Deck 14: The Cost of Capital

Question 1

For firms subject to the 40% marginal tax rate, the after-tax cost of ____ is roughly three-fifths the cost of preferred stock.

A) retained earnings
B) new common stock
C) long-term debt
D) None of these are correct

Answer 1

C

Question 2

The total return to stockholders, k_e, is composed of the ____.

A) opportunity cost plus a risk premium
B) dividend yield plus the price appreciation of the security
C) opportunity cost plus an inflation premium
D) dividend yield minus the risk premium

Answer 2

B

Question 3

The most appropriate weights to use in calculating a firm's cost of capital are the proportions of the components in the firm's ____ capital structure.

A) historical average
B) long-range target
C) current
D) industry average

Answer 3

B

Question 4

If a firm is losing money then the after-tax cost of debt is ____.

A) equal to k_d(1 - T)
B) found by trial and error
C) equal to the pretax cost of debt
D) equal to the yield to first call date

Question 5

A firm can raise up to $700 million for investment from a mixture of debt, preferred stock and retained equity. Above $700 million, the firm must issue new common stock. Assuming that debt costs and preferred stock costs remain unchanged, the marginal cost of capital for amounts up to $700 million will be ____ the marginal cost of capital for amounts over $700 million.

A) less than
B) equal to
C) greater than
D) Cannot be determined from the information given

Question 6

Studies analyzing the historical returns earned by common stock investors have found that the returns from average risk common stock investments over very long time periods have averaged approximately ____ percentage points ____ than holding period returns on corporate debt issues.

A) 7.5; higher
B) 7.5; lower
C) 5.7; lower
D) 5.7; higher

Question 7

The cost of internal common equity is represented in financial formulas as ____.

A) k_i
B) k_d
C) k'_e
D) k_e

Question 8

The cost of equity capital for non-dividend paying stocks can be determined by ____.
I. using the Capital Asset Pricing Model
II. estimating k_e for comparable dividend-paying stocks in their industry

A) Only statement I is correct.
B) Only statement II is correct.
C) Both statements I and II are correct.
D) Neither statement I nor II is correct.

Question 9

The CAPM assumes that the only risk of concern to the investor is ____, which is measured by ____.

A) unsystematic risk; beta
B) systematic risk; the return to the market portfolio
C) systematic risk; beta
D) unsystematic risk; the return to the market portfolio

Question 10

All of the following methods may be used to determine the cost of equity capital (k_e) for a non-dividend-paying stock EXCEPT ____.

A) the risk premium on debt approach
B) the Capital Asset Pricing Model approach
C) comparing with similar dividend-paying stocks in the industry
D) the simulation with growth expectations approach

Question 11

The cost of capital is ____.

A) the rate of return required by investors in the firm's securities
B) the minimum rate of return required on new investments of high risk undertaken by the firm
C) approximately 10 percent for most firms
D) concerned with plant and equipment only

Question 12

For a company that is not planning to change its target capital structure, the proportions of debt and equity used in calculating the weighted cost of capital should be based on the current ____ value weights of the individual components.

A) book
B) market
C) replacement
D) accounting

Question 13

If a preferred stock is callable, then the calculation of the cost of preferred stock financing is ____.

A) similar to that for bonds
B) equal to D_p/P_n
C) equal to D_p less flotation costs
D) less than D_p/P_n

Question 14

The historic beta of a firm is of little use as a forecast of the firm's future systematic risk characteristics when the firm is ____.

A) growing at a rate of 7-10 percent a year
B) expanding an existing product line
C) expanding into a new product line
D) All of these are correct

Question 15

The required rate of return on any security consists of a(n) ____.

A) risk premium plus an expected inflation rate
B) risk free rate plus a risk premium
C) inflation rate plus a marketability premium
D) risk free rate plus an inflation premium

Question 16

The constant growth valuation model approach to calculating the cost of equity assumes that ____.

A) earnings and dividends grow at a constant rate, but stock price growth is indeterminate
B) the growth rate is greater than or equal to k_e
C) dividends are constant
D) earnings, dividends, and stock price will grow at a constant rate

Question 17

Break points can be determined by dividing the amount of funds available from each financing source at a fixed cost by the ____ capital structure proportion for that financing source.

