13.1 A First Look at The Weighted Average Cost of Capital

Fundamentals of Corporate Finance, 4e, GE (Berk/DeMarzo/Harford)
Chapter 13 The Cost of Capital
13.1 A First Look at the Weighted Average Cost of Capital
1) Financial managers must determine their firm's overall cost of capital based on all sources of financing.
Answer: TRUE
Diff: 1 Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: KB
Question Status: Revised
2) To attract capital from outside investors, a firm must offer potential investors an expected return that is
commensurate with the level of risk that they can bear.
Answer: TRUE
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
Question Status: Previous Edition
3) One should use accounting-based book values rather than market values of debt and equity to
determine the weights for the different sources of capital.
Answer: FALSE
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
4) A firm's sources of financing, which usually consists of debt and equity, represent its ________.
A) total assets
B) capital
C) total liabilities
D) current liabilities
Answer: B
Diff: 1 Var: 1
Skill: Definition
Author: KB
1
Copyright © 2019 Pearson Education, Ltd.
5) The relative proportion of debt, equity, and other securities that a firm has outstanding constitute its
________.
A) asset ratio
B) current ratio
C) capital structure
D) retained earnings
Answer: C
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
6) A firm's overall cost of capital that is a blend of the costs of the different sources of capital is known as
the firm's ________.
A) weighted average cost of capital
B) cost of equity infusion
C) cost of debt
D) cost of preferred stock
Answer: A
Diff: 1 Var: 1
Skill: Definition
Author: KB
7) The book value of a firm's equity is $100 million and its market value of equity is $200 million. The face
value of its debt is $50 million and its market value of debt is $60 million. What is the market value of
assets of the firm?
A) $150 million
B) $160 million
C) $260 million
D) $250 million
Answer: C
Explanation: C) Market value of debt plus market value of equity gives market value of assets.
$200 + $60 = $260 million
Diff: 1 Var: 1
Skill: Analytical
Author: KB
2
8) A firm raised all its capital via equity rather than debt. Such a firm is also referred to as a(n) ________
firm.
A) levered
B) margined
C) risk less
D) unlevered
Answer: D
Diff: 1 Var: 1
Skill: Definition
Author: KB
9) A levered firm is one that has ________ outstanding.

A) debt
B) equity
C) preferred stock
D) equity options
Answer: A
Diff: 1 Var: 1
Skill: Definition
Author: KB
10) Leverage is the amount of ________ on a firm's balance sheet.

A) equity
B) debt
C) preferred stock
D) retained earnings
Answer: B
Diff: 1 Var: 1
Skill: Definition
Author: KB
11) For an unlevered firm, the cost of capital can be determined by using the ________.
A) yield on the traded debt
B) Capital Asset Pricing Model
C) dividend yield
D) preferred stock yield
Answer: B
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
3
12) Assume Lavender Corporation has a market value of $4 billion of equity and a market value of $19.8
billion of debt. What are the weights in equity and debt that are used for calculating the WACC?
A) 0.10, 0.90
B) 0.832, 0.168
C) 0.168, 0.832
D) 0.90, 0.10
Answer: C
Explanation: C) Weight in debt equals market value of debt divided by market value of debt plus equity.
Similarly, weight in equity is market value of equity divided by market value of debt plus equity.
Weight in equity = $4 billion / ($4 + $19.8) billion = 0.168;
Weight in debt = $19.8 billion / ($4 + $19.8) billion = 0.832
Diff: 1 Var: 9
Skill: Analytical
Author: KB
13) Assume Bismuth Electronics has a book value of $6 billion of equity and a face value of $19.7 billion of
debt. The market values of equity and debt are $2.5 billion and $18.5 billion. A Wall Street financial
analyst determines values of equity and debt as $3 billion and $20 billion. Which of the following values
should be used for calculating the firm's WACC?
A) $6 billion of equity and $19.7 billion of debt
B) $2.5 billion of equity and $20 billion of debt
C) $3 billion of equity and $19.9 billion of debt
D) $2.5 billion of equity and $18.5 billion of debt
Answer: D
Diff: 1 Var: 9
Skill: Conceptual
Author: KB
14) Assume the total market value of General Motors (GM) is $10 billion. GM has a market value of $6
billion of equity and a face value of $12 billion of debt. What are the weights in equity and debt that are
used for calculating the WACC?
A) 0.30, 0.70
B) 0.60, 0.40
C) 0.40, 0.60
D) cannot be determined
Answer: B
Explanation: B) Weight in debt equals market value of debt divided by market value of debt plus equity.
Similarly, weight in equity is market value of equity divided by market value of debt plus equity.
Equity = $6 million / $10 million = 0.60; Debt = ($10 million - $6 million) / $10 million = 0.40
Diff: 1 Var: 47
Skill: Analytical
Author: KB
4
15) The after-tax cost of equity is ________ the pretax cost of equity.
A) higher than
B) lower than
C) the same as
D) less than or equal to
Answer: C
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
16) Epiphany is an all-equity firm with an estimated market value of $400,000. The firm sells $225,000 of
debt and uses the proceeds to purchase outstanding equity. Compute the weight in equity and the weight
in debt after the proposed financing and repurchase of equity.
A) 0.28, 0.72
B) 0.44, 0.56
C) 0.39, 0.61
D) 0.56, 0.44
Answer: B
Explanation: B) Weight in debt = Debt raised / Market value of the firm
Weight in debt = $225,000 / $400,000 = 0.56
Weight in equity = 1- Weight in debt
Weight in equity = 1 - 0.56 = 0.44
Diff: 2 Var: 10
Skill: Analytical
Author: KB
A) 0.42, 0.58
B) 0.50, 0.50
C) 0.17, 0.83
D) 0.58, 0.42
Answer: C
Explanation: C) Weight in debt = Debt raised / Market value of firm
Weight in equity = 1 - Weight in debt
Weight in debt = $250,000 / $300,000 = 0.83
Diff: 2 Var: 6
Skill: Analytical
Author: KB
5
A) 0.15, 0.85
B) 0.18, 0.82
C) 0.30, 0.70
D) 0.70, 0.30
Answer: D
Explanation: D) Weight in debt = Debt raised / Market value of firm
Weight in equity = 1 - Weight in debt
Weight in debt = $150,000 / $500,000 = 0.30
Diff: 2 Var: 14
Skill: Analytical
Author: KB
19) Assume JUP has debt with a book value of $24 million, trading at 120% of par value. The firm has
book equity of $28 million, and 2 million shares trading at $20 per share. What weights should JUP use in
calculating its WACC?
A) 41.86% for debt, 58.14% for equity
B) 37.67% for debt, 62.33% for equity
C) 33.49% for debt, 66.51% for equity
D) 29.30% for debt, 70.70% for equity
Answer: A
Explanation: A) Market Value Debt = $24 million × 120% = $28.8 million
Market Value Equity = 2 million × $20 = $40 million
Total Market Value = $68.8 million
Weight of debt = $28.8 million / $68.8 million = 41.86%
Weight of equity = $40 million / $68.8 million = 58.14%
Diff: 1 Var: 50+
Skill: Analytical
Author: WC
Question Status: New
20) As a firm increases its level of debt relative to its level of equity, the firm is ________.
A) increasing the fraction of its equity
B) decreasing the fraction of its debt
C) decreasing its leverage
D) increasing its leverage
Answer: D
Diff: 1 Var: 1
Skill: Conceptual
Author: WC
6
21) Why do we use market values rather than book values in calculation of WACC?
Answer: We use market values rather than book values because the cost of capital is based on investors'
current assessment of the value of a firm and not on accounting-based book values.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
22) Why do we use leverage if it increases the risk of a firm?

