Q: Geothermal Inc. has a capital structure of 70% equity and 30% debt. The cost of equity is 14% and the cost of debt is 8%. What is the company's cost of capital (ignoring taxes)?

$$(.3 \times 8\%) + (.7 \times 14\%) = 12.2\%$$

Q: A company has $$D = \200$ million in debt, E$$ = \$$600$$ million in equity, a cost of debt of 7%, a cost of equity of 13%, and a tax rate of 21%. What is its WACC?

$$WACC = \frac{200}{800} \times 7\% \times (1-0.21) + \frac{600}{800} \times 13\% = 1.106\% + 9.75\% = 10.856\%$$

Q: A company has a beta of $$0.85$$, a risk-free rate of $$6\%$$, and a market risk premium of $$7\%. $$What is its cost of equity using CAPM?

$$r_e = 6\% + 0.85 \times 7\% = 6\% + 5.95\% = 11.95\%$$

Q: A company has $$D = \100$ million in debt, E$$ = \$$400$$ million in equity, a cost of debt of 5%, a cost of equity of 12%, and a tax rate of 21%. What is its WACC?

$$WACC = \frac{100}{500} \times 5\% \times (1-0.21) + \frac{400}{500} \times 12\% = 0.2 \times 3.95\% + 0.8 \times 12\% = 0.79\% + 9.6\% = 10.39\%$$

Question 1

Which of the following best describes the Weighted-Average Cost of Capital (WACC)?

Accepted Answer

The average rate of return required by all investors in a firm, weighted by the market value of each type of capital, and adjusted for tax savings on debt.

Question 2

Geothermal Inc. has a capital structure of 70% equity and 30% debt. The cost of equity is 14% and the cost of debt is 8%. What is the company's cost of capital (ignoring taxes)?

Accepted Answer

$$(.3 	imes 8\%) + (.7 	imes 14\%) = 12.2\%$$

Question 3

Which formula correctly calculates the after-tax cost of debt for WACC purposes?

Accepted Answer

$$r_{debt} 	imes (1 - T_c)$$

Question 4

A company has $$D = \200$ million in debt, E$$ = \$$600$$ million in equity, a cost of debt of 7%, a cost of equity of 13%, and a tax rate of 21%. What is its WACC?

Accepted Answer

$$WACC = \frac{200}{800} 	imes 7\% 	imes (1-0.21) + \frac{600}{800} 	imes 13\% = 1.106\% + 9.75\% = 10.856\%$$

Question 5

Why is it important to use market values rather than book values when estimating WACC?

Accepted Answer

Market values reflect the current value of securities and the true opportunity cost to investors, while book values may be outdated and not represent actual market conditions.

Question 6

A firm has issued $$4$$ million in debt (6% required return), $$2$$ million in preferred stock (12% required return), and $$6$$ million in common equity (18% required return). What is the WACC?

Accepted Answer

Question 7

If a firm's cost of equity is estimated using the CAPM, which formula should be used?

Accepted Answer

$$r_e = r_f + \beta (r_m - r_f)$$

Question 8

A company has a beta of $$0.85$$, a risk-free rate of $$6\%$$, and a market risk premium of $$7\%. $$What is its cost of equity using CAPM?

Accepted Answer

$$r_e = 6\% + 0.85 	imes 7\% = 6\% + 5.95\% = 11.95\%$$

Question 9

Which of the following is a correct interpretation of WACC?

Accepted Answer

WACC is the appropriate discount rate for projects that are carbon copies of the firm's existing business.

Question 10

When valuing a business for purchase, which cash flow should be used as the theoretical basis for present value calculations?

Accepted Answer

Free Cash Flows (FCF)

Question 11

A company has $$D = \100$ million in debt, E$$ = \$$400$$ million in equity, a cost of debt of 5%, a cost of equity of 12%, and a tax rate of 21%. What is its WACC?

Accepted Answer

$$WACC = \frac{100}{500} 	imes 5\% 	imes (1-0.21) + \frac{400}{500} 	imes 12\% = 0.2 	imes 3.95\% + 0.8 	imes 12\% = 0.79\% + 9.6\% = 10.39\%$$

Question 12

Which of the following is NOT a step in calculating the cost of capital?

Accepted Answer

Use the book value of securities to estimate proportions.

Question 13

A firm is considering increasing its debt financing. What are the two main costs associated with this decision?

Accepted Answer

Explicit cost: higher interest rates; Implicit cost: higher required return on equity due to increased risk.

Question 14

Which formula is used to calculate the horizon (terminal) value of a business using perpetuity growth?

Accepted Answer

$$PV_{horizon} = \frac{FCF_{horizon}}{WACC - g}$$

Question 15

If a firm's long-term bonds pay an 8% coupon and mature in 10 years, what is their market value assuming a 9% yield to maturity (YTM)?

Accepted Answer

The market value is the present value of all coupons and par value discounted at 9%.

Question 16

Which of the following statements about the cost of preferred stock is correct?

Accepted Answer

The cost of preferred stock is calculated as the preferred dividend divided by the price of preferred stock: $$r_{preferred} = \frac{Div_{preferred}}{P_{preferred}}$$

Question 17

A business has a capital structure of 60% equity and 40% debt. The required rate of return on equity is 12%, the interest rate on debt is 5%, and the tax rate is 21%. What is the WACC?

Accepted Answer

$$WACC = 0.4 	imes 5\% 	imes (1-0.21) + 0.6 	imes 12\% = 1.58\% + 7.2\% = 8.78\%$$

Question 18

Which of the following is a reason why the market price of a business may not always reflect the present value of its free cash flows?

Accepted Answer

Market prices can be influenced by investor sentiment, temporary market conditions, or incomplete information, leading to deviations from theoretical value.

Weighted-Average Cost of Capital (WACC) and Business Valuation: Study Notes

Study Guide - Practice Questions

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