Cost Capital

A major use of warrants in financing is to
Lower the cost of debt. Detailed Answer

Detailed Answer
Answer (A) is correct. Warrants are long-term options that give holders the right to
buy common stock in the future at a specific price. If the market price goes up, the
holders of warrants will exercise their rights to buy stock at the special price. If the
market price does not exceed the exercise price, the warrants will lapse. Issuers of
debt sometimes attach stock purchase warrants to debt instruments as an inducement
to investors. The investor then has the security of fixed-return debt plus the possibility
for large gains if stock prices increase significantly. If warrants are attached, debt can
sell at an interest rate slightly lower than the market rate.
Avoid dilution of earnings per share.

Maintain managerial control.
Permit the buy-back of bonds before maturity.
2
Maloney, Inc.’s 1,000 par value preferred stock paid its 100 per share
annual dividend on April 4 of the current year. The preferred stock’s
current market price is 960 a share on the date of the dividend
distribution. Maloney’s marginal tax rate (combined federal and state)
is 40%, and the firm plans to maintain its current capital structure
relationship. The component cost of preferred stock to Maloney would
be closest to
6%
6.25%
10%
10.4%Detailed Answer
Detailed Answer
Answer (D) is correct. The component cost of preferred stock is equal to the dividend
yield, i.e., the cash dividend divided by the market price of the stock. (Dividends on
preferred stock are not deductible for tax purposes; therefore, there is no adjustment
for tax savings.) The annual dividend on preferred stock is $100 when the price of the
stock is $960. This results in a cost of capital of about 10.4% ($100 ÷ $960).
3
The theory underlying the cost of capital is primarily concerned with
the cost of
Long-term funds and old funds.

Short-term funds and new funds.
Long-term funds and new funds. Detailed Answer
Detailed Answer
Answer (C) is correct. The theory underlying the cost of capital is based primarily on
the cost of long-term funds and the acquisition of new funds. The reason is that long-
term funds are used to finance long-term investments. For an investment alternative to
be viable, the return on the investment must be greater than the cost of the funds used.
The objective in short-term borrowing is different. Short-term loans are used to meet
working capital needs and not to finance long-term investments.
Short-term funds and old funds.

4
Osgood Products has announced that it plans to finance future

investments so that the firm will achieve an optimum capital structure.
Which one of the following corporate objectives is consistent with this
announcement?
Maximize earnings per share.

Minimize the cost of debt.
Maximize the net worth of the firm. Detailed Answer
Detailed Answer
Answer (C) is correct. Financial structure is the composition of the financing sources
of the assets of a firm. Traditionally, the financial structure consists of current
liabilities, long-term debt, retained earnings, and stock. For most firms, the optimum
structure includes a combination of debt and equity. Debt is cheaper than equity, but
excessive use of debt increases the firm’s risk and drives up the weighted-average
cost of capital.
Minimize the cost of equity.

When calculating the cost of capital, the cost assigned to retained
earnings should be
Zero.
Lower than the cost of external common equity. Detailed Answer
Detailed Answer
Answer (B) is correct. Newly issued or external common equity is more costly than
retained earnings. The company incurs issuance costs when raising new, outside
funds.
Equal to the cost of external common equity.

Higher than the cost of external common equity.
6
Global Company Press has $150 par value preferred stock with a
market price of $120 a share. The organization pays a 15 per share
annual dividend. Global’s current marginal tax rate is 40%. Looking to
the future, the company anticipates maintaining its current capital
structure. What is the component cost of preferred stock to Global?
6%
7.5%
10%
Detailed Answer
Answer (D) is correct. The component cost of preferred stock is the dividend divided
by the market price (also called the dividend yield). No tax adjustment is necessary
because dividends are not deductible. Since the market price is $120 when the
dividend is $15, the component cost of preferred capital is 12.5% ($15 ÷ $120).
What is the after-tax cost of preferred stock that sells for $5 per share
and offers a $0.75 dividend when the tax rate is 35%?
5.25%
9.75%
10.50%
15%Detailed Answer
Detailed Answer
Answer (D) is correct. The component cost of preferred stock is the dividend yield,
i.e., the cash dividend divided by the market price of the stock ($.75 ÷ $5.00 = 15%).
Preferred dividends are not deductible for tax purposes.
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?
8.775%
9.60%
11.40% Detailed Answer
Detailed Answer
Answer (C) is correct. The 12% debt coupon rate is reduced by the 35% tax shield,
resulting in a cost of debt of 7.8% [12% × (1.0 – .35)]. The average of the 15% equity
capital and 7.8% debt is 11.4%.
13.50%
9
If k is the cost of debt and t is the marginal tax rate, the after-tax cost of
debt, ki, is best represented by the formula
ki= k ÷ t
ki= k ÷ (1 – t)
ki = k(t)
ki = k(1 – t)Detailed Answer
Detailed Answer
Answer (D) is correct. The after-tax cost of debt is the cost of debt times the quantity
one minus the tax rate. For example, the after-tax cost of a 10% bond is 7% [10% × (1
– 30%)] if the tax rate is 30%.
10
A firm’s target or optimal capital structure is consistent with which one

of the following?
Maximum earnings per share.

