Deck 11: Cost of Capital

Question 1

Retained earnings represent an internal source of funds that is raised without the payment of interest, or cost to the firm's shareholders.

Answer 1

False

Question 2

The cost of retained earnings is equal to the required rate of return on a firm's outstanding common stock.

Answer 2

True

Question 3

The out-of-pocket cost of common stock is a good approximation of the cost of common stock equity.

Answer 3

False

Question 4

Weights used to calculate the weighted average cost of capital K_a are derived from the optimum capital structure.

Question 5

In determining the cost of debt, yields and prices of outstanding bonds are used.

Question 6

The cost of debt is equal to the current bond yield on bonds of similar risk class and adjusted for the corporate tax rate.

Question 7

A firm's cost of preferred stock is equal to the preferred dividend divided by market price plus the dividend growth rate (K_p = D/P_o + g).

Question 8

A firm's cost of preferred stock is equal to the preferred dividend divided by the net price after flotation costs K_p = (D_p/P_o - F).

Question 9

A firm that does not earn the cost of capital in the short run will probably be in bankruptcy.

Question 10

The cost of capital for each source of funds is a cost dependent on current market conditions and expected rates of return.

Question 11

K_e represents an expected return to shareholders as well as a cost to the firm.

Question 12

The only difference in the cost of common stock (K_e) and the cost of new common stock (K_n) is the flotation cost on new common stock.

Question 13

The discount rate that equates a future stream of expected dividends to the current price is a good approximation of the cost of common shares.

Question 14

Most firms are able to use 60%-75% debt in their capital structure without exceeding norms acceptable to most creditors and investors.

Question 15

It is standard practice to evaluate investment decisions using the cost of the specific financing method involved.

Question 16

The cost of new common stock is greater than the cost of outstanding common stock.

Question 17

A firm that does not earn the cost of capital in the long run will not maximize shareholder wealth.

Question 18

The calculation of the cost of capital depends upon historical costs of funds.

Question 19

In determining the cost of preferred stock, the dividend yield on outstanding preferred stock may be used as a proxy.

Question 20

According to traditional financial theory, the cost of capital curve is U-shaped over the range of debt-equity mixes.

Question 21

An increase in the risk-free rate causes the SML to shift down parallel to the old SML.

Question 22

Even though the CAPM model is exponential in nature, the model has historical consistency.

Question 23

The use of the optimum capital structure minimizes the cost of capital.

Question 24

The use of the weighted average cost of capital assumes that the firm is in its optimum capital structure range and the cost of each component stays constant over the range of financing.

Question 25

The SML helps us to identify the effects of several factors that can cause the cost of capital to change.

Question 26

Although the aftertax cost of debt is below the cost of equity, firms cannot increase their use of debt without limit.

Question 27

An increase in investors' aversion to risk causes the SML to shift up parallel to the old SML.

Question 28

A decrease in the risk free rate causes the SML to shift down parallel to the old SML.

Question 29

Research has indicated that betas are stable for individual stocks.

Question 30

Beta is a good measure of a stock's risk when the stock is combined into a portfolio.

Question 31

A firm should always be at a single optimum debt to equity ratio to minimize its cost of capital.

Question 32

All firms within particular industries have similar optimum capital structures.

Question 33

In determining the optimum capital structure it is assumed that the firm will raise capital in the optimum proportions every year.

Question 34

Companies prefer to maintain some financing flexibility in order to choose the lowest cost source of funds at a single point in time.

Question 35

Betas seem to be more stable in a portfolio context (group of stocks) than for individual stocks.

Question 36

The cost of capital for common stock (K_e) is not related to the concept of the security market line.

Question 37

By definition the market has a beta of zero.

Question 38

Regardless of the particular source of funds utilized for a project, the required rate of return, or discount rate, will be the weighted average cost of capital.

Question 39

The amount of debt capital used by a corporation is not related to the availability of equity funds from retained earnings and new common stock.

Question 40

The use of common stock equity in the weighted average cost of capital is always (K_e) and not (K_n), the cost of new common stock.

Question 41

Least squares regression analysis makes up the statistical equation for the capital asset pricing model.

