Question 1

Suppose you are the president of a small,publicly-traded corporation.Since you believe that your firm's stock price is temporarily depressed,all additional capital funds required during the current year will be raised using debt.In this case,the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt.

Accepted Answer

A) True 
 B)False

Question 2

The Anderson Company has equal amounts of low-risk,average-risk,and high-risk projects.The firm's overall WACC is 12%.The CFO believes that this is the correct WACC for the company's average-risk projects,but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects.The CEO disagrees,on the grounds that even though projects have different risks,the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources.If the CEO's position is accepted,what is likely to happen over time?

Accepted Answer

A)  The company will take on too many low-risk projects and reject too many high-risk projects.
B)  Things will generally even out over time, and, therefore, the firm's risk should remain constant over time.
C)  The company's overall WACC should decrease over time because its stock price should be increasing.
D)  The CEO's recommendation would maximize the firm's intrinsic value.
E)  The company will take on too many high-risk projects and reject too many low-risk projects.F) None of the above
G) All of the above

Question 3

As the assistant to the CFO of Johnstone Inc.,you must estimate its cost of common equity.You have been provided with the following data: D0 = $0.80; P0 = $22.50; and g = 8.00% (constant) .Based on the DCF approach,what is the cost of common from reinvested earnings?

Accepted Answer

A)  10.69%
B)  11.25%
C)  11.84%
D)  12.43%
E)  13.05%F) None of the above
G) A) and B)

Question 4

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 5

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 = 6.50% (constant) .Based on the DCF 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) B) and D)
G) B) and E)

Question 6

When estimating the cost of equity by use of the bond-yield-plus-risk-premium method,we can generally get a good idea of the interest rate on new long-term debt,but we cannot be sure that the risk premium we add is appropriate.This problem leaves us unsure of the true value of rs.

Accepted Answer

A) True 
 B)False

Question 7

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 D)
G) B) and C)

Question 8

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

Question 9

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

Question 10

Since 70% of the preferred dividends received by a corporation are excluded from taxable income,the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should,theoretically,be
Cost of equity = rs(0.30)(0.50)+ rps(1 − T)(0.70)(0.50).

Accepted Answer

A) True 
 B)False

Question 11

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

Question 12

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

Accepted Answer

A) True 
 B)False

Question 13

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 14

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

Question 15

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

Question 16

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 17

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 E)
G) B) and D)

Question 18

Firm J's earnings and stock price tend to move up and down with other firms in the S&P 500,while Firm F's earnings and stock price move counter cyclically with J and other S&P companies.Both J and F estimate their costs of equity using the CAPM,they have identical market values,their standard deviations of returns are identical,and they both finance only with common equity.Which of the following statements is CORRECT?

Accepted Answer

A)  J and F should have identical WACCs because their risks as measured by the standard deviation of returns are identical.
B)  If J and F merge, then the merged firm MW should have a WACC that is a simple average of J's and F's WACCs.
C)  Without additional information, it is impossible to predict what the merged firm's WACC would be if J and F merged.
D)  Since J and F move counter cyclically to one another, if they merged, the merged firm's WACC would be less than the simple average of the two firms' WACCs.
E)  J should have the lower WACC because it is like most other companies, and investors like that fact.F) C) and E)
G) All of the above

Question 19

Which of the following statements is CORRECT?

Accepted Answer

A)  WACC calculations should be based on the before-tax costs of all the individual capital components.
B)  Flotation costs associated with issuing new common stock normally reduce the WACC.
C)  If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline.
D)  An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.
E)  A change in a company's target capital structure cannot affect its WACC.F) A) and E)
G) B) and C)

Question 20

When estimating the cost of equity by use of the DCF 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

Exam 11: Determining the Cost of Capital

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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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?

Correct Answer
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Which of the following statements is CORRECT?

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

Correct Answer
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When estimating the cost of equity by use of the bond-yield-plus-risk-premium method,we can generally get a good idea of the interest rate on new long-term debt,but we cannot be sure that the risk premium we add is appropriate.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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Which of the following statements is CORRECT?

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

Correct Answer
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When estimating the cost of equity by use of the DCF 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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Which of the following statements is CORRECT?

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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As the assistant to the CFO of Johnstone Inc.,you must estimate its cost of common equity.You have been provided with the following data: D₀ = $0.80; P₀ = $22.50; and g = 8.00% (constant) .Based on the DCF approach,what is the cost of common from reinvested earnings?

Correct Answer
verified

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 = 6.50% (constant) .Based on the DCF approach,what is the cost of common from reinvested earnings?

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

Exam 11: Determining the Cost of Capital

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

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

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

Correct AnswerverifiedShow Answer

When estimating the cost of equity by use of the bond-yield-plus-risk-premium method,we can generally get a good idea of the interest rate on new long-term debt,but we cannot be sure that the risk premium we add is appropriate.This problem leaves us unsure of the true value of rs.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

When estimating the cost of equity by use of the DCF 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

Which of the following statements is CORRECT?

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

As the assistant to the CFO of Johnstone Inc.,you must estimate its cost of common equity.You have been provided with the following data: D0 = $0.80; P0 = $22.50; and g = 8.00% (constant) .Based on the DCF approach,what is the cost of common from reinvested earnings?

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 g = 6.50% (constant) .Based on the DCF approach,what is the cost of common from reinvested earnings?

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

Correct Answer
verified

Correct Answer
verified

Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
verified

When estimating the cost of equity by use of the bond-yield-plus-risk-premium method,we can generally get a good idea of the interest rate on new long-term debt,but we cannot be sure that the risk premium we add is appropriate.This problem leaves us unsure of the true value of r_s.

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

When estimating the cost of equity by use of the DCF 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
verified

Correct Answer
verified

Correct Answer
verified

As the assistant to the CFO of Johnstone Inc.,you must estimate its cost of common equity.You have been provided with the following data: D₀ = $0.80; P₀ = $22.50; and g = 8.00% (constant) .Based on the DCF approach,what is the cost of common from reinvested earnings?

Correct Answer
verified

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 = 6.50% (constant) .Based on the DCF approach,what is the cost of common from reinvested earnings?

Correct Answer
verified

Correct Answer
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