Chapter 8

The Cost of Capital

236

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

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

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

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

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

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

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

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

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

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

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

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

kd. the cost of retained earnings.30)(0.T). .Chapter 8 The Cost of Capital 238 In other words. A firm going from a lower to a higher tax bracket could increase its use of debt. e. an exception to this rule occurs when the stock price increases just prior to the firm issuing new equity such that it more than offsets the flotation costs and thus. other things held constant.T)(0.70)(0. MULTIPLE CHOICE 1. the cost of new equity. d. Preferred stock. In general. 29. ke becomes less than ks. to be lower than ks. 25. 28. The cost of debt. 27. the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt. Long-term debt. the component cost of equity for a company which pays half of its earnings out as common dividends and half as preferred dividends should. yet actually wind up with a lower after-tax cost of debt.50). b. the closer the values of ks and ke are to one another. it is not possible for ke. Since 70 percent of preferred dividends received by a corporation is excluded from taxable income. Firms should use their weighted average cost of capital (WACC) when they are funding their capital projects with a variety of sources. since a firm cannot be 100% debt financed. 26. However. 30. theoretically. the weighted average cost of capital will always be greater than kd(1 . All of the above are considered capital components for WACC and capital budgeting purposes. Short-term debt.50) + ks(1 . The steeper the demand curve for a firm's stock. when the firm plans on using only debt or only equity to fund a particular project.T) will certainly be less than ks. However. Therefore. Which of the following is not considered a capital component for the purpose of calculating the weighted average cost of capital as it applies to capital budgeting? a. is always less than ks. Common stock. it should use the after-tax cost of the specific source of capital to evaluate that project. c. be Cost of equity = ks(0. so kd(1 .

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

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

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

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

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

000 in earnings. 25. e. then retained earnings will have two breakpoints. if a firm has $100. A firm facing a steep demand curve (that is. . d. loyal stockholders receive. including those of greater than and lesser than average risks. and stockholders want $50.000 of those earnings paid as dividends. c. d. All of the above are false. similar to the treatment of debt interest. None of the above is a correct answer. but the firm has to pay flotation costs when issuing new common stock. and occurs at the point where the cost of that capital type increases. d. 0 < ks < ke. ks > ke. because new stockholders are willing to accept a lower return and "pay their dues" before they start receiving the higher returns that existing.T).Chapter 8 The Cost of Capital 244 23. d. None of the above is a correct statement. an increase in the required return demanded by investors for a new bond issue. The bond-yield-plus-risk-premium approach to estimating a firm's cost of common equity involves adding a subjectively determined risk-premium to the market risk-free bond rate. using retained earnings to fund new projects for the firm. issuing preferred stock to institutional investors. Which of the following statements is most correct? a. Which of the following statements is correct? a. b. increased flotation costs associated with seasoned equity offerings. Then the firm's after-tax cost of debt will equal its before-tax cost of debt. ks. What is the relationship between the cost of retained earnings (internal equity). e. a steeply upward sloping WACC curve. 0 = ks < ke. high flotation costs) for new equity would likely also face. The reason that a cost of capital is assigned to retained earnings is because these funds are already earning a return in the business. b. the reason does not involve the opportunity cost principle. because preferred stock dividends are treated as fixed charges. because there is a real cost to retaining income (earnings) for reinvestment. is not paying taxes. at some point. e. and that this situation is expected to persist for a few years whether or not the firm uses debt financing. 26. c. Which of the following is least likely to lead to a break point in the marginal cost of capital schedule? a. Answers a and b are both correct. A breakpoint is based on the dollar value used of a specific type of capital. Thus. because they both represent essentially the same source of funds. c. decreased liquidity in money markets leading to lower selling prices for commercial paper. Suppose a firm is losing money and thus. b. One purpose of calculating the WACC is to have a singular cost of capital measure that can be applied to evaluate all of the firm's projects. ks = ke. Consider the discussions concerning the cost of common equity. The component cost of preferred stock is expressed as kps(1 . e. 24. b. c. because there is no "real" cost to the income that the firm decides to retain to reinvest in assets rather than payout to common stockholders as dividends. ke? a. and the cost of new common equity (external equity). so they must have the same cost.

