Chapter 8

The Cost of Capital

236

CHAPTER 8—THE COST OF CAPITAL
TRUE/FALSE
1. Capital refers to items on the right-hand side of a firm's balance sheet.

2. The component costs of capital are market-determined variables in as much as they are based on investors' required returns.

3. The cost of debt is equal to one minus the marginal tax rate multiplied by the coupon rate on outstanding debt.

4. The cost of issuing preferred stock by a corporation must be adjusted to an after-tax figure because of the 70 percent dividend exclusion provision for corporations holding other corporations' preferred stock.

5. The firm's cost of external equity capital is the same as the required rate of return on the firm's outstanding common stock.

6. The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.

7. The cost of equity capital from the sale of new common stock (ke) is generally equal to the cost of equity capital from retention of earnings (ks), divided by one minus the flotation cost as a percentage of sales price (1 - F).

8. Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, but capital raised by selling new stock or bonds does have a cost.

9. The weighted average cost of capital increases if the total funds required call for an amount of equity in excess of what can be obtained as retained earnings.

10. The marginal cost of capital (MCC) is the cost of the last dollar of new capital that the firm raises, and the marginal cost declines as more and more of a specific type of capital is raised during a given period.

11. Even if a firm obtains all of its common equity from retained earnings, its MCC schedule might still increase if very large amounts of new capital are needed.

Flotation costs associated with issuing new equity cause the cost of external equity to be lower than the cost of retained earnings. The cost of capital is the firm's average cost funds given what the market demands be paid to attract the funds. 13. There is a jump. or break. in a firm's MCC schedule each time the firm runs out of a particular source of capital at a particular cost. assuming that new investments are of the same degree of risk as the firm's existing assets. 22. than on the interest rate on long-term debt. If expectations for long-term inflation rose. For example.Chapter 8 The Cost of Capital 237 12. ks. it should pay these funds to shareholders and let them invest directly in other assets that do provide this return. a firm may use up its 10 percent debt and can then issue more debt only if it offers a higher rate to investors. Tax adjustments to the cost of preferred stock must be made when determining the cost of capital since dividend expenses on preferred stocks are tax deductible. 16. Each component cost of particular types of capital is identical for each source of funds found in a firm's capital structure. but the slope of the SML remained constant. kd. The correct discount rate for a firm to use in capital budgeting. The cost of capital used in capital budgeting must be determined using the specific financing used to fund that particular project. 14. The firm's cost of capital represents the maximum rate of return that a firm can earn from its capital budgeting projects to ensure that the value of the firm increases. A firm's capital structure has no impact on the firm's weighted average cost of capital. . 23. 19. is its marginal cost of capital. 21. 15. If a firm cannot invest retained earnings and earn at least the cost of equity. 24. 18. Long-term capital gains are taxed at a lower rate than dividends for most stockholders leading companies to pay out dividends rather than use retained earnings to fund capital projects. for most firms. this would have a greater impact on the required rate of return on equity. 17. 20. The after tax cost of debt is used to calculate the weighted average cost of capital since we are concerned with the after-tax cash flows of the firm.

the component cost of equity for a company which pays half of its earnings out as common dividends and half as preferred dividends should. yet actually wind up with a lower after-tax cost of debt. Short-term debt.50). MULTIPLE CHOICE 1. A firm going from a lower to a higher tax bracket could increase its use of debt. . The cost of debt.T) will certainly be less than ks. 29. theoretically. 26. The steeper the demand curve for a firm's stock. ke becomes less than ks. Preferred stock. the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt. when the firm plans on using only debt or only equity to fund a particular project. Long-term debt. In general. it is not possible for ke.T)(0. Since 70 percent of preferred dividends received by a corporation is excluded from taxable income. d. since a firm cannot be 100% debt financed.50) + ks(1 . be Cost of equity = ks(0. kd. 30.70)(0. c. other things held constant. an exception to this rule occurs when the stock price increases just prior to the firm issuing new equity such that it more than offsets the flotation costs and thus. However. it should use the after-tax cost of the specific source of capital to evaluate that project. the cost of retained earnings. 27.Chapter 8 The Cost of Capital 238 In other words. the weighted average cost of capital will always be greater than kd(1 . the closer the values of ks and ke are to one another. the cost of new equity. All of the above are considered capital components for WACC and capital budgeting purposes. so kd(1 . Which of the following is not considered a capital component for the purpose of calculating the weighted average cost of capital as it applies to capital budgeting? a. However.T). e. is always less than ks. Common stock. b. 25. Therefore.30)(0. 28. to be lower than ks. Firms should use their weighted average cost of capital (WACC) when they are funding their capital projects with a variety of sources.

