Deck 13: The Cost of Capital

Question 1

The beta of the company is equal to the weighted-average sum of the betas of the individual projects that the company is currently operating.

Answer 1

True

Question 2

The finance balance sheet is based on market values, just like the accounting balance sheet.

Answer 2

False

Question 3

The issuance costs of new debt securities can be ignored since those costs will not be reflected in the yield to maturity of the debt in the future.

Answer 3

False

Question 4

Milton Company issued bonds 10 years ago with a coupon rate of 10 percent at a price of $1,000. The current price of the bonds is $980. The before-tax cost of the debt to the company is still 10 percent.

Question 5

Unique risk is the only risk that investors require compensation for bearing.

Question 6

The current cost of bank debt can be determined by asking the company's banker.

Question 7

Using the company's overall cost of capital to evaluate a project's cash flows is problematic in that the company is a collection of projects, with the possibility that each project has a different level of risk than the other projects currently working for the company.

Question 8

Long-term debt typically describes debt that will mature in two years or more.

Question 9

The cost of equity for the company must take the cost of preference share (if any has been issued) that the company has outstanding into account.

Question 10

If a company is interested in the current cost of its debt obligations, then it can simply look at the contractual rate of interest due lenders on those obligations.

Question 11

If a company finances the purchase of an asset with cash, then it has zero financial cost to the company.

Question 12

The yield to maturity for an annual coupon paying bond will accurately reflect the actual current annual pretax cost of the debt.

Question 13

If the market value of a company's assets is greater than the book value of a company's assets then the book value of the company's liabilities and equity must be less than the market value of the company's liabilities and equity.

Question 14

Long-term debt is generally viewed as a permanent financing source for the company.

Question 15

If a company is subject to income tax, then the after-tax cost of debt for the company will be less than the before-tax cost of debt.

Question 16

A company is currently taking on two projects with an individual cost of capital of 10 percent and 12 percent for each of the projects. That means that the before-tax cost of capital for the company must be between 10 and 12 percent.

Question 17

With respect to the cost of capital, we are generally interested in the cost of a source of financing on a particular date.

Question 18

Estimates of security returns will be reliable in all types of markets, including those deemed less efficient than others.

Question 19

If one observes the market quoted price of a debt security where the expected cash flows of that security are known, then one can calculate the current cost of that security to the company.

Question 20

The yield to maturity for a semiannual coupon paying bond will accurately reflect the actual current annual cost of the debt.

Question 21

A company's overall cost of capital is

A) equal to its cost debt.
B) a weighted average of the costs of capital for the collection of individual projects that the company is working on.
C) best measured by the cost of capital of the riskiest projects that the company is working on.
D) none of the above.

Question 22

When analysing a company's cost of debt, we are typically interested in

A) the cost of the debt on the date that the analysis is being completed.
B) the coupon rate on the company's bonds.
C) the risk-free rate plus half a percent.
D) none of the above.

Question 23

The beta for a company can be estimated by

A) adding up the betas of the individual projects of the company.
B) taking the weighted average of the beta for the individual projects of the company.
C) taking the simple average of the beta for the individual projects of the company.
D) None of the above.

Question 24

Which of the following need to be excluded from the calculation of the company's amount of permanent debt?

A) Long-term debt
B) Revolving lines of credit
C) Mortgage debt
D) None of the above

Question 25

Companies have no way to directly estimate the discount rate that reflects the risk of

A) a publicly traded security.
B) its debt securities.
C) the incremental cash flows from a particular project.
D) none of the above.

Question 26

The finance balance sheet is

A) the same as the accounting balance sheet, but it is based on market values.
B) the same as the accounting balance sheet, but it does not have to balance.
C) based on cash rather than accrual accounting.
D) profit.

Question 27

The proportions of debt and equity used to determine the weighted average cost of capital for the company is based on the market value of debt and equity outstanding.

Question 28

In order for a company to estimate its cost of debt capital by observing the price of its debt instruments,

A) the company must depend on markets being reasonably efficient.
B) the debt must be privately held.
C) the beta of the debt must be greater than the beta of the company's equity.
D) None of the above.

Question 29

When estimating the cost of debt capital for the company, we are primarily interested in,

A) the cost of short-term debt.
B) the cost of long-term debt.
C) the coupon rate of the debt.
D) none of the above.

Question 30

The company can be viewed as

A) a portfolio of individual projects, each with their own risks, cost of capital, and returns.
B) a collection of equity shares comprising it.
C) a collection of debt instruments financing it.
D) none of the above.

Question 31

When trying to estimate the cost of equity for a company using the CAPM, it is possible to find the beta of a comparable, publicly traded company whose primary business is closely related to the company at hand.

