Deck 12: The Cost of Capital

Question 1

For a typical firm with a given capital structure,which of the following is correct? (Note: r_a = WACC,and all rates are after taxes. )

A) r_d > r_e > r_s > r_a.
B) r_s > r_e > r_d > r_a.
C) r_a > r_e > r_s > r_d.
D) r_e > r_s > r_a > r_d.
E) None of the statements above is correct.

Answer 1

r_e > r_s > r_a > r_d.

Question 2

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

A) The cost of debt for Firm A is greater than the cost of equity for Firm A.
B) The cost of debt for Firm A is greater than the cost of equity for Firm B.
C) The cost of internally generated equity for Firm A is greater than the cost of externally generated equity funds for Firm A.
D) The cost of internally generated equity for Firm A is less than the cost of debt for Firm A.
E) None of the above could be true.

Answer 2

The cost of debt for Firm A is greater than the cost of equity for Firm B.

Question 3

Which of the following statements is false?

A) From a theoretical standpoint,the capital weights used to calculate the WACC should be based on the market values of the different securities.However,if a firm's book value weights are close to its market value weights,book value weights can be used as proxies.
B) Generally,only long-term debt is included in the calculation of the WACC,because the WACC is used for capital budgeting purposes,which includes long-term assets,and those assets are financed with long-term capital.
C) The first break point a firm encounters in capital budgeting is for retained earnings,unless a firm has zero or negative net income.
D) The weighted average cost of capital will change whenever a break point occurs.
E) Answers a and b are both false.

Answer 3

The first break point a firm encounters in capital budgeting is for retained earnings,unless a firm has zero or negative net income.

Question 4

Which of the following is not considered a capital component for the purpose of calculating the weighted average cost of capital as it applies to capital budgeting?

A) Long-term debt.
B) Common stock.
C) Short-term debt.
D) Preferred stock.
E) All of the above are considered capital components for WACC and capital budgeting purposes.

Question 5

Which of the following statements is most correct?

A) The weighted average cost of capital for a given capital budget level is a weighted average of the marginal cost of each relevant component that makes up the firm's target capital structure.
B) The weighted average cost of capital is calculated on a before-tax basis.
C) An increase in the risk-free rate is likely to increase the marginal cost of both debt and equity financing.
D) Answers a and c are both correct.
E) All of the above answers are correct.

Question 6

Typically,according to the text,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 MCC schedule

A) Is caused by economies of scale in financing.
B) Would be eliminated (that is,the MCC schedule would be horizontal)if the firm retained all of its earnings.
C) Results from a change in the debt-to-assets ratio as the firm expands.
D) Occurs because the firm must,if it is to expand,be willing to take on riskier and riskier projects,and this causes an increase in the cost of capital.
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 7

Which of the following statements is correct?

A) Because we often need to make comparisons among firms that are in different income tax brackets,it is best to calculate the WACC on a before-tax basis.
B) If a firm has been suffering accounting losses and is expected to continue suffering such losses,and therefore its tax rate is zero,it is possible that its after-tax component cost of preferred stock as used to calculate the WACC will be less than its after-tax component cost of debt.
C) Due to the way the MCC is constructed,the first break point in the MCC schedule must be associated with using up all available retained earnings and having to issue common stock.
D) Normally,the cost of external equity raised by issuing new common stock is above the cost of retained earnings.Moreover,the higher the growth rate is relative to the dividend yield,the more the cost of external equity will exceed the cost of retained earnings.
E) The lower a company's tax rate,the greater the advantage of using debt in terms of lowering its WACC.

Question 8

Which of the following statements is correct?

A) Capital components are the types of capital used by firms to raise money.All capital comes from one of three components: long-term debt,preferred stock,and equity.
B) Preferred stock does not involve any adjustment for flotation cost since the dividend and price are fixed.
C) The cost of debt used in calculating the WACC is an average of the after-tax cost of new debt and of outstanding debt.
D) The opportunity cost principle implies that if the firm cannot invest retained earnings and earn at least r_s,it should pay these funds to its stockholders and let them invest directly in other assets that do provide this return.
E) The cost of new common equity includes an adjustment for flotation costs that is expressed as a fixed percentage of the current stock price.The flotation percentage is determined jointly by the current price of the firm's stock and its growth rate.

Question 9

Which of the following statements is correct?

A) Although some methods of estimating the cost of capital encounter severe difficulties,the CAPM is a simple and reliable model that provides great accuracy and consistency in estimating the cost of capital.
B) The DCF model is preferred over other models to estimate the cost of equity because of the ease with which a firm's growth rate is obtained.
C) The bond-yield-plus-risk-premium approach to estimating the cost of equity is not always accurate but its advantages are that it is a standardized and objective model.
D) The tax savings associated with depreciation are an additional source of capital and,in fact,represent the largest single source of funds for some firms.
E) None of the above is a correct statement.

