Question 1

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

Accepted Answer

A) True 
 B)False  True

Question 2

Westbrook's Painting Co.plans to issue a $1,000 par value,20-year noncallable bond with a 7.00% annual coupon,paid semiannually.The company's marginal tax rate is 40.00%,but Congress is considering a change in the corporate tax rate to 30.00%.By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted?

Accepted Answer

A) 0.57% 
B) 0.63% 
C) 0.70% 
D) 0.77% 
E) 0.85% 
A) 0.57% 
B) 0.63% 
C) 0.70% 
D) 0.77% 
E) 0.85% C

Question 3

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

A) True 
 B)False  False

Question 4

You were recently hired by Garrett Design,Inc.to estimate its cost of common equity.You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.00% (constant); and F = 5.00%.What is the cost of equity raised by selling new common stock?

Accepted Answer

A) 10.77% 
B) 11.33% 
C) 11.90% 
D) 12.50% 
E) 13.12% 
A) 10.77% 
B) 11.33% 
C) 11.90% 
D) 12.50% 
E) 13.12%

Question 5

Weatherall Enterprises has no debt or preferred stock⎯it is an all-equity firm⎯and has a beta of 2.0.The chief financial officer is evaluating a project with an expected return of 14%,before any risk adjustment.The risk-free rate is 5%,and the market risk premium is 4%.The project being evaluated is riskier than an average project,in terms of both its beta risk and its total risk.Which of the following statements is CORRECT?

Accepted Answer

A) The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return. 
B) Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment. 
C) The accept/reject decision depends on the firm's risk-adjustment policy. If Weatherall's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project. 
D) Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision. 
E) The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return. 
A) The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return. 
B) Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment. 
C) The accept/reject decision depends on the firm's risk-adjustment policy. If Weatherall's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project. 
D) Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision. 
E) The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.

Question 6

The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

Accepted Answer

A) True 
 B)False

Question 7

Your consultant firm has been hired by Eco Brothers Inc.to help them estimate the cost of common equity.The yield on the firm's bonds is 8.75%,and your firm's economists believe that the cost of common can be estimated using a risk premium of 3.85% over a firm's own cost of debt.What is an estimate of the firm's cost of common from reinvested earnings?

Accepted Answer

A) 12.60% 
B) 13.10% 
C) 13.63% 
D) 14.17% 
E) 14.74% 
A) 12.60% 
B) 13.10% 
C) 13.63% 
D) 14.17% 
E) 14.74%

Question 8

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

A) True 
 B)False

Question 9

Which of the following statements is CORRECT?

Accepted Answer

A) The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the DCF model's logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain. 
B) The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm's own cost of debt and its risk premium, can be found by using standardized and objective procedures. 
C) Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity. 
D) The DCF model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield. 
E) Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs⎯beta, the risk-free rate, and the market risk premium⎯can be estimated with little error. 
A) The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the DCF model's logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain. 
B) The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm's own cost of debt and its risk premium, can be found by using standardized and objective procedures. 
C) Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity. 
D) The DCF model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield. 
E) Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs⎯beta, the risk-free rate, and the market risk premium⎯can be estimated with little error.

Question 10

Which of the following statements is CORRECT?

Accepted Answer

A) The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes. 
B) If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject. 
C) Because no flotation costs are required to obtain capital as reinvested earnings, the cost of reinvested earnings is generally lower than the after-tax cost of debt. 
D) Higher flotation costs tend to reduce the cost of equity capital. 
E) Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity. 
A) The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes. 
B) If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject. 
C) Because no flotation costs are required to obtain capital as reinvested earnings, the cost of reinvested earnings is generally lower than the after-tax cost of debt. 
D) Higher flotation costs tend to reduce the cost of equity capital. 
E) Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.

Question 11

Which of the following statements is CORRECT?

Accepted Answer

A) The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt. 
B) The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets. 
C) There is an "opportunity cost" associated with using reinvested earnings, hence they are not "free." 
D) The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year. 
E) The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital. 
A) The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt. 
B) The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets. 
C) There is an "opportunity cost" associated with using reinvested earnings, hence they are not "free." 
D) The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year. 
E) The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital.

Question 12

Bartlett Company's target capital structure is 40% debt,15% preferred,and 45% common equity.The after-tax cost of debt is 6.00%,the cost of preferred is 7.50%,and the cost of common using reinvested earnings is 12.75%.The firm will not be issuing any new stock.You were hired as a consultant to help determine their cost of capital.What is its WACC?

Accepted Answer

A) 8.98% 
B) 9.26% 
C) 9.54% 
D) 9.83% 
E) 10.12% 
A) 8.98% 
B) 9.26% 
C) 9.54% 
D) 9.83% 
E) 10.12%

Question 13

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method,the DCF method,and the bond-yield-plus-risk-premium method.Since we cannot be sure that the estimate obtained with any of these methods is correct,it is often appropriate to use all three methods,then consider all three estimates,and end up using a judgmental estimate when calculating the WACC.

Accepted Answer

A) True 
 B)False

Question 14

Which of the following statements is CORRECT?

Accepted Answer

A) The WACC is calculated using a before-tax cost for debt that is equal to the interest rate that must be paid on new debt, along with the after-tax costs for common stock and for preferred stock if it is used. 
B) An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity. 
C) The relevant WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm's target capital structure. 
D) Beta measures market risk, which is generally the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. However, this is not true unless all of the firm's stockholders are well diversified. 
E) The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the interest rate on the company's own long-term bonds. The size of the risk premium for bonds with different ratings is published daily in The Wall Street Journal. 
A) The WACC is calculated using a before-tax cost for debt that is equal to the interest rate that must be paid on new debt, along with the after-tax costs for common stock and for preferred stock if it is used. 
B) An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity. 
C) The relevant WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm's target capital structure. 
D) Beta measures market risk, which is generally the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. However, this is not true unless all of the firm's stockholders are well diversified. 
E) The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the interest rate on the company's own long-term bonds. The size of the risk premium for bonds with different ratings is published daily in The Wall Street Journal.

