Deck 14: The Cost of Capital

Question 1

The investor's required rate of return differs from the firm's cost of capital due to the

A) firm's beta.
B) tax deductibility of interest.
C) CAPM.
D) time value of money.

Answer 1

B

Question 2

The firm's weighted average cost of capital includes the cost of common stock, preferred stock and retained earnings, but not debt.

Answer 2

False

Question 3

Which of the following best describes a firm's cost of capital?

A) The average yield to maturity on debt
B) The average cost of the firm's assets
C) The rate of return that must be earned on its investments in order to satisfy the firm's investors
D) The coupon rate on preferred stock

Answer 3

C

Question 4

Which of the following is a correct formula for calculating the weighted average cost of capital?

A) WACC = weighted after-tax cost of debt + weighted cost of preferred stock + weighted cost of common stock
B) WACC = weighted after-tax cost of debt + weighted after-tax cost of preferred stock + weighted after-tax cost of common stock
C) WACC = (after-tax cost of debt + cost of preferred stock + cost of common stock )/3
D) WACC = weighted cost of debt + weighted cost of preferred stock + weighted cost of common stock

Question 5

For tax purposes, interest on corporate debt is

A) deductible for the investor, but not for the borrower.
B) deductible for the borrower, but not for the investor.
C) fully taxable for both the borrower and the investor.
D) fully deductible for both the borrower and the investor.

Question 6

Which of the following must be adjusted for the firm's tax rate when estimating the weighted average cost of capital WACC?

A) Cost of common equity
B) Cost of preferred stock
C) Cost of debt
D) All of the above

Question 7

In order to maximize firm value, management should invest in new assets when cash flows from the assets are discounted at the firm's ________ and result in a positive NPV.

A) cost of capital
B) cost of debt used to finance the project
C) rate of return on equity
D) internal rate of return

Question 8

The after-tax cost of capital is computed by multiplying the before-tax cost of capital by 1 minus the tax rate.

Question 9

A firm's capital structure consists of which of the following?

A) Common stock
B) Preferred stock
C) Bonds
D) All of the above

Question 10

When investors increase their required rate of return, the cost of capital increases simultaneously.

Question 11

The minimum rate of return necessary to attract an investor to purchase or hold a security is called the cost of capital.

Question 12

A firm's cost of capital is not affected by the amount of leverage it uses.

Question 13

The weighted average cost of capital is computed using before-tax costs of each of the sources of financing that a firm uses to finance a project.

Question 14

Briefly identify and describe some important uses of a firm's weighted average cost of capital.

Question 15

Which of the following reasons causes investors to require a lower rate of return on the firm's bonds than on its stock?

A) Bondholders bear less risk than common stockholders bear.
B) Bondholders have prior voting rights over common stockholders.
C) Bondholders receive greater returns than common stockholders.
D) Investors pay a lower tax rate on bond interest

Question 16

The percentage of debt in Spencer's weighted average cost of capital is

A) 38.1%.
B) 31.25.
C) 25%.
D) 57.14%.

Question 17

The cost of capital is

A) the opportunity cost of using funds to invest in new projects.
B) the rate of return the firm must earn on its investments in order to satisfy the required rate of return of the firm's investors.
C) the required rate of return for new capital investments which have typical or average risk.
D) all of the above.

Question 18

The percentage of common stock in Spencer's weighted average cost of capital is

A) 62.5%.
B) 66.7%.
C) 6.25%.
D) 31.25%.

Question 19

When Starbuck's decided to acquire Seattle's Best Coffee Company, it presumably concluded that the

A) the rate of return they would earn on Seattle's Best equaled or exceeded the risk-free rate.
B) the rate of return they would earn on Seattle's Best equaled or exceeded Starbucks overall cost of capital.
C) the rate of return they would earn on Seattle's Best would be equal to or higher than the rate of return they could earn on other investments of equal risk.
D) the rate of return they would earn on Seattle's Best equaled or exceeded what Seattle's best was earning prior to the acquisition.

