Question 1

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  True

Question 2

Bosio Inc.'s perpetual preferred stock sells for $97.50 per share,and it pays an $8.50 annual dividend.If the company were to sell a new preferred issue,it would incur a flotation cost of 4.00% of the price paid by investors.What is the company's cost of preferred stock for use in calculating the WACC?

Accepted Answer

A) 8.72% 
B) 9.08% 
C) 9.44% 
D) 9.82% 
E) 10.22% 
A) 8.72% 
B) 9.08% 
C) 9.44% 
D) 9.82% 
E) 10.22% B

Question 3

If investors' aversion to risk rose,causing the slope of the SML to increase,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.Other things held constant,this would lead to an increase in the use of debt and a decrease in the use of equity.However,other things would not stay constant if firms used a lot more debt,as that would increase the riskiness of both debt and equity and thus limit the shift toward debt.

Accepted Answer

A) True 
 B)False  True

Question 4

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 5

Exhibit 10.1
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%.
-Refer to Exhibit 10.1.Which of the following is the best estimate for the weight of debt for use in calculating the WACC?

Accepted Answer

A) 18.67% 
B) 19.60% 
C) 20.58% 
D) 21.61% 
E) 22.69% 
A) 18.67% 
B) 19.60% 
C) 20.58% 
D) 21.61% 
E) 22.69%

Question 6

The cost of equity raised by retaining earnings can be less than,equal to,or greater than the cost of external equity raised by selling new issues of common stock,depending on tax rates,flotation costs,the attitude of investors,and other factors.

Accepted Answer

A) True 
 B)False

Question 7

If a typical U.S.company correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years,then the firm will most likely

Accepted Answer

A) become riskier over time, but its intrinsic value will be maximized. 
B) become less risky over time, and this will maximize its intrinsic value. 
C) accept too many low-risk projects and too few high-risk projects. 
D) become more risky and also have an increasing WACC. Its intrinsic value will not be maximized. 
E) continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital. 
A) become riskier over time, but its intrinsic value will be maximized. 
B) become less risky over time, and this will maximize its intrinsic value. 
C) accept too many low-risk projects and too few high-risk projects. 
D) become more risky and also have an increasing WACC. Its intrinsic value will not be maximized. 
E) continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital.

Question 8

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 9

When estimating the cost of equity by use of the CAPM,three potential problems are (1)whether to use long-term or short-term rates for rRF,(2)whether or not the historical beta is the beta that investors use when evaluating the stock,and (3)how to measure the market risk premium,RPM.These problems leave us unsure of the true value of rs.

Accepted Answer

A) True 
 B)False

Question 10

Trahan Lumber Company hired you to help estimate its cost of capital.You obtained the following data: D1 = $1.25; P0 = $27.50; g = 5.00% (constant); and F = 6.00%.What is the cost of equity raised by selling new common stock?

Accepted Answer

A) 9.06% 
B) 9.44% 
C) 9.84% 
D) 10.23% 
E) 10.64% 
A) 9.06% 
B) 9.44% 
C) 9.84% 
D) 10.23% 
E) 10.64%

Question 11

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

Weaver Chocolate Co.expects to earn $3.50 per share during the current year,its expected dividend payout ratio is 65%,its expected constant dividend growth rate is 6.0%,and its common stock currently sells for $32.50 per share.New stock can be sold to the public at the current price,but a flotation cost of 5% would be incurred.What would be the cost of equity from new common stock?

Accepted Answer

A) 12.70% 
B) 13.37% 
C) 14.04% 
D) 14.74% 
E) 15.48% 
A) 12.70% 
B) 13.37% 
C) 14.04% 
D) 14.74% 
E) 15.48%

Question 14

Bankston Corporation forecasts that if all of its existing financial policies are followed,its proposed capital budget would be so large that it would have to issue new common stock.Since new stock has a higher cost than retained earnings,Bankston would like to avoid issuing new stock.Which of the following actions would REDUCE its need to issue new common stock?

Accepted Answer

A) Increase the dividend payout ratio for the upcoming year. 
B) Increase the percentage of debt in the target capital structure. 
C) Increase the proposed capital budget. 
D) Reduce the amount of short-term bank debt in order to increase the current ratio. 
E) Reduce the percentage of debt in the target capital structure. 
A) Increase the dividend payout ratio for the upcoming year. 
B) Increase the percentage of debt in the target capital structure. 
C) Increase the proposed capital budget. 
D) Reduce the amount of short-term bank debt in order to increase the current ratio. 
E) Reduce the percentage of debt in the target capital structure.

Question 15

You were hired as a consultant to Giambono Company,whose target capital structure is 40% debt,15% preferred,and 45% common equity.The after-tax cost of debt is 6.00%,the cost of preferred is 7.50%,and the cost of retained earnings is 12.75%.The firm will not be issuing any new stock.What is its WACC?

Accepted Answer

A) 8.98% 
B) 9.26% 
C) 9.54% 
D) 9.83% 
E) 10.12% 
A) 8.98% 
B) 9.26% 
C) 9.54% 
D) 9.83% 
E) 10.12%

Question 16

Which of the following statements is CORRECT?