A) weighted
B) target
C) economic
D) divisional

Question 18

The cost of external common equity is represented in financial formulas as ____.

A) k_i
B) k_d
C) k'_e
D) k_e

Question 19

If a firm adopts a large proportion of above-average-risk investment projects that are not offset by below-average-risk investment projects, ____.

A) its cost of capital will rise
B) the average risk premium for the firm will decline
C) the risk-free rate will increase as more risk is added
D) its cost of capital will fall

Question 20

There are four major components that determine the risk premium. They include all of the following EXCEPT ____ risk.

A) marketability
B) business
C) reinvestment rate
D) financial

Question 21

Determine the (after-tax) percentage cost of a $50 million debt issue that the Mattingly Corporation is planning to place privately with a large insurance company. Assume that the company has a 40% marginal tax rate. This long-term debt issue will yield 12% to the insurance company.

A) 4.8%
B) 7.2%
C) 12.0%
D) 10.6%

Question 22

Historic average capital costs are ____ making new (marginal) resource allocation decisions.

A) not relevant for
B) very useful when
C) necessary for
D) the relevant costs for

Question 23

Rank in ascending order (lowest to highest) investors' required rates of return on the various types of corporate securities.

A) preferred stock, corporate debt, common stock
B) common stock, preferred stock, corporate debt
C) preferred stock, common stock, corporate debt
D) corporate debt, preferred stock, common stock

Question 24

The cost of depreciation-generated funds is equal to ____.

A) the cost of equity capital
B) zero, because depreciation is a non-cash expense
C) the investment opportunity cost
D) the weighted cost of capital

Question 25

The optimal capital budget is indicated by the point at which the ____ and the ____ intersect.

A) depreciation schedule; investment opportunity schedule
B) investment opportunity curve; marginal cost of capital curve
C) investment opportunity curve; average cost of capital curve
D) efficient portfolio curve; marginal cost of capital curve

Question 26

The Allegheny Valley Power Company common stock has a beta of 0.80. Assume the current risk-free rate is 6.5% and the expected return on the stock market as a whole is 16%, determine the cost of equity capital for the firm (using the CAPM).

A) 14.1%
B) 7.6%
C) 6.5%
D) 13.0%

Question 27

The pretax cost of debt is represented in financial formulas as ____.

A) k_i
B) k_d
C) k'_e
D) ​k_e

Question 28

Retained earnings are a cheaper source of funds than the sale of new equity because ____.

A) retention defers the payment of taxable dividends to shareholders
B) there are no flotation costs
C) new shares are usually priced below current market price
D) All of these are correct

Question 29

It is difficult for small firms to apply for the dividend valuation model because ____.

A) the dividend valuation model depends on the Capital Asset Pricing Model, which small firms cannot use
B) of limited access to the capital markets for new equity
C) of prohibitively high common stock issuance costs
D) small firms often pay little or no dividends

Question 30

If a firm sells assets, generating cash flows, the cost of these funds is ____.

A) the firm's cost of equity
B) the firm's cost of cash flows
C) the firm's weighted cost of capital
D) zero

Question 31

The following financial information is available on Rawls Manufacturing Company: $\begin{array}{ll}\text {Current per share market price }& \$48.00\\\text { Current \( (t=0) \) per share dividend}&\$3.50 \\\text {Expected long-term growth rate }&5.0\% \\\end{array}$
? Rawls can issue new common stock to net the company $44 per share. Determine the cost of internal equity capital using the dividend capitalization model approach. (Compute answer to the nearest 0.1%.)

A) 12.3%
B) 13.4%
C) 13.0%
D) 12.7%

Question 32

The after-tax cost of debt is represented in financial formulas as ____.

A) k_i
B) k_d
C) k'_e
D) ​k_e

Question 33

Which of the following statements is true concerning companies that do not pay dividends?

A) The cost of equity capital can be estimated using the Capital Asset Pricing Model.
B) The cost of equity capital is equal to the growth short-term rate of earnings per share.
C) The dividend capitalization model can be used to determine an accurate cost of equity capital.
D) None of these are correct

Question 34

During the 1980s, the cost of capital for U.S. firms averaged about 3.3 percentage points higher than Japanese firms. During 1990 this disadvantage may have disappeared due to ____.

