Deck 14: The Cost of Capital

Question 1

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 preference shares + weighted cost of ordinary shares
B)WACC = weighted after-tax cost of debt + weighted after-tax cost of preference shares + weighted after-tax cost of ordinary shares
C)WACC = (after-tax cost of debt + cost of preference shares + cost of ordinary shares )/3
D)WACC = weighted cost of debt + weighted cost of preference shares + weighted cost of ordinary shares

Answer 1

A

Question 2

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.

Answer 2

B

Question 3

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.

Answer 3

True

Question 4

Use the following information to answer the following question(s).
The following data concerning
Spencer Transgenics' capital structure is available.

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

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

Question 5

Use the following information to answer the following question(s).
The following data concerning
Spencer Transgenics' capital structure is available.

The percentage of ordinary shares in Spencer's weighted average cost of capital is

A)62.5%.
B)66.7%.
C)6.25%.
D)38.1%.

Question 6

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

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

Question 7

In order to maximise 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 8

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

Question 9

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 10

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 ordinary equity
B)Cost of preference shares
C)Cost of debt
D)All of the above

Question 11

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

Question 12

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

A)Ordinary shares
B)Preference shares
C)Bonds
D)All of the above

Question 13

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 minimum rate of return that must be earned on its investments
D)The coupon rate on preference shares

Question 14

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 15

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

Question 16

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

Question 17

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

Question 18

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 19

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 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,ordinary shares,and ordinary shares and book values for retained earnings.
C)current market values.
D)subjective adjustments for firm risk.

Question 21

Use the following information to answer the following question(s).
The following data concerning
Spencer Transgenics' capital structure is available.

The percentage of preference shares in Spencer's weighted average cost of capital is

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

Question 22

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 23

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

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 expected dividend is $2.50 for a share of stock priced at $25.What is the cost of ordinary equity if the long-term growth in dividends is projected to be 4%?

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

Question 26

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

Question 27

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

Question 28

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

A)$1,275.
B)$2,400.
C)$2,250.
D)$1,575.

Question 29

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 30

The most expensive source of capital is usually

A)preference shares.
B)new ordinary shares.
C)debt.
D)retained earnings.

Question 31

Sonderson Corporation is undertaking a capital budgeting analysis.The firm's beta is 1.5.The rate on six-month treasury notes 5%,and the return on the ASX/S&P 200 index is 12%.What is the appropriate cost of ordinary equity in determining the firm's cost of capital?

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

Question 32

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

A)the expected growth rate of dividends
B)the risk-free rate
C)the dividend
D)both A and B

Question 33

The cost of preference shares is equal to

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

Question 34

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 35

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

A)Ordinary shares
B)Retained earnings
C)Debt
D)Preference shares

Question 36

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 37

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 38

Which of the following statements is true?

A)The level of general economic conditions will determine whether a firm should utilise an arithmetic average cost of capital or a weighted average cost of capital.
B)A firm should utilise 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 capitalised 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 is true.

Question 39

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 40

PVE,Inc.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,Inc.?

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

Question 41

MTD 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 42

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 43

A firm has an issue of preference shares 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 shares is

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

Question 44

The CAPM approach is used to determine the cost of

A)debt.
B)preference shares.
C)ordinary equity.
D)long term funds.

Question 45

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 46

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 ordinary shares.
B)The cost of a firm's preference shares is greater than the cost of its ordinary shares.
C)The cost of a firm's retained earnings is less than the cost of its bonds.
D)The cost of a firm's ordinary shares is greater than the cost of its bonds.

