FIN 390 EXAM II REVIEW QUESTIONS WITH VERIFIED
ACCURATE ANSWERS
Weighted Average Cost of Capital (WACC) - Answers - ·WACC = (Wd * Rd * (1-T)) +
(Wps * Rps) + (Wcs * Rcs)
· Wd = capital structure of weight
· Rd = pre tax cost of debt
· T = marginal tax rate
· Wps = weight of preferred stock
· Rps = cost of preferred stock
· Wcs = weight of common stock
· Rcs = cost of common stock
· W = means weight
Discount rate - Answers - WACC is the discount method for corporate valuation method
Hurdle rate - Answers - Used when considering a capital budgeting project
Example of Hurdle Rate - Answers - We want the return on the investment to exceed
the WACC
Factors that Influence WACC - Answers - Controllable and uncontrollable
Controllable factors example that influence WACC - Answers - § Capital structure policy
§ Dividend policy
§Investment policy
Uncontrollable factors example that influence WACC - Answers - § Market conditions
like interest rate
§ The market risk premium
§Tax rates
Flotation Costs - Answers - cost that the company incurs when it issues new securities
Example of Flotation Costs - Answers - commissions, legal expenses, fees
Low, medium, and high examples of flotation costs - Answers - o Low - debt
o Medium - preferred stock
o High - common equity
Capital Structure Weights excludes _____ & _______ and uses ________ - Answers -
accounts payable and accruals and use book value
Capital Structure Weights EXAMPLE
, Travelers INC (TII). has $10 million in accounts payable and $10 million in accruals. TII
also has $30 million in long term debt and $5 million in short term debt, but the short
term loans are used to finance receivables and inventories on a seasonal basis, so
bank loans are zero in the off season. Assume the market value of long term debt
equals the book value. TII's perpetual preferred stock has a $100 par value, and the
book value of preferred stock is $59 million. The current market price of TII's preferred
stock is $72.73. The company has 4 million shares of common stock outstanding, and
the current price is $20 per share. Tax rate is 35%. Cost of common equity is 16%. Cost
of preferred stock is 11.83%. The pre tax cost of debt is 12%. - Answers - § Market
value of debt = book value - 30,000,000
§ Pref stock = #shres * price = 50,000 * 72.73 = 3,636,500
· Book value/par value = 5,000,000/100 = 50,000
§ Common stock = # of sharles * price = 4,000,000 *20 = 80,000,000
§ Total capital = 30,000 +3,636,500 + 80,000,000 = 113,636,500
§ Long-term debt = 30,000,000/113,636,500 = 26.40%
§ Preferred stock = 3,636,500/113,636,500= 3.20%
§ Common equity = 80,000,000/113,636,500 = 70.40%
§WACC = (.264*.12*(1-.35))+(.032*.1183)+(.704*.16) = 13.70%
After-tax Cost of Debt (Formula) - Answers - RdAT = Rd * (1 - T)
After-tax Cost of Debt EXAMPLE
A 15 year, $1,000 par bond with a 12% annual coupon rate sells for $1,000. The tax
rate is 40%. What is the after-tax cost of this debt? - Answers - o N=15 PV=-1000
PMT=(0.12*1000)=120 FV=1000 I/Y=CPT=12%
§ OR par bonds coupon rate equals YTM (I/Y)
o 0.12*(1-0.40) = 7.2%
Cost of Preferred Stock = Rps (Formula) - Answers - P = D/Rps or Rps = D/P
Cost of Preferred Stock EXAMPLE
If preferred stock with an annual dividend of $5 sells for $50, what is the preferred
stock's required rate of return? - Answers - $5/$50 = 10%
Cost of Common Stock/Retained Earnings = Rcs
EXAMPLE
Summerdale resort's common stock is currently trading at $36 a share. The stock is
expected to pay a dividend of $3.00 a share at the ends of the year, and the company's
average ROE is 14.5% and its retention ratio is 37%. Estimate the growth rate and find