A) higher exports to the United States
B) higher real interest rates in Japan
C) larger shareholder interest
D) higher Japanese stock market

Question 35

Rank in ascending order (lowest to highest) the relative riskiness of the various types of corporate and government securities.

A) common stock, preferred stock, corporate debt, long-term government debt
B) corporate debt, long-term government debt, preferred stock, common stock
C) long-term government debt, corporate debt, preferred stock, common stock
D) corporate debt, preferred stock, long-term government debt, common stock

Question 36

The optimal capital budget is determined by comparing the expected project returns to the company's ____.

A) computed break points
B) cost of equity schedule
C) marginal cost of capital schedule
D) optimal opportunity curve

Question 37

Small firms are reluctant to obtain capital through the sale of common stock because of ____.

A) potential loss of voting control
B) high issuance costs
C) high cost of debt
D) All of these are correct

Question 38

Calculate the after-tax cost of preferred stock for Ohio Valley Power Company, which is planning to sell $100 million of $3.25 cumulative preferred stock to the public at a price of $25 per share. Flotation costs are $1.00 per share. Ohio Valley has a marginal income tax rate of 40%.

A) 13.0%
B) 7.8%
C) 8.12%
D) 13.54%

Question 39

Which of the following is NOT a typical source of debt funds for a small firm?

A) investment banking firms
B) commercial finance companies
C) Small Business Administration
D) leasing companies

Question 40

The cost of external equity is greater than the cost of internal equity because ____.

A) it decreases the earnings per share
B) it increases the market price of the stock
C) of the flotation costs
D) dividends are increased

Question 41

The following financial information is available on Rawls Manufacturing Company: $$\begin{array} { l r } \text { Current per share market price } & \$ 48.00 \\\text { Current per share dividend } & \$ 3.50 \\\text { Current per share earnings } & \$ 6.00 \\\text { Beta } & 12.0 \% \\\text { Expected rate of return on market } & 6.0 \% \\\text { Risk-free rate } & 5.0 \%\end{array}$$ ? Rawls can issue new common stock to net the company $44 per share. Determine the cost of external equity capital using the dividend capitalization model approach. (Compute answer to the nearest 0.1%.)

A) 12.7%
B) 14.4%
C) 12.6%
D) 13.4%

Question 42

Crickentree has a target capital structure of 30% debt and 70% equity. If the firm expects to have a net income of $1.7 million and a dividend payout ratio of 40%, what will be its equity break point?

A) $2,428,571
B) $1,457,143
C) $3,400,000
D) $971,429

Question 43

A firm with a 40% marginal tax rate has a capital structure of $60,000,000 in debt and $140,000,000 in equity. What is the firm's weighted cost of capital if the marginal pretax cost of debt is 12%, the firm's average pretax cost of debt outstanding is 8%, and the cost of equity is 14.5%?

A) 13.75%
B) 11.59%
C) 12.31%
D) 10.45%

Question 44

PDQ Inc. has a weighted cost of capital of 14.6% and has an opportunity to invest in the following average risk projects: $\begin{array}{lllc}\text { Project } & \text { Cost } & \text { Annual Cost Flow } & \text { Project life } \\1 & \$ 10,000 & \$ 1,992.43 & 10 \text { years } \\2 & \$ 21,000 & \$ 4,526.84 & 8 \text { years } \\3 & \$ 18,500 & \$ 4,580.34 & 7 \text { years }\end{array}$ ? In which projects should PDQ invest? Assume no capital rationing.

A) 1 and 2 only
B) 2 and 3 only
C) 1 and 3 only
D) Cannot be determined from the information provided

Question 45

Alpha Products maintains a capital structure of 40% debt and 60% common equity. To finance its capital budget for next year, the firm will sell $50 million of 11% debentures at par and finance the balance of its $125 million capital budget with retained earnings. Next year Alpha expects net income to grow 7% to $140 million, and dividends also are expected to increase 7% to $1.40 per share and to continue growing at that rate for the foreseeable future. The current market value of Alpha's stock is $30. If the firm has a marginal tax rate of 40%, what is its weighted cost of capital for the coming year?

