WRAP-UP EXERCISES (MULTIPLE-CHOICE QUESTIONS)

1. The theory underlying the cost of capital is primarily concerned with the cost of
a. Short-term funds and old funds c. Long-term funds and old funds
b. Short-term funds and new funds d. Long-term funds and new funds
2. Which one of a firm’s sources of new capital usually has the lowest after-tax cost?
a. Common stock c. Bonds
b. Preferred stock d. Retained earnings
3. The dividend growth rate is relevant to which of the following costs of capital?
a. Cost of debt and equity
b. Cost of common and preferred equity
c. Cost of common equity and retained earnings
d. Cost of debt, common equity and retained earnings
4. When calculating the cost of capital, the cost assigned to retained earnings should be
a. Zero
b. Equal to the cost of external common equity
c. Lower than the cost of external common equity
d. Higher than the cost of external common equity
5. Using the Capital Asset Pricing Model (CAPM) approach of computing the cost of common equity and
retained earnings, which among the following formulas is correctly stated?
a. KRF - (KM + KRF) β c. KRF + (KM - KRF) β
b. (KRF + KM) β d. (KM - KRF) β
6. If an individual stock’s beta is higher than 1.0, then the stock is:
a. Riskier than the market c. Exactly as risky as the market
b. Less risky than the market d. The exact opposite of market directions
7. According to the Capital Asset Pricing Model (CAPM), the relevant risk of a security is its
a. Systematic risk c. Company-specific risk
b. Diversifiable risk d. Total risk
8. The type of investment risk that can be avoided through proper diversification is called
a. Systematic risk c. Market risk
b. Unsystematic risk d. Non-controllable risk
9. The use of debt in the capital structure of a firm
a. Increases its financial leverage c. Decreases its financial leverage
b. Increases its operating leverage d. Decreases its operating leverage
10. Operating leverage x financial leverage =
a. Total leverage c. Business leverage
b. Margin of safety d. No meaningful amount
11. Capital structure decisions involve determining the proportions of financing from
a. Debt or equity c. Short-term or long-term assets
b. Short-term or long-term debt d. Retained earnings or common stock
12. It is generally more expensive for a firm to finance with equity capital than with debt capital because
a. Long-term bonds have a maturity date and must therefore be repaid in the future
b. Investors are exposed to greater risk with equity capital
c. Equity capital is in greater demand than debt capital
d. Dividends fluctuate to a greater extent than interest rates
13. Which of the following is considered as a hybrid financing that has features of both debt and equity,
requires a fixed charge and increases leverage, but dividend payment is not a legal obligation?
a. Bonds c. Common stock
b. Floating Lien d. Preferred stock
14. One reason that a financial manager may prefer to issue preferred stock rather than debt is because:
a. Payments to preferred stockholders are not considered fixed payments.
b. The preferred dividend is cumulative, whereas interest payments are not.
c. In a legal sense, preferred stock is equity; dividend payments are hence not legal obligations
d. The cost of fixed debt is less expensive since it is tax-deductible even if a sinking fund is
required to retire debt
15. A firm’s target or optimal capital structure is consistent with which one of the following?
a. Minimum risk c. Maximum earnings per share
b. Minimum cost of debt d. Minimum weighted-average cost of capital
16. Which of the following is NOT a relevant theory concerning capital structure and value of the firm?
a. Classic or Traditional Theory c. MM Theory
b. Pecking Order Theory d. Big Bang Theory
17. The overall or weighted average cost of capital is equal to the
a. Average rate of return a firm earns on its assets
b. Minimum rate a firm must earn on high-risk projects
c. Rate of return on assets that covers the costs associated with the funds employed
d. Cost of equity capital at which the market value of the firm will remain unchanged
18. What is the weighted average cost of capital for a firm with equal amounts of debt and equity financing,
a 15% before-tax company cost of equity capital, a 35% tax rate and a 12% coupon rate on its debt that
is selling at par value?
a. 13.50% c. 9.60%
b. 11.40% d. 8.78%
 SELF-TEST QUESTIONS – with suggested answers
(Sources: CMA/CIA/RPCPA/AICPA/Various test banks)
1. In an investment in plant asset, the return that keeps the market price of the firm stock unchanged is
B a. Net present value c. Adjusted rate of return
b. Cost of capital d. Unadjusted rate of return
2. Cost of capital is
C a. The amount the company must pay for its plant assets
b. The dividends a company must pay on its equity securities.
c. The cost the company must incur to obtain its capital resources.
d. The cost the company is charged by investment bankers who handle the issuance of equity or long-
term debt securities.
