Deck 13: Cost of Capital

Question 1

If a firm will use debt as well as equity funds next year, the ____ is the correct discount rate to use in the capital budgeting models (NPV, etc.)

A) component cost of equity
B) weighted average cost of capital
C) historical cost of funds
D) All of the above are correct

Answer 1

B

Question 2

The weighted-average cost of capital:

A) blends the returns required by all suppliers of funds.
B) incorporates the firm's capital structure in its calculation.
C) is virtually never lower than the cost of debt nor higher than the cost of equity.
D) All of the above

Answer 2

D

Question 3

For the purpose of calculating the cost of capital, the capital components are:

A) long-term debt and common stock.
B) debt and preferred stock.
C) long term debt, common stock and preferred stock.
D) long-term and short-term debt.

Answer 3

C

Question 4

To be accepted, projects that are unusually risky should have to earn IRRs that are ____ those earned by a firm's typical projects.

A) equal to
B) higher than
C) lower than
D) similar to

Question 5

Common equity does not come from:

A) the sale of new common stock.
B) the sale of new preferred stock.
C) retention of earnings.
D) Any of the above

Question 6

The cost of capital can be described best as the:

A) rate a firm pays for the use of invested funds.
B) the minimum return required of capital budgeting projects that are about as risky as the firm.
C) Either of the above
D) None of the above

Question 7

Although the money paid to investors is both the firm's cost and the investors return:

A) certain adjustments prevent the effective cost and return from being the same.
B) adjustments must be made to keep the effective cost and return equal.
C) adjustments keep the costs of common and preferred equity equal but debt's cost is usually higher.
D) a and c

Question 8

If a firm is losing money, the after-tax cost of debt is:

A) equal to k_d(1 - T).
B) found by trial and error.
C) equal to the pretax cost of debt.
D) None of the above

Question 9

Debt capital:

A) costs the least because it's the most risky to the firm (interest creates financial risk).
B) costs the most because it's safer and therefore more desirable.
C) is cheapest because it's safest from the investor's perspective and interest is tax deductible to the issuing company.
D) costs more than preferred because preferred is the most stable security.

Question 10

Which of the following is not a component used in calculating the cost of capital?

A) The cost of short-term debt
B) The cost of long-term debt
C) The cost of retained earnings
D) The cost of preferred stock
E) The cost of common stock

Question 11

The cost of capital is used primarily in:

A) negotiations with banks because it reflects the company's overall borrowing power.
B) setting the firm's basic risk level.
C) capital budgeting because it reflects what the firm pays for the money it invests.
D) negotiations with investment bankers because it establishes an overall return on which the market can base prices for the firm's securities.

Question 12

The cost of capital is:

A) related to the average rate of return required by investors in the firm's securities.
B) the minimum rate of return the firm should require on capital budgeting projects of average risk.
C) approximately 10 percent for most firms.
D) a and b

Question 13

The least precisely known capital component cost is:

A) debt, because the tax effect confuses things.
B) preferred stock, because it's not used by many companies and people aren't familiar with it.
C) equity because its future cash flows are uncertain.
D) they're all known with about the same level of certainty.

Question 14

The historic costs of a firm's capital components are ____ calculating its WACC.

A) not relevant for
B) very useful when
C) necessary for
D) the relevant costs for

Question 15

The cost of capital is:

A) the average return on investments.
B) the average rate paid for the use of investors' money.
C) used primarily in projecting financial statements.
D) Both b & c
E) All of the above

Question 16

Capital refers to funds acquired for use over long periods of time for the purpose of:

A) acquiring long-lived assets such as machinery, land, buildings, etc.
B) getting businesses started.
C) financing permanent working capital.
D) All of the above

Question 17

Although preferred stock is legally a form of equity, it is often referred to as a hybrid security:

A) because it has characteristics of both long-term debt and equity.
B) so in the context of the cost of capital, it is viewed as a third component.
C) it is considered as debt.
D) Both a and b

Question 18

A project's cost of capital is 10%. Which of the following would lead to its acceptance?