Minimum cost of debt.
Minimum risk.
Minimum weighted-average cost of capital.Detailed Answer
Detailed Answer
Answer (D) is correct. Ideally, a firm will have a capital structure that minimizes its
weighted-average cost of capital. This requires a balancing of both debt and equity
capital and their associated risk levels.
What return on equity do investors seem to expect for a firm with a $50
share price, an expected dividend of $5.50, a β of .9, and a constant
growth rate of 4.5%?
15.05%
Detailed Answer
Answer (B) is correct. Dividing the $5.50 dividend by the $50 share price produces an
11% dividend yield. Adding the 11% yield to the 4.5% growth rate produces a total
return of 15.5%. The beta coefficient is irrelevant.
15.95%
16.72%
2
In calculating the component costs of long-term funds, the appropriate

cost of retained earnings, ignoring flotation costs, is equal to
The cost of common stock. Detailed Answer

Detailed Answer
Answer (A) is correct. Common shareholders expect retained earnings to be paid out
in the form of dividends. Thus, the cost of retained earnings is an opportunity cost,
i.e., the rate that investors can earn elsewhere on investments of comparable risk.
The same as the cost of preferred stock.

The weighted average cost of capital for the firm.
Zero, or no cost.
3
Which of the following, when considered individually, would generally

have the effect of increasing a firm’s cost of capital?
I. The firm reduces its operating leverage.
II. The corporate tax rate is increased.
III. The firm pays off its only outstanding debt.
IV. The Treasury Bond yield increases.
I and III.
II and IV.
III and IV. Detailed Answer
Detailed Answer
Answer (C) is correct. Debt generally has a lower initial cost than equity. By
removing debt from the firm’s financing structure, the cost of capital is thereby
increased. Similarly, the increase in yield on Treasury bonds, a risk-free rate, would
cause the yield on all other bonds to also increase.
I, III and IV.

4
Angela Company’s capital structure consists entirely of long-term debt
and common equity. The cost of capital for each component is shown
below.
Long-term debt 8%
Common equity 15%
Angela pays taxes at a rate of 40%. If Angela’s weighted average cost of
capital is 10.41%, what proportion of the company’s capital structure is
in the form of long-term debt?
34%
45% Detailed Answer
Detailed Answer
Answer (B) is correct. The effective rate for Angela’s debt is the after-tax cost [8% ×
(1.0 – .40 tax rate) = 4.8%]. The formula for weighted-average cost of capital can be
solved as follows: (Debt weight × Cost of debt) + (Equity weight × Cost of equity) =
WACC (Debt weight ×.048) + (Equity weight × .15) = .1041 [(1 – Equity weight) ×
.048] + (Equity weight × .15) = .1041 .048 – (.048 × Equity weight) + (Equity weight
× .15) = .1041 – (.048 × Equity weight) + (Equity weight × .15) = .0561 Equity
weight × .102 = .0561 Equity weight = .55 Since equity is 55% of the capital
structure, debt makes up 45%.
55%
66%
5
Joint Products, Inc., a corporation with a 40% marginal tax rate, plans
to issue $1,000,000 of 8% preferred stock in exchange for $1,000,000 of
its 8% bonds currently outstanding. The firm’s total liabilities and
equity are equal to 10,000,000. The effect of this exchange on the firm’s
weighted average cost of capital is likely to be
No change, since it involves equal amounts of capital in the exchange and both
instruments have the same rate.
A decrease, since a portion of the debt payments are tax deductible.
A decrease, since preferred stock payments do not need to be made each year,
whereas debt payments must be made.
An increase, since a portion of the debt payments are tax deductible.Detailed
Answer
Detailed Answer
Answer (D) is correct. The payment of interest on bonds is tax-deductible, whereas
dividends on preferred stock must be paid out of after-tax earnings. Thus, when bonds
are replaced in the capital structure with preferred stock, an increase in the cost of
capital is likely because there is no longer a tax shield.
Zeta Corporation’s current-year earnings are $2.00 per share. Using a

discounted cash flow model, the controller determines that Zeta’s
common stock is worth 14 per share. Assuming a 5% long-term growth
rate, Zeta’s required rate of return is which one of the following?
20% Detailed Answer

