Question 1

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

Accepted Answer

A) True 
 B)False

Question 2

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 25%.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)   7.53%
B)   7.85%
C)   8.18%
D)   8.50%
E)   8.84%F) C) and D)
G) A) and E)

Question 3

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 bal ance sheet and some other in formation are provided below.
  Assets  Current assets $38,000,000 Net plant, property, and equipment 101,000,000 Total assets $139,000,000 Liabilities and Equity  Accounts payable $10,000,000 Accruals 9,000,000 Current liabilities $19,000,000 Long-term debt ( 40,000 bonds, $1,000 par value)  40,000,000 Total liabilities $59,000,000 Common stock (10,000,000 shares)  30,000,000 Retained earnings 50,000,000 Total shareholders’ equity $0,000,000 Total liabilities and shareholders’ equity $139,000,000\begin{array}{lr}	ext { Assets } \	ext { Current assets } & \$ 38,000,000 \	ext { Net plant, property, and equipment } & 101,000,000 \	ext { Total assets } & \$ 139,000,000\\	ext { Liabilities and Equity }\	ext { Accounts payable } & \$ 10,000,000 \	ext { Accruals } & 9,000,000 \	ext { Current liabilities } & \$ 19,000,000 \	ext { Long-term debt ( } 40,000 	ext { bonds, } \$ 1,000 	ext { par value)  } & 40,000,000 \	ext { Total liabilities } & \$ 59,000,000 \	ext { Common stock (10,000,000 shares)  } & 30,000,000 \	ext { Retained earnings } & 50,000,000 \	ext { Total shareholders&#x27; equity } & \$ 0,000,000 \	ext { Total liabilities and shareholders&#x27; equity } & \$ 139,000,000\end{array} Assets  Current assets  Net plant, property, and equipment  Total assets  Liabilities and Equity  Accounts payable  Accruals  Current liabilities  Long-term debt ( 40,000 bonds, $1,000 par value)   Total liabilities  Common stock (10,000,000 shares)   Retained earnings  Total shareholders’ equity  Total liabilities and shareholders’ equity ​$38,000,000101,000,000$139,000,000$10,000,0009,000,000$19,000,00040,000,000$59,000,00030,000,00050,000,000$0,000,000$139,000,000​ 
 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 25%.
-Refer to the data for the Collins Group.Based on the CAPM, what is the firm's cost of common stock?

Accepted Answer

A)   11.15%
B)   11.73%
C)   12.35%
D)   13.00%
E)   13.65% F) D) and E)
G) All of the above

Question 4

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) B) and E)
G) None of the above

Question 5

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.

Accepted Answer

A) True 
 B)False

Question 6

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 25%.What is the component cost of debt for use in the WACC calculation?

Accepted Answer

A)   5.35%
B)   5.58%
C)   5.81%
D)   6.04%
E)   6.28%F) C) and E)
G) A) and C)

Question 7

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) C) and E)
G) A) and E)

Question 8

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 25%.The firm will not be issuing any new common stock.What is Avery's WACC?

Accepted Answer

A)   8.49%
B)   8.83%
C)   9.19%
D)   9.55%
E)   9.94%F) B) and E)
G) B) and D)

Question 9

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?

Accepted Answer

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

Question 10

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 25%, but Congress is considering a change in the corporate tax rate to 15%.By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted?

Accepted Answer

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

Question 11

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 25%; 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)   7.34%
B)   7.73%
C)   8.14%
D)   8.56%
E)   8.99%F) C) and D)
G) A) and C)

Question 12

Weatherall Enterprises has no 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?

Accepted Answer

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

Question 13

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

Accepted Answer

A) True 
 B)False

Question 14

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?

Accepted Answer

A)   −1.49%
B)   −1.66%
C)   −1.84%
D)   −2.03%
E)   −2.23%F) A) and B)
G) None of the above

Question 15

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) None of the above
G) C) and E)

Question 16

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) B) and E)
G) C) and D)

Question 17

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) None of the above
G) B) and C)

Question 18

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 50% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

Accepted Answer

A) True 
 B)False

Question 19

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.

Accepted Answer

A) True 
 B)False

Question 20

Which of the following statements is CORRECT?

Accepted Answer

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 required return on debt used in calculating a firm's WACC should be based on the debt's current required return even if it is higher than the debt's coupon rate.
E)   The WACC is calculated using before-tax costs for all components.F) A) and B)
G) None of the above

Exam 9: The Cost of Capital

Which of the following statements is CORRECT?

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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The cost of preferred stock to a firm must be adjusted to an after-tax figure because 50% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

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

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Which of the following statements is CORRECT?

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

Correct Answer
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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 g_L = 6.50% (constant) .Based on the dividend growth approach, what is the cost of common from reinvested earnings?

Correct Answer
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Correct Answer
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Exam 9: The Cost of Capital

Which of the following statements is CORRECT?

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

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 50% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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

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

Correct AnswerverifiedShow Answer

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?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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Correct Answer
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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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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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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 g_L = 6.50% (constant) .Based on the dividend growth approach, what is the cost of common from reinvested earnings?

Correct Answer
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Correct Answer
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