Deck 14: The Cost of Capital

Question 1

The cost of capital is:

A)the opportunity cost of using funds to invest in new projects.
B)the rate of return the firm must earn on its investments in order to satisfy the required rate of return of the firm's investors.
C)the required rate of return for new capital investments which have typical or average risk.
D)all of the above.

Answer 1

D

Question 2

When investors increase their required rate of return,the cost of capital increases simultaneously.

Answer 2

True

Question 3

14.2 Determining the Firm's Capital Structure Weights
Use the following information to answer the following question(s).
The following data concerning Grafton Computer Peripherals' capital structure is available.

The percentage of common stock in Grafton's weighted average cost of capital is:

A)38.1%.
B)20%.
C)6.25%.
D)62.5%.

Answer 3

D

Question 4

Briefly identify and describe some important uses of a firm's weighted average cost of capital.

Question 5

14.2 Determining the Firm's Capital Structure Weights
Use the following information to answer the following question(s).
The following data concerning Grafton Computer Peripherals' capital structure is available.

The percentage of preferred stock in Grafton's weighted average cost of capital is:

A)5.9%.
B)6.25%.
C)4.76%.
D)62.5%.

Question 6

Which of the following would NOT be considered in calculating a firm's cost of capital?

A)Bonds
B)Accounts payable
C)Preferred Stock
D)common stock

Question 7

Which of the following must be adjusted for the firm's tax rate when estimating the weighted average cost of capital WACC?

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

Question 8

Which of the following is a correct formula for calculating the cost of capital?

A)WACC = weighted after-tax cost of debt + weighted cost of preferred stock + weighted cost of common stock
B)WACC = weighted after-tax cost of debt + weighted after-tax cost of preferred stock + weighted after-tax cost of common stock
C)WACC = (after-tax cost of debt + cost of preferred stock + cost of common stock )/3
D)WACC = weighted cost of debt + weighted cost of preferred stock + weighted cost of common stock

Question 9

The firm should continue to invest in new projects up to the point where the marginal rate of return earned on a new investment equals the marginal cost of new capital.

Question 10

The minimum rate of return necessary to attract an investor to purchase or hold a security is called the cost of capital.

Question 11

In order to maximize firm value,management should invest in new assets when cash flows from the assets are discounted at the firm's ________ and result in a positive NPV.

A)cost of capital
B)cost of debt used to finance the project
C)rate of return on equity
D)internal rate of return

Question 12

Business risk reflects the added variability in earnings available to a firm's shareholders.

Question 13

Cost of capital is:

A)the coupon rate of debt.
B)a minimum rate of return set by the board of directors.
C)the rate of return that must be earned on additional investment if firm value is to remain unchanged.
D)the average cost of the firm's assets.

Question 14

The weighted average cost of capital is computed using before-tax costs of each of the sources of financing that a firm uses to finance a project.

Question 15

Which of the following best describes a firm's cost of capital?

A)The average yield to maturity on debt
B)The average cost of the firm's assets
C)The rate of return that must be earned on its investments in order to satisfy the firm's investors
D)The coupon rate on preferred stock

Question 16

14.2 Determining the Firm's Capital Structure Weights
Use the following information to answer the following question(s).
The following data concerning Grafton Computer Peripherals' capital structure is available.

The percentage of debt in Grafton's weighted average cost of capital is:

A)38.1%.
B)25%.
C)31.25%.
D)57.14%.

Question 17

A firm's capital structure consists of which of the following?

A)Common stock
B)Preferred stock
C)Bonds
D)All of the above

Question 18

The weights used to determine the relative importance of the firm's sources of capital should reflect:

A)book values in accord with generally accepted accounting principles.
B)current market values for bonds,common stock,and preferred stock and book values for retained earnings.
C)current market values.
D)subjective adjustments for firm risk.

Question 19

Which of the following reasons causes bonds to be a less expensive form of capital for a public firm than the issuance of common stock? Bondholders:

A)bear less risk than common stockholders bear.
B)have prior voting rights over common stockholders.
C)receive greater returns than common stockholders.
D)investors pay a lower tax rate on bond interest

Question 20

The investor's required rate of return differs from the firm's cost of capital due to the:

A)firm's beta.
B)tax deductibility of interest.
C)CAPM.
D)time value of money.

