Question 1

Which one of these will increase a company's aftertax cost of debt?

Accepted Answer

A)  A decrease in the company's debt-equity ratio 
B)  A decrease in the company's tax rate 
C)  An increase in the credit rating of the company's bonds 
D)  An increase in the company's beta 
E)  A decrease in the market rate of interest

Question 2

The cost of preferred stock is computed the same as the:

Accepted Answer

A)  pretax cost of debt. 
B)  rate of return on an annuity. 
C)  aftertax cost of debt. 
D)  rate of return on a perpetuity. 
E)  cost of an irregular growth common stock.

Question 3

A group of individuals got together and purchased all of the outstanding shares of common stock of DL Smith Inc. What is the return that these individuals require on this investment called?

Accepted Answer

A)  Dividend yield 
B)  Cost of equity 
C)  Capital gains yield 
D)  Cost of capital 
E)  Income return

Question 4

The dividend growth model:

Accepted Answer

A)  is only as reliable as the estimated rate of growth. 
B)  can only be used if historical dividend information is available. 
C)  considers the risk that future dividends may vary from their estimated values. 
D)  applies only when a company is currently paying dividends. 
E)  is based solely on historical dividend information.

Question 5

The flotation cost for a company is computed as:

Accepted Answer

A)  the arithmetic average of the flotation costs of both debt and equity. 
B)  the weighted average of the flotation costs associated with each form of financing. 
C)  the geometric average of the flotation costs associated with each form of financing. 
D)  one-half of the flotation cost of debt plus one-half of the flotation cost of equity. 
E)  a weighted average based on the book values of the company's outstanding securities.

Question 6

Deep Mines has 43,800 shares of common stock outstanding with a beta of 1.54 and a market price of $51 a share. There are 10,000 shares of 7 percent preferred stock outstanding with a stated value of $100 per share and a market value of $83 a share. The 8 percent semiannual bonds have a face value of $1,000 and are selling at 96 percent of par. There are 5,000 bonds outstanding that mature in 13 years. The market risk premium is 7.5 percent, T-bills are yielding 3.6 percent, and the tax rate is 21 percent. What discount rate should the firm apply to a new project's cash flows if the project has the same risk as the company's typical project?

Accepted Answer

A)  9.59 percent 
B)  8.72 percent 
C)  9.17 percent 
D)  8.28 percent 
E)  9.30 percent

Question 7

Decker's is an all-equity financed chain of retail furniture stores. Furniture Fashions produces furniture and is the primary supplier to Decker's. Decker's has a beta of 1.62 as compared to Furniture Fashions' beta of 1.43. The risk-free rate of return is 3.1 percent and the market risk premium is 7.6 percent. What discount rate should Decker's use if it considers a project that involves the manufacturing of furniture?

Accepted Answer

A)  13.97 percent 
B)  12.92 percent 
C)  13.50 percent 
D)  14.08 percent 
E)  14.54 percent

Question 8

When computing the adjusted cash flow from assets, the tax amount is calculated as:

Accepted Answer

A)  EBT(T
C) . 
B)  (EBT − Depreciation)(T
C) . 
C)  (EBIT + Depreciation − Change in NWC − Capital spending)(T
C) . 
D)  EBIT(T
C) . 
E)  (EBIT − Depreciation − Change in NWC − Capital spending)(T
C) .

Question 9

The Pet Market has $1,000 face value bonds outstanding with 21 years to maturity, a coupon rate of 6.4 percent, annual interest payments, and a current price of $892. What is the aftertax cost of debt if the combined tax rate is 24 percent?

Accepted Answer

A)  6.79 percent 
B)  7.43 percent 
C)  4.61 percent 
D)  7.08 percent 
E)  5.65 percent

Question 10

Wayco Industrial Supply has a pretax cost of debt of 8.3 percent, a cost of equity of 14.7 percent, and a cost of preferred stock of 8.9 percent. The firm has 165,000 shares of common stock outstanding at a market price of $33 a share. There are 15,000 shares of preferred stock outstanding at a market price of $43 a share. The bond issue has a face value of $750,000 and a market quote of 101. The company's tax rate is 21 percent. What is the weighted average cost of capital?

