Question 1

The discount rate assigned to an individual project should be based on:

Accepted Answer

A) the firm's weighted average cost of capital. 
B) the actual sources of funding used for the project. 
C) an average of the firm's overall cost of capital for the past five years. 
D) the current risk level of the overall firm. 
E) the risks associated with the use of the funds required by the project. 
A) the firm's weighted average cost of capital. 
B) the actual sources of funding used for the project. 
C) an average of the firm's overall cost of capital for the past five years. 
D) the current risk level of the overall firm. 
E) the risks associated with the use of the funds required by the project.

Question 2

Incorporating flotation costs into the analysis of a project will:

Accepted Answer

A) cause the project to be improperly evaluated. 
B) increase the net present value of the project. 
C) increase the project's rate of return. 
D) increase the initial cash outflow of the project. 
E) have no effect on the present value of the project. 
A) cause the project to be improperly evaluated. 
B) increase the net present value of the project. 
C) increase the project's rate of return. 
D) increase the initial cash outflow of the project. 
E) have no effect on the present value of the project.

Question 3

You are evaluating a project which requires $230,000 in external financing.The flotation cost of equity is 11.6 percent and the flotation cost of debt is 5.4 percent.What is the initial cost of the project including the flotation costs if you maintain a debt-equity ratio of 0.45?

Accepted Answer

A) $248,494 
B) $249,021 
C) $254,638 
D) $255,551 
E) $255,646 
A) $248,494 
B) $249,021 
C) $254,638 
D) $255,551 
E) $255,646

Question 4

All else constant,which one of the following will increase a firm's cost of equity if the firm computes that cost using the security market line approach? Assume the firm currently pays an annual dividend of $1 a share and has a beta of 1.2.

Accepted Answer

A) a reduction in the dividend amount 
B) an increase in the dividend amount 
C) a reduction in the market rate of return 
D) a reduction in the firm's beta 
E) a reduction in the risk-free rate 
A) a reduction in the dividend amount 
B) an increase in the dividend amount 
C) a reduction in the market rate of return 
D) a reduction in the firm's beta 
E) a reduction in the risk-free rate

Question 5

Morris Industries has a capital structure of 55 percent common stock,10 percent preferred stock,and 45 percent debt.The firm has a 60 percent dividend payout ratio,a beta of 0.89,and a tax rate of 38 percent.Given this,which one of the following statements is correct?

Accepted Answer

A) The aftertax cost of debt will be greater than the current yield-to-maturity on the firm's bonds. 
B) The firm's cost of preferred is most likely less than the firm's actual cost of debt. 
C) The firm's cost of equity is unaffected by a change in the firm's tax rate. 
D) The cost of equity can only be estimated using the SML approach. 
E) The firm's weighted average cost of capital will remain constant as long as the capital structure remains constant. 
A) The aftertax cost of debt will be greater than the current yield-to-maturity on the firm's bonds. 
B) The firm's cost of preferred is most likely less than the firm's actual cost of debt. 
C) The firm's cost of equity is unaffected by a change in the firm's tax rate. 
D) The cost of equity can only be estimated using the SML approach. 
E) The firm's weighted average cost of capital will remain constant as long as the capital structure remains constant.

Question 6

Markley and Stearns is a multi-divisional firm that uses its WACC as the discount rate for all proposed projects.Each division is in a separate line of business and each presents risks unique to those lines.Given this,a division within the firm will tend to:

Accepted Answer

A) receive less project funding if its line of business is riskier than that of the other divisions. 
B) avoid risky projects so it can receive more project funding. 
C) become less risky over time based on the projects that are accepted. 
D) have equal probability of receiving funding as compared to the other divisions. 
E) prefer higher risk projects over lower risk projects. 
A) receive less project funding if its line of business is riskier than that of the other divisions. 
B) avoid risky projects so it can receive more project funding. 
C) become less risky over time based on the projects that are accepted. 
D) have equal probability of receiving funding as compared to the other divisions. 
E) prefer higher risk projects over lower risk projects.

Question 7

Deep Mining and Precious Metals are separate firms that are both considering a silver exploration project.Deep Mining is in the actual mining business and has an aftertax cost of capital of 12.8 percent.Precious Metals is in the precious gem retail business and has an aftertax cost of capital of 10.6 percent.The project under consideration has initial costs of $575,000 and anticipated annual cash inflows of $102,000 a year for ten years.Which firm(s),if either,should accept this project?

Accepted Answer

A) Company A only 
B) Company B only 
C) both Company A and Company B 
D) neither Company A or Company B 
E) cannot be determined without further information 
A) Company A only 
B) Company B only 
C) both Company A and Company B 
D) neither Company A or Company B 
E) cannot be determined without further information

Question 8

The cost of preferred stock is computed the same as the:

Accepted Answer

A) pre-tax cost of debt. 
B) return on an annuity. 
C) aftertax cost of debt. 
D) return on a perpetuity. 
E) cost of an irregular growth common stock. 
A) pre-tax cost of debt. 
B) return on an annuity. 
C) aftertax cost of debt. 
D) return on a perpetuity. 
E) cost of an irregular growth common stock.

Question 9

Kelso's has a debt-equity ratio of 0.6 and a tax rate of 35 percent.The firm does not issue preferred stock.The cost of equity is 14.5 percent and the aftertax cost of debt is 4.8 percent.What is the weighted average cost of capital?

Accepted Answer

A) 10.46 percent 
B) 10.67 percent 
C) 10.86 percent 
D) 11.38 percent 
E) 11.57 percent 
A) 10.46 percent 
B) 10.67 percent 
C) 10.86 percent 
D) 11.38 percent 
E) 11.57 percent

Question 10

Chelsea Fashions is expected to pay an annual dividend of $0.80 a share next year.The market price of the stock is $19.60 and the growth rate is 5 percent.What is the firm's cost of equity?

Accepted Answer

A) 7.58 percent 
B) 7.91 percent 
C) 8.24 percent 
D) 9.08 percent 
E) 10.00 percent 
A) 7.58 percent 
B) 7.91 percent 
C) 8.24 percent 
D) 9.08 percent 
E) 10.00 percent

Question 11

The aftertax cost of debt generally increases when:
I.a firm's bond rating increases.
II.the market rate of interest increases.
III.tax rates decrease.
IV.bond prices rise.

Accepted Answer

A) I and III only 
B) II and III only 
C) I, II, and III only 
D) II, III, and IV only 
E) I, II, III, and IV 
A) I and III only 
B) II and III only 
C) I, II, and III only 
D) II, III, and IV only 
E) I, II, III, and IV

Question 12

The Bakery is considering a new project it considers to be a little riskier than its current operations.Thus,management has decided to add an additional 1.5 percent to the company's overall cost of capital when evaluating this project.The project has an initial cash outlay of $58,000 and projected cash inflows of $17,000 in year one,$28,000 in year two,and $30,000 in year three.The firm uses 25 percent debt and 75 percent common stock as its capital structure.The company's cost of equity is 15.5 percent while the aftertax cost of debt for the firm is 6.1 percent.What is the projected net present value of the new project?

Accepted Answer

A) -$6,208 
B) -$1,964 
C) -$308 
D) $1,427 
E) $1,573 
A) -$6,208 
B) -$1,964 
C) -$308 
D) $1,427 
E) $1,573

Question 13

Phillips Equipment has 80,000 bonds outstanding that are selling at par.Bonds with similar characteristics are yielding 7.5 percent.The company also has 750,000 shares of 7 percent preferred stock and 2.5 million shares of common stock outstanding.The preferred stock sells for $65 a share.The common stock has a beta of 1.34 and sells for $42 a share.The U.S.Treasury bill is yielding 2.8 percent and the return on the market is 11.2 percent.The corporate tax rate is 38 percent.What is the firm's weighted average cost of capital?

