Deck 9: The Cost of Capital

Question 1

The market risk premium remains constant over time because the risk free rate of return moves inversely with beta.

Answer 1

False

Question 2

Other things equal,management should retain profits only if the company's investments within the firm are at least as attractive as the stockholders' other investment opportunities.

Answer 2

True

Question 3

The cost of capital is the rate that must be earned on an investment project if the project is to increase the value of the common shareholders' investment.

Answer 3

True

Question 4

The firm's cost of capital is important when evaluation the firm's overall value,but should not be used to evaluate individual projects which have their own unique characteristics.

Question 5

A reasonable estimate of the market risk premium based on historical data and expert opinion is between 5% and 7%.

Question 6

If preferred stock pays a $5 annual dividend and sells for $50 the cost of preferred stock financing is 10% since dividends are not tax deductible and preferred stock is sold without flotation costs.

Question 7

The cost of debt capital is obtained by substituting the net proceeds per bond for the bond price in the bond valuation equation and solving for the required return.

Question 8

Higher flotation costs will result in all of the following EXCEPT

A)higher after-tax cost of debt.
B)higher weighted average cost of capital.
C)higher cost of retained earnings.
D)higher cost of common equity when new common shares are sold.

Question 9

The firm financed completely with equity capital has a cost of capital equal to the required return on common stock.

Question 10

Flotation costs cause a corporation's cost of capital to be lower than its investors' required returns.

Question 11

The Capital Asset Pricing Model may be used to estimate the cost of retained earnings.

Question 12

The after-tax cost of equity equals one minus the marginal tax rate times the required rate of return on common stock.

Question 13

The cost of debt increases relative to the investor's required return due to flotation costs,but decreases relative to the investor's required return due to the tax deductibility of interest.

Question 14

Corporations have two costs of common equity,one for retained earnings and one if the company issues new common stock.

Question 15

A corporation's cost of common equity may be estimated using either a dividend valuation model or the capital asset pricing model.

Question 16

A firm's cost of capital is the required rate of return on the firm's average project.

Question 17

The cost of a particular source of capital (debt,preferred stock,common stock)is equal to the investor's required rate of return after adjusting for the effects of both flotation costs and corporate taxes.

Question 18

The firm's cost of capital may also be referred to as the firm's opportunity cost of capital.

Question 19

In order to create value a corporation must earn a rate of return on its invested capital that is higher than the market's required rate of return on that invested capital.

Question 20

The cost of preferred stock is equal to the preferred stock dividend divided by the net proceeds per preferred share.

Question 21

A security with a reasonably stable price will have a lower required rate of return than a security with an unstable price.

Question 22

The cost of debt measures the cost of a bank loan,while the cost of preferred stock is used as a proxy for the cost of a new bond issue.

Question 23

The capital asset pricing model uses three variables to evaluate required returns on common equity: the risk free rate,the beta coefficient,and the market risk premium.

Question 24

A company has preferred stock that can be sold for $21 per share.The preferred stock pays an annual dividend of 3.5% based on a par value of $100.Flotation costs associated with the sale of preferred stock equal $1.25 per share.The company's marginal tax rate is 35%.Therefore,the cost of preferred stock is

A)18.87%.
B)17.72%.
C)14.26%.
D)12.94%.

Question 25

A short-term T-bill's rate of return should be used in the CAPM formula to determine the cost of equity capital regardless of the length of the project under consideration.

Question 26

Due to changes in regulatory requirements,the transactions costs associated with selling corporate securities increased by $1 per share.This change will

A)cause the cost of capital to decrease.
B)cause the cost of capital to increase.
C)have no effect on the cost of capital because transactions costs are expensed immediately.
D)cause the cost of capital to decrease only if investors may be billed for part of the increase in transactions costs.

Question 27

Adventure Outfitter Corp.can sell common stock for $27 per share and its investors require a 17% return.However,the administrative or flotation costs associated with selling the stock amount to $2.70 per share.What is the cost of capital for Adventure Outfitter if the corporation raises money by selling common stock?

