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Corporate Finance, 12e (Ross)

Chapter 13 Risk, Cost of Capital, and Valuation

1) The cost of capital used to compute the present value of a project should be the rate that can
be earned on:
A) the overall market portfolio.
B) the sponsoring firm's return on assets.
C) a financial asset of comparable risk.
D) a riskless asset with a similar life span.
E) the sponsoring firm's return on equity.

Answer: C
Difficulty: 1 Easy
Section: 13.1 The Cost of Capital
Topic: Cost of capital - general
Bloom's: Remember
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

2) If the CAPM is used to estimate the cost of equity capital, the expected excess market return is
equal to the:
A) return on the stock minus the risk-free rate.
B) return on the market minus the risk-free rate.
C) beta times the market risk premium.
D) beta times the risk-free rate.
E) market rate of return.

Answer: B
Difficulty: 1 Easy
Section: 13.2 Estimating the Cost of Equity Capital with the CAPM
Topic: Capital asset pricing model
Bloom's: Remember
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

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3) The issuance of stock to fund a project tends to:

A) have no effect on the previous shareholders.
B) create costless benefits for the firm.
C) cause any potential gains to the firm from the project to be lost.
D) affect future dividends but not the appreciation realized by previous shareholders.
E) dilute the capital gains that would have been earned by the previous shareholders.

Answer: E
Difficulty: 1 Easy
Section: 13.2 Estimating the Cost of Equity Capital with the CAPM
Topic: Dilution
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

4) A project with the same level of risk as an all-equity firm should be accepted if the project's:
A) internal rate of return exceeds the firm's cost of equity capital.
B) expected rate of return exceeds the market rate of return.
C) anticipated rate of return exceeds the firm's return on assets.
D) internal rate of return is positive given this level of risk.
E) expected rate of return exceeds the risk-free rate.

Answer: A
Difficulty: 1 Easy
Section: 13.2 Estimating the Cost of Equity Capital with the CAPM
Topic: Project analysis and evaluation
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

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5) Which one of these statements is correct concerning the CAPM?

A) The CAPM is the only available method for determining an appropriate discount rate for a
proposed project.
B) The market rate of return is most commonly based on the forecasted return on the market for
the next 5-year period.
C) CAPM is used quite frequently by firms in their capital budgeting process.
D) The expected return on the 30-year U.S. Treasury bond is the most commonly used as the
risk-free rate of return.
E) An increase in the risk-free rate combined with a beta greater than 1.0 increases the discount
rate computed using the CAPM.

Answer: C
Difficulty: 1 Easy
Section: 13.2 Estimating the Cost of Equity Capital with the CAPM
Topic: Capital asset pricing model
Bloom's: Remember
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

6) When estimating the cost of equity using the DDM, the factor that is the most apt to add error
to this estimate is the:
A) value of the last dividend.
B) firm's tax rate.
C) historical beta.
D) dividend growth rate.
E) current stock price.

Answer: D
Difficulty: 1 Easy
Section: 13.2 Estimating the Cost of Equity Capital with the CAPM
Topic: Dividend discount model
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

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7) Which one of these statements related to beta is correct?

A) Firm betas have less error than industry betas.
B) Firms should always rely on their own beta rather than their industry's beta.
C) Beta is unaffected by a firm's capital structure.
D) The sample size used to compute beta may be too small to yield a reliable result.
E) Firm betas rarely vary over time.

Answer: D
Difficulty: 1 Easy
Section: 13.3 Estimation of Beta
Topic: Beta
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

8) The beta of a security is calculated as: (________ of a security's return with the return on the
market portfolio/________).
A) Variance; Covariance of the market return
B) Covariance; Variance of the market return
C) Covariance; Standard deviation of the market return
D) Variance; Covariance of the security return
E) Covariance; Variance of the security return

Answer: B
Difficulty: 1 Easy
Section: 13.3 Estimation of Beta
Topic: Beta
Bloom's: Remember
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

9) Assume you plot the monthly returns for a stock and also for the S&P 500. Using regression
analysis, the straight line through these points that is developed by the analysis is referred to as
the ________ which has a slope of ________ and an intercept of ________.
A) security market line; alpha; gamma
B) characteristic line; beta; alpha
C) characteristic line; alpha; beta
D) security market line; beta; gamma
E) characteristic line; gamma; alpha

Answer: B
Difficulty: 1 Easy
Section: 13.3 Estimation of Beta
Topic: Beta
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
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10) Companies will generally have a ________ beta if their:

A) low; stock price is relatively low.
B) high; sales are highly dependent on the market cycle.
C) high; sales are growing at a steady rate of increase.
D) high; sales are high compared to other firms in their industry.
E) low; production costs are primarily fixed in nature.

Answer: B
Difficulty: 1 Easy
Section: 13.4 Determinants of Beta
Topic: Beta
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

11) If a firm increases its use of both operating and financial leverage, then you should expect
the firm's:
A) asset beta to exceed its equity beta.
B) beta of debt to exceed 1.0.
C) beta to remain constant as the increased operating leverage will offset the increased financial
leverage.
D) equity beta to increase.
E) debt beta to exceed its equity beta.