Question 10

Which of the following statements is correct?

A) Beta measures market risk,but if a firm's stockholders are not well diversified,beta may not accurately measure the firm's total risk.
B) If the calculated beta underestimates the firm's true investment risk,then the CAPM method will overestimate r_s.
C) The discounted cash flow method of estimating the cost of equity can't be used unless the growth component,g,is constant during the analysis period.
D) An advantage shared by both the DCF and CAPM methods of estimating the cost of equity capital,is that they yield precise estimates and require little or no judgment.
E) None of the above is a correct statement.

Question 11

Which of the following statements is correct?

A) The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project.
B) The cost of debt used to calculate the weighted average cost of capital is based on an average of the cost of debt already issued by the firm and the cost of new debt.
C) One problem with the CAPM approach to estimating the cost of equity capital is that if a firm's stockholders are,in fact,not well diversified,beta might be a poor measure of the firm's true investment risk.
D) The bond-yield-plus-risk-premium approach is the most sophisticated and objective method of estimating a firm's cost of equity capital.
E) The cost of equity capital is generally easier to measure than the cost of debt,which varies daily with interest rates,or the cost of preferred stock that is issued infrequently.

Question 12

In applying the CAPM to estimate the cost of equity capital,which of the following elements is not subject to dispute or controversy?

A) Expected rate of return on the market,r_M.
B) The stock's beta coefficient,β_i.
C) Risk-free rate,r_RF.
D) Market risk premium (MRP).
E) All of the above are subject to dispute.

Question 13

Which of the following methods of estimating the cost of common equity for a firm treats risk explicitly?

A) DCF method.
B) CAPM method.
C) Composite method.
D) Bond-yield-plus-risk-premium method.
E) Answers b and d are both correct.

Question 14

Which of the following statements is correct?

A) The WACC should include only after-tax component costs.Therefore,the required rates of return (or "market rates")on debt,preferred,and common equity (r_d,r_ps,and r_{s or e})must be adjusted to an after-tax basis before they are used in the WACC equation.
B) The cost of retained earnings is generally higher than the cost of new common stock.
C) Preferred stock is riskier to investors than is debt.Therefore,if someone told you that the market rates showed r_d > r_ps for a given company,that person must have made a mistake.
D) When the MCC schedule is developed,the first break point always occurs as a result of using up retained earnings.
E) If a company with a debt-to-assets ratio of 50 percent were suddenly exempted from all future income taxes,then,all other things held constant,this would cause its WACC to increase.

Question 15

Which of the following statements is correct?

A) Under normal conditions,the CAPM approach to estimating a firm's cost of retained earnings gives a better estimate than the DCF approach.
B) The CAPM approach is typically used to estimate a firm's flotation cost adjustment factor,and this factor is added to the DCF cost estimate.
C) The risk premium used in the bond-yield-plus-risk-premium method is the same as the one used in the CAPM method.
D) In practice (as opposed to in theory),the DCF method and the CAPM method usually produce exactly the same estimate for r_s.
E) The above statements are all false.

Question 16

Which of the following is not considered a capital component?

A) Long-term debt.
B) Common stock.
C) Short-term debt.
D) Preferred stock.
E) All of the above are considered capital components.

Question 17

Which of the following statements is most correct?

A) If a company's tax rate increases but the yield to maturity of its noncallable bonds remains the same,the company's marginal cost of debt capital used to calculate its weighted average cost of capital will fall.
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) Answers a and b are both correct.
E) Answers b and c are both correct.

Question 18

Which of the following statements is most correct?

A) The before-tax cost of preferred stock may be lower than the before-tax cost of debt,even though preferred stock is riskier than debt.
B) If a company's stock price increases,this increases its cost of equity capital.
C) If the cost of equity capital is low enough,it may be cheaper to issue common stock than it is to finance projects with retained earnings.
D) Both a and b are correct.
E) Answers a,b,and c are all correct.

Question 19

Which of the following statements is most correct?

A) One purpose of calculating the WACC is to have a singular cost of capital measure that can be applied to evaluate all of the firm's projects,including those of greater than and lesser than average risks.
B) A firm facing a steep demand curve (that is,high flotation costs)for new equity would likely also face,at some point,a steeply upward sloping WACC curve.
C) A breakpoint is based on the dollar value used of a specific type of capital,and occurs at the point where the cost of that capital type increases.Thus,if a firm has $100,000 in earnings,and stockholders want $50,000 of those earnings paid as dividends,then retained earnings will have two breakpoints.
D) Answers a and b are both correct.
E) All of the above are false.

Question 20

Which of the following statements is most correct?

A) An increase in the corporate tax rate,would lower the weighted average cost of capital for an average firm,other things held constant.
B) Depreciation-generated funds have a cost equal to the firm's lowest WACC,and hence they have no impact on the MCC schedule.
C) As a firm's debt-to-assets ratio approaches 100 percent,the after-tax cost of debt,r_dT,will be at its lowest level.
D) Statements a,b,and c are all true.
E) Statements a,b,and c are all false.

