Cost of Capital

1. A firm’s overall cost of capital:
d. varies inversely with its cost of debt.
a. is unaffected by changes in the tax rate.
e. is another term for the firm s internal rate of return.
b. is the same as the firm s return on equity.
c. is the required return on the total assets of a firm.

2. Which one of the following represents the best estimate for a firm’s pre-tax cost of debt?
c. the current yield-to-maturity on the firm’s existing debt
b. the firm’s historical cost of capital
a. twice the rate of return currently offered on risk-free securities
e. the current coupon on the firm’s existing debt
d. the current yield on the firm’s existing debt

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3. An increase in the market value of a preferred stock will _____ the cost of preferred stock.
a. increase
c. not affect
d. either increase or decrease
e. either not affect or increase
b. decrease

4. Capital structure weights are based on the:
c. market values of a firm’s debt and equity.
d. market value of a firm’s equity and the face value of its debt.
b. initial issue values of a firm’s debt and equity.
a. book value of a firm’s debt and equity.
e. firm’s dividend and bond yields.

5. Which one of the following is a correct statement regarding a firm’s weighted average cost of capital (WACC)?
c. An increase in the market risk premium will tend to decrease a firm’s WACC.
e. A reduction in the risk level of a firm will tend to increase the firm’s WACC.
d. A 5 percent increase in a firm’s debt-equity ratio will tend to increase the firm’s WACC.
a. The WACC can be used as the required return for all new projects with similar risk to that of the existing firm.
b. The WACC will decrease when the tax rate decreases for all firms that utilize debt financing.

6. The rate of return on its existing assets that a firm must earn to maintain the current value of the firm’s stock is called the:
b. return on equity.
a. internal rate of return.
e. weighted average cost of capital.
c. weighted average cost of equity.
d. current yield.

7. A firm uses its weighted average cost of capital to evaluate the proposed projects for all of its varying divisions. By doing so, the firm: (I. automatically gives preferential treatment in the allocation of funds to its riskiest division; II. encourages the division managers to only recommend their most conservative projects; III. tends to change its overall risk structure over time; IV. tends to allocate money equally among its divisions)
a. I only
e. III and IV only
c. I and III only
b. II only
d. II and IV only

8. Winslow and Losefast is trying to determine how to assign discount rates to the various projects proposed by its numerous international divisions. The company should put the greatest emphasis on which one of the following when assigning the discount rates?
a. the geographic location where the project will be undertaken
e. the currency exchange rate that will apply to the project
c. the experience of the managers of the division which is proposing the project
b. the tax structure to which the project will be subjected
d. the various types of risk associated with the project

9. When using the pure play approach, a firm is seeking a rate of return which:
c. is based on book values rather than market values.
e. matches the expected internal rate of return of the investment being considered.
d. is applicable to the risk level of the investment under consideration.
a. will cause a project to have a positive net present value.
b. is lower than its own cost of capital.

10. A firm which assigns every project to a risk class which determines the required rate of return for the project is using the _____ approach.
e. normal
a. pure play
b. competitor’s
d. subjective
c. objective

11. Nelson Enterprises just paid an annual dividend of $1.56 per share. This dividend is expected to increase by 3 percent annually. Currently, the firm has a beta of 1.13 and a stock price of $28 a share. The risk-free rate is 3 percent and the market rate of return is 10.5 percent. What is your best estimate of Nelson’s cost of equity?
a. 8.74 percent
e. 11.48 percent
c. 9.72 percent
b. 9.38 percent
d. 10.11 percent

12. The Miller Co. has paid increasing dividends of $.54, $.58, $.62, $.67, and $.72 a share over the past five years, respectively. The firm estimates that future increases in their dividends will be comparable to the arithmetic average growth rate over these past five years. The stock is currently selling for $38.60 a share. The risk-free rate is 4 percent and the market risk premium is 8 percent. What is your best estimate of Miller’s cost of equity if their beta is 1.22?
e. 14.06 percent
a. 9.46 percent
d. 12.97 percent
b. 11.61 percent
c. 12.12 percent

13. Jennifer’s Boutique has 12,000 bonds outstanding at a quoted price of 98 percent of face value. The bonds mature in eleven years and carry a 9 percent annual coupon. What is Jennifer’s aftertax cost of debt if the applicable tax rate is 35 percent?
c. 6.14 percent
a. 5.77 percent
d. 6.23 percent
e. 6.33 percent
b. 6.04 percent

14. The preferred stock of ISO, Inc., pays an annual dividend of $6.50 a share and sells for $48 a share. What is ISO’s cost of preferred stock?
c. 9.19 percent
b. 7.38 percent
e. 13.54 percent
a. 3.12 percent
d. 9.46 percent

15. Market Basket, Inc., has 125,000 shares of common stock outstanding at a price of $43 a share. They also have 25,000 shares of preferred stock outstanding at a price of $55 a share. There are 10,000, 8 percent bonds outstanding that are priced at 99 percent of face value. The bonds mature in 16 years and pay interest semiannually. What is the capital structure weight of the preferred stock?
e. 17.77 percent
c. 9.98 percent
d. 13.67 percent
b. 8.26 percent
a. 7.68 percent

16. The Bigelow Company has a cost of equity of 12 percent, a pre-tax cost of debt of 7 percent, and a tax rate of 35 percent. What is the firm’s weighted average cost of capital if the debt-equity ratio is .60?
b. 9.21 percent
c. 10.01 percent
d. 10.13 percent
a. 6.58 percent
e. 11.11 percent

