Question

12.4 The Debt Cost of Capital

Use the following information to answer the question(s) below.

Consider the following information regarding corporate bonds:

RatingAAAAAABBBBBBCCC
Average Default Rate0.0%0.0%0.2%0.4%2.1%5.2%9.9%
Recession Default Rate0.0%1.0%3.0%3.0%8.0%16.0%43.0%
Average Beta0.050.050.051.00.170.260.31

1) Wyatt Oil has a bond issue outstanding with seven years to maturity, a yield to maturity of 7.0%, and a BBB rating. The corresponding risk-free rate is 3% and the market risk premium is 5%. Assuming a normal economy, the expected return on Wyatt Oil’s debt is closest to:

A) 3.0%

B) 3.5%

C) 4.9%

D) 5.5%

2) Wyatt Oil has a bond issue outstanding with seven years to maturity, a yield to maturity of 7.0%, and a BBB rating. The bondholders expected loss rate in the event of default is 70%. Assuming a normal economy the expected return on Wyatt Oil’s debt is closest to:

A) 3.0%

B) 3.5%

C) 4.9%

D) 6.7%

3) Wyatt Oil has a bond issue outstanding with seven years to maturity, a yield to maturity of 7.0%, and a BBB rating. The bondholders expected loss rate in the event of default is 70%. Assuming the economy is in recession, then the expected return on Wyatt Oil’s debt is closest to:

A) 3.5%

B) 4.9%

C) 5.5%

D) 7.0%

4) Rearden Metal has a bond issue outstanding with ten years to maturity, a yield to maturity of 8.6%, and a B rating. The corresponding risk-free rate is 3% and the market risk premium is 6%. Assuming a normal economy, the expected return on Rearden Metal’s debt is closest to:

A) 0.6%

B) 1.6%

C) 4.6%

D) 6.0%

5) Rearden Metal has a bond issue outstanding with ten years to maturity, a yield to maturity of 8.6%, and a B rating. The bondholders expected loss rate in the event of default is 50%. Assuming a normal economy the expected return on Rearden Metal’s debt is closest to:

A) 0.6%

B) 1.6%

C) 4.6%

D) 6.0%

6) Rearden Metal has a bond issue outstanding with ten years to maturity, a yield to maturity of 8.6%, and a B rating. The bondholders expected loss rate in the event of default is 50%. Assuming the economy is in recession, then the expected return on Rearden Metal’s debt is closest to:

A) 0.6%

B) 1.6%

C) 4.6%

D) 6.0%

7) Nielson Motors plans to issue 10-year bonds that it believes will have an BBB rating. Suppose AAA bonds with the same maturity have a 3.5% yield. Assume that the market risk premium is 5% and the expected loss rate in the event of default on the bonds is 60%. The yield that these bonds will have to pay during average economic times is closest to:

A) 3.50%

B) 3.75%

C) 4.00%

D) 5.50%

8) Nielson Motors plans to issue 10-year bonds that it believes will have an BBB rating. Suppose AAA bonds with the same maturity have a 3.5% yield. Assume that the market risk premium is 5% and the expected loss rate in the event of default on the bonds is 60%. The yield that these bonds will have to pay during a recession is closest to:

A) 3.50%

B) 3.75%

C) 4.00%

D) 5.50%

12.5 A Project’s Cost of Capital

Use the following information to answer the question(s) below.

Consider the following information regarding corporate bonds:

RatingAAAAAABBBBBBCCC
Average Default Rate0.0%0.0%0.2%0.4%2.1%5.2%9.9%
Recession Default Rate0.0%1.0%3.0%3.0%8.0%16.0%43.0%
Average Beta0.050.050.051.00.170.260.31
CompanyMarketCapitalization($mm)TotalEnterpriseValue ($mm)EquityBetaDebtRating
Taggart Transcontinental$4,5008,0001.1BBB
Rearden Metal$3,8007,2001.3AAA
Wyatt Oil$2,4003,8000.9A
Nielson Motors$1,5004,4001.75BB

1) Your estimate of the debt beta for Taggart Transcontinental would be:

A) 0.05

B) 0.10

C) 0.17

D) 1.00

2) Your estimate of the debt beta for Nielson Motors would be:

A) 0.10

B) 0.17

C) 1.00

D) 1.68

3) Your estimate of the asset beta for Taggart Transcontinental is closest to:

A) 0.42

B) 0.59

C) 0.66

D) 0.71

4) Your estimate of the asset beta for Rearden Metal is closest to:

A) 0.42

B) 0.59

C) 0.66

D) 0.71

5) Your estimate of the asset beta for Wyatt Oil is closest to:

A) 0.59

B) 0.66

C) 0.71

D) 0.90

6) Your estimate of the asset beta for Nielson Motors is closest to:

A) 0.59

B) 0.66

C) 0.71

D) 1.75

7) Suppose that because of the large need for steel in building railroad infrastructure, Taggart Transcontinental and Rearden Metal decide to into one large conglomerate. Your estimate of the asset beta for this new conglomerate is closest to:

A) 0.42

B) 0.59

C) 0.66

D) 0.68

Use the following information to answer the question(s) below.

Consider the following information regarding corporate bonds:

RatingAAAAAABBBBBBCCC
Average Default Rate0.0%0.0%0.2%0.4%2.1%5.2%9.9%
Recession Default Rate0.0%1.0%3.0%3.0%8.0%16.0%43.0%
Average Beta0.050.050.051.00.170.260.31

8) Galt Industries has a market capitalization of $50 billion, $30 billion in BBB rated debt, and $8 billion in cash. If Galt’s equity beta is 1.15, then Galt’s underlying asset beta is closest to:

A) 0.84

B) 0.92

C) 1.00

D) 1.15

9) Trucks R’ Us has a market capitalization of $142 billion, $78 billion in BB rated debt, and $10 billion in cash. If Trucks R’ Us’ equity beta is 1.68, then their underlying asset beta is closest to:

A) 1.00

B) 1.20

C) 1.32

D) 1.48

10) Luther Industries has a market capitalization of $23 billion, no debt, and $4 billion in cash. If Luther’s estimated equity beta is 1.32, then the beta of Luther’s underlying business enterprise is closest to:

A) 1.09

B) 1.32

C) 1.48

D) 1.60

11) Your firm is planning to invest in a new power generation system. Galt Industries is an all equity firm that specializes in this business. Suppose Galt’s equity beta is 0.75, the risk-free rate is 3%, and the market risk premium is 6%. If your firm’s project is all equity financed, then your estimate of your cost of capital is closest to:

A) 5.25%

B) 6.00%

C) 6.75%

D) 7.50%

12) Your firm is planning to invest in a new electrostatic power generation system. Electrostat Inc is a firm that specializes in this business. Electrostat has a stock price of $25 per share with 16 million shares outstanding. Electrostat’s equity beta is 1.18. It also has $220 million in debt outstanding with a debt beta of 0.08. Your estimate of the asset beta for electrostatic power generators is closest to:

A) 0.76

B) 0.79

C) 0.93

D) 1.10

13) Your firm is planning to invest in a new electrostatic power generation system. Electrostat Inc is a firm that specializes in this business. Electrostat has a stock price of $25 per share with 16 million shares outstanding. Electrostat’s equity beta is 1.18. It also has $220 million in debt outstanding with a debt beta of 0.08. If the risk-free rate is 3%, and the market risk premium is 6%, then your estimate of your cost of capital for electrostatic power generators is closest to:

A) 7.50%

B) 7.75%

C) 9.50%

D) 10.10%

14) The firm’s unlevered (asset) beta is

A) the weighted average of the equity beta and the debt beta.

B) the weighted average of the levered beta and the equity beta.

C) the debt beta minus the equity beta.

D) the unlevered beta minus the cost of capital.

15) The firm’s unlevered (asset) cost of capital is

A) the weighted average of the equity cost of capital and the debt cost of capital.

B) the weighted average of the levered cost of capital and the equity cost of capital.

C) the debt cost of capital minus the equity cost of capital.

D) the unlevered beta minus the cost of capital.

16) If a firm’s excess cash holdings are greater than its debt, using net debt as the measure of leverage will result in

A) its unlevered beta and cost of capital equalling zero.

B) its unlevered beta and cost of capital being greater than its equity beta and cost of capital.

C) the risk of the firm’s equity being increased by its cash holdings in excess of its operating needs.

D) the risk of the firm’s debt being increased by its cash holdings in excess of its operating needs.

17) Which of the following is true of asset betas?

A) Asset betas are expected to vary greatly within firms in the same industry.

B) Businesses that are less sensitive to market and economic conditions tend to have higher asset betas than more cyclical industries.

C) Businesses that are less sensitive to market and economic conditions tend to have lower asset betas than more cyclical industries.

D) A and B are correct.

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