Deck 11: The Cost of Capital

Question 1

The firm's cost of capital represents the maximum rate of return that a firm can earn from its capital budgeting projects to ensure that the value of the firm increases.

Answer 1

False

Question 2

The component costs of capital are market-determined variables in as much as they are based on investors' required returns.

Answer 2

True

Question 3

As per the Bond-Yield-Plus-Risk-Premium Approach, analysts estimate the cost of common equity by adding a risk premium of 3 to 5 percentage points to:

A) the cost of preferred stock of the firm.
B) the risk free rate of the common equity of the firm.
C) the interest rate on the long term debt of the firm.
D) the return on the firm's investment in municipal bonds.
E) the growth rate of the firm.

Answer 3

C

Question 4

Under normal circumstances, the weighted average cost of capital is used as the firm's required rate of return because:

A) as long as the firm's investments earn returns greater than the cost of capital, the value of the firm will not decrease.
B) returns below the cost of capital will cover all the fixed costs associated with the capital and provide excess returns to the firm's stockholders.
C) it is comparable to the average of all the interest rates on debt that currently prevail in the financial markets.
D) it is an indication of the return the firm is expecting to earn in future from all of its expansion plans.
E) the weighted average cost of capital remains unchanged if the components costs of capital changes.

Question 5

Which of the following statements is true of the capital asset pricing model (CAPM)?

A) The capital asset pricing model (CAPM) approach to estimating a firm's cost of retained earnings gives a better estimate than the discounted cash flow (DCF) approach.
B) The capital asset pricing model (CAPM) approach is typically used to estimate a firm's flotation cost adjustment factor, and this factor is added to the discounted cash flow (DCF) cost estimate.
C) The beta coefficient used in the capital asset pricing model (CAPM) approach is the same as the growth rate used in the discounted cash flow (DCF) method.
D) The capital asset pricing model (CAPM) approach and the discounted cash flow (DCF) approach always result in exactly the same estimate for r.
E) The capital asset pricing model (CAPM) approach assumes investors are well diversified and the discounted cash flow (DCF) approach assumes constant growth rate.

Question 6

Which of the following is an assumption in applying the capital asset pricing model (CAPM) to estimate the cost of equity capital?

A) The investors are well diversified.
B) The firm's dividends and earnings grow at a constant rate far into the future.
C) The cost of equity and the cost of debt of a firm are always equal.
D) The cost of retained earnings is lower than the cost of preferred stock due to the tax savings on earnings retained.
E) The investors always prefer to receive lower return on retained earnings than regular dividend payments.

Question 7

Which of the following may be true of the cost of debt and cost of equity?

A) The weighted average cost of capital is computed by assigning weights to the cost of debt and the cost of equity of a firm.
B) The cost of debt for a firm is always equal to the cost of equity to the firm.
C) The cost of internally generated equity for a firm is greater than the cost of externally generated equity funds for the firm.
D) The cost of internally generated equity for a firm is less than the cost of debt for the firm.
E) The cost of externally generated equity is the sum of the cost of debt and the cost of retained earnings.

Question 8

The before-tax cost of debt, rd, is the same as the:

A) average yield to maturity (YTM) associated with the firm's bonds.
B) dividend yield associated with the firm's common stock.
C) average coupon rate of the firm's bonds.
D) return on equity if the firm has no preferred stock.
E) the firm's marginal tax rate.

Question 9

The marginal cost of capital (MCC) is the cost of the last dollar of new capital that the firm raises, and the marginal cost declines as more and more of a specific type of capital is raised during a given period.

Question 10

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

Question 11

Omega Inc. has a history of abnormally high growth due to general economic fluctuations. Estimating the cost of common equity using the discounted cash flow approach is difficult because:

A) the dividend yield is extremely difficult to estimate.
B) the proper growth rate is difficult to establish.
C) the market price of the common equity is very volatile.
D) the firm grows at a constant rate in perpetuity.
E) the firm's historical data of dividend yield is unavailable.

Question 12

Even if a firm obtains all of its common equity from retained earnings, its MCC schedule might still increase if very large amounts of new capital are needed.

Question 13

Bouchard Company's stock sells for $20 per share, its last dividend (D0) was $1.00, its growth rate is a constant 6 percent, and the company would incur a flotation cost of 20 percent if it sold new common stock. Which of the following is the cost of issuing new common stock? (Round off the answer to two decimal places.)

A) 11.96 percent
B) 12.25 percent
C) 12.63 percent
D) 10.24 percent
E) 11.42 percent

Question 14

Which of the following statements is true of flotation costs?

