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Chapter 12—THE COST OF CAPITAL

MULTIPLE CHOICE

1. The Institutional Brokers' Estimate Service (IBES) summarizes analysts' _______.


a. short-term earnings forecasts
b. long-term earnings growth rates
c. bankruptcy forecasts
d. short-term earnings forecasts and long-term earnings growth rates
ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital TOP: Issues in implementation

2. Studies analyzing the historical returns earned by common stock investors have found that the returns
from average risk common stock investments over the years have averaged (arithmetically) _______
percentage points _______ than the returns on Treasury bills.
a. 6 to 8, higher
b. 1 to 2, lower
c. 3 to 4, higher
d. 8 to 9, higher
ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return
TOP: Capital asset pricing model approach

3. The cost of equity capital for non-dividend paying stocks can be determined by
a. using the Capital Asset Pricing Model
b. estimating ke for comparable dividend-paying stocks in their industry
c. forecasting the liquidation proceeds from the sale of the company's assets.
d. using the CAPM and by estimating ke for comparable dividend-paying stocks in their
industry
ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return
TOP: Risk premium on debt & other approaches for estimating...

4. For a company that is not planning to change its target capital structure, the proportions of debt and
equity used in calculating the weighted cost of capital should be based on the current _______ weights
of the individual components.
a. book value
b. market value
c. replacement value
d. accounting value
ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Determining the weighted cost of capital schedule

5. The cost of capital is


a. the rate of return required by investors in the firm's securities
b. the minimum rate of return required on new investments of high risk undertaken by the
firm
c. approximately 10 percent for most firms
d. concerned with plant and equipment only
ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital TOP: Introduction

6. A firm can raise up to $700 million for investment from a mixture of debt, preferred stock and retained
equity. Above $700 million, the firm must issue new common stock. Assuming that debt costs and
preferred stock costs remain unchanged, the marginal cost of capital for amounts up to $700 million
will be _______ the marginal cost of capital for amounts over $700 million.
a. less than
b. equal to
c. greater than
d. cannot be determined from the information given
ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Determining the weighted marginal cost of capital schedule

7. The CAPM assumes that the only risk of concern to the investor is _______, which is measured by
_______.
a. Unsystematic risk, beta
b. Systematic risk, the return to the market portfolio
c. Systematic risk, beta
d. Unsystematic risk, the return to the market portfolio
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Understand risk and return TOP: Capital asset pricing model approach | p. 462

8. If a firm adopts a large proportion of above-average-risk investment projects that are not offset by
below-average-risk investment projects
a. its cost of capital will rise
b. the average risk premium for the firm will decline
c. the risk-free rate will increase as more risk is added
d. its cost of capital will fall
ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital TOP: Divisional costs of capital

9. The most appropriate weights to use in calculating a firm's cost of capital are the proportions of the
components in the firm's _______ capital structure.
a. historical average
b. long-range target
c. current
d. industry average
ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: The problem of lumpy capital

10. For firms subject to the 34% marginal tax rate, the after-tax cost of _______ is roughly two-thirds the
cost of preferred stock.
a. retained earnings
b. new common stock
c. long-term debt
d. retained earnings and new common stock
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of debt

11. There are four major components that determine the risk premium. They include all the following
except
a. interest rate risk
b. business risk
c. reinvestment rate risk
d. financial risk
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return
TOP: Nature of risk premiums

12. The required rate of return on any security consists of a


a. risk premium plus an expected inflation rate
b. risk free rate plus a risk premium
c. inflation rate plus a marketability premium
d. risk free rate plus an inflation premium
ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Understand risk and return TOP: Nature of risk premiums

13. All of the following are true EXCEPT:


a. The claims of preferred stockholders on the firm's earnings are junior to those of debt-
holders.
b. The risk of recapitalization increases a firm's required rate of return.
c. Long-term state government securities are always less risky than corporate long-term
securities of the same maturity.
d. The cost of capital to the firm is equal to the equilibrium rate of return demanded by
investors in the capital markets for securities with that degree of risk
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital TOP: Relative costs of capital

14. Break points can be determined by dividing the amount of funds available from each financing source
at a fixed cost by the _____ proportion for that financing source.
a. weighted capital structure
b. target capital structure
c. economic capital structure
d. divisional capital structure
ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Determining the weighted cost of capital structure

15. If a preferred stock is callable, then the calculation of the cost of preferred stock financing is
a. similar to that for bonds
b. equal to Dp/Pn
c. equal to Dp less flotation costs
d. less than Dp/Pn
ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of preferred stock

16. The constant growth valuation model approach to calculating the cost of equity assumes that
a. earnings and dividends grow at a constant rate, but stock price growth is indeterminate
b. the growth rate is greater than or equal to ke
c. dividends are constant
d. earnings, dividends, and stock price will grow at a constant rate
ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Dividend valuation model approach

17. The total return to stockholders, ke, is composed of the


a. opportunity cost plus a risk premium
b. dividend yield plus the price appreciation of the security
c. opportunity cost plus an inflation premium
d. dividend yield minus the risk premium
ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Dividend valuation model approach

18. If a firm is losing money then the after-tax cost of debt is


a. equal to kd (1 - T)
b. found by trial and error
c. equal to the pretax cost of debt
d. equal to the yield to first call date
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of debt

19. The historic beta of a firm is of little use as a forecast of the firm's future systematic risk characteristics
when
a. the firm is growing at a rate of 7-10 percent a year
b. the firm is expanding an existing product line
c. the firm is expanding into a new product line
d. all of these answers are correct
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return
TOP: The capital asset pricing model approach

20. All of the following methods may be used to determine the cost of equity capital (k e) for a non-
dividend-paying stock except
a. the risk premium on debt approach
b. the Capital Asset Pricing Model approach
c. comparing with similar dividend-paying stocks in the industry
d. the simulation with growth expectations approach
ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return
TOP: Risk premium on debt & other approaches for estimating...

