Chapter 14

Chapter 14 Cost of Capital 1. The cost of capital depends primarily on the use of funds, not the source. Ans: True

Level: Basic

Subject: Cost Of Capital

Type: Concepts

2. The market value of a firm that invests in projects providing a return equal to its WACC will not change over time. Ans: True

Level: Basic


Type: Concepts

3. Suppose that new information regarding future inflation in Canada causes investors to become less risk averse. The SML approach indicates that, all else equal, firm cost of capital will increase. Ans: False

Level: Basic

Subject: Cost Of Equity

Type: Concepts

4. It is considered unlikely that the dividend growth and the SML approaches will result in different estimates of the cost of equity for a given firm Ans: False

Level: Basic


Type: Concepts

5. For the purpose of estimating the firm's cost of capital, one cannot look only at the coupon rate on the firm's existing debt. Ans: True

Level: Basic

Subject: Cost Of Debt

Type: Concepts

6. For the purpose of estimating the firm's cost of debt for a project, one could observe the yield-to-maturity on recently issued bonds with a similar rating and term-to-maturity. Ans: True

Level: Basic


Type: Concepts

7. In general, for the purpose of estimating the cost of preferred stock, one can ignore the current level of common stock dividends. Ans: True

Level: Basic

Subject: Cost Of Preferred

Type: Concepts

8. It is generally better to base estimates of the WACC on book value weights of debt and equity since market values, particularly those for equity, tend to fluctuate widely. Ans: False

Level: Basic

Subject: Capital Structure Weights

Type: Concepts

9. For a profitable firm, an increase in its marginal tax rate will increase its weighted average cost of capital. Ans: False

Level: Basic

Subject: Taxes And the WACC

Type: Concepts

10. By using a firm's WACC to analyze all potential investments, we risk incorrectly accepting some unsuitable projects. Ans: True

Level: Basic

Subject: WACC & Risk

Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited.

Page 1

Chapter 14 Cost of Capital

11. By using a firm's WACC to analyze all potential investments, we risk incorrectly accepting some suitable projects. Ans: False

Level: Basic


Type: Concepts

12. The best way to adjust for the existence of flotation costs is to add their percentage cost to the WACC. Ans: False

Level: Basic

Subject: Flotation Costs

Type: Concepts

13. The effect of flotation costs is to increase the computed NPV of any given project. Ans: False

Level: Basic


Type: Concepts

14. For a firm with both debt and equity in its capital structure, the weighted average flotation cost, fA, will simply be the sum of the percentage flotation cost of debt, fD, and the percentage flotation cost of equity, fE. Ans: False

Level: Basic


Type: Concepts

15. The opportunity cost associated with the firm's capital investment in a project is called its: A) Cost of capital. B) Beta coefficient. C) Capital gains yield. D) Sunk cost. E) Internal rate of return. Ans: A

Level: Basic


Type: Definitions

16. The return that shareholders require on their investment in the firm is called the: A) Dividend yield. B) Cost of equity. C) Capital gains yield. D) Cost of capital. E) Income return. Ans: B

Level: Basic


Type: Definitions

17. The return that lenders require on their loaned funds to the firm is called the: A) Coupon rate. B) Current yield. C) Cost of debt. D) Capital gains yield. E) Cost of capital. Ans: C

Level: Basic


Type: Definitions


Page 2


18. The proportions of the market value of the firm's assets financed via debt, common stock, and preferred stock are called the firm's _____________________. A) financing costs B) portfolio weights C) beta coefficients D) capital structure weights E) costs of capital Ans: D

Level: Basic


Type: Definitions

19. The weighted average of the firm's costs of equity, preferred stock, and after tax debt is the: A) Reward to risk ratio for the firm. B) Expected capital gains yield for the stock. C) Expected capital gains yield for the firm. D) Portfolio beta for the firm. E) Weighted average cost of capital (WACC) . Ans: E

Level: Basic

Subject: WACC

Type: Definitions

20. For a firm with multiple business units, the cost of capital developed for each unit is called a: A) Divisional cost of capital. B) Pure play approach. C) Subjective risk adjustment. D) Stratified beta coefficient. E) Fundamental beta coefficient. Ans: A

Level: Basic

Subject: Divisional Cost Of Capital

Type: Definitions

21. When firms develop a WACC for individual projects based on the cost of capital for other firms in similar lines of business as the project, the firm is utilizing a ____________________. A) subjective risk approach B) pure play approach C) divisional cost of capital approach D) capital adjustment approach E) security market line approach Ans: B

Level: Basic

Subject: Pure Play Approach

Type: Definitions

22. The costs incurred by the firm when new issues of stocks or bonds are sold are called: A) Required rates of return. B) Costs of capital. C) Flotation costs. D) Capital structure weights. E) Costs of equity and debt. Ans: C

Level: Basic


Type: Definitions


Page 3


23. The approach to computing the cost of equity financing which does not explicitly consider risk is called the: A) Weighted average cost of capital. B) After-tax cost of debt. C) Dividend growth model. D) Stock financing model. E) Security market line. Ans: C

Level: Basic

Subject: Dividend Growth Model

Type: Definitions

24. WACC is the overall rate of return a firm must earn on its assets to maintain: A) Its current credit rating. B) Its current level of cash flows. C) The book value of its assets. D) The value of its stock. E) Its current cost of debt. Ans: D

Level: Basic

Subject: WACC

Type: Definitions

25. The term used to indicate the percentage of financing derived from equity and the percentage derived from debt is: A) Capital structure. B) Weighted average cost of capital. C) Market rate of return. D) Book value weights. E) Market to book ratio Ans: A

Level: Basic

Subject: Capital Structure

Type: Definitions

26. WACC is the: A) Cost of obtaining equity financing. B) Required rate of return on a firm. C) Average IRR of the firm's current projects. D) Average rate of return needed to increase the value of a firm's stock. E) Discount rate based on the pre-tax cost of capital. Ans: B

Level: Basic

Subject: WACC

Type: Definitions

27. The target capital structure is the debt-equity mix that: A) Maximizes the cost of capital. B) Maximizes the value of the firm. C) Minimizes the cost of equity financing. D) Minimizes the cost of debt financing. E) Minimizes the overall debt level of a firm. Ans: B

Level: Basic

Subject: Target Capital Structure

Type: Definitions


Page 4


28. The approach to computing the cost of equity financing that utilizes the Treasury bill rate is called the: A) Dividend growth model. B) Weighted average cost of capital. C) Security market line. D) After-tax cost of equity. E) Inflation adjusted cost of equity. Ans: C

Level: Basic

Subject: SML

Type: Definitions

29. In the SML formula, g is defined as the: A) Most recent increase in the firm's dividend. B) Most recent increase in the firm's level of sales. C) Historical growth rate of a firm's dividends. D) Expected growth rate of a firm's dividends. E) Expected growth of a firm's sales. Ans: D

Level: Basic

Subject: SML

Type: Definitions

30. The market-required rate of return on debt is called the: A) Coupon rate. B) After-tax current yield. C) Yield to maturity. D) Yield to call. E) Current yield. Ans: C

Level: Basic

Subject: Yield-To-Maturity

Type: Definitions

31. When the number of shares of common stock outstanding multiplied by the price per share is divided by the total market value of the firm the resulting value is defined as the: A) Market weight of debt. B) Debt-equity ratio. C) Cost of capital ratio. D) Capital structure weight. E) Equity to market weight. Ans: D

Level: Basic

Subject: WACC Weight

Type: Definitions

32. The subjective approach: A) Can be defined as a stair step method of applying WACC. B) Is the method of using information from another firm when calculating WACC. C) Employs pure play strategy. D) Is defined as the application of one cost of capital rate to all projects under consideration. E) Is defined as the inclusion of flotation costs in the WACC. Ans: A

Level: Basic

Subject: Subjective Approach

Type: Definitions


Page 5


33. The cost of capital in a firm that has both debt and equity ____________________. A) is what a firm must earn on a project to compensate investors for the use of their funds B) depends on the source of the funds for a project C) is equal to the cost of debt or equity, depending on which type of financing the firm uses more D) is also known as the internal rate of return E) will be the same for its different divisions Ans: A

