Chapters 17 to 19 - WACC and the cost of finance

A company has a cost of equity (Ke) of 18% and a cost of debt (Kd) of 6%. It has 40% debt in it capital structure. It has two investment opportunities of similar risk to its existing business. A costs £4m, will yield 9% and be financed by debt and B costs £6m will yield 15% and be financed by equity. The company should:
1. Accept A alone
2. Accept B alone
3. Accept both projects
4. Accept neither project
Which of these is NOT an assumption behind use of WACC?
1. The project should be marginal
2. The project should produce a return at least equal to the source of finance used
3. The financing of the project should not change the company's capital structure
4. The project should have the same systematic risk as the average for the company
A new company is raising £2m to finance production that requires a return of 18%. It can raise all the money by a share issue (S) or half by debt at 10%(SD). Comparing the two options, the Ke and WACC will be as follows (ignoring tax):
1. (S) Ke 18%, WACC 18%
  (SD) Ke 26%, WACC 18%
2. (S) Ke 18%, WACC 18%
  (SD) Ke 18%, WACC 14%
3. (S) Ke 18%, WACC 18%
  (SD) Ke 14%, WACC 14%
4. (S) Ke 14%, WACC 14%
  (SD) Ke 18%, WACC 14%
Business risk is:
1. The systematic risk of the equity
2. The total risk of the company
3. The riskiness of the operating cash flows
4. Risk that is unique to the company
A company has a share ß of 1.4 and has 30% risk free debt in its capital structure. Its asset ß will be:
1. .42
2. .98
3. 1.2
4. 1.4
M&M's arbitrage proof shows that:
1. No matter what the capital structure, the overall WACC remains the same
2. WACC increases with the level of debt
3. Investors should choose companies with little debt
4. Overall risk increases as debt increases
Which of the following is NOT an assumption underlying the M&M arbitrage proof?
1. Shares in a geared company can be made a perfect substitute for shares in an ungeared company
2. There are no taxes
3. There is no difference in risk between company and private borrowing so far as the shareholder is concerned
4. Returns on shares remain constant
An ungeared company has an equity value of £20m. If the tax rate is 30% and the company refinances with 40% debt, the new value of equity will be:
1. £12m
2. £14.4m
3. £15.6m
4. £20m
The value of the tax shield:
1. Increases the value of debt
2. Reduces the value of debt
3. Increases the value of equity
4. Reduces the value of equity
In example 8, the WACC before borrowing was 18%. After borrowing it is:
1. 14%
2. 16%
3. 18%
4. 20%

Chapters 17 to 19 - WACC and the cost of finance

Quiz