21. The cost of external equity is greater than the cost of internal equity because
a. it decreases the earnings per share
b. it increases the market price of the stock
c. of the flotation costs
d. dividends are increased
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of external equity capital

22. Retained earnings are a cheaper source of funds than the sale of new equity because
a. retention defers the payment of taxable dividends to shareholders
b. there are no flotation costs
c. new shares are usually priced below current market price
d. all the above
ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of external equity capital

23. Historic average capital costs are _______ new (marginal) resource allocation decisions.
a. not relevant for making
b. very useful when making
c. necessary for making
d. the relevant costs for making
ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital TOP: Marginal costs

24. Which of the following is not a typical source of debt funds for a small firm?
a. investment banking firms
b. commercial finance companies
c. Small Business Administration
d. leasing companies
ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Entrepreneurial finance issues: The cost of capital

25. If a firm will use only equity funds during the current capital budgeting period then the _______ is the
correct capital cost to use for computing the cost of funds for the firm.
a. cost of equity capital
b. weighted cost of funds
c. historical cost of funds
d. all of these answers are correct
ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: The problem of lumpy capital

26. The optimal capital budget is determined by comparing the expected project returns to the company's
a. computed break points
b. cost of equity schedule
c. marginal cost of capital schedule
d. optimal opportunity curve
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Determining the optimal capital budget

27. The cost of depreciation-generated funds is equal to


a. the cost of equity capital
b. zero, because depreciation is a non-cash expense
c. the investment opportunity cost
d. the weighted cost of capital
ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: The cost of depreciation-generated funds

28. __________ refers to the variability in the firm's operating earnings.


a. Business risk
b. Financial risk
c. Marketability risk
d. Interest rate risk
ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return
TOP: Nature of risk premiums

29. The major components that determine the risk premium on a specific security at any point in time
include all of the following except
a. business risk
b. financial risk
c. interest rate risk
d. real rate of return risk
ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return
TOP: Nature of risk premiums

30. Rank in ascending order (lowest to highest) the relative riskiness of the various types of corporate and
government securities.
a. common stock, preferred stock, corporate debt, long-term government debt
b. corporate debt, long-term government debt, preferred stock, common stock
c. long-term government debt, corporate debt, preferred stock, common stock
d. corporate debt, preferred stock, long-term government debt, common stock
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return
TOP: Relative costs of capital

31. Rank in ascending order (lowest to highest) investors' required rates of return on the various types of
corporate securities.
a. preferred stock, corporate debt, common stock
b. common stock, preferred stock, corporate debt
c. preferred stock, common stock, corporate debt
d. corporate debt, preferred stock, common stock
ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital TOP: Relative costs of capital

32. Which of the following statements (if any) is (are) true concerning companies that do not pay
dividends?
a. The cost of equity capital can be estimated using the Capital Asset Pricing Model.
b. The cost of equity capital is equal to the growth short-term rate of earnings per share.
c. The dividend capitalization model can be used to determine an accurate cost of equity
capital.
d. The cost of equity capital cannot be determined by using the CAPM, the risk premium on
debt approach, or by estimating ke for comparable dividend-paying stocks in their
industry.

ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking


LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return
TOP: Risk premium on debt & other approaches for estimating...

33. The optimal capital budget is indicated by the point at which the __________ and the __________
intersect.
a. depreciation schedule; investment opportunity schedule
b. investment opportunity curve; marginal cost of capital curve
c. investment opportunity curve; average cost of capital curve
d. efficient portfolio curve; marginal cost of capital curve
ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Determining the optimal capital budget

34. During the 1980s, the cost of capital for U.S. firms averaged about 3.3 percentage points higher than
Japanese firms. During 1990 this disadvantage may have disappeared due to:
a. higher exports to the U.S.
b. higher real interest rates in Japan
c. larger shareholder interest
d. higher Japanese stock market
ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Multicultural understanding
LOC: Knowledge of financial markets and interest rates TOP: International issues

35. If a firm sells assets, generating cash flows, the cost of these funds is ______.
a. the firm's cost of equity
b. the firm's cost of cash flows
c. the firm's weighted cost of capital
d. zero
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of depreciation generated funds

36. Small firms are reluctant to obtain capital through the sale of common stock because of:
a. potential loss of voting control
b. high issuance costs
c. high cost of debt
d. both the potential loss of voting control and the high issuance costs
ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Understand the role of the finance function
TOP: Entrepreneurial finance issues

37. Determine the (after-tax) percentage cost of a $50 million debt issue that the Mattingly Corporation is
planning to place privately with a large insurance company. Assume that the company has a 40%
marginal tax rate. This long-term debt issue will yield 12% to the insurance company.
a. 4.8%
b. 7.2%
c. 12.0%
d. 10.6%
ANS: B
Solution:
ki = kd(1 - T) = 12%( 1- 0.40) = 7.2%

PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital
TOP: After-tax cost of debt calculation

38. Calculate the after-tax cost of preferred stock for Ohio Valley Power Company, which is planning to
sell $100 million of $3.25 cumulative preferred stock to the public at a price of $25 per share.
Flotation costs are $1.00 per share. Ohio Valley has a marginal income tax rate of 40%.
a. 13.0%
b. 7.8%
c. 8.12%
d. 13.54%
ANS: D
Solution:
kp = $3.25/($25 - $1) = 13.54%

PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of preferred calculation

39. The Allegheny Valley Power Company common stock has a beta of 0.80. If the current risk-free rate is
6.5% and the expected return on the stock market as a whole is 16%, determine the cost of equity
capital for the firm (using the CAPM).
a. 14.1%
b. 7.6%
c. 6.5%
d. 13.0%
ANS: A
Solution:
ke = rf + (km - rf) = 6.5% + 0.80(16% - 6.5%) = 14.1%

PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of equity (CAPM)

40. The following financial information is available on Rawls Manufacturing Company:

Current per share market price $48.00


Current (t = 0) per share dividend $3.50
Expected long-term growth rate 5.0%

Rawls can issue new common stock to net the company $44 per share. Determine the cost of internal
equity capital using the dividend capitalization model approach. (Compute answer to the nearest
0.1%).
a. 12.3%
b. 13.4%
c. 13.0%
d. 12.7%
ANS: D
Solution:
ke = $3.50(1.05)/$48 + 0.05 = 0.1266 (or 12.7%)

PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of internal equity - constant growth dividend...