Question 21

Bender and Co.is issuing a $1,000 par value bond that pays 9% interest annually.Investors are expected to pay $918 for the 10-year bond.What is the after-tax cost of debt if the firm is in the 34% tax bracket?

A)6.83%
B)9.00%
C)10.35%
D)15.68%

Question 22

Which of the following statements is true?

A)The level of general economic conditions will determine whether a firm should utilize an arithmetic average cost of capital or a weighted average cost of capital.
B)A firm should utilize a weighted average cost of capital for evaluating investment decisions rather than an arithmetic average cost of capital.
C)For an average firm that is capitalized with 65% equity,usage of an arithmetic average cost of capital will usually overstate the true cost of capital.
D)All of the above are true.
E)None of the above are true.

Question 23

The before-tax cost of this debt issue is:

A)12%.
B)7.92%.
C)9.97%.
D)13%.

Question 24

Sonderson Corporation is undertaking a capital budgeting analysis.The firm's beta is 1.5.The rate on six-month T-bills is 5%,and the return on the S&P 500 index is 12%.What is the appropriate cost of common equity in determining the firm's cost of capital?

A)13.1%
B)15.5%
C)17.7%
D)19.9%

Question 25

Which of the following is a valid issue in implementing the dividend growth model? The model:

A)is too complex to be used to estimate value.
B)does not require an accurate estimate of the rate of growth in future dividends.
C)is based upon the assumption that dividends are expected to grow at a constant rate forever.
D)both A and C.

Question 26

Alpha has an outstanding bond issue that has a 7.75% semiannual coupon,a current maturity of 20 years,and sells for $967.97.The firm's income tax rate is 40%.What should Alpha use as an after-tax cost of debt for cost of capital purposes?

A)2.42%
B)4.04%
C)4.85%
D)8.08%

Question 27

J & B,Inc.has $5 million of debt outstanding with a coupon rate of 12%.Currently,the yield to maturity on these bonds is 14%.If the firm's tax rate is 40%,what is the after-tax cost of debt to J & B?

A)12.0%
B)14.0%
C)8.4%
D)5.6%

Question 28

The expected dividend is $2.50 for a share of stock priced at $25.What is the cost of common equity if the long-term growth in dividends is projected to be 8%?

A)10%
B)8%
C)25%
D)18%

Question 29

When calculating the weighted average cost of capital,which of the following has to be adjusted for taxes?

A)Common stock
B)Retained earnings
C)Debt
D)Preferred stock

Question 30

Which of the following is NOT used to calculate the cost of debt?

A)Face value of the debt
B)Market price of the debt
C)Number of years to maturity
D)Risk-free rate

Question 31

14.2 Determining the Firm's Capital Structure Weights
Use the following information to answer the following question(s).
The following data concerning Grafton Computer Peripherals' capital structure is available.

The total capital that should be used in computing the weights for Grafton's WACC is:

A)$800.
B)$525.
C)$750.
D)$425.

Question 32

Capital structure represents the mix of long-term sources of funds used by a firm.

Question 33

The after-tax cost of this debt issue is:

A)7.92%.
B)6.58%.
C)12%.
D)3.39%.

Question 34

An increase in ________ will increase the cost of common equity.

A)the expected growth rate of dividends
B)the risk-free rate
C)a drop in the stock price
D)both A and B

Question 35

Busing Manufacturing has a new bond issue that will net the firm $1,069,000.The bonds have a $1,000,000 par value,pay interest annually at a 12% coupon rate,and mature in 10 years.The firm has a marginal tax rate of 34%.The after-tax cost of the debt issue is:

A)7.15%.
B)3.68%.
C)7.92%.
D)6.58%.

Question 36

Most firms use Treasury securities with maturities of ________ to determine the appropriate risk-free rate to use in the CAPM.

A)90 days
B)180 days
C)10 years
D)30 years

Question 37

A firm's weighted marginal cost of capital increases when internal equity financing is exhausted but is unaffected by an increase in the cost of other financing sources.

Question 38

The most expensive source of capital is usually:

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

Question 39

Why are market values preferred to book (balance sheet)values when computing a firm's weighted average cost of capital.

