Chapter 11

Financial Management: Core Concepts, 3e, GE (Brooks)
Chapter 11 The Cost of Capital
11.1 The Cost of Capital: A Starting Point
1) The ________ is the cost of each financing component multiplied by that component's percent of the
total funding amount.
A) NPV
B) IRR
C) cost of capital
D) cost of debt
Answer: C
Diff: 1
Topic: 11.1 The Cost of Capital: A Starting Point
AACSB: 3 Analytical Thinking
LO: 11.1 Understand the different kinds of financing available to a company: debt financing, equity financing, and
hybrid equity financing.
2) The cost of capital is ________.

A) the cost of debt in a firm that finances with both debt and equity
B) the cost of each financing component multiplied by that component's percent of the total borrowed
C) another name for the IRR
D) All of the above
Answer: B
Diff: 1
3) ________ refers to the way a company finances itself through some combination of loans, bond sales,
preferred stock sales, common stock sales, and retention of earnings.
A) Capital structure
B) Cost of capital
C) Working capital management
D) NPV
Answer: A
Diff: 1
Hmwrk Questions: * Taken from "Prepping for Exams" questions at the end of the chapter.
1
Copyright © 2016, Pearson Education, Ltd.
4) Which of the following is not considered a part of the firm's capital structure?
A) Long-term debt
B) Retained earnings
C) Inventory
D) Preferred stock
Answer: C
Diff: 1
5) A firm's capital structure can be determined by examining which parts of the firm's balance sheet?
A) The long-term assets
B) The debt and equity
C) The short-term assets and liabilities
D) None of the above because a firm's capital structure is best observed on the income statement.
Answer: B
Explanation: B) Long-term assets speak to the question of capital budgeting, short-term assets and
liabilities speak to net working capital decisions.
Diff: 1
6) Of the following, which is NOT a source of funds for a company?

A) Common shareholders
B) Commercial banks
C) Preferred stockholders
D) All are sources of funds for companies.
Answer: D
Diff: 1
2
7) Which of the following would be classified as debt lenders for a firm?
A) Preferred shareholders, banks, and nonbank lenders
B) Nonbank lenders, common shareholders, and commercial banks
C) Preferred shareholders, common shareholders, and suppliers
D) Suppliers, nonbank lenders, and commercial banks
Answer: D
Explanation: D) Preferred stockholders are hybrid equity lenders, common shareholders are owners, and
the rest of the choices may be considered a form of debt lender.
Diff: 2
8) Which of the following would be classified as equity financing for a firm?

A) Preferred shareholders, banks, and nonbank lenders
B) Nonbank lenders, common shareholders, and commercial banks
C) Preferred shareholders, common shareholders, and retained earnings
D) Suppliers, nonbank lenders, and commercial banks
Answer: C
Explanation: C) Bank and nonbank lenders, as well as suppliers, are sources of debt lending.
Diff: 2
9) When a company borrows money from a bank or sells bonds, it is called ________.
A) capital structure financing
B) stock financing
C) equity financing
D) debt financing
Answer: D
Diff: 1
10) Which of the items below is sometimes termed hybrid equity financing?
A) Retained earnings
B) Preferred stock
C) Callable bonds
D) Variable rate bonds
Answer: B
Diff: 1
3
11) Which of the statements below is NOT true?
A) Preferred stock is a form of hybrid equity financing.
B) Retained earnings are a form of hybrid equity financing.
C) Common stock is a form of equity financing.
D) Corporate bonds are a form of debt financing.
Answer: B
Explanation: B) Retained earnings are internal equity financing.
Diff: 1
12) The weighted average cost of capital is ________.

A) the average of the cost of each financing component, weighted by the proportion of each component
B) the cost of capital for the firm as a whole
C) made up of three financing components: the cost of debt, the cost of preferred stock, and the cost of
equity
D) All of the above
Answer: D
Diff: 2
13) Acme Supply Co. has a new project that will require the company to borrow $3,000,000. Acme has
made an agreement with three lenders for the needed financing. First National Bank will give $1,500,000
and wants 10% interest on the loan. Lockup Bank will give $1,000,000 and wants 12% interest on the loan.
Southern National Bank will give $500,000 and wants 13% interest on the loan. What is the weighted
average cost of capital for this $3,000,000?
A) 10.55%
B) 11.17%
C) 11.66%
D) 12.16%
Answer: B
Explanation: B) WACC = × 10% + × 12% + × 13% = 11.17%.
Diff: 2
4
14) Michigan Manufacturing Inc. (MM) has a new project that will require the company to borrow
$1,000,000. MM has made an agreement with three lenders for the needed financing. First National Bank
will give $500,000 and wants 9% interest on the loan. Key West Bank will give $300,000 and wants 11%
interest on the loan. Chase Bank will give $200,000 and wants 12% interest on the loan. What is the
weighted average cost of capital for this $1,000,000?
A) 10.67%
B) 10.20%
C) 10.00%
D) 9.67%
Answer: B
Explanation: B) WACC = × 9% + × 11% + × 12% = 10.20%.

Diff: 2
15) The choice of the borrowing proportion makes up the capital budgeting of the firm.
Answer: FALSE
Explanation: The choice of the borrowing proportion makes up the capital structure of the firm.
Diff: 1
16) When a company borrows from a bank or sells bonds, it is called equity financing.
Answer: FALSE
Explanation: When a company borrows from a bank or sells bonds, it is called debt financing.
Diff: 1
17) When a company "borrows" money from the owners by selling common stock or using internal funds,
it is called equity financing.
Answer: TRUE
Diff: 1
5
18) When estimating the cost of debt financing from bonds, a firm can use the yield-to-maturity as the
before-tax cost of debt.
Answer: TRUE
Diff: 1
19) The textbook labels preferred stock as "hybrid equity financing." Identify and explain the features of
preferred stock that give it the designation of "hybrid equity financing."
Answer: Preferred stock is identified as a hybrid equity security because even though it is equity, it has
features of debt as well. Like stock, it has no specific maturity and the principal is usually not repaid. Like
debt, preferred stock does not ordinarily have voting rights but under certain conditions it may be
converted to common stock. Preferred stock's annual dividend at a set rate is like the coupon payments
on a bond.
Diff: 1
11.2 Components of the Weighted Average Cost of Capital
1) In capital budgeting, the ________ is the appropriate discount rate to use when calculating the NPV of
an average risk project.
A) WACC
B) IRR
C) cost of debt
D) cost of Equity
Answer: A
Diff: 1
Topic: 11.2 Components of the Weighted Average Cost of Capital
LO: 11.2 Understand the debt and equity components of the weighted average cost of capital (WACC) and explain
the tax implications on debt financing and the adjustment to the WACC.
2) In capital budgeting, the appropriate decision rule for an average-risk project is to accept if the
________ is greater than the WACC.
A) NPV
B) IRR
C) cost of equity
D) cost of debt
Answer: B
Diff: 1
6
3) The ________ is the return that the bank or bondholder demands on new borrowing.
A) IRR
B) WACC
C) cost of equity
D) cost of debt
Answer: D
Diff: 1
4) The cost of debt could be which of the following?