Answer: D
Difficulty: 1 Easy
Section: 13.4 Determinants of Beta
Topic: Beta and leverage
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

12) The beta of debt is commonly considered to be:

A) equal to the market beta.
B) one-half of the equity beta.
C) equal to the asset beta.
D) zero.
E) one.

Answer: D
Difficulty: 1 Easy
Section: 13.4 Determinants of Beta
Topic: Beta
Bloom's: Remember
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
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13) Comparing two otherwise equivalent firms, the beta of the common stock of the levered firm
is ________ the beta of the common stock of the unlevered firm.
A) roughly equivalent to
B) significantly less than
C) slightly less than
D) greater than
E) equal to

Answer: D
Difficulty: 1 Easy
Section: 13.4 Determinants of Beta
Topic: Beta and leverage
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

14) The beta of a firm is more likely to be high under which two conditions?
A) High cyclical business activity and low operating leverage
B) High cyclical business activity and high operating leverage
C) Low cyclical business activity and low financial leverage
D) Low cyclical business activity and low operating leverage
E) Low financial leverage and low operating leverage

Answer: B
Difficulty: 1 Easy
Section: 13.4 Determinants of Beta
Topic: Beta and leverage
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

15) A firm with cyclical earnings is characterized by:

A) revenue patterns that vary with the business cycle.
B) high levels of debt in its capital structure.
C) high fixed costs.
D) high costs per unit.
E) low contribution margins.

Answer: A
Difficulty: 1 Easy
Section: 13.4 Determinants of Beta
Topic: Beta
Bloom's: Remember
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

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16) A firm with high operating leverage has:

A) low fixed costs in its production process.
B) high variable costs in its production process.
C) high fixed costs in its production process.
D) high total costs per unit.
E) low total costs per unit.

Answer: C
Difficulty: 1 Easy
Section: 13.4 Determinants of Beta
Topic: Beta and leverage
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

17) Assume LK Metals is similar to its industry with one exception; it has low fixed costs
relative to all other firms in that industry. Given this, you should expect LK Metals to have:
A) a lower beta than its industry.
B) the same beta as the industry but a lower beta than the other firms in the industry.
C) a higher beta than its industry.
D) a higher beta than the industry and all the firms within that industry.
E) the same beta as the industry but a higher beta than the other firms in the industry.

Answer: A
Difficulty: 1 Easy
Section: 13.4 Determinants of Beta
Topic: Beta and leverage
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

18) The use of leverage:

A) increases both the asset and the equity betas.
B) decreases both the asset and the equity betas.
C) decreases the equity beta and increases the asset beta.
D) increases the equity beta but does not affect the asset beta.
E) decreases the equity beta but does not affect the asset beta.

Answer: D
Difficulty: 1 Easy
Section: 13.4 Determinants of Beta
Topic: Beta and leverage
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

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19) An industry is likely to have a low beta if the:

A) stream of revenues within that industry is less volatile than the market.
B) economy is in a recessionary period.
C) market for its goods is highly affected by the market cycle.
D) number of firms within the industry is fairly constant.
E) industry tends to use a lot of debt financing.

Answer: A
Difficulty: 1 Easy
Section: 13.4 Determinants of Beta
Topic: Beta
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

20) For a levered firm the equity beta is ________ the asset beta.
A) greater than
B) less than
C) equal to
D) sometimes greater than and sometimes less than
E) unrelated to

Answer: A
Difficulty: 1 Easy
Section: 13.4 Determinants of Beta
Topic: Beta and leverage
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

21) The CAPM has an advantage over DDM because the CAPM:
A) explicitly adjusts for risk.
B) applies to firms that pay dividends.
C) has no measurement risk.
D) specifically considers a firm's rate of growth.
E) ignores changes in the overall market over time.

Answer: A
Difficulty: 1 Easy
Section: 13.5 The Dividend Discount Model Approach
Topic: Cost of equity
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

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22) Which one of these is a correct means of calculating an expected rate of growth?
A) ROA × Dividend payout ratio
B) ROE × Profit margin
C) ROA × Retention ratio
D) ROA × Profit margin
E) ROE × Retention ratio

Answer: E
Difficulty: 1 Easy
Section: 13.5 The Dividend Discount Model Approach
Topic: Growth rates
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

23) Lesco's is evaluating a project that has a different level of risk than the overall firm. This
project should be evaluated:
A) using the market beta.
B) using the overall firm's beta.
C) using a beta commensurate with the project's risks.
D) at the market rate of return.
E) at the T-bill rate of return.

Answer: C
Difficulty: 1 Easy
Section: 13.6 Cost of Capital for Divisions and Projects
Topic: Divisional and project costs of capital
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

24) The discount rate applied to an individual project should be based on the:
A) sources of funding for that project.
B) risks associated with the project's cash flows.
C) sponsoring firm's average level of risk.
D) expertise of the project's managers.
E) size and duration of the project's life.

Answer: B
Difficulty: 1 Easy
Section: 13.6 Cost of Capital for Divisions and Projects
Topic: Divisional and project costs of capital
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

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25) If a firm applies its overall firm's beta to projects with varying levels of risk, the firm will
tend to:
A) reject the riskiest projects.
B) accept all low-risk projects.
C) accept only projects of equal risk to its current operations.
D) remain at its current level of overall risk.
E) become riskier over time.

