Deck 13: The Cost of Capital

Question 1

The fact that the after-tax cost of debt is lower than the pretax cost of debt implicitly assumes that interest expense can be

A)expensed.
B)margined.
C)refinanced.
D)none of the above

Answer 1

A

Question 2

GM has a book value of $8 billion of equity and a face value of $12 billion of debt.What are the weights in debt and equity that are used for calculating the WACC?

A)0.4,0.6
B)0.6,0.4
C)0.5,0.5
D)cannot be determined

Answer 2

D

Question 3

The total market value of General Motors (GM)is $10 billion.GM has a market value of $7 billion of equity and a face value of $10 billion of debt.What are the weights in equity and debt that are used for calculating the WACC?

A)0.6,0.4
B)0.7,0.3
C)0.3,0.7
D)cannot be determined

Answer 3

B

Question 4

A firm incurs $40,000 in interest expenses each year.If the tax rate of the firm is 40%,what is the effective after-tax interest rate expense for the firm?

A)$22,000
B)$24,000
C)$27,000
D)$29,000

Question 5

The relative proportion of debt,equity,and other securities that a firm has outstanding constitute its

A)asset ratio.
B)current ratio.
C)capital structure.
D)none of the above

Question 6

A firm incurs $70,000 in interest expenses each year.If the tax rate of the firm is 20%,what is the effective after-tax interest rate expense for the firm?

A)$37,000
B)$49,000
C)$56,000
D)$65,000

Question 7

Why do we use leverage if it increases the risk of a firm?

Question 8

To attract capital from outside investors,a firm must offer potential investors an expected return that is commensurate with the level of risk that they can bear.

Question 9

A firm's sources of financing,which usually consists of debt and equity,represent its

A)total assets.
B)capital.
C)total liabilities.
D)current liabilities.

Question 10

Why do we use market values rather than book values in calculation of WACC?

Question 11

One should use accounting-based book values rather than market values of debt and equity to determine the weights for the different sources of capital.

Question 12

Apple computers has raised all its capital via equity rather than debt.Such a firm is also referred to as an ________ firm.

A)levered
B)margined
C)risk less
D)unlevered

Question 13

A levered firm is one that has ________ outstanding.

A)debt
B)equity
C)preferred stock
D)equity options

Question 14

Leverage is the amount of ________ on a firm's balance sheet.

A)equity
B)debt
C)preferred stock
D)none of the above

Question 15

For an unlevered firm,the cost of capital of the firm can be determined by using the

A)yield on the traded debt.
B)Capital Asset Pricing Model.
C)dividend yield.
D)preferred stock yield.

Question 16

A firm incurs $50,000 in interest expenses each year.If the tax rate of the firm is 30%,what is the effective after-tax interest rate expense for the firm?

A)$27,000
B)$29,000
C)$32,000
D)$35,000

Question 17

The firm's overall cost of capital that is a blend of the costs of the different sources of capital is known as the firm's

A)weighted average cost of capital.
B)cost of equity infusion.
C)cost of debt.
D)cost of preferred stock.

Question 18

The book value of equity of a firm is $100 million and the market value of equity is $200 million.The face value of debt of the firm is $50 million and the market value of debt is $60 million.What is the market value of assets of the firm?

A)$150 million
B)$160 million
C)$260 million
D)$250 million

Question 19

GM has a market value of $8 billion of equity and a market value of $12 billion of debt.What are the weights in equity and debt that are used for calculating the WACC?

A)0.5,0.5
B)0.6,0.4
C)0.4,0.6
D)0.8,0.2

Question 20

Financial managers do not need to use all sources of financing in order to determine the cost of capital.

Question 21

Preferred stock of Ford Motors pays a dividend of $2.5 each year and trades at a price of $25.What is the cost of preferred stock capital for Ford?

A)8%
B)9%
C)10%
D)11%

Question 22

IBM expects to pay a dividend of $3 next year and expects these dividends to grow at 8% a year.The price of IBM is $95 per share.What is IBM's cost of equity capital?

A)3.16%
B)4.84%
C)8%
D)11.16%

Question 23

The fact that the interest paid on debt is a tax-deductible expense increases the cost of debt financing.

Question 24

Outstanding debt of Home Depot trades with a yield to maturity of 7%.The tax rate of Home Depot is 30%.What is the effective cost of debt of Home Depot?

A)5.2%
B)7%
C)6.3%
D)4.9%

Question 25

Outstanding debt of Home Depot trades with a yield to maturity of 8%.The tax rate of Home Depot is 35%.What is the effective cost of debt of Home Depot?

A)5.2%
B)5.8%
C)6.2%
D)6.5%

Question 26

Preferred stock of Ford Motors pays a dividend of $3.5 each year and trades at a price of $25.What is the cost of preferred stock capital for Ford?