Detailed Answer
Answer (A) is correct. The dividend discount model (also known as the dividend
growth model) is a method of arriving at the value of a stock by using expected
dividends per share and discounting them back to present value. The formula is as
follows: DPS/(cost of capital-dividend growth rate) The current-year earnings per
share are $2.00. In order to calculate the correct dividend per share amount when
given only the amount of the last annual dividend paid, it is necessary to adjust to the
expected dividend using the growth rate of the company. Thus, the dividends per
share equal $2.10 [$2 × (1 + .05)]. The rate of return can now be solved for as
follows: $2.10 ÷ (x – .05 = 14 2.10 = $14x – .70 2.80 = $14x x = 20%
15%
10%
7%
7
A company has a weighted-average cost of capital of 12.8%. If the after-

tax cost of debt is 8%, and the weight on debt is 20%, what is the
company’s cost of equity? Assume the company has no preferred stock.
11.2%
Detailed Answer
Answer (B) is correct. The company’s cost of equity can be calculated using the
WAAC formula. WACC = Weight on equity × Cost of equity + Weight on debt ×
Cost of debt 1. 12.8% = 80% × Cost of equity + 20% × 8% 2. 12.8% = 80% × Cost of
equity + 1.6% 3. 11.2% = 80% × Cost of equity 4. 14% = Cost of equity
18.0%
26.0%
8
Ten years ago, Ellison Group issued perpetual preferred shares with a
par value of $50 and an annual dividend rate of 6%. Currently, there
are no dividends in arrears. Since the issue date, interest rates have
risen, and the shares are now selling at $38. The market’s current
required rate of return on these shares is
4.56%
6.00%
Detailed Answer
Answer (C) is correct. The required rate of return on these shares is calculated by
dividing the dividend by the issue price. Thus, $3 (6% × $50) must be divided by $38
to yield 7.89%.
15.79%
9
The weighted-average cost of capital is equal to the
Rate of return on assets that covers the costs associated with the funds employed.
Detailed Answer
Detailed Answer
Answer (A) is correct. The weighted-average cost of capital represents the minimum
rate of return at which a company produces value for its investors. Therefore, it is the
return on assets that covers the company’s costs.
Average rate of return a firm earns on its assets.

Minimum rate a firm must earn on high-risk projects.
Cost of the firm’s equity capital at which the market value of the firm will remain
unchanged.
10
Beck, Inc., issued $100,000, 15-year term bonds with a coupon rate of
8% at par. Interest is paid annually to bondholders. Beck’s effective
income tax rate is 35%. Beck used the proceeds to complete the
purchase of a supplier whose effective income tax rate is 20%. What is
the after-tax cost of debt?
8%
6.4%
Detailed Answer
Answer (C) is correct. Since the bond is issued at par, the coupon rate is equal to the
effective rate. The after-tax cost of debt is found by multiplying the effective rate by 1
minus the effective tax rate. Therefore, the answer is 5.2% [8% × (1 – .35 .
3.6%
A preferred stock is sold for $101 per share, has a face value of $100 per
share, underwriting fees of $5 per share, and annual dividends of $10
per share. If the tax rate is 40%, the cost of funds (capital) for the
preferred stock is
4.2%
6.25%
10.0%
Detailed Answer
Answer (D) is correct. The cost of capital for new preferred stock is equal to the
dividend on the stock divided by the net issue proceeds [$10 ÷ ($101 – $5) = 10.4%].
Because dividends on preferred stock are not deductible for tax purposes, the income
tax rate is irrelevant.
The FLF 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 FLF Corporation is provided:
 The market price of common stock is $60 per share.
 The dividend next year is expected to be $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 $3 million.
 The firm has a 40% marginal tax rate.
The after-tax cost to FLF Corporation of the new bond issue is
4%
6%Detailed Answer
Detailed Answer
Answer (B) is correct. Because the bonds are issued at their face value, the pretax
effective rate is 10%. However, interest is deductible for tax purposes, so the
government absorbs 40% of the cost, leaving a 6% after-tax cost.
10%
14%
3

If FLF Corporation must assume a 20% flotation cost on new stock
issuances, what is the cost of new common stock?
6.25%
15%
Detailed Answer
Answer (C) is correct. The company will receive only 80% of the $60 market price, or
$48. Consequently, the dividend yield is 6.25% ($3 ÷ $48). Adding the 10% growth
rate produces a cost of new common equity of 16.25%.
10%
4

