Question 1

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the DCF method is widely used in practice.

Accepted Answer

A) True 
 B)False

Question 2

The CFO of Lenox Industries hired you as a consultant to help estimate its cost of capital. You have obtained the following data: (1)  rd = yield on the firm's bonds = 7.00% and the risk premium over its own debt cost = 4.00%. (2)  rRF = 5.00%, RPM = 6.00%, and b = 1.25. (3)  D1 = $1.20, P0 = $35.00, and g = 8.00% (constant) . You were asked to estimate the cost of equity based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates. What is that difference?

Accepted Answer

A)   1.13%
B)   1.50%
C)   1.88%
D)   2.34%
E)   2.58%F) C) and E)
G) A) and B)

Question 3

Bouchard and Company hired you as a consultant to help estimate its cost of capital. You have obtained the following data: D0 = $0.85; P0 = $22.00; and g = 6.00% (constant) . The CEO thinks, however, that the stock price is temporarily depressed, and that it will soon rise to $40.00. Based on the DCF approach, by how much would the cost of equity from retained earnings change if the stock price changes as the CEO expects?

Accepted Answer

A)   -1.49%
B)   -1.66%
C)   -1.84%
D)   -2.03%
E)   -2.23%F) C) and D)
G) A) and E)

Question 4

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

Question 5

Which of the following statements is CORRECT?

Accepted Answer

A)   When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation.
B)   All else equal, an increase in a company's stock price will increase its marginal cost of retained earnings, rs.
C)   All else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re.
D)   Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt.
E)   If a company's tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall.F) A) and D)
G) A) and E)

Question 6

Bankston Corporation forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Since new stock has a higher cost than retained earnings, Bankston 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 dividend payout ratio for the upcoming year.
B)   Increase the percentage of debt in the target capital structure.
C)   Increase the proposed capital budget.
D)   Reduce the amount of short-term bank debt in order to increase the current ratio.
E)   Reduce the percentage of debt in the target capital structure.F) A) and B)
G) None of the above

Question 7

Sapp Trucking's balance sheet shows a total of noncallable $45 million long-term debt with a coupon rate of 7.00% and a yield to maturity of 6.00%. This debt currently has a market value of $50 million. The balance sheet also shows that the company has 10 million shares of common stock, and the book value of the common equity (common stock plus retained earnings)  is $65 million. The current stock price is $22.50 per share; stockholders' required return, rs, is 14.00%; and the firm's tax rate is 40%. The CFO thinks the WACC should be based on market value weights, but the president thinks book weights are more appropriate. What is the difference between these two WACCs?

Accepted Answer

A)   1.55%
B)   1.72%
C)   1.91%
D)   2.13%
E)   2.36%F) D) and E)
G) A) and E)

Question 8

For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is CORRECT?

Accepted Answer

A)   The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet.
B)   The WACC is calculated on a before-tax basis.
C)   The WACC exceeds the cost of equity.
D)   The cost of equity is always equal to or greater than the cost of debt.
E)   The cost of retained earnings typically exceeds the cost of new common stock.F) A) and B)
G) C) and D)

Question 9

You were hired as a consultant to Giambono Company, whose 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 retained earnings is 12.75%. The firm will not be issuing any new stock. What is its WACC?

Accepted Answer

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

Question 10

Which of the following statements is CORRECT?

Accepted Answer

A)   The WACC is calculated using before-tax costs for all components.
B)   The after-tax cost of debt usually exceeds the after-tax cost of equity.
C)   For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock.
D)   Retained earnings that were generated in the past and are reported on the firm's balance sheet are available to finance the firm's capital budget during the coming year.
E)   The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital.F) All of the above
G) D) and E)

Question 11

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

Accepted Answer

A) True 
 B)False

Question 12

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 13

Which of the following statements is CORRECT?

Accepted Answer

A)   The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital.
B)   The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt.
C)   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.
D)   There is an "opportunity cost" associated with using retained earnings, hence they are not "free."
E)   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.F) D) and E)
G) A) and B)

Question 14

Which of the following statements is CORRECT?

Accepted Answer

A)   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.
B)   A cost should be assigned to retained 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 paid out rather than retained and reinvested.
C)   No cost should be assigned to retained 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."
D)   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.
E)   If a firm has enough retained 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.F) None of the above
G) B) and D)

Question 15

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 16

For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure.

Accepted Answer

A)   rs > re > rd > WACC.
B)   re > rs > WACC > rd.
C)   WACC > re > rs > rd.
D)   rd > re > rs > WACC.
E)   WACC > rd > rs > re.F) B) and E)
G) B) and C)

Question 17

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 18

Schalheim Sisters Inc. has always paid out all of its earnings as dividends, hence the firm has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, 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 market risk premium declines.
B)   The flotation costs associated with issuing new common stock increase.
C)   The company's beta increases.
D)   Expected inflation increases.
E)   The flotation costs associated with issuing preferred stock increase.F) A) and B)
G) A) and C)

Question 19

When working with the CAPM, which of the following factors can be determined with the most precision?

Accepted Answer

A)   The market risk premium (RPM) .
B)   The beta coefficient, bi, of a relatively safe stock.
C)   The most appropriate risk-free rate, rRF.
D)   The expected rate of return on the market, rM.
E)   The beta coefficient of "the market," which is the same as the beta of an average stock.F) B) and E)
G) D) and E)

Question 20

Rivoli Inc. hired you as a consultant to help estimate its cost of capital. You have been provided with the following data: D0 = $0.80; P0 = $22.50; and g = 8.00% (constant) . Based on the DCF approach, what is the cost of equity from retained earnings?

Accepted Answer

A)   10.69%
B)   11.25%
C)   11.84%
D)   12.43%
E)   13.05%F) D) and E)
G) None of the above

Exam 11: Cost of Capital

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

Correct Answer
verified

Which of the following statements is CORRECT?

Correct Answer
verified

Correct Answer
verified

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 Answer
verified

Correct Answer
verified

Correct Answer
verified

For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure.

Correct Answer
verified

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 Answer
verified

Correct Answer
verified

Correct Answer
verified

When working with the CAPM, which of the following factors can be determined with the most precision?

Correct Answer
verified

Which of the following statements is CORRECT?

Correct Answer
verified

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

Correct Answer
verified

Rivoli Inc. hired you as a consultant to help estimate its cost of capital. You have been provided with the following data: D0 = $0.80; P0 = $22.50; and g = 8.00% (constant) . Based on the DCF approach, what is the cost of equity from retained earnings?

Correct Answer
verified

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
verified

Which of the following statements is CORRECT?

Correct Answer
verified

Which of the following statements is CORRECT?

Correct Answer
verified

Correct Answer
verified

For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is CORRECT?

Correct Answer
verified

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the DCF method is widely used in practice.

Correct Answer
verified

Exam 11: Cost of Capital

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

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

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

For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure.

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

When working with the CAPM, which of the following factors can be determined with the most precision?

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

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

Correct AnswerverifiedShow Answer

Rivoli Inc. hired you as a consultant to help estimate its cost of capital. You have been provided with the following data: D0 = $0.80; P0 = $22.50; and g = 8.00% (constant) . Based on the DCF approach, what is the cost of equity from retained earnings?

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

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the DCF method is widely used in practice.

Correct AnswerverifiedShow Answer

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified