Question 1

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.

Accepted Answer

A) True 
 B)False

Question 2

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

Accepted Answer

A) True 
 B)False

Question 3

Which of the following statements is CORRECT?

Accepted Answer

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.F) A) and B)
G) A) and C)

Question 4

Bloom and Co. has 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?

Accepted Answer

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.F) B) and C)
G) All of the above

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.

Accepted Answer

A) True 
 B)False

Question 6

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%F) B) and C)
G) A) and E) C

Question 7

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 8

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?

Accepted Answer

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

Question 9

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.F) A) and E)
G) C) and D)

Question 10

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

Accepted Answer

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

Question 11

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%F) B) and E)
G) D) and E) E

Question 12

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?

Accepted Answer

A)   11.30%
B)   11.64%
C)   11.99%
D)   12.35%
E)   12.72%F) All of the above
G) A) and D) A

Question 13

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.F) All of the above
G) A) and E)

Question 14

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?

Accepted Answer

A)   4.28%
B)   4.46%
C)   4.65%
D)   4.83%
E)   5.03%F) None of the above
G) All of the above

Question 15

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.

Accepted Answer

A) True 
 B)False

Question 16

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?

Accepted Answer

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

Question 17

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?

Accepted Answer

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

Question 18

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

Accepted Answer

A) True 
 B)False

Question 19

Careco Company and Audaco Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Careco having a WACC of 10% and Audaco a WACC of 12%. Careco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Careco project. Audaco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Audaco project. Now assume that the two companies merge and form a new company, Careco/Audaco Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is CORRECT?

Accepted Answer

A)   If evaluated using the correct post-merger WACC, Project X would have a negative NPV.
B)   After the merger, Careco/Audaco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y.
C)   Careco/Audaco's WACC, as a result of the merger, would be 10%.
D)   After the merger, Careco/Audaco should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%.
E)   If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.F) B) and E)
G) B) and C)

Question 20

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%F) All of the above
G) C) and D)

Exam 9: The Cost of Capital

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.

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

Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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Correct Answer
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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.

Correct Answer
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Correct Answer
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C

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 r_s.

Correct Answer
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Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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Correct Answer
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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: r_RF = 4.10%; RP_M = 5.25%; and b = 1.30. Based on the CAPM approach, what is the cost of common from reinvested earnings?

Correct Answer
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E

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

Correct Answer
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A

Which of the following statements is CORRECT?

Correct Answer
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Correct Answer
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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.

Correct Answer
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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?

Correct Answer
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Correct Answer
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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.

Correct Answer
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Correct Answer
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Exam 9: The Cost of Capital

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.

Correct AnswerverifiedShow Answer

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

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedC

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.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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?

Correct AnswerverifiedE

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?

Correct AnswerverifiedA

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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.

Correct AnswerverifiedShow Answer

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?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct Answer
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C

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 r_s.

Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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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: r_RF = 4.10%; RP_M = 5.25%; and b = 1.30. Based on the CAPM approach, what is the cost of common from reinvested earnings?

Correct Answer
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E

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

Correct Answer
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A

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