A) The required return on money borrowed as a long-term loan from a bank
B) The required return on money borrowed from a venture capitalist
C) The yield-to-maturity on money raised by selling bonds
D) All of the choices above could be considered the cost of debt.
Answer: D
Diff: 2
5) Which of the following would NOT be considered a cost of debt financing?

A) The required return on a bank loan
B) The required return on preferred stock
C) The yield-to-maturity of a bond issue
D) The required return on money borrowed from a venture capitalist
Answer: B
Diff: 2
7
6) Your firm has just issued a 20-year $1,000.00 par value, 10% annual coupon bond for a net price of
$964.00. What is the yield to maturity? Use a financial calculator to determine your answer.
A) 10.60%
B) 11.10%
C) 10.44%
D) 10.16%
Answer: C
Explanation: C)
Mode = P/Y = 1; C/Y = 1
Input 20 ? -964 100 1,000
Key N I/Y PV PMT FV
CPT 10.44%
Note that APR = EAR.
Diff: 2
7) Your firm has just issued a 20-year $1,000.00 par value, 6% coupon semiannual bond for a net price of
$964.00. What is the yield to maturity? Use a financial calculator to determine your answer.
A) 3.16%
B) 7.33%
C) 6.32%
D) 6.00%
Answer: C
Explanation: C)
Mode = P/Y = 2; C/Y = 2
Input 40 ? -964 30 1,000
Key N I/Y PV PMT FV
CPT 6.32%
Diff: 3
8
8) Your firm has issued a 10-year $1,000.00 par value semiannual 10% coupon bond that sells for $1,000 in
the market place. The proceeds from the sale of the bond issue are $975.00 per bond. What is your firm's
yield to maturity on this new bond issue? Use a financial calculator to determine your answer.
A) 5.15%
B) 10.16%
C) 10.30%
D) 10.41%
Answer: D
Explanation: D)
Mode = P/Y = 2; C/Y = 2
Input 20 ? -975 50 1,000
Key N I/Y PV PMT FV
CPT 10.41%
Diff: 3
9) A/An ________ facilitates the issuing and sale of bonds and for this service is paid a fee.
A) commercial banker
B) investment banker
C) dealer
D) broker
Answer: B
Diff: 1
10) An investment banker's fees are part of the ________ realized for issuing new debt or equity.
A) flotation costs
B) opportunity costs
C) revenues
D) benefits
Answer: A
Diff: 1
9
11) Pricing preferred stock is most similar to pricing ________.
A) constant growth common stock
B) a perpetuity
C) a zero-coupon bond
D) a three-month Treasury bill
Answer: B
Diff: 1
12) Your firm has preferred stock outstanding that pays a current dividend of $3.00 per year and has a
current price of $39.50. You anticipate that the economy will grow steadily at a rate of 3.00% per year for
the foreseeable future. What is the market required rate of return on your firm's preferred stock?
A) 10.82%
B) 10.59%
C) 7.59%
D) There is not enough information to answer this question.
Answer: C
Explanation: C) Rps = = = 7.59%.
Note: the growth rate in the economy is a red herring and has no bearing on the answer.
Diff: 3
13) Your firm has preferred stock outstanding that pays a current dividend of $2.00 per year and has a
current price of $21.50. Currently, preferred stock makes up approximately 15% of your firm's long-term
financing. What is the market required rate of return on your firm's preferred stock?
A) 8.70%
B) 9.00%
C) 9.30%
D) 15.00%
Answer: C
Explanation: C) Rps = = = 9.30%.
Diff: 3
10
14) The riskiness of a future cash flow is measured by ________ , and these are all components of the
SML.
A) the firm's standard deviation, correlation, and the market risk premium
B) beta, the market risk premium, and the firm's standard deviation
C) the market risk premium, beta, and correlation
D) beta, the market risk premium, and the risk-free rate
Answer: D
Diff: 2
15) Use the security market line to determine the required rate of return for the following firm's stock.
The firm has a beta of 1.25, the required return in the market place is 10.50%, the standard deviation of
returns for the market portfolio is 25.00%, and the standard deviation of returns for your firm is also
25.00%.
A) 13.13%
B) 10.50%
C) 31.25%
Answer: D
Explanation: D) Re = E(ri) = rf + [E(rm) - rf] βi.
This problem lacks information about the risk-free rate of return, and so we cannot solve for R e.
Diff: 3
16) Use the security market line to determine the required rate of return for the following firm's stock.
The firm has a beta of 0.80, the required return in the market place is 12.50%, and the risk-free rate of
return is 3.50%.
A) 13.50%
B) 10.70%
C) 7.20%
D) 2.80%
Answer: B
Explanation: B) Re = Rf + β × (Rm - Rf) = 3.50% + 0.80 × (12.50% - 3.50%) = 10.70%.
Diff: 3
11
17) Which of the following is an advantage of the dividend growth approach over the SML in estimating
the required return on equity?
A) The dividend growth model uses market information but the SML does not.
B) Dividend growth is known, whereas estimating beta for the SML is an art form.
C) It is easy to fit flotation costs into the dividend growth model but not the SML.
D) All are advantages of the dividend growth model for estimating the required return on equity.
Answer: C
Explanation: C) The dividend growth model solves for Re via Re = + g, but the SML has no
obvious method to adjust for flotation costs.

