Question 1

Which of the following may be true concerning debt and equity?

Accepted Answer

A)  The cost of debt for Firm A is greater than the cost of equity for Firm A. 
B)  The cost of debt for Firm A is greater than the cost of equity for Firm B. 
C)  The cost of internally generated equity for Firm A is greater than the cost of externally generated equity funds for Firm A. 
D)  The cost of internally generated equity for Firm A is less than the cost of debt for Firm A. 
E)  None of the above could be true. 
A)  The cost of debt for Firm A is greater than the cost of equity for Firm A. 
B)  The cost of debt for Firm A is greater than the cost of equity for Firm B. 
C)  The cost of internally generated equity for Firm A is greater than the cost of externally generated equity funds for Firm A. 
D)  The cost of internally generated equity for Firm A is less than the cost of debt for Firm A. 
E)  None of the above could be true.

Question 2

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

Accepted Answer

A) True 
 B)False

Question 3

The cost of debt,rd,is always less than rs,so rd(1 − T)will certainly be less than rs.Therefore,since a firm cannot be 100% debt financed,the weighted average cost of capital will always be greater than rd(1 − T).

Accepted Answer

A) True 
 B)False

Question 4

Which of the following statements is most correct?

Accepted Answer

A)  If a company's tax rate increases but the yield to maturity of its noncallable bonds remains the same,the company's marginal cost of debt capital used to calculate its weighted average cost of capital will fall. 
B)  All else equal,an increase in a company's stock price will increase the marginal cost of retained earnings. 
C)  All else equal,an increase in a company's stock price will increase the marginal cost of issuing new common equity. 
D)  Answers a and b are both correct. 
E)  Answers b and c are both correct. 
A)  If a company's tax rate increases but the yield to maturity of its noncallable bonds remains the same,the company's marginal cost of debt capital used to calculate its weighted average cost of capital will fall. 
B)  All else equal,an increase in a company's stock price will increase the marginal cost of retained earnings. 
C)  All else equal,an increase in a company's stock price will increase the marginal cost of issuing new common equity. 
D)  Answers a and b are both correct. 
E)  Answers b and c are both correct.

Question 5

Byron Corporation
Byron Corporation's present capital structure, which is also its target capital structure, is 40 percent debt and 60 percent common equity. Next year's net income is projected to be $21,000, and Byron's payout ratio is 30 percent. The company's earnings and dividends are growing at a constant rate of 5 percent; the last dividend (D0) was $2.00; and the current equilibrium stock price is $21.88. Byron can raise all the debt financing it needs at 14.0 percent. If Byron issues new common stock, a 20 percent flotation cost will be incurred. The firm's marginal tax rate is 40 percent.
-Refer to Byron Corporation.What is the maximum amount of new capital that can be raised at the lowest component cost of equity? (In other words,what is the retained earnings break point?
)

Accepted Answer

A)  $12,600 
B)  $14,700 
C)  $17,400 
D)  $21,000 
E)  $24,500 
A)  $12,600 
B)  $14,700 
C)  $17,400 
D)  $21,000 
E)  $24,500

Question 6

Gulf Electric Company (GEC)
Gulf Electric Company (GEC) uses only debt and equity in its capital structure. It can borrow unlimited amounts at an interest rate of 10 percent so long as it finances at its target capital structure, which calls for 55 percent debt and 45 percent common equity. Its last dividend was $2.20; its expected constant growth rate is 6 percent; its stock sells on the NYSE at a price of $35; and new stock would net the company $30 per share after flotation costs. GEC's tax rate is 40 percent, and it expects to have $100 million of retained earnings this year. GEC has two projects available: Project A has a cost of $200 million and a rate of return of 13 percent, while Project B has a cost of $125 million and a rate of return of 10 percent. All of the company's potential projects are equally risky.
-Refer to Gulf Electric Company.Assume now that GEC needs to raise $300 million in new capital.What is GEC's marginal cost of capital for evaluating the $300 million in capital projects and any others that might arise during the year?

Accepted Answer

A)  6.00% 
B)  13.77% 
C)  12.66% 
D)  9.50% 
E)  9.00% 
A)  6.00% 
B)  13.77% 
C)  12.66% 
D)  9.50% 
E)  9.00%

Question 7

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 is the firm's cost of retained earnings?

Accepted Answer

A)  10.0% 
B)  12.5% 
C)  15.5% 
D)  16.5% 
E)  18.0% 
A)  10.0% 
B)  12.5% 
C)  15.5% 
D)  16.5% 
E)  18.0%

Question 8

The cost of issuing preferred stock by a corporation must be adjusted to an after-tax figure because of the 70 percent dividend exclusion provision for corporations holding other corporations' preferred stock.

Accepted Answer

A) True 
 B)False

Question 9

An increase in total assets can be financed by an increase in which of the following capital components:

Accepted Answer

A)  debt 
B)  preferred stock 
C)  common equity 
D)  All of the above 
A)  debt 
B)  preferred stock 
C)  common equity 
D)  All of the above

Question 10

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.Where will a break in the WACC curve occur?