Answer: E
Difficulty: 1 Easy
Section: 13.6 Cost of Capital for Divisions and Projects
Topic: Divisional and project costs of capital
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

26) JR's is preparing to start a new project in an industry that differs significantly from its current
operations. JR's has searched and found the beta of a firm that is a good fit as a pure play for this
new project. Given this good fit, why might JR's assign a higher beta to the project than the beta
of the pure play?
A) JR's should assign a project beta that is based on the average of JR's and the pure play firm's
betas.
B) The expected project revenues may be less cyclical than those of the pure play firm.
C) JR's may use less debt in its operations than does the pure play firm.
D) The pure play firm has more experience in the new area than JR's does.
E) The project may incur flotation costs so a higher beta is warranted to offset the additional
cost.

Answer: D
Difficulty: 1 Easy
Section: 13.6 Cost of Capital for Divisions and Projects
Topic: Divisional and project costs of capital
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

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27) The cost of preferred stock:

A) should be adjusted for taxes when computing WACC.
B) is ignored by all firms when computing WACC.
C) is generally calculated using the overall firm's beta.
D) is equal to the stock's dividend yield.
E) is set equal to the pretax cost of debt since it is a fixed income security.

Answer: D
Difficulty: 1 Easy
Section: 13.7 Cost of Fixed Income Securities
Topic: Cost of preferred stock
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

28) Lewis Bros. currently has outstanding debt but has decided to issue additional debt for
expansion purposes. The pretax cost of the new debt is best estimated at the ________ of the
currently outstanding debt.
A) original yield to maturity
B) current yield to maturity
C) embedded cost
D) current yield
E) coupon rate

Answer: B
Difficulty: 1 Easy
Section: 13.7 Cost of Fixed Income Securities
Topic: Cost of debt
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

29) As of 2018, U.S. tax law limits the tax deduction for interest payments to 30 percent of:
A) EBIT.
B) EBT.
C) net income.
D) net revenue.
E) the total interest paid.

Answer: A
Difficulty: 1 Easy
Section: 13.7 Cost of Fixed Income Securities
Topic: Cost of debt
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

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30) When computing WACC, you should use the:

A) pretax cost of debt because most corporations pay taxes at the same tax rate.
B) pretax cost of debt because it is the actual rate the firm is paying its bondholders.
C) current yield because it is based on the current market price of debt.
D) aftertax cost of debt because interest is partially, if not fully, tax deductible.
E) pretax yield to maturity because it considers the current market price of debt.

Answer: D
Difficulty: 1 Easy
Section: 13.8 The Weighted Average Cost of Capital
Topic: Weighted average cost of capital
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

31) When computing the weighted average cost of capital, which of these are adjusted for taxes?
A) Cost of equity
B) Cost of preferred stock
C) Both the cost of equity and the cost of preferred stock
D) The costs of debt and preferred stock
E) Cost of debt

Answer: E
Difficulty: 1 Easy
Section: 13.8 The Weighted Average Cost of Capital
Topic: Weighted average cost of capital
Bloom's: Remember
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

32) All else held constant, which one of these is most apt to increase the WACC of a levered
firm?
A) An increase in the weight of debt
B) A decrease in a firm's equity beta
C) A decrease in the dividend growth rate
D) A decrease in the tax rate
E) An increase in the risk-free rate when the equity beta exceeds 1.0

Answer: D
Difficulty: 1 Easy
Section: 13.8 The Weighted Average Cost of Capital
Topic: Weighted average cost of capital
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

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33) The weighted average cost of capital for a firm is the:

A) discount rate which the firm should apply to all the projects it undertakes.
B) overall rate which the firm must earn on its existing assets to maintain the value of its stock.
C) rate the firm should expect to pay on its next bond issue.
D) maximum rate which the firm should require on any projects it undertakes.
E) rate of return that the firm's preferred stockholders should expect to earn over the long term.

Answer: B
Difficulty: 1 Easy
Section: 13.9 Valuation with WACC
Topic: Weighted average cost of capital
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

34) A firm's WACC can be correctly used to discount the expected cash flows of a new project
when that project will:
A) have the same level of risk as the firm's current operations.
B) be financed solely with new debt and internal equity.
C) be managed by the firm's current managers.
D) be financed based on the firm's current debt-equity ratio.
E) be financed solely with internal equity.

Answer: A
Difficulty: 1 Easy
Section: 13.9 Valuation with WACC
Topic: Weighted average cost of capital
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

35) When valuing a firm financed with debt and equity, the individual cash flows should be
discounted using:
A) the market rate of return.
B) the average of the DDM and CAPM costs of equity.
C) (1 + WACC)T.
D) (1 + CAPM)T.
E) (r − g).

Answer: C
Difficulty: 1 Easy
Section: 13.9 Valuation with WACC
Topic: Firm valuation
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
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36) The terminal value of a firm is also commonly referred to as the:

A) final value.
B) cash value.
C) non-constant value.
D) estimated value.
E) horizon value.

