Answers: L1CF-TBB207-1412 - Medium Lesson 2: Costs of The Different Sources of Capital

Answers
Question 1:
L1CF-TBB207-1412 - medium
Lesson 2: Costs of the Different Sources of Capital
What is the cost of preferred stock if the price is $49/share, the dividend is $2.30, and
the risk-free rate is 4%?
Use V-O keys to navigate.
Less than 4%.
More than 5%.
Between 4% and 5%.
Rationale
Rationale
The risk-free rate is not part of the equation for determining the cost of preferred
stock. Instead, the equation is simply the dividend divided by the price of the
preferred stock.
Question 2:
L1R36TB-AC002-1605 - medium
Lesson 1: Cost of Capital
An analyst is calculating the WACC for Lil-Up, Inc. The company uses both debt and
equity capital in financing itself. The analyst has determined that Lil-Up's debt has a
pretax cost of 10 percent and its equity has an estimated cost of 20 percent. The
company's most recent financial statements show that it pays an average tax rate of 24
percent and a marginal tax rate of 40 percent. Based on market values, the analyst has
also determined that Lil-Up's debt-to-equity ratio is 60 percent. The WACC the analyst
will calculate will be closest to:
12 percent.
13 percent.
15 percent.
Rationale
12 percent.
The first step is to transform the 60 percent debt-to-equity (D/E) ratio into the debt
weight (D/(D + E). This is done by dividing the D/E of 60 percent by 1 + D/E. We have
shown the calculation below:
With a 37.5 percent debt weight, equity must be 62.5 percent. The WACC can now be
calculated using the debt and equity costs, the weights just determined, and the
marginal tax rate of 40 percent.WACC = wd rd (1 − t) + wp rp + we re = (0.375)(0.10)(1
− 0.40) + (0)(0) + (0.625)(0.20) = 4.75 percent.
Rationale
13 percent.
− 0.40) + (0)(0) + (0.625)(0.20) = 4.75 percent.
Rationale
15 percent.
− 0.40) + (0)(0) + (0.625)(0.20) = 4.75 percent.
Question 3:
L1CF-PQ3631-1410 - medium
Lesson 3: Topics in Cost of Capital Estimation
Mega Associates wants to invest in a project in Elantica, an emerging country. It gathered

the following information:
 Yield on Elantica’s dollar-denominated 10-year government bond = 12%
 Yield on a 10-year U.S. Treasury bond = 3.5%
 Annualized standard deviation of Elantica’s stock market = 34%
 Annualized standard deviation of Elantica’s dollar-denominated 10-year government

bond = 25%
 Project’s beta = 1.3
 Expected return on the Elantican equity market = 11%
 Risk-free rate = 6%
The country risk premium and cost of equity for the project in Elantica are closest to:
Country Cost of Equity

Risk
Premium
A 11.56% 27.53%
B 11.56% 24.06%
C 16.32% 28.82%
Row A
Row B
Row C
Rationale
Rationale
Country risk premium = (0.12 – 0.035) × (0.34 / 0.25) = 11.56%
Cost of equity = 0.06 + [1.3 × (0.11 – 0.06 + 0.1156)] = 27.528%

Question 4:
An analyst covering Internet start-up companies has determined that the asset beta for
the sector is 1.80, the average equity beta is 2.40, and the average marginal tax rate is 15
percent. The industry average debt-to-equity ratio is closest to:
0.40.
0.50.
0.70.
Rationale
0.40.
It is possible to use either of the formulas from the pure-play method. We have
chosen the formula that levers the asset beta, only because it has less division. In
using this formula, we will input the information provided and then solve for the debt-
to-equity ratio:
Rationale
0.50.
to-equity ratio:
Rationale
0.70.
to-equity ratio:
Question 5:
A company's marginal tax rate is due to increase. The firm's weighted average cost of
capital (WACC) will most likely:
increase.
decrease.
remain the same.
Rationale
Rationale
An increase in the corporate tax rate in the WACC equation, as it relates to the cost of
debt, will lower the WACC.
Question 6:
L1R36TB-BW018-1612 - medium
Which of the following statements is false?
 Statement 1: Small-capitalization stocks have generally greater risks and return than
large-capitalization stocks in the long run.
 Statement 2: Pure-play is the method of estimating the beta of a company that is not
publicly traded by using the beta of a comparable company directly.
Statement 1 only
Statement 2 only
None of the above
Rationale
Statement 1 only
The first choice is incorrect. This is true based on Reading 36.
Rationale
Statement 2 only
The second choice is correct. Pure-play requires adjustment for differences in financial
leverage to match the beta of the comparable company to that of the beta of the
subject company that is not publicly traded.
Rationale
None of the above
The third choice is incorrect.

Question 7:
Command, Ltd, a computer maker, is starting a new product line to make smartphones.
The company will finance this expansion with 80 percent debt and 20 percent equity.
Jason Moore, an analyst covering the technology sector, is estimating the value of this
new product to Command and how it will affect the price of Command's common
shares. He has noted that Command's current debt-to-equity ratio is 1.0 and that this
ratio changes to 1.3 once the new project is funded. Moore has found four smartphone
companies that are comparable to Command's new product line and determined the
equity and asset betas for each. When converting the average asset beta for the
comparables into a project beta, Moore should use a debt-to-equity ratio that is closest
to:
1.0
1.3
4.0
Rationale
1.0
The debt-to-equity ratio for the project itself should be used in finding the project's
equity beta. With 80 percent debt and 20 percent equity, the project's debt-to-equity
ratio is 4.0 (0.8/0.2).
Rationale
1.3
ratio is 4.0 (0.8/0.2).
Rationale
4.0
ratio is 4.0 (0.8/0.2).
Question 8:
Donald Investments has a target debt-to-equity ratio of 0.8. Given that the after-tax cost
of debt is 5.6% and that the company’s weighted average cost of capital is 10.8%, its cost
of equity is closest to:
14.96%
31.60%
4.62%
Rationale
Rationale
0.108 = (1/1.8 × Cost of equity) + (0.8/1.8 × 0.056)
Cost of equity = 14.96%

Question 9:
Beta Inc. wants to raise capital amounting to $550 million. It has a target debt-to-equity
ratio of 1.2. The following table illustrates the company’s marginal cost of capital
schedule:
Amount of After-Tax Amount of Cost of Equity

New Debt ($ Cost of New Equity ($
millions) Debt millions)
0–100 3.5% 0–200 6.5%
100–250 4.5% 200–400 7.5%
250–450 5.5% 400–600 8.5%
The company’s weighted average cost of capital is closest to:
6.41%
5.86%
13.4%
Rationale
Rationale
Proportion of new debt raised = 550 × (1.2 / 2.2) = $300
Proportion of new equity raised = 550 (1 / 2.2) = $250
WACC = (0.055 × 1.2/2.2) + (0.075 × 1/2.2) = 6.4091%

Question 10:
An analyst is using both the yield-to-maturity (YTM) and the debt-rating approach to
estimate Yaz Corporation's pretax cost of debt. Five years ago, Yaz issued 10-year $1,000
par debt that has a 3.0 percent coupon, and the coupon interest is paid semiannually.
This debt is currently rated AAA. In the bond market, Yaz's debt is trading at $980. The
analyst has gathered the following information on corporate debt yields:
Rating Yield for 5- Yield for 10-Year Maturity

Year
Maturity
AAA 3.0 4.2 percent

percent
AA 3.2 4.7 percent

percent
A 3.5 5.3 percent

percent
In comparing the two approaches, the analyst will most likely conclude that the
estimated pretax cost of debt using the debt-rating approach is:
equal to the estimate using the YTM approach.
lower than the estimate using the YTM approach.
higher than the estimate using the YTM approach.

Rationale
equal to the estimate using the YTM approach.
If you have an understanding of how YTM works on bonds, then no calculations are
needed to answer this question. The debt has a remaining life of five years and is
rated AAA, so the estimated pretax cost of debt using the debt-rating approach is 3.0
percent. This is the rate for bonds of similar quality and maturity.
For the YTM, Yaz's debt has a 3.0 percent coupon and it is selling at a price below par.
When the price is below par ($980 price versus $1,000 par), the market is demanding
a higher return than the bond's coupon. This means we can assume that the YTM is
above 3.0 percent. Thus, the debt-rating approach's estimate of a 3.0 percent pretax
cost of debt is lower than the estimate of it being greater than 3.0 percent using the
yield-to-maturity approach.
The same conclusion can also be found by calculating the actual YTM and then
comparing it to the 3.0 percent pretax cost of debt estimated using the debt-rating
approach. Using your financial calculator, the YTM is found as follows:
HP12C: 980 CHS PV, 15 PMT, 10 n, 1,000 FVj, i = 1.72 semiannual; 3.44 percent annual
YTM
TI BAII+: 980 ± PV, 15 PMT, 10 N, 1,000 FV, CPT I/Y = 1.72 semiannual; 3.44 percent
annual YTM
In comparison, the estimated pretax cost of debt at 3.0 percent for the debt-rating
approach is lower than the 3.44 percent estimate found by using the YTM approach.
Rationale
lower than the estimate using the YTM approach.
rated AAA, so the estimated pretax cost of debt using the debt-rating approach is 3.0
YTM
annual YTM
Rationale
higher than the estimate using the YTM approach.
rated AAA, so the estimated pre-tax cost of debt using the debt-rating approach is 3.0
YTM
annual YTM
Question 11:
Beta estimates are least likely sensitive to:
The choice of the market index against which stock returns are regressed.
The capital structure of the company.
The length of the estimation period.
Rationale
Rationale
Beta estimates are not affected by the capital structure of the company.
Question 12:
An analyst is determining the cost of debt for an unrated company. The analyst
estimated the company's rating and then used this rating to assess the spread for credit
default risk on the company's bonds. The approach the analyst used is most likely the:
bond rating approach.
bond spread approach.
Rationale
bond rating approach.
The bond rating approach uses a company's bond rating and then compares this
rating to bond yields on publicly traded bonds that are rated the same. The credit
default spread for these bonds is implicitly being used as it goes into their yields.
Rationale
bond spread approach.

Rationale
Question 13:
Sun Corporation has the following capital structure:
Equity = 50%
Debt = 45%
Preferred stock = 5%
The company’s after-tax cost of debt is 14% and the cost of equity is 16%. Given that the
company’s weighted average cost of capital is 14.5%, its cost of preferred equity
is closest to:
4.5%
3.5%
4.0%
Rationale
Rationale
0.145 = (0.5 × 0.16) + (0.45 × 0.14) + (0.05 × Cost of preferred equity)

Cost of preferred equity = (0.145 – 0.143) / 0.05 = 4%
Question 14:
A recent offering from Bell Curve Systems, Co. are a seven-year maturity preferred
shares with annual dividends of $15. The par value of the shares is $120. The
shareholders require a 9% return from the shares. The market value of Bell Curve's share
is closest to:
$170.64
$123.08
$141.14
Rationale
$170.64
The first choice is incorrect.
Since the preferred shares are redeemable, they are valued as though they are bonds.
PV of dividends = 15 × ((1 + 1.09−7)/0.09) = 75.4943
PV of par = 120/(1.097)= 65.6441
Total/Market price of preferred shares = 75.4943 + 65.6441 = 141.14.

