Deck 9: The Cost of Capital

Question 1

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

Answer 1

True

Question 2

Perpetual preferred stock from Franklin Inc.sells for $97.50 per share, and it pays an $8.50 annual dividend.If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors.What is the company's cost of preferred stock for use in calculating the WACC?

A) 8.72%
B) 9.08%
C) 9.44%
D) 9.82%
E) 10.22%

Answer 2

B

Question 3

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

Answer 3

True

Question 4

The cost of capital used in capital budgeting should reflect the average after-tax cost of providing required returns to investors.

Question 5

If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.

Question 6

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.

Question 7

Collins Group
The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The bal ance sheet and some other in formation are provided below.
$\begin{array}{lr}\text { Assets } \\\text { Current assets } & \$ 38,000,000 \\\text { Net plant, property, and equipment } & 101,000,000 \\\text { Total assets } & \$ 139,000,000\\\\\text { Liabilities and Equity }\\\text { Accounts payable } & \$ 10,000,000 \\\text { Accruals } & 9,000,000 \\\text { Current liabilities } & \$ 19,000,000 \\\text { Long-term debt ( } 40,000 \text { bonds, } \$ 1,000 \text { par value) } & 40,000,000 \\\text { Total liabilities } & \$ 59,000,000 \\\text { Common stock (10,000,000 shares) } & 30,000,000 \\\text { Retained earnings } & 50,000,000 \\\text { Total shareholders' equity } & \$ 0,000,000 \\\text { Total liabilities and shareholders' equity } & \$ 139,000,000\end{array}$
The stock is currently selling for $\$ 15.25$ per share, and its noncallable $\$ 1,000$ par value, 20 -year, $7.25 \%$ bonds with semiannual payments are selling for $\$ 875.00$ . The betais 1.25 , the yield on a 6 -month Treasury bill is $3.50 \%$ , and the yield on a 20 -year Treasury bond is $5.50 \%$ . The required return on the stock market is $11.50 \%$ , but the market has had an average annual retum of $14.50 \%$ during the past 5 years. The firm's tax rate is $25 \%$ .

-Refer to the data for the Collins Group.What is the best estimate of the after-tax cost of debt?

A) 5.80%
B) 6.10%
C) 6.43%
D) 6.75%
E) 7.08%

Question 8

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.

Question 9

A company's perpetual preferred stock currently sells for $92.50 per share, and it pays an $8.00 annual dividend.If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price.What is the firm's cost of preferred stock?

A) 7.81%
B) 8.22%
C) 8.65%
D) 9.10%
E) 9.56%

Question 10

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

Question 11

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

Question 12

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 25%, what is the component cost of debt for use in the WACC calculation?

A) 5.44%
B) 5.73%
C) 6.03%
D) 6.35%
E) 6.67%

Question 13

The Lincoln Company sold a $1,000 par value, noncallable bond several years ago that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually.The bond currently sells for $925 and the company's tax rate is 25%.What is the component cost of debt for use in the WACC calculation?

A) 5.35%
B) 5.58%
C) 5.81%
D) 6.04%
E) 6.28%

Question 14

Which of the following statements is CORRECT?

A) Since its stockholders are not directly responsible for paying a corporation's income taxes, corporations should focus on before-tax cash flows when calculating the WACC.
B) An increase in a firm's tax rate will increase the component cost of debt, provided the YTM on the firm's bonds is not affected by the change in the tax rate.
C) When the WACC is calculated, it should reflect the costs of new common stock, reinvested earnings, preferred stock, long-term debt, short-term bank loans if the firm normally finances with bank debt, and accounts payable if the firm normally has accounts payable on its balance sheet.
D) If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the after-tax cost of debt.
E) Since the costs of internal and external equity are related, an increase in the flotation cost required to sell a new issue of stock will increase the cost of reinvested earnings.

Question 15

"Capital" is sometimes defined as funds supplied to a firm by investors.