Answer: E
Difficulty: 1 Easy
Section: 13.9 Valuation with WACC
Topic: Firm valuation
Bloom's: Remember
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

37) A firm's net cash flow is calculated as:

A) EBIT − Taxes + Depreciation − Capital spending − Increases in net working capital.
B) EBIT + Taxes + Depreciation − Capital spending − Increases in net working capital.
C) EBIT − Taxes − Depreciation − Capital spending + Increases in net working capital.
D) EBIT − Taxes + Depreciation + Capital spending − Increases in net working capital.
E) EBIT + Taxes + Depreciation − Capital spending + Increases in net working capital.

Answer: A
Difficulty: 1 Easy
Section: 13.9 Valuation with WACC
Topic: Firm valuation
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

38) Assume a levered firm plans to raise new capital to finance a project. To properly account for
the flotation costs, the firm should:
A) subtract the pretax flotation cost from the project's NPV.
B) deduct the amount of the flotation cost from the cash flows for Year 1 of the project.
C) add the percentage of the flotation cost to the WACC when discounting the cash flows.
D) divide the amount of project capital needed by (1 − Weighted average flotation cost).
E) increase the target weights of both debt and equity to account for the flotation percentage.

Answer: D
Difficulty: 1 Easy
Section: 13.11 Flotation Costs and the Weighted Average Cost of Capital
Topic: Flotation costs
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

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39) When calculating the weighted average flotation cost, the weights should be based on the:
A) mix of debt and equity that will be used to finance the specific project.
B) firm's target capital structure.
C) percentages of internal and external financing that will be used for the project.
D) firm's current mix of debt and equity.
E) average amounts of external capital raised during the past twelve months.

Answer: B
Difficulty: 1 Easy
Section: 13.11 Flotation Costs and the Weighted Average Cost of Capital
Topic: Flotation costs
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

40) The flotation cost of internal equity is:

A) assumed to be zero.
B) assumed to be the same as the cost of external equity.
C) assigned a cost equal to the aftertax cost of equity.
D) assumed to be the same as the firm's return on equity.
E) assigned a cost equal to the risk-free rate.

Answer: A
Difficulty: 1 Easy
Section: 13.11 Flotation Costs and the Weighted Average Cost of Capital
Topic: Flotation costs
Bloom's: Understand
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

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41) Consolidated Transfer is an all-equity financed firm. The beta is .75, the market risk
premium is 7.78 percent, and the risk-free rate is 3.84 percent. What is the expected rate of return
on this stock?
A) 6.80 percent
B) 8.22 percent
C) 9.54 percent
D) 9.68 percent
E) 8.46 percent

Answer: D
Explanation: RS = .0384 + .75(.0778)
RS = .0968, or 9.68%
Difficulty: 2 Medium
Section: 13.2 Estimating the Cost of Equity Capital with the CAPM
Topic: Cost of equity
Bloom's: Apply
AACSB: Knowledge Application
Accessibility: Keyboard Navigation

42) What is the cost of equity for a firm that has a beta of 1.2 if the risk-free rate of return is 2.9
percent and the expected market return is 11.4 percent?
A) 13.1 percent
B) 10.8 percent
C) 12.8 percent
D) 14.4 percent
E) 13.6 percent

Answer: A
Explanation: RS = .029 + 1.2(.114 − .029)
RS = .131, or 13.1%
Difficulty: 2 Medium
Section: 13.2 Estimating the Cost of Equity Capital with the CAPM
Topic: Cost of equity
Bloom's: Apply
AACSB: Knowledge Application
Accessibility: Keyboard Navigation

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43) Albert's recently paid its annual dividend of $1.98 per share. At that time, the firm announced
that all future dividends will be increased by 2.2 percent annually. What is the firm's cost of
equity if the stock is currently selling for $28.40 a share?
A) 9.33 percent
B) 11.32 percent
C) 10.47 percent
D) 11.08 percent
E) 10.06 percent

Answer: A
Explanation: Rs = [$1.98(1.022)]/$28.40 + .022
Rs = .0933, or 9.33%
Difficulty: 2 Medium
Section: 13.2 Estimating the Cost of Equity Capital with the CAPM
Topic: Cost of equity
Bloom's: Apply
AACSB: Knowledge Application
Accessibility: Keyboard Navigation

44) Winslow and Sons is expected to pay an annual dividend of $1.35 per share one year from
now with future increases of 2.5 percent annually. The stock currently sells for $14.70 a share.
What is the cost of equity?
A) 13.48 percent
B) 12.29 percent
C) 12.60 percent
D) 11.68 percent
E) 13.23 percent

Answer: D
Explanation: Rs = $1.35/$14.70 + .025
Rs = .1168, or 11.68%
Difficulty: 2 Medium
Section: 13.2 Estimating the Cost of Equity Capital with the CAPM
Topic: Cost of equity
Bloom's: Apply
AACSB: Knowledge Application
Accessibility: Keyboard Navigation

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45) The cost of equity for RJ Corporation is 8.4 percent and the debt-equity ratio is .6. The
expected return on the market is 10.4 percent and the risk-free rate is 3.8 percent. Using the
common assumption for the debt beta, what is the asset beta?
A) .70
B) .44
C) .62
D) .67
E) .59