Question 42

The weighted average cost of capital is used as a discount rate because

A) it is an indication of how much the firm is earning overall.
B) as long as the cost of capital is earned, the common stock value of the firm will be maintained.
C) it is comparable to the prevailing market interest rates.
D) returns below the cost of capital will cover all fixed costs associated with capital and provide an excess return to shareholders.

Question 43

A stock that had a beta of 2 would have a required rate of return that was twice the market risk premium.

Question 44

The capital asset pricing model relates the risk-return trade-offs of individual assets to market returns.

Question 45

In the traditional approach to cost-of-capital analysis, firm's value will be highest when it uses no debt in its capital structure.

Question 46

The market risk premium is equal to the market return minus the risk-free rate.

Question 47

The aftertax cost of preferred stock to the issuing corporation

A) is the same as the before-tax cost.
B) is usually lower than the cost of debt.
C) is dependent on the firm's tax bracket.
D) None of these

Question 48

A decrease in investors' risk aversion causes the slope of the SML to decline becoming more horizontal.

Question 49

If a firm's bonds are currently yielding 8% in the marketplace, why would the firm's cost of debt be lower?

A) interest rates have changed
B) additional debt can be issued more cheaply than the original debt
C) there should be no difference; cost of debt is the same as the bond's market yield
D) interest is tax-deductible

Question 50

Although debt financing is usually the cheapest component of capital, it cannot be used to excess because

A) interest rates may change.
B) the firm's share price will increase and raise the cost of equity financing.
C) the financial risk of the firm may increase and thus drive up the cost of all sources of financing.
D) underwriting costs may change.

Question 51

The security market line shows the relationship between the return on the market on the horizontal axis and the return of the individual stock on the vertical axis.

Question 52

An upward shift in the SML indicates that the prices of all assets will shift downward as interest rates move up.

Question 53

The final conclusions of Modigliani and Miller are most similar to the Net Income approach of Durand.

Question 54

Each project should be judged against

A) the specific means of financing used to support its implementation.
B) the going interest rate at that point in time.
C) the cost of new common stock equity.
D) None of these

Question 55

Modigliani and Miller originally suggested that firm value and the use of debt were independent.

Question 56

In the Net Operating Income approach to cost-of-capital analysis, a firm's value is directly related to its use of debt.

Question 57

The component parts of the cost of capital should be weighted by their proportion in the firm's

A) current capital structure.
B) historical capital structure.
C) optimum capital structure.
D) expected capital structure.

Question 58

A general increase in interest rates will raise the required rates of return for all stocks.

Question 59

For a firm paying 7% for new debt, the higher the firm's tax rate

A) the higher the aftertax cost of debt.
B) the lower the aftertax cost of debt.
C) aftertax cost is unchanged.
D) not enough information to judge

Question 60

The addition of bankruptcy costs in Modigliani and Miller's work suggests that the cost of capital will eventually increase as more debt is issued.

Question 61

Using the constant dividend growth model for common stock, if P_o goes up

A) the assumed cost goes up.
B) the assumed cost goes down.
C) the assumed cost remains unchanged.
D) need further information

Question 62

Marginal cost of capital

A) recognizes that cost of capital does not stay constant as more funds are raised.
B) usually provides the same capital budgeting choices as the use of weighted average cost of capital.
C) can be defined as the cost of capital when no retained earnings are available for expansion.
D) None of these apply

Question 63

The Halifax Corporation has 70% of its capital structure in the form of equity capital. $150,000 in capital needs to be raised for a project but only $30,000 in funds is available through retained earnings. How much must be raised through common stock to maintain Halifax Corporation's capital structure?

A) $105,000
B) $ 75,000
C) $120,000
D) $ 21,000

Question 64

The overall weighted average cost of capital is used instead of costs for specific sources of funds because

A) use of the cost for specific sources of capital would make investment decisions inconsistent.
B) a project with the highest return would always be accepted under the specific cost criteria.
C) investments funded by low cost debt would have an advantage over other investments.
D) two of the other answers are correct.

Question 65

The coupon rate on an issue of debt is 12%. The yield to maturity on this issue is 14%. The corporate tax rate is 31%. What would be the approximate aftertax cost of debt for a new issue of bonds?

