Question 2397 of 3960 from exam CFA® LEVEL 1: CFA® Level 1

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Question

While studying for the Level 1 CFA examination, Leonard Hart draws the following graph of a firm's capital structure. Using his graph and the assumptions below, determine which of the following statements A through D below is FALSE.

Answers

A. The value for X is $90 million.

B. The weighted average cost of capital (WACC) of 10.00% uses retained earnings, the WACC of 12.25% uses common stock.

C. The firm should use this graph to adjust projects for risk.

D. As the firm needs to raise more and more capital, the weighted average cost of capital (WACC) will remain lower than the marginal cost of capital.

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Explanations

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A. B. C. D.

This graph represents the marginal cost of capital (MCC).

BPRE= (Retained Earnings) / (Equity Fraction, we)

Here, RE = earnings * (1 "" Payout) = $100 million (1 "" 0.45) = $ 55.0 million,

And BPRE= $55.0 million / 0.50 = $110 million.

The other statements are true.

WACC using internal equity (retained earnings):

WACC = (wd)(kd) + (ws)(ks), where wd, wsare the weights used for debt and retained earnings.

WACC = (0.50 * 7.0%) + (0.50 * 13.0%) =10.00%.

WACC using external equity (common stock):

WACC = (wd)(kd) + (we)(ke), where wd, weare the weights used for debt and common equity.

WACC = (0.50 * 7.0%) + (0.50 * 17.5%) =12.25%.

Note:To save time on the exam, remember that internal equity cost is less than external equity cost (or ks< ke) due to floatation costs.

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