Deck 9: The Cost of Capital

Question 1

The cost of each type of capital depends on the

A) risk-free cost of that type of funds.
B) business risk of the firm.
C) financial risk of the firm.
D) all of the above.

Answer 1

all of the above.

Question 2

The cost of capital is used to decide whether a proposed corporate investment will increase or decrease the firm's stock price.

Answer 2

True

Question 3

The ________ is the rate of return a firm must earn on its investments in projects in order to maintain the market value of its stock.

A) net present value
B) cost of capital
C) internal rate of return
D) gross profit margin

Answer 3

cost of capital

Question 4

The cost of capital acts as a major link between the firm's long-term investment decisions and the wealth of the owners as determined by investors in the marketplace.

Question 5

The cost of capital is the rate of return a firm must earn on investments in order to leave share price unchanged.

Question 6

Holding risk constant, the implementation of projects with a rate of return above the cost of capital will decrease the value of the firm, and vice versa.

Question 7

The cost of capital reflects the cost of funds over the long run measured at a given point in time, based on the best information available.

Question 8

The cost of capital reflects the cost of funds

A) over a short-run time period.
B) at a given point in time.
C) over a long-run time period.
D) at current book values.

Question 9

The four basic sources of long-term funds for the business firm are

A) current liabilities, long-term debt, common stock, and preferred stock.
B) current liabilities, long-term debt, common stock, and retained earnings.
C) long-term debt, paid-in capital in excess of par, common stock, and retained earnings.
D) long-term debt, common stock, preferred stock, and retained earnings.

Question 10

The firm's optimal mix of debt and equity is called its

A) optimal ratio.
B) target capital structure.
C) maximum wealth.
D) maximum book value.

Question 11

The specific cost of each source of financing is the after-tax cost of obtaining the financing using the historically based cost reflected by the existing financing on the firm's books.

Question 12

The cost of common stock equity can be thought of as the "magic number" that is used to decide whether a proposed corporate investment will increase or decrease the firm's stock price.

Question 13

The cost of capital can be thought of as the "magic number" that is used to decide whether a proposed corporate investment will increase or decrease the firm's stock price.

Question 14

In using the cost of capital, it is important that it reflects the historical cost of raising funds over the long run.

Question 15

The ________ is the rate of return required by the market suppliers of capital in order to attract their funds to the firm.

A) yield to maturity
B) internal rate of return
C) cost of capital
D) gross profit margin

Question 16

The target capital structure is the desired optimal mix of debt and equity financing that most firms attempt to achieve and maintain.

Question 17

The cost of capital is a dynamic concept; it is affected by economic and firm-specific factors such as business risk and financial risk.

Question 18

Firms typically raise long-term funds

A) only at the inception of the firm.
B) on a continuous basis.
C) in lump sums as needed.
D) in proportion to the capital mixture of the target capital structure.

Question 19

The cost of capital can be thought of as the rate of return required by the market suppliers of capital in order to attract their funds to the firm.

Question 20

The cost of capital is a static concept; it is not affected by economic and firm-specific factors such as business risk and financial risk.

Question 21

A tax adjustment must be made in determining the cost of

A) long-term debt.
B) common stock.
C) preferred stock.
D) retained earnings.

Question 22

A company's historical target capital structure is 40 percent debt and 60 percent equity. The company expects to issue more equity in the upcoming year moving its capital structure to 50 percent debt and 50 percent equity for the long term. The company should use the current 40 percent debt/60 equity for its average weighted cost of capital.

Question 23

The ________ is a weighted average of the cost of funds which reflects the interrelationship of financing decisions.

A) risk premium
B) nominal cost
C) cost of capital
D) risk-free rate

Question 24

When the net proceeds from sale of a bond equal its par value, the before-tax cost would just equal the coupon interest rate.

Question 25

The ________ from the sale of a security are the funds actually received from the sale after ________, or the total costs of issuing and selling the security, which have been subtracted from the total proceeds.