A) An IRR of 10%
B) An NPV of ($2,000)
C) An NPV of $2,000
D) An IRR of 8%

Question 19

A firm's cost of capital is the appropriate rate to use in the evaluation of:

A) its common stock.
B) all capital budgeting proposals.
C) average risk on capital budgeting proposals.
D) None of the above

Question 20

Separately funded projects:

A) should be evaluated against the cost of their own dedicated capital
B) are usually funded by a source that's more expensive than the cost of capital
C) reinforces the need to match funding sources and uses with a firm's ability to raise capital
D) should be evaluated against the weighted average cost of capital despite the availability of separate funds

Question 21

The cost of equity from selling new stock is greater than the cost of retained earnings because:

A) selling new stock decreases the earnings per share.
B) selling new stock increases the market price of the stock.
C) of the flotation costs.
D) dividends are increased.

Question 22

The capital structure that should be used to plan for next year's capital program is the:

A) book value based capital structure.
B) market value based capital structure.
C) either the book value or the market value capital structure is satisfactory.
D) neither the book value or the market value capital structure is satisfactory.

Question 23

Which of the following is true of the book value of capital in calculating the WACC?

A) It reflects the revenues to be earned in the future.
B) It relates to the current state of capital markets.
C) It predicts the cost of capital to be raised in the near future.
D) It reflects the cost of capital already spent.

Question 24

The cost of particular capital components may be ____ the returns paid to investors in the underlying securities.

A) greater than
B) less than
C) equal to
D) All of the above

Question 25

Which of the following component costs is expressed on an after-tax basis in the calculation of a firm's cost of capital?

A) Cost of debt
B) Cost of preferred stock
C) Cost of common equity
D) b and c
E) All of the above

Question 26

The customary information needed to determine the firm's weighted average cost of capital (WACC) is:

A) the cost of each component and the target capital structure of the firm.
B) the book value capital components and the cost of each component.
C) the market value of the capital components and cost of each component.
D) Any of the above

Question 27

The component cost of a firm's preferred stock consists of:

A) the current dividend yield.
B) the expected growth rate of dividends.
C) dividends expressed as a percent of par value.
D) a and b

Question 28

Which of the following states the component cost preferred stock? (f is the flotation cost percent, D_p is the annual preferred dividend, and k_p is the preferred's market yield on the preferred stock?

A) D_p $\div$ [1 - f]
B) D_p $\div$ [k_p + f]
C) k_p $\div$ [1 + f]
D) k_p $\div$ [1 - f]

Question 29

The book value of a firm's capital accounts:

A) should be used when evaluating new projects.
B) fluctuates frequently.
C) represents the cost of existing capital.
D) Both a & c

Question 30

The WACC is used in evaluating newly proposed capital budgeting projects. It should therefore be calculated using capital component costs and a capital structure:

A) based on the capital on the firm's books because that's the capital it already has and will use to support new projects.
B) based on conditions the firm will encounter when raising new capital in the next year because that's the capital it will use to support new projects.
C) based on existing capital on the books because both old and new projects have to be supported.
D) based on existing equity but new debt amounts and costs.

Question 31

Under the customary approach, firms strive to either maintain their present capital structure or achieve some target structure. Both the current and the target structures must be based on:

A) market values.
B) book values.
C) intrinsic values.
D) future values.

Question 32

The CAPM's estimate of the component cost of common equity would be increased by an increase in:

A) the risk-free interest rate.
B) a firm's beta.
C) the return on the market.
D) b and c
E) All of the above

Question 33

Capital structures based on book and market values are generally different because:

A) market values of securities change all the time.
B) market values reflect the cost of capital already spent.
C) market values of securities are reflected on company books.
D) market values reflect the prices at which the securities are sold.

Question 34

If a firm had the following mix of capital components: $\begin{array}{ll}\text { Debt } & \$ 25,000 \\\text { Preferred stock } & \$ 20,000 \\\text { Common stock } & \$ 55,000\end{array}$ its capital structure would be described as:

A) 25% debt and 75% equity
B) 25% debt, 20% preferred stock, and 55% equity
C) 45% debt and 55% equity
D) both a and b

Question 35

Generally, the return on an equity investment is higher than the return on debt or preferred stock because:

A) equity's risk is higher.
B) people are more willing to invest in debt.
C) the cost of preferred stock is usually between the cost of debt and that of equity.
D) All of the above

Question 36

To determine a firm's WACC, it is necessary to compensate for the effect of:

A) transaction costs associated with doing business in financial markets.
B) the tax implications of debt.
C) None of the above
D) Both a and b

Question 37

According to finance theory, which of the following approaches can be used to estimate a firm's cost of equity?

