Question 1

When estimating the cost of equity by use of the DCF method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return. This problem leaves us unsure of the true value of rs.

Accepted Answer

A) True 
 B)False

Question 2

If 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 3

Bankston Corporation forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Since new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock?

Accepted Answer

A)  Increase the dividend payout ratio for the upcoming year. 
B)  Increase the percentage of debt in the target capital structure. 
C)  Increase the proposed capital budget. 
D)  Reduce the amount of short-term bank debt in order to increase the current ratio. 
E)  Reduce the percentage of debt in the target capital structure.

Question 4

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

Accepted Answer

A)  Long-term debt. 
B)  Accounts payable. 
C)  Retained earnings. 
D)  Common stock. 
E)  Preferred stock.

Question 5

Sorensen Systems Inc. is expected to pay a $2.50 dividend at year end (D1 = $2.50), the dividend is expected to grow at a constant rate of 5.50% a year, and the common stock currently sells for $52.50 a share. The before-tax cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of 45% debt and 55% common equity. What is the company's WACC if all the equity used is from retained earnings?

Accepted Answer

A)  7.07% 
B)  7.36% 
C)  7.67% 
D)  7.98% 
E)  8.29%

Question 6

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

Accepted Answer

A) True 
 B)False

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

The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 - F)."

Accepted Answer

A) True 
 B)False

Question 9

Which of the following statements is CORRECT?

Accepted Answer

A)  Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity. 
B)  The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes. 
C)  If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject. 
D)  Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt. 
E)  Higher flotation costs tend to reduce the cost of equity capital.

Question 10

(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 firm's WACC?

Accepted Answer

A)  10.85% 
B)  11.19% 
C)  11.53% 
D)  11.88% 
E)  12.24%

Question 11

Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets. They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.

Accepted Answer

A) True 
 B)False

Question 12

Norris Enterprises, an all-equity firm, has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than an average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT?

Accepted Answer

A)  The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return. 
B)  The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return. 
C)  Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment. 
D)  The accept/reject decision depends on the firm's risk-adjustment policy. If Norris' policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project. 
E)  Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision.

Question 13

Which of the following statements is CORRECT?

Accepted Answer

A)  The WACC is calculated using before-tax costs for all components. 
B)  The after-tax cost of debt usually exceeds the after-tax cost of equity. 
C)  For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock. 
D)  Retained earnings that were generated in the past and are reported on the firm's balance sheet are available to finance the firm's capital budget during the coming year. 
E)  The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital.

Question 14

The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant.

Accepted Answer

A) True 
 B)False

Question 15

If expectations for long-term inflation rose, but the slope of the SML remained constant, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Therefore, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt.

Accepted Answer

A) True 
 B)False

Exam 10: The Cost of Capital

When estimating the cost of equity by use of the DCF method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return. This problem leaves us unsure of the true value of rs.

If 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 is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

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

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 external equity capital raised by issuing new common stock (re) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 - F)."

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant.