
in the 40% tax bracket.
____ 19. Refer to Exhibit 10-1. What is the best estimate of the after-tax cost of debt for CGT?
a. 4.64%
b. 4.88%
c. 5.14%
d. 5.40%
e. 5.67%
____ 20. Refer to Exhibit 10-1. Using the CAPM approach, what is the best estimate of the cost of equity for CGT?
a. 13.00%
b. 13.52%
c. 14.06%
d. 14.62%
e. 15.21%
____ 21. Refer to Exhibit 10-1. Which of the following is the best estimate for the weights to be used when calculating
the WACC?
a. wc = 68.2%; wd = 31.8%
b. wc = 69.9%; wd = 30.1%
c. wc = 71.6%; wd = 28.4%
d. wc = 73.4%; wd = 26.6%
e. wc = 75.3%; wd = 24.7%
____ 22. Refer to Exhibit 10-1. What is the best estimate of the WACC for CGT?
a. 9.88%
b. 10.18%
c. 10.50%
d. 10.81%
e. 11.14%