Question 1

In capital budgeting and cost of capital analyses,the firm should always consider retained earnings as the first source of capital,because this is a free source of funding to the firm.

Accepted Answer

Retained earnings are not a free source of funding, as they represent profits that have been earned and retained by the company rather than distributed to shareholders. In addition, the use of retained earnings may incur opportunity costs if the firm foregoes other investment opportunities that would have generated higher returns. Therefore, the firm should consider a range of financing sources and evaluate the cost and availability of capital from each source.

Question 2

Capital refers to items on the right-hand side of a firm's balance sheet.

Accepted Answer

Capital is an accounting term that refers to the owner's equity or shareholders' equity on the right-hand side of a firm's balance sheet. Therefore, capital is correctly associated with the right-hand side of a firm's balance sheet, and the statement is true.

Question 3

The cost of equity obtained by retaining earnings is generally regarded as being the rate of return stockholders require on the firm's common stock.

Accepted Answer

The cost of equity obtained by retaining earnings is also known as the Cost of Retained Earnings or the Discount Rate of Retained Earnings. It is the minimum rate of return that a company must earn on the investments that it retains in the business to keep its shareholders happy. Therefore, it is generally regarded as the rate of return stockholders require on the firm's common stock.

Question 4

When a firm's stockholders are not well diversified,the firm's true investment risk will not be measured by beta and the CAPM procedure will ____ the correct value of r_s.

Accepted Answer

When stockholders are not well diversified, they are exposed to unsystematic risk, which is not captured by beta. Therefore, the CAPM, which only considers systematic risk, will understate the true required return (r_s) for these investors.

Question 5

An increase in total assets can be financed by an increase in which of the following capital components:

Accepted Answer

An increase in total assets can be financed by any or all of the three capital components: debt, preferred stock, and common equity. It is up to the company's management to determine the optimal mix of these components to achieve the desired capital structure.

Question 6

The cost of issuing preferred stock by a corporation must be adjusted to an after-tax figure because of the 70 percent dividend exclusion provision for corporations holding other corporations' preferred stock.

Accepted Answer

The cost of issuing preferred stock does not need to be adjusted to an after-tax figure because preferred stock dividends are paid from after-tax earnings and do not qualify for a tax deduction by the issuing corporation. The 70 percent dividend exclusion provision applies to the receiving corporation's taxation on dividends received, not the issuing corporation's cost of issuing preferred stock.

Question 7

The cost of equity capital from the sale of new common stock (r_e)is generally equal to the cost of equity capital from retention of earnings (r_s),divided by one minus the flotation cost as a percentage of sales price (1 − F).

Accepted Answer

The statement is incorrect. The cost of equity capital from the sale of new common stock is generally higher than the cost of equity capital from retention of earnings due to the flotation costs (such as underwriting fees, legal fees, and printing costs) associated with issuing new shares. The formula for the cost of equity from the sale of new common stock is r_e = r_s / (1 - F), where F represents the flotation cost as a percentage of sales price.

Question 8

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

Accepted Answer

The cost of debt is calculated as the coupon rate on outstanding debt multiplied by (one minus the marginal tax rate), not the other way around.

Question 9

____ is the portion of net income not paid out in the form of dividends.

Accepted Answer

Retained earnings is the portion of net income that is kept by the company and not distributed as dividends. It is a component of shareholders' equity and represents the cumulative earnings of the company since its inception, less any dividends paid out to shareholders.

Question 10

The ____ is the return that must be earned on invested funds to cover the cost of financing such investments

Accepted Answer

All the options provided represent different ways to describe the return that must be earned on invested funds to cover the cost of financing those investments. The cost of capital refers to the return a company needs to generate to cover the cost of its financing sources. The opportunity cost rate is the return foregone by investing in a specific project instead of the next best alternative. The required rate of return is the minimum return an investor expects to achieve by investing in a particular asset, taking into account its risk level. All these concepts relate to the return needed to justify the investment considering its financing costs.

Question 11

The cost of equity raised by retaining earnings can be less than,equal to,or greater than the cost of 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 12

The expected rate of return on a constant growth stock is equal to the ____ plus its ____.

Accepted Answer

The answer of The expected rate of return on a...

Question 13

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

Accepted Answer

The answer of The firm's cost of external equity capital...

Question 14

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

Accepted Answer

Flotation costs are considered when a firm issues new securities and can affect the choice between financing options, but the decision to use preferred stock or retained earnings over new common equity involves more factors, such as cost of capital, financial structure, and investor expectations, not just flotation costs.

Question 15

What is the best data to use for the growth rate estimate for DCF cost of capital estimates?

Accepted Answer

Analyst's forecasts can provide up-to-date and relevant information on a specific company, industry, or market, which makes them more reliable than using broad indicators such as GDP or inflation. Historical data can also be useful, but it may not reflect current market conditions or future expectations.

Question 16

The component costs of capital are market-determined variables in as much as 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 determined by the market's expectations and investors' required returns. These costs can fluctuate based on changes in market conditions and investors' perceptions of risk.