Question 47

Use the following information to answer the following question(s).
The current market price of an existing debt issue is $1,125.The bonds have a $1,000 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 this debt issue is

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

Question 48

Use the following information to answer the following question(s).
Berlioz Inc.is trying to estimate its cost of ordinary equity,and it has the following information.The firm has a beta of 0.90,the before-tax cost of the firm's debt is 7.75%,and the firm estimates that the risk-free rate is 4% while the current market return is 12%.Berlioz shares currently sell for $35.00 per share.The firm pays dividends annually and expects dividends to grow at a constant rate of 5% indefinitely.The most recent dividend per share,paid yesterday,is $2.00.Finally,the firm has a marginal tax rate of 34%.
The cost of ordinary equity using the CAPM is

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

Question 49

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

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

Question 50

Use the following information to answer the following question(s).
The current market price of an existing debt issue is $1,125.The bonds have a $1,000 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 before-tax cost of this debt issue is

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

Question 51

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 52

Use the following information to answer the following question(s).
Berlioz Inc.is trying to estimate its cost of ordinary equity,and it has the following information.The firm has a beta of 0.90,the before-tax cost of the firm's debt is 7.75%,and the firm estimates that the risk-free rate is 4% while the current market return is 12%.Berlioz shares currently sell for $35.00 per share.The firm pays dividends annually and expects dividends to grow at a constant rate of 5% indefinitely.The most recent dividend per share,paid yesterday,is $2.00.Finally,the firm has a marginal tax rate of 34%.
The cost of ordinary equity using the dividend-growth model is

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

Question 53

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 model is simple and uses variables that are easy to find.
C)Because the CAPM gives better treatment to flotation costs.
D)The CAPM uses data from the firm's financial statements.

Question 54

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 ordinary equity.

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

Question 55

The best estimate of the cost of new ordinary equity is

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

Question 56

Suncorp Limited is undertaking a capital budgeting analysis.The firm's beta is 1.5.The rate on Treasury notes is 5%,and the return on the ASX/S&P 200 index is 12%.What is the cost of Suncorp's common equity?

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

Question 57

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 58

The last paid dividend is $2 for a share of ordinary shares that is currently selling for $20.What is the cost of ordinary 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 59

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 60

Coca-Cola Amatil is undertaking a capital budgeting analysis.The rate on Treasury notes is 3.60%,and the return on the ASX/S&P 200 index is 11.6%.If the cost of Coc-Cola Amatil's ordinary equity is 19.6%,calculate their beta.

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

Question 61

The George Company 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 is after tax cost of debt?

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

Question 62

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

Question 63

A bond with a Moody's rating of Aaa and an 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 64

It is not possible for a firm's after-tax cost of ordinary equity to be lower than its after-tax cost of debt.

Question 65

The firm's weighted average cost of capital is

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

Question 66

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

Question 67

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

Question 68

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 ordinary shares are 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 69

Because issuing ordinary equity entails less risk to the firm,it is always less expensive than borrowing.

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

The after-tax cost of ordinary shares is

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

Question 72

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

Question 73

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

Question 74

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

Question 75

Use the following information to answer the following question(s).
A firm currently has the following capital structure ,which it intends to maintain.Debt: $3,000,000 par value of 9% bonds outstanding with an annual before-tax yield to maturity of 7.67% on a new issue.The bonds currently sell for $115 per $100 par value.Ordinary shares: 46,000 shares outstanding currently selling for $50 per share.The firm expects to pay a $5.50 dividend per share one year from now and is experiencing a 3.67% growth rate in dividends,which it expects to continue indefinitely.The firm's marginal tax rate is 40%.The company has no plans to issue new securities.
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 76

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 ordinary equity using the CAPM approach?

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

Question 77

Use the following information to answer the following question(s).
A firm currently has the following capital structure ,which it intends to maintain.Debt: $3,000,000 par value of 9% bonds outstanding with an annual before-tax yield to maturity of 7.67% on a new issue.The bonds currently sell for $115 per $100 par value.Ordinary shares: 46,000 shares outstanding currently selling for $50 per share.The firm expects to pay a $5.50 dividend per share one year from now and is experiencing a 3.67% growth rate in dividends,which it expects to continue indefinitely.The firm's marginal tax rate is 40%.The company has no plans to issue new securities.
The proportion of debt in this firm's capital structure is

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

Question 78

The after-tax cost of debt is

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

Question 79

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 80

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.