Question 1

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC)  for use in capital budgeting?

Accepted Answer

A)   Accounts payable.
B)   Common stock "raised" by reinvesting earnings.
C)   Common stock raised by new issues.
D)   Preferred stock.
E)   Long-term debt.F) C) and D)
G) A) and C)

Question 2

Because 50% of the preferred dividends received by a corporation are excluded from taxable income, the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be
​
Cost of equity = rs(0.30)(0.50) + rps(1 − T)(0.50)(0.50).

Accepted Answer

A) True 
 B)False  False

Question 3

Which of the following statements is CORRECT?

Accepted Answer

A)   The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt.
B)   The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets.
C)   There is an "opportunity cost" associated with using reinvested earnings, hence they are not "free."
D)   The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year.
E)   The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital.F) C) and E)
G) A) and B)

Question 4

Perpetual preferred stock from Franklin Inc.sells for $97.50 per share, and it pays an $8.50 annual dividend.If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors.What is the company's cost of preferred stock for use in calculating the WACC?

Accepted Answer

A)   8.72%
B)   9.08%
C)   9.44%
D)   9.82%
E)   10.22%F) All of the above
G) A) and C)

Question 5

Bartlett Company's target capital structure is 40% debt, 15% preferred, and 45% common equity.The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of common using reinvested earnings is 12.75%.The firm will not be issuing any new stock.You were hired as a consultant to help determine their cost of capital.What is its WACC?

Accepted Answer

A)   8.98%
B)   9.26%
C)   9.54%
D)   9.83%
E)   10.12%F) C) and D)
G) B) and E)

Question 6

Which of the following statements is CORRECT?

Accepted Answer

A)   A cost should be assigned to reinvested earnings due to the opportunity cost principle, which refers to the fact that the firm's stockholders would themselves expect to earn a return on earnings that were distributed rather than retained and reinvested.
B)   No cost should be assigned to reinvested earnings because the firm does not have to pay anything to raise them.They are generated as cash flows by operating assets that were raised in the past; hence, they are "free."
C)   Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into the foreseeable future.In this case, the firm's before-tax and after-tax costs of debt for purposes of calculating the WACC will both be equal to the interest rate on the firm's currently outstanding debt, provided that debt was issued during the past 5 years.
D)   If a firm has enough reinvested earnings to fund its capital budget for the coming year, then there is no need to estimate either a cost of equity or a WACC.
E)   The component cost of preferred stock is expressed as rp(1 − T) .This follows because preferred stock dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes.F) B) and C)
G) A) and B)

Question 7

Which of the following statements is CORRECT?

Accepted Answer

A)   We should use historical measures of the component costs from prior financings that are still outstanding when estimating a company's WACC for capital budgeting purposes.
B)   The cost of new equity (re)  could possibly be lower than the cost of reinvested earnings (rs)  if the market risk premium, risk-free rate, and the company's beta all decline by a sufficiently large amount.
C)   A company must try to adjust its current actual market value weights toward its target weights.
D)   The component cost of preferred stock is expressed as rp(1 − T) , because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt.
E)   In the WACC calculation, we must adjust the cost of preferred stock (the market yield)  to reflect the fact that 50% of the dividends received by corporate investors are excluded from their taxable income.F) A) and E)
G) B) and C)

Question 8

If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the dividend growth model, and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method.All this makes it especially difficult to estimate the cost of equity for a private company.

Accepted Answer

A) True 
 B)False

Question 9

The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC.

Accepted Answer

A) True 
 B)False

Question 10

Which of the following statements is CORRECT?

Accepted Answer

A)   The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average after-tax cost of all the firm's outstanding debt.
B)   Suppose some of a publicly-traded firm's stockholders are not diversified; they hold only the one firm's stock.In this case, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firm's intrinsic value.
C)   Whether shareholders are already equity holders or are brand-new equity holders, they all have the same required rate of return on stock.
D)   The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm's cost of equity capital.
E)   The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity.F) All of the above
G) B) and E)

Question 11

The reason why reinvested earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm's common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should distribute those earnings to its investors.Thus, the cost of reinvested earnings is based on the opportunity cost principle.

Accepted Answer

A) True 
 B)False

Question 12

To help them estimate the company's cost of capital, Smithco has hired you as a consultant.You have been provided with the following data: D1 = $1.45; P0 = $22.50; and gL = 6.50% (constant) .Based on the dividend growth approach, what is the cost of common from reinvested earnings?

Accepted Answer

A)   11.10%
B)   11.68%
C)   12.30%
D)   12.94%
E)   13.59%F) B) and D)
G) A) and E)

Question 13

The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 − F)."

Accepted Answer

A) True 
 B)False

Question 14

With its current financial policies, Flagstaff Inc.will have to issue new common stock to fund its capital budget.Since new stock has a higher cost than reinvested earnings, Flagstaff would like to avoid issuing new stock.Which of the following actions would REDUCE its need to issue new common stock?

