Question 1

The fact that the interest paid on debt is a tax-deductible expense increases the cost of debt financing.

Accepted Answer

The fact that the interest paid on debt is tax-deductible actually decreases the effective cost of debt financing, because it reduces the company's taxable income, thereby lowering its tax liability.

Question 2

Assume IBM just paid a dividend of $4.50 and expects these dividends to grow at 8% a year. The price of IBM is $100 per share. What is IBM's cost of equity capital?

Accepted Answer

The cost of equity capital can be calculated using the dividend growth model as follows:
Cost of equity = (Dividend / Price) + Growth rate
= (4.5/100) + 0.08
= 0.1286 or 12.86%
Therefore, the correct answer is D.

Question 3

IBM expects to pay a dividend of $5 next year and expects these dividends to grow at 7% a year. The price of IBM is $90 per share. What is IBM's cost of equity capital?

Accepted Answer

D) Cost of equity is the next period dividend divided by the price plus the growth rate in dividends. Cost of equity = (Div₁/ P_E) + g = ($5 / $90) + 0.07 = 0.1256 = 12.56%

Question 4

IBM expects to pay a dividend of $2 next year and expects these dividends to grow at 9% a year. The price of IBM is $80 per share. What is IBM's cost of equity capital?

Accepted Answer

D) Cost of equity is the next period dividend divided by the price plus the growth rate in dividends. Cost of equity = (Div₁/ P_E) + g = ($2 / $80) + 0.09 = 0.1150 = 11.50%

Question 5

Assume preferred stock of Ford Motors pays a dividend of $3.00 each year and trades at a price of $20. What is the cost of preferred stock capital for Ford?

Accepted Answer

C) Divide the dividend by the preferred stock price.
$3.00 / $20 = 0.150 or 15.0%

Question 6

Outstanding debt of Home Depot trades with a yield to maturity of 7%. The tax rate of Home Depot is 35%. What is the effective cost of debt of Home Depot?

Accepted Answer

A) Multiply the yield to maturity by 1 minus the tax rate.
0.07 × (1 - 0.35) = 0.046 = 4.55%

Question 7

The ________ of a firm's debt can be used as the firm's current cost of debt.

Accepted Answer

The yield to maturity represents the total return anticipated on a bond if held until it matures, and therefore can be used as the current cost of debt for a firm. The current yield only represents the annual income generated by a bond relative to its current market price, while the coupon rate represents the interest rate established when the bond is issued. The discount yield is the rate of return received on a bond when it is purchased at a discount to its par value, and is not necessarily reflective of the firm's current cost of debt.

Question 8

Outstanding debt of Home Depot trades with a yield to maturity of 5%. The tax rate of Home Depot is 40%. What is the effective cost of debt of Home Depot?

Accepted Answer

D) Multiply the yield to maturity by 1 minus the tax rate.
0.05 × (1 - 0.4) = 0.030 = 3.00%

Question 9

Assume JUP has debt with a book value of $24 million, trading at 120% of par value. The firm has book equity of $28 million, and 2 million shares trading at $20 per share. What weights should JUP use in calculating its WACC?

Accepted Answer

A) Market Value Debt = $24 million × 120% = $28.8 million
Market Value Equity = 2 million × $20 = $40 million
Total Market Value = $68.8 million
Weight of debt = $28.8 million / $68.8 million = 41.86%
Weight of equity = $40 million / $68.8 million = 58.14%

Question 10

Epiphany is an all-equity firm with an estimated market value of $300,000. The firm sells $250,000 of debt and uses the proceeds to purchase outstanding equity. Compute the weight in equity and the weight in debt after the proposed financing and repurchase of equity.

Accepted Answer

C) Weight in debt = Debt raised / Market value of firm
Weight in equity = 1 - Weight in debt
Weight in debt = $250,000 / $300,000 = 0.83
Weight in equity = 1 - 0.83 = 0.17

Question 11

Your estimate of the market risk premium is 6%. The risk-free rate of return is 4% and General Motors has a beta of 1.4. What is General Motors' cost of equity capital?

Accepted Answer

Using the Capital Asset Pricing Model (CAPM), 
GM's cost of equity capital = risk-free rate + beta x market risk premium
= 4% + 1.4 x 6%
= 4% + 8.4%
= 12.4%

Question 12

Assume preferred stock of Ford Motors pays a dividend of $4 each year and trades at a price of $35. What is the cost of preferred stock capital for Ford?

Accepted Answer

A) Divide the dividend by the preferred stock price.
$4 / $35 = 0.114 or 11.4%

Question 13

As a firm increases its level of debt relative to its level of equity, the firm is ________.

Accepted Answer

As a firm increases its level of debt relative to its level of equity, it is increasing its leverage. This is because it is relying more on debt financing, which magnifies the effects of both positive and negative financial outcomes.

Question 14

A firm's cost of debt is the rate of interest it would have to pay to refinance its existing debt.

Accepted Answer

The cost of debt refers to the rate of interest that a firm must pay on its debt in order to refinance or issue new debt.

Question 15

Why do we use market values rather than book values in calculation of WACC?

Accepted Answer

The answer of Why do we use market values rather...

Question 16

Why do we use leverage if it increases the risk of a firm?

Accepted Answer

The answer of Why do we use leverage if it...

Question 17

Outstanding debt of Home Depot trades with a yield to maturity of 8%. The tax rate of Home Depot is 30%. What is the effective cost of debt of Home Depot?

Accepted Answer

D) Multiply the yield to maturity by 1 minus the tax rate.
0.08 × (1 - 0.3) = 0.056 = 5.60%

Question 18

Your estimate of the market risk premium is 7%. The risk-free rate of return is 4% and General Motors has a beta of 1.6. What is General Motors' cost of equity capital?

Accepted Answer

A) Apply the CAPM equation.
Cost of equity = 0.04 + (1.6 × 0.07) = 0.152 = 15.2%

Question 19

Epiphany is an all-equity firm with an estimated market value of $500,000. The firm sells $150,000 of debt and uses the proceeds to purchase outstanding equity. Compute the weight in equity and the weight in debt after the proposed financing and repurchase of equity.

Accepted Answer

D) Weight in debt = Debt raised / Market value of firm
Weight in equity = 1 - Weight in debt
Weight in debt = $150,000 / $500,000 = 0.30
Weight in equity = 1 - 0.30 = 0.70

Question 20

Assume preferred stock of Ford Motors pays a dividend of $3.50 each year and trades at a price of $30. What is the cost of preferred stock capital for Ford?

Accepted Answer

B) Divide the dividend by the preferred stock price.
$3.50 / $30 = 0.117 or 11.7%

Quiz 13: The Cost of Capital