Question 1

The only difference in the cost of retained earnings (K_e) and the cost of new common stock (K_n) is the flotation cost on new common stock.

Accepted Answer

The cost of retained earnings and the cost of new common stock would be the same if there were no flotation costs on the new common stock. However, because there are flotation costs associated with issuing new common stock, the cost of new common stock is higher than the cost of retained earnings.

Question 2

The cost of new common stock is greater than the cost of outstanding common stock.

Accepted Answer

The cost of new common stock is greater than the cost of outstanding common stock due to factors such as flotation costs and the fact that new common stock may have a higher required rate of return from investors.

Question 3

A firm's cost of preferred stock is equal to the preferred dividend divided by the net price after flotation costs.

Accepted Answer

The cost of preferred stock is calculated using the formula: Cost of preferred stock = Preferred dividend / Net price after flotation costs.

Question 4

The use of the optimum capital structure minimizes the cost of capital.

Accepted Answer

The use of the optimum capital structure helps minimize the cost of capital because it involves finding the right mix of debt and equity financing that balances the benefits and risks of each. This can result in a lower overall cost of capital, as well as improved financial performance and higher shareholder value.

Question 5

In determining the cost of debt, yields and prices of the firm's outstanding bonds could be used.

Accepted Answer

The yields and prices of the firm's outstanding bonds are used to determine the cost of debt because these factors are indicative of the interest rates that the firm is paying on its debt. By analyzing the yields and prices of the bonds, analysts can calculate the average interest rate that the firm is paying and use it as a basis for determining the cost of debt.

Question 6

Regardless of the particular source of funds utilized for a project, the required rate of return, or discount rate, will be the weighted average cost of capital.

Accepted Answer

This statement is true. The weighted average cost of capital (WACC) is the expected rate of return that a company must pay to its investors in order to attract and retain funding. It takes into account the cost of all capital sources, including equity and debt, and calculates a weighted average based on the proportion of each source of financing. Ultimately, the WACC represents the required rate of return for a company's investments and projects, regardless of the particular funding source used.

Question 7

A firm's cost of preferred stock is equal to the preferred dividend divided by market price plus the dividend growth rate (K_p = D/P₀ + g). The correct formula is K_p = D_p/(P_p - F).

Accepted Answer

The correct formula for the firm's cost of preferred stock is K_p = D_p/(P_p - F), where F represents flotation costs.

Question 8

The out-of-pocket cost of common stock is a good approximation of the cost of common stock equity.
Flotation costs for new stock issues must be considered in the valuation, unlike existing stock.

Accepted Answer

The answer of The out-of-pocket cost of common stock is...

Question 9

The amount of debt capital used by a corporation is not related to the availability of equity funds from retained earnings and new common stock.

Accepted Answer

The amount of debt capital used by a corporation can be influenced by the availability of equity funds from retained earnings and new common stock. If a corporation has a larger amount of retained earnings or is able to issue new common stock, it may be able to rely less on debt financing. On the other hand, if equity financing is not available or not desirable, a corporation may have to rely more heavily on debt financing.

Question 10

It is standard practice to evaluate investment decisions using the cost of the specific financing method involved.

Accepted Answer

Standard practice involves using the weighted average cost of capital (WACC) for evaluating investment decisions, which considers the cost of all financing sources, not just the cost of a specific financing method.

Question 11

Retained earnings represent an internal source of funds that is raised without the payment of interest or cost to the firm's stockholders.
"Opportunity cost" must be considered since earnings could be issued to shareholders in the form of dividends.

Accepted Answer

The answer of Retained earnings represent an internal source of...

Question 12

The cost of retained earnings is considered to be equal to the required rate of return on a firm's outstanding common stock.

Accepted Answer

Retained earnings represent the profits that a company has reinvested in the business rather than paid out as dividends. The cost of retained earnings is considered to be the same as the required rate of return on the company's common stock because both represent the return that investors expect to earn on their investment in the company.

Question 13

The discount rate that equates a future stream of expected dividends to the current price is a good approximation of the cost of common stock.

Accepted Answer

This is known as the dividend discount model and is a commonly used method to estimate the cost of common stock.

Question 14

The calculation of the cost of capital depends upon the historical cost of funds.
Each project must be evaluated by the current cost of funds.

Accepted Answer

The calculation of the cost of capital depends upon the current cost of funds. Historical costs do not necessarily reflect current market conditions and may not accurately represent the cost of funds for a particular project.

Question 15

The use of common stock equity in the weighted average cost of capital is always (K_e) and not (K_n), the cost of new common stock. Either or both may be used; it is situation-dependent.

Accepted Answer

The use of common stock equity in the weighted average cost of capital calculation may depend on the situation. While the cost of new common stock (K_n) can be used in situations where the company is raising new capital, the cost of existing common stock (K_e) may be more appropriate in situations where the company is using already issued stock. Therefore, both the cost of new and existing common stock may be used in the weighted average cost of capital calculation depending on the circumstances.

Question 16

The cost of capital for each source of funds is dependent on current market conditions and expected rates of return.

Accepted Answer

The cost of capital for each source of funds is determined by various factors such as prevailing interest rates, creditworthiness of the company, and inflation expectations. Therefore, it can vary depending on the market conditions and expected rates of return.

Question 17

In determining the cost of preferred stock, the earnings on outstanding preferred stock may be used as a proxy.

Accepted Answer

The cost of preferred stock is typically calculated using the dividend approach, which involves dividing the annual preferred dividend by the current market price of the preferred stock, not by using the earnings on outstanding preferred stock.

Question 18

All firms within particular industries have similar optimum capital structures.

Accepted Answer

Optimum capital structure can vary for different firms within the same industry based on factors such as their specific business strategy, level of risk, and access to capital markets.

Question 19

K_e represents an expected return to stockholders as well as a cost to the firm.

Accepted Answer

K_e refers to the weighted average cost of capital (WACC), which represents the expected return to stockholders (the cost of equity) as well as the cost of debt and other forms of financing for the firm.

Question 20

The cost of debt is equal to the current bond yield on bonds of similar risk class, adjusted for the corporate tax rate.

Accepted Answer

This statement is true. The cost of debt is the amount a company pays in interest on its debt obligations. It is calculated as the current bond yield on bonds of similar risk adjusted for the corporate tax rate, as interest paid on debt is tax deductible.

Quiz 11: Cost of Capital

The only difference in the cost of retained earnings (Ke) and the cost of new common stock (Kn) is the flotation cost on new common stock.