Diff: 2
18) Use the dividend growth model to determine the required rate of return for equity. Your firm intends
to pay a dividend of $1.50 per share one year from today. Further, the recent stock price is $31.82 per
share, and you anticipate a growth rate in dividends of 4.00% per year for the foreseeable future.
A) 8.90%
B) 8.71%
C) 9.09%
Answer: B
Explanation: B) Re = + g = Re = + 0.04 = 8.71%.
Diff: 3
19) Use the dividend growth model to determine the required rate of return for equity. Your firm recently
paid a dividend of $2.25 per share, has a recent price of $40.20 per share, and anticipates a growth rate in
dividends of 3.00% per year for the foreseeable future.
A) 8.76%
B) 8.60%
C) 8.44%
Answer: A
Explanation: A) Re = + g = Re = $2.25 ∗ (1.03)/$40.20 + 0.03 = 8.76%.
Diff: 3
12
to issue new common stock. Your investment bankers have determined that the stock should be offered
at a price of $45.00 per share and that you should anticipate paying a dividend of $1.50 in one year. If you
anticipate a constant growth in dividends of 3.50% per year and the investment banking firm will take
7.00% per share as flotation costs, what is the required rate of return for this issue of new common stock?
A) 7.19%
B) 6.83%
C) 7.08%
Answer: C
Explanation: C) Re = +g= + 0.035 = 0.03584 + 0.035 ≈ 7.08%.
Diff: 3
to issue new common stock. Your investment bankers have determined that the stock should be offered
at a price of $20.00 per share and that you should anticipate paying a dividend of $0.75 in one year. If you
anticipate a constant growth in dividends of 3.00% per year and the investment banking firm will take
8.00% per share as flotation costs, what is the required rate of return for this issue of new common stock?
A) 6.83%
B) 7.08%
C) 7.19%
D) 10.20%
Answer: B
Explanation: B) Re = +g= + 0.0300 = 0.04076 + 0.0300 ≈ 7.08%.
Diff: 3
13
22) The cost of retained earnings ________.
A) is the loss of the dividend option for the owners
B) is the cost of issuing new common stock without the flotation costs
C) is the appropriate cost of capital for the shareholders
D) All of the above
Answer: D
Explanation: D) Retained earnings are the portion of net income not paid out as dividends. Because the
funds are kept by the firm, the managers have an obligation to meet the opportunity costs of the
shareholders so the cost of retained earnings should be considered the cost of raising new equity without
any additional flotation costs.
Diff: 2
23) When calculating the after-tax weighted average cost of capital (WACC), which of the following costs
is adjusted for taxes in the equation?
A) The before-tax cost of equity
B) The before-tax cost of debt
C) The before-tax cost of preferred stock
D) The after-tax cost of debt
Answer: B
Explanation: B) WACCadj = × Rd × (1 - Tc) + × Rps + × Re.
Diff: 1
24) Which of the following are tax-deductible expenses for corporations?

A) Interest expenses
B) Preferred stock dividends
C) Common stock dividends
D) All are tax-deductible for corporations.
Answer: A
Diff: 1
14
25) Which of the following is the proper way to adjust the cost of debt to estimate the after-tax cost of
debt?
A) Rd ÷ (1 + Tc)
B) Rd ÷ (1 - Tc)
C) Rd × (1 - Tc)
D) Rd × (1 + Tc)
Answer: C
Diff: 1
26) For estimating NPV, the IRR is the appropriate discount rate to use for an average-risk project.
Answer: FALSE
Explanation: For estimating NPV, the WACC is the appropriate discount rate to use for an average-risk
project.
Diff: 1
27) When evaluating an average-risk project using IRR, a firm should use the WACC as the hurdle rate.
Answer: TRUE
Diff: 1
28) Flotation costs reduce the cost of borrowing funds for the firms.
Answer: FALSE
Explanation: Flotation costs INCREASE the cost of borrowing funds for the firms.
Diff: 1
29) When determining the cost of bond financing a firm must determine the net proceeds from the sale of
the bond less the flotation cost charged by the investment banker to estimate the yield-to-maturity.
Answer: TRUE
Diff: 1
15
30) Two techniques for determining the cost of equity include using:
1. The Security Market Line, and 2. The Internal Rate of Return.
Answer: FALSE
Explanation: Two techniques for determining the cost of equity include using:
1. The Security Market Line, and 2. The Dividend Growth Model.
Diff: 1
31) It is easier to incorporate the impact of flotation costs on the cost of equity capital in using the
dividend growth model rather than the Security Market Line.
Answer: TRUE
Diff: 2
32) The cost of retained earnings is the cost of issuing new common stock without flotation costs.
Answer: TRUE
Diff: 1
33) To find the after-tax cost of debt for a corporation, one needs to multiply the before-tax cost of debt by
(1 + Tc), where Tc = the corporate tax rate.
Answer: FALSE
Explanation: To find the after-tax cost of debt for a corporation, one needs to multiply the before-tax cost
of debt by (1 - Tc), where Tc = the corporate tax rate.
Diff: 2
16
34) Theo has been assigned the task of determining the cost of capital for his division of the firm. His first
step is to determine the cost of debt. The firm has $1,000 par value bonds outstanding that have an annual
coupon rate of 8.00% and make semiannual payments. These bonds have twenty-three years remaining to
maturity and currently sell for $1,133.42. What is the yield-to-maturity on these bonds? Use a financial
calculator to determine your answer.
Answer: Mode = P/Y = 2; C/Y = 2
Input 46 ? -1,133.42 40 1,000
Key N I/Y PV PMT FV
CPT 6.84%
Diff: 2
35) Define flotation costs and explain how they are used when estimating a firm's yield-to-maturity.
Answer: Flotation costs are the costs incurred to sell a security. They are the fees charged by the
investment banker to facilitate the issuance and sale of the bond. To determine the yield-to-maturity of a
new issue of bonds, it is proper to use the bond selling price less the flotation cost as the net proceeds to
the firm. The net proceeds become the price used in the equation to determine the yield-to-maturity.
Diff: 2
36) Phillip Enterprises Inc. needs to determine its cost of equity capital. Use the following information to
estimate the firm's cost of equity using both the security market line and the dividend growth model. The
current market price of stock is $22.89, the risk-free rate is 4.00%, the required return on the market
portfolio is 13.50%, the firm has a constant growth rate in dividends of 3.00% per year, current dividends
are $2.00, and the firm's beta is 0.90.
Answer: For the dividend growth model, Re = +g= + .03 = 12.00%
For the SML, E(ri) = rf + [E(rm) - rf] βi = 0.04 + (.135 - .04) × 0.90 = 12.55%.
At this point, the student may choose either answer or to average the two answers.
Diff: 3
17
11.3 Weighting the Components: Book Value or Market Value?
1) The ________ of an asset or liability is its cost carried on the balance sheet.
A) market value
B) book value
C) hybrid value
D) theoretical value
Answer: B
Diff: 1
Topic: 11.3 Weighting the Components: Book Value or Market Value?
LO: 11.3 Calculate the weights of the components using book values or market values.
2) Elway Electronics has debt with a market value of $350,000, preferred stock with a market value of
$150,000, and common stock with a market value of $450,000. If debt has a cost of 8%, preferred stock a
cost of 10%, common stock a cost of 12%, and the firm has a tax rate of 30%, what is the WACC?
A) 8.64%
B) 9.12%
C) 9.33%
D) 9.46%
Answer: C
Explanation: C) WACC = × Rd × (1 - Tc) + × Rps + × R e.
WACC = × 8% × (1 - .30) + × 10% + × 12% = 9.33%.
Diff: 2
3) Rogers' Rotors has debt with a market value of $250,000, preferred stock with a market value of
$50,000, and common stock with a market value of $750,000. If debt has a cost of 7%, preferred stock a
cost of 9%, common stock a cost of 13%, and the firm has a tax rate of 30%, what is the WACC?
A) 8.64%
B) 9.12%
C) 9.33%
D) 10.88%
Answer: D
Explanation: D) WACC = × Rd × (1 - Tc) + × Rps + × R e.
WACC = × 7% × (1 - .30) + × 9% + × 13% = 10.88%.

