Deck 9: The Cost of Capital

Question 1

The investor's required rate of return will equal the firm's cost of capital if corporate transactions costs are taken into account.

Answer 1

False

Question 2

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

Answer 2

True

Question 3

The firm's cost of capital may also be referred to as the firm's opportunity cost of capital.

Answer 3

True

Question 4

The cost of debt increases relative to the investor's required return due to flotation costs,but decreases relative to the investor's required return due to the tax deductibility of interest.

Question 5

The cost of capital is the rate that must be earned on an investment project if the project is to increase the value of the common shareholders' investment.

Question 6

A firm's cost of capital is influenced by

A) the current ratio.
B) par value of common stock.
C) capital structure.
D) net income.

Question 7

The cost of preferred stock is equal to the preferred stock dividend divided by the net proceeds per preferred share.

Question 8

In order to create value,a corporation must earn a rate of return on its invested capital that is higher than the market's required rate of return on that invested capital.

Question 9

A corporation's cost of common equity may be estimated using either a dividend valuation model or the capital asset pricing model.

Question 10

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

Question 11

Which of the following statements is MOST correct?

A) Because the cost of debt is lower than the cost of equity, value-maximizing firms maintain debt ratios of close to 100%.
B) Corporations that are 100% equity financed will have a much lower weighted average cost of capital because the lack of debt lowers their risk of bankruptcy.
C) The source of capital with the lowest after-tax cost is preferred stock, because it is a hybrid security, part debt and part equity.
D) The cost of a particular source of capital is equal to the investor's required rate of return after adjusting for the effects of both flotation costs and corporate taxes.

Question 12

The cost of a particular source of capital (debt,preferred stock,common stock)is equal to the investor's required rate of return after adjusting for the effects of both flotation costs and corporate taxes.

Question 13

The firm's cost of capital is important when evaluating the firm's overall value,but it should not be used to evaluate individual projects which have their own unique characteristics.

Question 14

Which of the following causes a firm's cost of capital (WACC)to differ from an investor's required rate of return on the company's common stock?

A) the fact that the risk-free rate of interest has increased
B) the incurrence of flotation costs when new securities are issued
C) The market risk premium exceeds 12%.
D) None of the above - the WACC and required return are the same.

Question 15

Flotation costs cause a corporation's cost of capital to be lower than its investors' required returns.

Question 16

Two considerations that cause a corporation's cost of capital to be different than its investors' required returns are

A) corporate taxes and flotation costs.
B) individual taxes and corporate taxes.
C) individual taxes and dividends.
D) corporate taxes and the earned income tax credit.

Question 17

Corporations have two costs of common equity,one for retained earnings and one if the company issues new common stock.

Question 18

The cost of debt capital is obtained by substituting the net proceeds per bond for the bond price in the bond valuation equation and solving for the required return.

Question 19

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.

Question 20

Higher flotation costs will result in all of the following EXCEPT

A) higher after-tax cost of debt.
B) higher weighted average cost of capital.
C) higher cost of retained earnings.
D) higher cost of common equity when new common shares are sold.

Question 21

The capital asset pricing model uses three variables to evaluate required returns on common equity: the risk-free rate,the beta coefficient,and the market risk premium.

Question 22

The market risk premium remains constant over time because the risk-free rate of return moves inversely with beta.

Question 23

An increase in a corporation's marginal tax rate will decrease the corporation's cost of debt,but have no impact on its cost of preferred stock or cost of common equity.

Question 24

A reasonable estimate of the market risk premium based on historical data and expert opinion is between 5% and 7%.

Question 25

An increase in a corporation's marginal tax rate will cause the corporation's after-tax cost of debt to increase,other things remaining the same.

Question 26

The after-tax cost of equity equals one minus the marginal tax rate times the required rate of return on common stock.

Question 27

The required return of a preferred stockholder,rps,is higher than the cost of preferred stock for the corporation because stockholders must pay federal taxes on their dividend income.

Question 28

Financing with new common stock is generally more costly than financing with retained earnings due to increasing tax rates.

Question 29

Preferred dividends are paid with before-tax dollars because the dividend rate is known,whereas common stock dividends are paid with after-tax dollars.

Question 30

A short-term T-bill's rate of return should be used in the CAPM formula to determine the cost of equity capital regardless of the length of the project under consideration.

Question 31

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

Question 32

If preferred stock pays a $5 annual dividend and sells for $50,the cost of preferred stock financing is 10% since dividends are not tax deductible and preferred stock is sold without flotation costs.

Question 33

The Capital Asset Pricing Model may be used to estimate the cost of retained earnings.