Question 16

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 25%, but Congress is considering a change in the corporate tax rate to 15%.By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted?

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

Question 17

Which of the following statements is CORRECT?

A) All else equal, an increase in a company's stock price will increase its marginal cost of reinvested earnings (not newly issued stock), r_s.
B) All else equal, an increase in a company's stock price will increase its marginal cost of new common equity, r_e.
C) Since the money is readily available, the after-tax cost of reinvested earnings (not newly issued stock) is usually much lower than the after-tax cost of debt.
D) If a company's tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall.
E) When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation.

Question 18

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 50% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

Question 19

Because 50% of the preferred dividends received by a corporation are excluded from taxable income, the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be
​
Cost of equity = r_s(0.30)(0.50) + r_ps(1 − T)(0.50)(0.50).

Question 20

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

A) Accounts payable.
B) Common stock "raised" by reinvesting earnings.
C) Common stock raised by new issues.
D) Preferred stock.
E) Long-term debt.

Question 21

If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the required rate of return on equity, r_s, than on the interest rate on long-term debt, r_d, for most firms.Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity.However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit the shift toward debt.

Question 22

When working with the CAPM, which of the following factors can be determined with the most precision?

A) The beta coefficient, b_i, of a relatively safe stock.
B) The most appropriate risk-free rate, r_RF.
C) The expected rate of return on the market, r_M.
D) The beta coefficient of "the market," which is the same as the beta of an average stock.
E) The market risk premium (RP_M).

Question 23

For capital budgeting and cost of capital purposes, the firm should always consider reinvested earnings as the first source of capital⎯i.e., use these funds first⎯because reinvested earnings have no cost to the firm.

Question 24

To help them estimate the company's cost of capital, Smithco has hired you as a consultant.You have been provided with the following data: D₁ = $1.45; P₀ = $22.50; and g_L = 6.50% (constant).Based on the dividend growth approach, what is the cost of common from reinvested earnings?

A) 11.10%
B) 11.68%
C) 12.30%
D) 12.94%
E) 13.59%

Question 25

The reason why reinvested earnings have a cost equal to r_s is because investors think they can (i.e., expect to) earn r_s on investments with the same risk as the firm's common stock, and if the firm does not think that it can earn r_s on the earnings that it retains, it should distribute those earnings to its investors.Thus, the cost of reinvested earnings is based on the opportunity cost principle.

Question 26

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

Question 27

You have been hired as a consultant by Feludi Inc.'s CFO, who wants you to help her estimate the cost of capital.You have been provided with the following data: r_RF = 4.10%; RP_M = 5.25%; and b = 1.30.Based on the CAPM approach, what is the cost of common from reinvested earnings?

A) 9.67%
B) 9.97%
C) 10.28%
D) 10.60%
E) 10.93%

Question 28

As a consultant to Basso Inc., you have been provided with the following data: D₁ = $0.67; P₀ = $27.50; and g_L = 8.00% (constant).What is the cost of common from reinvested earnings based on the dividend growth approach?

A) 9.42%
B) 9.91%
C) 10.44%
D) 10.96%
E) 11.51%

Question 29

Adams Inc.has the following data: r_RF = 5.00%; RP_M = 6.00%; and b = 1.05.What is the firm's cost of common from reinvested earnings based on the CAPM?

A) 11.30%
B) 11.64%
C) 11.99%
D) 12.35%
E) 12.72%

Question 30

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the dividend growth method, and the bond-yield-plus-risk-premium method.However, only the dividend growth method is widely used in practice.

Question 31

When estimating the cost of equity by use of the dividend growth method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return.This problem leaves us unsure of the true value of r_s.

Question 32

When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to use long-term or short-term rates for r_RF, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and (3) how to measure the market risk premium, RP_M.These problems leave us unsure of the true value of r_s.

Question 33

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost.

