Cost of Capital

TESTBANK

Long Term Financing Decisions 1.) It is the rate that a firm must earn on the projects in which it invests to maintain the market value of its stock. a. stock price b. cost of capital

c. internal rate of return d. net present value

Answer: b Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

2.) It is the risk to the firm of being unable to cover operating costs – is assumed to be unchanged. This assumption means that the firm’s acceptance of a given project does not affect its ability to meet operating costs. a. business risk b. economic risk

c. financial risk d. accounting risk

Answer: a Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

3.) It is the risk to the firm of being unable to cover required financial obligations (interest, lease payments, preferred stock dividends) – is assumed to be unchanged. This assumption means that projects are financed in such a way that the firm’s ability to meet to meet required financing costs is unchanged. a. business risk b. economic risk

c. financial risk d. accounting risk

Answer: c Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

4.) The after-tax cost of today of raising long-term funds through bo rrowing. a. cost of common stock b. cost of retained earnings

c. cost of preferred stock d. cost of long-term debt

Answer: d Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

5.) The ratio of the preferred stock dividend to the firm’s net proceeds from the sale of preferred stock; calculated by dividing the annual an nual dividend, by the net n et proceeds from the sale of the preferred stock. a. cost of common stock b. cost of retained earnings



6.) The return required on the stock by b y investors in the marketplace. a. cost of common stock b. cost of retained earnings



7.) The same as the cost of an equivalent fully subscribed issue of additional common stock, which is equal to common stock equity. a. cost of common stock b. cost of retained earnings



8.) It reflects the expected average future cost of funds over the long run; found by weighting the cost of each specific type of capital by its proportion in the firm’s capital structure. a. cost of capital b. weighted average

c. weighted average cost of capital d. average cost


9.) Weights that use accounting values to measure the proportion of each type of capital in the firm’s financial structure. a. market value weights b. book value weights

c. target weights d. historical weights

5.) The ratio of the preferred stock dividend to the firm’s net proceeds from the sale of preferred stock; calculated by dividing the annual an nual dividend, by the net n et proceeds from the sale of the preferred stock. a. cost of common stock b. cost of retained earnings



6.) The return required on the stock by b y investors in the marketplace. a. cost of common stock b. cost of retained earnings



7.) The same as the cost of an equivalent fully subscribed issue of additional common stock, which is equal to common stock equity. a. cost of common stock b. cost of retained earnings



8.) It reflects the expected average future cost of funds over the long run; found by weighting the cost of each specific type of capital by its proportion in the firm’s capital structure. a. cost of capital b. weighted average

c. weighted average cost of capital d. average cost


9.) Weights that use accounting values to measure the proportion of each type of capital in the firm’s financial structure. a. market value weights b. book value weights



10.) Weights that use market values to measure the proportion of each type of capital in the firm’s financial structure. a. market value weights b. book value weights



11.) It can either be book or market value weights based on actual capital structure proportions. a. market value weights b. book value weights



12.) It can either be based on book or market values; reflect the firm’s desired capital structure proportions. Firms using these weights establish such proportion on the basis of the “optimal” capital structure they wish to achieve. a. market value weights b. book value weights



13.) It is concerned with the relationship between the firm’s sales revenue and its earnings before interest and taxes taxes or EBIT. a. total leverage b. financial leverage

c. operating leverage d. capital structure


14.) It is concerned with the relationship between the firm’s sales revenue and earning per share (EPS). a. total leverage b. financial leverage



15.) It is concerned with the relationship between the firm’s EBIT and its common stock earnings per share. a. total leverage b. financial leverage



16.) The mix of long-term debt and equity maintained by the firm. a. total leverage b. financial leverage



17.) The capital structure at which the weighted average cost of capital is minimized, thereby maximizing the firm’s value. a. cost of capital b. weighted average cost of capital

c. capital structure d. optimal capital structure


18.) Results from the use of fixed-cost assets or funds to magnify returns to the firm’s owners. a. leverage b. financial leverage Answer: a


Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

19.) Indicates the level of operations necessary to cover all operating costs and the profitability associated with various levels of sales. a. breakeven point b. breakeven analysis

c. operating breakeven point d. operating costs


20.) The level of sales necessary to cover all operating costs. a. breakeven point b. breakeven analysis

c. operating breakeven point d. operating costs


21.) The yield to maturity of a bond is: a. The discount rate in a present-value equation that equates the market price of a bond with present value of its future debt-service obligations. b. The average annual rate of return an investor expects to receive from buying and holding the bond until maturity. c. Equal to the coupon rate if the bond sells at par value. d. All of the above. Answer: d Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition.

