Question 1

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) D) and E)
G) B) and C)

Question 2

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

Accepted Answer

A) True 
 B)False

Question 3

Firm J's earnings and stock price tend to move up and down with other firms in the S&P 500,while Firm F's earnings and stock price move counter cyclically with J and other S&P companies.Both J and F estimate their costs of equity using the CAPM,they have identical market values,their standard deviations of returns are identical,and they both finance only with common equity.Which of the following statements is CORRECT?

Accepted Answer

A)   J and F should have identical WACCs because their risks as measured by the standard deviation of returns are identical.
B)   If J and F merge,then the merged firm MW should have a WACC that is a simple average of J's and F's WACCs.
C)   Without additional information,it is impossible to predict what the merged firm's WACC would be if J and F merged.
D)   Since J and F move counter cyclically to one another,if they merged,the merged firm's WACC would be less than the simple average of the two firms' WACCs.
E)   J should have the lower WACC because it is like most other companies,and investors like that fact.F) B) and E)
G) A) and E) B

Question 4

Adams Inc.has the following data: rRF = 5.00%;RPM = 6.00%;and b = 1.05.What is the firm's cost of common from reinvested earnings based on the CAPM?

Accepted Answer

A)   11.30%
B)   11.64%
C)   11.99%
D)   12.35%
E)   12.72%F) All of the above
G) A) and B)

Question 5

Westbrook's Painting Co.plans to issue a $1,000 par value,20-year noncallable bond with a 7.00% annual coupon,paid semiannually.The company's marginal tax rate is 40.00%,but Congress is considering a change in the corporate tax rate to 30.00%.By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted?

Accepted Answer

A)   0.57%
B)   0.63%
C)   0.70%
D)   0.77%
E)   0.85%F) B) and E)
G) None of the above

Question 6

As the winner of a contest,you are now CFO for the day for Maguire Inc.and your day's job involves raising capital for expansion.Maguire's common stock currently sells for $45.00 per share,the company expects to earn $2.75 per share during the current year,its expected payout ratio is 70%,and its expected constant growth rate is 6.00%.New stock can be sold to the public at the current price,but a flotation cost of 8% would be incurred.By how much would the cost of new stock exceed the cost of common from reinvested earnings?

Accepted Answer

A)   0.09%
B)   0.19%
C)   0.37%
D)   0.56%
E)   0.84%F) C) and D)
G) D) and E) C

Question 7

Assume that you are an intern with the Brayton Company,and you have collected the following data: The yield on the company's outstanding bonds is 7.75%;its tax rate is 40%;the next expected dividend is $0.65 a share;the dividend is expected to grow at a constant rate of 6.00% a year;the price of the stock is $15.00 per share;the flotation cost for selling new shares is F = 10%;and the target capital structure is 45% debt and 55% common equity.What is the firm's WACC,assuming it must issue new stock to finance its capital budget?

Accepted Answer

A)   6.89%
B)   7.26%
C)   7.64%
D)   8.04%
E)   8.44%F) C) and D)
G) C) and E)

Question 8

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.

Accepted Answer

A) True 
 B)False  True

Question 9

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) C) and D)
G) A) and B)

Question 10

Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years,then the firm will most likely

Accepted Answer

A)   become less risky over time,and this will maximize its intrinsic value.
B)   accept too many low-risk projects and too few high-risk projects.
C)   become more risky and also have an increasing WACC.Its intrinsic value will not be maximized.
D)   continue as before,because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital.
E)   become riskier over time,but its intrinsic value will be maximized.F) A) and E)
G) B) and D)

Question 11

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) C) and D)
G) B) and E)

Question 12

The lower the firm's tax rate,the lower will be its after-tax cost of debt and also its WACC,other things held constant.

Accepted Answer

A) True 
 B)False

Question 13

The cost of capital used in capital budgeting should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets.

Accepted Answer

A) True 
 B)False

Question 14

When estimating the cost of equity by use of the dividend growth method,the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return.This problem leaves us unsure of the true value of rs.

Accepted Answer

A) True 
 B)False

Question 15

Which of the following statements is CORRECT?

Accepted Answer

A)   The dividend growth model is generally preferred by academics and financial executives over other models for estimating the cost of equity.This is because of the dividend growth model's logical appeal and also because accurate estimates for its key inputs,the dividend yield and the growth rate,are easy to obtain.
B)   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.
C)   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,this increases the decision maker's confidence in the estimated cost of equity.
D)   The dividend growth model model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield.
E)   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.F) A) and B)
G) C) and E)

Question 16

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 17

As the assistant to the CFO of Johnstone Inc. ,you must estimate its cost of common equity.You have been provided with the following data: D0 = $0.80;P0 = $22.50;and gL = 8.00% (constant) .Based on the dividend growth model,what is the cost of common from reinvested earnings?