The cost of using FLF Corporation retained earnings for financing is
5%
9%
10%
15%Detailed Answer
Detailed Answer
Answer (D) is correct. The cost of internal equity capital equals the dividend yield
(dividends per share ÷ market price) plus the dividend growth rate. Dividing the $3
dividend by the $60 market price results in a yield of 5%. Adding the 10% dividend
growth rate produces a cost of 15% for retained earnings. No adjustment is made for
taxes because dividends are not tax deductible.
The maximum capital expansion that FLF Corporation can support in
the coming year without resorting to external equity financing is
$2 million.
$3 million.
$5 million. Detailed Answer
Detailed Answer
Answer (C) is correct. The current optimal capital structure is 40% debt and 60%
equity. The $3 million to be retained from earnings in the coming year represents the
equity portion of the maximum new capital outlay. To retain the optimal capital
structure, $2 million of debt must be added to the $3 million of retained earnings.
Hence, the maximum capital expansion is $5 million.
Cannot determine from the information given.

6

Without prejudice to your answers from any other questions, 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 $7 million for the coming year, what is the after-
tax weighted-average cost of capital to FLF Corporation?
11.14%
Detailed Answer
Answer (B) is correct. To maintain a capital structure of 40% debt and 60% equity,
the $7 million total must consist of $2.8 million of debt and $4.2 million of equity.
The equity will consist of $3 million of retained earnings and $1.2 million of new
stock. The weighted-average cost of the three sources of new capital is determined as
follows: Debt $2,800,000 ÷ $7,000,000 × 10% = 4.00% Common stock $1,200,000 ÷
$7,000,000 × 16% = 2.74% Retained earnings $3,000,000 ÷ $7,000,000 × 14% =
6.00% 12.74%
13.6%
16%
7

Without prejudice to your answers from any other questions, 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%. What is the
marginal cost of capital to FLF Corporation for any projected capital
expansion in excess of $7 million?
10%
12.74%
Detailed Answer
Answer (C) is correct. For this calculation, the weighted-average cost of capital is
based on the 16% cost of new common stock and the 10% cost of debt. Retained
earnings will not be considered because the amount available has been exhausted.
Thus, the weighted average of any additional capital required will be 13.6% [(60% ×
16% cost of new equity) + (40% × 10% cost of new debt)].
16%
8
Williams, Inc., is interested in measuring its overall cost of capital and

has gathered the following data. Under the terms described as follows,
the company can sell unlimited amounts of all instruments.
 Williams can raise cash by selling $1,000, 8%, 20-year bonds with
annual interest payments. In selling the issue, an average premium of
$30 per bond would be received, and the firm must pay flotation costs
of $30 per bond. The after-tax cost of funds is estimated to be 4.8%.
 Williams can sell $8 preferred stock at par value, $105 per share. The
cost of issuing and selling the preferred stock is expected to be $5 per
share.
 Williams’ common stock is currently selling for $100 per share. The
firm expects to pay cash dividends of $7 per share next year, and the
dividends are expected to remain constant. The stock will have to be
underpriced by $3 per share, and flotation costs are expected to amount
to $5 per share.
 Williams expects to have available 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.
 Williams’ preferred capital structure is
Long-term debt 30%
Preferred stock 20%
Common stock 50%
The cost of funds from the sale of common stock for Williams, Inc., is
7.0%
Detailed Answer
Answer (B) is correct. According to the dividend growth model, the cost of new
(external) common equity is the next dividend divided by the net issue proceeds plus
the dividend growth rate. Since flotation costs are incurred when issuing new stock,
they must be deducted from the market price to arrive at the amount of capital the
corporation will actually receive. Accordingly, the $100 selling price is reduced by
the $3 discount and the $5 flotation costs to arrive at the $92 to be received for the
stock. Because the dividend is not expected to increase in future years, no growth
factor is included in the calculation. Thus, the cost of the common stock is 7.6% ($7
dividend ÷ $92 net issue proceeds).
7.4%
8.1%
9
Williams, Inc., is interested in measuring its overall cost of capital and