A) 9.64%
B) 8.63%
C) 9.84%
D) 11.67%

Question 46

Witin's stock price is currently $34.25, and the current quarterly dividend is $0.25. Consensus estimates for Witin indicate a growth rate in earnings of 10% into the foreseeable future. If Witin plans to sell 1 million shares to raise new capital for expansion, what is the cost of new equity if the issuance costs are 8%?

A) 13.49%
B) 10.87%
C) 13.21%
D) 13.17%

Question 47

Pluega Inc. issued a $100 million 8.27% coupon debenture bond due in the next 20 years. The bonds each sold for $996. If the bonds pay interest semi-annually, what is Pluega's after cash cost of debt? Assume 40% tax rate.

A) 4.96%
B) 8.30%
C) 4.99%
D) 3.32%

Question 48

Haulsee Inc. pays no dividend currently but is expected to start paying a small dividend next year. The 5-year-old firm has a beta of 1.25 and current earnings of $0.90 per share. The current Treasury bill rate is 6.10%, and the market risk premium is 8.8%. Determine Haulsee's cost of equity if the firm's tax rate is 40%.

A) 9.48%
B) 17.1%
C) 14.9%
D) Cannot determined from the information provided

Question 49

What is the cost of equity for East Roon if the firm is expected to always pay a constant dividend of $2.22? The firm's common stock is presently selling for $18.50.

A) 8.3%
B) 12.0%
C) 10.2%
D) Cannot be determined from the information given

Question 50

Northeast Airlines (NA) has a current dividend of $1.80. Dividends are expected to grow at a rate of 7% a year into the foreseeable future. What is NA's cost of external equity if its stock can be sold to net $46 a share?

A) 10.9%
B) 11.2%
C) 7.2%
D) 21.0%

Question 51

The following financial information is available on Rawls Manufacturing Company: $$\begin{array} { l r } \text { Current per share market price } & \$ 48.00 \\\text { Beta } & 1.1 \\\text { Expected rate of return on market } & 12.0 \% \\\text { Risk-free rate } & 6.0 \%\end{array}$$ ? Rawls can issue new common stock to net the company $44 per share. Determine the cost of internal equity capital using the capital asset pricing model approach. (Compute answer to the nearest 0.1%.)

A) 12.9%
B) 12.6%
C) 13.0%
D) 11.8%

Question 52

Groves Inc. pays an annual dividend of $1.22. This dividend is expected to continue growing at a rate of about 5% each year. The firm is in a fairly risky business and has a beta of 1.45. The expected market rate of return is 13.5%, and the risk-free rate is 9.3%. What is the cost of equity for Groves?

A) 19.6%
B) 13.5%
C) 15.4%
D) 6.1%

Question 53

What is the cost of a preferred stock with a $100 par value that pays a $9.60 dividend per year? The security has a flotation cost of $3.37 and will be retired at its par value in 20 years.

A) 9.6%
B) 9.9%
C) 10.0%
D) 10.6%

Question 54

According to Value Line, Bestway has a beta of 1.15. If 3-month Treasury bills currently yield 7.9% and the market risk premium is estimated to be 8.3%, what is Bestway's cost of equity capital?

A) 17.45%
B) 8.36%
C) 9.55%
D) 16.2%

Question 55

Easy Slider Inc. sold a 15-year $1,000 face value bond with a 10% coupon rate. Interest is paid annually. After flotation costs, Easy Slider received $928 per bond. Compute the after-tax cost of debt for these bonds if the firm's marginal tax rate is 40%.

A) 6.0%
B) 7.2%
C) 7.8%
D) 6.6%

Question 56

GQ earned $740,000 before taxes this year. The firm has a debt ratio of 30%, a marginal tax rate of 35%, and a dividend payout ratio of 40%. GQ has no preferred stock. What is GQ's break point for equity?

A) $634,286
B) $962,000
C) $412,286
D) $288,600

Question 57

Determine the weighted cost of capital for the Mills Company that will finance its optimal capital budget with $120 million of long-term debt (k_d = 12.5%) and $180 million in retained earnings (k_e = 16.0%). Mills' present capital structure is considered optimal. The company's marginal tax rate is 40%. (Compute answer to nearest 0.1%.)

A) 14.3%
B) 12.6%
C) 14.6%
D) 11.9%

Question 58

Weltron has a target capital structure of 35% debt and 65% equity. If the firm expects net income of $12.3 million and an annual dividend of $0.12 per share, what is the expected equity break point? There are 12 million shares outstanding.