Diff: 2
18
4) The following information comes from the balance sheet of Roamer Enterprises. The value of common
stock is $60,000, retained earnings equal $40,000, total common equity equals $100,000, preferred stock
has a value of $10,000 and long-term debt totals $120,000. For purposes of estimating the firm's WACC,
what are the weights of long-term debt, preferred stock, and equity?
A) D/V = 52.17%, PS/V = 43.48%, and E/V = 4.35%
B) D/V = 52.17%, PS/V = 4.35%, and E/V = 43.48%
C) D/V = $120,000, PS/V = $10,000, and E/V =$100,000
Answer: B
Explanation: B) D/V = $120,000/$230,000 = 52.17%, P/V = $10,000/$230,000 = 4.35%,
E/V = $100,000/$230,000 = 43.48%.
Diff: 2
5) The following information comes from the Galaxy Construction balance sheet. The value of common
stock is $10,000, retained earnings equals $7,000, total common equity equals $17,000, preferred stock has
a value of $3,000, and long-term debt totals $15,000. If the cost of debt is 8.00%, preferred stock has a cost
of 10.00%, common stock has a cost of 12.00%, and the firm has a corporate tax rate of 30%, calculate the
firm's WACC adjusted for taxes.
A) 10.11%
B) 10.00%
C) 9.09%
Answer: C
Explanation: C) WACCadj = × Rd × (1 - Tc) + × Rps + × R e.
WACCadj = × 8% × (1 - .30) + × 10% + × 12% = 9.09%.
Diff: 3
19
6) The following market information was gathered for the ACME corporation. The common stock is
selling for $40.00 per share and there are 100,000 shares outstanding. Retained earnings equal $400,000,
preferred stock has 1,000 shares outstanding selling at $120.00 per share, and 500 outstanding long-term
bonds are selling for $1,035.00 each. For purposes of estimating the firm's WACC, what are the market
value weights of long-term debt, preferred stock, and equity?
A) D/V = 11.16%, PS/V = 2.59%, and E/V = 86.25%
B) D/V = 10.27%, PS/V = 2.38%, and E/V = 87.34%
C) D/V = 10.78%, PS/V = 3.08%, and E/V = 86.14%
D) D/V = 33.33%, PS/V = 33.33%, and E/V = 33.33%
Answer: A
Explanation: A) E = $40 × 100,000 shares = $4,000,000, P = $120 × 1,000 shares = $120,000, D = $1,035 × 500
bonds = $517,500. E/V = $4,000,000/$4,637,500 = 86.25%, P/V = $120,000/$4,637,500 = 2.59%, D/V =
$517,500/$4,637,500 = 11.16%.
Diff: 3
7) The following market information was gathered for the Blender Corporation. The firm has 1,000 bonds
outstanding, each selling for $1,100.00 with a required rate of return of 8.00%. Blenders has 5,000 shares of
preferred stock outstanding, selling for $40.00 per share and 50,000 shares of common stock outstanding,
selling for $18.00 per share. If the preferred stock has a required rate of return of 11.00% and the common
stock requires a 14.00% return, and the firm has a corporate tax rate of 30%, calculate the firm's WACC
adjusted for taxes.
A) 6.77%
B) 10.73%
C) 9.53%
D) There is not enough information to answer this question because there is no information provided
about the amount of retained earnings held by the firm.
Answer: C
Explanation: C) E = $18 × 50,000 shares = $900,000, PS = $40 × 5,000 shares = $200,000, D = $1,100 × 1,000
bonds = $1,100,000.
E/V = $900,000/$2,200,000 = 0.40909, P/V = $200,000/$2,200,000 = 0.0909, D/V = $1,100,000/$2,200,000 = 0.5.
WACC = × Rd × (1 - Tc) + × Rps + × Re = 0.5 × 8% × (1 - 0.30) + 0.0909 × 11% + 0.40909 × 14% =
9.53%.
Diff: 3
20
8) Market values require multiplying the ________ of each component source of capital by the ________.
A) price; quantity
B) book value; quantity
C) price; book value
D) None of the above
Answer: A
Diff: 1
9) Investors ________ for estimating the WACC.

