Question 1

In computing the cost of common equity, if D₁goes downward and P_o goes up, K_e will

Accepted Answer

In computing the cost of common equity, the cost of equity (KE) is directly proportional to the risk-free rate (DS) and the market risk premium (PS), so if D₁ goes downward and P_o goes up, KE will decrease, leading to a decrease in stock price. Therefore, K_e will also decrease, making choice B the correct answer.

Question 2

Expected cash dividends are $3.00, the dividend yield is 4%, flotation costs are 4% of price, and the growth rate is 3%. Compute cost of new common stock.

Accepted Answer

The cost of new common stock can be determined using the following formula:

Cost of new common stock = (Dividend yield + growth rate) / (1 - flotation costs)

Substituting the values, we get:

Cost of new common stock = (0.04 + 0.03) / (1 - 0.04) = 0.072, or 7.2%

Therefore, the best choice is B.

Question 3

A firm's debt to equity ratio varies at times because

Accepted Answer

All of these statements are accurate reasons why a firm's debt to equity ratio may vary over time. A firm may want to sell common stock when prices are high and bonds when interest rates are low, in order to obtain the most favorable terms for its securities. Timing fundraising efforts is also important for minimizing costs and maximizing returns over the long run. Additionally, the market may allow some flexibility in the debt to equity ratio before penalizing the firm with a higher cost of capital.

Question 4

For many firms, the cheapest and most important source of equity capital is in the form of

Accepted Answer

Retained earnings are profits that a company has kept instead of distributing as dividends to shareholders. This represents a cheap and important source of equity capital for firms as they do not have to pay underwriting fees or interest payments. Additionally, reinvesting profits allows for growth and expansion without diluting ownership through issuing additional shares.

Question 5

A firm's preferred stock pays an annual dividend of $2, and the stock sells for $65. Flotation costs for new issuances of preferred stock are 5% of the stock value. What is the after-tax cost of preferred stock if the firm's tax rate is 30%?

Accepted Answer

The cost of preferred stock can be calculated using the following formula:

Cost of preferred stock = Preferred stock dividend / Net issuing price

Net issuing price = Stock price - Flotation costs

Flotation costs = 5% x $65 = $3.25

Net issuing price = $65 - $3.25 = $61.75

Cost of preferred stock = $2 / $61.75 = 3.23%

After-tax cost of preferred stock = Cost of preferred stock x (1 - Tax rate)

After-tax cost of preferred stock = 3.23% x (1 - 0.30) = 2.26%

Therefore, the after-tax cost of preferred stock is 2.26%, which is closest to option C (3.20%).

Question 6

Firm X has a tax rate of 30%. The price of its new preferred stock is $75 and its flotation cost is $3.15. The cost of new preferred stock is 8%. What is the firm's dividend?

Accepted Answer

The answer of Firm X has a tax rate of...

Question 7

A firm is paying an annual dividend of $2.65 for its preferred stock which is selling for $57.00. There is a selling cost of $3.30. What is the after-tax cost of preferred stock if the firm's tax rate is 33%?

Accepted Answer

The answer of A firm is paying an annual dividend...

Question 8

In determining the cost of retained earnings

Accepted Answer

The capital asset pricing model (CAPM) can be used to determine the cost of retained earnings by estimating the expected return required by equity investors. This model takes into account the risk-free rate, the stock's beta (which measures its volatility relative to the market), and the market risk premium.

Question 9

Within the capital asset pricing model

Accepted Answer

Within the capital asset pricing model, beta measures the volatility of an individual stock relative to a stock market index. Choices A and B are incorrect. The risk-free rate is usually lower than the return in the market, and the higher the beta, the higher the required rate of return.

Question 10

New common stock is more expensive than K_e

Accepted Answer

The answer of New common stock is more expensive than...

Question 11

The after-tax cost of preferred stock to the issuing corporation

Accepted Answer

Preferred stock dividends are not tax-deductible, so the after-tax cost is the same as the before-tax cost.

Question 12

Ten years ago, Stigler Company issued $100 par value preferred stock yielding 6 percent. The preferred stock is now selling for $102 per share. What is the current yield or cost of the preferred stock? (Disregard flotation costs.)

Accepted Answer

The current yield or cost of the preferred stock is calculated as the annual dividend divided by the current price. The annual dividend is $6 (6% of $100 par value), and the current price is $102. So, the yield is $6 / $102 = 5.9%.

Question 13

Using the constant dividend growth model for common stock, if P_o goes up

Accepted Answer

In the constant dividend growth model, if the price of the stock (P_o) increases while dividends and growth rate remain constant, the implied cost of equity (required rate of return) decreases.

Question 14

Using the constant growth model, a firm's expected (D₁) dividend yield is 4% of the stock price, and its growth rate is 5%. If the tax rate is .35%, what is the firm's cost of equity?

Accepted Answer

The answer of Using the constant growth model, a firm's...

Question 15

Why is the cost of debt normally lower than the cost of preferred stock?

Accepted Answer

Interest paid on debt is tax-deductible, which reduces the overall cost of borrowing for the company. Preferred stock dividends, on the other hand, are not tax-deductible, making the cost of preferred stock higher than the cost of debt.

Question 16

If the flotation cost goes up, the cost of retained earnings will

Accepted Answer

Flotation costs are associated with issuing new securities and do not affect the cost of retained earnings, which are profits reinvested in the company rather than distributed to shareholders.

Question 17

If flotation costs go down, the cost of new preferred stock will

Accepted Answer

When flotation costs go down, it becomes cheaper for a company to issue new preferred stock. Therefore, the cost of new preferred stock will go down.

Question 18

A firm's stock is selling for $65. The dividend yield is 6%. A 7% growth rate is expected for the common stock. The firm's tax rate is 40%. What is the firm's cost of retained earnings?

Accepted Answer

The answer of A firm's stock is selling for $65....

Question 19

A firm's stock is selling for $62. The next annual dividend is expected to be $3.00. The growth rate is 9%. The flotation cost is $5.00. What is the cost of retained earnings?

Accepted Answer

The cost of retained earnings can be calculated using the Gordon Growth Model: Cost of Retained Earnings = (Dividend / Current Stock Price) + Growth Rate = ($3.00 / $62) + 9% = 13.84%.

Question 20

The cost of equity capital in the form of new common stock will be higher than the cost of retained earnings because of

Accepted Answer

The cost of equity capital in the form of new common stock will be higher than the cost of retained earnings because of the existence of flotation costs. Flotation costs refer to the expenses incurred in issuing new securities, including underwriting fees, legal fees, and other administrative expenses. These costs increase the cost of new common stock as compared to the cost of retained earnings, which do not involve such expenses.

Quiz 11: Cost of Capital

In computing the cost of common equity, if D1 goes downward and Po goes up, Ke will