Deck 11: Determining the Cost of Capital

Question 1

The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

Answer 1

False

Question 2

For capital budgeting and cost of capital purposes, the firm should always consider reinvested earnings as the first source of capital?i.e., use these funds first?because reinvested earnings have no cost to the firm.

Answer 2

False

Question 3

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.

Answer 3

True

Question 4

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

Question 5

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.

Question 6

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.

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?

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

Question 7

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.

Question 8

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

Question 9

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

Question 10

Perpetual preferred stock from Franklin Inc. sells for $97.50 per share, and it pays an $8.50 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is the company's cost of preferred stock for use in calculating the WACC?

A) 8.72%
B) 9.08%
C) 9.44%
D) 9.82%
E) 10.22%

Question 11

The Lincoln Company sold a $1,000 par value, noncallable bond several years ago that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually. The bond currently sells for $925 and the company's tax rate is 40%. What is the component cost of debt for use in the WACC calculation?

A) 4.28%
B) 4.46%
C) 4.65%
D) 4.83%
E) 5.03%

Question 12

Kenny Electric Company's noncallable bonds were issued several years ago and now have 20 years to maturity. These bonds have a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000. If the firm's tax rate is 40%, what is the component cost of debt for use in the WACC calculation?

A) 4.35%
B) 4.58%
C) 4.83%
D) 5.08%
E) 5.33%

Question 13

Westbrook's Painting Co. plans to issue a $1,000 par value, 20-year noncallable bond with a 7.00% annual coupon, paid semiannually. The company's marginal tax rate is 40.00%, but Congress is considering a change in the corporate tax rate to 30.00%. By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted?

A) 0.57%
B) 0.63%
C) 0.70%
D) 0.77%
E) 0.85%

Question 14

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

A) accounts payable.
B) common stock "raised" by reinvesting earnings.
C) common stock raised by new issues.
D) preferred stock.
E) long-term debt.

Question 15

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.

Question 16

The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

Question 17

Since 70% of the preferred dividends received by a corporation are excluded from taxable income, the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be??Cost of equity = rs(0.30)(0.50) + rps(1 ? T)(0.70)(0.50).

Question 18

"Capital" is sometimes defined as funds supplied to a firm by investors.

Question 19

A company's perpetual preferred stock currently sells for $92.50 per share, and it pays an $8.00 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price. What is the firm's cost of preferred stock?

A) 7.81%
B) 8.22%
C) 8.65%
D) 9.10%
E) 9.56%

Question 20

If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.

Question 21

The CEO of Harding Media Inc. as asked you to help estimate its cost of common equity. You have obtained the following data: D0 = $0.85; P0 = $22.00; and gL = 6.00% (constant). The CEO thinks, however, that the stock price is temporarily depressed, and that it will soon rise to $40.00. Based on the dividend growth model, by how much would the cost of common from reinvested earnings change if the stock price changes as the CEO expects?

A) ?1.49%
B) ?1.66%
C) ?1.84%
D) ?2.03%
E) ?2.23%

Question 22

To help estimate its cost of common equity, Maxwell and Associates recently hired you. You have obtained the following data: D0 = $0.90; P0 = $27.50; and gL = 7.00% (constant). Based on the dividend growth model, what is the cost of common from reinvested earnings?

A) 9.29%
B) 9.68%
C) 10.08%
D) 10.50%
E) 10.92%

Question 23

The reason why reinvested 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 distribute those earnings to its investors. Thus, the cost of reinvested earnings is based on the opportunity cost principle.

Question 24

When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to use long-term or short-term rates for rRF, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and (3) how to measure the market risk premium, RPM. These problems leave us unsure of the true value of rs.

Question 25

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.

Question 26

As a consultant to Basso Inc., you have been provided with the following data: D1 = $0.67; P0 = $27.50; and gL = 8.00% (constant). What is the cost of common from reinvested earnings based on the dividend growth approach?

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

Question 27

Adams Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of common from reinvested earnings based on the CAPM?

A) 11.30%
B) 11.64%
C) 11.99%
D) 12.35%
E) 12.72%

Question 28

If investors' aversion to risk rose, causing the slope of the SML to increase, 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. Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity. However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit the shift toward debt.

Question 29

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.

Question 30

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?

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

Question 31

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.

Question 32

To help them estimate the company's cost of capital, Smithco has hired you as a consultant. You have been provided with the following data: D1 = $1.45; P0 = $22.50; and gL = 6.50% (constant). Based on the dividend growth approach, what is the cost of common from reinvested earnings?

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

Question 33

In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project.

Question 34

For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity.

Question 35

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.

Question 36

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?

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

Question 37

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.

Question 38

The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.

Question 39

When working with the CAPM, which of the following factors can be determined with the most precision?

A) the beta coefficient, bi, of a relatively safe stock.
B) the most appropriate risk-free rate, rrf.
C) the expected rate of return on the market, rm.
D) the beta coefficient of "the market," which is the same as the beta of an average stock.
E) the market risk premium (rpm).

Question 40

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.

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. Based on the CAPM, what is the firm's cost of common stock?