17. Black and White has a cost of equity of 11 percent and a pre-tax cost of debt of 8.5 percent. The firm’s target weighted average cost of capital is 9 percent and its tax rate is 35 percent. What is the firm’s target debt-equity ratio?
e. 62.03
d. 57.56
c. 55.72
a. 48.29
b. 51.13

18. Gladstone and Moore has 10,000 shares of common stock outstanding at a price per share of $46 and a rate of return of 14 percent. The firm has 5,000 shares of 7 percent preferred stock outstanding at a price of $58 a share. The outstanding debt has a total face value of $200,000 and a market price equal to 98 percent of face value. The yield-to-maturity on the debt is 8.03 percent. What is the firm’s weighted average cost of capital if the tax rate is 34 percent?
c. 11.61 percent
e. 12.65 percent
a. 8.62 percent
b. 9.99 percent
d. 12.12 percent

19. The James Co. is considering a project with an initial cost of $6.2 million. The project will produce cash inflows of $1.8 million a year for five years. The firm uses the subjective approach to assign discount rates to projects. For this project, the subjective adjustment is +2 percent. The firm has a pre-tax cost of debt of 6.7 percent and a cost of equity of 9.4 percent. The debt-equity ratio is .6 and the tax rate is 35 percent. What is the net present value of the project?
e. $811,006
d. $790,909
b. $733,333
c. $742,067
a. $710,053

20. ABC, Inc., has three divisions: A, B, and C. Division A has the least risk and division C has the most risk. ABC has an aftertax cost of debt of 4.6 percent and a cost of equity of 9.5 percent. The firm is financed with 50 percent debt and 50 percent equity. Management has told the divisional manager of division A that projects in that division are assigned a discount rate that is 1 percent less than the firm’s weighted average cost of capital. What is the discount rate applicable to division A?
c. 6.65 percent
b. 6.31 percent
e. 7.18 percent
a. 6.05 percent
d. 7.05 percent

Solution Preview
Question 1 1 points Save
1. A firm’s overall cost of capital:
d. varies inversely with its cost of debt.
a. is unaffected by changes in the tax rate.
e. is another term for the firm s internal rate of return.
b. is the same as the firm s return on equity.
c. is the required return on the total assets of a firm.

Answer: c. is the required return on the total assets of a firm.

“Cost of capital:
increases with cost of debt,
is affected by tax rate as after tax cost of debt = before tax cost of debt x (1-tax rate)
is the weighted cost of capital (debt + equity) and not the cost of equity alone
in not the same as internal rate of return”

Question 2 1 points Save
2. Which one of the following represents the best estimate for a firm’s pre-tax cost of debt?
c. the current yield-to-maturity on the firm’s existing debt
b. the firm’s historical cost of capital
a. twice the rate of return currently offered on risk-free securities
e. the current coupon on the firm’s existing debt
d. the current yield on the firm’s existing debt

Answer: c. the current yield-to-maturity on the firm’s existing debt

Question 3 1 points Save
3. An increase in the market value of a preferred stock will _____ the cost of preferred stock.
a. increase
c. not affect
d. either increase or decrease
e. either not affect or increase
b. decrease

Answer: b. decrease
Cost of preferred stock = Annual dividend / Market price of preferred stock
annual dividend remains constant
Hence, increase in market price will decrease the cost of preferred stock

Question 4 1 points Save
4. Capital structure weights are based on the:
c. market values of a firm’s debt and equity.
d. market value of a firm’s equity and the face value of its debt.
b. initial issue values of a firm’s debt and equity.
a. book value of a firm’s debt and equity.
e. firm’s dividend and bond yields.

Answer: c. market values of a firm’s debt and equity.

Question 5 1 points Save
5. Which one of the following is a correct statement regarding a firm’s weighted average cost of capital (WACC)?
c. An increase in the market risk premium will tend to decrease a firm’s WACC.
e. A reduction in the risk level of a firm will tend to increase the firm’s WACC.
d. A 5 percent increase in a firm’s debt-equity ratio will tend to increase the firm’s WACC.
a. The WACC can be used as the required return for all new projects with similar risk to that of the existing firm.
b. The WACC will decrease when the tax rate decreases for all firms that utilize debt financing.

Answer: a. The WACC can be used as the required return for all new projects with similar risk to that of the existing firm.

“WACC:
-Will increase when market risk premium increases as cost of securities will increase
-Will decrease when risk reduces
Since debt has tax advantage, increase in debt will reducres WACC
The higher the tax the lower the after tax cost of debt and therefore, the WACC”

Question 6 1 points Save
6. The rate of return on its existing assets that a firm must earn to maintain the current value of the firm’s stock is called the:
b. return on equity.
a. internal rate of return.
e. weighted average cost of capital.
c. weighted average cost of equity.
d. current yield.

Answer: e. weighted average cost of capital.

Question 7 1 points Save
7. A firm uses its weighted average cost of capital to evaluate the proposed projects for all of its varying divisions. By doing so, the firm: (I. automatically gives preferential treatment in the allocation of funds to its riskiest division; II. encourages the division managers to only recommend their most conservative projects; III. tends to change its overall risk structure over time; IV. tends to allocate money equally among its divisions)
a. I only
e. III and IV only
c. I and III …

Solution Summary
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