Question 1

The Gordon model is based on the premise that the value of a share of stock is equal to the sum of all future dividends it is expected to provide over an infinite time horizon.

Accepted Answer

A) True 
 B)False

Question 2

A firm may face increases in the weighted average cost of capital either when retained earnings have been exhausted or due to increases in debt, preferred stock, and common equity costs as additional new funds are required.

Accepted Answer

A) True 
 B)False

Question 3

In computing the weighted average cost of capital, from a strictly theoretical point of view, the preferred weighing scheme is target market value proportions.

Accepted Answer

A) True 
 B)False

Question 4

In computing the weighted average cost of capital, the historic weights are either book value or market value weights based on actual capital structure proportions.

Accepted Answer

A) True 
 B)False

Question 5

The target capital structure is the desired optimal mix of debt and equity financing that most firms attempt to achieve and maintain.

Accepted Answer

A) True 
 B)False

Question 6

The Titanic Company has just gone public. Under a firm commitment agreement, Titanic received$14 for each of the 2 million shares sold. The initial offering price was $15 per share, and the stockrose to $16.40 per share in the first few minutes of trading. Titanic paid $500,000 in administrative costs. The total floatation costs for the new issue are

Accepted Answer

A)  $2,000,000. 
B)  $4,800,000. 
C)  $2,800,000. 
D)  $5,300,000.

Question 7

A firm has determined its optimal capital structure which is composed of the following sources and target market value proportions.
$$\begin{array} { l c } 
\text { Source of capital } & \begin{array} { c } 
\text { Target market } \
\text { proportions }
\end{array} \
\hline \text { Long-term debt } & 20 \% \
\text { Preferred stock } & 10 \
\text { Common stock equity } & 70
\end{array}$$
DEBT:  The firm can sell a 12-year, $1,000 par value, 7 percent bond for $960. A flotation cost of 2 percent of the face value would be required in addition to the discount of $40.
PREFERRED STOCK:  The firm has determined it can issue preferred stock at $75 per share par value. The stock will pay a
$10 annual dividend. The cost of issuing and selling the stock is $3 per share.
COMMON STOCK:   A firm's common stock is currently selling for $18 per share. The dividend expected to be paid at the
end of the coming year is $1.74. Its dividend payments have been growing at a constant rate for the last five years. Five years ago, the dividend was $1.50. It is expected that to sell, a new common stock issue must be underpriced $1 per share in
floatation costs. Additionally, the firm's marginal tax rate is 40 percent.
-The firm's cost of retained earnings is (See Figure 9.1)

Accepted Answer

A)  13.6 percent. 
B)  13.9 percent. 
C)  10.2 percent. 
D)  12.7 percent.

Question 8

The preferred capital structure weights to be used in the weighted average cost of capital are

Accepted Answer

A)  target weights. 
B)  historic weights. 
C)  market weights. 
D)  nominal weights.

Question 9

A firm has determined its optimal structure which is composed of the following sources and target market value proportions.
$$\begin{array} { l c } 
\text { Source of capital } & \begin{array} { c } 
\text { Target market } \
\text { Proportions }
\end{array} \
\hline \text { Long-term debt } & 60 \% \
\text { Common stock equity } & 40
\end{array}$$
DEBT:  The firm can sell a 15-year, $1,000 par value, 8 percent bond for $1,050.  A flotation cost of 2 percent of the face value would be required in addition to the premium of $50.
COMMON STOCK:  A firm's common stock is currently selling for $75 per share.  The dividend expected to be paid at the end of the coming year is $5. Its dividend payments have been growing at a constant rate for the last five years.  Five years ago, the dividend was $3.10.  It is expected that to sell, a new common stock issue must be underpriced $2 per share and the firm must pay $1 per share in flotation costs.  Additionally, the firm has a marginal tax rate of 40 percent.

-The firm's cost of retained earnings is

Accepted Answer

A)  10.2 percent. 
B)  14.3 percent. 
C)  17.0 percent. 
D)  16.7 percent.

Question 10

The net proceeds used in calculation of the cost of long-term debt are funds actually received from the sale after paying for flotation costs and taxes.

Accepted Answer

A) True 
 B)False

Question 11

A firm has determined its optimal structure which is composed of the following sources and target market value proportions.
$$\begin{array} { l c } 
\text { Source of capital } & \begin{array} { c } 
\text { Target market } \
\text { Proportions }
\end{array} \
\hline \text { Long-term debt } & 60 \% \
\text { Common stock equity } & 40
\end{array}$$
DEBT:  The firm can sell a 15-year, $1,000 par value, 8 percent bond for $1,050.  A flotation cost of 2 percent of the face value would be required in addition to the premium of $50.
COMMON STOCK:  A firm's common stock is currently selling for $75 per share.  The dividend expected to be paid at the end of the coming year is $5. Its dividend payments have been growing at a constant rate for the last five years.  Five years ago, the dividend was $3.10.  It is expected that to sell, a new common stock issue must be underpriced $2 per share and the firm must pay $1 per share in flotation costs.  Additionally, the firm has a marginal tax rate of 40 percent.

