Question 1

Trahern Baking Co. common stock sells for $32.50 per share. It expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, and its expected constant dividend growth rate is 6.0%. New stock can be sold to the public at the current price, but a flotation cost of 5% would be incurred. What would be the cost of equity from new common stock?

Accepted Answer

A)   12.70%
B)   13.37%
C)   14.04%
D)   14.74%
E)   15.48%F) B) and D)
G) B) and E)

Question 2

Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets. They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.

Accepted Answer

A) True 
 B)False

Question 3

For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity.

Accepted Answer

A) True 
 B)False

Question 4

When working with the CAPM, which of the following factors can be determined with the most precision?

Accepted Answer

A)   The beta coefficient, bi, of a relatively safe stock.
B)   The most appropriate risk-free rate, rRF.
C)   The expected rate of return on the market, rM.
D)   The beta coefficient of "the market," which is the same as the beta of an average stock.
E)   The market risk premium (RPM) .F) A) and D)
G) None of the above

Question 5

Which of the following statements is CORRECT?

Accepted Answer

A)   The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average after-tax cost of all the firm's outstanding debt.
B)   Suppose some of a publicly-traded firm's stockholders are not diversified; they hold only the one firm's stock. In this case, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firm's intrinsic value.
C)   The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity.
D)   The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm's cost of equity capital.
E)   The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity.F) A) and B)
G) C) and D)

Question 6

Westbrook's Painting Co. plans to issue a $1,000 par value, 20-year noncallable bond with a 7.00% annual coupon, paid semiannually. The company's marginal tax rate is 40.00%, but Congress is considering a change in the corporate tax rate to 30.00%. By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted?

Accepted Answer

A)   0.57%
B)   0.63%
C)   0.70%
D)   0.77%
E)   0.85%F) All of the above
G) B) and E)

Question 7

Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt.

Accepted Answer

A) True 
 B)False

Question 8

The CEO of Harding Media Inc. as asked you to help estimate its cost of common equity. You have obtained the following data: D0 = $0.85; P0 = $22.00; and gL = 6.00% (constant) . The CEO thinks, however, that the stock price is temporarily depressed, and that it will soon rise to $40.00. Based on the dividend growth model, by how much would the cost of common from reinvested earnings change if the stock price changes as the CEO expects?

Accepted Answer

A)   −1.49%
B)   −1.66%
C)   −1.84%
D)   −2.03%
E)   −2.23%F) C) and D)
G) All of the above

Question 9

Which of the following statements is CORRECT? Assume a company's target capital structure is 50% debt and 50% common equity.

Accepted Answer

A)   The WACC is calculated on a before-tax basis.
B)   The WACC exceeds the cost of equity.
C)   The cost of equity is always equal to or greater than the cost of debt.
D)   The cost of reinvested earnings typically exceeds the cost of new common stock.
E)   The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet.F) B) and E)
G) C) and D)

Question 10

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, is not deductible by the issuing firm.

Accepted Answer

A) True 
 B)False

Question 11

Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

Accepted Answer

A) True 
 B)False

Question 12

As the winner of a contest, you are now CFO for the day for Maguire Inc. and your day's job involves raising capital for expansion. Maguire's common stock currently sells for $45.00 per share, the company expects to earn $2.75 per share during the current year, its expected payout ratio is 70%, and its expected constant growth rate is 6.00%. New stock can be sold to the public at the current price, but a flotation cost of 8% would be incurred. By how much would the cost of new stock exceed the cost of common from reinvested earnings?

Accepted Answer

A)   0.09%
B)   0.19%
C)   0.37%
D)   0.56%
E)   0.84%F) D) and E)
G) B) and E)

Question 13

The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

Accepted Answer

A) True 
 B)False

Question 14

Taylor Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C)  should the company accept?

Accepted Answer

A)   Project C, which is of above-average risk and has a return of 11%.
B)   Project A, which is of average risk and has a return of 9%.
C)   None of the projects should be accepted.
D)   All of the projects should be accepted.
E)   Project B, which is of below-average risk and has a return of 8.5%.F) B) and E)
G) A) and C)

Question 15

The cost of capital used in capital budgeting should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets.

Accepted Answer

A) True 
 B)False

Question 16

Weatherall Enterprises has no debt or preferred stock⎯it is an all-equity firm⎯and has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than an average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT?

Accepted Answer

A)   The project should definitely be rejected because its expected return (before risk adjustment)  is less than its required return.
B)   Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment.
C)   The accept/reject decision depends on the firm's risk-adjustment policy. If Weatherall's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project.
D)   Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision.
E)   The project should definitely be accepted because its expected return (before any risk adjustments)  is greater than its required return.F) B) and E)
G) B) and D)

Question 17

Which of the following statements is CORRECT?

Accepted Answer

A)   The after-tax cost of debt usually exceeds the after-tax cost of equity.
B)   For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock.
C)   Retained earnings that were generated in the past and are reported on the firm's balance sheet are available to finance the firm's capital budget during the coming year.
D)   The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital.
E)   The WACC is calculated using before-tax costs for all components.F) None of the above
G) A) and B)

Question 18

Since 70% of the preferred dividends received by a corporation are excluded from taxable income, the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be
Cost of equity = rs(0.30)(0.50) + rps(1 − T)(0.70)(0.50).

Accepted Answer

A) True 
 B)False

Question 19

Which of the following statements is CORRECT?

Accepted Answer

A)   The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt.
B)   The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets.
C)   There is an "opportunity cost" associated with using reinvested earnings, hence they are not "free."
D)   The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year.
E)   The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital.F) C) and D)
G) B) and E)

Question 20

If expectations for long-term inflation rose, but the slope of the SML remained constant, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Therefore, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt.

Accepted Answer

A) True 
 B)False

Exam 9: The Cost of Capital

The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

Correct Answer
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Correct Answer
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Correct Answer
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Which of the following statements is CORRECT? Assume a company's target capital structure is 50% debt and 50% common equity.

Correct Answer
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Correct Answer
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Taylor Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?

Correct Answer
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When working with the CAPM, which of the following factors can be determined with the most precision?

Correct Answer
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The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, is not deductible by the issuing firm.

Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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The cost of capital used in capital budgeting should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets.

Correct Answer
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Correct Answer
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Correct Answer
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For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity.

Correct Answer
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Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

Correct Answer
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Exam 9: The Cost of Capital

The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT? Assume a company's target capital structure is 50% debt and 50% common equity.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Taylor Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?

Correct AnswerverifiedShow Answer

When working with the CAPM, which of the following factors can be determined with the most precision?

Correct AnswerverifiedShow Answer

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, is not deductible by the issuing firm.

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

The cost of capital used in capital budgeting should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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