Question 1

Which of the following statements is most correct?

Accepted Answer

A)  An increase in the corporate tax rate,would lower the weighted average cost of capital for an average firm,other things held constant. 
B)  Depreciation-generated funds have a cost equal to the firm's lowest WACC,and hence they have no impact on the MCC schedule. 
C)  As a firm's debt-to-assets ratio approaches 100 percent,the after-tax cost of debt,rdT,will be at its lowest level. 
D)  Statements a,b,and c are all true. 
E)  Statements a,b,and c are all false. 
A)  An increase in the corporate tax rate,would lower the weighted average cost of capital for an average firm,other things held constant. 
B)  Depreciation-generated funds have a cost equal to the firm's lowest WACC,and hence they have no impact on the MCC schedule. 
C)  As a firm's debt-to-assets ratio approaches 100 percent,the after-tax cost of debt,rdT,will be at its lowest level. 
D)  Statements a,b,and c are all true. 
E)  Statements a,b,and c are all false.

Question 2

Global Advertising Company
The Global Advertising Company had net income after interest but before taxes of $40,000 this year. The marginal tax rate is 40 percent, and the dividend payout ratio is 30 percent. The company can raise debt at a 12 percent interest rate for any amount of debt less than $8,000. If the firm raises $8,000 or more of debt, a 15 percent interest rate will apply to that new debt. The last dividend paid by Global was $0.90. Global's common stock is selling for $8.59 per share, and its expected growth rate in earnings and dividends is 5 percent. If Global issues new common stock, the flotation cost incurred will be 10 percent. Global plans to finance all capital expenditures with 30 percent debt and 70 percent equity.
-Refer to Global Advertising Company.What is the break point due to retained earnings being used up?

Accepted Answer

A)  $17,000 
B)  $30,000 
C)  $56,000 
D)  $24,000 
E)  $10,000 
A)  $17,000 
B)  $30,000 
C)  $56,000 
D)  $24,000 
E)  $10,000

Question 3

The correct discount rate for a firm to use in capital budgeting,assuming that new investments are of the same degree of risk as the firm's existing assets,is its marginal cost of capital.

Accepted Answer

A) True 
 B)False

Question 4

Rollins Corporation
Rollins Corporation is constructing its MCC schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock that pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find rs. The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent.
-Refer to Rollins Corporation.What is Rollins' WACC once it starts using new common stock financing?

Accepted Answer

A)  13.6% 
B)  14.1% 
C)  16.0% 
D)  16.6% 
E)  16.9% 
A)  13.6% 
B)  14.1% 
C)  16.0% 
D)  16.6% 
E)  16.9%

Question 5

Becker Glass Corporation
Becker Glass Corporation expects to have earnings before interest and taxes during the coming year of $1,000,000, and it expects its earnings and dividends to grow indefinitely at a constant annual rate of 12.5 percent. The firm has $5,000,000 of debt outstanding bearing a coupon interest rate of 8 percent, and it has 100,000 shares of common stock outstanding. Historically, Becker has paid 50 percent of net earnings to common shareholders in the form of dividends. The current price of Becker's common stock is $40, but it would incur a 10 percent flotation cost if it were to sell new stock. The firm's tax rate is 40 percent.
-Refer to J.Ross and Sons.What will be the WACC above this break point?

Accepted Answer

A)  12.5% 
B)  8.3% 
C)  10.6% 
D)  11.9% 
E)  14.1% 
A)  12.5% 
B)  8.3% 
C)  10.6% 
D)  11.9% 
E)  14.1%

Question 6

Which of the following statements is false?