Level: Basic


Type: Concepts

34. Which of the following is/are true: The cost of capital _______________________. I. is an opportunity cost that depends on the use of the funds, not the source II. is the same thing as the required rate of return III. is the same as the WACC for projects with equal risk to the firm as a whole IV. is also known as the appropriate discount rate A) II and III only B) I, II, and IV only C) II, III, and IV only D) I, III, and IV only E) I, II, III, and IV Ans: E

Level: Basic


Type: Concepts

35. The appropriate discount rate to be used when analyzing an investment project is _______________. A) the rate of return that will result in the highest NPV B) the internal rate of return on that investment C) equal to the cost of capital based on the firm's historical assets D) the rate of return financial markets offer on investments of similar risk E) the rate of interest the firm would pay if it sold bonds Ans: D

Level: Basic

Subject: Discount Rate

Type: Concepts

36. The appropriate cost of capital for a project depends on __________________. A) the risk associated with the project B) the type of security issued to finance the project C) the type of assets used in the project (that is, whether they are current or fixed assets) D) the total risk of the firm's equity E) the interest rate on the firm's outstanding long-term bonds Ans: A

Level: Basic


Type: Concepts

37. The interest rate that should be used when evaluating a capital investment project is sometimes called the ___________________. I. internal rate of return II. appropriate discount rate III. cost of capital A) I only B) II only C) III only D) II and III only E) I, II and III Ans: D

Level: Basic


Type: Concepts


Page 6


38. Which of the following formulas correctly describes the cost of equity capital? A) RE = D0/P0 + g B) RE = D1+ g/P0 C) RE = D1/P0 + g D) RE = Rf – b ´ (Rf – Rm) E) RE = Rf + b ´ (Rm + Rf) Ans: C

Level: Basic


Type: Concepts

39. Which of the following are potential problems associated with the use of the dividend growth model to compute the cost of equity? I. The estimated cost of equity is sensitive to the estimated dividend growth rate II. Everything needed for the model is directly observable except the current dividend III. The approach explicitly considers risk A) I only B) II only C) III only D) I and II only E) II and III only Ans: A

Level: Basic


Type: Concepts

40. Which of the following is true about estimating a firm's cost of equity capital? A) We have no model that will provide reasonable estimates. B) It is relatively easy to calculate the firm's cost of debt and then back out the cost of equity. C) The cost of equity is equal to the weighted average cost of capital. D) The cost of equity depends on the total risk of the firm's equity. E) There is no way to directly observe the return required by the firm's equity investors. Ans: E

Level: Basic


Type: Concepts

41. Which of the following is true regarding the use of the dividend growth model for estimating the cost of equity capital? A) A key advantage to this model is its high degree of complexity. B) The results from this model are not sensitive to changes in the dividend growth rate. C) One method of estimating future growth rates is the use of historical growth rates. D) The model works particularly well for companies that maintain a mostly unsteady dividend growth rate. E) The model explicitly considers risk. Ans: C

Level: Basic


Type: Concepts

42. You need to calculate the cost of equity capital for a firm that is traded on the Toronto Stock Exchange. Which of the following would likely be least helpful to you? A) The rate of return on stocks of similar risk. B) Knowledge of the stock's price six months ago. C) An investment publication that provides an estimate of the firm's beta. D) An investment survey that projects future dividend growth rates for the firm. E) A data set containing dividends paid for the past 10 years. Ans: B

Level: Basic


Type: Concepts


Page 7


43. Which of the following is NOT accurate regarding cost of equity capital estimates calculated using the SML approach? A) The SML applies only to firms with stable dividend growth rates. B) Like the dividend growth model, SML generally relies on using the past to predict the future. C) Unlike the dividend growth model, the SML estimate adjusts for risk. D) To implement this approach, the financial manager must estimate a market risk premium and a beta coefficient. E) The quality of the estimate using the SML approach is sensitive to the quality of the estimates for the input variables in the model. Ans: A

Level: Basic


Type: Concepts

44. Which of the following is a disadvantage of the dividend growth model when estimating the cost of equity? A) It applies only to firms whose dividend growth rate fluctuates widely. B) It only applies to companies which are not currently paying dividends. C) It explicitly considers risk. D) The estimated cost of equity is highly sensitive to the estimated growth rate. E) It does not use discounted cash flow techniques. Ans: D

Level: Basic


Type: Concepts

45. Which of the following is considered an advantage to using the SML approach for calculating the cost of equity? I. This approach explicitly accounts for risk. II. This approach applies only to companies that pay dividends. III. Unlike the dividend growth model, the SML approach is not sensitive to the estimates used as inputs in the model. A) I only B) III only C) I and II only D) II and III only E) I, II, and III Ans: A

Level: Basic


Type: Concepts

46. Which of the following will always decrease a firm's cost of equity, when calculated using the SML approach? I. A decrease in the pure time value of money. II. A decrease in the amount of systematic risk. III. A decrease in the reward for bearing systematic risk. A) I only B) III only C) II only D) II and III only E) I, II, and III Ans: D

Level: Basic


Type: Concepts


Page 8


47. Which of the following is NOT generally considered to be a problem when estimating the cost of equity? A) We must estimate beta using historical information. B) We must estimate a dividend growth rate. C) We must estimate the market risk premium. D) We must estimate the risk-free rate of interest. E) If we use the dividend growth model, we cannot adjust for differences in risk. Ans: D

Level: Basic


Type: Concepts

48. Suppose that the Federal Reserve takes actions that causes the risk-free rate to fall. All else the same, we would expect a firm's cost of equity to ____________________. A) increase if we are using the SML B) decrease if we are using the SML C) either increase or decrease if we are using the SML, but we can't determine which without more information D) increase if expected return on the market decreases E) decrease if the firm's beta increases Ans: C

Level: Basic


Type: Concepts

49. The cost of debt capital for a firm _________________________. A) is the return that the firm's creditors demand for new borrowings B) can be calculated by estimating the beta of the firm's equity and then using the SML C) can be estimated by finding the yield on recently-issued bonds with lower bond ratings D) can be calculated by looking at the coupon rates on existing bonds of similar risk E) can be observed directly even if the firm's bonds are not publicly traded Ans: A

Level: Basic


Type: Concepts

50. Which of the following is NOT true regarding a firm's cost of debt? A) The cost of debt must be adjusted lower due to the firm's tax deductibility of interest expense. B) The firm's cost of debt based on its past borrowing is known as its embedded debt cost. C) It is possible to determine a firm's cost of debt by using the SML. D) The coupon rate on outstanding debt is not necessarily the firm's current cost of debt. E) A firm's cost of equity is generally easier to calculate than a firm's cost of debt. Ans: E

Level: Basic


Type: Concepts

51. Which of the following is generally true about a firm's cost of debt? A) It is equal to the yield to maturity on the firm's outstanding bonds. B) It is greater than the cost of equity. C) It normally cannot be observed, directly or indirectly, in the marketplace. D) It is greater than the average coupon payments on outstanding debt. E) It is equal to the coupon rate on the firm's outstanding bonds. Ans: A

Level: Basic


Type: Concepts


Page 9


52. We can estimate a firm's cost of debt by _____________________. A) observing the yield to maturity on the firm's outstanding bonds B) observing the coupon rate on the firm's outstanding bonds C) observing the yield to maturity on newly-issued debt of other firms without regard to risk D) observing the risk-free rate and adding a risk premium to the coupon rate of existing debt E) observing the firm's bank borrowing rate on short-term loans Ans: A

Level: Basic


Type: Concepts

53. Ignoring taxes, if a firm issues debt at par, then _____________________. I. the cost of debt is equal to its coupon rate II. the cost of debt is equal to its yield to maturity III. the YTM cannot be computed A) I only B) I and II only C) II only D) I and III only E) I, II, and III Ans: B

Level: Basic


Type: Concepts

54. The _______________ is the firm's cost of debt based on its historic borrowings. A) actual cost B) embedded debt cost C) aftertax yield D) market rate E) yield to maturity Ans: B

Level: Basic

Subject: Embedded Cost Of Debt

Type: Concepts

55. Which of the following is NOT a legitimate reason why it is generally considered easier to estimate the cost of preferred stock than it is to estimate the cost of common stock? A) Preferred stock generally carries with it a fixed dividend payment. B) Preferred stock is often rated for default risk. C) The cost of preferred stock can be calculated as a perpetuity based on the fixed dividend payment and the present stock price. D) Calculation of the cost of preferred stock does not require any information about future preferred dividends. E) The cost of preferred stock is simply equal to its dividend yield. Ans: D

