Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case, the appropriate marginal cost of capital for use in capital budgeting during the current year is the WACC. True or False

Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case, the appropriate marginal cost of capital for use in capital budgeting during the current year is the WACC. True or False

Financial Reporting, Financial Statement Analysis and Valuation

8th Edition

ISBN:9781285190907

Author:James M. Wahlen, Stephen P. Baginski, Mark Bradshaw

Publisher:James M. Wahlen, Stephen P. Baginski, Mark Bradshaw

Chapter12: Valuation: Cash-flow Based Approaches

Section: Chapter Questions

Problem 6QE: Suppose you are valuing a healthy, growing, profitable firm and you project that the firm will...

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(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.
The financial manager of a large national firm was overheard making the following statement: 'We try to use as much retained earnings as possible for capital budgeting purposes because there is no explicit cost to these funds, and this allows us to invest in relatively low yielding projects that would not be feasible if we had to use new common stock. We actually use retained earnings to invest in projects with yields below the coupon rate on our bonds." Comment on the validity of this statement from your point of view.
Suppose you are the president of a large corporation located in Seattle, Washington. How do you think the stockholders will react if you decide to increase the proportion of the company’s assets that is financed with debt from 35 percent to 50 percent? In other words, what if the firm used much more debt to finance its assets?
WorldTrans is a family owned concern. It has been using the residual dividend model, but family members who hold a majority of the stock want more cash dividends, even if that means a slower future growth rate. Neither the net income nor the capital structure will change during the coming year as a result of a dividend policy change to the indicated target payout ratio. By how much would the capital budget have to be cut to enable the firm to achieve the new target dividend payout ratio? Do not round intermediate calculations. % Debt 45% % Equity = 1.0 – % Debt 55% Capital budget under the residual dividend model $5,000,000 Net income; it will not change this year even if dividends increase $3,500,000 Equity to support the capital budget = % Equity × Capital budget $2,750,000 Dividends paid = NI – Equity needed $750,000 Currently projected dividend payout ratio 21.4% Target dividend payout ratio 43% Group of answer choices -$1,249,182…
Kosm Limited has hired you on as a consultant to assist with their capital budgeting. Their target capital structure is 40% debt, 10% preferred stock, and 50% common equity. The interest rate on new debt is 6.25%, the yield on the preferred stock is 7.00%, the cost of retained earnings is 10.75%, and the tax rate is 21%. The company will not be issuing any new stock. What is their WACC?
The WACC is a weighted average of the costs of debt, preferred stock, and common equity.Would the WACC be different if the equity for the coming year came solely in the form ofretained earnings versus some equity from the sale of new common stock? Would the calculatedWACC depend in any way on the size of the capital budget? How might dividendpolicy affect the WACC?
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?
For firms that have debt on their balance sheets, interest expense is commonly seen as an expense on the firm's income statement. In capital budgeting, however, we ignore interest expense. Why? Group of answer choices A) Because the cost of debt is already included in the WACC, and including interest expense in the calculation of cash flows would then be "double counting" it. B) Capital budgeting is done from the perspective of the common stockholders, so it ignores interest expense (Wrong Choice) C) Like depreciation, interest expense is a "non-cash" expense D) Because firms ignore the pleas of banks and bondholders to pay their interest. This is why Silicon Valley Bank failed.
You work in the corporate finance division of The Home Depot and your boss has asked you toreview the firm’s capital structure. Specifically, your boss is considering changing the firm’s debtlevel. Your boss remembers something from his MBA program about capital structure beingirrelevant, but isn’t quite sure what that means. You know that capital structure is irrelevant underthe conditions of perfect markets and will demonstrate this point for your boss by showing thatthe weighted average cost of capital remains constant under various levels of debt. Income StatementsTotal Revenue $70,395,000Cost of Revenue $46,133,000Gross Profit $24,262,000Operating ExpensesSales, General and Admin. $16,028,000Other Operating Items $1,573,000Operating Income $6,661,000Add'l income/expense items $13,000Earnings Before Interest and Tax $6,674,000Interest Expense $606,000Earnings Before Tax $6,068,000Income Tax $2,185,000Net Income-Cont. Operations $3,883,000Net Income $3,883,000Net Income Applicable…
For firms that have debt on their balance sheets, interest expense is commonly seen as an expense on the firm's income statement. In capital budgeting, however, we ignore interest expense. Why? Group of answer choices A) Because the cost of debt is already included in the WACC, and including interest expense in the calculation of cash flows would then be "double counting" it. B) Capital budgeting is done from the perspective of the common stockholders, so it ignores interest expense C) Like depreciation, interest expense is a "non-cash" expense D) Because firms ignore the pleas of banks and bondholders to pay their interest. This is why Silicon Valley Bank failed.
Quinlan Electrical has quite a few positive NPV projects from which to choose. The problem is that it has more of these projects than it can finance without issuing new stock and the board of directors refuses to issue any new shares in the foreseeable future. Quinlan's projected net income is $150.0 million, its target capital structure is 25% debt and 75% equity, and its target payout ratio is 65%. The CFO now wants to determine how the maximum capital budget would be affected by changes in capital structure policy and/or the target dividend payout policy. Versus the current policy, how much larger could the capital budget be if (1) the target debt ratio were raised to 75%, other things held constant, (2) the target payout ratio were lowered to 20%, other things held constant, and (3) the debt ratio and payout were both changed by the indicated amounts.
The WACC is a weighted average of the costs of debt, preferred stock, and common equity. Would the WACC be different if the equity for the coming year came solely in the form of retained earnings versus some equity from the sale of new common stock? Would the calculated WACC depend in any way on the size of the capital budget?