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

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 3

Which of the following statements is CORRECT?

Accepted Answer

A)  A change in a company's target capital structure cannot affect its WACC. 
B)  WACC calculations should be based on the before-tax costs of all the individual capital components. 
C)  Flotation costs associated with issuing new common stock normally reduce the WACC. 
D)  If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline. 
E) 	An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing. 
A)  A change in a company's target capital structure cannot affect its WACC. 
B)  WACC calculations should be based on the before-tax costs of all the individual capital components. 
C)  Flotation costs associated with issuing new common stock normally reduce the WACC. 
D)  If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline. 
E) 	An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.

Question 4

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

Accepted Answer

A)  Long-term debt. 
B)  Accounts payable. 
C)  Retained earnings. 
D)  Common stock. 
E)  Preferred stock. 
A)  Long-term debt. 
B)  Accounts payable. 
C)  Retained earnings. 
D)  Common stock. 
E)  Preferred stock.

Question 5

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 6

Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.
   The stock is currently selling for $15.25 per share, and its noncallable
$1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%.
-Based on the CAPM, what is the firm's cost of common stock?

Accepted Answer

A)  11.15% 
B)  11.73% 
C)  12.35% 
D)  13.00% 
E)  13.65% 
A)  11.15% 
B)  11.73% 
C)  12.35% 
D)  13.00% 
E)  13.65%

Question 7

Which of the following statements is CORRECT?

Accepted Answer

A)  Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs--beta, the risk-free rate, and the market risk premium--can be estimated with little error. 
B)  The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the DCF model's logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain. 
C)  The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm's own cost of debt and its risk premium, can be found by using standardized and objective procedures. 
D)  Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity. 
E) 	The DCF model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield. 
A)  Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs--beta, the risk-free rate, and the market risk premium--can be estimated with little error. 
B)  The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the DCF model's logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain. 
C)  The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm's own cost of debt and its risk premium, can be found by using standardized and objective procedures. 
D)  Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity. 
E) 	The DCF model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield.

Question 8

Assume that Kish Inc. hired you as a consultant to help estimate its cost of common equity. 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 common 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%

Question 9

O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b =
1.05. What is the firm's cost of common 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 10

Cranberry Corp. has two divisions of equal size: a computer manufacturing division and a data processing division. Its CFO believes that stand-alone data processor companies typically have a WACC of 8%, while stand-alone computer manufacturers typically have a 12% WACC. He also believes that the data processing and manufacturing divisions have the same risk as their typical peers. Consequently, he estimates that the composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the data processing division and a 12% hurdle rate for the manufacturing division. However, the CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is CORRECT?

Accepted Answer

A) 	While the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant’s recommendation, this should not affect the firm’s intrinsic value. 
B) 	The decision not to adjust for risk means, in effect, that it is favoring the data processing division.	Therefore, that division is likely to become a larger part of the consolidated company over time. 
C) 	The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division.	This will lead to a reduction in the firm’s intrinsic value over time. 
D) 	The decision not to risk-adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business.	This will lead to a reduction in its intrinsic value over time. 
E) 	The decision not to risk adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business.	This may affect the firm’s capital structure but it will not affect its intrinsic value. 
A) 	While the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant’s recommendation, this should not affect the firm’s intrinsic value. 
B) 	The decision not to adjust for risk means, in effect, that it is favoring the data processing division.	Therefore, that division is likely to become a larger part of the consolidated company over time. 
C) 	The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division.	This will lead to a reduction in the firm’s intrinsic value over time. 
D) 	The decision not to risk-adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business.	This will lead to a reduction in its intrinsic value over time. 
E) 	The decision not to risk adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business.	This may affect the firm’s capital structure but it will not affect its intrinsic value.

Question 11

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 deductable by the issuing firm.

Accepted Answer

A) True 
 B)False

Question 12

Which of the following statements is CORRECT?

