Corporate Finance - Corporate Finance Section 2
| Before-tax cost of new debt | 10 percent |
| Tax rate | 35 percent |
| D/E | 0.6660 |
| Stock price | $30 |
| Next year’s dividend | $2.50 |
| Estimated growth rate | 6.5 percent |
Using the dividend discount model, the company’s WACC is closest to:
- Option : A
- Explanation : Cost of equity = (D1 / P0 ) + g = ($2.50 / $30) + 0.065 = 8.3% + 6.5% = 14.8% Wd = (D/E) / (D/E + 1)= 0.6660 / 1.6660 = 0.40 WACC = [(0.40) (0.10) (1 - 0.35)] + [(0.60) (0.148)] = 11.5%
- Option : B
- Explanation : The best estimate of cost of capital for an average-risk project of a company is the weighted average cost of capital using weights derived from the current capital structure.
- Option : B
- Explanation : Taxes affect cost of debt only, since interest is tax deductible. WACC = Wd Rd (1 – t) + We Re, where Wd + We = 1 7.11 = (1 – We ) * 6 * (1 – 0.4) + We * 9, We = 65%.
19. Which of the following statements is most likely true?
- A
The investment opportunity schedule, for a given company, is upward sloping because as a company invests more in capital projects, the returns from investing keep on increasing.
- B
In order to determine the after-tax cost of debt, the appropriate tax rate to use is the average rate.
- C
The after-tax debt cost, for a given company, is generally less than both the cost of preferred equity and the cost of common equity.
- Option : C
- Explanation : Generally, debt is less costly than both preferred and common stock. If interest expense is tax deductible, then the cost of debt is further reduced.
20. Which of the following components of WACC is affected by taxes?
- Option : B
- Explanation : Interest is tax deductible and it provides tax savings which lowers the cost of debt.
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