Question 1

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.

Accepted Answer

A) True 
 B)False

Question 2

Bartlett Company's target capital structure is 40% debt,15% preferred,and 45% common equity.The after-tax cost of debt is 6.00%,the cost of preferred is 7.50%,and the cost of common using reinvested earnings is 12.75%.The firm will not be issuing any new stock.You were hired as a consultant to help determine their cost of capital.What is its WACC?

Accepted Answer

A)  8.98% 
B)  9.26% 
C)  9.54% 
D)  9.83% 
E)  10.12% 
A)  8.98% 
B)  9.26% 
C)  9.54% 
D)  9.83% 
E)  10.12%

Question 3

The higher the firm's flotation cost for new common equity,the more likely the firm is to use preferred stock,which has no flotation cost,and reinvested earnings,whose cost is the average return on the assets that are acquired.

Accepted Answer

A) True 
 B)False

Question 4

Careco Company and Audaco Inc are identical in size and capital structure.However,the riskiness of their assets and cash flows are somewhat different,resulting in Careco having a WACC of 10% and Audaco a WACC of 12%.Careco is considering Project X,which has an IRR of 10.5% and is of the same risk as a typical Careco project.Audaco is considering Project Y,which has an IRR of 11.5% and is of the same risk as a typical Audaco project. Now assume that the two companies merge and form a new company,Careco/Audaco Inc.Moreover,the new company's market risk is an average of the pre-merger companies' market risks,and the merger has no impact on either the cash flows or the risks of Projects X and Y.Which of the following statements is CORRECT?

Accepted Answer

A)  If evaluated using the correct post-merger WACC, Project X would have a negative NPV. 
B)  After the merger, Careco/Audaco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y. 
C)  Careco/Audaco's WACC, as a result of the merger, would be 10%. 
D)  After the merger, Careco/Audaco should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%. 
E)  If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time. 
A)  If evaluated using the correct post-merger WACC, Project X would have a negative NPV. 
B)  After the merger, Careco/Audaco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y. 
C)  Careco/Audaco's WACC, as a result of the merger, would be 10%. 
D)  After the merger, Careco/Audaco should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%. 
E)  If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.

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. 
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.

Question 6

The president and CFO of Spellman Transportation are having a disagreement about whether to use market value or book value weights in calculating the WACC.Spellman's balance sheet shows a total of noncallable $45 million long-term debt with a coupon rate of 7.00% and a yield to maturity of 6.00%.This debt currently has a market value of $50 million.The company has 10 million shares of common stock,and the book value of the common equity (common stock plus retained earnings)is $65 million.The current stock price is $22.50 per share; stockholders' required return,rs,is 14.00%; and the firm's tax rate is 40%.The CFO thinks the WACC should be based on market value weights,but the president thinks book weights are more appropriate.What is the difference between these two WACCs?

Accepted Answer

A)  1.55% 
B)  1.72% 
C)  1.91% 
D)  2.13% 
E)  2.36% 
A)  1.55% 
B)  1.72% 
C)  1.91% 
D)  2.13% 
E)  2.36%

Question 7

As the assistant to the CFO of Johnstone Inc.,you must estimate its cost of common equity.You have been provided with the following data: D0 = $0.80; P0 = $22.50; and g = 8.00% (constant).Based on the DCF approach,what is the cost of common from reinvested earnings?

Accepted Answer

A)  10.69% 
B)  11.25% 
C)  11.84% 
D)  12.43% 
E)  13.05% 
A)  10.69% 
B)  11.25% 
C)  11.84% 
D)  12.43% 
E)  13.05%

Question 8

Which of the following statements is CORRECT?