Rationale
$123.08
The second choice is incorrect.
PV of dividends = 15 × ((1+1.09−7)/0.09) = 75.4943
PV of par = 120/(1.097) = 65.6441
Total/Market price of preferred shares = 75.4943 + 65.6441 = 141.14
Rationale
$141.14
The third choice is correct.
PV of dividends = 15 × ((1 + 1.09−7)/0.09) = 75.4943
PV of par = 120/(1.097) = 65.6441
Total/Market price of preferred shares = 75.4943 + 65.6441 = 141.14

Question 15:
Last year, a company issued $50 million of debt that was entirely bought by a private
investor. This debt, which was issued at par and is not traded, has a nine-year remaining
life and pays 8.0 percent interest on a semiannual basis. If the company were to issue
$10 million in new debt today at par value, it would have to pay a coupon of 12.0
percent. The company's equity has an estimated market value of $5 million and the
estimated cost of equity capital is 20 percent. The company has no additional debt or
equity outstanding and is currently, and for the foreseeable future, paying no taxes due
to past and expected future losses. In determining the company's weighted average cost
of capital, the appropriate after-tax cost of debt is closest to:
8.7 percent.
12.0 percent.
13.0 percent.
Rationale
8.7 percent.
When calculating the weighted average cost of capital, we always use the marginal
cost for each input. For debt, the cost to issue debt today is 12 percent and this is the
amount we use for the pretax cost of debt. Given the 0 percent tax rate that is
expected to continue, the after-tax cost of debt will equal the pretax cost of debt and
therefore the correct answer is 12.0 percent.
Rationale
12.0 percent.
Rationale
13.0 percent.
Question 16:
L1CFR36-LIC011-1510 - medium
A company has a target capital structure of 70% debt and 30% equity. If the company
raises equity of less than $10 million, then its cost of equity is 12%. If the new equity
issued is above $10 million, its cost of equity is 14%. The first break point in the cost of
capital raised due to the change in the cost of equity is closest to:
$10.00 million.
$14.29 million.
$33.33 million.
Rationale
Rationale
Break point
= Amount of capital at which cost of equity changes / Proportion of equity in new

capital = $10 million/0.30
= $33.33 million.
Question 17:
An analyst gathered the following information about a company:
Stock price: $45
Last dividend: $5 per share
Dividend growth rate: 8%
Cost of debt: 9%
Tax rate: 35%
Target debt-to-equity ratio: 0.4
The firm’s WACC is closest to:
14.34%
15.96%
16.86%
Rationale
Rationale
We use the Gordon growth model to estimate the company’s WACC.
Cost of equity = [5(1 + 0.08)/45] + 0.08 = 20%
After-tax cost of debt = 0.09(1 – 0.35) = 5.85%
WACC = 20%(1/1.4) + 5.85%(0.4/1.4) = 15.96%

Question 18:
The beta of ABC's common stock is 1.1, the dividend paid is $3.50, and the stock price is
$82.00. The expected market return is 12% and the risk-free rate is 6%. The cost of
equity is closest to:
6.6%.
12.6%.
13.2%.
Rationale
Rationale
Using the capital asset pricing model (CAPM) to calculate the cost of equity gives:
Question 19:
The rate of return required by owners of a company's common stock is equal to the:
cost of equity.
expected market return.
weighted average cost of capital.
Rationale
cost of equity.
The cost of equity
is
the rate of return required by stockholders.
Rationale
expected market return.

The cost of equity
is
Rationale
weighted average cost of capital.
The cost of equity
is

Question 20:
The weighted-average cost of capital (WACC) often uses target weights. In practice,
analysts often estimate the target weightings using:
The optimal weightings, which will minimize the cost of capital.
The weightings in the current capital structure, based on market values.
The weightings based on the book value of the components of the company's
capital structure.
Rationale
Rationale
When using the current capital structure, it is usual to use market values, where
available, since these reflect the current cost of capital.
Question 21:
An analyst gathered the following information regarding Alpha Associates:
Source of Book Market Value ($ millions)

Capital Value ($
millions)
Common 37.5 52.8

stock
Preferred 30 31.68
stock
Bonds 7.5 11.52

outstanding
Total capital 75 96
The company’s before-tax cost of debt and the cost of common equity are 9% and the
cost of preferred equity is 11%. Given that the company’s marginal tax rate is 30%, its
weighted average cost of capital is closest to:
9.66%
9.48%
9.34%
Rationale
Rationale
Percentage of equity in the capital structure = 52.8 / 96 = 55%
Percentage of debt in the capital structure = 11.52 / 96 = 12%
Percentage of preferred stock in the capital structure = 31.68 / 96 = 33%
WACC = (0.55 × 0.09) + [0.12 × 0.09 × (1 – 0.3)] + (0.33 × 0.11) = 9.336%

Question 22:
A company is considering a project in a developing country. An analyst has determined

that the asset and project betas are 0.80 and 1.60, respectively. In addition, the analyst
has estimated a sovereign yield spread of 3.0 percent and a country (equity) risk
premium of 6.0 percent. Which of the following statements is most likely correct?
The annualized standard deviation of the developing country's equity index is

approximately twice the annualized standard deviation of the developed
country's equity index.

approximately twice the annualized standard deviation of the developing
country's sovereign bond market in terms of the developed market currency.
The annualized standard deviation of the developing country's sovereign bond

market in terms of the developed market currency is approximately twice the
annualized standard deviation of the developed country's sovereign bond market.
Rationale

approximately twice the annualized standard deviation of the developed
country's equity index.
This country risk premium is calculated as follows:

Thus, for the country risk premium to be approximately twice that of the sovereign
yield spread, the numerator of the last term in the equation must be approximately
twice the denominator in this same last term. In other words, the annualized standard
deviation of the developing country's equity index is approximately twice the
annualized standard deviation of the developing country's sovereign bond market in
terms of the developed market currency.
Rationale

approximately twice the annualized standard deviation of the developing
country's sovereign bond market in terms of the developed market currency.
Rationale
The annualized standard deviation of the developing country's sovereign bond

market in terms of the developed market currency is approximately twice the
annualized standard deviation of the developed country's sovereign bond
market.

Question 23:
AM Industries (AMI) is based in a country that taxes the first $1 million of corporate
pretax profits at 10 percent and any corporate pretax profits above $1 million are taxed
at 30 percent. AMI earned pretax profits of $2 million last year and expects to earn
pretax profits of $3 million in the current year. In calculating the company's weighted
average cost of capital (WACC), the tax rate an analyst will use to find the after-tax debt
cost is closest to:
20 percent.
23 percent.
30 percent.
Rationale
20 percent.
The marginal tax rate, which is the tax paid on the last dollar earned, should be used
in calculating a company's WACC. AM Industries is paying 10 percent on its first $1
million of pretax profits and 30% on each dollar of pretax profits earned above the $1
million threshold. Since, AMI is earning pretax profits well in excess of the threshold; it
is paying the 30 percent tax rate on each additional pretax dollar of profit it earns.
Hence, the marginal tax rate for AMI is 30 percent.
Rationale
23 percent.
Rationale
30 percent.
Question 24:
L1CF-TBP113-1504 - hard
The following information relates to Welhem Industries and the market.
Risk-free rate of return: 4%
Beta for Welhem's common stock: 1.2
Current annual dividend yield of equity market index: 9%
Forward annual dividend yield of equity market index: 10%
Dividend growth rate of equity market index: 2%
Current market value of Welhem's stock: $18
Welhem's cost of equity will be closest to:
12.4%.
13.6%.
14.4%.
Rationale
Rationale
Cost of equity as per CAPM = Risk-free rate + Beta of the stock × (Expected return on
the market – Risk-free rate)
Expected return on the market using the dividend discount model = Forward annual
dividend yield of market + Dividend growth rate of market = 10% + 2% = 12%
Cost of equity = 4% + 1.2 × (12% – 4%) = 13.6%

Question 25:
Which of the following statements are true?
 Statement 1: The weights given to each component cost of capital is based on the
desired composition of sources of capital that will support the investment.
 Statement 2: Equal weights are given to each component cost of capital if the
desired capital structure is not provided.
Statement 1 only
Statement 2 only
None of the above
Rationale
Statement 1 only
The first choice is correct. This is correct based on Reading 36.
Rationale
Statement 2 only
The second choice is incorrect. Market values of each source of capital will be the
primary basis of the weights used in determining WACC. If the market values are not
determinable, the book values of the debt and equity of the company shall be used.
Rationale
None of the above
The third choice is incorrect. Statement 1 is a correct statement.

Question 26:
Alan DeVito, CFA, estimates the required rate of return on the equity of Pianco
Corporation. The information of the company is as follows:
Total no. of equity 1,000,000

shares
Common stock $5,000,000
Earnings yield 8%
Net income $2,000,000
Retained earnings $6,500,000
Payout ratio 50%
Beta 0.8
IRR of the 9%
outstanding debt
Current yield of the 8%

most recently issued
debt
Marginal tax rate 30%
Expected market 13%

returns
Treasury bills yield 3%

Based on the information provided, the cost of equity using the Gordon growth model
(GGM) and the capital asset pricing model (CAPM) is closest to:
Gordon CAPM
Growth
model
A 11% 8.7%
.
B. 11% 13.04%
C. 13.04% 11%
Row A
Row B
Row C
Rationale
Rationale
Earnings per share (EPS) = Net income / Total number of shares = $2,000,000 /
1,000,000 = $2
Current market price of Pianco's share (P0) = EPS / Earnings yield = $2 / 8% = $25
Current dividend per share = (Net income × Payout ratio) / Total number of shares =
($2,000,000 × 50%) / 1,000,000 = $1
Return on equity (ROE) = Net income / Total owners' equity = $2,000,000 /

($5,000,000 + $6,500,000) = 17.39%
Sustainable growth rate (g) = ROE × (1 – Payout ratio) = 17.39% × (1 – 50%) = 8.70%
Expected dividend per share (D1) = Current dividend × (1 + Growth rate) = $1 × (1 +

8.7%) = $1.09
Cost of equity as per the dividend discount model = (D1 / P0) + g = ($1.09 / $25) +
8.7% = 13.06%
Cost of equity as per CAPM = Risk-free rate + (Beta × Market risk premium) = 3% + 0.8
× (13% − 3%) = 11%
Question 27:
F&G, S.A. has a current capital structure that is 20 percent debt and 80 percent equity
and its cost of debt and equity are 6.2 and 8.0 percent, respectively. The company's
marginal tax rate is 30 percent and its equity beta is 0.9.
A new project being considered by F&G, S.A. will be funded with €40 million of debt and
€60 million of equity. The new project is in a totally new business for F&G, but it will be
taxed at the same rate that F&G already pays. An internal analyst at F&G has found one
company that is comparable to the new project. This comparable has an equity beta of
1.8, debt of €100 million, equity of €50 million, and a marginal tax rate of 20 percent.
The beta used to calculate F&G's equity cost associated with the new project will
be closest to:
0.8
0.9
1.0
Rationale
0.8
The project's cost of equity can be found by unlevering the comparable company's
beta and then relevering it for the project's financial risk. The calculations are as
follows:
Rationale
0.9
follows:
Rationale
1.0
follows:
Question 28:
Which of the following is most likely to cause a reduction in the firm’s WACC?
An increase in the market risk premium
A decrease in the firm’s tax rate
A decrease in the company’s equity beta
Rationale
Rationale
A decrease in the risk company’s equity beta reduces its cost of equity and therefore
its WACC.
Question 29:
Consider the following statements about the dividend discount model (DDM).
I. The DDM gives an incorrect estimate of the cost of equity when the intrinsic value of
the stock is not equal to the current price of the stock.
II. The DDM cannot estimate the value of the stock when the retention rate retained
earnings are more than the payout rate.
Which of the following is true?
I only.
II only.
Both I and II.
Rationale
Rationale
The DDM gives an incorrect estimate of the cost of equity when the intrinsic value of
the stock is not equal to the current price of the stock because the assumption of
DDM is that the intrinsic value of a stock is equal to the current price.
Question 30:
A firm has debt with a book value of £40 million and equity with a book value of £10
million. In past earnings conference calls, the firm's management has indicated that the
long-term goal is to have a capital structure comprised of 25 percent debt and 75
percent equity. An analyst is planning to calculate the firm's WACC to use in security
valuation and has determined that the market values of the firm's debt and equity are
£50 million and £100 million, respectively. In calculating the WACC, the debt and equity
weights the analyst should use are closest to:
25 and 75 percent, respectively.
Rationale
The firm's management has stated that its long-term goal is to have 25 percent debt
and 75 percent equity. This goal is the target capital structure. For determining the
WACC, the target capital structure is always preferable.
Rationale
Rationale
Question 31:
Dolphin Inc. has a return on equity of 15%. Its next year’s dividend is forecasted to be
$1.52 per share and the current stock price is $43. Given that the company’s cost of
equity is 16%, its earnings retention rate is closest to:
15.50%
83.10%
60.43%
Rationale
Rationale
0.16 = (1.52 / 43) + Dividend growth rate
Dividend growth rate = 12.4651%
0.124651 = Retention rate × 0.15
Retention rate = 83.10%