A) gross proceeds; the after-tax costs
B) gross proceeds; the flotation costs
C) net proceeds; the flotation costs
D) net proceeds; the after-tax costs

Question 26

The specific cost of each source of long-term financing is based on ________ and ________ costs.

A) before-tax; historical
B) after-tax; historical
C) before-tax; book value
D) after-tax; current

Question 27

When determining the after-tax cost of a bond, the face value of the issue must be adjusted to the net proceeds amounts by considering

A) the risk.
B) the flotation costs.
C) the approximate returns.
D) the taxes.

Question 28

Nico Trading Corporation is considering issuing long-term debt. The debt would have a 30 year maturity and a 10 percent coupon rate. In order to sell the issue, the bonds must be underpriced at a discount of 5 percent of face value. In addition, the firm would have to pay flotation costs of 5 percent of face value. The firm's tax rate is 35 percent. Given this information, the after tax cost of debt for Nico Trading would be 7.26 percent.

Question 29

The before-tax cost of debt for a firm which has a 40 percent marginal tax rate is 12 percent. The after-tax cost of debt is

A) 4.8 percent.
B) 6.0 percent.
C) 7.2 percent.
D) 12 percent.

Question 30

The net proceeds used in calculation of the cost of long-term debt are funds actually received from the sale after paying for flotation costs and taxes.

Question 31

The marginal cost of capital necessary to raise the next marginal dollar of financing is relevant for evaluating the firm's future investment opportunities.

Question 32

Flotation costs reduce the net proceeds from the sale of a bond whether sold at a premium, at a discount, or at its par value.

Question 33

The ________ is the firm's desired optimal mix of debt and equity financing.

A) book value
B) market value
C) cost of capital
D) target capital structure

Question 34

A corporation has concluded that its financial risk premium is too high. In order to decrease this, the firm can

A) increase the proportion of long-term debt to decrease the cost of capital.
B) increase short-term debt to decrease the cost of capital.
C) decrease the proportion of common stock equity to decrease financial risk.
D) increase the proportion of common stock equity to decrease financial risk.

Question 35

From a bond issuer's perspective, the IRR on a bond's cash flows is its yield to maturity (YTM); from the investor's perspective, the IRR on a bond's cash flows is the cost to maturity.

Question 36

The cost to a corporation of each type of capital is dependent upon

A) the risk-free rate of bonds plus the business risk of the firm.
B) the risk-free rate of each type of capital plus the business risk of the firm.
C) the risk-free rate of each type of capital plus the financial risk of the firm.
D) the risk-free rate of each type of capital plus the business risk and the financial risk of the firm.

Question 37

In general, floatation costs include two components, underwriting costs and administrative costs.

Question 38

In order to recognize the interrelationship between financing and investments, the firm should use ________ when evaluating an investment.

A) the least costly source of financing
B) the most costly source of financing
C) the weighted average cost of all financing sources
D) the current opportunity cost

Question 39

From a bond issuer's perspective, the IRR on a bond's cash flows is its cost to maturity; from the investor's perspective, the IRR on a bond's cash flows is the yield to maturity (YTM).

Question 40

Nico Trading Corporation is considering issuing long-term debt. The debt would have a 30 year maturity and a 10 percent coupon rate. In order to sell the issue, the bonds must be underpriced at a discount of 5 percent of face value. In addition, the firm would have to pay flotation costs of 5 percent of face value. The firm's tax rate is 35 percent. Given this information, the after tax cost of debt for Nico Trading would be 11.17 percent.

Question 41

Tangshan Mining is considering issuing preferred stock. The preferred stock would have a par value of $75, and a 5.50 percent dividend. What is the cost of preferred stock for Tangshan if flotation costs would amount to 5.5 percent of par value?

A) 5.50%
B) 5.27%
C) 7.73%
D) 5.82%

Question 42

Nico Trading Corporation is considering issuing preferred stock. The preferred stock would have a par value of $75 and a preferred dividend of 7.5 percent of par. In order to issue the stock, Nico trading would have to pay flotation costs of 6 percent of par value. Given this information, Nico Trading's cost of preferred stock would be 7.5 percent.

