Deck 11: Cost of Capital

Question 1

Use of the marginal cost of capital:

A) acknowledges that when retained earnings is used up as a source of equity the cost of capital lowers as new common stock is sold to support more growth.
B) recognizes that the return from the last dollar of funds generated should be less than the cost of the last dollar of funds raised.
C) acknowledges that when retained earnings is used up as a source of equity the cost of capital rises as new common stock is sold to support more growth.
D) recognizes that the return from the last dollar of funds generated should be more than the cost of the last dollar of funds raised.

Answer 1

C

Question 2

The overall weighted average cost of capital is used instead of costs for specific sources of funds because:

A) use of the cost for specific sources of capital would make investment decisions consistent.
B) it is the minimum point for the firms cost of capital given the current equity mix.
C) investments funded by low cost debt would have a disadvantage over other investments.
D) a project with the lowest return would always be accepted under the specific cost criteria.

Answer 2

B

Question 3

For a firm paying 7% for new debt,the higher the firm's tax rate:

A) the higher the after tax cost of debt.
B) the lower the after tax cost of debt.
C) after tax cost is unchanged.
D) Not enough information to judge.

Answer 3

B

Question 4

In determining the cost of retained earnings:

A) the dividend valuation model is inappropriate.
B) flotation costs are included.
C) growth is not considered.
D) the capital asset pricing model can be used.

Question 5

Each project should be judged against:

A) the specific means of financing used to support its implementation.
B) the going interest rate at that point in time.
C) the cost of new common stock equity.
D) the risk and return to the shareholder.

Question 6

Although debt financing is usually the cheapest component of capital,it cannot be used to excess because:

A) interest rates may change.
B) the firm's share price will increase and raise the cost of equity financing.
C) the financial risk of the firm may increase and thus drive up the cost of all sources of financing.
D) underwriting costs may change.

Question 7

Within the capital asset pricing model:

A) the risk-free rate is usually higher than the return in the market.
B) the higher the beta the lower the required rate of return.
C) beta measures the volatility of an individual stock relative to a stock market index.
D) beta is added to the market risk free rate.

Question 8

Using the constant dividend growth model for common stock,if P_o goes up:

A) the assumed cost goes up.
B) the assumed cost goes down.
C) the assumed cost remains unchanged.
D) Need further information.

Question 9

A firm in a cyclical industry should use:

A) a large amount of debt to lower the cost of capital.
B) no debt at all.
C) preferred stock in place of debt.
D) a limited amount of debt to lower the cost of capital.

Question 10

Expected cash dividends are $2.50,the dividend yield is 6%,flotation costs are 4%,and the growth rate is 3%.Compute cost of the new common stock.

A) 9.00%
B) 9.25%
C) 9.18%
D) 9.38%

Question 11

Marginal cost of capital:

A) recognizes that cost of capital does not stay constant as more funds are raised.
B) usually provides the same capital budgeting choices as the use of weighted average cost of capital.
C) can be defined as the cost of capital when no retained earnings are available for expansion.
D) assumes an increasing cost of equity.

Question 12

The cost of debt is determined by taking the:

A) present value of the interest payments and principal times one minus the tax rate.
B) historical yield on bonds times one minus the tax rate.
C) estimated yield on new bond issues of the same risk times one minus the shareholder marginal tax rate.
D) yield and subtracting the tax rate.

Question 13

The after tax cost of preferred stock to the issuing corporation:

A) is the same as the before-tax cost.
B) is usually lower than the cost of debt.
C) is dependent on the firm's tax bracket.
D) is determined by the dividend payment.

Question 14

If a firm's bonds are currently yielding 8% in the marketplace,why would the firm's cost of debt be lower?

A) Interest rates have changed.
B) Additional debt can be issued more cheaply than the original debt.
C) There should be no difference; cost of debt is the same as the bond's market yield.
D) Interest is tax-deductible.

Question 15

The cost of capital is used as a discount rate because:

A) it is an indication of how much the firm is earning overall.
B) as long as the cost of capital is earned,the common stock value of the firm will be maintained.
C) it is comparable to the prevailing market interest rates.
D) returns below the cost of capital will cover all fixed costs associated with capital and provide an excess return to shareholders.

