Question 1

The slope of the security market line (SML) will often increase when the economy is in a boom period.

Accepted Answer

The answer of The slope of the security market line...

Question 2

Given an optimal capital structure that is 50% debt and 50% common stock, calculate the weighted average cost of capital for Stone Corp. given the following additional information: Bond coupon rate………………..8%
Bond yield to maturity…………..6%
Dividend, expected……………..$5
Price, common………………….$80
Growth rate…………………….5%
Corporate tax rate………………30%

Accepted Answer

The answer of Given an optimal capital structure that is...

Question 3

A firm's cost of financing, in an overall sense, is equal to its

Accepted Answer

A firm's cost of financing is a comprehensive concept that takes into account the cost of all types of capital invested in the company, which may include equity, debt, and other securities. The weighted average cost of capital (WACC) is the most widely used metric to measure a firm's cost of financing as it considers both the cost of equity and debt based on their respective weightings in the overall capital structure. Additionally, the required yield and required rate of return that investors demand for different securities also influence the firm's cost of financing. Therefore, all the options mentioned are correct and contribute to the firm's cost of financing in different ways.

Question 4

The overall weighted average cost of capital is used instead of costs for specific sources of funds because

Accepted Answer

Using specific costs of capital can lead to inconsistent investment decisions and also give an advantage to investments funded by low-cost debt. The overall weighted average cost of capital takes into account the costs of all sources of funds that a company uses, which makes it a better measure for investment decisions.

Question 5

For a firm paying 5% for new debt, the higher the firm's tax rate

Accepted Answer

The higher the firm's tax rate, the greater the tax shield from interest payments. This results in a lower after-tax cost of debt for the firm.

Question 6

The coupon rate on a debt issue is 6%. If the yield to maturity on the debt is 9%, what is the after-tax cost of debt in the weighted average cost of capital if the firm's tax rate is 34%?

Accepted Answer

The answer of The coupon rate on a debt issue...

Question 7

The pre-tax cost of debt for a new issue of debt is determined by

Accepted Answer

The pre-tax cost of debt for a new issue of debt is determined by the yield to maturity of outstanding or comparable bonds. The yield to maturity reflects the current market interest rates and the risk premium associated with the specific issuer. The coupon rate of existing debt represents the interest rate that was determined at the time the debt was issued and may not reflect current market conditions. The investor's required rate of return on issued stock is not relevant to the cost of debt.

Question 8

A firm with a higher beta than another firm will have a higher required rate of return. Beta is a direct measure of risk, so K_j must be higher.

Accepted Answer

This statement is true as a higher beta indicates higher systematic risk and investors will demand a higher return to compensate for this increased risk.

Question 9

Financial capital does not include

Accepted Answer

Financial capital refers to the capital raised by a company or individual from investors to fund investments or operations, such as stocks, bonds, and preferred stocks. Working capital refers to the funds used for day-to-day operations of a company, such as cash, inventory, and receivables, and is not considered part of financial capital. Therefore, the correct answer is D.

Question 10

A firm has $50 million in assets and its optimal capital structure is 60% equity. If the firm has $12 million in retained earnings, at what asset level will the firm need to issue additional stock? (Assume no growth in retained earnings.)

Accepted Answer

The optimal capital structure is 60% equity, which means that the firm can have $20 million in debt ($50 million assets * 0.4 debt ratio) and $30 million in equity ($50 million assets * 0.6 equity ratio). The firm currently has $12 million in retained earnings, which means it can add another $18 million in equity without issuing additional stock ($30 million equity - $12 million retained earnings). Therefore, the firm can increase its assets to $20 million ($20 million assets * 0.6 equity ratio = $12 million equity needed) before needing to issue additional stock.

Question 11

Tobin's Barbeque has a bank loan at 8% interest and an after-tax cost of debt of 6%. What will the after-tax cost of debt be when the loan is due if a new loan is taken out yielding 11%.