A) $18,923,076
B) $16,707,692
C) $10,061,538
D) $2,215,385

Question 59

Wellington Gas has a target capital structure of 50% common equity, 40% debt, and 10% preferred stock. The cost of retained earnings is 16%, and the cost of new equity (external) is 16.7%. Wellington can sell debentures that will have an after-tax cost of 8.3% and the after-tax cost of preferred stock will be 11.9%. What is the marginal cost of capital before and after the break point?

A) 12.51% and 12.86%
B) 11.18% and 11.53%
C) 14.23% and 14.68%
D) 12.51% and 11.53%

Question 60

Mid-South Utilities will sell $10 million of $100 par value preferred stock that will pay an annual dividend of $9.75. Mid-South will receive $93.98 per share after flotation costs. If the issue must be retired in 20 years, what is the cost of the preferred issue?

A) 10.37%
B) 10.50%
C) 10.23%
D) 9.75%

Question 61

There are two primary ways that capital is raised. Which of the following statements is (are) correct?
I. Capital is raised internally by using retained earnings.
II. Capital is raised externally by selling fixed assets.

A) Only statement I is correct.
B) Only statement II is correct.
C) Both statements I and II are correct.
D) Neither statement I nor II is correct.

Question 62

Heleveton Industries is 100% equity financed. Its current beta is 1.1. The expected market risk premium is 8.5%, and the risk-free rate is 4.2%. If Heleveton changes its capital structure to 25% debt, it estimates its beta will increase to 1.2. If the after-tax cost of debt will be 6%, should Heleveton make the capital structure change?

A) Yes, cost of capital decreases by 2.52%
B) Yes, cost of capital decreases 1.67%
C) No, stock price would decrease due to increased risk
D) No, cost of capital increases by 0.85%

Question 63

Whipple Industries Inc. is in the process of determining its optimal capital budget for next year. The following investment projects are under consideration: $\begin{array}{lll}& \text { Required } & \text { Expected Rate } \\\text { Project } & \text { Investment } & \text { of Retum }\\\text { A } & \$ 2 \text { million } & 20.0 \% \\\mathrm{~B} & \$ 3 \text { million } & 15.0 \% \\\mathrm{C} & \$ 1 \text { million } & 13.5 \% \\\mathrm{D} & \$ 4 \text { million } & 13.0 \% \\\mathrm{E} & \$ 1 \text { million } & 12.5 \% \\\mathrm{~F} & \$ 3 \text { million } & 12.0 \% \\\mathrm{G} & \$ 5 \text { million } & 11.5 \%\end{array}$ ? The firm's marginal cost of capital schedule is as follows: $\begin{array}{ll}\text { Amount of }\\\text { Funds Raised } & \text { Cost } \\\$ 0-\$ 6 \text { million } & 12.0 \% \\\$ 6 \text { million - } \$ 12 \text { million } & 12.5 \% \\\$ 12 \text { million }-\$ 18 \text { million } & 13.5 \% \\\text { Over } \$ 18 \text { million } & 15.0 \%\end{array}$ ?
Determine Whipple's optimal capital budget (in dollars) for the coming year.

A) $11 million
B) $10 million
C) $5 million
D) $14 million

Question 64

Sadaplast has a target capital structure of 65% common equity, 30% debt, and 5% preferred stock. The cost of retained earnings is 14%, and the cost of new equity is 15.5%. Sadaplast expects to have a net income of $85 million in the coming year. If the firm sells bonds, up to $25 million can be sold at par value to yield an after-tax cost of 5.4%. An additional $20 million of debentures could be sold to yield an after-tax cost of 7.0%. The after-tax cost of preferred stock financing is estimated to be 11%. Sadaplast has a dividend payout ratio of 25%. What is Sadaplast's cost of capital between the first and second break points?

A) 12.25%
B) 11.27%
C) 11.75%
D) 12.73%

Question 65

Mid-States Utility Company just issued a $3.20 cumulative preferred stock at a price to the public of $30 a share. The flotation costs were $1.50 a share, and the issue will be retired in 20 years at its $30 par value. What is the cost of this preferred issue?

