Question 1

The cost of common stock is the rate of return the marginal shareholder requires on the firm's common stock.

Accepted Answer

A) True 
 B)False  True

Question 2

You were hired as a consultant to Kroncke Company, whose target capital structure is 40% debt, 10% preferred, and 50% 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 13.25%. The firm will not be issuing any new stock. What is its WACC?

Accepted Answer

A)   9.48%
B)   9.78%
C)   10.07%
D)   10.37%E) B) and C)
F) B) and D)

Question 3

Crary Consolidated has 2 divisions of equal size: a computer division and a restaurant division. Its CFO believes that stand-alone restaurant companies typically have a WACC of 8%, and stand-alone computer companies typically have a 12% WACC. He also believes that Crary's restaurant and computer divisions have the same risk as their typical peers. Consequently, Crary estimates that its composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the restaurant division and a 12% hurdle rate for the computer division. However, Crary's CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is correct?

Accepted Answer

A)   While Crary's decision not to use risk-adjusted WACCs will result in its accepting more projects in the computer division and fewer projects in its restaurant division than if it followed the consultant's recommendation, this should not affect the firm's intrinsic value.
B)   Crary's decision not to adjust for risk means, in effect, that it is favouring the restaurant division. Therefore, that division is likely to become a larger part of the consolidated company over time.
C)   Crary's decision not to adjust for risk means that the company will accept too many projects in the computer business and too few projects in the restaurant business. This will lead to a reduction in the firm's intrinsic value over time.
D)   Crary's decision to not risk adjust means that the company will accept too many projects in the restaurant business and too few projects in the computer business. This will lead to a reduction in its intrinsic value over time.E) B) and C)
F) A) and C)

Question 4

P. Lange Inc. hired your consulting firm to help the company estimate the cost of equity. The yield on Lange's bonds is 7.25%, and your firm's economists believe that the cost of equity can be estimated using a risk premium of 3.50% over a firm's own cost of debt. What is an estimate of Lange's cost of equity from retained earnings?

Accepted Answer

A)   10.75%
B)   11.18%
C)   11.63%
D)   12.09%E) A) and D)
F) None of the above

Question 5

Safeco Company and Risco Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Safeco having a WACC of 10% and Risco a 12% WACC. Safeco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Safeco project. Risco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Risco project. Now assume that the two companies merge and form a new company, Safeco/Risco Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is correct?

Accepted Answer

A)   If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will become riskier over time.
B)   If evaluated using the correct post-merger WACC, Project X would have a negative NPV.
C)   After the merger, Safeco/Risco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y.
D)   Safeco/Risco's WACC, as a result of the merger, would be 10%.E) C) and D)
F) A) and B)

Question 6

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 cost of equity is always equal to or greater than the cost of debt.
B)   The WACC is calculated on a before-tax basis.
C)   The WACC exceeds the cost of equity.
D)   The cost of retained earnings typically exceeds the cost of new common stock.E) B) and D)
F) A) and C)

Question 7

Mihov Inc. hired you as a consultant to help estimate its cost of capital. You have been provided with 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) A) and B)
F) None of the above

Question 8

The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and retained earnings, whose cost is the average return on assets.

Accepted Answer

A) True 
 B)False

Question 9

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new common shares or bonds does have a cost.

Accepted Answer

A) True 
 B)False

Question 10

Vang Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C)  should the company accept?

Accepted Answer

A)   Project B is of below-average risk and has a return of 8.5%.
B)   Project C is of above-average risk and has a return of 11%.
C)   Project A is of average risk and has a return of 9%.
D)   None of the projects should be accepted.E) C) and D)
F) B) and D)

Question 11

Which of the following statements is correct?

Accepted Answer

A)   An increase in the flotation cost required to sell a new issue of stock will increase the cost of retained earnings.
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.
C)   When the WACC is calculated, it should reflect the cost of new common stock, retained 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) A) and C)
F) A) and B) D

Question 12

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 costs associated with issuing new common equity are typically smaller than the flotation costs 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) All of the above
F) A) and B)

Question 13

Among various sources of financing, which of the following will receive favourable tax treatments by issuers?

Accepted Answer

A)   long-term debt
B)   common stock
C)   retained earnings
D)   preferred stockE) A) and B)
F) A) and C) A

Question 14

You have the following data: D1 = $1.30; P0 = $42.50; and g = 7.00% (constant) . What is the cost of equity from retained earnings based on the DCF approach?

