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Chapter 12

Cost of Capital

True/False

1. The firm financed completely with equity capital has a cost of capital equal to the required return on common stock.

Difficulty: Moderate

Keywords: cost of common equity

2. The cost of debt is equal to one minus the marginal tax rate times the coupon rate of interest on the firm’s outstanding debt.

Difficulty: Moderate

Keywords: cost of debt

3. The weighted average cost of capital is the minimum required return that must be earned on additional investment if firm value is to remain unchanged.

Difficulty: Moderate

Keywords: weighted average cost of capital

4. Assuming an after-tax cost of preferred stock of 12% and a corporate tax rate of 40%, a firm must earn at least $20 before tax on every $100 invested.

Difficulty: Moderate

Keywords: cost of preferred stock

5. Other things equal, management should retain profits only if the company’s investments within the firm are at least as attractive as the stockholders’ other investment opportunities.

Difficulty: Moderate

Keywords: retained earnings

6. The cost of retained earnings takes into account flotation costs.

Difficulty: Moderate

Keywords: cost of retained earnings

7. The weighted cost of capital assumes that the company maintains a constant dividend payout ratio.

Difficulty: Moderate

Keywords: weighted average cost of capital, dividend payout

8. If a firm was to earn exactly its cost of capital, we would expect the price of its common stock to remain unchanged.

Difficulty: Moderate

Keywords: cost of capital, price of common stock

9. The minimum rate of return necessary to attract an investor to purchase or hold a security is called the cost of capital.

Difficulty: Easy

Keywords: required rate of return

10. The weighted average cost of capital is computed using before-tax costs of each of the sources of financing that a firm uses to finance a project.

Difficulty: Easy

Keywords: weighted average cost of capital, after-tax component costs

11. A security with a reasonably stable price will require a higher required return than a security with an unstable price.

Difficulty: Moderate

Keywords: required return

12. The average cost of capital is the appropriate rate to use when evaluating new investments, even though the new investments might be in a higher risk class.

Difficulty: Moderate

Keywords: weighted average cost of capital

13. If the before-tax cost of debt is 9% and the firm has a 34% marginal tax rate, the after-tax cost of debt is 5.94%.

Difficulty: Moderate

Keywords: after-tax cost of debt

14. No adjustment is made in the cost of preferred stock for taxes since preferred stock dividends are not tax-deductible.

Difficulty: Moderate

Keywords: cost of preferred stock

15. The cost of internal common funds is already on an after-tax basis since dividends paid to common stockholders are not tax-deductible.

Difficulty: Moderate

Keywords: cost of internal common funds

16. Financial risk is the variability in returns on assets and is affected by the firm’s investment decisions.

Difficulty: Moderate

Keywords: financial risk

17. The tax rate selected to determine a company’s after-tax cost of debt is their effective rate.

Difficulty: Moderate

Keywords: after-tax cost of debt

18. In most instances, as the amount of debt rises, the common stockholders will decrease their required rate of return.

Difficulty: Moderate

Keywords: debt financing

19. The cost of common equity is usually higher than the rate the firm must earn to satisfy the common stockholders’ required rate of return.

Difficulty: Moderate

Keywords: cost of common equity

20. PepsiCo’s cost of equity is based on the capital asset pricing model (CAPM).

Difficulty: Moderate

Keywords: PepsiCo cost of equity

21. As the tax rate increases, the weighted average cost of capital decreases.

Difficulty: Moderate

Keywords: weighted average cost of capital, tax rate

22. Capital structure represents the mix of long-term sources of funds used by a firm.

Difficulty: Easy

Keywords: capital structure

23. As more securities are issued, additional flotation costs affect the percentage cost of the funds to the firm.

Difficulty: Moderate

Keywords: flotation costs

24. Business risk reflects the added variability in earnings available to a firm’s shareholders.

Difficulty: Easy

Keywords: business risk, financial risk

25. When investors increase their required rate of return, the cost of capital increases simultaneously.

Difficulty: Moderate

Keywords: cost of capital, investors’ required return

26. The data a firm used to calculate its cost of capital is appropriate for varying levels of debt and equity in the firm’s capital structure.

Difficulty: Moderate

Keywords: cost of capital

27. The firm should continue to invest in new projects up to the point where the marginal rate of return earned on a new investment equals the marginal cost of new capital.

Difficulty: Moderate

Keywords: marginal rate of return, cost of capital

28. A firm’s weighted marginal cost of capital increases when internal equity financing is exhausted but is unaffected by an increase in the cost of other financing sources.

Difficulty: Moderate

Keywords: weighted marginal cost of capital

29. Using a firm’s overall cost of capital to evaluate divisional projects can lead to the rejection of good investments in low-risk divisions and the acceptance of poor projects in high-risk divisions.

Difficulty: Moderate

Keywords: divisional cost of capital

Multiple Choice

30. Cost of capital is:

a. the coupon rate of debt.

b. a hurdle rate set by the board of directors.

c. the rate of return that must be earned on additional investment if firm value is to remain unchanged.

d. the average cost of the firm’s assets.

Difficulty: Moderate

Keywords: cost of capital

31. An increase in ___________ would increase the weighted average cost of capital.

a. flotation costs

b. projected dividends

c. the tax rate

1. both a and c
2. all of the above

Difficulty: Moderate

Keywords: weighted average cost of capital

32. J & B, Inc. has $5 million of debt outstanding with a coupon rate of 12%. Currently, the yield to maturity on these bonds is 14%. If the firm’s tax rate is 40%, what is the cost of debt to J & B?

a. 12.0%

b. 14.0%

c. 8.4%

d. 5.6%

Difficulty: Moderate

Keywords: cost of debt

33. The expected dividend is $2.50 for a share of stock priced at $25. What is the cost of retained earnings if the long-term growth in dividends is projected to be 8%?

a. 10%

b. 8%

c. 25%

d. 18%

Difficulty: Moderate

Keywords: cost of retained earnings

34. The average cost associated with each additional dollar of financing for investment projects is:

a. the incremental return.

b. the marginal cost of capital.

c. risk-free rate.

d. beta.

