Deck 13: The Cost of Capital

Question 1

Milton Corp. issued bonds 10 years ago with a coupon rate of 10 percent at a price of $1,000. The current price of the bonds is $980. The before-tax cost of the debt to the firm is still 10 percent.

Answer 1

False

Question 2

Long-term debt is generally viewed as a permanent financing source for a firm.

Answer 2

True

Question 3

A firm is currently taking on two projects with an individual cost of capital of 10 percent and 12 percent for each of the projects. This means that the before-tax cost of capital for the firm must be between 10 and 12 percent.

Answer 3

False

Question 4

The finance balance sheet is based on market values, just like the accounting balance sheet.

Question 5

The historic cost of long-term debt is the appropriate cost of debt for WACC calculations.

Question 6

The beta of a firm is equal to the weighted-average sum of the betas of the individual projects that the firm is currently operating.

Question 7

If one observes the market quoted price of a debt security where the expected cash flows of that security are known, then one can calculate the current cost of that security to the firm.

Question 8

With respect to the cost of capital, we are generally interested in the current cost of a source of financing.

Question 9

The issuance costs of new debt securities can be ignored since those costs will not be reflected in the yield to maturity of the debt in the future.

Question 10

Using a firm's overall cost of capital to evaluate a project's cash flows is problematic in that the firm is a collection of projects, with the possibility that each project has a different level of risk than the other projects currently working for the firm.

Question 11

The current cost of bank debt of a firm can be determined by asking the firm's banker.

Question 12

Utilizing the CAPM to estimate the cost of capital for a project is difficult in practice because analysts do not have the stock returns from individual projects that are necessary to use in a regression analysis for estimating a project's beta.

Question 13

Long-term debt typically describes debt that will mature in two years or more.

Question 14

The yield to maturity for an annual coupon paying bond will always be equal to the coupon rate.

Question 15

If a firm finances the purchase of an asset with cash, then it has zero financial cost to the firm.

Question 16

Due to the effect of diversification, the risk associated with the assets of a firm must be less than the risk associated with the financing, or debt and equity that a firm is utilizing for its assets.

Question 17

If a firm is subject to income taxes, then the after-tax cost of debt for the firm will be less than the before-tax cost of debt.

Question 18

The yield to maturity is the discount rate that makes the present value of coupon and principal payments equal to the price of the bond.

Question 19

Systematic risk is the only risk that investors require compensation for bearing.

Question 20

If the market value of a firm's assets is greater than the book value of its assets then the book value of the firm's liabilities and equity must be less than the market value of the firm's liabilities and equity.

Question 21

The estimated cost of capital the financial manager uses for efficiency projects tends to be higher than the cost of capital used to evaluate new projects.

Question 22

If a company's weighted average cost of capital is less than the required return on equity, then the firm

A) is financed with more than 50% debt.
B) is perceived to be safe.
C) has debt in its capital structure.
D) must have preferred stock in its capital structure.

Question 23

The value of the cash flows that the assets of a firm are expected to generate must equal

A) the value of the cash flows claimed by the equity investors.
B) the value of the cash flows claimed by the debt investors.
C) the value of the cash flows claimed by both the equity and debt investors.
D) the revenue produced by the firm.

Question 24

The proportions of debt and equity used to determine the weighted average cost of capital for a firm is based on the market value of debt and equity outstanding.

Question 25

When trying to estimate the cost of equity for a firm using the CAPM, it is possible to find the beta of a comparable, publicly traded firm whose primary business is closely related to the firm.

Question 26

Firms have no way to directly estimate the discount rate that reflects the risk of

A) a publicly traded security.
B) its debt securities.
C) the incremental cash flows from a particular project.
D) None of the above

Question 27

Estimates of expected returns based on market security prices will be reliable in all types of markets, including those deemed less efficient than others.

Question 28

The cost of equity for a firm must take the cost of preferred stock (if any has been issued) that the firm has outstanding into account.

Question 29

The CAPM can only be used to determine the cost of common equity.

Question 30

The correctly calculated weighted average cost of capital for a firm can be used to discount the cash flows for any new project that the firm may undertake in the future.

Question 31

When using a single rate, such as the WACC, to discount cash flows for all projects of a particular company, the discount rate could lead to accepting projects that will actually have a negative NPV.

Question 32

If a firm is currently paying common share dividends to investors and those dividends are expected to grow at a low but steady rate in the future, then the cost of common equity for the firm can be calculated by using the current price of the firm's common shares.