A) Flotation costs decrease the cost of preferred stock to the issuing firm.
B) Flotation costs are added to the issue price of preferred stock to compute the cost of preferred stock.
C) Floatation costs are added to the cost of debt to compute the weighted average cost of capital of a firm.
D) Floatation costs result in higher funds available from the issue of preferred stock to the firm.
E) Floatation costs increase the rate the issuing firm must earn to pay the preferred dividend.

Question 15

Which of the following statements is true of the impact of tax on the cost of capital of a firm?

A) All else being equal, an increase in the corporate tax rate results in a decrease in the weighted average cost of capital.
B) The before-tax cost of debt is the cheapest component of the cost of capital since the tax paid is a deductible expense.
C) The before-tax cost of debt is always less than the after-tax cost of debt of a firm.
D) The tax paid on dividends of preferred stock reduces the amount of funds that the firm can use for financing capital budgeting projects.
E) All else being equal, an increase in the equity capital that a firm raises by retaining earnings results in in the increase in the tax rate applicable to the firm.

Question 16

The correct discount rate for a firm to use in capital budgeting, assuming that new investments are as risky as the firm's existing assets, is its marginal cost of capital.

Question 17

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

Question 18

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

Question 19

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

Question 20

The after-tax cost of debt is used to calculate the weighted average cost of capital since we are concerned with the after-tax cash flows of the firm.

Question 21

The MCC schedule is either horizontal or rising, which implies that the cost of capital to a firm increases as it raises larger and larger amounts of capital. The rising section of the MCC schedule:

A) is caused by economies of scale in financing.
B) would be horizontal if the firm retained all of its earnings.
C) results from a change in the debt ratio as the firm expands.
D) occurs because the firm must, if it is to expand, be willing to take on riskier projects
E) results from flotation costs associated with the sale of new common and preferred stock, along with higher debt costs, as the firm's rate of expansion increases.

Question 22

SW Inc.'s preferred stock, which pays a $5 dividend each year, currently sells for $62.50. The company's marginal tax rate is 40 percent. What is the cost of preferred stock, rps, that should be included in the computation of the SW Inc.'s weighted average cost of capital (WACC)?

A) 10.00 percent
B) 4.00 percent
C) 5.00 percent
D) 8.00 percent
E) 2.00 percent

Question 23

The before-tax cost of debt of a firm using funds from bond issue is equal to the _____ of the bond.

A) yield to maturity (YTM)
B) maturity value
C) coupon rate
D) discount rate
E) internal rate of return

Question 24

Which of the following is a capital component for the purpose of calculating the weighted average cost of capital in capital budgeting?

A) The after-tax cost of long-term debt
B) The after-tax cost of common stock
C) The after-tax cost of preferred stock
D) The after-tax cost of retained earnings
E) The after-tax cost of new equity

Question 25

J. Ross and Sons Inc. has a target capital structure that calls for 40 percent debt, 10 percent preferred stock, and 50 percent common equity. Ross' common stock currently sells for $40 per share. The firm recently paid a dividend of $2 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year. Which of the following is the firm's cost of retained earnings? (Round off the answer to two decimal places.)

A) 16.34 percent
B) 10.42 percent
C) 15.50 percent
D) 12.20 percent
E) 13.25 percent

Question 26

Which of the following components of capital structure is adjusted to account for tax savings?

A) Cost of preferred stock
B) Cost of debt
C) Cost of retained earnings
D) Cost of new issue of common stock
E) Cost of dividend payout

Question 27

Super Solutions Inc. is a constant growth firm, which just paid a dividend of $3.00, sells for $33.00 per share, and has a growth rate of 6 percent. Which of the following is the cost of retained earnings using the discounted cash flow (DCF) approach? (Round off the answer to two decimal places.)

A) 12.55 percent
B) 15.64 percent
C) 16.25 percent
D) 13.35 percent
E) 12.40 percent

Question 28

The _____ is equal to the average rate of return that investors require to provide funds to the firm in the form of debt.

A) Coupon rate
B) Yield to maturity (YTM)
C) Maturity value
D) Discount rate
E) Internal rate of return

Question 29

Tangerine Inc.'s target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm's marginal tax rate is 40 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find the cost of retained earnings. Which of the following is Tangerine's component cost of retained earnings?

A) 8 percent
B) 10 percent
C) 12 percent
D) 14 percent
E) 16 percent

Question 30

Oval Inc. has just paid a dividend of $1.50 per share on its common stock, and it expects this dividend to grow by 4 percent per year, indefinitely. The firm plans to issue common stock at $16. The firm's investment bankers believe that new issues of common stock would have a flotation cost equal to 4 percent of the current market price. Which of the following is the cost of newly issued common stock? (Round off the answer to two decimal places.)