A) The capital-asset-pricing model approach
B) The dividend growth approach
C) The risk premium approach
D) All of the above

Question 38

In the calculation of the component cost of a firm's debt, the yield-to-maturity on the firm's bonds:

A) is equal to the component cost of debt.
B) must be adjusted for expected capital gains or losses on the bonds.
C) must be adjusted for the tax-deductibility of interest expense.
D) b and c

Question 39

Flotation costs are administrative fees and expenses incurred in:

A) the process of issuing and selling securities
B) listing the company's stock on a stock exchange
C) lawsuits alleging fraud in the issue of securities
D) None of the above

Question 40

Which of the following is usually the lowest?

A) After-tax cost of debt
B) Before-tax cost of debt
C) Cost of preferred stock
D) Cost of common stock
E) Marginal cost of capital

Question 41

Since equity cash flows are uncertain, the following approaches are used in estimating the cost of equity:

A) CAPM and the dividend growth model.
B) risk premiums, the dividend growth model, and the accounting beta method.
C) the dividend growth model, risk premiums, and CAPM.
D) All of the methods mentioned above are used, but CAPM is unquestionably the best.

Question 42

If a project comes with its own funding offered at a rate lower than the cost of capital, the capital budgeting analysis should be conducted using:

A) the offered rate because it is appropriate to match sources and uses of funding whenever possible.
B) the cost of capital because to do otherwise would be unfair to departments whose projects don't happen to have separate funding.
C) the cost of capital because doing otherwise leads to irrational capital budgeting decisions.
D) an average of the offered rate and the cost of capital because that gives the best measure of the effect of the offer on the firm.

Question 43

When is a second break in the MCC likely to occur?

A) As the stock gets continually harder to sell.
B) When debt gets more expensive with increasing financial risk.
C) Never, the MCC generally only breaks once.
D) Somewhat later, but breaks after the first are irrelevant because they're beyond the IOS.

Question 44

A firm pays its bondholders a 12% return. Its cost of retained earnings may be estimated by:

A) adding one to three percentage points to the 12% pretax cost of debt.
B) adding three to five percentage points to the 12% pretax cost of debt.
C) multiplying the firm's beta by three to five percentage points and adding it to the 12% pretax cost of debt.
D) None of the above

Question 45

Which of the following statements about the marginal cost of capital (MCC) and the investment opportunity schedule (IOS) is incorrect?

A) A company's WACC for the planning period is at the intersection of the MCC and the IOS.
B) The MCC will break when low cost debt runs out and is replaced with higher cost debt.
C) The IOS ranks projects from highest to lowest according to their individual NPV's.
D) A break in the MCC may occur because of the floatation costs associated with issuing new stock.
E) All of the above statements are correct.

Question 46

Retained earnings are:

A) the only internally generated capital source.
B) the least expensive source of capital because they're not subject to administrative expenses.
C) free to the company because they come from ordinary operating earnings.
D) All of the above

Question 47

Which of the following is NOT true regarding the marginal cost of capital (MCC)?

A) Is a graph of the WACC
B) Breaks when common stock is exhausted
C) Increases due to flotation costs
D) Represents the cost of the next dollar raised

Question 48

Projects with IRRs above the intersection of the IOS and MCC:

A) should be accepted.
B) should be rejected.
C) have returns greater than the cost of financing.
D) Both a & c

Question 49

In calculating the WACC, it's most appropriate to use:

A) market values for structure and component costs because the best reflect next year's capital costs which will be encountered when money is raised for future projects.
B) book values for structure and component costs because these reflect the actual existing capital structure and what the firm really pays for the capital it has.
C) the target structure because it's in some sense the best.
D) market values for structure and target values for costs because they're the most practical.

Question 50

Which of the following would increase the WACC?

A) an increase in flotation costs
B) a decrease in tax rates
C) a decrease in preferred dividends
D) Both a & b
E) All of the above

Question 51

Which of the following is false?

A) The IOS plots the IRRs of available projects in descending order.
B) Breaks in the MCC are caused by increases in project IRRs.
C) A break in the MCC will occur where retained earnings are exhausted.
D) The intersection of the MCC and the IOS determines the WACC for the planning period.