has gathered the following data. Under the terms described as follows,
the company can sell unlimited amounts of all instruments.
 Williams can raise cash by selling $1,000, 8%, 20-year bonds with
annual interest payments. In selling the issue, an average premium of
$30 per bond would be received, and the firm must pay flotation costs
of $30 per bond. The after-tax cost of funds is estimated to be 4.8%.
 Williams can sell $8 preferred stock at par value, $105 per share. The
cost of issuing and selling the preferred stock is expected to be $5 per
share.
 Williams’ common stock is currently selling for $100 per share. The
firm expects to pay cash dividends of $7 per share next year, and the
dividends are expected to remain constant. The stock will have to be
underpriced by $3 per share, and flotation costs are expected to amount
to $5 per share.
 Williams expects to have available 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.
 Williams’ preferred capital structure is
Long-term debt 30%
Preferred stock 20%
Common stock 50%
If Williams, Inc., needs a total of 200,000, the firm’s weighted-average
cost of capital would be
19.8%
4.8%
Detailed Answer
Answer (C) is correct. Because Williams can sell unlimited amounts of all of its
instruments, it can maintain its preferred capital structure. The cost of new debt is
given as 4.8%. The cost of new preferred stock is 8.0% ($8 dividend ÷ $100 net issue
proceeds). No new common stock needs to be issued since sufficient retained earnings
are available ($200,000 capital needed × 50% common stock = $100,000). Thus, the
component cost of retained earnings can be used for the common stock component of
the WACC calculation: Cost of Weighted Component Weight Capital Cost New long-
term debt 30% × 4.8% = 1.44% New preferred stock 20% × 8.0% = 1.60% Retained
earnings 50% × 7.0% = 3.50% Total 6.54%
6.8%
10
DQZ Telecom is considering a project for the coming year that will cost
$50 million. DQZ plans to use the following combination of debt and
equity to finance the investment.
 Issue $15 million of 20-year bonds at a price of $101, with a coupon
rate of 8%, and flotation costs of 2% of par.
 Use $35 million of funds generated from earnings.
 The equity market is expected to earn 12%. U.S. Treasury bonds are
currently yielding 5%. The beta coefficient for DQZ is estimated to be
.60. DQZ is subject to an effective corporate income tax rate of 40%.
The before-tax cost of DQZ’s planned debt financing, net of flotation
costs, in the first year is
11.80%
Detailed Answer
Answer (B) is correct. The cost of new debt equals the annual interest divided by the
net issue proceeds. The annual interest is $1.2 million ($15,000,000 × .08 coupon
rate). The proceeds amount to $14,850,000 [($15,000,000 × 1.01) market price –
($15,000,000 × .02) flotation costs]. Thus, the company is paying $1.2 million
annually for the use of $14,850,000, a cost of 8.08% ($1,200,000 ÷ $14,850,000).
10.00%
7.92%
1
DQZ Telecom is considering a project for the coming year that will cost
$50 million. DQZ plans to use the following combination of debt and
equity to finance the investment.
 Issue $15 million of 20-year bonds at a price of $101, with a coupon
rate of 8%, and flotation costs of 2% of par.
 Use $35 million of funds generated from earnings.
 The equity market is expected to earn 12%. U.S. Treasury bonds are
currently yielding 5%. The beta coefficient for DQZ is estimated to be
.60. DQZ is subject to an effective corporate income tax rate of 40%.
Assume that the after-tax cost of debt is 7% and the cost of equity is
12%. Determine the weighted-average cost of capital to DQZ.

Detailed Answer
Answer (A) is correct. The 7% debt cost and the 12% equity cost should be weighted
by the proportions of the total investment represented by each source of capital. The
total project costs $50 million, of which debt is $15 million, or 30% of the total.
Equity capital is the other 70%. Consequently, the weighted-average cost of capital is
10.5% [(30% × 7%) + (70% × 12%)].
8.50%
9.50%
6.30%
2
The common stock of the Nicolas Corporation is currently selling at $80

per share. The leadership of the company intends to pay a $4 per share
dividend next year. With the expectation that the dividend will grow at
5% perpetually, what will the market’s required return on investment
be for Nicolas common stock?
5%
5.25%
7.5%
10%Detailed Answer
Detailed Answer
Answer (D) is correct. The dividend growth model estimates the cost of retained
earnings using the dividends per share, the market price, and the expected growth rate.
The current dividend yield is 5% ($4 ÷ $80). Adding the growth rate of 5% to the
yield of 5% results in a required return of 10%.
Enert, Inc.’s current capital structure is shown below. This structure is

optimal, and the company wishes to maintain it.
Debt 25%
Preferred equity 5
Common equity 70
Enert’s management is planning to build a $75 million facility that will
be financed according to this desired capital structure. Currently, $15
million of cash is available for capital expansion. The percentage of the
$75 million that will come from a new issue of common stock is
52.50%
50.00%
70.00%
Detailed Answer
Answer (D) is correct. Because $15 million is already available, the company must
finance $60 million ($75 million – $15 million). Of this amount, 70%, or $42 million,
should come from the issuance of common stock to maintain the current capital
structure. The $42 million represents 56% of the total $75 million.
Which one of a firm’s sources of new capital usually has the lowest
after-tax cost?
Retained earnings.
Bonds. Detailed Answer
Detailed Answer
Answer (B) is correct. Debt financing, such as bonds, normally has a lower after-tax
cost than does equity financing. The interest on debt is tax deductible, whereas the
dividends on equity are not. Also, bonds are slightly less risky than stock because the
bond holders have a first right to assets at liquidation.
Preferred stock.
Common stock.
5
The DCL Corporation is preparing to evaluate the capital expenditure