Question 43

Debt is generally the least expensive source of capital. This is primarily due to

A) fixed interest payments.
B) its position in the priority of claims on assets and earnings in the event of liquidation.
C) the tax deductibility of interest payments.
D) the secured nature of a debt obligation.

Question 44

The cost of common stock equity may be measured using either the constant growth valuation model or the capital asset pricing model.

Question 45

The cost of preferred stock is typically higher than the cost of long-term debt (bonds) because the cost of long-term debt (interest) is tax deductible.

Question 46

If a corporation has an average tax rate of 40 percent, the approximate, annual, after-tax cost of debt for a 15-year, 12 percent, $1,000 par value bond, selling at $950 is

A) 10 percent.
B) 10.6 percent.
C) 7.6 percent.
D) 6.0 percent.

Question 47

Since preferred stock is a form of ownership, it has no maturity date.

Question 48

Nico Trading Corporation is considering issuing long-term debt. The debt would have a 30 year maturity and a 10 percent coupon rate. In order to sell the issue, the bonds must be underpriced at a discount of 5 percent of face value. In addition, the firm would have to pay flotation costs of 5 percent of face value. The firm's tax rate is 35 percent. Given this information, the after tax cost of debt for Nico Trading would be

A) 7.26%.
B) 11.17%.
C) 10.00%.
D) none of the above.

Question 49

A firm has determined it can issue preferred stock at $115 per share par value. The stock will pay a $12 annual dividend. The cost of issuing and selling the stock is $3 per share. The cost of the preferred stock is

A) 6.4 percent.
B) 10.4 percent.
C) 10.7 percent.
D) 12 percent.

Question 50

Preferred stock represents a special type of ownership interest in the firm. Preferred stockholders must receive their stated dividends prior to the distribution of any earnings to common stockholders and bondholders.

Question 51

A firm has issued 10 percent preferred stock, which sold for $100 per share par value. The cost of issuing and selling the stock was $2 per share. The firm's marginal tax rate is 40 percent. The cost of the preferred stock is

A) 3.9 percent.
B) 6.1 percent.
C) 9.8 percent.
D) 10.2 percent.

Question 52

The approximate before-tax cost of debt for a 10-year, 8 percent, $1,000 par value bond selling at $1,150 is

A) 6 percent.
B) 8.3 percent.
C) 8.8 percent.
D) 9 percent.

Question 53

If a corporation has an average tax rate of 40 percent, the approximate annual, after-tax cost of debt for a 10-year, 8 percent, $1,000 par value bond selling at $1,150 is

A) 3.6 percent.
B) 4.8 percent.
C) 6 percent.
D) 8 percent.

Question 54

A firm has issued preferred stock at its $125 per share par value. The stock will pay a $15 annual dividend. The cost of issuing and selling the stock was $4 per share. The cost of the preferred stock is

A) 7.2 percent.
B) 12 percent.
C) 12.4 percent.
D) 15 percent.

Question 55

The amount of preferred stock dividends that must be paid each year may be stated in dollars or as a percentage of the firm's earnings.

Question 56

Tangshan Mining is considering issuing long-term debt. The debt would have a 30 year maturity and a 12 percent coupon rate and make semiannual coupon payments. In order to sell the issue, the bonds must be underpriced at a discount of 2.5 percent of face value. In addition, the firm would have to pay flotation costs of 2.5 percent of face value. The firm's tax rate is 33 percent. Given this information, the after tax cost of debt for Tangshan Mining would be

A) 6.38%.
B) 12.76%.
C) 4.98%.
D) 8.55%.

Question 57

The approximate before-tax cost of debt for a 15-year, 10 percent, $1,000 par value bond selling at $950 is

A) 10 percent.
B) 10.6 percent.
C) 12 percent.
D) 15.4 percent.