Accepted Answer

A)  In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income. 
B)  We should use historical measures of the component costs from prior financings that are still outstanding when estimating a company's WACC for capital budgeting purposes. 
C)  The cost of new equity (re) could possibly be lower than the cost of retained earnings (rs) if the market risk premium, risk-free rate, and the company's beta all decline by a sufficiently large amount. 
D)  A firm's cost of retained earnings is the rate of return stockholders require on a firm's common stock. 
E)  The component cost of preferred stock is expressed as rp(1 - T), because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt. 
A)  In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income. 
B)  We should use historical measures of the component costs from prior financings that are still outstanding when estimating a company's WACC for capital budgeting purposes. 
C)  The cost of new equity (re) could possibly be lower than the cost of retained earnings (rs) if the market risk premium, risk-free rate, and the company's beta all decline by a sufficiently large amount. 
D)  A firm's cost of retained earnings is the rate of return stockholders require on a firm's common stock. 
E)  The component cost of preferred stock is expressed as rp(1 - T), because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt.

Question 13

The CFO of Lenox Industries hired you as a consultant to help estimate its cost of common equity. You have obtained the following data: (1) rd = yield on the firm's bonds = 7.00% and the risk premium over its own debt cost = 4.00%. (2) rRF = 5.00%, RPM = 6.00%, and b = 1.25. (3) D1 =
$1)20, P0 = $35.00, and g = 8.00% (constant). You were asked to estimate the cost of common based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates. What is that difference?

Accepted Answer

A)  1.13% 
B)  1.50% 
C)  1.88% 
D)  2.34% 
E)  2.58%
Multiple Part: 
A)  1.13% 
B)  1.50% 
C)  1.88% 
D)  2.34% 
E)  2.58%
Multiple Part:

Question 14

Bolster Foods' (BF) balance sheet shows a total of $25 million long- term debt with a coupon rate of 8.50%. The yield to maturity on this debt is 8.00%, and the debt has a total current market value of $27 million. The balance sheet also shows that the company has 10 million shares of stock, and the stock has a book value per share of $5.00. The current stock price is $20.00 per share, and stockholders' required rate of return, rs, is 12.25%. The company recently decided that its target capital structure should have 35% debt, with the balance being common equity. The tax rate is 40%. Calculate WACCs based on book, market, and target capital structures. What is the sum of these three WACCs?

Accepted Answer

A)  28.36% 
B)  29.54% 
C)  30.77% 
D)  32.00% 
E)  33.28% 
A)  28.36% 
B)  29.54% 
C)  30.77% 
D)  32.00% 
E)  33.28%

Question 15

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 16

Firm M's earnings and stock price tend to move up and down with other firms in the S&P 500, while Firm W's earnings and stock price move counter cyclically with M and other S&P companies. Both M and W estimate their costs of equity using the CAPM, they have identical market values, their standard deviations of returns are identical, and they both finance only with common equity. Which of the following statements is CORRECT?

Accepted Answer

A)  M should have the lower WACC because it is like most other companies, and investors like that fact. 
B)  M and W should have identical WACCs because their risks as measured by the standard deviation of returns are identical. 
C)  If M and W merge, then the merged firm MW should have a WACC that is a simple average of M's and W's WACCs. 
D)  Without additional information, it is impossible to predict what the merged firm's WACC would be if M and W merged. 
E)  Since M and W move counter cyclically to one another, if they merged, the merged firm's WACC would be less than the simple average of the two firms' WACCs.
Problems 
A)  M should have the lower WACC because it is like most other companies, and investors like that fact. 
B)  M and W should have identical WACCs because their risks as measured by the standard deviation of returns are identical. 
C)  If M and W merge, then the merged firm MW should have a WACC that is a simple average of M's and W's WACCs. 
D)  Without additional information, it is impossible to predict what the merged firm's WACC would be if M and W merged. 
E)  Since M and W move counter cyclically to one another, if they merged, the merged firm's WACC would be less than the simple average of the two firms' WACCs.
Problems

Question 17

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 18

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

Accepted Answer

A) True 
 B)False

Question 19

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. However, only the CAPM method always provides an accurate and reliable estimate.

Accepted Answer

A) True 
 B)False

Question 20

The reason why retained earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm's common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should distribute those earnings to its investors. Thus, the cost of retained earnings is based on the opportunity cost principle.

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 interest rate on new debt.

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?

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

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.

Which of the following statements is CORRECT?

Assume that Kish Inc. hired you as a consultant to help estimate its cost of common equity. 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 common from retained earnings?

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

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 deductable by the issuing firm.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

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).

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

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. However, only the CAPM method always provides an accurate and reliable estimate.

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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