cash flow methods of analyses, the cost of capital for the firm must be
estimated. The following information for DCL Corporation is provided.
 Market price of common stock is $50 per share.
 The dividend next year is expected to be $2.50 per share.
If the firm must assume a 10% flotation cost on new stock issuances,
what is the cost of new common stock?
16.11%
Detailed Answer
Answer (B) is correct. Because of flotation costs, DCL will only receive $45 from
each new common share issued ($50 × 90%). The cost of this new common equity
issue can thus be calculated as follows: Cost of new common stock = (Next dividend
÷ Net issue proceeds) + Dividend growth rate = ($2.50 ÷ $45.00) + 0.1 = 0.0556 0.1 =
0.1556
15.05%
15.00%
6
Rogers, Inc., operates a chain of restaurants located in the Southeast.

The company has steadily grown to its present size of 48 restaurants.
The board of directors recently approved a large-scale remodeling of
the restaurants, and the company is now considering two financing
alternatives.
 The first alternative would consist of
 Bonds that would have a 9% coupon rate and reissued at their base
amount would net $19.2 million after a 4% flotation cost
 Preferred stock with a stated rate of 6% that would yield $4.8 million
after a 4% flotation cost
 Common stock that would yield $24 million after a 5% flotation cost
 The second alternative would consist of a public offering of bonds that
would have a 9% coupon rate and an 11% market rate and would net
$48 million after a 4% flotation cost.
Rogers’ current capital structure, which is considered optimal, consists
of 40% long-term debt, 10% preferred stock, and 50% common stock.
The current market value of the common stock is $30 per share, and the
common stock dividend during the past 12 months was $3 per share.
Investors are expecting the growth rate of dividends to equal the
historical rate of 6%. Rogers is subject to an effective income tax rate of
40%. The after-tax cost of the common stock proposed in Rogers’ first
financing alternative would be
16.00%
16.53%
16.60%
Detailed Answer
Answer (D) is correct. To determine the cost of new common stock, the dividend
growth model is used. Cost of new common stock = (Next dividend ÷ Net issue
proceeds) + Dividend growth rate = [($3.00 × 1.06) ÷ ($30.00 × .95)] + .06 = ($3.18 ÷
$28.50) + .06 = .1116 .06 = 17.16%
Rogers, Inc., operates a chain of restaurants located in the Southeast.

The company has steadily grown to its present size of 48 restaurants.
The board of directors recently approved a large-scale remodeling of
the restaurants, and the company is now considering two financing
alternatives.
 The first alternative would consist of
 Bonds that would have a 9% coupon rate and reissued at their base
amount would net $19.2 million after a 4% flotation cost
 Preferred stock with a stated rate of 6% that would yield $4.8 million
after a 4% flotation cost
 Common stock that would yield $24 million after a 5% flotation cost
 The second alternative would consist of a public offering of bonds that
would have a 9% coupon rate and an 11% market rate and would net
$48 million after a 4% flotation cost.
Rogers’ current capital structure, which is considered optimal, consists
of 40% long-term debt, 10% preferred stock, and 50% common stock.
The current market value of the common stock is $30 per share, and the
common stock dividend during the past 12 months was $3 per share.
Investors are expecting the growth rate of dividends to equal the
historical rate of 6%. Rogers is subject to an effective income tax rate of
40%.
The after-tax weighted marginal cost of capital for Rogers’ second
financing alternative consisting solely of bonds would be
5.13%
5.40%
Detailed Answer
Answer (C) is correct. Annual cash interest is $4,500,000 {[$48,000,000 ÷ (1.0 – .04
flotation cost)] × .09}. The cost of the new bonds equals the annual cash interest
divided by the net issue proceeds, times one minus the tax rate, or 5.63% [($4,500,000
÷ $48,000,000) × (100% – 40% .
6.60%
8
Maylar Corporation has sold $50 million of $1,000 par value, 12%
coupon bonds. The bonds were sold at a discount and the corporation
received $985 per bond. If the corporate tax rate is 40%, the after-tax
cost of these bonds for the first year (rounded to the nearest hundredth
percent) is

