Question 1

The cost of debt, rd, is always less than rs, so rd(1 - T) will certainly be less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital will always be greater than rd(1 - T).

Accepted Answer

A) True 
 B)False

Question 2

Hilliard Corp. wants to calculate its weighted average cost of capital (WACC)• The company's long-term bonds currently offer a yield to maturity of 8 percent. • The company's stock price is $32 per share (P0 = $32)• The company recently paid a dividend of $2 per share (D0 = $2.00)• The dividend is expected to grow at a constant rate of 6 percent a year (g = 6%)• The company pays a 10 percent flotation cost whenever it issues new common stock (F = 10%)• The company's target capital structure is 75 percent equity and 25 percent debt.
• The company's tax rate is 40 percent.
• The company anticipates issuing new common stock during the upcoming year.
What is the company's WACC?

Accepted Answer

A)  10.67% 
B)  11.22% 
C)  11.47% 
D)  12.02% 
E)  12.56%

Question 3

An analyst has collected the following information regarding Christopher Co.: • The company's capital structure is 70 percent equity, 30 percent debt.
• The yield to maturity on the company's bonds is 9 percent.
• The company's year-end dividend is forecasted to be $0.80 a share.
• The company expects that its dividend will grow at a constant rate of 9 percent a year.
• The company's stock price is $25.
• The company's tax rate is 40 percent.
• The company anticipates that it will need to raise new common stock this year. Its investment bankers anticipate that the total flotation cost will equal 10 percent of the amount issued. Assume the company accounts for flotation costs by adjusting the cost of capital. Given this information, calculate the company's WACC.

Accepted Answer

A)  10.41% 
B)  12.56% 
C)  10.78% 
D)  13.55% 
E)  9.29%

Question 4

The cost of issuing preferred stock by a corporation must be adjusted to an after-tax figure because of the 70 percent dividend exclusion provision for corporations holding other corporations' preferred stock.

Accepted Answer

A) True 
 B)False

Question 5

The common stock of Anthony Steel has a beta of 1.20. The risk-free rate is 5 percent and the market risk premium (rM - rRF) is 6 percent. What is the company's cost of common stock, rs?

Accepted Answer

A)  7.0% 
B)  7.2% 
C)  11.0% 
D)  12.2% 
E)  12.4%

Question 6

Bouchard Company's stock sells for $20 per share, its last dividend (D0) was $1.00, and its growth rate is a constant 6 percent. What is its cost of common stock, rs?

Accepted Answer

A)  5.0% 
B)  5.3% 
C)  11.0% 
D)  11.3% 
E)  11.6%

Question 7

The 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 8

J. Ross and Sons Inc. has a target capital structure that calls for 40 percent debt, 10 percent preferred stock, and 50 percent common equity. The firm's current after tax cost of debt is 6 percent, and it can sell as much debt as it wishes at this rate. The firm's preferred stock currently sells for $90 per share and pays a dividend of $10 per share; however, the firm will net only $80 per share from the sale of new preferred stock. Ross's common stock currently sells for $40 per share. The firm recently paid a dividend of $2 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year.
-What is the firm's cost of common stock, rs?

Accepted Answer

A)  10.0% 
B)  12.5% 
C)  15.5% 
D)  16.5% 
E)  18.0%

Question 9

The cost of capital should reflect the average cost of the various sources of long-term funds a firm uses to support its assets.

Accepted Answer

A) True 
 B)False

Question 10

The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock which has no flotation cost and retained earnings whose cost is the average return on assets.

Accepted Answer

A) True 
 B)False

Question 11

Martin Corporation's common stock is currently selling for $50 per share. The current dividend is $2.00 per share. If dividends are expected to grow at 6 percent per year, then what is the firm's cost of common stock?

Accepted Answer

A)  10.0% 
B)  10.2% 
C)  10.6% 
D)  10.8% 
E)  11.0%

Question 12

A company has a capital structure which consists of 50 percent debt and 50 percent equity. Which of the following statements is most correct?

Accepted Answer

A)  The cost of equity financing is greater than or equal to the cost of debt financing. 
B)  The WACC exceeds the cost of equity financing. 
C)  The WACC is calculated on a before-tax basis. 
D)  The WACC represents the cost of capital based on historical averages. In that sense, it does not represent the marginal cost of capital. 
E)  The cost of retained earnings exceeds the cost of issuing new common stock.

Question 13

Which of the following statements is most correct?

Accepted Answer

A)  Although some methods of estimating the cost of equity capital encounter severe difficulties, the CAPM is a simple and reliable model that provides great accuracy and consistency in estimating the cost of equity capital. 
B)  The DCF model is preferred over other models to estimate the cost of equity because of the ease with which a firm's growth rate is obtained. 
C)  The bond-yield-plus-risk-premium approach to estimating the cost of equity is not always accurate but its advantages are that it is a standardized and objective model. 
D)  Depreciation-generated funds are an additional source of capital and, in fact, represent the largest single source of funds for some firms. 
E)  None of the statements above is correct.