Level: Basic


Type: Concepts

56. Calculation of the weighted average cost of capital requires all of the following EXCEPT: A) The total market value of a firm's debt via the number of bonds outstanding and the current par value per bond. B) The market value of bonds outstanding relative to the total market value of the firm. C) The corporate tax rate. D) The current market value of a firm's equity via the total number of shares and the stock price. E) The market value of equity outstanding relative to the total market value of the firm. Ans: A

Level: Basic

Subject: WACC

Type: Concepts


Page 10


57. The BongoBongo Drum Co. uses debt and equity in its capital structure and has positive earnings. Which of the following would decrease the firm's WACC, all else the same? I. A decrease in the corporate tax rate II. A decrease in investor risk aversion III. An increase in the firm's debt rating from BBB to A A) I only B) II only C) III only D) I and III only E) II and III only Ans: E

Level: Basic

Subject: WACC

Type: Concepts

58. For purposes of finding the WACC, which of the following is/are correct? I. D/V + E/V = 1.00 II. V = D – E III. V = A + L + E IV. D/V + E/V = V A) I only B) I and II only C) II only D) I and III only E) I, II, III, and IV Ans: A

Level: Basic

Subject: WACC

Type: Concepts

59. Which of the following correctly describes the computation of the firm's weighted average cost of capital (WACC) ? A) (E/V) + RE + (D/V) + RD + (1 – TC) B) (E/V) ´ RE ´ (1 – TC) + (D/V) ´ RD C) (D/V) ´ RE + (E/V) ´ RD ´ (1 – TC) D) (E/V) + RE + (D/V) + RD E) (E/V) ´ RE + (D/V) ´ RD ´ (1 – TC) Ans: E

Level: Basic

Subject: WACC

Type: Concepts

60. Which of the following is NOT correct? A) The cost of equity is the return that equity investors require on their investment in the firm. B) The cost of equity can be found by either the dividend growth approach or the SML approach. C) The cost of debt is the return that lenders require on the firm's debt. D) If the firm has preferred stock in its capital structure, the cost of preferred stock should be included in the cost of capital. E) Book value capital structure weights should be used to calculate the WACC rather than market value weights. Ans: E

Level: Basic

Subject: WACC

Type: Concepts


Page 11


61. You are comparing two firms. All you know about them is that the WACC of firm A is 12% and the WACC of firm B is 15%. Which of the following can you infer from this? I. B has more systematic risk II. A uses more debt III. A and B are not in the same line of business IV. A uses preferred stock but B does not A) I and II only B) I and III only C) II and III only D) I, II, and IV only E) You cannot infer any of the above without additional information Ans: E

Level: Basic

Subject: WACC

Type: Concepts

62. All else the same, a higher corporate tax rate ____________________. A) will increase the WACC of a firm with debt and equity in its capital structure B) will decrease the WACC of a firm with some debt in its capital structure C) will not affect the WACC of a firm with debt in its capital structure D) will decrease the WACC of a firm with only equity in its capital structure E) will change the WACC of a firm with debt in its capital structure, but the direction is unknown. Ans: B

Level: Basic

Subject: Taxes & The WACC

Type: Concepts

63. Which of the following is false? A) The WACC is equal to the firm's embedded debt cost times (1 - the tax rate) . B) The WACC requires the cost of debt be decreased by (1 - the tax rate) . C) The WACC is not directly observable in financial markets. D) The WACC is the required return on any investments a firm makes that have a level of risk equal to that of present operations. E) The WACC reflects the risk and target capital structure of a firm's existing assets as a whole. Ans: A

Level: Basic

Subject: Weighted Average Cost Of Capital

Type: Concepts

64. Why it is necessary to make sure a project is in the same risk class as existing operations before using the WACC as the discount rate? A) If a project has high risk, then it should be rejected. B) A firm that uses its WACC to evaluate projects without regarding the risk class of the project will tend to become riskier over time. C) Only projects with similar risk can result in positive NPVs. D) If a project is in a different risk class then a different tax rate must be used. E) The risk class of a proposed project is important only if it affects the firm's bond ratings. Ans: B

Level: Basic

Subject: Risk Class

Type: Concepts


Page 12


65. A firm that uses its WACC as a cutoff without considering project risk: I. Tends to become less risky over time. II. Tends to accept negative NPV projects over time. III. Likely will see its WACC rise over time. A) II only B) I and II only C) I and III only D) II and III only E) I, II, and III Ans: D

Level: Basic


Type: Concepts

66. Suppose a firm uses a constant WACC in determining the value of capital budgeting projects rather than using the security market line. The firm will tend to _____________________. A) accept profitable, low risk projects and reject unprofitable, high risk projects B) accept profitable, low risk projects and accept unprofitable, high risk projects C) reject unprofitable, high risk projects D) become more risky over time E) accept profitable, low risk projects Ans: D

Level: Basic


Type: Concepts

67. In which of the following cases would it most likely be appropriate to use the WACC that relates to existing operations? A) A pizza delivery service is planning to expand by adding a sit-down pizza restaurant B) A grocery store owner is considering adding a bakery and a delicatessen to his store C) A gas tank manufacturer is contemplating switching to manufacturing tie-outs for dogs D) A gas station owner is considering adding a convenience store E) A manufacturer of garbage bags is considering expanding production capacity to meet increasing overseas demand Ans: E

Level: Basic


Type: Concepts

68. Ajax Corp. has been operating as three separate divisions over the past ten years, although all capital budgeting decisions are ultimately made at the home office using the firm's overall WACC. Just recently, they discovered the divisions have significantly different risks. Which of the following is also likely to be true? A) The divisions are being rewarded for decreasing their risk. B) Higher earning divisions will be less risky than the lower earning divisions. C) Its low earning division tends to be ignored in capital allocation even though it tends to maintain lower levels of risk. D) The differences in risk among the divisions has no impact on the capital budgeting process. E) The highest divisional cost of capital will approximately equal the firm's overall cost of capital. Ans: C

Level: Intermediate



Type: Concepts

Page 13


69. A firm has three divisions. A capital budgeting request has just come through for Division C showing a positive NPV at the firm's overall WACC. The financial manager of the firm knows that Division C is the riskiest of the three divisions. The financial manager should A) deny the request since it was computed in error B) approve the request since it has a positive NPV C) ask that the NPV be recomputed at a cost of capital appropriate for the division D) approve the request if neither of the other two divisions have any capital budgeting projects with positive NPVs E) subjectively reduce the NPV to reflect the difference in risk and then accept the project if NPV is still positive Ans: C

Level: Intermediate


Type: Concepts

70. The pure play approach: A) Cannot be used if the firm has preferred stock outstanding. B) Is easier to implement than the subjective approach. C) Is most useful when each division makes a multitude of different products. D) Should be used only if a firm has more than three divisions. E) Can be used to find the cost of capital for a division. Ans: E

Level: Basic


Type: Concepts

71. In using the ___________ approach to estimating the cost of capital for a division, an analyst proceeds by observing the returns for a firm whose operations are in the same risk class as the division. A) pure play B) conglomerate C) market specialist D) correspondent division E) parallel risk class Ans: A

Level: Basic


Type: Concepts

72. In using the ___________ approach, we place projects into risk classes in order to assign discount rates. A) subjective B) capital analysis C) pure play D) SML E) yield play Ans: A

Level: Basic


Type: Concepts

73. A firm should consider using ________ approach if it only calculates the WACC for the firm as a whole, yet it has divisions with substantially different risk characteristics. A) an unbiased B) an empirical C) an objective D) a subjective E) a simulation Ans: D

Level: Basic

Subject: Subjective Adjustment Of WACC


Type: Concepts

Page 14


74. A firm is considering expanding its operations. The expansion is in the same risk class as existing operations and requires issuance of debt or equity or both. Since flotation costs will be involved, _______________. A) the WACC should be adjusted upward to reflect the flotation costs B) the firm should determine the highest level of flotation costs under the different financing scenarios and incorporate this into the borrowing costs C) the firm should increase the amount of funds needed by an amount equal to the estimated weighted average flotation costs D) the WACC should be adjusted downward E) the firm should decrease the amount of the future cash flows to reflect the level of flotation costs that will be incurred Ans: C