Detailed Answer
Answer (A) is correct. Interest is 12%, and the annual interest payment on one bond is
$120. Thus, the effective rate is 12.18% ($120 ÷ $985). Reducing this rate by the 40%
tax savings lowers the cost to 7.31%.
4.87%
12.00%
7.09%
9
Acme Corporation is selling $25 million of cumulative, non-
participating preferred stock. The issue will have a par value of $65 per
share with a dividend rate of 6%. The issue will be sold to investors for
$68 per share, and issuance costs will be $4 per share. The cost of
preferred stock to Acme is
5.42%
5.74%
6.00%
Detailed Answer
Answer (D) is correct. Acme’s cost of capital for its new preferred stock is calculated
as follows: Cost of new preferred stock = Dividend ÷ Net issue proceeds = ($65 ×
6%) ÷ ($68 – 4 = $3.90 ÷ $64 = 6.09%
10
By using the dividend growth model, estimate the cost of equity capital
for a firm with a stock price of $30.00, an estimated dividend at the end
of the first year of $3.00 per share, and an expected growth rate of 10%.
21.1%
12.2%
11.0%
Detailed Answer
Answer (D) is correct. Under the dividend growth model, the cost of equity equals the
expected growth rate plus the quotient of the next dividend and the current market
price. Thus, the cost of equity capital is 20% [10% + ($3 ÷ $30)]. This model assumes
that the payout ratio, retention rate, and the earnings per share growth rate are all
constant.
A firm seeking to optimize its capital budget has calculated its marginal
cost of capital and projected rates of return on several potential
projects. The optimal capital budget is determined by
Calculating the point at which marginal cost of capital meets the projected rate of
return, assuming that the most profitable projects are accepted first. Detailed Answer
Detailed Answer
Answer (A) is correct. In economics, a basic principle is that a firm should increase
output until marginal cost equals marginal revenue. Similarly, the optimal capital
budget is determined by calculating the point at which marginal cost of capital (which
increases as capital requirements increase) and marginal efficiency of investment
(which decreases if the most profitable projects are accepted first) intersect.
Calculating the point at which average marginal cost meets average projected rate
of return, assuming the largest projects are accepted first.
Accepting all potential projects with projected rates of return exceeding the
lowest marginal cost of capital.
Accepting all potential projects with projected rates of return lower than the
highest marginal cost of capital.
2
A company has made the decision to finance next year’s capital projects
through debt rather than additional equity. The benchmark cost of
capital for these projects should be
The before-tax cost of new-debt financing.

The after-tax cost of new-debt financing.
The cost of equity financing.
The weighted-average cost of capital.Detailed Answer
Detailed Answer
Answer (D) is correct. A weighted average of the costs of all financing sources should
be used, with the weights determined by the usual financing proportions. The terms of
any financing raised at the time of initiating a particular project do not represent the
cost of capital for the firm. When a firm achieves its optimal capital structure, the
weighted-average cost of capital is minimized.
The firm’s marginal cost of capital
Should be the same as the firm’s rate of return on equity.

Is unaffected by the firm’s capital structure.
Is inversely related to the firm’s required rate of return used in capital budgeting.
Is a weighted average of the investors’ required returns on debt and
equity.Detailed Answer
Detailed Answer
Answer (D) is correct. The marginal cost of capital is the cost of the next dollar of
capital. The marginal cost continually increases because the lower cost sources of
funds are used first. The marginal cost represents a weighted average of both debt and
equity capital.
Datacomp Industries, which has no current debt, has a beta of .95 for
its common stock. Management is considering a change in the capital
structure to 30% debt and 70% equity. This change would increase the
beta on the stock to 1.05, and the after-tax cost of debt will be 7.5%.
The expected return on equity is 16%, and the risk-free rate is 6%.
Should Datacomp’s management proceed with the capital structure
change?
No, because the cost of equity capital will increase.

Yes, because the cost of equity capital will decrease.
Yes, because the weighted-average cost of capital will decrease. Detailed Answer
Detailed Answer
Answer (C) is correct. The important consideration is whether the overall cost of
capital will be lower for a given proposal. According to the Capital Asset Pricing
Model, the change will result in a lower average cost of capital. For the existing
structure, the cost of equity capital is 15.5% [6% + .95 (16% – 6%)]. Because the
company has no debt, the average cost of capital is also 15.5%. Under the proposal,
the cost of equity capital is 16.5% [6% + 1.05 (16% – 6%)], and the weighted average
cost of capital is 13.8% [.3(.075) + .7(.165)]. Hence, the proposal of 13.8% should be
accepted.
No, because the weighted-average cost of capital will increase.