Answer: Usually, the cost of debt is cheaper than the cost of equity due to lower risk of the debt holders
as well as tax deductibility of interest payment. Thus, including debt, everything else remaining same,
reduces the cost of capital for a firm.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
13.2 The Firm's Costs of Debt and Equity Capital
1) A firm's cost of debt is the rate of interest it would have to pay to refinance its existing debt.
Answer: TRUE
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
2) The fact that the interest paid on debt is a tax-deductible expense increases the cost of debt financing.
Answer: FALSE
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
3) The ________ of a firm's debt can be used as the firm's current cost of debt.
A) current yield
B) coupon rate
C) yield to maturity
D) discount yield
Answer: C
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
7
4) Outstanding debt of Home Depot trades with a yield to maturity of 8%. The tax rate of Home Depot is
30%. What is the effective cost of debt of Home Depot?
A) 5.88%
B) 8%
C) 6.44%
D) 5.60%
Answer: D
Explanation: D) Multiply the yield to maturity by 1 minus the tax rate.
0.08 × (1 - 0.3) = 0.056 = 5.60%
Diff: 1 Var: 18
Skill: Analytical
Author: KB
A) 4.50%
B) 4.65%
C) 3.60%
D) 3.00%
Answer: D
Explanation: D) Multiply the yield to maturity by 1 minus the tax rate.
0.05 × (1 - 0.4) = 0.030 = 3.00%
Diff: 1 Var: 18
Skill: Analytical
Author: KB
A) 4.55%
B) 5.01%
C) 5.46%
D) 5.69%
Answer: A
Explanation: A) Multiply the yield to maturity by 1 minus the tax rate.
0.07 × (1 - 0.35) = 0.046 = 4.55%
Diff: 1 Var: 18
Skill: Analytical
Author: KB
8
7) Assume preferred stock of Ford Motors pays a dividend of $4 each year and trades at a price of $35.
What is the cost of preferred stock capital for Ford?
A) 11.4%
B) 12.6%
C) 13.7%
D) 14.9%
Answer: A
Explanation: A) Divide the dividend by the preferred stock price.
$4 / $35 = 0.114 or 11.4%
Diff: 1 Var: 50
Skill: Analytical
Author: KB
8) Assume preferred stock of Ford Motors pays a dividend of $3.50 each year and trades at a price of $30.
A) 10.5%
B) 11.7%
C) 11.1%
D) 10.7%
Answer: B
Explanation: B) Divide the dividend by the preferred stock price.
$3.50 / $30 = 0.117 or 11.7%
Diff: 1 Var: 25
Skill: Analytical
Author: KB
9) Assume preferred stock of Ford Motors pays a dividend of $3.00 each year and trades at a price of $20.
A) 12.0%
B) 13.5%
C) 15.0%
D) 16.5%
Answer: C
Explanation: C) Divide the dividend by the preferred stock price.
$3.00 / $20 = 0.150 or 15.0%
Diff: 1 Var: 25
Skill: Analytical
Author: KB
9
10) IBM expects to pay a dividend of $2 next year and expects these dividends to grow at 9% a year. The
price of IBM is $80 per share. What is IBM's cost of equity capital?
A) 9.20%
B) 10.35%
C) 10.93%
D) 11.50%
Answer: D
Explanation: D) Cost of equity is the next period dividend divided by the price plus the growth rate in
dividends.
Cost of equity = (Div1 / PE) + g = ($2 / $80) + 0.09 = 0.1150 = 11.50%
Diff: 1 Var: 50+
Skill: Analytical
Author: KB
11) IBM expects to pay a dividend of $5 next year and expects these dividends to grow at 7% a year. The
price of IBM is $90 per share. What is IBM's cost of equity capital?
A) 3.77%
B) 5.02%
C) 7%
D) 12.56%
Answer: D
dividends.
Cost of equity = (Div1 / PE) + g = ($5 / $90) + 0.07 = 0.1256 = 12.56%
Diff: 1 Var: 50+
Skill: Analytical
Author: KB
12) Assume IBM just paid a dividend of $4.50 and expects these dividends to grow at 8% a year. The price
of IBM is $100 per share. What is IBM's cost of equity capital?
A) 3.86%
B) 8%
C) 12.22%
D) 12.86%
Answer: D
dividends.
Diff: 1 Var: 50+