A) 14.16 percent
B) 10.15 percent
C) 15.36 percent
D) 13.80 percent
E) 16.92 percent

Question 31

The target capital structure of a firm is the capital structure that:

A) minimizes the operating risk of the firm's assets.
B) maximizes the tax shield created by debt.
C) minimizes the default risk of long-term debt.
D) maximizes the price of the firm's stock.
E) minimizes the risk premium paid on long-term debt.

Question 32

Beige Inc. plans to issue preferred stock that pays an $11.50 dividend per share and sells for $120 per share in the market. It will cost 4 percent, or $4.80 per share, to issue the new preferred stock, so Beige will net $115.20 per share. Which of the following is Beige's cost of preferred stock? (Round off the answer to two decimal places.)

A) 8.89 percent
B) 12.25 percent
C) 11.50 percent
D) 15.20 percent
E) 9.98 percent

Question 33

Marigold Inc.'s common stock currently sells for $40 per share, but the firm will net only $34 per share from the sale of new common stock. The firm recently paid a dividend of $2 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year. Which of the following is the cost of newly issued common stock? (Round off the answer to two decimal places.)

A) 12.24 percent
B) 13.56 percent
C) 14.12 percent
D) 16.47 percent
E) 17.53 percent

Question 34

Coral Inc.'s preferred stock currently sells for $90 a share and pays a dividend of $10 per share; however, the firm will net only $80 per share from the sale of new preferred stock. What is the firm's cost of newly issued preferred stock? (Round off the answer to two decimal places.)

A) 11.15 percent
B) 12.50 percent
C) 16.45 percent
D) 10.52 percent
E) 13.46 percent

Question 35

The Jackson Company has just paid a dividend of $3.00 per share on its common stock, and it expects this dividend to grow by 10 percent per year, indefinitely. The firm has a beta of 1.50; the risk-free rate is 10 percent; and the expected return on the market is 14 percent. Which of the following is the required rate of return as per the capital asset pricing model (CAPM) approach?

A) 9 percent
B) 12 percent
C) 7 percent
D) 16 percent
E) 18 percent

Question 36

Rollins Corporation is constructing its MCC schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm's marginal tax rate is 40 percent. Which of the following is Rollins' component cost of debt? (Round off the answer to one decimal place.)

A) 8.4 percent
B) 7.2 percent
C) 6.8 percent
D) 5.3 percent
E) 9.5 percent

Question 37

Smith and Sons Inc. has a target capital structure that calls for 40 percent debt, 10 percent preferred stock, and 50 percent common equity. The firm's current after-tax cost of debt is 6 percent, and it can sell as much debt as it wishes at this rate. The firm expects to retain $15,000 in earnings over the next year. Where will a break in the WACC curve occur?

A) $12,500
B) $15,000
C) $30,000
D) $25,000
E) $42,500

Question 38

Alpha Inc.'s beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Which of the following is Alpha's cost of retained earnings using the capital asset pricing model (CAPM) approach?

A) 8 percent
B) 10 percent
C) 12 percent
D) 14 percent
E) 16 percent

Question 39

Diggin Tools just issued new preferred stock, which sold for $85 in the stock markets. Holders of the stock will receive an annual dividend equal to $9.35. The flotation costs associated with the new issue were 6 percent and Diggin's marginal tax rate is 30 percent. Which of the following is the component cost of preferred stock, rps? (Round off the answer to two decimal places.)

A) 10.75 percent
B) 10.52 percent
C) 12.25 percent
D) 11.70 percent
E) 11.05 percent

Question 40

The _____ of the bond is a cost to the firm for using investors' funds.

A) Coupon rate
B) Internal rate of return
C) Yield to maturity (YTM)
D) Maturity value
E) Discount rate

Question 41

Beige Inc. has to choose from three projects whose internal rates of return (IRRs) are more than the marginal cost of capital (MCC). Beige should choose those projects that _____.

A) minimize the marginal cost of capital
B) maximize the excess of internal rate of return over marginal costs
C) maximize the dividend payout
D) maximize the cash flow from investment in projects
E) minimize the rate of return to the investors

Question 42

Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent common equity. The firm expects to earn $150,000 in after-tax income during the coming year, and it will retain 40 percent of those earnings. What is the break point of retained earnings?

A) $125,000
B) $100,000
C) $150,000
D) $110,000
E) $135,000

Question 43

The cost of debt to the firm is adjusted for _____.

A) marginal revenue generated
B) taxes
C) interest rate
D) internal rate of return
E) return to investors

Question 44

Which of the following is true of the change in the weighted average cost of capital of a firm?

A) A decrease in the weighted average cost of the capital increases the value of the firm.
B) An increase in the weighted average cost of the capital increases the value of the firm.
C) A decrease in the weighted average cost of the capital decreases the value of the firm.
D) A decrease in the weighted average cost of the capital increases the cash flow generated by the investments.
E) Any change in the weighted average cost of capital results in no change in the value of the firm.