Accepted Answer

A)   10.69%
B)   11.25%
C)   11.84%
D)   12.43%
E)   13.05%F) A) and D)
G) A) and E)

Question 18

The CEO of Harding Media Inc.as asked you to help estimate its cost of common equity.You have obtained the following data: D0 = $0.85;P0 = $22.00;and gL = 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 dividend growth model,by how much would the cost of common from reinvested 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) A) and B)
G) A) and C)

Question 19

You have been hired as a consultant by Feludi Inc.'s CFO,who wants you to help her estimate the cost of capital.You have been provided with the following data: rRF = 4.10%;RPM = 5.25%;and b = 1.30.Based on the CAPM approach,what is the cost of common from reinvested earnings?

Accepted Answer

A)   9.67%
B)   9.97%
C)   10.28%
D)   10.60%
E)   10.93%F) A) and B)
G) All of the above

Question 20

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 reinvested earnings,whose cost is the average return on the assets that are acquired.

Accepted Answer

A) True 
 B)False

Exam 9: The Cost of Capital

Correct Answer
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The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

Correct Answer
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Correct Answer
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B

Adams Inc.has the following data: r_RF = 5.00%;RP_M = 6.00%;and b = 1.05.What is the firm's cost of common from reinvested earnings based on the CAPM?

Correct Answer
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Correct Answer
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C

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The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.

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True

Which of the following statements is CORRECT?

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Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years,then the firm will most likely

Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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The lower the firm's tax rate,the lower will be its after-tax cost of debt and also its WACC,other things held constant.

Correct Answer
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The cost of capital used in capital budgeting should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets.

Correct Answer
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When estimating the cost of equity by use of the dividend growth method,the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return.This problem leaves us unsure of the true value of r_s.

Correct Answer
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Which of the following statements is CORRECT?

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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As the assistant to the CFO of Johnstone Inc. ,you must estimate its cost of common equity.You have been provided with the following data: D₀ = $0.80;P₀ = $22.50;and g_L = 8.00% (constant) .Based on the dividend growth model,what is the cost of common from reinvested earnings?

Correct Answer
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Correct Answer
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You have been hired as a consultant by Feludi Inc.'s CFO,who wants you to help her estimate the cost of capital.You have been provided with the following data: r_RF = 4.10%;RP_M = 5.25%;and b = 1.30.Based on the CAPM approach,what is the cost of common from reinvested earnings?

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 reinvested earnings,whose cost is the average return on the assets that are acquired.

Correct Answer
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Exam 9: The Cost of Capital

Correct AnswerverifiedShow Answer

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedB

Adams Inc.has the following data: rRF = 5.00%;RPM = 6.00%;and b = 1.05.What is the firm's cost of common from reinvested earnings based on the CAPM?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedC

Correct AnswerverifiedShow Answer

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.

Correct AnswerverifiedTrue

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years,then the firm will most likely

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

The lower the firm's tax rate,the lower will be its after-tax cost of debt and also its WACC,other things held constant.

Correct AnswerverifiedShow Answer

The cost of capital used in capital budgeting should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets.

Correct AnswerverifiedShow Answer

When estimating the cost of equity by use of the dividend growth method,the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return.This problem leaves us unsure of the true value of rs.

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

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

As the assistant to the CFO of Johnstone Inc. ,you must estimate its cost of common equity.You have been provided with the following data: D0 = $0.80;P0 = $22.50;and gL = 8.00% (constant) .Based on the dividend growth model,what is the cost of common from reinvested earnings?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

You have been hired as a consultant by Feludi Inc.'s CFO,who wants you to help her estimate the cost of capital.You have been provided with the following data: rRF = 4.10%;RPM = 5.25%;and b = 1.30.Based on the CAPM approach,what is the cost of common from reinvested earnings?

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 reinvested earnings,whose cost is the average return on the assets that are acquired.

Correct AnswerverifiedShow Answer

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B

Adams Inc.has the following data: r_RF = 5.00%;RP_M = 6.00%;and b = 1.05.What is the firm's cost of common from reinvested earnings based on the CAPM?

Correct Answer
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Correct Answer
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Correct Answer
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C

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True

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Correct Answer
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Correct Answer
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Correct Answer
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When estimating the cost of equity by use of the dividend growth method,the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return.This problem leaves us unsure of the true value of r_s.

Correct Answer
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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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As the assistant to the CFO of Johnstone Inc. ,you must estimate its cost of common equity.You have been provided with the following data: D₀ = $0.80;P₀ = $22.50;and g_L = 8.00% (constant) .Based on the dividend growth model,what is the cost of common from reinvested earnings?

Correct Answer
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Correct Answer
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You have been hired as a consultant by Feludi Inc.'s CFO,who wants you to help her estimate the cost of capital.You have been provided with the following data: r_RF = 4.10%;RP_M = 5.25%;and b = 1.30.Based on the CAPM approach,what is the cost of common from reinvested earnings?

Correct Answer
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Correct Answer
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