3. A company with cost of capital of 15% plans to finance an investment with debt that bears 10% interest. The rate it
should use to discount the cash flows is
B a. 10% c. 25%
b. 15% d. 150%
4. If bonds are currently yielding 8% in the marketplace, why is the firm’s cost of debt lower?
D a. Market interest rates have increased
b. Additional debt can be issued more cheaply than the original debt
c. There should be no difference; cost of debt is the same as the bonds’ market yield
d. Interest is deductible for tax purposes
5. Tabaco Co. has 5% preferred stock with a par value of P 100. Selling price is P 123.50 per share and flotation costs are
P 0.50 per share. If tax rate is 20%, then what is the cost of preferred stock?
B a. 4.03% c. 4.7%
b. 4.07% d. 5%
6. Malaysia Company’s 10% preferred stock that has a par value of P 100 per share is sold for P 101, gross of underwriting
fees of P 5 per share. If the tax rate is 40%, what is the cost of funds for preferred stock?
D a. 4.2% c. 10.0%
b. 6.2% d. 10.4%
7. The term “underwriting spread” as an example of flotation costs refers to the
C a. Commission percentage an investment banker receives for underwriting a security issue
b. Discount investment bankers receive on securities they purchase from the issuing company
c. Difference between the price the investment banker pays for a new security issue and the price at
which the securities are resold
d. Commission a broker receives for either buying or selling a security on behalf of an investor.
8. The three elements needed to estimate the cost of equity capital for use in determining a firm’s weighted average cost
of capital are
D a. Current dividends per share, expected growth rate in dividends per share, and current book value per
share of common stock
b. Expected earnings per share, expected growth rate in dividends per share, and current market price
per share of common stock
c. Current earnings per share, expected growth rate in earnings per share, and current book value per
share of common stock
d. Expected dividends per share, expected growth rate in dividends per share, the current market price
per share of common stock
9. Pili Company is attempting to compute the cost of internal and external equity. The company’s common stock is currently
selling at P 62.50 per share with flotation cost of P 5 per share. The next dividend per share is P 5.42. Earnings and
dividends are expected to grow at a constant rate of 5%. What is the cost of new common stock (C/S) and retained
earnings (R/E)?
B a. C/S: 13.67%; R/E: 13.67% c. C/S: 13.67%; R/E: 14.43%
b. C/S: 14.43%; R/E: 13.67% d. C/S: 14.43%; R/E: 14.43%
10. The investment-banking firm of Syria & Associates will use a dividend valuation model to appraise the shares of the
Lebanon Corporation. Dividends (D1) at the end of the current year will be P 1.20. The growth rate (g) is 9 percent and
the discount rate (K) is 13 per cent. What should be the price of the stock to the public?
C a. P 28.75 c. P 30.00
b. P 29.00 d. P 31.50
11. Ceteris paribus, the market value of a firm’s outstanding common shares will be higher if
A a. Investors have a lower required return on equity
b. Investors expect lower dividend growth
c. Investors have longer expected holding periods
d. Investors have shorter expected holding periods
12. With everything else held constant, if investors expect high growth in dividends, then:
D a. Price and dividend yield will be low
b. Price and dividend yield will be high
c. Price will be low and dividend yield will be high
d. Price will be high and dividend yield will be low
13. France Co. paid cash dividends to its common stockholders over the past 12 months at P 2.20 per share. The current
market value of the common stocks is P 40 per share, and investors are anticipating the common dividends to grow at
a rate of 6% annually. The cost to issue new common stocks will be 5% of the market value. What will be the cost of
the new common stock issue?