Question 52

Assume a firm's bonds are currently yielding new investors 6%. The combined federal and state tax rate is 40%. What is the firm's after-tax cost of debt is?

A) 3.6%
B) 4.0%
C) 4.8%
D) 6.0%

Question 53

The proportions of debt and equity used in calculating the weighted average cost of capital (WACC) should be based on the current ____ weights of the individual components.

A) book value
B) market value
C) replacement value
D) a and b

Question 54

All of the following represent adjustments to the cost of capital components except:

A) the tax effect on debt.
B) the tax effect on equity.
C) floatation costs when issuing preferred stock.
D) floatation costs when issuing common stock.
E) All of the above could represent adjustments to the cost of capital components.

Question 55

A firm's WACC for capital budgeting purposes for a planning period is:

A) the height of the MCC schedule at the expected level of capital spending.
B) at the intersection of the MCC and the IOS.
C) always beyond the break point of the MCC.
D) usually less than the cost of debt.

Question 56

The cost of retained earnings differs from the cost of new equity due to:

A) flotation costs.
B) dividends.
C) capital gains yields.
D) Both a & c
E) All of the above

Question 57

The cost of new equity would increase with an increase in ____.

A) growth rate
B) stock price
C) flotation costs
D) Both a & c
E) All of the above

Question 58

The first break in the MCC usually occurs because:

A) debt costs more as more is raised because the firm appears riskier to investors.
B) equity capital is more expensive when raised from outside sources.
C) the firm runs out of money.
D) it becomes impossible to sell more preferred stock.

Question 59

The cost of retained earnings can be estimated through the ____ approach.

A) CAPM
B) dividend growth
C) MCC
D) Both a & b
E) All of the above

Question 60

Which of the following is a reason why calculating the capital structure based on market prices is considered tedious?

A) Accurate market prices can never be determined.
B) Dividend payout ratios on stocks are usually unpredictable.
C) The market-based structure is constantly changing.
D) The implied error in market-based structures is large.

Question 61

The following financial information is available on Simmons Inc.: $\begin{array}{lr}\text {Current stock price }&\%48.00\\\text { Beta}&1.1\\\text {Expected rate of return on market }&12.0\%\\\text {Risk-free rate }&6.0\%\\\end{array}$
Determine the cost of retained earnings using the capital asset pricing model approach. (Compute answer to the nearest 0.1%).

A) 12.9%
B) 12.6%
C) 13.0%
D) None of the above

Question 62

What is the cost of retained earnings for East Roon, if the firm is expected to always pay a constant dividend of $2.22? The firm's common stock is presently selling for $18.50.

A) 8.3%
B) 12.0%
C) 10.2%
D) Cannot be determined from the information given

Question 63

Bonds issued last year by Gowen Inc. carried a coupon rate of 7%. Bonds issued today by Gowen Inc. would carry a coupon rate of 9%. Assume a corporate tax rate of 40%. What is the after tax cost of debt?

A) 4.2%
B) 4.8%
C) 5.4%
D) 7.0%
E) 9.0%

Question 64

The following financial information is available on Rawls Manufacturing Company: $\begin{array}{lr}\text {Current per share market price }&\$48.00\\\text { Most recent per share dividend }&\$3.50\\\text { Expected long-term growth rate}&5.0\%\\\end{array}$
Rawls can issue new common stock to net the company $44 per share. Determine the cost of retained earnings using the dividend growth model approach. (Compute answer to the nearest .1%).

A) 12.3%
B) 13.4%
C) 13.0%
D) 12.7%

Question 65

According to Value Line, Bestway has a beta of 1.15. If 3-month Treasury bills currently yield 7.9 percent and the market risk premium is estimated to be 8.3 percent, what is Bestway's cost of retained earnings?

A) 17.45%
B) 8.36%
C) 9.55%
D) None of the above

Question 66

Assume a firm has 20-year, 8% coupon bonds with a current market yield of 10%. With a combined federal and state corporate tax rate of 40%, the firm's after-tax cost of debt is:

A) 3.2%
B) 4.0%
C) 4.8%
D) 6.0%

Question 67

The following financial information is available on the Haverty Company: $\begin{array}{lr}\text {Current per share market price }&\$48.00\\\text {Most recent per share dividend }&\$3.50\\\text { Expected long term growth rate}&5.0\%\\\end{array}$
Haverty can issue new common stock to net the company $44 per share. Determine the cost of equity raised through selling new stock using the dividend growth model approach. (Compute answer to the nearest .1%).