Question 34

Due to changes in regulatory requirements,the transactions costs associated with selling corporate securities increased by $1 per share.This change will

A) cause the cost of capital to decrease.
B) cause the cost of capital to increase.
C) have no effect on the cost of capital because transactions costs are expensed immediately.
D) cause the cost of capital to decrease only if investors may be billed for part of the increase in transactions costs.

Question 35

A security with a reasonably stable price will have a lower required rate of return than a security with an unstable price.

Question 36

A company has preferred stock that can be sold for $21 per share.The preferred stock pays an annual dividend of 3.5% based on a par value of $100.Flotation costs associated with the sale of preferred stock equal $1.25 per share.The company's marginal tax rate is 35%.Therefore,the cost of preferred stock is

A) 18.87%.
B) 17.72%.
C) 14.26%.
D) 12.94%.

Question 37

Adventure Outfitter Corp.can sell common stock for $27 per share and its investors require a 17% return.However,the administrative or flotation costs associated with selling the stock amount to $2.70 per share.What is the cost of capital for Adventure Outfitter if the corporation raises money by selling common stock?

A) 27.00%
B) 18.89%
C) 18.33%
D) 17.00%

Question 38

Because investors like dividends,the higher the company's dividend growth rate,the lower the company's cost of common equity.

Question 39

The cost of debt measures the cost of a bank loan,while the cost of preferred stock is used as a proxy for the cost of a new bond issue.

Question 40

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.

Question 41

Sentry Manufacturing paid a dividend yesterday of $5 per share (D0 = $5).The dividend is expected to grow at a constant rate of 8% per year.The price of Sentry Manufacturing's stock today is $29 per share.If Sentry Manufacturing decides to issue new common stock,flotation costs will equal $2.50 per share.Sentry Manufacturing's marginal tax rate is 35%.Based on the above information,the cost of retained earnings is

A) 28.38%.
B) 24.12%.
C) 26.62%.
D) 31.40%.

Question 42

GPS Inc.wishes to estimate its cost of retained earnings.The firm's beta is 1.3.The rate on 6-month T-bills is 2%,and the return on the S&P 500 index is 15%.What is the appropriate cost for retained earnings in determining the firm's cost of capital?

A) 17.0%
B) 19.5%
C) 18.9%
D) 22.1%

Question 43

The cost of retained earnings is less than the cost of new common stock because

A) marginal tax brackets increase.
B) flotation costs are incurred when new stock is issued.
C) dividends are not tax deductible.
D) accounting rules allow a deduction when using retained earnings.

Question 44

The risk-free rate of return is 3% and the expected return on the market portfolio is 14%.Oklahoma Oilco has a beta of 2.0 and a standard deviation of returns of 26%.Oilco's marginal tax rate is 35%.Analysts expect Oilco's net income to grow by 12% per year for the next 5 years.Using the capital asset pricing model,what is Oklahoma Oilco's cost of retained earnings?

A) 18.6%
B) 21.2%
C) 22.8%
D) 25.0%

Question 45

In capital budgeting analysis,when computing the weighted average cost of capital,the CAPM approach is typically used to find which of the following?

A) market value weight of equity
B) pretax component cost of debt
C) after-tax component cost of debt
D) component cost of internal equity

Question 46

Johnson Production Company paid a dividend yesterday of $3.50 per share.The dividend is expected to grow at a constant rate of 10% per year.The price of KayCee's common stock today is $40 per share.If KayCee decides to issue new common stock,flotation costs will equal $4.00 per share.KayCee's marginal tax rate is 35%.Based on the above information,the cost of retained earnings is

A) 26.41%.
B) 20.09%.
C) 19.63%.
D) 17.55%.

Question 47

Phillips Enterprises Inc.is expected to pay a dividend of $2.60 next year.Dividends are expected to grow at a constant rate of 8% per year,and the stock price is currently $20.00.New stock can be sold at this price subject to flotation costs of 15%.The company's marginal tax rate is 35%.Compute the cost of internal equity (retained earnings)and the cost of external equity (new common stock),respectively.

A) 0, 21.00%
B) 8.00%, 23.29%
C) 21.00%, 23.29%
D) 23.00%, 25.48%

Question 48

Which of the following differentiates the cost of retained earnings from the cost of newly-issued common stock?

A) the cost of the pre-emptive rights held by existing shareholders
B) the greater marginal tax rate faced by the now-larger firm
C) the flotation costs incurred when issuing new securities
D) the larger dividends paid to the new common stockholders

Question 49

Sentry Manufacturing paid a dividend yesterday of $5 per share (D0 = $5).The dividend is expected to grow at a constant rate of 8% per year.The price of Sentry Manufacturing's stock today is $29 per share.If Sentry Manufacturing decides to issue new common stock,flotation costs will equal $2.50 per share.Sentry Manufacturing's marginal tax rate is 35%.Based on the above information,the cost of new common stock is

A) 28.38%.
B) 24.12%.
C) 26.62%.
D) 31.40%.