Difficulty: Moderate

Keywords: marginal cost of capital

35. Shawhan Supply plans to maintain its optimal capital structure of 30% debt, 20% preferred stock, and 50% common stock far into the future. The required return on each component is: debt–10%; preferred stock–11%; and common stock–18%. Assuming a 40% marginal tax rate, what after-tax rate of return must Shawhan Supply earn on its investments if the value of the firm is to remain unchanged?

a. 18.0%

b. 13.0%

c. 10.0%

d. 14.2%

Difficulty: Moderate

Keywords: weighted average cost of capital

36. PepsiCo uses 30-year Treasury bonds to measure the risk-free rate because:

a. these bonds are essentially free of business risk.

b. they capture the long-term inflation expectations of investors associated with investments in long-term assets.

c. these bonds are essentially free of interest rate risk.

d. none of the above.

Difficulty: Moderate

Keywords: PepsiCo risk-free rate

37. The marginal cost of preferred stock is equal to:

a. the preferred stock dividend divided by market price.

b. the preferred stock dividend divided by its par value.

c. (1 - tax rate) times the preferred stock dividend divided by net price.

d. the preferred stock dividend divided by the net market price.

Difficulty: Moderate

Keywords: marginal cost of preferred stock

38. The most expensive source of capital is:

a. preferred stock.

b. new common stock.

c. debt.

d. retained earnings.

Difficulty: Easy

Keywords: new common stock

39. The XYZ Company is planning a $50 million expansion. The expansion is to be financed by selling $20 million in new debt and $30 million in new common stock. The before-tax required rate of return on debt is 9%, and the required rate of return on equity is 14%. If the company is in the 40% tax bracket, what is the marginal cost of capital?

a. 14.0%

b. 9.0%

c. 10.6%

d. 11.5%

Difficulty: Moderate

Keywords: marginal cost of capital

40. When calculating the average cost of capital, which of the following has to be adjusted for taxes?

a. Common stock

b. Retained earnings

c. Debt

d. Preferred stock

Difficulty: Easy

Keywords: after-tax cost of debt

41. The cost of newly issued common stock is greater than the cost of retained earnings due to:

a. flotation costs.

b. taxes.

c. higher risk.

1. both a and c.
2. all of the above.

Difficulty: Moderate

Keywords: cost of new common stock

42. In order to maximize firm value, management should invest in new assets when the internal rate of return is:

a. greater or equal to the firm’s marginal cost of capital.

b. greater than the cost of debt financing.

c. less than or equal to the accounting rate of return.

d. less than or equal to the firm’s marginal cost of capital.

Difficulty: Moderate

Keywords: marginal cost of capital

43. Bender and Co. is issuing a $1,000 par value bond that pays 9% interest annually. Investors are expected to pay $918 for the 10-year bond. Bender will have to pay $33 per bond in flotation costs. What is the cost of debt if the firm is in the 34% tax bracket?

a. 7.23%

b. 9.01%

c. 9.23%

d. 11.95%

Difficulty: Moderate

Keywords: after-tax cost of debt

44. Larger issues of new common stock can cause ________ to increase.

a. flotation costs

b. the investor’s required rate of return

c. the stock price

d. the tax rate

Difficulty: Moderate

Keywords: new common stock

45. Which of the following is NOT used to calculate the cost of debt?

a. Maturity value of the debt

b. Market price of the debt

c. Number of years to maturity

d. Risk-free rate

Difficulty: Easy

Keywords: cost of debt

46. Which of the following is considered a problem in using the dividend-growth model to estimate the cost of equity?

a. Estimating the expected growth rate of future dividends

b. Determining the expectations of the minds of the investors

1. Using subjectivity in estimating the risk premium
2. Both a and b

e. All of the above are correct

Difficulty: Moderate

Keywords: cost of equity, dividend-growth model

47. Given the following information, determine the risk-free rate.

Cost of equity = 12%

Beta = 1.50

Market risk premium = 3%

a. 8.0%

b. 7.5%

c. 7.0%

d. 6.5%

Difficulty: Moderate

Keywords: capital asset pricing model

48. Armadillo Mfg. Co. has a target capital structure of 50% debt and 50% equity. They are planning to invest in a project which will necessitate raising new capital. New debt will be issued at a before-tax yield of 12%, with a coupon rate of 10%. The equity will be provided by internally generated funds. No new outside equity will be issued. If the required rate of return on the firm’s stock is 15% and its marginal tax rate is 40%, compute the firm’s cost of capital.

a. 13.5%

b. 12.5%

c. 7.2%

d. 11.1%

Difficulty: Moderate

Keywords: weighted average cost of capital

49. As financial manager for ABZ Corporation, you are trying to determine the appropriate cost of capital for the firm. The firm is considering an investment which will require an initial outlay of $100,000. The firm can issue bonds at a price of $940.82 which have a coupon rate of 8% on 10 years to maturity and a face value of $1,000. However, the underwriter would charge flotation costs of $5 per bond. The company can issue new equity at a before-tax cost of 16%. It has $75,000 of internal equity available for investment projects at this time. The required rate of return on the company’s stock is 14%, and its marginal tax rate is 34%. If the company wishes to maintain its current capital structure of 60% debt and 40% equity, what is the appropriate cost of capital to use for this project’s capital budgeting analysis?

a. 14%

b. 8.77%

c. 9.16%

d. 10%

Difficulty: Hard

Keywords: weighted average cost of capital

50. Verigreen Lawn Care products just paid a dividend of $1.85. This dividend is expected to grow at a constant rate of 3% per year, so the next expected dividend is $1.90. The stock price is currently $12.50. New stock can be sold at this price subject to flotation costs of 15%. The company’s marginal tax rate is 40%. Compute the cost of internal (retained) earnings and the cost of external equity (new common stock).

a. 0, 17.8%

b. 15.2%, 17.8%

c. 18.2%, 20.9%

d. 18.2%, 16.21%

Difficulty: Moderate

Keywords: cost of new equity

51. PepsiCo calculates unlevered betas for each peer group in order to:

a. eliminate different business risks.

b. eliminate competitive factors.

c. eliminate judgment factors.

d. eliminate different financial risks.