Question 21

Your company's stock sells for $50 per share,its last dividend (D₀)was $2.00,its growth rate is a constant 5 percent,and the company would incur a flotation cost of 15 percent if it sold new common stock.Net income for the coming year is expected to be $500,000,the firm's payout ratio is 60 percent,and its common equity ratio is 30 percent.If the firm has a capital budget of $1,000,000,what component cost of common equity will be built into the WACC for the last dollar of capital the company raises?

A) 9.20%
B) 9.94%
C) 10.50%
D) 11.75%
E) 12.30%

Question 22

Company can't lower its total cost of the $100 million of debt very much if any by the mix of debentures or mortgage bonds.
2)Debentures' risk rises as mortgage debt rises.
3)Mortgage bonds' risk rises as more mortgage bonds are issued.
4)So,the "WACD" will likely remain fairly stable.
25)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.Retained earnings for the coming year are expected to be $1,000,000,and the common equity ratio is 60 percent.If Bouchard has a capital budget of $2,000,000,what component cost of common equity will be built into the WACC for the last dollar of capital the company raises?

A) 11.30%
B) 11.45%
C) 11.80%
D) 12.15%
E) 12.63%

Question 23

Takeda Enterprises has four investment opportunities with the following costs (all costs are paid at t = 0)and estimated internal rates of return (IRR): The company wants to maintain a capital structure of 50 percent debt and 50 percent equity.The company anticipates that it can issue up to $2,000 of debt at an interest rate of 10 percent;if it issues more than $2,000 of debt its interest rate will increase to 11 percent.The company's stock price (P₀)is currently $90 per share,its expected dividend ( )is $6,and its dividend growth rate is 5 percent.The company expects to have $3,000 in retained earnings and its tax rate is 30 percent.What percentage flotation cost makes the net present value of accepting Project D zero?
(Hint: Project D will be selected only after Projects A,B,and C have been selected. )

A) 18.77%
B) 22.12%
C) 24.10%
D) 27.33%
E) 30.25%

Question 24

Global Advertising Company
The Global Advertising Company had net income after interest but before taxes of $40,000 this year. The marginal tax rate is 40 percent, and the dividend payout ratio is 30 percent. The company can raise debt at a 12 percent interest rate for any amount of debt less than $8,000. If the firm raises $8,000 or more of debt, a 15 percent interest rate will apply to that new debt. The last dividend paid by Global was $0.90. Global's common stock is selling for $8.59 per share, and its expected growth rate in earnings and dividends is 5 percent. If Global issues new common stock, the flotation cost incurred will be 10 percent. Global plans to finance all capital expenditures with 30 percent debt and 70 percent equity.
Refer to Global Advertising Company.What is the cost of common equity raised by selling new stock?

A) 12.22%
B) 17.22%
C) 10.33%
D) 9.66%
E) 16.00%

Question 25

S.Claus & Company is planning a zero coupon bond issue.The bond has a par value of $1,000,matures in 2 years,and will be sold at a price of $826.45.The firm's marginal tax rate is 40 percent.What is the annual after-tax cost of debt to the company on this issue?

A) 4.0%
B) 6.0%
C) 8.0%
D) 10.0%
E) 12.0%

Question 26

Gulf Electric Company (GEC)
Gulf Electric Company (GEC) uses only debt and equity in its capital structure. It can borrow unlimited amounts at an interest rate of 10 percent so long as it finances at its target capital structure, which calls for 55 percent debt and 45 percent common equity. Its last dividend was $2.20; its expected constant growth rate is 6 percent; its stock sells on the NYSE at a price of $35; and new stock would net the company $30 per share after flotation costs. GEC's tax rate is 40 percent, and it expects to have $100 million of retained earnings this year. GEC has two projects available: Project A has a cost of $200 million and a rate of return of 13 percent, while Project B has a cost of $125 million and a rate of return of 10 percent. All of the company's potential projects are equally risky.
Refer to Gulf Electric Company.Assume now that GEC needs to raise $300 million in new capital.What is GEC's marginal cost of capital for evaluating the $300 million in capital projects and any others that might arise during the year?

A) 6.00%
B) 13.77%
C) 12.66%
D) 9.50%
E) 9.00%

Question 27

Tapley Inc.'s current (target)capital structure has a target debt-to-assets ratio (D/TA)of 60 percent.The firm can raise up to $5 million in new debt at a before-tax cost of 8 percent.If more debt is required,the initial cost will be 8.5 percent,and if more than $10 million of debt is required,the cost will be 9 percent.Net income for the previous year was $10 million,and it is expected to increase by 10 percent this year.The firm expects to maintain its dividend payout ratio of 40 percent on the 1 million shares of common stock outstanding.If it must sell new common stock,it would encounter a 10 percent flotation cost on the first $2 million,a 15 percent cost if more than $2 million but less than $4 million is needed,and a 20 percent cost if more than $4 million of new outside equity is required.Tapley's tax rate is 30 percent,and its current stock price is $88 per share.If the firm has an unlimited number of projects that will earn a 10.25 percent return,what is the maximum capital budget that can be adopted without adversely affecting stockholder wealth?

