Question 1

The cost of equity raised by retaining earnings can be less than,equal to,or greater than the cost of external equity raised by selling new issues of common stock,depending on tax rates,flotation costs,the attitude of investors,and other factors.

Accepted Answer

A) True 
 B)False

Question 2

Suppose the debt ratio is 50%,the interest rate on new debt is 8%,the current cost of equity is 16%,and the tax rate is 40%.An increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC).

Accepted Answer

A) True 
 B)False

Question 3

Which of the following statements is CORRECT?

Accepted Answer

A)   A change in a company's target capital structure cannot affect its WACC.
B)   WACC calculations should be based on the before-tax costs of all the individual capital components.
C)   Flotation costs associated with issuing new common stock normally reduce the WACC.
D)   If a company's tax rate increases,then,all else equal,its weighted average cost of capital will decline.
E)   An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.F) None of the above
G) A) and E)

Question 4

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 5

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 CAPM method always provides an accurate and reliable estimate.

Accepted Answer

A) True 
 B)False

Question 6

Cranberry Corp.has two divisions of equal size: a computer manufacturing division and a data processing division.Its CFO believes that stand-alone data processor companies typically have a WACC of 8%,while stand-alone computer manufacturers typically have a 12% WACC.He also believes that the data processing and manufacturing divisions have the same risk as their typical peers.Consequently,he estimates that the composite,or corporate,WACC is 10%.A consultant has suggested using an 8% hurdle rate for the data processing division and a 12% hurdle rate for the manufacturing division.However,the 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 the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant's recommendation,this should not affect the firm's intrinsic value.
B)   The decision not to adjust for risk means,in effect,that it is favoring the data processing division.Therefore,that division is likely to become a larger part of the consolidated company over time.
C)   The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division.This will lead to a reduction in the firm's intrinsic value over time.
D)   The decision not to risk adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business.This will lead to a reduction in its intrinsic value over time.
E)   The decision not to risk adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business.This may affect the firm's capital structure but it will not affect its intrinsic value.F) A) and E)
G) A) and B) C

Question 7

Eakins Inc.'s common stock currently sells for $50.00 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 retained earnings? Do not round your intermediate calculations.

Accepted Answer

A)   0.23%
B)   0.33%
C)   0.44%
D)   0.20%
E)   0.40%F) A) and B)
G) B) and C)

Question 8

Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.

Accepted Answer

A)   If a firm has a beta that is less than 1.0,say 0.9,this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms' assets.
B)   If a firm's managers want to maximize the value of the stock,they should,in theory,concentrate on project risk as measured by the standard deviation of the project's expected future cash flows.
C)   If a firm evaluates all projects using the same cost of capital,and the CAPM is used to help determine that cost,then its risk as measured by beta will probably decline over time.
D)   Projects with above-average risk typically have higher-than-average expected returns.Therefore,to maximize a firm's intrinsic value,its managers should favor high-beta projects over those with lower betas.
E)   Project A has a standard deviation of expected returns of 20%,while Project B's standard deviation is only 10%.A's returns are negatively correlated with both the firm's other assets and the returns on most stocks in the economy,while B's returns are positively correlated.Therefore,Project A is less risky to a firm and should be evaluated with a lower cost of capital.F) A) and D)
G) A) and C)

Question 9

Since 70% 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)(0.70)(0.50).

Accepted Answer

A) True 
 B)False

Question 10

Which of the following statements is CORRECT?

Accepted Answer

A)   In the WACC calculation,we must adjust the cost of preferred stock (the market yield) to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income.
B)   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.
C)   The cost of new equity (re) could possibly be lower than the cost of retained earnings (rs) if the market risk premium,risk-free rate,and the company's beta all decline by a sufficiently large amount.
D)   Its cost of retained earnings is the rate of return stockholders require on a firm's common stock.
E)   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.F) A) and B)
G) None of the above

Question 11

Which of the following statements is CORRECT?

Accepted Answer

A)   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 retained earnings.
B)   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.
C)   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.
D)   When the WACC is calculated,it should reflect the costs 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.
E)   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.F) A) and B)
G) D) and E)

Question 12

Vang Enterprises,which is debt-free and finances only with equity from retained earnings,is considering 7 equal-sized capital budgeting projects.Its CFO hired you to assist in deciding whether none,some,or all of the projects should be accepted.You have the following information: rRF = 4.50%;RPM = 5.50%;and b = 0.86.The company adds or subtracts a specified percentage to the corporate WACC when it evaluates projects that have above- or below-average risk.Data on the 7 projects are shown below.If these are the only projects under consideration,how large should the capital budget be? ​
RF = 4.50%;RPM = 5.50%;and b = 0.86.The company adds or subtracts a specified percentage to the corporate WACC when it evaluates projects that have above- or below-average risk.Data on the 7 projects are shown below.If these are the only projects under consideration,how large should the capital budget be? ​   A)  $150 million B)  $175 million C)  $75 million D)  $100 million E)  $125 million" class="answers-bank-image d-inline" rel="preload" >

Accepted Answer

A)   $150 million
B)   $175 million
C)   $75 million
D)   $100 million
E)   $125 millionF) B) and D)
G) B) and C)

Question 13

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 the assets that are acquired.

Accepted Answer

A) True 
 B)False  False

Question 14

Trahan Lumber Company hired you to help estimate its cost of capital.You obtained the following data: D1 = $1.25;P0 = $20.00;g = 5.00% (constant) ;and F = 6.00%.What is the cost of equity raised by selling new common stock?

