Deck 13: The Cost of Capital

Question 1

Assume Lavender Corporation has a market value of $4 billion of equity and a market value of $19.8 billion of debt. What are the weights in equity and debt that are used for calculating the WACC?

A) 0.10, 0.90
B) 0.832, 0.168
C) 0.168, 0.832
D) 0.90, 0.10

Answer 1

0.168, 0.832

Question 2

A 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

Answer 2

weighted average cost of capital

Question 3

A levered firm is one that has ________ outstanding.

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

Answer 3

debt

Question 4

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

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

Question 5

Epiphany is an all-equity firm with an estimated market value of $400,000. The firm sells $225,000 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) 0.28, 0.72
B) 0.44, 0.56
C) 0.39, 0.61
D) 0.56, 0.44

Question 6

Assume the total market value of General Motors (GM) is $10 billion. GM has a market value of $6 billion of equity and a face value of $12 billion of debt. What are the weights in equity and debt that are used for calculating the WACC?

A) 0.30, 0.70
B) 0.60, 0.40
C) 0.40, 0.60
D) cannot be determined

Question 7

Epiphany is an all-equity firm with an estimated market value of $500,000. The firm sells $150,000 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) 0.15, 0.85
B) 0.18, 0.82
C) 0.30, 0.70
D) 0.70, 0.30

Question 8

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

A) increasing the fraction of its equity
B) decreasing the fraction of its debt
C) decreasing its leverage
D) increasing its leverage

Question 9

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 10

Assume JUP has debt with a book value of $24 million, trading at 120% of par value. The firm has book equity of $28 million, and 2 million shares trading at $20 per share. What weights should JUP use in calculating its WACC?

A) 41.86% for debt, 58.14% for equity
B) 37.67% for debt, 62.33% for equity
C) 33.49% for debt, 66.51% for equity
D) 29.30% for debt, 70.70% for equity

Question 11

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

A) equity
B) debt
C) preferred stock
D) retained earnings

Question 12

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) retained earnings

Question 13

For an unlevered firm, the cost of capital 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 14

Assume Bismuth Electronics has a book value of $6 billion of equity and a face value of $19.7 billion of debt. The market values of equity and debt are $2.5 billion and $18.5 billion. A Wall Street financial analyst determines values of equity and debt as $3 billion and $20 billion. Which of the following values should be used for calculating the firm's WACC?

A) $6 billion of equity and $19.7 billion of debt
B) $2.5 billion of equity and $20 billion of debt
C) $3 billion of equity and $19.9 billion of debt
D) $2.5 billion of equity and $18.5 billion of debt

Question 15

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 16

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 17

Epiphany is an all-equity firm with an estimated market value of $300,000. The firm sells $250,000 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) 0.42, 0.58
B) 0.50, 0.50
C) 0.17, 0.83
D) 0.58, 0.42

Question 18

Financial managers must determine their firm's overall cost of capital based on all sources of financing.

Question 19

The book value of a firm's equity is $100 million and its market value of equity is $200 million. The face value of its debt is $50 million and its 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 20

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

A) higher than
B) lower than
C) the same as
D) less than or equal to

Question 21

Your estimate of the market risk premium is 7%. The risk-free rate of return is 4% and General Motors has a beta of 1.6. What is General Motors' cost of equity capital?

A) 15.2%
B) 14.4%
C) 16.0%
D) 13.7%

Question 22

Your estimate of the market risk premium is 6%. The risk-free rate of return is 4% and General Motors has a beta of 1.4. What is General Motors' cost of equity capital?

A) 11.2%
B) 12.4%
C) 11.8%
D) 13.0%

Question 23

Assume IBM just paid a dividend of $4.50 and expects these dividends to grow at 8% a year. The price of IBM is $100 per share. What is IBM's cost of equity capital?

A) 3.86%
B) 8%
C) 12.22%
D) 12.86%

Question 24

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 25

Assume preferred stock of Ford Motors pays a dividend of $3.00 each year and trades at a price of $20. What is the cost of preferred stock capital for Ford?

A) 12.0%
B) 13.5%
C) 15.0%
D) 16.5%

Question 26

IBM expects to pay a dividend of $2 next year and expects these dividends to grow at 9% a year. The price of IBM is $80 per share. What is IBM's cost of equity capital?

A) 9.20%
B) 10.35%
C) 10.93%
D) 11.50%

Question 27

Assume preferred stock of Ford Motors pays a dividend of $3.50 each year and trades at a price of $30. What is the cost of preferred stock capital for Ford?

A) 10.5%
B) 11.7%
C) 11.1%
D) 10.7%

Question 28

Outstanding debt of Home Depot trades with a yield to maturity of 8%. The tax rate of Home Depot is 30%. What is the effective cost of debt of Home Depot?