Accepted Answer

A) 10.15 percent 
B) 10.64 percent 
C) 11.18 percent 
D) 11.30 percent 
E) 11.56 percent 
A) 10.15 percent 
B) 10.64 percent 
C) 11.18 percent 
D) 11.30 percent 
E) 11.56 percent

Question 14

Assigning discount rates to individual projects based on the risk level of each project:

Accepted Answer

A) may cause the firm's overall weighted average cost of capital to either increase or decrease over time. 
B) will prevent the firm's overall cost of capital from changing over time. 
C) will cause the firm's overall cost of capital to decrease over time. 
D) decreases the value of the firm over time. 
E) negates the firm's goal of creating the most value for the shareholders. 
A) may cause the firm's overall weighted average cost of capital to either increase or decrease over time. 
B) will prevent the firm's overall cost of capital from changing over time. 
C) will cause the firm's overall cost of capital to decrease over time. 
D) decreases the value of the firm over time. 
E) negates the firm's goal of creating the most value for the shareholders.

Question 15

The dividend growth model can be used to compute the cost of equity for a firm in which of the following situations?
I.firms that have a 100 percent retention ratio
II.firms that pay a constant dividend
III.firms that pay an increasing dividend
IV.firms that pay a decreasing dividend

Accepted Answer

A) I and II only 
B) I and III only 
C) II and III only 
D) I, II, and III only 
E) II, III, and IV only 
A) I and II only 
B) I and III only 
C) II and III only 
D) I, II, and III only 
E) II, III, and IV only

Question 16

Jiminy's Cricket Farm issued a 30-year,8 percent,semiannual bond 6 years ago.The bond currently sells for 114 percent of its face value.What is the aftertax cost of debt if the company's tax rate is 31 percent?

Accepted Answer

A) 4.63 percent 
B) 4.70 percent 
C) 4.75 percent 
D) 4.82 percent 
E) 4.86 percent 
A) 4.63 percent 
B) 4.70 percent 
C) 4.75 percent 
D) 4.82 percent 
E) 4.86 percent

Question 17

Which one of the following statements is correct for a firm that uses debt in its capital structure?

Accepted Answer

A) The WACC should decrease as the firm's debt-equity ratio increases. 
B) When computing the WACC, the weight assigned to the preferred stock is based on the coupon rate multiplied by the par value of the preferred. 
C) The firm's WACC will decrease as the corporate tax rate decreases. 
D) The weight of the common stock used in the computation of the WACC is based on the number of shares outstanding multiplied by the book value per share. 
E) The WACC will remain constant unless a firm retires some of its debt. 
A) The WACC should decrease as the firm's debt-equity ratio increases. 
B) When computing the WACC, the weight assigned to the preferred stock is based on the coupon rate multiplied by the par value of the preferred. 
C) The firm's WACC will decrease as the corporate tax rate decreases. 
D) The weight of the common stock used in the computation of the WACC is based on the number of shares outstanding multiplied by the book value per share. 
E) The WACC will remain constant unless a firm retires some of its debt.

Question 18

Scholastic Toys is considering developing and distributing a new board game for children.The project is similar in risk to the firm's current operations.The firm maintains a debt-equity ratio of 0.40 and retains all profits to fund the firm's rapid growth.How should the firm determine its cost of equity?

Accepted Answer

A) by adding the market risk premium to the aftertax cost of debt 
B) by multiplying the market risk premium by (1 - 0.40) 
C) by using the dividend growth model 
D) by using the capital asset pricing model 
E) by averaging the costs based on the dividend growth model and the capital asset pricing model 
A) by adding the market risk premium to the aftertax cost of debt 
B) by multiplying the market risk premium by (1 - 0.40) 
C) by using the dividend growth model 
D) by using the capital asset pricing model 
E) by averaging the costs based on the dividend growth model and the capital asset pricing model

Question 19

The pre-tax cost of debt:

Accepted Answer

A) is based on the current yield to maturity of the firm's outstanding bonds. 
B) is equal to the coupon rate on the latest bonds issued by a firm. 
C) is equivalent to the average current yield on all of a firm's outstanding bonds. 
D) is based on the original yield to maturity on the latest bonds issued by a firm. 
E) has to be estimated as it cannot be directly observed in the market. 
A) is based on the current yield to maturity of the firm's outstanding bonds. 
B) is equal to the coupon rate on the latest bonds issued by a firm. 
C) is equivalent to the average current yield on all of a firm's outstanding bonds. 
D) is based on the original yield to maturity on the latest bonds issued by a firm. 
E) has to be estimated as it cannot be directly observed in the market.