e. c. e. Expected growth rate. an increase in a company's stock price will increase the marginal cost of issuing new common equity. This can be seen from the equation stock is . The debt cost used to calculate a firm's WACC is kd (1-T). Which of the following statements is most correct? a. c. The firm should try to increase the WACC because such an action will decrease the value of the firm. kd (1-T). If a company's tax rate increases but the yield to maturity of its noncallable bonds remains the same. Answers b and c are both correct. Answers a and b are both correct. All else equal. Dividend yield. 3.Chapter 8 The Cost of Capital 239 2. if a company's stock price increases. All of the above are equally difficult to estimate. which of the following results would be preferred? a. c. . d. 4. If a firm can shift its capital structure so as to change its weighted average cost of capital (WACC). and all else remains constant. Required return. Which of the following factors in the discounted cash flow (DCF) approach to estimating the cost of common equity is the least difficult to estimate? a. Statement c is also false for the same reason. an increase in a company's stock price will increase the marginal cost of retained earnings. The cost of issuing a new common . If kd remains constant but T increases. d. b. the company's marginal cost of debt capital used to calculate its weighted average cost of capital will fall. The firm should not try to change the WACC because changing the WACC will not change the value of the firm. b. All else equal. The firm should try to increase the WACC because such an action will increase the value of the firm. The firm should try to decrease the WACC because such an action will increase the value of the firm. then the dividend yield decreases and ks decreases. Statement b is false. If P0 increases but there's no change in the flotation cost. ke will decrease. g b. Expected rate of return. ks d. The firm should try to decrease the WACC because such an action will decrease the value of the firm. decreases. e. then the term (1-T) decreases and the value of the entire equation.

as long as the firm's investments earn returns greater than the cost of capital. 7. is the same as the a.e. Alice Stewart. kd. Which of the following relationships should be correct for Meyers Foods? a. d. c. d. One of the assignments Alice gave her class was to compute the component costs of capital for Meyers Foods. internal equity). is teaching an upper-level course in corporate finance at the University of Phoenix. b. equity. the value of the firm will not decrease. the firm's marginal tax rate. who is the CFO of Meyers Foods. average yield to maturity (YTM) associated with the firm's bonds. the after-tax cost of debt. . Meyers Foods uses debt and common stock (no preferred stock) to finance its investments. ke < ks < kdT e. e. ks < kdT < ke c. ke. it is comparable to the average of all the interest rates on debt that currently prevail in the financial markets.. the same as the firm's internal rate of return (IRR). it is an indication of the return the firm is earning from all of its assets in combination. kdT. None of the above is a correct relationship. d. which are the returns demanded by investors. ks. regulated by the Internal Revenue Service (IRS) because tax-deductible debt is included in the computation. Under normal circumstances. c. determined by the financial markets because investors provide the funds used by firms and these funds have costs. The before-tax cost of debt. set by the board of directors of the firm because it is the benchmark they use to evaluate upper management.Chapter 8 The Cost of Capital 240 5. ke if the firm has no preferred stock. the total net present value (NPV) of all the capital budgeting projects in which the firm invests in any year. dividend yield associated with the firm's common stock. returns below the cost of capital will cover all the fixed costs associated with capital and provide excess returns to the firm's stockholders. 8. or external. c. e. b. the cost of retained earnings (i. ke < kdT < ks d. Students in the class did not reach the same conclusions about the relationships among the components costs—that is. The firm's weighted average cost of capital (WACC) is a. kdT < ks < ke b. b. and the cost of new. the weighted average cost of capital is used as the firm's required rate of return because a. average coupon rate of the firm's bonds. 6.