Answer: B
Explanation: .084 = .038 + βEquity(.104 − .038)
βEquity = .697
βAsset = (1/1.6)(.697)
βAsset = .44
Difficulty: 2 Medium
Section: 13.4 Determinants of Beta
Topic: Beta and leverage
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46) Barges has an asset beta of .57, the risk-free rate is 4.3 percent, and the market risk premium
is 7.7 percent. What is the equity beta if the firm has a debt-equity ratio of .56?
A) .46
B) .89
C) .74
D) .37
E) .32

Answer: B
Explanation: βEquity = .57/(1/1.56)
βEquity = .89
Difficulty: 2 Medium
Section: 13.4 Determinants of Beta
Topic: Beta and leverage
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47) HNT is an all-equity firm with a beta of .88. What will the firm's equity beta be if the firm
switches to a debt-equity ratio of .35?
A) .88
B) 1.23
C) .97
D) 1.19
E) 1.06

Answer: D
Explanation: βEquity = .88/(1/1.35)
βEquity = 1.19
Difficulty: 2 Medium
Section: 13.4 Determinants of Beta
Topic: Beta and leverage
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48) A firm has an equity beta of 1.2, the risk-free rate is 3.4 percent, the market return is 15.7
percent, and the pretax cost of debt is 9.4 percent. The debt-equity ratio is .47. If you apply the
common beta assumptions, what is the firm's asset beta?
A) .82
B) .61
C) .67
D) .58
E) .73

Answer: A
Explanation: βAsset = (1/1.47)(1.2)
βAsset = .82
Difficulty: 2 Medium
Section: 13.4 Determinants of Beta
Topic: Beta and leverage
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49) BG's cost of equity is 9.4 percent, the expected return on the market is 13.6 percent, and the
risk-free rate is 3.8 percent. What is the firm's debt-equity ratio if its asset beta is .36? Assume
there is no preferred stock.
A) .52
B) .59
C) .82
D) .77
E) .63

Answer: B
Explanation: .094 = .038 + βEquity(.136 − .038)
βEquity = .5714
.36 = [S/(B + S)](.5714)
[S/(B + S)] = .63
(B + S)/S = 1/.63
B/S + 1 = 1.59
B/S = .59
Difficulty: 2 Medium
Section: 13.4 Determinants of Beta
Topic: Beta and leverage
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50) LR Engines stock is selling for $42.39 a share, has an ROE of 14.3 percent, and a dividend
payout ratio of 35 percent. The next expected dividend is $1.62 a share. What is the cost of
equity for this firm?
A) 12.86 percent
B) 13.12 percent
C) 13.47 percent
D) 12.52 percent
E) 13.70 percent

Answer: B
Explanation: RS = $1.62/$42.39 + (1 − .35)(.143)
RS = .1312, or 13.12%
Difficulty: 2 Medium
Section: 13.5 The Dividend Discount Model Approach
Topic: Cost of equity
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51) Clancy's just paid its annual dividend of $1.48 per share. Analysts expect the stock price to
increase by 2.1 percent annually and value the stock at $14.65 per share currently. What is the
cost of equity for this firm?
A) 12.41 percent
B) 13.32 percent
C) 12.20 percent
D) 13.87 percent
E) 14.06 percent

Answer: A
Explanation: RS = [$1.48(1.021)]/$14.65 + .021
RS = .1241, or 12.41%
Difficulty: 2 Medium
Section: 13.5 The Dividend Discount Model Approach
Topic: Cost of equity
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52) Southern Imports is an all-equity firm with a beta of 1.32. The firm is considering a new
project that entails less risk than its current operations and thus management feels that the firm's
beta should be lowered by .18 when assigning a discount rate to this project. The market rate of
return is 9.4 percent and the risk-free rate is 2.8 percent. What discount rate should be assigned
to this project?
A) 11.46 percent
B) 11.21 percent
C) 10.87 percent
D) 6.49 percent
E) 10.32 percent

Answer: E
Explanation: RProject = .028 + (1.32 − .18)(.094 − .028)
RProject = .1032, or 10.32%
Difficulty: 2 Medium
Section: 13.6 Cost of Capital for Divisions and Projects
Topic: Divisional and project costs of capital
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53) APL has an overall cost of capital of 11.6 percent and a beta of 1.31. The firm is
contemplating a new project that is unrelated to the firm's current operations. SKL is a firm that
operates similarly to the new project and SKL has a cost of capital of 10.7 percent. APL knows
that it will be less efficient than SKL and thus feels that an adjustment of +1 percent should be
added to the project's discount rate to allow for this inefficiency. What discount rate should be
assigned to the new project?
A) 10.7 percent
B) 11.3 percent
C) 11.7 percent
D) 11.6 percent
E) 12.6 percent

Answer: C
Explanation: The pure play approach applies, so:
RProject = .107 + .01
RProject = .117, or 11.7%
Difficulty: 2 Medium
Section: 13.6 Cost of Capital for Divisions and Projects
Topic: Divisional and project costs of capital
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54) The Shoe Box pays an annual dividend of $3.80 on its preferred stock. What is the cost of
preferred if the stock currently sells for $42.70 a share and the tax rate is 21 percent?
A) 7.94 percent
B) 11.87 percent
C) 6.68 percent
D) 9.39 percent
E) 8.90 percent