Question 32:
Which of the following is least likely to be true?
For a company having the same preferred share yield and common stock yield,
the cost of preferred stock is equal to the cost of common stock when the growth
rate of the equity dividend is zero.
An issue of new preferred stock increases the financial leverage of a company,

but the marginal cost of equity is not affected by a new issue of preferred stock.
Accumulated dividend on cumulative preference shares does not affect the

working capital, but accrued dividend on the common stock decreases the
working capital.
Rationale
Rationale
An issue of new preferred stock increases the financial leverage of a company. It also
increases the marginal cost of equity because of the increased risk attached to the
company.
Question 33:
A company has a target capital structure of 20 percent debt and 80 percent equity. The
company has determined the following with respect to raising capital:
Costs of Debt and Equity Schedule
Amount of After-Tax Amount of New Cost of Equity

New Debt (in Cost of Equity (in
millions) Debt millions)
new debt < 4.0 new equity < 8.0 percent

$10 percent $40
$10 < new 5.0 $40 < new 10.0 percent

debt < $25 percent equity < $80
$25 < new 5.5 $80 < new 11.0 percent

debt percent equity
The third debt break point is closest to:
$50 million in new debt capital being raised.
$125 million in new total capital being raised.
Rationale
The calculation of the third debt break point is:
Debt break point 2 = $25 million/0.2 debt weight = $125 million
If the company raises $125 million in new capital, 20 percent, or $25 million, will come
from debt and the remaining $100 million, or 80 percent, will come from equity.
Rationale
Rationale
$125 million in new total capital being raised.

Question 34:
L1CF-TBP204-1504 - easy
The pure-play method of determining the beta of a firm involves using the:
Equity beta of a company with the same debt-to-equity ratio and adjusting it for
the differences in the operating risk.
Asset beta of a company with the same systematic risk and adjusting it for the
changes in the debt-to-equity ratio.
Asset beta of a company with the same sales and business volatility and adjusting
it for the changes in the capital structure.
Rationale
Rationale
The pure-play method of determining the beta of a firm involves using the asset beta
of a company with the same sales and business volatility and adjusting it for the
changes in the capital structure.
Question 35:
North Company has a common stock price of $72. The latest reported earnings per share
were $4.80 and dividends per share were $1.60. The return on equity (ROE) is 8%. The
cost of equity is closest to:
7.46%.
7.55%.
7.67%.
Rationale
Rationale
The growth rate is the earnings retention rate multiplied by the ROE, which is 5.33%.
Next year's dividends will be $1.60 × 1.0533 = $1.685.
Question 36:
Where is the optimal point of capital budgeting on the investment opportunity schedule
(IOS) as it relates to the marginal cost of capital (MCC)?
MCC is above the IOS.
MCC is at the IOS.
MCC is beneath the IOS.
Rationale
Rationale
The optimal capital budget occurs at the point where the marginal cost of capital
(MCC) intersects with the investment opportunity schedule (IOS).
Question 37:
Which of the following is least likely an issue in estimating the cost of debt?
The company’s currently outstanding bonds contain embedded options.
The company uses leases as a source of finance.
The company uses fixed-rate debt.
Rationale
Rationale
A company's using fixed-rate debt is not an issue in calculating the cost of equity.
However, floating-rate debt is an issue because the floating rate is reset periodically
based on a reference rate and is, therefore, more difficult to estimate than the cost of
fixed-rate debt.
Question 38:
An analyst has gathered the following information on a company and the market:
Current market price of $10.20

company's common shares
Common stock dividend yield, 2.45 percent

based on most recent
dividend paid
Expected dividend payout rate 20 percent
Expected return on equity 15 percent

(ROE)
Beta for company's common 1.4

stock
Asset beta for company's 0.9

industry
Expected rate of return for the 10 percent

market portfolio
Risk-free rate of return 4 percent
Using the dividend discount model (DDM) approach, the cost of equity is closest to:
14.0 percent.
14.5 percent.
14.7 percent.
Rationale
14.0 percent.
To use the DDM approach, we need the growth rate and the dividend yield based on
next year's dividend. Let's start with the growth rate, which is calculated using the
sustainable growth rate method:
To find the dividend yield on next year's dividend, we can either calculate the current
year's dividend, grow this amount at our 12 percent growth rate, and then divide by
the stock price or we can more simply (if you have a strong understanding of how the
numbers work) grow the current dividend yield of 2.45 percent by 12 percent. The
two approaches are shown below:
Approach 1: D0 = Current Yield × Price = 0.0245 × $10.20 = $0.25
Yield based on next year's dividend = $0.28/$10.20 = 0.02744
Approach 2: Yield based on next year's dividend = 0.0245 × (1 + 0.12) = 0.02744
Now, we can find the cost of equity:
Rationale
14.5 percent.
Rationale
14.7 percent.

Question 39:
Which of the following is least likely an assumption when using WACC as the discount
rate to evaluate a particular project?
The project will have a constant capital structure throughout its life.
The company’s market values of debt and equity are available.
The project under consideration is an average-risk project.
Rationale
Rationale
Availability of a company's market values of debt and equity is not an assumption

when using WACC as the discount rate to evaluate a particular project.
Question 40:
The country risk premium (CRP) is calculated as the:
Product of the sovereign yield spread and the ratio of the volatility of the
sovereign bond market denominated in terms of the currency of a developed
country to the volatility of the developing country's equity market.
Sum of the sovereign yield spread and the ratio of the volatility of the developing
country's equity market to the volatility of the sovereign bond market
denominated in terms of the currency of a developed country.
Product of the sovereign yield spread and the ratio of the volatility of the
developing country's equity market to the volatility of the sovereign bond market
denominated in terms of the currency of a developed country.
Rationale
Rationale
The country risk premium (CRP) is calculated as the product of the sovereign yield
spread and the ratio of the volatility of the developing country's equity market to the
volatility of the sovereign bond market denominated in terms of the currency of a
developed country.
Question 41:
Jupiter Inc. is planning to invest $142,000 in a new project. The company’s directors
have been provided with the following information:
Expected future cash flows = $25,000 every year for the next six years
Before-tax cost of debt = 7.5%
Current market share price = $37.5
Expected market risk premium = 5%
Risk-free rate = 6%
Beta of the stock = 1.4
Target debt-to-equity ratio = 0.5
Marginal tax rate = 30%
Flotation costs for equity = 3.5%
The net present value of the project is closest to:
−$39,405
−$34,435
−$37,749
Rationale
Rationale
After-tax cost of debt = 0.075 × (1 – 0.3) = 5.25%
Cost of equity = 0.06 + (1.4 × 0.05) = 13%
WACC = (0.13 × 1/1.5) + (0.0525 × 0.5/1.5) = 10.4167%
Dollar amount of flotation costs = 142,000 × 1/1.5 × 0.035 = $3,313.3333
Therefore, initial investment = 142,000 + 3,313.3333 = $145,313.3333
Use the following keystrokes to calculate the NPV of the project:
[CF] [2ND] [CE|C]
145,313.3333 [+|−] [ENTER] [↓]
25,000 [ENTER] [↓]
6 [ENTER]
[NPV] 10.4167 [ENTER] [↓] [CPT]
NPV = −$37,748.64
Question 42:
An analyst has gathered the following information on a company and the market:
Current market price of $10.20

company's common shares
Common stock dividend yield, 2.45 percent

based on most recent
dividend paid
Expected dividend payout rate 20 percent
Expected return on equity 15 percent

(ROE)
Beta for company's common 1.4

stock
Asset beta for company's 0.9

industry
Expected rate of return for the 10 percent

market portfolio
Risk-free rate of return 4 percent
Using the capital asset pricing model (CAPM) approach, the cost of equity is closest to:
9.4 percent.
12.4 percent.
18.0 percent.
Rationale
9.4 percent.
The cost of equity using the CAPM is as follows:
Rationale
12.4 percent.
Rationale
18.0 percent.

Question 43:
L1R36TB-BW020-1612 -
Use this data from Ytterby Energies Corp. to determine the project's beta in Japan:
Expected 15%
market
return
Risk-free rate 5.4%
Country risk 3.35%

premium
Cost of 16.27
equity for
the project
i.
Expected market return: 14.83%
Risk-free rate: 6.7%
Country risk premium: 3.03%
Cost of equity for the project: 17.302%
What is the project beta?
0.84
0.97
0.75
Rationale
This Answer is Correct
The first choice is correct. 16.27 = 5.4 + X(15 – 5.4 + 3.35); X = 0.8394
Rationale
This Answer is Incorrect
The second choice is incorrect. 16.27 = 5.4 + X(15 – 5.4 + 3.35); X = 0.8394
Rationale
The third choice is incorrect. 16.27 = 5.4 + X(15 – 5.4 + 3.35); X = 0.8394
Question 44:
An analyst is calculating the weighted average cost of capital (WACC) for STR Industries.
The analyst has gathered the following data for his calculation:
Market value of $5.6 billion

STR's equity
Common shares 200 million

outstanding for
STR
Pretax cost of 5.5 percent

new debt for STR
Market value of $12.3 billion

STR's debt
STR's equity beta 1.2
Next year's $1.40 per share

dividend for
STR's shares
STR's growth 3.5 percent

rate
Risk-free rate of 2.0 percent

interest
Equity risk 4.0 percent

premium
STR's marginal 30 percent

tax rate
The company's WACC using the dividend discount model is closest to:
4.8 percent.
5.3 percent.
6.4 percent.
Rationale
4.8 percent.
The first step is to find the cost of equity using the dividend discount model. The stock
price used in the model is $28, which is the total equity of $5.6 billion divided by 200
million shares. The calculated cost of equity is:
The WACC is then calculated using the data provided and the calculated cost of equity
from above.
Rationale
5.3 percent.
from above.
Rationale
6.4 percent.
from above.
Question 45:
A company is currently financed using debt and equity. The market value of debt is $25
million, and the market value of equity is $40 million. The company has recently
announced that it will reduce the proportion of debt financing so the debt-to-equity
ratio is 45%. The current after-tax cost of debt and equity are 8% and 12%, respectively.
Using the current capital structure and target capital structure, the company's costs of
capital are closest to:
Current Target
A 7.4% 10.2%
.
B. 10.5% 10.2%
C. 10.5% 10.8%
Row A
Row B
Row C
Rationale
Rationale
The current cost of capital is given by:
A debt-to-equity ratio of 45% indicates the target weighting of debt is 45/145 = 31%.
The target cost of capital is:

Question 46:
A project with multiple IRRs will most likely be characterized by:
alternating streams of cash outflow and inflow.
one significant outflow followed by a series of cash inflows.
a series of cash outflows followed by a series of cash inflows.
Rationale
Rationale
A project with alternating streams of cash outflow and inflow can have multiple IRRs.
The multiple IRR problem will not occur with more conventional projects
characterized by negative cash flows followed by positive cash flows.
Question 47:
The yield-to-maturity on Capital One’s long-term debt is 8%. The risk premium is
estimated to be 5.5%. Given that the company’s marginal tax rate is 40%, its cost of
equity and debt are closest to:
Cost Cost of Debt

of
Equity
A 10.3% 8.0%
B 13.5% 4.8%
C 10.3% 4.8%
Row A
Row B
Row C
Rationale
Rationale
Cost of equity = 0.08 + 0.055 = 13.5%

After-tax cost of debt = 0.08(1 – 0.4) = 4.8%
Question 48:
In capital budgeting, flotation costs should most likely be:
incorporated into the cost of capital by increasing the cost of equity.
incorporated into the cost of the project by increasing the project's initial cash
outflow.
incorporated into the cost of capital by adding the percentage cost to the
preexisting WACC.
Rationale
incorporated into the cost of capital by increasing the cost of equity.
Per the assigned reading in the CFA examination curriculum, the correct treatment of
flotation costs is to incorporate them into the cost of project. Hence, they are treated
as an initial cash outflow for the project.
Rationale
incorporated into the cost of the project by increasing the project's initial
cash outflow.
Rationale
incorporated into the cost of capital by adding the percentage cost to the
preexisting WACC.
Question 49:
An analyst gathered the following information regarding MT Technologies:
Current market share price = $42
Current dividend = $1.02 per share
Earnings retention rate = 70%
Return on equity = 22%
After-tax cost of debt = 9%
Marginal tax rate = 35%
The company’s weighted average cost of capital is closest to:
16.08%
15.35%
15.44%
Rationale
Rationale
Dividend growth rate = 0.7 × 0.22 = 15.4%
Next year’s expected dividend = 1.02 × 1.154 = $1.17708
Cost of equity = (1.17708 / 42) + 0.154 = 18.2026%
WACC = (0.182026 × 1/1.3) + (0.09 × 0.3/1.3) = 16.08%

Question 50:
Dagg Corporation is a medium-sized company, and Venso Corporation is a large player;

both companies operate in the same industry. The financials of the two companies are
given below. Based on this information, the weighted average cost of capital (WACC) of
Dagg, as compared to Venso, is most likely:
Dag Venso
g
Equity (in $ 40 87
millions)
Debt (in $ millions) 55 120
Marginal tax rates 45% 40%
Current yield 6.0% 6.8%
IRR of existing debt 8% 7.5%
Required rate of 11% 11%

return on
company's equity
higher because of a higher IRR on its debt.
higher because of a lower current yield on its debt.
lower because of its higher marginal tax rate.

Rationale
Rationale
The overall WACC of Dagg is less than that of Venso, because Dagg has a higher
marginal tax rate.
Question 51:
An equity analyst at an investment firm is estimating the cost of capital for Latham Gore,
Inc. (LGI). The analyst plans to use her estimate in assessing the effect of LGI's new
projects on the company's value. On a recent earnings release conference call, the
analyst heard the LGI's CFO state the following:
“LGI has a long-term target capital structure of 40 percent debt and 60 percent equity.
Our current capital structure differs from this target and this has been the case for many
years. Over the coming years, we plan to move toward our target.”
From the recently released financial statements and her own calculations, the analyst
has gathered the following data for Latham Gore:
Current Levels ($)
Debt at book 130

value
Debt at market 150

value
Shareholders' 20
equity at book
value
Shareholders' 100
equity at market
value
The debt and equity weights the analyst should use in finding LGI's cost of capital
are closest to:
40 percent debt and 60 percent equity.
Rationale
If the target capital structure weights are known, they should be used. If the target
structure is unknown, then weights based on market values (if available) should be
used. As a last resort, book value weights can be used.
Rationale
Rationale
Question 52:
L1R36TB-BW010-1612 - easy
Consider the following information for Jasmine Inc.:
 Beta, Jasmine Inc.: 1.39
 Risk-free rate: 7%
 Return on market portfolio: 18%
 Company tax rate: 40%
What is the cost of the common equity of Jasmine Inc.?
32.02%
19.49%
22.29%
Rationale
32.02%
The first choice is incorrect. CAPM: Cost of equity = Risk-free rate + Risk premium ×
Beta
Rationale
19.49%
The second choice is incorrect. CAPM: Cost of equity = Risk-free rate + Risk premium ×
Beta
Rationale
22.29%
The third choice is correct. CAPM: Cost of equity = Risk-free rate + Risk premium ×
Beta
Cost of equity = 7% + (18% − 7%) × (1.39)= 22.29%

Question 53:
An analyst makes the following two statements:
1. “Because the profit from investing in a new project adds to a company's preexisting
income before taxes and this additional pretax income will be taxed at the company's
marginal tax rate, the marginal tax rate is the appropriate tax rate to use in the
adjustment of the before-tax cost of debt in determining the after-tax cost of debt.”
2. “For a given company, the intersection of the investment opportunity schedule and
the marginal cost of capital schedule is the point where the company's weighted
average cost of capital is minimized.”
With respect to these two statements, the analyst is most likely correct in making:
statement 1 only.
both statements 1 and 2.
neither statement 1 nor 2.
Rationale
statement 1 only.
Statement 1 is correct in that we use the marginal tax rate because this rate will apply
to the additional pretax profits the company earns if the project is funded. Statement
2 is incorrect. The intersection of the two lines is the optimal capital budget. In
contrast, the point where the WACC is minimized is where the value of the firm is
maximized by achieving the optimal capital structure.
Rationale
both statements 1 and 2.
Rationale
neither statement 1 nor 2.
Question 54:
Amrito Corporation is under financial distress and raises debt because it has several
projects that are expected to generate profit in the future. When calculating its weighted
average cost of capital (WACC):
The appropriate cost of debt would be the tax-adjusted marginal cost of debt.
The tax adjustment should not be made to calculate at the cost of debt.
The cost of debt should be equal to the yield to maturity of the bonds.
Rationale
Rationale
While calculating its WACC, the company should use the tax-adjusted marginal cost of
debt as the cost of debt even if the company is incurring a loss. This is because the
adjustment is made using the marginal tax rate and not the effective tax rate.
Question 55:
Which of the following statements are true?
 Statement 1: One of the reasons cost of capital changes as new capital is raised is the
existence of covenants that restrict incurrence of debt with similar seniority to that
of the existing debt.
 Statement 2: Flotation costs cause the issuance of new sources of capital to be more
expensive.
Statement 1 only
Statement 2 only
All of the above
Rationale
Statement 1 only
The first choice is incorrect. Both statements are true. The third choice is the
appropriate answer.
Rationale
Statement 2 only
The second choice is incorrect. Both statements are true. The third choice is the
appropriate answer.
Rationale
All of the above
The third choice is correct. Both statements are true.

Question 56:
The cost of debt of a company will least likely:
increase if the bond is callable.
increase if the bond is putable.
include both the cost of operating and capital leases.
Rationale
Rationale
A call feature most likely increases the required yield of a similar noncallable bond
because it accounts for the additional risk that the bond may be called; likewise a put
feature reduces the required yield because of the option to sell back at a
predetermined price. Although only capital leases are included on the balance sheet,
both operating and capital leases should be reflected in the cost of debt as they both
represent borrowing.
Question 57:
Helena, Inc. is considering an entirely new line of business. The company has
investigated the business by identifying comparable companies. The data for these
comparables is below:
Comparable Sales in Market Value Market Equity Tax Share Price ($)
Millions Equity in Value Debt Beta Rate
($) Millions ($) in Millions (%)
($)
Comp A 258 1,300 1,045 ??? 18.0 32.50
Comp B 635 4,254 1,263 1.15 22.0 12.28
If the asset beta for Comp A is 0.78, then the weighted average asset beta (based on
equity market values) for the pure players in the new line of business is closest to:
0.90
0.95
1.00
Rationale
0.90
This problem first requires finding the asset beta for Comp B, which is calculated as
follows:
Now the weighted average asset beta can be calculated:
Rationale
0.95
follows:
Rationale
1.00
follows:
Question 58:
L1CF-TBP114-1504 - medium
A business should stop raising any more capital to invest in new projects when the
investment opportunity curve crosses:
The current yield curve.
The total cost of capital curve.
The marginal cost of capital curve.
Rationale
Rationale
A firm should stop raising any more capital to invest in new projects when the
investment opportunity curve crosses the marginal cost of capital curve. Beyond this
point, the marginal cost of capital will be higher than the rate of return on
investments.
Question 59:
Which of the following best describes the optimal capital budget?
The optimal capital budget is the amount of capital that allows the company to
take all projects available.
The optimal capital budget is the optimal amount of capital that can maximize
overall shareholder value.
The optimal capital budget is not relevant in choosing which combination of

projects needs to be taken.
Rationale
The optimal capital budget is the amount of capital that allows the company to
take all projects available.
The first choice is incorrect. A company cannot take all projects available (i.e.,
unprofitable ones).
Rationale
The optimal capital budget is the optimal amount of capital that can
maximize overall shareholder value.
The second choice is correct. The optimal capital budget, taken together with the NPV
analysis, helps in deciding which projects can be taken without sacrificing overall
profitability.
Rationale
The optimal capital budget is not relevant in choosing which combination of

projects needs to be taken.
The third choice is incorrect. It is relevant.

Question 60:
An analyst gathered the following information regarding Star Traders Inc.:
Market price of preferred stock = $52
Common stock (issued 300,000 common shares) = $3,000,000
Preferred stock (issued 40,000 preferred shares) = $800,000
The company pays dividends of $3.40 per share and $5.60 per share on its common and
preferred stock respectively. The company’s cost of preferred stock is closest to:
9.48%
10.77%
11.63%
Rationale
Rationale
Cost of preferred stock = 5.6 / 52 = 10.769%

Question 61:
Percea Corporation pays a consultant $20,000 to analyze a new investment proposal.