A) $32.0 million
B) $15.9 million
C) $23.0 million
D) $10.6 million
E) $26.5 million

Question 28

Heavy Metal Corp.is a steel manufacturer that finances its operations with 40 percent debt,10 percent preferred stock,and 50 percent equity.Its net income is $100 million and it has a payout ratio of 35 percent.The interest rate on the company's debt is 11 percent.The preferred stock pays an annual dividend of $2 and sells for $20 a share.The company's common stock trades at $30 a share and its current dividend (D₀)of $2 a share is expected to grow at a constant rate of 8 percent per year.The flotation cost of external equity is 15 percent of the dollar amount issued,while the flotation cost on preferred stock is 10 percent.The company estimates that its WACC is 12.30 percent.Assume that the company is raising $150 million in total capital.What is the company's tax rate?

A) 30.33%
B) 32.87%
C) 35.75%
D) 38.12%
E) 40.98%

Question 29

Which of the following statements is correct?

A) Because we often need to make comparisons among firms that are in different income tax brackets,it is best to calculate the WACC on a before-tax basis.
B) If a firm has been suffering accounting losses and is expected to continue suffering such losses (and therefore its tax rate is zero),it is possible that its after-tax component cost of preferred stock as used to calculate the WACC will be less than its after-tax component cost of debt.
C) Due to the way the MCC is constructed,the first break point in the MCC schedule must be associated with using up all available retained earnings and having to issue common stock.
D) Normally,the cost of external equity raised by issuing new common stock is above the cost of retained earnings.Moreover,the higher the growth rate relative to the dividend yield,the more the cost of external equity will exceed the cost of retained earnings.
E) None of the above is a correct statement.

Question 30

Your company's stock sells for $50 per share,its last dividend (D₀)was $2.00,its growth rate is a constant 5 percent,and the company would incur a flotation cost of 15 percent if it sold new common stock.Net income for the coming year is expected to be $500,000 and the firm's payout ratio is 60 percent.The firm's common equity ratio is 30 percent and it has no preferred stock outstanding.The firm can borrow up to $300,000 at an interest rate of 7 percent;any additional debt will have an interest rate of 9 percent.Your company's tax rate is 40 percent.If the firm has a capital budget of $1,000,000,what is the WACC for the last dollar of capital the company raises?

A) 3.78%
B) 6.76%
C) 9.94%
D) 11.81%
E) 13.25%

Question 31

Byron Corporation
Byron Corporation's present capital structure, which is also its target capital structure, is 40 percent debt and 60 percent common equity. Next year's net income is projected to be $21,000, and Byron's payout ratio is 30 percent. The company's earnings and dividends are growing at a constant rate of 5 percent; the last dividend (D0) was $2.00; and the current equilibrium stock price is $21.88. Byron can raise all the debt financing it needs at 14.0 percent. If Byron issues new common stock, a 20 percent flotation cost will be incurred. The firm's marginal tax rate is 40 percent.
Refer to Byron Corporation.What is the maximum amount of new capital that can be raised at the lowest component cost of equity? (In other words,what is the retained earnings break point?
)

A) $12,600
B) $14,700
C) $17,400
D) $21,000
E) $24,500

Question 32

Martin Corporation's common stock is currently selling for $50 per share.The current dividend is $2.00 per share.If dividends are expected to grow at 6 percent per year and if flotation costs are 10 percent,then what is the firm's cost of retained earnings and what is its cost of new common stock?

A) 10.71%;10.24%
B) 10.24%;10.71%
C) 10.24%;11.38%
D) 11.38%;10.71%
E) 9.31%;9.86%

Question 33

Suppose a new company decides to raise its initial $200 million of capital as $100 million of common equity and $100 million of long-term debt.By an iron-clad provision in its charter,the company can never borrow any more money.Which of the following statements is correct?

A) If the debt were raised by issuing $50 million of debentures and $50 million of first mortgage bonds,we could be absolutely certain that the firm's total interest expense would be lower than if the debt were raised by issuing $100 million of debentures.
B) If the debt were raised by issuing $50 million of debentures and $50 million of first mortgage bonds,we could be absolutely certain that the firm's total interest expense would be lower than if the debt were raised by issuing $100 million of first mortgage bonds.
C) The higher the percentage of total debt represented by debentures,the greater the risk of,and hence the interest rate on,the debentures.
D) The higher the percentage of total debt represented by mortgage bonds,the riskier both types of bonds will be,and,consequently,the higher the firm's total dollar interest charges will be.
E) In this situation,we cannot tell for sure how,or whether,the firm's total interest expense on the $100 million of debt would be affected by the mix of debentures versus first mortgage bonds.Interest rates on the two types of bonds would vary as their percentages were changed,but the result might well be such that the firm's total interest charges would not be affected materially by the mix between the two.