A)27.00%
B)18.89%
C)18.33%
D)17.00%

Question 28

The required return of a preferred stockholder,r_ps,is higher than the cost of preferred stock for the corporation because stockholder's must pay federal taxes on their dividend income.

Question 29

Financing with new common stock is generally more costly than financing with retained earnings due to increasing tax rates.

Question 30

The investor's required rate of return will equal the firm's cost of capital if corporate transactions costs are taken into account.

Question 31

Two factors that cause the investor's required rate of return to differ from the company's cost of capital are

A)taxes and risk.
B)transactions costs and risk.
C)taxes and transactions costs.
D)risk and opportunity cost differences.

Question 32

An increase in a corporation's marginal tax rate will decrease the corporation's cost of debt,but have no impact on its cost of preferred stock or cost of common equity.

Question 33

Sentry Manufacturing paid a dividend yesterday of $5 per share (D₀ = $4).The dividend is expected to grow at a constant rate of 8% per year.The price of Sentry Manufacturing's stock today is $29 per share.If Sentry Manufacturing decides to issue new common stock,flotation costs will equal $2.50 per share.Sentry Manufacturing's marginal tax rate is 35%.Based on the above information,the cost of retained earnings is

A)28.38%.
B)24.12%.
C)26.62%.
D)31.40%.

Question 34

Investors require higher rates of return to compensate for purchasing power losses resulting from inflation.

Question 35

Because investors like dividends,the higher the company's dividend growth rate,the lower the company's cost of common equity.

Question 36

The firm's best financial structure is determined by finding the capital structure that minimizes the firm's cost of capital.

Question 37

Preferred dividends are paid with before-tax dollars because the dividend rate is known,whereas common stock dividends are paid with after-tax dollars.

Question 38

The cost of internal common equity is already on an after-tax basis since dividends paid to common stockholders are not tax deductible.

Question 39

An increase in a corporation's marginal tax rate will cause the corporation's after tax cost of debt to increase,other things remaining the same.

Question 40

Two considerations that cause a corporation's cost of capital to be different than its investors' required returns are

A)corporate taxes and flotation costs.
B)individual taxes and corporate taxes.
C)individual taxes and dividends.
D)corporate taxes and the earned income tax credit.

Question 41

A firm's cost of capital is influenced by

A)the current ratio.
B)par value of common stock.
C)capital structure.
D)net income.

Question 42

In general,the least expensive source of capital is

A)debt.
B)new common stock.
C)preferred stock
D)retained earnings.

Question 43

Sentry Manufacturing paid a dividend yesterday of $5 per share (D₀ = $4).The dividend is expected to grow at a constant rate of 8% per year.The price of Sentry Manufacturing's stock today is $29 per share.If Sentry Manufacturing decides to issue new common stock,flotation costs will equal $2.50 per share.Sentry Manufacturing's marginal tax rate is 35%.Based on the above information,the cost of new common stock is

A)28.38%.
B)24.12%.
C)26.62%.
D)31.40%.

Question 44

Which of the following differentiates the cost of retained earnings from the cost of newly-issued common stock?

A)the cost of the pre-emptive rights held by existing shareholders
B)the greater marginal tax rate faced by the now-larger firm
C)the flotation costs incurred when issuing new securities
D)the larger dividends paid to the new common stockholders

Question 45

Jiffy Co.expects to pay a dividend of $3.00 per share in one year.The current price of Jiffy common stock is $60 per share.Flotation costs are $3.00 per share when Jiffy issues new stock.What is the cost of internal common equity (retained earnings)if the long-term growth in dividends is projected to be 8 percent indefinitely?

A)13 percent
B)14 percent
C)15 percent
D)16 percent

Question 46

The cost of retained earnings is less than the cost of new common stock because

A)marginal tax brackets increase.
B)flotation costs are incurred when new stock is issued.
C)dividends are not tax deductible.
D)accounting rules allow a deduction when using retained earnings.