Question 40

The cost of preferred stock is equal to:

A)the preferred stock dividend divided by market price.
B)the preferred stock dividend divided by its par value.
C)(1 - tax rate)times the preferred stock dividend divided by net price.
D)the preferred stock dividend divided by the net market price.

Question 41

The CAPM approach is used to determine the cost of:

A)debt.
B)preferred stock.
C)common equity.
D)long term funds.

Question 42

The current total value of the firm is:

A)$6,450,000.
B)$5,750,000.
C)$4,950,000.
D)$3,250,000.

Question 43

The cost of common equity using the dividend-growth model is:

A)11.00%.
B)11.32%.
C)11.50%.
D)11.72%.

Question 44

Alpha's beta is 1.06,the present T-bond rate is 6%,and the return on the S & P 500 is 15.25%.What is Alpha's cost of common equity using the CAPM approach?

A)21.25%
B)15.81%
C)9.25%
D)6.32%

Question 45

Dublin International Corporation's marginal tax rate is 40%.It can issue three-year bonds with a coupon rate of 8.5% and par value of $1,000.The bonds can be sold now at a price of $938.90 each.Determine the appropriate after-tax cost of debt for Dublin International to use in a capital budgeting analysis.

A)11.0%
B)5.2%
C)6.6%
D)7.2%

Question 46

Pony Corporation is undertaking a capital budgeting analysis.The firm's beta is 1.5.The rate on 10-year U.S.Treasury bonds is 5%,and the return on the S & P 500 index is 12%.What is the cost of Pony's common equity?

A)13.3%
B)15.5%
C)17.7%
D)19.9%

Question 47

Given the following information,determine the risk-free rate.

A)8.0%
B)7.5%
C)7.0%
D)6.5%

Question 48

In calculating the cost of capital for an average firm,which of the following statements is true?

A)The cost of a firm's bonds is greater than the cost of its common stock.
B)The cost of a firm's preferred stock is greater than the cost of its common stock.
C)The cost of a firm's retained earnings is less than the cost of its bonds.
D)The cost of a firm's common stock is greater than the cost of its bonds.

Question 49

The last paid dividend is $2 for a share of common stock that is currently selling for $20.What is the cost of common equity if the long-term growth rate in dividends for the firm is expected to be 8%?

A)10.8%
B)12.8%
C)14.8%
D)16.8%
E)18.8%

Question 50

XYZ Corporation is trying to determine the appropriate cost of preferred stock to use in determining the firm's cost of capital.This firm's preferred stock is currently selling for $29.89 and pays a perpetual annual dividend of $2.60 per share.Compute the cost of preferred stock for XYZ.

A)7.2%
B)6.2%
C)8.7%
D)16.7%

Question 51

The George Company,Inc. ,has two issues of debt.Issue A has a maturity value of 8 million dollars,a coupon rate of 8%,paid annually,and is selling at par.Issue B was issued as a 15 year bond 5 years ago.Its coupon rate is 9%,paid annually.Investors demand a pre-tax return of 9.3% on this bond.The maturity value of Issue B is 6 million dollars.The George company has a marginal tax rate of 35%.What is the company's after tax cost of debt?

A)4.73%
B)5.56%
C)7.36%
D)8.47%

Question 52

The cost of common equity using the CAPM is:

A)11.00%.
B)11.20%.
C)11.50%.
D)11.72%.

Question 53

Hill Town Motels has $5 million of debt outstanding with a coupon rate of 12%.Currently,the yield to maturity on these bonds is 14%.If the firm's tax rate is 40%,what is the after-tax cost of debt to Hill Town Motels?

A)5.43%
B)11.2%
C)8.4%
D)5.6%

Question 54

Walker & Son is issuing a 10-year,$1,000 par value bond that pays 9% interest annually.The bond is expected to sell for $885.What is Walker & Son's after-tax cost of debt if the firm is in the 34% tax bracket?

A)7.23%
B)8.01%
C)9.15%
D)10.35%

Question 55

A firm has an issue of preferred stock that pays an annual dividend of $2.00 per share and currently is selling for $18.50 per share.Finally,the firm's marginal tax rate is 34%.This firm's cost of financing with new preferred stock is:

A)10%.
B)7.13%.
C)10.81%.
D)6.6%.

Question 56

Paramount,Inc.just paid a dividend of $2.05 per share,and the firm is expected to experience constant growth of 12.50% over the foreseeable future.The common stock is currently selling for $65.90 per share.What is Paramount's cost of retained earnings using the Dividend Growth Model approach?