Question 34

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

Question 35

As the assistant to the CFO of Johnstone Inc., you must estimate its cost of common equity.You have been provided with the following data: D₀ = $0.80; P₀ = $22.50; and g_L = 8.00% (constant).Based on the dividend growth model, what is the cost of common from reinvested earnings?

A) 10.69%
B) 11.25%
C) 11.84%
D) 12.43%
E) 13.05%

Question 36

To help estimate its cost of common equity, Maxwell and Associates recently hired you.You have obtained the following data: D₀ = $0.90; P₀ = $27.50; and g_L = 7.00% (constant).Based on the dividend growth model, what is the cost of common from reinvested earnings?

A) 9.29%
B) 9.68%
C) 10.08%
D) 10.50%
E) 10.92%

Question 37

If expectations for long-term inflation rose, but the slope of the SML remained constant, this would have a greater impact on the required rate of return on equity, r_s, than on the interest rate on long-term debt, r_d, for most firms.Therefore, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt.

Question 38

Collins Group
The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The bal ance sheet and some other in formation are provided below.
$\begin{array}{lr}\text { Assets } \\\text { Current assets } & \$ 38,000,000 \\\text { Net plant, property, and equipment } & 101,000,000 \\\text { Total assets } & \$ 139,000,000\\\\\text { Liabilities and Equity }\\\text { Accounts payable } & \$ 10,000,000 \\\text { Accruals } & 9,000,000 \\\text { Current liabilities } & \$ 19,000,000 \\\text { Long-term debt ( } 40,000 \text { bonds, } \$ 1,000 \text { par value) } & 40,000,000 \\\text { Total liabilities } & \$ 59,000,000 \\\text { Common stock (10,000,000 shares) } & 30,000,000 \\\text { Retained earnings } & 50,000,000 \\\text { Total shareholders' equity } & \$ 0,000,000 \\\text { Total liabilities and shareholders' equity } & \$ 139,000,000\end{array}$
The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00.The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%.The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years.The firm's tax rate is 25%.

-Refer to the data for the Collins Group.Based on the CAPM, what is the firm's cost of common stock?

A) 11.15%
B) 11.73%
C) 12.35%
D) 13.00%
E) 13.65%

Question 39

The CEO of Harding Media Inc.as asked you to help estimate its cost of common equity.You have obtained the following data: D₀ = $0.85; P₀ = $22.00; and g_L = 6.00% (constant).The CEO thinks, however, that the stock price is temporarily depressed, and that it will soon rise to $40.00.Based on the dividend growth model, by how much would the cost of common from reinvested earnings change if the stock price changes as the CEO expects?

A) −1.49%
B) −1.66%
C) −1.84%
D) −2.03%
E) −2.23%

Question 40

Which of the following statements is CORRECT?

A) If the calculated beta underestimates the firm's true investment risk⎯i.e., if the forward-looking beta that investors think exists exceeds the historical beta⎯then the CAPM method based on the historical beta will produce an estimate of r_s and thus WACC that is too high.
B) Beta measures market risk, which is, theoretically, the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value.This is true even if not all of the firm's stockholders are well diversified.
C) An advantage shared by both the dividend growth model and CAPM methods when they are used to estimate the cost of equity is that they are both "objective" as opposed to "subjective," hence little or no judgment is required.
D) The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach.
E) The discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever.

Question 41

In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources.However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project.

Question 42

Which of the following statements is CORRECT? Assume a company's target capital structure is 50% debt and 50% common equity.

A) The WACC is calculated on a before-tax basis.
B) The WACC exceeds the cost of equity.
C) The cost of equity is always equal to or greater than the cost of debt.
D) The cost of reinvested earnings typically exceeds the cost of new common stock.
E) The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet.

Question 43

Which of the following statements is CORRECT?