A)12.6%
B)14.0%
C)13.5%
D)12.8%

Question 27

IBM expects to pay a dividend of $4 next year and expects these dividends to grow at 7% a year.The price of IBM is $90 per share.What is IBM's cost of equity capital?

A)9.65%
B)10.23%
C)10.89%
D)11.44%

Question 28

Your estimate of the market risk premium is 7%.The risk-free rate of return is 4% and General Motors has a beta of 1.5.What is General Motors' cost of equity capital?

A)13.5%
B)14.5%
C)13.9%
D)14.8%

Question 29

Outstanding debt of Home Depot trades with a yield to maturity of 6%.The tax rate of Home Depot is 40%.What is the effective cost of debt of Home Depot?

A)5.3%
B)5.7%
C)4.5%
D)3.6%

Question 30

As a firm increases its level of debt relative to its level of equity,the firm is:

A)increasing the fraction of the firm financed with equity.
B)decreasing the fraction of the firm financed with debt.
C)decreasing its leverage.
D)increasing its leverage.

Question 31

Epiphany is an all-equity firm with an estimated market value of $400,000.The firm sells $300,000 of debt and uses the proceeds to purchase outstanding equity.Compute the weight in equity and the weight in debt after the proposed financing and repurchase of equity.

A)0.2,0.8
B)0.25,0.75
C)0.4,0.6
D)0.5,0.5

Question 32

Epiphany is an all-equity firm with an estimated market value of $300,000.The firm sells $100,000 of debt and uses the proceeds to purchase outstanding equity.Compute the weight in equity and the weight in debt after the proposed financing and repurchase of equity.

A)0.2,0.8
B)0.25,0.75
C)0.67,0.33
D)0.5,0.5

Question 33

IBM just paid a dividend of $3.5 and expects these dividends to grow at 9% a year.The price of IBM is $100 per share.What is IBM's cost of equity capital?

A)3.5%
B)9%
C)12.5%
D)12.82%

Question 34

Epiphany is an all-equity firm with an estimated market value of $500,000.The firm sells $200,000 of debt and uses the proceeds to purchase outstanding equity.Compute the weight in equity and the weight in debt after the proposed financing and repurchase of equity.

A)0.2,0.8
B)0.25,0.75
C)0.4,0.6
D)0.6,0.4

Question 35

Assume JUP has debt with a book value of $20 million,trading at 120% of par value.The firm has book equity of $20 million,and 2 million shares trading at $18 per share.What weights should JUP use in calculating its WACC?

A)40% for debt,60% for equity
B)50% for debt,50% for equity
C)36% for debt,64%% for equity
D)45% for debt,55% for equity

Question 36

The ________ of a firm's debt can be used as the firm's current cost of debt.

A)current yield
B)coupon rate
C)yield to maturity
D)discount yield

Question 37

The after-tax cost of equity is ________ the pretax cost of equity.

A)higher than
B)lower than
C)the same as
D)none of the above

Question 38

Your estimate of the market risk premium is 6%.The risk-free rate of return is 5% and General Motors has a beta of 1.2.What is General Motors' cost of equity capital?

A)12.2%
B)11.8%
C)12.9%
D)11.4%

Question 39

Preferred stock of Ford Motors pays a dividend of $4 each year and trades at a price of $30.What is the cost of preferred stock capital for Ford?

A)13.3%
B)14.5%
C)15.5%
D)16.2%

Question 40

A firm's cost of debt is the rate of interest it would have to pay to refinance its existing debt.

Question 41

The outstanding debt of Berstin Corp.has eight years to maturity,a current yield of 8%,and a price of $95.What is the pretax cost of debt if the tax rate is 30%.

A)5.6%
B)6.5%
C)8.5%
D)more information needed

Question 42

An all-equity firm produced a dividend flow of $30,000 last year.The market value of the firm is $875,000 and the dividend is expected to increase at 3% each year.What is the cost of equity capital for this firm?

A)6.53%
B)6.91%
C)7.45%
D)7.89%

Question 43

What is the difference between the effective cost of debt and the cost of debt?

Question 44

SIROM Scientific Solutions has $10 million of outstanding equity and $5 million of bank debt.The bank debt costs 5% per year.The estimated equity beta is 2.If the market risk premium is 7% and the risk-free rate is 4%,compute the weighted average cost of capital if the firm's tax rate is 30%.

A)13.16%
B)13.52%
C)13.76%
D)14.21%

Question 45

Should a firm with high retained earnings have a lower cost of equity?

Question 46

An all-equity firm produced a dividend flow of $40,000 last year.The market value of the firm is $800,000 and the dividend is expected to increase at 5% each year.What is the cost of equity capital for this firm?

A)9.18%
B)9.75%
C)10.25%
D)11.89%

Question 47

Which of the three costs - debt,preferred stock and common equity - is most difficult to estimate?

