Question 1

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

Accepted Answer

A)  The market risk premium (RPM). 
B)  The beta coefficient, bi, of a relatively safe stock. 
C)  The most appropriate risk-free rate, rRF. 
D)  The expected rate of return on the market, rM. 
E)  The beta coefficient of "the market," which is the same as the beta of an average stock. 
A)  The market risk premium (RPM). 
B)  The beta coefficient, bi, of a relatively safe stock. 
C)  The most appropriate risk-free rate, rRF. 
D)  The expected rate of return on the market, rM. 
E)  The beta coefficient of "the market," which is the same as the beta of an average stock.

Question 2

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 3

You were recently hired by Scheuer Media Inc. to estimate its cost of common equity. 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 4

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 5

Assume that you are on the financial staff of Vanderheiden Inc., and you have collected the following data: The yield on the company's outstanding bonds is 7.75%; its tax rate is 40%; the next expected dividend is $0.65 a share; the dividend is expected to grow at a constant rate of 6.00% a year; the price of the stock is $15.00 per share; the flotation cost for selling new shares is F = 10%; and the target capital structure is 45% debt and 55% common equity. What is the firm's WACC, assuming it must issue new stock to finance its capital budget?

Accepted Answer

A)  6.89% 
B)  7.26% 
C)  7.64% 
D)  8.04% 
E)  8.44% 
A)  6.89% 
B)  7.26% 
C)  7.64% 
D)  8.04% 
E)  8.44%

Question 6

When estimating the cost of equity by use of the DCF method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return. This problem leaves us unsure of the true value of rs.

Accepted Answer

A) True 
 B)False

Question 7

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 8

You were hired as a consultant to Quigley Company, whose target capital structure is 35% debt, 10% preferred, and 55% common equity. The interest rate on new debt is 6.50%, the yield on the preferred is 6.00%, the cost of common from retained earnings is 11.25%, and the tax rate is 40%. The firm will not be issuing any new common stock. What is Quigley's WACC?

Accepted Answer

A)  8.15% 
B)  8.48% 
C)  8.82% 
D)  9.17% 
E)  9.54% 
A)  8.15% 
B)  8.48% 
C)  8.82% 
D)  9.17% 
E)  9.54%

Question 9

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

Accepted Answer

A) True 
 B)False

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

Norris Enterprises, an all-equity firm, 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 accepted because its expected return (before any risk adjustments) is greater than its required return. 
B) 	The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return. 
C) 	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. 
D) 	The accept/reject decision depends on the firm's risk-adjustment policy.	If Norris' policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project. 
E) 	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. 
A) 	The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return. 
B) 	The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return. 
C) 	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. 
D) 	The accept/reject decision depends on the firm's risk-adjustment policy.	If Norris' policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project. 
E) 	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.

Question 12

Which of the following statements is CORRECT?

Accepted Answer

A)  When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation. 
B)  All else equal, an increase in a company's stock price will increase its marginal cost of retained earnings, rs. 
C)  All else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re. 
D)  Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt. 
E)  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. 
A)  When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation. 
B)  All else equal, an increase in a company's stock price will increase its marginal cost of retained earnings, rs. 
C)  All else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re. 
D)  Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt. 
E)  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.

Question 13

The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 - F)."

Accepted Answer

A) True 
 B)False

Question 14

Eakins Inc.'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 retained earnings?

Accepted Answer

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

Question 15

To help finance a major expansion, Castro Chemical Company sold a noncallable bond several years ago that now has 20 years to maturity. This bond has 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%

Question 16

Which of the following statements is CORRECT?

Accepted Answer

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 investors' expected returns, and that leads to a reduction in a company’s WACC. 
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 investors' expected returns, and that leads to a reduction in a company’s WACC.

Question 17

Which of the following statements is CORRECT?

Accepted Answer

A) 	The component cost of preferred stock is expressed as rp(1 - T). This follows because preferred stock dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes. 
B) 	A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firm’s stockholders would themselves expect to earn a return on earnings that were distributed rather than retained and reinvested. 
C) 	No cost should be assigned to retained earnings because the firm does not have to pay anything to raise them.	They are generated as cash flows by operating assets that were raised in the past; hence, they are “free.” 
D) 	Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into the foreseeable future.	In this case, the firm’s before-tax and after-tax costs of debt for purposes of calculating the WACC will both be equal to the interest rate on the firm’s currently outstanding debt, provided that debt was issued during the past 5 years. 
E) 	If a firm has enough retained earnings to fund its capital budget for the coming year, then there is no need to estimate either a cost of equity or a WACC. 
A) 	The component cost of preferred stock is expressed as rp(1 - T). This follows because preferred stock dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes. 
B) 	A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firm’s stockholders would themselves expect to earn a return on earnings that were distributed rather than retained and reinvested. 
C) 	No cost should be assigned to retained earnings because the firm does not have to pay anything to raise them.	They are generated as cash flows by operating assets that were raised in the past; hence, they are “free.” 
D) 	Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into the foreseeable future.	In this case, the firm’s before-tax and after-tax costs of debt for purposes of calculating the WACC will both be equal to the interest rate on the firm’s currently outstanding debt, provided that debt was issued during the past 5 years. 
E) 	If a firm has enough retained earnings to fund its capital budget for the coming year, then there is no need to estimate either a cost of equity or a WACC.

Question 18

The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant.

Accepted Answer

A) True 
 B)False

Question 19

Sorensen Systems Inc. is expected to pay a $2.50 dividend at year end (D1 = $2.50), the dividend is expected to grow at a constant rate of 5.50% a year, and the common stock currently sells for $52.50 a share. The before-tax cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of 45% debt and 55% common equity. What is the company's WACC if all the equity used is from retained earnings?

Accepted Answer

A)  7.07% 
B)  7.36% 
C)  7.67% 
D)  7.98% 
E)  8.29% 
A)  7.07% 
B)  7.36% 
C)  7.67% 
D)  7.98% 
E)  8.29%

Question 20

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

Accepted Answer

A) True 
 B)False

Exam 9: The Cost of Capital

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

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.

You were recently hired by Scheuer Media Inc. to estimate its cost of common equity. 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?

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.

When estimating the cost of equity by use of the DCF method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return. This problem leaves us unsure of the true value of rs.

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

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

Which of the following statements is CORRECT?

The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 - F)."

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant.

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

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

Risks and Rates of Return

Stocks and Their Valuation

Financial Options and Applications in Corporate Finance

The Basics of Capital Budgeting

Cash Flow Estimation and Risk Analysis

Financial Planning and Forecasting Financial Statements

Corporate Valuation, Value-Based Management, and Corporate Governance

Distributions to Shareholders: Dividends and Repurchases

Capital Structure Decisions

Working Capital Management

Multinational Financial Management

Lease Financing

Hybrid Financing: Preferred Stock, Warrants, and Convertibles

Initial Public Offerings, Investment Banking, and Financial Restructuring

Mergers, Lbos, Divestitures, and Holding Companies

Bankruptcy, Reorganization, and Liquidation

Derivatives and Risk Management

Portfolio Theory, Asset Pricing Models, and Behavioral Finance

Real Options

Analysis of Capital Structure Theory

Providing and Obtaining Credit

Advanced Issues in Cash Management and Inventory Control

Pension Plan Management

Financial Management in Not-For-Profit Businesses

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