Question 32

If markets are not reasonably efficient, then,

A) the estimates of expected returns are not needed.
B) the need for a discount rate to analyse project cash flows is not needed.
C) estimates of expected returns that were based on security prices will not be reliable.
D) none of the above.

Question 33

The CAPM can only be used to determine the cost of common equity.

Question 34

The market risk premium for the future is always perfectly known, and it is 6.51 percent.

Question 35

The correct Treasury rate to use in calculating the cost of equity (when using the CAPM) for a company is a short-term rate.

Question 36

If a company is currently paying common share dividends to investors and those dividends are expected to grow at a low but steady rate in the future, then the cost of common equity for the company can be determined by also using the current price of the company's common shares.

Question 37

The value of the cash flows that the assets of the company are expected to generate must equal

A) the value of the cash flows claimed by the equity investors.
B) the value of the cash flows claimed by the debt investors.
C) the value of the cash flows claimed by both the equity and debt investors.
D) the revenue produced by the company.

Question 38

Long-term debt typically describes,

A) debt with a maturity greater than one year.
B) only coupon debt.
C) publicly traded debt.
D) none of the above.

Question 39

The correctly calculated weighted-average cost of capital for the company can be used to discount the cash flows for any new project that the company may undertake in the future.

Question 40

The current cost of preference shares can be found by taking the ratio of the dividend to the current price of preference shares.

Question 41

In order to use the WACC to evaluate a future project's flows, which of the following must hold?

A) The project will be financed with the same proportion of debt and equity as the company.
B) The systematic risk of the project is the same as the overall systematic risk of the company.
C) The project must be viable.
D) a and b above.

Question 42

The cost of equity: The Dedus Shoes Ltd has common shares with a price of $28.76 per share. The company paid a dividend of $1.00 yesterday, and dividends are expected to grow at 10 percent for two years and then at 5 percent thereafter. What is the implied cost of ordinary shares for Dedus?

A) 7.00%
B) 8.00%
C) 9.00%
D) 10.00%

Question 43

The cost of equity: Gangland Water Guns Ltd is expected to pay a dividend of $2.10 one year from today. If the company's growth in dividends is expected to remain at a flat 3 percent forever, then what is the cost of equity capital for Gangland if the price of its ordinary shares is currently $17.50?

A) 12.00%
B) 14.65%
C) 15.00%
D) 15.36%

Question 44

The cost of equity: Tranquility Ltd has common shares with a price of $18.37 per share. The company paid a dividend of $1.50 yesterday, and dividends are expected to grow at 9 percent for three years and then at 2 percent thereafter. What is the implied cost of ordinary shares for Tranquility?

A) 9%
B) 10%
C) 11%
D) 12%

Question 45

The cost of equity: Rubber Chicken Ltd was paid a dividend of $1.87 last year. If the company's growth in dividends is expected to be 10 percent next year and then zero thereafter, then what is the cost of equity capital for Rubber Chicken if the price of its ordinary shares is currently $25.71?

A) 7.27%
B) 8.00%
C) 18.00%
D) The problem is not solvable with the information that is given.

Question 46

Bond issuance costs include,

A) investment banking fees.
B) legal fees.
C) accountant fees.
D) all of the above.

Question 47

The average risk-premium for the Australian market from 1974 to 2009 was

A) 8.00%.
B) 4.20%.
C) 6.51%.
D) 6.51% + the Treasury rate.

Question 48

A bond has a coupon rate of 6 percent and the bond makes semiannual coupon payments. The dollar amount of coupon interest received every six months is (Assume $100 Face Value)

A) $60.
B) $30.
C) $30 plus or minus the prorate portion of the discount or premium that the bond was purchased for.
D) none of the above.

Question 49

The cost of equity: RadicalVenOil Ltd has a cost of equity capital equal to 22.8 percent. If the risk-free rate of return is 10 percent and the expected return on the market is 18 percent, then what is the company's beta if the company's company tax rate is 35 percent?

A) 1.0
B) 1.28
C) 1.60
D) 4.10

Question 50

The cost of debt: Beckham company has bonds outstanding with 13 years to maturity and are currently priced at $746.16. If the bonds have a coupon rate of 8.5 percent, then what is the after-tax cost of debt for Beckham if its company tax rate is 35%?

