Question 1

The fact that the after-tax cost of debt is lower than the pretax cost of debt implicitly assumes that interest expense can be ________.

Accepted Answer

Interest expense can be deducted from taxable income, effectively reducing the amount of tax a company has to pay. This deduction lowers the after-tax cost of debt compared to the pretax cost.

Question 2

The outstanding debt of Berstin Corp. has five years to maturity, a current yield of 6%, and a price of $95. What is the pretax cost of debt if the tax rate is 30%.

Accepted Answer

C) Current yield = coupon / price;
0.06 = coupon / 95; hence, coupon = 0.06 × 95 = 5.7.
yield to maturity = pretax cost of debt;
using financial calculator, -95 PV, 100 FV, 5.7 PMT, 5 N, CPT I = 6.9%

Question 3

A firm has $2 million market value and it sells preferred stock with a par value of $100. If the coupon rate on the preferred stock is 6% and the preferred stock trades at $98, what is the cost of preferred stock capital?

Accepted Answer

B) 11eaabab_c07e_e3a7_b90e_2f4a05fe36fd_TB5536_00 Cost of preferred stock capital = (6% × $100) / $98 = 6.12%

Question 4

A firm incurs $35,000 in interest expenses each year. If the tax rate of the firm is 30%, what is the effective after-tax interest rate expense for the firm?

Accepted Answer

B) 11eaabab_c07f_a6ff_b90e_436e869e8421_TB5536_00 11eaabab_c07f_a700_b90e_9b36038e8f74_TB5536_00

Question 5

A firm has a pre-tax cost of debt of 9.0%. If the firm has a marginal tax rate of 35%, what is its effective cost of debt?

Accepted Answer

A) 9.0% × (1 - 0.35) = 5.9%

Question 6

An all-equity firm had a dividend expense of $45,000 last year. The market value of the firm is $800,000 and the dividend is expected to increase at 7% each year. What is the cost of equity for this firm?

Accepted Answer

C) 11eaabab_c07f_31cb_b90e_b3657c6e66ad_TB5536_00 Cost of equity = ($45,000 × (1 + 0.07) / $800,000) + 0.07 = 13.02%

Question 7

Which of the three costs-debt, preferred stock and common equity-is most difficult to estimate?

Accepted Answer

The answer of Which of the three costs-debt, preferred stock...

Question 8

An all-equity firm had a dividend expense of $20,000 last year. The market value of the firm is $600,000 and the dividend is expected to increase at 5% each year. What is the cost of equity for this firm?

Accepted Answer

C) Cost of equity = Dividend (in one year) / Current Price + Dividend Growth Rate
Cost of equity = ($20,000 × (1 + 0.05) / $600,000 )+ 0.05 = 8.50%

Question 9

Among the two models Constant Dividend Growth Model (CDGM) and Capital Asset Pricing Model (CAPM), which is a better method for computation of the cost of equity?

Accepted Answer

The answer of Among the two models Constant Dividend Growth...

Question 10

The outstanding debt of Berstin Corp. has ten years to maturity, a current yield of 7%, and a price of $95. What is the pretax cost of debt if the tax rate is 30%.

Accepted Answer

D) Current yield = coupon / price;
0.07 = coupon / 95; hence, coupon = 0.07 × 95 = 6.65;
yield to maturity = pretax cost of debt;
using a financial calculator, -95 PV, 100 FV, 6.65 PMT, 10 N, CPT I = 7.37%

Question 11

A firm has $1 million market value and it sells preferred stock with a par value of $100. If the coupon rate on the preferred stock is 5% and the preferred stock trades at $91, what is the cost of preferred stock capital?

Accepted Answer

D) 11eaabab_c07e_e3a6_b90e_21cefff2c5d2_TB5536_00 Cost of preferred stock capital = (5% × $100) / $91 = 5.49%

Question 12

A firm incurs $70,000 in interest expenses each year. If the tax rate of the firm is 30%, what is the effective after-tax interest rate expense for the firm?

Accepted Answer

C) 11eaabab_c07f_a701_b90e_05d5929c541a_TB5536_00 11eaabab_c07f_a702_b90e_718917f082a7_TB5536_00

Question 13

The outstanding debt of Berstin Corp. has eight years to maturity, a current yield of 7%, and a price of $85. What is the pretax cost of debt if the tax rate is 40%?

Accepted Answer

C) Current yield = Coupon / Price;
0.07 = Coupon / $85; hence, Coupon = 0.07 × $85 = $5.95.
Yield to maturity = Pretax cost of debt; 11eaabab_c07f_58dc_b90e_65875b6ccba3_TB5536_00

Question 14

A firm incurs $40,000 in interest expenses each year. If the tax rate of the firm is 30%, what is the effective after-tax interest rate expense for the firm?

Accepted Answer

D) 11eaabab_c07f_7fed_b90e_1d219976834a_TB5536_00 11eaabab_c07f_7fee_b90e_e71ee7116f05_TB5536_00

Question 15

A firm has $3 million market value and it sells preferred stock with a par value of $100. If the coupon rate on the preferred stock is 8% and the preferred stock trades at $92, what is the cost of preferred stock capital?

Accepted Answer

B) 11eaabab_c07f_0ab8_b90e_0b723cf67833_TB5536_00 Cost of preferred stock capital = (8% × $100) / $92 = 8.70%

Question 16

Should a firm with high retained earnings have a lower cost of equity?

Accepted Answer

The answer of Should a firm with high retained earnings...

Question 17

What is the difference between the effective cost of debt and the cost of debt?

Accepted Answer

The answer of What is the difference between the effective...

Question 18

Is it incorrect to use the coupon rate of debt toward cost of debt?

Accepted Answer

The answer of Is it incorrect to use the coupon...

Question 19

The after-tax cost of debt ________ the before-tax cost of debt for a firm that has a positive marginal tax rate.

Accepted Answer

The after-tax cost of debt is always less than the before-tax cost of debt for a firm that has a positive marginal tax rate because the interest paid on the debt is tax-deductible, thus reducing the amount of taxable income and resulting in a lower effective cost of debt.

Question 20

An all-equity firm had a dividend expense of $30,000 last year. The market value of the firm is $900,000 and the dividend is expected to increase at 6% each year. What is the cost of equity for this firm?

Accepted Answer

A) Cost of equity = 11eaabab_c07f_0ab9_b90e_7f5876b383b9_TB5536_00 11eaabab_c07f_31ca_b90e_af596e81a308_TB5536_00

Quiz 13: The Cost of Capital