Deck 13: The Cost of Capital

Question 1

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.

Answer 1

True

Question 2

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

Answer 2

0.6, 0.4

Question 3

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

Answer 3

0.25, 0.75

Question 4

Brisbane Broncos Limited has raised all its capital via equity rather than debt. Such a firm is also referred to as a(n)________ firm.

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

Question 5

Financial managers need to use all sources of financing in order to determine the cost of capital.

Question 6

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

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

Question 7

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)0.67, 0.33
C)0.25, 0.75
D)0.5, 0.5

Question 8

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

Question 9

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 10

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

Question 11

The total market value of Downunder Minerals is $10 billion. The company 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)0.3, 0.7
B)0.6, 0.4
C)0.7, 0.3
D)cannot be determined

Question 12

We use market values rather than book values because the cost of capital is based on investors' current assessment of the value of the firm and not the assessment of accounting-based book values.

Question 13

As a firm increases its level of debt relative to its level of equity, the firm is decreasing its leverage.

Question 14

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

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

Question 15

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

Question 16

Assume JBH 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 JBH use in calculating its WACC?

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

Question 17

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

Question 18

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

Question 19

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

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

Question 20

A levered firm is one that has ________ outstanding.

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

Question 21

Preference shares of Dunmovin pay a dividend of $4 each year and trade at a price of $30. What is the cost of preference share capital for Dunmovin?

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

Question 22

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

Question 23

The outstanding debt of Flight Centre (FLT)trades with a yield to maturity of 8%. The tax rate of FLT is 25%. What is the effective cost of debt of FLT?

A)6.3%
B)6.0%
C)5.2%
D)7%

Question 24

Your estimate of the market risk premium is 8%. The risk-free rate of return is 2.5% and Virgin Australia has a beta of 1.5. What is Virgin's cost of equity capital?

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

Question 25

Why do we use leverage if it increases the risk of a firm?
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Question 26

Preference shares of Dunmovin pay a dividend of $3.50 each year and trade at a price of $25. What is the cost of preference share capital for Dunmovin?

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

Question 27

'Cost of equity' is the return that equity holders expect from the firm and is directly related to the firm's retained earnings.

Question 28

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

Question 29

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

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

Question 30

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

Question 31

MNP expects to pay a dividend of $5 next year and expects these dividends to grow at 6% a year. The price of MNP is $78.50 per share. What is MNP's cost of equity capital?

A)10.23%
B)6.00%
C)10.89%
D)12.37%

Question 32

MNP just paid a dividend of $2.75 and expects these dividends to grow at 5.5% a year. The price of MNP is $60 per share. What is MNP's cost of equity capital?

A)10.08%
B)12.51%
C)3.55%
D)9.09%

Question 33

The 'cost of debt' is the before-tax cost of debt while the effective cost of debt is the after-tax cost of debt, which is lower for a profitable tax-paying firm.

Question 34

Your estimate of the market risk premium is 5%. The risk-free rate of return is 2% and Virgin Australia has a beta of 1.2. What is Virgin's cost of equity capital?

A)8.0%
B)9.8%
C)8.4%
D)9.9%

Question 35

The outstanding debt of Flight Centre (FLT)trades with a yield to maturity of 8%. The tax rate of FLT is 35%. What is the effective cost of debt of FLT?

A)4.5%
B)5.7%
C)5.3%
D)5.2%

Question 36

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

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

Question 37

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

Question 38

Preference shares of Dunmovin pay a dividend of $2.50 each year and trade at a price of $25. What is the cost of preference share capital for Dunmovin?

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

Question 39

MNP expects to pay a dividend of $2.50 next year and expects these dividends to grow at 3% a year. The price of MNP is $50 per share. What is MNP's cost of equity capital?

A)8.84%
B)4.58%
C)8.00%
D)3.16%

Question 40

Outstanding debt of Flight Centre (FLT)trades with a yield to maturity of 7%. The tax rate of FLT is 40%. What is the effective cost of debt of FLT?

A)4.8%
B)4.5%
C)5.2%
D)4.2%

Question 41

The WACC depends on the risk of a company's line of business.

Question 42

A firm has $1 million market value and it sells preference shares for $100 per share. If the annual dividend on the preference share is $7 and it trades at $95, what is the cost of preference share capital?

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

Question 43

Massive Inc shares have a market capitalisation 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, Massive 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)7.91%
B)8.31%
C)7.45%
D)8.11%

Question 44

A firm has outstanding debt with a coupon rate of 7%, seven years' maturity, and a price of $1 000 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)5.9%
D)5.5%

Question 45

Of the Constant Dividend Growth Model (CDGM)and Capital Asset Pricing Model (CAPM), which is a better method for computation of the cost of equity?
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Question 46

A firm has outstanding debt with a coupon rate of 6%, 10 years' maturity, and a price of $1 000 per $1 000 face value. What is the after-tax cost of debt if the marginal tax rate of the firm is 30%?

