Question 1

Even if a firm obtains all of its common equity from retained earnings, its MCC schedule might still increase if very large amounts of new capital are needed.

Accepted Answer

A) True 
 B)False

Question 2

Smith 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 expects to retain $15,000 in earnings over the next year. Where will a break in the WACC curve occur?

Accepted Answer

A)  $12,500 
B)  $15,000 
C)  $30,000 
D)  $25,000 
E)  $42,500

Question 3

Which of the following statements is true of marginal cost of capital?

Accepted Answer

A)  All else equal, an increase in the tax rate would decrease the marginal cost of debt capital. 
B)  All else equal, an increase in a company's stock price will increase the marginal cost of retained earnings. 
C)  All else equal, an increase in a company's stock price will increase the marginal cost of issuing new common equity. 
D)  All else equal, an increase in the capital raised in a period will decrease the marginal cost of debt capital. 
E)  All else equal, an increase in the weighted cost of capital will decrease the marginal cost of retained capital.

Question 4

Everything else equal, an asset's value is directly related to:

Accepted Answer

A)  the cost of raising additional capital. 
B)  the rate of return investors require to invest in that asset. 
C)  the risk associated with the investment in that asset. 
D)  the cash flow the asset is expected to generate. 
E)  the rate of return that the firm must earn to satisfy investors' demands.

Question 5

Which of the following may be true of the cost of debt and cost of equity?

Accepted Answer

A)  The weighted average cost of capital is computed by assigning weights to the cost of debt and the cost of equity of a firm. 
B)  The cost of debt for a firm is always equal to the cost of equity to the firm. 
C)  The cost of internally generated equity for a firm is greater than the cost of externally generated equity funds for the firm. 
D)  The cost of internally generated equity for a firm is less than the cost of debt for the firm. 
E)  The cost of externally generated equity is the sum of the cost of debt and the cost of retained earnings.

Question 6

The next year's net income of Byron Corporation is projected to be $21,000, and its payout ratio is 30 percent. Its target capital structure is 40 percent debt and 60 percent common equity. What is the retained earnings break point?

Accepted Answer

A)  $35,000 
B)  $24,500 
C)  $6,300 
D)  $12,600 
E)  $8,400

Question 7

The after-tax cost of debt is used to calculate the weighted average cost of capital since we are concerned with the after-tax cash flows of the firm.

Accepted Answer

A) True 
 B)False

Question 8

The before-tax cost of debt, rd, is the same as the:

Accepted Answer

A)  average yield to maturity (YTM) associated with the firm's bonds. 
B)  dividend yield associated with the firm's common stock. 
C)  average coupon rate of the firm's bonds. 
D)  return on equity if the firm has no preferred stock. 
E)  the firm's marginal tax rate.

Question 9

The value of any asset-real or financial-is based on _____ and _____.

Accepted Answer

A)  the weighted average cost of investment; the rate of return achieved by the investment firm 
B)  the cash flow expected to be generated by the asset; the rate of return required by investors 
C)  the marginal return to investor from the investment asset; the additional cash flow generated by the asset 
D)  the rate of return achieved by the investment firm; the weighted average cost of investment to the investor 
E)  the rate of return achieved by the investment firm; the cash flow expected to be generated by the asset

Question 10

The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of 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 11

The Jackson Company has just paid a dividend of $3.00 per share on its common stock, and it expects this dividend to grow by 10 percent per year, indefinitely. The firm has a beta of 1.50; the risk-free rate is 10 percent; and the expected return on the market is 14 percent. Which of the following is the required rate of return as per the capital asset pricing model (CAPM) approach?

Accepted Answer

A)  9 percent 
B)  12 percent 
C)  7 percent 
D)  16 percent 
E)  18 percent

Question 12

Tangerine Inc.'s target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm's marginal tax rate is 40 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find the cost of retained earnings. Which of the following is Tangerine's component cost of retained earnings?

Accepted Answer

A)  8 percent 
B)  10 percent 
C)  12 percent 
D)  14 percent 
E)  16 percent

Question 13

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. Ross' 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. Which of the following is the firm's cost of retained earnings? (Round off the answer to two decimal places.)