A) 11.3%
B) 10.3%
C) 10.7%
D) 11.6%

Question 66

Columbia Gas Company's (CG) current capital structure is 35% debt and 65% equity. This year CG has earnings after tax of $5.31 million and is paying $1.6 million in dividends. To finance a transmission pipe line, CG can borrow $2 million at a cost of 10%, the same rate that CG is currently paying on a total of $15 million long-term debt. CG has 1,000,000 shares outstanding, and its current market price is $31. If CG's long-term growth rate of dividends is expected to be 8%, what is the weighted cost of capital for the firm? Assume a marginal tax rate of 40%.

A) 10.9%
B) 13.6%
C) 19.6%
D) 16.9%

Question 67

Wright Express (WE) has a capital structure of 30% debt and 70% equity. WE is considering a project that requires an investment of $2.6 million. To finance this project, WE plans to issue 10-year bonds with a coupon interest rate of 12%. Each of these bonds has a $1,000 face value and will be sold to net WE $980. If the current risk-free rate is 7% and the expected market return is 14.5%, what is the weighted cost of capital for WE? Assume WE has a beta of 1.20 and a marginal tax rate of 40%.

A) 14.9%
B) 12.4%
C) 13.4%
D) 16.0%

Question 68

Zappin' Skeeters Corporation needs to know its cost of retained earnings. Based on the following information, compute the cost of retained earnings: The stock sells for $25, flotation costs are $3, and the firm is in the 35% tax bracket. $$\begin{array} { l l } \text { Year } & \text { Dividend } \\2014 & \$ 1.55 \\2013 & \$ 1.40 \\2012 & \$ 1.35 \\2011 & \$ 1.32\end{array}$$

A) 15.71%
B) 9.11%
C) 12.56%
D) 10.72%

Question 69

Investors can form earnings growth expectations from various sources, including ____.

A) potential sales growth
B) current earnings and retention rates
C) assumed product development
D) investors' required rate of return

Question 70

The cost of debt must account for all of the following inputs EXCEPT ____.

A) bond ratings
B) issuance costs
C) flotation costs
D) the tax rate

Question 71

The cost of internal equity is cheaper than the cost of external equity. Which of the following statements is (are) correct?
I. External equity may incur expenses that are deducted from the capital received for the sale of the
Security.
II. Corporations generally discount the price of the securities that are sold to the public in order to raise
Capital.

A) Only statement I is correct.
B) Only statement II is correct.
C) Both statements I and II are correct.
D) Neither statement I nor II is correct.

Question 72

Temple Company's common stock dividends have grown over the past 5-year period from $0.60 per share to $0.89 (today). Assume that Temple's dividends are expected to grow at this rate for the foreseeable future. Temple's stock is currently selling for $12 per share. New common stock can be sold to net the company $11 per share. Determine the costs of internal and external equity to Temple.

A) 18.1%; 18.9%
B) 15.9%; 16.6%
C) 16.2%; 16.9%
D) 15.9%; 18.9%

Question 73

Far Out Tech (FOT) has a debt ratio of 0.3, and it considers this to be its optimal capital structure. FOT has no preferred stock. FOT has analyzed four capital projects for the coming year as follows: $$\begin{array} { l l l } \text { Project } & \text { Net Investment } & \text { IRR } \\1 & \$ 3,000,000 & 13.5 \% \\2 & \$ 1,500,000 & 18.0 \% \\3 & \$ 2,000,000 & 12.6 \% \\4 & \$ 1,600,000 & 16.0 \%\end{array}$$ ? FOT expects to earn $2.7 million after tax next year and pay out $700,000 in dividends. Dividends are expected to be $1.05 a share during the coming year and are expected to grow at a constant rate of 10% a year for the foreseeable future. The current market price of FOT stock is $22 and up to $2 million in new equity can be raised for a flotation cost of 10%. If more than $2 million is sold then the flotation cost will be 15%. Up to $2 million in debt can be sold at par with a coupon rate of 10%. Any debt over $2 million will carry a 12% coupon rate and be sold at par. If FOT has a marginal tax rate of 40%, in which projects should it invest?