22.) For a given company, the cost of prefferd stock is less than the cost of common stock because: a. Dividends paid on preferred stock are tax deductible expenses for the company while dividends paid on common stock are paid out of after-tax earnings. b. Preferred stock represents a less risky source of funds from the company’s viewpoint than common stock. c. Investors expect cash flows from common stock have a higher degree of uncertainty that the expected cash flows from preferred stock. d. All of the above. Answer: c

Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition.

23.) For a given company, Investors’ required return on the company’s common stock is: a. b. c. d.

Equal to the company’s cost of retained earnings Equal to the company’s cost of new common stock if inflation costs are zero. Always less that the cost of new common stock if inflation costs are not zero. All of the above.

Answer: d Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition.

24.) Which of the following situations should never occur: a. Within the company, the required return on common equity is less than the required return on preferred stock. b. The required return on one company’s common stock is lower than the required yield on another company’s preferred stock. c. Within one company, the cost of debt is less than the cost of equity. d. a and b. Answer: a Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition.

25.) GBF Co. is preparing to float a new issue of bonds. The bonds will have the following characteristics: Coupon rate Term to maturity Face value Issue price

8.4% 10 years P1,000 P900.30

GBF s marginal tax rate is 34%. The coupon payments are paid semiannually. GBF’s cost of debt (ki) for this bond issue will be nearest: a. 5.0% b. 1.7%

c. 3.3% d. 6.6%

Answer: d

At 6.6% the present value of the maturity of the bonds (P1,000) plus the present value of the semi-annual interest payments will equal P900.30.


26.) DRW, Inc. is preparing to issue preferred stock. The preferred stock will have a P100 par value and will pay P8 per year in dividends. DRW’s marginal tax rate is 34%. Flotation cost for the new issue will be P2.38 per share. The issue price is expected to be P96.50 per share. Based on this information, DRW’s cost of preferred stock is nearest: a. 5.3% b. 8.5%

c. 5.6% d. 8.0%

Answer: b

P8 / (P96.50-P2.38) = 8.5% Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition. Use this information for questions 27 and 28. Ames Co. is preparing to issue new common stock. Ames stock is currently selling in the market for P50. Very recently, the stock paid a dividend of P2 per share. Dividend are expected to gorw at 10% per year through the foreseeable future. Floatation costs on the new issue will be P3 per share. Ames’ marginal tax rate is 34%. Assume that the new stock can be sold to investors at the current price of the price existing shares.

27.) Based on the information given above, Ames’ cost of retained earnings is nearest: a. 4.4% b. 4.7%

c. 14.0% d. 14.4%

Answer: d

[(P2 x 110%) / P50] + 10% = 14.4% 28.) Based on the information given above, Ames’ cost of new common stock is nearest: a. 8.33% b. 14.40%

c. 14.68% d. 14.25%

Answer: c

[(P2 x 110%) / (P50 - P3] + 10% = 14.68% Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition.

29.) GMR Corporation is preparing to issue common stock. The Chief Financial Officer is attempting to estimate GMR’s cost of new common stock. The next dividend is expected

to be P4.25 and will be paid one year from now. The current market price reflects an 18% expected annual return to investors. Dividends are expected to grow at a constant 8% per year. Flotation cost costs on the new issue will be P1.25 per share. GMR;s cost of new common stock is nearest. a. 18.30% b. 19.25%

c. 18.00% d. 19.44%

Answer: a

P4.25 / (18% - 8%) = P42.50

P4.25 / (P42.50 – P1.25) + 8% = 18.3%


30.) RMG Corporation is preparing to issue common stock. The Chief Financial Officer is attempting to estimate RMG’s cost of new common stock. The next dividend is expected to be P3.70 and will be paid one year from now. Dividends are expected to grow at a constant 7% per year. Flotation cost costs on the new issue will be P2.25 per share. RMG’s Beta coefficient is 1.5, the risk-fee rate is 7.5%, and the expected return on the DJ Industrial Average is 12.5%. Based on this information, RMG”s cost of new common stock is nearest. a. 8.4% b. 12.5%

c. 13.7% d. 15.4%

Answer: d

P3.70 / (15% - 7%) = P46.25

P3.70 / (P46.25 – P2.25) + 7% = 15.4%

Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition. The following data apply to items 31-34. Williams Inc. is interested in measuring its overall cost of capital and has gathered the following data. Under the terms described below, the company can sell unlimited amounts of all instruments. 

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Williams can raise cash by selling P1,000, 8 percent, 20-year bonds with annual interest payments. In selling the issue, an average premium of P30 per bond would be received, and the firm must pay flotation costs of P30 per bond. The after-tax cost of funds as estimated to be 4.8 percent. Williams can sell 8 percent preferred stock at par value, P105 per share. The cost of issuing and selling the preferred stock is expected to be P5 per share.

