The Cost of Capital

The Equity Cost of Capital

Use the following information to answer the question(s) below.

"Eenie"
"Meenie"
"Miney"
"Moe"

Beta
0.45
0.75
1.05
1.20

Volatility
20%
18%
35%
25%

Assume that the risk-free rate of interest is 3% and you estimate the market's expected return to
be 9%.
1) Which firm has the most total risk?
A) Eenie
B) Meenie
C) Miney
D) Moe
Answer: C
Explanation: C) Total risk is measured using volatility and Miney has the highest volatility,
hence the most total risk.
Diff: 1
Section: 12.1 The Equity Cost of Capital
Skill: Analytical
2) Which firm has the least market risk?
A) Eenie
B) Meenie
C) Miney
D) Moe
Answer: A
Explanation: A) Market risk is measured using beta and Eenie has the lowest beta, hence the
lowest market risk.
Diff: 1
Section: 12.1 The Equity Cost of Capital
Skill: Analytical

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3) Which firm has the highest cost of equity capital?

A) Eenie
B) Meenie
C) Miney
D) Moe
Answer: D
Explanation: D) Cost of capital is measured using the CAPM and is a linear function of beta.
Therefore the firm with the highest beta (Moe) has the highest cost of equity capital.
Diff: 1
Section: 12.1 The Equity Cost of Capital
Skill: Analytical
4) The equity cost of capital for "Miney" is closest to:
A) 6.30%
B) 7.50%
C) 9.30%
D) 9.75%
Answer: C
Explanation: C) rMiney = 3% + 1.05(9% - 3%) = 9.3%
Diff: 1
Section: 12.1 The Equity Cost of Capital
Skill: Analytical
5) The equity cost of capital for "Meenie" is closest to:
A) 4.50%
B) 7.50%
C) 9.30%
D) 9.75%
Answer: B
Explanation: B) rMeenie = 3% + 0.75(9% - 3%) = 7.5%
Diff: 1
Section: 12.1 The Equity Cost of Capital
Skill: Analytical
6) The risk premium for "Meenie" is closest to:
A) 4.50%
B) 7.50%
C) 9.30%
D) 9.75%
Answer: A
Explanation: A) risk premiumMeenie = 0.75(9% - 3%) = 4.5%
Diff: 2
Section: 12.1 The Equity Cost of Capital
Skill: Analytical

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Beta Estimation
Use the following information to answer the question(s) below.

Year
2007
2008
2009

Risk-free
Return
3.0%
1.5%
1.0%

Market
Return
6.0%
-38.5%
22.5%

Wyatt Oil
Return
5.5%
-32.6%
19.6%

Market
Excess
Return
3.0%
.40%
21.5%

Wyatt Oil
Excess
Return
2.5%
-34.1%
18.6%

Beta
0.833
0.853
0.865

1) Wyatt Oil's average historical return is closest to:

A) -2.50%
B) -3.33%
C) -4.33%
D) -5.17%
Answer: A
Explanation: A) raverage =
Risk-free
Return
3.0%
1.5%
1.0%
1.83%

Market
Return
6.0%
-38.5%
22.5%
-3.33%

Year
2007
2008
2009
Average
Diff: 1
Section: 12.3 Beta Estimation
Skill: Analytical

Wyatt Oil
Return
5.5%
-32.6%
19.6%
-2.50%

Market
Excess
Return
3.0%
-40.0%
21.5%
-5.17%

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Wyatt Oil
Excess
Return
2.5%
-34.1%
18.6%
-4.33%

2) The Market's average historical return is closest to:

A) -2.50%
B) -3.33%
C) -4.33%
D) -5.17%
Answer: B
Explanation: B) raverage =
Risk-free
Return
3.0%
1.5%
1.0%
1.83%

Market
Return
6.0%
-38.5%
22.5%
-3.33%

Year
2007
2008
2009
Average
Diff: 1
Section: 12.3 Beta Estimation
Skill: Analytical

Wyatt Oil
Return
5.5%
-32.6%
19.6%
-2.50%

Market
Excess
Return
3.0%
-40.0%
21.5%
-5.17%

Wyatt Oil
Excess
Return
2.5%
-34.1%
18.6%
-4.33%

3) Wyatt Oil's average historical excess return is closest to:

A) -2.50%
B) -3.33%
C) -4.33%
D) -5.17%
Answer: C
Explanation: C) excess returnaverage =
Risk-free
Return
3.0%
1.5%
1.0%
1.83%