Question 14

Which of the following statements is most correct?

Accepted Answer

A)  Since stockholders do not generally pay corporate taxes, corporations should focus on before-tax cash flows when calculating the weighted average cost of capital (WAC
C) . 
B)  When calculating the weighted average cost of capital, firms should include the cost of accounts payable. 
C)  When calculating the weighted average cost of capital, firms should rely on historical costs rather than marginal costs of capital. 
D)  Answers a and b are correct. 
E)  None of the answers above is correct.

Question 15

Wyden Brothers uses the CAPM to calculate the cost of equity capital. The company's capital structure consists of common stock, preferred stock, and debt. Which of the following events will reduce the company's WACC?

Accepted Answer

A)  A reduction in the market risk premium. 
B)  An increase in the risk-free rate. 
C)  An increase in the company's beta. 
D)  An increase in expected inflation. 
E)  An increase in the flotation costs associated with issuing preferred stock.

Question 16

Which of the following statements is most correct?

Accepted Answer

A)  Suppose a firm is losing money and thus, is not paying taxes, and that this situation is expected to persist for a few years whether or not the firm uses debt financing. Then the firm's after-tax cost of debt will equal its before-tax cost of debt. 
B)  The component cost of preferred stock is expressed as rps(1 - T), because preferred stock dividends are treated as fixed charges, similar to the treatment of debt interest. 
C)  The reason that a cost is assigned to retained earnings is because these funds are already earning a return in the business; the reason does not involve the opportunity cost principle. 
D)  The bond-yield-plus-risk-premium approach to estimating a firm's cost of common equity involves adding a subjectively determined risk-premium to the market risk-free bond rate. 
E)  All of the statements above are false.

Question 17

In applying the CAPM to estimate the cost of equity capital, which of the following elements is not subject to dispute or controversy?

Accepted Answer

A)  The expected rate of return on the market, rM. 
B)  The stock's beta coefficient, bi. 
C)  The risk-free rate, rRF. 
D)  The market risk premium (RPM). 
E)  All of the above are subject to dispute.

Question 18

For a typical firm with a given capital structure, which of the following is correct? (Note: All rates are after taxes.)

Accepted Answer

A)  rd > rs > WACC. 
B)  rs > rd > WACC. 
C)  WACC > rs > rd. 
D)  rs > WACC > rd. 
E)  None of the statements above is correct.

Question 19

Which of the following is not considered a capital component for the purpose of calculating the weighted average cost of capital as it applies to capital budgeting?

Accepted Answer

A)  Long-term debt. 
B)  Common stock. 
C)  Accounts payable. 
D)  Preferred stock. 
E)  All of the above are considered capital components for WACC and capital budgeting purposes.

Question 20

The cost of debt is equal to one minus the marginal tax rate multiplied by the coupon rate on outstanding debt.

Accepted Answer

A) True 
 B)False

Exam 10: Determining the Cost of Capital

The cost of debt, rd, is always less than rs, so rd(1 - T) will certainly be less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital will always be greater than rd(1 - T).

The cost of issuing preferred stock by a corporation must be adjusted to an after-tax figure because of the 70 percent dividend exclusion provision for corporations holding other corporations' preferred stock.

The common stock of Anthony Steel has a beta of 1.20. The risk-free rate is 5 percent and the market risk premium (rM - rRF) is 6 percent. What is the company's cost of common stock, rs?

Bouchard Company's stock sells for $20 per share, its last dividend (D0) was $1.00, and its growth rate is a constant 6 percent. What is its cost of common stock, rs?

The 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.

The cost of capital should reflect the average cost of the various sources of long-term funds a firm uses to support its assets.

The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock which has no flotation cost and retained earnings whose cost is the average return on assets.

Martin Corporation's common stock is currently selling for $50 per share. The current dividend is $2.00 per share. If dividends are expected to grow at 6 percent per year, then what is the firm's cost of common stock?

A company has a capital structure which consists of 50 percent debt and 50 percent equity. Which of the following statements is most correct?

Which of the following statements is most correct?

Which of the following statements is most correct?

Wyden Brothers uses the CAPM to calculate the cost of equity capital. The company's capital structure consists of common stock, preferred stock, and debt. Which of the following events will reduce the company's WACC?

Which of the following statements is most correct?

In applying the CAPM to estimate the cost of equity capital, which of the following elements is not subject to dispute or controversy?

For a typical firm with a given capital structure, which of the following is correct? (Note: All rates are after taxes.)

Which of the following is not considered a capital component for the purpose of calculating the weighted average cost of capital as it applies to capital budgeting?

The cost of debt is equal to one minus the marginal tax rate multiplied by the coupon rate on outstanding debt.