A) 6.250%
B) 8.164%
C) 12.500%
D) 12.890%

Question 51

The cost of debt: Bellamee Ltd has bonds outstanding with five years to maturity and are priced at $920.87. If the bonds have a coupon rate of 7 percent, then what is the YTM for the bonds? (Assume $1000 Face Value of Bonds)

A) 4.5%
B) 7.0%
C) 9.0%
D) 9.2%

Question 52

The cost of debt: Dynamo company has bonds outstanding with 12 years to maturity and are currently priced at $1,080.29. If the bonds have a coupon rate of 8 percent, then what is the equivalent annual return (EAR) to the investor for purchasing the bonds at the described price? (Semiannual interest)

A) 3.5%
B) 7.00%
C) 7.12%
D) 8.00%

Question 53

The cost of equity: Jacque Ewing Drilling Ltd has a beta of 1.3 and is trying to calculate its cost of equity capital. If the risk-free rate of return is 8 percent and the expected return on the market is 12 percent, then what is the company's after-tax cost of equity capital if the company's company tax rate is 40 percent?

A) 7.92%
B) 13.20%
C) 15.57%
D) 23.60%

Question 54

The cost of equity: TeleNyckel Ltd has a beta of 1.4 and is trying to calculate its cost of equity capital. If the risk-free rate of return is 9 percent and the market risk premium is 5 percent, then what is the company's after-tax cost of equity capital if the company's company tax rate is 30 percent?

A) 11.20%
B) 10.60%
C) 15.14%
D) 16.00%

Question 55

The recommended model to estimate the cost of ordinary shares for a company is

A) a one-stage constant growth model.
B) a multistage growth model.
C) the CAPM.
D) none of the above.

Question 56

The cost of equity: UltraFlex Diving Boards Ltd just paid a dividend of $1.50. If the company's growth in dividends is expected to remain at a flat 4 percent forever, then what is the cost of equity capital for Ultra Flex Diving Boards if the price of its ordinary shares is currently $26.00?

A) 5.77%
B) 6.00%
C) 9.77%
D) 10.00%

Question 57

The appropriate risk-free rate to use when calculating the cost of equity for a company is

A) a long-term Treasury rate.
B) a short-term Treasury rate.
C) a 50/50 mix of short-term and long-term Treasury rates.
D) none of the above.

Question 58

Income tax have the effect of,

A) increasing the cost of debt.
B) decreasing the cost of debt.
C) decreasing the cost of capital for the company.
D) both b and c are correct.

Question 59

The cost of debt: PackMan company has bonds outstanding with nine years to maturity and are currently priced at $754.08. If the bonds have a coupon rate of 7.25 percent, then what is the after-tax cost of debt for Beckham if its company tax rate is 30 percent?

A) 8.28%
B) 7.225%
C) 11.750%
D) 12.095%

Question 60

If a company has bonds outstanding and the company would like to calculate the current cost of debt for the bonds, then the company would

A) use the coupon rate of the bonds to estimate the cost.
B) use the current yield to maturity of the bonds to estimate the cost.
C) use the current coupon yield of the bonds to estimate the cost.
D) none of the above.

Question 61

Explain the conditions under which the constant-growth dividend formula for the cost of ordinary shares can be used to find the cost of equity capital for the company.

Question 62

Using the WACC in practice: Maloney's, Ltd., has found that its cost of equity capital is 17 percent and its cost of debt capital is 6 percent. If the company is financed with $3,000,000 of ordinary shares (market value) and $2,000,000 of debt, then what is the after-tax weighted average cost of capital for Maloney's if it is subject to a 40 percent company tax rate?

A) 8.96%
B) 11.16%
C) 11.64%
D) 12.60%

Question 63

Using the WACC in practice: Marley's Pipe Shops has found that its equity capital shares have a beta equal to 1.5 while the risk-free return is 8 percent and the expected return on the market is 14 percent. Its cost of debt financing is 12 percent. If the company is financed with $120,000,000 of ordinary shares (market value) and $80,000,000 of debt, then what is the after-tax weighted average cost of capital for Marley's if it is subject to a 35 percent company tax rate?

A) 10.20%
B) 11.76%
C) 11.88%
D) 13.32%

Question 64

The cost of preference shares: Billy's Goat Coats has a preference share issue outstanding with a current price of $38.89. The company last paid a dividend on the issue of $3.50 per share. What is the company's cost of preference shares?

A) 7%
B) 8%
C) 9%
D) 10%

Question 65

Overall cost of capital: If the market risk premium is currently 6 percent and the risk-free rate of return is 4 percent, then what is the expected return on a common share with a beta equal to 2?

A) 8.0%
B) 10.0%
C) 12.0%
D) 16.0%

Question 66

How companies estimate their cost of capital: You are analysing the cost of capital for a company that is financed with 65 percent equity and 35 percent debt. The cost of debt capital is 8 percent, while the cost of equity capital is 20 percent for the company. What is the overall cost of capital for the company?