Market
Return
6.0%
-38.5%
22.5%
-3.33%

Year
2007
2008
2009
Average
Diff: 2
Section: 12.3 Beta Estimation
Skill: Analytical

Wyatt Oil
Return
5.5%
-32.6%
19.6%
-2.50%

Market
Excess
Return
3.0%
-40.0%
21.5%
-5.17%

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Wyatt Oil
Excess
Return
2.5%
-34.1%
18.6%
-4.33%

4) The Market's average historical excess return is closest to:

A) -2.50%
B) -3.33%
C) -4.33%
D) -5.17%
Answer: D
Explanation: D) excess returnaverage =

Risk-free
Market
Year
Return
Return
2007
3.0%
6.0%
2008
1.5%
-38.5%
2009
1.0%
22.5%
Average
1.83%
-3.33%
Diff: 2
Section: 12.3 Beta Estimation
Skill: Analytical

Wyatt Oil
Return
5.5%
-32.6%
19.6%
-2.50%

Market
Excess
Return
3.0%
-40.0%
21.5%
-5.17%

Wyatt
Oil
Excess
Return
2.5%
-34.1%
18.6%
-4.33%

Market
Excess
Return
3.0%
-40.0%
21.5%
-5.17%

Wyatt
Oil
Excess
Return
2.5%
-34.1%
18.6%
-4.33%

5) Wyatt Oil's excess return for 2009 is closest to:

A) 18.6%
B) 19.6%
C) 20.0%
D) 21.5%
Answer: A
Explanation: A) excess returne = (rWO - rrf)2009

Risk-free
Market
Year
Return
Return
2007
3.0%
6.0%
2008
1.5%
-38.5%
2009
1.0%
22.5%
Average
1.83%
-3.33%
Diff: 1
Section: 12.3 Beta Estimation
Skill: Analytical

Wyatt Oil
Return
5.5%
-32.6%
19.6%
-2.50%

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6) The Market's excess return for 2008 is closest to:

A) -40.0%
B) -38.5%
C) -37.0%
D) -34.1%
Answer: A
Explanation: A) excess returne = (rWO - rrf)2009

Risk-free
Return
3.0%
1.5%
1.0%
1.83%

Market
Return
6.0%
-38.5%
22.5%
-3.33%

Year
2007
2008
2009
Average
Diff: 1
Section: 12.3 Beta Estimation
Skill: Analytical

Wyatt Oil
Return
5.5%
-32.6%
19.6%
-2.50%

Market
Excess
Return
3.0%
-40.0%
21.5%
-5.17%

Wyatt Oil
Excess
Return
2.5%
-34.1%
18.6%
-4.33%

7) Using just the return data for 2009, your estimate of Wyatt Oil's Beta is closest to:
A) 0.84
B) 0.87
C) 1.00
D) 1.16
Answer: B
Explanation: B)
Market
Wyatt Oil
Risk-free
Market
Wyatt Oil
Excess
Excess
Year
Return
Return
Return
Return
Return
2007
3.0%
6.0%
5.5%
3.0%
2.5%
2008
1.5%
-38.5%
-32.6%
-40.0%
-34.1%
2009
1.0%
22.5%
19.6%
21.5%
18.6%
Average
1.83%
-3.33%
-2.50%
-5.17%
-4.33%
WO =

= .8651

Diff: 2
Section: 12.3 Beta Estimation
Skill: Analytical
8) Using just the return data for 2008, your estimate of Wyatt Oil's Beta is closest to:
A) 0.85
B) 0.87
C) 1.00
D) 1.17
Answer: A
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Explanation: A)

Year
2007
2008
2009
Average
WO =

Risk-free
Return
3.0%
1.5%
1.0%
1.83%

Market
Return
6.0%
-38.5%
22.5%
-3.33%
-

Wyatt Oil
Return
5.5%
-32.6%
19.6%
-2.50%

Market
Excess
Return
3.0%
-40.0%
21.5%
-5.17%

Wyatt Oil
Excess
Return
2.5%
-34.1%
18.6%
-4.33%

= .8525

Diff: 2
Section: 12.3 Beta Estimation
Skill: Analytical
13) Which of the following statements is FALSE?
A) Securities that tend to move more than the market have betas higher than 0.
B) Securities whose returns tend to move in tandem with the market on average have a beta of 1.
C) Beta corresponds to the slope of the best fitting line in the plot of the securities excess returns
versus the market excess return.
D) The statistical technique that identifies the bets-fitting line through a set of points is called
linear regression.
Answer: A
Diff: 2
Section: 12.3 Beta Estimation
Skill: Conceptual