The cost of internally generated equity for Firm A is less than the cost of debt for Firm A. b. decreases c. the current price of the common equity is always changing making it difficult to determine. d. b. Although it is a subjective measure. b. the risk free rate. changes in an unpredictable way e. c. maximizes the tax shield created by debt. The target capital structure of a firm is the capital structure that a. d. minimizes the operating risk of the firm's assets. The cost of debt for Firm A is greater than the cost of equity for Firm B. Which of the following may be true concerning debt and equity? a. none of the above. a. d. The marginal cost of capital __________ as more capital is raised during a given period. b. 11.Chapter 8 The Cost of Capital 241 9. all of the above are difficult to estimate. minimizes the default risk of long-term debt. a. approaches zero 13. optimal capital budget schedule 14. the growth rate of the firm. interest rate on the firm's long term debt. c. does not change b. A graph of a firm's acceptable capital projects ranked in the order of the projects' internal rate of return is called the firm's ______________. investment opportunity schedule c. c. c. The cost of debt for Firm A is greater than the cost of equity for Firm A. internal project classification schedule e. The cost of internally generated equity for Firm A is greater than the cost of externally generated equity funds for Firm A. modified internal rate of return schedule d. d. 10. e. marginal cost of capital schedule b. e. analysts often estimate the cost of common equity by adding a risk premium of 3 to 5 percentage points to the a. increases d. the dividend yield is extremely difficult to estimate. maximizes the price of the firm's stock. Estimating the cost of common equity using the discounted cash flow approach may be difficult to evaluate because a. None of the above could be true. e. . the market return. the proper growth rate is difficult to establish. the cost of preferred stock for the firm. 12.

Which of the following statements is correct? a. . c. Would be eliminated (that is. the CAPM approach to estimating a firm's cost of retained earnings gives a better estimate than the DCF approach. As a firm's debt ratio approaches 100 percent. c. b. the MCC schedule would be horizontal) if the firm retained all of its earnings. Occurs because the firm must. preferred stock. as the firm's rate of expansion increases. Under normal conditions. and hence they have no impact on the MCC schedule. and c are all true. the after-tax cost of debt. The risk premium used in the bond-yield-plus-risk-premium method is the same as the one used in the CAPM method. be willing to take on riskier and riskier projects. b. Is caused by economies of scale in financing. e. Which of the following statements is correct? a. Results from a change in the debt ratio as the firm expands. d. and c are all false. 18. b. The opportunity cost principle implies that if the firm cannot invest retained earnings and earn at least ks. c. Statements a. along with higher debt costs. the DCF method and the CAPM method usually produce exactly the same estimate for k. c. Capital components are the types of capital used by firms to raise money. d. 16. The above statements are all false. other things held constant. according to the text. and this causes an increase in the cost of capital. Preferred stock does not involve any adjustment for flotation cost since the dividend and price are fixed. b. at its lowest level. The flotation percentage is determined jointly by the current price of the firm's stock and its growth rate. if it is to expand. Which of the following statements is most correct? a. All capital comes from one of three components: long-term debt. b. and this factor is added to the DCF cost estimate. Results from flotation costs associated with the sale of new common and preferred stock.Chapter 8 The Cost of Capital 242 15. Depreciation-generated funds have a cost equal to the firm's lowest WACC. An increase in the corporate tax rate would lower the weighted average cost of capital for an average firm. e. The CAPM approach is typically used to estimate a firm's flotation cost adjustment factor. kdT. 17. b. Typically. e. d. The rising section of MCC schedule a. The cost of debt used in calculating the WACC is an average of the after-tax cost of new debt and of outstanding debt. the MCC schedule is either horizontal or rising. which implies that the cost of capital to a firm increases as it raises larger and larger amounts of capital. e. d. and equity. In practice (as opposed to theory). The cost of new common equity includes an adjustment for flotation costs which is expressed as a fixed percentage of the current stock price. it should pay these funds to its stockholders and let them invest directly in other assets that do provide this return. Statements a.

