Question 1

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

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

If a typical U.S. company correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely

Accepted Answer

A)  become riskier over time, but its intrinsic value will be maximized. 
B)  become less risky over time, and this will maximize its intrinsic value. 
C)  accept too many low-risk projects and too few high-risk projects. 
D)  become more risky and also have an increasing WACC. Its intrinsic value will not be maximized. 
E)  continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital. 
A)  become riskier over time, but its intrinsic value will be maximized. 
B)  become less risky over time, and this will maximize its intrinsic value. 
C)  accept too many low-risk projects and too few high-risk projects. 
D)  become more risky and also have an increasing WACC. Its intrinsic value will not be maximized. 
E)  continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital.

Question 4

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

Question 5

You were recently hired by Scheuer Media Inc. to estimate its cost of capital. You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.00% (constant); and F = 5.00%. What is the cost of equity raised by selling new common stock?

Accepted Answer

A)  10.77% 
B)  11.33% 
C)  11.90% 
D)  12.50% 
E)  13.12% 
A)  10.77% 
B)  11.33% 
C)  11.90% 
D)  12.50% 
E)  13.12%

Question 6

Which of the following statements is CORRECT?

Accepted Answer

A)  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. 
B)  The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes. 
C)  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. 
D)  Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt. 
E)  Higher flotation costs tend to reduce the cost of equity capital. 
A)  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. 
B)  The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes. 
C)  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. 
D)  Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt. 
E)  Higher flotation costs tend to reduce the cost of equity capital.

Question 7

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 8

Which of the following statements is CORRECT?

Accepted Answer

A)  The "break point" as discussed in the text refers to the point where the firm's tax rate increases. 
B)  The "break point" as discussed in the text refers to the point where the firm has raised so much capital that it is simply unable to borrow any more money. 
C)  The "break point" as discussed in the text refers to the point where the firm is taking on investments that are so risky the firm is in serious danger of going bankrupt if things do not go exactly as planned. 
D)  The "break point" as discussed in the text refers to the point where the firm has raised so much capital that it has exhausted its supply of new retained earnings and thus must raise equity by issuing stock. 
E)  The "break point" as discussed in the text refers to the point where the firm has exhausted its supply of new retained earnings and thus must begin to finance with preferred stock. 
A)  The "break point" as discussed in the text refers to the point where the firm's tax rate increases. 
B)  The "break point" as discussed in the text refers to the point where the firm has raised so much capital that it is simply unable to borrow any more money. 
C)  The "break point" as discussed in the text refers to the point where the firm is taking on investments that are so risky the firm is in serious danger of going bankrupt if things do not go exactly as planned. 
D)  The "break point" as discussed in the text refers to the point where the firm has raised so much capital that it has exhausted its supply of new retained earnings and thus must raise equity by issuing stock. 
E)  The "break point" as discussed in the text refers to the point where the firm has exhausted its supply of new retained earnings and thus must begin to finance with preferred stock.

Question 9

When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs.

Accepted Answer

A) True 
 B)False

Question 10

Which of the following statements is CORRECT?

Accepted Answer

A)  The WACC is calculated using before-tax costs for all components. 
B)  The after-tax cost of debt usually exceeds the after-tax cost of equity. 
C)  For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock. 
D)  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. 
E)  The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital. 
A)  The WACC is calculated using before-tax costs for all components. 
B)  The after-tax cost of debt usually exceeds the after-tax cost of equity. 
C)  For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock. 
D)  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. 
E)  The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital.

Question 11

Rivoli Inc. hired you as a consultant to help estimate its cost of capital. 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 equity from retained 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 12

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

Question 13

Which of the following statements is CORRECT?

Accepted Answer

A)  Since the costs of internal and external equity are related, an increase in the flotation cost required to sell a new issue of stock will increase the cost of retained earnings. 
B)  Since its stockholders are not directly responsible for paying a corporation's income taxes, corporations should focus on before-tax cash flows when calculating the WACC. 
C)  An increase in a firm's tax rate will increase the component cost of debt, provided the YTM on the firm's bonds is not affected by the change in the tax rate. 
D)  When the WACC is calculated, it should reflect the costs of new common stock, retained earnings, preferred stock, long-term debt, short-term bank loans if the firm normally finances with bank debt, and accounts payable if the firm normally has accounts payable on its balance sheet. 
E)  If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the after-tax cost of debt. 
A)  Since the costs of internal and external equity are related, an increase in the flotation cost required to sell a new issue of stock will increase the cost of retained earnings. 
B)  Since its stockholders are not directly responsible for paying a corporation's income taxes, corporations should focus on before-tax cash flows when calculating the WACC. 
C)  An increase in a firm's tax rate will increase the component cost of debt, provided the YTM on the firm's bonds is not affected by the change in the tax rate. 
D)  When the WACC is calculated, it should reflect the costs of new common stock, retained earnings, preferred stock, long-term debt, short-term bank loans if the firm normally finances with bank debt, and accounts payable if the firm normally has accounts payable on its balance sheet. 
E)  If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the after-tax cost of debt.

