Test Prep Test Prep Certifications BUSINESS-ENVIRONMENT-AND-CONCEPTS Questions & Answers

• Question 81:

  When a firm finances each asset with a financial instrument of the same approximate maturity as the life of the asset, it is applying:

  A. Working capital management.

  B. Return maximization.

  C. Financial leverage.

  D. Operating leverage.

  Correct Answer: A

  Choice "a" is correct. Appropriate working capital management matches the maturity life of each asset with the length of the financial instrument used to finance that asset. Choice "b" is incorrect. Return maximization seeks to obtain the optimal return rate by asset utilization. It is not necessarily related to the maturity of the asset. Choice "c" is incorrect. Financial leverage is the amount of debt used to finance an asset. Higher leverage equals more debt. It is unrelated to the maturity life of an asset. Choice "d" is incorrect. Operating leverage is the degree that fixed costs are used in the production process. Operating leverage is unrelated to the methods used to finance assets.

• Question 82:

  Assume the following facts about Martin Corporation:

  •

  The long-term debt was originally issued at par ($1,000/bond) and is currently trading at $1,250 per bond.

  •

  Martin Corporation can now issue debt at 150 basis points over U.S. treasury bonds.

  •

  The current risk-free rate (U.S. treasury bonds) is 7 percent.

  •

  Martin's common stock is currently selling at $32 per share.

  •

  The expected market return is currently 15 percent.

  •

  The beta value for Martin is 1.25.

  •

  Martin's effective corporate income tax rate is 40 percent.

  Based on these assumptions, what is the current net after-tax cost of debt for Martin Corporation?

  A. 5.5 percent.

  B. 7.0 percent.

  C. 5.1 percent.

  D. 8.5 percent.

  Correct Answer: C

  Choice "c" is correct. 5.1 percent current net cost of debt.

  The fact pattern states that debt can be currently secured at 150 basis points above the Treasury bond

  rate. A basis point is equal to 1/100 of 1% (1% of 1%).

  Applying the decimals, it's:

  150 basis points x 1/100 of 1% (or .0001)

  this yields .015 or 1.5%

  Add the additional basis points converted to percentage (1.5%) to the Treasury bond rate of 7% to arrive at

  the pre-tax debt cost of 8.5%. Apply 1 - tax rate to arrive at the current net cost of debt as follows:

  

• Question 83:

  DQZ Telecom is considering a project for the coming year, which will cost $50 million. DQZ plans to use the following combination of debt and equity to finance the investment.

  •

  Issue $15 million of 20-year bonds at a price of 101, with a coupon rate of 8 percent, and flotation costs of 2 percent of par.

  •

  Use $35 million of funds generated from earnings.

  The equity market is expected to earn 12 percent. U.S. treasury bonds are currently yielding 5 percent.

  The beta coefficient for DQZ is estimated to be .60. DQZ is subject to an effective corporate income tax

  rate of 40 percent.

  The before-tax cost of DQZ's planned debt financing, net of flotation costs, in the first year is:

  A. 11.80 percent.

  B. 8.08 percent.

  C. 10.00 percent.

  D. 7.92 percent.

  Correct Answer: B

  Choice "b" is correct. 8.08 percent before-tax cost of debt financing, net of flotation costs.

  

• Question 84:

  

  Additional Data

  •

  The long-term debt was originally issued at par ($1,000/bond) and is currently trading at $1,250 per bond.

  •

  Martin Corporation can now issue debt at 150 basis points over U.S. treasury bonds.

  •

  The current risk-free rate (U.S. treasury bonds) is 7 percent.

  •

  Martin's common stock is currently selling at $32 per share.

  •

  The expected market return is currently 15 percent.

  •

  The beta value for Martin is 1.25.

  •

  Martin's effective corporate income tax rate is 40 percent.

  Using the Capital Asset Pricing Model (CAPM), Corporation's current cost of common equity is:

  A. 10.00 percent.

  B. 15.00 percent.

  C. 17.00 percent.

  D. 18.75 percent.

  Correct Answer: C

  Choice "c" is correct. 17.00 percent. Using the CAPM model, Martin's current cost of common equity would

  be:

  Cost of equity = Capital risk free rate + Beta (market rate - risk free rate)

  Cost of equity = 7% + 1.25 (15% - 7%)

  Cost of equity = 7% + 1.25 (8%)

  Cost of equity = 7% + 10%

  Cost of equity = 17%

• Question 85:

  A preferred stock is sold for $101 per share, has a face value of $100 per share, underwriting fees of $5 per share, and annual dividends of $10 per share. If the tax rate is 40 percent, the cost of funds (capital) for the preferred stock is:

  A. 4.2 percent.

  B. 6.2 percent.

  C. 10.0 percent.

  D. 10.4 percent.

  Correct Answer: D

  Choice "d" is correct. The stock is issued for a net of $96 per share ($101 less $5 underwriting fee). Because preferred stock dividends are not tax deductible, the cost to the company is $10/share (the tax rate is a distractor). Therefore, the cost of the preferred stock is:

  

  Choices "a", "b", and "c" are incorrect, per the above calculation.