A) are indifferent between using market and book value
B) prefer book value to market value
C) prefer market value to book value
D) prefer a mix of book and market value
Answer: C
Diff: 1
10) Generally speaking, when the information is available, investors prefer to use ________ rather than
________ when evaluating a firm.
A) past data; current data
B) market values; book values
C) current data; market values
D) book values; market values
Answer: B
Diff: 1
11) The formula for the adjusted WACC = × Rd + × Rps + × Re × (1 - Tc).
Answer: FALSE
Explanation: The formula for the adjusted WACC = × Rd × (1 - Tc) + × Rps + × R e.

Diff: 2
21
12) To estimate the market value of a publicly traded bond that has a broad market with frequent trading,
it is usually best to multiply the number of bonds outstanding by the bond par value.
Answer: FALSE
Explanation: To estimate the market value of a publicly traded bond that has a broad market with
frequent trading, it is usually best to multiply the number of bonds outstanding by the bond market
price.
Diff: 2
13) When possible, investors and analysts prefer to use book value to market value for estimating the
WACC.
Answer: FALSE
Explanation: When possible, investors and analysts prefer to use MARKET value to BOOK value for
estimating the WACC.
Diff: 2
14) Equity is an attractive form of financing for a firm because it has additional tax advantages for the
firm compared to debt.
Answer: FALSE
Explanation: DEBT is an attractive form of financing for a firm because it has additional tax advantages
for the firm compared to EQUITY.
Diff: 2
15) When estimating a weighted average cost of capital, a firm can use either book values or market
values for estimating the value of the component sources of capital. Where would you find book values,
and what value do they represent? How would you calculate market values? In general, would you
prefer to use market or book values for estimating the WACC? Under what circumstances would you use
book values?
Answer: Book values for debt and equity are found on a firm's balance sheet and represent historical
costs. Market values are calculated by multiplying the market price of the debt by the number of
outstanding bonds and multiplying the number of outstanding shares of stock by the current market
price. Market values represent the market's best estimate of the current value of future cash flows to be
realized from owning debt or equity. In general we prefer to use market values because they are forward-
looking rather than historical in nature. However, market values may not be available for privately held
firms or for very small companies and then book value becomes the only practical, although inaccurate,
alternative.
Diff: 2
22
11.4 Using the Weighted Average Cost of Capital in a Budgeting Decision
1) Your firm has an average-risk project under consideration. You choose to fund the project in the same
manner as the firm's existing capital structure. If the cost of debt is 9.00%, the cost of preferred stock is
12.00%, the cost of common stock is 16.00%, and the WACC adjusted for taxes is 14.00%, what is the NPV
of the project, given the expected cash flows listed here?
Category T0 T1 T2 T3
Investment -$2,000,000
NWC -$250,000 $250,000
Operating Cash Flow $850,000 $850,000 $850,000
Salvage $50,000
Total Incremental Cash Flow -$2,250,000 $850,000 $850,000 $1,150,000
A) -$74,121
B) $499,604
C) $2,175,879
D) $2,479,604
Answer: A
Explanation: A) In this problem we have divided the T3 payment into two parts to facilitate ease of
calculation. NPV = PV of cash inflows - the initial investment.
PMT = $850,000, FV = $1,150,000 - $850,000, N = 3, I% = 14.00%. PV = $2,175,879. Then, NPV = $2,175,879 -
$2,250,000 = -$74,121.
Diff: 3
Topic: 11.4 Using the Weighted Average Cost of Capital in a Budgeting Decision
LO: 11.4 Explain how the capital budgeting models use WACC.
23
12.00%, the cost of common stock is 16.00%, and the WACC adjusted for taxes is 14.00%, what is the IRR
of the project given the expected cash flows listed here? Use a financial calculator to determine your
answer.
NWC -$250,000 $250,000
Salvage $50,000
A) About 12.13%
B) About 14.00%
C) About 24.95%
Answer: A
Explanation: A) In this problem we have divided the T3 payment into two parts to facilitate ease of
calculation. To solve for the IRR, input the following values:
PMT = $850,000, FV = $300,000, N = 3, PV = -$2,250,000, and solve for I% to get the IRR = 12.125% or
"about 12.13%."
Diff: 3
24
Investment -$800,000
NWC -$50,000 $50,000
Salvage $20,000
Total Incremental Cash Flow -$850,000 $350,000 $350,000 $420,000
A) $1,150,904
B) $898,415
C) $300,904
D) $48,415
Answer: D
Explanation: D) NPV = PV of cash inflows - the initial investment.
PMT = $350,000, FV = $420,000 - $350,000, N = 3, I% = 11.50%. PV = $898,415. Then, NPV = $898,415 -
$850,000 = $48,415.
Diff: 3
25
of the project, given the expected cash flows listed here? Use a financial calculator to determine your
answer.
Investment -$800,000
NWC -$50,000 $50,000
Salvage $20,000
Total Incremental Cash Flow -$850,000 $350,000 $350,000 $420,000
A) About 11.50%
B) About 28.30%
C) About 14.67%
Answer: C
Explanation: C) To solve for the IRR, input the following values: PMT = $350,000, FV = $70,000, N = 3, PV
= -$850,000, and solve for I% to get the IRR = 14.666% or "about 14.67%."
Diff: 3
26
NWC -$350,000 $350,000
Salvage $50,000
A) -$917,930
B) -$293,289
C) $0
D) $126,471
Answer: A
Explanation: A) NPV = PV of cash inflows - the initial investment.
PMT = $950,000, FV = $1,350,000 - $950,000, N = 3, I% = 15.00%. PV = $2,432,070. Then,
NPV = $2,432,070 -$ 3,350,000 = -$917,930.
Diff: 3
27
of the project, given the expected cash flows listed here? Use a financial calculator to determine your
answer.
NWC -$350,000 $350,000
Operating Cash Flow $1,200,000 $1,200,000 $1,200,000
Salvage $50,000
Total Incremental Cash Flow -$3,350,000 $1,200,000 $1,200,000 $1,600,000
A) About 13.11%
B) About 12.02%
C) About 11.16%
D) About 8.94%
Answer: D
Explanation: D) To solve for the IRR, input the following values: PMT = $1,200,000, FV = $400,000, N = 3,
PV = -$3,350,000, and solve for I% to get the IRR = 8.943%, or "about 8.94%."
Diff: 3
7) If all projects are assigned the same discount rate for purposes of evaluation, which of the following
could occur?
A) Low-risk projects could be rejected when in fact they are good investment choices.
B) High-risk projects could be accepted when in fact they are poor investment choices.
C) High-risk projects could be accepted when in fact they are good investment choices.
D) All of the choices could occur when using a single discount rate for all projects.
Answer: D
Diff: 2
8) It is necessary to assign the appropriate cost of capital for each individual project that reflects that
project's ________ when doing capital budgeting.
A) life
B) cash flows
C) riskiness
D) managers
Answer: C
Diff: 1
28
9) Takelmer Industries has a different WACC for each of three types of projects. Low-risk projects have a
WACC of 8.00%, average-risk projects a WACC of 10.00%, and high-risk projects a WACC of 12%. Which
of the following projects do you recommend the firm accept?
Project Level of Risk IRR