Level: Basic

Subject: WACC & Flotation Costs

Type: Concepts

75. The cost of capital depends primarily on the: A) Amount of equity financing employed. B) Type of debt used as a funding source. C) Marginal tax rate. D) Use of the funds acquired. E) Amount of preferred stock used as a source of funds. Ans: D

Level: Basic


Type: Concepts

76. Which of the following are considered, directly or indirectly, in the weighted average cost of capital? I. The marginal tax rate of the firm II. The amount of equity financing as a percent of the total financing III. The risk-free rate of return IV. The risk tolerance level of investors A) I, II, and IV only B) I, III, and IV only C) I, II, and III only D) II, III, and IV only E) I, II, III, and IV Ans: E

Level: Intermediate

Subject: WACC

Type: Concepts

77. The security market line approach depends on which three factors to estimate the expected return on a risky asset? I. Risk-free rate of return II. Marginal tax rate III. Market risk premium IV. Systematic risk of the asset A) I, II, and III only B) I, II, and IV only C) I, III, and IV only D) II, III, and IV only E) I, II, III, and IV only Ans: C

Level: Intermediate

Subject: SML Approach

Type: Concepts


Page 15


78. Which one of the following statements concerning the dividend growth model is correct? A) One of the advantages is that it applies to all dividend paying stocks. B) The estimated cost of equity financing is very dependent upon the assumed rate of growth. C) The estimated cost of equity will be directly affected by changes in the risk-free rate of return. D) The risk level of the use of the funds will be directly considered by the model. E) The main problem with the model is that it is so simplistic. Ans: B

Level: Intermediate


Type: Concepts

79. The weights placed on each source of financing when computing the WACC are based on the: A) Most recent book values available. B) The latest book values filed with the OSC. C) Market value of the equity portion and the face value of the debt portion. D) Market value of both the equity and the debt outstanding. E) Par value of the equity and the face value of the debt outstanding. Ans: D

Level: Intermediate

Subject: WACC Weights

Type: Concepts

80. The relevant cost of debt for use in a WACC computation which will be used as the required rate of return for a new project should be the rate that is the: A) Average coupon rate for all outstanding bond issues. B) Average yield-to-call for all callable bond issues. C) After-tax weighted average yield-to-maturity of all outstanding bonds. D) After-tax yield-to-maturity of the highest rated bond available on the market. E) Average of the risk-free rate of return and the after-tax weighted average yield-to-maturity of all outstanding bonds. Ans: C

Level: Intermediate


Type: Concepts

81. If the stock market increases in value, all else constant, then the WACC of most firms will tend to: A) Remain constant. B) Decrease. C) Increase. D) Change, but the direction of the change cannot be determined from the information given. Ans: D

Level: Challenge

Subject: WACC

Type: Concepts

82. A firm's WACC is applicable to those projects that: A) Are considered within one year of the date of the information used in the WACC computation. B) Are similar in risk to the current operations of the firm. C) Represent new avenues of business for the firm. D) Payback within the required period of time. E) Are pure plays in new areas of business. Ans: B

Level: Intermediate

Subject: WACC Applications

Type: Concepts


Page 16


83. A company has a market-to-book ratio that is greater than 1.0. If this company uses book values to determine their WACC, they will derive a value that is ______ the market based WACC. because _______ A) Equivalent to; the ratio of debt to equity is the same whether book values or market values are used. B) Greater than; the ratio of debt to equity will be greater than if the ratio was based on market values. C) Greater than; the ratio of debt to equity will be less than if the ratio was based on market values. D) Less than; the ratio of debt to equity will be greater than if the ratio was based on market values. E) Less than; the ratio of debt to equity will be less than if the ratio was based on market values. Ans: D

Level: Intermediate

Subject: Book Based WACC

Type: Concepts

84. A firm is considering a project that is virtually risk-free. The company has a beta of 1.3 and a debt-equity ratio of .4. The appropriate discount rate to use in analyzing this project is: A) The firm's latest WACC. B) An adjusted WACC based on a beta of 1.0. C) The cost of equity capital. D) The Treasury bill rate. E) Zero. Ans: D

Level: Intermediate

Subject: Risk-Free Rate

Type: Concepts

85. If a firm recalculates its WACC based solely on lower growth expectations for the firm, the new WACC will be: A) The same as the previous WACC because growth expectations do not affect WACC. B) Lower than the previous WACC because the cost of debt will decline. C) Lower than the previous WACC because the cost of equity will decline. D) Higher than the previous WACC because the cost of debt will increase. E) Higher than the previous WACC because the cost of equity will increase. Ans: C

Level: Intermediate

Subject: Rate Of Growth

Type: Concepts

86. A firm currently has a debt-equity ratio of .50, an after-tax cost of debt of 8%, and a cost of equity of 12%. The firm changes its debt-equity ratio to .40, all else constant. This change will: A) Increase the total debt level of the firm. B) Decrease the firm's WACC. C) Increase the cost of equity financing. D) Cause the NPV of projects under consideration to decrease. E) Not affect the firm's capital budgeting decisions. Ans: D

Level: Intermediate

Subject: Capital Structure

Type: Concepts

87. Which one of the following would tend to have the greatest effect on the cost of equity? A) A 10% one-time increase in a firm's dividend B) A 10% increase in the growth rate of a firm's dividends C) The elimination of one dividend payment five years from now D) A 10% decline in the market value of a firm's common stock E) A 10% increase in the market value of a firm's common stock Ans: B

Level: Intermediate


Type: Concepts


Page 17


88. The cost of debt is affected by which of the following? I. Investors' risk tolerance level II. The coupon rate of a firm's outstanding bonds III. Marginal tax rate IV. The current yield-to-maturity of the firm's bonds A) II and III only B) III and IV only C) I, II, and III only D) II, III, and IV only E) I, II, III, and IV Ans: E

Level: Intermediate


Type: Concepts

89. Which one of the following will increase the WACC of a firm? A) An increase in the marginal tax B) An increase in the debt-equity ratio C) An increase in the risk-free rate of return D) A decrease in the level of risk of a project E) A decrease in the yield-to-maturity of the bonds Ans: C

Level: Intermediate

Subject: WACC

Type: Concepts

90. The amount raised to finance a project when new securities are issued can be defined as the: A) Total value of the new securities issued multiplied by the quantity of 1 minus the flotation cost expressed as a percentage of the amount raised. B) Cash needed to fund the project excluding any flotation costs. C) Cash needed to fund the project multiplied by the quantity of 1 minus the flotation cost expressed as a percentage. D) Total market value of the new securities minus the flotation cost. E) Outside amount needed for the project divided by the quantity of 1 minus the flotation cost expressed as a percentage of the amount raised. Ans: E

Level: Intermediate

Subject: Flotation Cost

Type: Concepts

91. When calculating the flotation cost of a project, you should use: A) The current pre-tax debt to equity weights. B) The weights based on the actual intended sources of capital for the project. C) The target capital structure percentages. D) The weighted average of the market values of the current capital structure. E) The weighted average of the book values of the current capital structure. Ans: C

Level: Intermediate


Type: Concepts

92. The inclusion of flotation costs in capital budgeting analysis will cause the: A) Net present value of a project to decrease. B) Annual cash flows of a project to decrease. C) Initial cash outlay for a project to decrease. D) Debt-equity ratio of a firm to change. E) WACC to increase. Ans: A

Level: Intermediate


Type: Concepts


Page 18


93. Assume the government just increased corporate tax rates. This change will cause the: A) After-tax cost of debt to increase. B) After-tax cost of equity to decline. C) After-tax flotation cost to rise. D) WACC to increase. E) Target debt-equity ratio to change. Ans: E

Level: Intermediate

Subject: Tax Effect

Type: Concepts

94. The cost of preferred stock is based on the: A) Average yield-to-maturity of the outstanding securities. B) After tax average coupon rate. C) Annual stated dividend multiplied by (1 - Tc). D) Perpetuity rate of return on the security. E) Stated dividend adjusted for any flotation costs. Ans: D

Level: Intermediate

Subject: Cost Of Preferred Stock

Type: Concepts

95. Given the following information, what is the average annual dividend growth rate? Year 1994 1995 1996 1997 Dividend $2.50 $2.60 $2.65 $2.78 A) B) C) D) E)

