Practice Problems

Cost of capital

1. The pre-tax cost of debt:

A. is based on the current yield to maturity of the firm's outstanding bonds.
B. is equal to the coupon rate on the latest bonds issued by a firm.
C. is equivalent to the average current yield on all of a firm's outstanding bonds.
D. is based on the original yield to maturity on the latest bonds issued by a firm.
E. has to be estimated as it cannot be directly observed in the market.

2. Markley and Stearns is a multi-divisional firm that uses its WACC as the discount rate for ALL
proposed projects. Each division is in a separate line of business and each presents risks unique
to those lines. Given this, the firm will:
A. Accept negative NPV projects from high-risk divisions.*
B. Accept negative NPV projects from low-risk divisions.
C. Allocate too much funding for low risk divisions.
D. Allocate insufficient funding for high risk divisions.

3. Chelsea Fashions is expected to pay an annual dividend of $0.80 a share next year. The market
price of the stock is $22.40 and the growth rate is 5 percent. What is the firm's cost of equity?
A. 7.58 percent
B. 7.91 percent
C. 8.24 percent
D. 8.57 percent
E. 9.00 percent

4. Tidewater Fishing has a current beta of 1.48. The market risk premium is 8.9 percent and the
risk-free rate of return is 3.2 percent. By how much will the cost of equity increase if the
company expands its operations such that the company beta rises to 1.60?
A. 0.88 percent
B. 1.07 percent
C. 1.50 percent
D. 2.10 percent
E. 2.26 percent
Increase in cost of equity = (1.60 - 1.48) × 0.089 = 1.07 percent
 5. Dog Gone Good Engines has a bond issue outstanding with 17 years to maturity. These bonds
have a $1,000 face value, a 9 percent coupon, and pay interest semi-annually. The bonds are
currently selling for $870. What is the company's pre-tax cost of debt if the tax rate is 38
percent?
A. 4.10 percent
B. 4.42 percent
C. 6.61 percent
D. 8.90 percent
E. 10.67 percent

N = 17*2=34 ; PV = -870; PMT = 90/2 = 45; FV = 1000; Solve for I/Y = 5.337%
Cost of debt = 5.337%*2 = 10.67%

6. The outstanding bonds of Tech Express are priced at $989 and mature in 8 years. These bonds
have a 6 percent coupon and pay interest annually. The firm's tax rate is 39 percent. What is the
firm's aftertax cost of debt?
A. 3.01 percent
B. 3.22 percent
C. 3.35 percent
D. 3.77 percent
E. 4.41 percent

7. New York Deli's has preferred stocks that pays $7 annual dividend and sells for $36 a share.
What is the cost of preferred stock?
A. 13.68 percent
B. 14.00 percent
C. 14.29 percent
D. 19.44 percent
E. 19.80 percent

Rp = $7/$36 = 19.44 percent

 8. Wayco Industrial Supply has a pre-tax cost of debt of 7.6 percent, a cost of equity of 14.3
percent, and a cost of preferred stock of 8.5 percent. The firm has 220,000 shares of common
stock outstanding at a market price of $27 a share. There are 25,000 shares of preferred stock
outstanding at a market price of $41 a share. The bond issue has a face value of $550,000 and a
market quote of 101.2. The company's tax rate is 37 percent. What is the firm's weighted
average cost of capital?
A. 10.18 percent
B. 10.84 percent
C. 11.32 percent
D. 12.60 percent
E. 12.81 percent

WACC = ($5,940,000/$7,521,600) (0.143) + ($1,025,000/$7,521,600) (0.085) + ($556,600/$7,521,600)

(0.076) (1 - 0.37) = 12.81 percent

9. Using Ford Motor Co. stock returns and S&P returns, you estimate Ford stock beta to be 3.0. Ford
has a D/E ratio of 11.9 and marginal tax rate of 35%. What is the asset beta (unlevered beta) of
Ford?
a. 0.23
b. 0.34*
c. 1.00
d. 3.00

10. You company has $200 million of retained earnings. Your stock is trading at $85 and you expect
to pay $2 dividend next quarter with a constant growth rate of 3.5% per quarter. The floatation
cost of issuing new stock is $5 per share. What is the cost of internal and external equity of your
company?