Question 50

The cost of new preferred stock is equal to

A) the preferred stock dividend divided by the 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) preferred stock dividend divided by the net selling price of preferred.

Question 51

The cost of external equity capital is greater than the cost of retained earnings because of

A) flotation costs on new equity.
B) increasing marginal tax rates.
C) higher dividends.
D) greater risk for shareholders.

Question 52

In general,which of the following rankings,from highest to lowest cost,is most accurate?

A) cost of new common stock, cost of preferred stock, cost of debt, cost of retained earnings
B) cost of debt, cost of preferred stock, cost of new common stock, cost of retained earnings
C) cost of new common stock, cost of retained earnings, cost of preferred stock, cost of debt
D) cost of preferred stock, cost of new common stock, cost of retained earnings, cost of debt

Question 53

JPR Company's preferred stock is currently selling for $28.00,and pays a perpetual annual dividend of $2.00 per share.Underwriters of a new issue of preferred stock would charge $3 per share in flotation costs.The firm's tax rate is 40%.Compute the cost of new preferred stock for JPR.

A) 4.80%
B) 7.14%
C) 8.00%
D) 9.15%

Question 54

A company has preferred stock with a current market price of $18 per share.The preferred stock pays an annual dividend of 4% based on a par value of $100.Flotation costs associated with the sale of preferred stock equal $1.50 per share.The company's marginal tax rate is 40%.Therefore,the cost of preferred stock is

A) 28.80%.
B) 24.24%.
C) 22.22%.
D) 14.55%.

Question 55

JPR Company is financed 75 percent by equity and 25 percent by debt.If the firm expects to earn $30 million in net income next year and retain 40% of it,how large can the capital budget be before common stock must be sold?

A) $7.5 million
B) $12.0 million
C) $15.5 million
D) $16.0 million

Question 56

Jiffy Co.expects to pay a dividend of $3.00 per share in one year.The current price of Jiffy common stock is $60 per share.Flotation costs are $3.00 per share when Jiffy issues new stock.What is the cost of internal common equity (retained earnings)if the long-term growth in dividends is projected to be 8 percent indefinitely?

A) 13 percent
B) 14 percent
C) 15 percent
D) 16 percent

Question 57

Johnson Production Company paid a dividend yesterday of $3.50 per share.The dividend is expected to grow at a constant rate of 10% per year.The price of KayCee's common stock today is $40 per share.If KayCee decides to issue new common stock,flotation costs will equal $4.00 per share.KayCee's marginal tax rate is 35%.Based on the above information,the cost of new common stock is

A) 26.41%.
B) 20.09%.
C) 19.63%.
D) 17.55%.

Question 58

In general,the least expensive source of capital is

A) debt.
B) new common stock.
C) preferred stock
D) retained earnings.

Question 59

The risk-free rate of return is 2.5% and the market risk premium is 8%.Rogue Transport has a beta of 2.2 and a standard deviation of returns of 28%.Rogue Transport's marginal tax rate is 35%.Analysts expect Rogue Transport's dividends to grow by 6% per year for the foreseeable future.Using the capital asset pricing model,what is Rogue Transport's cost of retained earnings?

A) 16.4%
B) 17.7%
C) 19.6%
D) 20.1%

Question 60

Crandal Dockworks is undergoing a major expansion.The expansion will be financed by issuing new 15-year,$1,000 par,9% annual coupon bonds.The market price of the bonds is $1,070 each.Five Rivers flotation expense on the new bonds will be $50 per bond.Crandal's marginal tax rate is 35%.What is the yield to maturity on the newly-issued bonds?

A) 6.95%
B) 7.99%
C) 8.17%
D) 9.82%

Question 61

Dickerson Corporation's common stock is currently selling for $38.Last year's dividend was $4.00 per share.Investors expect dividends to grow at an annual rate of 7 percent indefinitely.Flotation costs of 4% will be incurred when new stock is sold.
a.What is the cost of internal common equity?
b.What is the cost of new common equity?

Question 62

Haroldson Inc.common stock is selling for $22 per share.The last dividend was $1.20,and dividends are expected to grow at a 6% annual rate.Flotation costs on new stock sales are 5% of the selling price.What is the cost of Haroldson Inc.'s new common stock?

A) 5.73%
B) 11.45%
C) 11.78%
D) 12.09%

Question 63

All else equal,an increase in beta results in

A) an increase in the cost of retained earnings.
B) an increase in the cost of newly issued common stock.
C) an increase in the after-tax cost of debt.
D) an increase in the cost of common equity, whether or not the funds come from retained earnings or newly issued common stock.