Question 20

Phil's is a sit-down restaurant that specializes in home-cooked meals.Theresa's is a walk-in deli that specializes in specialty soups and sandwiches.Both firms are currently considering expanding their operations during the summer months by offering pre-wrapped donuts,sandwiches,and wraps at a local beach.Phil's currently has a WACC of 14 percent while Theresa's WACC is 10 percent.The expansion project has a projected net present value of $12,600 at a 10 percent discount rate and a net present value of -$2,080 at a 14 percent discount rate.Which firm or firms should expand and offer food at the local beach during the summer months?

Accepted Answer

A) Phil's only 
B) Theresa's only 
C) both Phil's and Theresa's 
D) neither Phil's nor Theresa's 
E) cannot be determined from the information provided 
A) Phil's only 
B) Theresa's only 
C) both Phil's and Theresa's 
D) neither Phil's nor Theresa's 
E) cannot be determined from the information provided

Exam 14: Cost of Capital

The discount rate assigned to an individual project should be based on:

Incorporating flotation costs into the analysis of a project will:

You are evaluating a project which requires $230,000 in external financing.The flotation cost of equity is 11.6 percent and the flotation cost of debt is 5.4 percent.What is the initial cost of the project including the flotation costs if you maintain a debt-equity ratio of 0.45?

All else constant,which one of the following will increase a firm's cost of equity if the firm computes that cost using the security market line approach? Assume the firm currently pays an annual dividend of $1 a share and has a beta of 1.2.

Morris Industries has a capital structure of 55 percent common stock,10 percent preferred stock,and 45 percent debt.The firm has a 60 percent dividend payout ratio,a beta of 0.89,and a tax rate of 38 percent.Given this,which one of the following statements is correct?

Markley and Stearns is a multi-divisional firm that uses its WACC as the discount rate for all proposed projects.Each division is in a separate line of business and each presents risks unique to those lines.Given this,a division within the firm will tend to:

The cost of preferred stock is computed the same as the:

Kelso's has a debt-equity ratio of 0.6 and a tax rate of 35 percent.The firm does not issue preferred stock.The cost of equity is 14.5 percent and the aftertax cost of debt is 4.8 percent.What is the weighted average cost of capital?

Chelsea Fashions is expected to pay an annual dividend of $0.80 a share next year.The market price of the stock is $19.60 and the growth rate is 5 percent.What is the firm's cost of equity?

The aftertax cost of debt generally increases when: I.a firm's bond rating increases. II.the market rate of interest increases. III.tax rates decrease. IV.bond prices rise.

Assigning discount rates to individual projects based on the risk level of each project:

The dividend growth model can be used to compute the cost of equity for a firm in which of the following situations? I.firms that have a 100 percent retention ratio II.firms that pay a constant dividend III.firms that pay an increasing dividend IV.firms that pay a decreasing dividend

Jiminy's Cricket Farm issued a 30-year,8 percent,semiannual bond 6 years ago.The bond currently sells for 114 percent of its face value.What is the aftertax cost of debt if the company's tax rate is 31 percent?

Which one of the following statements is correct for a firm that uses debt in its capital structure?

The pre-tax cost of debt:

Introduction to Corporate Finance

Financial Statements, Taxes, and Cash Flow

Working With Financial Statements

Long-Term Financial Planning and Growth

Introduction to Valuation: The Time Value of Money

Discounted Cash Flow Valuation

Interest Rates and Bond Valuation

Stock Valuation

Net Present Value and Other Investment Criteria

Making Capital Investment Decisions

Project Analysis and Evaluation

Some Lessons From Capital Market History

Return, Risk, and the Security Market Line

Raising Capital

Financial Leverage and Capital Structure Policy

Dividends and Payout Policy

Short-Term Finance and Planning

Cash and Liquidity Management

Credit and Inventory Management

International Corporate Finance

Behavioral Finance: Implications for Financial Management

Enterprise Risk Management

Options and Corporate Finance

Option Valuation

Mergers and Acquisitions

Leasing

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