A Low 9.50%
B Average 8.50%
C Average 7.50%
D Low 9.50%
E High 14.50%
F High 17.50%
G Average 11.50%
A) A, B, C, D, G
B) B, C, E, F, G
C) A, D, E, F, G,
D) A, B, C, D, E, F, G
Answer: C
Diff: 2
10) Johnson's Diner has an adjusted WACC of 10.08%. The company has a capital structure consisting of
70% equity and 30% debt, a cost of equity of 12.00%, a before-tax cost of debt of 8.00%, and a tax rate of
30%. Johnson is considering expanding by building a new diner in a distant city and considers the project
to be riskier than his current operation. He estimates his existing beta to be 1.0, the required return on the
market portfolio to be 12.00%, the risk-free rate to be 3.00%, and the beta for the new project to be 1.40.
Given this information, and assuming the cost of debt will not change if Johnson undertakes the new
project, what adjusted WACC should he use in his decision-making?
A) 10.08%
B) 12.60%
C) 13.32%
D) 14.16%
Answer: B
Explanation: B) Re = E(ri) = rf + [E(rm) - rf] βi = 3.00% + [12.00% - 3.00%] × 1.4 = 15.60%.
WACC = × Rd × (1 - Tc) + × Re = 0.30 × (8.00%) × (1 - .30) + 0.70 × (15.60%) = 12.60%.

Diff: 3
29
11) Acme Business Connections (ABC) has an adjusted WACC of 8.56%. The company has a capital
structure consisting of 60% equity and 40% debt, a cost of equity of 11.00%, a before-tax cost of debt of
7.00%, and a tax rate of 30%. ABC is considering expanding by building a new shop in a distant city and
considers the project to be riskier than the current operation. ABC has an existing beta of 1.0, the required
return on the market portfolio to be 11.00%, the risk-free rate to be 3.00%, and the beta for the new project
to be 1.30. Given this information, and assuming the cost of debt will not change if ABC undertakes the
new project, what adjusted WACC should be used in decision-making?
A) 8.56%
B) 9.84%
C) 10.00%
D) 11.24%
Answer: C
Explanation: C) Re = E(ri) = rf + [E(rm) - rf] βi = 3.00% + [11.00% - 3.00%] × 1.3 = 13.40%.
WACC = × Rd × (1 - Tc) + × Re = 0.40 × (7.00%) × (1 - .30) + 0.60 × (13.40%) = 10.00%.

Diff: 3
12) The adjusted WACC is the correct discount rate to use when evaluating a firm's average-risk projects.
Answer: TRUE
Diff: 1
13) Using the WACC to evaluate all projects has the effect of making low-risk projects look MORE
attractive and high-risk projects look LESS attractive.
Answer: FALSE
Explanation: Using the WACC to evaluate all projects has the effect of making low-risk projects look
LESS attractive and high-risk projects look MORE attractive.
Diff: 1
14) You have learned how to use NPV and IRR to evaluate projects as part of a capital budgeting
decision-making process. How is WACC used in each of these capital-budgeting processes?
Answer: When calculating the NPV of a project, the WACC is the appropriate required rate of return if
the project is of average risk. It is also the starting point for making subjective adjustments to the required
rate of return for projects of greater or lesser risk than average. When calculating the IRR, the WACC is
the appropriate hurdle rate for determining if a project meets the investment criteria.
Diff: 2
30
15) Using the WACC to evaluate all projects may lead managers into accepting high-risk projects that do
not compensate adequately for risk and into rejecting low-risk projects that compensate fully for the level
of risk but may not have particularly high rates of return. Describe the situations when using a WACC is
not appropriate and how these incorrect decisions may be made.
Answer: If managers could estimate the beta for every project and thereby a required rate of return for
every project, then the capital budgeting process would always lead to good decision-making. Higher-
risk projects would have a higher required return and lower-risk projects would have a lower required
return. But assigning a "one-size-fits-all" WACC to every project could lead a manager to accept a project
that has an IRR that is greater than the WACC (i.e., a positive NPV) but that is lower than its true
required rate of return. Conversely, a manager might reject a low-risk project with an acceptable return
for that level of risk because the IRR is less than the WACC (implying a negative NPV). In that case, the
WACC would be a value that is too high to correctly evaluate the lower-risk project.
Diff: 2
31
16) Michigan Industries has three projects under consideration. Project L is a lower-than-average-risk
project, project A is an average-risk project, and project H is a higher-than-average-risk project. You have
gathered the following information to determine if one or more of these projects has an acceptable rate of
return for the firm.
• Sources of financing 50% debt and 50% equity

