The goodsmith charitable foundation which is tax exempt

11.

value: 1.00 points

Speedy Delivery Systems can buy a piece of equipment that is anticipated to provide a return of 11 percent and can be financed at 8 percent with debt. Later in the year, the firm turns down an opportunity to buy a new machine that would yield a return of 18 percent but would cost 20 percent to finance through common equity. Assume debt and common equity each represent 50 percent of the firm’s capital structure.

a.

Compute the weighted average cost of capital. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Weighted average cost of capital

%

b.

Which project(s) should be accepted?

New machine

Piece of equipment

12.

value: 1.00 points

A brilliant young scientist is killed in a plane crash. It is anticipated that he could have earned $310,000 a year for the next 30 years. The attorney for the plaintiff’s estate argues that the lost income should be discounted back to the present at 4 percent. The lawyer for the defendant’s insurance company argues for a discount rate of 9 percent.

What is the difference between the present value of the settlement at 4 percent and 9 percent? Compute each one separately. Use Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods. (Do not round intermediate calculations. Round your answers to 2 decimal places.)

Present Value

PV at 4% rate

$

PV at 9% rate

Difference

$

13.

value: 1.00 points

The Goodsmith Charitable Foundation, which is tax-exempt, issued debt last year at 13 percent to help finance a new playground facility in Los Angeles. This year the cost of debt is 20 percent higher; that is, firms that paid 15 percent for debt last year will be paying 18.00 percent this year.

a.

If the Goodsmith Charitable Foundation borrowed money this year, what would the aftertax cost of debt be, based on their cost last year and the 20 percent increase? (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Aftertax cost of debt

%

b.

If the receipts of the foundation were found to be taxable by the IRS (at a rate of 20 percent because of involvement in political activities), what would the aftertax cost of debt be? (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Aftertax cost of debt

%

14.

value: 1.00 points

Airborne Airlines Inc. has a $1,000 par value bond outstanding with 20 years to maturity. The bond carries an annual interest payment of $96 and is currently selling for $960. Airborne is in a 40 percent tax bracket. The firm wishes to know what the aftertax cost of a new bond issue is likely to be. The yield to maturity on the new issue will be the same as the yield to maturity on the old issue because the risk and maturity date will be similar.

a.

Compute the yield to maturity on the old issue and use this as the yield for the new issue. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Yield on new issue

%

b.

Make the appropriate tax adjustment to determine the aftertax cost of debt. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Aftertax cost of debt

%

15.

value: 1.00 points

Terrier Company is in a 35 percent tax bracket and has a bond outstanding that yields 9 percent to maturity.

a.

What is Terrier’s aftertax cost of debt? (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Aftertax cost of debt

%

b.

Assume that the yield on the bond goes down by 1 percentage point, and due to tax reform, the corporate tax rate falls to 20 percent. What is Terrier’s new aftertax cost of debt? (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Aftertax cost of debt

%

c.

Has the aftertax cost of debt gone up or down from part a to part b?

It has gone up

It has gone down

16.

value: 2.00 points

KeySpan Corp. is planning to issue debt that will mature in 2035. In many respects, the issue is similar to the currently outstanding debt of the corporation. Use Table 11-3.

a.

Calculate the yield to maturity on similarly outstanding debt for the firm, in terms of maturity. (Input your answer as a percent rounded to 2 decimal places.)

Yield

%

Assume that because the new debt wil be issued at par, the required yield to maturity will be .15 percent higher than the value determined in part a.

b.

What is the new yield to maturity? (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Yield

%

c.

If the firm is in a 30 percent tax bracket, what is the aftertax cost of debt for the yield determined in partb? (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Aftertax cost of debt

%

17.

value: 1.00 points

Wallace Container Company issued $100 par value preferred stock 10 years ago. The stock provided a 7 percent yield at the time of issue. The preferred stock is now selling for $72.

What is the current yield or cost of the preferred stock? (Disregard flotation costs.) (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Current yield

%

18.

value: 2.00 points

The treasurer of Riley Coal Co. is asked to compute the cost of fixed income securities for her corporation. Even before making the calculations, she assumes the aftertax cost of debt is at least 2 percent less than that for preferred stock.

