Question 1

The return that shareholders require on their investment in the firm is called the:

Accepted Answer

The cost of equity represents the return that shareholders require on their investment in the firm, and is therefore the most appropriate choice. Dividend yield and capital gains yield are components of the total return that shareholders receive, while cost of capital and income return refer to the overall cost of financing the firm or the return on investment for all types of investors.

Question 2

Katie's Boutique has zero-coupon bonds outstanding that mature in four years. The bonds have a face value of $1,000 and a current market price of $820. What is the company's pre-tax cost of debt?

Accepted Answer

Using a financial calculator:
PV = -820, FV = 1,000, PMT = 0, N = 4, CPT I/Y = 5.09%

Question 3

The overall cost of capital for a retail store:

Accepted Answer

The overall cost of capital reflects the return investors require on the total assets of the firm.

Question 4

Use the data provided on Cadbury to answer the question below. The risk free rate is 4.25%. The expected return on the market portfolio is 9.75%. The corporate tax rate is 40%. The face value of Cadbury's outstanding bonds is 2.450 billion pounds sterling. The coupon rate on Cadbury's bonds is 4.5%. Assume that the bonds pay annual coupons. The yield to maturity on Cadbury's bonds is 4.5%. Cadbury's bonds mature in 7 years. Cadbury has 1.650 billion common shares outstanding. The market price of Cadbury's common shares as of Dec 31, 2008 is 6.25 pounds sterling. Cadbury's Beta is 0.8. What is Cadbury's cost of debt (after-tax)?

Accepted Answer

After-tax cost of debt = k_d(1 - T) 0.045(1 - 0.40) = 0.027 or 2.70%

Question 5

The cost of capital assigned to an individual project should be that rate which:

Accepted Answer

The cost of capital for an individual project should consider both the nature and characteristics of the project as well as the project-specific risk. This is because each project may have unique risks and may require different sources of funding, which can result in varying costs of capital. Therefore, it is important to carefully consider the specific details of the project when determining its cost of capital.

Question 6

Wilson's Cabinets has bonds outstanding that mature in eight years, have a 6 percent coupon and pay interest annually. These bonds have a face value of $1,000 and a current market price of $1,020. What is the company's pre-tax cost of debt?

Accepted Answer

The answer of Wilson's Cabinets has bonds outstanding that mature...

Question 7

The discount rate assigned to an individual project should be based on:

Accepted Answer

The discount rate for an individual project should be based on the risk level of the project itself. This is because the level of risk will affect the expected return on investment, and therefore the discount rate required to make the project economically viable. Using the firm's overall cost of capital may not accurately reflect the risk associated with the individual project. Similarly, the sources of funding used for the project may not reflect the true risk of the project. Therefore, E is the best choice.

Question 8

The weighted average of the firm's costs of equity, preferred stock, and after tax debt is the:

Accepted Answer

The weighted average of the firm's costs of equity, preferred stock, and after tax debt is commonly known as the weighted average cost of capital (WACC). It is used to determine the minimum return that the firm must earn on its investments in order to satisfy its creditors, owners, and other stakeholders. Therefore, the correct answer is E- weighted average cost of capital (WACC).

Question 9

The cost of capital:

Accepted Answer

The cost of capital for a firm depends on how the funds are going to be utilized.

Question 10

The Delta Co. owns retail stores that market home building supplies. Largo, Inc. builds single family homes in residential developments. Delta has a beta of 1.22 and Largo has a beta of 1.34. The risk-free rate of return is 4 percent and the market risk premium is 6.5 percent. What should Delta use as their cost of equity if they decide to purchase some land and create a new residential community?

Accepted Answer

k_e = k_F + β(k_M - k_F) k_e= 0.04 + 1.34(.065) k_e = 12.71%

Question 11

The opportunity cost associated with the firm's capital investment in a project is called its:

Accepted Answer

A firm's cost of capital is its opportunity cost of making a capital investment.

Question 12

When evaluating a project, a firm's managers should select projects whose cash flows

Accepted Answer

Decision criterion for internal rate of return required the project's IRR exceed the cost of capital.

Question 13

A firm can raise its value without earning at least the WACC.

Accepted Answer

A firm must earn at least the weighted average cost of capital or the value of the firm will fall.

Question 14

Pan American Airlines' shares are currently trading at $69.25 each. The yield on Pan Am's debt is 4% and the firm's beta is 0.7. The T-Bill rate is 4% and the expected return on the market (E (k_M))is 9%. The company's target capital structure is 25% debt and 75% equity. Pan American Airlines pays a combined federal and state tax rate of 35%. What is Pan Am's cost of debt (after tax)?

Accepted Answer

The pre-tax cost of debt is the yield to maturity on the company's bonds, or 4%. After-tax cost of debt = k_d(1 - T) 0.04(1 - 0.35) = 2.6%

Question 15

Pan American Airlines' shares are currently trading at $69.25 each. The yield on Pan Am's debt is 4% and the firm's beta is 0.7. The T-Bill rate is 4% and the expected return on the market (E (k_M))is 9%. The company's target capital structure is 25% debt and 75% equity. Pan American Airlines pays a combined federal and state tax rate of 35%. What is Pan Am's cost of equity?

Accepted Answer

k_e = k_F + β(k_M - k_F) k_e= 0.04 + 0.70(0.09 - 0.04) k_e = 7.5%

Question 16

A firm's cost of debt often differs from the yield reported on its bonds because

Accepted Answer

The interest paid on corporate bonds is tax deductible, which reduces the effective cost of debt for the firm. Therefore, the yield reported on its bonds may be higher than its actual cost of debt.

Question 17

Which of the following statements is incorrect?

Accepted Answer

The cost of debt can be adjusted even if the firm does not sell new bonds. It is important to regularly review and update the cost of debt as market conditions and the company's financial position change.

Question 18

The Bet-r-Bilt Company has a six-year bond outstanding with a 5 percent coupon. Interest payments are paid semi-annually. The face amount of the bond is $1,000. This bond is currently selling for 98 percent of its face value. What is the company's pre-tax cost of debt?

Accepted Answer

Using a financial calculator:
PV = -980, FV = 1,000, PMT = 25, N = 12, CPT I/Y = 2.697 × 2 = 5.39%

Question 19

Ernst's Electrical has a bond issue outstanding with ten years to maturity. These bonds have a $1,000 face value, a 5 percent coupon, and pay interest semi-annually. The bonds are currently quoted at 96 percent of face value. What is Ernst's pre-tax cost of debt?

Accepted Answer

Using a financial calculator:
PV = -960, FV = 1,000, PMT = 25, N = 20, CPT I/Y = 2.763 × 2 = 5.53%

Question 20

Assigning separate discount rates to individual projects when determining which projects should be accepted by the firm:

Accepted Answer

Assigning different discount rates to individual projects may alter the risk level of the company, which could lead to variation in the firm's overall weighted average cost of capital over time. As a result, it is critical to carefully analyze the overall intrinsic value of each project and the potential impact on the firm's overall risk level when determining which projects to pursue.

Quiz 11: Cost of Capital