Skill: Analytical
Author: KB
10
13) Your estimate of the market risk premium is 7%. The risk-free rate of return is 4% and General Motors
has a beta of 1.6. What is General Motors' cost of equity capital?
A) 15.2%
B) 14.4%
C) 16.0%
D) 13.7%
Answer: A
Explanation: A) Apply the CAPM equation.
Cost of equity = 0.04 + (1.6 × 0.07) = 0.152 = 15.2%
Diff: 1 Var: 50+
Skill: Analytical
Author: KB
14) Your estimate of the market risk premium is 6%. The risk-free rate of return is 4% and General Motors
has a beta of 1.4. What is General Motors' cost of equity capital?
A) 11.2%
B) 12.4%
C) 11.8%
D) 13.0%
Answer: B
Explanation: B) Apply the CAPM equation.
Cost of equity = 0.04 + (1.4 × 0.06) = 0.124 = 12.4%
Diff: 1 Var: 50+
Skill: Analytical
Author: KB
15) Your estimate of the market risk premium is 9%. The risk-free rate of return is 4.1% and General
Motors has a beta of 1.8. What is General Motors' cost of equity capital?
A) 20.3%
B) 18.3%
C) 19.3%
D) 21.3%
Answer: A
Explanation: A) Apply the CAPM equation.
Cost of equity = 0.041 + (1.8 × 0.09) = 0.203 = 20.3%
Diff: 1 Var: 50+
Skill: Analytical
Author: KB
11
16) A firm has outstanding debt with a coupon rate of 8%, seven years maturity, and a price of $1,000.
What is the after-tax cost of debt if the marginal tax rate of the firm is 35%?
A) 5.2%
B) 5.5%
C) 5.7%
D) 6.0%
Answer: A
Explanation: A) YTM = coupon rate in this case since the bond is selling at par. Therefore,
Therefore, after-tax cost = 0.08 × (1 - 0.35) = 0.052 or 5.2%.

Diff: 1 Var: 15
Skill: Analytical
Author: KB
17) A firm has outstanding debt with a coupon rate of 8%, nine years maturity, and a price of $1,000.
What is the after-tax cost of debt if the marginal tax rate of the firm is 40%?
A) 3.8%
B) 4.8%
C) 4.3%
D) 4.4%
Answer: B
Explanation: B) YTM = coupon rate in this case since the bond is selling at par. Therefore,
Therefore, after-tax cost = 0.08 × (1 - 0.4) = 4.8%.

Diff: 1 Var: 14
Skill: Analytical
Author: KB
18) A firm has outstanding debt with a coupon rate of 5%, ten years maturity, and a price of $1,000. What
is the after-tax cost of debt if the marginal tax rate of the firm is 35%?
A) 2.6%
B) 2.9%
C) 3.3%
D) 3.4%
Answer: C
Explanation: C) YTM = coupon rate in this case since the bond is selling at par. Therefore,
Therefore, after-tax cost = 0.05 × (1 - 0.35) = 3.3%.

Diff: 1 Var: 15
Skill: Analytical
Author: KB
12
19) A firm has $1 million market value and it sells preferred stock with a par value of $100. If the coupon
rate on the preferred stock is 5% and the preferred stock trades at $91, what is the cost of preferred stock
capital?
A) 4.67%
B) 4.95%
C) 5.22%
D) 5.49%
Answer: D
Explanation: D)
Cost of preferred stock capital = (5% × $100) / $91 = 5.49%
Diff: 1 Var: 50+
Skill: Analytical
Author: KB
capital?
A) 5.82%
B) 6.12%
C) 6.43%
D) 6.73%
Answer: B
Explanation: B)
Diff: 1 Var: 50+
Skill: Analytical
Author: KB
capital?
A) 8.26%
B) 8.70%
C) 9.13%
D) 9.57%
Answer: B
Explanation: B)
Diff: 1 Var: 50+
Skill: Analytical
Author: KB
13
22) An all-equity firm had a dividend expense of $30,000 last year. The market value of the firm is
$900,000 and the dividend is expected to increase at 6% each year. What is the cost of equity for this firm?
A) 9.53%
B) 10.01%
C) 10.96%
D) 11.44%
Answer: A
Explanation: A) Cost of equity =
Diff: 1 Var: 50+

