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5/26/2018 Problem Set_ Cost of Capital
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1Copyright 2014 Pearson Education, Inc.
The Cost of Capital
The Equity Cost of Capital
Use the following information to answer the question(s) below.
Beta Volatility
"Eenie" 0.45 20%
"Meenie" 0.75 18%
"Miney" 1.05 35%
"Moe" 1.20 25%
Assume that the risk-free rate of interest is 3% and you estimate the market's expected return tobe 9%.
1) Which firm has the most total risk?A) EenieB) MeenieC) MineyD) MoeAnswer: CExplanation: C) Total risk is measured using volatility and Miney has the highest volatility,hence the most total risk.Diff: 1Section: 12.1 The Equity Cost of CapitalSkill: Analytical
2) Which firm has the least market risk?A) EenieB) MeenieC) MineyD) MoeAnswer: AExplanation: A) Market risk is measured using beta and Eenie has the lowest beta, hence thelowest market risk.Diff: 1Section: 12.1 The Equity Cost of Capital
Skill: Analytical
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2Copyright 2014 Pearson Education, Inc.
3) Which firm has the highest cost of equity capital?A) EenieB) MeenieC) MineyD) Moe
Answer: DExplanation: D) Cost of capital is measured using the CAPM and is a linear function of beta.Therefore the firm with the highest beta (Moe) has the highest cost of equity capital.Diff: 1Section: 12.1 The Equity Cost of CapitalSkill: Analytical
4) The equity cost of capital for "Miney" is closest to:A) 6.30%B) 7.50%C) 9.30%D) 9.75%Answer: CExplanation: C) rMiney= 3% + 1.05(9% - 3%) = 9.3%
Diff: 1Section: 12.1 The Equity Cost of CapitalSkill: Analytical
5) The equity cost of capital for "Meenie" is closest to:A) 4.50%B) 7.50%C) 9.30%
D) 9.75%Answer: BExplanation: B) rMeenie= 3% + 0.75(9% - 3%) = 7.5%
Diff: 1Section: 12.1 The Equity Cost of CapitalSkill: Analytical
6) The risk premium for "Meenie" is closest to:A) 4.50%B) 7.50%C) 9.30%
D) 9.75%Answer: AExplanation: A) risk premiumMeenie= 0.75(9% - 3%) = 4.5%
Diff: 2Section: 12.1 The Equity Cost of CapitalSkill: Analytical
5/26/2018 Problem Set_ Cost of Capital
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3Copyright 2014 Pearson Education, Inc.
Beta Estimation
Use the following information to answer the question(s) below.
YearRisk-freeReturn
MarketReturn
Wyatt OilReturn
Market
ExcessReturn
Wyatt Oil
ExcessReturn Beta
2007 3.0% 6.0% 5.5% 3.0% 2.5% 0.833
2008 1.5% -38.5% -32.6% .40% -34.1% 0.853
2009 1.0% 22.5% 19.6% 21.5% 18.6% 0.865
1) Wyatt Oil's average historical return is closest to:A) -2.50%B) -3.33%C) -4.33%D) -5.17%
Answer: A
Explanation: A) raverage=
Year
Risk-free
Return
Market
Return
Wyatt Oil
Return
Market
Excess
Return
Wyatt Oil
Excess
Return
2007 3.0% 6.0% 5.5% 3.0% 2.5%
2008 1.5% -38.5% -32.6% -40.0% -34.1%
2009 1.0% 22.5% 19.6% 21.5% 18.6%
Average 1.83% -3.33% -2.50% -5.17% -4.33%
Diff: 1
Section: 12.3 Beta EstimationSkill: Analytical
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4Copyright 2014 Pearson Education, Inc.
