1. Schalheim Sisters Inc. has always paid out all of its earnings as dividends,
ID: 2665620 • Letter: 1
Question
1. Schalheim Sisters Inc. has always paid out all of its earnings as dividends, hence the firm has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC?a. The market risk premium declines.
b. The company’s beta increases.
c. The flotation costs associated with issuing new common stock increase.
d. Expected inflation increases.
e. The flotation costs associated with issuing preferred stock increase.
2. For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure. Note that rs is the cost of internal equity or retained earnings, re is the cost of newly issued equity, rd is the cost of debt, and WACC is the weighted average cost of capital.
a. WACC > re > rs > rd.
b. WACC > rd > rs > re.
c. rs > re > rd > WACC.
d. re > rs > WACC > rd.
e. rd > re > rs > WACC.
3. Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A’s cost of capital is 10.0%, Division B’s cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A’s projects are equally risky, as are all of Division B's projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept?
a. A Division A project with a 9% return.
b. A Division B project with a 13% return.
c. A Division B project with an 11% return.
d. A Division A project with an 11% return.
e. A Division B project with a 12% return.
4. If a typical U.S. company correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely
a. become riskier over time, but its intrinsic value will be maximized.
b. become less risky over time, and this will maximize its intrinsic value.
c. become more risky and also have an increasing WACC. Its intrinsic value will not be maximized.
d. continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital.
e. accept too many low-risk projects and too few high-risk projects.
Explanation / Answer
1
a. The market risk premium declines.
2
d. re > rs > WACC > rd
3
A Division A project with an 11% return
4
a. become riskier over time, but its intrinsic value will be maximized
1
a. The market risk premium declines.
2
d. re > rs > WACC > rd
3
A Division A project with an 11% return
4
a. become riskier over time, but its intrinsic value will be maximized
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