A) 11.15%
B) 11.73%
C) 12.35%
D) 13.00%
E) 13.65%

Question 41

Which of the following statements is CORRECT?

A) a cost should be assigned to reinvested 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 distributed rather than retained and reinvested.
B) no cost should be assigned to reinvested 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."
C) 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.
D) if a firm has enough reinvested 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.
E) 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.

Question 42

Your consultant firm has been hired by Eco Brothers Inc. to help them estimate the cost of common equity. The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of common can be estimated using a risk premium of 3.85% over a firm's own cost of debt. What is an estimate of the firm's cost of common from reinvested earnings?

A) 12.60%
B) 13.10%
C) 13.63%
D) 14.17%
E) 14.74%

Question 43

Which of the following statements is CORRECT?

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 inputs?beta, the risk-free rate, and the market risk premium?can be estimated with little error.

Question 44

Which of the following statements is CORRECT?

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.

Question 45

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.

Question 46

Which of the following statements is CORRECT?

A) when calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.
B) because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the capm.
C) if a company's beta increases, this will increase the cost of equity used to calculate the wacc, but only if the company does not have enough reinvested earnings to take care of its equity financing and hence must issue new stock.
D) higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's wacc.
E) when calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.

Question 47

When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs.

Question 48

Which of the following statements is CORRECT?

A) the percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt.
B) 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.
C) there is an "opportunity cost" associated with using reinvested earnings, hence they are not "free."
D) 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.
E) the wacc as used in capital budgeting is an estimate of a company's before-tax cost of capital.

Question 49

Which of the following statements is CORRECT?

A) the after-tax cost of debt that should be used as the component cost when calculating the wacc is the average after-tax cost of all the firm's outstanding debt.
B) suppose some of a publicly-traded firm's stockholders are not diversified; they hold only the one firm's stock. in this case, the capm approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firm's intrinsic value.
C) the cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity.
D) the bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm's cost of equity capital.
E) the cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity.

Question 50

The cost of debt, rd, is normally less than rs, so rd(1 ? T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 ? T).

Question 51

Firm J's earnings and stock price tend to move up and down with other firms in the S&P 500, while Firm F's earnings and stock price move counter cyclically with J and other S&P companies. Both J and F 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?

A) j and f should have identical waccs because their risks as measured by the standard deviation of returns are identical.
B) if j and f merge, then the merged firm mw should have a wacc that is a simple average of j's and f's waccs.
C) without additional information, it is impossible to predict what the merged firm's wacc would be if j and f merged.
D) since j and f 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.
E) j should have the lower wacc because it is like most other companies, and investors like that fact.

Question 52

Which of the following statements is CORRECT?

A) 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.
B) the cost of new equity (re) could possibly be lower than the cost of reinvested earnings (rs) if the market risk premium, risk-free rate, and the company's beta all decline by a sufficiently large amount.
C) a firm's cost of reinvesting earnings is the rate of return stockholders require on a firm's common stock.
D) 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.
E) 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.

Question 53

Which of the following statements is CORRECT?

A) if the calculated beta underestimates the firm's true investment risk?i.e., if the forward-looking beta that investors think exists exceeds the historical beta?then the capm method based on the historical beta will produce an estimate of rs and thus wacc that is too high.
B) beta measures market risk, which is, theoretically, the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. this is true even if not all of the firm's stockholders are well diversified.
C) an advantage shared by both the dividend growth model and capm methods when they are used to estimate the cost of equity is that they are both "objective" as opposed to "subjective," hence little or no judgment is required.
D) the specific risk premium used in the capm is the same as the risk premium used in the bond-yield-plus-risk-premium approach.
E) the discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever.

Question 54

Which of the following statements is CORRECT?

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 55

Which of the following statements is CORRECT?

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 56

Which of the following statements is CORRECT?

A) the tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes.
B) if a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.
C) because no flotation costs are required to obtain capital as reinvested earnings, the cost of reinvested earnings is generally lower than the after-tax cost of debt.
D) higher flotation costs tend to reduce the cost of equity capital.
E) since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.

Question 57

For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure.

A) re > rs > wacc > rd.
B) wacc > re > rs > rd.
C) rd > re > rs > wacc.
D) wacc > rd > rs > re.
E) rs > re > rd > wacc.

Question 58

Which of the following statements is CORRECT? Assume a company's target capital structure is 50% debt and 50% common equity.

A) the wacc is calculated on a before-tax basis.
B) the wacc exceeds the cost of equity.
C) the cost of equity is always equal to or greater than the cost of debt.
D) the cost of reinvested earnings typically exceeds the cost of new common stock.
E) the interest rate used to calculate the wacc is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet.

Question 59

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?

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

Question 60

Which of the following statements is CORRECT?

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

Question 61

If the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common stock (re) is equal to the cost of equity capital from retaining earnings (rs) divided by one minus the percentage flotation cost required to sell the new stock, (1 ? F). If the expected growth rate is not zero, then the cost of external equity must be found using a different formula.

Question 62

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.

Question 63

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?

