Finance

American University in Bulgaria

BUS 330: Corporate Finance I

FALL 2012, AUBG

MIDTERM EXAM 2

Name: ___________________________________ ID _________

Version 2 Solution Guide

INSTRUCTIONS:

You have 75 minutes to complete the exam.

The exam is worth a total of 100 points.

3. You may use a calculator and scratch paper sheets. You must hand in the sheets with your exam (put your name on it).

4. Allocate your time wisely. Use the number of points assigned to each problem as your guide.

In order to get full credit on the problems, you must show ALL your work!

6. You can get partial credits if you show your calculations or provide arguments to support your answer.

No credits will be warded if you fail to state your assumptions or conclusions explicitly.

Part A: Multiple choice questions (2 points each, 12 points in total):

1. Which of the following statements is CORRECT?

a. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.

b. When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.

c. Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM.

d. If a company’s beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence must issue new stock.

e. Higher flotation costs reduce shareholders' expected returns and equity cost, and that leads to a reduction in a company’s WACC.

Answer: A

2. Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

a....