The Debt Cost of Capital

Use the following information to answer the question(s) below.
Consider the following information regarding corporate bonds:
Rating
Average Default Rate
Recession Default Rate
Average Beta

AAA
0.0%
0.0%
0.05

AA
0.1%
1.0%
0.05

A
0.2%
3.0%
0.05

BBB
0.5%
3.0%
0.10

BB
B
CCC
2.2% 5.5% 12.2%
8.0% 16.0% 48.0%
0.17 0.26 0.31

1) Wyatt Oil has a bond issue outstanding with seven years to maturity, a yield to maturity of
7.0%, and a BBB rating. The corresponding risk-free rate is 3% and the market risk premium is
5%. Assuming a normal economy, the expected return on Wyatt Oil's debt is closest to:
A) 3.0%
B) 3.5%
C) 4.9%
D) 5.5%
Answer: B
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Explanation: B) rd = rrf + (rm - rrf) = 3% + 0.1(5%) = 3.5%

Diff: 1
Section: 12.4 The Debt Cost of Capital
Skill: Analytical
2) Wyatt Oil has a bond issue outstanding with seven years to maturity, a yield to maturity of
7.0%, and a BBB rating. The bondholders' expected loss rate in the event of default is 70%.
Assuming a normal economy the expected return on Wyatt Oil's debt is closest to:
A) 3.0%
B) 3.5%
C) 4.9%
D) 6.7%
Answer: D
Explanation: D) rd = ytm - prob(default) loss rate = 7% - 0.4%(70%) = 6.72%
Diff: 2
Section: 12.4 The Debt Cost of Capital
Skill: Analytical

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3) Wyatt Oil has a bond issue outstanding with seven years to maturity, a yield to maturity of
7.0%, and a BBB rating. The bondholders' expected loss rate in the event of default is 70%.
Assuming the economy is in recession, then the expected return on Wyatt Oil's debt is closest to:
A) 3.5%
B) 4.9%
C) 5.5%
D) 7.0%
Answer: B
Explanation: B) rd = ytm - prob(default) loss rate = 7% - 3.0%(70%) = 4.9%
Diff: 2
Section: 12.4 The Debt Cost of Capital
Skill: Analytical
4) Rearden Metal has a bond issue outstanding with ten years to maturity, a yield to maturity of
8.6%, and a B rating. The corresponding risk-free rate is 3% and the market risk premium is 6%.
Assuming a normal economy, the expected return on Rearden Metal's debt is closest to:
A) 0.6%
B) 1.6%
C) 4.6%
D) 6.0%
Answer: C
Explanation: C) rd = rrf + (rm - rrf) = 3% + 0.26(6%) = 4.56%
Diff: 1
Section: 12.4 The Debt Cost of Capital
Skill: Analytical
5) Rearden Metal has a bond issue outstanding with ten years to maturity, a yield to maturity of
8.6%, and a B rating. The bondholders expected loss rate in the event of default is 50%.
Assuming a normal economy the expected return on Rearden Metal's debt is closest to:
A) 0.6%
B) 1.6%
C) 4.6%
D) 6.0%
Answer: D
Explanation: D) rd = ytm - prob(default) loss rate = 8.6% - 5.2%(50%) = 6.00%
Diff: 2
Section: 12.4 The Debt Cost of Capital
Skill: Analytical

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6) Rearden Metal has a bond issue outstanding with ten years to maturity, a yield to maturity of
8.6%, and a B rating. The bondholders expected loss rate in the event of default is 50%.
Assuming the economy is in recession, then the expected return on Rearden Metal's debt is
closest to:
A) 0.6%
B) 1.6%
C) 4.6%
D) 6.0%
Answer: A
Explanation: A) rd = ytm - prob(default) loss rate = 8.6% - 16.0%(50%) = 0.6%
Diff: 2
Section: 12.4 The Debt Cost of Capital
Skill: Analytical
7) Nielson Motors plans to issue 10-year bonds that it believes will have an BBB rating.
Suppose AAA bonds with the same maturity have a 3.5% yield. Assume that the market risk
premium is 5% and the expected loss rate in the event of default on the bonds is 60%. The yield
that these bonds will have to pay during average economic times is closest to:
A) 3.50%
B) 3.75%
C) 4.00%
D) 5.50%
Answer: C
Explanation: C) For AAA rd = rrf + (rm - rrf) = rrf + 0.05(5%) = 3.5% rrf = 3.25%
For BBB rd = rrf + (rm - rrf) = 3.25% + 0.10(5%) = 3.75%
rd = ytm - prob(default) loss rate 3.75% = ytm - 0.4%(60%) ytm = 3.99%
Diff: 3
Section: 12.4 The Debt Cost of Capital
Skill: Analytical
8) Nielson Motors plans to issue 10-year bonds that it believes will have an BBB rating.
Suppose AAA bonds with the same maturity have a 3.5% yield. Assume that the market risk
premium is 5% and the expected loss rate in the event of default on the bonds is 60%. The yield
that these bonds will have to pay during a recession is closest to:
A) 3.50%
B) 3.75%
C) 4.00%
D) 5.50%
Answer: D
Explanation: D) For AAA rd = rrf + (rm - rrf) = rrf + 0.05(5%) = 3.5% rrf = 3.25%
For BBB rd = rrf + (rm - rrf) = 3.25% + 0.10(5%) = 3.75%
rd = ytm - prob(default) loss rate 3.75% = ytm - 3.0%(60%) ytm = 5.55%
Diff: 3
Section: 12.4 The Debt Cost of Capital
Skill: Analytical