• Rd = 8.00% before taxes
• Tax Rate = 30%
• Average beta for Michigan Industries = 1.0
• Rm = 13.00%
• Rf = 4.00%
• Adjusted WACC = 9.30%
• Beta for project L = 0.80, for project A = 1.00, and for project H = 1.20
• IRRL = 9.00%, IRRA = 10.00%, and IRRH = 11.00%
Calculate the required rate of return for each project and determine which, if any, projects are acceptable
to the firm.
Answer: Adjusted WACC for each project:
For project L, Re = Rf + β × (Rm - Rf) = 4.00% + 0.80 × (13.00% - 4.00%) = 11.20%
RL = 8.00% × (.50) × (1 -.30) + 11.20% × (.50) = 8.40%
IRRL = 9.00% is greater than RL = 8.40%. Therefore, this is an acceptable project.
For project A, Re = Rf + β × (Rm - Rf) = 4.00% + 1.00 × (13.00% - 4.00%) = 13.00%

RA = 8.00% × (.50) × (1 -.30) + 13.00% × (.50) = 9.30%
IRRA = 10.00% is greater than RA = 9.30%. Therefore, this is an acceptable project.
For project H, Re = Rf + β × (Rm - Rf) = 4.00% + 1.20 × (13.00% - 4.00%) = 14.80%

RH = 8.00% × (.50) × (1 -.30) + 14.80% × (.50) = 10.20%
IRRH = 11.00% is greater than RH = 10.20%. Therefore, this is an acceptable project.
Diff: 3
11.5 Selecting Appropriate Betas for Projects
1) The appropriate capital budgeting decision rule is ________.

A) to accept projects with an NPV greater than $0
B) to reject projects with an IRR greater than the required rate of return
C) to reject projects with an NPV greater than $0
D) to reject projects with an IRR greater than the required payback period
Answer: A
Diff: 1
Topic: 11.5 Selecting Appropriate Betas for Projects
LO: 11.5 Determine a project's beta and its implications in capital budgeting problems.
32
2) Clearinghouse Publications is adding a new magazine project to the company portfolio and has the
following information: the expected market return is 12%, the risk-free rate is 4%, and the expected return
on the new project is 20%. What is the beta of the project?
A) 1.00
B) 1.50
C) 1.75
D) 2.00
Answer: D
Explanation: D) This problem requires the student to rearrange the SML equation; it is not specifically
covered in the text.
Re = rf + [E(rm) - rf] β, and therefore, β = = = 2.00.
Diff: 2
3) Penney Fashions is adding a new line of shoes to the company portfolio and has the following
information: the expected market return is 13%, the risk-free rate is 3%, and the expected return on the
new project is 11%. What is the beta of the project?
A) 0.60
B) 0.70
C) 0.80
D) 0.90
Answer: C
Explanation: C) This problem requires the student to rearrange the SML equation; it is not specifically
covered in the text.
Re = rf + [E(rm) - rf] β, and therefore, β = = = 0.80.
Diff: 2
4) Under which of the following circumstances is the pure play method of estimating a project's beta
particularly useful?
A) The firm is looking to expand its current business operations, doing essentially the same work.
B) The firm is looking to expand its current business operations into a brand new area unlike any of its
internal projects.
C) The firm is looking to expand its current business operations. The work will be essentially the same as
current operations but there is no obvious outside provider of the same service or product.
D) The pure play method works equally effectively under each and all of these scenarios.
Answer: B
Diff: 2
33
5) ________ refers to a method of matching a single project of a company to another company with a
single business focus in an effort to assign an appropriate level of risk to the project.
A) Ghosting
B) Pure play
C) Outside assignment
D) Subjective assignment
Answer: B
Diff: 1
6) Richard works for a firm that is expanding into a completely new line of business. He has been asked
to determine an appropriate WACC for an average-risk project in the expansion division. Richard finds
two publicly traded stand-alone firms that produce the same products as his new division. The average of
the two firms' betas is 1.25. Further, he determines that the expected return on the market portfolio is
13.00% and the risk-free rate of return is 4.00%. Richard's firm finances 50% of its projects with equity and
50% with debt, and has a before-tax cost of debt of 9% and a corporate tax rate of 30%. What is the WACC
for the new line of business?
A) About 12.64%
B) About 13.00%
C) About 10.78%
D) About 11.29%
Answer: C
Explanation: C) Re = rf + [E(rm) - rf] β = 4% + (13% - 4%) × 1.25 = 15.25%
WACC = × Rd × (1 - Tc) + × Re = 0.50 × (9.00%) × (1 - .30) + 0.50 × (15.25%) = 10.775%, or about
10.78%.
Diff: 3
7) Fortunately for investors, assigning a beta to individual projects is more of a science than an art.
Answer: FALSE
Explanation: Assigning a beta to individual projects is more of an art than a science.
Diff: 1
8) The simplest application of assigning a beta to an individual project is called a "pure play," in which a
manager finds the beta of a firm whose sole business is similar to the project in question and assigns that
beta to the project.
Answer: TRUE
Diff: 1
34
9) In general, a subjective assessment of betas and projects is preferred to the pure play approach.
Answer: FALSE
Explanation: In general, a pure play approach to assigning betas to projects is preferred to a subjective
assessment.
Diff: 1
10) Using beta as a risk measurement device has not caught on in the real world because finding the value
is nearly impossible for most investors.
Answer: FALSE
Explanation: Most online investment information sources provide estimates of beta for publicly traded
securities; e.g. finance.yahoo.com.
Diff: 1
11) Define "pure play" as it applies to assigning a beta to a project. Under what circumstances do you
think the pure-play approach to assigning project betas would be particularly useful?
Answer: Pure play is the art of determining the beta of an individual project by matching it to a publicly
traded company whose sole business is similar to the project's. This technique is particularly useful when
a company is looking to expand its business into an area where it has no internal projects that it can use
for estimating the new project's beta.
Diff: 2
11.6 Constraints on Borrowing and Selecting Projects for the Portfolio
1) The best rule for choosing projects when a firm has a limited amount of funds is to accept the group of
projects with the greatest combined ________.
A) number of projects
B) IRR
C) NPV
D) time to completion
Answer: C
Diff: 1
Topic: 11.6 Constraints on Borrowing and Selecting Projects for the Portfolio
LO: 11.6 Select optimal project combinations from a company's portfolio of acceptable projects.
35
2) Your firm has $2,000,000 available for investment in capital projects. Which combination of projects is
the best, given this budget constraint?
Project Initial Investment NPV