Question 47

The risk free rate of return is 2.5% and the market risk premium is 8%.Rogue Transport has a beta of 2.2 and a standard deviation of returns of 28%.Rogue Transport's marginal tax rate is 35%.Analysts expect Rogue Transport's dividends to grow by 6% per year for the foreseeable future.Using the capital asset pricing model,what is Rogue Transport's cost of retained earnings?

A)16.4%
B)17.7%
C)19.6%
D)20.1%

Question 48

The average cost associated with each additional dollar of financing for investment projects is

A)the incremental return.
B)the marginal cost of capital.
C)CAPM required return.
D)the component cost of capital.

Question 49

Johnson Production Company paid a dividend yesterday of $3.50 per share.The dividend is expected to grow at a constant rate of 10% per year.The price of KayCee's common stock today is $40 per share.If KayCee decides to issue new common stock,flotation costs will equal $4.00 per share.KayCee's marginal tax rate is 35%.Based on the above information,the cost of new common stock is

A)26.41%.
B)20.09%.
C)19.63%.
D)17.55%.

Question 50

In capital budgeting analysis,when computing the weighted average cost of capital,the CAPM approach is typically used to find which of the following?

A)market value weight of equity
B)pretax component cost of debt
C)after-tax component cost of debt
D)component cost of internal equity

Question 51

The cost of external equity capital is greater than the cost of retained earnings because of

A)flotation costs on new equity.
B)increasing marginal tax rates.
C)higher dividends.
D)greater risk for shareholders.

Question 52

Johnson Production Company paid a dividend yesterday of $3.50 per share.The dividend is expected to grow at a constant rate of 10% per year.The price of KayCee's common stock today is $40 per share.If KayCee decides to issue new common stock,flotation costs will equal $4.00 per share.KayCee's marginal tax rate is 35%.Based on the above information,the cost of retained earnings is

A)26.41%.
B)20.09%.
C)19.63%.
D)17.55%.

Question 53

The cost of new preferred stock is equal to

A)the preferred stock dividend divided by the market price.
B)the preferred stock dividend divided by its par value.
C)(1 - tax rate)times the preferred stock dividend divided by net price.
D)preferred stock dividend divided by the net selling price of preferred.

Question 54

A company has preferred stock with a current market price of $18 per share.The preferred stock pays an annual dividend of 4% based on a par value of $100.Flotation costs associated with the sale of preferred stock equal $1.50 per share.The company's marginal tax rate is 40%.Therefore,the cost of preferred stock is

A)28.80%.
B)24.24%.
C)22.22%.
D)14.55%.

Question 55

In general,which of the following rankings,from highest to lowest cost,is most accurate?

A)cost of new common stock,cost of preferred stock,cost of debt,cost of retained earnings
B)cost of debt,cost of preferred stock,cost of new common stock,cost of retained earnings
C)cost of new common stock,cost of retained earnings,cost of preferred stock,cost of debt
D)cost of preferred stock,cost of new common stock,cost of retained earnings,cost of debt

Question 56

The risk free rate of return is 3% and the expected return on the market portfolio is 14%.Oklahoma Oilco has a beta of 2.0 and a standard deviation of returns of 26%.Oilco's marginal tax rate is 35%.Analysts expect Oilco's net income to grow by 12% per year for the next 5 years.Using the capital asset pricing model,what is Oklahoma Oilco's cost of retained earnings?

A)18.6%
B)21.2%
C)22.8%
D)25.0%

Question 57

JPR Company's preferred stock is currently selling for $28.00,and pays a perpetual annual dividend of $2.00 per share.Underwriters of a new issue of preferred stock would charge $3 per share in flotation costs.The firm's tax rate is 40%.Compute the cost of new preferred stock for JPR.

A)4.80%
B)7.14%
C)8.00%
D)9.15%

Question 58

Phillips Enterprises Inc.is expected to pay a dividend of $2.60 next year.Dividends are expected to grow at a constant rate of 8% per year,and the stock price is currently $20.00.New stock can be sold at this price subject to flotation costs of 15%.The company's marginal tax rate is 35%.Compute the cost of internal equity (retained earnings)and the cost of external equity (new common stock),respectively.