7. Determine each point at which a break in the marginal cost of capital schedule occurs. 13. Allison can issue new common stock at a 15 percent flotation cost. Determine the cost of capital for each component in the intervals between the breaks. The current market price of the firm's stock is P0 = $28.8% b.45% c. the cost of external equity raised by issuing new common stock is above the cost of retained earnings.30% b.15% e. If a firm has been suffering accounting losses and is expected to continue suffering such losses (and therefore its tax rate is zero). e. d. 11. b.7% .3% e.9% d. c. what component cost of common equity will be built into the WACC for the last dollar of capital the company raises? a. Estimate the change in the cost of capital within each interval.000. the first break point in the MCC schedule must be associated with using up all available retained earnings and having to issue common stock. Which of the following steps is not necessary for calculating the marginal cost of capital schedule? a. and it will retain 40 percent of those earnings.00.9% c. What will Allison's marginal cost of equity capital (not the WACC) be if it must fund a capital budget requiring $600 in total new capital? a. the higher the growth rate relative to the dividend yield. it is possible that its after-tax component cost of preferred stock as used to calculate the WACC will be less than its after-tax component cost of debt. 28. c. None of the above is a correct statement. 11.Chapter 8 The Cost of Capital 245 27. Which of the following statements is correct? a. 12. Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent common equity. If Bouchard has a capital budget of $2. it is best to calculate the WACC on a before-tax basis.80% d. Make a list of all the break points. Moreover. Calculate the weighted averages of these component costs to obtain the WACCs in each interval. d. Bouchard Company's stock sells for $20 per share. the more the cost of external equity will exceed the cost of retained earnings. 15.000.000. and the common equity ratio is 60 percent. 14. 29. and its expected dividend growth rate is 6 percent.20. b.63% 30. Retained earnings for the coming year are expected to be $1. and the company would incur a flotation cost of 20 percent if it sold new common stock. 11. its last dividend was D0 = $2. e. 12. its last dividend (D0) was $1.000. The firm expects to earn $600 in after-tax income during the coming year. Normally. its growth rate is a constant 6 percent. Because we often need to make comparisons among firms that are in different income tax brackets. 9. Due to the way the MCC is constructed.

50% e. 6. 13. The firm's common equity ratio is 30 percent and it has no preferred stock outstanding.0% b. Its last dividend was $2. 9.000 at an interest rate of 7 percent.000.000. All of the company's potential projects are equally risky.77% b. which pays a $5 dividend each year.00% 34. Refer to Gulf Electric Company. SW Ink's preferred stock. The dividend growth rate is needed to compute kps.33% d. 10. What is GEC's cost of equity from newly issued stock? a. its growth rate is a constant 5 percent.29% e. If the firm has a capital budget of $1.94% d. 33. 12.66% c. None of the above is correct. and new stock would net the company $30 per share after flotation costs. What is the cost of preferred stock. its stock sells on the NYSE at a price of $35. 13. 8. 3. It can borrow unlimited amounts at an interest rate of 10 percent so long as it finances at its target capital structure.000 and the firm's payout ratio is 60 percent. and the company would incur a flotation cost of 15 percent if it sold new common stock. The company's marginal tax rate is 40 percent.00% . What is GEC's marginal cost of capital for evaluating the $300 million in capital projects and any others that might arise during the year? a. The firm can borrow up to $300. 13.20. 13. GEC's tax rate is 40 percent. and it expects to have $100 million of retained earnings this year.00% b. Assume now that GEC needs to raise $300 million in new capital. currently sells for $62. so not enough information is given to answer this question. which calls for 55 percent debt and 45 percent common equity.Chapter 8 The Cost of Capital 246 31.25% 32.77% c.66% d.78% b. 6.8% c. Your company's stock sells for $50 per share.00.76% c. its last dividend (D0) was $2. 9.50. what is the WACC for the last dollar of capital the company raises? a. its expected constant growth rate is 6 percent. Net income for the coming year is expected to be $500. any additional debt will have an interest rate of 9 percent.81% e. kps. 12. 12. that should be included in the computation of the SW Ink's weighted average cost of capital (WACC)? a. e. Your company's tax rate is 40 percent. 11. Gulf Electric Company Gulf Electric Company (GEC) uses only debt and equity in its capital structure.2% d. 3. Refer to Gulf Electric Company. GEC has two projects available: Project A has a cost of $200 million and a rate of return of 13 percent. while Project B has a cost of $125 million and a rate of return of 10 percent. 9. 4.

Refer to Byron Corporation.0 percent. is 40 percent debt and 60 percent common equity. 16. 14. what is the retained earnings break point?) a. If Byron issues new common stock. Refer to Byron Corporation. The company's earnings and dividends are growing at a constant rate of 5 percent.0% d. $17.6% e.500 36. What is the component cost of the equity raised by selling new common stock? a.4% c.0% .8% b. 10. the last dividend (D0) was $2. Assume (contrary to the situation in the question just above) that at one point along the marginal cost of capital schedule the component cost of equity is 18. What is the maximum amount of new capital that can be raised at the lowest component cost of equity? (In other words.000 e. 14. 15.0% b. Next year's net income is projected to be $21. and the current equilibrium stock price is $21.000. 35. $21.88. 18.0% .6% c. Refer to Byron Corporation.700 c.Chapter 8 The Cost of Capital 247 Byron Corporation Byron Corporation's present capital structure.4% e.00. Byron can raise all the debt financing it needs at 14. which is also its target capital structure. 13. and Byron's payout ratio is 30 percent. 17.600 b. $24. a 20 percent flotation cost will be incurred. 12.2% d. What is the weighted average cost of capital at that point? a. $12.400 d.0 percent. The firm's marginal tax rate is 40 percent. 37. 16. $14.