A) 12.3%
B) 13.4%
C) 13.0%
D) 12.7%

Question 68

Calculate the cost of preferred stock for Ohio Valley Power Company, which is planning to sell $100 million of $3.25 cumulative preferred stock to the public at a price of $25 per share. Flotation costs are $1.00 per share. Ohio Valley has a marginal income tax rate of 40%.

A) 13.0%
B) 7.8%
C) 8.12%
D) 13.54%

Question 69

If a firm issuing additional common equity can estimate the return investors require on its stock (k_e) at 12% and knows that flotation costs are about 18%, its component cost of equity capital for the new funds will be:

A) 30.0%
B) 14.2%
C) 13.6%
D) 14.6%

Question 70

A firm's preferred stock is selling at $83 and pays a 9.5% annual dividend on a $100 par value. What is the cost of preferred if flotation costs are 12%?

A) 10.64%
B) 13.01%
C) 10.79%
D) 11.45%

Question 71

Allegheny Valley Power Company common stock has a beta of 0.80. If the current risk-free rate is 6.5% and the expected return on the stock market as a whole is 16%, determine the cost of retained earnings for the firm (using the CAPM).

A) 14.1%
B) 7.6%
C) 6.5%
D) None of the above

Question 72

Assume the following information about a firm's capital components: $\begin{array}{lll}\text { Debt } & \text { Capital Structure } & \text { Cost } \\\text { Preferred stock } & \$ 20,000 & 8 \% \\\text { Common stock } & \$ 20,000 & 11 \% \\& \$ 60,000 & 14 \%\end{array}$ The firm's WACC is:

A) 11.00%.
B) 11.90%.
C) 12.20%.
D) 12.05%.

Question 73

Northeast Airlines has a current dividend of $1.80. Dividends are expected to grow at 7% into the foreseeable future. What is the firm's cost of equity from new stock if its shares can be sold to net the company $46 after administrative expenses (flotation costs)?

A) 10.9%
B) 11.2%
C) 7.2%
D) None of the above

Question 74

Kirchner Exports has a beta of 1.2. The risk free rate is 5% and the return on an average stock is 10.6%. Estimate Kirchner's cost of retained earnings.

A) 10.60%
B) 11.72%
C) 12.72%
D) 13.72%
E) 16.60%

Question 75

Last year's dividend was $2.50, the anticipated constant growth rate is 4%, the selling price today is $28 per share, and flotation costs are 18%. What is the cost of new equity?

A) 15.3%
B) 14.9%
C) 12.9%
D) 13.3%

Question 76

Donoho Corp. issued 20-year, $1,000 par bonds eight years ago with a 10% coupon paying semiannually that are now selling for $1,152.47. Estimate the cost of retained earnings assuming investors generally demand a 5% risk premium on equity over the cost of debt.

A) 8%
B) 9%
C) 11%
D) 13%
E) 15%

Question 77

With a market yield on preferred stock of 8% and a proposed annual dividend rate of 7.5% on a $100 par value, what is the component cost of capital for a new preferred stock issue if flotation costs of 16% are assumed?

A) 8.93%
B) 9.28%
C) 9.52%
D) 8.70%

Question 78

The most recent dividend was $2.50, the anticipated constant growth rate is 4%, the selling price today is $28 per share, and flotation costs are 18%. What is the cost of retained earnings?

A) 15.3%
B) 14.9%
C) 12.9%
D) 13.3%

Question 79

Dudek Manufacturing's common stock is currently selling for $45/share. Their most recent dividend (annual) was $2.50, and is expected to grow at 5% per year indefinitely. What is Dudek's cost of retained earnings?

A) 10.56%
B) 10.83%
C) 12.14%
D) 13.00%
E) 17.14%

Question 80

Determine the (after-tax) component cost of a $50 million debt issue that the Mattingly Corporation is planning to place with a large insurance company. Assume the company is subject to a 40% tax rate. This long-term debt issue will yield 12% to the insurance company.

A) 4.8%
B) 7.2%
C) 12.0%
D) None of the above