Question 15

With its current financial policies,Flagstaff Inc.will have to issue new common stock to fund its capital budget.Since new stock has a higher cost than reinvested earnings,Flagstaff would like to avoid issuing new stock.Which of the following actions would REDUCE its need to issue new common stock?

Accepted Answer

A) Increase the percentage of debt in the target capital structure. 
B) Increase the proposed capital budget. 
C) Reduce the amount of short-term bank debt in order to increase the current ratio. 
D) Reduce the percentage of debt in the target capital structure. 
E) Increase the dividend payout ratio for the upcoming year. 
A) Increase the percentage of debt in the target capital structure. 
B) Increase the proposed capital budget. 
C) Reduce the amount of short-term bank debt in order to increase the current ratio. 
D) Reduce the percentage of debt in the target capital structure. 
E) Increase the dividend payout ratio for the upcoming year.

Question 16

Which of the following statements is CORRECT?

Accepted Answer

A) The after-tax cost of debt usually exceeds the after-tax cost of equity. 
B) For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock. 
C) Retained earnings that were generated in the past and are reported on the firm's balance sheet are available to finance the firm's capital budget during the coming year. 
D) The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital. 
E) The WACC is calculated using before-tax costs for all components. 
A) The after-tax cost of debt usually exceeds the after-tax cost of equity. 
B) For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock. 
C) Retained earnings that were generated in the past and are reported on the firm's balance sheet are available to finance the firm's capital budget during the coming year. 
D) The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital. 
E) The WACC is calculated using before-tax costs for all components.

Question 17

Kenny Electric Company's noncallable bonds were issued several years ago and now have 20 years to maturity.These bonds have a 9.25% annual coupon,paid semiannually,sells at a price of $1,075,and has a par value of $1,000.If the firm's tax rate is 40%,what is the component cost of debt for use in the WACC calculation?

Accepted Answer

A) 4.35% 
B) 4.58% 
C) 4.83% 
D) 5.08% 
E) 5.33% 
A) 4.35% 
B) 4.58% 
C) 4.83% 
D) 5.08% 
E) 5.33%

Question 18

Trahern Baking Co.common stock sells for $32.50 per share.It expects to earn $3.50 per share during the current year,its expected dividend payout ratio is 65%,and its expected constant dividend growth rate is 6.0%.New stock can be sold to the public at the current price,but a flotation cost of 5% would be incurred.What would be the cost of equity from new common stock?

Accepted Answer

A) 12.70% 
B) 13.37% 
C) 14.04% 
D) 14.74% 
E) 15.48% 
A) 12.70% 
B) 13.37% 
C) 14.04% 
D) 14.74% 
E) 15.48%

Question 19

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,is not deductible by the issuing firm.

Accepted Answer

A) True 
 B)False

Question 20

You have been hired by the CFO of Lugones Industries to help estimate its cost of common equity.You have obtained the following data:
(1)rd = yield on the firm's bonds = 7.00% and the risk premium over its own debt cost = 4.00%.
(2)rRF = 5.00%,RPM = 6.00%,and b = 1.25.
(3)D1 = $1.20,P0 = $35.00,and g = 8.00% (constant).You were asked to estimate the cost of common based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates.What is that difference?

Accepted Answer

A) 1.13% 
B) 1.50% 
C) 1.88% 
D) 2.34% 
E) 2.58% 
A) 1.13% 
B) 1.50% 
C) 1.88% 
D) 2.34% 
E) 2.58%

Exam 11: Determining the Cost of Capital

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

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.

You were recently hired by Garrett Design,Inc.to estimate its cost of common equity.You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.00% (constant); and F = 5.00%.What is the cost of equity raised by selling new common stock?

The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

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.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

With its current financial policies,Flagstaff Inc.will have to issue new common stock to fund its capital budget.Since new stock has a higher cost than reinvested earnings,Flagstaff would like to avoid issuing new stock.Which of the following actions would REDUCE its need to issue new common stock?

Which of the following statements is CORRECT?

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,is not deductible by the issuing firm.

An Overview of Financial Management and the Financial Environment

Risk and Return: Part I

Risk and Return: Part Ii

Bond Valuation

Financial Options

Accounting for Financial Management

Analysis of Financial Statements

Basic Stock Valuation

Corporate Valuation and Financial Planning

Corporate Governance

Capital Budgeting: Decision Rules

Cash Flow Estimation and Risk Analysis

Real Options

Distributions to Shareholders: Dividends and Repurchases

Capital Structure Decisions

Dynamic Capital Structures and Corporate Valuation

Initial Public Offerings, investment Banking, and Financial Restructuring

Lease Financing

Hybrid Financing: Preferred Stock, Warrants, and Convertibles

Supply Chains and Working Capital Management

Providing and Obtaining Credit

Advanced Issues in Cash Management and Inventory Control

Enterprise Risk Management

Bankruptcy, reorganization, and Liquidation

Mergers and Corporate Control

Multinational Financial Management

Time Value of Money

Basic Financial Tools: a Review

Pension Plan Management

Financial Management in Not-For-Profit Businesses

a Values of the Areas Under the Standard Normal

Filters

You were recently hired by Garrett Design,Inc.to estimate its cost of common equity.You obtained the following data: D₁ = $1.75; P₀ = $42.50; g = 7.00% (constant); and F = 5.00%.What is the cost of equity raised by selling new common stock?