Question 33

The beta for a firm can be estimated by

A) adding up the betas of the individual projects of the firm.
B) taking the weighted average of the betas for the individual projects of the firm.
C) taking the simple average of the betas for the individual projects of the firm.
D) None of the above

Question 34

The finance balance sheet is

A) the same as the accounting balance sheet, but it is based on market values.
B) the same as the accounting balance sheet, but it does not have to balance.
C) based on cash rather than accrual accounting.
D) the same as the accounting balance sheet, but it is based on historical values.

Question 35

In order for a firm to estimate its cost of debt capital by observing the price of its debt instruments,

A) the firm must depend on markets being reasonably efficient.
B) the debt must be privately held by the firm.
C) the beta of the debt must be greater than the beta of the firm's equity.
D) None of the above

Question 36

The market risk premium for the future is always perfectly known, and it is 6.51 percent.

Question 37

A firm can be viewed as

A) a portfolio of individual projects, each with its own risks, cost of capital, and returns.
B) a collection of equity shares comprising it.
C) a collection of debt instruments financing it.
D) a portfolio of all individual projects in the industry, each with its own risks, cost of capital, and returns.

Question 38

The correct Treasury rate to use in calculating the cost of equity (when using the CAPM) for a firm is a short-term rate.

Question 39

The current cost of preferred equity can be found by taking the ratio of the annual dividend on the preferred stock to the current price of preferred shares.

Question 40

A firm's overall cost of capital is

A) less than its cost of debt.
B) a weighted average of the costs of capital for the collection of individual projects that the firm is working on.
C) best measured by the cost of capital of the riskiest projects that the firm is working on.
D) None of the above

Question 41

Bellamee, Inc. has semiannual bonds outstanding with five years to maturity, and the bonds are priced at $920.87. If the bonds have a coupon rate of 7 percent, then what is the YTM for the bonds? Round your final percentage answer to two decimal places.

A) 4.5%
B) 7.0%
C) 9.0%
D) 9.2%

Question 42

Jacque Ewing Drilling, Inc. has a beta of 1.3.. If the risk-free rate of return is 8 percent and the expected return on the market is 12 percent, then what is the firm's after-tax cost of equity capital if the firm's marginal tax rate is 40 percent?

A) 7.92%
B) 13.20%
C) 15.57%
D) 23.60%

Question 43

PackMan Corporation has semiannual bonds outstanding with nine years to maturity and the bonds are currently priced at $754.08. If the bonds have a coupon rate of 7.25 percent, then what is the after-tax cost of debt for Beckham if its marginal tax rate is 30 percent? Round your intermediate calculation to two decimal places & final percentage answer to three decimal places.

A) 7.050%
B) 8.225%
C) 11.750%
D) 12.095%

Question 44

The appropriate risk-free rate to use when calculating the cost of equity for a firm is

A) a long-term Treasury rate.
B) a short-term Treasury rate.
C) an equal mix of short-term and long-term Treasury rates.
D) None of the above

Question 45

Which of the following need to be excluded from the calculation of a firm's amount of permanent debt?

A) Long-term debt
B) Revolving lines of credit
C) Mortgage debt
D) None of the above

Question 46

Radical VenOil, Inc. has a cost of equity capital equal to 22.8 percent. If the risk-free rate of return is 10 percent and the expected return on the market is 18 percent, then what is the firm's beta if the marginal tax rate is 35 percent?

A) 1.0
B) 1.28
C) 1.60
D) 4.10

Question 47

TeleNyckel, Inc. has a beta of 1.4. If the risk-free rate of return is 9 percent and the market risk premium is 5 percent, then what is the firm's after-tax cost of equity capital if the firm's marginal tax rate is 30 percent?

A) 11.20%
B) 10.60%
C) 15.14%
D) 16.00%

Question 48

The recommended model to estimate the cost of common equity for a firm is

A) the one-stage constant growth dividend model.
B) the multistage -growth dividend model.
C) the capital asset pricing model(CAPM).
D) None of the above

Question 49

Long-term debt typically describes

A) debt with a maturity greater than one year.
B) coupon debt only.
C) publicly traded debt.
D) None of the above

Question 50

When estimating the cost of debt capital for a firm, we are primarily interested in

A) the weighted average cost of capital.
B) the cost of long-term debt.
C) the coupon rate of the debt.
D) None of the above

Question 51

If markets are not reasonably efficient, then

A) the estimates of expected returns are not needed.
B) the need for a discount rate to analyze project cash flows is not needed.
C) estimates of expected returns based on security prices will not be reliable.
D) None of the above

Question 52

The average risk-premium for the market from 1926 to 2012 was

A) 8.00%.
B) 7.50%.
C) 5.71% .
D) 6.51% + the Treasury rate.