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Williams’ common stock is currently selling for P100 per share. The firm expects to pay cash dividends of P7 per share next year, and the dividends are expected to remain constant. The stock will have to be under priced by P3 per share, and flotation costs are expected to amount to P5 per share. Williams expects to have available P100,000 of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing. Williams desired capital structure is Long term debt 30% Preferred stock 20 Common stock 50

31.) The cost of funds from the sale of common stock for Williams Inc. is a. 7.0 percent b. 7.6 percent

c. 7.4 percent d. 8.1 percent

Answer: b

P7 / (P100 - P3 – P5) = 7.6% 32.) The cost of funds from retained earnings for Williams Inc. is a. 7.0 percent b. 7.6 percent


Answer: a

P7 / P100 = 7% 33.) If Williams Inc. needs a total of P200,000, the firm’s weighted average cost of capital would be a. 19.8 percent b. 4.8 percent


Answer: c

LT Debt PS CS

30% 20 50

4.8% 1.4% 8.0 1.6 7.0 3.5 6.5%

34.) If Williams Inc. needs a total of P1,000,000, the firm’s weighted average cost of capital would be a. 6.8 percent b. 4.8 percent


Answer: a

LT Debt PS CS

30% 20 50

4.8% 1.4% 8.0 1.6 7.6 3.8 6.8%


35.) The overall cost of capital is the a. b. c. d.

rate of return on assets that covers the costs associated with the funds employed. average rate of return a firm earns on its assets. minimum rate a firm must earn on high risk projects. cost of the firm’s equity capital at which the market value of the firm will remain unchanged.

(CMA Adapted) Answer: a Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition.

36.) If Golda Corporation’s bonds are cur rently yielding 8 percent in the marketplace, why would the firm’s cost of debt be lower? a. b. c. d.

Market interest rates have increased Additional debt can be issued more cheaply than the original debt. There should be no difference; cost of debt is the same as the bonds’ market yield. Interest is deductible for tax purposes.

(CMA Adapted) Answer: d Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition.

37.) The theory underlying the cost of capital is primarily concerned with the cost of a. long-term funds and old finds.

b. short-term funds and new funds. c. long-term funds and new funds. d. short-term funds and old funds. Answer: c Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition.

38.) A preferred stock is sold for P101 per share, has a face value of P100 per share, underwriting fees of P5 per share, and annual dividends of P10 per share. If the tax rate is 40 percent, the cost of funds (capital) for the preferred stock is a. 4.2 percent b. 6.2 percent


Answer: d

P10 / (P101 – P5) = 10.4% Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition.

39.) Which one of a firm’s sources of new capital usually has the lowest after -tax cost? a. Retained earnings b. Bonds

c. Preferred stock d. Common stock

Answer: b Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition.

40.) Using the Capital Asset Pricing Model (CAPM), the required rate of return for a firm with a beta of 1.25 when the market return is 14 percent and the risk-free rate is 6 percent is a. 14.0 percent b. 6.0 percent


Answer: d

6% + (14% - 6%) (1.25) = 16% Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition.

41.) Which one of the following statements is correct when comparing bond financing alternatives?

a. A bond with a call provision typically has a lower yield to maturity than a similar bond without a call provision. b. A convertible bond must be converted to common stock prior to its maturity. c. A call provision is generally considered detrimental to the investor. d. A call premium requires the investor to pay an amount greater than par at the time of purchase. Answer: c Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition.

42.) Maybelle Corporation has 6,000 shares of 5 percent, cumulative, P100 par value preferred stock outstanding and 200,000 shares of common stock outstanding. Maybelle’s Board of Directors last declared dividends for the year ended May 31, 19x3, and there were no dividends in arrears. For the year May 31, 19X5, Maybelle had net income of P1,750,000. The Board of Directors is declaring a dividend for common shareholders equivalent to 20 percent of net income. The total amount of dividends to be paid by Maybelle at May 31, 19x% is a. P350,000 b. P380,000

c. 206,000 d. 410,000

Answer: d Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition. The following data apply to items 43 and 44. Shen Corporation Statement of Financial Position December 31, 19x4 (Pesos in millions) Assets Current assets Plant and equipment Total assets

Liabilities and shareholder’s equity Current liabilities Long term debt (12%) Common equity: Common stock, P1 par Additional paid in capital Retained earnings Total liabilities and SHE

P 75 250 P325

P 46 64 10 100 105 P325

Additional Data The long-term debt was originally issued at par (P1,000/ bond) and is currently trading at P1,250 per bond. Shen Corporation can now issue debt at 150 basis points over Metro Manila treasury stock. The current risk-free rate is 7 percent. Martin’s common stock is currently selling at P32 per share. The expected market return is currently 15 percent. The beta value for Shen is 1.25. Shen’s effective corporate income tax rate is 40 percent. 