41. The following financial information is available on Rawls Manufacturing Company:

Current per share market price $48.00


Beta 1.1
Expected rate of return on market 12.0%
Risk-free rate 6.0%

Rawls can issue new common stock to net the company $44 per share. Determine the cost of internal
equity capital using the capital asset pricing model approach. (Compute answer to the nearest 0.1%).
a. 12.9%
b. 12.6%
c. 13.0%
d. 11.8%
ANS: B
Solution:
ke = rf + (km- rf) = 0.06 + 1.1(0.12 - 0.06) = 0.126 = 12.6%

PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of equity - CAPM approach

42. The following financial information is available on Rawls Manufacturing Company:

Current per share market price $48.00


Current per share dividend $ 3.50
Current per share earnings $ 6.00
Beta 1.1
Expected rate of return on market 12.0%
Risk-free rate 6.0%
Expected long-term growth rate 5.0%

Rawls can issue new common stock to net the company $44 per share. Determine the cost of external
equity capital using the dividend capitalization model approach. (Compute answer to the nearest
0.1%).
a. 12.7%
b. 14.4%
c. 12.6%
d. 13.35%
ANS: D
Solution:
ke' = (D1/Pnet) + g = [$3.50(1.05)/$44] + 0.05 = 0.1335 or 13.4%

PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of external equity - constant growth dividend...

43. Determine the weighted cost of capital for the Mills Company that will finance its optimal capital
budget with $120 million of long-term debt (kd = 12.5%) and $180 million in retained earnings (ke =
16.0%). Mills' present capital structure is considered optimal. The company's marginal tax rate is 40%.
(Compute answer to nearest .1%).
a. 14.3%
b. 12.6%
c. 14.6%
d. 11.9%
ANS: B
Solution:
ka = 0.40 x 12.5%(1 - 0.4) + 0.60 x 16.0% = 12.6%

PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skill


LOC: Knowledge of capital budgeting and cost of capital TOP: Weighted cost of capital

44. What is the cost of a preferred stock with a $100 par value that pays a $9.60 dividend per year? The
security has a flotation cost of $3.37 and will be retired at its par value in 20 years.
a. 9.6%
b. 9.9%
c. 10.0%
d. 10.6%
ANS: C
Solution:
Try kp = 10%
$9.60(8.514) + $100(0.149) = $96.63

PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of preferred stock - finite life

45. What is the cost of equity for East Roon, if the firm is expected to always pay a constant dividend of
$2.22? The firm's common stock is presently selling for $18.50.
a. 8.3%
b. 12.0%
c. 10.2%
d. cannot be determined from the information given
ANS: B
Solution:
ke = $2.22/$18.50 = 0.12 or 12%

PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of common equity - zero growth

46. According to Value Line, Bestway has a beta of 1.15. If 3-month Treasury bills currently yield 7.9
percent and the market risk premium is estimated to be 8.3 percent, what is Bestway's cost of equity
capital?
a. 17.45%
b. 8.36%
c. 9.55%
d. 16.2%
ANS: A
Solution:
ke = 7.9% + 1.15(8.3%) = 17.45%

PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of common equity - CAPM

47. Northeast Airlines (NA) has a current dividend of $1.80. Dividends are expected to grow at a rate of 7
percent a year into the foreseeable future. What is NA's cost of external equity if its stock can be sold
to net $46 a share?
a. 10.9%
b. 11.2%
c. 7.2%
d. 21.0%
ANS: B
Solution:
ke = $1.80(1.07)/$46 + 0.07 = 0.112 or 11.2%

PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of common equity - constant growth

48. A firm with a 40 percent marginal tax rate has a capital structure of $60,000,000 in debt and
$140,000,000 in equity. What is the firm's weighted cost of capital if the marginal pretax cost of debt is
12 percent, the firm's average pretax cost of debt outstanding is 8%, and the cost of equity is 14.5
percent?
a. 13.75%
b. 11.59%
c. 12.31%
d. 10.45%
ANS: C
Solution:
ka = 0.3(0.12)(1 - 0.4) + 0.7(0.145) = 0.1231 or 12.31%

PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital
TOP: Weighted cost of capital calculation

49. Crickentree has a target capital structure of 30 percent debt and 70 percent equity. If the firm expects
to have a net income of $1.7 million and a dividend payout ratio of 40 percent, what will be its equity
break point?
a. $2,428,571
b. $1,457,143
c. $3,400,000
d. $ 971,429
ANS: B
Solution:
x = $1.7(1 - 0.4)/0.7 = $1.457 or $1,457,143
PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills
LOC: Knowledge of capital budgeting and cost of capital TOP: Break point calculation

50. Easy Slider Inc. sold a 15 year $1,000 face value bond with a 10 percent coupon rate. Interest is paid
annually. After flotation costs, Easy Slider received $928 per bond. Compute the after-tax cost of debt
for these bonds if the firm's marginal tax rate is 40 percent.
a. 6.0%
b. 7.2%
c. 7.8%
d. 6.6%
ANS: D
Solution:
(try 11%) ki = 11%(0.6) = 6.6%
$928 = $100(7.191) + $1000(0.209)  $928
so kd = 11%
ki = 11%(0.6) = 6.6%

PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of debt

51. Easy Slider recently sold a 15 year $1,000 face value bond at a discount for $700 that net the firm
$692 after flotation costs. The low coupon bond has a 6% coupon with interest paid semiannually. If
Easy Slider has a marginal tax rate of 40 percent, what is its after-tax cost of debt for these bonds?
a. 10.0%
b. 6.0%
c. 9.2%
d. 7.8%
ANS: B
Solution:
(Try 5% semiannually ): $692 = $30(15.373) + $1,000(0.231) = $692
Therefore kd = 10% and ki = 10%(1 - 0.4) = 6%

PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of debt

52. Alpha Products maintains a capital structure of 40 percent debt and 60 percent common equity. To
finance its capital budget for next year, the firm will sell $50 million of 11 percent debentures at par
and finance the balance of its $125 million capital budget with retained earnings. Next year Alpha
expects net income to grow 7 percent to $140 million, and dividends also are expected to increase 7
percent to $1.40 per share and to continue growing at that rate for the foreseeable future. The current
market value of Alpha's stock is $30. If the firm has a marginal tax rate of 40 percent, what is its
weighted cost of capital for the coming year?
a. 9.64%
b. 8.63%
c. 9.84%
d. 11.67%
ANS: A
Solution:
ke = $1.40/$30 + 0.07 = 0.1167
ka = 0.6(0.1167) + 0.4(0.11)(1 - 0.4) = 0.0964 or 9.64%
PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills
LOC: Knowledge of capital budgeting and cost of capital TOP: Weighted cost of capital

53. Wellington Gas has a target capital structure of 50 percent common equity, 40 percent debt, and 10
percent preferred stock. The cost of retained earnings is 16 percent, and the cost of new equity
(external) is 16.7 percent. Wellington can sell debentures that will have an after-tax cost of 8.3 percent
and the after-tax cost of preferred stock will be 11.9 percent. What is the marginal cost of capital
before and after the break point?
a. 12.51% and 12.86%
b. 11.18% and 11.53%
c. 14.23% and 14.68%
d. 12.51% and 11.53%
ANS: A
Solution:
ka1 = 0.5(0.16) + 0.4(0.083) + 0.1(0.119) = 0.1251
ka2 = 0.5(0.167) + 0.4(0.083) + 0.1(0.119) = 0.1286

PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital TOP: Weighted cost of capital

54. GQ earned $740,000 before taxes this year. The firm has a debt ratio of 30 percent, a marginal tax rate
of 35 percent, and a dividend payout ratio of 40 percent. GQ has no preferred stock. What is GQ's
break point for equity?
a. $634,286
b. $962,000
c. $412,286
d. $288,600
ANS: C
Solution:
Retained earnings = $740,000(1 - 0.35)(1 - 0.4) = $288,600
Break point =$288,600/0.7 = $412,286

PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital TOP: Break point determination

55. Groves, Inc. pays an annual dividend of $1.22. This dividend is expected to continue growing at a rate
of about 5 percent each year. The firm is in a fairly risky business and has a beta of 1.45. The expected
market rate of return is 13.5 percent, and the risk-free rate is 9.3 percent. What is the cost of equity for
Groves?
a. 19.6%
b. 13.5%
c. 15.4%
d. 6.1%
ANS: C
Solution:
ke = 0.093 + 1.45(0.135 - 0.093) = 0.154

PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of equity - CAPM

56. PDQ Inc. has a weighted cost of capital of 14.6 percent and has an opportunity to invest in the
following average risk projects:
Project Cost Annual Cost Flow Project life
1 $10,000 $1,992.43 10 years
2 $21,000 $4,526.84 8 years
3 $18,500 $4,580.34 7 years

In which projects should PDQ invest? Assume no capital rationing.


a. 1 & 2
b. 2 & 3
c. 1 & 3
d. cannot be determined from the information provided
ANS: C
Solution:
IRR1 = $10,000/$1,992.43 = 5.019 so IRR = 15%
IRR2 = $21,000/$4,526.84 = 4.639 so IRR = 14%
IRR3 = $18,500/$4,580.34 = 4.039 so IRR = 16%
Invest in projects 1 and 3 because their IRR is greater than 14.6%

PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital
TOP: Calculation of optimal capital budget

57. Mid-South Utilities will sell $10 million of $100 par value preferred stock that will pay an annual
dividend of $9.75. Mid-South will receive $93.98 per share after flotation costs. If the issue must be
retired in 20 years, what is the cost of the preferred issue?
a. 10.37%
b. 10.50%
c. 10.23%
d. 9.75%
ANS: B
Solution:
10.5 % (by calculator)

PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills


LOC: knowledge of capital budgeting and cost of capital
TOP: Cost of finite maturity preferred stock

58. Witin's stock price is currently $34.25 and the current quarterly dividend is $0.25. Consensus estimates
for Witin indicate a growth rate in earnings of 10% into the foreseeable future. If Witin plans to sell 1
million shares to raise new capital for expansion, what is the cost of new equity if the issuance costs
are 8%?
a. 13.49%
b. 10.87%
c. 13.21%
d. 13.17%
ANS: A
Solution:
ke = 1.00(1.10) + .10 = .1349 or 13.49%
31.51

PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of equity
59. Weltron has a target capital structure of 35% debt and 65% equity. If the firm expects net income of
$12.3 million and an annual dividend of $0.12 per share, what is the expected equity break point?
There are 12 million shares outstanding.
a. $18,923,076
b. $16,707,692
c. $10,061,538
d. $ 2,215,385
ANS: B
Solution:
Payout = 12,000(.12) = $1,440,000
BP = (12.3 - 1.44)/.65 = $16,707,692

PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital TOP: Break point for equity

60. Pluega Inc. issued a $100 million 8.27% coupon debenture bond due in the next 20 years. The bonds
each sold for $996. If the bonds pay interest semi-annually, what is Pluega's after cash cost of debt?
Assume 40% tax rate.
a. 4.96%
b. 8.30%
c. 4.99%
d. 3.32%
ANS: C
Solution:
8.31(1-.4) = 4.986 or 4.99% (by calculator)

PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of debt

61. Haulsee Inc. pays no dividend currently but is expected to start paying a small dividend next year. The
5-year old firm has a beta of 1.25 and current earnings of $0.90 per share. The current Treasury bill
rate is 6.10% and the market risk premium is 8.8%. Determine Haulsee's cost of equity if the firm's tax
rate is 40%.
a. 9.48%
b. 17.1%
c. 14.9%
d. cannot determined from the information provided
ANS: B
Solution:
ke = 6.10 + 1.25(8.8) = 17.1%

PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of equity
62. Sharp's current capital structure of 60 percent equity, 35 percent debt, and 5 percent preferred stock is
considered optimal. This year Sharp expects to have earnings after tax of $3.6 million and to pay out
$600,000 in dividends. Sharp can also raise up to $2 million in long-term debt at a pretax interest rate
of 10.6 percent (all debt over $2 million will cost 11.4% pretax), and sell preferred stock at a cost of
11.5 percent. Sharp's marginal tax rate is 40 percent. The current value of Sharp's common stock is $36
and a dividend of $2.15 is expected to be paid during the coming year. Dividends have been growing
at an annual compound rate of 8 percent a year and are expected to continue growing at that rate. New
shares can be sold to net the firm $34.50. Sharp has an opportunity to invest in the following capital
projects. Which one(s) should be accepted?

Project Cost Annual Cash Flow Project Life


1 $3.0 million $552,893 10 years
2 $2.5 million $693,481 5 years
3 $2.0 million $345,220 10 years

a. 1 and 2
b. 1 and 3
c. 1, 2, and 3
d. cannot be determined from the information provided
ANS: A
Solution:
Equity break point = $3,000,000/0.6 = $5,000,000
Debt break point = $2,000,000/0.35 = $5,714,286
ke = $2.15/$36 + 0.08 = 0.140
ki = 0.106(1 - 0.4) = 0.0636
k'e = $2.15/$34.50 + 0.08 = 0.142
ka1 = 0.6(0.140) + 0.35(0.0636) + 0.05(0.115) = 0.112
ka2 = 0.6(0.142) + 0.35(0.0636) + 0.05(0.115) = 0.113
ka3 = 0.6(.142) + 0.35(0.114)(0.6) + 0.05(0.115) = 0.115

IRR1 = $3,000,000/$552,893 = 5.426 or 13%


IRR2 = $2,500,000/$693,481 = 3.605 or 12%
IRR3 = $2,000,000/$345,220 = 5.793 or 11.4% (by calculator)

PTS: 1 OBJ: TYPE: C. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital
TOP: Weighted cost of capital and optimal capital structure

63. Far Out Tech (FOT) has a debt ratio of 0.3 and it considers this to be its optimal capital structure. FOT
has no preferred stock. FOT has analyzed four capital projects for the coming year as follows:

Project Net Investment IRR


1 $3,000,000 13.5%
2 $1,500,000 18.0%
3 $2,000,000 12.6%
4 $1,600,000 16.0%
FOT expects to earn $2.7 million after tax next year and pay out $700,000 in dividends. Dividends are
expected to be $1.05 a share during the coming year and are expected to grow at a constant rate of 10
percent a year for the foreseeable future. The current market price of FOT stock is $22 and up to $2
million in new equity can be raised for a flotation cost of 10 percent. If more than $2 million is sold
then the flotation cost will be 15 percent. Up to $2 million in debt can be sold at par with a coupon rate
of 10 percent. Any debt over $2 million will carry a 12 percent coupon rate and be sold at par. If FOT
has a marginal tax rate of 40 percent, in which projects should it invest?
a. 1, 2, 3, & 4
b. 2
c. 1, 2, and 4
d. 2 and 4
ANS: C
Solution:
Break point for common equity = $2,000,000/0.7 = $2,857,143
Second equity break point = $4,000,000/0.7 = $5,714,286
Debt break point = $2,000,000/0.3 = $6,666,667

ke = $1.05/$22 + 0.10 = 0.148


k'e1 = $1.05/$19.80 + 0.10 = 0.153
k'e2 = $1.05/$18.70 + 0.10 = 0.156
ka1 = 0.7(0.148) + 0.3(0.10)0.6 = 0.122
ka2 = 0.7(0.153) + 0.3(0.10)0.6 = 0.125
ka3 = 0.7(0.156) + 0.3(0.10)0.6 = 0.127
ka4 = 0.7(0.156) + 0.3(0.12)0.6 = 0.131

PTS: 1 OBJ: TYPE: C. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital
TOP: Weighted cost of capital and optimal capital structure

64. Temple Company's common stock dividends have grown over the past 5-year period from $0.60 per
share to $0.89 (today). Assume that Temple's dividends are expected to grow at this rate for the
foreseeable future. Temple's stock is currently selling for $12 per share. New common stock can be
sold to net the company $11 per share. Determine the costs of internal and external equity to Temple.
a. 18.1%; 18.9%
b. 15.9%; 16.6%
c. 16.2%; 16.9%
d. 15.9%; 18.9%
ANS: C
Solution:
$0.89 = $0.60 (FVIFg, 5 )
g = 8.2% by calculator or interpolation
ke = $0.96/$12 + 0.082 = 0.162 or 16.2%
k'e = $0.96/$11 + 0.082 = 0.169 or 16.9%

PTS: 1 OBJ: TYPE: C. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of equity capital

65. Whipple Industries, Inc. is in the process of determining its optimal capital budget for next year. The
following investment projects are under consideration:

Required Expected Rate


Project Investment of Return
A $2 million 20.0%
B 3 million 15.0
C 1 million 13.5
D 4 million 13.0
E 1 million 12.5
F 3 million 12.0
G 5 million 11.5

The firm's marginal cost of capital schedule is as follows:

Amount of
Funds Raised Cost
$0 - $6 million 12.0%
$6 million - $12 million 12.5%
$12 million - $18 million 13.5%
Over $18 million 15.0%

Determine Whipple's optimal capital budget (in dollars) for the coming year.
a. $11 million
b. $10 million
c. $5 million
d. $14 million
ANS: A
Solution:

Required Cumulative Expected Marginal


Project Investment Investment Rate of Return Cost of Capital
A $2 million $2 million 20.0% 12.0%
B 3 million 5 million 15.0 12.0
C 1 million 6 million 13.5 12.0
D 4 million 10 million 13.0 12.5
E 1 million 11 million 12.5 12.5
F 3 million 14 million 12.0 12.5 and 13.5
G 5 million 19 million 11.5 13.5 and 15.0

Optimal Capital budget: $11 million (Projects A,B,C.D,E)

PTS: 1 OBJ: TYPE: C. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital TOP: Optimal capital budget

66. American Dental Laser is selling a 10 year $1,000 face value bond with a 8% coupon rate. Interest is
paid annually. The price to the public is $820 and the issue costs per bond are $10 each. Compute the
pretax cost of debt for these bonds.
a. 11.1%
b. 11.3%
c. 11.5%
d. 11.8%
ANS: B
Solution:
$810 = $80(PVIFAkd,10) + $1000(PVIFkd,10)
try 11%: $80(5.889) + $1000(0.352) = $823.12
try 12%: $80(5.650) + $1000(0.322) = $774.00
kd = 11% + $13.12 (12% - 11%) = 11.3%
$13.12 + $36

PTS: 1 OBJ: TYPE: C. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of debt--deep discount bond

67. Mid-States Utility Company just issued at $3.20 cumulative preferred stock at a price to the public of
$30 a share. The flotation costs were $1.50 a share and the issue will be retired in 20 years at its $30
par value. What is the cost of this preferred issue?
a. 11.3%
b. 10.3%
c. 10.7%
d. 11.6%
ANS: A
Solution:
$28.50 = $3.20(PVIFAkp,20) + $30(PVIFkp,20)
try 11%: $3.20(7.963) + $30(0.124) = $29.20
try 12%: $3.20(7.469) + $30(0.104) =$27.02

$0.70
kp = 11% + (12% - 11%) = 11.3%
$0.70 + $1.48

PTS: 1 OBJ: TYPE: C. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of preferred stock

68. Wright Express(WE) has a capital structure of 30% debt and 70% equity. WE is considering a project
that requires an investment of $2.6 million. To finance this project, WE plans to issue 10-year bonds
with a coupon interest rate of 12%. Each of these bonds has a $1,000 face value and will be sold to net
WE $980. If the current risk-free rate is 7% and the expected market return is 14.5%, what is the
weighted cost of capital for WE? Assume WE has a beta of 1.20 and a marginal tax rate of 40%.
a. 14.9%
b. 12.4%
c. 13.4%
d. 16.0%
ANS: C
Solution:
try 12%: $120(5.650) + $10000(.322) = $1,000
try 13%: $120(5.426) + $1000(0.295) = $946.12

$20
kd = 12% + (13% - 12%) = 12.4%
$20 + $33.88

ke = 7% + $1.20(14.5% - 7%) = 16%


ka = 0.3(12.4%)(1 - 0.4) + 0.7(16%) = 13.4%

PTS: 1 OBJ: TYPE: C. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital TOP: Weighted cost of capital
69. California Best (CB), a sport shoe store, expects an operating income of $2.3 million this year. CB has
no long-term debt. The firm is considering as expansion project. The current risk-free rate of return is
7% and the current market risk premium is 8.3%. If CB's beta is 20% greater than the overall market,
what is the firm's cost of capital? Assume that CB has a marginal tax rate of 40%.
a. 8.3%
b. 16.96%
c. 9.96%
d. 15.3%
ANS: B
Solution:
ka = ke = 7% + 1.2(8.3%) = 16.96%

PTS: 1 OBJ: TYPE: C. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of equity

70. Columbia Gas Company's(CG) current capital structure is 35% debt and 65% equity. This year CG has
earnings after tax of $5.31 million and is paying $1.6 million in dividends. To finance a transmission
pipe line, CG can borrow $2 million at a cost of 10%, the same rate that CG is currently paying on a
total of $15 million long-term debt. CG has 1,000,000 shares outstanding and its current market price
is $31. If CG's long-term growth rate of dividends is expected to be 8%, what is the weighted cost of
capital for the firm? Assume a marginal tax rate of 40%.
a. 10.9%
b. 13.6%
c. 19.6%
d. 16.9%
ANS: A
Solution:
kd = 10%(1 - 0.4) = 6%
ke = $1.6(1.08)/$31 + 0.08 = .136 or 13.6%
ka = 0.35(6%) + 0.65(13.6%) = 10.9%

PTS: 1 OBJ: TYPE: C. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital TOP: Weighted cost of capital

71. Heleveton Industries is 100% equity financed. Its current beta is 1.1. The expected market risk
premium is 8.5% and the risk-free rate is 4.2%. If Heleveton changes its capital structure to 25% debt,
it estimates its beta will increase to 1.2. If the after-tax cost of debt will be 6%, should Heleveton make
the capital structure change?
a. Yes, cost of capital decreases by 2.52%
b. Yes, cost of capital decreases 1.67%.
c. No, stock price would decrease due to increased risk
d. No, cost of capital increases by 0.85%.
ANS: B
Solution:
Old ke = 4.2 + 1.1(8.5) = 13.55% = ka
New ke = 4.2 + 1.2(8.5) = 14.4%
New ka = .7(14.4) + .3(6) = 11.88%
Stock price is maximized where the cost of capital is minimized.

PTS: 1 OBJ: TYPE: C. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of capital
72. Sadaplast has a target capital structure of 65% common equity, 30% debt, and 5% preferred stock. The
cost of retained earnings is 14% and the cost of new equity is 15.5%. Sadaplast expects to have a net
income of $85 million in the coming year. If the firm sells bonds, up to $25 million can be sold at par
value to yield an after-tax cost of 5.4%. An additional $20 million of debentures could be sold to yield
an after-tax cost of 7.0%. The after-tax cost of preferred stock financing is estimated to be 11%.
Sadaplast has a dividend payout ratio of 25%. What is Sadaplast's cost of capital between the first and
second break points?
a. 12.25%
b. 11.27%
c. 11.75%
d. 12.73%
ANS: C
Solution:
RE = .75($85 million) = $63.75 million
BPe = $63.75 million / 0.65 = $98.077 million
BPd = $25 million / 0.30 = $83.333 million
BPd' = $45 million / .30 = $150 million
ka = 0.65(0.14) + 0.30(0.07) + 0.05(0.11) = 0.1175 or 11.75%

PTS: 1 OBJ: TYPE: C. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital TOP: Weighted cost of capital

73. Bay State Technology has determined that its cost of equity is 15% and its after-tax cost of debt is
7.2%. Bay State expects to earn $14 million after taxes next year and, as a new firm, does not pay any
dividends. The stock sells for $24. Bonds are currently selling at par value. Compute Bay State's
weighted cost of capital. A partial balance sheet is shown below:

Current liabilities $ 300,000


Long-term debt 1,000,000
Common stock at $1 par 100,000
Paid in capital 900,000
Retained earnings 3,000,000
Total liabilities and stockholders' equity $5,300,000

a. 13.4%
b. 13.1%
c. 11.6%
d. 12.7%
ANS: D
Solution:
Capital structure: Debt = $1,000,000
Market value of Equity: 100,000 shares($24) = 2,400,000
Total $3,400,000

Capital structure: Debt = $1/$3.4 = 29.41%


Equity=2.4/3.4 = 70.59%
ka = 0.2941(7.2%) + 0.7059(15.0%) = 12.71%

PTS: 1 OBJ: TYPE: C. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital
TOP: Capital structure and cost of capital
74. Mahlo is planing to diversify into the bakery industry. As a result, its beta should drop from 1.4 to 1.2
and the expected long-term growth rate of dividends will drop from 12% to 9%. The risk-free rate is
4%, the expected market risk premium is 9%, and the current dividend per share paid by Mahlo is
$2.10. Should Mahlo complete the diversification into the bakery industry?
a. No, stock price drops about $11.70
b. Yes, stock price increases about $9.40
c. Yes, stock price increases about $1.80
d. No, stock price drops about $9.40
ANS: A
Solution:
Current ke = 0.04 + 1.4(0.09) = 0.166 or 16.6%
P0 = $2.10(1.12) / (0.166 - 0.12) = $51.13
New ke = 0.04 + 1.2(0.09) = 0.148 or 14.8%
New P0 = $2.10(1.09) / (0.148 - 0.09) = $39.47

PTS: 1 OBJ: TYPE: C. Prob. NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of capital

75. Which of the following statements regarding the cost of capital is/are correct?
I. The weighted cost of capital is the discount rate used when computing the net present value.
II. The after-tax cost of capital is weighted by the proportions of the capital components in the firm’s
long-range target capital structure.
a. I only
b. II only
c. Both I and II
d. Neither I nor II
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital TOP: Weighted cost of capital

76. The cost of debt must account for all of the following inputs EXCEPT:
a. Bond ratings.
b. Issuance costs.
c. flotation costs.
d. The tax rate.
ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of debt

77. There are two primary ways that capital is raised. Which of the following statements is/are correct?
I. Capital is raised internally by using retained earnings.
II. Capital is raised externally by selling fixed assets.
a. I only
b. II only
c. Both I and II
d. Neither I nor II
ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of equity capital

78. Investors can form earnings growth expectations from various sources, including
a. potential sales growth.
b. current earnings and retention rates.
c. assumed product development.
d. investors’ required rate of return.
ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Understand the role of the finance function TOP: Issues in implementation

79. What is the weighted average cost of capital for Mud Bug Corporation?
Source of Capital Capital Components Cost
Long Term Debt $60,000 5.6%
Preferred Stock $15,000 10.6%
Common Stock $75,000 13.0%

a. 6.9%
b. 8.5%
c. 10.2%
d. 9.8%
ANS: D PTS: 1 OBJ: TYPE: E. Prob.
NAT: Analytic skills LOC: Knowledge of capital budgeting and cost of capital
TOP: Weighted cost of capital

80. Zappin’ Skeeters Corporation needs to know its cost of retained earnings. Based on the following
information, compute the cost of retained earnings: The stock sells for $25, flotation costs are $3 and
the firm is in the 35% tax bracket.

Year Dividend
2004 $1.55
2003 $1.40
2002 $1.35
2001 $1.32

a. 15.71%
b. 9.11%
c. 12.56%
d. 10.72%
ANS: C PTS: 1 OBJ: TYPE: C. Prob.
NAT: Analytic skills LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of internal equity - constant growth dividend...

