Deck 13: The Cost of Capital

Question 1

The beta of the firm is equal to the weighted-average sum of the betas of the individual projects that the firm is currently operating.

Answer 1

True

Question 2

Unique risk is the only risk that investors require compensation for bearing.

Answer 2

True

Question 3

If a firm finances the purchase of an asset with cash, then it has zero financial cost to the firm.

Answer 3

False

Question 4

If one observes the market quoted price of a debt security where the expected cash flows of that security are known, then one can calculate the current cost of that security to the firm.

Question 5

Milton Corp. issued bonds 10 years ago with a coupon rate of 10 percent at a price of $1,000. The current price of the bonds is $980. The before-tax cost of the debt to the firm is still 10 percent.

Question 6

If a firm is interested in the current cost of its debt obligations, then it can simply look at the contractual rate of interest due lenders on those obligations.

Question 7

Using the firm's overall cost of capital to evaluate a project's cash flows is problematic in that the firm is a collection of projects, with the possibility that each project has a different level of risk than the other projects currently working for the firm.

Question 8

With respect to the cost of capital, we are generally interested in the cost of a source of financing on a particular date.

Question 9

If the market value of a firm's assets are greater than the book value of a firm's assets then the book value of the firm's liabilities and equity must be less than the market value of the firm's liabilities and equity.

Question 10

A firm is currently taking on two projects with an individual cost of capital of 10 percent and 12 percent for each of the projects. That means that the before-tax cost of capital for the firm must be between 10 and 12 percent.

Question 11

The yield to maturity for an annual coupon paying bond will accurately reflect the actual current annual pretax cost of the debt.

Question 12

The finance balance sheet is based on market values, just like the accounting balance sheet.

Question 13

Long-term debt typically describes debt that will mature in two years or more.

Question 14

The issuance costs of new debt securities can be ignored since those costs will not be reflected in the yield to maturity of the debt in the future.

Question 15

Due to the magic of diversification, the risk associated with the assets of the firm must be less than the risk associated with the financing, or debt and equity, that the firm is utilizing for its assets.

Question 16

The yield to maturity for a semiannual coupon paying bond will accurately reflect the actual current annual cost of the debt.

Question 17

Utilizing the CAPM to estimate the cost of capital for a project is difficult in practice because analysts do not have the stock returns from individual projects that are necessary to use in a regression analysis for estimating a project's beta.

Question 18

Long-term debt is generally viewed as a permanent financing source for the firm.

Question 19

The current cost of bank debt can be determined by asking the firm's banker.

Question 20

Estimates of security returns will be reliable in all types of markets, including those deemed less efficient than others.

Question 21

When trying to estimate the cost of equity for a firm using the CAPM, it is possible to find the beta of a comparable, publicly traded firm whose primary business is closely related to the firm at hand.

Question 22

The estimated cost of capital financial managers use for efficiency projects tends to be higher than the cost of capital used to evaluate new projects.

Question 23

If a firm is currently paying common share dividends to investors and those dividends are expected to grow at a low but steady rate in the future, then the cost of common equity for the firm can be determined by also using the current price of the firm's common shares.

Question 24

The firm can be viewed as

A) a portfolio of individual projects, each with their own risks, cost of capital, and returns.
B) a collection of equity shares comprising it.
C) a collection of debt instruments financing it.
D) none of the above.

Question 25

The current cost of preferred equity can be found by taking the ratio of the dividend to the current price of preferred shares.

Question 26

The cost of equity for the firm must take the cost of preferred stock (if any has been issued) that the firm has outstanding into account.

Question 27

The beta for a firm can be estimated by

A) adding up the betas of the individual projects of the firm.
B) taking the weighted average of the beta for the individual projects of the firm.
C) taking the simple average of the beta for the individual projects of the firm.
D) None of the above.

Question 28

The correct Treasury rate to use in calculating the cost of equity (when using the CAPM) for a firm is a short-term rate.

Question 29

The CAPM can only be used to determine the cost of common equity.

Question 30

The finance balance sheet is

A) the same as the accounting balance sheet, but it is based on market values.
B) the same as the accounting balance sheet, but it does not have to balance.
C) based on cash rather than accrual accounting.
D) net income.

Question 31

A firm's overall cost of capital is

A) equal to its cost debt.
B) a weighted average of the costs of capital for the collection of individual projects that the firm is working on.
C) best measured by the cost of capital of the riskiest projects that the firm is working on.
D) none of the above.

Question 32

The value of the cash flows that the assets of the firm are expected to generate must equal

A) the value of the cash flows claimed by the equity investors.
B) the value of the cash flows claimed by the debt investors.
C) the value of the cash flows claimed by both the equity and debt investors.
D) the revenue produced by the firm.