• Question 86:

  Youngsten Electric is contemplating new projects for the next year that will require $30,000,000 of new financing. In keeping with its capital structure, Youngsten plans to use debt and equity financing as follows:

  *

  Issue $10,000,000 of 20-year bonds at a price of 101.5, with a coupon of 10%, and flotation costs of 2.5% of par value.

  *

  Use internal funds generated from earnings of $20,000,000.

  The equity market is expected to earn 15%. U.S. treasury bonds currently are yielding 9%. The beta coefficient for Youngsten's common stock is estimated to be .8. Youngsten is subject to a 40% corporate income tax rate. Youngsten has a price/earnings ratio of 10, a constant dividend payout ratio of 40%, and an expected growth rate of 12%. An analysis of Youngsten's planned equity financing using Capital Asset Pricing Model (or Security Market Line) would incorporate only the:

  A. Expected market earnings, the current U.S. Treasury bond yield, and the beta coefficient.

  B. Expected market earnings and the price' earnings ratio.

  C. Current U.S. Treasury bond yield, the price/earnings ratio, and the beta coefficient.

  D. Current U.S. Treasury bond yield and the dividend payout ratio.

  Correct Answer: A

  Choice "a" is correct. The capital asset pricing model formula is:

  R = RF + B (RM-RF)

  Where:

  R = Required return rate on equity

  RF = Risk free rate earned on U.S. treasury bonds.

  B = Beta coefficient

  RM = Expected market return (earnings).

  Choices "b", "c", and "d" are incorrect, per the above Explanation.

• Question 87:

  Osgood Products has announced that it plans to finance future investments so that the firm will achieve an optimum capital structure. Which one of the following corporate objectives is consistent with the announcement?

  A. Maximize earnings per share.

  B. Minimize the cost of debt.

  C. Maximize the net worth of the firm.

  D. Minimize the cost of equity.

  Correct Answer: C

  Choice "c" is correct. The optimal capital structure is the financial structure that would theoretically maximize shareholder wealth by maximizing the net worth of the company. Choices "a", "b", and "d" are incorrect. Strategies (not objectives) for creating an optimal capital structure to maximize net worth include:

  1.

  Maximizing earnings per share (choice "a").

  2.

  Minimizing the cost of debt (choice "b").

  3.

  Minimizing the cost of equity (choice "d").

  4.

  Maximizing cash flow (choice not given).

• Question 88:

  Williams, Inc. is interested in measuring its overall cost of capital and has gathered the following data. Under the terms described below, the company can sell unlimited amounts of all instruments.

  •

  Williams can raise cash by selling $1,000, 8 percent, 20-year bonds with annual interest payments. In

  selling the issue, an average premium of $30 per bond would be received, and the firm must pay floatation

  costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8 percent.

  •

  Williams can sell 8 percent preferred stock at par value, $105 per share. The cost of issuing and selling

  the preferred stock is expected to be $5 per share.

  •

  Williams’ common stock is currently selling for $100 per share. The firm expects to pay cash dividends of

  $7 per share next year, and the dividends are expected to remain constant. The stock will have to be

  underpriced by $3 per share, and floatation costs are expected to amount to $5 per share.

  •

  Williams expects to have available $100,000 of retained earnings in the coming year; once these retained

  earnings are exhausted, the firm will use new common stock as the form of common stock equity

  financing.

  •

  Williams’ preferred capital structure is:

  Long-term debt 30%

  Preferred stock 20

  Common stock 50

  If Williams, Inc. needs a total of $1,000,000, the firm's weighted-average cost of capital would be:

  A. 6.8 percent.

  B. 4.8 percent.

  C. 6.5 percent.

  D. 9.1 percent.

  Correct Answer: A

  Choice "a" is correct. 6.8%. This question pertains to the manner in which changes in the required amount of capital will impact the weighted average cost of capital governed by the target capital structure. The rates are given, and you must derive the weights. The company needs a total of $1,000,000. The total Retained Earnings is $100,000, which will only represent 10% of the total amount needed. In J92-1.01, we computed the cost of new common share issues at 7.6%, and we know that we can issue unlimited amounts of each security. Based on these assumptions, we know that the target capital structure will remain unchanged but that the components of common equity will be priced differently because Retained Earnings only equals $100/$1,000 (or 10%). If the target capital structure calls for 50% common stock and only 10% is available from retained earnings, then 40% must come from the issuance of new common shares. The weighted average is computed as follows: Choices "b", "c", and "d" are incorrect, per the above calculation.