5
Lox has sold 1,000 shares of $100 par, 8% preferred stock at an issue
price of $92 per share. Stock issue costs were 5 per share. Lox pays
taxes at the rate of 40%. What is Lox’s cost of preferred stock capital?
8.00%
8.25%
8.70%
Detailed Answer
Answer (D) is correct. Because the dividends on preferred stock are not deductible for
tax purposes, the effect of income taxes is ignored. Thus, the relevant calculation is to
divide the $8 annual dividend by the quantity of funds received from the issuance. In
this case, the funds received equal $87 ($92 proceeds – $5 issue costs). Thus, the cost
of capital is 9.2% ($8 ÷ $87).
The management of Old Fenske Company (OFC has been reviewing the
company’s financing arrangements. The current financing mix is
$750,000 of common stock, $200,000 of preferred stock ($50 par) and
$300,000 of debt. OFC currently pays a common stock cash dividend of
$2. The common stock sells for $38, and dividends have been growing at
about 10% per year. Debt currently provides a yield to maturity to the
investor of 12%, and preferred stock pays a dividend of 9% to yield
11%. Any new issue of securities will have a flotation cost of
approximately 3%. OFC has retained earnings available for the equity
requirement. The company’s effective income tax rate is 40%. Based on
this information, the cost of capital for retained earnings is
9.5%
14.2%
Detailed Answer
Answer (C) is correct. The cost of new common stock is the next dividend ($2.20)
divided by the net proceeds of the stock. If this were to involve a new sale of stock,
the flotation costs would be deducted from the selling price to get the net proceeds.
However, this was for retained earnings, so there is no deduction. The calculation is to
divide the $2.20 dividend by the $38 selling price to get 5.8%. Add the 10% growth
rate and the answer is 15.8%.
16.0%
7
Pane Software, Inc., has total capital of $100 million, and its cost of
capital is 12%. A new project has been proposed that will require
additional capital of $10 million. The firm estimates that the additional
capital can be raised at a pre-tax cost of 10%. The company’s marginal
income tax rate is 36%. What discount rate should Pane use in
evaluating the new project?

Detailed Answer
Answer (A) is correct. The discount rate used in evaluating the new project should be
the after-tax cost of the additional capital. Therefore, the discount rate to be used by
Pane in evaluating its new project should be 6.40% [10% × (1 – .36 .
7.56%
10.00%
11.82%
8
Peson, Inc., a manufacturer of printers, is attempting to determine its

cost of common equity for cost of capital purposes. Peson’s long-term
debt is rated AA by Standard & Poor’s. Peson’s common shares trade
on the NASDAQ and the current market price is $26.87. The most
recent yearly common share dividend Peson paid common shareholders
was $1.04. The consensus forecast of security analysts who follow
Peson’s common shares is that earnings growth will average 12.5% over
the long term. Peson’s marginal income tax rate is 40%. Using the
dividend discount model, what is Peson’s cost of equity capital for cost
of capital purposes?
9.82%
10.11%
16.37%
Detailed Answer
Answer (D) is correct. Under the dividend growth model, the cost of equity equals the
expected growth rate plus the quotient of the next dividend and the current market
price. The next dividend is calculated as $1.17 [$1.04 dividend × (1 + .125 growth)].
Thus, the cost of equity capital is 16.85% [12.5% + ($1.17 ÷ $26.87)]. This model
assumes that the payout ratio, retention rate, and the earnings per share growth rate
are all constant.
A profitable firm is reviewing alternatives to raise additional capital. It

estimates that it can issue debt at a yield of 6% or, alternately, issue
preferred shares at a yield of 7%. If the firm’s marginal income tax rate
is 37%, what would be the cost for each alternative?
-6.00%, preferred shares- 7.00%-

-3.78%, preferred shares- 7.00%-Detailed Answer
Detailed Answer
Answer (B) is correct. The cost of the debt would be 3.78% [6% × (1 – .37)] since
interest payments are tax-deductible by the firm. The preferred shares would cost 7%.

10
Mackinaw Coats, Inc., is planning to issue additional shares of common

stock in a public offering. The current market price of Mackinaw stock
is $38, and the dividend for the past year was $2.25. A well-known
investment advisory firm forecasts dividend growth of 8%, and an
investment banker estimates that the flotation costs would be 6% of the
issue price. What cost of equity should Mackinaw use in its cost of
capital calculation?
13.9%
14.0%
14.3%
Detailed Answer
Answer (D) is correct. The next dividend that Mackinaw will pay is $2.43 ($2.25 ×
1.08). The net issue proceeds are $35.85 ($38 ÷ 1.06) after taking the flotation costs
into account. Therefore, the cost of capital is 14.8% [($2.43 ÷ $35.85) + .08].

Cost Capital

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