A) 12.2%
B) 14.0%
C) 15.8%
D) 20.0%

Question 67

How companies estimate their cost of capital: The Diverse Co. has invested 40 percent of the company's assets in a project with a beta of 0.4 and the remaining assets in a project with a beta of 1.8. What is the beta of the company?

A) 0.96
B) 1.24
C) 1.28
D) None of the above

Question 68

Using the WACC in practice: Swirlpool Ltd has found that its cost of equity capital is 18 percent, and its cost of debt capital is 8 percent. If the company is financed with 60 percent ordinary shares and 40 percent debt, then what is the after-tax weighted average cost of capital for Swirlpool if it is subject to a 40 percent company tax rate?

A) 10.37%
B) 12.00%
C) 12.72%
D) 14.00%

Question 69

The cost of equity: Wally's War Duds has a preference share issue outstanding with a current price of $26.57. The company is expected to pay a dividend of $1.86 per share a year from today. What is the company's cost of preference shares?

A) 6.50%
B) 7.00%
C) 7.50%
D) 8.00%

Question 70

Using the WACC in practice: Ronnie's Comics has found that its cost of equity capital is 15 percent and its cost of debt capital is 12 percent. If the company is financed with $250,000,000 of ordinary shares (market value) and $750,000,000 of debt, then what is the after-tax weighted average cost of capital for Ronnie's if it is subject to a 35 percent company tax rate?

A) 6.05%
B) 6.95%
C) 8.75%
D) 13.65%

Question 71

The cost of equity: Oasis Ltd has common shares with a price of $21.12 per share. The company is expected to pay a dividend of $1.75 one year from today, and dividends are expected to grow at 10 percent for two years after that and then at 5 percent thereafter. What is the implied cost of ordinary shares for Oasis?

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

Question 72

Using the WACC in practice: Poly's Parrot Shops has found that its cost of equity capital is 17 percent. It has 7-year maturity bonds outstanding with a price of $767.03 that have a coupon rate of 7 percent. If the company is financed with $120,000,000 of ordinary shares (market value) and $80,000,000 of debt, then what is the after-tax weighted average cost of capital for Poly's if it is subject to a 35 percent company tax rate?

A) 10.20%
B) 11.76%
C) 11.88%
D) 13.32%

Question 73

Overall cost of capital: Stryder Ltd has 3 million shares outstanding at a current price of $15 per share. The book value of the shares is $10 per share. The company also has $30 million in par value of bonds outstanding. The bonds are selling at a price equal to 101 percent of par. What is the market value of the company?

A) $30.0 million
B) $45.0 million
C) $75.0 million
D) $75.3 million

Question 74

Using the WACC in practice: Droz's Hiking Gear Ltd has found that its equity capital shares have a beta equal to 1.5 while the risk-free return is 8 percent and the expected return on the market is 14 percent. It has 7-year maturity bonds outstanding with a price of $767.03 that have a coupon rate of 7 percent. If the company is financed with $120,000,000 of ordinary shares (market value) and $80,000,000 of debt, then what is the after-tax weighted average cost of capital for Droz's if it is subject to a 35 percent company tax rate?

A) 10.20%
B) 11.76%
C) 11.88%
D) 13.32%

Question 75

How companies estimate their cost of capital: The WACC for a company is 13.00 percent. You know that the company's cost of debt capital is 10 percent and the cost of equity capital is 20%. What proportion of the company is financed with debt?

A) 30%
B) 33%
C) 50%
D) 70%

Question 76

The cost of equity: Melba's Toast has a preference share issue outstanding with a current price of $19.50. The company is expected to pay a dividend of $2.34 per share a year from today. What is the company's cost of preference shares?

A) 11.50%
B) 11.75%
C) 12.00%
D) 12.25%

Question 77

Briefly explain why the book value of debt might not reflect the current cost of debt for the company, with respect to a single issuance of debt?

Question 78

How companies estimate their cost of capital: The WACC for a company is 19.75 percent. You know that the company is financed with $75 million of equity and $25 million of debt. The cost of debt capital is 7 percent. What is the cost of equity for the company?

A) 19.75%
B) 24.00%
C) 32.50%
D) 58.00%

Question 79

How companies estimate their cost of capital: You are analysing the cost of capital for a company that is financed with $300 million of equity and $200 million of debt. The cost of debt capital for the company is 9 percent, while the cost of equity capital is 19 percent. What is the overall cost of capital for the company?

A) 13.0%
B) 14.0%
C) 15.0%
D) 16.0%

Question 80

Overall cost of capital: What is the beta of a company whose equity has an expected return of 21.3 percent when the risk-free rate of return is 7.0 percent and the expected return on the market is 18.0 percent?

A) 0.79
B) 1.30
C) 1.57
D) none of the above