A) The dividend growth model is generally preferred by academics and financial executives over other models for estimating the cost of equity.This is because of the dividend growth 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 dividend growth model 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 44

Collins Group
The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital.The balance sheet and some other information are provided below.
$\begin{array}{lr}\text { Assets } \\\text { Current assets } & \$ 38,000,000 \\\text { Net plant, property, and equipment } & 101,000,000 \\\text { Total assets } & \$ 139,000,000\\\\\text { Liabilities and Equity }\\\text { Accounts payable } & \$ 10,000,000 \\\text { Accruals } & 9,000,000 \\\text { Current liabilities } & \$ 19,000,000 \\\text { Long-term debt ( } 40,000 \text { bonds, } \$ 1,000 \text { par value) } & 40,000,000 \\\text { Total liabilities } & \$ 59,000,000 \\\text { Common stock (10,000,000 shares) } & 30,000,000 \\\text { Retained earnings } & 50,000,000 \\\text { Total shareholders' equity } & \$ 0,000,000 \\\text { Total liabilities and shareholders' equity } & \$ 139,000,000\end{array}$
The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00.The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%.The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years.The firm's tax rate is 25%.

-Refer to the data for the Collins Group.Which of the following is the best estimate for the weight of debt for use in calculating the firm's WACC?

A) 18.67%
B) 19.60%
C) 20.58%
D) 21.61%
E) 22.69%

Question 45

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.

Question 46

Which of the following statements is CORRECT?

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 47

Which of the following statements is CORRECT?

A) We should use historical measures of the component costs from prior financings that are still outstanding when estimating a company's WACC for capital budgeting purposes.
B) The cost of new equity (r_e) could possibly be lower than the cost of reinvested earnings (r_s) if the market risk premium, risk-free rate, and the company's beta all decline by a sufficiently large amount.
C) A company must try to adjust its current actual market value weights toward its target weights.
D) The component cost of preferred stock is expressed as r_p(1 − T), because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt.
E) In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 50% of the dividends received by corporate investors are excluded from their taxable income.

Question 48

Which of the following statements is CORRECT?

A) WACC calculations should be based on the before-tax costs of all the individual capital components.
B) Flotation costs associated with issuing new common stock normally reduce the WACC.
C) If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline.
D) An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.
E) A change in a company's target capital structure cannot affect its WACC.

Question 49

Suppose you are the president of a small, publicly-traded corporation.Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt.In this case, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt.

Question 50

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?

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

Question 51

The president and CFO of Spellman Transportation are having a disagreement about whether to use market value or book value weights in calculating the WACC.Spellman's balance sheet shows a total of noncallable $45 million long-term debt with a coupon rate of 7.00% and a yield to maturity of 6.00%.This debt currently has a market value of $50 million.The company has 10 million shares of common stock, and the book value of the common equity (common stock plus retained earnings) is $65 million.The current stock price is $22.50 per share; stockholders' required return, r_s, is 14.00%; and the firm's tax rate is 25%.The CFO thinks the WACC should be based on market value weights, but the president thinks book weights are more appropriate.What is the difference between these two WACCs?

A) 1.42%
B) 1.57%
C) 1.75%
D) 1.94%
E) 2.16%

Question 52

Which of the following statements is CORRECT?

A) A cost should be assigned to reinvested earnings due to the opportunity cost principle, which refers to the fact that the firm's stockholders would themselves expect to earn a return on earnings that were distributed rather than retained and reinvested.
B) No cost should be assigned to reinvested earnings because the firm does not have to pay anything to raise them.They are generated as cash flows by operating assets that were raised in the past; hence, they are "free."
C) Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into the foreseeable future.In this case, the firm's before-tax and after-tax costs of debt for purposes of calculating the WACC will both be equal to the interest rate on the firm's currently outstanding debt, provided that debt was issued during the past 5 years.
D) If a firm has enough reinvested earnings to fund its capital budget for the coming year, then there is no need to estimate either a cost of equity or a WACC.
E) The component cost of preferred stock is expressed as r_p(1 − T).This follows because preferred stock dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes.

Question 53

The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant.

Question 54

Which of the following statements is CORRECT?