Accepted Answer

A)  From a theoretical standpoint,the capital weights used to calculate the WACC should be based on the market values of the different securities.However,if a firm's book value weights are close to its market value weights,book value weights can be used as proxies. 
B)  Generally,only long-term debt is included in the calculation of the WACC,because the WACC is used for capital budgeting purposes,which includes long-term assets,and those assets are financed with long-term capital. 
C)  The first break point a firm encounters in capital budgeting is for retained earnings,unless a firm has zero or negative net income. 
D)  The weighted average cost of capital will change whenever a break point occurs. 
E)  Answers a and b are both false. 
A)  From a theoretical standpoint,the capital weights used to calculate the WACC should be based on the market values of the different securities.However,if a firm's book value weights are close to its market value weights,book value weights can be used as proxies. 
B)  Generally,only long-term debt is included in the calculation of the WACC,because the WACC is used for capital budgeting purposes,which includes long-term assets,and those assets are financed with long-term capital. 
C)  The first break point a firm encounters in capital budgeting is for retained earnings,unless a firm has zero or negative net income. 
D)  The weighted average cost of capital will change whenever a break point occurs. 
E)  Answers a and b are both false.

Question 7

Which of the following statements is most correct?

Accepted Answer

A)  The before-tax cost of preferred stock may be lower than the before-tax cost of debt,even though preferred stock is riskier than debt. 
B)  If a company's stock price increases,this increases its cost of equity capital. 
C)  If the cost of equity capital is low enough,it may be cheaper to issue common stock than it is to finance projects with retained earnings. 
D)  Both a and b are correct. 
E)  Answers a,b,and c are all correct. 
A)  The before-tax cost of preferred stock may be lower than the before-tax cost of debt,even though preferred stock is riskier than debt. 
B)  If a company's stock price increases,this increases its cost of equity capital. 
C)  If the cost of equity capital is low enough,it may be cheaper to issue common stock than it is to finance projects with retained earnings. 
D)  Both a and b are correct. 
E)  Answers a,b,and c are all correct.

Question 8

Retained earnings costs are lower than the costs of newly issued equity since a new issue will have flotation costs.

Accepted Answer

A) True 
 B)False

Question 9

Flotation costs lower the cost of capital to a firm when issuing new securities.

Accepted Answer

A) True 
 B)False

Question 10

Which of the following statements is correct?

Accepted Answer

A)  Because we often need to make comparisons among firms that are in different income tax brackets,it is best to calculate the WACC on a before-tax basis. 
B)  If a firm has been suffering accounting losses and is expected to continue suffering such losses,and therefore its tax rate is zero,it is possible that its after-tax component cost of preferred stock as used to calculate the WACC will be less than its after-tax component cost of debt. 
C)  Due to the way the MCC is constructed,the first break point in the MCC schedule must be associated with using up all available retained earnings and having to issue common stock. 
D)  Normally,the cost of external equity raised by issuing new common stock is above the cost of retained earnings.Moreover,the higher the growth rate is relative to the dividend yield,the more the cost of external equity will exceed the cost of retained earnings. 
E)  The lower a company's tax rate,the greater the advantage of using debt in terms of lowering its WACC. 
A)  Because we often need to make comparisons among firms that are in different income tax brackets,it is best to calculate the WACC on a before-tax basis. 
B)  If a firm has been suffering accounting losses and is expected to continue suffering such losses,and therefore its tax rate is zero,it is possible that its after-tax component cost of preferred stock as used to calculate the WACC will be less than its after-tax component cost of debt. 
C)  Due to the way the MCC is constructed,the first break point in the MCC schedule must be associated with using up all available retained earnings and having to issue common stock. 
D)  Normally,the cost of external equity raised by issuing new common stock is above the cost of retained earnings.Moreover,the higher the growth rate is relative to the dividend yield,the more the cost of external equity will exceed the cost of retained earnings. 
E)  The lower a company's tax rate,the greater the advantage of using debt in terms of lowering its WACC.

Question 11

A firm must earn the marginal cost of capital on new investments if it is to meet the return requirements of creditors and equity investors.

