Deck 10: Cost of Capital

Question 1

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.

Answer 1

False

Question 2

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.

Answer 2

False

Question 3

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.

Answer 3

True

Question 4

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 5

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

Question 6

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 7

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 8

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

Question 9

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 10

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 11

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 12

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

Question 13

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 14

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

Question 15

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 16

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 17

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 distribute those earnings to its investors Thus, the cost of retained earnings is based on the opportunity cost principle.

Question 18

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 19

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

Question 20

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

Question 21

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 22

its current financial policies, Flagstaff Incwill have to issue new common stock to fund its capital budget Since new stock has a higher cost than retained earnings, Flagstaff would like to avoid issuing new stock Which of the following actions would REDUCE its need to issue new common stock?

A) Increase the percentage of debt in the target capital structure.
B) Increase the proposed capital budget.
C) Reduce the amount of short-term bank debt in order to increase the current ratio.
D) Reduce the percentage of debt in the target capital structure.
E) Increase the dividend payout ratio for the upcoming year.

Question 23

Perpetual preferred stock from Franklin Incsells 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 24

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.

Question 25

estimating the cost of equity by use of the DCF 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 26

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 27

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 g = 6.50% (constant) Based on the DCF approach, what is the cost of common from retained earnings?

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

Question 28

Taylor Incestimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12% Which of the following projects (A, B, and C) should the company accept?

A) Project C, which is of above-average risk and has a return of 11%.
B) Project A, which is of average risk and has a return of 9%.
C) None of the projects should be accepted.
D) All of the projects should be accepted.
E) Project B, which is of below-average risk and has a return of 8.5%.

Question 29

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

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

Question 30

Bloom and Cohas no debt or preferred stock-it uses only equity capital, and has two equally-sized divisions Division X's cost of capital is 10.0%, Division Y's cost is 14.0%, and the corporate (composite) WACC is 12.0% All of Division X's projects are equally risky, as are all of Division Y's projects However, the projects of Division X are less risky than those of Division Y Which of the following projects should the firm accept?

A) A Division Y project with a 12% return.
B) A Division X project with an 11% return.
C) A Division X project with a 9% return.
D) A Division Y project with an 11% return.
E) A Division Y project with a 13% return.

Question 31

Tierney Group has two divisions of equal size: an office furniture manufacturing division and a data processing division Its CFO believes that stand-alone data processor companies typically have a WACC of 9%, while stand-alone furniture manufacturers typically have a 13% WACC She also believes that the data processing and manufacturing divisions have the same risk as their typical peers Consequently, she estimates that the composite, or corporate, WACC is 11% A consultant has suggested using a 9% hurdle rate for the data processing division and a 13% hurdle rate for the manufacturing division However, the CFO disagrees, and she has assigned an 11% WACC to all projects in both divisions Which of the following statements is CORRECT?

A) 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.
B) 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.
C) 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.
D) 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.
E) 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.

Question 32

Anderson Company has equal amounts of low-risk, average-risk, and high-risk projects The firm's overall WACC is 12% The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources If the CEO's position is accepted, what is likely to happen over time?

A) The company will take on too many low-risk projects and reject too many high-risk projects.
B) Things will generally even out over time, and, therefore, the firm's risk should remain constant over time.
C) The company's overall WACC should decrease over time because its stock price should be increasing.
D) The CEO's recommendation would maximize the firm's intrinsic value.
E) The company will take on too many high-risk projects and reject too many low-risk projects.

Question 33

Weatherall Enterprises has not debt or preferred stock-it is an all-equity firm-and has a beta of 2.0 The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment The risk-free rate is 5%, and the market risk premium is 4% The project being evaluated is riskier than an average project, in terms of both its beta risk and its total risk Which of the following statements is CORRECT?

A) The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return.
B) Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment.
C) The accept/reject decision depends on the firm's risk-adjustment policy. If Weatherall's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project.
D) Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision.
E) The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.

Question 34

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).

Question 35

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) Retained earnings.
C) Common stock.
D) Preferred stock.
E) Long-term debt.

Question 36

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

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

Question 37

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 38

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 39

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 40

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 retained earnings?

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

Question 41

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 g = 7.00% (constant) Based on the DCF approach, what is the cost of common from retained earnings?

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

Question 42

Quinlan Enterprises stock trades for $52.50 per shareIt 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 retained earnings?

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

Question 43

Trahern Baking Cocommon stock sells for $32.50 per shareIt 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 44

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 structuresWhat is the sum of these three WACCs?

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

Question 45

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; g = 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 46

the winner of a contest, you are now CFO for the day for Maguire Incand your day's job involves raising capital for expansionMaguire'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 retained earnings?

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

Question 47

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 retained 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 48

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 49

were recently hired by Garrett Design, Incto estimate its cost of common equity You obtained the following data: D1 = $1.75; P0 = $42.50; g = 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 50

president and CFO of Spellman Transportation are having a disagreement about whether to use market value or book value weights in calculating the WACCSpellman'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 millionThe 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 51

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 g = 8.00% (constant) Based on the DCF approach, what is the cost of common from retained earnings?

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

Question 52

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 53

estimate the company's WACC, Marshall Increcently 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 54

consultant firm has been hired by Eco Brothers Incto 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 retained earnings?

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

Question 55

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 retained 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 capitalWhat is its WACC?

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

Question 56

CEO of Harding Media Incas asked you to help estimate its cost of common equity You have obtained the following data: D0 = $0.85; P0 = $22.00; and g = 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 DCF approach, by how much would the cost of common from retained 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 57

Westbrook's Painting Coplans 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%