Question 1

Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

Accepted Answer

A) True 
 B)False

Question 2

You have been hired as a consultant by Feludi Inc.'s CFO, who wants you 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 common from reinvested earnings?

Accepted Answer

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

Question 3

Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt.

Accepted Answer

A) True 
 B)False

Question 4

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the dividend growth method, and the bond-yield-plus-risk-premium method. However, only the CAPM method always provides an accurate and reliable estimate.

Accepted Answer

A) True 
 B)False

Question 5

Bartlett Company's target capital structure is 40% debt, 15% preferred, and 45% common equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of common using reinvested earnings is 12.75%. The firm will not be issuing any new stock. You were hired as a consultant to help determine their cost of capital. What is its WACC?

Accepted Answer

A)  8.98% 
B)  9.26% 
C)  9.54% 
D)  9.83% 
E)  10.12%

Question 6

You are a finance intern at Chambers and Sons and they have asked you to help estimate the company's cost of common equity. You obtained the following data: D1 = $1.25; P0 = $27.50; gL = 5.00% (constant); and F = 6.00%. What is the cost of equity raised by selling new common stock?

Accepted Answer

A)  9.06% 
B)  9.44% 
C)  9.84% 
D)  10.23% 
E)  10.64%

Question 7

Which of the following statements is CORRECT?

Accepted Answer

A)  since its stockholders are not directly responsible for paying a corporation's income taxes, corporations should focus on before-tax cash flows when calculating the wacc. 
B)  an increase in a firm's tax rate will increase the component cost of debt, provided the ytm on the firm's bonds is not affected by the change in the tax rate. 
C)  when the wacc is calculated, it should reflect the costs of new common stock, reinvested earnings, preferred stock, long-term debt, short-term bank loans if the firm normally finances with bank debt, and accounts payable if the firm normally has accounts payable on its balance sheet. 
D)  if a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the after-tax cost of debt. 
E)  since the costs of internal and external equity are related, an increase in the flotation cost required to sell a new issue of stock will increase the cost of reinvested earnings.

Question 8

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 9

Which of the following statements is CORRECT?

Accepted Answer

A)  the wacc is calculated using a before-tax cost for debt that is equal to the interest rate that must be paid on new debt, along with the after-tax costs for common stock and for preferred stock if it is used. 
B)  an increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity. 
C)  the relevant wacc can change depending on the amount of funds a firm raises during a given year. moreover, the wacc at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm's target capital structure. 
D)  beta measures market risk, which is generally the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. however, this is not true unless all of the firm's stockholders are well diversified. 
E)  the bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the interest rate on the company's own long-term bonds. the size of the risk premium for bonds with different ratings is published daily in the wall street journal.

Question 10

Granby Foods' (GF) balance sheet shows a total of $25 million long-term debt with a coupon rate of 8.50%. The yield to maturity on this debt is 8.00%, and the debt has a total current market value of $27 million. The company has 10 million shares of stock, and the stock has a book value per share of $5.00. The current stock price is $20.00 per share, and stockholders' required rate of return, rs, is 12.25%. The company recently decided that its target capital structure should have 35% debt, with the balance being common equity. The tax rate is 40%. Calculate WACCs based on book, market, and target capital structures. What is the sum of these three WACCs?

Accepted Answer

A)  28.36% 
B)  29.54% 
C)  30.77% 
D)  32.00% 
E)  33.28%

Question 11

As the assistant to the CFO of Johnstone Inc., you must estimate its cost of common equity. You have been provided with the following data: D0 = $0.80; P0 = $22.50; and gL = 8.00% (constant). Based on the dividend growth model, what is the cost of common from reinvested earnings?

Accepted Answer

A)  10.69% 
B)  11.25% 
C)  11.84% 
D)  12.43% 
E)  13.05%

Question 12

Which of the following statements is CORRECT?

Accepted Answer

A)  the dividend growth model is generally preferred by academics and financial executives over other models for estimating the cost of equity. this is because of the dividend growth model's logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain. 
B)  the bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm's own cost of debt and its risk premium, can be found by using standardized and objective procedures. 
C)  surveys indicate that the capm is the most widely used method for estimating the cost of equity. however, other methods are also used because capm estimates may be subject to error, and people like to use different methods as checks on one another. if all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity. 
D)  the dividend growth model model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield. 
E)  although some methods used to estimate the cost of equity are subject to severe limitations, the capm is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. in particular, academics and corporate finance people generally agree that its key inputsσbeta, the risk-free rate, and the market risk premiumσcan be estimated with little error.