Debt can be issued at a yield of 8.5 percent, and the corporate tax rate is 25 percent. Preferred stock will be priced at $70 and pay a dividend of $5.50. The flotation cost on the preferred stock is $3.

a.

Compute the aftertax cost of debt. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Aftertax cost of debt

%

b.

Compute the aftertax cost of preferred stock. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Aftertax cost of preferred stock

%

c.

Based on the facts given above, is the treasurer correct?

Yes, the treasurer is correct.

No, the treasurer is incorrect.

19.

value: 2.00 points

Compute Ke and Kn under the following circumstances:

a.

D1 = $6.00, P0 = $74, g = 5%, F = $5.00. (Do not round intermediate calculations. Round your answers to 2 decimal places.)

Ke

%

Kn

%

b.

D1 = $.30, P0 = $34, g = 9%, F = $2.50. (Do not round intermediate calculations. Round your answers to 2 decimal places.)

Ke

%

Kn

%

c.

E1 (earnings at the end of period one) = $9, payout ratio equals 20 percent, P0 = $38, g = 8.0%, F = $3.10. (Do not round intermediate calculations. Round your answers to 2 decimal places.)

Ke

%

Kn

%

d.

D0 (dividend at the beginning of the first period) = $8, growth rate for dividends and earnings (g) = 3%,P0 = $64, F = $2. (Do not round intermediate calculations. Round your answers to 2 decimal places.)

Ke

%

Kn

%

20.

value: 1.00 points

Global Technology’s capital structure is as follows:

Debt

50

%

Preferred stock

35

Common equity

15

The aftertax cost of debt is 8.00 percent; the cost of preferred stock is 12.00 percent; and the cost of common equity (in the form of retained earnings) is 15.00 percent.

Calculate the Global Technology’s weighted cost of each source of capital and the weighted average cost of capital. (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)

Weighted Cost

Debt (Kd)

%

Preferred stock (Kp)

Common equity (Ke)

Weighted average cost of capital (Ka)

%

21.

value: 2.00 points

Sauer Milk Inc. wants to determine the minimum cost of capital point for the firm. Assume it is considering the following financial plans:

Cost (aftertax)

Weights

Plan A

Debt

6.0

%

25

%

Preferred stock

12.0

15

Common equity

16.0

60

Plan B

Debt

6.2

%

35

%

Preferred stock

12.2

15

Common equity

17.0

50

Plan C

Debt

7.0

%

45

%

Preferred stock

11.7

15

Common equity

7.6

40

Plan D

Debt

7.0

%

55

%

Preferred stock

12.6

15

Common equity

9.8

30

a-1.

Compute the weighted average cost for four plans. (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)

Weighted Cost

Plan A

%

Plan B

%

Plan C

%

Plan D

%

a-2.

Which of the four plans has the lowest weighted average cost of capital?

Plan A

Plan B

Plan C

Plan D

b.

What is the relationship between the various types of financing costs and the debt-to-equity ratio?

All types of financing costs increase as the debt-to-equity ratio increases.

All types of financing costs decrease as the debt-to-equity ratio increases.

22.

value: 2.00 points

A-Rod Manufacturing Company is trying to calculate its cost of capital for use in making a capital budgeting decision. Mr.Jeter, the vice-president of finance, has given you the following information and has asked you to compute the weighted average cost of capital.

The company currently has outstanding a bond with a 9.7 percent coupon rate and another bond with an 7.3 percent rate. The firm has been informed by its investment banker that bonds of equal risk and credit rating are now selling to yield 10.6 percent. The common stock has a price of $51 and an expected dividend (D1) of $1.71 per share. The historical growth pattern (g) for dividends is as follows:

$1.26

1.40

1.55

1.71

The preferred stock is selling at $71 per share and pays a dividend of $6.70 per share. The corporate tax rate is 30 percent. The flotation cost is 3.0 percent of the selling price for preferred stock. The optimum capital structure for the firm is 25 percent debt, 20 percent preferred stock, and 55 percent common equity in the form of retained earnings.

a.