The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project. e. Answers a and b are both false. d. e. which of the following elements is not subject to dispute or controversy? a. βi. Which of the following statements is correct? a. if a firm's book value weights are closest to its market value weights. c. e. but if a firm's stockholders are not well diversified. All of the above are subject to dispute. Market risk premium (MRP). Which of the following statements is correct? a. d. In applying the CAPM to estimate the cost of equity capital. Risk-free rate. The weighted average cost of capital will change whenever a break point occurs. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method of estimating a firm's cost of equity capital. c. book value weights can be used as proxies. Beta measures market risk. which varies daily with interest rates. b. d. Expected rate of return on the market. c. The stock's beta coefficient. If the calculated beta underestimates the firm's true investment risk. 22. The cost of debt used to calculate the weighted average cost of capital is based on an average of the cost of debt already issued by the firm and the cost of new debt. then the CAPM method will overestimate ks. However. beta may not accurately measure the firm's total risk. Which of the following statements is false? a. None of the above is a correct statement. The first break point a firm encounters in capital budgeting is for retained earnings. because the WACC is used for capital budgeting purposes. is constant during the analysis period. b. One problem with the CAPM approach to estimating the cost of equity capital is that if a firm's stockholders are. d. b. c. which includes long-term assets. 21. is that they yield precise estimates and require little or no judgement. . 20. An advantage shared by both the DCF and CAPM methods of estimating the cost of equity capital.Chapter 8 The Cost of Capital 243 19. and those assets are financed with long-term capital. e. The cost of equity capital is generally easier to measure than the cost of debt. kM. beta might be a poor measure of the firm's true investment risk. The discounted cash flow method of estimating the cost of equity can't be used unless the growth component. From a theoretical standpoint. only long-term debt is included in the calculation of the WACC. kRF. or the cost of preferred stock which is issued infrequently. the capital weights used to calculate the WACC should be based on the market values of the different securities. b. g. not well diversified. in fact. Generally. unless a firm has zero or negative net income.

Answers a and b are both correct. ks. The component cost of preferred stock is expressed as kps(1 . b. c. similar to the treatment of debt interest. decreased liquidity in money markets leading to lower selling prices for commercial paper. Thus. issuing preferred stock to institutional investors. ke? a. c.000 of those earnings paid as dividends. What is the relationship between the cost of retained earnings (internal equity). because new stockholders are willing to accept a lower return and "pay their dues" before they start receiving the higher returns that existing. Then the firm's after-tax cost of debt will equal its before-tax cost of debt. then retained earnings will have two breakpoints. A firm facing a steep demand curve (that is. 26. e. e. Which of the following statements is correct? a. a steeply upward sloping WACC curve. because there is no "real" cost to the income that the firm decides to retain to reinvest in assets rather than payout to common stockholders as dividends. 0 < ks < ke.000 in earnings. c. Which of the following statements is most correct? a. and stockholders want $50. 25. None of the above is a correct statement. because they both represent essentially the same source of funds. b. using retained earnings to fund new projects for the firm. e. 24. including those of greater than and lesser than average risks. 0 = ks < ke. loyal stockholders receive. The bond-yield-plus-risk-premium approach to estimating a firm's cost of common equity involves adding a subjectively determined risk-premium to the market risk-free bond rate. . Suppose a firm is losing money and thus. but the firm has to pay flotation costs when issuing new common stock. Consider the discussions concerning the cost of common equity. and occurs at the point where the cost of that capital type increases. if a firm has $100. high flotation costs) for new equity would likely also face.Chapter 8 The Cost of Capital 244 23. All of the above are false. The reason that a cost of capital is assigned to retained earnings is because these funds are already earning a return in the business. and the cost of new common equity (external equity). so they must have the same cost. at some point. is not paying taxes. d. increased flotation costs associated with seasoned equity offerings. e. because preferred stock dividends are treated as fixed charges. d. One purpose of calculating the WACC is to have a singular cost of capital measure that can be applied to evaluate all of the firm's projects.T). b. c. an increase in the required return demanded by investors for a new bond issue. b. A breakpoint is based on the dollar value used of a specific type of capital. d. Which of the following is least likely to lead to a break point in the marginal cost of capital schedule? a. and that this situation is expected to persist for a few years whether or not the firm uses debt financing. ks = ke. because there is a real cost to retaining income (earnings) for reinvestment. the reason does not involve the opportunity cost principle. d. None of the above is a correct answer. ks > ke.