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43.) Shen Corporation’s current net cost of debt is a. 5.5 percent b. 7.0 percent


Answer: c

(7% + 1.5%) (60%) = 5.1% 44.) Using the Capital Asset Pricing Model (CAPM), Shen Corporation’s current cost of common equity is a. 8.75 percent b. 10.00 percent


Answer: d

7% + (15% - 7%) (1.25%) = 17% Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition.

45.) The Dizon Corporation has an outstanding one-year bank loan of P300,000 at a stated interest rate of 8 percent. In addition, Dizon is required to maintain a 20 percent compensating balance in its checking account. Assuming the company would normally maintain zero balance in its checking account, the effective interest rate on the loan is a. 6.4 percent b. 8.0 percent


Answer: d

8% / (100% - 20%) = 10% Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition.

46.) Elan Corporation is considering borrowing P100,000 from a bank for one year at a stated interest rate of 9 percent. What is the effective interest rate of Elan if this borrowing is in the form of a discounted note? a. 8.10 percent b. 9.00 percent


Answer: d

9% / (100% - 9%) = 9.89% Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition. The following data apply to items 47-49. Analen Company presently sells 400,000 bottles of perfume each year. Each bottle costs P.84 to produce and sells for P1.00. Fixed costs are P28,000 per year. The firm has annual interest expense of P6,000, preferred stock dividends of 2,000 per year, and a 40 percent tax rate. Analen uses the following formulas to determine the company’s leverage.

Operating leverage Financial leverage Total leverage Where:

Q FC VC S I P t EBIT

= = = = = = = =

= = =

[Q (S – VC)] / [Q (S – VC) – FC] EBIT / EBIT – I – [P / (1 – t)] [Q (S – VC)] / Q (S – VC) – FC – I – [P / (1 – t)]

Quantity Fixed cost Variable cost Selling price Interest expense Preferred dividends Tax rate Earnings before interest and taxes

47.) The degree of operating leverage for Analen Company is a. 2.4 b. 1.78

c. 1.35 d. 1.2

Answer: b

48.) The degree of financial leverage for Analen Company is a. 2.4 b. 1.78 Answer: c

c. 1.35 d. 1.2

49.) If Analen Company did not have preferrd stock, the degree of total leverage would

a. b. c. d.

decrease in proportion to a decrease in financial leverage. increase in proportion to an increase in financial leverage. remain the same. decrease bit not be proportional to the decrease in financial leverage.

Answer: a Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition.

50.) Pelagio Corporation has sold P50 million of P1,000 par value, 12 percent coupon bonds. The bonds were sold at a discount and the corporation received P985 per bond. If the corporate tax rate is 40 percent, the after-tax cost of these bonds for the first year (rounded to the nearest hundredth percent) is a. 7.31 percent b. 12.18 percent


Answer: a

P120 (60%) / P985 = 7.31% Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition.

51.) Horario Corporation is selling P25 million of cumulative, non-participating preferred stock. The issue will have a par value of P65 per share with a dividend rate of 6 percent. The issue will be sold to investors for P68 per share and issuance cost will be P4 per share. The cost of preferred stock to Horario is a. 5.42 percent b. 5.74 percent


Answer: d

P65 x 6% = P3.90 Dividends

P3.90 / (P68 – P4) = 6.09%


52.) Anabel Inc. is planning to use retained earnings to finance anticipated capital expenditures. The beta coefficient for Anabel’s stock is 1.15, the risk -free rate of interest is 8.5 percent, and the market return is estimated at 12.4 percent. If a new issue of common stock was used in this model, the flotation costs would be 7 percent. By using the Capital Asset Pricing Model equation [R = RF + ß (RM – RF)], the cost of using retained earnings to finance the capital expenditures is

a. 13.96 percent b. 12.99 percent


Answer: b

8.5% + 1.15 (12.4% - 8.5%) = 12.99% Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition.

53.) Mariday Inc. paid a cash dividend to its common shareholders over the past twelve months of P2.20 per share. The current market value of the common stock is P40 per share and investors are investors are anticipating the common dividend to grow at a rate of 6 percent annually. The costs to issue new common stock will be 5 percent of the market value. The cost of a new common stock issue will be a. 11.50 percent b. 11.79 percent


Answer: d

[P2.20 (1.06) / 40 (1 - .05)] + 6% = 12.14% Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition.

54.) Datacomp Industries, which has no current debt, has a beta of .95 for its common stock. Management is considering a change in the capital structure to 30 percent debt and 70 percent equity. This change would increase the beta on the stock to 1.05, and the aftertax cost of debt will be 7.5 percent. The expected return on equity is 16 percent, and the risk-free rate is 6 percent. Should Datacomp’s management proceed with the capital structure change? a. b. c. d.