ACCURATE ANSWERS
Weighted Average Cost of Capital (WACC) - Answers - ·WACC = (Wd * Rd * (1-T)) +
(Wps * Rps) + (Wcs * Rcs)
· Wd = capital structure of weight
· Rd = pre tax cost of debt
· T = marginal tax rate
· Wps = weight of preferred stock
· Rps = cost of preferred stock
· Wcs = weight of common stock
· Rcs = cost of common stock
· W = means weight
Discount rate - Answers - WACC is the discount method for corporate valuation method
Hurdle rate - Answers - Used when considering a capital budgeting project
Example of Hurdle Rate - Answers - We want the return on the investment to exceed
the WACC
Factors that Influence WACC - Answers - Controllable and uncontrollable
Controllable factors example that influence WACC - Answers - § Capital structure policy
§ Dividend policy
§Investment policy
Uncontrollable factors example that influence WACC - Answers - § Market conditions
like interest rate
§ The market risk premium
§Tax rates
Flotation Costs - Answers - cost that the company incurs when it issues new securities
Example of Flotation Costs - Answers - commissions, legal expenses, fees
Low, medium, and high examples of flotation costs - Answers - o Low - debt
o Medium - preferred stock
o High - common equity
Capital Structure Weights excludes _____ & _______ and uses ________ - Answers -
accounts payable and accruals and use book value
Capital Structure Weights EXAMPLE
, Travelers INC (TII). has $10 million in accounts payable and $10 million in accruals. TII
also has $30 million in long term debt and $5 million in short term debt, but the short
term loans are used to finance receivables and inventories on a seasonal basis, so
bank loans are zero in the off season. Assume the market value of long term debt
equals the book value. TII's perpetual preferred stock has a $100 par value, and the
book value of preferred stock is $59 million. The current market price of TII's preferred
stock is $72.73. The company has 4 million shares of common stock outstanding, and
the current price is $20 per share. Tax rate is 35%. Cost of common equity is 16%. Cost
of preferred stock is 11.83%. The pre tax cost of debt is 12%. - Answers - § Market
value of debt = book value - 30,000,000
§ Pref stock = #shres * price = 50,000 * 72.73 = 3,636,500
· Book value/par value = 5,000,000/100 = 50,000
§ Common stock = # of sharles * price = 4,000,000 *20 = 80,000,000
§ Total capital = 30,000 +3,636,500 + 80,000,000 = 113,636,500
§ Long-term debt = 30,000,000/113,636,500 = 26.40%
§ Preferred stock = 3,636,500/113,636,500= 3.20%
§ Common equity = 80,000,000/113,636,500 = 70.40%
§WACC = (.264*.12*(1-.35))+(.032*.1183)+(.704*.16) = 13.70%
After-tax Cost of Debt (Formula) - Answers - RdAT = Rd * (1 - T)
After-tax Cost of Debt EXAMPLE
A 15 year, $1,000 par bond with a 12% annual coupon rate sells for $1,000. The tax
rate is 40%. What is the after-tax cost of this debt? - Answers - o N=15 PV=-1000
PMT=(0.12*1000)=120 FV=1000 I/Y=CPT=12%
§ OR par bonds coupon rate equals YTM (I/Y)
o 0.12*(1-0.40) = 7.2%
Cost of Preferred Stock = Rps (Formula) - Answers - P = D/Rps or Rps = D/P
Cost of Preferred Stock EXAMPLE
If preferred stock with an annual dividend of $5 sells for $50, what is the preferred
stock's required rate of return? - Answers - $5/$50 = 10%
Cost of Common Stock/Retained Earnings = Rcs
EXAMPLE
Summerdale resort's common stock is currently trading at $36 a share. The stock is
expected to pay a dividend of $3.00 a share at the ends of the year, and the company's
average ROE is 14.5% and its retention ratio is 37%. Estimate the growth rate and find