Question 33

In order for a firm to estimate its cost of debt capital by observing the price of its debt instruments,

A) the firm must depend on markets being reasonably efficient.
B) the debt must be privately held.
C) the beta of the debt must be greater than the beta of the firm's equity.
D) None of the above.

Question 34

The market risk premium for the future is always perfectly known, and it is 6.51 percent.

Question 35

When estimating the cost of debt capital for the firm, we are primarily interested in

A) the cost of short-term debt.
B) the cost of long-term debt.
C) the coupon rate of the debt.
D) none of the above.

Question 36

Firms have no way to directly estimate the discount rate that reflects the risk of

A) a publicly traded security.
B) its debt securities.
C) the incremental cash flows from a particular project.
D) none of the above.

Question 37

The proportions of debt and equity used to determine the weighted average cost of capital for the firm is based on the market value of debt and equity outstanding.

Question 38

The correctly calculated weighted-average cost of capital for the firm can be used to discount the cash flows for any new project that the firm may undertake in the future.

Question 39

If a firm is subject to income taxes, then the after-tax cost of debt for the firm will be less than the before-tax cost of debt.

Question 40

If markets are not reasonably efficient, then

A) the estimates of expected returns are not needed.
B) the need for a discount rate to analyze project cash flows is not needed.
C) estimates of expected returns that were based on security prices will not be reliable.
D) none of the above.

Question 41

How firms estimate their cost of capital: You are analyzing the cost of capital for a firm that is financed with $300 million of equity and $200 million of debt. The cost of debt capital for the firm is 9 percent, while the cost of equity capital is 19 percent. What is the overall cost of capital for the firm?

A) 13.0%
B) 14.0%
C) 15.0%
D) 16.0%

Question 42

How firms estimate their cost of capital: The Diverse Co. has invested 40 percent of the firm's assets in a project with a beta of 0.4 and the remaining assets in a project with a beta of 1.8. What is the beta of the firm?

A) 0.96
B) 1.24
C) 1.28
D) None of the above

Question 43

The appropriate risk-free rate to use when calculating the cost of equity for a firm is

A) a long-term Treasury rate.
B) a short-term Treasury rate.
C) a 50/50 mix of short-term and long-term Treasury rates.
D) none of the above.

Question 44

Bond issuance costs include

A) investment banking fees.
B) legal fees.
C) accountant fees.
D) all of the above.

Question 45

Long-term debt typically describes

A) debt with a maturity greater than one year.
B) only coupon debt.
C) publicly traded debt.
D) none of the above.

Question 46

Overall cost of capital: What is the beta of a firm whose equity has an expected return of 21.3 percent when the risk-free rate of return is 7.0 percent and the expected return on the market is 18.0 percent?

A) 0.79
B) 1.30
C) 1.57
D) none of the above

Question 47

When analyzing a firm's cost of debt, we are typically interested in

A) the cost of the debt on the date that the analysis is being completed.
B) the coupon rate on the firm's bonds.
C) the risk-free rate plus half a percent.
D) none of the above.

Question 48

Income taxes have the effect of

A) increasing the cost of debt.
B) decreasing the cost of debt.
C) decreasing the cost of capital for the firm.
D) both b and c are correct.

Question 49

Which of the following need to be excluded from the calculation of the firm's amount of permanent debt?

A) Long-term debt
B) Revolving lines of credit
C) Mortgage debt
D) None of the above

Question 50

How firms estimate their cost of capital: The WACC for a firm is 13.00 percent. You know that the firm's cost of debt capital is 10 percent and the cost of equity capital is 20%. \ What proportion of the firm is financed with debt?

A) 30%
B) 33%
C) 50%
D) 70%

Question 51

Overall cost of capital: If the market risk premium is currently 6 percent and the risk-free rate of return is 4 percent, then what is the expected return on a common share with a beta equal to 2?

A) 8.0%
B) 10.0%
C) 12.0%
D) 16.0%

Question 52

The average risk-premium for the market from 1926 to 2009 was

A) 8.00%.
B) 7.50%.
C) 6.01%.
D) 6.51% + the Treasury rate.

Question 53

Overall cost of capital: Stryder, Inc., has 3 million shares outstanding at a current price of $15 per share. The book value of the shares is $10 per share. The firm also has $30 million in par value of bonds outstanding. The bonds are selling at a price equal to 101 percent of par. What is the market value of the firm?

A) $30.0 million
B) $45.0 million
C) $75.0 million
D) $75.3 million

Question 54

The recommended model to estimate the cost of common equity for a firm is

A) a one-stage constant growth model.
B) a multistage growth model.
C) the CAPM.
D) none of the above.