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 required return on debt used in calculating a firm's WACC should be based on the debt's current required return even if it is higher than the debt's coupon rate.
E) The WACC is calculated using before-tax costs for all components.

Question 55

To estimate the company's WACC, Marshall Inc.recently hired you as a consultant.You have obtained the following information.(1) The firm's noncallable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $1,000, and a market price of $1,050.00.(2) The company's tax rate is 25%.(3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock's beta is 1.20.(4) The target capital structure consists of 35% debt and the balance is common equity.The firm uses the CAPM to estimate the cost of common stock, and it does not expect to issue any new shares.What is its WACC?

A) 7.48%
B) 7.88%
C) 8.29%
D) 8.73%
E) 9.19%

Question 56

The cost of debt, r_d, is normally less than r_s, so r_d(1 − T) will normally be much less than r_s.Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than r_d(1 − T).

Question 57

Quinlan Enterprises stock trades for $52.50 per share.It is expected to pay a $2.50 dividend at year end (D₁ = $2.50), and the dividend is expected to grow at a constant rate of 5.50% a year.The before-tax cost of debt is 7.50%, and the tax rate is 25%.The target capital structure consists of 45% debt and 55% common equity.What is the company's WACC if all the equity used is from reinvested earnings?

A) 7.53%
B) 7.85%
C) 8.18%
D) 8.50%
E) 8.84%

Question 58

Which of the following statements is CORRECT?

A) When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.
B) Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM.
C) If a company's beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough reinvested earnings to take care of its equity financing and hence must issue new stock.
D) Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC.
E) When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.

Question 59

Which of the following statements is CORRECT?

A) The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average after-tax cost of all the firm's outstanding debt.
B) Suppose some of a publicly-traded firm's stockholders are not diversified; they hold only the one firm's stock.In this case, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firm's intrinsic value.
C) Whether shareholders are already equity holders or are brand-new equity holders, they all have the same required rate of return on stock.
D) The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm's cost of equity capital.
E) The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity.

Question 60

Avery Corporation's target capital structure is 35% debt, 10% preferred, and 55% common equity.The interest rate on new debt is 6.50%, the yield on the preferred is 6.00%, the cost of common from reinvested earnings is 11.25%, and the tax rate is 25%.The firm will not be issuing any new common stock.What is Avery's WACC?

A) 8.49%
B) 8.83%
C) 9.19%
D) 9.55%
E) 9.94%

Question 61

If the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common stock (r_e) is equal to the cost of equity capital from retaining earnings (r_s) divided by one minus the percentage flotation cost required to sell the new stock, (1 − F).If the expected growth rate is not zero, then the cost of external equity must be found using a different formula.

Question 62

Which of the following statements is CORRECT?

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 WACC for a firm that pays dividends and regularly issues new equity will be greater than the WACC for an otherwise identical company that pays lower dividends and that rarely issues new equity.
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 63

Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.

A) If a firm's managers want to maximize the value of their firm's stock, they should, in theory, concentrate on project risk as measured by the standard deviation of the project's expected future cash flows.
B) If a firm evaluates all projects using the same cost of capital, and the CAPM is used to help determine that cost, then its risk as measured by beta will probably decline over time.
C) Projects with above-average risk typically have higher than average expected returns.Therefore, to maximize a firm's intrinsic value, its managers should favor high-beta projects over those with lower betas.
D) Project A has a standard deviation of expected returns of 20%, while Project B's standard deviation is only 10%.A's returns are negatively correlated with both the firm's other assets and the returns on most stocks in the economy, while B's returns are positively correlated.Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital.
E) If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms' assets.