Answer: E
Explanation: RP = $3.80/$42.70
RP = .0890, or 8.90%
Difficulty: 2 Medium
Section: 13.7 Cost of Fixed Income Securities
Topic: Cost of preferred stock
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55) Ladder Works has debt outstanding with a coupon rate of 6 percent and a yield to maturity of
6.8 percent. What is the aftertax cost of debt if the tax rate is 21 percent? Assume all interest is
tax deductible.
A) 5.37 percent
B) 4.86 percent
C) 4.74 percent
D) 5.29 percent
E) 5.13 percent

Answer: A
Explanation: RD = .068(1 − .21)
RD = .0537, or 5.37%
Difficulty: 2 Medium
Section: 13.7 Cost of Fixed Income Securities
Topic: Cost of debt
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56) High Road Tours has an aftertax cost of debt of 5.1 percent at its current tax rate of 34
percent. What will its aftertax cost of debt be if the tax rate drops to 21 percent? Assume all
interest is tax deductible.
A) 6.10 percent
B) 5.92 percent
C) 6.17 percent
D) 4.03 percent
E) 4.47 percent

Answer: A
Explanation: RD = [.051/(1 − .34)](1 − .21)
RD = .0610, or 6.10%
Difficulty: 2 Medium
Section: 13.7 Cost of Fixed Income Securities
Topic: Cost of debt
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57) Jack's Construction Co. has 80 bonds outstanding that are selling at their par value of $1,000
each. Bonds with similar characteristics are yielding a pretax 8.6 percent. The firm also has 4,000
shares of common stock outstanding. The stock has a beta of 1.1 and sells for $40 a share. The
U.S. T-bill is yielding 4 percent, the market risk premium is 8 percent, and the firm's tax rate is
21 percent. What is the firm's weighted average cost of capital assuming its earnings are
sufficient to classify all interest as a tax-deductible expense?
A) 10.10 percent
B) 11.39 percent
C) 10.80 percent
D) 10.65 percent
E) 11.40 percent

Answer: C
Explanation: Re = .04 + 1.1(.08)
Re = .128
Debt = 80($1,000)
Debt = $80,000
Common stock = 4,000($40)
Common stock = $160,000
Total debt and equity = $80,000 + 160,000
Total debt and equity = $240,000
WACC = ($160,000/$240,000)(.128) + ($80,000/$240,000)(.086)(1 − .21)
WACC = .1080, or 10.80%
Difficulty: 2 Medium
Section: 13.8 The Weighted Average Cost of Capital
Topic: Weighted average cost of capital
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58) Peter's Audio has a yield to maturity on its debt of 7.8 percent, a cost of equity of 12.4
percent, and a cost of preferred stock of 8 percent. The firm has 105 shares of common stock
outstanding at a market price of $22 a share. There are 25 shares of preferred stock outstanding
at a market price of $45 a share. The bond issue has a total face value of $1,500 and sells at 98
percent of face value. If the tax rate is 21 percent, what is the weighted average cost of capital
assuming all interest is tax deductible?
A) 9.68 percent
B) 8.54 percent
C) 8.69 percent
D) 9.52 percent
E) 9.45 percent

Answer: D
Explanation: Debt = $1,500(.98)
Debt = $1,470
Preferred stock = 25($45)
Preferred stock = $1,125
Common stock = 105($22)
Common stock = $2,310
Total debt and equity = $1,470 + 1,125 + 2,310
Total debt and equity = $4,905
WACC = ($2,310/$4,905)(.124) + ($1,125/$4,905)(.08) + [($1,470/$4,905)(.078)(1 − .21)
WACC = .0952, or 9.52%
Difficulty: 2 Medium
Section: 13.8 The Weighted Average Cost of Capital
Topic: Weighted average cost of capital
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59) Phil's Carvings wants to have a weighted average cost of capital of 9.5 percent. The firm has
an aftertax cost of debt of 6.5 percent and a cost of equity of 12.75 percent. What debt-equity
ratio is needed for the firm to achieve its targeted weighted average cost of capital?
A) .84
B) .92
C) 1.08
D) .76
E) .67

Answer: C
Explanation: .095 = .1275We + (1 − We)(.065)
We = .48
D/E = (1 − .48)/.48
D/E = 1.08
Difficulty: 2 Medium
Section: 13.8 The Weighted Average Cost of Capital
Topic: Weighted average cost of capital
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60) Sound Systems has 200 shares of common stock outstanding at a market price of $37 a share.
The firm recently paid an annual dividend in the amount of $1.20 per share and has a dividend
growth rate of 4 percent. The firm also has 5 bonds outstanding with a face value of $1,000 per
bond that are selling at 99 percent of par. The bonds have a coupon rate of 6 percent and a yield
to maturity of 6.7 percent. All interest is tax deductible. If the tax rate is 21 percent, what is the
weighted average cost of capital?
A) 5.93 percent
B) 6.87 percent
C) 6.37 percent
D) 6.54 percent
E) 7.08 percent