Skill: Analytical
Author: KB
A) 6.80%
B) 7.65%
C) 8.50%
D) 9.35%
Answer: C
Explanation: C) Cost of equity = Dividend (in one year) / Current Price + Dividend Growth Rate
Cost of equity = ($20,000 × (1 + 0.05) / $600,000 )+ 0.05 = 8.50%
Diff: 1 Var: 50+
Skill: Analytical
Author: KB
A) 11.72%
B) 12.37%
C) 13.02%
D) 14.32%
Answer: C
Explanation: C)
Cost of equity = ($45,000 × (1 + 0.07) / $800,000) + 0.07 = 13.02%
Diff: 1 Var: 50+
Skill: Analytical
Author: KB
14
25) The outstanding debt of Berstin Corp. has ten years to maturity, a current yield of 7%, and a price of
$95. What is the pretax cost of debt if the tax rate is 30%.
A) 4.9%
B) 6.5%
C) 7.0%
D) 7.37%
Answer: D
Explanation: D) Current yield = coupon / price;
0.07 = coupon / 95; hence, coupon = 0.07 × 95 = 6.65;
yield to maturity = pretax cost of debt;
using a financial calculator, -95 PV, 100 FV, 6.65 PMT, 10 N, CPT I = 7.37%
Diff: 2 Var: 1
Skill: Analytical
Author: KB
26) The outstanding debt of Berstin Corp. has five years to maturity, a current yield of 6%, and a price of
$95. What is the pretax cost of debt if the tax rate is 30%.
A) 4.2%
B) 4.8%
C) 6.9%
D) more information needed
Answer: C
Explanation: C) Current yield = coupon / price;
0.06 = coupon / 95; hence, coupon = 0.06 × 95 = 5.7.
yield to maturity = pretax cost of debt;
using financial calculator, -95 PV, 100 FV, 5.7 PMT, 5 N, CPT I = 6.9%
Diff: 2 Var: 1
Skill: Analytical
Author: KB
27) The outstanding debt of Berstin Corp. has eight years to maturity, a current yield of 7%, and a price of
$85. What is the pretax cost of debt if the tax rate is 40%?
A) 5.1%
B) 5.9%
C) 8.5%
D) more information needed
Answer: C
Explanation: C) Current yield = Coupon / Price;
0.07 = Coupon / $85; hence, Coupon = 0.07 × $85 = $5.95.
Yield to maturity = Pretax cost of debt;
Diff: 2 Var: 48
Skill: Analytical
Author: KB
15
28) A firm has a pre-tax cost of debt of 9.0%. If the firm has a marginal tax rate of 35%, what is its effective
cost of debt?
A) 5.9%
B) 4.1%
C) 9.4%
D) 9.1%
Answer: A
Explanation: A) 9.0% × (1 - 0.35) = 5.9%
Diff: 1 Var: 50+
Skill: Analytical
Author: WC
29) The after-tax cost of debt ________ the before-tax cost of debt for a firm that has a positive marginal
tax rate.
A) is always greater than
B) is always equal to
C) is always less than
D) may be greater than or less than
Answer: C
Diff: 1 Var: 1
Skill: Conceptual
AACSB Objective: Reflective Thinking Skills
Author: WC
30) A firm incurs $40,000 in interest expenses each year. If the tax rate of the firm is 30%, what is the
effective after-tax interest rate expense for the firm?
A) $21,000.00
B) $22,400.00
C) $23,800.00
D) $28,000.00
Answer: D
Explanation: D)
Diff: 1 Var: 14
Skill: Analytical
Author: KB
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A) $22,050.00
B) $24,500.00
C) $28,175.00
D) $29,400.00
Answer: B
Explanation: B)
Diff: 1 Var: 21
Skill: Analytical
Author: KB
A) $34,300.00
B) $39,200.00
C) $49,000.00
D) $56,350.00
Answer: C
Explanation: C)
Diff: 1 Var: 28
Skill: Analytical
Author: KB
33) The fact that the after-tax cost of debt is lower than the pretax cost of debt implicitly assumes that
interest expense can be ________.
A) expensed
B) margined
C) refinanced
D) capitalized
Answer: A
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
17
34) Is it incorrect to use the coupon rate of debt toward cost of debt?
Answer: Yes, it is inaccurate to use the coupon rate of debt as a company's cost of capital is forward
looking while the coupon rate is a historic rate prevalent at the time of issuance of the debt.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
35) What is the difference between the effective cost of debt and the cost of debt?
Answer: The cost of debt is the before tax cost of debt while the effective cost of debt is the after-tax cost
of debt, which is lower for a profitable tax paying firm.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
36) Should a firm with high retained earnings have a lower cost of equity?
Answer: Cost of equity is the return that equity holders expect from a firm and is not directly related to
the firm's retained earnings.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
37) Among the two models Constant Dividend Growth Model (CDGM) and Capital Asset Pricing Model
(CAPM), which is a better method for computation of the cost of equity?
Answer: The Capital Asset Pricing Model (CAPM) is more popular for estimating the cost of equity
because of the difficulties in estimating the dividend growth rate required for the Constant Dividend
Growth Model (CDGM).
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
38) Which of the three costs—debt, preferred stock and common equity—is most difficult to estimate?
Answer: The cost of common equity is most difficult to estimate as it has the highest uncertainty about its
cash flows. The cash flows for debt and preferred stock are quite predictable, and hence their costs are
easier to calculate.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
18
13.3 A Second Look at the Weighted Average Cost of Capital
1) The WACC does not depend on the risk of a company's line of business.
Answer: FALSE
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
2) Assume Time Warner shares have a market capitalization of $40 billion. The company is expected to
pay a dividend of $0.25 per share and each share trades for $40. The growth rate in dividends is expected
to be 7% per year. Also, Time Warner has $20 billion of debt that trades with a yield to maturity of 9%. If
the firm's tax rate is 40%, what is the WACC?
A) 5.85%
B) 6.54%
C) 6.88%
D) 7.57%
Answer: C
Explanation: C) Cost of equity is the next period dividend divided by the price plus the growth rate in
dividends. Cost of debt is the yield to maturity times one minus the tax rate. WACC is the weight of
debt times cost of debt plus weight of equity times cost of equity.
Cost of equity = ($0.25 / $40) + 0.07 = 0.07625 or 7.63%;
Cost of debt = 0.09 × (1 - 0.4) = 0.054 or 5.4%;
WACC = ($40 billion × 0.07625) / $60 billion + ($20 billion × 0.054) / $60 billion = 0.0688 or 6.88%
Diff: 2 Var: 50+
Skill: Analytical
Author: KB
19
3) Assume Time Warner shares have a market capitalization of $60 billion. The company is expected to