Question 53

When analyzing a firm's cost of debt, we are typically interested in

A) the cost of the debt on the date that the analysis is being completed.
B) the coupon rate on the firm's bonds.
C) the cost of the debt and cost of preferred stock on the date that the analysis is being completed.
D) None of the above

Question 54

If a firm has bonds outstanding and the firm would like to calculate the current cost of debt for the bonds, then the firm would

A) use the coupon rate of the bonds to estimate the cost.
B) use the current yield to maturity of the bonds to estimate the cost.
C) use the current coupon yield of the bonds to estimate the cost.
D) None of the above

Question 55

A recent leveraged buyout was financed with $50M: $12M in equity capital, $20M unsecured debt borrowed at 7% from one bank, and the remaining debt from another bank at 8.5% of, ,. What is the overall after-tax cost of the debt financing if the firm's marginal tax rate is 33%?

A) 2.55%
B) 3.34%
C) 5.17%
D) 7.71%

Question 56

A bond has a coupon rate of 6 percent and the bond makes semiannual coupon payments. The dollar amount of coupon interest received every six months is

A) $60.
B) $30.
C) $30 plus or minus the prorated portion of the discount or premium that the bond was purchased for.
D) $60 plus or minus the prorated portion of the discount or premium that the bond was purchased for.

Question 57

Bond issuance costs include

A) investment banking fees.
B) legal fees.
C) accountant fees.
D) All of the above

Question 58

Beckham Corporation has semiannual bonds outstanding with 13 years to maturity and the bonds are currently priced at $746.16. If the bonds have a coupon rate of 8.5 percent, then what is the after-tax cost of debt for Beckham if its marginal tax rate is 35%? Round your intermediate calculation to two decimal places & final percentage answer to three decimal places.

A) 6.250%
B) 8.125%
C) 12.500%
D) 12.890%

Question 59

Income taxes have the effect of

A) increasing the cost of debt for a firm.
B) decreasing the cost of debt for a firm.
C) decreasing the cost of equity for a firm.
D) Both B and C are correct

Question 60

Dynamo Corporation has semiannual bonds outstanding with 12 years to maturity, and the bonds are currently priced at $1,080.29. If the bonds have a coupon rate of 8 percent, then what is the equivalent annual return (EAR) to the investor for purchasing the bonds at the described price? Round your final percentage answer to two decimal places.

A) 3.5%
B) 7.00%
C) 7.12%
D) 8.00%

Question 61

The Diverse Co. has invested 40 percent of the firm's assets in a project with a beta of 0.4 and the remaining assets in a project with a beta of 1.8. What is the beta of the firm?

A) 0.96
B) 1.24
C) 1.28
D) None of the above

Question 62

Wally's War Duds has a preferred share issue outstanding with a current price of $26.57. The firm is expected to pay a dividend of $1.86 per share a year from today. What is the firm's cost of preferred equity? Round your final answer to nearest percentage.

A) 6.50%
B) 7.00%
C) 7.50%
D) 8.00%

Question 63

Maloney's, Inc. has found that its cost of common equity capital is 17 percent and its cost of debt capital is 6 percent. The firm is financed with $3,000,000 of common shares (market value) and $2,000,000 of debt. What is the after-tax weighted average cost of capital for Maloney's, if it is subject to a 40 percent marginal tax rate?

A) 8.96%
B) 11.16%
C) 11.64%
D) 12.60%

Question 64

Oasis, Inc. has common shares with a price of $21.12 per share. The firm is expected to pay a dividend of $1.75 one year from today, and dividends are expected to grow at 10 percent for two years after that and then at 5 percent thereafter. What is the implied cost of common equity capital for Oasis? Round your final answer to nearest percentage.

A) 13%
B) 14%
C) 15%
D) 16%

Question 65

Melba's Toast has a preferred share issue outstanding with a current price of $19.50. The firm is expected to pay a dividend of $2.34 per share a year from today. What is the firm's
Cost of preferred equity?

A) 11.50%
B) 11.75%
C) 12.00%
D) 12.25%

Question 66

Tranquility, Inc. has common shares with a price of $18.37 per share. The firm paid a dividend of $1.50 yesterday, and dividends are expected to grow at 9 percent for three years and then at 2 percent thereafter. What is the implied cost of common equity capital for Tranquility? Round your final percentage answer to 1 decimal place.