Question 34

Gulf Electric Company (GEC)
Gulf Electric Company (GEC) uses only debt and equity in its capital structure. It can borrow unlimited amounts at an interest rate of 10 percent so long as it finances at its target capital structure, which calls for 55 percent debt and 45 percent common equity. Its last dividend was $2.20; its expected constant growth rate is 6 percent; its stock sells on the NYSE at a price of $35; and new stock would net the company $30 per share after flotation costs. GEC's tax rate is 40 percent, and it expects to have $100 million of retained earnings this year. GEC has two projects available: Project A has a cost of $200 million and a rate of return of 13 percent, while Project B has a cost of $125 million and a rate of return of 10 percent. All of the company's potential projects are equally risky.
Refer to Gulf Electric Company.What is GEC's cost of equity from newly issued stock?

A) 13.77%
B) 12.66%
C) 13.33%
D) 12.29%
E) 10.00%

Question 35

Which of the following statements is correct?

A) Suppose a firm is losing money and thus,is not paying taxes,and that this situation is expected to persist for a few years whether or not the firm uses debt financing.Then the firm's after-tax cost of debt will equal its before-tax cost of debt.
B) The component cost of preferred stock is expressed as r_ps(1 − T),because preferred stock dividends are treated as fixed charges,similar to the treatment of debt interest.
C) The reason that a cost of capital is assigned to retained earnings is because these funds are already earning a return in the business;the reason does not involve the opportunity cost principle.
D) The bond-yield-plus-risk-premium approach to estimating a firm's cost of common equity involves adding a subjectively determined risk-premium to the market risk-free bond rate.
E) None of the above is a correct statement.

Question 36

Global Advertising Company
The Global Advertising Company had net income after interest but before taxes of $40,000 this year. The marginal tax rate is 40 percent, and the dividend payout ratio is 30 percent. The company can raise debt at a 12 percent interest rate for any amount of debt less than $8,000. If the firm raises $8,000 or more of debt, a 15 percent interest rate will apply to that new debt. The last dividend paid by Global was $0.90. Global's common stock is selling for $8.59 per share, and its expected growth rate in earnings and dividends is 5 percent. If Global issues new common stock, the flotation cost incurred will be 10 percent. Global plans to finance all capital expenditures with 30 percent debt and 70 percent equity.
Refer to Global Advertising Company.What is Global's cost of retained earnings?

A) 12.22%
B) 17.22%
C) 10.33%
D) 9.66%
E) 16.00%

Question 37

Global Advertising Company
The Global Advertising Company had net income after interest but before taxes of $40,000 this year. The marginal tax rate is 40 percent, and the dividend payout ratio is 30 percent. The company can raise debt at a 12 percent interest rate for any amount of debt less than $8,000. If the firm raises $8,000 or more of debt, a 15 percent interest rate will apply to that new debt. The last dividend paid by Global was $0.90. Global's common stock is selling for $8.59 per share, and its expected growth rate in earnings and dividends is 5 percent. If Global issues new common stock, the flotation cost incurred will be 10 percent. Global plans to finance all capital expenditures with 30 percent debt and 70 percent equity.
Refer to Global Advertising Company.What is the break point due to retained earnings being used up?

A) $17,000
B) $30,000
C) $56,000
D) $24,000
E) $10,000

Question 38

Global Advertising Company
The Global Advertising Company had net income after interest but before taxes of $40,000 this year. The marginal tax rate is 40 percent, and the dividend payout ratio is 30 percent. The company can raise debt at a 12 percent interest rate for any amount of debt less than $8,000. If the firm raises $8,000 or more of debt, a 15 percent interest rate will apply to that new debt. The last dividend paid by Global was $0.90. Global's common stock is selling for $8.59 per share, and its expected growth rate in earnings and dividends is 5 percent. If Global issues new common stock, the flotation cost incurred will be 10 percent. Global plans to finance all capital expenditures with 30 percent debt and 70 percent equity.
Refer to Global Advertising Company.There are two break points in Global's MCC schedule,one when retained earnings have been used up,and one when low-cost debt has been used up ($26,667).Therefore,there are three intervals in the MCC schedule.What is the marginal cost of capital in each of these intervals?
1st interval 2nd interval 3rd interval

A) 13.99% 15.64% 14.21%
B) 14.80% 15.64% 16.92%
C) 13.36% 14.21% 14.75%
D) 13.36% 13.49% 14.75%
E) 13.99% 14.21% 16.92%

Question 39

Anderson Company has four investment opportunities with the following costs (all costs are paid at t = 0)and estimated internal rates of return (IRR): The company has a target capital structure that consists of 40 percent common equity,40 percent debt,and 20 percent preferred stock.The company has $1,000 in retained earnings.The company expects its year-end dividend to be $3.00 per share (i.e. , = $3.00).The dividend is expected to grow at a constant rate of 5 percent a year.The company's stock price is currently $42.75.If the company issues new common stock,the company will pay its investment bankers a 10 percent flotation cost.The company can issue corporate bonds with a yield to maturity of 10 percent.The company is in the 35 percent tax bracket.How large can the cost of preferred stock be (including flotation costs)and it still be profitable for the company to invest in all four projects?

