Question 1

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 2

If the MCC includes five break points, then there will be ____ different WACCs.

Accepted Answer

A)  2 
B)  3 
C)  4 
D)  5 
E)  6 
A)  2 
B)  3 
C)  4 
D)  5 
E)  6

Question 3

Marginal Cost of Capital
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 4

Which of the following statements is correct?

Accepted Answer

A)  The WACC should include only after-tax component costs.Therefore, the required rates of return (or "market rates") on debt, preferred, and common equity (rd, rps, and rs or e) must be adjusted to an after-tax basis before they are used in the WACC equation. 
B)  The cost of retained earnings is generally higher than the cost of new common stock. 
C)  Preferred stock is riskier to investors than is debt.Therefore, if someone told you that the market rates showed rd > rps for a given company, that person must have made a mistake. 
D)  When the MCC schedule is developed, the first break point always occurs as a result of using up retained earnings. 
E)  If a company with a debt-to-assets ratio of 50 percent were suddenly exempted from all future income taxes, then, all other things held constant, this would cause its WACC to increase. 
A)  The WACC should include only after-tax component costs.Therefore, the required rates of return (or "market rates") on debt, preferred, and common equity (rd, rps, and rs or e) must be adjusted to an after-tax basis before they are used in the WACC equation. 
B)  The cost of retained earnings is generally higher than the cost of new common stock. 
C)  Preferred stock is riskier to investors than is debt.Therefore, if someone told you that the market rates showed rd > rps for a given company, that person must have made a mistake. 
D)  When the MCC schedule is developed, the first break point always occurs as a result of using up retained earnings. 
E)  If a company with a debt-to-assets ratio of 50 percent were suddenly exempted from all future income taxes, then, all other things held constant, this would cause its WACC to increase.

Question 5

WACC
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 rS1U1B1sS1U1B0.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' cost of preferred stock?

Accepted Answer

A)  10.0% 
B)  11.0% 
C)  12.0% 
D)  12.6% 
E)  13.2% 
A)  10.0% 
B)  11.0% 
C)  12.0% 
D)  12.6% 
E)  13.2%

Question 6

The weighted average cost of capital increases if the total funds required call for an amount of equity in excess of what can be obtained as retained earnings.

Accepted Answer

A) True 
 B)False

Question 7

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 8

The steeper the demand curve for a firm's stock, the closer the values of rs and re are to one another, other things held constant.

Accepted Answer

A) True 
 B)False

Question 9

The component costs of capital are market-determined variables in as much as they are based on investors' required returns.

Accepted Answer

A) True 
 B)False

Question 10

Only long-term debt should be used to compute the component cost of debt used in the WACC.

Accepted Answer

A) True 
 B)False

Question 11

Which of the following statements is correct?

Accepted Answer

A)  Beta measures market risk, but if a firm's stockholders are not well diversified, beta may not accurately measure the firm's total risk. 
B)  If the calculated beta underestimates the firm's true investment risk, then the CAPM method will overestimate rs. 
C)  The discounted cash flow method of estimating the cost of equity can't be used unless the growth component, g, is constant during the analysis period. 
D)  An advantage shared by both the DCF and CAPM methods of estimating the cost of equity capital, is that they yield precise estimates and require little or no judgment. 
E)  None of the above is a correct statement. 
A)  Beta measures market risk, but if a firm's stockholders are not well diversified, beta may not accurately measure the firm's total risk. 
B)  If the calculated beta underestimates the firm's true investment risk, then the CAPM method will overestimate rs. 
C)  The discounted cash flow method of estimating the cost of equity can't be used unless the growth component, g, is constant during the analysis period. 
D)  An advantage shared by both the DCF and CAPM methods of estimating the cost of equity capital, is that they yield precise estimates and require little or no judgment. 
E)  None of the above is a correct statement.

Question 12

In general, it is not possible for re, the cost of new equity, to be lower than rs, the cost of retained earnings.However, an exception to this rule occurs when the stock price increases just prior to the firm issuing new equity such that it more than offsets the flotation costs and thus, re becomes less than rs.