A) 9.5%
B) 10.5%
C) 11.5%
D) 12.5%

Question 67

Ronnie's Comics has found that its cost of common equity capital is 15 percent and its cost of debt capital is 12 percent. The firm is financed with $250,000,000 of common shares (market value) and $750,000,000 of debt. What is the after-tax weighted average cost of capital for Ronnie's, if it is subject to a 35 percent marginal tax rate?

A) 6.05%
B) 9.6%
C) 8.75%
D) 13.65%

Question 68

In order to use a firm's WACC to evaluate its future project's flows, which of the following must hold?

A) The project will be financed with the same proportion of debt and equity as the firm.
B) The systematic risk of the project is the same as the overall systematic risk of the firm.
C) The project should have conventional cash flows.
D) Both A and B above

Question 69

UltraFlex Diving Boards, Inc. just paid a dividend of $1.50. If the firm's growth in dividends is expected to remain at a flat 4 percent forever, then what is the cost of equity capital for Ultra Flex Diving Boards if the price of its common shares is currently $26.00?

A) 5.77%
B) 6.00%
C) 9.77%
D) 10.00%

Question 70

What is the beta of a firm whose equity has an expected return of 21.3 percent when the risk-free rate of return is 7.0 percent and the expected return on the market is 18.0 percent?

A) 0.79
B) 1.30
C) 1.57
D) None of the above

Question 71

Gangland Water Guns, Inc. is expected to pay a dividend of $2.10 one year from today. If the firm's growth in dividends is expected to remain at a flat 3 percent forever, then what is the cost of equity capital for Gangland if the price of its common shares is currently $17.50?

A) 12.00%
B) 14.65%
C) 15.00%
D) 15.36%

Question 72

If the market risk premium is currently 6 percent and the risk-free rate of return is 4 percent, then what is the expected return on a common share with a beta equal to 2?

A) 8.0%
B) 10.0%
C) 12.0%
D) 16.0%

Question 73

Swirlpool, Inc. has found that its cost of common equity capital is 18 percent, and its cost of debt capital is 8 percent. The firm is financed with 60 percent common shares and 40 percent debt. What is the after-tax weighted average cost of capital for Swirlpool, if it is subject to a 40 percent marginal tax rate?

A) 10.37%
B) 12.00%
C) 12.72%
D) 14.00%

Question 74

The WACC for a firm is 13.00 percent. You know that the firm's cost of debt capital is 10 percent and the cost of equity capital is 20%. What proportion of the firm is financed with debt? Assume the firm pays no tax..

A) 30%
B) 33%
C) 50%
D) 70%

Question 75

The WACC for a firm is 19.75 percent. You know that the firm is financed with $75 million of equity and $25 million of debt. The cost of debt capital is 7 percent. What is the cost of equity for the firm? Assume the firm pays no tax..

A) 19.75%
B) 24.00%
C) 32.50%
D) 58.00%

Question 76

Turquoise Electronics, Inc. paid a dividend of $1.87 last year. If the firm's growth in dividends is expected to be 10 percent next year and then zero thereafter, then what is its cost of equity capital if the price of its common shares is currently $25.71?

A) 7.27%
B) 8.00%
C) 18.00%
D) The problem is not solvable with the information that is given.

Question 77

Billy's Goat Coats has a preferred share issue outstanding with a current price of $38.89. The firm last paid a dividend on the issue of $3.50 per share. What is the firm's cost of preferred equity? Round your final answer to nearest percentage.

A) 7%
B) 8%
C) 9%
D) 10%

Question 78

The Dedus Shoes, Inc. has common shares with a price of $28.76 per share. The firm paid a dividend of $1.00 yesterday, and dividends are expected to grow at 10 percent for two years and then at 5 percent, thereafter. What is the implied cost of common equity capital for Dedus? Round your final percentage answer to 1 decimal place.

A) 7.00%
B) 8.00%
C) 9.00%
D) 10.00%

Question 79

You are analyzing the cost of capital for a firm that is financed with $300 million of equity and $200 million of debt. The cost of debt capital for the firm is 9 percent, while the cost of equity capital is 19 percent. What is the overall cost of capital for the firm? Assume the firm pays no tax.

A) 13.0%
B) 14.0%
C) 15.0%
D) 16.0%

Question 80

Stryder, Inc. has 3 million shares outstanding at a current price of $15 per share. The book value of the shares is $10 per share. The firm also has $30 million in par value of bonds outstanding. The bonds are selling at a price equal to 101 percent of par. What is the market value of the firm?

A) $30.0 million
B) $45.0 million
C) $75.0 million
D) $75.3 million