A)2.9%
B)3.2%
C)3.9%
D)4.2%

Question 47

A firm has $2 million market value and it sells preference shares for $100 per share. If the annual dividend on the preference share is $8 and it trades at $90, what is the cost of preference share capital?

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

Question 48

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

Question 49

The outstanding debt of Billabong has 10 years to maturity, a current yield of 7%, and a price of $95. What is the pre-tax cost of debt if the tax rate is 30%?

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

Question 50

A firm has outstanding debt with a coupon rate of 9%, nine years' maturity, and a price of $1 000 per $1 000 face value. What is the after-tax cost of debt if the marginal tax rate of the firm is 30%?

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

Question 51

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

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

Question 52

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

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

Question 53

A firm has $3 million market value and it sells preference shares at $100 per share. If the annual dividend on the preference share is $9 and it trades at $95, what is the cost of preference share capital?

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

Question 54

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)13.9%
C)13.5%
D)14.4%

Question 55

Which of the three costs-debt, preference share capital and ordinary share capital-is most difficult to estimate?
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Question 56

Most practitioners would use net debt when calculating the weights for the WACC, which is total debt outstanding minus cash and other risk-free securities.

Question 57

Massive Inc shares have a market capitalisation 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, Massive 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)7.91%
C)7.24%
D)7.45%

Question 58

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)may be greater than or less than
D)is always less than

Question 59

A firm has a pre-tax cost of debt of 8.5%. If the firm has a marginal tax rate of 30%, what is its effective cost of debt?

A)3.4%
B)8.1%
C)6.0%
D)8.5%

Question 60

Is it incorrect to use the coupon rate of debt toward cost of debt?
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Question 61

When a firm is evaluating the purchase of a business that is unrelated to its current business, it is appropriate to use the current WACC of the firm that is purchasing the business.

Question 62

Qantas is discussing new ways to recapitalise and raise additional capital. Its current capital structure has a 20% weight in ordinary shares, 10% in preference shares and 70% in debt. The cost of equity capital is 14%, the cost of preference shares is 10%, and the pre-tax cost of debt is 9%. What is the weighted average cost of capital for Qantas if its marginal tax rate is 30%?

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

Question 63

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 pre-tax cost of debt is 6%. If the marginal tax rate of the firm is 30%, compute the weighted average cost of capital of the firm.

A)4.9%
B)4.6%
C)5.2%
D)5.7%

Question 64

Using WACC in evaluating a firm's project implies that the risk of the project is comparable to the average risk of the firm's other investments.

Question 65

Sirtex Medical 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)13.52%
B)14.21%
C)13.76%
D)13.16%

Question 66

Qantas is discussing new ways to recapitalise the firm and raise additional capital. Its current capital structure has a 10% weight in ordinary shares, 20% in preference shares, and 70% in debt. The cost of equity capital is 15%, the cost of preference shares is 10%, and the pre-tax cost of debt is 8%. What is the weighted average cost of capital for Qantas if its marginal tax rate is 30%?

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

Question 67

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 pre-tax 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)11.1%
B)11.7%
C)10.3%
D)9.8%

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)similar
B)lower
C)higher
D)None of the above.

Question 69

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 pre-tax cost of debt is 7%. If the marginal tax rate of the firm is 30%, compute the weighted average cost of capital of the firm.

A)7.3%
B)6.8%
C)5.6%
D)6.3%

Question 70

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

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

Question 71

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

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

Question 72

Holding everything else constant, an increase in cash ________ the firm's net debt.

A)will decrease
B)may increase or decrease
C)will have no impact on
D)will increase

Question 73

Qantas is discussing new ways to recapitalise the firm and raise additional capital. Its current capital structure has a 30% weight in ordinary shares, 10% in preference shares, and 60% in debt. The cost of equity capital is 17%, the cost of preference shares is 11%, and the pre-tax cost of debt is 8%. What is the weighted average cost of capital for Qantas if its marginal tax rate is 30%?

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

Question 74

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

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

Question 75

Coca-Cola Amatil (CCL)has a weighted average cost of capital of 9%. CCL is considering investing in a new plant that will save the company $25 million over each of the first two years, and then $10 million each year thereafter. If the investment is $100 million, what is the net present value (NPV)of the project?

A)$39.7 million
B)$37.5 million
C)$36.5 million
D)$34.2 million

Question 76

Sirtex Medical 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)5.38%
B)5.98%
C)5.01%
D)4.65%

Question 77

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

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

Question 78

Massive Inc shares have a market capitalisation 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, Massive 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)7.93%
B)7.45%
C)6.81%
D)6.85%

Question 79

Assume JBH has debt with a book value of $20 million, trading at 120% of par value. The bonds have a yield to maturity of 6%. The firm has book equity of $20 million, and 2 million shares trading at $18 per share. The firm's cost of equity is 12%. What is JBH's WACC if the firm's marginal tax rate is 30%?

A)9.00%
B)8.88%
C)6.24%
D)9.60%

Question 80

Sirtex Medical 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)10.21%
B)11.45%
C)9.56%
D)10.95%