Accepted Answer

A) True 
 B)False

Question 13

WACC
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 rS1U1B1sS1U1B0.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' retained earnings break point?

Accepted Answer

A)  $600,000 
B)  $800,000 
C)  $1,000,000 
D)  $1,200,000 
E)  $1,400,000 
A)  $600,000 
B)  $800,000 
C)  $1,000,000 
D)  $1,200,000 
E)  $1,400,000

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

____ is the portion of net income not paid out in the form of dividends.

Accepted Answer

A)  Par value 
B)  Paid in capital 
C)  Retained earnings 
D)  Common equity 
A)  Par value 
B)  Paid in capital 
C)  Retained earnings 
D)  Common equity

Question 16

The ____ is the dollar value of new capital that can be raised before an increase in the firm's weighted cost of capital.

Accepted Answer

A)  marginal cost of capital 
B)  inflection point 
C)  break even quantity 
D)  break point 
A)  marginal cost of capital 
B)  inflection point 
C)  break even quantity 
D)  break point

Question 17

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 18

Which of the following factors in the discounted cash flow (DCF) approach to estimating the cost of common equity is the least difficult to estimate?

Accepted Answer

A) Expected growth rate, g. 
B) Dividend yield,   . 
C) Required return, rs. 
D) Expected rate of return,   . 
E)  All of the above are equally difficult to estimate. 
A) Expected growth rate, g. 
B) Dividend yield,   . 
C) Required return, rs. 
D) Expected rate of return,   . 
E)  All of the above are equally difficult to estimate.

Question 19

Which of the following methods of estimating the cost of common equity for a firm treats risk explicitly?

Accepted Answer

A)  DCF method. 
B)  CAPM method. 
C)  Composite method. 
D)  Bond-yield-plus-risk-premium method. 
E)  Answers b and d are both correct. 
A)  DCF method. 
B)  CAPM method. 
C)  Composite method. 
D)  Bond-yield-plus-risk-premium method. 
E)  Answers b and d are both correct.

Question 20

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

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.

If the MCC includes five break points, then there will be ____ different WACCs.

Which of the following statements is correct?

The weighted average cost of capital increases if the total funds required call for an amount of equity in excess of what can be obtained as retained earnings.

The steeper the demand curve for a firm's stock, the closer the values of r_s and r_e are to one another, other things held constant.

The component costs of capital are market-determined variables in as much as they are based on investors' required returns.

Only long-term debt should be used to compute the component cost of debt used in the WACC.

Which of the following statements is correct?

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

____ is the portion of net income not paid out in the form of dividends.

The ____ is the dollar value of new capital that can be raised before an increase in the firm's weighted cost of capital.

Which of the following factors in the discounted cash flow (DCF) approach to estimating the cost of common equity is the least difficult to estimate?

Which of the following methods of estimating the cost of common equity for a firm treats risk explicitly?

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.

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 Concepts

Security Valuation and Selection

Filters

Exam 12: The Cost of Capital

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.

If the MCC includes five break points, then there will be ____ different WACCs.

Which of the following statements is correct?

The weighted average cost of capital increases if the total funds required call for an amount of equity in excess of what can be obtained as retained earnings.

The steeper the demand curve for a firm's stock, the closer the values of rs and re are to one another, other things held constant.

The component costs of capital are market-determined variables in as much as they are based on investors' required returns.

Only long-term debt should be used to compute the component cost of debt used in the WACC.

Which of the following statements is correct?

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

____ is the portion of net income not paid out in the form of dividends.

The ____ is the dollar value of new capital that can be raised before an increase in the firm's weighted cost of capital.

Which of the following factors in the discounted cash flow (DCF) approach to estimating the cost of common equity is the least difficult to estimate?

Which of the following methods of estimating the cost of common equity for a firm treats risk explicitly?

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.

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 Concepts

Security Valuation and Selection

Filters

The steeper the demand curve for a firm's stock, the closer the values of r_s and r_e are to one another, other things held constant.