D a. 11.50% c. 11.83%
b. 11.79% d. 12.14%
 14. The weighted average cost of capital approach to decision making is not directly affected by the
C a. Value of common stock
b. Cost of debt outstanding
c. Current budget for expansion
d. Proposed mix of debt, equity, and existing funds used to implement the project
15. The market value of Bato Company’s common stock (book value: P 65M) is estimated at P 60 M and the market value
of its interest-bearing debt (book value: P 35M) is estimated at P 40M. The average before tax yield on these liabilities
is 15% per year. Income taxes are 40%. The company is expected to pay a dividend of P 10 per share and the stock
is selling at a price of P 100 per share. The growth rate of dividend is projected to be 2.5% per year. What is the
weighted average cost of capital (WACC) of the company as a whole?
B a. 9% c. 21.5%
b. 11.1% d. 25%
16. Which of the following are acceptable criteria for determining the weights in WACC?
C a. Book value and target capital structure c. Market value and target capital structure
b. Book value and historical capital structure d. Market value and historical capital structure
17. A company has P 1,000,000 in shareholders’ equity and P 2,000,000 in debt (8% bonds). Its after-tax weighted average
cost of capital is 12%, but it uses 15% as the hurdle rate in capital budgeting decisions. During the past year, its
operating income before tax and interest was P 500,000. Its tax rate is 40%. What is the company’s cost of equity
capital?
D a. 8% c. 15%
b. 12% d. 26.4%
18. A single, overall cost of capital is often used to evaluate projects because:
A a. It avoids the problem of computing the required rate of return for each investment proposal.
b. It acknowledges that most new investment projects offer about the same expected return.
c. It acknowledges that most new investment projects have about the same degree of risk.
d. It is the only way to measure a firm's required return.
Items 19 to 24 are based on the following information
England Corporation is preparing to evaluate capital expenditure proposals for the coming year. Because the firm
employs discounted cash flow methods, the cost of capital for the firm must be estimated. The following information
for England Corporation is provided:
 The market price of common stock is 60 per share.
 The dividend next year is expected to be P 3 per share.
 Expected growth in dividends is a constant 10%.
 New bonds can be issued at face value with a 10% coupon rate.
 The current capital structure of 40% long-term debt and 60% equity is considered to be optimal.
 Anticipated earnings to be retained in the coming year are P 3 million
 The firm has a 40% marginal tax rate.
19. What is the after-tax cost of the new bond issue?
B a. 4% c. 10%
b. 6% d. 14%
20. What is the cost of using retained earnings for financing?
D a. 5% c. 10%
b. 9% d. 15%
21. If the company must assume a 20% flotation cost on new stock issuances, what is the cost of new common stock?
D a. 6.25% c. 15%
b. 10% d. 16.25%
22. What is the maximum capital expansion that can be supported in the coming year without resorting to external equity
financing?
C a. P 2 million c. P 5 million
b. P 3 million d. Cannot be determined from information given
23. Assume that the after-tax cost of debt financing is 10%, the cost of retained earnings is 14%, and the cost of new
common stock is 16%. If capital expansion needs to be P 7 million for the coming year, what is the after-tax weighted-
average cost of capital?
B a. 11.14% c. 13.60%
b. 12.74% d. 16.00%
24. Assume that after-tax cost of debt is 10%, the cost of retained earnings is 14%, and the cost of new common stock is
16%. What is the marginal cost of capital for a projected capital expansion in excess of P 7 million?
C a. 10.00% c. 13.60%
b. 12.74% d. 16.00%
25. Which model explicitly recognizes a firm’s risk when determining the estimated cost of equity?
A a. Capital asset pricing model c. Bond-yield-plus model
b. Dividend-yield-plus-growth model d. Return on equity model
26. Using Capital Asset Pricing Model (CAPM), what is the required rate of return for a firm with a beta of 1.25 when the
market rate is 14% and the risk-free rate is 6%?
D a. 6% c. 14%
b. 7.5% d. 16%
27. Tibet plans to use retained earnings to finance capital expenditures. The beta coefficient for Tibet stocks is 1.15, the
risk-free rate of interest is 8.5%, and the market return is 12.4%. The flotation costs for the issue of new common
would be 7%. Under CAPM, what is the cost of using retained earnings to finance the capital expenditures?