Question 16

Which is not true about debt financing and the weighted average cost of capital?

A) Debt is usually the cheapest source of financing
B) As the level of debt increases beyond the optimum capital structure,the cost of capital increases
C) No debt in the firm's capital structure will minimize the firm's weighted-average cost of capital
D) The cost of debt and the weighted average cost of capital both go down as the tax rate goes up.

Question 17

The pre-tax cost of debt for a new issue of debt is determined by:

A) the investor's required rate of return on issued stock.
B) the coupon rate of existing debt.
C) the yield to maturity of outstanding bonds.
D) the coupon rate of potential bonds.

Question 18

The component parts of the cost of capital should be weighted by their proportion in the firm's:

A) current capital structure.
B) historical capital structure.
C) optimum capital structure.
D) expected capital structure.

Question 19

New common stock is more expensive than k_e:

A) to compensate for risk.
B) to compensate for more dividends.
C) to compensate for expansionary problems.
D) to cover distribution costs.

Question 20

A firm's debt to equity ratio varies at times because:

A) a firm will want to sell common stock when prices are low and bond when interest rates are high.
B) a firm will want to take advantage of timing its fund raising in order to maximize costs over the long run.
C) the market allows no leeway in the debt to equity ratio before penalizing the firm with a higher cost of capital.
D) a company will sell bonds when interest rates are low and stock prices are high.

Question 21

A firm's stock is selling for $85.The dividend yield is 5%.A 7% growth rate is expected for the common stock.The firm's tax rate is 32%.What is the firm's cost of common equity?

A) 8.16%
B) 12.00%
C) 12.35%
D) 10.40%

Question 22

The general rule for using the weighted average cost of capital (WACC)in capital budgeting decisions is accept all projects with:

A) rates of return greater than or equal to the WACC.
B) rates of return less than the WACC.
C) rates of return equal to or less than the WACC.
D) positive rates of return.

Question 23

The cost of equity capital in the form of new common stock will be higher than the cost of retained earnings because of:

A) the existence of taxes.
B) the existence of flotation costs.
C) investors' unwillingness to purchase additional shares of common stock.
D) the existence of financial leverage.

Question 24

There may be a change in the marginal cost of capital curve because:

A) the tax rate charged to investors changes.
B) the firm has exhausted its supply of retained earnings.
C) the firm is limited in the amount of amortization it can take.
D) the firm has invested in a new project.

Question 25

The coupon rate on an issue of debt is 12%.The yield to maturity on this issue is 14%.The corporate tax rate is 31%.What would be the approximate after tax cost of debt for a new issue of bonds?

A) 4.34%
B) 3.72%
C) 9.66%
D) 8.28%

Question 26

The weighted average cost of capital for firm X is currently 10%.Firm X is considering a new project but must raise new debt to finance the project.Debt represents 25% of the capital structure.If the after tax cost of debt will rise from 7% to 8%,what is the marginal cost of capital?

A) 8.00%
B) 10.25%
C) 10.75%
D) 12.00%

Question 27

A firm's cost of financing,in an overall sense,is equal to its:

A) weighted average cost of capital.
B) yield from various kinds of marketable securities.
C) rate of return from various kinds of marketable securities.
D) rate of return of debt required by its investors.

Question 28

A firm's stock is selling for $78.The next annual dividend is expected to be $2.34.The growth rate is 9%.The flotation cost is $5.00.What is the cost of retained earnings?

A) 12.82%
B) 12.21%
C) 12.00%
D) 9.41%

Question 29

A firm can issue $1,000 par value bond that pays $100 per year in interest at a price of $980.The bond will have a 5-year life.The firm is in a 35% tax bracket.What is the after tax cost of debt?

A) 10.53%
B) 10.20%
C) 6.85%
D) 6.50%

Question 30

For many firms,the cheapest and most important source of equity capital is in the form of:

A) debt.
B) common stock.
C) preferred stock.
D) retained earnings.

Question 31

The optimal capital structure for firms in cyclical industries should contain ________________ than firms in stable industries.

A) more debt
B) less debt
C) an equal amount of debt
D) There is no relationship between the cyclical nature of an industry and optimal capital structure.

Question 32

Most firms are able to use _________ percent debt in their capital structure without exceeding norms acceptable to creditors and investors.

A) 20-50
B) 30-60
C) 40-70
D) 50-80

Question 33

The Halifax Corporation has 70% of its capital structure in the form of equity capital.$150,000 in capital needs to be raised for a project but only $30,000 in funds is available through retained earnings.How much must be raised through common stock to maintain Halifax Corporation's capital structure?

A) $105,000
B) $75,000
C) $120,000
D) $21,000

Question 34

If the flotation cost goes up,the cost of retained earnings will:

A) go up.
B) go down.
C) stay the same.
D) slowly increase.

Question 35

The coupon rate on a debt issue is 12%.If the yield to maturity on the debt is 9.33%,what is the after tax cost of debt (for a cost of capital calculation)if the firm's tax rate is 34%?

A) 3.17%
B) 4.08%
C) 6.16%
D) 7.92%

Question 36

The after tax cost of debt will usually be below:

A) the cost of dividends.
B) the weighted average cost of capital less the cost of equity.
C) the cost of equity.
D) the floatation cost.

Question 37

A firm is paying an annual dividend of $3.63 for its preferred stock which is selling for $62.70.There is a selling cost of $3.30.What is the after tax cost of preferred stock if the firm's tax rate is 33%?

A) 2.02%
B) 4.09%
C) 5.79%
D) 6.11%

Question 38

In computing the cost of common equity,if D₁ goes downward and P_o goes up,K_e will:

A) go up.
B) go down.
C) stay the same.
D) slowly increase.

Question 39

Firm X has a tax rate of 30%.The price of its new preferred stock is $63 and its flotation cost is $3.15.The cost of new preferred stock is 12%.What is the firm's dividend?

A) $7.18
B) $5.03
C) $7.56
D) $6.30

Question 40

Financial capital does not include:

A) common equity capital.
B) bonds.
C) preferred shares.
D) working capital.

Question 41

The risk-free rate of interest:

A) is independent of market rates of returns on short-term securities.
B) can be thought of as a real rate of interest on a short-term riskless government security.
C) is influenced by the treasury bill's beta.
D) is calculated by multiplying the market rate of risk by beta.

Question 42

The Security Market Line (SML):

A) shows the relationship between a stock return and the market return but ignores risk.
B) shows the relationship between risk and return.
C) uses the AAA corporate bond rate for a riskless rate of return.
D) shows the market risk relative to the industry risk.

Question 43

As investors become more pessimistic (risk averse):

A) they require smaller premiums for taking risk.
B) they require larger betas for taking risk.
C) prices of securities fall in order to raise their expected rate of return.
D) they invest in a portfolio with a high beta.

Question 44

In the Net Operating Income approach to cost-of-capital analysis,a firm's value depends on:

A) its net operating income.
B) its use of debt.
C) size of the firm.
D) retained earnings as a proportion of debt.

Question 45

Modigliani and Miller's analysis of the tax deductible nature of debt suggested that firm value would:

A) decrease as the firm's use of debt increased.
B) increase as the firm's use of debt increased.
C) be unrelated to the firm's use of debt.
D) be unrelated to earnings before taxes and interest on the firm's debt.

Question 46

In the equation K_j = R_f + ß_j (R_m - R_f):

A) R_f is the return expected in the future.
B) R_f is the return expected on a corporate AAA bond.
C) R_f is the risk free rate of interest represented by a Canadian government treasury bill.
D) R_f is a risk premium expected over the market return.

Question 47

In the equation K_j = α + ß_j R_m + e:

A) beta (ß)is a stock's measure of volatility (risk)relative to the market.
B) beta is the stock's expected return.
C) beta is the market's adjusted return.
D) beta is an accurate predictor of one stock's future risk.

Question 48

Retained earnings has a cost associated with it because:

A) new funds must be raised.
B) there is an opportunity cost associated with shareholder funds.
C) K_e > g.
D) flotation costs increase the cost of funding.

Question 49

Under the traditional approach to cost-of-capital analysis,a firm's value:

A) remains the same,regardless of the amount of debt used.
B) increases as more debt is used.
C) decreases as more debt is used.
D) is at its maximum when the weighted average cost of capital is minimized.

Question 50

Why is the cost of debt normally lower than the cost of preferred shares?

A) Preferred share dividends are tax deductible.
B) Interest is tax deductible.
C) Preferred share dividends must be paid before common share dividends.
D) Common share dividends are not tax deductible.

Question 51

A reduction in the willingness of investors to take on risk would have what effect on the Security Market Line (CAPM)?

A) No effect
B) Rotate the SML counter clockwise around the risk-free rate
C) Rotate the SML clockwise around the risk-free rate
D) Shift the SML upward,parallel to its previous location

Question 52

The capital asset pricing model:

A) expresses a linear relationship between returns on individual stocks and the market over time.
B) can be used to examine common stock returns but not the risk of the stock.
C) is not very useful because it is unrealistically a linear model.
D) is a linear model used to evaluate risk free rate.

Question 53

According to the original approach of Modigliani and Miller (M&M),a firm's value is:

A) unaffected by its capital structure.
B) positively related to its use of debt.
C) negatively related to its use of debt.
D) positively related to its use of debt,but only up to some maximum debt/equity mix.

Question 54

If the investor desires less risk than the market,he or she:

A) buys stocks with alphas of zero.
B) buys stocks with betas less than 1.0.
C) makes sure the risk-free rate is higher than the expected market return.
D) buys stocks only when the slope of the security market line is on a 45 degree angle.

Question 55

When both the tax deductibility of debt and the present value of potential bankruptcy costs are included,the cost of capital for a firm tends to:

A) be constant regardless of the level of debt usage.
B) decrease as the level of debt increases.
C) increase as the level of debt increases.
D) decrease up to some debt-value ratio,then increase as bankruptcy costs become significant.

Question 56

Analysis of returns using the SML would indicate that:

A) as betas increase,the expected return decreases.
B) the required return for all securities can be expressed as the risk free rate minus a premium for risk.
C) if beta is positive a negative correlation exists between market risk and the risk free rate.
D) if the beta is 2.0,twice the market risk premium must be earned.

Question 57

In the equation K_j = R_f + ß_j (R_m - R_f):

A) beta (ß_j)is the stock's measure of volatility relative to the company's historical volatility.
B) R_m - R_f is the dollar discount on the market rate.
C) K_j is the expected volatility of company j.
D) ß_j (R_m - R_f)is the expected return above the risk-free rate for the stock of company j.

Question 58

Each project should be judged against:

A) the specific means of financing used to support its implementation.
B) the going interest rate at that point in time.
C) the cost of new common stock equity.
D) the weighted average cost of capital.

Question 59

The difference between the return on the market and the risk-free return in the Capital Asset Pricing Model is known:

A) as the market return.
B) as the market risk premium.
C) as the risk-free rate of return.
D) as the security market return.

Question 60

The required rate of return for a stock which has 1.5 times the risk of the market in general will be:

A) 1.5 times the risk-free rate.
B) 1.5 times the market rate of return.
C) 1.5 times the market risk premium,plus the risk-free rate.
D) 1.5 times the risk-free rate,plus the market risk premium.

Question 61

In determining the cost of preferred stock,the dividend yield on outstanding preferred stock may be used as a proxy.

Question 62

For a firm paying 7% for new debt,the lower the firm's tax rate:

A) the higher the after tax cost of debt.
B) the lower the after tax cost of debt.
C) after tax cost is unchanged.
D) not enough information to judge.

Question 63

According to traditional financial theory,the cost of capital curve is U-shaped over the range of debt-equity mixes.

Question 64

The after tax cost of preferred stock to the issuing corporation:

A) is lower than the before-tax cost.
B) is usually lower than the cost of debt.
C) is dependent on the firm's tax bracket.
D) is the same as the before -tax cost.

Question 65

A firm's bond have a coupon rate of 8.80%.They currently have a yield-to-maturity of 9.75%.if the firm's tax rate is 25%,its after-tax cost of debt is _______.