2) The Market's average historical return is closest to:A) -2.50%B) -3.33%C) -4.33%D) -5.17%
Answer: BExplanation: B) raverage=
Year
Risk-free
Return
Market
Return
Wyatt Oil
Return
Market
Excess
Return
Wyatt Oil
Excess
Return
2007 3.0% 6.0% 5.5% 3.0% 2.5%
2008 1.5% -38.5% -32.6% -40.0% -34.1%
2009 1.0% 22.5% 19.6% 21.5% 18.6%
Average 1.83% -3.33% -2.50% -5.17% -4.33%
Diff: 1
Section: 12.3 Beta EstimationSkill: Analytical
3) Wyatt Oil's average historical excess return is closest to:A) -2.50%B) -3.33%C) -4.33%D) -5.17%Answer: C
Explanation: C) excess returnaverage=
Year
Risk-free
Return
Market
Return
Wyatt Oil
Return
MarketExcess
Return
Wyatt OilExcess
Return
2007 3.0% 6.0% 5.5% 3.0% 2.5%
2008 1.5% -38.5% -32.6% -40.0% -34.1%
2009 1.0% 22.5% 19.6% 21.5% 18.6%
Average 1.83% -3.33% -2.50% -5.17% -4.33%
Diff: 2Section: 12.3 Beta EstimationSkill: Analytical
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5Copyright 2014 Pearson Education, Inc.
4) The Market's average historical excess return is closest to:A) -2.50%B) -3.33%C) -4.33%D) -5.17%
Answer: DExplanation: D) excess returnaverage=
Year
Risk-free
Return
Market
Return
Wyatt Oil
Return
Market
Excess
Return
Wyatt
Oil
Excess
Return
2007 3.0% 6.0% 5.5% 3.0% 2.5%
2008 1.5% -38.5% -32.6% -40.0% -34.1%
2009 1.0% 22.5% 19.6% 21.5% 18.6%
Average 1.83% -3.33% -2.50% -5.17% -4.33%
Diff: 2Section: 12.3 Beta EstimationSkill: Analytical
5) Wyatt Oil's excess return for 2009 is closest to:A) 18.6%B) 19.6%C) 20.0%D) 21.5%Answer: AExplanation: A) excess returne= (rWO- rrf)2009
Year
Risk-free
Return
Market
Return
Wyatt Oil
Return
Market
Excess
Return
Wyatt
Oil
Excess
Return
2007 3.0% 6.0% 5.5% 3.0% 2.5%
2008 1.5% -38.5% -32.6% -40.0% -34.1%
2009 1.0% 22.5% 19.6% 21.5% 18.6%
Average 1.83% -3.33% -2.50% -5.17% -4.33%
Diff: 1Section: 12.3 Beta EstimationSkill: Analytical
5/26/2018 Problem Set_ Cost of Capital
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6Copyright 2014 Pearson Education, Inc.
6) The Market's excess return for 2008 is closest to:A) -40.0%B) -38.5%C) -37.0%D) -34.1%
Answer: AExplanation: A) excess returne= (rWO- rrf)2009
Year
Risk-free
Return
Market
Return
Wyatt Oil
Return
Market
Excess
Return
Wyatt Oil
Excess
Return
2007 3.0% 6.0% 5.5% 3.0% 2.5%
2008 1.5% -38.5% -32.6% -40.0% -34.1%
2009 1.0% 22.5% 19.6% 21.5% 18.6%
Average 1.83% -3.33% -2.50% -5.17% -4.33%
Diff: 1
Section: 12.3 Beta EstimationSkill: Analytical
7) Using just the return data for 2009, your estimate of Wyatt Oil's Beta is closest to:A) 0.84B) 0.87C) 1.00D) 1.16Answer: BExplanation: B)
Year
Risk-free
Return
Market
Return
Wyatt Oil
Return
MarketExcess
Return
Wyatt OilExcess
Return
2007 3.0% 6.0% 5.5% 3.0% 2.5%
2008 1.5% -38.5% -32.6% -40.0% -34.1%
2009 1.0% 22.5% 19.6% 21.5% 18.6%
Average 1.83% -3.33% -2.50% -5.17% -4.33%
WO = = = .8651
Diff: 2Section: 12.3 Beta EstimationSkill: Analytical
8) Using just the return data for 2008, your estimate of Wyatt Oil's Beta is closest to:A) 0.85B) 0.87C) 1.00D) 1.17Answer: A
5/26/2018 Problem Set_ Cost of Capital
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7Copyright 2014 Pearson Education, Inc.