Question 14

O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of equity from retained earnings based on the CAPM?

Accepted Answer

A)  11.30% 
B)  11.64% 
C)  11.99% 
D)  12.35% 
E)  12.72% 
A)  11.30% 
B)  11.64% 
C)  11.99% 
D)  12.35% 
E)  12.72%

Question 15

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 16

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 17

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. Since we cannot be sure that the estimate obtained with any of these methods is correct, it is often appropriate to use all three methods, then consider all three estimates, and end up using a judgmental estimate when calculating the WACC.

Accepted Answer

A) True 
 B)False

Question 18

Several years ago the Jakob Company sold a $1,000 par value, noncallable bond that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually. The bond currently sells for $925, and the company's tax rate is 40%. What is the component cost of debt for use in the WACC calculation?

Accepted Answer

A)  4.28% 
B)  4.46% 
C)  4.65% 
D)  4.83% 
E)  5.03% 
A)  4.28% 
B)  4.46% 
C)  4.65% 
D)  4.83% 
E)  5.03%

Question 19

The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.

Accepted Answer

A) True 
 B)False

Question 20

Assume that Kish Inc. hired you as a consultant to help estimate its cost of capital. You have obtained the following data: D0 = $0.90; P0 = $27.50; and g = 7.00% (constant). Based on the DCF approach, what is the cost of equity from retained earnings?

Accepted Answer

A)  9.29% 
B)  9.68% 
C)  10.08% 
D)  10.50% 
E)  10.92% 
A)  9.29% 
B)  9.68% 
C)  10.08% 
D)  10.50% 
E)  10.92%

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.

If a typical U.S. company correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely

LaPango 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?

You were recently hired by Scheuer Media Inc. to estimate its cost of capital. You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.00% (constant); and F = 5.00%. What is the cost of equity raised by selling new common stock?

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.

Which of the following statements is CORRECT?

When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs.

Which of the following statements is CORRECT?

Rivoli Inc. hired you as a consultant to help estimate its cost of capital. 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 equity from retained earnings?

Which of the following statements is CORRECT?

O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of equity from retained earnings based on the CAPM?

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

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

The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.

Assume that Kish Inc. hired you as a consultant to help estimate its cost of capital. You have obtained the following data: D0 = $0.90; P0 = $27.50; and g = 7.00% (constant). Based on the DCF approach, what is the cost of equity from retained earnings?

Overview

Financial Markets

Financial Statements

Statement Analysis

Time Value of Money

Interest Rates

Bonds

Risk and Return

Stocks

Capital Budgeting

Cash Flow and Risk

Real Options

Capital Structure

Dividends

Working Capital

Forecasting

Derivatives

Multinational

Hybrid Financing

Mergers

Filters

Exam 10: Cost of Capital

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.

If a typical U.S. company correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely

LaPango 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?

You were recently hired by Scheuer Media Inc. to estimate its cost of capital. You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.00% (constant); and F = 5.00%. What is the cost of equity raised by selling new common stock?

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.

Which of the following statements is CORRECT?

When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs.

Which of the following statements is CORRECT?

Rivoli Inc. hired you as a consultant to help estimate its cost of capital. 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 equity from retained earnings?

Which of the following statements is CORRECT?

O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of equity from retained earnings based on the CAPM?

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

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

The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.

Assume that Kish Inc. hired you as a consultant to help estimate its cost of capital. You have obtained the following data: D0 = $0.90; P0 = $27.50; and g = 7.00% (constant). Based on the DCF approach, what is the cost of equity from retained earnings?

Overview

Financial Markets

Financial Statements

Statement Analysis

Time Value of Money

Interest Rates

Bonds

Risk and Return

Stocks

Capital Budgeting

Cash Flow and Risk

Real Options

Capital Structure

Dividends

Working Capital

Forecasting

Derivatives

Multinational

Hybrid Financing

Mergers

Filters