B a. 12.40% c. 13.96%
b. 12.99% d. 14.26%
 28. Under CAPM, the required rate of return on a security is the sum of a risk premium and
A a. Risk-free rate c. Operating risk
b. Financial risk d. Diversifiable risk
29. A measure that describes the risk of an investment project relative to other investments in general is the
B a. Coefficient of variation c. Standard deviation
b. Beta coefficient d. Expected return
30. What conclusion can be drawn on a stock’s beta based on the following value changes? Month 1: stock +1.5%, market,
+1.1%; Month 2: stock +2%, market, +1.4%, Month 3: stock -2.5%, market -2%
A a. Beta is greater than 1.0 c. Beta is less than 1.0
b. Beta equals 1.0 d. There is no consistent pattern of returns
31. The market risk premium is equal to the return on market portfolio minus the:
A a. Risk-free rate of interest c. Expected rate of inflation
b. Return on average stocks d. Return on average corporate bonds
32. What is the difference between the required rate of return on a given risky investment and that on a risk-free investment
with the same expected return?
A a. Risk premium c. Standard deviation
b. Coefficient of variation d. Beta coefficient
33. The risk to which all investment securities are subject is known as
D a. Credit risk c. Unsystematic risk
b. Diversifiable risk d. Systematic risk
34. All of the following are diversifiable (unsystematic) risks, except:
A a. Market risk c. Business risk
b. Default risk d. Liquidity risk
35. All of the following are non-diversifiable (systematic) risks, except:
B a. Market risk c. Interest rate risk
b. Business risk d. Purchasing power risk
36. The risk that securities cannot be sold at a reasonable price of short notice is called
B a. Default risk c. Interest-rate risk
b. Liquidity risk d. Purchasing-power risk
Items 37 to 40 are based on the following information
Spain, Inc. is interested in measuring its overall cost of capital and has gathered the following data. Under the terms
described below, the company can sell unlimited amounts of all instruments.
• Spain can raise cash by selling P 1,000, 8%, 20-year bonds with annual interest payments. In selling the issue, an
average premium of P 30 per bond would be received, and the firm must pay flotation costs of P 30 per bond. The
after-tax cost of funds is estimated to be 4.8%.
• Spain can sell 8% preferred stock at P 105 per share. The cost of issuing and selling the preferred stock is expected
to be P 5 per share.
• Spain’s common stock is currently selling for P 100 per share. The firm expects to pay next year cash dividends of
P 7 per share, and the dividends are expected to remain constant. The stock will have to be underpriced by P 3 per
share, and flotation costs are expected to amount to P 5 per share.
• Spain expects to have available P 100,000 of retained earnings in the coming year, once these retained earnings
are exhausted, the firm will use new common stock as the form of common stock equity financing.
• Spain’s preferred capital structure is: Long-term debt 30%, Preferred stock 20%, and Common stock 50%.
37. What is the cost of funds from sale of common stock for Spain?
C a. 7.0% c. 7.6%
b. 7.4% d. 8.1%
38. What is the cost of funds from retained earnings for Spain?
A a. 7.0% c. 7.6%
b. 7.4% d. 8.1%
39. If Spain needs a total of P 200,000, what would be the firm’s weighted average cost of capital?
B a. 4.8% c. 6.8%
b. 6.5% d. 19.80%
40. If Spain needs a total of P 1,000,000, what would be the firm’s weighted average cost of capital?
C a. 4.8% c. 6.8%
b. 6.5% d. 27.4%
41. A company has P 1,000,000 in shareholders’ equity and P 2,000,000 in debt (8% bonds). Its after-tax weighted average
cost of capital is 12%, but it uses 15% as the hurdle rate in capital budgeting decisions. During the past year, its
operating income before tax and interest was P 500,000. Its tax rate is 40%. What is the cost of equity capital?