Accepted Answer

A)  All else equal, an increase in a company's stock price will increase its marginal cost of reinvested earnings (not newly issued stock), rs. 
B)  All else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re. 
C)  Since the money is readily available, the after-tax cost of reinvested earnings (not newly issued stock) is usually much lower than the after-tax cost of debt. 
D)  If a company's tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall. 
E)  When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation. 
A)  All else equal, an increase in a company's stock price will increase its marginal cost of reinvested earnings (not newly issued stock), rs. 
B)  All else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re. 
C)  Since the money is readily available, the after-tax cost of reinvested earnings (not newly issued stock) is usually much lower than the after-tax cost of debt. 
D)  If a company's tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall. 
E)  When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation.

Question 9

Burnham Brothers Inc.has no retained earnings since it has always paid out all of its earnings as dividends.This same situation is expected to persist in the future.The company uses the CAPM to calculate its cost of equity,and its target capital structure consists of common stock,preferred stock,and debt.Which of the following events would REDUCE its WACC?

Accepted Answer

A)  The flotation costs associated with issuing new common stock increase. 
B)  The company's beta increases. 
C)  Expected inflation increases. 
D)  The flotation costs associated with issuing preferred stock increase. 
E)  The market risk premium declines. 
A)  The flotation costs associated with issuing new common stock increase. 
B)  The company's beta increases. 
C)  Expected inflation increases. 
D)  The flotation costs associated with issuing preferred stock increase. 
E)  The market risk premium declines.

Question 10

The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

Accepted Answer

A) True 
 B)False

Question 11

You have been hired as a consultant by Feludi Inc.'s CFO,who wants you to help her estimate the cost of capital.You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30.Based on the CAPM approach,what is the cost of common from reinvested earnings?

Accepted Answer

A)  9.67% 
B)  9.97% 
C)  10.28% 
D)  10.60% 
E)  10.93% 
A)  9.67% 
B)  9.97% 
C)  10.28% 
D)  10.60% 
E)  10.93%

Question 12

Which of the following statements is CORRECT?

Accepted Answer

A)  When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation. 
B)  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. 
C)  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 reinvested earnings to take care of its equity financing and hence must issue new stock. 
D)  Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC. 
E)  When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation. 
A)  When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation. 
B)  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. 
C)  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 reinvested earnings to take care of its equity financing and hence must issue new stock. 
D)  Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC. 
E)  When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.

Question 13

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them,and no flotation costs are required to raise them,but capital raised by selling new stock or bonds does have a cost.

Accepted Answer

A) True 
 B)False

Question 14

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% 
A)  0.57% 
B)  0.63% 
C)  0.70% 
D)  0.77% 
E)  0.85%

Question 15

For a typical firm,which of the following sequences is CORRECT? All rates are after taxes,and assume that the firm operates at its target capital structure.

Accepted Answer

A)  re > rs > WACC > rd. 
B)  WACC > re > rs > rd. 
C)  rd > re > rs > WACC. 
D)  WACC > rd > rs > re. 
E)  rs > re > rd > WACC. 
A)  re > rs > WACC > rd. 
B)  WACC > re > rs > rd. 
C)  rd > re > rs > WACC. 
D)  WACC > rd > rs > re. 
E)  rs > re > rd > WACC.

Question 16

Your consultant firm has been hired by Eco Brothers Inc.to help them estimate the cost of common equity.The yield on the firm's bonds is 8.75%,and your firm's economists believe that the cost of common can be estimated using a risk premium of 3.85% over a firm's own cost of debt.What is an estimate of the firm's cost of common from reinvested earnings?

Accepted Answer

A)  12.60% 
B)  13.10% 
C)  13.63% 
D)  14.17% 
E)  14.74% 
A)  12.60% 
B)  13.10% 
C)  13.63% 
D)  14.17% 
E)  14.74%

Question 17

Which of the following statements is CORRECT?

Accepted Answer

A)  The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes. 
B)  If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject. 
C)  Because no flotation costs are required to obtain capital as reinvested earnings, the cost of reinvested earnings is generally lower than the after-tax cost of debt. 
D)  Higher flotation costs tend to reduce the cost of equity capital. 
E)  Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity. 
A)  The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes. 
B)  If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject. 
C)  Because no flotation costs are required to obtain capital as reinvested earnings, the cost of reinvested earnings is generally lower than the after-tax cost of debt. 
D)  Higher flotation costs tend to reduce the cost of equity capital. 
E)  Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.