Question 20

The weights used to determine the relative importance of the firm's sources of capital should reflect

A) book values in accord with generally accepted accounting principles.
B) current market values for bonds, common stock, and preferred stock and book values for retained earnings.
C) current market values.
D) subjective adjustments for firm risk.

Question 21

Sonderson Corporation is undertaking a capital budgeting analysis. The firm's beta is 1.5. The rate on 10 year T-Bonds is 1.6% and the return on the S&P 500 index is 8%. What is the appropriate cost of common equity in determining the firm's cost of capital?

A) 12.0%
B) 11.2%
C) 13.6%
D) 9.6%

Question 22

PVE, Inc. has $15 million of debt outstanding with a coupon rate of 9%. Currently, the yield to maturity on these bonds is 7%. If the firm's tax rate is 35%, what is the after-tax cost of debt to PVE?

A) 10.76%
B) 5.85%
C) 4.55%
D) 5.4%

Question 23

The amount of debt in the firm's capital structure should include all interest-bearing debt, both long-term and short-term.

Question 24

When computing a firm's cost of capital, book values should be used be used because they are more objective.

Question 25

Book values are sometimes used to compute the percentage of debt in an firm's capital structure because much corporate debt is infrequently traded and market prices cannot be obtained.

Question 26

The market values of Spencer's long-term capital sources differ from the book values because

A) market values are easier to verify than book values.
B) book vales are established at the time securities are issued rather than what the same securities could be sold for if they were issued today.
C) market values are established according to generally accepted accounting principles (GAAP).
D) All of the above are true.

Question 27

The total capital that should be used in computing the weights for Spencer's WACC is

A) $1,275
B) $2,400
C) $2,250
D) $1,575

Question 28

The percentage of debt in the firm's capital structure should be adjusted by muliplying by 1 minus the firm's marginal tax rate.

Question 29

The most expensive source of capital is usually

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

Question 30

The expected dividend is $2.50 for a share of stock priced at $25. What is the cost of common equity if the long-term growth in dividends is projected to be 4%?

A) 10%
B) 8%
C) 14%
D) 18%

Question 31

Bender and Co. is issuing a $1,000 par value bond that pays 9% interest annually. Investors are expected to pay $918 for the 10-year bond. What is the after-tax cost of debt if the firm is in the 34% tax bracket?

A) 6.83%
B) 9.00%
C) 10.35%
D) 15.68%

Question 32

When calculating the weighted average cost of capital, which of the following has to be adjusted for taxes?

A) Common stock
B) Retained earnings
C) Debt
D) Preferred stock

Question 33

Which of the following is a valid issue in implementing the dividend growth model? The model

A) is too complex to be used to estimate value.
B) does not require an accurate estimate of the rate of growth in future dividends.
C) is based upon the assumption that dividends are expected to grow at a constant rate forever.
D) both A and C.

Question 34

Most firms use Treasury securities with maturities of ________ to determine the appropriate risk-free rate to use in the CAPM.

A) 90 days
B) 180 days
C) 10 years
D) 30 years

Question 35

Why are market values preferred to book (balance sheet) values when computing a firm's weighted average cost of capital?

Question 36

The cost of preferred stock is equal to

A) the preferred stock dividend divided by 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) the preferred stock dividend divided by the net market price.

Question 37

Capital structure represents the mix of equity and interest-bearing debt used by a firm.

Question 38

The percentage of preferred stock in Spencer's weighted average cost of capital is

A) 5.9%.
B) 62.5%.
C) 4.76%.
D) 6.25%.

Question 39

An increase in ________ will increase the cost of common equity.

A) the expected growth rate of dividends
B) the risk-free rate
C) the dividend
D) both A and B

Question 40

Which of the following is NOT used to calculate the cost of debt?

A) Face value of the debt
B) Market price of the debt
C) Number of years to maturity
D) Risk-free rate

Question 41

The cost of common equity using the CAPM is

A) 11.00%.
B) 11.20%.
C) 11.50%.
D) 11.72%.

Question 42

Toujours 29 has the following record of paying dividends: What are the arithmetic and geometric average growth rates of DIY's dividend payments?

