Question 1

City Rentals has 44,000 shares of common stock outstanding at a market price of $32 a share.The common stock just paid a $1.50 annual dividend and has a dividend growth rate of 2.5 percent.There are 7,500 shares of $9 preferred stock outstanding at a market price of $72 a share.The outstanding bonds mature in 11 years, have a total face value of $825,000, a face value per bond of $1,000, and a market price of $989 each, and a pretax yield to maturity of 8.3 percent.The tax rate is 35 percent.What is the firm's weighted average cost of capital?

Accepted Answer

A) 7.76 percent 
B) 8.68 percent 
C) 9.29 percent 
D) 9.97 percent 
E) 10.30 percent

Question 2

Piedmont Hotels is an all-equity firm with 48,000 shares of stock outstanding.The stock has a beta of 1.19 and a standard deviation of 14.8 percent.The market risk premium is 7.8 percent and the risk-free rate of return is 4.1 percent.The company is considering a project that it considers riskier than its current operations so has assigned an adjustment of 1.35 percent to the project's discount rate.What should the firm set as the required rate of return for the project?

Accepted Answer

A) 9.85 percent 
B) 10.92 percent 
C) 15.39 percent 
D) 14.73 percent 
E) 17.33 percent

Question 3

Cool Fire, Inc.has 7.2 percent bonds outstanding that mature in 15 years.The bonds pay interest semiannually and have a face value of $1,000.Currently, the bonds are selling for $975.

Accepted Answer

A) 7.61 percent 
B) 7.48 percent 
C) 7.78 percent 
D) 7.95 percent 
E) 7.04 percent

Question 4

Commercial Construction Builders has a beta of 1.34, a dividend growth rate of 2.1 percent for the foreseeable future, a stock price of $15 per share, and an expected annual dividend of $0.45 per share next year.The market rate of return is 12.8 percent and the risk-free rate is 4.2 percent.What is the firm's average cost of equity?

Accepted Answer

A) 8.79 percent 
B) 10.41 percent 
C) 10.35 percent 
D) 10.77 percent 
E) 8.51 percent

Question 5

Which one of the following statements concerning capital structure weights is correct?

Accepted Answer

A) Target capital structure rates for a firm are irrelevant to individual projects. 
B) The weights are unaffected when a bond issue matures. 
C) An increase in the debt-equity ratio will increase the weight of the common stock. 
D) The repurchase of preferred stock will increase the weight of debt. 
E) The issuance of additional shares of common stock will increase the weight of both the common and preferred stock.

Question 6

The results of the dividend growth model:

Accepted Answer

A) vary directly with the market rate of return. 
B) can only be applied to projects that have a growth rate equal to that of the current firm. 
C) are highly dependent upon the beta used in the model. 
D) are sensitive to the rate of dividend growth. 
E) are most reliable when the growth rate exceeds 10 percent.

Question 7

Muttly Engineering announced this morning that its next annual dividend will be decreased to $2.45 a share and that all future dividends will be decreased by an additional 1.45 percent annually.What is the current value per share if the required return is 19.5 percent?

Accepted Answer

A) $10.33 
B) $11.69 
C) $11.89 
D) $11.41 
E) $11.95

Question 8

The 7 percent preferred stock of Midwest Muffler and Towing is selling for $65 per share.What is the firm's cost of preferred stock if the tax rate is 21 percent and the par value per share is $100?

Accepted Answer

A) 12.79 percent 
B) 11.21 percent 
C) 11.46 percent 
D) 10.55 percent 
E) 10.77 percent

Question 9

Musical Charts just paid an annual dividend of $1.84 per share.This dividend is expected to increase by 2.1 percent annually.Currently, the firm has a beta of 1.12 and a stock price of $31 a share.The risk-free rate is 4.3 percent and the market rate of return is 13.2 percent.What is the cost of equity capital for this firm?

Accepted Answer

A) 13.28 percent 
B) 11.21 percent 
C) 12.29 percent 
D) 11.95 percent 
E) 13.42 percent

Question 10

Traditional Bank has an issue of preferred stock with an annual dividend of $7.50 that just sold for $62 a share.What is the bank's cost of preferred stock?

Accepted Answer

A) 12.91 percent 
B) 12.10 percent 
C) 11.23 percent 
D) 13.47 percent 
E) 11.32 percent

Question 11

A firm that uses its weighted average cost of capital as the required return for all of its investments will:

Accepted Answer

A) maintain a constant value for its shareholders. 
B) increase the risk level of the firm over time. 
C) make the best possible accept and reject decisions related to those investments. 
D) find that its cost of capital declines over time. 
E) accept only the projects that add value to the firm's shareholders.

Question 12

Farmer's Supply is considering opening a clothing store, which would be a new line of business for the firm.Management has decided to use the cost of capital of a similar clothing store as the discount rate to evaluate this proposed expansion.Which one of the following terms describes this evaluation approach?