Difficulty: Moderate

Keywords: PepsiCo, unlevered beta

52. Your company is considering an investment in a project which would require an initial outlay of $300,000 and produce expected cash flows in Years 1 through 5 of $87,385 per year. You have determined that the current after-tax cost of the firm’s capital (required rate of return) for each source of financing is as follows:

Cost of debt 8%

Cost of preferred stock 12%

Cost of common stock 16%

Long-term debt currently makes up 20% of the capital structure,

preferred stock 10%, and common stock 70%. What is the net present

value of this project?

a. $463

b. $871

c. $1,241

d. $1,568

Difficulty: Hard

Keywords: weighted average cost of capital, net present value

53. Dublin International Corporation’s marginal tax rate is 40%. It can issue three-year bonds with a coupon rate of 8.5% and par value of $1,000. The bonds can be sold now at a price of $938.90 each. The underwriters will charge $23 per bond in flotation costs. Determine the appropriate after-tax cost of debt for Dublin International to use in a capital budgeting analysis.

a. 4.5%

b. 5.2%

c. 6.0%

d. 7.2%

Difficulty: Moderate

Keywords: after-tax cost of debt

54. XYZ Corporation is trying to determine the appropriate cost of preferred stock to use in determining the firm’s cost of capital. This firm’s preferred stock is currently selling for $36.00 and pays a perpetual annual dividend of $2.60 per share. Underwriters of a new issue of preferred stock would charge $6 per share in flotation costs. Compute the cost of new preferred stock for XYZ.

a. 7.2%

b. 6.2%

c. 8.7%

d. 16.7%

Difficulty: Moderate

Keywords: cost of new preferred stock

55. ____________ is the largest source of capital for most U.S. corporations.

a. Long-term debt

b. Preferred stock

c. Internal common equity

d. External common equity

Difficulty: Moderate

Keywords: internal common equity, sources of capital

56. Sonderson Corporation is undertaking a capital budgeting analysis. The firm’s beta is 1.5. The rate on six-month T-bills is 5%, and the return on the S&P 500 index is 12%. What is the appropriate cost for retained earnings in determining the firm’s cost of capital?

a. 13.1%

b. 15.5%

c. 17.7%

d. 19.9%

Difficulty: Moderate

Keywords: cost of retained earnings

57. Given the following information for PepsiCo, determine the company’s weighted average cost of capital.

Value Cost of Capital

Restaurant Division $ 5 Billion 13%

Snack Foods Division 7 Billion 12%

Beverages Division 13 Billion 8%

a. 10.12%

b. 11.00%

c. 12.10%

d. 13.00%

Difficulty: Moderate

Keywords: weighted average cost of capital, PepsiCo

58. Given the following information on S & G, Inc. capital structure, compute the company’s weighted average cost of capital. The company’s marginal tax rate is 40%.

Type of Percent of Before-Tax

Capital Capital Structure Component Cost

Bonds 40% 7.5%

Preferred stock 5% 11%

Common stock (internal only) 55% 15%

a. 13.3%

b. 7.1%

c. 10.6%

d. 10.0%

Difficulty: Moderate

Keywords: weighted average cost of capital

59. Mars Car Company has a capital structure made up of 40% debt and 60% equity and a tax rate of 30%. A new issue of bonds maturing in 20 years can be issued with a coupon of 9% at a price of $1,098.18 with no flotation costs. The firm has no internal equity available for investment at this time but can issue new common stock at a price of $45. The next expected dividend on the stock is $2.70. The dividend for Mars Co. is expected to grow at a constant annual rate of 5% per year indefinitely. Flotation costs on new equity will be $7.00 per share. The company has the following investment projects available:

Project Initial Outlay Internal Rate of Return

1 $100,000 10%

2 $ 10,000 8.5%

3 $ 50,000 12.5%

Which of the above projects should the company take on?

a. Project 3 only

b. Projects 1 and 2

c. Projects 1 and 3

d. Projects 1, 2, and 3

Difficulty: Hard

Keywords: weighted average cost of capital, selecting projects

60. The CAPM approach is used to determine the cost of:

a. debt.

b. preferred stock.

c. retained earnings.

d. new common stock.

Difficulty: Easy

Keywords: cost of retained earnings

61. New Lead Technology Group has determined that their marginal cost of capital from $0 to $75,000 is 8.5%, from $75,001 to $250,000 is 9.3%, and from $250,001 to $500,000 is 10.1%. Amounts above $500,000 are associated with a cost of capital of 12%. The company has the following investment projects available:

Required Project Outlay IRR

1 $150,000 13%

2 20,000 9.5%

3 25,000 9%

4 70,000 14%

Which project(s) should the company take on?

a. Projects 1 and 4

b. Projects 2, 3, and 4

c. Projects 1, 2, and 4

d. Projects 1 and 2

Difficulty: Hard

Keywords: weighted average cost of capital, selecting projects

62. The cost of capital is:

a. the opportunity cost of using funds to invest in new projects.

b. the rate of return the firm must earn on its investments in order to satisfy the required rate of return of the firm’s investors.

c. the hurdle rate for new capital investments which have typical or average risk.

d. all of the above.

Difficulty: Moderate

Keywords: cost of capital

63. As the size of a financing issue increases, the _____ decreases.

a. weighted cost of capital

b. flotation cost of the issue

c. effective tax rate

d. both a and b

e. all of the above

Difficulty: Moderate

Keywords: size of issue

64. The investor’s required rate of return differs from the firm’s cost of capital due to the:

a. firm’s beta.

b. tax deductibility of interest.

c. CAPM.

d. time value of money.

Difficulty: Moderate

Keywords: cost of capital

65. The cost of capital for a firm which uses 45% debt at an after-tax cost of 10% and 55% common stock at a 15% cost is:

a. 12.25%.

b. 12.50%.

c. 12.75%.

d. 13.00%.

e. 13.25%.

Difficulty: Easy

Keywords: weighted average cost of capital

Use the following information to answer questions 66-67. The current market price of an existing debt issue is $1,125. The bonds have a $1,000 par value, pay interest annually at a 12% coupon rate, and mature in 10 years. The firm has a marginal tax rate of 34%.