Chapter 8 The Cost of Capital 245 27. b. Which of the following statements is correct? a. None of the above is a correct statement. 9. 15. and its expected dividend growth rate is 6 percent. the more the cost of external equity will exceed the cost of retained earnings. and it will retain 40 percent of those earnings. Normally. d. 11. If a firm has been suffering accounting losses and is expected to continue suffering such losses (and therefore its tax rate is zero). The current market price of the firm's stock is P0 = $28.8% b.80% d. e. e. the first break point in the MCC schedule must be associated with using up all available retained earnings and having to issue common stock. Bouchard Company's stock sells for $20 per share. 11. 12. 11. c. d. Make a list of all the break points. If Bouchard has a capital budget of $2. it is possible that its after-tax component cost of preferred stock as used to calculate the WACC will be less than its after-tax component cost of debt. 14. Due to the way the MCC is constructed.7% .20. the cost of external equity raised by issuing new common stock is above the cost of retained earnings. Determine the cost of capital for each component in the intervals between the breaks. what component cost of common equity will be built into the WACC for the last dollar of capital the company raises? a. its growth rate is a constant 6 percent. The firm expects to earn $600 in after-tax income during the coming year. Allison can issue new common stock at a 15 percent flotation cost. 28. Calculate the weighted averages of these component costs to obtain the WACCs in each interval. What will Allison's marginal cost of equity capital (not the WACC) be if it must fund a capital budget requiring $600 in total new capital? a. Which of the following steps is not necessary for calculating the marginal cost of capital schedule? a.15% e. 7. Determine each point at which a break in the marginal cost of capital schedule occurs. c.000.000. Because we often need to make comparisons among firms that are in different income tax brackets.9% d. and the company would incur a flotation cost of 20 percent if it sold new common stock. 13. its last dividend was D0 = $2. 12. b.000.45% c. Retained earnings for the coming year are expected to be $1. Moreover. its last dividend (D0) was $1. Estimate the change in the cost of capital within each interval.00. Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent common equity. and the common equity ratio is 60 percent.3% e. 29. it is best to calculate the WACC on a before-tax basis. the higher the growth rate relative to the dividend yield.9% c.63% 30.30% b.000.

