Corporate Finance - Corporate Finance Section 2
| 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 |
- Option : A
- Explanation : 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%
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- Option : B
- Explanation : 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.
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- Option : B
- Explanation : 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%.
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19. Which of the following statements is most likely true?
- A
The investment opportunity schedule, for a given company, is upward sloping because as a company invests more in capital projects, the returns from investing keep on increasing.
- B
In order to determine the after-tax cost of debt, the appropriate tax rate to use is the average rate.
- C
The after-tax debt cost, for a given company, is generally less than both the cost of preferred equity and the cost of common equity.
- Option : C
- Explanation : 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.
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20. Which of the following components of WACC is affected by taxes?
- Option : B
- Explanation : Interest is tax deductible and it provides tax savings which lowers the cost of debt.
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