pay a dividend of $0.30 per share and each share trades for $40. The growth rate in dividends is expected
to be 7% per year. Also, Time Warner has $20 billion of debt that trades with a yield to maturity of 8%. If
the firm's tax rate is 35%, compute the WACC?
A) 6.05%
B) 6.40%
C) 6.76%
D) 7.11%
Answer: D
Cost of equity = ($0.30 / $40) + 0.07 = 0.0775 or 7.75%;
Cost of debt = 0.08 × (1 - 0.35) = 0.052 or 5.2%;
WACC = ($60 billion × 0.0775) / $80 billion + ($20 billion × 0.052) / $80 billion = 0.0711 or 7.11%
Diff: 2 Var: 50+
Skill: Analytical
Author: KB
4) Assume Time Warner shares have a market capitalization of $65 billion. The company just paid a
dividend of $0.40 per share and each share trades for $25. The growth rate in dividends is expected to be
7.00% per year. Also, Time Warner has $10 billion of debt that trades with a yield to maturity of 7%. If the
firm's tax rate is 40%, compute the WACC?
A) 7.70%
B) 8.11%
C) 8.92%
D) 9.33%
Answer: B
Explanation: B) Cost of equity is the next period dividend divided by the price plus the growth rate in
Cost of equity = ($0.40 × 1.07) / $25 + 0.07 = 0.08712 or 8.712%;
Cost of debt = 0.07 × (1 - 0.4) = 0.042 or 4.2%;
WACC = ($65 billion × 0.08712) / $75 billion + $10 billion × 0.042 / $75 billion = 0.0811 or 8.11%
Diff: 2 Var: 50+
Skill: Analytical
Author: KB
20
5) Assume the market value of Fords' equity, preferred stock, and debt are$6 billion, $2 billion, and $13
billion, respectively. Ford has a beta of 1.7, the market risk premium is 8%, and the risk-free rate of
interest is 3%. Ford's preferred stock pays a dividend of $4 each year and trades at a price of $30 per
share. Ford's debt trades with a yield to maturity of 8.0%. What is Ford's weighted average cost of capital
if its tax rate is 30%?
A) 9.95%
B) 9.48%
C) 10.43%
D) 11.38%
Answer: B
Explanation: B) Cost of equity is the next period dividend divided by the price plus the growth rate in
Cost of equity = 0.03 + 1.7 × 0.08 = 0.166;
Cost of debt = 0.08 × (1 - 0.3) = 0.056;
Cost of preferred stock = 4 / 30 = 0.13333333;
WACC = $6 billion × 0.166 / $21 billion + $2 billion × 0.13333333 / $21 billion + $13 billion × 0.056 / $21
billion = 0.09479 or 9.48%
Diff: 2 Var: 50+
Skill: Analytical
Author: KB
6) Assume the market value of Fords' equity, preferred stock and debt are $6 billion, $3 billion, and $13
billion, respectively. Ford has a beta of 1.7, the market risk premium is 8%, and the risk-free rate of
interest is 3%. Ford's preferred stock pays a dividend of $2.50 each year and trades at a price of $30 per
share. Ford's debt trades with a yield to maturity of 9.5%. What is Ford's weighted average cost of capital
if its tax rate is 35%?
A) 9.78%
B) 10.24%
C) 9.31%
D) 11.18%
Answer: C
Explanation: C) Cost of equity is the next period dividend divided by the price plus the growth rate in
Cost of equity = 0.03 + 1.7 × 0.08 = 0.166;
Cost of debt = 0.095 × (1 - 0.35) = 0.06175;
Cost of preferred stock = $2.50 / $30 = 0.08333333;
WACC = $6 billion × 0.166 / $22 billion + $3 billion × 0.08333333 / $22 billion + $13 billion × 0.06175 / 22 =
0.09313 or 9.31%
Diff: 2 Var: 50+
Skill: Analytical
Author: KB
21
7) Assume the market value of Fords' equity, preferred stock and debt are $7 billion, $4 billion and $10
billion respectively. Ford has a beta of 1.4, the market risk premium is 6% and the risk-free rate of interest
is 4%. Ford's preferred stock pays a dividend of $3 each year and trades at a price of $25 per share. Ford's
debt trades with a yield to maturity of 8.5%. What is Ford's weighted average cost of capital if its tax rate
is 35%?
A) 7.69%
B) 8.15%
C) 8.60%
D) 9.05%
Answer: D
Cost of equity = 0.04 + 1.4 × 0.06 = 0.124;
Cost of debt = 0.085 × (1 - 0.35) = 0.05525;
Cost of preferred stock = $3 / $25 = 0.12;
WACC = $7 billion × 0.124 / $21 billion + $4 billion × 0.12 / $21 billion + $10 billion × 0.05525 / $21 billion =
0.09050 or 9.05%
Diff: 2 Var: 50+
Skill: Analytical
Author: KB
8) When calculating the WACC, it is a standard practice to subtract ________ to compute the net debt
outstanding.
A) equity
B) dividends
C) cash and risk-free securities
D) coupons
Answer: C
Diff: 2 Var: 1
Skill: Conceptual
Author: KB
9) Many financial managers use market risk premiums that are closer to 5%, which is lower than
historical averages, because ________.
A) the return investors require as compensation for taking on the risk of investing in equity markets has
diminished over a period of time
B) investors require a higher risk premium for holding risky securities than in the past
C) investors require a supernormal risk premium for holding risky securities as compared with the past
D) investors require the same premium for holding risky securities as in the past
Answer: A
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
22
10) When corporate tax rates decline, the net cost of debt financing ________.
A) decreases
B) is unchanged
C) increases
D) doubles
Answer: C
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
11) Assume Ford Motor Company is discussing new ways to recapitalize the firm and raise additional
capital. Its current capital structure has a 25% weight in equity, 10% in preferred stock, and 65% in debt.
The cost of equity capital is 13%, the cost of preferred stock is 9%, and the pretax cost of debt is 8%. What
is the weighted average cost of capital for Ford if its marginal tax rate is 40%?
A) 6.91%
B) 7.27%
C) 8.00%
D) 8.36%
Answer: B
Explanation: B) rwacc = rEE% + rD (1 - Tc) D% + rpfdP%
rwacc = 0.25 × 0.13 + 0.65 × 0.08 × (1 - 0.4) + 0.1 × 0.09 = 0.0727 = 7.27%
Diff: 2 Var: 50+
Skill: Analytical
Author: KB
The cost of equity capital is 16%, the cost of preferred stock is 11%, and the pretax cost of debt is 8%.
What is the weighted average cost of capital for Ford if its marginal tax rate is 40%?
A) 9.09%
B) 9.54%
C) 10.00%
D) 10.45%
Answer: A
Explanation: A) rwacc = rEE% + rD (1 - Tc) D% + rpfdP%
rwacc = 0.3 × 0.16 + 0.55 × 0.08 × (1 - 0.4) + 0.15 × 0.11 = 0.0909 = 9.09%
Diff: 2 Var: 50+
Skill: Analytical
Author: KB
23
The cost of equity capital is 16%, the cost of preferred stock is 10%, and the pretax cost of debt is 8%.
What is the weighted average cost of capital for Ford if its marginal tax rate is 40%?
A) 6.61%
B) 6.96%
C) 7.31%
D) 7.66%
Answer: B
Explanation: B) rwacc = rEE% + rD (1 - Tc) D% + rpfdP%
Diff: 2 Var: 50+

