Question 1

Since 70% of the preferred dividends received by a corporation are excluded from taxable income, the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be
Cost of equity = rs(0.30)(0.50) + rps(1 - T)(0.70)(0.50).

Accepted Answer

A) True 
 B)False  False

Question 2

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  False

Question 3

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 4

For 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 5

For capital budgeting and cost of capital purposes, the firm should always consider retained earnings as the first source of capital--i.e., use these funds first--because retained earnings have no cost to the firm.

Accepted Answer

A) True 
 B)False

Question 6

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.

Question 7

If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the DCF model, and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method. All this makes it especially difficult to estimate the cost of equity for a private company.

Accepted Answer

A) True 
 B)False

Question 8

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the CAPM method always provides an accurate and reliable estimate.

Accepted Answer

A) True 
 B)False

Question 9

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 the assets that are acquired.

Accepted Answer

A) True 
 B)False

Question 10

The MacMillen Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 12%. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO's position is accepted, what is likely to happen over time?

Accepted Answer

A)   The company will take on too many high-risk projects and reject too many low-risk projects.
B)   The company will take on too many low-risk projects and reject too many high-risk projects.
C)   Things will generally even out over time, and, therefore, the firm's risk should remain constant over time.
D)   The company's overall WACC should decrease over time because its stock price should be increasing.
E)   The CEO's recommendation would maximize the firm's intrinsic value.

Question 11

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

Accepted Answer

A) True 
 B)False

Question 12

Teall Development Company hired you as a consultant to help them estimate its cost of capital. You have been provided with the following data: D1 = $1.45; P0 = $22.50; and g = 6.50% (constant). Based on the DCF approach, what is the cost of equity from retained earnings?

Accepted Answer

A)   11.10%
B)   11.68%
C)   12.30%
D)   12.94%
E)   13.59%

Question 13

The 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 14

For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure.

Accepted Answer

A)   rs > re > rd > WACC.
B)   re > rs > WACC > rd.
C)   WACC > re > rs > rd.
D)   rd > re > rs > WACC.
E)   WACC > rd > rs > re.

Question 15

Schalheim Sisters Inc. has always paid out all of its earnings as dividends, hence the firm has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC?

Accepted Answer

A)   The market risk premium declines.
B)   The flotation costs associated with issuing new common stock increase.
C)   The company's beta increases.
D)   Expected inflation increases.
E)   The flotation costs associated with issuing preferred stock increase.

Question 16

(The following information applies to Problems 91, 92, 93, and 94.)
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%.
-What is the best estimate of the after-tax cost of debt?

Accepted Answer

A)   4.64%
B)   4.88%
C)   5.14%
D)   5.40%
E)   5.67%

Question 17

LaPango Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?

Accepted Answer

A)   Project B, which is of below-average risk and has a return of 8.5%.
B)   Project C, which is of above-average risk and has a return of 11%.
C)   Project A, which is of average risk and has a return of 9%.
D)   None of the projects should be accepted.
E)   All of the projects should be accepted.

Question 18

Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant). What is the cost of equity from retained earnings based on the DCF approach?

Accepted Answer

A)   9.42%
B)   9.91%
C)   10.44%
D)   10.96%
E)   11.51%

Question 19

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

Accepted Answer

A) True 
 B)False

Question 20

Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A's cost of capital is 10.0%, Division B's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A's projects are equally risky, as are all of Division B's projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept?

Accepted Answer

A)   A Division B project with a 13% return.
B)   A Division B project with a 12% return.
C)   A Division A project with an 11% return.
D)   A Division A project with a 9% return.
E)   A Division B project with an 11% return.

Exam 10: The Cost of Capital

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.

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

For 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.

For capital budgeting and cost of capital purposes, the firm should always consider retained earnings as the first source of capital--i.e., use these funds first--because retained earnings have no cost to the firm.

Which of the following statements is CORRECT?

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the CAPM method always provides an accurate and reliable estimate.

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 the assets that are acquired.

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

Teall Development Company hired you as a consultant to help them estimate its cost of capital. You have been provided with the following data: D1 = $1.45; P0 = $22.50; and g = 6.50% (constant) . Based on the DCF approach, what is the cost of equity from retained earnings?

The 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.

For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure.

LaPango Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?

Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant) . What is the cost of equity from retained earnings based on the DCF approach?

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