Question 1

The weighted average cost of capital should be used when making investment decisions regardless of the specific financing used to fund a project.

Accepted Answer

A) True 
 B)False  True

Question 2

The cost of equity capital from the sale of new common stock (re)is generally equal to the cost of equity capital from retention of earnings (rs),divided by one minus the flotation cost as a percentage of sales price (1 − F).

Accepted Answer

A) True 
 B)False  False

Question 3

When a firm's stockholders are not well diversified,the firm's true investment risk will not be measured by beta and the CAPM procedure will ____ the correct value of rs.

Accepted Answer

A)   overstate
B)   accurately predict
C)   understate
D)   none of the above. C

Question 4

Your company's stock sells for $50 per share,its last dividend (D0)was $2.00,its growth rate is a constant 5 percent,and the company would incur a flotation cost of 15 percent if it sold new common stock.Net income for the coming year is expected to be $500,000,the firm's payout ratio is 60 percent,and its common equity ratio is 30 percent.If the firm has a capital budget of $1,000,000,what component cost of common equity will be built into the WACC for the last dollar of capital the company raises?

Accepted Answer

A)   9.20%
B)   9.94%
C)   10.50%
D)   11.75%
E)   12.30%

Question 5

Which of the following statements is most correct?

Accepted Answer

A)   The weighted average cost of capital for a given capital budget level is a weighted average of the marginal cost of each relevant component that makes up the firm's target capital structure.
B)   The weighted average cost of capital is calculated on a before-tax basis.
C)   An increase in the risk-free rate is likely to increase the marginal cost of both debt and equity financing.
D)   Answers a and c are both correct.
E)   All of the above answers are correct.

Question 6

Which of the following statements is correct?

Accepted Answer

A)   Under normal conditions,the CAPM approach to estimating a firm's cost of retained earnings gives a better estimate than the DCF approach.
B)   The CAPM approach is typically used to estimate a firm's flotation cost adjustment factor,and this factor is added to the DCF cost estimate.
C)   The risk premium used in the bond-yield-plus-risk-premium method is the same as the one used in the CAPM method.
D)   In practice (as opposed to in theory) ,the DCF method and the CAPM method usually produce exactly the same estimate for rs.
E)   The above statements are all false.

Question 7

If the MCC includes five break points,then there will be ____ different WACCs.

Accepted Answer

A)   2
B)   3
C)   4
D)   5
E)   6

Question 8

Which of the following statements is correct?

Accepted Answer

A)   The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project.
B)   The cost of debt used to calculate the weighted average cost of capital is based on an average of the cost of debt already issued by the firm and the cost of new debt.
C)   One problem with the CAPM approach to estimating the cost of equity capital is that if a firm's stockholders are,in fact,not well diversified,beta might be a poor measure of the firm's true investment risk.
D)   The bond-yield-plus-risk-premium approach is the most sophisticated and objective method of estimating a firm's cost of equity capital.
E)   The cost of equity capital is generally easier to measure than the cost of debt,which varies daily with interest rates,or the cost of preferred stock that is issued infrequently.

Question 9

Rollins Corporation
Rollins Corporation is constructing its MCC schedule. Its 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 could sell, at par, $100 preferred stock that pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 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 rs. The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent.
-Refer to Rollins Corporation.What is Rollins' lowest WACC?

Accepted Answer

A)   13.6%
B)   14.1%
C)   16.0%
D)   16.6%
E)   16.9%

Question 10

The component costs of capital are market-determined variables in as much as they are based on investors' required returns.

Accepted Answer

A) True 
 B)False

Question 11

What is the best data to use for the growth rate estimate for DCF cost of capital estimates?

Accepted Answer

A)   Growth in the GDP
B)   Inflation
C)   Historical data
D)   Analyst's forecasts

Question 12

The items in the asset section of the balance are its capital components.

Accepted Answer

A) True 
 B)False

Question 13

Which of the following statements is correct?

