Question 1

Firm M's earnings and stock price tend to move up and down with other firms in the S&P 500,while Firm W's earnings and stock price move counter cyclically with M and other S&P companies.Both M and W estimate their costs of equity using the CAPM,they have identical market values,their standard deviations of returns are identical,and they both finance only with common equity.Which of the following statements is CORRECT?

Accepted Answer

A) M should have the lower WACC because it is like most other companies, and investors like that fact. 
B) M and W should have identical WACCs because their risks as measured by the standard deviation of returns are identical. 
C) If M and W merge, then the merged firm MW should have a WACC that is a simple average of M's and W's WACCs. 
D) Without additional information, it is impossible to predict what the merged firm's WACC would be if M and W merged. 
E) Since M and W move counter cyclically to one another, if they merged, the merged firm's WACC would be less than the simple average of the two firms' WACCs.

Question 2

The lower the firm's tax rate,the lower will be its after-tax cost of debt and also its WACC,other things held constant.

Accepted Answer

A) True 
 B)False

Question 3

If expectations for long-term inflation rose,but the slope of the SML remained constant,this would have a greater impact on the required rate of return on equity,rs,than on the interest rate on long-term debt,rd,for most firms.Therefore,the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt.

Accepted Answer

A) True 
 B)False

Question 4

Teall Development Company hired you as a consultant to help them estimate its cost of capital.You have been provided with the following data: D1 = $1.45; P0 = $22.50; and g = 6.50% (constant).Based on the DCF approach,what is the cost of equity from retained earnings?

Accepted Answer

A) 11.10% 
B) 11.68% 
C) 12.30% 
D) 12.94% 
E) 13.59%

Question 5

The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

Accepted Answer

A) True 
 B)False

Question 6

The reason why retained earnings have a cost equal to rs is because investors think they can (i.e.,expect to)earn rs on investments with the same risk as the firm's common stock,and if the firm does not think that it can earn rs on the earnings that it retains,it should pay those earnings out to its investors.Thus,the cost of retained earnings is based on the opportunity cost principle.

Accepted Answer

A) True 
 B)False

Question 7

The text identifies three methods for estimating the cost of common stock from retained earnings:
 the CAPM method,the DCF method,and the bond-yield-plus-risk-premium method.However,only the DCF method is widely used in practice.

Accepted Answer

A) True 
 B)False

Question 8

Assume that you are a consultant to Broske Inc.,and you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant).What is the cost of equity from retained earnings based on the DCF approach?

Accepted Answer

A) 9.42% 
B) 9.91% 
C) 10.44% 
D) 10.96% 
E) 11.51%

Question 9

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them,and no flotation costs are required to raise them,but capital raised by selling new stock or bonds does have a cost.

Accepted Answer

A) True 
 B)False

Question 10

The before-tax cost of debt,which is lower than the after-tax cost,is used as the component cost of debt for purposes of developing the firm's WACC.

Accepted Answer

A) True 
 B)False

Question 11

The higher the firm's flotation cost for new common equity,the more likely the firm is to use preferred stock,which has no flotation cost,and retained earnings,whose cost is the average return on the assets that are acquired.

Accepted Answer

A) True 
 B)False

Question 12

Schalheim Sisters Inc.has always paid out all of its earnings as dividends,hence the firm has no retained earnings.This same situation is expected to persist in the future.The company uses the CAPM to calculate its cost of equity,its target capital structure consists of common stock,preferred stock,and debt.Which of the following events would REDUCE its WACC?

Accepted Answer

A) The market risk premium declines. 
B) The flotation costs associated with issuing new common stock increase. 
C) The company's beta increases. 
D) Expected inflation increases. 
E) The flotation costs associated with issuing preferred stock increase.

Question 13

Which of the following statements is CORRECT?

Accepted Answer

A) The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital. 
B) The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt. 
C) The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets. 
D) There is an "opportunity cost" associated with using retained earnings, hence they are not "free." 
E) The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year.

Question 14

Scanlon Inc.'s CFO hired you as a consultant to help her estimate the cost of capital.You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30.Based on the CAPM approach,what is the cost of equity from retained earnings?

Accepted Answer

A) 9.67% 
B) 9.97% 
C) 10.28% 
D) 10.60% 
E) 10.93%

Question 15

Which of the following statements is CORRECT?

Accepted Answer

A) The component cost of preferred stock is expressed as rp(1 − T). This follows because preferred stock dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes. 
B) A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firm's stockholders would themselves expect to earn a return on earnings that were paid out rather than retained and reinvested. 
C) No cost should be assigned to retained earnings because the firm does not have to pay anything to raise them. They are generated as cash flows by operating assets that were raised in the past, hence they are "free." 
D) Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into the foreseeable future. In this case, the firm's before-tax and after-tax costs of debt for purposes of calculating the WACC will both be equal to the interest rate on the firm's currently outstanding debt, provided that debt was issued during the past 5 years. 
E) If a firm has enough retained earnings to fund its capital budget for the coming year, then there is no need to estimate either a cost of equity or a WACC.

Question 16

The text identifies three methods for estimating the cost of common stock from retained earnings:
 the CAPM method,the DCF method,and the bond-yield-plus-risk-premium method.Since we cannot be sure that the estimate obtained with any of these methods is correct,it is often appropriate to use all three methods,then consider all three estimates,and end up using a judgmental estimate when calculating the WACC.