66. The before-tax cost of this debt issue is:

a. 12%.

b. 7.92%.

c. 9.97%.

d. 13%.

Difficulty: Moderate

Keywords: before-tax cost of debt

67. The after-tax cost of this debt issue is:

a. 7.92%.

b. 6.58%.

c. 12%.

d. 3.39%.

Difficulty: Moderate

Keywords: after-tax cost of debt

68. Assume the following facts about a firm’s financing in the next year, and calculate the component cost of debt.

Weighted average cost of capital = 11.3%

Proportion debt financing = 45%

Proportion internal equity financing = 55%

Cost of internal equity = 14.0%

Cost of after-tax debt = ?????

a. 7%

b. 8%

c. 9%

d. 10%

Difficulty: Moderate

Keywords: cost of debt

69. Busing Manufacturing has a new bond issue that will net the firm $1,069 after flotation costs. The bonds have a $1,000 par value, pay interest annually at a 12% coupon rate, and mature in 10 years. The firm has a marginal tax rate of 34%. The after-tax cost of the debt issue is:

a. 7.15%.

b. 3.68%.

c. 7.92%.

d. 6.58%.

Difficulty: Moderate

Keywords: after-tax cost of debt

70. Alpha has an outstanding bond issue that has a 7.75% semiannual coupon, a current maturity of 20 years, and sells for $967.97. The firm’s income tax rate is 40%. If the firm were to issue new bonds today, they would incur flotation costs of $7.50 per bond. What is Alpha’s yield-to-maturity on its outstanding bonds?

a. 6.32%

b. 4.55%

c. 9.27%

d. 8.15%

Difficulty: Moderate

Keywords: yield to maturity

71. Alpha has an outstanding bond issue that has a 7.75% semiannual coupon, a current maturity of 20 years, and sells for $967.97. The firm’s income tax rate is 40%. If the firm were to issue new bonds today, they would incur flotation costs of $7.50 per bond. What should Alpha use as an after-tax cost of debt for cost of capital purposes?

a. 6.22%

b. 8.51%

c. 4.89%

d. 3.64%

Difficulty: Moderate

Keywords: after-tax cost of debt

72. A firm has an issue of preferred stock that pays an annual dividend of $2.00 per share and currently is selling for $20.00 per share. If the firm wishes to raise new capital by selling additional shares of preferred stock, it will net $18.50 per share. Finally, the firm’s marginal tax rate is 34%. This firm’s cost of financing with new preferred stock is:

a. 10%.

b. 7.13%.

c. 10.81%.

d. 6.6%.

Difficulty: Moderate

Keywords: cost of preferred stock

73. New England Power (NEP) has an outstanding issue of $100 par, preferred stock. The preferred stock sells for $107.50 per share; it pays a dividend rate of 8.75%. If NEP sold new shares of preferred stock for $107.50 per share, the firm would incur flotation costs of $3.50 per share. What is NEP’s cost of preferred stock?

a. 8.41%

b. 3.50%

c. 8.75%

d. 6.25%

Difficulty: Moderate

Keywords: cost of preferred stock

74. Alpha’s beta is 1.06, the present T-bond rate is 6%, and the return on the S & P 500 is 15.25%. What is Alpha’s cost of retained earnings using the CAPM approach?

a. 21.25%

b. 15.81%

c. 9.25%

d. 6.32%

Difficulty: Moderate

Keywords: cost of retained earnings, CAPM

75. Paramount, Inc. just paid a dividend of $2.05 per share, and the firm is expected to experience constant growth of 12.50% over the foreseeable future. The common stock is currently selling for $65.90 per share. What is Paramount’s cost of retained earnings using the Gordon Model (DCF) approach?

a. 12.50%

b. 17.90%

c. 16.00%

d. 14.55%

Difficulty: Moderate

Keywords: cost of retained earnings, Gordon Model

76. Paramount, Inc. just paid a dividend of $2.05 per share, and the firm is expected to experience constant growth of 12.50% over the foreseeable future. The common stock is currently selling for $65.90 per share. Flotation costs on new common stock are expected to be 9.75%, and the firm’s marginal tax rate is 40%. Using the Gordon (DCF) Model, what is Paramount’s cost of newly issued common stock?

a. 11.80%

b. 22.25%

c. 9.65%

d. 16.38%

Difficulty: Moderate

Keywords: cost of new common stock

Use the following information to answer questions 77-79. A firm is trying to estimate its cost of common equity, and it has the following information. The firm has a beta of 0.90, the before-tax cost of the firm’s debt is 7.75%, and the firm estimates that the risk-free rate is 7% while the current market return is 12%. The firm pays dividends annually and expects dividends to grow at a constant rate of 5% indefinitely. The most recent dividend per share, paid yesterday, is $2.00. The firm thinks that its common shareholders require a 4% risk premium for assuming greater risk than the firm’s bondholders. Currently, the firm’s stock sells for $35.00 per share, but if the firm issues new shares, it will net $33.25 per share. Finally, the firm has a marginal tax rate of 34%.

77. The cost of internal common stock using the dividend-growth model is:

a. 11.00%.

b. 11.32%.

c. 11.50%.

d. 11.72%.

Difficulty: Moderate

Keywords: cost of retained earnings

78. The cost of common stock using the CAPM is:

a. 11.00%.

b. 11.32%.

c. 11.50%.

d. 11.72%.

Difficulty: Moderate

Keywords: cost of common stock, CAPM

79. The cost of new common stock is:

a. 11.00%.

b. 11.32%.

c. 11.50%.

d. 11.72%.

Difficulty: Moderate

Keywords: cost of new common stock

Use the following information to answer questions 80-82. Sigma Corp. has a target financing mix of 30% debt and 70% common equity. The before-tax cost of Sigma’s debt is 10%. Sigma estimates its cost of internal equity at 14% and its cost of new common equity at 17%. Sigma’s marginal tax rate is 34%, and it expects to have $2,100,000 of profit available for reinvestment in the firm.