Internal equity
Re = 2/85 + 0.035 = 5.85%

External equity
Re = 2/80 +0.035 = 6%
Raising Capital

11. What is the definition of a syndicate?

A. a venture capitalist
B. a group of attorneys providing services for an IPO
C. block of investors who control a firm
D. a bank that loans funds to finance the start-up of a new firm
E. a group of underwriters sharing the risk of selling a new issue of securities

12. D.L. Jones & Co. recently went public. The firm received $20.80 a share on the entire offer of
25,000 shares. Keeser & Co. served as the underwriter and was able to sell 23,700 shares to the
public at the IPO price of $22 a share. What type of underwriting was this?
A. best efforts
B. Rights offering
C. over-subscribed
D. private placement
E. firm commitment

13. Which of the following should be considered when selecting a venture capitalist?
I. level of involvement
II. past experiences
III. termination of funding
IV. financial strength
A. I and III only
B. II and IV only
C. I, III, and IV only
D. I, II, and IV only
E. I, II, III, and IV

14. If an IPO is underpriced then the:

A. investors in the IPO are generally unhappy with the underwriters.
B. issue is less likely to sell out.
C. stock price will generally decline on the first day of trading.
D. issuing firm is guaranteed to be successful in the long term.
E. There is a wealth transfer from pre-IPO shareholders to new shareholders.
 15. Nelson Paints recently went public by offering 65,000 shares of common stock to the public. The
underwriters provided their services in a best efforts underwriting. The offering price was set at
$16 a share and the gross spread was $2. After completing their sales efforts, the underwriters
determined that they sold a total of 57,500 shares. How much cash did Nelson Paints receive
from its IPO?
A. $805,000
B. $910,000
C. $920,000
D. $1,035,000
E. $1,040,000
Total cash received = 57,500 × ($16 - $2) = $805,000

16. Mountain Teas wants to raise $11.6 million to open a new production center. The company
estimates the issue costs including the legal and accounting fees will be $440,000. The
underwriters have set the stock price at $17.50 a share and the underwriting spread (fee) at 9
percent. How many shares of stock does Mountain Teas have to sell to meet its cash need?
A. 728,414 shares
B. 756,044 shares
C. 769,315 shares
D. 772,200 shares
E. 781,909 shares
Total value of issue = ($11,600,000 + $440,000)/(1 - 0.09) = $13,230,769
Number of shares needed = $13,230,769/$17.50 = 756,044 shares

17. The Motor Plant wants to raise $21.4 million through a rights offering so it can modernize its
facilities. The subscription price for the offering is set at $12 a share. Currently, the company has
2.6 million shares of stock outstanding at a market price of $12.50 a share. Each shareholder will
receive one right for each share of stock they own. How many rights will a shareholder need to
purchase one new share of stock in this offering?
A. 1.46 rights
B. 1.52 rights
C. 1.55 rights
D. 1.60 rights
E. 1.67 rights

Number of rights issued = 1 × 2.6m = 2.6m; Number of shares needed = $21.4m/$12 = 1,783,333.33;
Rights needed for each new share = 2.6m/1,783,333.33 = 1.46 rights

(Use the following information for the next three questions)

Suppose you are the lead underwriter for a start-up company. The company plans to sell 10
million shares at the price of $46 per share. It also provides you an over-allotment option of
1.5 million additional shares. Recent road show estimates demand to be around 20 million
shares at $46. There is lots of uncertainty about how the stock will perform after trading
starts. Consider the following decisions.

18. Before the trading starts tomorrow, you need to allocate (sell) a number of shares to the
institutional investors now at the IPO price. How many shares will you allocate?
a. 9 million shares
b. 10 million shares
c. 11.5 million shares*
d. 15 million shares
e. 20 million shares

19. After trading starts, what will you do if the stock price increases to $70?
a. Ask investors to buy shares from the market.
b. Sell shares back to the Issuing company.
c. Exercise Green shoe option.*
d. Do nothing.
e. Ask investors to sell stock to depress stock price

20. After trading start, up to how many shares can you buy from the market if stock price
start to fall below the IPO price?
a. zero shares
b. 1.5 million shares
c. 10 million shares
d. 20 million shares
e. As many as I want