No, because the cost of equity capital will increase. Yes, because the cost of equity capital will decrease. Yes, because the weighted average cost of capital will decrease. No, because the weighted average cost of capital will increase.

Answer: c

WACC (present) E: 6% + (16% - 6%) (.95)

=

5.5%

WACC (proposed) D: 7.5% x 30% = E: [6% + (16% - 6%) (1.05)] x 70% =

2.25% 11.55 13.80%


55.) A company obtained a short-term bank loan of P500,000 at an annual interest rate of eight percent. As a condition of the loan, the company is required to maintain a compensating balance of P100,000 in its checking account. The checking account earns interest at an annual rate of three percent. Ordinarily, the company maintains a balance of P50,000 in its account for transaction purposes. What is the effective interest rate of the loan? a. 7.77 percent b. 8.50 percent


Answer: d Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition.

56.) An automated clearinghouse (ACH) electronic transfer is a(n) a. b. c. d.

electronic payment to a company’s account at a concentration bank. check that must be immediately cleared by the Bangko Sentral. computer-generated deposit ticket verifying deposit of funds. check-like instrument drawn against the payor and not against the bank.

Answer: a Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition.

57.) Assume that each day a company writes and receives checks totaling P10,000. If it takes five days for the checks to clear and be deducted from the company’s account, and only four days for the deposits to clear, what is the float? a. P10,000 b. P0

c. P(10,000) d. P50,000

Answer: a Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition. The following data apply to items 58-60. WXY Telecom is considering a project for the coming year which will cost P50 million. WXY plans to use the following combination of debt and equity to finance the investment. 

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Issue P15 million of 20-year bonds at price 101, with a coupon rate of 8 percent, and flotation costs of 2 percent to par. Use P35 million of funds generated from earnings.

The equity market is expected to earn 12 percent. The treasury bonds are currently yielding 5 percent. The beta coefficient for WXY is estimated to be .60. WXY is subject to an effective corporate income tax rate of 40 percent. 58.) The before-tax cost of WXY’s planned debt financing, net of flotation costs, in the first year is a. 11.80 percent b. 8.08 percent


Answer: b

8% / (101% - 2%) = 8.08% 59.) Without prejudice to your answer to item 58, assume that the after-tax cost of debt is 7 percent and the cost of equity is 12 percent. Determine the weighted average cost of capital. a. 10.50 percent b. 8.50 percent


Answer: a

8% 12%

x x

30% 70%

= =

2.1% 8.4% 10.5%

60.) The Capital Asset Pricing Model (CAPM) computes the expected return on a security by adding the risk-free rate of return to the incremental yield of the expected market return which is adjusted by the company’s beta. Compute WXY’s expected rate of return. a. 9.20 percent b. 12.20 percent


Answer: a

5% + (12% - 5%) (.6) = 9.20% Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition. The following data apply to items 61-62. Currently, Warren Industries can sell 15-year, $1,000-par-value bonds paying annual interest at 12% coupon rate. As a result of current interest rates, the bonds can be sold for $1,010 each; flotation costs of $30 per bond will be incurred in this process. The firm is in the 40% tax bracket.

61.) Find the net proceeds from sale of the bond. a. $1,010 b. $980

c. $1,000 d. $950

Answer: b

62.) Use the approximation formula to estimate the after-tax costs of the d ebt. a. 7.36% after tax b. 7.32% after tax

c. 8.00% after tax d. 8.30% after tax

Answer: a Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition) The following data apply to items 63-64. J&M Corporation common stock has a beta, b, of 1.2. The risk-free rate is 6%, and the market return is 11%.

63.) Determine the risk premium on J&M common stock. a. 3% b. 5%

c. 6% d. 4%

Answer: c

64.) Determine the required return that J&M common stock should provide. a. 8% b. 10%

c. 12% d. 12.5%

Answer: c Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition) The following data apply to items 65-66. Ross Textiles wishes to measure its cost of common stock equity. The firm’s stock is currently selling for $57.50. The firm expects to pay a $3.40 dividend at the end of the year (2004). The dividends for the past 5 years are shown in the following table.

Year 2003 2002 2001

Dividend $3.10 2.92 2.60

2000 1999

2.30 2.12

After under pricing and flotation costs, the firm expects to net $52 per share on a new issue. 65.) Using the constant-growth valuation model, determine the cost of retained earnings. a. 15.91% b. 15.99%

c. 15.80% d. 15.75%

Answer: a

66.) Using the constant-growth valuation model, determine the cost of new common stock. a. 16.50% b. 16.40%

c. 16.45% d. 16.54%

Answer: d Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition) The following data apply to items 67-68. Equity Lightning Corp. wishes to explore the effect on its cost of capital of the rate at which the company pays taxes. The firm wishes to maintain a capital structure of 30% debt, 10% preferred stock, and 60% common stock. The cost of financing with retained earnings is 14%, the cost of preferred stock financing is 9%, and the before-tax cost of debt financing is 11%. Calculate the weighted average cost of capital (WACC) given the tax rate assumptions.