Accepted Answer

A)   The WACC should include only after-tax component costs.Therefore,the required rates of return (or "market rates") on debt,preferred,and common equity (rd,rps,and rs or e) must be adjusted to an after-tax basis before they are used in the WACC equation.
B)   The cost of retained earnings is generally higher than the cost of new common stock.
C)   Preferred stock is riskier to investors than is debt.Therefore,if someone told you that the market rates showed rd > rps for a given company,that person must have made a mistake.
D)   When the MCC schedule is developed,the first break point always occurs as a result of using up retained earnings.
E)   If a company with a debt-to-assets ratio of 50 percent were suddenly exempted from all future income taxes,then,all other things held constant,this would cause its WACC to increase.

Question 14

Suppose a new company decides to raise its initial $200 million of capital as $100 million of common equity and $100 million of long-term debt.By an iron-clad provision in its charter,the company can never borrow any more money.Which of the following statements is correct?

Accepted Answer

A)   If the debt were raised by issuing $50 million of debentures and $50 million of first mortgage bonds,we could be absolutely certain that the firm's total interest expense would be lower than if the debt were raised by issuing $100 million of debentures.
B)   If the debt were raised by issuing $50 million of debentures and $50 million of first mortgage bonds,we could be absolutely certain that the firm's total interest expense would be lower than if the debt were raised by issuing $100 million of first mortgage bonds.
C)   The higher the percentage of total debt represented by debentures,the greater the risk of,and hence the interest rate on,the debentures.
D)   The higher the percentage of total debt represented by mortgage bonds,the riskier both types of bonds will be,and,consequently,the higher the firm's total dollar interest charges will be.
E)   In this situation,we cannot tell for sure how,or whether,the firm's total interest expense on the $100 million of debt would be affected by the mix of debentures versus first mortgage bonds.Interest rates on the two types of bonds would vary as their percentages were changed,but the result might well be such that the firm's total interest charges would not be affected materially by the mix between the two.

Question 15

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 16

The cost of capital used to evaluate investment opportunities should be calculated as a weighted average of the various types of funds generally used,regardless of the specific financing used to fund a particular project.

Accepted Answer

A) True 
 B)False

Question 17

There is a jump,or break,in a firm's MCC schedule each time the firm runs out of a particular source of capital at a particular cost.For example,a firm may use up its 10 percent debt and can then issue more debt only if it offers a higher rate to investors.

Accepted Answer

A) True 
 B)False

Question 18

Retained earnings have no cost since the firm does not have to issue securities to raise retained earnings.

Accepted Answer

A) True 
 B)False

Question 19

The weighted average cost of capital increases if the total funds required call for an amount of equity in excess of what can be obtained as retained earnings.

Accepted Answer

A) True 
 B)False

Question 20

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

Accepted Answer

A) True 
 B)False

Exam 12: The Cost of Capital

The weighted average cost of capital should be used when making investment decisions regardless of the specific financing used to fund a project.

The cost of equity capital from the sale of new common stock (r_e)is generally equal to the cost of equity capital from retention of earnings (r_s),divided by one minus the flotation cost as a percentage of sales price (1 − F).

When a firm's stockholders are not well diversified,the firm's true investment risk will not be measured by beta and the CAPM procedure will ____ the correct value of r_s.

Which of the following statements is most correct?

Which of the following statements is correct?

If the MCC includes five break points,then there will be ____ different WACCs.

Which of the following statements is correct?

The component costs of capital are market-determined variables in as much as they are based on investors' required returns.

What is the best data to use for the growth rate estimate for DCF cost of capital estimates?

The items in the asset section of the balance are its capital components.

Which of the following statements is correct?

Suppose a new company decides to raise its initial $200 million of capital as $100 million of common equity and $100 million of long-term debt.By an iron-clad provision in its charter,the company can never borrow any more money.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 equity raised by selling new issues of common stock,depending on tax rates,flotation costs,the attitude of investors,and other factors.

The cost of capital used to evaluate investment opportunities should be calculated as a weighted average of the various types of funds generally used,regardless of the specific financing used to fund a particular project.

There is a jump,or break,in a firm's MCC schedule each time the firm runs out of a particular source of capital at a particular cost.For example,a firm may use up its 10 percent debt and can then issue more debt only if it offers a higher rate to investors.

Retained earnings have no cost since the firm does not have to issue securities to raise retained earnings.

The weighted average cost of capital increases if the total funds required call for an amount of equity in excess of what can be obtained as retained earnings.

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