Accepted Answer

A)  $30,000 
B)  $20,000 
C)  $10,000 
D)  $42,000 
E)  There will be no breaks in the WACC curve. 
A)  $30,000 
B)  $20,000 
C)  $10,000 
D)  $42,000 
E)  There will be no breaks in the WACC curve.

Question 11

Your company's stock sells for $50 per share,its last dividend (D0)was $2.00,its growth rate is a constant 5 percent,and the company would incur a flotation cost of 15 percent if it sold new common stock.Net income for the coming year is expected to be $500,000 and the firm's payout ratio is 60 percent.The firm's common equity ratio is 30 percent and it has no preferred stock outstanding.The firm can borrow up to $300,000 at an interest rate of 7 percent;any additional debt will have an interest rate of 9 percent.Your company's tax rate is 40 percent.If the firm has a capital budget of $1,000,000,what is the WACC for the last dollar of capital the company raises?

Accepted Answer

A)  3.78% 
B)  6.76% 
C)  9.94% 
D)  11.81% 
E)  13.25% 
A)  3.78% 
B)  6.76% 
C)  9.94% 
D)  11.81% 
E)  13.25%

Question 12

Which of the following is not considered a capital component?

Accepted Answer

A)  Long-term debt. 
B)  Common stock. 
C)  Short-term debt. 
D)  Preferred stock. 
E)  All of the above are considered capital components. 
A)  Long-term debt. 
B)  Common stock. 
C)  Short-term debt. 
D)  Preferred stock. 
E)  All of the above are considered capital components.

Question 13

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.There are two break points in Global's MCC schedule,one when retained earnings have been used up,and one when low-cost debt has been used up ($26,667).Therefore,there are three intervals in the MCC schedule.What is the marginal cost of capital in each of these intervals?
1st interval 2nd interval 3rd interval

Accepted Answer

A)  13.99% 15.64% 14.21% 
B)  14.80% 15.64% 16.92% 
C)  13.36% 14.21% 14.75% 
D)  13.36% 13.49% 14.75% 
E)  13.99% 14.21% 16.92% 
A)  13.99% 15.64% 14.21% 
B)  14.80% 15.64% 16.92% 
C)  13.36% 14.21% 14.75% 
D)  13.36% 13.49% 14.75% 
E)  13.99% 14.21% 16.92%

Question 14

The ____ is the return that must be earned on invested funds to cover the cost of financing such investments

Accepted Answer

A)  cost of capital 
B)  opportunity cost rate 
C)  required rate of return 
D)  All of the above. 
A)  cost of capital 
B)  opportunity cost rate 
C)  required rate of return 
D)  All of the above.

Question 15

Tapley Inc.'s current (target)capital structure has a target debt-to-assets ratio (D/TA)of 60 percent.The firm can raise up to $5 million in new debt at a before-tax cost of 8 percent.If more debt is required,the initial cost will be 8.5 percent,and if more than $10 million of debt is required,the cost will be 9 percent.Net income for the previous year was $10 million,and it is expected to increase by 10 percent this year.The firm expects to maintain its dividend payout ratio of 40 percent on the 1 million shares of common stock outstanding.If it must sell new common stock,it would encounter a 10 percent flotation cost on the first $2 million,a 15 percent cost if more than $2 million but less than $4 million is needed,and a 20 percent cost if more than $4 million of new outside equity is required.Tapley's tax rate is 30 percent,and its current stock price is $88 per share.If the firm has an unlimited number of projects that will earn a 10.25 percent return,what is the maximum capital budget that can be adopted without adversely affecting stockholder wealth?

Accepted Answer

A)  $32.0 million 
B)  $15.9 million 
C)  $23.0 million 
D)  $10.6 million 
E)  $26.5 million 
A)  $32.0 million 
B)  $15.9 million 
C)  $23.0 million 
D)  $10.6 million 
E)  $26.5 million

Question 16

The investment opportunity schedule is a graph of the firm's investment opportunities ranked in order of the projects' expected rates of return.

Accepted Answer

A) True 
 B)False

Question 17

Which of the following statements is correct?

Accepted Answer

A)  Although some methods of estimating the cost of capital encounter severe difficulties,the CAPM is a simple and reliable model that provides great accuracy and consistency in estimating the cost of capital. 
B)  The DCF model is preferred over other models to estimate the cost of equity because of the ease with which a firm's growth rate is obtained. 
C)  The bond-yield-plus-risk-premium approach to estimating the cost of equity is not always accurate but its advantages are that it is a standardized and objective model. 
D)  The tax savings associated with depreciation are an additional source of capital and,in fact,represent the largest single source of funds for some firms. 
E)  None of the above is a correct statement. 
A)  Although some methods of estimating the cost of capital encounter severe difficulties,the CAPM is a simple and reliable model that provides great accuracy and consistency in estimating the cost of capital. 
B)  The DCF model is preferred over other models to estimate the cost of equity because of the ease with which a firm's growth rate is obtained. 
C)  The bond-yield-plus-risk-premium approach to estimating the cost of equity is not always accurate but its advantages are that it is a standardized and objective model. 
D)  The tax savings associated with depreciation are an additional source of capital and,in fact,represent the largest single source of funds for some firms. 
E)  None of the above is a correct statement.