Accepted Answer

Since the company has an after-tax cost of debt of 6%, we know that its pre-tax cost of debt is 8% (since interest payments are tax-deductible). 
If the company takes out a new loan at 11%, its pre-tax cost of debt will increase to 11%. 
To calculate the new after-tax cost of debt, we can use the formula: 
After-tax cost of debt = Pre-tax cost of debt x (1 - Tax rate) 
Assuming a tax rate of 30%, we get: 
New after-tax cost of debt = 11% x (1 - 0.3) = 7.7% 
Therefore, the best choice is B, which is closest to our calculated value of 7.7%.

Question 12

Although debt financing is generally cheaper than equity financing, financial managers should not use debt financing significantly above the industry standard because it can increase the firm's overall cost of capital.

Accepted Answer

While debt financing may be cheaper than equity financing, using too much debt can increase a company's risk and raise their cost of capital, which ultimately harms the business.

Question 13

Debreu Beverages has an optimal capital structure that is 70% common equity, 20% debt, and 10% preferred stock. Debreu's pretax cost of equity is 9%. Its pretax cost of preferred equity is 7%, and its pretax cost of debt is also 5%. If the corporate tax rate is 35%, what is the weighed average cost of capital?

Accepted Answer

The weighted average cost of capital (WACC) is the average cost of capital for a company, taking into account the cost of each type of capital and the proportion of each type of capital in the company's capital structure. The WACC is calculated as follows:WACC = (Cost of equity * Proportion of equity) + (Cost of debt * Proportion of debt) + (Cost of preferred stock * Proportion of preferred stock)In this case, the cost of equity is 9%, the proportion of equity is 70%, the cost of debt is 5%, the proportion of debt is 20%, the cost of preferred stock is 7%, and the proportion of preferred stock is 10%. Therefore, the WACC is:WACC = (0.09 * 0.70) + (0.05 * 0.20) + (0.07 * 0.10) = 0.083Therefore, the WACC is between 8% and 9%.

Question 14

Lewis, Schultz, and Nobel Development Corp. has an after-tax cost of debt of 4.5%. With a tax rate of 30%, what is the yield on the debt?

Accepted Answer

The answer of Lewis, Schultz, and Nobel Development Corp. has...

Question 15

The cost of capital generally varies inversely with the size of the capital structure.

Accepted Answer

The cost of capital is determined by various factors such as market conditions, investor perception, credit rating, and the risk associated with the investment. The size of the capital structure may not necessarily have a direct impact on the cost of capital. It is the efficient management of capital that can help reduce the cost of capital.

Question 16

As the risk-free rate increases, the required rate of return for common stock decreases. "K" is utilized in all cost of capital decisions and bears a direct relationship to increases and decreases in R_f.

Accepted Answer

The statement is incorrect. The required rate of return for common stock actually increases as the risk-free rate increases. Additionally, the statement regarding "K" is unclear and has insufficient context.

Question 17

If a firm's bonds are currently yielding 6% in the marketplace, why would the firm's cost of debt be lower?

Accepted Answer

The firm's cost of debt is lower than the bond's market yield because interest paid on debt is tax-deductible. This tax shield reduces the effective cost of debt for the firm.

Question 18

The cost of a firm's debt is determined by taking the

Accepted Answer

The answer of The cost of a firm's debt is...

Question 19

The coupon rate on an issue of debt is 8%. The yield to maturity on this issue is 10%. The corporate tax rate is 31%. What would be the approximate after-tax cost of debt for a new issue of bonds?

Accepted Answer

The after-tax cost of debt is calculated as follows: 
After-tax cost of debt = Before-tax cost of debt x (1 - Corporate tax rate) 
Before-tax cost of debt = Yield to maturity = 10% 
After-tax cost of debt = 10% x (1 - 31%) ≈ 6.90% 
Therefore, the approximate after-tax cost of debt for a new issue of bonds is 6.90%.

Question 20

Each project should be judged against

Accepted Answer

None of the provided options are relevant criteria for judging a project. A project should be judged based on its expected return, risk, and alignment with the overall goals and strategy of the organization. Factors such as financing, interest rates, and cost of equity may be relevant for determining how to fund a project, but they should not be used as the sole basis for evaluating the merits of the project itself.

Quiz 11: Cost of Capital