Question 1

Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt.

Accepted Answer

False

Question 2

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.

Accepted Answer

This formula is used to calculate the after-tax cost of debt. The marginal tax rate reduces the cost of debt as interest payments are tax-deductible.

Question 3

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

Accepted Answer

False

Question 4

The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

Accepted Answer

The cost of debt is calculated as the average coupon rate on all outstanding debt multiplied by (one minus the marginal tax rate), not the other way around. This formula accounts for the tax deductibility of interest expenses.

Question 5

"Capital" is sometimes defined as funds supplied to a firm by investors.

Accepted Answer

This definition of capital is accurate, as investors supply funds to a firm in exchange for ownership in the form of stocks or equity.

Question 6

The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

Accepted Answer

The cost of external equity raised by issuing new stock is often higher than the required rate of return on the firm's outstanding common stock due to additional flotation costs and other issuing expenses.

Question 7

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the DCF method is widely used in practice.

Accepted Answer

The text correctly identifies the three methods for estimating the cost of common stock from retained earnings, but it states that only the CAPM and bond-yield-plus-risk-premium methods are widely used in practice, not the DCF method.

Question 8

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

Accepted Answer

Retained earnings refer to the profit that a company chooses to keep instead of paying out dividends to shareholders. The cost of retained earnings is the rate of return that the marginal (or additional) stockholder requires on the company's common stock. Therefore, the statement is true.

Question 9

For capital budgeting and cost of capital purposes, the firm should always consider retained earnings as the first source of capital--i.e., use these funds first--because retained earnings have no cost to the firm.

Accepted Answer

Retained earnings do have a cost to the firm in the form of opportunity cost. By retaining earnings and not distributing them as dividends, the firm is forgoing the opportunity to invest those funds elsewhere, potentially earning a higher return. Therefore, the firm should weigh the cost of retained earnings against other sources of capital when making capital budgeting decisions.

Question 10

The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and retained earnings, whose cost is the average return on the assets that are acquired.

Accepted Answer

The answer of The higher the firm's flotation cost for...

Question 11

For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity.

Accepted Answer

For capital budgeting and cost of capital purposes, it is necessary to assume that each dollar of capital is obtained in accordance with the firm's target capital structure, which usually consists of a combination of debt, preferred stock, and common equity.

Question 12

The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC.

Accepted Answer

The after-tax cost of debt is used as the component cost of debt for purposes of developing the firm's WACC, not the before-tax cost. This is because interest payments on debt are tax deductible, which reduces the effective cost of debt for the firm.

Question 13

The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

Accepted Answer

The component costs of capital, such as the cost of debt and cost of equity, are determined by the market based on investors' required returns. This is because investors will only invest in a company if they can earn a return that compensates them for the risk they are taking. As a result, companies must offer a rate of return that is competitive with other investment opportunities in the market.

Question 14

The reason why retained earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm's common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should pay those earnings out to its investors. Thus, the cost of retained earnings is based on the opportunity cost principle.

Accepted Answer

The statement correctly explains the basis for the cost of retained earnings, which is the opportunity cost principle. Investors expect to earn a certain return on their investments, and if the firm can't earn that return on its retained earnings, it should pay those earnings out to shareholders instead. This is why the cost of retained earnings is equal to the investor's required rate of return (rs).

Question 15

The cost of capital used in capital budgeting should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets.

Accepted Answer

The cost of capital used in capital budgeting should reflect the weighted average cost of the various sources of long-term funds a firm uses to acquire assets.

Question 16

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, is not deductable by the issuing firm.

Accepted Answer

Preferred dividends, unlike interest on debt, is not deductible by the issuing firm, so no adjustment is needed for taxes when calculating the cost of perpetual preferred stock.

Question 17

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost.

Accepted Answer

Even though retained earnings do not involve direct payments like dividends or interest, they are not cost-free. They represent an opportunity cost, as shareholders could have received these funds as dividends and invested them elsewhere for a return.

Question 18

The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.

Accepted Answer

The answer of The cost of equity raised by retaining...

Question 19

In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project.

Accepted Answer

The answer of In general, firms should use their weighted...

Question 20

If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.

Accepted Answer

The answer of If a firm's marginal tax rate is...

Quiz 10: The Cost of Capital