Question 1

Trahan Lumber Company hired you to help estimate its cost of capital. 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 2

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 DCF method is widely used in practice.

Accepted Answer

A) True 
 B)False

Question 3

Which of the following statements is CORRECT?

Accepted Answer

A)  When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation. 
B)  When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation. 
C)  Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM. 
D)  If a company's beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence must issue new stock. 
E)  Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC.

Question 4

The 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 5

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

Accepted Answer

A) True 
 B)False

Question 6

When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs.

Accepted Answer

A) True 
 B)False

Question 7

Which of the following statements is CORRECT?

Accepted Answer

A)  A change in a company's target capital structure cannot affect its WACC. 
B)  WACC calculations should be based on the before-tax costs of all the individual capital components. 
C)  Flotation costs associated with issuing new common stock normally reduce the WACC. 
D)  If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline. 
E)  An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.

Question 8

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 9

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, is not deductable by the issuing firm.

Accepted Answer

A) True 
 B)False

Question 10

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

Accepted Answer

A) True 
 B)False

Question 11

A company's perpetual preferred stock currently sells for $92.50 per share, and it pays an $8.00 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price. What is the firm's cost of preferred stock?

Accepted Answer

A)  7.81% 
B)  8.22% 
C)  8.65% 
D)  9.10% 
E)  9.56%

Question 12

(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%.
-Based on the CAPM, what is the firm's cost of equity?

Accepted Answer

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

Question 13

If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.

Accepted Answer

A) True 
 B)False

Question 14

Suppose the debt ratio is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC).

Accepted Answer

A) True 
 B)False

Question 15

Rivoli Inc. hired you as a consultant to help estimate its cost of capital. You have been provided with the following data: D0 = $0.80; P0 = $22.50; and g = 8.00% (constant). Based on the DCF approach, what is the cost of equity from retained earnings?

Accepted Answer

A)  10.69% 
B)  11.25% 
C)  11.84% 
D)  12.43% 
E)  13.05%

Question 16

"Capital" is sometimes defined as funds supplied to a firm by investors.

Accepted Answer

A) True 
 B)False

Question 17

You were hired as a consultant to Giambono Company, whose target capital structure is 40% debt, 15% preferred, and 45% common equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of retained earnings is 12.75%. The firm will not be issuing any new stock. What is its WACC?

Accepted Answer

A)  8.98% 
B)  9.26% 
C)  9.54% 
D)  9.83% 
E)  10.12%

Question 18

Which of the following statements is CORRECT?

Accepted Answer

A)  The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital. 
B)  The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt. 
C)  The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets. 
D)  There is an "opportunity cost" associated with using retained earnings, hence they are not "free." 
E)  The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year.

Question 19

The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.

Accepted Answer

A) True 
 B)False

Question 20

You were hired as a consultant to Quigley Company, whose target capital structure is 35% debt, 10% preferred, and 55% common equity. The interest rate on new debt is 6.50%, the yield on the preferred is 6.00%, the cost of retained earnings is 11.25%, and the tax rate is 40%. The firm will not be issuing any new stock. What is Quigley's WACC?

Accepted Answer

A)  8.15% 
B)  8.48% 
C)  8.82% 
D)  9.17% 
E)  9.54%

Exam 10: The Cost of Capital

Trahan Lumber Company hired you to help estimate its cost of capital. 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 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 DCF method is widely used in practice.

Which of the following statements is CORRECT?

The 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.

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs.

Which of the following statements is CORRECT?

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, is not deductable by the issuing firm.

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

A company's perpetual preferred stock currently sells for $92.50 per share, and it pays an $8.00 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price. What is the firm's cost of preferred stock?

If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.

Suppose the debt ratio is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC).

Rivoli Inc. hired you as a consultant to help estimate its cost of capital. You have been provided with the following data: D0 = $0.80; P0 = $22.50; and g = 8.00% (constant) . Based on the DCF approach, what is the cost of equity from retained earnings?

"Capital" is sometimes defined as funds supplied to a firm by investors.

Which of the following statements is CORRECT?

The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.