Question 1

cost of capital used in capital budgeting should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets.

Accepted Answer

A) True 
 B)False

Question 2

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%

Question 3

before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC.

Accepted Answer

A) True 
 B)False

Question 4

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.

Question 5

capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity.

Accepted Answer

A) True 
 B)False

Question 6

Which of the following statements is CORRECT?

Accepted Answer

A) In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income. 
B) We should use historical measures of the component costs from prior financings that are still outstanding when estimating a company's WACC for capital budgeting purposes. 
C) The cost of new equity (re) could possibly be lower than the cost of retained earnings (rs) if the market risk premium, risk-free rate, and the company's beta all decline by a sufficiently large amount. 
D) A firm's cost of retained earnings is the rate of return stockholders require on a firm's common stock. 
E) The component cost of preferred stock is expressed as rp(1 - T), because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt.

Question 7

help finance a major expansion, Castro Chemical Company sold a noncallable bond several years ago that now has 20 years to maturity.This bond has a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000.If the firm's tax rate is 40%, what is the component cost of debt for use in the WACC calculation?

Accepted Answer

A) 4.35% 
B) 4.58% 
C) 4.83% 
D) 5.08% 
E) 5.33%

Question 8

CFO of Lenox Industries hired you as a consultant to help estimate its cost of common equity.You have obtained the following data: You were asked to estimate the cost of common based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates.What is that difference?

Accepted Answer

A) 1.13% 
B) 1.50% 
C) 1.88% 
D) 2.34% 
E) 2.58%

Question 9

firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

Accepted Answer

A) True 
 B)False

Question 10

Based on the CAPM, what is the firm's cost of common stock?

Accepted Answer

A) 11.15% 
B) 11.73% 
C) 12.35% 
D) 13.00% 
E) 13.65%

Question 11

Daves Inc.recently hired you as a consultant to estimate the company's WACC.You have obtained the following information.(1) The firm's noncallable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $1,000, and a market price of $1,050.00.(2) The company's tax rate is 40%.(3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock's beta is 1.20.(4) The target capital structure consists of 35% debt and the balance is common equity.The firm uses the CAPM to estimate the cost of common stock, and it does not expect to issue any new shares.What is its WACC?

Accepted Answer

A) 7.16% 
B) 7.54% 
C) 7.93% 
D) 8.35% 
E) 8.79%

Question 12

reason why retained earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm's common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should distribute those earnings to its investors.Thus, the cost of retained earnings is based on the opportunity cost principle.

Accepted Answer

A) True 
 B)False

Question 13

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

Accepted Answer

A) True 
 B)False

Question 14

Which of the following is the best estimate for the weight of debt for use in calculating the firm's WACC?

Accepted Answer

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

Question 15

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%

Question 16

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%

Question 17

Trahan Lumber Company hired you to help estimate its cost of common equity.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%

Question 18

the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common stock If the expected growth rate is not zero, then the cost of external equity must be found using a different formula.

Accepted Answer

A) True 
 B)False

Question 19

Which of the following statements is CORRECT?

Accepted Answer

A) The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the interest rate on the company's own long-term bonds.The size of the risk premium for bonds with different ratings is published daily in The Wall Street Journal. 
B) The WACC is calculated using a before-tax cost for debt that is equal to the interest rate that must be paid on new debt, along with the after-tax costs for common stock and for preferred stock if it is used. 
C) An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity. 
D) The relevant WACC can change depending on the amount of funds a firm raises during a given year.Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm's target capital structure. 
E) Beta measures market risk, which is generally the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value.However, this is not true unless all of the firm's stockholders are well diversified.

Question 20

Which of the following statements is CORRECT?

Accepted Answer

A) Since the costs of internal and external equity are related, an increase in the flotation cost required to sell a new issue of stock will increase the cost of retained earnings. 
B) Since its stockholders are not directly responsible for paying a corporation's income taxes, corporations should focus on before-tax cash flows when calculating the WACC. 
C) An increase in a firm's tax rate will increase the component cost of debt, provided the YTM on the firm's bonds is not affected by the change in the tax rate. 
D) When the WACC is calculated, it should reflect the costs of new common stock, retained earnings, preferred stock, long-term debt, short-term bank loans if the firm normally finances with bank debt, and accounts payable if the firm normally has accounts payable on its balance sheet. 
E) If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the after-tax cost of debt.

Exam 9: Cost of Capital

cost of capital used in capital budgeting should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets.

before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC.

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

capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity.

Which of the following statements is CORRECT?

firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

Based on the CAPM, what is the firm's cost of common stock?

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

Which of the following is the best estimate for the weight of debt for use in calculating the firm's WACC?

Trahan Lumber Company hired you to help estimate its cost of common equity.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?

the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common stock If the expected growth rate is not zero, then the cost of external equity must be found using a different formula.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?