A)0,21.00%
B)8.00%,23.29%
C)21.00%,23.29%
D)23.00%,25.48%

Question 59

GPS Inc.wishes to estimate its cost of retained earnings.The firm's beta is 1.3.The rate on 6-month T-bills is 2%,and the return on the S&P 500 index is 15%.What is the appropriate cost for retained earnings in determining the firm's cost of capital?

A)17.0%
B)19.5%
C)18.9%
D)22.1%

Question 60

JPR Company is financed 75 percent by equity and 25 percent by debt.If the firm expects to earn $30 million in net income next year and retain 40% of it,how large can the capital budget be before common stock must be sold?

A)$7.5 million
B)$12.0 million
C)$15.5 million
D)$16.0 million

Question 61

Crandal Dockworks is undergoing a major expansion.The expansion will be financed by issuing new 15-year,$1,000 par,9% annual coupon bonds.The market price of the bonds is $1,070 each.Crandal's flotation expense on the new bonds will be $50 per bond.Crandal's marginal tax rate is 35%.What is the pre-tax cost of debt for the newly-issued bonds?

A)8.76%
B)8.12%
C)7.49%
D)10.25%

Question 62

New Jet Airlines plans to issue 14-year bonds with a par value of $1,000 that will pay $60 every six months.The bonds have a market price of $1,220.Flotation costs on new debt will be 4% of the selling price.If the firm has a 35% marginal tax bracket,compute the following:
a.Yield to maturity of debt
b.After-tax cost of existing debt
c.After-tax cost of new debt

Question 63

Grandview Inc.will issue new common stock to finance an expansion.The existing common stock just paid a $1.50 dividend,and dividends are expected to grow at a constant rate 8% indefinitely.The stock sells for $45,and flotation expenses of 5% of the selling price will be incurred on new shares.What is the cost of retained earnings for Grandview?

A)11.33%
B)11.51%
C)11.60%
D)11.79%
E)12.53%

Question 64

Haroldson Inc.common stock is selling for $22 per share.The last dividend was $1.20,and dividends are expected to grow at a 6% annual rate.Flotation costs on new stock sales are 5% of the selling price.What is the cost of Haroldson Inc.'s new common stock?

A)5.73%
B)11.45%
C)11.78%
D)12.09%

Question 65

Sutter Corporation's common stock is selling for $16.80 a share.Last year Sutter paid a dividend of $.80.Investors are expecting Sutter's dividends to grow at an annual rate of 5% per year.What is the cost of internal equity?

Question 66

The common stock for El Viss Company currently sells for $20 per share.The firm just paid a dividend of $1.50,and the dividend three years ago was $1.30.Dividends per share are anticipated to grow at the same rate in the future as they have over the past three years.Flotation costs for new shares will be 6% of the selling price.Calculate the following:
a.the cost of retained earnings
b.the cost of external equity capital

Question 67

A company is going to issue a $1,000 par value bond that pays a 7% annual coupon.The company expects investors to pay $942 for the 20-year bond.The expected flotation cost per bond is $42,and the firm is in the 34% tax bracket.Compute the following:
a.The yield to maturity on the firm's bonds
b.The firm's after-tax cost of existing debt
c.The firm's after-tax cost of new debt

Question 68

Dickerson Corporation's common stock is currently selling for $38.Last year's dividend was $4.00 per share.Investors expect dividends to grow at an annual rate of 7 percent indefinitely.Flotation costs of 4% will be incurred when new stock is sold.
a.What is the cost of internal common equity?
b.What is the cost of new common equity?

Question 69

Alarm Systems Corporation's preferred stock pays a dividend of $3.60 and sells for $28.00.Alarm Systems Corporation has a marginal tax rate of 35%.What is the cost of preferred financing?

Question 70

Gibson Industries is issuing a $1,000 par value bond with an 8% annual interest coupon rate that matures in 11 years.Investors are willing to pay $972,and flotation costs will be 9%.Gibson is in the 34% tax bracket.What will be the after-tax cost of new debt for the bond?