80. If Sigma can meet all of its financing needs with debt and internally generated equity, then Sigma’s weighted cost of capital is:

a. 11.78%.

b. 12.38%.

c. 13.88%.

d. 14.28%.

Difficulty: Moderate

Keywords: weighted average cost of capital

81. What is the total dollar amount of new investment that Sigma can support without issuing new common equity?

a. $1,500,000

b. $2,000,000

c. $2,500,000

d. $3,000,000

Difficulty: Moderate

Keywords: break point

82. If Sigma cannot meet all of its financing needs with debt and internally generated equity, then Sigma’s weighted cost of capital is:

a. 11.78%.

b. 12.38%.

c. 13.88%.

d. 14.28%.

Difficulty: Moderate

Keywords: weighted average cost of capital

Use the following information to answer questions 83-87. A firm currently has the following capital structure which it views as optimal. Debt: $3,000,000 par value of 9% bonds outstanding with an annual before-tax yield to maturity of 7.67% on a new issue. The bonds currently sell for $115 per $100 par value. Common stock: 46,000 shares outstanding currently selling for $50 per share. The firm expects to pay a $5.50 dividend per share one year from now and is experiencing a 3.67% growth rate in dividends, which it expects to continue indefinitely. The firm’s marginal tax rate is 40%, and it expects to be able to finance all new projects with debt and internal common equity.

83. The current total value of the firm is:

a. $6,450,000.

b. $5,750,000.

c. $4,950,000.

d. $3,250,000.

Difficulty: Moderate

Keywords: value of the firm

84. The proportion of debt in this firm’s capital structure is:

a. 40%.

b. 50%.

c. 60%.

d. 70%.

Difficulty: Moderate

Keywords: proportion of debt financing

85. The after-tax cost of debt is:

a. 6.20%.

b. 5.40%.

c. 4.60%.

d. 3.80%.

Difficulty: Moderate

Keywords: after-tax cost of debt

86. The after-tax cost of common stock is:

a. 14.67%.

b. 13.23%.

c. 12.41%.

d. 11.65%.

Difficulty: Moderate

Keywords: after-tax cost of common stock

87. The firm’s weighted average cost of capital is:

a. 10.47%.

b. 9.29%.

c. 8.63%.

d. 7.71%.

Difficulty: Moderate

Keywords: weighted average cost of capital

88. Metals Corp. uses a "target" capital structure of 48% debt, 8% preferred stock, and 44% common equity. Metals Corp.’s preferred stock has a cost of 8.25%, and newly issued common stock has a cost of 17.50%. If the company’s weighted average cost of capital is 10.52%, what is their after-tax cost of debt?

a. 4.5%

b. 5.0%

c. 5.5%

d. 6.0%

Difficulty: Moderate

Keywords: after-tax cost of debt

89. Which of the following best describes a firm’s cost of capital?

a. The average yield to maturity on debt

b. The average cost of the firm’s assets

c. The rate of return that must be earned on its investments in order to satisfy the firm’s investors

d. The coupon rate on preferred stock

Difficulty: Moderate

Keywords: cost of capital

90. A firm’s capital structure consists of which of the following?

a. Common stock

b. Preferred stock

c. Bonds

d. All of the above

Difficulty: Easy

Keywords: capital structure

91. Which of the following would be considered in calculating a firm’s cost of capital?

a. Bonds

b. Accruals

c. Preferred Stock

d. Both a and c

e. All of the above

Difficulty: Easy

Keywords: cost of capital components

92. Which of the following is the preferred method in estimating a firm’s cost of capital?

a. Consider the cost of a specific source of financing that will be used for a firm’s new projects; i.e., the marginal cost of capital.

b. Calculate the weighted average cost of new capital to be utilized in financing a firm’s projects.

c. Calculate the firm’s weighted average CAPM to be utilized in financing a firm’s projects.

d. All of the above are equally acceptable.

Difficulty: Moderate

Keywords: cost of capital

93. Which of the following statements is true?

a. The level of general economic conditions will determine whether a firm should utilize an arithmetic average cost of capital or a weighted average cost of capital.

b. A firm should utilize a weighted average cost of capital for evaluating investment decisions rather than an arithmetic average cost of capital.

c. For an average firm that is capitalized with 65% equity, usage of an arithmetic average cost of capital will usually overstate the true cost of capital.

d. All of the above are true.

e. None of the above are true.

Difficulty: Moderate

Keywords: weighted average cost of capital, arithmetic average

94. An increase in _________ will increase the cost of retained earnings.

a. the expected growth rate

b. the future dividends expected

c. the flotation costs

d. both a and b

e. all of the above

Difficulty: Moderate

Keywords: cost of retained earnings

95. J & B, Inc. has $5 million of new debt to finance a project with a coupon rate of 12%, paid semiannually and has a par value of $1,000. The bonds will mature in 14 years and are priced at $850, net of flotation costs. If the firm’s tax rate is 40%, what is the cost of debt to J & B? (Round to the nearest whole percentage.)

a. 9%

b. 11%

c. 13%

d. 15%

Difficulty: Hard

Keywords: after-tax cost of debt

96. Which of the following is a valid issue in implementing the dividend growth model? The model:

a. is too complex to be used to estimate value.

b. does not require an accurate estimate of the rate of growth in future dividends.

c. is based upon the fundamental assumption that dividends are expected to grow at a constant rate forever.

1. both a and c.
2. all of the above.

Difficulty: Moderate

Keywords: dividend growth model

97. Which of the following statements regarding calculating a firm’s cost of capital is correct?

a. The after-tax cost of debt is generally more expensive than the after-tax cost of preferred stock.

b. Since retained earnings are readily available, the cost of retained earnings is generally lower than the cost of debt.

c. If a company’s beta increases, this will increase the cost of equity financing.

d. The level of general economic conditions will determine whether a firm should utilize an arithmetic average cost of capital or a weighted average cost of capital.

Difficulty: Moderate

Keywords: beta, cost of equity

98. A company has a capital structure that consists of 50% debt and 50% equity. Which of the following is true?

a. The weighted average cost of capital is less than the cost of equity financing.

b. The cost of equity financing is greater than the cost of debt financing.

c. The weighted average cost of capital is calculated on a before-tax basis.

d. Both a and b.