D a. 8% c. 15%
b. 12% d. 26.4%
42. A firm with a higher degree of operating leverage when compared to industry average implies that the
D a. Firm is less risky
b. Firm is more profitable
c. Firm has higher variable costs
d. Firm’s profits are more sensitive to changes in sales volume
43. For a firm with a degree of operating leverage of 3.5, an increase in sales of 6% will
C a. Increase pre-tax profits by 3.5% c. Increase pre-tax profits by 21%
b. Decrease pre-tax profits by 3.5% d. Increase pre-tax profits by 1.71%
44. Securing of funds for investment at a fixed rate of return to fund suppliers, to enhance the well-being of the common
stockholders is known as:
A a. Financial leverage c. Prudent borrowing
b. Fund management d. Financial arbitrage
 45. In 2022, Thailand Corporation increased earnings before interest and taxes by 17%. During the same period, net income
after tax increased by 42%. What is the degree of financial leverage for 2022?
C a. 1.70 c. 2.47
b. 4.20 d. 5.90
Items 46 to 48 are based on the following information
Vatican Company currently sells 400,000 bottles of perfume each year. Each bottle costs P 0.84 to produce and sells
for P 1.00. Fixed costs are P 28,000 per year. The firm has annual interest expense of P 6,000, preferred stock
dividends of P 2,000 per year, and a 40% tax rate.
46. What is the degree of operating leverage for Vatican Company?
B a. 2.4 c. 1.35
b. 1.78 d. 1.2
47. What is the degree of financial leverage for Vatican Company?
C a. 2.4 c. 1.35
b. 1.78 d. 1.2
48. If Vatican Company did not have preferred stock, the degree of total leverage would
A a. Decrease in proportion to a decrease in financial leverage
b. Increase in proportion to an increase in financial leverage
c. Remain the same
d. Decrease but not be proportional to the decrease in financial leverage
49. Financial leverage is concerned with the relationship between
A a. Changes in EBIT and changes in EPS
b. Changes in EBIT and changes in operating income
c. Changes in volume and changes in EPS
d. Changes in volume and changes in EBIT
50. Equity in a firm with no debt is called
B a. Levered equity c. Riskless equity
b. Unlevered equity d. Risky equity
51. A company has unit sales of 300,000, unit variable cost of P 1.50, unit sales price of P 2.00 and annual fixed costs of P
50,000. Furthermore, the annual interest expense is P 20,000, and the company has no preferred stock. Accordingly,
what is the degree of combined leverage?
A a. 1.875 c. 1.25
b. 1.50 d. 1.20
52. Combined leverage is concerned with the relationship between
C a. Changes in EBIT and changes in EPS c. Changes in volume and changes in EPS
b. Changes in EBIT and changes in net income d. Changes in volume and changes in EBIT
53. Assume that Company A and Company B are alike in all respects except that Company A utilizes more debt financing
and less equity financing that does Company B. Which of the following statements is true?
A a. Company A has more net earnings variability than Company B
b. Company A has more operating earnings variability than Company B
c. Company A has less operating earnings variability than Company B
d. Company A has less financial leverage than Company B
54. A company has announced that it plans to finance future investments so that the firm will achieve an optimum capital
structure. Which corporate objective is consistent with this announcement?
C a. Maximize earnings per share c. Maximize the net worth of the firm
b. Minimize the cost of debt d. Minimize the cost of equity
55. Ideally, a firm’s capital structure is one that balances the cost of debt and equity capital and their associated risk levels.
The optimal capital structure that minimizes the firm’s
D a. Cost of debt c. Earnings per share
b. Cost of equity d. Weighted average cost of capital
56. Which of the following factors generally does not impact management’s capital structure strategy?
D a. Business risk c. Management’s aggressiveness
b. Tax position d. Expected return on assets
57. Which of the following is not a source of long-term financing?
D a. Common stock c. Bonds
b. Preferred stock d. Line of credit
58. Generally speaking, the most expensive source of financing is:
D a. Debt c. Retained earnings
b. Preferred stock d. New common stock
59. Which of the following is an advantage of equity financing in comparison to debt financing?
C a. Issuance costs are greater than for debt
b. Ownership is given up with respect to the issuance of common stock
c. The company has no firm obligation to pay dividends to common shareholders
d. Dividends are not tax deductible by the corporation whereas interest is tax deductible
60. All of the following are advantages of debt financing, EXCEPT
B a. Interest is tax deductible
b. The acquisition of debt decreases stockholders’ risk
c. The use of debt will assist in lowering the firm’s cost of capital
d. In periods of inflation, debt is paid back with pesos that are worth less than the ones borrowed

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