Question 17

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 developing the firm's WACC because it reflects the tax savings obtained by deducting interest expense from taxable income. The before-tax cost of debt does not take into account these tax savings and is not a relevant measure for determining a firm's cost of debt capital.

Question 18

Gargoyle Unlimited
Gargoyle Unlimited is planning to issue a zero coupon bond to fund a project that will yield its first positive cash flow in three years. That cash flow will be sufficient to pay off the entire debt issue. The bond's par value will be $1,000, it will mature in 3 years, and it will sell in the market for $727.25. The firm's marginal tax rate is 40 percent.
-Refer to Gargoyle Unlimited.What is the expected after-tax cost of this debt issue?

Accepted Answer

The after-tax cost of debt for a zero coupon bond can be calculated using the formula for yield to maturity (YTM) on a zero coupon bond, which is [(Face Value / Present Value)^(1/n)] - 1, where n is the number of years until maturity. Here, it is [(1000 / 727.25)^(1/3)] - 1 = 0.112 or 11.20% before tax. The after-tax cost of debt is then 11.20% * (1 - 0.40) = 6.72%.

Question 19

The ____ is the dollar value of new capital that can be raised before an increase in the firm's weighted cost of capital.

Accepted Answer

The break point is the dollar value of new capital that can be raised before an increase in the firm's weighted cost of capital. This means that beyond the break point, the cost of capital will increase and it will no longer be profitable for the firm to raise additional capital. The other answer choices are not directly related to this concept.

Question 20

If the MCC includes five break points,then there will be ____ different WACCs.

Accepted Answer

If the Marginal Cost of Capital (MCC) schedule includes five break points, there will be six different Weighted Average Cost of Capital (WACC) segments. Each break point introduces a new segment, plus the initial segment before the first break point.

Quiz 12: The Cost of Capital

In capital budgeting and cost of capital analyses,the firm should always consider retained earnings as the first source of capital,because this is a free source of funding to the firm.

Capital refers to items on the right-hand side of a firm's balance sheet.

The cost of equity obtained by retaining earnings is generally regarded as being the rate of return stockholders require on the firm's common stock.

When a firm's stockholders are not well diversified,the firm's true investment risk will not be measured by beta and the CAPM procedure will ____ the correct value of r_s.

An increase in total assets can be financed by an increase in which of the following capital components:

The cost of issuing preferred stock by a corporation must be adjusted to an after-tax figure because of the 70 percent dividend exclusion provision for corporations holding other corporations' preferred stock.

The cost of equity capital from the sale of new common stock (r_e)is generally equal to the cost of equity capital from retention of earnings (r_s),divided by one minus the flotation cost as a percentage of sales price (1 − F).

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

____ is the portion of net income not paid out in the form of dividends.

The ____ is the return that must be earned on invested funds to cover the cost of financing such investments

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

The expected rate of return on a constant growth stock is equal to the plus its .

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

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

What is the best data to use for the growth rate estimate for DCF cost of capital estimates?

The component costs of capital are market-determined variables in as much as they are based on investors' required returns.

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.

The ____ is the dollar value of new capital that can be raised before an increase in the firm's weighted cost of capital.

If the MCC includes five break points,then there will be ____ different WACCs.

Quiz 12: The Cost of Capital

In capital budgeting and cost of capital analyses,the firm should always consider retained earnings as the first source of capital,because this is a free source of funding to the firm.

Capital refers to items on the right-hand side of a firm's balance sheet.

The cost of equity obtained by retaining earnings is generally regarded as being the rate of return stockholders require on the firm's common stock.

When a firm's stockholders are not well diversified,the firm's true investment risk will not be measured by beta and the CAPM procedure will ____ the correct value of rs.

An increase in total assets can be financed by an increase in which of the following capital components:

The cost of issuing preferred stock by a corporation must be adjusted to an after-tax figure because of the 70 percent dividend exclusion provision for corporations holding other corporations' preferred stock.

The cost of equity capital from the sale of new common stock (re)is generally equal to the cost of equity capital from retention of earnings (rs),divided by one minus the flotation cost as a percentage of sales price (1 − F).

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

____ is the portion of net income not paid out in the form of dividends.

The ____ is the return that must be earned on invested funds to cover the cost of financing such investments

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

The expected rate of return on a constant growth stock is equal to the ____ plus its ____.

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

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

What is the best data to use for the growth rate estimate for DCF cost of capital estimates?

The component costs of capital are market-determined variables in as much as they are based on investors' required returns.

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.

The ____ is the dollar value of new capital that can be raised before an increase in the firm's weighted cost of capital.

If the MCC includes five break points,then there will be ____ different WACCs.

When a firm's stockholders are not well diversified,the firm's true investment risk will not be measured by beta and the CAPM procedure will ____ the correct value of r_s.

The cost of equity capital from the sale of new common stock (r_e)is generally equal to the cost of equity capital from retention of earnings (r_s),divided by one minus the flotation cost as a percentage of sales price (1 − F).

The expected rate of return on a constant growth stock is equal to the plus its .