Question

#11 The cost of a firmʹs equity

A)is independent of the firmʹs capital structure

B) can be substantially higher than the firmʹs weighted average cost of capital                                       

C) must always be less than the firmʹs weighted average cost of capital

D) will always be higher than the stated interest rate on the financial debt of the firm

#12 Assume a firm is financed with $1000 debt that has a market beta of 0.4 and $3000 equity. The risk -free rate is 3%, the equity premium is 6%, and the firmʹs overall cost of capital is 11%. What is the expected return on the firmʹs debt?

A) 5.4%                                                         

B)6.0%

C) 4.5%

D) 3.0%

#13 According to the M&M propositions, in a perfect market which of the following statements is true?  

A)The net present value of a firmʹs projects will be higher if they are financed with debt since debt carries a lower cost

B) The net present value of a firmʹs projects should exceed the present value of the firmʹs issued claims

C) The value of the firm will be equal to the net present value of its underlying project

D) The value of the firm is higher when financed with debt due to its lower cost

Answer 1

#11) WACC comprises of debt cost and cost of equity. Cost of debt has tax benefits and hence reduced its cost thus bringing down the WACC. Hence, Cost of equity > WACC.

Hence, B is the right option.

#12) Debt = $1000, Equity = $3000, Beta= 0.4, WACC= 11%, Rfree = 3%, Rpremium = 6%

Cost of equity = Rf + Beta*Rprem

= 3% + 0.4* 6% = 5.4%

WACC = E/V *Re + D/V * Rd

11% = 3000/4000 * 5.4% + 1000/4000 * Rd

or 11% = 4.05 % + 25% Rd

or 6.95 % = 25% Rd

or Rd = 27.8 %

13) Value of a firm is independent of the capital structure and depends on the way it operates. Hence C is the right option