Deck 8: Cost of Capital

Question 1

Which answer appropriately ranks the securities according to seniority risk, from highest risk first to lowest risk last?

A)common stock, bonds, preferred stock
B)preferred stock, common stock, bonds
C)common stock, preferred stock, bonds
D)bonds, preferred stock, common stock

Answer 1

C

Question 2

The cost of a firm's internal common equity is generally higher than the costs of a firm's external common equity due to issuance costs.

Answer 2

False

Question 3

Funds raised by the issuance of preferred stock are not considered part of a firm's capital.

Answer 3

False

Question 4

A firm's weighted average cost of capital is a marginal measurement meaning it is concerned with measuring the cost of funds already raised and previously invested in the firm.

Question 5

Which of the following should not be included in a firm's cost of capital estimation?

A)the cost of permanent sources of short-term debt
B)the cost of common stock
C)the cost of retained earnings
D)the cost of seasonal sources of short-term debt

Question 6

The cost of raising capital with debt is typically less costly for a firm than raising capital with preferred stock. Which one of the following is one of the reasons for this?

A)Preferred stocks are more senior than bonds.
B)Interest is a tax-deductible cost, preferred dividends are not.
C)Bonds generally have a longer maturity than preferred stocks.
D)The interest from bonds is compounded more frequently than the dividends from preferred stocks.

Question 7

Which model is typically used to estimate the cost of using external equity capital?

A)dividend valuation model
B)capital asset pricing model
C)arbitrage pricing theory model
D)rate of return on perpetuity model

Question 8

What is meant by measuring the weighted average cost of capital on a marginal basis?

A)to measure only the cost of historic capital
B)to measure the cost on a weighted average basis of both new and historic capital
C)to measure only the cost of new capital
D)to measure only the cost of internal capital

Question 9

A firm's weighted average cost of capital should not do which one of the following?

A)measure the cost of short-term sources of funds
B)measure cost on a marginal basis
C)measure cost on an after-tax basis
D)measure the cost of long-term sources of funds

Question 10

If a project is to be 100% financed with debt, then the cost of debt-not the weighted average cost of capital-should be used to evaluate the project.
MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.

Question 11

The weights in a firm's weighted average cost of capital should be a measure of the firm's target capital structure.

Question 12

__________ represents the long-term or permanent sources of the firm's financing.

A)Financial structure
B)Equity structure
C)Capital structure
D)Leverage structure

Question 13

Issuance or flotation costs are the costs investors pay to brokers when they purchase common stock.

Question 14

Why is external common equity capital more expensive then internal common equity capital?

A)Actually, external equity is not more expensive than internal, they both have the same cost.
B)Because the capital asset pricing model is used to estimate the cost of internal and the dividend valuation model is used to estimate cost of external.
C)Because internal is free, it has no cost since there is no need to attract investors to raise internal equity.
D)Because the cost of external must take into account flotation costs, internal does not.

Question 15

Which of the following is typically not treated as one of the components of capital in cost of capital schedule calculations?

A)long-term debt
B)short-term debt
C)common equity
D)preferred stock

Question 16

Taxes are a relevant cost that should be accounted for in the firm's weighted average cost of capital.

Question 17

Preferred stock has higher seniority than bonds and common stock.

Question 18

The cost of capital raised by the issuance of bonds is typically lower than the cost of capital raised from the issuance of preferred stock or common stock.

Question 19

The cost of external equity is greater than the cost of internal equity because

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

Question 20

A firm's weighted average cost of capital is the average cost of the various short-term sources of financing employed by the firm.

Question 21

Young's Specialized Cruises plans to issue preferred stock at a price of $25 per share. The annual dividend will be $2.18 per share and issuance costs are expected to be $2.00 per share. What is the cost of raising funds with preferred stock for Young?

A)8.72%
B)9.48%
C)8.76%
D)8.00%

Question 22

Alishas Travel Tours expects to sell a new bond issue at its par value. The coupon rate is 10 7/8%. Because issuance costs are so small, Alishas plans to ignore the impact of issuance costs on the after-tax cost. What is the after-tax cost of these bonds if Alishas' marginal tax rate is 40%?

A)10.825%
B)4.35%
C)6.53%
D)15.225%

Question 23

Shamas Famous Restaurants expects to pay a common stock dividend of $1.50 per share next year d₁). Dividends are expected to grow at a 4% rate for the foreseeable future. Shamas' common stock is selling for $18.50 per share and issuance costs are $3.50 per share. What is Shamas cost of internal equity?

A)20.59%
B)12.11%
C)14.00%
D)10.00%

Question 24

Jose's Cantinas Incorporated plans to issue preferred stock at a price of $48 per share. The annual dividend will be $5.10 per share and issuance costs are expected to be $3.00 per share. What is the cost of raising funds with preferred stock for Jose's?

A)10.85%
B)10.20%
C)10.63%
D)11.33%

Question 25

Dou's Oriental Hotels, Incorporated sold an issue of 10-year bonds. The bonds sold at $995 each. After issuance costs, Dou's Oriental Hotels received $985 each. The maturity value is $1,000 each and the coupon rate is 7 5/8% and paid annually. What is the after-tax cost of debt for these bonds if Dou's Oriental Hotels' marginal tax rate is 40%?

A)7.70%
B)4.62%
C)7.85%
D)4.71%

Question 26

Spencers Magic Shows Incorporated is financed 100% with equity and intends to remain this way. Spencers' common stock beta is 0.85, the expected market return average market return)is 14%, and the risk-free rate is 6%. If all of Spencers' equity is internal, what are the cost of equity and the weighted average cost of capital for Spencers?

A)12.80%
B)5.48%
C)14.00%
D)13.10%

Question 27

Tokyo Food Supplies Corporation sold an issue of 12-year bonds. The bonds sold at $980 each. After issuance costs, Tokyo Food Supplies received $975 each. The maturity value is $1,000 each and the coupon rate is 9% and paid annually. What is the after-tax cost of debt for these bonds if Tokyo Food Supplies' marginal tax rate is 40%?

A)5.61%
B)9.36%
C)9.28%
D)5.57%

Question 28

Shamas Famous Restaurants expects to pay a common stock dividend of $1.50 per share next year d₁). Dividends are expected to grow at a 4% rate for the foreseeable future. Shamas' common stock is selling for $18.50 per share and issuance costs are $3.50 per share. What is Shamas cost of external equity?

A)20.59%
B)12.11%
C)14.00%
D)10.00%

Question 29

Marion's Miraculous Resorts has a current capital structure that is 50% equity, 40% debt, and 10% preferred stock. This is considered optimal. Marion is considering a $40 million capital budgeting project. Marion has estimated the following: After-tax cost of debt: 8.5%
Cost of preferred stock: 9.5%
Cost of internal equity: 14.0%
If all equity comes from internal sources, what should Marion's cost of capital be for this project?

A)10.67%
B)11.35%
C)9.45%
D)12.15%

Question 30

Penny's Budget Gourmet Restaurants has a current capital structure that is 70% equity, 20% debt, and 10% preferred stock. This is considered optimal. Penny is considering a $100 million capital budgeting project. Penny has estimated the following: After-tax cost of debt: 7.0%
Cost of preferred stock: 8.0%
Cost of internal equity: 13.0%
Cost of external equity: 15.0%
Penny expects to have $40 million of new retained earnings available to finance this project. What is Marion's cost of capital for this project?

A)12.10%
B)10.75%
C)11.90%
D)12.45%