A) 1, 2, 3, and 4
B) 2 only
C) 1, 2, and 4 only
D) 2 and 4 only

Question 74

California Best (CB), a sports shoes store, expects an operating income of $2.3 million this year. CB has no long-term debt. The firm is considering as expansion project. The current risk-free rate of return is 7%, and the current market risk premium is 8.3%. If CB's beta is 20% greater than the overall market, what is the firm's cost of capital? Assume that CB has a marginal tax rate of 40%.

A) 8.3%
B) 16.96%
C) 9.96%
D) 15.3%

Question 75

Bay State Technology has determined that its cost of equity is 15% and its after-tax cost of debt is 7.2%. Bay State expects to earn $14 million after taxes next year and, as a new firm, does not pay any dividends. The stock sells for $24. Bonds are currently selling at par value. Compute Bay State's weighted cost of capital. A partial balance sheet is shown below: $$\begin{array} { l r } \text { Current liabilities } & \$ 300,000 \\\text { Long-term debt } & \$ 1,000,000 \\\text { Common stock at } \$ 1 \text { par } & \$ 100,000 \\\text { Paid in capital } & \$ 900,000 \\\text { Retained earnings } & \$ 3,000,000 \\\text { Total liabilities and stockholders' equity } & \$ 5,300,000\end{array}$$

A) 13.4%
B) 13.1%
C) 11.6%
D) 12.7%

Question 76

Sharp's current capital structure of 60% equity, 35% debt, and 5% preferred stock is considered optimal. This year Sharp expects to have earnings after tax of $3.6 million and to pay out $600,000 in dividends. Sharp can also raise up to $2 million in long-term debt at a pretax interest rate of 10.6% (all debt over $2 million will cost 11.4% pretax), and sell preferred stock at a cost of 11.5%. Sharp's marginal tax rate is 40%. The current value of Sharp's common stock is $36 and a dividend of $2.15 is expected to be paid during the coming year. Dividends have been growing at an annual compound rate of 8% a year and are expected to continue growing at that rate. New shares can be sold to net the firm $34.50. Sharp has an opportunity to invest in the following capital projects. Which one(s) should be accepted? $\begin{array}{lllc}\text { Project } & \text { Cost } & \text { Annual Cash Flow } & \text { Project Life } \\1 & \$ 3.0 \text { million } & \$ 552,893 & 10 \text { years } \\2 & \$ 2.5 \text { million } & \$ 693,481 & 5 \text { years } \\3 & \$ 2.0 \text { million } & \$ 345,220 & 10 \text { years }\end{array}$

A) 1 and 2 only
B) 1 and 3 only
C) 1, 2, and 3
D) Cannot be determined from the information provided

Question 77

American Dental Laser is selling a 10-year $1,000 face value bond with an 8% coupon rate. Interest is paid annually. The price to the public is $820, and the issue costs per bond are $10 each. Compute the pretax cost of debt for these bonds.

A) 11.1%
B) 11.3%
C) 11.5%
D) 11.8%

Question 78

What is the weighted average cost of capital for Mud Bug Corporation? ? $$\begin{array} { l l r } \text { Source of Capital } & \text { Capital Components } & \text { Cost } \\\text { Long-Term Debt } & \$ 60,000 & 5.6 \% \\\text { Preferred Stock } & \$ 15,000 & 10.6 \% \\\text { Common Stock } & \$ 75,000 & 13.0 \%\end{array}$$

A) 6.9%
B) 8.5%
C) 10.2%
D) 9.8%

Question 79

Mahlo is planning to diversify into the bakery industry. As a result, its beta should drop from 1.4 to 1.2 and the expected long-term growth rate of dividends will drop from 12% to 9%. The risk-free rate is 4%, the expected market risk premium is 9%, and the current dividend per share paid by Mahlo is $2.10. Should Mahlo complete the diversification into the bakery industry?

A) No, stock price drops about $11.70
B) Yes, stock price increases about $9.40
C) Yes, stock price increases about $1.80
D) No, stock price drops about $9.40

Question 80

Which of the following statements regarding the cost of capital is (are) correct?
I. The weighted cost of capital is the discount rate used when computing the net present value.
II. The after-tax cost of capital is weighted by the proportions of the capital components in the firm's long-range target capital structure.

A) Only statement I is correct.
B) Only statement II is correct.
C) Both statements I and II are correct.
D) Neither statement I nor II is correct.