1. All of the above.

Difficulty: Moderate

Keywords: component cost of capital, weighted average cost of capital

99. Hill Town Motels has $5 million of debt outstanding with a coupon rate of 12%. Currently, the yield to maturity on these bonds is 14%. If the firm’s tax rate is 40%, what is the after-tax cost of debt to Hill Town Motels?

a. 14.8%

b. 11.2%

c. 8.4%

d. 5.6%

Difficulty: Moderate

Keywords: after-tax cost of debt

100. The last paid dividend is $2 for a share of common stock that is currently selling for $20. What is the cost of retained earnings if the long-term growth rate in dividends for the firm is expected to be 8%?

a. 10.8%

b. 12.8%

c. 14.8%

d. 16.8%

e. 18.8%

Difficulty: Moderate

Keywords: cost of retained earnings

101. New York Key is planning a $50 million expansion. The expansion is to be financed by selling $20 million in new debt and $30 million in new common stock. The before-tax required rate of return on debt is 9%, and the required rate of return on equity is 13.75%. If the company is in the 40% tax bracket, what is New York Key’s weighted marginal cost of capital?

a. 7.5%

b. 9.2%

c. 10.4%

d. 13.8%

Difficulty: Moderate

Keywords: weighted marginal cost of capital

102. Metals Corp. has $2,575,000 of debt, $550,000 of preferred stock, and $18,125,000 of common equity. Metals Corp.’s after-tax cost of debt is 5.25%, preferred stock has a cost of 6.35%, and newly issued common stock has a cost of 14.05%. What is Metals Corp.’s weighted average cost of capital?

a. 12.78%

b. 10.84%

c. 8.32%

d. 6.56%

Difficulty: Moderate

Keywords: weighted average cost of capital

103. East Man Kodiac plans to maintain its optimal capital structure of 30% debt, 20% preferred stock, and 50% common stock. Bondholders require a return on East Man’s bonds of 10%; preferred shareholders require 11%; and common stockholders require 16%. Assuming that the firm has a marginal tax rate of 40%, what after-tax rate of return must East Man Kodiac earn on its investments if the value of the firm is to remain unchanged?

a. 10%

b. 12%

c. 14%

d. 16%

Difficulty: Moderate

Keywords: weighted average cost of capital

104. Walker & Son is issuing a 10-year, $1,000 par value bond that pays 9% interest annually. The bond is expected to sell for $885. What is Walker & Son’s cost of debt if the firm is in the 34% tax bracket?

a. 7.23%

b. 8.01%

c. 9.15%

d. 10.35%

Difficulty: Moderate

Keywords: cost of debt

105. Roto Roofing Corporation just paid a dividend of $1.85. This dividend is expected to grow at a constant annual rate of 3% per year. Roto Roofing’s common stock is currently selling for $12.50. The firm can sell new stock at this price subject to flotation costs of 15%. The firm’s marginal tax rate is 40%. What will the cost of the newly issued stock be?

a. 17.8%

1. 16.2%
2. 18.5%
3. 19.7%

e. 20.9%

Difficulty: Moderate

Keywords: cost of new stock

106. Pony Corporation is undertaking a capital budgeting analysis. The firm’s beta is 1.5. The rate on 30-year U.S. Treasury bonds is 5%, and the return on the S & P 500 index is 12%. What is the cost of Pony’s retained earnings?

a. 13.3%

b. 15.5%

c. 17.7%

d. 19.9%

Difficulty: Moderate

Keywords: cost of retained earnings

107. Sola Cola Corporation is undertaking a capital budgeting analysis. The rate on 30-year U.S. Treasury bonds is 6.3%, and the return on the S & P 500 index is 18.5%. If the cost of Sola Cola’s retained earnings is 19.7%, calculate their beta.

a. 1.1

b. 1.3

c. 1.5

d. 1.7

Difficulty: Moderate

Keywords: cost of retained earnings, beta

108. Seven Eleven Stores is planning an expansion project that it desires to finance with newly issued preferred stock. The firm has an outstanding issue of preferred stock that pays a dividend of $4.25 per share, which is trading for $65 per share. The investment bankers have advised Seven Eleven that flotation costs will be 8% per share. What will be the cost of the newly issued preferred shares?

a. 6.5%

b. 7.1%

c. 8.3%

d. 9.7%

Difficulty: Moderate

Keywords: cost of preferred stock

109. Johnstown desires to open a new plant that will require an investment of $5 million. The firm has decided to finance the plant with a new issue of preferred stock. Johnstown already has one issue of preferred stock outstanding that pays a dividend of $2.50 per share and which is trading for $35 per share. The investment bankers have advised Johnstown that the cost of the newly issued preferred stock would be 7.7%. How much are the investment bankers charging in flotation costs?

a. 5.5%

b. 7.5%

c. 9.5%

d. 11.5%

Difficulty: Moderate

Keywords: flotation costs, cost of preferred stock

110. In calculating the cost of capital for an average firm, which of the following statements is true?

a. The cost of a firm’s bonds is greater than the cost of its common stock.

b. The cost of a firm’s preferred stock is greater than the cost of its common stock.

c. The cost of a firm’s retained earnings is less than the cost of its bonds.

d. The cost of a firm’s common stock is greater than the cost of its bonds.

Difficulty: Moderate

Keywords: component costs of capital

111. Many corporate finance professionals favor the CAPM for determining the cost of equity. Which of the following is a reason for this preference?

a. The data is less expensive.

b. The variables in the model that apply to public corporations are readily available from public sources.

c. Because the CAPM gives better treatment to flotation costs.

d. The CAPM gives a superior calculation to the cost of newly issued warrants.

Difficulty: Moderate

Keywords: CAPM

112. The cost of newly issued common stock is greater than the cost of retained earnings because of which of the following?

a. Capital gains taxes on retained earnings

b. Flotation costs on newly issued common stock

c. Capital gains taxes on newly issued common stock

d. All of the above

e. The cost of newly issued common stock is not greater than the cost of retained earnings.