A) 7.75%
B) 8.90%
C) 10.46%
D) 11.54%
E) 12.68%

Question 40

Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent common equity.The firm expects to earn $600 in after-tax income during the coming year,and it will retain 40 percent of those earnings.The current market price of the firm's stock is P₀ = $28;its last dividend was D₀ = $2.20,and its expected dividend growth rate is 6 percent.Allison can issue new common stock at a 15 percent flotation cost.What will Allison's marginal cost of equity capital (not the WACC)be if it must fund a capital budget requiring $600 in total new capital?

A) 15.8%
B) 13.9%
C) 7.9%
D) 14.3%
E) 9.7%

Question 41

Rollins Corporation
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 could sell, at par, $100 preferred stock that pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 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 rs. The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent.
Refer to Rollins Corporation.What is Rollins' cost of retained earnings using the CAPM approach?

A) 13.6%
B) 14.1%
C) 16.0%
D) 16.6%
E) 16.9%

Question 42

Becker Glass Corporation
Becker Glass Corporation expects to have earnings before interest and taxes during the coming year of $1,000,000, and it expects its earnings and dividends to grow indefinitely at a constant annual rate of 12.5 percent. The firm has $5,000,000 of debt outstanding bearing a coupon interest rate of 8 percent, and it has 100,000 shares of common stock outstanding. Historically, Becker has paid 50 percent of net earnings to common shareholders in the form of dividends. The current price of Becker's common stock is $40, but it would incur a 10 percent flotation cost if it were to sell new stock. The firm's tax rate is 40 percent.
Refer to J.Ross and Sons.What is the firm's cost of newly issued preferred stock?

A) 10.0%
B) 12.5%
C) 15.5%
D) 16.5%
E) 18.0%

Question 43

Byron Corporation
Byron Corporation's present capital structure, which is also its target capital structure, is 40 percent debt and 60 percent common equity. Next year's net income is projected to be $21,000, and Byron's payout ratio is 30 percent. The company's earnings and dividends are growing at a constant rate of 5 percent; the last dividend (D0) was $2.00; and the current equilibrium stock price is $21.88. Byron can raise all the debt financing it needs at 14.0 percent. If Byron issues new common stock, a 20 percent flotation cost will be incurred. The firm's marginal tax rate is 40 percent.
Refer to Byron Corporation.What is the component cost of the equity raised by selling new common stock?

A) 17.0%
B) 16.4%
C) 15.0%
D) 14.6%
E) 12.0%

Question 44

Rollins Corporation
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 could sell, at par, $100 preferred stock that pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 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 rs. The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent.
Refer to Rollins Corporation.What is Rollins' cost of retained earnings using the bond-yield-plus-risk-premium approach?

A) 13.6%
B) 14.1%
C) 16.0%
D) 16.6%
E) 16.9%

Question 45

Becker Glass Corporation
Becker Glass Corporation expects to have earnings before interest and taxes during the coming year of $1,000,000, and it expects its earnings and dividends to grow indefinitely at a constant annual rate of 12.5 percent. The firm has $5,000,000 of debt outstanding bearing a coupon interest rate of 8 percent, and it has 100,000 shares of common stock outstanding. Historically, Becker has paid 50 percent of net earnings to common shareholders in the form of dividends. The current price of Becker's common stock is $40, but it would incur a 10 percent flotation cost if it were to sell new stock. The firm's tax rate is 40 percent.
Refer to Becker Glass Corporation.What is Becker's cost of newly issued stock?

A) 16.0%
B) 16.5%
C) 17.0%
D) 17.5%
E) 18.0%

Question 46

Rollins Corporation
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 could sell, at par, $100 preferred stock that pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 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 rs. The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent.
Refer to Rollins Corporation.What is the firm's cost of retained earnings using the DCF approach?