81. The cost of internal equity is cheaper than the cost of external equity. Which of the following
statements is/are correct?
I. External equity may incur expenses which are deducted from the capital received for the sale of the
security.
II. Corporations generally discount the price of the securities that are sold to the public in order to
raise capital.
a. I only
b. II only
c. Both I and II
d. Neither I nor II
ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of external equity capital
82. What is the cost of preferred stock if the stock is selling for $208, the dividend is $35 and flotation
costs are 5% of the selling price?
a. 17.7%
b. 25.2%
c. 12.5%
d. 10.8%
ANS: A PTS: 1 OBJ: TYPE: E. Prob.
NAT: Analytic skills LOC: Cost of capital
TOP: Cost of preferred calculation

83. What would be the weighted average cost of capital for Limp Linguini Noodle Makers, Inc. under the
following conditions:
*The capital structure is 40% debt and 60% equity
*The before-tax cost of debt (which includes flotation costs) is 20% and the firm is in the 40% tax
bracket.
*The firm’s beta is 1.7
*The risk-free rate is 7% and the market risk premium is 6%

a. 15.12%
b. 18.7%
c. 17.2%
d. 12%
ANS: A
Determine the cost of equity: 1.7(6%) + 7% = 17.2%
Determine the cost of debt: 20% X .60 = 12
Determine the weighted cost of capital:
17.2(.60) + 12(.40) = 15.12%

PTS: 1 OBJ: TYPE: C. Prob NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital
TOP: Computing the component costs of capital

84. A firm has a beta of 1.2. The return in the market is 14% and the risk-free rate is 6%. The estimated
cost of common stock equity is:
a. 6%
b. 7.2%
c. 15.6%
d. 14%
ANS: C
Solution: 1.2 (14% - 6%) + 6% = 15.6%

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital
TOP: Computing the component costs of capital

85. The optimal capital budget occurs at the point where two curves intersect. Which of the following is
one of those curves?
I. Weighted marginal cost of capital curve
II. Investment opportunity curve

a. I only
b. II only
c. Both I and II
d. Neither I nor II
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Determining the optimal capital budget

86. The cost of common stock equity may be estimated by using which of the following?
a. Earnings curve
b. Dupont analysis
c. Capital asset pricing model
d. Price/Earnings ratio
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of external equity capital

87. A firm is determining its cost of common stock equity. It last paid a divided of $.52, the dividends are
growing at 5%, flotation costs are $2 per share and the firm will net $72 per share upon the sale of the
stock. What is the firm’s cost of common equity?
a. 3.49%
b. 8.22%
c. 6.11%
d. 5.76%
ANS: D
Solution:
$.52 (1 + .05) = $.55

(.55/72) + .05 = 5.75%

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of external equity capital

88. Surfin’ Bubba Surfboard Shop is currently selling for $34.25 a share with a current dividend of $1.00.
It is estimated that Surfin’ Bubba will have a growth rate in earnings of 10% into the foreseeable
future. If Surfin’ Bubba plans to raise new capital for expansion, what is the cost of new equity if
flotation costs are 8% of the price.
a. 13.49%
b. 11.57%
c. 12.21%
d. 10.87%
ANS: A
Solution:

1.00 X 1.10 = $1.10

1.10 + .10 = 13.49%


(34.25 x .92)

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of external equity capital

89. What is Bodacious Bodywear’s weighted average cost of capital under the following conditions:
* The firm has 30% debt, 10% preferred stock, and 60% equity
*The cost of common equity is 14% and the cost of preferred stock is 9%
* The firm’s debt has a before-tax cost of debt of 10% (including flotation costs)
* The firm is in the 40% tax bracket
a. 11.1%
b. 8.5%
c. 12.3%
d. 10.5%
ANS: A
Solution:

(.60 X 14%) + (.10 X 9%) + (10% X .6 X .30) = 11.1%

PTS: 1 OBJ: TYPE: E Prob NAT: Analytic skills


LOC: Knowledge of capital budgeting and cost of capital
TOP: Computing the component costs of capital

90. In determining the cost of debt, several factors must be considered. All of the following are those
factors EXCEPT:
a. the firm’s before-tax cost of debt
b. the firm’s tax rate
c. flotation costs
d. the firm’s growth rate of dividends
ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of debt

ESSAY

1. In considering the SML concept, the required returns for any individual security are dependent on
certain values. List and discuss those values.

ANS:
1. The risk-free rate: The 3-month or 6-month Treasury Bill rate is generally used for this
value.
2. The expected market return: This is the return that investors expect to earn on stocks with
a beta of 1.0.
3. The beta of the corporation: Beta is normally estimated by using historic values reflecting
the relationship between a security’s returns and the market returns.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking


LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return
TOP: Capital asset pricing model (CAPM) approach

2. What are the reasons that the cost of external equity is greater than the cost of internal equity?

ANS:
1. External equity has issuance costs associated with new shares. These costs are generally
significant enough that they cannot be ignored.
2. The price of the new shares being sold to the public is normally set to an amount less than
the market price of the stock before the announcement of the new issue.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking


LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of external equity capital

3. Firms can raise capital in two ways. Why is it that internal funding does not have a zero cost?

ANS:
Firms using internal funding, or retained earnings, incur an opportunity cost. When funds are
generated through the earnings of the firm, either managers can pay out funds as dividends to common
stockholders, or the funds can be retained and reinvested in the firm. If the funds are paid out to
stockholders, they could reinvest the funds elsewhere to earn an appropriate return, given the risk of
the investment. If managers decide to retain earnings and reinvest them in the firm, there must be
investment opportunities in a firm offering a return equivalent to the returns available to stockholders
in alternative investments on a risk-adjusted basis.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking


LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of internal equity capital

4. How is the marginal cost of the various component capital sources determined?

ANS:
The marginal cost of funds is the cost of the next increments of capital raised by the firm. When
computing the marginal cost of the various component capital sources, companies typically estimate
the component costs they anticipate encountering, or paying, during the coming year. If capital costs
change significantly during the year, it may be necessary to recompute the new capital costs and use
the new estimates when evaluating projects from that time forward,

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking


LOC: Knowledge of capital budgeting and cost of capital
TOP: Computing the component costs of capital; Marginal costs

5. What is the investment opportunity curve and how is it accomplished?

ANS:
The investment opportunity curve is the graph which illustrates the comparison between the expected
project return to the company’s marginal cost of capital schedule. It is accomplished by first plotting
the returns expected from the proposed capital expenditure projects against the cumulative funds
required. The optimal capital budget is indicated by the point at which the investment opportunity
curve and the marginal cost of capital curve intersect.

PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking


LOC: Knowledge of capital budgeting and cost of capital
TOP: Determining the optimal capital budget