Question 1

The after tax cost of debt is used to calculate the weighted average cost of capital since we are concerned with the after-tax cash flows of the firm.

Accepted Answer

The after-tax cost of debt reflects the actual cost of borrowing for the firm and takes into account the tax savings resulting from the deductibility of interest expenses on the firm's taxable income. As the weighted average cost of capital is used to evaluate the profitability of investment projects, it is important to consider the net cash flows available to the firm after paying taxes on its earnings.

Question 2

Each component cost of particular types of capital is identical for each source of funds found in a firm's capital structure.

Accepted Answer

The cost of capital may vary depending on the source of funds, such as debt or equity, and their specific characteristics, such as interest rates and the risk involved. Therefore, the statement is false.

Question 3

The firm's cost of external equity capital is the same as the required rate of return on the firm's outstanding ordinary shares.

Accepted Answer

False

Question 4

The weighted average cost of capital increases if the total funds required call for an amount of equity in excess of what can be obtained as retained earnings.

Accepted Answer

When the total funds required exceed what can be obtained through retained earnings, the company would have to issue new equity or debt which can increase the cost of capital. The cost of new equity or debt may be higher than the cost of retained earnings, thus increasing the average cost of capital.

Question 5

Even if a firm obtains all of its ordianry equity from retained earnings, its MCC schedule might still increase if very large amounts of new capital are needed.

Accepted Answer

The MCC schedule takes into account the cost of all types of capital, not just ordinary equity obtained from retained earnings. If a firm needs to raise a significant amount of new capital, it may need to issue other types of securities such as debt or preferred stock, which will increase its weighted average cost of capital.

Question 6

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, but capital raised by selling new shares or bonds does have a cost.

Accepted Answer

Retained earnings have an opportunity cost, as they could have been distributed to shareholders as dividends or invested elsewhere.

Question 7

The firm's cost of capital represents the maximum rate of return that a firm can earn from its capital budgeting projects to ensure that the value of the firm increases.

Accepted Answer

The answer of The firm's cost of capital represents the...

Question 8

A firm's capital structure has no impact on the firm's weighted average cost of capital.

Accepted Answer

A firm's capital structure, specifically the proportion of debt and equity financing, can impact the cost of capital. Debt financing typically has a lower cost than equity financing, but also comes with additional risks. Therefore, a change in a firm's capital structure can impact the overall cost of capital.

Question 9

The cost of issuing preference shares by a corporation must be adjusted to an after-tax figure because of the dividend exclusion provision for corporations holding other corporations' preference shares.

Accepted Answer

The cost of issuing preference shares is not adjusted to an after-tax figure because dividends on preference shares are not tax-deductible for the issuing corporation.

Question 10

Capital refers to items on the right-hand side of a firm's balance sheet.

Accepted Answer

Capital is one of the major categories on the right-hand side (liabilities and owner's equity) of a firm's balance sheet. It represents the funds provided by the owners and can include common stock, preferred stock, retained earnings, and other reserves.

Question 11

The cost of equity capital from the sale of ordinary shares (ke) is generally equal to the cost of equity capital from retention of earnings (rs), divided by one minus the flotation cost as a percentage of sales price (1 - F).

Accepted Answer

The cost of equity capital from the sale of ordinary shares (ke) is generally higher than the cost of equity capital from retention of earnings (rs), and the relationship between the two is not directly affected by the flotation cost.

Question 12

Tax adjustments to the cost of preference shares must be made when determining the cost of capital since dividend expenses on preference shares are tax deductible.

Accepted Answer

Dividends on preference shares are not tax deductible, so no tax adjustments are needed when determining the cost of capital.

Question 13

The cost of capital is the firm's average cost funds given what the market demands be paid to attract the funds.

Accepted Answer

The cost of capital is the weighted average cost of all the sources of capital for a firm, and it takes into consideration the cost of equity, cost of debt, and cost of preferred stock. The cost of capital is influenced by the market demands for returns on investments and the risk associated with the investment. Therefore, the statement is true.

Question 14

There is a jump, or break, in a firm's MCC schedule each time the firm runs out of a particular source of capital at a particular cost.For example, a firm may use up its 10 percent debt and can then issue more debt only if it offers a higher rate to investors.

Accepted Answer

This statement is true. Each time a firm runs out of a particular source of capital at a particular cost, there is a jump or break in the firm's MCC schedule. This is because the firm would have to offer a higher rate of return to investors for the next batch of capital raised, causing a higher cost of capital for the firm.

Question 15

The component costs of capital are market-determined variables in as much as 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 determined by the market based on investors' required returns. These costs will vary depending on factors such as the economic environment, company-specific risk, and market conditions.

Question 16

The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of equity raised by selling new issues of ordinary shares, 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 17

The correct discount rate for a firm to use in capital budgeting, assuming that new investments are of the same degree of risk as the firm's existing assets, is its marginal cost of capital.

Accepted Answer

The marginal cost of capital represents the cost of obtaining additional funds for investment, and is therefore the appropriate discount rate to use in evaluating capital budgeting projects. This assumes that the level of risk for new investments is similar to that of the firm's existing assets.

Question 18

The cost of capital used in capital budgeting must be determined using the specific financing used to fund that particular project.

Accepted Answer

The cost of capital used in capital budgeting should be determined using the company's overall cost of capital, which reflects the average cost of all the sources of financing (debt, equity, retained earnings, etc.), not just the specific financing used for a particular project.

Question 19

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

Accepted Answer

The answer of The cost of debt is equal to...

Question 20

The marginal cost of capital (MCC) is the cost of the last rand of new capital that the firm raises, and the marginal cost declines as more and more of a specific type of capital is raised during a given period.

Accepted Answer

The marginal cost of capital typically increases as more capital is raised due to the rising cost of obtaining additional funds and the increased risk perceived by investors.

Quiz 11: The Cost of Capital