Deck 21: Cost of Capital

Question 1

As the firm increases its use of equity instead of debt financing, the cost of equity rises.

Answer 1

False

Question 2

An increase in the debt ratio may be associated with an increase in risk.

Answer 2

True

Question 3

The weighted cost of capital includes the cost of all the components of a firm's capital structure.

Answer 3

True

Question 4

The lower the firm's tax rate, the larger is the incentive to use preferred stock instead of bonds.

Question 5

The weighted cost of capital includes the cost of debt and the cost of equity.

Question 6

If the firm issues debentures instead of preferred stock to raise additional funds, the cost of capital rises.

Question 7

The optimal capital structure does not necessarily minimize the cost of equity.

Question 8

The cost of debt is less than the cost of equity.

Question 9

Because interest is a tax-deductible expense, the effective cost of debt is less than the stated rate of interest.

Question 10

The cost of debt exceeds the cost of equity.

Question 11

Retained earnings are more expensive than issuing new shares because of flotation costs.

Question 12

If a firm's optimal capital structure is 45 percent debt financing, then the firm may borrow $55 for every $45 of equity financing.

Question 13

The cost of preferred stock is greater than the cost of debt primarily as the result of the difference in tax treatment of dividends and interest.

Question 14

If management substitutes new common stock for retained earnings, that tends to reduce the cost of capital.

Question 15

The cost of retained earnings tends to exceed the cost of issuing new stock because of the flotation costs.

Question 16

A firm will prefer to issue preferred stock rather than debt because the dividend is tax deductible.

Question 17

The optimal capital structure minimizes the weighted average of the cost of debt and the cost of equity.

Question 18

A firm may initially increase its use of debt without increasing the cost of capital.

Question 19

The cost of preferred stock is less than the cost of debt.

Question 20

The optimal capital structure minimizes the cost of debt financing.

Question 21

A firm can initially increase its use of debt financing without increasing the cost of debt.

Question 22

Preferred stock increases common stockholders' return​

A) ​more than an equal dollar amount of debt
B) less than an equal dollar amount of debt​
C) more than an equal dollar amount of retained earnings​
D) less than an equal dollar amount of retained earnings​

Question 23

If the marginal cost of capital rises, that suggests the cost of some component of the firm's capital structure has risen.

Question 24

If the dividend growth model is used, the cost of equity depends on
​1) the firm's earnings growth rate
2) the current dividend payment
3) the price of the stock

A)​1 and 2
B)1 and 3​
C)2 and 3​
D)1, 2, and 3​

Question 25

As a firm increases its use of debt, it becomes more financially leveraged and riskier.

Question 26

Retained earnings​

A) ​have no cost
B) are the firm's cheapest source of funds​
C) ​have a cost that equals the cost of capital
D) are cheaper than the cost of new common stock

Question 27

The effective cost of debt is reduced because​

A) ​interest is a tax-deductible expense
B) interest is not a tax deducible expense​
C) interest is paid before preferred dividends​
D) interest is paid after common stock dividends​

Question 28

The effective cost of debt depends on
1) the firm's total assets
2) the firm's tax rate
3) the stated interest rate

A)​1 and 2
B)​1 and 3
C)2 and 3​
D)1, 2, and 3​

Question 29

Debt financing is more risky for firms than preferred stock financing because​

A) ​preferred dividend payments are legal obligations
B) interest payments are legal obligations​
C) preferred stock must be retired​
D) debt need not be refinanced​

Question 30

The optimal capital structure involves

A) ​maximizing the cost of all funds
B) ​minimizing the cost of all funds
C) ​using no financial leverage
D) ​minimizing the weighted average of the cost of funds

Question 31

The marginal cost of capital rises​
1) because the cost of retained earnings exceeds the cost of new shares
2) because the cost of new shares exceeds the cost of retained earnings
3) if the firm issues secured debt instead of debentures
4) if the firm issues debentures instead of secured debt

A)​1 and 3
B)​1 and 4
C)2 and 3​
D)2 and 4​

Question 32

If equity is negative,​

A) ​debt exceeds total assets
B) ​total assets exceed debt
C) ​equity exceeds assets
D) equity exceeds debt​

Question 33

In order to maximize the value of the firm, the financial manager must determine the firm's optimal capital structure.

Question 34

The average cost of capital is the cost of additional financing.

Question 35

The cost of equity​
1) is less than the cost of debt
2) is greater than the cost of debt
3) depends on the riskiness of the firm
4) depends on the firm's current ratio

A)​1 and 3
B)1 and 4​
C)2 and 3​
D)2 and 4​

Question 36

The optimal capital structure is the firm's best combination of debt and equity funds.

