Question 1

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

Accepted Answer

False

Question 2

In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project.

Accepted Answer

False

Question 3

The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

Accepted Answer

The component costs of capital such as cost of debt, cost of equity, and cost of preferred stock are all determined by the market and are based on investors' required rates of return.

Question 4

The reason why retained earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm's common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should distribute those earnings to its investors. Thus, the cost of retained earnings is based on the opportunity cost principle.

Accepted Answer

The statement correctly explains the reason why retained earnings have a cost equal to rs based on the opportunity cost principle.

Question 5

When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to use long-term or short-term rates for rRF, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and (3) how to measure the market risk premium, RPM. These problems leave us unsure of the true value of rs.

Accepted Answer

These three potential problems can affect the accuracy of the estimated cost of equity using the CAPM, making it difficult to determine the true value of rs.

Question 6

The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

Accepted Answer

The cost of external equity raised by issuing new stock typically involves additional transaction costs such as investment banking fees, underwriting fees, and legal fees, which increase the total cost of equity. Therefore, it is typically higher than the required rate of return on the firm's outstanding common stock.

Question 7

If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.

Accepted Answer

The answer of If a firm's marginal tax rate is...

Question 8

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost.

Accepted Answer

Even though retained earnings do not involve direct payments like dividends or interest, they are not cost-free. They represent an opportunity cost, as shareholders could have received these funds as dividends and invested them elsewhere for a return.

Question 9

The cost of capital used in capital budgeting should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets.

Accepted Answer

The cost of capital used in capital budgeting should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets. This includes sources such as borrowing from banks or issuing bonds, as well as using equity financing from shareholders. It is important to calculate the average cost of all of these sources of financing in order to accurately determine the cost of capital for a company.

Question 10

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, is not deductable by the issuing firm.

Accepted Answer

This statement is correct. The cost of perpetual preferred stock can be calculated by dividing the annual dividend by the market price of the preferred stock. Unlike interest on debt, preferred dividends are not tax-deductible, so no adjustment is needed for taxes.

Question 11

The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.

Accepted Answer

The answer of The cost of equity raised by retaining...

Question 12

Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt.

Accepted Answer

The answer of Suppose you are the president of a...

Question 13

The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

Accepted Answer

The cost of debt is calculated as the average coupon rate on all outstanding debt multiplied by (one minus the marginal tax rate), not the other way around. This formula accounts for the tax deductibility of interest expenses.

Question 14

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.

Accepted Answer

This is known as the after-tax cost of debt formula. Subtracting the tax rate from 1 provides the portion of interest expense that is paid after taxes, and multiplying that by the interest rate gives the after-tax cost of debt.

Question 15

The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and retained earnings, whose cost is the average return on the assets that are acquired.

Accepted Answer

The answer of The higher the firm's flotation cost for...

Question 16

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

Accepted Answer

The cost of common equity obtained by retaining earnings is often referred to as the cost of retained earnings. It is the rate of return that the marginal stockholder requires on the firm's common stock, and it is calculated by using the dividend growth model or the capital asset pricing model (CAPM).

Question 17

For capital budgeting and cost of capital purposes, the firm should always consider retained earnings as the first source of capital--i.e., use these funds first--because retained earnings have no cost to the firm.

Accepted Answer

Retained earnings do have a cost, which is the opportunity cost of not distributing those earnings to shareholders in the form of dividends. The cost of retained earnings is known as the cost of equity, which represents the return shareholders require to invest in the company rather than investing elsewhere. Therefore, the firm should consider all available sources of capital, including retained earnings and their associated cost, before making investment decisions.

Question 18

For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity.

Accepted Answer

This statement is true. The target capital structure of a firm is the mix of debt, preferred stock, and common equity that it plans to use to finance its projects and operations. In order to calculate the cost of capital, the firm must use this target capital structure and assume that each dollar of capital is obtained in accordance with it. This is because the cost of each type of financing (debt, preferred stock, common equity) is different, and the overall cost of capital depends on the relative weights of each type of financing in the capital structure.

Question 19

"Capital" is sometimes defined as funds supplied to a firm by investors.

Accepted Answer

This indicates that the statement is true. "Capital" usually refers to the money invested or available to a company or organization for use in their business operations. It can come from various sources such as shareholders, debt financing, or retained earnings.

Question 20

The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC.

Accepted Answer

The after-tax cost of debt is used as the component cost of debt for purposes of developing the firm's WACC. This is because interest expenses are tax-deductible, thus reducing the actual cost of debt for the firm.

Quiz 9: The Cost of Capital