67.) Tax rate = 40% a. 11.28% b. 11.45%

c. 11.17% d. 11.54%

Answer: a

68.) Tax rate = 35% a. 11.28% b. 11.45%

c. 11.17% d. 11.54%

Answer: b Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition) The following data apply to items 69-70.

Afrer careful analysis, Dexter Brothers has determined that its optimal capital structure is composed of the sources and target market weights shown in the following table. Source of capital LT debt Preferred stock Common stock equity Total

Target market value weight 30% 15 55 100%

The cost of debt is estimated to be 7.2%; the cost of preferred stock is estimated to be 13.5%; the cost of retained earnings is estimated to be 16.0%; and the cost of new common stock estimated to be 18.0%. All of these are after-tax rates. The company’s debt represents 25%, the preferred stock represents 10%, and the common stock equity represents 65% of total capital on the basis of the market values of the three components. The company expects to have a significant amount of retained earnings available and does not expect to sell any common stock. 69.) Calculate the weighted average cost of capital on the basis of historical market value weights. a. 13.55% b. 13.45%

c. 13.75% d. 13.00%

Answer: a

70.) Calculate the weighted average cost of capital on the basis of target market value weights. a. 13.505% b. 12.645%

c. 13.759% d. 12.985%


71.) Grainer Corp., a supplier of fitness equipment, is trying to decide whether to undertake any or all of the proposed projects in its investment opportunities schedule (IOS). The firm’s cost of capital schedule and investment opportunity schedules follow.

Range of new financing

Cost of Capital Schedule Source Weight

After-tax cost

0 - $600,000

Debt Preferred Stock Common stock

.50 .10 .40

6.3% 12.5 15.3

$600,000 - $1,000,000


.50 .10 .40

6.3% 12.5 16.4

$1,000,000 and above


.50 .10 .40

6.3% 12.5 16.4

Investment Opportunities Schedule Investment Opportunity Internal rate of Return Project H 14.5% Project G 13.0 Project K 12.8 Project M 11.4

Cost $200,000 700,000 500,000 600,000

Determine the WACC for 0 to $600,000 and $600,001 to $1,000,000. a. 10.25% and 10.69% b. 10.96% and 10.52%

c. 10.52% and 10.96% d. 10.69% and 10.25%

Answer: c Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition) The following data apply to items 72-73. Barry Carter is considering opening a record store. He wants to estimate the number of CDs he must sell to break even. The CDs will be sold for $13.98 each, variable operating costs are $10.48 per CD, and annual fixed operating costs are $73,500.

72.) Find the operating breakeven point in number of CDs. a. 21,000 CDs b. 22,000 CDs

c. 25,000 CDs d. 24,000 CDs

Answer: a

73.) Calculate the total operating cots at the breakeven volume found in number 71. a. $293,550 b. $293,580

c. $239,580 d. $230,000

Answer: b Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition) The following data apply to items 74-76. Molly Jasper and her sister, Caitlin Peters, got into the novelties business almost by accident. Molly, a talented sculptor, often made little figurines as gifts for friends. Occasionally, she and Caitlin would set up a booth at a crafts fair and sell a few of the figurines along with jewelry that Caitlin made. Little by little, demand for the figurines, now called Mollycaits, grew and the sisters began to reproduce some of the favorites in resin, using molds of the originals. The day came when a buyer for a major department store offered them a contract to produce 1,500 figurines of various designs for $10,000. Molly and Caitlin realized that it was time to get down to business. To make bookkeeping simpler, Molly had priced all the figurines at $8.00. Variable operating costs amounted to an average of $6.00 per unit. In order to produce the order, Molly and Caitlin would have to rent industrial facilities for a month, which would cost them $4,00 0.

74.) Calculate Mollycait’s operating breakeven point. a. 2,500 figures b. 1,800 figures

c. 1,400 figures d. 2,000 figures

Answer: d

75.) Calculate Mollycait’s EBIT on the department stor e order. a. - $1,000 b. - $3,000

c. - $1,550 d. - $2,000

Answer: b

76.) If Molly renegotiates the contract at a price of $10.00, what will the EBIT be? a. $1,000 b. $2,500

c. $2,000 d. $2,800

Answer: c Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition) The following data apply to items 77-79. Grey Products has fixed operating costs of $380,000, variable operating costs of $16 per unit, and a selling price of $63.50 per unit.