A) 9.75%
B) 2.44%
C) 7.31%
D) 8.80%

Question 66

Figs,Dates and Other Things (FDT)has the following cost of capital structure: $$\begin{array} { | l | c | c | } \hline & \text { Weight } & \text { Cost } \\\hline \text { Debt } & 45 \% & 4.50 \% \\\hline \text { Preferred Shares } & 10 \% & 5.80 \% \\\hline \text { Equity } & 45 \% & 9.20 \% \\\hline\end{array}$$ What is FDT's WACC?

A) 6.50%
B) 5.00%
C) 7.50%
D) 6.75%

Question 67

Morgan Corporation has 60% of its capital structure in the form of equity capital.$200,000 in capital needs to be raised for a project but only $50,000 in funds is available through retained earnings.How much must be raised through common stock to maintain Morgan Corporation's capital structure?

A) $70,000
B) $50,000
C) $120,000
D) $90,000

Question 68

The coupon rate on a debt issue is 13%.If the yield to maturity on the debt is 10%,what is the after tax cost of debt (for a cost of capital calculation)if the firm's tax rate is 34%?

A) 4.42%
B) 3.00%
C) 8.58%
D) 6.60%

Question 69

Expected cash dividends are $4.50,the dividend yield is 8%,flotation costs are 5%,and the growth rate is 4%.Compute cost of the new common stock.

A) 13.00%
B) 12.63%
C) 8.42%
D) 4.21%

Question 70

A firm's debt to equity ratio varies at times because:

A) a firm will want to sell common stock when prices are low and bond when interest rates are high.
B) a firm will want to take advantage of timing its fund raising in order to minimize costs over the long run.
C) the market allows extensive leeway in the debt to equity ratio before penalizing the firm with a higher cost of capital.
D) of the cyclical nature of the industry in which the firm operates.

Question 71

The cost of new common stock is greater than the cost of outstanding common stock.

Question 72

A firm is paying an annual dividend of $2.50 for its preferred stock which is selling for $50.00.There is a selling cost of $4.00.What is the after tax cost of preferred stock if the firm's tax rate is 33%?

A) 5.00%
B) 8.00%
C) 5.43%
D) 6.20%

Question 73

You have determined that a stock has a required rate of return of 18%.If the market risk premium is 10.50%,and the 91 day T-bill is yielding 2.50%,what is the stock's Beta?

A) 1.00
B) 2.00
C) 1.48
D) 0.95

Question 74

Wonder Warp Corp.(WWC)recently reported that is after-tax cost of debt capital was 6.50%.If WWC's average tax rate is 30% what is the yield-to-maturity on WWC's bonds?

A) 6.90%
B) 8.97%
C) 9.30%
D) 21.67%

Question 75

In determining the cost of debt,yields and prices of outstanding bonds are used.

Question 76

Use of the marginal cost of capital:

A) acknowledges that when retained earnings is used up as a source of equity the cost of capital decreases as new common stock is sold to support more growth.
B) recognizes that the return from the last dollar of funds generated should be less than the cost of the last dollar of funds raised.
C) is highly dependent on the investment opportunities available to the firm.
D) is the cost of borrowing privately.

Question 77

A firm can issue $1,000 par value bond that pays $90 per year in interest at a price of $950.The bond will have a 10-year life.The firm is in a 35% tax bracket.What is the after tax cost of debt?

A) 9.81%
B) 10.20%
C) 6.37%
D) 6.50%

Question 78

It is standard practice to evaluate investment decisions using the cost of the specific financing method involved.

Question 79

The weighted average cost of capital for Patrick Corp.is currently 10%.Patrick Corp.is considering a new project but must raise new debt to finance the project.Debt represents 25% of the capital structure.If the after tax cost of debt will rise from 6% to 10%,what is the marginal cost of capital?

A) 10.25%
B) 10.75%
C) 11.00%
D) 11.50%

Question 80

Micro Brew (MB)is considering issuing new common stock.MB currently trades at $32.50 a share and MB's investment bankers estimate that it will cost $2.30 a share to issue new common stock.What is MB's estimated cost of new common shares,if the firm's cost of retained earnings is 12.01%?

A) 8.50%
B) 12.25%
C) 13.02%
D) 15.00%