Question 1

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 by taking the average coupon rate on all outstanding debt and then adjusting it for the tax savings due to interest expense being tax-deductible. This is typically done by multiplying the average coupon rate by (1 - marginal tax rate), not one minus the product of the marginal tax rate and the average coupon rate.

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 after-tax cost of debt is used as the component cost of debt for purposes of developing the firm's WACC, as it takes into account the tax deductibility of interest expenses.

Question 3

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 reinvested earnings,whose cost is the average return on the assets that are acquired.

Accepted Answer

Flotation costs are associated with issuing new securities, including both common and preferred stock. Preferred stock typically does have flotation costs, though they might differ in magnitude from those of common equity. Reinvested earnings (retained earnings) are considered a cheaper source of financing due to the absence of flotation costs, but the statement incorrectly suggests preferred stock has no flotation costs.

Question 4

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 influenced by market factors and are based on investors' expectations of returns. Therefore, they are determined by market forces.

Question 5

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 6

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

Accepted Answer

Reinvested earnings are not free; they represent an opportunity cost, as these funds could have been returned to shareholders as dividends. The cost of reinvested earnings is often estimated by the return shareholders expect on their investment.

Question 7

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

Accepted Answer

Capital refers to the funds supplied to a firm by investors or owners, which can be in the form of equity or debt.

Question 8

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 weighted average cost of the various sources of long-term funds a firm uses to acquire assets, taking into account factors such as the proportion of each source of funds and their respective costs.

Question 9

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

Accepted Answer

The statement accurately reflects the opportunity cost principle, where investors expect a return equal to the firm's cost of equity capital, which is represented as r_s. If the firm can't earn this return on the earnings it retains, it should distribute them to investors instead. Therefore, the cost of reinvested earnings is equal to r_s.

Question 10

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 cost of preferred stock to a firm is not adjusted for taxes because dividends paid on preferred stock are not tax-deductible expenses for the firm.

Question 11

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 12

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 13

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 r_RF, (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,RP_M.These problems leave us unsure of the true value of r_s.

Accepted Answer

The statement is correct and outlines the potential problems associated with estimating the cost of equity using the CAPM model. These problems imply a certain degree of uncertainty in the true value of r_s.

Question 14

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

It is important for firms to consider their target capital structure when determining the cost of capital, as this structure typically includes a mix of debt, preferred stock, and common equity. This allows the firm to achieve the optimal balance between risk and return in its capital structure.

Question 15

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

This is correct. The cost of common equity obtained by retaining earnings is also known as the "retained earnings cost of equity" and represents the rate of return the company must earn on its retained earnings to satisfy the expectations of its shareholders. This is because retaining earnings means that the company is not paying out dividends to its shareholders, so the return they receive on their investment comes from an increase in the value of the company's stock. Therefore, shareholders will require a rate of return on their investment that is at least equal to the return they would receive if they received dividends instead.

Question 16

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

Accepted Answer

The cost of debt is reduced by the tax savings from deducting the interest expense on the company's tax return. Therefore, the formula to calculate the cost of debt is (1 - marginal tax rate) x interest rate on new debt.

Question 17

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 deductible by the issuing firm.

Accepted Answer

The statement is correct. Perpetual preferred stock's cost is determined by dividing the annual dividend by the market price of the stock, and no adjustments are required for taxes because the issuing firm cannot deduct preferred dividends, unlike interest on debt.

Question 18

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. The cost of retained earnings is the opportunity cost of not distributing those earnings to shareholders, who could invest them elsewhere for a return.

Question 19

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

In general, this statement is false, because the firm should be viewed as an ongoing entity, and using debt (or equity) to fund a given project will change the capital structure, and this factor should be recognized by basing the cost of capital for all projects on a target capital structure. Under some special circumstances, where a project is set up as a separate entity, then "project financing" may be used, and only the project's specific situation is considered. This is a specific situation, however, and not the "in general" case.

Question 20

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 is generally higher than the required rate of return on the firm's outstanding common stock due to the issuance of new shares leading to dilution of ownership and earnings per share.

Quiz 11: Determining the Cost of Capital