77.) Calculate the operating breakeven point in units. a. 8,000 units

c. 6,000 units

b. 10,000 units

d. 7,000 units

Answer: a

78.) Calculate the firm’s EBIT at 10,000 units. a. $91,000 b. $95,000

c. $96,000 d. $92,000

Answer: b

79.) Use the formula for degree of operating leverage to determine the DOL at 10,000 units. a. 5.00 b. 4.00

c. 6.00 d. 3.00


80.) Northwestern Savings and Loan has a current capital structure consisting of $250,000 of 16% (annual interest) debt and 2,000 shares of common stock. The firm pays taxes at the rate of 40%. Using $80,000 of EBIT as a base, calculate the degree of financial leverage (DFL). a. 3 b. 2

c. 1 d. 4

Answer: b Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition) The following data apply to items 81-83. Carolina Fastener, Inc., makes patented marine bulkhead latch that wholesales for $6.00. Each latch has variable operating costs of $3.50. Fixed operating costs are $50,000 per year. The firm pays $13,000 interest and preferred dividends of $7, 000 per year. At this point, the firm is selling 30,000 latches a year and is taxed at 40%.

81.) Calculate Carolina Fastener’s operating breakeven point. a. 21,000 latches b. 25,000 latches Answer: c

c. 20,000 latches d. 22,000 latches

82.) On the basis of the firm’s current sales of 30,000 units per year and its interest and preferred dividend costs, calculate its EBIT and net profits. a. $6,155 b. $5,000

c. $7,200 d. $9,000

Answer: c

83.) Calculate the firm’s degree of total leverage (DTL). a. 235.45 b. 215.40

c. 279.95 d. 225.24


84.) Wren Manufacturing is in the process of analyzing its investment decision-making procedures. The two projects evaluated by the firm during the past month were projects 263 and 264. The basic variables surrounding each project analysis using the IRR decision technique and the resulting decision actions are summarized in the following table. Basic variables Cost Life IRR Least-cost financing Source Cost (after-tax) Decision Action Reject

a. 11.6% b. 12.4%

Project 263 $64,000 15 years 8%

Project 264 $58,000 15 years 15%

Debt 7%

Equity 16%

Accept 8% IRR > 7% cost

Reject 15% IRR < 16% cost

c. 12.9% d. 13.7%

Answer: b Source: (Lawrence J. Gitman, Principles of Managerial Finance, 9th Edition) The following data apply to items 85-86. For each of the following $1,000 par-value bonds, assuming annual interest payment and a 40% tax rate:

Bond

Life

A B

20 years 22

Underwriting fee $25 20

Discount (-) or premium (+) -$20 - 60

Coupon interest rate 9% 11

85.) Calculate the after-tax cost to maturity using the approx imation formula for Bond A. a. 5.20% b. 5.71%

c. 5.94% d. 5.66%

Answer: d

86.) For Bond B. a. 7.20% b. 7.15%

c. 7.10% d. 7.18%

Answer: c Source: (Lawrence J. Gitman, Principles of Managerial Finance, 9th Edition) The following data apply to items 87-88. Webster Company has compiled the information shown in the following table. Source of capital Long-term debt Preferred stock Common stock equity Totals

Book value $4,000,000 40,000 1,060,000 $5,100,000

Market value $3,840,000 60,000 3,000,000 $6,900,000

After-tax cost 6.0% 13.0 17.0

87.) Calculate the weighted average cost of capital using the book value weights. a. 8.344% b. 8.721%

c. 8.560% d. 8.212%

Answer: a

88.) Calculate the weighted average cost of capital using the market value weights. a. 10.902% b. 10.854%

c. 11.002% d. 10.866%


89.) Edna Recording Studios, Inc., reported earnings available to common stock of $4,200,000 last year. From that, the company paid a dividend of $1.26 on each of its 1,000,000 common shares outstanding. The capital structure of the company includes 40% debt, 10% preferred stock, and 50% common stock. It is taxed at a rate of 40%. The company can issue $2.00 dividend preferred stock for a market price of $25.00 per share. Flotation costs would amount to $3.00 per share. What is the cost of preferred stock financing? a. 9.2% b. 9.1%

c. 9.4% d. 9.6%

Answer: b Source: (Lawrence J. Gitman, Principles of Managerial Finance, 9th Edition) The following data apply to items 90-92. Lang Enterprises is interested in measuring its overall cost of capital. Current investigation has gathered the following data. The firm is in the 40% tax bracket. Debt The firm can raise an unlimited amount of debt by selling $1,000 par-value, 8% coupon interest rate, 20-year bonds on which annual interest payments will be made. To sell the issue, an average discount of $30 per bond would have to be given. The firm also must pay floatation costs of $30 per bond.