6. The dividend growth rate is needed to compute kps. Gulf Electric Company Gulf Electric Company (GEC) uses only debt and equity in its capital structure. None of the above is correct. and the company would incur a flotation cost of 15 percent if it sold new common stock. 3.81% e.000. 10.66% d.00. The company's marginal tax rate is 40 percent. 11. It can borrow unlimited amounts at an interest rate of 10 percent so long as it finances at its target capital structure.78% b.66% c. while Project B has a cost of $125 million and a rate of return of 10 percent. its stock sells on the NYSE at a price of $35.25% 32. The firm's common equity ratio is 30 percent and it has no preferred stock outstanding.00% 34. What is the cost of preferred stock.29% e. 12.77% b. 3. 9. The firm can borrow up to $300. 12. What is GEC's cost of equity from newly issued stock? a. that should be included in the computation of the SW Ink's weighted average cost of capital (WACC)? a. GEC has two projects available: Project A has a cost of $200 million and a rate of return of 13 percent. 13. 13. 8. so not enough information is given to answer this question. any additional debt will have an interest rate of 9 percent. 12. e. what is the WACC for the last dollar of capital the company raises? a.33% d. Your company's stock sells for $50 per share.000 and the firm's payout ratio is 60 percent. What is GEC's marginal cost of capital for evaluating the $300 million in capital projects and any others that might arise during the year? a. which calls for 55 percent debt and 45 percent common equity. SW Ink's preferred stock.00% b. its last dividend (D0) was $2.76% c. currently sells for $62.00% . 33. 6. Refer to Gulf Electric Company. GEC's tax rate is 40 percent. 9.50% e. and it expects to have $100 million of retained earnings this year. 4. 9.50. 13. and new stock would net the company $30 per share after flotation costs. kps.8% c.77% c.Chapter 8 The Cost of Capital 246 31. Assume now that GEC needs to raise $300 million in new capital. Your company's tax rate is 40 percent. Net income for the coming year is expected to be $500.0% b. All of the company's potential projects are equally risky. its expected constant growth rate is 6 percent. Refer to Gulf Electric Company. Its last dividend was $2.000. its growth rate is a constant 5 percent. If the firm has a capital budget of $1.94% d.20.000 at an interest rate of 7 percent.2% d. which pays a $5 dividend each year. 13.

a 20 percent flotation cost will be incurred. and the current equilibrium stock price is $21. 17.600 b.8% b.0% d.4% e. Assume (contrary to the situation in the question just above) that at one point along the marginal cost of capital schedule the component cost of equity is 18. 35. Refer to Byron Corporation.400 d. 10.700 c. 14. $21. 16. what is the retained earnings break point?) a. $24. 16. Refer to Byron Corporation. and Byron's payout ratio is 30 percent.0 percent. The firm's marginal tax rate is 40 percent.88.000 e. the last dividend (D0) was $2. which is also its target capital structure. 12. What is the maximum amount of new capital that can be raised at the lowest component cost of equity? (In other words.0 percent. Byron can raise all the debt financing it needs at 14. 13. $14.6% e. 14. The company's earnings and dividends are growing at a constant rate of 5 percent. $17.000. 37. is 40 percent debt and 60 percent common equity. 18. If Byron issues new common stock.4% c.0% .0% .6% c. $12.00. Refer to Byron Corporation.0% b. What is the component cost of the equity raised by selling new common stock? a.500 36. Next year's net income is projected to be $21.Chapter 8 The Cost of Capital 247 Byron Corporation Byron Corporation's present capital structure.2% d. 15. What is the weighted average cost of capital at that point? a.

and the firm's marginal tax rate is 40 percent. Rollins is a constant growth firm which just paid a dividend of $2.00 per share. and has a growth rate of 8 percent. and sell for $1.1% c. Its target capital structure is 20 percent debt.0% d. 9. a current maturity of 20 years. Flotation costs on new common stock total 10 percent. 11. 10. Refer to Rollins Corporation. What is Rollins' cost of preferred stock? a. Refer to Rollins Corporation.6% d. What is Rollins' cost of retained earnings using the CAPM approach? a.0% d. Its bonds have a 12 percent coupon.Chapter 8 The Cost of Capital 248 Rollins Corporation Rollins Corporation is constructing its MCC schedule. What is Rollins' component cost of debt? a.6% b. 12. sells for $27.9% 41. and its dividend payout ratio is 40 percent.2.2% 39. 16. 13.0% d. 8. 16. 38.6% e.1% c.6% b. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find ks. at par.9% . paid semiannually. 16. The firm could sell.000. 16. 13.2% 40. and the market risk premium is 5 percent. 8. Refer to Rollins Corporation. and 60 percent common equity. Rollins' beta is 1.6% e. 20 percent preferred stock. Refer to Rollins Corporation. 16.0% e. What is the firm's cost of retained earnings using the DCF approach? a. The firm's net income is expected to be $1 million.0% c. 12. but flotation costs of 5 percent would be incurred. the risk-free rate is 10 percent.6% e. 14. 7.1% c.0% b.00. 14. 13. $100 preferred stock which pays a 12 percent annual dividend.0% b. 16. 10.