Accepted Answer

A)  16.34 percent 
B)  10.42 percent 
C)  15.50 percent 
D)  12.20 percent 
E)  13.25 percent

Question 14

Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent common equity. The firm expects to earn $150,000 in after-tax income during the coming year, and it will retain 40 percent of those earnings. What is the break point of retained earnings?

Accepted Answer

A)  $125,000 
B)  $100,000 
C)  $150,000 
D)  $110,000 
E)  $135,000

Question 15

The _____ is equal to the average rate of return that investors require to provide funds to the firm in the form of debt.

Accepted Answer

A)  Coupon rate 
B)  Yield to maturity (YTM) 
C)  Maturity value 
D)  Discount rate 
E)  Internal rate of return

Question 16

SW Inc.'s preferred stock, which pays a $5 dividend each year, currently sells for $62.50. The company's marginal tax rate is 40 percent. What is the cost of preferred stock, rps, that should be included in the computation of the SW Inc.'s weighted average cost of capital (WACC)?

Accepted Answer

A)  10.00 percent 
B)  4.00 percent 
C)  5.00 percent 
D)  8.00 percent 
E)  2.00 percent

Question 17

Omega Inc.'s net income is expected to be $600,000 and the firm's payout ratio is 60 percent. The firm's common stock ratio is 30 percent and it has no preferred stock outstanding. Which of the following is the retained earnings break point for Omega Inc.?

Accepted Answer

A)  $400,000 
B)  $250,000 
C)  $375,000 
D)  $100,000 
E)  $800,000

Question 18

The before-tax cost of debt of a firm using funds from bond issue is equal to the _____ of the bond.

Accepted Answer

A)  yield to maturity (YTM) 
B)  maturity value 
C)  coupon rate 
D)  discount rate 
E)  internal rate of return

Question 19

Diggin Tools just issued new preferred stock, which sold for $85 in the stock markets. Holders of the stock will receive an annual dividend equal to $9.35. The flotation costs associated with the new issue were 6 percent and Diggin's marginal tax rate is 30 percent. Which of the following is the component cost of preferred stock, rps? (Round off the answer to two decimal places.)

Accepted Answer

A)  10.75 percent 
B)  10.52 percent 
C)  12.25 percent 
D)  11.70 percent 
E)  11.05 percent

Question 20

A graph of a firm's acceptable capital projects ranked in the order of the projects' internal rates of return is called the firm's _____.

Accepted Answer

A)  marginal cost of capital schedule 
B)  investment opportunity schedule 
C)  modified internal rate of return schedule 
D)  internal project classification schedule 
E)  optimal capital budget schedule

Exam 11: The Cost of Capital

Even if a firm obtains all of its common equity from retained earnings, its MCC schedule might still increase if very large amounts of new capital are needed.

Which of the following statements is true of marginal cost of capital?

Everything else equal, an asset's value is directly related to:

Which of the following may be true of the cost of debt and cost of equity?

The next year's net income of Byron Corporation is projected to be $21,000, and its payout ratio is 30 percent. Its target capital structure is 40 percent debt and 60 percent common equity. What is the retained earnings break point?

The after-tax cost of debt is used to calculate the weighted average cost of capital since we are concerned with the after-tax cash flows of the firm.

The before-tax cost of debt, rd, is the same as the:

The value of any asset-real or financial-is based on _ and _.

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

Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent common equity. The firm expects to earn $150,000 in after-tax income during the coming year, and it will retain 40 percent of those earnings. What is the break point of retained earnings?

The _____ is equal to the average rate of return that investors require to provide funds to the firm in the form of debt.

SW Inc.'s preferred stock, which pays a $5 dividend each year, currently sells for $62.50. The company's marginal tax rate is 40 percent. What is the cost of preferred stock, rps, that should be included in the computation of the SW Inc.'s weighted average cost of capital (WACC) ?

Omega Inc.'s net income is expected to be $600,000 and the firm's payout ratio is 60 percent. The firm's common stock ratio is 30 percent and it has no preferred stock outstanding. Which of the following is the retained earnings break point for Omega Inc.?

The before-tax cost of debt of a firm using funds from bond issue is equal to the _____ of the bond.

A graph of a firm's acceptable capital projects ranked in the order of the projects' internal rates of return is called the firm's _____.