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A Project's Cost of Capital

Use the following information to answer the question(s) below.
Consider the following information regarding corporate bonds:
Rating
Average Default Rate
Recession Default Rate
Average Beta

AAA
0.0%
0.0%
0.05

AA
0.1%
1.0%
0.05

A
BBB BB
B
CCC
0.2% 0.45% 2.2% 5.5% 12.2%
3.0% 3.0% 8.0% 16.0% 48.0%
0.05 0.10 0.17 0.26 0.31

Market
Total
Capitalization Enterprise
Company
($mm)
Value ($mm)
Taggart Transcontinental
$4,500
8,000
Rearden Metal
$3,800
7,200
Wyatt Oil
$2,400
3,800
Nielson Motors
$1,500
4,400

Equity
Beta
1.1
1.3
0.9
1.75

Debt
Rating
BBB
AAA
A
BB

1) Your estimate of the debt beta for Taggart Transcontinental would be:
A) 0.05
B) 0.10
C) 0.17
D) 1.00
Answer: B
Explanation: B) Since Taggart has a rating of BBB, the appropriate debt beta from the table is
0.10.
Diff: 1
Section: 12.5 A Project's Cost of Capital
Skill: Analytical
2) Your estimate of the debt beta for Nielson Motors would be:
A) 0.10
B) 0.17
C) 1.00
D) 1.68
Answer: B
Explanation: B) Since Nielson has a rating of BB, the appropriate debt beta from the table is
0.17.
Diff: 1
Section: 12.5 A Project's Cost of Capital
Skill: Analytical

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3) Your estimate of the asset beta for Taggart Transcontinental is closest to:
A) 0.42
B) 0.59
C) 0.66
D) 0.71
Answer: C
Explanation: C) Since Taggart has a rating of BBB, the appropriate debt beta from the table is
0.10.
U =

E +

D =

1.1 +

0.10 = 0.6625

Diff: 2
Section: 12.5 A Project's Cost of Capital
Skill: Analytical
4) Your estimate of the asset beta for Rearden Metal is closest to:
A) 0.42
B) 0.59
C) 0.66
D) 0.71
Answer: D
Explanation: D) Since Rearden has a rating of AAA, the appropriate debt beta from the table is
0.05.
U =

E +

D =

1.3 +

0.05 = 0.709722

Diff: 2
Section: 12.5 A Project's Cost of Capital
Skill: Analytical
5) Your estimate of the asset beta for Wyatt Oil is closest to:
A) 0.59
B) 0.66
C) 0.71
D) 0.90
Answer: A
Explanation: A) Since Wyatt has a rating of A, the appropriate debt beta from the table is 0.05.
U =

E +

D =

0.9 +

0.05 = 0.586842

Diff: 2
Section: 12.5 A Project's Cost of Capital
Skill: Analytical

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6) Your estimate of the asset beta for Nielson Motors is closest to:
A) 0.59
B) 0.66
C) 0.71
D) 1.75
Answer: C
Explanation: C) Since Nielson has a rating of BB, the appropriate debt beta from the table is
0.17.
U =

E +

D =

1.75 +

0.17 = 0.708636

Diff: 2
Section: 12.5 A Project's Cost of Capital
Skill: Analytical
7) Suppose that because of the large need for steel in building railroad infrastructure, Taggart
Transcontinental and Rearden Metal decide to form into one large conglomerate. Your estimate
of the asset beta for this new conglomerate is closest to:
A) 0.42
B) 0.59
C) 0.66
D) 0.68
Answer: D
Explanation: D) Since Taggart has a rating of BBB, the appropriate debt beta from the table is
0.10.
U =