The company hires an investment bank to underwrite a $12 million equity issue to
finance the new project. Flotation costs are 2% of the total amount of capital raised. The
company uses NPV to make capital budgeting decisions. The most preferred treatment
of fees will:
increase the initial cash outflow by $260,000.
ignore consultant fees of $20,000 and adjust the discount rate for the project to
account for flotation costs.
ignore consultant fees of $20,000 and increase the initial cash outflow by
$240,000.
Rationale
Rationale
Consultant fees are a sunk cost and should not be considered in the NPV analysis. The
most preferred treatment of flotation costs is to add them to the initial cash outflow
of the project. An adjustment to the discount rate of the project applies a fixed
percentage to the present value of all future cash flows, which less accurately reflects
the timing of the flotation costs.
Question 62:
An analyst has gathered the following information on a private company and its publicly
traded competitor:
Market Value Market Value Equity Tax Rate (%)

Equity in Debt in Beta
Millions ($) Millions ($)
Private 100 150 N.A. 20.0

company
Public 900 600 1.30 25.0

company
Using the pure-play method, the estimated equity beta for the private company
is closest to:
1.5.
1.7.
1.9.
Rationale
1.5.
This problem first requires finding the asset beta for the industry by unlevering the
public company's equity beta:
Next, we relever the asset beta using the private company's data:
Rationale
1.7.
Rationale
1.9.
Question 63:
Escrow House Co. has a desired capital structure of 20-30-50 (preferred shares, debt,
and ordinary shares, respectively). If the tax rate shifts from 38% to 30%, use the
following information to determine the impact on WACC of the company:
 Before-tax cost of preferred stock: 8%
 Before-tax cost of common stock: 14%
 Before-tax cost debt: 17%
No effect
Decrease of 0.408%
Increase of 0.408%
Rationale
No effect
Only the cost of debt is affected by the change in tax rate. An increase in tax rate
results in a lower after-tax cost of debt, hence lowering the WACC.
Difference in tax rate: 8% (decrease)

Weighted differential after-tax cost of debt: 8% × 30% × 17% = 0.408% (increase in
WACC)
Rationale
Decrease of 0.408%
The second choice is incorrect. Only the cost of debt is affected by the change in tax
rate. An increase in tax rate results in a lower after-tax cost of debt, hence lowering
the WACC.

WACC)
Rationale
Increase of 0.408%
The third choice is correct.
Only the cost of debt is affected by the change in tax rate. An increase in tax rate
results in a lower after-tax cost of debt, hence lowering the WACC.

WACC)
Question 64:
Consider the following statements:
Statement 1: A company’s existing debt covenants that restrict it from issuing debt with
similar seniority cause its marginal cost of capital to increase as additional capital is
raised.
Statement 2: Deviation from its target capital structure over the short term causes the
marginal cost of capital to increase as additional capital is raised.
Which of the following is most likely?
Only Statement 1 is incorrect.
Only Statement 2 is incorrect.
Both statements are correct.
Rationale
Rationale
Both statements are correct.

Question 65:
A comparable firm's asset beta:
Is a comparable firm's beta that is levered.
Is multiplied by 1 plus the post-tax debt-to-equity ratio to arrive at a project's

beta.
None of the above.
Rationale
Is a comparable firm's beta that is levered.
The first choice is incorrect. Asset beta is the same as the unlevered beta.
Rationale
Is multiplied by 1 plus the post-tax debt-to-equity ratio to arrive at a project's

beta.
The second choice is correct. This is correct based from Reading 36.
Rationale
None of the above.
The third choice is incorrect. The second answer is correct.

Question 66:
When using the dividend discount model, what happens to the formula's usefulness
when dividend growth rates exceed the firm's cost of capital?
DDM becomes more useful.
DDM becomes less useful.
There is no difference in DDM usefulness.
Rationale
Rationale
When dividend growth rates exceed the cost of capital in the DDM, negative price
values are derived, rendering the formula useless.
Question 67:
L1R36TB-BW017-1612 - hard
A stock of Celadon, currently priced at $20, pays about 28% of its net income as
dividends to its 78,000 shareholders. The shareholders hold an average of three shares
each, and they require a 14.63% return on the stock. Celadon's analyst reports that its
net income is projected to be $1.67 million. The return on equity of Celadon is:
6.44%.
5.81%.
5.49%.
Rationale
6.44%.
The first choice is correct.
First, we need to determine the sustainable growth rate:
Dividend per share = 1,670,000 × 28%/(78,000 × 3) = 467,600/234,000 = 1.9983
k = (1.9983/20) + g = 0.1463
g = 0.04639
The retention rate is 72%. g = 0.04639 = X × 72%; X = 6.44%

Rationale
5.81%.
k = (1.9983 / 20) + g = 0.1463
g = 0.04639
Rationale
5.49%.
k = (1.9983/20) + g = 0.1463
g = 0.04639

Question 68:
Nancy Mines currently has a marginal tax rate of 40 percent and it has the following
debt and equity outstanding:
 $100 million in face value debt issued 10 years ago and 10 years remaining to
maturity. These bonds pay a 9 percent coupon with semiannual payments. When
issued, the company received proceeds of $110 million and in the market today the
bond issue has a value of $130 million.
 20 million common shares are outstanding with a par value of $0.50 per share.
Currently, the shares have a market price of $13 each and the stock beta is 1.6.
Nancy Mines, in order to buy property for a new mine, needs to raise $20 million. The
company has determined that it can issue $5 million in new debt at par if the bonds
yield an amount equal to yield-to-maturity for its preexisting debt. If more debt than $5
million is issued, then the yield required on the entire issue will be 10 percent.
Investment bankers for the Nancy Mines have told the company that it can issue up to
$30 million in new common stock at a price of $13 per share. The current risk-free rate is
2.0 percent and the expected return on the market is 9.0 percent.
If Nancy Mines maintains the same debt-to-equity ratio while raising the $20 million, its
weighted average cost of capital is closest to:
9 percent.
10 percent.
11 percent
Rationale
9 percent.
The current capital structure is needed in order to determine how much debt and
equity are required to raise $20 million. The company's debt has a market value of
$130 million and the total equity market value is $260 million (20 million shares × $13
price per share). Therefore, the firm's total capital is $390 million (debt of $130
million + equity of $260 million) and debt and equity's shares are 1/3 ($130/$390) and
2/3 ($260/$390), respectively.
If $20 million is raised, 1/3 or approximately $6.67 million will be debt and 2/3 or
approximately $13.33 million will be equity. Since the debt being raised is greater than
$5 million, the entire amount of $6.67 million will be issued to yield 10 percent. This
10 percent is the before-tax cost of debt. Notice that we are not concerned with the
yield-to-maturity on the existing debt.
The $13.33 million in equity can be raised at the current stock price and the cost of
equity using the CAPM is:
Now, the WACC is found as follows:
The 10.8 percent is closest to 11.0 percent.
Rationale
10 percent.
Rationale
11 percent

Question 69:
Zenuess Corporation is planning to issue 15-year, $1,000 face (par) value bonds with a 7
percent coupon paid semiannually. These bonds are expected to sell for $1,100 each and
the company's after-tax cost of debt will be 4.2 percent. The marginal tax rate for
Zenuess is closest to:
30 percent.
35 percent.
40 percent.
Rationale
30 percent.
The first step is to find the pretax cost of debt. For the bonds being issued, this cost
will equal their YTM:
TI BAII+: 1,100 +/− PV, 35 PMT, 30 N, 1,000 FV, CPT I/Y = 2.99 percent semiannual;
5.98 percent annual
HP12C: 1,100 CHS PV, 35 PMT, 30 n, 1,000 FV, i = 2.99 percent semiannual; 5.98
percent annual
Now we can use this amount and the after-tax cost of debt of 4.2 percent to find the
marginal tax rate
Rationale
35 percent.
5.98 percent annual
percent annual
marginal tax rate
Rationale
40 percent.
5.98 percent annual
percent annual
marginal tax rate
Question 70:
Risk-free rate: 8%
Equity market risk premium: 6%
Firm’s beta: 1.2
Cost of debt: 10%
Tax rate: 30%
Assuming a target debt-to-equity ratio of 0.3, calculate the firm’s WACC.
13.31%
14%
12.74%
Rationale
Rationale
Cost of equity = 0.08 + (1.2)(0.06) = 15.2%

After-tax cost of debt = 0.1(1 – 0.3) = 7%
WACC = 15.2%(1/1.3) + 7%(0.3/1.3) = 13.31%

Question 71:
Determine the cost of preferred equity of Cayman Inc.
35% Tax rate
$34.00 Par value of preferred shares
$5.10 Dividend per preferred share
$49.00 Current price of the preferred share
15.00%
6.77%
10.41%
Rationale
15.00%
The first choice is incorrect. k = 5.10/49.00 = 10.41%
Rationale
6.77%
The second choice is incorrect. k = 5.10/49.00 = 10.41%
Rationale
10.41%
The third choice is correct. k = 5.10/49.00 = 10.41%

Question 72:
The WACC of Fiber Link Co. is 9.35%. Its tax rate is 32% and has a desired capital
structure is 35-25-40 for debt, preferred equity, and common equity. What is the pretax
cost of debt if the cost of the equity are 6.5% (preferred) and 11% (common) before tax
is applied?
15.41%
16.81%
13.97%
Rationale
15.41%
Rationale
16.81%

Rationale
13.97%
The third choice is correct. Using the formula to compute WACC: 9.35% = 0.35 × (1 −
0.32) × + 0.25 × 0.065 + 0.40 × 0.11, we get the pretax cost of debt by solving for x. x =
13.9706%
Question 73:
Alem Retail Inc. issues noncallable, nonconvertible preferred stock that pays a dividend
of $7 per share. The company is expected to grow at a constant growth rate of 8%, and
its preferred shares are traded at $160. The company's cost of preferred stock is closest
to:
4.05%.
4.38%.
4.73%.
Rationale
Rationale
rp
Dp
Pp
= $7 / $160 = 4.38%
Question 74:
The current debt-to-equity ratio of Lonarde Corporation is 1.2. It has a target debt-to-
equity ratio of 0.8. Its cost of equity is 6% up to $120,000 in total equity, after which the
weighted average cost of capital (WACC) will increase. The corresponding break point in
Lonarde's marginal cost of capital schedule is closest to:
$216,000.
$264,000.
$270,000.
Rationale
Rationale
Percentage of equity in the total capital structure = 1 / (1 + Debt-to-equity ratio) = 1 /

(1 + 0.8) = 56%
Break point = Amount of capital at which the source's cost of capital changes /
Proportion of new capital raised from the source
= $120,000 / 0.56 = $216,000

Question 75:
Which of the following statements is most likely true of capital budgeting methods?
A change in the risk-free rate influences the result of the IRR method and the
profitability index.
The payback method ignores the time value of money, whereas profitability index
considers the time value of money.
The payback period takes into account outflows other than the initial outflow, but
the profitability index takes into account only the initial outflow.
Rationale
Rationale
The payback method ignores the time value of money, whereas profitability index
considers the time value of money.
Question 76:
Weber & Wagner, GmbH, an Austrian company traded on the Vienna stock exchange
(Wiener Börse), is considering expansion into Russia. An analyst at a British investment
management company that owns shares in the company is worried that the expansion
may change the risk profile of Weber & Wagner. The analyst has gathered the following
information:
Weber & Wagner's 25 percent

marginal tax rate
Market value of €850 million (€21.25 per share)