1998 $2.89

1999 $3.05

3.0% 3.8% 4.1% 4.6% 5.4%

Ans: C

Level: Basic

Subject: Estimated Dividend Growth

Type: Problems

96. Given the following information, what is your best estimate for the firm's cost of equity on January 2, 1999, if the stock sells for $60 on that day? Date 12/31/94 12/31/95 12/31/96 12/31/97 12/31/98 Dividend $3.50 $3.68 $3.95 $4.29 $4.32 A) B) C) D) E)

12.1% 12.6% 13.0% 14.4% 20.2%

Ans: C

Level: Basic


Type: Problems

97. Treasury bills currently have a return of 3.5% and the market risk premium is 8%. If a firm has a beta of 1.6, what is its cost of equity? A) 8.8% B) 10.7% C) 12.8% D) 16.3% E) 18.8% Ans: D

Level: Basic


Type: Problems


Page 19


98. Suppose that two firms, A and B, are considering the same project which has the same risk as firm B's overall operations. The project has an IRR of 14.0%. Firm A has a beta of 1.4, while firm B's beta is 1.1. If the risk-free rate is 5.25% and the market risk premium is 7.0%, which firm(s) should take the project? A) A only B) B only C) Both A and B D) Neither A nor B E) Cannot be determined without additional information Ans: C

Level: Basic


Type: Problems

99. Given the following: the risk-free rate is 8% and the market risk premium is 8.5%. Which projects should be accepted if the firm's beta is 1.2? Project Beta Expected return I 0.65 12% II 0.90 17% III 1.40 19% A) B) C) D) E)

I only II only III only I and II only None of the projects are acceptable

Ans: B

Level: Basic


Type: Problems

100. Rattle me Bones, Inc. 's common stock is currently selling for $66.25 per share. You expect the next dividend to be $5.30 per share. If the firm has a dividend growth rate of 4% that is expected to remain constant indefinitely, what is the firm's cost of equity? A) 12.0% B) 12.3% C) 13.5% D) 13.9% E) 14.1% Ans: A

Level: Basic


Type: Problems

101. Topstone Industries is expected to pay a dividend of $2.10 per share in one year. This dividend, along with the firm's earnings, is expected to grow at a rate of 5% forever. If the current market price for a share of Topstone is $38.62, what is the cost of equity? A) 6.00% B) 10.44% C) 10.71% D) 11.00% E) 11.22% Ans: B

Level: Basic


Type: Problems


Page 20


102. The common stock of Tommy's Tools sells for $27.50. The firm's beta = 1.2, the risk-free rate is 4%, and the market risk premium is 8%. Next year's dividend is expected to be $1.50. Assuming that dividend growth is expected to remain constant for Tommy's over the foreseeable future, what is the firm's anticipated dividend growth rate? A) 7.6% B) 7.8% C) 8.1% D) 9.2% E) 10.1% Ans: C

Level: Basic


Type: Problems

103. The long-term debt of Topstone Industries is currently selling for 104.50% of its face value. The issue matures in 10 years and pays an annual coupon of 8%. What is the cost of debt? A) 6.75% B) 7.35% C) 7.84% D) 8.60% E) 9.45% Ans: B

Level: Basic


Type: Problems

104. RMB, Inc. sold a 20-year bond at par 12 years ago. The bond pays an 8% annual coupon, has a $1,000 face value, and currently sells for $893.30. What is the firm's cost of debt? A) 8.0% B) 9.2% C) 9.5% D) 10.0% E) 10.5% Ans: D

Level: Basic


Type: Problems

105. Anthony's Anchovies, Inc. sold a 20-year bond issue two years ago. The bond has a 5.35% annual coupon and a $1,000 face value. If the current market price of the bond is $751.64 and the tax rate is 34%, what is the aftertax cost of debt? A) 4.2% B) 4.4% C) 8.0% D) 6.6% E) 5.3% Ans: E

Level: Basic


Type: Problems

106. Ponderosa's bonds sell for $846.04. The coupon rate is 8%, the bonds mature in 25 years, and interest is paid semiannually. The tax rate is 34%. What is Ponderosa's aftertax cost of debt? A) 3.18% B) 4.99% C) 9.64% D) 9.34% E) 6.36% Ans: A

Level: Basic


Type: Problems


Page 21


107. Greene Co. is planning a project for which it will issue new bonds. Bonds in the same risk class issued by another firm are currently priced at $954.90, have 25 years remaining to maturity, and pay coupons of $75 every year. If Greene's marginal tax rate is 34%, what is the pretax cost of debt for the project? A) 7.92% B) 7.50% C) 7.20% D) 8.12% E) 9.04% Ans: A

Level: Basic

Subject: Zero Coupon Debt

Type: Problems

108. Roberts Co.'s zero coupon bonds mature in 22 years and have a yield to maturity of 12.01%. Each zero has a face value of $1,000 and there are 2,000 of the bonds outstanding. If the market value of Roberts' equity is $1,000,000, what capital structure weight for debt would you use in calculating the WACC, assuming Roberts' only debt consists of the zeros? A) 11.9% B) 14.2% C) 15.8% D) 18.9% E) 66.7% Ans: B

Level: Basic

Subject: Zero Coupon Debt

Type: Problems

109. Anthony's Antiques, Inc. has preferred stock outstanding which pays a dividend of $4 per share a year. The current stock price is $32 per share. What is the cost of preferred stock? A) 8.0% B) 9.0% C) 10.0% D) 11.0% E) 12.5% Ans: E

Level: Basic


Type: Problems

110. Topstone Industries' preferred stock pays an annual dividend of $4 per share. When issued, the shares sold for their par value of $100 per share. What is the cost of preferred stock if the current price is $125 per share? A) 3.2% B) 3.7% C) 4.0% D) 4.7% E) 31.3% Ans: A

Level: Basic


Type: Problems


Page 22


111. Suppose a firm has 10.4 million shares of common stock outstanding with a par value of $1 per share. The current market price per share is $12. The firm has outstanding debt with a par value of $56 million selling at 102% of par. What capital structure weight would you use for debt when calculating the firm's WACC? A) 0.157 B) 0.314 C) 0.686 D) 0.739 E) 0.843 Ans: B

Level: Basic


Type: Problems

112. KCE Co. is operating at its target capital structure with market values of $110 million in equity and $175 million in debt outstanding. KCE plans to finance a new $32 million project using the same relative weights of debt and equity. Ignoring flotation costs, how much new debt must be issued to fund the project? A) $12.4 million B) $18.5 million C) $19.6 million D) $24.8 million E) $32.0 million Ans: C

Level: Basic


Type: Problems

113. Given the following information, what is the value of XYZ Corporation? Common Stock: 14. 2 million shares outstanding, price = $35 per share Bond Issue 1: $500 million total face value, price = 102% of face value Bond Issue 2: $175 million total face value, price = $850 per bond A) $697.52 million B) $874.82 million C) $987.24 million D) $1,049.43 million E) $1,155.75 million Ans: E

Level: Basic

Subject: Value Of The Firm

Type: Problems

114. The market value of DRK Inc.'s debt is $200 million and the total market value of the firm is $600 million. The cost of equity is 15%, the cost of debt is 8%, and the tax rate is 34%. What is this firm's WACC? A) 11.14% B) 11.76% C) 12.25% D) 12.67% E) 14.07% Ans: B

Level: Basic

Subject: WACC

Type: Problems


Page 23


115. Suppose that Topstone Industries has a cost of equity of 14% and a cost of debt of 9%. If the target debt/equity ratio is 75%, and the tax rate is 34%, what is Topstone's weighted average cost of capital (WACC) ? A) 6.6% B) 7.9% C) 8.4% D) 10.5% E) 10.9% Ans: D

Level: Basic

Subject: WACC

Type: Problems

116. Given the following information, what is JEM Inc.'s weighted average cost of capital? Market value of equity = $50 million; market value of debt = $30 million; cost of equity = 16%; cost of debt = 8%; equity beta = 1.25; tax rate = 34%. A) 11.98% B) 11.45% C) 11.29% D) 12.32% E) 13.00% Ans: A

