Question 1

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

False

Question 2

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 before-tax cost of debt is higher than the after-tax cost because interest expenses are tax-deductible, reducing the effective cost of debt for the firm. The after-tax cost of debt is used in calculating the WACC.

Question 3

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 also known as the retained earnings cost. It is the rate of return that the marginal stockholder requires on the firm's common stock, and it can be calculated using the capital asset pricing model (CAPM) or the dividend growth model.

Question 4

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 all the long-term sources of funds a firm uses to acquire assets, including debt, preferred stock, and common stock. This helps the firm accurately estimate the return on investment and make informed decisions on which projects to invest in.

Question 5

When estimating the cost of equity by use of the DCF method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return. This problem leaves us unsure of the true value of rs.

Accepted Answer

This statement is true. When using the DCF method to estimate the cost of equity, the growth rate used to estimate future returns is a key component. However, this growth rate can be difficult to accurately determine, leading to uncertainty in the calculation of the cost of equity.

Question 6

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 7

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

The cost of perpetual preferred stock is calculated by dividing the annual dividend by the market price, and no tax adjustment is needed because preferred dividends are not tax-deductible.

Question 8

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

Accepted Answer

Capital refers to the funds contributed by investors, including both debt and equity financing.

Question 9

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

The statement correctly identifies three potential problems when estimating the cost of equity using CAPM, which could lead to uncertainty in determining the true value of rs.

Question 10

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 as firms typically have a target capital structure that includes a mix of debt, preferred stock, and common equity. The firm should assume that each dollar of capital is obtained in accordance with this target mix when making capital budgeting decisions and calculating the cost of capital.

Question 11

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

The answer of In general, firms should use their weighted...

Question 12

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 (also known as the cost of new equity) is usually higher than the required rate of return on outstanding common stock due to factors such as flotation costs and dilution of ownership.

Question 13

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 the cost of debt and cost of equity, are based on the required returns of investors in the market. These required returns are influenced by various factors such as inflation, risk preferences, and overall market conditions. Therefore, the component costs of capital are market-determined variables.

Question 14

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 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

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 to the firm in the form of opportunity cost. By keeping the earnings within the company, the firm is forgoing the opportunity to invest those funds elsewhere and earn a return on them. Therefore, it is not always the best choice to use retained earnings as the first source of capital.

Question 17

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

Accepted Answer

This formula accounts for the fact that the interest paid on debt can be tax-deductible, therefore lowering the effective cost of the debt.

Question 18

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 cost of retained earnings is considered the opportunity cost of not distributing profits to shareholders, who could otherwise invest them elsewhere at a rate rs, which is the expected return on investments with similar risk.

Question 19

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

The answer of The cost of preferred stock to a...

Question 20

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.

Quiz 9: The Cost of Capital