A) 5.88%
B) 8%
C) 6.44%
D) 5.60%

Question 29

A firm has outstanding debt with a coupon rate of 5%, ten years maturity, and a price of $1,000. What is the after-tax cost of debt if the marginal tax rate of the firm is 35%?

A) 2.6%
B) 2.9%
C) 3.3%
D) 3.4%

Question 30

Assume preferred stock of Ford Motors pays a dividend of $4 each year and trades at a price of $35. What is the cost of preferred stock capital for Ford?

A) 11.4%
B) 12.6%
C) 13.7%
D) 14.9%

Question 31

IBM expects to pay a dividend of $5 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) 3.77%
B) 5.02%
C) 7%
D) 12.56%

Question 32

A firm has outstanding debt with a coupon rate of 8%, seven years maturity, and a price of $1,000. What is the after-tax cost of debt if the marginal tax rate of the firm is 35%?

A) 5.2%
B) 5.5%
C) 5.7%
D) 6.0%

Question 33

Outstanding debt of Home Depot trades with a yield to maturity of 7%. The tax rate of Home Depot is 35%. What is the effective cost of debt of Home Depot?

A) 4.55%
B) 5.01%
C) 5.46%
D) 5.69%

Question 34

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

Question 35

Outstanding debt of Home Depot trades with a yield to maturity of 5%. The tax rate of Home Depot is 40%. What is the effective cost of debt of Home Depot?

A) 4.50%
B) 4.65%
C) 3.60%
D) 3.00%

Question 36

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

Question 37

A firm has outstanding debt with a coupon rate of 8%, nine years maturity, and a price of $1,000. What is the after-tax cost of debt if the marginal tax rate of the firm is 40%?

A) 3.8%
B) 4.8%
C) 4.3%
D) 4.4%

Question 38

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

Question 39

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

Question 40

Your estimate of the market risk premium is 9%. The risk-free rate of return is 4.1% and General Motors has a beta of 1.8. What is General Motors' cost of equity capital?

A) 20.3%
B) 18.3%
C) 19.3%
D) 21.3%

Question 41

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) capitalized

Question 42

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 43

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 6% and the preferred stock trades at $98, what is the cost of preferred stock capital?

A) 5.82%
B) 6.12%
C) 6.43%
D) 6.73%

Question 44

A firm incurs $35,000 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) $22,050.00
B) $24,500.00
C) $28,175.00
D) $29,400.00

Question 45

A firm has a pre-tax cost of debt of 9.0%. If the firm has a marginal tax rate of 35%, what is its effective cost of debt?

A) 5.9%
B) 4.1%
C) 9.4%
D) 9.1%

Question 46

An all-equity firm had a dividend expense of $45,000 last year. The market value of the firm is $800,000 and the dividend is expected to increase at 7% each year. What is the cost of equity for this firm?

A) 11.72%
B) 12.37%
C) 13.02%
D) 14.32%

Question 47

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

Question 48

An all-equity firm had a dividend expense of $20,000 last year. The market value of the firm is $600,000 and the dividend is expected to increase at 5% each year. What is the cost of equity for this firm?

A) 6.80%
B) 7.65%
C) 8.50%
D) 9.35%

Question 49

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 50

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 51

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 5% and the preferred stock trades at $91, what is the cost of preferred stock capital?

A) 4.67%
B) 4.95%
C) 5.22%
D) 5.49%

Question 52

A firm incurs $70,000 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) $34,300.00
B) $39,200.00
C) $49,000.00
D) $56,350.00

Question 53

The outstanding debt of Berstin Corp. has eight years to maturity, a current yield of 7%, and a price of $85. What is the pretax cost of debt if the tax rate is 40%?

A) 5.1%
B) 5.9%
C) 8.5%
D) more information needed

Question 54

A firm incurs $40,000 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) $21,000.00
B) $22,400.00
C) $23,800.00
D) $28,000.00

Question 55

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 8% and the preferred stock trades at $92, what is the cost of preferred stock capital?

A) 8.26%
B) 8.70%
C) 9.13%
D) 9.57%

Question 56

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

Question 57

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

Question 58

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

Question 59

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 60

An all-equity firm had a dividend expense of $30,000 last year. The market value of the firm is $900,000 and the dividend is expected to increase at 6% each year. What is the cost of equity for this firm?

A) 9.53%
B) 10.01%
C) 10.96%
D) 11.44%

Question 61

Assume the market value of Fords' equity, preferred stock and debt are $6 billion, $3 billion, and $13 billion, respectively. Ford has a beta of 1.7, the market risk premium is 8%, and the risk-free rate of interest is 3%. Ford's preferred stock pays a dividend of $2.50 each year and trades at a price of $30 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 35%?

A) 9.78%
B) 10.24%
C) 9.31%
D) 11.18%

Question 62

Assume Time Warner shares have a market capitalization of $40 billion. The company is expected to pay a dividend of $0.25 per share and each share trades for $40. The growth rate in dividends is expected to be 7% per year. Also, Time Warner has $20 billion of debt that trades with a yield to maturity of 9%. If the firm's tax rate is 40%, what is the WACC?