Answer: D
Explanation: Debt = 5($1,000)(.99)
Debt = $4,950
Common stock = 200($37)
Common stock = $7,400
Total debt and equity = $4,950 + $7,400
Total debt and equity = $12,350
Re = $1.20(1.04)/$37 + .04
Re = .07373, or 7.373%
WACC = ($7,400/$12,350)(.07373) + ($4,950/$12,350)(.067)(1 − .21)]
WACC = .0654, or 6.54%
Difficulty: 2 Medium
Section: 13.8 The Weighted Average Cost of Capital
Topic: Weighted average cost of capital
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61) Suppose Simmons' common stock has a beta of 1.37, the risk-free rate is 3.4 percent, and the
market risk premium is 8.2 percent. The yield to maturity on the firm's bonds is 7.6 percent and
the debt-equity ratio is .45. What is the WACC if the tax rate is 23 percent and all interest is tax
deductible?
A) 14.07 percent
B) 10.94 percent
C) 12.60 percent
D) 10.59 percent
E) 11.91 percent

Answer: E
Explanation: Rs = .034 + 1.37(.082)
Rs = .14634, or 14.634%
WACC = (1/1.45)(.14634) + (.45/1.45)(.076)(1 − .23)
WACC = .1191, or 11.91%
Difficulty: 2 Medium
Section: 13.8 The Weighted Average Cost of Capital
Topic: Weighted average cost of capital
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62) Tin Roof's net cash flows for the next three years are projected at $72,000, $78,000, and
$84,000, respectively. After that, the cash flows are expected to increase by 3.2 percent annually.
The aftertax cost of debt is 6.2 percent and the cost of equity is 11.4 percent. What is the value of
the firm if it is financed with 40 percent debt and 60 percent equity?
A) $1,215,650
B) $1,328,141
C) $1,461,439
D) $1,575,941
E) $1,279,623

Answer: E
Explanation: WACC = .60(.114) + .40(.062)
WACC = .0932, or 9.32%
PV0 = $72,000/1.0932 + $78,000/1.09322 + $84,000/1.09323 + [$84,000(1.032)]/(.0932 − .
032)]/1.09323
PV0 = $1,279,623
Difficulty: 2 Medium
Section: 13.9 Valuation with WACC
Topic: Firm valuation
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63) The expected net cash flows of Advantage Leasing for the next three years are $42,000,
$49,000, and $64,000, respectively. After three years, the growth rate of these cash flows will be
a constant 2 percent annually. The WACC is 8 percent. What is the present value of the terminal
value?
A) $881,822
B) $863,689
C) $959,259
D) $910,444
E) $828,406

Answer: B
Explanation: PVTerminal value = [$64,000(1.02)/(.08 − .02)]/1.083
PVTerminal value = $863,689
Difficulty: 2 Medium
Section: 13.9 Valuation with WACC
Topic: Firm valuation
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64) Norris Co. has developed an improved version of its most popular product. To get this
improvement to the market will cost $48 million but the project will return an additional $13.5
million for 5 years in net cash flows. The firm's debt-equity ratio is .25, the cost of equity is 13
percent, the pretax cost of debt is 9 percent, and the tax rate is 21 percent. All interest is tax
deductible. What is the net present value of this proposed project?
A) $906,411
B) $902,459
C) $879,838
D) $884,318
E) $889,760

Answer: C
Explanation: WACC = (1/1.25)(.13) + (.25/1.25)(.09)(1 − .21)
WACC = .11822
NPV = −$48,000,000 + $13,500,000[(1 − 1/1.118225)/.11822]
NPV = $879,838
Difficulty: 2 Medium
Section: 13.9 Valuation with WACC
Topic: Project analysis and evaluation
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65) Hu's has 25,000 shares of common stock outstanding with a beta of 1.4, a market price of
$32 a share, and a dividend yield of 5.7 percent. Dividends increase by 4.2 percent annually. The
firm also has $450,000 of debt outstanding that is selling at 102 percent of par that has a yield to
maturity of 6.8 percent. The tax rate is 21 percent and all interest is tax deductible. The firm is
considering a project that has the same risk level as the firm's current operations, an initial cost of
$328,000 and cash inflows of $52,500, $155,000, and $225,000 for Years 1 to 3, respectively.
What is the NPV of the project?
A) $28,515
B) $31,492
C) $36,511
D) $27,006
E) $30,157

Answer: E
Explanation: Common stock = 25,000($32)
Common stock = $800,000
Debt = $450,000(1.02)
Debt = $459,000
Total debt and equity = $800,000 + 459,000
Total debt and equity = $1,259,000
Rs = .057 + .042
Rs = .099, or 9.9%
WACC = ($800,000/$1,259,000)(.099) + ($459,000/$1,259,000)(.068)(1 − .21)
WACC = .0825, or 8.25%
NPV = −$328,000 + $52,500/1.0825 + $155,000/1.08252 + $225,000/1.08253
NPV = $30,157
Difficulty: 2 Medium
Section: 13.9 Valuation with WACC
Topic: Project analysis and evaluation
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66) ABC is considering acquiring XYZ and has compiled this information on XYZ:

Year 1 2 3
EBIT $ 318,000 $ 364,000 $ 392,000
Capital spending 46,500 28,000 36,200
Increases in net working capital 5,500 6,500 1,200
Depreciation 34,000 32,100 28,700

The applicable tax rate is 21 percent and the terminal value of XYZ as of Year 3 is $2.5 million.
What is the NPV of this acquisition if the discount rate is 7.1 percent and the acquisition cost is
$2.25 million?
A) $538,316
B) $509,482
C) $499,003
D) $506,048
E) $496,399