Question 45

The marginal cost of capital _____ as more capital is raised during a given period.

A) remains the same
B) decreases
C) increases
D) changes in an unpredictable way
E) approaches zero

Question 46

Omega Inc.'s net income is expected to be $600,000 and the firm's payout ratio is 60 percent. The firm's common stock ratio is 30 percent and it has no preferred stock outstanding. Which of the following is the retained earnings break point for Omega Inc.?

A) $400,000
B) $250,000
C) $375,000
D) $100,000
E) $800,000

Question 47

The value of any asset-real or financial-is based on _____ and _____.

A) the weighted average cost of investment; the rate of return achieved by the investment firm
B) the cash flow expected to be generated by the asset; the rate of return required by investors
C) the marginal return to investor from the investment asset; the additional cash flow generated by the asset
D) the rate of return achieved by the investment firm; the weighted average cost of investment to the investor
E) the rate of return achieved by the investment firm; the cash flow expected to be generated by the asset

Question 48

The next year's net income of Byron Corporation is projected to be $21,000, and its payout ratio is 30 percent. Its target capital structure is 40 percent debt and 60 percent common equity. What is the retained earnings break point?

A) $35,000
B) $24,500
C) $6,300
D) $12,600
E) $8,400

Question 49

Everything else equal, an asset's value is directly related to:

A) the cost of raising additional capital.
B) the rate of return investors require to invest in that asset.
C) the risk associated with the investment in that asset.
D) the cash flow the asset is expected to generate.
E) the rate of return that the firm must earn to satisfy investors' demands.

Question 50

Which of the following statements is true of marginal cost of capital?

A) All else equal, an increase in the tax rate would decrease the marginal cost of debt capital.
B) All else equal, an increase in a company's stock price will increase the marginal cost of retained earnings.
C) All else equal, an increase in a company's stock price will increase the marginal cost of issuing new common equity.
D) All else equal, an increase in the capital raised in a period will decrease the marginal cost of debt capital.
E) All else equal, an increase in the weighted cost of capital will decrease the marginal cost of retained capital.

Question 51

Alpha Inc. combines the marginal cost of capital (MCC) and the investment opportunity schedules (IOS) on a graph. Which of the following areas on the graph shows the maximum excess of returns over costs?

A) The area that is below the WACC
B) The area that is above the IOS
C) The point of intersection of WACC and IOS
D) All the investment opportunities along the IOS line would have maximum excess of returns over costs.
E) The area that is above the WACC but below the IOS.

Question 52

A graph of a firm's acceptable capital projects ranked in the order of the projects' internal rates of return is called the firm's _____.

A) marginal cost of capital schedule
B) investment opportunity schedule
C) modified internal rate of return schedule
D) internal project classification schedule
E) optimal capital budget schedule

Question 53

A firm's weighted average cost of capital (WACC) is:

A) set by the board of directors of the firm because it is the benchmark they use to evaluate upper management.
B) regulated by the Internal Revenue Service (IRS) because tax-deductible debt is included in the computation.
C) determined by the financial markets because investors provide the funds used by firms and these funds have costs, which are the returns demanded by investors.
D) the same as the firm's internal rate of return (IRR).
E) the total net present value (NPV) of all the capital budgeting projects in which the firm invests in any year.

Question 54

A firm should continue to invest in capital budgeting projects until its marginal cost of capital is:

A) equal to the net present value (NPV) of the last project purchased.
B) equal to the internal rate of return (IRR) of the first project purchased.
C) equal to the marginal return generated by the last project purchased.
D) equal to the cash generated by the last project purchased.
E) equal to the weighted average cost of all the projects purchased.

Question 55

If a project's _____ exceeds the firm's cost of capital, its NPV will be positive.

A) marginal cost of capital
B) cash flow
C) rate of return expected by investors
D) internal rate of return (IRR)
E) discount rate

Question 56

The rates of return, or costs, that a firm must pay to raise funds to invest in capital budgeting projects are determined by:

A) the marginal revenue generated by investment in the new projects.
B) the investors who purchase the firm's stocks and bonds.
C) the internal rate of return of the firm.
D) the cash flow generated by the investment in the additional projects.
E) the dividend payout ratio fixed by the firm.

Question 57

The investment opportunity schedule (IOS) plotted on a graph shows:

A) the optimal components for capital financing for a firm.
B) the amount of investment at different rates of return for a firm.
C) the net present values of different projects of a firm.
D) the average cost of capital of a firm.
E) the marginal increase in the weighted average capital due to change in capital components.