Explanation: A)
Year
Risk-free
Return
Market
Return
Wyatt Oil
Return
Market
Excess
Return
Wyatt Oil
Excess
Return
2007 3.0% 6.0% 5.5% 3.0% 2.5%
2008 1.5% -38.5% -32.6% -40.0% -34.1%2009 1.0% 22.5% 19.6% 21.5% 18.6%
Average 1.83% -3.33% -2.50% -5.17% -4.33%
WO = - = .8525
Diff: 2Section: 12.3 Beta EstimationSkill: Analytical
13) Which of the following statements is FALSE?
A) Securities that tend to move more than the market have betas higher than 0.B) Securities whose returns tend to move in tandem with the market on average have a beta of 1.C) Beta corresponds to the slope of the best fitting line in the plot of the securities excess returnsversus the market excess return.D) The statistical technique that identifies the bets-fitting line through a set of points is calledlinear regression.Answer: ADiff: 2Section: 12.3 Beta EstimationSkill: Conceptual
The Debt Cost of Capital
Use the following information to answer the question(s) below.
Consider the following information regarding corporate bonds:
Rating AAA AA A BBB BB B CCC
Average Default Rate 0.0% 0.1% 0.2% 0.5% 2.2% 5.5% 12.2%
Recession Default Rate 0.0% 1.0% 3.0% 3.0% 8.0% 16.0% 48.0%
Average Beta 0.05 0.05 0.05 0.10 0.17 0.26 0.31
1) Wyatt Oil has a bond issue outstanding with seven years to maturity, a yield to maturity of7.0%, and a BBB rating. The corresponding risk-free rate is 3% and the market risk premium is5%. Assuming a normal economy, the expected return on Wyatt Oil's debt is closest to:A) 3.0%B) 3.5%C) 4.9%D) 5.5%Answer: B
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8Copyright 2014 Pearson Education, Inc.
Explanation: B) rd= rrf+ (rm- rrf) = 3% + 0.1(5%) = 3.5%
Diff: 1Section: 12.4 The Debt Cost of CapitalSkill: Analytical
2) Wyatt Oil has a bond issue outstanding with seven years to maturity, a yield to maturity of7.0%, and a BBB rating. The bondholders' expected loss rate in the event of default is 70%.Assuming a normal economy the expected return on Wyatt Oil's debt is closest to:A) 3.0%B) 3.5%C) 4.9%D) 6.7%Answer: DExplanation: D) rd= ytm - prob(default) loss rate = 7% - 0.4%(70%) = 6.72%
Diff: 2Section: 12.4 The Debt Cost of Capital
Skill: Analytical
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9Copyright 2014 Pearson Education, Inc.