Accepted Answer

A)   9.08%
B)   9.56%
C)   10.06%
D)   10.56%E) B) and C)
F) A) and D)

Question 15

What is the best estimate of the after-tax cost of debt for CGT?

Accepted Answer

A)   4.64%
B)   4.88%
C)   5.14%
D)   5.40%E) A) and B)
F) C) and D)

Question 16

Which of the following statements is correct?

Accepted Answer

A)   Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, then decision makers can have more confidence in the estimated cost of equity.
B)   The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the DCF model's logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain.
C)   The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm's own cost of debt and its risk premium, can be found by using standardized and objective procedures.
D)   Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs-beta, the risk-free rate, and the market risk premium-can be estimated with little error.E) B) and D)
F) All of the above

Question 17

Hettenhouse Company's perpetual preferred stock sells for $102.50 per share, and it pays a $9.50 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)   9.27%
B)   9.65%
C)   10.04%
D)   10.44%E) B) and D)
F) B) and C)

Question 18

Accepted Answer

A)   A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firm's stockholders could themselves earn a return on earnings if they were paid out rather than retained and reinvested.
B)   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."
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 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 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.E) A) and D)
F) None of the above

Question 19

Assume that you are on the financial staff of Michelson Inc., and you have collected the following data: - The yield on the company's outstanding bonds is 8.00%, and its tax rate is 40%.
- The next expected dividend is $0.65 a share, and the dividend is expected to grow at a constant rate of 6.00% a year.
- The price of Michelson's stock is $17.50 per share, and the flotation cost for selling new shares is F
= 10%.
- The target capital structure is 45% debt and the balance is common equity. What is Michelson's
WACC, assuming it must issue new stock to finance its capital budget?

Accepted Answer

A)   6.63%
B)   6.98%
C)   7.34%
D)   7.73%E) None of the above
F) A) and B)

Question 20

The cost of debt, rd, is normally less than rs, so rd(1 - T) will normally be less than rs. Therefore, as long as the firm is not completely debt financed, the WACC will normally be greater than rd(1 - T).

Accepted Answer

A) True 
 B)False

Exam 9: The Cost of Capital

The cost of common stock is the rate of return the marginal shareholder requires on the firm's common stock.

Correct Answer
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True

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

Correct Answer
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Correct Answer
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The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and retained earnings, whose cost is the average return on assets.

Correct Answer
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Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new common shares or bonds does have a cost.

Correct Answer
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Vang Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?

Correct Answer
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Which of the following statements is correct?

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D

Which of the following statements is correct?

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Among various sources of financing, which of the following will receive favourable tax treatments by issuers?

Correct Answer
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A

You have the following data: D1 = $1.30; P0 = $42.50; and g = 7.00% (constant) . What is the cost of equity from retained earnings based on the DCF approach?

Correct Answer
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What is the best estimate of the after-tax cost of debt for CGT?

Correct Answer
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Which of the following statements is correct?

Correct Answer
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Correct Answer
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The cost of debt, rd, is normally less than rs, so rd(1 - T) will normally be less than rs. Therefore, as long as the firm is not completely debt financed, the WACC will normally be greater than rd(1 - T).

Correct Answer
verified

Exam 9: The Cost of Capital

The cost of common stock is the rate of return the marginal shareholder requires on the firm's common stock.

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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

Correct AnswerverifiedShow Answer

The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and retained earnings, whose cost is the average return on assets.

Correct AnswerverifiedShow Answer

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new common shares or bonds does have a cost.

Correct AnswerverifiedShow Answer

Vang Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?

Correct AnswerverifiedShow Answer

Which of the following statements is correct?

Correct AnswerverifiedD

Which of the following statements is correct?

Correct AnswerverifiedShow Answer

Among various sources of financing, which of the following will receive favourable tax treatments by issuers?

Correct AnswerverifiedA

You have the following data: D1 = $1.30; P0 = $42.50; and g = 7.00% (constant) . What is the cost of equity from retained earnings based on the DCF approach?

Correct AnswerverifiedShow Answer

What is the best estimate of the after-tax cost of debt for CGT?

Correct AnswerverifiedShow Answer

Which of the following statements is correct?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

The cost of debt, rd, is normally less than rs, so rd(1 - T) will normally be less than rs. Therefore, as long as the firm is not completely debt financed, the WACC will normally be greater than rd(1 - T).

Correct AnswerverifiedShow Answer

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