A) 2.97%, 2.97%
B) 29.00%, 28.5%
C) 3.87%, 3.86%
D) 4.55%, 4.49%

Question 43

DIY Building Supplies has the following record of paying dividends What are the arithmetic and geometric average growth rates of DIY's dividend payments?

A) 4.09%, 8.35%
B) 3.09%, 3.08%
C) 3.87%, 3.86%
D) 4.55%, 4.49%

Question 44

The best estimate of the cost of new common equity is

A) 11.00%.
B) between 11.0%. and 11.2%
C) 11.50%.
D) between 10%. and 12%

Question 45

The after-tax cost of this debt issue is

A) 7.92%.
B) 6.58%.
C) 12%.
D) 3.39%.

Question 46

Pony Corporation is undertaking a capital budgeting analysis. The firm's beta is 1.5. The rate on 10-year U.S. Treasury bonds is 5%, and the return on the S & P 500 index is 12%. What is the cost of Pony's common equity?

A) 13.3%
B) 15.5%
C) 17.7%
D) 19.9%

Question 47

Welch's Lawn Care products just paid a dividend of $1.85. This dividend is expected to grow at a constant rate of 3% per year, so the next expected dividend is $1.90. The stock price is currently $12.50. . The company's marginal tax rate is 35%. Compute the cost of common equity.

A) 11.83%
B) 9.9%
C) 18.2%
D) 15.2%

Question 48

The CAPM approach is used to determine the cost of

A) debt.
B) preferred stock.
C) common equity.
D) long term funds.

Question 49

Walker & Son is issuing a 10-year, $1,000 par value bond that pays 9% interest annually. The bond is expected to sell for $885. What is Walker & Son's after-tax cost of debt if the firm is in the 34% tax bracket?

A) 7.23%
B) 8.01%
C) 9.15%
D) 10.35%

Question 50

MTD Inc. has a new bond issue that will net the firm $1,603,500. The bonds have a $1,500,000 par value, pay interest annually at a 6% coupon rate, and mature in 10 years. The firm has a marginal tax rate of 34%. The after-tax cost of the debt issue is

A) 5.1%.
B) 3.37%.
C) 5.6%.
D) 6.58%.

Question 51

Liverpool International Corporation's marginal tax rate is 35%. It can issue three-year bonds with a coupon rate of 4.5%. The bonds can be sold now at their par value of $1,000. Determine the appropriate after-tax cost of debt for Dublin International to use in a capital budgeting analysis.

A) 6.92%%
B) 4.50%
C) 2.93%
D) 1.58%

Question 52

The before-tax cost of this debt issue is

A) 12%.
B) 7.92%.
C) 9.97%.
D) 13%.

Question 53

Alpha has an outstanding bond issue that has a 7.75% semiannual coupon, a current maturity of 20 years, and sells for $967.97. The firm's income tax rate is 40%. What should Alpha use as an after-tax cost of debt for cost of capital purposes?

A) 2.42%
B) 4.04%
C) 4.85%
D) 8.08%

Question 54

Green Valley Motels has $5 million of debt outstanding with a coupon rate of 8.2%. Currently, the yield to maturity on these bonds is 7.3%. If the firm's tax rate is 34%, what is the after-tax cost of debt to Hill Town Motels?

A) 5.33%
B) 11.23%%
C) 4.75%
D) Cannot be determined because the maturity of the bonds is unknown.

Question 55

A firm has an issue of preferred stock that pays an annual dividend of $2.00 per share and currently is selling for $18.50 per share. Finally, the firm's marginal tax rate is 34%. This firm's cost of financing with new preferred stock is

A) 10%.
B) 7.13%.
C) 10.81%.
D) 6.6%.

Question 56

The cost of common equity using the dividend-growth model is

A) 11.00%.
B) 11.32%.
C) 11.50%.
D) 11.72%.

Question 57

Sola Cola Corporation is undertaking a capital budgeting analysis. The rate on 10-year U.S. Treasury bonds is 3.60%, and the return on the S & P 500 index is 11.6%. If the cost of Sola Cola's common equity is 19.6%, calculate their beta.