and its dividend payout ratio is 40 percent.2. 16. The firm's net income is expected to be $1 million. and the market risk premium is 5 percent. 16. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find ks. and sell for $1. and has a growth rate of 8 percent. sells for $27. 12. 13. 16.1% c. Refer to Rollins Corporation.6% e.9% 41. Flotation costs on new common stock total 10 percent. 13. 14. 16. 8. and 60 percent common equity.9% .6% b.2% 40. 16.00.1% c. 11. at par. 14.0% c. $100 preferred stock which pays a 12 percent annual dividend. The firm could sell. Rollins' beta is 1. 7. Its target capital structure is 20 percent debt. Refer to Rollins Corporation.1% c. What is Rollins' cost of retained earnings using the CAPM approach? a.0% d.6% b. Its bonds have a 12 percent coupon. What is the firm's cost of retained earnings using the DCF approach? a. 10. the risk-free rate is 10 percent. 13. 12. Refer to Rollins Corporation.0% b. What is Rollins' component cost of debt? a. 16. and the firm's marginal tax rate is 40 percent. What is Rollins' cost of preferred stock? a.000.0% d.0% d. a current maturity of 20 years. Refer to Rollins Corporation. 20 percent preferred stock. paid semiannually. 8. Rollins is a constant growth firm which just paid a dividend of $2. 9.0% e.Chapter 8 The Cost of Capital 248 Rollins Corporation Rollins Corporation is constructing its MCC schedule.00 per share.0% b. but flotation costs of 5 percent would be incurred. 38.6% d.6% e.2% 39.6% e. 10.

6% e.6% b. Refer to Rollins Corporation. What is Rollins' lowest WACC? a. $800. 13. 13. Refer to Rollins Corporation. 16.Chapter 8 The Cost of Capital 249 42. Refer to Rollins Corporation.200.000 c.000 d. 16. What is Rollins' retained earnings break point? a.400. 14. $1. What is Rollins' WACC once it starts using new common stock financing? a. 16.9% 44.000. $1.1% c. 16. $1.0% d. 16. What is Rollins' cost of retained earnings using the bond-yield-plus-risk-premium approach? a.000 e.6% b. 16.6% b. Refer to Rollins Corporation. 16.6% e. $600. 16.1% c.1% c.000 45.0% d.0% d.6% e. 14. 13.9% .000 b. 16.9% 43. 14.

5% d. Refer to Jackson Company.85% J. 10.0% 48.5% c. Ross expects to retain $15. and it expects this dividend to grow by 10 percent per year. Refer to J. 10. Refer to J.0% b. 18. 12. indefinitely. 10 percent preferred stock. Ross' common stock currently sells for $40 per share. and it can sell as much debt as it wishes at this rate.5% d.Chapter 8 The Cost of Capital 250 Jackson Company The Jackson Company has just paid a dividend of $3. 12. 10.5% c.25% b. 16. but the firm will net only $34 per share from the sale of new common stock.000 in earnings over the next year.0% .5% e. 47.00 per share on its common stock. 16. the risk-free rate is 10 percent. 46.5% e. and 50 percent common equity. What is the firm's cost of retained earnings? a.5% e. and the expected return on the market is 14 percent. The firm recently paid a dividend of $2 per share on its common stock.47% e. The firm's preferred stock currently sells for $90 a share and pays a dividend of $10 per share.0% b.32% c.5% c. Ross and Sons Inc. 15. 12. has a target capital structure that calls for 40 percent debt. The firm's investment bankers believe that new issues of common stock would have a flotation cost equal to 5 percent of the current market price. however. Ross and Sons Inc. 16. 18. and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year.0% 49.50.0% b. What will be Jackson's cost of new common stock if it issues new stock in the marketplace today? a.00% d.5% d. Refer to J. the firm will net only $80 per share from the sale of new preferred stock. 12. Ross and Sons Inc. 15. 15. 17. What is the firm's cost of newly issued common stock? a. 16. J. Ross and Sons Inc. 18. The firm's current after-tax cost of debt is 6 percent. 9. The firm has a beta of 1. Ross and Sons Inc. What is the firm's cost of newly issued preferred stock? a. 15.

Chapter 8 The Cost of Capital 251 50.000 e. Refer to J. 51.6% d. What will be the WACC above this break point? a. Where will a break in the WACC curve occur? a.3% c. Refer to J.000 b.000 c. 10. $20. $42. $10.9% e. $30. 8. 14.000 d. 11.5% b.1% . Ross and Sons Inc. There will be no breaks in the WACC curve. 12. Ross and Sons Inc.

Chapter 8 The Cost of Capital 236 .

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

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