Question 37

If the capital asset pricing model is used, the cost of equity depends on
1) the firm's earnings growth rate
2) the firm's beta
3) the return on the market

A)​1 and 2
B)​1 and 3
C)​2 and 3
D)​1, 2, and 3

Question 38

Debt financing​
1) increases stockholders' return more than an equal dollar amount of preferred stock
2) increases stockholders' return less than an equal dollar amount of preferred stock
3) is less risky to the investor than preferred stock
4) is more risky to the investor than preferred stock

A)​1 and 3
B)1 and 4​
C)2 and 3​
D)2 and 4​

Question 39

If a firm must issue subordinated debentures instead of equipment trust certificates, the marginal cost of capital may rise even though the optimal capital structure is maintained.

Question 40

The cost of capital includes​
1) cost of debt
2) cost of preferred stock
3) cost of retained earnings

A)​1 and 2
B)1 and 3​
C)2 and 3​
D)1, 2, and 3​

Question 41

In the capital assets pricing model, the cost of equity is investors' required return and includes​
1) the expected return on the market
2) the firm's beta
3) the firm's tax rate

A)​1 and 2
B)1 and 3​
C)2 and 3​
D)1, 2, and 3​

Question 42

Given the following information: $$\begin{array} { l c } \text { interest rate } & 8 \% \\\text { tax rate } & 30 \% \\\text { dividend } & \$ 1 \\\text { price of the common stock } & \$ 50 \\\text { growth rate of dividends } & 7 \% \\\text { debt ratio } & 40 \%\end{array}$$ ​
a. Determine the firm's cost of capital.
b. If the debt ratio rises to 50 percent and the cost of funds remains the same, what is the new cost of capital?
c. If the debt ratio rises to 60 percent, the interest rate rises to 9 percent, and the price of the stock falls to $30, what is the cost of capital? Why is this cost different?

Question 43

The cost of debt is​

A) ​less than the cost of equity
B) greater than the cost of equity​
C) ​equal to the firm's interest rate
D) ​greater than the cost of preferred stock

Question 44

As a firm uses excessive amounts of debt financing,
​1) its debt ratio increases
2) the value of its stock declines
3) its cost of capital increases

A)​1 and 2
B)1 and 3​
C)2 and 3​
D)1, 2, and 3​

Question 45

The marginal cost of capital​

A) ​is the firm's cost of debt and equity finance
B) ​is constant given an optimal capital structure
C) ​declines as flotation costs alter equity financing
D) refers to the cost of additional financing​

Question 46

The firm's cost of debt is 8 percent, and the cost of retained earnings is 14 percent. However, if the firm exhausts its retained earnings of $23,678, the cost of equity rises to 14.9 percent. Currently management believes that the firm's current combination of 35 percent debt and 65 percent equity is the optimal capital structure.​
a. What is the firm's cost of capital if it uses only retained earnings?
​
b.What is the firm's cost of capital if it uses new equity?
c. How much total financing may the firm have before the marginal cost of capital rises?

Question 47

Flotation costs of issuing new securities​

A) ​decrease the cost of capital
B) encourage the retention of earnings​
C) encourage external financing​
D) do not affect the cost of capital​

Question 48

a.​Given the following schedules,
​
$$\begin{array} { c c c } \text { debt/assets } & \text { cost of } & \text { cost of } \\\text { debt } & \text { equity } \\0 \% & 7 \% & 14 \% \\10 & 7 & 14 \\20 & 7 & 14 \\30 & 8 & 14 \\40 & 8 & 16 \\50 & 10 & 18 \\60 & 12 & 20\end{array}$$ ​
what is firm's cost of capital at the various combinations of debt and equity?
b. What is the firm's optimal capital structure? Construct a balance sheet showing that combination of debt and equity financing.​
$\text { Balance Sheet for Firm } \mathrm{X} \text { as of } \mathrm{XX} / \mathrm{XX} / \mathrm{XX}$
$\begin{array}{ll}\hline\text { Assets }&\$100&\text { Debt Equity }&\$100\end{array}$

c. If the firm earns $10 on every $100 of assets, will the stockholders receive more or less than their required rate of return if the firm uses its optimal combination of debt and equity financing?
d. If the above cost of equity is the cost of retained earnings,what happens to the cost of capital if the cost of new shares is one percentage point higher at the firm's optimal capital structure?
e. If the firm has retained earnings of $1,500,000, what is the cost of capital at the optimal capital structure if the firm needs $2,000,000?

Question 49

The cost of debt is affected by​
1) retained earnings
2) firm's tax rate
3) interest rate

A)​1 and 2
B)1 and 3​
C)2 and 3​
D)1, 2, and 3​

Question 50

Retained earnings​

A) ​have no cost
B) are the firm's cheapest sources of funds​
C) have the same cost as new shares of stock​
D) are cheaper than the cost of new shares​