has made the decision to finance next year’s capital projects through debt rather than additional equity. The benchmark cost of capital for these projects should be the WACC rather than the after tax cost of debt. [S2] The general rule for using the WACC in long term investment decisions is to accept all projects with rates of return greater than or equal to the WACC. a. both are true b. both are false c. S1 is true

has made the decision to finance next year’s capital projects through debt rather than additional equity. The benchmark cost of capital for these projects should be the WACC rather than the after tax cost of debt. [S2] The general rule for using the WACC in long term investment decisions is to accept all projects with rates of return greater than or equal to the WACC. a. both are true b. both are false c. S1 is true

Intermediate Financial Management (MindTap Course List)

13th Edition

ISBN:9781337395083

Author:Eugene F. Brigham, Phillip R. Daves

Publisher:Eugene F. Brigham, Phillip R. Daves

Chapter16: Capital Structure Decisions

Section: Chapter Questions

Problem 11P: WACC and Optimal Capital Structure F. Pierce Products Inc. is considering changing its capital...

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Which of the following statements is CORRECT? Group of answer choices Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes. If a company assigns the same cost of capital to all of its projects regardless of each project’s risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject. Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt. Higher flotation costs tend to reduce the cost of equity capital.
(a) What is the unlevered cost of capital? What is the (post-tax) weighted average cost of capital? [SHOW YOUR WORKING] (b) Should the firm do the project? (Yes/No). How much firm increases in value thanks to the new project? [SHOW YOUR WORKING] (c) What is the debt capacity for the new project in year 0? [SHOW YOUR WORKING]
How should the capital structure weights used to calculate the WACC be determined? Suppose a firm estimates its WACC to be 10%. Should the WACC be used to evaluate all of its potential projects, even if they vary in risk? If not, what might be “reasonable” costs of capital for average-, high-, and low-risk projects? If Congress increased the personal tax rate on interest, dividends, and capital gains but simultaneously reduced the rate on corporate income, what effect would this have on the average company’s capital structure? If a firm goes from zero debt to successively higher levels of debt, why would you expect its stock price to rise first, then hit a peak, and then begin to decline?
Suppose a firm estimates its WACC to be 10%. Should the WACC be used to evaluate all of its potential projects, even if they vary in risk? If not, what might be “reasonable” costs of capital for average-, high-, and low-risk projects? If Congress increased the personal tax rate on interest, dividends, and capital gains but simultaneously reduced the rate on corporate income, what effect would this have on the average company’s capital structure? If a firm goes from zero debt to successively higher levels of debt, why would you expect its stock price to rise first, then hit a peak, and then begin to decline?
1. In the context of capital budgeting, what is an opportunity cost?2. Given the choice, would a firm prefer to use MACRS depreciation or straight-line depreciation? Why?3. In our capital budgeting examples, we assumed that a firm would recover all of the working capital it invested in a project. Is this a reasonable assumption? When might it not be valid?4. Suppose a financial manager is quoted as saying, “Our firm uses the stand-alone principle. Because we treat projects like minifirms in our evaluation process, we include financing costs because they are relevant at the firm level.” Critically evaluate this statement.
Which of the following statements are incorrect regarding how much debt a company should borrow? Choose all that apply. Question 9 options: A As long as the company can generate higher returns on its new projects than its borrowing interest rate, borrowing more debt will enhance the company's ROE. B Borrowing more debt will increase a company's distress level. C The bigger the company, the more it should borrow D Debt is considered a more expensive capital source.
(a) Identify and briefly describe two phases of the capital budgeting process. (b) Would saving time by skipping one of these phases in the capital budgeting process make sense financially? Financially, why would a company: (a) increase its dividend; (b) buy back some of its common stock shares; (c) pay down some of its debt; (d) increase its use of internal financing; (e) take the public firm private? Explain how a company could: (a) avoid a backlog of orders when sales exceed expectations; (b) avoid product defects on new products; (c) offer more credit to its customers when it already has a bad debt problem; (d) improve its credit rating with suppliers after paying some late; (e) lower its cost of financing when the market interest rate has increased. FE5 Describe a business practice that would help a company manage each of the following financial risks: (a) liquidity risk; (b) interest rate risk; c) credit risk.
8.4 Richmond Clinic has obtained the following estimates for its costs of debt and equity at various capital structures: Debt (%) After-Tax Cost of Debt (%) Cost of Equity (%) 0 — 16.0 20 6.6 17.0 40 7.8 19.0 60 10.2 22.0 80 14.0 27.0 What is the firm’s optimal capital structure? (Hint: Calculate its corporate cost of capital at each structure. Also, note that data on component costs at alternative capital structures are not reliable in real-world situations)
Finance Companies A and B are each considering an unanticipated new investment opportunity that will marginally increase the value of the company and will also increase the company’s level of diversication. Company A is unlevered, and company B has a capital structure of 50% debt. Assume that the shareholders control the company, which one of the following statements is correct. a) Since NPV of the investment is positive both company A and B will accept the project. b) Since the project only marginally increase company values but decreases return variance of the company’s assets both companies will reject the project. c) It is more obvious that Company B invests since for levered company the diversication benefits are more important. d) None of the given alternative.
8) Which of the following is a key rule for analysing indivisible one-period capital rationing problems? A) Examine all the feasible alternative combinations B) Make tax reduction a primary aim C) Focus on maintaining present value D) Focus on initial outlay
Axon Industries needs to raise $22.41M for a new investment project. If the firm issues one-year debt, it may haveto pay an interest rate of 9.44 %, although Axon's managers believe that 5.51 % would be a fair rate given the level of risk. If the firm issues equity, they believe the equity may be underpriced by 11.26 %. What is the cost to current shareholders of financing the project out of Equity? NOTE: Provide your answers in Millions. E.G. for 100M you must enter 100.0000, for 20M you must enter 20.0000, etc.
KT Enterprises is considering undertaking a new project. Based upon the analysis of firms with similar projects, KT has determined that an unlevered cost of equity of 12% is suitable for their project. KT's marginal tax rate is 35%, its borrowing rate is 7%, and KT does not believe that its borrowing rate will change if the new project is accepted. If KT expects to maintain a debt to equity ratio for this project of .6 then KT's equity cost of capital, rE, for this project is closest to: A. 5.0% B.12% C.15.0% D. 17.0%