Deck 11: Cost of Capital

Question 1

In determining the cost of debt, a firm could use its yields and prices of outstanding bonds.

Answer 1

True

Question 2

A firm's cost of preferred stock is equal to the preferred dividend divided by market price plus the dividend growth rate (K_p = D/P₀ + g).
The correct formula is K_p = D_p/(P_p - F).

Answer 2

False

Question 3

Regardless of the particular source of funds utilized for a project, the required rate of return, or discount rate, will be the weighted average cost of capital.

Answer 3

True

Question 4

The measurement of common stock equity in weighted average cost of capital uses the cost of retained earnings (K_e) ,but not the cost of new common stock (K_n).
Either or both may be used; it is situation-dependent.

Question 5

It is standard practice to evaluate investment decisions using the cost of the specific financing method involved.

Question 6

The out-of-pocket cost of common stock is a good approximation of the cost of common stock equity.
Flotation costs for new stock issues must be considered in the valuation, unlike existing stock.

Question 7

The cost of new common stock is greater than the cost of outstanding common stock.

Question 8

The cost of debt is equal to the current bond yield on bonds of similar risk class, adjusted for the corporate tax rate.

Question 9

The cost of capital for each source of funds is dependent on current market conditions and expected rates of return.

Question 10

The cost of capital refers to the cost that a company takes on to purchase a big project.

Question 11

Retained earnings represent an internal source of funds that is raised without the payment of interest or cost to the firm's stockholders.
"Opportunity cost" must be considered since earnings could be issued to shareholders in the form of dividends.

Question 12

The cost of retained earnings is considered to be equal to the required rate of return on a firm's outstanding common stock.

Question 13

The calculation of the cost of capital depends upon the historical cost of funds.
Each project must be evaluated by the current cost of funds.

Question 14

The amount of debt capital used by a corporation is not related to the availability of equity funds from retained earnings and new common stock.

Question 15

A firm's cost of preferred stock is equal to the preferred dividend divided by the net price after flotation costs.

Question 16

The cost of debt needs to consider tax, while the cost of stock does not need to consider tax.

Question 17

The discount rate that equates a future stream of expected dividends to the current price is a good approximation of the cost of common stock.

Question 18

In determining the cost of preferred stock, the earnings on outstanding preferred stock may be used as a proxy.

Question 19

The only difference in the cost of retained earnings (K_e) and the cost of new common stock (K_n) is the flotation cost on new common stock.

Question 20

K_e represents an expected return to stockholders as well as a cost to the firm.

Question 21

In the capital asset pricing model (CAPM), beta measures the volatility of the market.
Beta represents the volatility of one particular stock against an index of the overall market.

Question 22

Market values rather than book values should be used for determining the optimal capital structure; however, in practice, book value is commonly used.

Question 23

A firm that does not earn the cost of capital in the short run will probably be in bankruptcy.
Proper management of the sources of capital can allow a firm to survive short-term interruptions in its income stream.

Question 24

All firms within particular industries have similar optimum capital structures.

Question 25

Taking on additional debt will reduce the cost of equity.

Question 26

The use of the optimum capital structure minimizes the cost of capital.

Question 27

Companies prefer to maintain some financing flexibility in order to choose the lowest-cost source of funds at a single point in time.

Question 28

Weights used to calculate the weighted average cost of capital K_a are derived from the optimum capital structure.

Question 29

In determining the optimum capital structure, it is assumed that the firm will raise capital in the optimum proportions every year.
The firm must constantly reevaluate its capital structure for changes, in order to allow them to change its approach in the next round of financing.

Question 30

The capital asset pricing model (CAPM) relates the risk-return tradeoffs of individual assets to market returns.

Question 31

The pretax cost of debt is generally less than the pretax cost of equity.

Question 32

A firm should always be at a single optimum debt-to-equity ratio to minimize its cost of capital.

Question 33

According to traditional financial theory, the cost of capital curve is U-shaped over the range of debt-equity mixes.

Question 34

Most firms are able to use 60% to 70% debt in their capital structure without exceeding norms acceptable to most creditors and investors.
Lenders and investors generally become concerned when debt exceeds 50% of the overall capital structure.

Question 35

Firms in stable industries are advised to keep debt levels very low so that shareholders, rather than creditors, receive the benefits of steady cash flows.
Firms in a stable industry are more apt to use financial leverage (greater proportionate debt) to amplify their earnings per common share.

Question 36

The use of the weighted average cost of capital assumes that the firm is in its optimum capital structure range and the cost of each component stays constant over the range of financing.

Question 37

The weighted average cost of capital calculates the average cost of issued or new issuance of debt and equity for a firm.

Question 38

Although the after-tax cost of debt is below the cost of equity, firms cannot increase their use of debt to endless amounts.