Weber & Wagner's
equity
Weber & Wagner's 0.8

equity beta
Weber & Wagner's €40 million (€1.00 per share)

most recent common
dividend
Weber & Wagner's 3.0 percent

growth rate

interest, Austria
Equity risk premium, 6.5 percent

Austria

interest, Russia
Equity risk premium, 7.2 percent
Russia
If the capital asset pricing model (CAPM) is used, Weber & Wagner's cost of equity
capital for its typical project is closest to:
5.5 percent.
6.7 percent.
9.3 percent.
Rationale
5.5 percent.
For assessing the company's typical project, the data related to Austria should be used
along with Weber & Wagner's equity beta in the CAPM:
Rationale
6.7 percent.
Rationale
9.3 percent.
Question 77:
Which of the following statements about the marginal cost of capital schedule
is correct?
Marginal cost of capital increases at a constant rate between any two break
points.
A company having a single financing source will have one break point on the
marginal cost of capital schedule.
The marginal cost of capital schedule is typically an upward-sloping step-up cost

schedule.
Rationale
Rationale
The marginal cost of capital schedule is an upward-sloping step-up cost schedule. In

reality a company may have to deviate from its target capital structure when raising
new capital, which results in the step-up.
Question 78:
BobProds, an extremely large Internet retailer of products ranging from books to

electronics to household products, is considering expanding. The expansion project
under consideration would entail opening office supply stores in locations near the
company's existing distribution warehouses. These stores would benefit from the
BobProds' buying power, as the company already buys large quantities of offices supplies
that it sells online. Given this buying power, the new stores will be able to undercut
prices charged at other stores. The project (the new stores) will be funded with debt and
equity that exactly matches the company's existing levels, which also match the
company's target level. Relative to BobProds' WACC, the WACC used to discount the cash
flows for the expansion project into office supply stores will most likely:
differ because a startup business, even one having the same leverage as
BobProds, is always riskier.
differ because the asset beta for general internet retailing will likely differ from
the asset beta for office supply stores.
be the same because the financing is the same for the startup and the startup is
selling products that company already sells.
Rationale
differ because a startup business, even one having the same leverage as
BobProds, is always riskier.
The WACC will

most likely
differ, because the company is starting a new business and it is highly likely that the
asset beta for office supply stores is different than the asset beta for an Internet
retailer selling a wide range of products. The differences in the businesses include
how the products are sold—in a physical store with its costs and risks versus being
sold online—and the amount of product diversification—office supplies only versus a
wide range of products.
Rationale
differ because the asset beta for general internet retailing will likely differ
from the asset beta for office supply stores.
The WACC will
most likely
Rationale
be the same because the financing is the same for the startup and the
startup is selling products that company already sells.
The WACC will

most likely
Question 79:
It is recommended that flotation costs when a firm issues new equity are:
Ignored.
Incorporated in the calculation of a firm's cost of capital.
Treated as a cash outflow at the time of the issue of the new equity.
Rationale
Rationale
The cost of raising new equity is usually much higher than that of raising new debt, so
it should not be ignored. It is preferable to treat flotation costs as an initial cash
outflow as opposed to adjusting the cost of capital, and therefore the discount factor
is applied to all future cash flows.
Question 80:
Satchels Corp. is a medium-size company that expects growth of 6% annually, a

confidence based on its stellar performance for the past few years and the opportunities
in the coming year. Its shares are priced at $27, and the board recently approved the
increase of its dividends by 15%. The dividends prior to the increase were $4 per share.
What is the cost of equity?
23.04%
17.04%
16.07%
Rationale
23.04%
Dividend in the next year: 4 × 1.15 = 4.60
Growth rate = 6%
k = (4.60/27) + .06 = 23.04%

Rationale
17.04%
Growth rate = 6%
k = (4.60/27) + .06 = 23.04%
Rationale
16.07%
Growth rate = 6%
k = (4.60/27) + .06 = 23.04%

Question 81:
Jones-Day Corporation's equity beta recently fell, but in contrast, its asset beta is
unchanged. Which of the following best explains the equity beta decline combined with
an unchanged asset beta?
The company's tax rate declined.
The company's leverage decreased.
The outcome described cannot occur; a decline in an equity beta is always caused
by an asset beta decline.
Rationale
The company's tax rate declined.
When a company's leverage declines, its equity beta will fall to reflect lower financial
risk and its asset beta will not change because the asset beta is an unlevered beta.
Rationale
The company's leverage decreased.

Rationale
The outcome described cannot occur; a decline in an equity beta is always

caused by an asset beta decline.
Question 82:
An analyst at an airline is estimating the levered beta for a new project to expand into
intercity bus service—a whole new line of business. The airline has a current debt-to-
equity ratio of 1.8 and the beta for its common shares is 2.2. The company has decided
to finance the new bus operation using $100 million of debt and $100 million of equity.
The analyst could find only one comparable for the intercity bus business. This
comparable company had a debt-to-equity ratio of 1.2, its common share beta was 1.4,
and it pays the same tax rate as is expected for the airline's intercity bus service. The
beta the analyst will use in calculating the cost of equity for the new bus business
will most likely be:
less than 1.4.
greater than or equal to 2.2.
greater than 1.4 and less than 2.2.
Rationale
less than 1.4.
No calculations are needed. With the same tax rates, the only difference between the
comparable company and the startup bus service is the leverage. The new intercity
bus business will have a debt-to-equity ratio of 1.0. This is lower than the
comparable's debt-to-equity ratio, so the new business has less financial risk. Since
both the new startup and the company comparable are in the same business, the
lower financial risk of the startup will result in it having a lower equity beta than the
comparable's.
Rationale
greater than or equal to 2.2.
comparable's.
Rationale
greater than 1.4 and less than 2.2.
comparable's.
Question 83:
Which of the following statements regarding a stock’s beta is least accurate?
It is believed to revert toward 1 over time.
It is calculated by regressing market returns against the company’s stock returns

over a given period.
Some experts argue that the betas of small companies should be adjusted
upward to reflect greater risk.
Rationale
Rationale
Beta is calculated by regressing the company’s stock returns against market returns
over a given period, rather than the reverse. In other words, the company’s stock beta
is the dependent variable (y) in the regression because it depends on the value of
market beta.
Question 84:
Which of the following is included in the computation of the WACC of an entity?
Cost of preferred shares
Tax shelter from debt costs
Cost of borrowings (before taxes)
Rationale
Cost of preferred shares
Rationale
Tax shelter from debt costs
The second choice is incorrect. The tax-sheltered portion is not a cost and is excluded
from the WACC calcuation.
Rationale
Cost of borrowings (before taxes)
The third choice is correct. After-tax cost of debt is used in coming up with the cost of
debt, because interest is generally tax deductible.
Question 85:
South Corp.'s target capital structure is 50% debt, 10% preferred stock, and 40%
common equity. If the before-tax costs of debt, preferred stock, and common equity are
10%, 11%, and 14%, respectively, and the marginal tax rate is 40%, the WACC
is closest to:
9.3%.
9.7%.
10.3%.
Question 86:
Alton Technologies is planning to set up a new plant in a foreign country. The company
has the following capital structure:
Capital Required Rate of Return

Structure
45% 8%
common
stock
35% debt 7%
20% 9%
preferred
stock
The company’s directors have estimated the cost of the investment to be $55 million and
plan to finance $33 million by issuing common stock and $22 million by issuing debt.
Given that the company’s marginal tax rate is 40%, its weighted average cost of capital
is closest to:
20.10%
7.60%
6.48%
Rationale
Rationale
Percentage of equity in the capital structure = 33 / 55 = 60%
Percentage of debt in the capital structure = 22 / 55 = 40%
WACC = (0.6 × 0.08) + (0.4 × 0.07 × 0.6) = 6.48%

Question 87:
Jason Corporation has the following capital structure:
Equity = 65%
Debt = 25%
Preferred stock = 10%
The company’s before-tax cost of debt is 10%, cost of common equity is 12%, and cost of
preferred equity is 13%. Given that the company’s marginal tax rate is 35%, its weighted
average cost of capital is closest to:
12.48%
11.60%
10.73%
Rationale
Rationale
WACC = (0.65 × 0.12) + [0.25 × 0.1 × (1 – 0.35)] + (0.1 × 0.13) = 10.725%

Question 88:
Capital Required Rate of Return

Structure
25% debt 12%
35% 14%
preferred
stock
40% 17%
common
stock
Assuming a tax rate of 30%, the company’s cost of capital is closest to:
14.7%
13.8%
12.6%
Rationale
Rationale
WACC = (0.25)(0.12)(1 – 0.3) + (0.35)(0.14) + (0.4)(0.17) = 13.8%

Question 89:
A company has a target capital structure of 30% debt and 70% equity. If the company
raises debt of less than $1 million, then its after-tax cost of debt is 3%. If the new debt
issued is above $1 million, its after-tax cost of debt is 3.5%. The first break point in the
cost of capital raised due to the change in the cost of debt is closest to:
$1.00 million.
$3.00 million.
$3.33 million.
Rationale
Rationale
Break point
= Amount of capital at which cost of debt changes / Proportion of debt in new capital
= $1 million / 0.3
= $3.33 million.
Question 90:
A developing country has a sovereign yield spread of 4.5 percent and its:
i. government bond, when measured in terms of a developed country's currency, is

more volatile than its equity market, and
ii. equity market is less volatile the developed country's equity market.
An analyst assessing the developing country can conclude that the country's risk (equity)
premium will most likely be:
less than its sovereign yield spread.
zero, as its markets are less volatile.
more than its sovereign yield spread.
Rationale
less than its sovereign yield spread.
To find the developing country's risk (equity) premium, the sovereign yield spread is
multiplied by the relative volatility between the country's equity market and its
government bond measured in terms of a developed country's currency. In (i) above,
the analyst noted lower volatility for the equity market, so the sovereign yield spread
is multiplied by a number that is less than 1.0 and the result is a country risk premium
that is below its sovereign yield spread.
Rationale
zero, as its markets are less volatile.
Rationale
more than its sovereign yield spread.
Question 91:
Fruitobest Foods Inc. currently trades at $525 per share. It recently paid a dividend of
$2.45, which is expected to grow at a constant rate of 6%. The company's cost of debt is
equal to 8% and the risk-free rate is 4%. Calculate its cost of equity.
6.42%
6.47%
6.49%
Question 92:
Halogen Inc.'s analyst knows that its cost of equity is 19.74%. A default-free bond
instrument in Halogen's country has a yield of 3.5%. The market has an expected return
of 9.46%. Based on this information, the analyst concludes that the beta of the company
is closest to:
2.72.
2.94.
4.64.
Rationale
2.72.
Using the capital asset pricing model, we get the beta:
3.5 + b(9.46 – 3.5) = 19.74
b = 2.725
Rationale
2.94.
3.5 + b(9.46 – 3.5) = 19.74
b= 2.725
Rationale
4.64.
3.5 + b(9.46 – 3.5) = 19.74
b= 2.725
Question 93:
L1R36TB-ITEMSET-BW022-1612 - - hard
Rovin Wells, CFA, wants to investigate the beta of Threadless Co. Spindle Co. is a
company with similar risks that has almost the same business as that of Threadless Co.
Threadless's debt-to-equity ratio is higher compared to Spindle's. Furthermore, Spindle
has an equity beta of 0.98. Threadless has a D/E ratio of 1.5 and Spindle has a D/E ratio
of 0.82. The tax rates for Threadless and Spindle are 40% and 36%, respectively.
i.
The unlevered beta of Spindle is:
.4833
.6427
.5629
Rationale
Rationale
The second choice is correct. Asset beta = 0.98/[1 + (1− 0.36)(0.82)] = 0.6427
Rationale
ii.
Rovin finds out that the beta of Threadless is:
1.2211
1.0371
1.1481
Rationale
The first choice is correct. Project's beta = 0.6427 × [1 + (1 − 0.40)(1.5)] = 1.2211