Question 64

Toto and Associates' preferred stock is selling for $27.50 a share.The firm nets $25.60 after issuance costs.The stock pays an annual dividend of $3.00 per share.What is the cost of existing,and new,preferred stock respectively?

Question 65

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 new preferred stock?

Question 66

Grandview Inc.will issue new common stock to finance an expansion.The existing common stock just paid a $1.50 dividend,and dividends are expected to grow at a constant rate 8% indefinitely.The stock sells for $45,and flotation expenses of 5% of the selling price will be incurred on new shares.What is the cost of retained earnings for Grandview?

A) 11.33%
B) 11.51%
C) 11.60%
D) 11.79%
E) 12.53%

Question 67

New Jet Airlines plans to issue 14-year bonds with a par value of $1,000 that will pay $60 every six months.The bonds have a market price of $1,220.Flotation costs on new debt will be 4% of the selling price.If the firm has a 35% marginal tax bracket,compute the following:
a.Yield to maturity of debt
b.After-tax cost of existing debt
c.After-tax cost of new debt

Question 68

Tempo Corp.will issue preferred stock to finance a new artillery line.The firm's existing preferred stock pays a dividend of $4.00 per share and is selling for $40 per share.Investment bankers have advised Tempo that flotation costs on the new preferred issue would be 5% of the selling price.Tempo's marginal tax rate is 30%.What is the relevant cost of new preferred stock?

A) 7.00%
B) 7.37%
C) 10.00%
D) 10.53%
E) 15.00%

Question 69

Haroldson Inc.common stock is selling for $22 per share.The last dividend was $1.20,and dividends are expected to grow at a 6% annual rate.Flotation costs on new stock sales are 5% of the selling price.What is the cost of Haroldson's retained earnings?

A) 5.73%
B) 11.45%
C) 11.78%
D) 12.09%

Question 70

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 an annual rate of 5% per year.What is the cost of internal equity?

Question 71

Which of the following should NOT be considered when calculating a firm's WACC?

A) cost of preferred stock
B) after-tax cost of bonds
C) cost of common stock
D) cost of carrying inventory

Question 72

Keystone Corporation will issue new common stock to finance an expansion.The existing common stock just paid a $1.50 dividend,and dividends are expected to grow at a constant rate 8% indefinitely.The stock sells for $45,and flotation expenses of 5% of the selling price will be incurred on new shares.What is the cost of new common stock be for Keystone Corp.?

A) 11.33%
B) 11.51%
C) 11.60%
D) 11.79%
E) 12.53%

Question 73

Which of the following should NOT be considered when calculating a firm's WACC?

A) after-tax YTM on a firm's bonds
B) after-tax cost of accounts payable
C) cost of newly issued preferred stock
D) cost of newly issued common stock

Question 74

A company is going to issue a $1,000 par value bond that pays a 7% annual coupon.The company expects investors to pay $942 for the 20-year bond.The expected flotation cost per bond is $42,and the firm is in the 34% tax bracket.Compute the following:
a.the yield to maturity on the firm's bonds
b.the firm's after-tax cost of existing debt
c.the firm's after-tax cost of new debt

Question 75

The common stock for El Viss Company currently sells for $20 per share.The firm just paid a dividend of $1.50,and the dividend three years ago was $1.30.Dividends per share are anticipated to grow at the same rate in the future as they have over the past three years.Flotation costs for new shares will be 6% of the selling price.Calculate the following:
a.the cost of retained earnings
b.the cost of external equity capital

Question 76

Alarm Systems Corporation's preferred stock pays a dividend of $3.60 and sells for $28.00.Alarm Systems Corporation has a marginal tax rate of 35%.What is the cost of preferred financing?

Question 77

Glenna Gayle common stock sells for $55,and dividends paid last year were $1.35.Flotation costs on issuing stock will be 8% of the market price.The dividends are predicted to have a 10% growth rate.What is the cost of internal equity,and new equity,respectively for Glenna Gayle?

Question 78

NewLinePhone Corp.is very risky,with a beta equal to 2.8 and a standard deviation of returns of 32%.The risk-free rate of return is 3% and the market risk premium is 8%.NewLinePhone's marginal tax rate is 35%.Use the capital asset pricing model to estimate NewLinePhone's cost of retained earnings.

Question 79

Crandal Dockworks is undergoing a major expansion.The expansion will be financed by issuing new 15-year,$1,000 par,9% annual coupon bonds.The market price of the bonds is $1,070 each.Crandal's flotation expense on the new bonds will be $50 per bond.Crandal's marginal tax rate is 35%.What is the pre-tax cost of debt for the newly-issued bonds?

A) 8.76%
B) 8.12%
C) 7.49%
D) 10.25%

Question 80

Gibson Industries is issuing a $1,000 par value bond with an 8% annual interest coupon rate 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 new debt for the bond?