Accepted Answer

A) True 
 B)False

Question 12

Gargoyle Unlimited
Gargoyle Unlimited is planning to issue a zero coupon bond to fund a project that will yield its first positive cash flow in three years. That cash flow will be sufficient to pay off the entire debt issue. The bond's par value will be $1,000, it will mature in 3 years, and it will sell in the market for $727.25. The firm's marginal tax rate is 40 percent.
-Refer to Gargoyle Unlimited.What is the dollar value of the interest tax savings to the firm in the third year of the issue?

Accepted Answer

A)  $32.58 
B)  $40.29 
C)  $100.72 
D)  $60.43 
E)  $109.10 
A)  $32.58 
B)  $40.29 
C)  $100.72 
D)  $60.43 
E)  $109.10

Question 13

Even if a firm obtains all of its common equity from retained earnings,its MCC schedule might still increase if very large amounts of new capital are needed.

Accepted Answer

A) True 
 B)False

Question 14

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

Accepted Answer

A) True 
 B)False

Question 15

Anderson Company has four investment opportunities with the following costs (all costs are paid at t = 0)and estimated internal rates of return (IRR):   The company has a target capital structure that consists of 40 percent common equity,40 percent debt,and 20 percent preferred stock.The company has $1,000 in retained earnings.The company expects its year-end dividend to be $3.00 per share (i.e. ,   = $3.00).The dividend is expected to grow at a constant rate of 5 percent a year.The company's stock price is currently $42.75.If the company issues new common stock,the company will pay its investment bankers a 10 percent flotation cost.The company can issue corporate bonds with a yield to maturity of 10 percent.The company is in the 35 percent tax bracket.How large can the cost of preferred stock be (including flotation costs)and it still be profitable for the company to invest in all four projects?

Accepted Answer

A)  7.75% 
B)  8.90% 
C)  10.46% 
D)  11.54% 
E)  12.68% 
A)  7.75% 
B)  8.90% 
C)  10.46% 
D)  11.54% 
E)  12.68%

Question 16

Capital refers to items on the right-hand side of a firm's balance sheet.

Accepted Answer

A) True 
 B)False

Question 17

In applying the CAPM to estimate the cost of equity capital,which of the following elements is not subject to dispute or controversy?

Accepted Answer

A)  Expected rate of return on the market,rM. 
B)  The stock's beta coefficient,βi. 
C)  Risk-free rate,rRF. 
D)  Market risk premium (MRP). 
E)  All of the above are subject to dispute. 
A)  Expected rate of return on the market,rM. 
B)  The stock's beta coefficient,βi. 
C)  Risk-free rate,rRF. 
D)  Market risk premium (MRP). 
E)  All of the above are subject to dispute.

Question 18

Becker Glass Corporation
Becker Glass Corporation expects to have earnings before interest and taxes during the coming year of $1,000,000, and it expects its earnings and dividends to grow indefinitely at a constant annual rate of 12.5 percent. The firm has $5,000,000 of debt outstanding bearing a coupon interest rate of 8 percent, and it has 100,000 shares of common stock outstanding. Historically, Becker has paid 50 percent of net earnings to common shareholders in the form of dividends. The current price of Becker's common stock is $40, but it would incur a 10 percent flotation cost if it were to sell new stock. The firm's tax rate is 40 percent.
-Refer to Becker Glass Corporation.What is Becker's cost of newly issued stock?

Accepted Answer

A)  16.0% 
B)  16.5% 
C)  17.0% 
D)  17.5% 
E)  18.0% 
A)  16.0% 
B)  16.5% 
C)  17.0% 
D)  17.5% 
E)  18.0%

Question 19

Company can't lower its total cost of the $100 million of debt very much if any by the mix of debentures or mortgage bonds.
2)Debentures' risk rises as mortgage debt rises.
3)Mortgage bonds' risk rises as more mortgage bonds are issued.
4)So,the "WACD" will likely remain fairly stable.
25)Bouchard Company's stock sells for $20 per share,its last dividend (D0)was $1.00,its growth rate is a constant 6 percent,and the company would incur a flotation cost of 20 percent if it sold new common stock.Retained earnings for the coming year are expected to be $1,000,000,and the common equity ratio is 60 percent.If Bouchard has a capital budget of $2,000,000,what component cost of common equity will be built into the WACC for the last dollar of capital the company raises?