Question 39

Larger bond issues can lower "liquidity risk," or the possibility that an investor will not be able to sell a bond quickly and easily.

Question 40

A firm that does not earn the cost of capital in the long run will not maximize shareholder wealth.

Question 41

The cost of capital generally varies inversely with the size of the capital structure.

Question 42

The financial managers of the firm decide on its cost of capital for financing projects.
Managers will consistently analyze alternatives and select the optimum, but they cannot dictate the actual cost itself.

Question 43

If a firm's bonds are currently yielding 6% in the marketplace, why would the firm's cost of debt be lower?

A) Interest rates have changed.
B) Additional debt can be issued more cheaply than the original debt.
C) There should be no difference; the cost of debt is the same as the bond's market yield.
D) Interest is tax-deductible, so tax savings are considered.

Question 44

Given an optimal capital structure that is 50% debt and 50% common stock, calculate the weighted average cost of capital for the company given the following additional information:

A) Less than 6%.
B) More than 6% and less than 7%.
C) More than 7% and less than 8%.
D) More than 8%.

Question 45

Debreu Beverages has an optimal capital structure that is 70% common equity, 10% preferred stock, and 20% debt. Debreu's pretax cost of equity is 9%. Its pretax cost of preferred equity is 7%, and its pretax cost of debt is also 5%. If the corporate tax rate is 35%, what is the weighted average cost of capital?

A) 8.74%
B) 8%
C) 5.2%
D) 7.65%;

Question 46

As the risk-free rate increases, the required rate of return for common stock decreases.
"K" is utilized in all cost of capital decisions and bears a direct relationship to increases and decreases in R_f.

Question 47

The coupon rate on a debt issue is 6%. If the yield to maturity on the debt is 9%, what is the after-tax cost of debt in the weighted average cost of capital if the firm's tax rate is 34%?

A) 3.96%
B) 4.08%
C) 5.94%
D) 7.92%

Question 48

Although debt financing is generally cheaper than equity financing, financial managers should not use debt financing significantly above the industry standard because it can increase the firm's overall cost of capital.

Question 49

Debreu Beverages has an optimal capital structure that is 70% common equity, 20% debt, and 10% preferred stock. Debreu's pretax cost of equity is 9%. Its pretax cost of preferred equity is 7%, and its pretax cost of debt is also 5%. If the corporate tax rate is 35%, what is the weighted average cost of capital?

A) Between 7% and 8%
B) Between 8% and 9%
C) Between 9% and 10%
D) Between 10% and 12%

Question 50

Per the capital asset pricing model, the slope of the security market line (SML) must be 1.0.

Question 51

The cost of debt, preferred stock, and common equity must all be adjusted for tax implications.
The cost of debt financing has direct tax implications; equity financing does not.

Question 52

Each project should be judged against

A) the specific means of financing used to support its implementation.
B) the exiting interest rate at that point in time.
C) the cost of new common stock equity.
D) None of these options are true.

Question 53

The cost of a firm's debt is determined by taking the

A) present value of the interest payments and principal times one minus the tax rate.
B) coupon rate on bonds times one minus the tax rate.
C) yield on bonds issued minus the corporation 's marginal tax rate.
D) None of these options are true.

Question 54

The overall weighted average cost of capital is used instead of costs for individual sources of funds because

A) the use of the cost for individual sources of capital would make investment decisions inconsistent.
B) a project with the highest return would always be accepted under the specific cost criteria.
C) investments funded by low-cost debt would have an advantage over other investments.
D) the use of the cost for specific sources of capital would make investment decisions inconsistent, and investments funded by low-cost debt would have an advantage over other investments.

Question 55

Financial capital does not include

A) stocks.
B) bonds.
C) preferred stocks.
D) working capital.

Question 56

The coupon rate on an issue of debt is 8%. The yield to maturity on this issue is 10%. The corporate tax rate is 31%. What would be the approximate after-tax cost of debt for a new issue of bonds?

A) 5.28%
B) 2.48%
C) 6.90%
D) 3.14%

Question 57

For a firm paying 5% for new debt, the higher the firm's tax rate

A) the higher the after-tax cost of debt.
B) the lower the after-tax cost of debt.
C) the after-tax cost is unchanged.
D) Not enough information to judge.

Question 58

The slope of the security market line (SML) will often increase when the economy is in a boom period.

Question 59

A firm's cost of financing, in an overall sense, is equal to its

A) weighted average cost of capital.
B) required yield that investors seek for various kinds of securities.
C) required rate of return that investors seek for various kinds of securities.
D) all of these options are true.

Question 60

A firm with a higher beta than another firm will have a higher required rate of return.
Beta is a direct measure of risk, so K_j must be higher.

Question 61

A firm is paying an annual dividend of $2.65 for its preferred stock that is selling for $57.00. There is a selling cost of $3.30. What is the after-tax cost of preferred stock if the firm's tax rate is 33%?

