Corporate Finance MCQ - Corporate Finance Section 2

16 An analyst gathers the following data about a company to compute its weighted average cost of capital (WACC).

Before-tax cost of new debt	10 percent
Tax rate	35 percent
D/E	0.6660
Stock price	$30
Next year’s dividend	$2.50
Estimated growth rate	6.5 percent

Using the dividend discount model, the company’s WACC is closest to:

Cost of equity = (D1 / P0 ) + g
= ($2.50 / $30) + 0.065 = 8.3% + 6.5% = 14.8%
Wd = (D/E) / (D/E + 1)= 0.6660 / 1.6660 = 0.40
WACC = [(0.40) (0.10) (1 - 0.35)] + [(0.60) (0.148)] = 11.5%

17 Digital Design Corporation has an after-tax cost of debt capital of 7 percent, a cost of preferred stock of 9 percent, a cost of equity capital of 11 percent, and a weighted average cost of capital of 8.5 percent. In raising additional capital, the company intends to maintain its current capital structure. In order to make a capital - budgeting decision for an average risk project, the relevant cost of capital is:

The best estimate of cost of capital for an average-risk project of a company is the weighted average cost of capital using weights derived from the current capital structure.

18 A firm with a marginal tax rate of 40% has a weighted average cost of capital of 7.11%. The before-tax cost of debt is 6%, and the before-tax cost of equity is 9%. The weight of equity in the firm's capital structure is closest to:

Taxes affect cost of debt only, since interest is tax deductible.
WACC = Wd Rd (1 – t) + We Re,
where Wd + We = 1 7.11 = (1 – We ) * 6 * (1 – 0.4) + We * 9,
We = 65%.

19 Which of the following statements is most likely true?

Generally, debt is less costly than both preferred and common stock. If interest expense is tax deductible, then the cost of debt is further reduced.

20 Which of the following components of WACC is affected by taxes?

Interest is tax deductible and it provides tax savings which lowers the cost of debt.