Skill: Analytical
Author: KB
14) Assume JUP has debt with a book value of $20 million, trading at 120% of par value. The bonds have
a yield to maturity of 7%. The firm's book value of equity is $16 million, and it has 2 million shares
trading at $19 per share. The firm's cost of equity is 12%. What is JUP's WACC if the firm's marginal tax
rate is 35%?
A) 10.03%
B) 9.12%
C) 9.57%
D) 7.29%
Answer: B
Explanation: B) Market value debt = $20 million × 120% = $24 million
Market value equity = 2 million × $19 = $38 million
Total market value = $62 million
D% = $24 / $62 = 38.7096774%
E% = $38 / $62 = 61.2903226%
Diff: 2 Var: 50+

Skill: Analytical
Author: WC
15) Holding everything else constant, an increase in cash ________ a firm's net debt.
A) will decrease
B) will have no impact on
C) will increase
D) may increase or decrease
Answer: A
Diff: 1 Var: 1
Skill: Conceptual
Author: WC
24
16) SIROM Scientific Solutions has $10 million of outstanding equity and $5 million of bank debt. The
bank debt costs 5% per year. The estimated equity beta is 2. If the market risk premium is 9% and the
risk-free rate is 3%, compute the weighted average cost of capital if the firm's tax rate is 30%.
A) 15.17%
B) 15.93%
C) 16.68%
D) 17.44%
Answer: A
Explanation: A) Cost of debt = rate on bank debt = 5%
Cost of equity = Risk-free rate + Beta × Market risk premium
Weight of debt = 1- Weight of equity.
Cost of equity = 0.03 + 2 × 0.09 = 0.21 or 21%

Weight of equity = 10/(10 + 5) = 0.66666667 or 66.67%
Weight of debt = 1 - 0.66666667 = 0.33333333 or 33.33%
Diff: 2 Var: 50+

Skill: Analytical
Author: KB
17) SIROM Scientific Solutions has $5 million of outstanding equity and $5 million of bank debt. The bank
debt costs 4% per year. The estimated equity beta is 2. If the market risk premium is 8% and the risk-free
rate is 4%, compute the weighted average cost of capital if the firm's tax rate is 35%.
A) 11.87%
B) 12.43%
C) 11.30%
D) 13.00%
Answer: C
Explanation: C) Cost of debt = rate on bank debt
Cost of equity = 0.04 + 2 × 0.08 = 0.2 or 20%

Weight of equity = 5/(5 + 5) = 0.5 or 50%
Weight of debt = 1 - 0.5 = 0.5 or 50%
Diff: 2 Var: 50+

Skill: Analytical
Author: KB
25
18) SIROM Scientific Solutions has $12 million of outstanding equity and $4 million of bank debt. The
bank debt costs 4% per year. The estimated equity beta is 1. If the market risk premium is 8% and the
risk-free rate is 4%, compute the weighted average cost of capital if the firm's tax rate is 30%.
A) 8.73%
B) 9.22%
C) 9.70%
D) 10.67%
Answer: C
Explanation: C) Cost of debt = rate on bank debt
Cost of equity = 0.04 + 1 × 0.08 = 0.12 or 12%

Weight of equity= 12/(12 + 4) = 0.75 or 75%
Weight of debt = 1 - 0.75 = 0.25 or 25%
Diff: 2 Var: 50+

Skill: Analytical
Author: KB
19) A firm has a capital structure with $50 million in equity and $100 million of debt. The cost of equity
capital is 11% and the pretax cost of debt is 5%. If the marginal tax rate of the firm is 40%, compute the
weighted average cost of capital of the firm.
A) 4.5%
B) 5.1%
C) 5.67%
D) 6.5%
Answer: C
Explanation: C)
Diff: 2 Var: 50+

Skill: Analytical
Author: KB
26
A) 6.7%
B) 7.0%
C) 7.8%
D) 8.6%
Answer: C
Explanation: C)
Diff: 2 Var: 50+

Skill: Analytical
Author: KB
A) 7.3%
B) 7.6%
C) 8.0%
D) 8.4%
Answer: A
Explanation: A)
Diff: 2 Var: 50+

Skill: Analytical
Author: KB
22) What type of adjustment to debt is in practice?