Level: Basic

Subject: WACC

Type: Problems

117. A firm has 2,000,000 shares of common stock outstanding with a market price of $2 per share. It has 2,000 bonds outstanding, each selling for $1,200. The bonds mature in 15 years, have a coupon rate of 10%, and pay coupons annually. The firm's beta is 1.2, the risk free rate is 5%, and the market risk premium is 7%. The tax rate is 34%. Calculate the WACC. A) 5.42% B) 6.53% C) 9.36% D) 10.28% E) 11.57% Ans: D

Level: Basic

Subject: WACC

Type: Problems

118. A firm has a WACC of 12%. It is financed with 40% debt and 60% equity. The firm's cost of debt is 10% and its tax rate is 40%. If the firm's dividend growth rate is 8% and its current stock price is $40, what is the value of the next dividend the firm is expected to pay? A) Less than $3.00 B) Between $3.01 and $3.50, inclusive C) Between $3.51 and $4.25, inclusive D) Greater than $4.25 E) Cannot be determined without additional information Ans: B

Level: Basic

Subject: WACC

Type: Problems


Page 24


119. Given the following information, what is WBM Corporation's WACC? Common Stock: 1 million shares outstanding, $40 per share, $1 par value, beta = 1.3 Bonds: 10,000 bonds outstanding, $1,000 face value each, 8% annual coupon, 22 years to maturity, market price = $1,101.23 per bond Market risk premium = 8. 6%, risk-free rate = 4. 5%, marginal tax rate = 34% A) 7.89% B) 9.90% C) 12.19% D) 13.30% E) 15.78% Ans: D

Level: Basic

Subject: WACC

Type: Problems

120. Given the following information, what is JHM Corporation's WACC? Common Stock: 2 million shares outstanding $30 per share, $1 par value b = .5 Bonds: 80,000 bonds outstanding $1,000 face value for each bond 7% annual coupon 10 years to maturity Selling at 108.25% of face Market risk premium: 7% Risk free rate: 5% Tax rate: 34% A) B) C) D) E)

5.77% 6.54% 7.90% 7.97% 9.61%

Ans: A

Level: Basic

Subject: WACC

Type: Problems

121. JLP Industries has 6.5 million shares of common stock outstanding with a market price of $14 per share. The company also has outstanding preferred stock with a market value of $10 million, and 25,000 bonds outstanding, each with face value $1,000 and selling at 90% of par value. The cost of equity is 14%, the cost of preferred is 10%, and the cost of debt is 7.25%. If JLP's tax rate is 34%, what is the WACC? A) 9.5% B) 10.0% C) 10.8% D) 11.6% E) 12.0% Ans: E

Level: Basic

Subject: WACC

Type: Problems


Page 25


122. A firm is considering a project that will generate perpetual cash flows of $15,000 per year beginning next year. The project has the same risk as the firm's overall operations and must be financed externally. Equity costs 14% and debt costs 4% on an aftertax basis. The firm's D/E ratio is 0.8. What is the most the firm can pay for the project and still earn its required return? A) $138,000 B) $157,000 C) $164,000 D) $182,000 E) $199,000 Ans: B

Level: Intermediate

Subject: WACC & Acceptable Project Cost

Type: Problems

123. A proposed project lasts three years and has an initial investment of $200,000. The aftertax cash flows are estimated at $60,000 for year 1, $120,000 for year 2, and $135,000 for year 3. The firm has a target debt/equity ratio of 1.2. The firm's cost of equity is 14% and its cost of debt is 9%. The tax rate is 34%. What is the NPV of this project? A) –$12,370 B) $13,687 C) $37,723 D) $46,120 E) $57,185 Ans: E

Level: Intermediate

Subject: WACC & NPV

Type: Problems

124. A firm needs to raise $165 million for a project. If external financing is used, the firm faces flotation costs of 8% for equity and 2.5% for debt. If the project is to be financed 60% with equity and 40% with debt, how much cash must the firm raise in order to finance the project? A) $128.6 million B) $142.2 million C) $161.7 million D) $171.6 million E) $175.2 million Ans: E

Level: Intermediate


Type: Problems

125. Your firm is considering a project which requires an initial investment of $5 million. Your target D/E ratio is 0.67. Flotation costs for equity are 8% and flotation costs for debt are 2%. What is the true cost (in dollars) of the project when you consider flotation costs? A) $5.00 million B) $5.24 million C) $5.30 million D) $5.57 million E) $5.61 million Ans: C

Level: Intermediate


Type: Problems


Page 26

Chapter 14 Cost of Capital Use the following to answer questions 126-129: Kottinger's Kamp Supplies is considering an investment in new manufacturing equipment. The equipment costs $220,000 and will provide annual aftertax inflows of $50,000 at the end of each of the next seven years. The firm's market value debt/equity ratio is 25%, its cost of equity is 14%, and its pretax cost of debt is 7%. The flotation costs of debt and equity are 3% and 9%, respectively. The firm's combined marginal federal and provincial tax rate is 40%. Assume the project is of approximately the same risk as the firm's existing operations. 126. What is Kottinger's weighted average cost of capital? A) 8.91% B) 9.99% C) 10.86% D) 11.14% E) 12.04% Ans: E

Level: Intermediate

Subject: WACC

Type: Problems

127. Ignoring flotation costs, what is the NPV of the proposed project? A) $6,297 B) $7,899 C) $9,156 D) $13,436 E) $15,984 Ans: B

Level: Intermediate

Subject: NPV

Type: Problems

128. What is the weighted average flotation cost for Kottinger's? A) 3.0% B) 6.0% C) 7.8% D) 8.2% E) 9.1% Ans: C

Level: Intermediate


Type: Problems

129. After considering flotation costs, what is the NPV of the proposed project? A) –$10,713 B) –$9,261 C) –$7,098 D) $2,122 Ans: A

Level: Intermediate

Subject: NPV

Type: Problems

Use the following to answer questions 130-134: Hartley, Inc. needs to purchase equipment for its 2,000 drive-ins nationwide. The total cost of the equipment is $2 million. It is estimated that the aftertax cash inflows from the project will be $210,000 annually in perpetuity. Hartley has a market value debt-to-assets ratio of 40%. The firm's cost of equity is 13%, its pretax cost of debt is 8%, and the flotation costs of debt and equity are 2% and 8%, respectively. The tax rate is 34%. Assume the project is of similar risk to the firm's existing operations.


Page 27


130. What is Hartley's weighted average cost of capital? A) 6.09% B) 8.73% C) 8.95% D) 9.05% E) 9.91% Ans: E

Level: Intermediate

Subject: WACC

Type: Problems

131. Ignoring flotation costs, what is the NPV of the proposed project? A) $33,966 B) $65,990 C) $98,542 D) $119,072 E) $128,034 Ans: D

Level: Intermediate

Subject: NPV

Type: Problems

132. What is the weighted average flotation cost for Hartley? A) 3.0% B) 5.6% C) 5.8% D) 6.3% E) 7.4% Ans: B

Level: Intermediate


Type: Problems

133. What is the dollar flotation cost for the proposed financing? A) $112,000 B) $118,644 C) $131,230 D) $142,098 E) $159,001 Ans: B

Level: Intermediate

Subject: Dollar Flotation Cost

Type: Problems

134. After considering flotation costs, what is the NPV of the proposed project? A) –$ 2,957 B) $428 C) $2,091 D) $7,072 E) $178,675 Ans: B

Level: Intermediate

Subject: NPV

Type: Problems


Page 28


135. The common stock of a firm is currently priced at $53 a share. The company paid $1.40 in common dividends last year and expects to increase this amount by 3% annually. The stock has a beta of 1.40, which is about equal to its industry average. Given this information, what is the cost of equity financing? A) 3.81% B) 5.64% C) 5.72% D) 6.70% E) 8.01% Ans: C

Level: Intermediate


Type: Problems

136. The Windsor Group has paid dividends of $0.50, $0.60, $0.75, $0.90, and $0.99 over the past five years, respectively. Based on this information, D1 can be estimated as _____ and g can be estimated as ______ for use in the dividend growth model. A) $.99; 18.75% B) $1.08; 9% C) $1.08; 20% D) $1.18; 10% E) $1.18; 18.75% Ans: E

Level: Intermediate


Type: Problems

137. The common stock of Chelsea, Inc. has a beta of 1.14, a market price of $38.90, and an expected dividend of $.90 next year. The market risk premium is 6% and the risk-free rate of return is 3%. What is the average expected cost of equity for Chelsea, Inc.? A) 6.42% B) 8.31% C) 9.08% D) 9.42% E) 9.84% Ans: E

