Corporate Finance - Cost of Capital and Capital Structure

Which of the following statements is correct?

• The appropriate tax rate to use in the adjustment of the before-tax

  cost of debt to determine the after-tax cost of debt is the average tax rate because interest is deductible against the company's entire taxable income.

• For a given company, the after-tax cost of debt is generally less than both

  the cost of preferred equity and the cost of common equity.

• For a given company, the after-tax cost of debt is generally higher than both

  the cost of preferred equity and the cost of common equity.

Turk, Inc. has determined that it could issue $1,000 face value bonds with an 8%

coupon paid semi-annually and a five-year maturity at $900 per bond. If Turk Inc.’s marginal tax rate is 38%, its after-tax cost of debt is closest to:

• 6.2%

• 6.4%

• 6.6%

Brandon Wiene is a financial analyst covering the beverage industry. He is evaluating the impact of DEF Beverage’s new product line of flavored waters. DEF currently has a debt-to- equity ratio of 0.6. The new product line would be financed with $50 million of debt and $100 million of equity. In estimating the valuation impact of this new product line on DEF’s value, Wiene has estimated the equity beta and asset beta of comparable companies. In calculating the equity beta for the product line, Wiene is intending to use DEF's existing capital structure when converting the asset beta into a project beta. Which of the following statements is correct?

• Using DEF’s debt-to-equity ratio of 0.6 is appropriate in calculating the new

  product line’s equity beta

• Using DEF’s debt-to-equity

  ratio of 0.6 is not appropriate; rather, the debt-to-equity

  ratio of the new product, 0.5, is appropriate to use in calculating

  the new product line’s equity beta.

• Wiene should use the new debt-to-

  equity ratio of DEF that would result

  from the additional $50 million debt and $100 million equity in calculating

  the new product line’s equity beta.

Happy Resorts Company currently has 1.2 million common shares of stock outstanding, and the stock has a beta of 2.2. It also has $10 million face value of bonds that have five years remaining to maturity and an 8% coupon with semi-annual payments and are priced to yield 13.65%. If Happy issues up to $2.5 million of new bonds, the bonds will be priced at par and will have a yield of 13.65%; if it issues bonds beyond $2.5 million, the expected yield on the entire issuance will be 16%. Happy has learned that it can issue new common stock at $10 a share. The current risk-free rate of interest is 3%, and the expected market return is 10%. Happy’s marginal tax rate is 30%. If Happy raises $7.5 million of new capital while maintaining the same debt-to-equity ratio, its weighted average cost of capital will be closest to:

• 14.5%

• 15.5%

• 16.5%

An analyst gathered the following information about a private company and its

publicly traded competitor.

The estimated equity beta for the private company is closest to:

• 1.029.

• 1.104.

• 1.877.

Which of the following is least likely to affect the capital structure of Longdrive

Trucking Company? Longdrive has moderate leverage today.

• The acquisition of a major competitor for shares

• A substantial increase in share price

• The payment of a stock dividend

Which of the following mature companies is most likely to employ a high proportion of debt in its capital structure?

• A mining company with a large, fixed asset base

• A software company with very stable and predictable revenues and an asset-light business model

• An electric utility

If investors have homogeneous expectations, the market is efficient, and there

are no taxes, no transaction costs, and no bankruptcy costs, Modigliani and

Miller’s Proposition I states that:

• bankruptcy risk rises with more leverage.

• managers cannot change the value of the company by changing the amount

  of debt.

• managers cannot increase the value of the company by employing tax-saving strategies.

The current weighted average cost of capital (WACC) for Van der Welde is

10%. The company announced a debt offering that raises the WACC to 13%.

The most likely conclusion is that for Van der Welde:

• the company’s prospects are improving.

• equity financing is cheaper than debt financing.

• the company’s debt/equity has moved beyond the optimal range.

Vega Company has announced that it intends to raise capital next year, but

it is unsure as to the appropriate method of raising capital. White, the CFO,

has concluded that Vega should apply the pecking order theory to determine

the appropriate method of raising capital. Based on White’s conclusion, Vega

should raise capital in the following order:

• debt, internal financing, equity.

• equity, debt, internal financing.

• internal financing, debt, equity.