Answer: Most practitioners use net debt, which is total debt outstanding minus cash and other risk-free
securities.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
27
13.4 Using the WACC to Value a Project
1) When a firm is evaluating the purchase of a business that is unrelated to its current business, it is
appropriate to use the current WACC of the firm that is purchasing the business.
Answer: FALSE
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
2) Assume General Motors has a weighted average cost of capital of 9%. GM is considering investing in a
new plant that will save the company $20 million over each of the first two years, and then $10 million
each year thereafter. If the investment is $100 million, what is the net present value (NPV) of the project?
A) $25.8 million
B) $31.6 million
C) $28.7 million
D) $27.3 million
Answer: C
Explanation: C) Compute the present value of future cash flows using the WACC, and subtract the
investment cost.
million
NPV = -$100 million + $20 million / (1.09) + ($20 million + 111.111111 million) / (1.09)2 = $28.7 million
Diff: 2 Var: 24
Skill: Analytical
Author: KB
3) Assume General Motors has a weighted average cost of capital of 10%. GM is considering investing in
a new plant that will save the company $30 million over each of the first two years, and then $15 million
A) $18.2 million
B) $20.8 million
C) $23.4 million
D) $26.0 million
Answer: D
Explanation: D) Compute the present value of future cash flows using the WACC, and subtract the
investment cost.
NPV = -$150 million + $30 million / (1.1) + ($30 million + 150 million) / (1.1)2
Diff: 2 Var: 24
Skill: Analytical
Author: KB
28
4) Assume General Motors has a weighted average cost of capital of 10%. GM is considering investing in
a new plant that will save the company $30 million over each of the first two years, and then $25 million
A) $65.2 million
B) -$76.1 million
C) -$86.9 million
D) $108.7 million
Answer: D
Explanation: D) Compute the present value of future cash flows using the WACC, and subtract the
investment cost.
NPV = -$150 million + $30 million / 1.1 + ($30 million + $250 million) / (1.1)2
Diff: 2 Var: 15
Skill: Analytical
Author: KB
5) When we use the WACC to assess a project, we assume that the ________ ratio does not change.
A) reward to systematic risk
B) risk to reward
C) debt to equity
D) volatility to systematic risk
Answer: C
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
6) When we compute the cost of equity capital for a project we assume that the ________ of the project is
equivalent to the average market risk of the firm's investments.
A) diversifiable risk
B) market risk
C) unsystematic risk
D) volatility
Answer: B
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
29
7) Assume SAP Inc. received a $1 million grant under its Small Business Innovation program. SAP
invested the grant money and developed a system to remove metal contaminants from storm water in
shipyards. The firm estimates that each shipyard spends $500,000 a year on storm water clean-up efforts.
If SAP is able to sign up and retain four shipyards from the first year onwards, what is the present value
(PV) of the project (net of investment) if the cost of capital for SAP is 20% per year? Assume a cost of
operations and other costs for SAP equal 60% of revenue.
A) $3.00 million
B) $3.30 million
C) 3.60 million
D) $3.90 million
Answer: A
Explanation: A) Net present value = -Investment + Present Value of (Revenues × (1 - proportion of costs))
Diff: 1 Var: 30
Skill: Analytical
Author: KB
8) Assume SAP Inc. received a $2 million grant under its Small Business Innovation program. SAP
invested the grant money and developed a system to remove metal contaminants from storm water in
shipyards. The firm estimates that each shipyard spends $600,000 a year on storm water clean-up efforts.
If SAP is able to sign up and retain four shipyards from the first year onwards, what is the present value
(PV) of the project (net of investment) if the cost of capital for SAP is 14% per year? Assume a cost of
operations and other costs for SAP equal 60% of revenue.
A) $3.89 million
B) $4.13 million
C) $4.86 million
D) $5.10 million
Answer: C
Explanation: C) Net present value = -Investment + Present Value of
Diff: 1 Var: 24
Skill: Analytical
Author: KB
30
9) SAP Inc. received a $1.5 million grant under its Small Business Innovation program. SAP invested the
grant money and developed a system to remove metal contaminants from storm water in shipyards. The
firm estimates that each shipyard spends $500,000 a year on storm water clean-up efforts. If SAP is able to
sign up and retain four shipyards in the first year onwards, what is the present value (PV) of the project
(net of investment) if the cost of capital for SAP is 14% per year? Assume a cost of operations and other
costs for SAP equal 50% of revenue.
A) $4.51 million
B) $4.80 million
C) $5.93 million
D) $5.64 million
Answer: D
Explanation: D) Net present value = -Investment + Present Value of
Diff: 1 Var: 30
Skill: Analytical
Author: KB
10) A firm is considering investing in a new project with an upfront cost of $400 million. The project will
generate an incremental free cash flow of $50 million in the first year and this cash flow is expected to
grow at an annual rate of 3% forever. If the firm's WACC is 12%, what is the value of this project?
A) $155.6 million
B) $555.6 million
C) $583.3 million
D) $183.3 million
Answer: A
Explanation: A) Value of the project = FCF0 + FCF1/(rwacc - g) = -$400 million + $50 million /(0.12 - 0.03)
= $155.6 million
Diff: 2 Var: 36
Skill: Analytical
Author: WC
11) Which of the following is NOT a step in the WACC valuation method?
A) Compute the weighted average cost of capital.
B) Discount the incremental free cash flows of the investment using the weighted average cost of capital.
C) Determine the incremental free cash flows of the investment.
D) Determine the mean weighted average cost of capital for the firm's industry.
Answer: D
Diff: 1 Var: 1
Skill: Conceptual
Author: WC
31
12) What is the assumption about risk when using WACC to evaluate a project?
Answer: Using WACC in evaluating a firm's project implies that the risk of the project is comparable to
the average risk of the firm's other investments.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
13) What is the assumption about leverage when using WACC to evaluate a project?
Answer: The implied assumption in using WACC to evaluate a firm's project is that the firm is
continuously maintaining a constant ratio of market value of debt to market value of equity—a
relationship referred to as the debt-equity ratio.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
13.5 Project-Based Costs of Capital
1) Firms that have many divisions with different lines of business do not use a companywide WACC to
evaluate projects.
Answer: TRUE
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
2) Divisional costs of capital are more appropriate when evaluating a project for a line of business when
the types of business in a firm are ________.
A) mature businesses
B) similar
C) new businesses
D) different
Answer: D
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
32
3) Anheuser Busch, a manufacturer of beverages, is planning to purchase Six Flags theme parks.
Anheuser Busch should use the ________ to evaluate the business of Six Flags.
A) WACC of Anheuser Busch
B) WACC of Six Flags
C) average market return
D) divisional cost of capital
Answer: B
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
4) Different divisions with differing lines of business use different costs of capital because their cost of
________ could be different.
A) debt
B) equity
C) capital
D) assets
Answer: C
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
5) Different divisions with differing lines of business use different costs of capital because their cost of
equity is different and also because the ________ could be different.
A) optimal volatility
B) optimal current ratio
C) optimal asset mix
D) optimal debt-equity ratio
Answer: D
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
33
6) Verano Inc. has two business divisions—a software product line and a waste water clean-up product
line. The software business has a cost of equity capital of 10% and the waste water clean-up business has
a cost of equity capital of 7%. Verano has 50% of its revenue from software and the rest from the waste
water business. Verano is considering a purchase of another company in the waste water business using
equity financing. What is the appropriate cost of capital to evaluate the business?
A) 10.0%
B) 7.0%
C) 8.5%
D) 9.0%
Answer: B
Explanation: B) Cost of capital = Cost of capital for the related division
Cost of capital = 7%
Diff: 1 Var: 14
Skill: Analytical
AACSB Objective: Reflective Thinking Skills
Author: KB
A) 11.0%
B) 7.5%
C) 4.0%
D) 6.0%
Answer: C
Explanation: C) Cost of capital = Cost of capital for the related division
Diff: 1 Var: 14
Skill: Analytical
Author: KB
34
A) 10.0%
B) 8.0%
C) 9.0%
D) 11.0%
Answer: B
Explanation: B) Cost of capital = Cost of capital for the related division
Diff: 1 Var: 22
Skill: Analytical
Author: KB
13.6 When Raising External Capital Is Costly
1) The costs of external financing must be deducted from the net present value (NPV) of a project to
evaluate if it is worth undertaking.
Answer: TRUE
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
2) Internal financing is more costly than external financing because of issuance costs.
Answer: FALSE
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
35
3) Assume Ford Motors expects a new hybrid-engine project to produce incremental cash flows of $90
million each year and expects these to grow at 3% each year. The upfront project costs are $900 million
and Ford's weighted average cost of capital is 9%. If the issuance costs for external finances are $20
million, what is the net present value (NPV) of the project?
A) $986 million
B) $696 million
C) $609 million
D) $580 million
Answer: D
Explanation: D) Compute present value of the cash flows at WACC and subtract investment costs as well
as issuance costs.
Cash outflows = $900 million + $20 million = $920 million;

