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Scanlon Inc.'s CFO hired you as a consultant to help her estimate the cost of capital. You have been provided with the following data: rRF = 5.00%; RPM = 6.00%; and b = 0.90. Based on the CAPM approach, what is the cost of equity from retained earnings?


A) 9.49%
B) 9.79%
C) 10.09%
D) 10.40%

E) A) and B)
F) None of the above

Correct Answer

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LePage Co. expects to earn $2.50 per share during the current year, its expected payout ratio is 55%, its expected constant dividend growth rate is 6.0%, and its common stock currently sells for $22.50 per share. 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) 11.81%
B) 12.43%
C) 13.05%
D) 14.39%

E) None of the above
F) All of the above

Correct Answer

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Which of the following is the best estimate for the weights to be used when calculating the WACC?


A) wc = 68.2% wd = 31.8%
B) wc = 69.9% wd = 30.1%
C) wc = 71.6% wd = 28.4%
D) wc = 73.4% wd = 26.6%

E) All of the above
F) C) and D)

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For a typical firm, which of the following sequences is correct? All rates are after taxes, and assume the firm operates at its target capital structure.


A) re > rs > WACC > rd
B) rs > re > rd > WACC
C) WACC > re > rs > rd
D) rd > re > rs > WACC

E) B) and C)
F) A) and D)

Correct Answer

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What are flotation costs?


A) They are part of the capital cost calculations for all debt and equity component.
B) They are normally ignored for long-term debt.
C) They are not considered for retained earnings.

D) All of the above
E) A) and B)

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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.

A) True
B) False

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Several years ago the Pettijohn Company sold a $1,000 par value, noncallable bond that now has 15 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) 4.35%
B) 4.53%
C) 4.72%
D) 4.90%

E) A) and B)
F) All of the above

Correct Answer

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Which of the following statements is correct?


A) When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.
B) When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.
C) Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock.
D) If a company's beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence needs to issue new stock.

E) A) and C)
F) A) and D)

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Given that Firms X and Y are two separate entities, the cost of debt for X can be greater than the cost of equity for Y.

A) True
B) False

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If expectations for long-term inflation rose, but the slope of the SML remained constant, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Therefore, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt.

A) True
B) False

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If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity. However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit the shift toward debt.

A) True
B) False

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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.

A) True
B) False

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The lower the firm's tax rate, the lower will be its after-tax cost of debt and WACC, other things held constant.

A) True
B) False

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You were hired as a consultant to Quigley Company, whose target capital structure is 40% debt, 10% preferred, and 50% common equity. The interest rate on new debt is 6.50%, the yield on the preferred is 6.00%, the cost of retained earnings is 12.25%, and the tax rate is 40%. The firm will not be issuing any new stock. What is Quigley's WACC?


A) 8.29%
B) 8.62%
C) 9.32%
D) 9.69%

E) A) and D)
F) B) and D)

Correct Answer

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You have the following data: D1 = $0.80; P0 = $22.50; and g = 5.00% (constant) . Based on the DCF approach, what is the cost of equity from retained earnings?


A) 7.34%
B) 7.72%
C) 8.13%
D) 8.56%

E) None of the above
F) B) and C)

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.


A) 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.
B) If a firm's managers want to maximize the value of the stock, they should, in theory, concentrate on project risk as measured by the standard deviation of the project's expected future cash flows.
C) 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.
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) A) and D)
F) All of the above

Correct Answer

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Nelson Enterprises, an all-equity firm, has a beta of 2.0. Nelson's chief financial officer is evaluating a project with an expected return of 21%, before any risk adjustment. The risk-free rate is 7%, and the market risk premium is 6%. The project being evaluated is riskier than Nelson's 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 accepted because its expected return (before any risk adjustments) is greater than its required return.
B) The project should definitely be rejected because its expected return (before risk adjustmenT) is less than its required return.
C) 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.
D) The accept/reject decision depends on the firm's risk-adjustment policy. If Nelson's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project.

E) A) and B)
F) All of the above

Correct Answer

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A company's perpetual preferred stock currently trades at $87.50 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) 8.25%
B) 8.69%
C) 9.14%
D) 9.62%

E) A) and C)
F) B) and C)

Correct Answer

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Which of the following statements is correct?


A) The WACC is calculated using before-tax costs for all components.
B) The after-tax cost of debt usually exceeds the after-tax cost of equity.
C) Retained earnings that were generated in the past and are reflected on the firm's balance sheet are generally available to finance the firm's capital budget during the coming year.
D) The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital.

E) A) and C)
F) C) and D)

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

A) True
B) False

Correct Answer

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