3) Wyatt Oil has a bond issue outstanding with seven years to maturity, a yield to maturity of7.0%, and a BBB rating. The bondholders' expected loss rate in the event of default is 70%.Assuming the economy is in recession, then the expected return on Wyatt Oil's debt is closest to:A) 3.5%B) 4.9%
C) 5.5%D) 7.0%Answer: BExplanation: B) rd= ytm - prob(default) loss rate = 7% - 3.0%(70%) = 4.9%
Diff: 2Section: 12.4 The Debt Cost of CapitalSkill: Analytical
4) Rearden Metal has a bond issue outstanding with ten years to maturity, a yield to maturity of8.6%, and a B rating. The corresponding risk-free rate is 3% and the market risk premium is 6%.Assuming a normal economy, the expected return on Rearden Metal's debt is closest to:
A) 0.6%B) 1.6%C) 4.6%D) 6.0%Answer: CExplanation: C) rd= rrf+ (rm- rrf) = 3% + 0.26(6%) = 4.56%
Diff: 1Section: 12.4 The Debt Cost of CapitalSkill: Analytical
5) Rearden Metal has a bond issue outstanding with ten years to maturity, a yield to maturity of
8.6%, and a B rating. The bondholders expected loss rate in the event of default is 50%.Assuming a normal economy the expected return on Rearden Metal's debt is closest to:A) 0.6%B) 1.6%C) 4.6%D) 6.0%Answer: DExplanation: D) rd= ytm - prob(default) loss rate = 8.6% - 5.2%(50%) = 6.00%
Diff: 2Section: 12.4 The Debt Cost of CapitalSkill: Analytical
5/26/2018 Problem Set_ Cost of Capital
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10Copyright 2014 Pearson Education, Inc.
6) Rearden Metal has a bond issue outstanding with ten years to maturity, a yield to maturity of8.6%, and a B rating. The bondholders expected loss rate in the event of default is 50%.Assuming the economy is in recession, then the expected return on Rearden Metal's debt isclosest to:A) 0.6%
B) 1.6%C) 4.6%D) 6.0%Answer: AExplanation: A) rd= ytm - prob(default) loss rate = 8.6% - 16.0%(50%) = 0.6%
Diff: 2Section: 12.4 The Debt Cost of CapitalSkill: Analytical
7) Nielson Motors plans to issue 10-year bonds that it believes will have an BBB rating.Suppose AAA bonds with the same maturity have a 3.5% yield. Assume that the market risk
premium is 5% and the expected loss rate in the event of default on the bonds is 60%. The yieldthat these bonds will have to pay during average economic times is closest to:A) 3.50%B) 3.75%C) 4.00%D) 5.50%Answer: CExplanation: C) For AAA rd= rrf+ (rm- rrf) = rrf+ 0.05(5%) = 3.5% rrf= 3.25%
For BBB rd= rrf+ (rm- rrf) = 3.25% + 0.10(5%) = 3.75%
rd= ytm -prob(default) loss rate 3.75% = ytm - 0.4%(60%) ytm = 3.99%
Diff: 3
Section: 12.4 The Debt Cost of CapitalSkill: Analytical
8) Nielson Motors plans to issue 10-year bonds that it believes will have an BBB rating.Suppose AAA bonds with the same maturity have a 3.5% yield. Assume that the market riskpremium is 5% and the expected loss rate in the event of default on the bonds is 60%. The yieldthat these bonds will have to pay during a recession is closest to:A) 3.50%B) 3.75%C) 4.00%D) 5.50%
Answer: DExplanation: D) For AAA rd= rrf+ (rm- rrf) = rrf+ 0.05(5%) = 3.5% rrf= 3.25%
For BBB rd= rrf+ (rm- rrf) = 3.25% + 0.10(5%) = 3.75%
rd= ytm -prob(default) loss rate 3.75% = ytm - 3.0%(60%) ytm = 5.55%
Diff: 3Section: 12.4 The Debt Cost of CapitalSkill: Analytical
5/26/2018 Problem Set_ Cost of Capital
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11Copyright 2014 Pearson Education, Inc.
A Project's Cost of Capital
Use the following information to answer the question(s) below.
Consider the following information regarding corporate bonds:
Rating AAA AA A BBB BB B CCC
Average Default Rate 0.0% 0.1% 0.2% 0.45% 2.2% 5.5% 12.2%
Recession Default Rate 0.0% 1.0% 3.0% 3.0% 8.0% 16.0% 48.0%
Average Beta 0.05 0.05 0.05 0.10 0.17 0.26 0.31
Company
Market
Capitalization
($mm)
Total
Enterprise
Value ($mm)
Equity
Beta
Debt
Rating
Taggart Transcontinental $4,500 8,000 1.1 BBB
Rearden Metal $3,800 7,200 1.3 AAA
Wyatt Oil $2,400 3,800 0.9 ANielson Motors $1,500 4,400 1.75 BB
1) Your estimate of the debt beta for Taggart Transcontinental would be:A) 0.05B) 0.10C) 0.17D) 1.00Answer: BExplanation: B) Since Taggart has a rating of BBB, the appropriate debt beta from the table is0.10.