E +

D =

1.1 +

0.10 = 0.6625

Since Rearden has a rating of AAA, the appropriate debt beta from the table is 0.05.
U =

E +

D =

1.3 +

= WTT
=

0.05 = 0.709722

+ WRM

(0.6625) +

(0.709722) = 0.684868

Diff: 2
Section: 12.5 A Project's Cost of Capital
Skill: Analytical

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11) Your firm is planning to invest in a new power generation system. Galt Industries is an all
equity firm that specializes in this business. Suppose Galt's equity beta is 0.75, the risk-free rate
is 3%, and the market risk premium is 6%. If your firm's project is all equity financed, then your
estimate of your cost of capital is closest to:
A) 5.25%
B) 6.00%
C) 6.75%
D) 7.50%
Answer: D
Explanation: D) ri = rrf + (rm - rrf) = .03 + .75(.06) = .075 or 7.5%
Diff: 1
Section: 12.5 A Project's Cost of Capital
Skill: Analytical
12) Your firm is planning to invest in a new electrostatic power generation system. Electrostat
Inc is a firm that specializes in this business. Electrostat has a stock price of $25 per share with
16 million shares outstanding. Electrostat's equity beta is 1.18. It also has $220 million in debt
outstanding with a debt beta of 0.08. Your estimate of the asset beta for electrostatic power
generators is closest to:
A) 0.76
B) 0.79
C) 0.93
D) 1.10
Answer: B
Explanation: B) U =

E +

D =

1.18 +

0.789677
Diff: 2
Section: 12.5 A Project's Cost of Capital
Skill: Analytical

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0.08 =

13) Your firm is planning to invest in a new electrostatic power generation system. Electrostat
Inc is a firm that specializes in this business. Electrostat has a stock price of $25 per share with
16 million shares outstanding. Electrostat's equity beta is 1.18. It also has $220 million in debt
outstanding with a debt beta of 0.08. If the risk-free rate is 3%, and the market risk premium is
6%, then your estimate of your cost of capital for electrostatic power generators is closest to:
A) 7.50%
B) 7.75%
C) 9.50%
D) 10.10%
Answer: B
Explanation: D) U =

E +

D =

1.18 +

0.08 =

0.789677
ri = rrf + (rm - rrf) = .03 + .789677(.06) = .07738 or 7.74%
Diff: 3
Section: 12.5 A Project's Cost of Capital
Skill: Analytical
14) The firm's unlevered (asset) beta is:
A) the weighted average of the equity beta and the debt beta.
B) the weighted average of the levered beta and the equity beta.
C) the debt beta minus the equity beta.
D) the unlevered beta minus the cost of capital.
Answer: A
Diff: 1
Section: 12.5 A Project's Cost of Capital
Skill: Definition
15) The firm's unlevered (asset) cost of capital is:
A) the weighted average of the equity cost of capital and the debt cost of capital.
B) the weighted average of the levered cost of capital and the equity cost of capital.
C) the debt cost of capital minus the equity cost of capital.
D) the unlevered beta minus the cost of capital.
Answer: A
Diff: 1
Section: 12.5 A Project's Cost of Capital
Skill: Definition

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Project Risk Characteristics and Financing

Use the following information to answer the question(s) below.

Division
Oil Exploration
Oil Refining
Gas & Convenience Stores

Asset
Beta
1.4
1.1
0.8

Next Period's Expected

Free Cash
Flow ($mm)
450
525
600

The risk-free rate of interest is 3% and the market risk premium is 5%.
1) The cost of capital for the oil exploration division is closest to:
A) 6.0%
B) 7.0%
C) 8.5%
D) 10.0%
Answer: D
Explanation: D) ri = rrf + (rm - rrf) = .03 + 1.4(.05) = .10 or 10.0%
Diff: 1
Section: 12.6 Project Risk Characteristics and Financing
Skill: Analytical
2) The cost of capital for the oil refining division is closest to:
A) 6.5%
B) 7.0%
C) 8.5%
D) 10.0%
Answer: C
Explanation: C) ri = rrf + (rm - rrf) = .03 + 1.1(.05) = .085 or 8.5%
Diff: 1
Section: 12.6 Project Risk Characteristics and Financing
Skill: Analytical
3) The value of the oil exploration division is closest to:
A) $4,500
B) $7,500
C) $8,750
D) $10,000
Answer: B
Explanation: B) ri = rrf + (rm - rrf) = .03 + 1.4(.05) = .10 or 10.0%
V=