A) 1.69
B) 5.4
C) 2.0
D) 1.38

Question 58

Many corporate finance professionals favor the CAPM for determining the cost of equity. Which of the following is a reason for this preference?

A) The data is less expensive.
B) The variables in the model that apply to public corporations are readily available from public sources.
C) Because the CAPM gives better treatment to flotation costs.
D) The CAPM uses data from the firm's financial statements.

Question 59

The last paid dividend is $2 for a share of common stock that is currently selling for $20. What is the cost of common equity if the long-term growth rate in dividends for the firm is expected to be 8%?

A) 10.8%
B) 12.8%
C) 14.8%
D) 16.8%
E) 18.8%

Question 60

Given the following information, determine the risk-free rate. Cost of equity = 12%
Beta = 1.50
Market risk premium = 6%

A) 6.0%
B) 3.0%
C) 9.0%
D) 6.5%

Question 61

A bond with a Moody's rating of Aaa and and S&P rating of AAA will have a higher required return than a bond with a Moody's rating of Aa1 and an S&P rating of AA+.

Question 62

Assuming an after-tax cost of preferred stock of 10% and a corporate tax rate of 34%, a firm must earn at least $15.15 before tax on every $100 invested.

Question 63

If the before-tax cost of debt is 9% and the firm has a 34% marginal tax rate, the after-tax cost of debt is 5.94%.

Question 64

The after-tax cost of common stock is

A) 14.67%.
B) 13.23%.
C) 12.41%.
D) 11.65%.

Question 65

The firm's weighted average cost of capital is

A) 10.47%.
B) 9.29%.
C) 8.63%.
D) 7.71%.

Question 66

The George Company, Inc., has two issues of debt. Issue A has a maturity value of 8 million dollars, a coupon rate of 8%, paid annually, and is selling at par. Issue B was issued as a 15 year bond 5 years ago. Its coupon rate is 9%, paid annually. Investors demand a pre-tax return of 9.3% on this bond. The maturity value of Issue B is 6 million dollars. The George company has a marginal tax rate of 35%. What is the company's after tax cost of debt?

A) 4.73%
B) 5.56%
C) 7.36%
D) 8.47%

Question 67

Explain why the investor's required return on debt is not equal to the corporation's cost of debt, and explain why the investor's required return on equity is not equal to the corporation's cost of equity.

Question 68

Spencer Bioengineering's preferred stock has a par value of $100 and pays a dividend of $4.50. The current price of Spencer's preferred is $75. Spencer's tax rate is 34%. The before tax and after tax cost of preferred equity to Spencer is

A) 4.5%, 2.97%.
B) 6.00%, 3.96%.
C) 6.00% , 6.00%.
D) 8.04%, 6.00%.

Question 69

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

Question 70

The proportion of debt in this firm's capital structure is

A) 40%.
B) 50%.
C) 60%.
D) 70%.

Question 71

No adjustment is made in the cost of preferred stock for taxes since preferred stock dividends are not tax-deductible.

Question 72

Because issuing common equity entails less risk to the firm, it is always less expensive than borrowing.

Question 73

Alpha's beta is 1.06, the present T-bond rate is 6%, and the return on the S & P 500 is 15.25%. What is Alpha's cost of common equity using the CAPM approach?

A) 21.25%
B) 15.81%
C) 9.25%
D) 6.32%

Question 74

The after-tax cost of debt is

A) 6.20%.
B) 5.40%.
C) 4.60%.
D) 3.80%.

Question 75

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

Question 76

A firm can estimate it's cost of debt by finding the yield on bonds issued by other firms with similar ratings and maturities.

Question 77

The cost of debt is equal to one minus the marginal tax rate times the coupon rate of interest on the firm's outstanding debt.

Question 78

The current total value of the firm is

A) $6,450,000.
B) $5,750,000.
C) $4,950,000.
D) $3,250,000.

Question 79

It is not possible for a firm's after-tax cost of common equity to be lower than its after-tax cost of debt.

Question 80

Discuss the primary advantages of the CAPM approach in determining the cost of common equity.