Diff: 1Section: 12.5 A Project's Cost of CapitalSkill: Analytical
2) Your estimate of the debt beta for Nielson Motors would be:A) 0.10B) 0.17C) 1.00D) 1.68Answer: BExplanation: B) Since Nielson has a rating of BB, the appropriate debt beta from the table is
0.17.Diff: 1Section: 12.5 A Project's Cost of CapitalSkill: Analytical
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12Copyright 2014 Pearson Education, Inc.
3) Your estimate of the asset beta for Taggart Transcontinental is closest to:A) 0.42B) 0.59C) 0.66D) 0.71
Answer: CExplanation: C) Since Taggart has a rating of BBB, the appropriate debt beta from the table is0.10.
U= E+ D= 1.1 + 0.10 = 0.6625
Diff: 2Section: 12.5 A Project's Cost of CapitalSkill: Analytical
4) Your estimate of the asset beta for Rearden Metal is closest to:A) 0.42
B) 0.59C) 0.66D) 0.71Answer: DExplanation: D) Since Rearden has a rating of AAA, the appropriate debt beta from the table is0.05.
U= E+ D= 1.3 + 0.05 = 0.709722
Diff: 2Section: 12.5 A Project's Cost of CapitalSkill: Analytical
5) Your estimate of the asset beta for Wyatt Oil is closest to:A) 0.59B) 0.66C) 0.71D) 0.90
Answer: AExplanation: A) Since Wyatt has a rating of A, the appropriate debt beta from the table is 0.05.
U= E+ D= 0.9 + 0.05 = 0.586842
Diff: 2Section: 12.5 A Project's Cost of CapitalSkill: Analytical
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13Copyright 2014 Pearson Education, Inc.
6) Your estimate of the asset beta for Nielson Motors is closest to:A) 0.59B) 0.66C) 0.71D) 1.75
Answer: CExplanation: C) Since Nielson has a rating of BB, the appropriate debt beta from the table is0.17.
U= E+ D= 1.75 + 0.17 = 0.708636
Diff: 2Section: 12.5 A Project's Cost of CapitalSkill: Analytical
7) Suppose that because of the large need for steel in building railroad infrastructure, TaggartTranscontinental and Rearden Metal decide to form into one large conglomerate. Your estimate
of the asset beta for this new conglomerate is closest to:A) 0.42B) 0.59C) 0.66D) 0.68Answer: DExplanation: D) Since Taggart has a rating of BBB, the appropriate debt beta from the table is0.10.
U= E+ D= 1.1 + 0.10 = 0.6625
Since Rearden has a rating of AAA, the appropriate debt beta from the table is 0.05.
U= E+ D= 1.3 + 0.05 = 0.709722
= WTT + WRM
= (0.6625) + (0.709722) = 0.684868
Diff: 2Section: 12.5 A Project's Cost of CapitalSkill: Analytical
5/26/2018 Problem Set_ Cost of Capital
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14Copyright 2014 Pearson Education, Inc.