Question 18

Heavy Metal Corp.is a steel manufacturer that finances its operations with 40 percent debt,10 percent preferred stock,and 50 percent equity.Its net income is $100 million and it has a payout ratio of 35 percent.The interest rate on the company's debt is 11 percent.The preferred stock pays an annual dividend of $2 and sells for $20 a share.The company's common stock trades at $30 a share and its current dividend (D0)of $2 a share is expected to grow at a constant rate of 8 percent per year.The flotation cost of external equity is 15 percent of the dollar amount issued,while the flotation cost on preferred stock is 10 percent.The company estimates that its WACC is 12.30 percent.Assume that the company is raising $150 million in total capital.What is the company's tax rate?

Accepted Answer

A)  30.33% 
B)  32.87% 
C)  35.75% 
D)  38.12% 
E)  40.98% 
A)  30.33% 
B)  32.87% 
C)  35.75% 
D)  38.12% 
E)  40.98%

Question 19

Assume that a firm's financial analysts determine that a decrease in the firm's debt-to-assets ratio will cause a decrease in both the component cost of debt rd(1 − T)and the component cost of equity (rs).This information tells us that the firm's present debt-to-assets ratio is above its optimal ratio.

Accepted Answer

A) True 
 B)False

Question 20

Which of the following statements is correct?

Accepted Answer

A)  Capital components are the types of capital used by firms to raise money.All capital comes from one of three components: long-term debt,preferred stock,and equity. 
B)  Preferred stock does not involve any adjustment for flotation cost since the dividend and price are fixed. 
C)  The cost of debt used in calculating the WACC is an average of the after-tax cost of new debt and of outstanding debt. 
D)  The opportunity cost principle implies that if the firm cannot invest retained earnings and earn at least rs,it should pay these funds to its stockholders and let them invest directly in other assets that do provide this return. 
E)  The cost of new common equity includes an adjustment for flotation costs that is expressed as a fixed percentage of the current stock price.The flotation percentage is determined jointly by the current price of the firm's stock and its growth rate. 
A)  Capital components are the types of capital used by firms to raise money.All capital comes from one of three components: long-term debt,preferred stock,and equity. 
B)  Preferred stock does not involve any adjustment for flotation cost since the dividend and price are fixed. 
C)  The cost of debt used in calculating the WACC is an average of the after-tax cost of new debt and of outstanding debt. 
D)  The opportunity cost principle implies that if the firm cannot invest retained earnings and earn at least rs,it should pay these funds to its stockholders and let them invest directly in other assets that do provide this return. 
E)  The cost of new common equity includes an adjustment for flotation costs that is expressed as a fixed percentage of the current stock price.The flotation percentage is determined jointly by the current price of the firm's stock and its growth rate.

Which of the following may be true concerning debt and equity?

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

The cost of debt,r_d,is always less than r_s,so r_d(1 − T)will certainly be less than r_s.Therefore,since a firm cannot be 100% debt financed,the weighted average cost of capital will always be greater than r_d(1 − T).

Which of the following statements is most correct?

The cost of issuing preferred stock by a corporation must be adjusted to an after-tax figure because of the 70 percent dividend exclusion provision for corporations holding other corporations' preferred stock.

An increase in total assets can be financed by an increase in which of the following capital components:

Which of the following is not considered a capital component?

The ____ is the return that must be earned on invested funds to cover the cost of financing such investments

The investment opportunity schedule is a graph of the firm's investment opportunities ranked in order of the projects' expected rates of return.

Which of the following statements is correct?

Which of the following statements is correct?

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 may be true concerning debt and equity?

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

The cost of debt,rd,is always less than rs,so rd(1 − T)will certainly be less than rs.Therefore,since a firm cannot be 100% debt financed,the weighted average cost of capital will always be greater than rd(1 − T).

Which of the following statements is most correct?

The cost of issuing preferred stock by a corporation must be adjusted to an after-tax figure because of the 70 percent dividend exclusion provision for corporations holding other corporations' preferred stock.

An increase in total assets can be financed by an increase in which of the following capital components:

Which of the following is not considered a capital component?

The ____ is the return that must be earned on invested funds to cover the cost of financing such investments

The investment opportunity schedule is a graph of the firm's investment opportunities ranked in order of the projects' expected rates of return.

Which of the following statements is correct?

Which of the following statements is correct?

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

The cost of debt,r_d,is always less than r_s,so r_d(1 − T)will certainly be less than r_s.Therefore,since a firm cannot be 100% debt financed,the weighted average cost of capital will always be greater than r_d(1 − T).