Question 1

Perpetual preferred stock from Franklin Inc.sells for $97.50 per share,and it pays an $8.50 annual dividend.If the company were to sell a new preferred issue,it would incur a flotation cost of 4.00% of the price paid by investors.What is the company's cost of preferred stock for use in calculating the WACC?

Accepted Answer

A)   8.72%
B)   9.08%
C)   9.44%
D)   9.82%
E)   10.22%F) A) and D)
G) A) and C)

Question 2

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 B)
G) A) and C)

Question 3

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock.No adjustment is needed for taxes because preferred dividends,unlike interest on debt,is not deductible by the issuing firm.

Accepted Answer

A) True 
 B)False

Question 4

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

Question 5

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 D)
G) B) and D)

Question 6

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

Question 7

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.

Accepted Answer

A) True 
 B)False

Question 8

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) All of the above
G) C) and E)

Question 9

Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets.They then provide funds to their different divisions for investment in capital projects.The divisions may vary in risk,and the projects within the divisions may also vary in risk.Therefore,it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.

Accepted Answer

A) True 
 B)False

Question 10

Trahern Baking Co.common stock sells for $32.50 per share.It expects to earn $3.50 per share during the current year,its expected dividend payout ratio is 65%,and its expected constant dividend growth rate is 6.0%.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?

Accepted Answer

A)   12.70%
B)   13.37%
C)   14.04%
D)   14.74%
E)   15.48%F) A) and E)
G) C) and D)

Question 11

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 40%.The firm will not be issuing any new common stock.What is Avery's WACC?

Accepted Answer

A)   8.15%
B)   8.48%
C)   8.82%
D)   9.17%
E)   9.54%F) B) and E)
G) C) and D)

Question 12

"Capital" is sometimes defined as funds supplied to a firm by investors.

Accepted Answer

A) True 
 B)False

Question 13

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 14

Which of the following statements is CORRECT?

Accepted Answer

A)   When calculating the cost of preferred stock,companies must adjust for taxes,because dividends paid on preferred stock are deductible by the paying corporation.
B)   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 as measured by the CAPM.
C)   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 reinvested earnings to take care of its equity financing and hence must issue new stock.
D)   Higher flotation costs reduce investors' expected returns,and that leads to a reduction in a company's WACC.
E)   When calculating the cost of debt,a company needs to adjust for taxes,because interest payments are deductible by the paying corporation.F) A) and B)
G) A) and C)

Question 15

When estimating the cost of equity by use of the CAPM,three potential problems are (1)whether to use long-term or short-term rates for rRF, (2)whether or not the historical beta is the beta that investors use when evaluating the stock,and (3)how to measure the market risk premium,RPM.These problems leave us unsure of the true value of rs.

Accepted Answer

A) True 
 B)False

Question 16

For capital budgeting and cost of capital purposes,the firm should assume that each dollar of capital is obtained in accordance with its target capital structure,which for many firms means partly as debt,partly as preferred stock,and partly common equity.

Accepted Answer

A) True 
 B)False

Question 17

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) B) and E)
G) A) and E)

Question 18

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 19

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 20

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.Since we cannot be sure that the estimate obtained with any of these methods is correct,it is often appropriate to use all three methods,then consider all three estimates,and end up using a judgmental estimate when calculating the WACC.

Accepted Answer

A) True 
 B)False

Exam 9: The Cost of Capital

For capital budgeting and cost of capital purposes,the firm should assume that each dollar of capital is obtained in accordance with its target capital structure,which for many firms means partly as debt,partly as preferred stock,and partly common equity.

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.

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
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Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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Which of the following statements is CORRECT?

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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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
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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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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?

Correct Answer
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The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock.No adjustment is needed for taxes because preferred dividends,unlike interest on debt,is not deductible by the issuing firm.

Correct Answer
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"Capital" is sometimes defined as funds supplied to a firm by investors.

Correct Answer
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Exam 9: The Cost of Capital

For capital budgeting and cost of capital purposes,the firm should assume that each dollar of capital is obtained in accordance with its target capital structure,which for many firms means partly as debt,partly as preferred stock,and partly common equity.

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

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

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

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

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

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

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?

Correct AnswerverifiedShow Answer

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock.No adjustment is needed for taxes because preferred dividends,unlike interest on debt,is not deductible by the issuing firm.

Correct AnswerverifiedShow Answer

"Capital" is sometimes defined as funds supplied to a firm by investors.

Correct AnswerverifiedShow 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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