Accepted Answer

A)  12.18 percent 
B)  10.84 percent 
C)  14.32 percent 
D)  12.60 percent 
E)  13.25 percent

Question 11

Hydro Systems has bonds outstanding with a face value of $1,000, 13 years to maturity, and a coupon rate of 6.5 percent, paid annually. What is the company's pretax cost of debt if the bonds currently sell for $1,056?

Accepted Answer

A)  5.87 percent 
B)  6.42 percent 
C)  4.71 percent 
D)  5.36 percent 
E)  5.55 percent

Question 12

The aftertax cost of debt:

Accepted Answer

A)  varies inversely to changes in market interest rates. 
B)  will generally exceed the cost of equity if the relevant tax rate is zero. 
C)  will generally equal the cost of preferred if the tax rate is zero. 
D)  is unaffected by changes in the market rate of interest. 
E)  is highly dependent upon a company's tax rate.

Question 13

The Downtowner has 168,000 shares of common stock outstanding valued at $53 a share along with 13,000 bonds selling for $1,008 each. What weight should be given to the debt when the company computes its weighted average cost of capital?

Accepted Answer

A)  46.67 percent 
B)  65.05 percent 
C)  51.79 percent 
D)  59.54 percent 
E)  48.27 percent

Question 14

The capital asset pricing model approach to equity valuation:

Accepted Answer

A)  is dependent upon the unsystematic risk of a security. 
B)  assumes the reward-to-risk ratio increases as beta increases. 
C)  can only be applied to dividend-paying firms. 
D)  assumes a firm's future risks will be higher than its current risks. 
E)  assumes the reward-to-risk ratio is constant.

Question 15

A company's current cost of capital is based on:

Accepted Answer

A)  only the return required by the company's current shareholders. 
B)  the current market rate of return on equity shares. 
C)  the weighted costs of all future funding sources. 
D)  both the returns currently required by its debtholders and stockholders. 
E)  the company's original debt-equity ratio.

Question 16

Why does the tax amount need to be adjusted when valuing a firm using the cash flow from assets approach?

Accepted Answer

A)  The tax effect of the dividend payments must be eliminated. 
B)  Only straight-line depreciation can be used when computing taxes for valuation purposes. 
C)  Taxes must be computed for valuation purposes based solely on the marginal tax rate. 
D)  The tax effect of the interest expense must be removed. 
E)  The taxes must be computed for valuation purposes based on the average tax rate for the past ten years.

Question 17

The primary advantage of using the dividend growth model to estimate a company's cost of equity is:

Accepted Answer

A)  the ability to apply either current or future tax rates. 
B)  the model's applicability to all corporations. 
C)  is the model's consideration of risk. 
D)  the stability of the computed cost of equity over time. 
E)  the simplicity of the model.

Question 18

Sister Pools sells outdoor swimming pools and currently has an aftertax cost of capital of 10.6 percent. Al's Construction builds and sells water features and fountains and has an aftertax cost of capital of 10.2 percent. Sister Pools is considering building and selling its own water features and fountains. The initial cash outlay for this project would be $75,000. The expected net cash inflows are $18,000 a year for seven years. What is the net present value of the Sister Pools project?

Accepted Answer

A)  -$4,608 
B)  $12,057 
C)  $2,262 
D)  -$11,508 
E)  $5,220

Question 19

Assigning discount rates to individual projects based on the risk level of each project:

Accepted Answer

A)  may cause the company's overall weighted average cost of capital to either increase or decrease over time. 
B)  will prevent the company's overall cost of capital from changing over time. 
C)  will cause the company's overall cost of capital to decrease over time. 
D)  decreases the value of the company over time. 
E)  negates the company's goal of creating the most value for its shareholders.

Question 20

Black River Tours has a capital structure of 60 percent common stock, 5 percent preferred stock, and 35 percent debt. The dividend payout ratio is 30 percent, the company's beta is 1.21, and the tax rate is 21 percent. Given this, which one of the following statements is correct?

Accepted Answer

A)  The aftertax cost of debt will be greater than the current yield-to-maturity on the company's outstanding bonds. 
B)  The company's cost of preferred is most likely less than the company's actual cost of debt. 
C)  The cost of equity is unaffected by a change in the company's tax rate. 
D)  The cost of equity can only be estimated using the capital asset pricing model. 
E)  The weighted average cost of capital will remain constant as long as the company's capital structure remains constant.

Exam 14: Cost of Capital