Deck 14: The Cost of Capital

Question 1

The [blank] incorporates the required rates of return of the firm's lenders and investors along with the particular mix of financing sources that the firm uses.

A)WACC
B)EBIT
C)flotation cost
D)NPV

Answer 1

A

Question 2

The cost of capital is the discount rate that is used to calculate a firm's overall value.

Answer 2

True

Question 3

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

Answer 3

False

Question 4

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

Question 5

A firm's cost of capital is not affected by the amount of leverage it uses.

Question 6

Use the following information to answer the following question(s).
The following data concerning Dwight's Dollar Store capital structure is available.

The percentage of debt in Dwight's weighted average cost of capital is [blank].

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

Question 7

Use the following information to answer the following question(s).
The following data concerning Dwight's Dollar Store capital structure is available.

The percentage of common stock in Dwight's weighted average cost of capital is [blank].

A)62.5
B)66.7
C)6.25
D)31.25

Question 8

Use the following information to answer the following question(s).
The following data concerning Dwight's Dollar Store capital structure is available.

The percentage of preference share in Dwight's weighted average cost of capital is [blank].

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

Question 9

When Starbucks decided to acquire Seattle's Best Coffee Company, it presumably concluded that the

A)the rate of return they would earn on Seattle's Best equaled or exceeded the risk-free rate.
B)the rate of return they would earn on Seattle's Best equaled or exceeded Starbucks overall cost of capital.
C)the rate of return they would earn on Seattle's Best would be equal to or higher than the rate of return they could earn on other investments of equal risk.
D)the rate of return they would earn on Seattle's Best equaled or exceeded what Seattle's best was earning prior to the acquisition.

Question 10

Which of the following is the last step for estimating the firm's WACC?

A)Define the firm's capital structure
B)Estimate the cost of each of the sources of financing
C)Calculate a weighted average of the costs of the financing sources
D)Any of the steps can be done last

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 [blank] 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

For tax purposes, interest on corporate debt is

A)deductible for the investor, but not for the borrower.
B)deductible for the borrower, but not for the investor.
C)fully taxable for both the borrower and the investor.
D)fully deductible for both the borrower and the investor.

Question 13

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

Question 14

Which of the following is the first step for estimating the firm's weighted average cost of capital (WACC)?

A)Define the firm's capital structure
B)Estimate the cost of each of the sources of financing
C)Calculate a weighted average of the costs of the financing sources
D)Any of the steps can be done first

Question 15

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 preference share
C)Cost of debt
D)All of the above

Question 16

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

Question 17

The after-tax cost of capital is calculated by multiplying the before-tax cost of capital by 1 minus the tax rate.

Question 18

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.

Question 19

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 20

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 preference share and book values for retained earnings.
C)current market values.
D)subjective adjustments for firm risk.

Question 21

When computing a firm's cost of capital, book values should be used because they are more objective.

Question 22

Book values are sometimes used to calculate the percentage of debt in a firm's capital structure because much corporate debt is infrequently traded and market prices cannot be obtained.

Question 23

Atlas Inc.has a new bond issue that will net the firm $1,603 500.The bonds have a $1,500,000 par value, pay interest annually at a 6% 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)5.1%.
B)3.37%.
C)5.6%.
D)6.58%.

Question 24

The amount of debt in the firm's capital structure should include all interest-bearing debt, both long term and short term.

Question 25

The percentage of debt in the firm's capital structure should be adjusted by multiplying by 1 minus the firm's marginal tax rate.

Question 26

Omega 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 Omega 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

Bloomingdale Inc.is undertaking a capital budgeting analysis.The firm's beta is 1.5.The rate on 10-year T-Bonds is 1.6% and the return on the S&P 500 index is 8%.What is the appropriate cost of common equity in determining the firm's cost of capital?

A)12.0%
B)11.2%
C)13.6%
D)9.6%

Question 28

Use the following information to answer the following question(s).
The following data concerning Dwight's Dollar Store capital structure is available.

The total capital that should be used in computing the weights for Dwight's WACC is [blank].