Question 55

If a firm has bonds outstanding and the firm would like to calculate the current cost of debt for the bonds, then the firm would

A) use the coupon rate of the bonds to estimate the cost.
B) use the current yield to maturity of the bonds to estimate the cost.
C) use the current coupon yield of the bonds to estimate the cost.
D) none of the above.

Question 56

How firms estimate their cost of capital: You are analyzing the cost of capital for a firm that is financed with 65 percent equity and 35 percent debt. The cost of debt capital is 8 percent, while the cost of equity capital is 20 percent for the firm. What is the overall cost of capital for the firm?

A) 12.2%
B) 14.0%
C) 15.8%
D) 20.0%

Question 57

In order to use the WACC to evaluate a future project's flows, which of the following must hold?

A) The project will be financed with the same proportion of debt and equity as the firm.
B) The systematic risk of the project is the same as the overall systematic risk of the firm.
C) The project must be viable.
D) a and b above.

Question 58

The cost of debt: Bellamee, Inc., has semiannual bonds outstanding with five years to maturity and are priced at $920.87. If the bonds have a coupon rate of 7 percent, then what is the YTM for the bonds?

A) 4.5%
B) 7.0%
C) 9.0%
D) 9.2%

Question 59

How firms estimate their cost of capital: The WACC for a firm is 19.75 percent. You know that the firm is financed with $75 million of equity and $25 million of debt. The cost of debt capital is 7 percent. What is the cost of equity for the firm?

A) 19.75%
B) 24.00%
C) 32.50%
D) 58.00%

Question 60

A bond has a coupon rate of 6 percent and the bond makes semiannual coupon payments. The dollar amount of coupon interest received every six months is

A) $60.
B) $30.
C) $30 plus or minus the prorate portion of the discount or premium that the bond was purchased for.
D) none of the above.

Question 61

Using the WACC in practice: Poly's Parrot Shops has found that its cost of common equity capital is 17 percent. It has 7-year maturity semiannual bonds outstanding with a price of $767.03 that have a coupon rate of 7 percent. If the firm is financed with $120,000,000 of common shares (market value) and $80,000,000 of debt, then what is the after-tax weighted average cost of capital for Poly's if it is subject to a 35 percent marginal tax rate?

A) 10.20%
B) 11.76%
C) 11.88%
D) 13.32%

Question 62

The cost of debt: Dynamo Corporation has semiannual bonds outstanding with 12 years to maturity and are currently priced at $1,080.29. If the bonds have a coupon rate of 8 percent, then what is the equivalent annual return (EAR) to the investor for purchasing the bonds at the described price?

A) 3.5%
B) 7.00%
C) 7.12%
D) 8.00%

Question 63

The cost of equity: TeleNyckel, Inc., has a beta of 1.4 and is trying to calculate its cost of equity capital. If the risk-free rate of return is 9 percent and the market risk premium is 5 percent, then what is the firm's after-tax cost of equity capital if the firm's marginal tax rate is 30 percent?

A) 11.20%
B) 10.60%
C) 15.14%
D) 16.00%

Question 64

The cost of equity: Jacque Ewing Drilling, Inc., has a beta of 1.3 and is trying to calculate its cost of equity capital. If the risk-free rate of return is 8 percent and the expected return on the market is 12 percent, then what is the firm's after-tax cost of equity capital if the firm's marginal tax rate is 40 percent?

A) 7.92%
B) 13.20%
C) 15.57%
D) 23.60%

Question 65

The cost of equity: Melba's Toast has a preferred share issue outstanding with a current price of $19.50. The firm is expected to pay a dividend of $2.34 per share a year from today. What is the firm's cost of preferred equity?

A) 11.50%
B) 11.75%
C) 12.00%
D) 12.25%

Question 66

Using the WACC in practice: Marley's Pipe Shops has found that its common equity capital shares have a beta equal to 1.5 while the risk-free return is 8 percent and the expected return on the market is 14 percent. Its cost of debt financing is 12 percent. If the firm is financed with $120,000,000 of common shares (market value) and $80,000,000 of debt, then what is the after-tax weighted average cost of capital for Marley's if it is subject to a 35 percent marginal tax rate?

A) 10.20%
B) 11.76%
C) 11.88%
D) 13.32%

Question 67

The cost of equity: Oasis, Inc., has common shares with a price of $21.12 per share. The firm is expected to pay a dividend of $1.75 one year from today, and dividends are expected to grow at 10 percent for two years after that and then at 5 percent thereafter. What is the implied cost of common equity capital for Oasis?