6% e. $800.9% 43. 16.000 b. Refer to Rollins Corporation. 16.000. 16.000 c.1% c. What is Rollins' retained earnings break point? a. 14. $600. 16. $1. 13. $1.0% d.6% b.000 e.000 45. Refer to Rollins Corporation. Refer to Rollins Corporation.0% d. What is Rollins' cost of retained earnings using the bond-yield-plus-risk-premium approach? a.200. 14. $1. 16.1% c. 16.6% e.000 d. 13. 16.6% b. 13. Refer to Rollins Corporation. 14. 16.9% 44.6% b.9% .6% e.0% d. What is Rollins' WACC once it starts using new common stock financing? a.400. 16. What is Rollins' lowest WACC? a.Chapter 8 The Cost of Capital 249 42.1% c.

47% e. 15.0% b. 10. 15. 18. Ross and Sons Inc. Refer to J. Refer to Jackson Company.25% b. 46. Ross and Sons Inc. The firm recently paid a dividend of $2 per share on its common stock.5% d. J.00% d.0% b. and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year.5% e. Ross' common stock currently sells for $40 per share. Refer to J.32% c. Ross and Sons Inc. 16. 17.0% b. Refer to J. 18.00 per share on its common stock. 10. 9. 10.5% c. however. The firm's preferred stock currently sells for $90 a share and pays a dividend of $10 per share. and it expects this dividend to grow by 10 percent per year. The firm's investment bankers believe that new issues of common stock would have a flotation cost equal to 5 percent of the current market price.5% e. 12. 15. 10 percent preferred stock.0% 49.0% . 15. 47. but the firm will net only $34 per share from the sale of new common stock.000 in earnings over the next year. Ross and Sons Inc.5% e. 12. and the expected return on the market is 14 percent. The firm has a beta of 1. and 50 percent common equity. 12.5% d.85% J.5% d. indefinitely.0% 48.Chapter 8 The Cost of Capital 250 Jackson Company The Jackson Company has just paid a dividend of $3. has a target capital structure that calls for 40 percent debt. What is the firm's cost of newly issued common stock? a. 16. 18.5% c. What is the firm's cost of newly issued preferred stock? a. What is the firm's cost of retained earnings? a. Ross and Sons Inc.5% c. the firm will net only $80 per share from the sale of new preferred stock. 16. The firm's current after-tax cost of debt is 6 percent.50. Ross expects to retain $15. 16. 12. the risk-free rate is 10 percent. and it can sell as much debt as it wishes at this rate. What will be Jackson's cost of new common stock if it issues new stock in the marketplace today? a.

What will be the WACC above this break point? a. 8. Ross and Sons Inc.3% c. $30.000 e. Where will a break in the WACC curve occur? a. Ross and Sons Inc. 11.5% b. Refer to J. $20. There will be no breaks in the WACC curve. 51. $42.1% .000 d. $10. 12. Refer to J.000 c.000 b. 10. 14.6% d.9% e.Chapter 8 The Cost of Capital 251 50.

Chapter 8 The Cost of Capital 236 .

D 28. T 3. B 29. C 26. E 30. C 45. D 27. F 15. C 23. A 44. F 17. F 5. B 15. T 26. B 24. F 18. C 38. F 29. E 36. F 9. F 27. F 4. A 5. B 14.Chapter 8 The Cost of Capital 236 TRUE/FALSE 1. F MULTIPLE CHOICE 1. F 19. A 31. A 22. B 4. B 50. C 43. E 19. A 34. A 33. F 23. T 10. T 20. C 2. B 47. A 3. D 16. T 22. C 42. A 7. D 12. C 48. E 39. T 2. B 46. F 24. C 13. D . D 49. T 13. T 14. C 11. C 41. A 37. F 8. F 6. A 51. F 28. F 11. A 17. E 20. F 7. E 18. F 25. B 32. D 35. T 30. T 12. A 25. T 16. D 40. A 9. A 8. C 6. B 10. C 21. F 21.