NPV = $1500 million - $920 million = $580 million
Diff: 2 Var: 50+
Skill: Analytical
Author: KB
million each year, and expects these to grow at 4% each year. The upfront project costs are $420 million
A) $504 million
B) $560 million
C) $588 million
D) $616 million
Answer: B
Explanation: B) Compute present value of the cash flows at WACC and subtract investment costs as well
as issuance costs.
Cash outflows = $420 million + $20 million = $440 million;

Diff: 2 Var: 50+
Skill: Analytical
Author: KB
36
million each year, and expects these to grow at 3% each year. The upfront project costs are $380 million
A) $324 million
B) $378 million
C) $360 million
D) $396 million
Answer: C
Explanation: C) Compute present value of the cash flows at WACC and subtract investment costs as well
as issuance costs.
cash outflows = $380 million + $10 million = $390 million;

Diff: 2 Var: 50+
Skill: Analytical
Author: KB
6) A firm is considering acquiring a competitor. The firm plans on offering $160 million for the
competitor. The firm will need to issue new debt and equity to finance the acquisition. You estimate the
issuance costs to be $10 million. The acquisition will generate an incremental free cash flow of $20 million
in the first year and this cash flow is expected to grow at an annual rate of 3% forever. If the firm's WACC
is 13%, what is the value of this project?
A) $30 million
B) $38 million
C) $45 million
D) $53 million
Answer: A
Explanation: A) NPV = FCF0 + FCF1/(rwacc - g)
FCF0= -$160 - $10 = -$170
NPV = -$170 + $20 / (0.13 - 0.03) = $30.00 million
Diff: 2 Var: 50+
Skill: Analytical
Author: WC
37
7) Which of the following statements is FALSE?
A) Issuance costs increase the WACC.
B) External equity is less expensive than retained earnings.
C) A project that can be financed with internal funds will be less costly than the same project if it were
financed with external funds.
D) Issuance costs should be treated as cash outflows in NPV analysis.
Answer: B
Diff: 1 Var: 1
Skill: Conceptual
Author: WC
38

13.1 A First Look at The Weighted Average Cost of Capital

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13.1 A First Look at The Weighted Average Cost of Capital

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Fundamentals of Corporate Finance, 4e, GE (Berk/DeMarzo/Harford)

Chapter 13 The Cost of Capital

13.1 A First Look at the Weighted Average Cost of Capital

9) A levered firm is one that has ________ outstanding.

10) Leverage is the amount of ________ on a firm's balance sheet.

22) Why do we use leverage if it increases the risk of a firm?

13.2 The Firm's Costs of Debt and Equity Capital

Diff: 1 Var: 50+

Therefore, after-tax cost = 0.08 × (1 - 0.35) = 0.052 or 5.2%.

Therefore, after-tax cost = 0.08 × (1 - 0.4) = 4.8%.

Therefore, after-tax cost = 0.05 × (1 - 0.35) = 3.3%.

Diff: 1 Var: 50+

Diff: 2 Var: 50+

Diff: 2 Var: 50+

Weight of debt = 1- Weight of equity.

Cost of equity = 0.03 + 2 × 0.09 = 0.21 or 21%

Diff: 2 Var: 50+

Weight of debt = 1- Weight of equity.

Cost of equity = 0.04 + 2 × 0.08 = 0.2 or 20%

Diff: 2 Var: 50+

Weight of debt = 1- Weight of equity.

Cost of equity = 0.04 + 1 × 0.08 = 0.12 or 12%

Diff: 2 Var: 50+

Diff: 2 Var: 50+

Diff: 2 Var: 50+

Diff: 2 Var: 50+

22) What type of adjustment to debt is in practice?

13.5 Project-Based Costs of Capital

13.6 When Raising External Capital Is Costly

Cash outflows = $900 million + $20 million = $920 million;

Cash outflows = $420 million + $20 million = $440 million;

cash outflows = $380 million + $10 million = $390 million;

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