Accepted Answer

A)   Increase the percentage of debt in the target capital structure.
B)   Increase the proposed capital budget.
C)   Reduce the amount of short-term bank debt in order to increase the current ratio.
D)   Reduce the percentage of debt in the target capital structure.
E)   Increase the dividend payout ratio for the upcoming year.F) A) and E)
G) B) and D)

Question 15

Burnham Brothers Inc.has no retained earnings since it has always paid out all of its earnings as dividends.This same situation is expected to persist in the future.The company uses the CAPM to calculate its cost of equity, and its target capital structure consists of common stock, preferred stock, and debt.Which of the following events would REDUCE its WACC?

Accepted Answer

A)   The flotation costs associated with issuing new common stock increase.
B)   The company's beta increases.
C)   Expected inflation increases.
D)   The flotation costs associated with issuing preferred stock increase.
E)   The market risk premium declines.F) B) and E)
G) All of the above

Question 16

The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

Accepted Answer

A) True 
 B)False

Question 17

Kenny Electric Company's noncallable bonds were issued several years ago and now have 20 years to maturity.These bonds have a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000.If the firm's tax rate is 25%, what is the component cost of debt for use in the WACC calculation?

Accepted Answer

A)   5.44%
B)   5.73%
C)   6.03%
D)   6.35%
E)   6.67%F) B) and E)
G) None of the above

Question 18

Weatherall Enterprises has no debt or preferred stock⎯it is an all-equity firm⎯and has a beta of 2.0.The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment.The risk-free rate is 5%, and the market risk premium is 4%.The project being evaluated is riskier than an average project, in terms of both its beta risk and its total risk.Which of the following statements is CORRECT?

Accepted Answer

A)   The project should definitely be rejected because its expected return (before risk adjustment)  is less than its required return.
B)   Riskier-than-average projects should have their expected returns increased to reflect their higher risk.Clearly, this would make the project acceptable regardless of the amount of the adjustment.
C)   The accept/reject decision depends on the firm's risk-adjustment policy.If Weatherall's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project.
D)   Capital budgeting projects should be evaluated solely on the basis of their total risk.Thus, insufficient information has been provided to make the accept/reject decision.
E)   The project should definitely be accepted because its expected return (before any risk adjustments)  is greater than its required return.F) A) and B)
G) A) and C)

Question 19

Which of the following statements is CORRECT?

Accepted Answer

A)   Since its stockholders are not directly responsible for paying a corporation's income taxes, corporations should focus on before-tax cash flows when calculating the WACC.
B)   An increase in a firm's tax rate will increase the component cost of debt, provided the YTM on the firm's bonds is not affected by the change in the tax rate.
C)   When the WACC is calculated, it should reflect the costs of new common stock, reinvested earnings, preferred stock, long-term debt, short-term bank loans if the firm normally finances with bank debt, and accounts payable if the firm normally has accounts payable on its balance sheet.
D)   If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the after-tax cost of debt.
E)   Since the costs of internal and external equity are related, an increase in the flotation cost required to sell a new issue of stock will increase the cost of reinvested earnings.F) B) and D)
G) C) and D) D

Question 20

The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

Accepted Answer

A) True 
 B)False  True

Exam 9: The Cost of Capital

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

Correct Answer
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False

Which of the following statements is CORRECT?

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Which of the following statements is CORRECT?

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Which of the following statements is CORRECT?

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The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC.

Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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To help them estimate the company's cost of capital, Smithco has hired you as a consultant.You have been provided with the following data: D₁ = $1.45; P₀ = $22.50; and g_L = 6.50% (constant) .Based on the dividend growth approach, what is the cost of common from reinvested earnings?

Correct Answer
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The cost of external equity capital raised by issuing new common stock (r_e) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (r_s), divided by one minus the percentage flotation cost required to sell the new stock, (1 − F)."

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The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

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Which of the following statements is CORRECT?

Correct Answer
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D

The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

Correct Answer
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True

Exam 9: The Cost of Capital

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedFalse

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

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Which of the following statements is CORRECT?

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Correct AnswerverifiedShow Answer

The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC.

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

To help them estimate the company's cost of capital, Smithco has hired you as a consultant.You have been provided with the following data: D1 = $1.45; P0 = $22.50; and gL = 6.50% (constant) .Based on the dividend growth approach, what is the cost of common from reinvested earnings?

Correct AnswerverifiedShow Answer

The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 − F)."

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedD

The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

Correct AnswerverifiedTrue

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False

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To help them estimate the company's cost of capital, Smithco has hired you as a consultant.You have been provided with the following data: D₁ = $1.45; P₀ = $22.50; and g_L = 6.50% (constant) .Based on the dividend growth approach, what is the cost of common from reinvested earnings?

Correct Answer
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The cost of external equity capital raised by issuing new common stock (r_e) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (r_s), divided by one minus the percentage flotation cost required to sell the new stock, (1 − F)."

Correct Answer
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D

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True