Rationale
Rationale

Question 94:
Massie Corporation has a stable operating history since its inception 10 years ago. It
trades on all major stock markets. During the past three years, Massie has made several
acquisitions financed by newly issued bonds. Based solely on the given information,
which estimation period is best suited to estimate beta for Massie?
3 years.
7 years.
10 years.
Rationale
Rationale
Longer estimation periods are generally appropriate for companies with stable
operating histories. Massie's financial leverage, however, has likely changed
significantly due to the recent acquisitions; a shorter period will better reflect the
company-specific changes that have occurred over the past three years.
Question 95:
Pluto Inc. issues a semiannual pay bond to finance a new project. The bond has a 20-
year term, a par value of $1,000, and offers a 7% coupon rate. Given that the bond is
issued at $984.50 and that the company’s marginal tax rate is 40%, the after-tax cost of
debt is closest to:
3.57%
4.29%
7.15%
Rationale
Rationale
N = 40; PV = −$984.5; FV = $1,000; PMT = $35; CPT I/Y; I/Y = 3.5734%
Before-tax cost of debt = 3.5734 × 2 = 7.1468%

Question 96:
A company is considering a project in a developing country. An analyst has determined

that the asset and project betas are 0.82 and 1.36, respectively. The risk-free rates of
interest in the developed and developing countries are 2.3 percent and 6.3 percent,
respectively. The analyst has estimated a sovereign yield spread of 4.0 percent and a
country (equity) risk premium of 5.2 percent. The historical equity risk premium for the
developed market has been 4.1 percent and it has been 7.8 percent for the developing
country. The analyst will calculate a project cost of equity that is closest to:
14.9 percent.
16.9 percent.
18.5 percent.
Rationale
14.9 percent.
To use the CAPM for the project in the developing country, we need to adjust the
developed country's equity risk premium for the additional country's (equity) risk
premium of 5.2 percent found for the developing country. Using the developed
country's risk-free rate and the project's equity beta, the cost of equity is then
calculated as follows:
Rationale
16.9 percent.
Rationale
18.5 percent.
Question 97:
Prime Systems Inc. has a substantial amount of its capital in the form of debt. The
accounting estimates adopted by Prime Systems often give rise to temporary differences
between the taxes payable and the income tax expense, resulting in deferred tax assets
or deferred tax liabilities being reported on its balance sheet. The company anticipates
an income tax rate cut and evaluates the effects. All else being equal, which of the
following is the most likely consequence of this change?
A decrease in the deferred tax liability and a decrease in the overall cost of debt.
An increase in the deferred tax asset and an increase in the overall cost of debt.
A decrease in the deferred tax asset and an increase in the overall cost of debt.
Rationale
Rationale
A decrease in the income tax rate will lead to a decrease in the deferred tax asset if
the temporary differences in the tax expense and tax payable continue to exist. A
decrease in the tax rate will also increase the overall cost of debt by decreasing the
amount of tax advantage on the interest payments.
Question 98:
ABC Corp. issued nonconvertible, noncallable preferred stock last year at an issue price
of $100; it pays a dividend of $5 per annum. The stock is now trading at $110. The
company's marginal tax rate is 40%. The cost of preferred stock for ABC Corp isclosest to:
2.7%.
3.0%.
4.5%.
Rationale
Rationale
The cost of preferred stock is the dividend divided by the price. There is no
adjustment for tax, since a preferred dividend is not a tax-deductible expense. The
cost is $5 / $110 = 4.5%.
Question 99:
ABC Corp. has a 6% 10-year bond outstanding, which is trading at a yield to maturity of
8%. The company's marginal tax rate is 40%. The component cost of debt for ABC Corp.
is closest to:
3.6%.
4.8%.
8.0%.
Rationale
Rationale
The cost of debt is the required return of investors in the bond, which is the yield to
maturity less tax savings, which is:
Question 100:
Southeast Inc.'s existing operations have a beta of 0.9, and its cost of capital is 14%. The
risk-free rate is 6%. It is considering investing in a new project that has a beta of 1.4. The
company's assets would then be split between 75% in the original business and 25% in
the new project. The company will remain debt free. If the new project does not alter
the valuation of the company, the new cost of capital for the company is closest to:
15.1%.
16.2%.
18.5%.
Rationale
Rationale
The market return is given by applying CAPM to the original business:
The required return for the new business is 6% + 1.4 (14.9% – 6%) = 18.46%. The
weighted-average required return = (0.75 × 14%) + (0.25 × 18.46%) = 15.1%. This is
the same as the cost of capital.
Question 101:
Which of the following is least likely a method for calculating the cost of debt?
Yield-to-maturity approach
Bond yield plus risk premium approach
Debt rating approach
Rationale
Rationale
Bond yield plus risk premium approach is used to calculate the cost of equity.
Question 102:
A company is considering a project that has an asset beta of 0.76. The company's debt-
to-capital ratio is 50 percent and the project itself will be financed with 75 percent debt.
If the company's and project's marginal tax rate is 32 percent, the estimated beta for the
project is closest to:
1.2
1.5
2.3
Rationale
1.2
The asset beta, which is the unlevered beta, needs to be relevered using the financing
weights for the project:
Rationale
1.5
Rationale
2.3
Question 103:
A project with no IRR most likely may have:
an IRR of the project equal to zero.
a positive NPV for all discount rates.
an indeterminate NPV.
Rationale
Rationale
Projects with no IRR have a positive NPV for all the discount rates. No IRR is not
equivalent to zero IRR.
Question 104:
Stanley Wills, CFA, wants to determine the cost of debt of DB-Locke Co. The firm's debt
is not publicly traded, so Stanley uses the debt rating of a comparable bond with a
maturity close to that of DB-Locke's debt. Stanley is using the:
Substitution approach.
Evaluated pricing approach.
Discount pricing.
Rationale
Substitution approach.
The first choice is incorrect based on Reading 36.
Rationale
Evaluated pricing approach.
The second choice is correct. This approach is an example of matrix pricing or

evaluation pricing.
Rationale
Discount pricing.
The third choice is incorrect based on Reading 36.

Question 105:
Which of the following statements is most accurate?
Dividend payments provide a tax shield and, therefore, should be adjusted for tax
savings in the WACC formula.
A company’s marginal cost of capital increases as it raises additional capital.
The profitability of the company’s investment opportunities increases as the

company makes additional investments.
Rationale
Rationale
Interest payments provide a tax shield and, therefore, should be adjusted for tax
savings in the WACC formula.
The profitability of the company’s investment opportunities decreases as the

company makes additional investments.
Question 106:
A company issued fixed-rate perpetual preferred stock two years ago. The shares were
issued at a price of $50 and they currently trade at a price of $62 per share. If the
company were to issue preferred stock today, the yield would have to be 7.0 percent.
The dividend on the previously issued preferred shares is closest to:
$3.50
$3.92
$4.34
Rationale
$3.50
We are given the current price per share and the current required yield and are asked
to find the dividend. We can use the formula for finding the cost of preferred stock
and solve for the missing item—the dividend:
Rationale
$3.92
Rationale
$4.34
Question 107:
L1R36TB-BW016-1612 - hard
Calcite Development Corporation is a small corporation that has about 35,000

shareholders, each holding an average of seven shares each. The shares are selling for
$12.30. The company's return on equity is stable at around 4.5%. Net income of Calcite
was expected to be $1,100,000. It also pays out 20% of its net income to its
shareholders. As the company's analyst, you are asked to determine the cost of equity.
What is Calcite's cost of equity?
8.48%
10.09%
9.77%
Rationale
8.48%
Find the company's sustainable growth rate:
g = ROE × retention rate
g = 4.5% × 80% = 3.6%
Find the cost of equity:

Dividend per share = 1,100,000 × 20%/(7 × 35,000) = 220,000/245,000 = 0.8796 per
share
k = (0.8796 / 12.3) + 0.036 = 10.9%
Rationale
10.09%
The second choice is correct.
g = 4.5% × 80% = 3.6%

share
k = (0.8796/12.3) + 0.036 = 10.9%
Rationale
9.77%

g = 4.5% × 80% = 3.6%

share
k = (0.8796/12.3) + 0.036 = 10.9%

Question 108:
Political instability in a country is widely perceived as a systematic risk. Political

instability will most likely be seen as an unsystematic risk for U.S.-based companies if:
there is a political instability in the United States.
there is political coup in one of the countries in the Middle East and the United
States depends on the Middle East for 90% of its energy requirements.
they have business units operating in the Middle East, when there is a political
coup in the Middle East.
Rationale
Rationale
For U.S. companies operating in the Middle East, any political instability in the Middle
East will be an unsystematic risk. The other cases are examples of systematic risk
because all the businesses in the United States will be affected by political instability
in the United States or the Middle East.
Question 109:
L1R36TB-ITEMSET-BW007-1612 - - hard
Given the following information from two similar companies, answer the following
questions:
Fabien Avi
Cost of 8% 9.5%
Debt
Cost of 10% 12%

Equity
Tax Rate 32% 40%
Debt 320,000.00 400,000.00

(Book
Value)
Equity 780,000.00 680,000.00

(Book
Value)
Fabien Distillers Inc. aims to maintain a debt-to-equity ratio of 4:6. Avi, on the other
hand, desires a capital structure with a debt-to-equity ratio of 3:7.
i.
Determine Fabien's WACC.
7.8%
8.2%
8.6%
Rationale
The first choice is incorrect. 8 × (1− 0.32) × 0.40 + 10 × 0.60 = 8.176
Rationale
The second choice is correct. 8 × (1 − 0.32) × 0.40 + 10 × 0.60 = 8.176
Rationale
The third choice is incorrect. 8 × (1 − 0.32) × 0.40 + 10 × 0.60 = 8.176
Weight debt = 600/1500 = .4
Weight equity = 900/1500 = .6
ii.
Determine Avi's WACC.

10.11%
8.71%
6.21%
Rationale
The first choice is correct. 0.30 × 9.5 × (1 − 0.40) + 0.70 × 12 = 10.11%
Rationale
The second choice is incorrect. 0.30 × 9.5 × (1 − 0.40) + 0.70 × 12 = 10.11%
Rationale
The third choice is incorrect. 0.30 × 9.5 × (1 − 0.40) + 0.70 × 12 = 10.11%
iii.
Suppose the two companies don't have a desired capital structure, and the market
values of the equity of the two companies are 1.7 times its book value. Fabien's debt is
quoted at $375,000 and Avi's debt is quoted at $425,000. If the desired capital structure
is not provided but the market values are provided, how much greater will Avi's WACC
be than Fabien's?
1.49%
1.36%
1.31%
Rationale
Rationale
Fabien Avi
A. Market $375,000.00 $425,000.00

value of debt
B. Market 1,326,000.00 1,156,000.00

value of
equity
(BV×1.7)
C. Total (A + B) 1,701,000.00 1,581,000.00
Weights – 22.0459% 26.8817%

Debt (A/C)
Weights – 77.9541% 73.1183%

Equity (B/C)
Fabien's WACC = 8 × (1 − 0.32) × 0.220459 + 10 × 0.779541 = 8.995%
Avi's WACC = 0.268817 × 9.5 × (1 − 0.40) + 0.731183 × 12 = 10.306%
Difference = 10.306 − 8.995 = 1.312%
Rationale
The third choice is correct. 6.6622 – 4.8606 = 1.8016

