Question 1

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

Accepted Answer

The cost of capital used in capital budgeting should reflect the weighted average cost of capital (WACC) which takes into account the cost of various sources of funding such as debt, equity, and preferred stock.

Question 2

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 3

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

False

Question 4

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 typically higher than the required rate of return on the firm's outstanding common stock due to additional issuance costs and risk associated with new investors.

Question 5

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

Accepted Answer

This definition of "capital" is accurate.

Question 6

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 statement is incorrect. While the DCF method is a common approach to estimating the cost of common stock from retained earnings, the CAPM and bond-yield-plus-risk-premium methods are also used in practice.

Question 7

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 8

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 using retained earnings, the firm is forgoing opportunities to invest in other projects or distribute dividends to shareholders, which could potentially generate higher returns. Therefore, the firm should consider other sources of capital as well and weigh the cost and benefits of each before making a decision.

Question 9

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 for calculating the cost of debt takes into account the tax deduction on interest payments, resulting in a lower effective rate for the company.

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

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 accurately explains the reason why retained earnings have a cost equal to rs.

Question 12

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 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 the cost of equity, are influenced by investors' required returns. These returns are determined by market conditions and investors' expectations for the future.

Question 14

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...

Question 15

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, are not deductible by the issuing firm.

Accepted Answer

This statement is true. The cost of perpetual preferred stock is calculated by dividing the annual dividend by the market price of the stock. Unlike interest on debt, preferred dividends are not tax-deductible for the issuing firm, so no adjustment is necessary for taxes.

Question 16

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 because interest expense is tax-deductible, resulting in a lower after-tax cost of debt.

Question 17

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

The answer of The cost of preferred stock to a...

Question 18

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

When a company retains earnings, it is essentially reinvesting those earnings to generate growth and increase the value of the company. As a result, the cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock. This is because shareholders expect to receive a return on their investment and will demand a rate of return that is in line with the level of risk associated with the investment.

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

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 accurate capital budgeting and cost of capital calculations, the firm should assume that capital is obtained in accordance with its target capital structure, which usually includes debt, preferred stock, and common equity.

Quiz 10: The Cost of Capital