11) Your firm is planning to invest in a new power generation system. Galt Industries is an allequity firm that specializes in this business. Suppose Galt's equity beta is 0.75, the risk-free rateis 3%, and the market risk premium is 6%. If your firm's project is all equity financed, then yourestimate of your cost of capital is closest to:
A) 5.25%B) 6.00%C) 6.75%D) 7.50%Answer: DExplanation: D) ri= rrf+ (rm- rrf) = .03 + .75(.06) = .075 or 7.5%
Diff: 1Section: 12.5 A Project's Cost of CapitalSkill: Analytical
12) Your firm is planning to invest in a new electrostatic power generation system. Electrostat
Inc is a firm that specializes in this business. Electrostat has a stock price of $25 per share with16 million shares outstanding. Electrostat's equity beta is 1.18. It also has $220 million in debtoutstanding with a debt beta of 0.08. Your estimate of the asset beta for electrostatic powergenerators is closest to:A) 0.76B) 0.79C) 0.93D) 1.10Answer: B
Explanation: B) U= E+ D= 1.18 + 0.08 =
0.789677Diff: 2Section: 12.5 A Project's Cost of CapitalSkill: Analytical
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15Copyright 2014 Pearson Education, Inc.
13) Your firm is planning to invest in a new electrostatic power generation system. ElectrostatInc is a firm that specializes in this business. Electrostat has a stock price of $25 per share with16 million shares outstanding. Electrostat's equity beta is 1.18. It also has $220 million in debtoutstanding with a debt beta of 0.08. If the risk-free rate is 3%, and the market risk premium is6%, then your estimate of your cost of capital for electrostatic power generators is closest to:
A) 7.50%B) 7.75%C) 9.50%D) 10.10%Answer: B
Explanation: D) U= E+ D= 1.18 + 0.08 =
0.789677ri= rrf+ (rm- rrf) = .03 + .789677(.06) = .07738 or 7.74%
Diff: 3Section: 12.5 A Project's Cost of Capital
Skill: Analytical
14) The firm's unlevered (asset) beta is:A) the weighted average of the equity beta and the debt beta.B) the weighted average of the levered beta and the equity beta.C) the debt beta minus the equity beta.D) the unlevered beta minus the cost of capital.Answer: ADiff: 1Section: 12.5 A Project's Cost of CapitalSkill: Definition
15) The firm's unlevered (asset) cost of capital is:A) the weighted average of the equity cost of capital and the debt cost of capital.B) the weighted average of the levered cost of capital and the equity cost of capital.C) the debt cost of capital minus the equity cost of capital.D) the unlevered beta minus the cost of capital.Answer: ADiff: 1Section: 12.5 A Project's Cost of CapitalSkill: Definition
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16Copyright 2014 Pearson Education, Inc.
Project Risk Characteristics and Financing
Use the following information to answer the question(s) below.
Division
Asset
Beta
Next Period's ExpectedFree Cash
Flow ($mm)
ExpectedGrowth
Rate
Oil Exploration 1.4 450 4.0%
Oil Refining 1.1 525 2.5%
Gas & Convenience Stores 0.8 600 3.0%
The risk-free rate of interest is 3% and the market risk premium is 5%.
1) The cost of capital for the oil exploration division is closest to:A) 6.0%
B) 7.0%C) 8.5%D) 10.0%Answer: DExplanation: D) ri= rrf+ (rm- rrf) = .03 + 1.4(.05) = .10 or 10.0%
Diff: 1Section: 12.6 Project Risk Characteristics and FinancingSkill: Analytical
2) The cost of capital for the oil refining division is closest to:A) 6.5%
B) 7.0%C) 8.5%D) 10.0%Answer: CExplanation: C) ri= rrf+ (rm- rrf) = .03 + 1.1(.05) = .085 or 8.5%
Diff: 1Section: 12.6 Project Risk Characteristics and FinancingSkill: Analytical
3) The value of the oil exploration division is closest to:A) $4,500
B) $7,500C) $8,750D) $10,000Answer: BExplanation: B) ri= rrf+ (rm- rrf) = .03 + 1.4(.05) = .10 or 10.0%
V = = = $7,500
Diff: 2Section: 12.6 Project Risk Characteristics and Financing
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17Copyright 2014 Pearson Education, Inc.
