Chapter 14 - Cost of Capital
88. Give an example of a situation where a firm should adopt the pure play approach for determining the cost of capital for a project.
Student examples will vary but should illustrate a project that is unrelated to the current
operations of Firm A. The example should explain why the WACC of Firm B, which is engaged in the type of operations Firm A is considering, should be used as the basis for setting the discount rate for the proposed project.
Feedback: Refer to section 14.5
AACSB: Reflective thinking Bloom's: Synthesis Difficulty: Intermediate Learning Objective: 14-5 Section: 14.5 Topic: Pure Play
89. Suppose your boss comes to you and asks you to re-evaluate a capital budgeting project. The first evaluation was in error, he explains, because it ignored flotation costs. To correct for this, he asks you to evaluate the project using a higher cost of capital which incorporates these costs. Is your boss' approach correct? Why or why not?
Your boss is confused since it is the use of funds, and not the source of funds, that determines the cost of capital. Flotation costs should be included in the initial cash flow of a project and not in the cost of capital.
Feedback: Refer to section 14.6
AACSB: Reflective thinking Bloom's: Analysis
Difficulty: Intermediate Learning Objective: 14-4 Section: 14.6
Topic: Flotation costs
14-49
Chapter 14 - Cost of Capital
90. Explain how the use of internal equity rather than external equity affects the analysis of a project.
Internal equity avoids the flotation costs associated with raising external equity. Therefore, by utilizing internal equity rather than external equity, the initial cost of the project is decreased. Decreasing the initial cost increases the NPV of the project.
Feedback: Refer to section 14.6
AACSB: Reflective thinking Bloom's: Analysis
Difficulty: Intermediate Learning Objective: 14-4 Section: 14.6
Topic: Flotation costs
Multiple Choice Questions
91. The City Street Corporation's common stock has a beta of 1.2. The risk-free rate is 3.5 percent and the expected return on the market is 13 percent. What is the firm's cost of equity? A. 11.4 percent B. 12.8 percent C. 14.9 percent D. 17.6 percent E. 19.1 percent
RE = 0.035 + 1.2(0.13 - 0.035) = 14.9 percent
AACSB: Analytic Bloom's: Application Difficulty: Basic EOC #: 14-2
Learning Objective: 14-1 Section: 14.2
Topic: Cost of equity
14-50
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