  

• Question 89:

  Williams, Inc. is interested in measuring its overall cost of capital and has gathered the following data. Under the terms described below, the company can sell unlimited amounts of all instruments.

  •

  Williams can raise cash by selling $1,000, 8 percent, 20-year bonds with annual interest payments.

  In selling the issue, an average premium of $30 per bond would be received, and the firm must pay

  floatation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8 percent.

  •

  Williams can sell 8 percent preferred stock at par value, $105 per share. The cost of issuing and selling

  the preferred stock is expected to be $5 per share.

  •

  Williams’ common stock is currently selling for $100 per share. The firm expects to pay cash dividends of

  $7 per share next year, and the dividends are expected to remain constant. The stock will have to be

  underpriced by $3 per share, and floatation costs are expected to amount to $5 per share.

  •

  Williams expects to have available $100,000 of retained earnings in the coming year; once these retained

  earnings are exhausted, the firm will use new common stock as the form of common stock equity

  financing.

  •

  Williams’ preferred capital structure is:

  Long-term debt 30%

  Preferred stock 20

  Common stock 50

  If Williams, Inc. needs a total of $200,000, the firm's weighted-average cost of capital would be closest to:

  A. 4.8 percent.

  B. 6.6 percent.

  C. 6.8 percent.

  D. 7.3 percent.

  Correct Answer: B

  Choice "b" is correct. 6.6%. Williams' after tax cost of debt is 4.8% and cost of preferred stock is 8.4% ($105/share less issue costs of $5/share). The cost of equity (as calculated in a prior question) is 7.0%. This question pertains to the manner in which changes in the required amount of capital will impact the weighted average cost of capital governed by the target capital structure. The rates are given, and you must derive the weights. The company needs a total of $200,000. The question gives you the amount of Retained Earnings at $100,000, the source of 7% dividend payments on common shares. If all that is needed is $200,000, then, by definition, the target capital structure is "priced out" as shown with 7% common equity of $100,000 being equal to 50% of the target capital structure totaling $200,000 without any modification: Choices "a", "c", and "d" are incorrect, per the above Explanation.

  

• Question 90:

  Williams, Inc. is interested in measuring its overall cost of capital and has gathered the following data. Under the terms described below, the company can sell unlimited amounts of all instruments.

  •

  Williams can raise cash by selling $1,000, 8 percent, 20-year bonds with annual interest payments.

  In selling the issue, an average premium of $30 per bond would be received, and the firm must pay

  floatation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8 percent.

  •

  Williams can sell 8 percent preferred stock at par value, $105 per share. The cost of issuing and selling

  the preferred stock is expected to be $5 per share.

  •

  Williams' common stock is currently selling for $100 per share. The firm expects to pay cash dividends of

  $7 per share next year, and the dividends are expected to remain constant. The stock will have to be

  underpriced by $3 per share, and floatation costs are expected to amount to $5 per share.

  •

  Williams expects to have available $100,000 of retained earnings in the coming year; once these retained

  earnings are exhausted, the firm will use new common stock as the form of common stock equity

  financing.

  •

  Williams' preferred capital structure is:

  Long-term debt 30%

  Preferred stock 20

  Common stock 50

  The cost of funds from the sale of common stock for Williams, Inc. is:

  A. 7.0 percent.

  B. 7.6 percent.

  C. 7.4 percent.

  D. 7.8 percent.

  Correct Answer: B

  Choice "b" is correct. 7.6%. Williams would receive $92 per share ($100 less $5 flotation cost and $3 underpricing) and pay an annual dividend of $7/share. The annual cost is:

  

  This question purely asks the cost of new common shares issued. The problem gives you the expected dividend to be paid annually ($7) and the net proceeds after issue costs and market adjustments $92 (current selling price of $100 minus the $3 market adjustment and the $5 floatation costs). The cost of common shares issued is the finance charge (dividend) divided by the net proceeds of the issue $92 or 7.6%. Choices "a", "c", and "d" are incorrect, per above.