Quiz 3 MBA 730 Fall 2006 Instructor: Marlena L. Akhbari Name: _______________________
Problem 1 (15 Points) JLP Industries has the following securities outstanding: Debt: 50,000 bonds, each with a face value of $1,000, each selling at 120% of face value. The coupon rate is 8% and payments are made semiannually. There are 10 years left to maturity. Flotation cost for debt will run 2% of market value. Preferred Stock: 50,000 shares of 7% preferred stock with a $100 par value outstanding with a market value of $85 per share. Flotation costs for preferred stock will run 5% of market value 12 million shares of common stock outstanding with a market price of $4.00 per share. The last dividend paid was $.40, the expected constant dividend growth rate is 7%. Flotation costs are anticipated to be 9% of market value.
Common Stock:
The firm's tax rate is 40%. Please calculate the firm's weighted average cost of capital.
MV of Debt = 50,000 * 1200 = 60,000,000 MV of P. S. = 50,000 * 85 = 4,250,000 MV of C.S. = 12,000,000 * 4 = 48,000,000 Total = 112,250,000 Wd = 60,000,000 / 112,250,000 = .5345 Wps = 4,250,000 / 112,250,000 = .0379 Wcs = 48,000,000,/,112,250,000 = .4276 Cost of Debt N = 20 I/Y = ???
PV = -1176
PMT = 40
FV = 1000
I/Y = 2.835 * 2 = 5.67% After tax cost of debt = Rd (1-T) = 5.67% (.60) = 3.40% Cost of Preferred Stock Rps = Dps / Pnet ps = $7.00 / 80.75 = 8.67% Cost of Retained Earnings Rre = D1 / P + g = .40 (1.07) / 4 + .07 = 17.7%
Cost of External equity Rcs = D1 / Pnet + g = .40(1.07) /3.64 + .07 = 18.76 MCC1 Debt P.S. RE
.5345 * 3.40% = 1.8173% .0379 * 8.67% = .3286% .4276 * 17.7% = 7.5685% WACC 1 = 9.71%
MCC2 Debt P.S. External C.S.
.5345 * 3.40% = 1.8173% .0379 * 8.67% = .3286% .4276 * 18.76% = 8.0218% WACC2 = 10.17%
Section II. Multiple Choice Questions. There is only one correct answer for each question. Please choose carefully. (1 Point each) 1. The appropriate discount rate to be used when analyzing an investment project is a. b. c. d. e. the rate of return that will result in a positive NPV usually called the internal rate of return on that investment equal to the cost of capital for an unlevered firm with identical assets. The rate of return financial markets offer on investments of similar risk. The rate of interest the firm would pay if it borrowed money from the bank.
2. Which of the following are valid approaches to estimating a firm's cost of debt? I. II. III. IV. a. b. c. d. e. use the yield to maturity of the firm's outstanding debt. Use the coupon rate on the firm's outstanding debt. Use the yield to maturity on newly-issued debt of other firms with the same default rating as this firm. Use the coupon rate on the outstanding debt of firms similar to ours. I only I and IV only II only I and III only I, II, III and IV
3. Suppose the Federal Reserve takes actions that cause the risk-free rate to rise. All else equal, we would expect a firm's cost of capital to ___________. a. b. c. d. increase decrease remain unchanged depends
4. Which of the following will always increase a firm's cost of equity when using the SML approach? I. II. III. a. b. c. d. e. An increase in the risk-free rate. An increase in the firm's equity beta. An increase in the market risk premium. I only III only II only II and III only I, II, and III.
5. In which of the following cases would it most likely be appropriate to use the WACC that relates to existing operations? a. A pizza delivery service is planning to expand its delivery area. b. A grocery store owner is considering adding a bakery and a delicatessen to his store. c. A gas tank manufacturer is contemplating switching to manufacturing tie-outs for dogs. d. A gas station owner is considering adding a convenience store. e. A manufacturer of tire irons is considering starting up a chain of retail stores in which to sell its products.