Skill: Analytical
4) The value of the gas and convenience store division is closest to:A) $4,500B) $6,000
C) $8,600D) $15,000Answer: DExplanation: D) ri= rrf+ (rm- rrf) = .03 + 0.8(.05) = .07 or 7.0%
V = = = $15,000
Diff: 2Section: 12.6 Project Risk Characteristics and FinancingSkill: Analytical
5) The overall value of Wyatt Oil (in $ millions) is closest to:
A) $25,000B) $18,846C) $31,250D) $15,000Answer: CExplanation: C) Oil Exploration Division:ri= rrf+ (rm- rrf) = .03 + 1.4(.05) = .10 or 10.0%
V = = = $7,500
Oil Refining:ri= rrf+ (rm- rrf) = .03 + 1.1(.05) = .085 or 8.5%
V = = = $8,750
Convenience Store;ri= rrf+ (rm- rrf) = .03 + 0.8(.05) = .07 or 7.0%
V = = = $15,000
Total Value = 7,500 + 8,750 + 15,000 = $31,250Diff: 3Section: 12.6 Project Risk Characteristics and FinancingSkill: Analytical
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18Copyright 2014 Pearson Education, Inc.
6) The overall asset beta for Wyatt Oil is closest to:A) 0.95B) 1.05C) 1.15D) 1.25
Answer: BExplanation: B) Oil Exploration Division:ri= rrf+ (rm- rrf) = .03 + 1.4(.05) = .10 or 10.0%
V = = = $7,500
Oil Refining:ri= rrf+ (rm- rrf) = .03 + 1.1(.05) = .085 or 8.5%
V = = = $8,750
Convenience Store:ri= rrf+ (rm- rrf) = .03 + 0.8(.05) = .07 or 7.0%
V = = = $15,000
Total Value = 7,500 + 8,750 + 15,000 = $31,250
WO= wOEOE+ wOROR+ wCSCS
= (1.4) + (1.1) + (0.8) = 1.028
Diff: 3Section: 12.6 Project Risk Characteristics and FinancingSkill: Analytical
7) The overall cost of capital for Wyatt Oil is closest to:A) 8.1%B) 8.5%C) 8.8%D) 9.3%Answer: AExplanation: A) Oil Exploration Division:ri= rrf+ (rm- rrf) = .03 + 1.4(.05) = .10 or 10.0%
V = = = $7,500
Oil Refining:ri= rrf+ (rm- rrf) = .03 + 1.1(.05) = .085 or 8.5%
V = = = $8,750
Convenience Store:ri= rrf+ (rm- rrf) = .03 + 0.8(.05) = .07 or 7.0%
V = = = $15,000
Total Value = 7,500 + 8,750 + 15,000 = $31,250
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19Copyright 2014 Pearson Education, Inc.
rWO= wOErOE+ wORrOR+ wCSrCS
= (.10) + (.085) + (.07) = .0814
Diff: 3
Section: 12.6 Project Risk Characteristics and FinancingSkill: Analytical
Use the following information to answer the question(s) below.
Luther Industries has 25 million shares outstanding trading at $18 per share. In addition, Lutherhas $150 million in outstanding debt. Suppose Luther's equity cost of capital is 13%, its debt costof capital is 7%, and the corporate tax rate is 40%.
15) Luther's after-tax debt cost of capital is closest to:A) 4.2%B) 5.4%C) 7.0%D) 9.8%Answer: AExplanation: A) Effective after-tax interest rate = r(1 - Tc) = .07(1 - .40) = .042 or 4.2%
Diff: 1Section: 12.6 Project Risk Characteristics and FinancingSkill: Analytical
16) Luther's weighted average cost of capital is closest to:A) 9.8%B) 10.8%C) 11.5%D) 13.0%Answer: B
Explanation: B) rU= rE+ (1 - Tc)
= (13%) + (7%)(1 - .4) = 10.8%
Diff: 1
Section: 12.6 Project Risk Characteristics and FinancingSkill: Analytical