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

Question 64

Assume that you are an intern with the Brayton Company, and you have collected the following data: The yield on the company's outstanding bonds is 7.75%; its tax rate is 40%; the next expected dividend is $0.65 a share; the dividend is expected to grow at a constant rate of 6.00% a year; the price of the stock is $15.00 per share; the flotation cost for selling new shares is F = 10%; and the target capital structure is 45% debt and 55% common equity. What is the firm's WACC, assuming it must issue new stock to finance its capital budget?

A) 6.89%
B) 7.26%
C) 7.64%
D) 8.04%
E) 8.44%

Question 65

You have been hired by the CFO of Lugones Industries to help estimate its cost of common equity. You have obtained the following data: (1) rd = yield on the firm's bonds = 7.00% and the risk premium over its own debt cost = 4.00%. (2) rRF = 5.00%, RPM = 6.00%, and b = 1.25. (3) D1 = $1.20, P0 = $35.00, and gL = 8.00% (constant). You were asked to estimate the cost of common based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates. What is that difference?

A) 1.13%
B) 1.50%
C) 1.88%
D) 2.34%
E) 2.58%

Question 66

You were recently hired by Garrett Design, Inc. to estimate its cost of common equity. You obtained the following data: D1 = $1.75; P0 = $42.50; gL = 7.00% (constant); and F = 5.00%. What is the cost of equity raised by selling new common stock?

A) 10.77%
B) 11.33%
C) 11.90%
D) 12.50%
E) 13.12%

Question 67

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.

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. Which of the following is the best estimate for the weight of debt for use in calculating the firm's WACC?

A) 18.67%
B) 19.60%
C) 20.58%
D) 21.61%
E) 22.69%

Question 68

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?

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

Question 69

As the winner of a contest, you are now CFO for the day for Maguire Inc. and your day's job involves raising capital for expansion. Maguire's common stock currently sells for $45.00 per share, the company expects to earn $2.75 per share during the current year, its expected payout ratio is 70%, and its expected constant growth rate is 6.00%. New stock can be sold to the public at the current price, but a flotation cost of 8% would be incurred. By how much would the cost of new stock exceed the cost of common from reinvested earnings?

A) 0.09%
B) 0.19%
C) 0.37%
D) 0.56%
E) 0.84%

Question 70

To estimate the company's WACC, Marshall Inc. recently hired you as a consultant. You have obtained the following information. (1) The firm's noncallable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $1,000, and a market price of $1,050.00. (2) The company's tax rate is 40%. (3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock's beta is 1.20. (4) The target capital structure consists of 35% debt and the balance is common equity. The firm uses the CAPM to estimate the cost of common stock, and it does not expect to issue any new shares. What is its WACC?

A) 7.16%
B) 7.54%
C) 7.93%
D) 8.35%
E) 8.79%

Question 71

The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 ? F)."

Question 72

Trahern Baking Co. common stock sells for $32.50 per share. It expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, and its expected constant dividend growth rate is 6.0%. New stock can be sold to the public at the current price, but a flotation cost of 5% would be incurred. What would be the cost of equity from new common stock?

A) 12.70%
B) 13.37%
C) 14.04%
D) 14.74%
E) 15.48%

Question 73

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. 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.

Question 74

Avery Corporation's target capital structure is 35% debt, 10% preferred, and 55% common equity. The interest rate on new debt is 6.50%, the yield on the preferred is 6.00%, the cost of common from reinvested earnings is 11.25%, and the tax rate is 40%. The firm will not be issuing any new common stock. What is Avery's WACC?

A) 8.15%
B) 8.48%
C) 8.82%
D) 9.17%
E) 9.54%

Question 75

The president and CFO of Spellman Transportation are having a disagreement about whether to use market value or book value weights in calculating the WACC. Spellman's balance sheet shows a total of noncallable $45 million long-term debt with a coupon rate of 7.00% and a yield to maturity of 6.00%. This debt currently has a market value of $50 million. The company has 10 million shares of common stock, and the book value of the common equity (common stock plus retained earnings) is $65 million. The current stock price is $22.50 per share; stockholders' required return, rs, is 14.00%; and the firm's tax rate is 40%. The CFO thinks the WACC should be based on market value weights, but the president thinks book weights are more appropriate. What is the difference between these two WACCs?

A) 1.55%
B) 1.72%
C) 1.91%
D) 2.13%
E) 2.36%

Question 76

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?

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

Question 77

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.

Question 78

Which of the following statements is CORRECT?

A) all else equal, an increase in a company's stock price will increase its marginal cost of reinvested earnings (not newly issued stock), rs.
B) all else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re.
C) since the money is readily available, the after-tax cost of reinvested earnings (not newly issued stock) is usually much lower than the after-tax cost of debt.
D) if a company's tax rate increases but the ytm on its noncallable bonds remains the same, the after-tax cost of its debt will fall.
E) when calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation.

Question 79

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.

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 firm's WACC?

A) 10.85%
B) 11.19%
C) 11.53%
D) 11.88%
E) 12.24%

Question 80

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 reinvested earnings, whose cost is the average return on the assets that are acquired.