A)12.50%
B)17.90%
C)16.00%
D)14.55%

Question 57

Sola Cola Corporation is undertaking a capital budgeting analysis.The rate on 10-year U.S.Treasury bonds is 3.60%,and the return on the S & P 500 index is 11.6%.If the cost of Sola Cola's common equity is 19.6%,calculate their beta.

A)1.69
B)5.4
C)2.0
D)1.38

Question 58

The best estimate of the cost of new common equity is:

A)11.00%.
B)between 11.0%.and 11.2%
C)11.50%.
D)between 10%.and 12%

Question 59

Many corporate finance professionals favor the CAPM for determining the cost of equity.Which of the following is a reason for this preference?

A)The data is less expensive.
B)The variables in the model that apply to public corporations are readily available from public sources.
C)Because the CAPM gives better treatment to flotation costs.
D)The CAPM uses data from the firm's financial statements.

Question 60

Verigreen Lawn Care products just paid a dividend of $1.85.This dividend is expected to grow at a constant rate of 3% per year,so the next expected dividend is $1.90.The stock price is currently $12.50.New stock can be sold at this price subject to flotation costs of 15%.The company's marginal tax rate is 40%.Compute the cost of common equity.

A)18.0%
B)17.8%
C)18.2%
D)15.2%

Question 61

A bond with a Moody's rating of Aaa and and S&P rating of AAA will have a higher required return than a bond with an unstable price a Moody's rating of Aa1 and and S&P rating of AA+.

Question 62

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

Question 63

Vipsu Corporation plans to issue 10-year bonds with a par value of $1,000 that will pay $55 every six months.The net amount of capital to the firm from the sale of each bond is $840.68.If Vipsu is in the 25% tax bracket,what is the after-tax cost of debt?

Question 64

If the before-tax cost of debt is 9% and the firm has a 34% marginal tax rate,the after-tax cost of debt is 5.94%.

Question 65

Sutter Corporation's common stock is selling for $16.80 a share.Last year,Sutter paid a dividend of $.80.Investors are expecting Sutter's dividends to grow at a rate of 5% per year.What is the cost of common equity?

Question 66

No adjustment is made in the cost of preferred stock for taxes since preferred stock dividends are not tax-deductible.

Question 67

The cost of debt is equal to one minus the marginal tax rate times the coupon rate of interest on the firm's outstanding debt.

Question 68

Explain why the investor's required return on debt is not equal to the corporation's cost of debt,and explain why the investor's required return on equity is not equal to the corporation's cost of equity.

Question 69

The cost of common equity is usually higher than the firm's WACC.

Question 70

The after-tax cost of common stock is:

A)14.67%.
B)13.23%.
C)12.41%.
D)11.65%.

Question 71

The proportion of debt in this firm's capital structure is:

A)40%.
B)50%.
C)60%.
D)70%.

Question 72

Only a small minority of bonds issued by large corporations are rated by Moody's or S&P.

Question 73

Moore Financing Corporation has preferred stock in its capital structure paying a dividend of $3.75 and selling for $25.00.If the marginal tax rate for Moore is 34%,what is the after-tax cost of preferred financing?

Question 74

Hoak Company's common stock is currently selling for $50.Last year's dividend was $1.83 per share.Investors expect dividends to grow at an annual rate of 9% into the future.
a.What is Hoak's cost of common equity?
b.Selling new common stock is expected to decrease the price of the stock by $5.00.What is the cost of new common stock? Dividends will remain the same.

Question 75

The firm's weighted average cost of capital is:

A)10.47%.
B)9.29%.
C)8.63%.
D)7.71%.

Question 76

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

Question 77

The after-tax cost of debt is:

A)6.20%.
B)5.40%.
C)4.60%.
D)3.80%.

Question 78

Assuming an after-tax cost of preferred stock of 12% and a corporate tax rate of 40%,a firm must earn at least $20 before tax on every $100 invested.

Question 79

Toto and Associates' preferred stock is selling for $18.40.The stock pays an annual dividend of $2.21 per share.What is the cost of preferred stock to the company?

Question 80

Discuss the primary advantages of the CAPM approach in determining the cost of common equity.