Accepted Answer

A) Equity approach 
B) Aftertax approach 
C) Subjective approach 
D) Market play 
E) Pure play approach

Question 13

The market rate of return is 12.65 percent and the risk-free rate is 3.1 percent.Galaxy Co.has 15 percent more systematic risk than the overall market and has a dividend growth rate of 3.75 percent.The firm's stock is currently selling for $53 a share and has a dividend yield of 4.53 percent.What is the firm's average cost of equity?

Accepted Answer

A) 11.18 percent 
B) 12.36 percent 
C) 10.87 percent 
D) 17.33 percent 
E) 12.16 percent

Question 14

Appalachian Mountain Goods has paid increasing dividends of $10, $.12, $.15, and $.20 a share over the past four years, respectively.The firm estimates that future increases in its dividends will be equal to the arithmetic average growth rate over these past four years.The stock is currently selling for $12.50 a share.The risk-free rate is 3.4 percent and the market risk premium is 8.1 percent.What is the cost of equity for this firm if its beta is 1.46?

Accepted Answer

A) 18.34 percent 
B) 16.91 percent 
C) 19.78 percent 
D) 21.68 percent 
E) 22.03 percent

Question 15

Stock in ABC Enterprises has a beta of 1.28.The market risk premium is 7.4 percent, and T-bills are currently yielding 3.6 percent.ABC's most recently paid dividend was $1.62 per share, and dividends are expected to grow at an annual rate of 2 percent indefinitely.If the stock sells for $38 a share, what is your best estimate of ABC's cost of equity?

Accepted Answer

A) 9.78 percent 
B) 7.82 percent 
C) 9.71 percent 
D) 9.41 percent 
E) 7.41 percent

Question 16

Electronic Products has 22,500 bonds outstanding that are currently quoted at 101.6.The bonds mature in 8 years and pay an annual coupon payment of $90.What is the firm's aftertax cost of debt if the applicable tax rate is 34 percent?

Accepted Answer

A) 5.47 percent 
B) 4.79 percent 
C) 5.75 percent 
D) 6.98 percent 
E) 6.67 percent

Question 17

Which one of the following is used as the pretax cost of debt?

Accepted Answer

A) Average coupon rate on the firm's outstanding bonds 
B) Coupon rate on the firm's latest bond issue 
C) Weighted average yield to maturity on the firm's outstanding debt 
D) Average current yield on the firm's outstanding debt 
E) Annual interest divided by the market price per bond for the latest bond issue

Question 18

What is the primary reason why the cash flow from assets (CFA) is adjusted when used to value a firm?

Accepted Answer

A) Depreciation is a non-cash expense so both it and the depreciation tax shield must be eliminated from the CFA. 
B) Net working capital (NW
C)  is excluded from firm valuations so the change in NWC must be added back to the "normal" CFA calculation 
C) Interest expense is a financing cost and thus the tax benefit of this expense needs to be eliminated from the CFA. 
D) CFA is normally based on historical performance but since firm valuations are forward looking the CFA must be adjusted for timing. 
E) The CFA must be lowered by the amount of the noncash expenses to ascertain a more accurate firm value.

Question 19

The cost of preferred stock:

Accepted Answer

A) increases when a firm's tax rate decreases. 
B) is constant over time. 
C) is unaffected by changes in the market price of the stock. 
D) is equal to the stock's dividend yield. 
E) increases as the price of the stock increases.

Question 20

Casper's is analyzing a proposed expansion project that is much riskier than the firm's current operations.Thus, the project will be assigned a discount rate equal to the firm's cost of capital plus 2.5 percent.The proposed project has an initial cost of $18.1 million that will be depreciated on a straight-line basis to a zero book value over 20 years.The project also requires additional inventory of $428,000 over the project's life.Management estimates the facility will generate cash inflows of $2.46 million a year over its 20-year life.After 20 years, the company plans to sell the facility for an aftertax amount of$1.4 million.The company has 58,000 shares of common stock outstanding at a market price of $52 a share.This stock just paid an annual dividend of $2.84 a share.The dividend is expected to increase by 3.6 percent annually.The firm also has 15,000 shares of 9 percent preferred stock with a market value of $87 a share.The preferred stock has a par value of $100.The company has $1.2 million of face value bonds with semiannual payments and a coupon rate of 9 percent.The bonds are currently priced at 102 percent of face value and mature in 13 years.The tax rate is 35 percent.Should the firm pursue the expansion project at this point in time? Why or why not?

Accepted Answer

A) Accept; The NPV is $2.6 million. 
B) Accept; The NPV is $1.0 million. 
C) Reject; the NPV is -$3.2 million. 
D) Reject; the NPV is -$3.0 million. 
E) Reject; the NPV is -$1.4 million.

Exam 12: Cost of Capital