Accepted Answer

A) The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity. 
B) The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average after-tax cost of all the firm's outstanding debt. 
C) Suppose some of a publicly-traded firm's stockholders are not diversified; they hold only the one firm's stock. In this case, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firm's intrinsic value. 
D) The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity. 
E) The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm's cost of equity capital. 
A) The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity. 
B) The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average after-tax cost of all the firm's outstanding debt. 
C) Suppose some of a publicly-traded firm's stockholders are not diversified; they hold only the one firm's stock. In this case, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firm's intrinsic value. 
D) The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity. 
E) The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm's cost of equity capital.

Question 17

For a company whose target capital structure calls for 50% debt and 50% common equity,which of the following statements is CORRECT?

Accepted Answer

A) The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet. 
B) The WACC is calculated on a before-tax basis. 
C) The WACC exceeds the cost of equity. 
D) The cost of equity is always equal to or greater than the cost of debt. 
E) The cost of retained earnings typically exceeds the cost of new common stock. 
A) The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet. 
B) The WACC is calculated on a before-tax basis. 
C) The WACC exceeds the cost of equity. 
D) The cost of equity is always equal to or greater than the cost of debt. 
E) The cost of retained earnings typically exceeds the cost of new common stock.

Question 18

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 retained earnings is 11.25%,and the tax rate is 40%.The firm will not be issuing any new 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 19

Sapp Trucking's balance sheet shows a total of noncallable $45 million long-term debt with a coupon rate of 7.00% and a yield to maturity of 6.00%.This debt currently has a market value of $50 million.The balance sheet also shows that the company has 10 million shares of common stock,and the book value of the common equity (common stock plus retained earnings)is $65 million.The current stock price is $22.50 per share; stockholders' required return,rs,is 14.00%; and the firm's tax rate is 40%.The CFO thinks the WACC should be based on market-value weights,but the president thinks book weights are more appropriate.What is the difference between these two WACCs?

Accepted Answer

A) 1.55% 
B) 1.72% 
C) 1.91% 
D) 2.13% 
E) 2.36% 
A) 1.55% 
B) 1.72% 
C) 1.91% 
D) 2.13% 
E) 2.36%

Question 20

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

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

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 cost of equity raised by retaining earnings can be less than,equal to,or greater than the cost of external equity raised by selling new issues of common stock,depending on tax rates,flotation costs,the attitude of investors,and other factors.

If a typical U.S.company correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years,then the firm will most likely

Trahan Lumber Company hired you to help estimate its cost of capital.You obtained the following data: D₁ = $1.25; P₀ = $27.50; g = 5.00% (constant); and F = 6.00%.What is the cost of equity raised by selling new common stock?

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

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

For a company whose target capital structure calls for 50% debt and 50% common equity,which of the following statements is CORRECT?

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

An Overview of Financial Management

Financial Markets and Institutions

Financial Statements, cash Flow, and Taxes

Analysis of Financial Statements

Time Value of Money

Interest Rates

Bonds and Their Valuation

Risk and Rates of Return

Stocks and Their Valuation

The Basics of Capital Budgeting

Cash Flow Estimation and Risk Analysis

Real Options and Other Topics in Capital Budgeting

Capital Structure and Leverage

Distributions to Shareholders: Dividends and Share Repurchases

Working Capital Management

Financial Planning and Forecasting

Derivatives and Risk Management

Multinational Financial Management

Hybrid Financing: Preferred Stock, leasing, warrants, and Convertibles

Mergers and Acquisitions

Continuous Compounding and Discounting

Zero Coupon Bonds

Bankruptcy and Reorganization

Calculating Beta Coefficients

Using the Capm to Estimate the Risk-Adjusted Cost of Capital

Techniques for Measuring Beta Risk

Degree of Leverage

Filters

Exam 10: The Cost of Capital

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

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 cost of equity raised by retaining earnings can be less than,equal to,or greater than the cost of external equity raised by selling new issues of common stock,depending on tax rates,flotation costs,the attitude of investors,and other factors.

If a typical U.S.company correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years,then the firm will most likely

Trahan Lumber Company hired you to help estimate its cost of capital.You obtained the following data: D1 = $1.25; P0 = $27.50; g = 5.00% (constant); and F = 6.00%.What is the cost of equity raised by selling new common stock?

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

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

For a company whose target capital structure calls for 50% debt and 50% common equity,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)."

An Overview of Financial Management

Financial Markets and Institutions

Financial Statements, cash Flow, and Taxes

Analysis of Financial Statements

Time Value of Money

Interest Rates

Bonds and Their Valuation

Risk and Rates of Return

Stocks and Their Valuation

The Basics of Capital Budgeting

Cash Flow Estimation and Risk Analysis

Real Options and Other Topics in Capital Budgeting

Capital Structure and Leverage

Distributions to Shareholders: Dividends and Share Repurchases

Working Capital Management

Financial Planning and Forecasting

Derivatives and Risk Management

Multinational Financial Management

Hybrid Financing: Preferred Stock, leasing, warrants, and Convertibles

Mergers and Acquisitions

Continuous Compounding and Discounting

Zero Coupon Bonds

Bankruptcy and Reorganization

Calculating Beta Coefficients

Using the Capm to Estimate the Risk-Adjusted Cost of Capital

Techniques for Measuring Beta Risk

Degree of Leverage

Filters

Trahan Lumber Company hired you to help estimate its cost of capital.You obtained the following data: D₁ = $1.25; P₀ = $27.50; g = 5.00% (constant); and F = 6.00%.What is the cost of equity raised by selling new common stock?

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

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