Answer: E
Explanation: CF1 = $318,000(1 − .21) + 34,000 − 46,500 − 5,500
CF1= $233,220
CF2 = $364,000(1 − .21) + 32,100 − 28,000 − 6,500
CF2 = $285,160
CF3 = $392,000(1 − .21) + 28,700 − 36,200 − 1,200
CF3 = $300,980
NPV = −$2,250,000 + $233,220/1.071 + $285,160/1.0712 + ($300,980 + 2,500,000)/1.0713
NPV = $496,399
Difficulty: 2 Medium
Section: 13.9 Valuation with WACC
Topic: Firm valuation
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67) The Upper Tier has a current debt-equity ratio of .52 and a target debt-equity ratio of .45. The
cost of floating equity is 9.5 percent and the flotation cost of debt is 6.6 percent. What should the
firm use as their weighted average flotation cost?
A) 8.01 percent
B) 8.51 percent
C) 8.33 percent
D) 7.76 percent
E) 8.60 percent

Answer: E
Explanation: ƒ = (1/1.45)(.095) + (.45/1.45)(.066)
ƒ = .0860, or 8.60%
Difficulty: 2 Medium
Section: 13.11 Flotation Costs and the Weighted Average Cost of Capital
Topic: Flotation costs
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68) Downtown Stores can issue equity at a flotation cost of 8.76 percent and debt at 5.93 percent.
The firm currently has a debt-equity ratio of .37 but prefers a ratio of .35. What should this firm
use as their weighted average flotation cost?
A) 8.26 percent
B) 8.03 percent
C) 8.34 percent
D) 8.37 percent
E) 8.00 percent

Answer: B
Explanation: ƒ = (1/1.35)(.0876) + (.35/1.35)(.0593)
ƒ = .0803 or 8.03%
Difficulty: 2 Medium
Section: 13.11 Flotation Costs and the Weighted Average Cost of Capital
Topic: Flotation costs
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69) Explain a) the factors that determine a security's beta and b) how asset beta relates to equity
beta.

Answer:
∙ The key factors affecting a security's beta are the cyclicality of revenues, operating leverage,
and financial leverage.
∙ The asset beta equals the equity beta for an all-equity firm. The equity beta is greater than the
asset beta for a levered firm.
Difficulty: 2 Medium
Section: 13.4 Determinants of Beta
Topic: Beta
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70) The Neptune Company offers network communications systems to computer users. The
company is planning a major investment expansion but is unsure of the cost of equity capital as it
has no publicly-traded equity. Your assignment is to determine an appropriate equity cost. List
and explain the steps you will need to take to complete this assignment.

Answer: Step 1: Collect estimates of equity betas for firms in the same business as Neptune.
Step 2: Collect market values and debt-equity ratios for each business in Step 1.
Step 3: De-lever the individual equity betas and estimate an average asset beta for the group.
Step 4: Re-lever the average asset beta using Neptune's target debt-equity ratio to determine
Neptune's equity beta.
Step 5: Determine the risk-free rate and the market risk premium.
Step 6: Calculate the estimated cost of equity capital using Neptune's estimated equity beta.
Difficulty: 2 Medium
Section: 13.4 Determinants of Beta
Topic: Beta and leverage
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71) World Corporation has traditionally employed a firm-wide discount rate for capital budgeting
purposes. However, its two divisions, publishing and entertainment, have different degrees of
risk given by βP = 1.1, βE = 1.8, while the beta for the overall firm is 1.3. The publishing
division has proposed three projects with these internal rates of return: P1 = 13.2 percent; P2 =
12.4 percent; and P3 = 9.8 percent. The entertainment division has presented their three projects:
E1 = 16.4 percent; E2 = 17.8 percent; and E3 = 14.7 percent. The risk-free rate is 4 percent and
the market risk premium is 8 percent. Identify which projects will be accepted if the firm applies
its overall beta to all projects. Then identify which projects will be accepted if the division betas
are properly applied.

Answer: RF = .04 + 1.3(.08)

RF = .144, or 14.4%
RP = .04 + 1.1(.08)
RP = .128, or 12.8%
RE = .04 + 1.8(.08)
RE = .184. or 18.4%

Based on the firm's beta, the firm will accept projects E1, E2, and E3.
Based on the division's betas, the firm will only accept project P1.
Difficulty: 2 Medium
Section: 13.9 Valuation with WACC
Topic: Project analysis and evaluation
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72) On-line Text Co. has four new text publishing products that it is considering. The projects are
of equal risk with a beta of 1.6. The risk-free rate is 4.2 percent and the market rate is expected to
be 12.3 percent. The projects and their expected internal rates of return are: W = 14.4 percent; X
= 18 percent, Y = 16.4 percent; and Z = 17.2 percent. Which projects should be accepted? Justify
your acceptance decision.

Answer: Rs = .042 + 1.6(.123 − .042)

Rs = .1716, or 17.16%
Accept projects X and Z because their IRR's exceed the required return of 17.16 percent, which
is computed using the appropriate beta of 1.6.
Difficulty: 2 Medium
Section: 13.9 Valuation with WACC
Topic: Project analysis and evaluation
Bloom's: Analyze
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation

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