Compute the historical growth rate. (Do not round intermediate calculations. Round your answer to the nearest whole percent and use this value as g. Input your answer as a whole percent.)

Growth rate

%

b.

Compute the cost of capital for the individual components in the capital structure. (Use the rounded whole percent computed in part a for g. Do not round any other intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)

Cost of Capital

Debt (Kd)

%

Preferred stock (Kp)

Common equity (Ke)

c.

Calculate the weighted cost of each source of capital and the weighted average cost of capital. (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)

Weighted Cost

Debt (Kd)

%

Preferred stock (Kp)

Common equity (Ke)

Weighted average cost of capital (Ka)

%

23.

value: 2.00 points

Northwest Utility Company faces increasing needs for capital. Fortunately, it has an Aa3 credit rating. The corporate tax rate is 40 percent. Northwest’s treasurer is trying to determine the corporation’s current weighted average cost of capital in order to assess the profitability of capital budgeting projects.

Historically, the corporation’s earnings and dividends per share have increased about 6.4 percent annually and this should continue in the future. Northwest’s common stock is selling at $73 per share, and the company will pay a $4.60 per share dividend (D1).

The company’s $114 preferred stock has been yielding 10 percent in the current market. Flotation costs for the company have been estimated by its investment banker to be $8.00 for preferred stock.

The company’s optimum capital structure is 60 percent debt, 25 percent preferred stock, and 15 percent common equity in the form of retained earnings. Refer to the following table on bond issues for comparative yields on bonds of equal risk to Northwest.

Data on Bond Issues

Issue

Moody’s Rating

Price

Yield to Maturity

Utilities:

Southwest electric power––7 1/4 2023

Aa2

$

940.18

8.35

%

Pacific bell––7 3/8 2025

Aa3

900.25

8.88

Pennsylvania power & light––8 1/2 2022

A2

970.66

8.88

Industrials:

Johnson & Johnson––6 3/4 2023

Aaa

890.24

8.66

%

Dillard’s Department Stores––7 3/8 2023

A2

950.92

8.66

Marriott Corp.––10 2015

B2

1,080.10

9.55

a.

Compute the cost of debt, Kd (use the accompanying table—relate to the utility bond credit rating for yield.) (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Cost of debt

%

b.

Compute the cost of preferred stock, Kp. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Cost of preferred stock

%

c.

Compute the cost of common equity in the form of retained earnings, Ke. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Cost of common equity

%

d.

Calculate the weighted cost of each source of capital and the weighted average cost of capital. (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)

Weighted Cost

Debt (Kd)

%

Preferred stock (Kp)

Common equity (Ke)

Weighted average cost of capital (Ka)

%

24.

value: 2.00 points

Delta Corporation has the following capital structure:

Cost (aftertax)

Weights

Weighted Cost

Debt (Kd)

6.1

%

30

%

1.83

%

Preferred stock (Kp)

7.6

20

1.52

Common equity (Ke) (retained earnings)

13.1

50

6.55

Weighted average cost of capital (Ka)

9.90

%

a.

If the firm has $23 million in retained earnings, at what size capital structure will the firm run out of retained earnings? (Enter your answer in millions of dollars (e.g., $10 million should be entered as "10").)

Capital structure size (X)

$ million

b.

The 6.1 percent cost of debt referred to earlier applies only to the first $6 million of debt. After that, the cost of debt will go up. At what size capital structure will there be a change in the cost of debt? (Enter your answer in millions of dollars (e.g., $10 million should be entered as "10").)

Capital structure size (Z)

$ million

26.

value: 2.00 points

Eaton Electronic Company’s treasurer uses both the capital asset pricing model and the dividend valuation model to compute the cost of common equity (also referred to as the required rate of return for common equity).

Assume:

Rf

=

8

%

Km

=

13

%

β

=

1.5

D1

=

$.90

P0

=

$16

g

=

9

%

a.

Compute Ki (required rate of return on common equity based on the capital asset pricing model). (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Ki

%

b.

Compute Ke (required rate of return on common equity based on the dividend valuation model). (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)