Difficulty: Moderate

Keywords: cost of retained earnings

113. Which of the following reasons causes bonds to be a less expensive form of capital for a public firm than the issuance of common stock? Bondholders:

a. bear less risk than common stockholders.

b. have prior voting rights over common stockholders.

c. receive greater returns than common stockholders.

d. do not have a contractual claim on the firm.

Difficulty: Easy

Keywords: cost of debt

114. Which of the following statements is true?

a. The cost of debt for a public corporation that has bonds outstanding is equal to one minus the marginal tax rate multiplied by the coupon rate on the outstanding bonds.

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

c. Newly issued common stock is more expensive to a corporation than either newly issued bonds or newly issued preferred stock because common stockholders bear greater risk.

d. All of the above are true.

Difficulty: Moderate

Keywords: component costs of capital

115. Financial risk refers to which of the following?

a. The usage of newly issued common stock in a firm’s capital structure

b. The risk that a firm might go out of business

c. The added variability in earnings available to common shareholders caused by the issuance of securities that give investors a fixed return

d. The risk that investors incur when they purchase common or preferred stock

Difficulty: Moderate

Keywords: financial risk

116. Business risk refers to which of the following?

a. The potential variability in a firm’s operating profit that results from the nature of the firm’s business endeavors.

b. The usage of newly issued common stock in a firm’s capital structure.

c. The risk that investors incur when they purchase common or preferred stock.

d. One firm doing business with another firm that is in an entirely different industry.

Difficulty: Moderate

Keywords: business risk

Short Answer

117. Give two reasons why the investors’ required rate of return is not equal to the cost of capital of a firm.

Difficulty: Easy

Keywords: cost of capital, required rate of return

118. Discuss the primary advantages of the CAPM approach in determining the cost of common equity.

Difficulty: Moderate

Keywords: CAPM, cost of common equity

119. Vipsu Corporation plans to issue 10-year bonds with a par value of $1,000 that will pay $55 every six months. The net amount of capital to the firm from the sale of each bond is $840.68. If Vipsu is in the 25% tax bracket, what is the after-tax cost of debt?

Find the present value factors that equate

$840.67 = $55(PVIFA, 20, r/2) + $1,000(PVIF, 20, r/2)

r = 0.14

kd = 14(1 - 0.25) = .105 = 10.5%

Difficulty: Moderate

Keywords: after-tax cost of debt

120. Moore Financing Corporation has preferred stock in its capital structure paying a dividend of $3.75 and selling for $25.00. If the marginal tax rate for Moore is 34%, what is the after-tax cost of preferred financing?

Difficulty: Moderate

Keywords: after-tax cost of preferred

121. Hoak Company’s common stock is currently selling for $50. Last year’s dividend was $1.83 per share. Investors expect dividends to grow at an annual rate of 9% into the future.

a. What is the cost of internal common equity?

b. Selling new common stock is expected to decrease the price of the

stock by $5.00. What is the cost of new common stock?

a. Kr = [$1.83(1.09)/$50] + 0.09 = 0.13

b. Ks = [$1.83(1.09)/$50 - $5] + 0.09 = 0.134

Difficulty: Moderate

Keywords: cost of internal equity, cost of new common stock

122. The treasurer of American Industries believes that his firm’s optimal capital structure is 40% debt and 60% equity capital. The required rate of return on American’s debt is 10.5% (ignore flotation cost for debt). American follows a strict 50% payout policy. Over the past nine years, dividends have doubled, and next year’s dividend is expected to be $2.00. Similar growth is expected far into the future. The company currently has 400,000 shares of common stock outstanding. Investment bankers have advised American’s management that flotation costs for new common stock will amount to 10% of the present price of $20 per share. The tax rate is 34%.

a. Calculate the after-tax component cost of debt and retained

earnings.

b. Assuming no new common stock is sold, calculate the weighted

marginal cost of capital.

c. Suppose that American has the following investment opportunity

schedule:

Amount Internal Rate of Return

Project A $800,000 19.0%

Project B 300,000 18.1%

Project C 400,000 16.5%

Project D 400,000 15.1%

Project E 200,000 14.5%

Project F 300,000 14.0%

Which projects should be accepted? Why?

a. kd = 10.5(1 - 0.34) = 6.93%

$2.00/$1.00 = PVIF[g%,9]

g = 9.0%

kc = ($2.00/$20) + .09 = .19

b. Ko = 0.4 × 6.93 + 0.6 × 19.00

Ko = 14.17%

c. Select A-E. All have an internal rate of return greater than Ko.

Difficulty: Hard

Keywords: weighted average cost of capital, project acceptance

123. Last year Gator Getters, Inc. had $50 million in total assets. Management desires to increase its plant and equipment during the coming year by $12 million. The company plans to finance 40% of the expansion with debt and the remaining 60% with equity capital. Bond financing will be at a 9% rate and will be sold at its par value. Common stock is currently selling for $50 per share, and flotation costs for new common stock will amount to $5 per share. The expected dividend next year for Gator is $2.50. Furthermore, dividends are expected to grow at a 6% rate far into the future. The marginal corporate tax rate is 34%. Internal funding available from additions to retained earnings is $4,000,000.

a. What amount of new common stock must be sold if the existing

capital structure is to be maintained?

b. Calculate the weighted marginal cost of capital at an investment

level of $12 million.

a. $12 million × 0.6 = $7.2 million

Less additions to R/E 4.0 million

New common stock $3.2 million

b. Kd = 9(1 - .34) = 5.94%

Knc = ($2.50/$45) + 0.06

Knc = 11.5%

Ko = 0.4 × 5.94% + 0.6 × 11.5%

Ko = 9.27%

Difficulty: Moderate

Keywords: cost of new common stock, marginal cost of capital

124. The Mayfair Company plans to use the following capital structure mix to finance all future expansion:

Debt 60%

Preferred stock 10%

Equity capital 30%

The company has $100,000 in earnings available to common stock. Assuming that management intends to maintain the above financial structure, what is the maximum amount of total investment that can be undertaken by the firm if it (a) issues $200,000 of preferred stock, (b) pays a $50,000 dividend, (c) issues $200,000 of new common stock plus all internally generated equity capital?