Question 71

Keystone Corporation will issue new common stock to finance an expansion.The existing common stock just paid a $1.50 dividend,and dividends are expected to grow at a constant rate 8% indefinitely.The stock sells for $45,and flotation expenses of 5% of the selling price will be incurred on new shares.What is the cost of new common stock be for Keystone Corp.?

A)11.33%
B)11.51%
C)11.60%
D)11.79%
E)12.53%

Question 72

NewLinePhone Corp.is very risky,with a beta equal to 2.8 and a standard deviation of returns of 32%.The risk free rate of return is 3% and the market risk premium is 8%.NewLinePhone's marginal tax rate is 35%.Use the capital asset pricing model to estimate NewLinePhone's cost of retained earnings.

Question 73

Haroldson Inc.common stock is selling for $22 per share.The last dividend was $1.20,and dividends are expected to grow at a 6% annual rate.Flotation costs on new stock sales are 5% of the selling price.What is the cost of Haroldson's retained earnings?

A)5.73%
B)11.45%
C)11.78%
D)12.09%

Question 74

Which of the following statements is MOST correct?

A)Because the cost of debt is lower than the cost of equity,value-maximizing firms maintain debt ratios of close to 100%.
B)Corporations that are 100% equity financed will have a much lower weighted average cost of capital because the lack of debt lowers their risk of bankruptcy.
C)The source of capital with the lowest after-tax cost is preferred stock,because it is a hybrid security,part debt and part equity.
D)The cost of a particular source of capital is equal to the investor's required rate of return after adjusting for the effects of both flotation costs and corporate taxes.

Question 75

Crandal Dockworks is undergoing a major expansion.The expansion will be financed by issuing new 15-year,$1,000 par,9% annual coupon bonds.The market price of the bonds is $1,070 each.Five Rivers flotation expense on the new bonds will be $50 per bond.Crandal's marginal tax rate is 35%.What is the yield to maturity on the newly-issued bonds?

A)6.95%
B)7.99%
C)8.17%
D)9.82%

Question 76

Toto and Associates' preferred stock is selling for $27.50 a share.The firm nets $25.60 after issuance costs.The stock pays an annual dividend of $3.00 per share.What is the cost of existing,and new,preferred stock respectively?

Question 77

Last year Gator Getters,Inc.had $50 million in total assets.Management desires to increase its plant and equipment during the coming year by $12 million.The company plans to finance 40 percent of the expansion with debt and the remaining 60 percent with equity capital.Bond financing will be at a 9 percent rate and will be sold at its par value.Common stock is currently selling for $50 per share,and flotation costs for new common stock will amount to $5 per share.The expected dividend next year for Gator is $2.50.Furthermore,dividends are expected to grow at a 6 percent rate far into the future.The marginal corporate tax rate is 34 percent.Internal funding available from additions to retained earnings is $4,000,000.
a.What amount of new common stock must be sold if the existing capital structure is to be maintained?
b.Calculate the weighted marginal cost of capital at an investment level of $12 million.

Question 78

All else equal,an increase in beta results in

A)an increase in the cost of retained earnings.
B)an increase in the cost of newly issued common stock .
C)an increase in the after-tax cost of debt.
D)an increase in the cost of common equity,whether or not the funds come from retained earnings or newly issued common stock.

Question 79

The preferred stock of Wells Co.sells for $17 and pays a $1.75 dividend.The net price of the stock after issuance costs is $15.30.What is the cost of capital for new preferred stock?

Question 80

Tempo Corp.will issue preferred stock to finance a new artillery line.The firm's existing preferred stock pays a dividend of $4.00 per share and is selling for $40 per share.Investment bankers have advised Tempo that flotation costs on the new preferred issue would be 5% of the selling price.Tempo's marginal tax rate is 30%.What is the relevant cost of new preferred stock?

A)7.00%
B)7.37%
C)10.00%
D)10.53%
E)15.00%