A) 5.85%
B) 6.54%
C) 6.88%
D) 7.57%

Question 63

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

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

Question 64

SIROM Scientific Solutions has $5 million of outstanding equity and $5 million of bank debt. The bank debt costs 4% per year. The estimated equity beta is 2. If the market risk premium is 8% and the risk-free rate is 4%, compute the weighted average cost of capital if the firm's tax rate is 35%.

A) 11.87%
B) 12.43%
C) 11.30%
D) 13.00%

Question 65

Assume Time Warner shares have a market capitalization of $65 billion. The company just paid a dividend of $0.40 per share and each share trades for $25. The growth rate in dividends is expected to be 7.00% per year. Also, Time Warner has $10 billion of debt that trades with a yield to maturity of 7%. If the firm's tax rate is 40%, compute the WACC?

A) 7.70%
B) 8.11%
C) 8.92%
D) 9.33%

Question 66

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

A) decreases
B) is unchanged
C) increases
D) doubles

Question 67

Assume 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, 15% in preferred stock, and 55% in debt. The cost of equity capital is 16%, 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 40%?

A) 9.09%
B) 9.54%
C) 10.00%
D) 10.45%

Question 68

Assume the market value of Fords' equity, preferred stock and debt are $7 billion, $4 billion and $10 billion respectively. Ford has a beta of 1.4, the market risk premium is 6% 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 $25 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 35%?

A) 7.69%
B) 8.15%
C) 8.60%
D) 9.05%

Question 69

SIROM Scientific Solutions has $12 million of outstanding equity and $4 million of bank debt. The bank debt costs 4% per year. The estimated equity beta is 1. If the market risk premium is 8% and the risk-free rate is 4%, compute the weighted average cost of capital if the firm's tax rate is 30%.

A) 8.73%
B) 9.22%
C) 9.70%
D) 10.67%

Question 70

A firm has a capital structure with $50 million in equity and $100 million of debt. The cost of equity capital is 11% and the pretax cost of debt is 5%. If the marginal tax rate of the firm is 40%, compute the weighted average cost of capital of the firm.

A) 4.5%
B) 5.1%
C) 5.67%
D) 6.5%

Question 71

Assume Ford Motor Company is discussing new ways to recapitalize the firm and raise additional capital. Its current capital structure has a 25% weight in equity, 10% in preferred stock, and 65% in debt. The cost of equity capital is 13%, the cost of preferred stock is 9%, and the pretax cost of debt is 8%. What is the weighted average cost of capital for Ford if its marginal tax rate is 40%?

A) 6.91%
B) 7.27%
C) 8.00%
D) 8.36%

Question 72

A firm has a capital structure with $75 million in equity and $45 million of debt. The cost of equity capital is 10% 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) 6.7%
B) 7.0%
C) 7.8%
D) 8.6%

Question 73

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

Question 74

Many financial managers use market risk premiums that are closer to 5%, which is lower than historical averages, because ________.

A) the return investors require as compensation for taking on the risk of investing in equity markets has diminished over a period of time
B) investors require a higher risk premium for holding risky securities than in the past
C) investors require a supernormal risk premium for holding risky securities as compared with the past
D) investors require the same premium for holding risky securities as in the past

Question 75

Assume the market value of Fords' equity, preferred stock, and debt are$6 billion, $2 billion, and $13 billion, respectively. Ford has a beta of 1.7, the market risk premium is 8%, and the risk-free rate of interest is 3%. 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 8.0%. What is Ford's weighted average cost of capital if its tax rate is 30%?

A) 9.95%
B) 9.48%
C) 10.43%
D) 11.38%

Question 76

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 9% and the risk-free rate is 3%, compute the weighted average cost of capital if the firm's tax rate is 30%.

A) 15.17%
B) 15.93%
C) 16.68%
D) 17.44%

Question 77

Assume Time Warner shares have a market capitalization of $60 billion. The company is expected to pay a dividend of $0.30 per share and each share trades for $40. The growth rate in dividends is expected to be 7% per year. Also, Time Warner has $20 billion of debt that trades with a yield to maturity of 8%. If the firm's tax rate is 35%, compute the WACC?

A) 6.05%
B) 6.40%
C) 6.76%
D) 7.11%

Question 78

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

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

Question 79

Assume JUP has debt with a book value of $20 million, trading at 120% of par value. The bonds have a yield to maturity of 7%. The firm's book value of equity is $16 million, and it has 2 million shares trading at $19 per share. The firm's cost of equity is 12%. What is JUP's WACC if the firm's marginal tax rate is 35%?

A) 10.03%
B) 9.12%
C) 9.57%
D) 7.29%

Question 80

Assume 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 16%, 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 40%?

A) 6.61%
B) 6.96%
C) 7.31%
D) 7.66%