header bg

Download PASSEMALL Prep app now

Scan QR code or get instant email to install app

Question:

Which of the following approaches is least likely to be used in determining a company’s cost of debt?

A Pure‐play approach
explanation

The pure‐play method is used to estimate the beta of a project, which is then used to determine the cost of equity.

Explore more Cfa questions
Take more free practice tests for other PASSEMALL topics with our cfa exam prep now!

Comments

Leave a Reply

Your email address will not be published.

*

Related Questions

A manufacturing firm issues a semi‐annual coupon bond to finance a new project. The bond has a par value of $1,000, offers a coupon rate of 9%, and will mature in 15 years. Given that the bond’s current market value is $1,020.63, and the applicable tax rate is 35%, the company’s after‐ tax cost of debt is closest to:

5.69%.

N = 30; PV = –$1,020.63; FV = $1,000; PMT = $45; CPT I/Y; I/Y = 4.375
The yield to maturity on a BEY basis equals 4.375 x 2 = 8.75%. This is the before‐tax cost of debt (rd).
After‐tax cost of debt = rd (1 – t) = 8.75 (1 – 0.35) = 5.688%

While analyzing HMS Inc., Fred Browne notes that the company's liquidity as measured by its quick ratio has decreased over time while its current liabilities have remained constant. This could be explained by:

a decrease in accounts receivable.

The quick ratio is defined as: (cash + marketable securities + accounts receivable) / current liabilities. If current liabilities have remained constant, cash, marketable securities, or accounts receivable must have decreased. Inventory is not included in the quick ratio.

Williams Inc. borrows $1.5m for a month through a banker’s acceptance. The company is offered an all‐inclusive rate of 9%. Its effective borrowing cost is closest to:

9.07%.

1212 %

Consider the following statements:
Statement 1: Dual-class share structures can easily be changed over time.
Statement 2: Activist investors tend to have little impact on the company’s long-term investors.
Which of the following is most likely?

Both statements are incorrect.

Dual-share systems are virtually impossible to dismantle once they are in place. It is very important for long-term investors to consider how activist investors affect the company, as they can materially change a company’s strategic direction.

Which of the following is least likely an issue in estimating a company’s cost of debt?

Companies in different jurisdictions may face different tax rates.

Different tax rates across companies do not create problems in estimating the cost of debt. Once the before‐tax cost of debt has been determined, it is adjusted for the company’s tax rate to determine the after‐tax cost of debt.

The following data are reported for Moving Vans, Inc.:
Dividend yield 5%
Dividend payout 20%
Return on equity 15%
Assuming Moving Vans' dividend yield, dividend payout, and return on equity will remain constant indefinitely, the cost of equity capital is closest to:

17%.

1212Using the constant growth dividend model, the price for a common stock is:
Solving for k :
where:
P = current stock price
D = year end expected dividend
k = cost of common equity capital
g = sustainable (constant) growth of equity, earnings, and dividends
The sustainable growth for a company's dividends equal the ROE times the earnings retention rate. The earnings retention rate equals 1 minus the dividend payout rate. Therefore:
g = 0.15 × (1 − 0.20) = 0.12

Wreathfield, Inc. is choosing between two mutually exclusive projects. The cash flows for the two projects are below. The firm has a cost of capital of 12%, and the risk of the projects is equivalent to the average risk of the firm.
Wreathfield should accept:

Neither project J nor project K.

Project J: I/Y = 12; CF0 = (12,000); CF, = 4,000; CF2 = 5,000; CF3 - 6,000; CPT NPV = -172.
Project K: same process. NPV = -1,025

The NPV profile of Project A is steeper than that of Project B. Which of the following is most likely that the crossover point occurs at an NPV of $5,000?

Project A receives most of its cash flows later in its life.

The steeper NPV profile indicates that:
• Project A has higher total expected cash flows (higher y‐intercept).
More of Project A’s cash flows come later in its life.
• Project A has a lower IRR (lower x‐intercept).

An analyst gathers the following information about the cost of raising new debt and equity for a company:
The company’s target capital structure is 70% equity and 30% debt. If the company raises $12m in financing, its cost of capital will be closest to:

10.60%.

Break point for debt = 5 / 0.3 = $16.67m
Because the company will only be raising $12m (less than the break point for debt), its after‐tax cost of debt equals 5%.
Break point for equity = 6 / 0.7 = $8.57m
Because the company will be raising $12m (more than the break point for equity) its cost of equity equals 13%.
WACC = [0.13 x 0.7] + [0.05 x 0.3] = 10.6%.

Which of the following is most likely to create an incentive for senior managers to act in the best interests of shareholders?

The threat of a hostile takeover.

The threat of a hostile takeover, one in which senior managers are replaced, can act as a strong incentive for senior managers to act in shareholders' interests by growing the value of the company's equity shares. Companies where management has followed their own interests rather than those of shareholders can show slow growth and low return on assets and attract an outside buyer who hopes to profit from improving company operations and strategy.

Mentemeyer Corporation is a small firm that needs to increase short-term liquidity but has weak credit. The source of short term financing that would most likely be available to Mentemeyer is:

nonbank finance companies.

Nonbank finance companies are a source of short-term financing for smaller firms and firms with lower credit ratings. Commercial paper issuance and revolving credit agreements are typically only available to larger corporations with high credit ratings.

ABC Company currently has a debt‐to‐equity ratio of 0.3. Its target debt‐to‐equity ratio is 0.4. The risk‐free rate is 6%, and expected equity market return is 12%. ABC is considering a project that has a beta of 1.2. Given that the company’s after‐tax cost of debt is 7%, and the applicable tax rate is 40%, the WACC that should be used in evaluating this project is closest to:

11.43%.

Cost of equity = 0.06 + 1.2 (0.12 − 0.06) = 13.2%
Using component weights in the target capital structure:
WACC = [0.132 x (1/1.4)] + [0.07 x (0.4 /1.4)] = 11.43%

A firm has one actively traded bond issue outstanding, with a 6% coupon and a yield to maturity of 5%. When estimating the firm's weighted average cost of capital (WACC), the appropriate after-tax cost of debt capital should most likely be:

less than 5%.

Yield to maturity is an appropriate estimate of a firm's before-tax cost of capital. Its after-tax cost of capital may be estimated as YTM x (1 – tax rate) and will be less than the before-tax cost of capital, as long as the firm faces a positive tax rate, which is the most likely case.

Consider the following statements:
Statement 1: Any amendments to the company’s bylaws typically occur at Extraordinary General Meetings (EGMs).
Statement 2: Proxy voting is adopted as a practice in order to protect the rights of creditors.
Which of the following is most likely?

Only Statement 1 is correct.

An amendment to corporate bylaws would normally take place during an EGM, which covers significant changes to a company, such as bylaw amendments. Proxy voting is put in place to protect shareholders. Debtholders use collateral and covenants to protect their interests.