Question 18

If a firm is privately owned,and its stock is not traded in public markets,then we cannot measure its beta for use in the CAPM model,we cannot observe its stock price for use in the DCF model,and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method.All this makes it especially difficult to estimate the cost of equity for a private company.

Accepted Answer

A) True 
 B)False

Question 19

"Capital" is sometimes defined as funds supplied to a firm by investors.

Accepted Answer

A) True 
 B)False

Question 20

Kenny Electric Company's noncallable bonds were issued several years ago and now have 20 years to maturity.These bonds have a 9.25% annual coupon,paid semiannually,sells at a price of $1,075,and has a par value of $1,000.If the firm's tax rate is 40%,what is the component cost of debt for use in the WACC calculation?

Accepted Answer

A)  4.35% 
B)  4.58% 
C)  4.83% 
D)  5.08% 
E)  5.33% 
A)  4.35% 
B)  4.58% 
C)  4.83% 
D)  5.08% 
E)  5.33%

Exam 9: The Cost of Capital

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.

The higher the firm's flotation cost for new common equity,the more likely the firm is to use preferred stock,which has no flotation cost,and reinvested earnings,whose cost is the average return on the assets that are acquired.

Which of the following statements is CORRECT?

As the assistant to the CFO of Johnstone Inc.,you must estimate its cost of common equity.You have been provided with the following data: D0 = $0.80; P0 = $22.50; and g = 8.00% (constant).Based on the DCF approach,what is the cost of common from reinvested earnings?

Which of the following statements is CORRECT?

The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

You have been hired as a consultant by Feludi Inc.'s CFO,who wants you to help her estimate the cost of capital.You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30.Based on the CAPM approach,what is the cost of common from reinvested earnings?

Which of the following statements is CORRECT?

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them,and no flotation costs are required to raise them,but capital raised by selling new stock or bonds does have a cost.

For a typical firm,which of the following sequences is CORRECT? All rates are after taxes,and assume that the firm operates at its target capital structure.

Which of the following statements is CORRECT?

"Capital" is sometimes defined as funds supplied to a firm by investors.

An Overview of Financial Management and the Financial Environment

Financial Statements, cash Flow, and Taxes

Analysis of Financial Statements

Time Value of Money

Bonds, bond Valuation, and Interest Rates

Risk and Return

Valuation of Stocks and Corporations

Financial Options and Applications in Corporate Finance

The Basics of Capital Budgeting: Evaluating Cash Flows

Cash Flow Estimation and Risk Analysis

Corporate Valuation and Financial Planning

Agency Conflicts and Corporate Governance

Distributions to Shareholders: Dividends and Repurchases

Capital Structure Decisions

Supply Chains and Working Capital Management

Multinational Financial Management

Public and Private Financing: Initial Offerings, seasoned Offerings, and Investment Banks

Extension 18 A: Rights Offerings

Lease Financing

Hybrid Financing: Preferred Stock, warrants, and Convertibles

Dynamic Capital Structures

Mergers and Corporate Control

Enterprise Risk Management

Bankruptcy, reorganization, and Liquidation

Portfolio Theory and Asset Pricing Models

Real Options

Providing and Obtaining Credit

Advanced Issues in Cash Management and Inventory Control

Pension Plan Management

Financial Management in Not For Profit Businesses

Filters

As the assistant to the CFO of Johnstone Inc.,you must estimate its cost of common equity.You have been provided with the following data: D₀ = $0.80; P₀ = $22.50; and g = 8.00% (constant).Based on the DCF approach,what is the cost of common from reinvested earnings?

You have been hired as a consultant by Feludi Inc.'s CFO,who wants you to help her estimate the cost of capital.You have been provided with the following data: r_RF = 4.10%; RP_M = 5.25%; and b = 1.30.Based on the CAPM approach,what is the cost of common from reinvested earnings?