Question 110:
The current debt-to-equity ratio of Crimson Corporation is 2.5. The company has failed
to give a comprehensive estimate of its target capital structure. The other financial
details of the company are as follows:
Book value $250,000

of debt
Book value $100,000

of equity
Market $350,000
value of
debt
Market $400,000
value of
equity
Current 6%
yield of
debt
Yield to 7.50%
maturity of
debt
Effective 30%
tax rate
Marginal 35%
tax rate
Equity risk 4.50%
premium
The risk premium for bearing additional risk associated with the company's stock
compared to that of bonds is 3.5%. The company's weighted average cost of capital
(WACC) is closest to:
6.63%.
7.69%.
8.14%.
Rationale
Rationale
WACC = (Percentage of debt in the capital × After-tax cost of debt) + (Percentage of

equity in the capital × Cost of equity)
% of debt in the capital = $350,000 / ($350,000 + $400,000) = 47%
% of equity in the capital = $400,000 / ($350,000 + $400,000) = 53%
The cost of debt = 7.5% × (1 – 0.35) = 4.88%
Using the bond yield plus risk premium approach, the cost of equity = 7.5% + 3.5% =
11%
WACC = (47% × 0.0488) + (53% × 0.11) = 8.14%

Question 111:
JB Associates earned a net income of $4.5 million in 2009. The company announced
dividends of $0.818 per share, which will grow at a constant rate forever. Given that the
weighted average number of common shares outstanding in 2009 is 2.2 million and that
the company’s book value of equity in 2008 and 2009 is $22 million and $28 million,
respectively, its annual growth rate in dividends is closest to:
10.8%
10.4%
10.6%
Rationale
Rationale
EPS in 2009 = Net income / Weighted average number of common shares
EPS in 2009 = 4.5 / 2.2 = $2.045
Dividend payout ratio = 0.818 / 2.045 = 40%
Return on equity = 4.5 / [(22 + 28) / 2] = 18%
Dividend growth rate = (1 – 0.4) × 0.18 = 10.8%

Question 112:
Chango, Inc. is considering an entirely new line of business. The company has
investigated the business by identifying comparable companies. The data for these
comparables is below:
Comparable Sales in Market Value Market Equity Tax Share Price ($)
Millions Equity in Value Debt Beta Rate
($) Millions ($) in Millions (%)
($)
Comp A 258 1,300 1,045 ??? 18.0 32.50
Comp B 635 3,254 1,263 1.45 22.0 12.28
If the asset beta for Comp A is 0.65, then Comp A's equity beta is closest to:
0.90
1.10
1.45
Rationale
0.90
This problem requires relevering Comp A's asset beta. The calculation is as follows:
Rationale
1.10
Rationale
1.45
Question 113:
In calculating the cost of preferred stock:
The after-tax cost should be used, since the preferred dividends are paid from
pretax profits.
The cost should be adjusted for flotation costs, since it is the cost of issuing new
preferred stock in the current market.
If the stock has no maturity date, we can apply a perpetuity formula to find the
discount factor, which is the cost of the preferred stock.
Rationale
Rationale
Preferred stock is valued using a perpetuity formula, so the third choice is correct. The
dividend is not tax deductible, and flotation costs should be reflected in cash flows, as
they are a one-off expense.
Question 114:
Maxwell Electronics, a consumer electronics company, plans to expand its operations in

the Asia-Pacific region. The company has debt of $4 million and assets worth $14
million. Cuprum Electricals Inc., the market leader, has similar revenue, net income, and
business risk. The information of the two companies is as follows:
Debt of Cuprum $7 million

Electricals Inc.
Equity of Cuprum $35 million

Electricals Inc.
Levered beta of 0.8

Cuprum
Electricals Inc.
Marginal tax rate 40%
Risk-free rate 5%
Market risk 10%

premium
Based on the information provided, calculate the cost of equity of Maxwell Electronics.
10.76%.
13.37%.
13.86%.
Rationale
Rationale
Equity of Maxwell Electronics = $14 million – $4 million = $10 million
βU, Comparable = βL, Comparable / [1 + (1 – tcomparable) (Dcomparable /

Ecomparable)]
βU, Cuprum = 0.8 / [1 + (1 – 0.40) × (7 / 35)] = 0.7142
βL, project = βU, Comparable × [1 + (1 – tproject) (Dproject / Eproject)] = 0.7143 × [1 +

(0.60) × (4 / 10)] = 0.8857
Cost of equity = RFR + βL, project × Market risk premium = 13.86%

Question 115:
Which of the following is not true?
The WACC decreases as the amount of capital being raised is increased.
The point at which the marginal cost of capital curve and the investment
opportunity schedule meet is described as the optimal capital budget.
If the IRR of a project is greater than the marginal cost of capital, the project must
be taken.
Rationale
The WACC decreases as the amount of capital being raised is increased.
The first choice is correct. The statement is false because the marginal cost of capital
is upward-sloping.
Rationale
The point at which the marginal cost of capital curve and the investment
opportunity schedule meet is described as the optimal capital budget.
The second choice is incorrect. This is a true statement according to Reading 36.
Rationale
If the IRR of a project is greater than the marginal cost of capital, the project
must be taken.
The third choice is incorrect. This is a fundamental decision rule in capital budgeting.
Question 116:
Jones Industries issued fixed-rate perpetual preferred stock ten years ago. This preferred
stock was issued at $40 per share in a private offering and at the time of issuance, the
yield was 10 percent. If Jones issued the same preferred stock today, it would yield 6
percent. Today's value per share for the originally-issued preferred shares is closest to:
$30
$50
$70
Rationale
$30
At the time of issuance, the preferred stock price was $40 and the yield was 10
percent. Therefore, the dividend on these shares is $4.00 per share and this is
If the required yield is 6 percent, the shares should trade at approximately $67 each,
which is closest to $70. This value is calculated as follows:
Rationale
$50
Rationale
$70
Question 117:
An analyst at Highland Industrials is investigating a project in a developing country. She

has estimated that the sovereign yield spread for the developing country is 5.2 percent
and that the equity risk premium for a project in the developing country is 6.8 percent.
The analyst is now calculating the cost of equity for the project using the CAPM and she
observes that the risk-free rate is 3 percent and the expected return on the market is 8
percent in the developed country where Highland is based. If the appropriate beta is 1.4,
the project's cost of equity is closest to:
9.5 percent.
19.5 percent.
23.7 percent.
Rationale
9.5 percent.
With an expected return on the market of 8 percent and a risk-free rate of 3 percent,
the equity risk premium is 5 percent. To use the CAPM for the project in the
developing country, we need to adjust the developed country's equity risk premium
for the additional equity risk premium of 6.8 percent found for the project in the
developing country. The cost of equity is then calculated as follows:
E(Ri) = 0.03 + 1.4(0.05 + 0.068) = 19.52 percent

Rationale
19.5 percent.
E(Ri) = 0.03 + 1.4(0.05 + 0.068) = 19.52 percent
Rationale
23.7 percent.
E(Ri) = 0.03 + 1.4(0.05 + 0.068) = 19.52 percent

Question 118:
Which of the following statements about the cost of equity of a company calculated
using the DDM is most likely true?
When the stock price of a company increases at a higher rate than its dividend,
its cost of equity will increase.
A company's cost of equity is equal to its dividend yield if all its prospective
investments have an internal rate of return (IRR) less than their cost of capital.
A company's earnings retention rate is high when the future investments have a
net present value (NPV) of zero.
Rationale
Rationale
When the IRR of all the prospective projects are less than the cost of capital, there will
be no dividend growth for the company and its cost of equity will simply be its
dividend divided by its current price, which is its dividend yield. If the future
investments are not adding any value to the company, then it is most likely that the
company will distribute its profits in the form of dividends.
Question 119:
Which of the following is the least likely reason for an increase in the marginal cost of
capital of a company?
A deviation in the target capital structure due to the repurchase of shares.
An issue of callable bonds.
An issue of subordinated bonds.
Rationale
Rationale
The repurchase of shares is least likely to increase the cost of capital. Callable bonds
carry a higher rate than plain-vanilla bonds and have a higher cost of debt. Companies
issue subordinated bonds at a higher cost of debt due to bond covenants.
Question 120:
An analyst gathered the following information regarding Moon Traders:
Risk-free rate = 6%
Current market risk premium = 7%
Beta of stock = 1.4
The company has a capital structure that includes BB-rated bonds with five years to
maturity. The yield-to-maturity on a comparable BB-rated bond with a similar term to
maturity is 8%. Given that the company’s marginal tax rate is 40%, its weighted average
cost of capital is closest to:
12.66%
13.57%
11.40%
Rationale
Rationale
Cost of equity = 0.06 + (1.4 × 0.07) = 15.8%
WACC = (0.158 × 1/1.4) + (0.048 × 0.4/1.4) = 12.66%

Question 121:
An analyst using the CAPM to estimate a company's cost of equity has gathered the
following information:
 Risk-free rate = 3.5 percent
 Expected return on the market = 8.0 percent
 Company's common stock beta = 0.8
 Marginal tax rate for the company = 30 percent
The analyst's estimate of the cost of equity will be closest to:
5.0 percent.
7.1 percent.
9.9 percent.
Rationale
5.0 percent.
The calculation is as follows:

Rationale
7.1 percent.
Rationale
9.9 percent.

Answers: L1CF-TBB207-1412 - Medium Lesson 2: Costs of The Different Sources of Capital

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Lesson 2: Costs of the Different Sources of Capital

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Less than 4%.

More than 5%.

Between 4% and 5%.

Lesson 1: Cost of Capital

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Lesson 3: Topics in Cost of Capital Estimation

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Mega Associates wants to invest in a project in Elantica, an emerging country. It gathered

 Yield on Elantica’s dollar-denominated 10-year government bond = 12%

 Yield on a 10-year U.S. Treasury bond = 3.5%

 Annualized standard deviation of Elantica’s stock market = 34%

 Annualized standard deviation of Elantica’s dollar-denominated 10-year government

 Project’s beta = 1.3

 Expected return on the Elantican equity market = 11%

Country Cost of Equity

Country risk premium = (0.12 – 0.035) × (0.34 / 0.25) = 11.56%

Cost of equity = 0.06 + [1.3 × (0.11 – 0.06 + 0.1156)] = 27.528%

Lesson 3: Topics in Cost of Capital Estimation

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Lesson 1: Cost of Capital

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remain the same.

Lesson 3: Topics in Cost of Capital Estimation

Which of the following statements is false?

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None of the above

The first choice is incorrect. This is true based on Reading 36.

None of the above

The third choice is incorrect.

Lesson 3: Topics in Cost of Capital Estimation

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Lesson 2: Costs of the Different Sources of Capital

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0.108 = (1/1.8 × Cost of equity) + (0.8/1.8 × 0.056)

Cost of equity = 14.96%

Lesson 3: Topics in Cost of Capital Estimation

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Amount of After-Tax Amount of Cost of Equity

0–100 3.5% 0–200 6.5%

100–250 4.5% 200–400 7.5%

250–450 5.5% 400–600 8.5%

The company’s weighted average cost of capital is closest to:

Proportion of new equity raised = 550 (1 / 2.2) = $250

WACC = (0.055 × 1.2/2.2) + (0.075 × 1/2.2) = 6.4091%

Lesson 2: Costs of the Different Sources of Capital

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Rating Yield for 5- Yield for 10-Year Maturity

AAA 3.0 4.2 percent

AA 3.2 4.7 percent

A 3.5 5.3 percent

equal to the estimate using the YTM approach.

lower than the estimate using the YTM approach.

higher than the estimate using the YTM approach.

equal to the estimate using the YTM approach.

lower than the estimate using the YTM approach.

higher than the estimate using the YTM approach.

Lesson 3: Topics in Cost of Capital Estimation

Beta estimates are least likely sensitive to:

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The capital structure of the company.