(a) $2.0 million

(b) $164,000

(c) $1.0 million

Difficulty: Moderate

Keywords: component cost of capital

125. The common stock for Grapevine Plumbing Company currently sells for $40 per share. If a new issue is sold, the flotation cost is estimated to be $7 per share. The company had earnings of $2.00 per share four years ago. Next year, the company expects to have earnings of $3.22 per share. The company maintains a constant dividend payout ratio of 40%. Earnings per share are anticipated to grow at the same rate in the future. The firm’s marginal tax rate is 30%. Calculate the cost of internal equity capital and external equity capital.

$3.22 = $2.00 FVIF[g,5]

1.61 = FVIF[g,5]

Growth rate in earnings = growth rate in dividends = .10

Kc = [($3.22)(.40)/$40] + .10 = .1322

Knc = [($3.22)(.40)/($40 - $7)] + .10 = .1390

Difficulty: Moderate

Keywords: cost of internal equity, cost of external equity

126. Sam McDowell, vice president of Ace Discount Stores, has to decide which of the following five projects should be adopted by his company:

Internal

Investment Cost Rate of Return

Project

A $200,000 26%

B 100,000 12%

C 175,000 18%

D 100,000 22%

E 150,000 16%

The company finances all expansion with 30% debt and 70% equity capital. The cost of debt (before tax) is 10% for the first $100,000. The cost of any additional debt (before tax) is 14%. The company’s common stock is currently selling for $50 per share. Flotation costs are 15% of the selling price. The company’s growth rate in earnings per share is anticipated to continue at a constant rate of 12% per year. The company’s earnings per share this year was $5.50. The company pays out 60% of its earnings as dividends. The company has $170,000 of internal funds available for investment purposes. Which projects should the company accept? (Use a corporate tax rate of 25%.)

Cost of debt = (1 - .25)(.10) = .075

Debt > $100,000

Cost of debt = (1 - .25)(.14) = .105

Equity financing <= $170,000

Kc = [($5.50)(1 + .12)(.60)/$50] + .12 = .1939

Equity financing > $170,000

Knc = [($5.50)(1 + .12)(.60)/($50)(1 - .15)] + .12 = .2070

Debt break point = $100,000/.30 = $333,333

Equity break point = $170,000/.70 = $242,857

Cost of capital - total investment <= $242,857

Ko = (.30)(.075) + (.70)(.1939) = .1582

Cost of capital - $242,857 < total investment <= $333,333

Ko = (.30)(.075) + (.70)(.2070) = .1674

Cost of capital - $333,333 < total investment

Ko = (.30)(.105) + (.70)(.2070) = .1764

The investment opportunity curve can be plotted using this data.

Difficulty: Hard

Keywords: weighted average cost of capital, project selection

127. A company is going to issue a $1,000 par value bond which pays 8% in annual interest. The company expects investors to pay $910 for the 20-year bond. The expected flotation cost per bond is $42. What is the firm’s cost of debt in this example? (Assume a 34% tax rate.)

Difficulty: Moderate

Keywords: after-tax cost of debt

128. Toto and Associates’ preferred stock is selling for $19.20 a share. The firm nets $18.40 after issuance costs. The stock pays an annual dividend of $2.21 per share. What is the cost of preferred stock to the company?

Difficulty: Moderate

Keywords: cost of preferred stock

129. Sutter Corporation’s common stock is selling for $16.80 a share. Last year, Sutter paid a dividend of $.80. Investors are expecting Sutter’s dividends to grow at a rate of 5% per year. What is the cost of internal equity?

Difficulty: Moderate

Keywords: cost of internal equity

130. Gibson Industries is issuing a $1,000 par value bond with an 8% annual interest coupon rate and that matures in 11 years. Investors are willing to pay $972, and flotation costs will be 9%. Gibson is in the 34% tax bracket. What will be the after-tax cost of debt of the bond?

After-tax cost of debt = 9.76%(1 - .34)

After-tax cost of debt = 6.44%

Difficulty: Moderate

Keywords: after-tax cost of debt

131. The preferred stock of Wells Co. sells for $17 and pays a $1.75 dividend. The net price of the stock after issuance costs is $15.30. What is the cost of capital for preferred stock?

Cost of preferred stock = 1.75/15.30

Cost of preferred stock = 11.44%

Difficulty: Moderate

Keywords: cost of preferred stock

132. Caribe’s common stock sells for $41, and dividends paid last year were $1.18. Flotation costs on issuing stock will be 12% of the market price. The dividends and earnings per share are predicted to have a 10% growth rate. What is the cost of internal equity for Caribe?

Cost of internal equity = ((1.18(1 + .10))/41) + .10

Cost of internal equity = 13.17%

Difficulty: Moderate

Keywords: cost of internal equity

133. Combs, Inc. is issuing new common stock at a market price of $22. Dividends last year were $1.15 per share and are expected to grow at a rate of 7%. Flotation costs will be 5% of the market price. What is Combs, Inc.’s cost of external equity?

Cost of equity = ((1.15(1 + .07))/(22 - (22(.05)))) + .07

Cost of equity = (1.23/20.9) + .07

Cost of equity = 12.89%

Difficulty: Moderate

Keywords: cost of external equity

134. The Curry Company is analyzing two capital investments. The financial vice president insists on examining the risk of the projects in terms of their effect on the risk of a diversified portfolio. The standard deviation of Projects X and Y are 10.2% and 8.4%, respectively. The expected return for a diversified portfolio is 15% with a standard deviation of 4.5%. The correlation coefficient between Project X and the portfolio is 0.65. Between Project Y and the portfolio, the correlation coefficient is 0.81. The expected returns are 18.1% for Project X and 18.8% for Project Y. The risk-free rate is 8%. Which investment(s) should the company accept?

Kj = Rf + (Rm - Rf) <(rjm ơj)/ơm>

Kx = .08 + (.15 - .08)[(.65)(.102)/.045]

Kx = .183, Reject

Ky = .08 + (.15 - .08)[(.81)(.074)/.045]

Ky = .173, Accept

Difficulty: Moderate

Keywords: CAPM, project selection