A) 13.6%
B) 14.1%
C) 16.0%
D) 16.6%
E) 16.9%

Question 47

Becker Glass Corporation
Becker Glass Corporation expects to have earnings before interest and taxes during the coming year of $1,000,000, and it expects its earnings and dividends to grow indefinitely at a constant annual rate of 12.5 percent. The firm has $5,000,000 of debt outstanding bearing a coupon interest rate of 8 percent, and it has 100,000 shares of common stock outstanding. Historically, Becker has paid 50 percent of net earnings to common shareholders in the form of dividends. The current price of Becker's common stock is $40, but it would incur a 10 percent flotation cost if it were to sell new stock. The firm's tax rate is 40 percent.
Refer to J.Ross and Sons.Where will a break in the WACC curve occur?

A) $30,000
B) $20,000
C) $10,000
D) $42,000
E) There will be no breaks in the WACC curve.

Question 48

Becker Glass Corporation
Becker Glass Corporation expects to have earnings before interest and taxes during the coming year of $1,000,000, and it expects its earnings and dividends to grow indefinitely at a constant annual rate of 12.5 percent. The firm has $5,000,000 of debt outstanding bearing a coupon interest rate of 8 percent, and it has 100,000 shares of common stock outstanding. Historically, Becker has paid 50 percent of net earnings to common shareholders in the form of dividends. The current price of Becker's common stock is $40, but it would incur a 10 percent flotation cost if it were to sell new stock. The firm's tax rate is 40 percent.
Refer to J.Ross and Sons.What is the firm's cost of retained earnings?

A) 10.0%
B) 12.5%
C) 15.5%
D) 16.5%
E) 18.0%

Question 49

Rollins Corporation
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 could sell, at par, $100 preferred stock that pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 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 rs. The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent.
Refer to Rollins Corporation.What is Rollins' lowest WACC?

A) 13.6%
B) 14.1%
C) 16.0%
D) 16.6%
E) 16.9%

Question 50

Becker Glass Corporation
Becker Glass Corporation expects to have earnings before interest and taxes during the coming year of $1,000,000, and it expects its earnings and dividends to grow indefinitely at a constant annual rate of 12.5 percent. The firm has $5,000,000 of debt outstanding bearing a coupon interest rate of 8 percent, and it has 100,000 shares of common stock outstanding. Historically, Becker has paid 50 percent of net earnings to common shareholders in the form of dividends. The current price of Becker's common stock is $40, but it would incur a 10 percent flotation cost if it were to sell new stock. The firm's tax rate is 40 percent.
Refer to J.Ross and Sons.What is the firm's cost of newly issued common stock?

A) 10.0%
B) 12.5%
C) 15.5%
D) 16.5%
E) 18.0%

Question 51

Jackson Company
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. The firm's investment bankers believe that new issues of common stock would have a flotation cost equal to 5 percent of the current market price.
Refer to Jackson Company.What will be Jackson's cost of new common stock if it issues new stock in the marketplace today?

A) 15.25%
B) 16.32%
C) 17.00%
D) 12.47%
E) 9.85%

Question 52

Becker Glass Corporation
Becker Glass Corporation expects to have earnings before interest and taxes during the coming year of $1,000,000, and it expects its earnings and dividends to grow indefinitely at a constant annual rate of 12.5 percent. The firm has $5,000,000 of debt outstanding bearing a coupon interest rate of 8 percent, and it has 100,000 shares of common stock outstanding. Historically, Becker has paid 50 percent of net earnings to common shareholders in the form of dividends. The current price of Becker's common stock is $40, but it would incur a 10 percent flotation cost if it were to sell new stock. The firm's tax rate is 40 percent.
Refer to J.Ross and Sons.What will be the WACC above this break point?

A) 12.5%
B) 8.3%
C) 10.6%
D) 11.9%
E) 14.1%

Question 53

Rollins Corporation
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 could sell, at par, $100 preferred stock that pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 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 rs. The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent.
Refer to Rollins Corporation.What is Rollins' cost of preferred stock?

A) 10.0%
B) 11.0%
C) 12.0%
D) 12.6%
E) 13.2%

Question 54

Jackson Company
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. The firm's investment bankers believe that new issues of common stock would have a flotation cost equal to 5 percent of the current market price.
Refer to Jackson Company.How much should an investor be willing to pay for this stock today?

A) $62.81
B) $70.00
C) $43.75
D) $55.00
E) $30.00

Question 55

Rollins Corporation
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 could sell, at par, $100 preferred stock that pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 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 rs. The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent.
Refer to Rollins Corporation.What is Rollins' retained earnings break point?

A) $600,000
B) $800,000
C) $1,000,000
D) $1,200,000
E) $1,400,000

Question 56

Rollins Corporation
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 could sell, at par, $100 preferred stock that pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 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 rs. The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent.
Refer to Rollins Corporation.What is Rollins' WACC once it starts using new common stock financing?