A $750,000 $100,000
B $1,500,000 $125,000
C $500,000 $75,000
D $500,000 $35,000
A) B, C
B) A, B, C
C) A, B, C, D
D) A, C, D
Answer: D
Diff: 2
3) What could happen to "unused" dollars after a firm has chosen capital projects but still has remaining
unallocated funds?
A) The remaining funds may be invested at the "going rate" of the company.
B) The remaining funds, if internally generated, may be paid back to shareholders as a dividend.
C) If the remaining funds are part of borrowing, then the firm may choose to borrow less money.
D) All of the choices above are potential uses of unallocated funds.
Answer: D
Diff: 2
36
4) Your firm has $4,000,000 available for investment in capital projects. Which combination of projects is
the best, given this budget constraint?
Project Initial Investment NPV

A $1,000,000 $150,000
B $500,000 $200,000
C $1,500,000 $175,000
D $1,750,000 $135,000
A) A, B, C
B) A, B, D
C) A, C, D
D) B, C, D
Answer: A
Diff: 2
5) On a practical basis a, manager should always accept all positive NPV projects even if this means
exceeding a limited budget.
Answer: FALSE
Explanation: On a practical basis, a manager should accept the combination of positive NPV projects that
maximizes the total NPV while still operating within budget.
Diff: 2
6) Unused capital budget funds are assumed to earn the same rate of return as the average IRR of
accepted projects.
Answer: FALSE
Explanation: Unused capital budget funds are assumed to earn the same rate of return as the firm's
"going rate." Or, excess funds may be returned to investors via dividends or lesser amounts of borrowing.
Diff: 2
7) Unused capital budget funds are assumed to earn the same rate of return as the average cost of capital
for the firm. In other words they may be invested in $0.0 NPV projects. (Or, alternatively, excess funds
may be returned to creditors and shareholders.)
Answer: TRUE
Diff: 2
37
8) With an unlimited amount of funds, a firm could accept all positive NPV projects. However, with
limited budgets, managers are forced to accept some positive NPV projects while rejecting others. What
overall financial rule should managers follow when choosing the portfolio of projects to accept? Why?
Answer: Managers should maximize the NPV of the portfolio of accepted projects. NPV measures the
total financial benefit to existing shareholders. Other techniques are flawed in some fashion. For instance,
IRR measures the return per dollar spent, but does not necessarily maximize the total return to
shareholders.
Diff: 2
38

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Chapter 11

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Financial Management: Core Concepts, 3e, GE (Brooks)

Chapter 11 The Cost of Capital

11.1 The Cost of Capital: A Starting Point

2) The cost of capital is ________.

6) Of the following, which is NOT a source of funds for a company?

8) Which of the following would be classified as equity financing for a firm?

12) The weighted average cost of capital is ________.

Explanation: B) WACC = × 9% + × 11% + × 12% = 10.20%.

11.2 Components of the Weighted Average Cost of Capital

4) The cost of debt could be which of the following?

5) Which of the following would NOT be considered a cost of debt financing?

obvious method to adjust for flotation costs.

Explanation: B) Re = + g = Re = + 0.04 = 8.71%.

Explanation: A) Re = + g = Re = $2.25 ∗ (1.03)/$40.20 + 0.03 = 8.76%.

Explanation: C) Re = +g= + 0.035 = 0.03584 + 0.035 ≈ 7.08%.

Explanation: B) Re = +g= + 0.0300 = 0.04076 + 0.0300 ≈ 7.08%.

24) Which of the following are tax-deductible expenses for corporations?

Answer: For the dividend growth model, Re = +g= + .03 = 12.00%

Explanation: C) WACC = × Rd × (1 - Tc) + × Rps + × R e.

WACC = × 8% × (1 - .30) + × 10% + × 12% = 9.33%.

Explanation: D) WACC = × Rd × (1 - Tc) + × Rps + × R e.

WACC = × 7% × (1 - .30) + × 9% + × 13% = 10.88%.

WACCadj = × 8% × (1 - .30) + × 10% + × 12% = 9.09%.

WACC = × Rd × (1 - Tc) + × Rps + × Re = 0.5 × 8% × (1 - 0.30) + 0.0909 × 11% + 0.40909 × 14% =

9) Investors ________ for estimating the WACC.

11) The formula for the adjusted WACC = × Rd + × Rps + × Re × (1 - Tc).

Explanation: The formula for the adjusted WACC = × Rd × (1 - Tc) + × Rps + × R e.

Project Level of Risk IRR

WACC = × Rd × (1 - Tc) + × Re = 0.30 × (8.00%) × (1 - .30) + 0.70 × (15.60%) = 12.60%.

WACC = × Rd × (1 - Tc) + × Re = 0.40 × (7.00%) × (1 - .30) + 0.60 × (13.40%) = 10.00%.

• Sources of financing 50% debt and 50% equity

For project A, Re = Rf + β × (Rm - Rf) = 4.00% + 1.00 × (13.00% - 4.00%) = 13.00%

For project H, Re = Rf + β × (Rm - Rf) = 4.00% + 1.20 × (13.00% - 4.00%) = 14.80%

11.5 Selecting Appropriate Betas for Projects

1) The appropriate capital budgeting decision rule is ________.

Re = rf + [E(rm) - rf] β, and therefore, β = = = 2.00.

Re = rf + [E(rm) - rf] β, and therefore, β = = = 0.80.

WACC = × Rd × (1 - Tc) + × Re = 0.50 × (9.00%) × (1 - .30) + 0.50 × (15.25%) = 10.775%, or about

11.6 Constraints on Borrowing and Selecting Projects for the Portfolio

Project Initial Investment NPV

Project Initial Investment NPV

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