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1. Bankston Corporation forecasts
that if all of its existing financial policies are followed, its proposed
capital budget would be so large that it would have to issue new common stock.
Since new stock has a higher cost than retained earnings, Bankston would like
to avoid issuing new stock. Which of the following actions would REDUCE its
need to issue new common stock?
a. Increase the dividend payout
ratio for the upcoming year.
b. Increase the percentage of
debt in the target capital structure.
c. Increase the proposed capital
budget.
d. Reduce the amount of
short-term bank debt in order to increase the current ratio.
e. Reduce the percentage of debt
in the target capital structure.
2. LaPango Inc. estimates that
its average-risk projects have a WACC of 10%, its below-average risk projects
have a WACC of 8%, and its above-average risk projects have a WACC of 12%.
Which of the following projects (A, B, and C) should the company accept?
a. Project B, which is of
below-average risk and has a return of 8.5%.
b. Project C, which is of
above-average risk and has a return of 11%.
c. Project A, which is of average
risk and has a return of 9%.
d. None of the projects should be
accepted.
e. All of the projects should be
accepted.
3. Which of the following
statements is CORRECT?
a. When calculating the cost of
preferred stock, a company needs to adjust for taxes, because preferred stock
dividends are deductible by the paying corporation.
b. All else equal, an increase in
a company’s stock price will increase its marginal cost of retained earnings,
rs.
c. All else equal, an increase in
a company’s stock price will increase its marginal cost of new common equity,
re.
d. Since the money is readily
available, the after-tax cost of retained earnings is usually much lower than
the after-tax cost of debt.
e. If a company’s tax rate
increases but the YTM on its noncallable bonds remains the same, the after-tax
cost of its debt will fall.
4. Which of the following
statements is CORRECT?
a. 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.
b. The tax-adjusted cost of debt
is always greater than the interest rate on debt, provided the company does in
fact pay taxes.
c. 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.
d. 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.
e. Higher flotation costs tend to
reduce the cost of equity capital.
5. Cranberry Corp. has two
divisions of equal size: a computer manufacturing division and a data
processing division. Its CFO believes that stand-alone data processor companies
typically have a WACC of 8%, while stand-alone computer manufacturers typically
have a 12% WACC. He also believes that the data processing and manufacturing
divisions have the same risk as their typical peers. Consequently, he estimates
that the composite, or corporate, WACC is 10%. A consultant has suggested using
an 8% hurdle rate for the data processing division and a 12% hurdle rate for
the manufacturing division. However, the CFO disagrees, and he has assigned a
10% WACC to all projects in both divisions. Which of the following statements
is CORRECT?
a. While the decision to use just
one WACC will result in its accepting more projects in the manufacturing
division and fewer projects in its data processing division than if it followed
the consultant’s recommendation, this should not affect the firm’s intrinsic
value.
b. The decision not to adjust for
risk means, in effect, that it is favoring the data processing division.
Therefore, that division is likely to become a larger part of the consolidated
company over time.
c. The decision not to adjust for
risk means that the company will accept too many projects in the manufacturing
division and too few in the data processing division. This will lead to a
reduction in the firm’s intrinsic value over time.
d. The decision not to
risk-adjust means that the company will accept too many projects in the data
processing business and too few projects in the manufacturing business. This
will lead to a reduction in its intrinsic value over time.
e. The decision not to risk adjust means that the
company will accept too many projects in the manufacturing business and too few
projects in the data processing business. This may affect the firm’s capital
structure but it will not affect its intrinsic value
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