Level: Intermediate

Subject: Average Weighted Cost Of Capital

Type: Problems

138. The Jackson Co. is currently in the business of making kitchen cabinets. They have $400,000 in outstanding bonds with a coupon rate of 8% and a yield-to-maturity of 7.5%. The company is seeking additional financing so they can start a new venture, which involves the sales and installation of patio rooms, including spas and hot tubs. Their biggest competitor, who specializes solely in patio rooms, has $600,000 in outstanding bonds with a 9% coupon rate and an 11% yield-to-maturity. Jackson's marginal tax rate is 35% and the competitor's marginal tax rate is 34%. What after-tax rate cost of debt should the Jackson Co. use in their WACC calculation? A) 4.88% B) 5.85% C) 5.94% D) 7.15% E) 7.26% Ans: D

Level: Intermediate

Subject: After-Tax Cost Of Debt


Type: Problems

Page 29


139. Adapt Electric Cars has two preferred stock offerings. The first consists of 100,000 shares of Class A preferred which yield 9%. The second consists of 200,000 shares of Class B preferred with a yield of 7.8%. The class A shares are currently selling at $81 a share and the Class B shares are currently selling at $56 a share. What is the weighted average cost of preferred stock? A) 8.20% B) 8.30% C) 8.40% D) 8.50% E) 8.60% Ans: B

Level: Intermediate

Subject: Cost Of Preferred Stock

Type: Problems

140. McQuinty, Inc. has a beta of 1.34 and a marginal tax rate of 31%. The company has one bond issue outstanding with a total face value of $750,000. The bonds are currently quoted at 98.6. These bonds have seven years to maturity, a 6% coupon rate, and pay interest semi-annually. What is the after-tax cost of debt for McQuinty, Inc.? A) 4.14% B) 4.31% C) 5.16% D) 5.55% E) 6.25% Ans: B

Level: Intermediate


Type: Problems

141. A firm has 100,000 shares of common stock and 40,000 shares of preferred stock outstanding. The common stock has a market value of $15 a share and the preferred stock is priced at $21 a share. The firm also has 1,000 bonds outstanding with a market price of $989 and a 5% coupon rate. The bonds mature in fifteen years and pay interest semi-annually. The weights for the common stock, the preferred stock, and the debt are _____________ , respectively. A) 45%, 25%, 30% B) 45%, 30%, 25% C) 50%, 30%, 20% D) 50%, 20%, 30% E) 55%, 35%, 10% Ans: A

Level: Intermediate


Type: Problems

142. A firm has three bond issues outstanding as shown below. Based on this information what is the weighted average cost of debt? Market value Coupon Rate Yield to Maturity $500,000 8.00% 7.20% $600,000 7.00% 8.40% $900,000 6.00% 7.80% A) B) C) D) E)

6.80% 7.32% 7.46% 7.83% 8.01%

Ans: D

Level: Intermediate

Subject: Weighted Average Cost Of Debt


Type: Problems

Page 30


143. A firm finances its projects with 45% common stock, 15% preferred stock, and 40% debt. The firm has a 34% marginal tax rate. The cost of equity is 9%, the cost of preferred is 8%, and the cost of debt is 7%. What is the WACC? A) 6.98% B) 7.10% C) 7.24% D) 7.80% E) 8.05% Ans: B

Level: Intermediate

Subject: WACC

Type: Problems

144. A firm uses 55% equity and 45% debt for all of its financing needs. Shares of the common stock sell at $43. The company expects to pay $1.30 in dividends next year and increase that amount by 3% annually. The bonds have a 7% coupon rate and a yield-to-maturity of 6.8%. The company has a beta of 1.39 and a 34% marginal tax rate. What is the WACC? A) 5.33% B) 5.48% C) 5.88% D) 6.03% E) 6.37% Ans: A

Level: Intermediate

Subject: WACC

Type: Problems

145. A firm has a debt-equity ratio of .25. What weight should be given to the equity for the WACC computation? A) 20% B) 25% C) 40% D) 60% E) 80% Ans: E

Level: Intermediate

Subject: Debt-Equity Ratio

Type: Problems

146. A firm has a target debt-equity ratio of .37. The cost of debt is 9% and the cost of equity is 15%. The company has a 34% tax rate. A project has an initial cost of $70,000 and an annual after-tax cash flow of $21,000 for six years. There is no salvage value or net working capital requirement. What is the net present value of the project using the WACC? A) $14,092 B) $14,899 C) $15,011 D) $15,513 E) $15,942 Ans: C

Level: Intermediate

Subject: NPV

Type: Problems


Page 31


147. A company has a project with an initial after-tax cash savings of $40,000 at the end of the first year. These savings will increase by 2% annually. The firm has a debt-equity ratio of 1/3, a cost of equity of 16%, a cost of debt of 10%, and a 35% tax rate. The project is equal in risk to the current overall risk of the company. What is the present value of the project? A) $321,906 B) $343,938 C) $355,800 D) $357,021 E) $361,016 Ans: B

Level: Intermediate

Subject: PV With Growing Perpetuity

Type: Problems

148. Company A produces milk containers and has a beta of .65. Company B produces cardboard boxes and has a beta of 1.30. The market risk premium is 9% and the risk-free rate of return is 3%. Both companies are considering a new project, which involves creating toys made of cardboard, that is similar in risk to producing cardboard boxes. The project has an estimated rate of return of 13%. Which company should accept the project? A) Neither A nor B B) A only C) B only D) Both A and B E) This problem cannot be answered with the information given. Ans: A

Level: Intermediate

Subject: Pure Play

Type: Problems

Use the following to answer questions 149-154: The Smith Company has 10,000 bonds outstanding. The bonds are selling at 101% of face value, have a 7% coupon rate, pay interest annually, and mature in 9 years. There are 500,000 shares of 8% preferred stock outstanding with a current market price of $91 a share. In addition, there are 1.25 million shares of common stock outstanding with a market price of $63 a share and a beta of .97. The common stock paid a total of $1.20 in dividends last year and expects to increase those dividends by 3% annually. The firm's marginal tax rate is 35%. The overall stock market is yielding 11% and the Treasury bill rate is 3.5%. 149. What is the cost of equity based on the dividend growth model? A) 4.81% B) 4.85% C) 4.91% D) 4.96% E) 5.01% Ans: D

Level: Intermediate


Type: Problems

150. What is the cost of equity based on the security market line? A) 7.28% B) 10.67% C) 10.78% D) 11.34% E) 14.17% Ans: C

Level: Intermediate

Subject: SML

Type: Problems


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151. What is the cost of financing using preferred stock? A) 7.06% B) 7.28% C) 8.13% D) 8.48% E) 8.79% Ans: E

Level: Intermediate

Subject: Preferred Stock

Type: Problems

152. What is the after-tax cost of debt financing? A) 4.45% B) 4.55% C) 6.25% D) 6.75% E) 6.85% Ans: A

Level: Intermediate


Type: Problems

153. What weight should be given to the preferred stock in the weighted average cost of capital computation? A) 32% B) 34% C) 37% D) 38% E) 39% Ans: B

Level: Intermediate


Type: Problems

154. What is the total market value of the Smith Company? A) $133.65MM B) $133.75MM C) $134.25MM D) $134.35MM E) $134.45MM Ans: D

Level: Intermediate

Subject: Market Value Of The Firm

Type: Problems

Use the following to answer questions 155-159: Taylor Enterprises has 12,000 bonds outstanding that have a 6% coupon rate. The bonds are selling at 98% of face value, pay interest semi-annually, and mature in 28 years. There are 400,000 shares of 9% preferred stock outstanding with a current market price of $83 a share. In addition, there are 1.40 million shares of common stock outstanding with a market price of $54 a share and a beta of 1.2. The common stock paid a total of $1.80 in dividends last year and expects to increase those dividends by 4% annually. The firm's marginal tax rate is 34%. The overall stock market is yielding 12% and the Treasury bill rate is 4.0%.