A) 13%
B) 14%
C) 15%
D) 16%

Question 68

The cost of equity: The Dedus Shoes, Inc., has common shares with a price of $28.76 per share. The firm paid a dividend of $1.00 yesterday, and dividends are expected to grow at 10 percent for two years and then at 5 percent thereafter. What is the implied cost of common equity capital for Dedus?

A) 7.00%
B) 8.00%
C) 9.00%
D) 10.00%

Question 69

The cost of equity: RadicalVenOil, Inc., has a cost of equity capital equal to 22.8 percent. If the risk-free rate of return is 10 percent and the expected return on the market is 18 percent, then what is the firm's beta if the firm's marginal tax rate is 35 percent?

A) 1.0
B) 1.28
C) 1.60
D) 4.10

Question 70

The cost of equity: Tranquility, Inc., has common shares with a price of $18.37 per share. The firm paid a dividend of $1.50 yesterday, and dividends are expected to grow at 9 percent for three years and then at 2 percent thereafter. What is the implied cost of common equity capital for Tranquility?

A) 9%
B) 10%
C) 11%
D) 12%

Question 71

The cost of preferred equity: Billy's Goat Coats has a preferred share issue outstanding with a current price of $38.89. The firm last paid a dividend on the issue of $3.50 per share. What is the firm's cost of preferred equity?

A) 7%
B) 8%
C) 9%
D) 10%

Question 72

The cost of equity: Wally's War Duds has a preferred share issue outstanding with a current price of $26.57. The firm is expected to pay a dividend of $1.86 per share a year from today. What is the firm's cost of preferred equity?

A) 6.50%
B) 7.00%
C) 7.50%
D) 8.00%

Question 73

The cost of equity: UltraFlex Diving Boards, Inc., is just paid a dividend of $1.50. If the firm's growth in dividends is expected to remain at a flat 4 percent forever, then what is the cost of equity capital for Ultra Flex Diving Boards if the price of its common shares is currently $26.00?

A) 5.77%
B) 6.00%
C) 9.77%
D) 10.00%

Question 74

The cost of equity: Gangland Water Guns, Inc., is expected to pay a dividend of $2.10 one year from today. If the firm's growth in dividends is expected to remain at a flat 3 percent forever, then what is the cost of equity capital for Gangland if the price of its common shares is currently $17.50?

A) 12.00%
B) 14.65%
C) 15.00%
D) 15.36%

Question 75

The cost of debt: Beckham Corporation has semiannual bonds outstanding with 13 years to maturity and are currently priced at $746.16. If the bonds have a coupon rate of 8.5 percent, then what is the after-tax cost of debt for Beckham if its marginal tax rate is 35%? Assume that your calculation is made as on Wall Street.

A) 6.250%
B) 8.125%
C) 12.500%
D) 12.890%

Question 76

The cost of equity: Rubber Chicken, Inc., was paid a dividend of $1.87 last year. If the firm's growth in dividends is expected to be 10 percent next year and then zero thereafter, then what is the cost of equity capital for Rubber Chicken if the price of its common shares is currently $25.71?

A) 7.27%
B) 8.00%
C) 18.00%
D) The problem is not solvable with the information that is given.

Question 77

The cost of debt: PackMan Corporation has semiannual bonds outstanding with nine years to maturity and are currently priced at $754.08. If the bonds have a coupon rate of 7.25 percent, then what is the after-tax cost of debt for Beckham if its marginal tax rate is 30 percent? Complete the calculation as is done on Wall Street.

A) 7.050%
B) 8.225%
C) 11.750%
D) 12.095%

Question 78

Using the WACC in practice: Ronnie's Comics has found that its cost of common equity capital is 15 percent and its cost of debt capital is 12 percent. If the firm is financed with $250,000,000 of common shares (market value) and $750,000,000 of debt, then what is the after-tax weighted average cost of capital for Ronnie's if it is subject to a 35 percent marginal tax rate?

A) 6.05%
B) 9.6%
C) 8.75%
D) 13.65%

Question 79

Using the WACC in practice: Maloney's, Inc., has found that its cost of common equity capital is 17 percent and its cost of debt capital is 6 percent. If the firm is financed with $3,000,000 of common shares (market value) and $2,000,000 of debt, then what is the after-tax weighted average cost of capital for Maloney's if it is subject to a 40 percent marginal tax rate?

A) 8.96%
B) 11.16%
C) 11.64%
D) 12.60%

Question 80

Using the WACC in practice: Swirlpool, Inc., has found that its cost of common equity capital is 18 percent, and its cost of debt capital is 8 percent. If the firm is financed with 60 percent common shares and 40 percent debt, then what is the after-tax weighted average cost of capital for Swirlpool if it is subject to a 40 percent marginal tax rate?

A) 10.37%
B) 12.00%
C) 12.72%
D) 14.00%