Accepted Answer

A) True 
 B)False

Question 17

Cranberry Corp.has two divisions of equal size: a computer manufacturing division and a data processing division.Its CFO believes that stand-alone data processor companies typically have a WACC of 8%,while stand-alone computer manufacturers typically have a 12% WACC.He also believes that the data processing and manufacturing divisions have the same risk as their typical peers.Consequently,he estimates that the composite,or corporate,WACC is 10%.A consultant has suggested using an 8% hurdle rate for the data processing division and a 12% hurdle rate for the manufacturing division.However,the CFO disagrees,and he has assigned a 10% WACC to all projects in both divisions.Which of the following statements is CORRECT?

Accepted Answer

A) While the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant's recommendation, this should not affect the firm's intrinsic value. 
B) The decision not to adjust for risk means, in effect, that it is favoring the data processing division. Therefore, that division is likely to become a larger part of the consolidated company over time. 
C) The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division. This will lead to a reduction in the firm's intrinsic value over time. 
D) The decision not to risk-adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business. This will lead to a reduction in its intrinsic value over time. 
E) The decision not to risk adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business. This may affect the firm's capital structure but it will not affect its intrinsic value.

Question 18

Which of the following statements is CORRECT?

Accepted Answer

A) In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income. 
B) We should use historical measures of the component costs from prior financings that are still outstanding when estimating a company's WACC for capital budgeting purposes. 
C) The cost of new equity (re) could possibly be lower than the cost of retained earnings (rs) if the market risk premium, risk-free rate, and the company's beta all decline by a sufficiently large amount. 
D) Its cost of retained earnings is the rate of return stockholders require on a firm's common stock. 
E) The component cost of preferred stock is expressed as rp(1 − T), because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt.

Question 19

Which of the following statements is CORRECT?

Accepted Answer

A) A change in a company's target capital structure cannot affect its WACC. 
B) WACC calculations should be based on the before-tax costs of all the individual capital components. 
C) Flotation costs associated with issuing new common stock normally reduce the WACC. 
D) If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline. 
E) An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.

Question 20

The cost of capital used in capital budgeting should reflect the average cost of the various sources of investor-supplied funds a firm uses to acquire assets.

Accepted Answer

A) True 
 B)False

Exam 10: The Cost of Capital

The lower the firm's tax rate,the lower will be its after-tax cost of debt and also its WACC,other things held constant.

Teall Development Company hired you as a consultant to help them estimate its cost of capital.You have been provided with the following data: D₁ = $1.45; P₀ = $22.50; and g = 6.50% (constant) .Based on the DCF approach,what is the cost of equity from retained earnings?

The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method,the DCF method,and the bond-yield-plus-risk-premium method.However,only the DCF method is widely used in practice.

Assume that you are a consultant to Broske Inc.,and you have been provided with the following data: D₁ = $0.67; P₀ = $27.50; and g = 8.00% (constant) .What is the cost of equity from retained earnings based on the DCF approach?

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them,and no flotation costs are required to raise them,but capital raised by selling new stock or bonds does have a cost.

The before-tax cost of debt,which is lower than the after-tax cost,is used as the component cost of debt for purposes of developing the firm's WACC.

The higher the firm's flotation cost for new common equity,the more likely the firm is to use preferred stock,which has no flotation cost,and retained earnings,whose cost is the average return on the assets that are acquired.

Which of the following statements is CORRECT?

Scanlon Inc.'s CFO hired you as a consultant to help her estimate the cost of capital.You have been provided with the following data: r_RF = 4.10%; RP_M = 5.25%; and b = 1.30.Based on the CAPM approach,what is the cost of equity from retained earnings?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

The cost of capital used in capital budgeting should reflect the average cost of the various sources of investor-supplied funds a firm uses to acquire assets.

Exam 10: The Cost of Capital

The lower the firm's tax rate,the lower will be its after-tax cost of debt and also its WACC,other things held constant.

Teall Development Company hired you as a consultant to help them estimate its cost of capital.You have been provided with the following data: D1 = $1.45; P0 = $22.50; and g = 6.50% (constant) .Based on the DCF approach,what is the cost of equity from retained earnings?

The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method,the DCF method,and the bond-yield-plus-risk-premium method.However,only the DCF method is widely used in practice.

Assume that you are a consultant to Broske Inc.,and you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant) .What is the cost of equity from retained earnings based on the DCF approach?

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them,and no flotation costs are required to raise them,but capital raised by selling new stock or bonds does have a cost.

The before-tax cost of debt,which is lower than the after-tax cost,is used as the component cost of debt for purposes of developing the firm's WACC.

The higher the firm's flotation cost for new common equity,the more likely the firm is to use preferred stock,which has no flotation cost,and retained earnings,whose cost is the average return on the assets that are acquired.

Which of the following statements is CORRECT?

Scanlon Inc.'s CFO hired you as a consultant to help her estimate the cost of capital.You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30.Based on the CAPM approach,what is the cost of equity from retained earnings?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

The cost of capital used in capital budgeting should reflect the average cost of the various sources of investor-supplied funds a firm uses to acquire assets.

Teall Development Company hired you as a consultant to help them estimate its cost of capital.You have been provided with the following data: D₁ = $1.45; P₀ = $22.50; and g = 6.50% (constant) .Based on the DCF approach,what is the cost of equity from retained earnings?

Assume that you are a consultant to Broske Inc.,and you have been provided with the following data: D₁ = $0.67; P₀ = $27.50; and g = 8.00% (constant) .What is the cost of equity from retained earnings based on the DCF approach?

Scanlon Inc.'s CFO hired you as a consultant to help her estimate the cost of capital.You have been provided with the following data: r_RF = 4.10%; RP_M = 5.25%; and b = 1.30.Based on the CAPM approach,what is the cost of equity from retained earnings?