A)$1275
B)$2400
C)$2250
D)$1575

Question 29

Which of the following is the rate that has to be received from an investment in order to achieve the required rate of return for the creditors?

A)Cost of debt
B)Cost of preference shares
C)Risk of premium
D)Divisional WACC

Question 30

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)Preference share

Question 31

The market values of Dwight's long-term capital sources differ from the book values because

A)market values are easier to verify than book values.
B)book vales are established at the time securities are issued rather than what the same securities could be sold for if they were issued today.
C)market values are established according to generally accepted accounting principles (GAAP).
D)All of the above are true.

Question 32

Capital structure represents the mix of equity and interest-bearing debt used by a firm.

Question 33

Most firms use Treasury securities with maturities of [blank] 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 34

The after-tax cost of this debt issue is [blank].

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

Question 35

Which of the following is the amount by which the required rate of return exceeds the risk-free rate of interest?

A)Cost of debt
B)Cost of preference shares
C)Risk of premium
D)Divisional WACC

Question 36

ABC Co.has $15 million of debt outstanding with a coupon rate of 9%.Currently, the yield to maturity on these bonds is 7%.If the firm's tax rate is 35%, what is the after-tax cost of debt to PVE?

A)10.76%
B)5.85%
C)4.55%
D)5.4%

Question 37

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 4%?

A)10%
B)8%
C)14%
D)18%

Question 38

Which of the following is the rate of return that must be earned on preference shareholders' investment in order to satisfy their required rate of return?

A)Cost of debt
B)Cost of preference shares
C)Risk of premium
D)Divisional WACC

Question 39

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 40

Clipper Co.is issuing a $1000 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 41

Flenderson Group 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 Flenderson Group's common equity is 19.6%, calculate their beta.

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

Question 42

The CAPM approach is used to determine the cost of

A)debt.
B)preference share.
C)common equity.
D)long-term funds.

Question 43

The proportion of debt in this firm's capital structure is [blank].

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

Question 44

The after-tax cost of debt is [blank].

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

Question 45

Junction Inc.'s marginal tax rate is 35%.It can issue three-year bonds with a coupon rate of 4.5%.The bonds can be sold now at their par value of $1000.Determine the appropriate after-tax cost of debt for Dublin International to use in a capital budgeting analysis.

A)6.92%%
B)4.50%
C)2.93%
D)1.58%

Question 46

The current total value of the firm is [blank].

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

Question 47

DIY Building Supplies has the following record of paying dividends What are the arithmetic and geometric average growth rates of DIY's dividend payments?

A)4.09%, 8.35%
B)3.09%, 3.08%
C)3.87%, 3.86%
D)4.55%, 4.49%

Question 48

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 49

O'Malley Retirement homes has $5 million of debt outstanding with a coupon rate of 8.2%.Currently, the yield to maturity on these bonds is 7.3%.If the firm's tax rate is 34%, what is the after-tax cost of debt?

A)5.33%
B)11.23%
C)4.75%
D)Cannot be determined because the maturity of the bonds is unknown.

Question 50

Monarch'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 Monarch's cost of common equity using the CAPM approach?

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

Question 51

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

Question 52

The cost of preference share financing is estimated very similar to that for debt.

Question 53

A firm has an issue of preference share 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 preference share is

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

Question 54

Vandelay Industries 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 five 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 Vandelay 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 55

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 56

Watkins Co.is issuing a 10-year, $1000 par value bond that pays 9% interest annually.The bond is expected to sell for $885.What is Watkins Co.'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 57

Littlefield Architect's preference share has a par value of $100 and pays a dividend of $4.50.The current price of Littlefield's preference is $75.Littlefield's tax rate is 34%.The before tax and after tax cost of preference equity to Littlefield is

A)4.5%, 2.97%.
B)6.00%, 3.96%.
C)6.00%, 6.00%.
D)8.04%, 6.00%.

Question 58

Given the following information, determine the risk-free rate. Cost of equity = 12%
Beta = 1.50
Market risk premium = 6%

A)6.0%
B)3.0%
C)9.0%
D)6.5%

Question 59

The firm's weighted average cost of capital is [blank].

