Question 1

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?

Accepted Answer

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

Question 2

Which of the following statements is CORRECT?

Accepted Answer

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.F) None of the above
G) A) and C)

Question 3

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?

Accepted Answer

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

Question 4

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.

Accepted Answer

A) True 
 B)False

Question 5

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

Accepted Answer

A) True 
 B)False

Question 6

Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely

Accepted Answer

A)   become less risky over time, and this will maximize its intrinsic value.
B)   accept too many low-risk projects and too few high-risk projects.
C)   become more risky and also have an increasing WACC. Its intrinsic value will not be maximized.
D)   continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital.
E)   become riskier over time, but its intrinsic value will be maximized.F) All of the above
G) B) and C)

Question 7

Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.

Accepted Answer

A)   If a firm's managers want to maximize the value of their firm's stock, they should, in theory, concentrate on project risk as measured by the standard deviation of the project's expected future cash flows.
B)   If a firm evaluates all projects using the same cost of capital, and the CAPM is used to help determine that cost, then its risk as measured by beta will probably decline over time.
C)   Projects with above-average risk typically have higher than average expected returns. Therefore, to maximize a firm's intrinsic value, its managers should favor high-beta projects over those with lower betas.
D)   Project A has a standard deviation of expected returns of 20%, while Project B's standard deviation is only 10%. A's returns are negatively correlated with both the firm's other assets and the returns on most stocks in the economy, while B's returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital.
E)   If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms' assets.F) C) and D)
G) C) and E)

Question 8

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

Accepted Answer

A) True 
 B)False

Question 9

Which of the following statements is CORRECT?

Accepted Answer

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.F) None of the above
G) A) and E)

Question 10

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

Accepted Answer

A)   Accounts payable.
B)   Common stock "raised" by reinvesting earnings.
C)   Common stock raised by new issues.
D)   Preferred stock.
E)   Long-term debt.F) B) and E)
G) C) and E)

Question 11

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?

Accepted Answer

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

Question 12

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?

Accepted Answer

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

Question 13

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.

Accepted Answer

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.F) B) and C)
G) C) and D)

Question 14

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).

Accepted Answer

A) True 
 B)False

Question 15

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.

Accepted Answer

A) True 
 B)False

Question 16

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?

Accepted Answer

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

Question 17

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.

Accepted Answer

A) True 
 B)False

Question 18

Which of the following statements is CORRECT?

Accepted Answer

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

Question 19

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

Accepted Answer

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

Question 20

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.

Accepted Answer

A) True 
 B)False

Exam 9: The Cost of Capital

Correct Answer
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The cost of debt, r_d, is normally less than r_s, so r_d(1 − T) will normally be much less than r_s. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than r_d(1 − T).

Correct Answer
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Correct Answer
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Correct Answer
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Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.

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

Correct Answer
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Correct Answer
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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.

Correct Answer
verified

Which of the following statements is CORRECT?

Correct Answer
verified

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.

Correct Answer
verified

Correct Answer
verified

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.

Correct Answer
verified

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.

Correct Answer
verified

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; g_L = 7.00% (constant) ; and F = 5.00%. What is the cost of equity raised by selling new common stock?

Correct Answer
verified

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.

Correct Answer
verified

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

Correct Answer
verified

Which of the following statements is CORRECT?

Correct Answer
verified

Which of the following statements is CORRECT?

Correct Answer
verified

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.

Correct Answer
verified

Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely

Correct Answer
verified

Exam 9: The Cost of Capital

Correct AnswerverifiedShow Answer

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).

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.

Correct AnswerverifiedShow Answer

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?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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.

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

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.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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.

Correct AnswerverifiedShow Answer

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.

Correct AnswerverifiedShow Answer

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?

Correct AnswerverifiedShow Answer

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.

Correct AnswerverifiedShow Answer

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

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

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.

Correct AnswerverifiedShow Answer

Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely

Correct AnswerverifiedShow Answer

Correct Answer
verified

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

Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
verified

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

Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
verified

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; g_L = 7.00% (constant) ; and F = 5.00%. What is the cost of equity raised by selling new common stock?

Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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