Guys this is very Important Please Please make sure of all the answers. Thanks i
ID: 2719109 • Letter: G
Question
Guys this is very Important Please Please make sure of all the answers. Thanks in Advance.
1)The cost of retained earnings can be less than, equal to, or greater than the cost of new common stock, depending on taxes, flotation costs, investors’ attitudes, etc.
A)True
B)False
2) Hilliard Corp. needs to estimate its cost of capital. The company’s CFO has the following information:
The company’s target capital structure is 25% debt and 75% equity; its tax rate is 40%.
Long-term bonds yield 8%; the cost of retained earnings is 12.63%, that of new common stock is 13.36%.
Since the firm expects to have no retained earnings, it plans to issue new common stock.
Hilliard’s weighted average cost of capital is:
a. 10.67%.
b. I l .22%.
c. 11.47%.
d. 12.02%.
e. 12.56%.
3) If a company uses the same discount rate to evaluate all projects,
A) it will become riskier over time, and its value will decline.
B )it will become riskier over time, and its value will rise.
C) it will become less risky over time, and its value will rise.
D )it will become less risky over time, and its value will decline.
E) there is no reason to expect its risk position or value to change.
4) Tropicali’s overall average cost of capital is 10%. Its frozen foods division is riskier than the firm as a whole, its fresh produce division has risk similar to the firm’s, and its institutional foods division has less risk. Tropicali adjusts for both divisional and project risk by adding/subtracting 2 percentage points to/from its corporate cost of capital. The hurdle rate for a low-risk project in the frozen foods division is:
a. 6%.
b. 8%.
c. 10%.
d. 12%.
e. 14%.
Explanation / Answer
1. Cost of Retained Earnings: The firms’ though earn good profits; all those profits are not distributed to equity shareholders. A part of earnings are retained in the business to finance the growth activities of the firms. This retention part is called as retained earnings. Retention of earnings represents withholding of dividends from holders of equity shares. These retained earnings have some opportunity cost. The cost of retained earnings is equal to the cost new issue of ordinary shares less the floatation costs. New issue of ordinary shares involve floatation costs, where as retained earnings does not involve any floatation costs. Hence, we can say that the cost of retained earnings area a little bit less than the cost of raising new common shares. So the above statement is False. The correct choice of answer is ‘B’.
2. Calculation of weighted average cost of capital (WACC):
Capital structure contains: 25 % of Debt: 75% of Equity, or 1:3 ratio
Cost of debt before tax = 8%
After cost of Debt= 8(1tax rate)
After cost of Debt= 8(1 0.40)
After cost of Debt= 8(0.60)
After cost of Debt= 4.80%
Cost of equity= 13.36% (tax deductable advantage is not there for Equity)
Weighted average cost of capital:
Sources Proportion Cost of each source WACC
Debit 0.25 0.048 0.0120
Equity 0.75 0.1336 0.1002
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WACC 0.1122 or 11.22%
Weighted average cost of capital is 11.22%. Choice ‘b’ is the correct answer. The Cost of retained earnings has not taken into account since there is the source of retained earnings in the present capital structure.
3. Choice 'E' is the correct answer.
4. Calculation of hurdle rate for low-risk project in frozen food division:
Overall average cost of capital =10%
Frozen food division‘s cost of capital (10%+2%) =12%
Low-risk project in frozen foods cost of capital (12% 2%) =10%
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