Question 48

Is it incorrect to use the coupon rate of debt toward cost of debt?

Question 49

A firm has outstanding debt with a coupon rate of 6%,ten years maturity,and a price of $1000 per $1000 face value.What is the after-tax cost of debt if the marginal tax rate of the firm is 40%?

A)2.9%
B)3.2%
C)3.6%
D)3.9%

Question 50

The outstanding debt of Berstin Corp.has five years to maturity,a current yield of 6%,and a price of $95.What is the pretax cost of debt if the tax rate is 30%.

A)4.2%
B)4.8%
C)6.9%
D)more information needed

Question 51

SIROM Scientific Solutions has $10 million of outstanding equity and $10 million of bank debt.The bank debt costs 7% per year.The estimated equity beta is 2.If the market risk premium is 6% and the risk-free rate is 5%,compute the weighted average cost of capital if the firm's tax rate is 30%.

A)9.56%
B)10.21%
C)10.95%
D)11.45%

Question 52

A firm has outstanding debt with a coupon rate of 7%,seven years maturity,and a price of $1000 per $1000 face value.What is the after-tax cost of debt if the marginal tax rate of the firm is 30%?

A)4.9%
B)5.2%
C)5.5%
D)5.9%

Question 53

The outstanding debt of Berstin Corp.has ten years to maturity,a current yield of 7%,and a price of $95.What is the pretax cost of debt if the tax rate is 30%.

A)4.9%
B)6.5%
C)7.0%
D)7.37%

Question 54

A firm has $2 million market value and it sells preferred stock with a par value of $100.If the coupon rate on the preferred stock is 8% and the preferred stock trades at $90,what is the cost of preferred stock financing?

A)8.75%
B)8.89%
C)9.21%
D)9.35%

Question 55

Among the two models Constant Dividend Growth Model (CDGM)and Capital Asset Pricing Model (CAPM),which is a better method for computation of the cost of equity?

Question 56

An all-equity firm produced a dividend flow of $20,000 last year.The market value of the firm is $650,000 and the dividend is expected to increase at 4% each year.What is the cost of equity capital for this firm?

A)5.5%
B)6.2%
C)7.2%
D)7.8%

Question 57

A firm has $1 million market value and it sells preferred stock with a par value of $100.If the coupon rate on the preferred stock is 7% and the preferred stock trades at $95,what is the cost of preferred stock financing?

A)6.75%
B)7.15%
C)7.21%
D)7.37%

Question 58

Your estimate of the market risk premium is 6%.The risk-free rate of return is 4.5% and General Motors has a beta of 1.6.What is General Motors' cost of equity capital?

A)14.1%
B)13.5%
C)13.9%
D)14.4%

Question 59

A firm has outstanding debt with a coupon rate of 9%,nine years maturity,and a price of $1000 per $1000 face value.What is the after-tax cost of debt if the marginal tax rate of the firm is 30%?

A)4.9%
B)6.3%
C)5.8%
D)5.9%

Question 60

A firm has $3 million market value and it sells preferred stock with a par value of $100.If the coupon rate on the preferred stock is 9% and the preferred stock trades at $95,what is the cost of preferred stock financing?

A)8.75%
B)9.47%
C)10.21%
D)10.41%

Question 61

Time Warner shares have a market capitalization of $50 billion.The company is expected to pay a dividend of $0.30 per share and each share trades for $30.The growth rate in dividends is expected to be 7% per year.Also,Time Warner has $15 billion of debt that trades with a yield to maturity of 8%.If the firm's tax rate is 30%,what is the WACC?

A)6.55%
B)7.24%
C)7.45%
D)7.91%

Question 62

When calculating the WACC,it is standard practice to subtract ________ to compute the net debt outstanding.

A)equity
B)dividends
C)cash and risk-free securities
D)coupons

Question 63

A firm has a pre-tax cost of debt of 8.5%.If the firm has a marginal tax rate of 40%,what is its effective cost of debt?

A)5.1%
B)3.4%
C)8.5%
D)8.1%

Question 64

The WACC does not depend on the risk of a company's line of business.

Question 65

When corporate tax rates decline,the net cost of debt financing

A)decreases.
B)is unchanged.
C)increases.
D)none of the above

Question 66

A firm has a capital structure with $50 million in equity and $100 million of debt.The cost of equity capital is 12% and the pretax cost of debt is 7%.If the marginal tax rate of the firm is 40%,compute the weighted average cost of capital of the firm.

A)5.6%
B)6.3%
C)6.8%
D)7.7%

Question 67

Ford Motor Company is discussing new ways to recapitalize the firm and raise additional capital.Its current capital structure has a 10% weight in equity,20% in preferred stock,and 70% in debt.The cost of equity capital is 15%,the cost of preferred stock is 10%,and the pretax cost of debt is 8%.What is the weighted average cost of capital for Ford if its marginal tax rate is 30%?