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155. What is the cost of equity based on the dividend growth model? A) 7.16% B) 7.28% C) 7.33% D) 7.47% E) 7.58% Ans: D

Level: Intermediate


Type: Problems

156. What is the cost of equity based on the security market line? A) 9.60% B) 13.60% C) 14.40% D) 17.60% E) 18.40% Ans: B

Level: Intermediate

Subject: SML

Type: Problems

157. What is the cost of financing using preferred stock? A) 7.47% B) 9.00% C) 9.66% D) 10.32% E) 10.84% Ans: E

Level: Intermediate

Subject: Preferred Stock

Type: Problems

158. What is the pre-tax cost of debt financing? A) 6.15% B) 6.18% C) 6.23% D) 6.31% E) 6.34% Ans: A

Level: Intermediate

Subject: Pre-Tax Cost Of Debt

Type: Problems

159. What weight should be given to equity in the weighted average cost of capital computation? A) 57% B) 59% C) 61% D) 63% E) 65% Ans: D

Level: Intermediate


Type: Problems


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160. What are the consequences of using a discount rate that is higher or lower than the firm's true required return? Ans: As a general rule, if the discount rate used is too high, the firm will tend to accept unprofitable projects and reject profitable projects, becoming riskier over time). If the rate is too low, again, the firm will tend to accept unprofitable projects, but whether or not the firm becomes riskier over time depends on what type of projects are ultimately accepted. Level: Intermediate

Subject: Appropriate Discount Rate

Type: Essays

161. Consider the following statement by a financial manager: "Since we are financing our new manufacturing facility 100% with equity, we must evaluate it using a higher rate of return than we would if we financed a portion of the facility with debt." Do you agree? Why or why not? Be sure to fully explain the rationale behind your argument. Ans: This financial manager is violating the basic rule that the cost of capital depends on the use of funds, not the source. The student might go on to explain that the cost of capital represents an opportunity cost in the sense that investors typically have numerous investment opportunities open to them, and choose between them based on their risk-return characteristics. For example, if a firm invests in risk-free projects, investors should only expect to earn the risk-free rate of return. Level: Challenge

Subject: Project Cost Of Capital

Type: Essays

162. Suppose your firm is going to finance a new project 100% with retained earnings. Your boss claims that since the earnings are already being retained and that since no outside financing is required, the project should be evaluated at the risk-free rate of return. Is this appropriate? Are retained earnings risk-free? Why or why not? Ans: Students should recognize that retained earnings essentially belong to equityholders and that the appropriate cost is the cost of equity. Moreover, the boss is basing the cost of capital on the source of funds, not the use. Level: Challenge

Subject: Retained Earnings

Type: Essays

163. Your firm is about to issue new, AA rated bonds to finance an expansion project. This new issue would double the amount of AA rated publicly traded bonds the firm has outstanding. Explain each of the ways the firm might use to determine the cost of debt for the project. Ans: This question requires a simple recitation of the basics presented in section 14. 3. In brief, the firm can compute the yield on its already publicly traded debt or it can observe the yields on recently issued bonds that have a similar rating to those that are to be issued. Level: Intermediate


Type: Essays

164. Since debt is typically a cheaper source of financing than is equity, why don't firms use as close to 100% debt financing as possible? Ans: This question is a prelude to the next chapter and is designed to get students thinking about the tradeoffs between the two types of financing and the advantages and disadvantages of each. Level: Challenge

Subject: Debt vs. Equity

Type: Essays


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165. Why is it important for financial decision makers to obtain a good estimate of the firm's cost of capital? Ans: The student should indicate that making decisions that maximize firm value is not possible unless one employs the appropriate discount rate. Level: Intermediate

Subject: WACC

Type: Essays

166. What role does the cost of capital play in the overall financial decision making of the firm's top managers? Ans: This is a very open-ended question. Students should explain that using the appropriate discount rate in making a capital budgeting decision is crucial to project analysis. Using the wrong discount rate effectively makes useless the care taken to make sure cash flow estimates are reasonable. In a broader sense, it is only by using a cost of capital that accurately reflects the rate of return demanded by the providers of capital that firm managers can act to maximize shareholder wealth. Level: Challenge

Subject: WACC

Type: Essays

167. Why do you think some managers employ the subjective approach in assigning a discount rate to proposed projects? Ans: Students should explain that there are practical difficulties involved in developing an appropriate discount rate for each and every project. First, it may be difficult to come up with accurate estimates. Second, while it may be possible to come up with more accurate estimates than the subjective approach provides, it may not be beneficial when compared to the cost of doing so. The subjective approach provides a practical compromise in terms of analysis costs versus the desire to incorporate, at least to a rough degree, the differential risk profiles of the varied investment projects of the firm. Level: Intermediate


Type: Essays

168. Compare and contrast the subjective and pure play approaches to estimating the cost of capital. Under what conditions is each appropriate? What are the dangers of computing the cost of capital incorrectly? Ans: The desired response here is self-explanatory - a reasonable answer will discuss the material appearing in section 14. 5 of the chapter. Level: Intermediate

Subject: Subjective & Pure Play Approaches

Type: Essays

169. Mustard Patch Doll Company needs to purchase new plastic molding machines to meet the demand for its product. The cost of the equipment is $100,000. It is estimated that the firm will increase operating cash flow (OCF) by $22,000 annually for the next seven years. The firm is financed with 40% debt and 60% equity, both based on market values. The firm's cost of equity is 16% and its pre-tax cost of debt is 8%. The flotation costs of debt and equity are 2% and 8%, respectively. Assume the firm's tax rate is 34%. (A) What is the firm's WACC? (B) Ignoring flotation costs, what is the NPV of the proposed project? (C) What is the weighted average flotation cost, fA, for the firm? (D) What is the dollar flotation cost of the proposed financing? (E) After considering flotation costs, what is the NPV of the proposed project? Ans: This is simply a long problem similar to those in previous sections; the point here is to provide material for those instructors who wish to give partial credit. The answers are below. a. WACC = . 4(8)(1 – .34) + .6(16) = 11.7% b. NPV = 22,000PVIFA(11.7,7) – 100,000 = $1,365 c. fA = .4(2) + .6(8) = 5.6% d. Flotation cost = 100,000/(1 – .056) – 100,000 = $5,932 e. NPV = 22,000PVIFA(11.7,7) – 105,932 = –$4,567


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Level: Challenge

Subject: Flotation Costs and NPV

Type: Essays

170. Suppose your boss comes to you and asks you to re-evaluate a capital budgeting project. The first evaluation was in error, he explains, because it ignored flotation costs. To correct for this, he asks you to evaluate the project using a higher cost of capital. Is his approach correct? Why or why not? Ans: He is confused about the cost of capital that is appropriate for a project. It depends on the use of the funds, not the source. It would be more appropriate to determine the level of flotation costs and add those to the cost of the project. Level: Intermediate


Type: Essays

171. Explain the interactions between market efficiency, capital budgeting, and the cost of capital. Ans: This question will likely take the good student some time to complete. They should explain how using the correct cost of capital is crucial in making capital budgeting decisions. Also, the cost of capital is determined by the use of funds, not the source, so the riskiness of the project is important. Furthermore, in an efficient market, project NPVs will be zero, on average. Thus, managers should carefully examine projects with positive NPVs to determine their source of value and to determine the reasonableness of the cash flow estimates underlying the calculation. Finally, if markets are efficient, then the cost of capital observed in the market is a "fair" estimate of the return required by the firm's investors. Level: Challenge

Subject: Capital Budgeting, EMH, & Cost

Type: Essays

172. Compare and contrast the pure play and the subjective approaches to WACC. Ans: Both the pure play and the subjective approaches are designed to adjust WACC for the risk level of each individual project. The pure play finds a firm that specializes solely in the type of work that the project entails and utilizes information from that firm to compute an appropriate WACC. As long as your firm operates in a similar manner to the pure play firm, this should produce a reliable WACC. The subjective approach uses your own firm's WACC as the base value and then increases or decreases that rate to tentatively adjust to the risk level of the project. Level: Intermediate

Subject: Pure Play Versus Subjective

Type: Essays

173. Explain the basic assumption that is being made about a firm's capital structure when market values are used in the WACC computation. Why is this considered to be a good assumption? Ans: The base assumption is that the current mixture of the firm's debt and equity will be used for projects under consideration. Since many firms tend to maintain a relatively steady debt-equity ratio, this is generally considered a good assumption. If a different debt-equity ratio is to be used, then WACC should be adjusted accordingly. Level: Intermediate


Type: Essays


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Chapter 14

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