Question 64

Collins Group
The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital.The balance sheet and some other information are provided below.
$\begin{array}{lr}\text { Assets } \\\text { Current assets } & \$ 38,000,000 \\\text { Net plant, property, and equipment } & 101,000,000 \\\text { Total assets } & \$ 139,000,000\\\\\text { Liabilities and Equity }\\\text { Accounts payable } & \$ 10,000,000 \\\text { Accruals } & 9,000,000 \\\text { Current liabilities } & \$ 19,000,000 \\\text { Long-term debt ( } 40,000 \text { bonds, } \$ 1,000 \text { par value) } & 40,000,000 \\\text { Total liabilities } & \$ 59,000,000 \\\text { Common stock (10,000,000 shares) } & 30,000,000 \\\text { Retained earnings } & 50,000,000 \\\text { Total shareholders' equity } & \$ 0,000,000 \\\text { Total liabilities and shareholders' equity } & \$ 139,000,000\end{array}$
The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00.The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%.The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years.The firm's tax rate is 25%.

-The cost of external equity capital raised by issuing new common stock (r_e) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (r_s), divided by one minus the percentage flotation cost required to sell the new stock, (1 ? F)."

Question 65

As the winner of a contest, you are now CFO for the day for Maguire Inc.and your day's job involves raising capital for expansion.Maguire's common stock currently sells for $45.00 per share, the company expects to earn $2.75 per share during the current year, its expected payout ratio is 70%, and its expected constant growth rate is 6.00%.New stock can be sold to the public at the current price, but a flotation cost of 8% would be incurred.By how much would the cost of new stock exceed the cost of common from reinvested earnings?

A) 0.09%
B) 0.19%
C) 0.37%
D) 0.56%
E) 0.84%

Question 66

Which of the following statements is CORRECT?

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 67

For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure.

A) r_e > r_s > WACC > r_d.
B) WACC > r_e > r_s > r_d.
C) r_d > r_e > r_s > WACC.
D) WACC > r_d > r_s > r_e.
E) r_s > r_e > r_d > WACC.

Question 68

Bloom and Co.has no debt or preferred stock⎯it uses only equity capital, and has two equally-sized divisions.Division X's cost of capital is 10.0%, Division Y's cost is 14.0%, and the corporate (composite) WACC is 12.0%.All of Division X's projects are equally risky, as are all of Division Y's projects.However, the projects of Division X are less risky than those of Division Y.Which of the following projects should the firm accept?

A) A Division Y project with a 12% return.
B) A Division X project with an 11% return.
C) A Division X project with a 9% return.
D) A Division Y project with an 11% return.
E) A Division Y project with a 13% return.

Question 69

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?

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

Question 70

Collins Group
The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital.The balance sheet and some other information are provided below.
$\begin{array}{lr}\text { Assets } \\\text { Current assets } & \$ 38,000,000 \\\text { Net plant, property, and equipment } & 101,000,000 \\\text { Total assets } & \$ 139,000,000\\\\\text { Liabilities and Equity }\\\text { Accounts payable } & \$ 10,000,000 \\\text { Accruals } & 9,000,000 \\\text { Current liabilities } & \$ 19,000,000 \\\text { Long-term debt ( } 40,000 \text { bonds, } \$ 1,000 \text { par value) } & 40,000,000 \\\text { Total liabilities } & \$ 59,000,000 \\\text { Common stock (10,000,000 shares) } & 30,000,000 \\\text { Retained earnings } & 50,000,000 \\\text { Total shareholders' equity } & \$ 0,000,000 \\\text { Total liabilities and shareholders' equity } & \$ 139,000,000\end{array}$
The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00.The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%.The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years.The firm's tax rate is 25%.

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

Question 71

Collins Group
The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital.The balance sheet and some other information are provided below.
$\begin{array}{lr}\text { Assets } \\\text { Current assets } & \$ 38,000,000 \\\text { Net plant, property, and equipment } & 101,000,000 \\\text { Total assets } & \$ 139,000,000\\\\\text { Liabilities and Equity }\\\text { Accounts payable } & \$ 10,000,000 \\\text { Accruals } & 9,000,000 \\\text { Current liabilities } & \$ 19,000,000 \\\text { Long-term debt ( } 40,000 \text { bonds, } \$ 1,000 \text { par value) } & 40,000,000 \\\text { Total liabilities } & \$ 59,000,000 \\\text { Common stock (10,000,000 shares) } & 30,000,000 \\\text { Retained earnings } & 50,000,000 \\\text { Total shareholders' equity } & \$ 0,000,000 \\\text { Total liabilities and shareholders' equity } & \$ 139,000,000\end{array}$
The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00.The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%.The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years.The firm's tax rate is 25%.