A)7.01%
B)7.42%
C)7.98%
D)8.01%

Question 68

Many financial managers use market risk premiums that are closer to 5%,which is lower than historical averages,because investors require a ________ risk premium for holding risky securities than in the past.

A)lower
B)higher
C)similar
D)none of the above

Question 69

The market value of Fords' equity,preferred stock and debt are $7 billion,$3 billion,and $10 billion,respectively.Ford has a beta of 1.8,the market risk premium is 7%,and the risk-free rate of interest is 4%.Ford's preferred stock pays a dividend of $3.5 each year and trades at a price of $27 per share.Ford's debt trades with a yield to maturity of 9.5%.What is Ford's weighted average cost of capital if its tax rate is 30%?

A)10.12%
B)10.34%
C)11.08%
D)11.47%

Question 70

Time Warner shares have a market capitalization of $55 billion.The company just paid a dividend of $0.35 per share and each share trades for $35.The growth rate in dividends is expected to be 6.5% per year.Also,Time Warner has $20 billion of debt that trades with a yield to maturity of 7%.If the firm's tax rate is 30%,compute the WACC?

A)6.81%
B)6.85%
C)7.45%
D)7.93%

Question 71

What type of adjustment to net debt are prevalent in practice?

Question 72

A firm has a capital structure with $100 million in equity and $100 million of debt.The cost of equity capital is 14% and the pretax cost of debt is 8%.If the marginal tax rate of the firm is 30%,compute the weighted average cost of capital of the firm.

A)9.8%
B)10.3%
C)11.1%
D)11.7%

Question 73

The market value of Fords' equity,preferred stock,and debt are $6 billion,$2 billion,and $15 billion,respectively.Ford has a beta of 1.5,the market risk premium is 7%,and the risk-free rate of interest is 4%.Ford's preferred stock pays a dividend of $3 each year and trades at a price of $27 per share.Ford's debt trades with a yield to maturity of 8.5%.What is Ford's weighted average cost of capital if its tax rate is 30%?

A)8.87%
B)8.63%
C)9.56%
D)10.13%

Question 74

SIROM Scientific Solutions has $4 million of outstanding equity and $12 million of bank debt.The bank debt costs 5% per year.The estimated equity beta is 1.If the market risk premium is 7% and the risk-free rate is 4%,compute the weighted average cost of capital if the firm's tax rate is 30%.

A)4.65%
B)5.01%
C)5.38%
D)5.98%

Question 75

The market value of Fords' equity,preferred stock and debt are $8 billion,$4 billion and $12 billion respectively.Ford has a beta of 1.3,the market risk premium is 7% and the risk-free rate of interest is 4%.Ford's preferred stock pays a dividend of $4 each year and trades at a price of $30 per share.Ford's debt trades with a yield to maturity of 8.5%.What is Ford's weighted average cost of capital if its tax rate is 30%?

A)8.01%
B)8.34%
C)9.46%
D)9.56%

Question 76

Time Warner shares have a market capitalization of $60 billion.The company is expected to pay a dividend of $0.35 per share and each share trades for $30.The growth rate in dividends is expected to be 8% per year.Also,Time Warner has $15 billion of debt that trades with a yield to maturity of 7%.If the firm's tax rate is 30%,compute the WACC?

A)7.45%
B)7.91%
C)8.11%
D)8.31%

Question 77

The after-tax cost of debt ________ the before-tax cost of debt for a firm that has a positive marginal tax rate.

A)is always greater than
B)is always equal to
C)is always less than
D)may be greater than or less than

Question 78

Ford Motor Company is discussing new ways to recapitalize the firm and raise additional capital.Its current capital structure has a 20% weight in equity,10% in preferred stock,and 70% in debt.The cost of equity capital is 14%,the cost of preferred stock is 10%,and the pretax cost of debt is 9%.What is the weighted average cost of capital for Ford if its marginal tax rate is 30%?

A)7.87%
B)8.21%
C)8.89%
D)9.21%

Question 79

Ford Motor Company is discussing new ways to recapitalize the firm and raise additional capital.Its current capital structure has a 30% weight in equity,10% in preferred stock,and 60% in debt.The cost of equity capital is 17%,the cost of preferred stock is 11%,and the pretax cost of debt is 8%.What is the weighted average cost of capital for Ford if its marginal tax rate is 30%?

A)9.56%
B)9.96%
C)10.25%
D)10.73%

Question 80

A firm has a capital structure with $30 million in equity and $90 million of debt.The cost of equity capital is 10% and the pretax cost of debt is 6%.If the marginal tax rate of the firm is 40%,compute the weighted average cost of capital of the firm.

A)4.6%
B)4.9%
C)5.2%
D)5.8%