Accepted Answer

A)  11.30% 
B)  11.45% 
C)  11.80% 
D)  12.15% 
E)  12.63% 
A)  11.30% 
B)  11.45% 
C)  11.80% 
D)  12.15% 
E)  12.63%

Question 20

Gargoyle Unlimited
Gargoyle Unlimited is planning to issue a zero coupon bond to fund a project that will yield its first positive cash flow in three years. That cash flow will be sufficient to pay off the entire debt issue. The bond's par value will be $1,000, it will mature in 3 years, and it will sell in the market for $727.25. The firm's marginal tax rate is 40 percent.
-Refer to Gargoyle Unlimited.What is the expected after-tax cost of this debt issue?

Accepted Answer

A)  11.20% 
B)  4.48% 
C)  6.72% 
D)  6.10% 
E)  4.00% 
A)  11.20% 
B)  4.48% 
C)  6.72% 
D)  6.10% 
E)  4.00%

Which of the following statements is most correct?

The correct discount rate for a firm to use in capital budgeting,assuming that new investments are of the same degree of risk as the firm's existing assets,is its marginal cost of capital.

Which of the following statements is false?

Which of the following statements is most correct?

Retained earnings costs are lower than the costs of newly issued equity since a new issue will have flotation costs.

Flotation costs lower the cost of capital to a firm when issuing new securities.

Which of the following statements is correct?

A firm must earn the marginal cost of capital on new investments if it is to meet the return requirements of creditors and equity investors.

Even if a firm obtains all of its common equity from retained earnings,its MCC schedule might still increase if very large amounts of new capital are needed.

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

Capital refers to items on the right-hand side of a firm's balance sheet.

In applying the CAPM to estimate the cost of equity capital,which of the following elements is not subject to dispute or controversy?

An Overview of Finance

Financial Assets Instruments

Financial Markets and the Investment Banking Process

Financial Intermediaries and the Banking System

The Cost of Money Interest Rates

Business Organizations and the Tax Environment

Analysis of Financial Statements

Financial Planning and Control

Time Value of Money

Valuation Concepts

Risk and Rates of Return

Capital Budgeting

Capital Structure and Dividend Policy Decisions

Working Capital Management

Investment and Securities

Investment Analysis and Valuation Techniques

Filters

Exam 12: The Cost of Capital

Which of the following statements is most correct?

The correct discount rate for a firm to use in capital budgeting,assuming that new investments are of the same degree of risk as the firm's existing assets,is its marginal cost of capital.

Which of the following statements is false?

Which of the following statements is most correct?

Retained earnings costs are lower than the costs of newly issued equity since a new issue will have flotation costs.

Flotation costs lower the cost of capital to a firm when issuing new securities.

Which of the following statements is correct?

A firm must earn the marginal cost of capital on new investments if it is to meet the return requirements of creditors and equity investors.

Even if a firm obtains all of its common equity from retained earnings,its MCC schedule might still increase if very large amounts of new capital are needed.

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

Capital refers to items on the right-hand side of a firm's balance sheet.

In applying the CAPM to estimate the cost of equity capital,which of the following elements is not subject to dispute or controversy?

An Overview of Finance

Financial Assets Instruments

Financial Markets and the Investment Banking Process

Financial Intermediaries and the Banking System

The Cost of Money Interest Rates

Business Organizations and the Tax Environment

Analysis of Financial Statements

Financial Planning and Control

Time Value of Money

Valuation Concepts

Risk and Rates of Return

Capital Budgeting

Capital Structure and Dividend Policy Decisions

Working Capital Management

Investment and Securities

Investment Analysis and Valuation Techniques

Filters