A) 3.30%
B) 4.93%
C) 5.79%
D) 6.11%

Question 62

Firm X has a tax rate of 30%. The price of its new preferred stock is $75 and its flotation cost is $3.15. The cost of new preferred stock is 8%. What is the firm's dividend?

A) $7.18
B) $5.75
C) $7.56
D) $4.03

Question 63

If the flotation cost goes up, the cost of retained earnings will

A) go up.
B) go down.
C) stay the same.
D) slowly increase.

Question 64

Ten years ago, Stigler Company issued $100 par value preferred stock yielding 6%. The preferred stock is now selling for $102 per share. What is the approximate current yield or cost of the preferred stock? (Disregard flotation costs.)

A) 7.76%
B) 8%
C) 5.9%
D) There is not enough information to answer the question.

Question 65

Within the capital asset pricing model

A) the risk-free rate is usually higher than the return in the market.
B) the higher the beta, the lower the required rate of return.
C) beta measures the volatility of an individual stock relative to a stock market index.
D) dividends are considered in the calculations.

Question 66

The pre-tax cost of debt for a new issue of debt is determined by

A) the investor's required rate of return on issued stock.
B) the coupon rate of existing debt.
C) the yield to maturity of outstanding or comparable bonds.
D) All of these options are true.

Question 67

The after-tax cost of preferred stock to the issuing corporation

A) is the same as the before-tax cost.
B) is usually lower than the cost of debt.
C) is dependent on the firm's tax bracket.
D) None of these options are true.

Question 68

If flotation costs go down, the cost of new preferred stock will

A) go up.
B) go down.
C) stay the same.
D) slowly increase.

Question 69

Tobin's Barbeque has a bank loan at 8% interest and an after-tax cost of debt of 6%. What will the after-tax cost of debt be if a new loan is taken out yielding 11%.

A) 7.52%
B) 8.25%
C) 13.33%
D) None of these options are true.

Question 70

A firm's preferred stock pays an annual dividend of $2, and the stock sells for $65. Flotation costs for new issuances of preferred stock are 5% of the stock value. What is the after-tax cost of preferred stock if the firm's tax rate is 30%?

A) 1.2%
B) 1.58%
C) 3.20%
D) 5.26%

Question 71

The cost of equity capital in the form of new common stock will be higher than the cost of retained earnings because of

A) the existence of taxes.
B) the existence of flotation costs.
C) investors' unwillingness to purchase additional shares of common stock.
D) the existence of financial leverage.

Question 72

New common stock is more expensive than required rate of return (K_e)because new common stock has to

A) compensate for risk.
B) compensate for more dividends.
C) compensate for expansionary problems.
D) cover distribution costs.

Question 73

Why is the cost of debt normally lower than the cost of preferred stock?

A) Preferred stock dividends are tax deductions.
B) Interest on debt is tax deductible.
C) Preferred stock dividends must be paid before common stock dividends.
D) Common stock dividends are not tax-deductible.

Question 74

In determining the cost of retained earnings

A) the dividend valuation model is inappropriate.
B) flotation costs are included.
C) growth is not considered.
D) the capital asset pricing model can be used.

Question 75

Flotation cost is the

A) cost of holding stock on hand.
B) cost of issuing new debt.
C) cost of issuing new stock.
D) sales price of common stock.

Question 76

In computing the cost of common equity, if the dividend (D₁) goes downward and market price (P₀) goes up, required rate of return (K_e) will

A) go up.
B) go down.
C) stay the same.
D) slowly increase.

Question 77

Using the constant dividend growth model for common stock, if the market price of stock (P₀) goes up,

A) the assumed cost goes up.
B) the assumed cost goes down.
C) the assumed cost remains unchanged.
D) Further information is needed to answer the question.

Question 78

Lewis, Schultz, and Nobel Development Corp. has an after-tax cost of debt of 4.5%. With a tax rate of 30%, what is the yield on the debt?

A) 4.5%
B) 9.0%
C) 1.89%
D) 6.43%

Question 79

A firm has $50 million in assets and its optimal capital structure is 60% equity. If the firm has $12 million in retained earnings available to invest, at what asset level will the firm need to issue additional stock? (Assume no growth in retained earnings.)

A) The firm should have already issued additional stock.
B) The firm can increase assets by $30 million.
C) The firm can increase assets by $20 million.
D) There is insufficient information to determine an answer.

Question 80

A firm's debt-to-equity ratio varies at times because

A) a firm will want to sell common stock when prices are high and bonds when interest rates are low.
B) a firm will want to take advantage of timing its fund-raising in order to minimize costs over the long run.
C) the market allows some leeway in the debt-to-equity ratio before penalizing the firm with a higher cost of capital.
D) All of these are accurate statements.