Question 58

Nico Trading Corporation is considering issuing preferred stock. The preferred stock would have a par value of $75 and a preferred dividend of 7.5 percent of par. In order to issue the stock, Nico trading would have to pay flotation costs of 6 percent of par value. Given this information, Nico Trading's cost of preferred stock would be 7.98 percent.

Question 59

The approximate after-tax cost of debt for a 20-year, 7 percent, $1,000 par value bond selling at $960 (assume a marginal tax rate of 40 percent) is

A) 4.41 percent.
B) 5.15 percent.
C) 7 percent.
D) 7.35 percent.

Question 60

What is the dividend on an 8 percent preferred stock that currently sells for $45 and has a face value of $50 per share?

A) $3.33
B) $3.60
C) $4.00
D) $5.00

Question 61

The cost of retained earnings is generally higher than both the cost of debt and cost of preferred stock.

Question 62

When the constant growth valuation model is used to find the cost of common stock equity capital, it can easily be adjusted for flotation costs to find the cost of new common stock; the Capital Asset Pricing Model (CAPM) does not provide a simple adjustment mechanism.

Question 63

The cost of retained earnings for Tangshan Mining would be 16.64 percent if the firm just paid a dividend of $4.00, the stock price is $50.00, dividends are expected to grow at 8 percent indefinitely, and flotation costs are $5.00 per share.

Question 64

The cost of common stock equity capital represents the return required by existing shareholders on their investment in order to leave the market price of the firm's outstanding share unchanged.

Question 65

The constant growth model uses the market price as a reflection of the expected risk-return preference of investors in the marketplace.

Question 66

The capital asset pricing model describes the relationship between the required return, or the cost of common stock equity capital, and the nonsystematic risk of the firm as measured by the beta coefficient.

Question 67

The cost of common stock equity is

A) the cost of the guaranteed stated dividend.
B) the rate at which investors discount the expected dividends of the firm.
C) the after-tax cost of the interest obligations.
D) the historical cost of floating the stock issue.

Question 68

The cost of retained earnings for Tangshan Mining would be 17.60 percent if the firm just paid a dividend of $4.00, the stock price is $50.00, dividends are expected to grow at 8 percent indefinitely, and flotation costs are $5.00 per share.

Question 69

In computing the cost of retained earnings, the net proceeds represents the amount of money retained net of any underpricing and/or flotation costs.

Question 70

One measure of the cost of common stock equity is the rate at which investors discount the expected dividends of the firm to determine its share value.

Question 71

The cost of new common stock is normally greater than any other long-term financing cost.

Question 72

The cost of retained earnings equity for Tangshan Mining would be 18.00 percent if the expected return on U.S. Treasury Bills is 5.00 percent, the market risk premium is 10.00 percent, and the firm's beta is 1.3.

Question 73

A firm can retain more of its earnings if it can convince its stockholders that it will earn at least their required return on the reinvested funds.

Question 74

Since the net proceeds from sale of new common stock will be less than the current market price, the cost of new issues will always be less than the cost of existing issues.

Question 75

The Gordon model is based on the premise that the value of a share of stock is equal to sum of all future dividends it is expected to provide over an infinite time horizon.

Question 76

The cost of retained earnings is always lower than the cost of a new issue of common stock due to the absence of flotation costs when financing projects with retained earnings.

Question 77

Using the Capital Asset Pricing Model (CAPM), the cost of common stock equity is the return required by investors as compensation for the firm's nondiversifiable risk.

Question 78

The cost of retained earnings equity for Tangshan Mining would be 18.00 percent if the expected return on U.S. Treasury Bills is 5.00 percent, the market return is 10.00 percent, and the firm's beta is 1.3.

Question 79

The cost of new common stock equity for Tangshan Mining would be 17.60 percent if the firm just paid a dividend of $4.00, the stock price is $50.00, dividends are expected to grow at 8 percent indefinitely, and flotation costs are $5.00 per share.

Question 80

Use of the Capital Asset Pricing Model (CAPM) in measuring the cost of common stock equity differs from the constant growth valuation model in that it directly considers the firm's risk as reflected by beta.