A) 13.6%
B) 14.1%
C) 16.0%
D) 16.6%
E) 16.9%

Question 57

Becker Glass Corporation
Becker Glass Corporation expects to have earnings before interest and taxes during the coming year of $1,000,000, and it expects its earnings and dividends to grow indefinitely at a constant annual rate of 12.5 percent. The firm has $5,000,000 of debt outstanding bearing a coupon interest rate of 8 percent, and it has 100,000 shares of common stock outstanding. Historically, Becker has paid 50 percent of net earnings to common shareholders in the form of dividends. The current price of Becker's common stock is $40, but it would incur a 10 percent flotation cost if it were to sell new stock. The firm's tax rate is 40 percent.
Refer to Becker Glass Corporation.What is the firm's cost of retained earnings?

A) 15.0%
B) 15.5%
C) 16.0%
D) 16.5%
E) 17.0%

Question 58

Byron Corporation
Byron Corporation's present capital structure, which is also its target capital structure, is 40 percent debt and 60 percent common equity. Next year's net income is projected to be $21,000, and Byron's payout ratio is 30 percent. The company's earnings and dividends are growing at a constant rate of 5 percent; the last dividend (D0) was $2.00; and the current equilibrium stock price is $21.88. Byron can raise all the debt financing it needs at 14.0 percent. If Byron issues new common stock, a 20 percent flotation cost will be incurred. The firm's marginal tax rate is 40 percent.
Refer to Byron Corporation.Assume that at one point along the marginal cost of capital schedule the component cost of equity is 18.0 percent.What is the weighted average cost of capital at that point?

A) 10.8%
B) 13.6%
C) 14.2%
D) 16.4%
E) 18.0%

Question 59

Gargoyle Unlimited
Gargoyle Unlimited is planning to issue a zero coupon bond to fund a project that will yield its first positive cash flow in three years. That cash flow will be sufficient to pay off the entire debt issue. The bond's par value will be $1,000, it will mature in 3 years, and it will sell in the market for $727.25. The firm's marginal tax rate is 40 percent.
Refer to Gargoyle Unlimited.What is the dollar value of the interest tax savings to the firm in the third year of the issue?

A) $32.58
B) $40.29
C) $100.72
D) $60.43
E) $109.10

Question 60

Rollins Corporation
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 could sell, at par, $100 preferred stock that pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 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 rs. The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent.
Refer to Rollins Corporation.What is Rollins' component cost of debt?

A) 10.0%
B) 9.1%
C) 8.6%
D) 8.0%
E) 7.2%

Question 61

In capital budgeting and cost of capital analyses,the firm should always consider retained earnings as the first source of capital,because this is a free source of funding to the firm.

Question 62

Capital refers to items on the right-hand side of a firm's balance sheet.

Question 63

The cost of equity obtained by retaining earnings is generally regarded as being the rate of return stockholders require on the firm's common stock.

Question 64

When a firm's stockholders are not well diversified,the firm's true investment risk will not be measured by beta and the CAPM procedure will ____ the correct value of r_s.

A) overstate
B) accurately predict
C) understate
D) none of the above.

Question 65

An increase in total assets can be financed by an increase in which of the following capital components:

A) debt
B) preferred stock
C) common equity
D) All of the above

Question 66

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 67

The cost of equity capital from the sale of new common stock (r_e)is generally equal to the cost of equity capital from retention of earnings (r_s),divided by one minus the flotation cost as a percentage of sales price (1 − F).

Question 68

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

Question 69

____ is the portion of net income not paid out in the form of dividends.

A) Par value
B) Paid in capital
C) Retained earnings
D) Common equity

Question 70

The ____ is the return that must be earned on invested funds to cover the cost of financing such investments

A) cost of capital
B) opportunity cost rate
C) required rate of return
D) All of the above.

Question 71

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 72

The expected rate of return on a constant growth stock is equal to the ____ plus its ____.

A) risk-free rate;inflation premium
B) risk-free rate;expected growth rate
C) dividend yield;risk premium
D) dividend yield;expected growth rate

Question 73

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 74

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

Question 75

What is the best data to use for the growth rate estimate for DCF cost of capital estimates?

A) Growth in the GDP
B) Inflation
C) Historical data
D) Analyst's forecasts

Question 76

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

Question 77

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 78

Gargoyle Unlimited
Gargoyle Unlimited is planning to issue a zero coupon bond to fund a project that will yield its first positive cash flow in three years. That cash flow will be sufficient to pay off the entire debt issue. The bond's par value will be $1,000, it will mature in 3 years, and it will sell in the market for $727.25. The firm's marginal tax rate is 40 percent.
Refer to Gargoyle Unlimited.What is the expected after-tax cost of this debt issue?

A) 11.20%
B) 4.48%
C) 6.72%
D) 6.10%
E) 4.00%

Question 79

The ____ is the dollar value of new capital that can be raised before an increase in the firm's weighted cost of capital.

A) marginal cost of capital
B) inflection point
C) break even quantity
D) break point

Question 80

If the MCC includes five break points,then there will be ____ different WACCs.

A) 2
B) 3
C) 4
D) 5
E) 6