Question 13

Quinlan Enterprises stock trades for $52.50 per share. It is expected to pay a $2.50 dividend at year end (D1 = $2.50), and the dividend is expected to grow at a constant rate of 5.50% a year. The before-tax cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of 45% debt and 55% common equity. What is the company's WACC if all the equity used is from reinvested earnings?

Accepted Answer

A)  7.07% 
B)  7.36% 
C)  7.67% 
D)  7.98% 
E)  8.29%

Question 14

When estimating the cost of equity by use of the dividend growth method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return. This problem leaves us unsure of the true value of rs.

Accepted Answer

A) True 
 B)False

Question 15

If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the dividend growth model, and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method. All this makes it especially difficult to estimate the cost of equity for a private company.

Accepted Answer

A) True 
 B)False

Question 16

Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets. They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.

Accepted Answer

A) True 
 B)False

Question 17

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, is not deductible by the issuing firm.

Accepted Answer

A) True 
 B)False

Question 18

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the dividend growth method, and the bond-yield-plus-risk-premium method. However, only the dividend growth method is widely used in practice.

Accepted Answer

A) True 
 B)False

Question 19

Collins Group
The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.
 $\begin{array}{l}
\text { Assets }\
\begin{array}{lr}
\text { Current assets } & \$ 38,000,000 \
\text { Net plant, property, and equipment } & 101,000,000\
\text { Total assets }&\$ 139,000,000\
\
\text { Liabilities and Equity }\
\text { Accounts payable } & \$ 10,000,000 \
\text { Accruals } & 9,000,000 \
\text { Current liabilities } & \$ 19,000,000 \
\text { Long-term debt }(40,000 \text { bonds, } \$ 1,000 \text { par value) } & 40,000,000\
\text { Total liabilities }&\$ 59,000,000 \
\text { Common stock ( } 10,000,000 \text { shares) } & 30,000,000 \
\text { Retained earnings } & 50,000,000 \
 \text { Total shareholders' equity } & 80,000,000 \
\text { Total liabilities and shareholders' equity } & \$ 139,000,000
\end{array}
\end{array}$ 
The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%.
-Refer to the data for the Collins Group. What is the best estimate of the after-tax cost of debt?

Accepted Answer

A)  4.64% 
B)  4.88% 
C)  5.14% 
D)  5.40% 
E)  5.67%

Question 20

Which of the following statements is CORRECT?

Accepted Answer

A)  the after-tax cost of debt usually exceeds the after-tax cost of equity. 
B)  for a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock. 
C)  retained earnings that were generated in the past and are reported on the firm's balance sheet are available to finance the firm's capital budget during the coming year. 
D)  the wacc that should be used in capital budgeting is the firm's marginal, after-tax cost of capital. 
E)  the wacc is calculated using before-tax costs for all components.

Exam 11: Determining the Cost of Capital

Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

You have been hired as a consultant by Feludi Inc.'s CFO, who wants you 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 common from reinvested earnings?

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the dividend growth method, and the bond-yield-plus-risk-premium method. However, only the CAPM method always provides an accurate and reliable estimate.

You are a finance intern at Chambers and Sons and they have asked you to help estimate the company's cost of common equity. You obtained the following data: D1 = $1.25; P0 = $27.50; gL = 5.00% (constant) ; and F = 6.00%. What is the cost of equity raised by selling new common stock?

Which of the following statements is CORRECT?

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.

Which of the following statements is CORRECT?

As the assistant to the CFO of Johnstone Inc., you must estimate its cost of common equity. You have been provided with the following data: D0 = $0.80; P0 = $22.50; and gL = 8.00% (constant) . Based on the dividend growth model, what is the cost of common from reinvested earnings?

Which of the following statements is CORRECT?

When estimating the cost of equity by use of the dividend growth method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return. This problem leaves us unsure of the true value of rs.

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, is not deductible by the issuing firm.

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the dividend growth method, and the bond-yield-plus-risk-premium method. However, only the dividend growth method is widely used in practice.

Which of the following statements is CORRECT?