= $7,500

Diff: 2
Section: 12.6 Project Risk Characteristics and Financing
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Expected
Growth
Rate
4.0%
2.5%
3.0%

Skill: Analytical
4) The value of the gas and convenience store division is closest to:
A) $4,500
B) $6,000
C) $8,600
D) $15,000
Answer: D
Explanation: D) ri = rrf + (rm - rrf) = .03 + 0.8(.05) = .07 or 7.0%
V=

= $15,000

Diff: 2
Section: 12.6 Project Risk Characteristics and Financing
Skill: Analytical
5) The overall value of Wyatt Oil (in $ millions) is closest to:
A) $25,000
B) $18,846
C) $31,250
D) $15,000
Answer: C
Explanation: C) Oil Exploration Division:
ri = rrf + (rm - rrf) = .03 + 1.4(.05) = .10 or 10.0%
V=

= $7,500

Oil Refining:
ri = rrf + (rm - rrf) = .03 + 1.1(.05) = .085 or 8.5%
V=

= $8,750

Convenience Store;
ri = rrf + (rm - rrf) = .03 + 0.8(.05) = .07 or 7.0%
V=

= $15,000

Total Value = 7,500 + 8,750 + 15,000 = $31,250

Diff: 3
Section: 12.6 Project Risk Characteristics and Financing
Skill: Analytical

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Copyright 2014 Pearson Education, Inc.

6) The overall asset beta for Wyatt Oil is closest to:

A) 0.95
B) 1.05
C) 1.15
D) 1.25
Answer: B
Explanation: B) Oil Exploration Division:
ri = rrf + (rm - rrf) = .03 + 1.4(.05) = .10 or 10.0%
V=

= $7,500

Oil Refining:
ri = rrf + (rm - rrf) = .03 + 1.1(.05) = .085 or 8.5%
V=

= $8,750

Convenience Store:
ri = rrf + (rm - rrf) = .03 + 0.8(.05) = .07 or 7.0%
V=

= $15,000

Total Value = 7,500 + 8,750 + 15,000 = $31,250

WO = wOE OE+ wOR OR + wCS CS
=

(1.4) +

(1.1) +

(0.8) = 1.028

Diff: 3
Section: 12.6 Project Risk Characteristics and Financing
Skill: Analytical
7) The overall cost of capital for Wyatt Oil is closest to:
A) 8.1%
B) 8.5%
C) 8.8%
D) 9.3%
Answer: A
Explanation: A) Oil Exploration Division:
ri = rrf + (rm - rrf) = .03 + 1.4(.05) = .10 or 10.0%
V=

= $7,500

Oil Refining:
ri = rrf + (rm - rrf) = .03 + 1.1(.05) = .085 or 8.5%
V=

= $8,750

Convenience Store:
ri = rrf + (rm - rrf) = .03 + 0.8(.05) = .07 or 7.0%
V=

= $15,000

Total Value = 7,500 + 8,750 + 15,000 = $31,250

18
Copyright 2014 Pearson Education, Inc.

rWO = wOE rOE+ wOR rOR + wCS rCS

=

(.10) +

(.085) +

(.07) = .0814

Diff: 3
Section: 12.6 Project Risk Characteristics and Financing
Skill: Analytical

Use the following information to answer the question(s) below.

Luther Industries has 25 million shares outstanding trading at $18 per share. In addition, Luther
has $150 million in outstanding debt. Suppose Luther's equity cost of capital is 13%, its debt cost
of capital is 7%, and the corporate tax rate is 40%.

15) Luther's after-tax debt cost of capital is closest to:

A) 4.2%
B) 5.4%
C) 7.0%
D) 9.8%
Answer: A
Explanation: A) Effective after-tax interest rate = r(1 - Tc) = .07(1 - .40) = .042 or 4.2%
Diff: 1
Section: 12.6 Project Risk Characteristics and Financing
Skill: Analytical
16) Luther's weighted average cost of capital is closest to:
A) 9.8%
B) 10.8%
C) 11.5%
D) 13.0%
Answer: B
Explanation: B) rU =
=

rE +
(13%) +

(1 - Tc)
(7%)(1 - .4) = 10.8%

Diff: 1
Section: 12.6 Project Risk Characteristics and Financing
Skill: Analytical

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Copyright 2014 Pearson Education, Inc.