-Assuming the firm plans to pay out all of its earnings as dividends, the weighted average cost of capital is

Accepted Answer

A)  10.9 percent. 
B)  11.6 percent. 
C)  9.6 percent. 
D)  12.1 percent.

Question 12

The before-tax cost of debt for a firm which has a 40 percent marginal tax rate is 12 percent. Theaftertax cost of debt is

Accepted Answer

A)  6.0 percent. 
B)  7.2 percent. 
C)  12 percent. 
D)  4.8 percent.

Question 13

A firm has determined its optimal structure which is composed of the following sources and target market value proportions.
$$\begin{array} { l c } 
\text { Source of capital } & \begin{array} { c } 
\text { Target market } \
\text { Proportions }
\end{array} \
\hline \text { Long-term debt } & 60 \% \
\text { Common stock equity } & 40
\end{array}$$
DEBT:  The firm can sell a 15-year, $1,000 par value, 8 percent bond for $1,050.  A flotation cost of 2 percent of the face value would be required in addition to the premium of $50.
COMMON STOCK:  A firm's common stock is currently selling for $75 per share.  The dividend expected to be paid at the end of the coming year is $5. Its dividend payments have been growing at a constant rate for the last five years.  Five years ago, the dividend was $3.10.  It is expected that to sell, a new common stock issue must be underpriced $2 per share and the firm must pay $1 per share in flotation costs.  Additionally, the firm has a marginal tax rate of 40 percent.

-The firm's beforetax cost of debt is

Accepted Answer

A)  7.7 percent. 
B)  12.7 percent. 
C)  10.6 percent. 
D)  11.2 percent.

Question 14

What is the dividend on an 8 percent preferred stock that currently sells for $45 and has a face value of $50 per share?

Accepted Answer

A)  $5.00 
B)  $4.00 
C)  $3.60 
D)  $3.33

Question 15

While the return will increase with the acceptance of more projects, the weighted marginal cost of capital will increase because greater amounts of financing will be required.

Accepted Answer

A) True 
 B)False

Question 16

If a corporation has an average tax rate of 40 percent, the approximate, annual, aftertax cost of debtfor a 15-year, 12 percent, $1,000 par value bond, selling at $950 is

Accepted Answer

A)  6.0 percent. 
B)  10 percent. 
C)  10.6 percent. 
D)  7.6 percent.

Question 17

A firm has issued 10 percent preferred stock, which sold for $100 per share par value. The cost ofissuing and selling the stock was $2 per share. The firm's marginal tax rate is 40 percent. The costof the preferred stock is

Accepted Answer

A)  9.8 percent. 
B)  6.1 percent. 
C)  10.2 percent. 
D)  3.9 percent.

Question 18

The__________ is the rate of return required by the market suppliers of capital in order to attract their funds to the firm.

Accepted Answer

A)  gross profit margin 
B)  internal rate of return 
C)  cost of capital 
D)  yield to maturity

Question 19

The weighted marginal cost of capital is the firm's weighted average cost of capital associated withits next dollar of total financing.

Accepted Answer

A) True 
 B)False

Question 20

Circumstances in which the constant growth valuation model-the Gordon model-for estimating the value of a share of stock should be used include

Accepted Answer

A)  the lack of dividends. 
B)  a steady growth rate in dividends. 
C)  an erratic dividend stream. 
D)  declining dividends.

Exam 9: The Cost of Capital

The Gordon model is based on the premise that the value of a share of stock is equal to the sum of all future dividends it is expected to provide over an infinite time horizon.

A firm may face increases in the weighted average cost of capital either when retained earnings have been exhausted or due to increases in debt, preferred stock, and common equity costs as additional new funds are required.

In computing the weighted average cost of capital, from a strictly theoretical point of view, the preferred weighing scheme is target market value proportions.

In computing the weighted average cost of capital, the historic weights are either book value or market value weights based on actual capital structure proportions.

The target capital structure is the desired optimal mix of debt and equity financing that most firms attempt to achieve and maintain.

The preferred capital structure weights to be used in the weighted average cost of capital are

The net proceeds used in calculation of the cost of long-term debt are funds actually received from the sale after paying for flotation costs and taxes.

The before-tax cost of debt for a firm which has a 40 percent marginal tax rate is 12 percent. Theaftertax cost of debt is

What is the dividend on an 8 percent preferred stock that currently sells for $45 and has a face value of $50 per share?

While the return will increase with the acceptance of more projects, the weighted marginal cost of capital will increase because greater amounts of financing will be required.

If a corporation has an average tax rate of 40 percent, the approximate, annual, aftertax cost of debtfor a 15-year, 12 percent, $1,000 par value bond, selling at $950 is

A firm has issued 10 percent preferred stock, which sold for $100 per share par value. The cost ofissuing and selling the stock was $2 per share. The firm's marginal tax rate is 40 percent. The costof the preferred stock is

The__________ is the rate of return required by the market suppliers of capital in order to attract their funds to the firm.

The weighted marginal cost of capital is the firm's weighted average cost of capital associated withits next dollar of total financing.

Circumstances in which the constant growth valuation model-the Gordon model-for estimating the value of a share of stock should be used include