-Refer to the data for the Collins Group.What is the best estimate of the firm's WACC?

A) 11.08%
B) 11.42%
C) 11.77%
D) 12.13%
E) 12.49%

Question 72

Careco Company and Audaco Inc are identical in size and capital structure.However, the riskiness of their assets and cash flows are somewhat different, resulting in Careco having a WACC of 10% and Audaco a WACC of 12%.Careco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Careco project.Audaco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Audaco project. Now assume that the two companies merge and form a new company, Careco/Audaco Inc.Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y.Which of the following statements is CORRECT?

A) If evaluated using the correct post-merger WACC, Project X would have a negative NPV.
B) After the merger, Careco/Audaco would have a corporate WACC of 11%.Therefore, it should reject Project X but accept Project Y.
C) Careco/Audaco's WACC, as a result of the merger, would be 10%.
D) After the merger, Careco/Audaco should select Project Y but reject Project X.If the firm does this, its corporate WACC will fall to 10.5%.
E) If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.

Question 73

Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets.They then provide funds to their different divisions for investment in capital projects.The divisions may vary in risk, and the projects within the divisions may also vary in risk.Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.

Question 74

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?

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

Question 75

You are a finance intern at Chambers and Sons and they have asked you to help estimate the company's cost of common equity.You obtained the following data: D₁ = $1.25; P₀ = $27.50; g_L = 5.00% (constant); and F = 6.00%.What is the cost of equity raised by selling new common stock?

A) 9.06%
B) 9.44%
C) 9.84%
D) 10.23%
E) 10.64%

Question 76

Assume that you are an intern with the Brayton Company, and you have collected the following data: The yield on the company's outstanding bonds is 7.75%; its tax rate is 25%; the next expected dividend is $0.65 a share; the dividend is expected to grow at a constant rate of 6.00% a year; the price of the stock is $15.00 per share; the flotation cost for selling new shares is F = 10%; and the target capital structure is 45% debt and 55% common equity.What is the firm's WACC, assuming it must issue new stock to finance its capital budget?

A) 7.34%
B) 7.73%
C) 8.14%
D) 8.56%
E) 8.99%

Question 77

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_L = 7.00% (constant); and F = 5.00%.What is the cost of equity raised by selling new common stock?

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

Question 78

The Tierney Group has two divisions of equal size: an office furniture manufacturing division and a data processing division.Its CFO believes that stand-alone data processor companies typically have a WACC of 9%, while stand-alone furniture manufacturers typically have a 13% WACC.She also believes that the data processing and manufacturing divisions have the same risk as their typical peers.Consequently, she estimates that the composite, or corporate, WACC is 11%.A consultant has suggested using a 9% hurdle rate for the data processing division and a 13% hurdle rate for the manufacturing division.However, the CFO disagrees, and she has assigned an 11% WACC to all projects in both divisions.Which of the following statements is CORRECT?

A) The decision not to adjust for risk means, in effect, that it is favoring the data processing division.Therefore, that division is likely to become a larger part of the consolidated company over time.
B) The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division.This will lead to a reduction in the firm's intrinsic value over time.
C) The decision not to risk-adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business.This will lead to a reduction in its intrinsic value over time.
D) The decision not to risk-adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business.This may affect the firm's capital structure but it will not affect its intrinsic value.
E) While the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant's recommendation, this should not affect the firm's intrinsic value.

Question 79

When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate.This problem leaves us unsure of the true value of r_s.

Question 80

If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the dividend growth model, and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method.All this makes it especially difficult to estimate the cost of equity for a private company.