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

Question 60

Toujours 29 has the following record of paying dividends: What are the arithmetic and geometric average growth rates of DIY's dividend payments?

A)2.97%, 2.97%
B)29.00%, 28.5%
C)3.87%, 3.86%
D)4.55%, 4.49%

Question 61

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

Question 62

Reliable Metals plans to issue bonds that will mature in 20 years.They will have a semi-annual coupon rate of 7% and a Moody's rating of Aa2.Bonds of other metals companies with similar maturities and ratings currently yield an average of 6.3%.

A)Reliable's bonds will sell at a price to yield about 6.3% because that is the investors' opportunity cost.
B)Reliable's bonds should be priced to yield a rate close to the coupon rate.
C)Reliable's bonds should yield more than 6.3% because they are new.
D)Reliable's bonds should yield less than 6.3% because they are new.

Question 63

Howard Enterprise's preference share is selling for $18.40.The stock pays an annual dividend of $2.21 per share.What is the cost of preference share to the company?

Question 64

Metals Corp.has $2,575,000 of debt, $550 000 of preference share and $18,125,000 of common equity.Metals Corp.'s after-tax cost of debt is 5.25%, preference share has a cost of 6.35% and newly issued common stock has a cost of 14.05%.What is Metals Corp.'s weighted average cost of capital?

A)12.78%
B)10.84%
C)8.32%
D)6.56%

Question 65

Scott Paper Company has preference share in its capital structure paying a dividend of $3.75 and selling for $25.00.If the marginal tax rate for Scott is 34%, what is the after-tax cost of preference financing?

Question 66

Three approaches are widely used to estimate the cost of ordinary share financing.

Question 67

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 68

The preference share of Masterson's sells for $15.30 and pays a $1.75 dividend.What is the cost of capital for preference share?

Question 69

Assuming an after-tax cost of preference share of 10% and a corporate tax rate of 34%, a firm must earn at least $15.15 before tax on every $100 invested.

Question 70

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 71

Tropical Fruit Drinks issued $10,000,000 in bonds to expand its production facilities.After issuing the bonds, the company was 60% debt financed and 40% common equity financed.Tropical intends to retire 20% of the bonds each year for the next five years and not to issue any new debt.

A)All things equal, we would expect Tropical Fruit Drinks cost of capital to decrease gradually over the next five years.
B)All things equal, we would expect Tropical Fruit Drinks cost of capital to increase gradually over the next five years.
C)All things equal, we would expect Tropical Fruit Drinks cost of capital to stay the same for the next five years, then decrease rapidly.
D)All things equal, we would expect Tropical Fruit Drinks cost of capital to stay the same for the next five years, then increase rapidly.

Question 72

Vance Refrigeration plans to issue 10-year bonds with a par value of $1000 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 Vance is in the 25% tax bracket, what is the after-tax cost of debt?

Question 73

Which of the following is the preference method in estimating a firm's cost of capital?

A)Consider the cost of a specific source of financing that will be used for a firm's new projects, i.e.the marginal cost of capital.
B)Calculate the weighted average cost of new capital to be utilized in financing a firm's projects.
C)Calculate the firm's weighted average CAPM to be utilized in financing a firm's projects.
D)Calculate the firm's cost of capital using the historical cost of components.

Question 74

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 75

Capital budgeting analyses typically assume a constant cost of capital, even though the analysts know it will change.One reason for this practice is that

A)the changes are too small to affect the decision.
B)a constant cost of capital is the most conservative assumption.
C)the changes are unpredictable.
D)NPV calculations do not allow more than one discount rate.

Question 76

Martin and Sons is issuing a $1000 par value bond with an 8% semi-annual interest coupon rate and that matures in 11 years.Investors are willing to pay $972 for these bonds.Martin is in the 34% tax bracket.What will be the after-tax cost of debt of the bond?

Question 77

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

Question 78

Estimating the cost of preference shares is more difficult to do than the cost of ordinary shares.

Question 79

Preference shareholders' required rate of return = preference dividends/preference share price

Question 80

A firm can estimate its cost of debt by finding the yield on bonds issued by other firms with similar ratings and maturities.