The firm can sell 8% preferred stock at its $95-per-share par value. The Preferred stock cost of issuing and selling the preferred stock is expected to be $5 per share. An unlimited amount of preferred stock can be sold under these terms. The firm’s common stock is currently selling for $90 per share. The firm Common stock expects to pay cash dividends of $7 per share next year. The firm’s dividends have been growing at an annual rate of 6%, and this is expected to continue into the future. The stock must be underpriced by $7 per share, and flotation costs are expected to amount to $5 per share. The firm can sell an unlimited amount of new common stock under these terms. Retained earnings When measuring this cost, the firm does not concern itself with the tax bracket or brokerage fees of owners. It expects to have available $100,000 of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing. Source of capital Long-term debt Preferred stock Common stock equity Total

Weight 30% 20 50 100%

The firm’s capital structure weights used in calculating its weighted average cost of capital are shown in the table above. (Round answer to the nearest .1%)

90.) Calculate the single breaking point associated with the firm’s financial situation. ( Hint: This point results from exhaustion of the firm’s retained earnings.) a. $250,000 b. $200,500

c. $200,000 d. $210,000

Answer: c

91.) Calculate the weighted average cost of capital associated with total new financing below the breaking point calculated in (88). a. 11.5% b. 10.1%

c. 9.8% d. 9.3%

Answer: b

92.) Calculate the weighted average cost of capital associated with total new financing above the breaking point calculated in (88). a. 10.7% b. 10.5%

c. 10.2% d. 10.6%

Answer: a Source: (Lawrence J. Gitman, Principles of Managerial Finance, 9th Edition) The following data apply to items 93-94. Cartwell Products has complied the data shown in the following table for the current cost of its three basic sources of capital – long-term debt, preferred stock, and common stock equity – for various ranges of new financing. Source of capital

Range of new financing

Long-term debt

$0 to $320,000 $320,000 and above

After-tax cost 6% 8

Preferred stock Common stock equity

$0 and above $0 to $200,000 $200,000 and above

17% 20% 24

The company’s capital structure weights used in calculating its weighted average cost of capital are shown in the following table. Source of capital Long-term debt Preferred stock Common stock equity Total

Weight 40% 20 40 100%

93.) Determine the breaking points (levels of total new financing) at which the firm’s weighted average cost of capital will change. a. $500,000 and $700,000 b. $600,000 and $800,000

c. $500,000 and $800,000 d. $800,000 and $900,000

Answer: c

94.) Calculate the weighted average cost of capital of over $800,000 range of total new financing. a. 15.9% b. 16.0%

c. 16.8% d. 16.2%


95.) Southland Industries has $60,000 of 17% (annual interest) bonds outstanding, 1,500 shares of preferred stock paying an annual dividend of $5 per share, and 4,000 shares of common stock outstanding. Assuming that the firm has a 40% tax rate, compute earnings per share (EPS) for $24,600 EBIT. a. $0.375 b. $0.415

c. $0.420 d. $0.330


96.) Wells and Associates has EBIT of $67,500. Interest costs are $22,500, and the firm has 15,000 shares of common stock outstanding, Assume a 40% tax rate. Use the degree of financial leverage (DFL) formula to calculate the DFL for the firm. a. 1.3 b. 1.9

c. 1.5 d. 1.7


97.) Play-More Toys produces inflatable beach balls, selling 400,000 balls a year. Each ball produced has a variable operating cost of $0.84 and sells for $1.00. Fixed operating costs are $28,000. The firm has annual interest charges of $6,000, preferred dividends of $2,000, and a 40% tax rate. Calculate the operating breakeven point in units

a. 190,000 units b. 175,000 units

c. 185,000 units d. 193,000 units

Answer: b Source: (Lawrence J. Gitman, Principles of Managerial Finance, 9th Edition) The following data apply to items 98-99. Charter Enterprises currently has $1 million in total assets and is totally equity financed. It is contemplating a change in capital structure.

98.) Compute the amount of debt that would be outstanding if the firm were to shift to 40% debt ratio. a. Debt $300,000 b. Debt $400,000

c. Debt $600,000 d. Debt $200,000

Answer: b

99.) Compute the amount of equity that would be outstanding if the firm were to shift to 40% debt ratio. a. Equity $700,000 b. Equity $300,000

c. Equity $600,000 d. Equity $500,000


100.) Medallion Cooling Systems, Inc., has total assets of $10,000,000, EBIT of $2,000,000, preferred dividends of $200,000 and is taxed at a rate of 40%. In an effort to determine the optimal capital structure, the firm has assembled data on the cost of debt, the number of common shares for various levels of indebtedness, and the overall required return on investment: Capital structure debt ratio 0% 15 30 45 60

Cost of debt 0% 8 9 12 15

Number of common shares 200,000 170,000 140,000 110,000 80,000

Calculate earnings per share at 30% level of indebtedness. a. $5.75

c. $5.50

Required return 12% 13 14 16 20

Cost of Capital

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