A) 4.34%
B) 3.72%
C) 9.66%
D) 8.28%

Question 66

A firm's debt to equity ratio varies at times because

A) a firm will want to sell common stock when prices are high and bond when interest rates are low.
B) a firm will want to take advantage of timing its fund raising in order to minimize costs over the long run.
C) the market allows some leeway in the debt to equity ratio before penalizing the firm with a higher cost of capital.
D) all of the other answers are correct.

Question 67

New common stock is more expensive than k_e

A) to compensate for risk.
B) to compensate for more dividends.
C) to compensate for expansionary problems.
D) to cover distribution costs.

Question 68

The cost of debt is determined by taking the

A) present value of the interest payments and principal times one minus the tax rate.
B) historical yield on bonds times one minus the tax rate
C) estimated yield on new bond issues of the same risk times one minus the shareholder marginal tax rate.
D) none of the other answers are correct.

Question 69

A firm is paying an annual dividend of $3.63 for its preferred stock which is selling for $62.70. There is a selling cost of $3.30. What is the aftertax cost of preferred stock if the firm's tax rate is 33%?

A) 2.02%
B) 4.09%
C) 5.79%
D) 6.11%

Question 70

A firm in a cyclical industry should use

A) a large amount of debt to lower the cost of capital.
B) no debt at all.
C) preferred stock in place of debt.
D) a limited amount of debt to lower the cost of capital.

Question 71

The pre-tax cost of debt for a new issue of debt is determined by

A) the investor's required rate of return on issued stock.
B) the coupon rate of existing debt.
C) the yield to maturity of outstanding bonds.
D) none of the other answers are correct.

Question 72

Use of the marginal cost of capital

A) acknowledges that when retained earnings is used up as a source of equity the cost of capital rises as new common stock is sold to support more growth.
B) recognizes that the return from the last dollar of funds generated should be equal to the cost of the last dollar of funds raised.
C) two of the other answers are correct.
D) none of the other answers are correct.

Question 73

Within the capital asset pricing model

A) the risk-free rate is usually higher than the return in the market.
B) the higher the beta the lower the required rate of return.
C) beta measures the volatility of an individual stock relative to a stock market index.
D) two of the answers are correct

Question 74

In determining the cost of retained earnings

A) the dividend valuation model is inappropriate.
B) flotation costs are included.
C) growth is not considered.
D) the capital asset pricing model can be used.

Question 75

Which is not true about debt financing and the weighted average cost of capital?

A) debt is usually the cheapest source of financing
B) as the level of debt increases beyond the optimum capital structure, the cost of capital increases
C) no debt in the firm's capital structure will minimize the firm's weighted-average cost of capital
D) none of the other answers are correct

Question 76

Expected cash dividends are $2.50, the dividend yield is 6%, flotation costs are 4%, and the growth rate is 3%. Compute cost of the new common stock.

A) 9.00%
B) 9.25%
C) 9.18%
D) 9.375%

Question 77

A firm's stock is selling for $78. The next annual dividend is expected to be $2.34. The growth rate is 9%. The flotation cost is $5.00. What is the cost of retained earnings?

A) 12.82%
B) 12.21%
C) 12.00%
D) 9.41%

Question 78

The weighted average cost of capital for firm X is currently 10%. Firm X is considering a new project but must raise new debt to finance the project. Debt represents 25% of the capital structure. If the aftertax cost of debt will rise from 7% to 8%, what is the marginal cost of capital?

A) 10.25%
B) 10.75%
C) 12.00%
D) not enough information

Question 79

The coupon rate on a debt issue is 12%. If the yield to maturity on the debt is 9.33%, what is the aftertax cost of debt (for a cost of capital calculation) if the firm's tax rate is 34%?

A) 3.17%
B) 4.08%
C) 6.16%
D) 7.92%

Question 80

A firm's stock is selling for $85. The dividend yield is 5%. A 7% growth rate is expected for the common stock. The firm's tax rate is 32%. What is the firm's cost of common equity?

A) 8.16%
B) 12.00%
C) 12.35%
D) 10.40%