Accepted Answer

A)   13.98%
B)   11.65%
C)   12.35%
D)   11.07%
E)   13.75%F) B) and D)
G) B) and E)

Question 15

Which of the following statements is CORRECT?

Accepted Answer

A)   The "break point" as discussed in the text refers to the point where the firm's tax rate increases.
B)   The "break point" as discussed in the text refers to the point where the firm has raised so much capital that it is simply unable to borrow any more money.
C)   The "break point" as discussed in the text refers to the point where the firm is taking on investments that are so risky the firm is in serious danger of going bankrupt if things do not go exactly as planned.
D)   The "break point" as discussed in the text refers to the point where the firm has raised so much capital that it has exhausted its supply of additions to retained earnings and thus must raise equity by issuing stock.
E)   The "break point" as discussed in the text refers to the point where the firm has exhausted its supply of additions to retained earnings and thus must begin to finance with preferred stock.F) All of the above
G) A) and E)

Question 16

Suppose you are the president of a small,publicly-traded corporation.Since you believe that your firm's stock price is temporarily depressed,all additional capital funds required during the current year will be raised using debt.In this case,the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt.

Accepted Answer

A) True 
 B)False

Question 17

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 D)
G) A) and D)

Question 18

Teall Development Company hired you as a consultant to help them estimate its cost of capital.You have been provided with the following data: D1 = $1.45;P0 = $28.00;and g = 6.50% (constant) .Based on the DCF approach,what is the cost of equity from retained earnings?

Accepted Answer

A)   9.34%
B)   12.15%
C)   10.16%
D)   10.51%
E)   11.68%F) B) and D)
G) None of the above

Question 19

Sorensen Systems Inc.is expected to pay a $2.50 dividend at year end (D1 = $2.50) ,the dividend is expected to grow at a constant rate of 5.50% a year,and the common stock currently sells for $87.50 a share.The before-tax cost of debt is 7.50%,and the tax rate is 25%.The target capital structure consists of 45% debt and 55% common equity.What is the company's WACC if all the equity used is from retained earnings? Do not round your intermediate calculations.

Accepted Answer

A)   5.69%
B)   6.62%
C)   7.35%
D)   7.13%
E)   5.10%F) A) and B)
G) A) and C)

Question 20

A company's perpetual preferred stock currently sells for $105.00 per share,and it pays an $8.00 annual dividend.If the company were to sell a new preferred issue,it would incur a flotation cost of 5.00% of the issue price.What is the firm's cost of preferred stock?

Accepted Answer

A)   8.02%
B)   6.18%
C)   9.14%
D)   9.70%
E)   6.66%F) All of the above
G) A) and B) A

Exam 11: The Cost of Capital

The cost of equity raised by retaining earnings can be less than,equal to,or greater than the cost of external equity raised by selling new issues of common stock,depending on tax rates,flotation costs,the attitude of investors,and other factors.

Correct Answer
verified

Suppose the debt ratio is 50%,the interest rate on new debt is 8%,the current cost of equity is 16%,and the tax rate is 40%.An increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC).

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
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 CAPM method always provides an accurate and reliable estimate.

Correct Answer
verified

Correct Answer
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C

Correct Answer
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Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.

Correct Answer
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Correct Answer
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Which of the following statements is CORRECT?

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 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 the assets that are acquired.

Correct Answer
verified
False

Trahan Lumber Company hired you to help estimate its cost of capital.You obtained the following data: D₁ = $1.25;P₀ = $20.00;g = 5.00% (constant) ;and F = 6.00%.What is the cost of equity raised by selling new common stock?

Correct Answer
verified

Which of the following statements is CORRECT?

Correct Answer
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Correct Answer
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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

Teall Development Company hired you as a consultant to help them estimate its cost of capital.You have been provided with the following data: D₁ = $1.45;P₀ = $28.00;and g = 6.50% (constant) .Based on the DCF approach,what is the cost of equity from retained earnings?

Correct Answer
verified

Correct Answer
verified

A company's perpetual preferred stock currently sells for $105.00 per share,and it pays an $8.00 annual dividend.If the company were to sell a new preferred issue,it would incur a flotation cost of 5.00% of the issue price.What is the firm's cost of preferred stock?

Correct Answer
verified
A

Exam 11: The Cost of Capital

The cost of equity raised by retaining earnings can be less than,equal to,or greater than the cost of external equity raised by selling new issues of common stock,depending on tax rates,flotation costs,the attitude of investors,and other factors.

Correct AnswerverifiedShow Answer

Suppose the debt ratio is 50%,the interest rate on new debt is 8%,the current cost of equity is 16%,and the tax rate is 40%.An increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC).

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

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 CAPM method always provides an accurate and reliable estimate.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedC

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.

Correct AnswerverifiedShow Answer

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

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 the assets that are acquired.

Correct AnswerverifiedFalse

Trahan Lumber Company hired you to help estimate its cost of capital.You obtained the following data: D1 = $1.25;P0 = $20.00;g = 5.00% (constant) ;and F = 6.00%.What is the cost of equity raised by selling new common stock?

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

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

Teall Development Company hired you as a consultant to help them estimate its cost of capital.You have been provided with the following data: D1 = $1.45;P0 = $28.00;and g = 6.50% (constant) .Based on the DCF approach,what is the cost of equity from retained earnings?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

A company's perpetual preferred stock currently sells for $105.00 per share,and it pays an $8.00 annual dividend.If the company were to sell a new preferred issue,it would incur a flotation cost of 5.00% of the issue price.What is the firm's cost of preferred stock?

Correct AnswerverifiedA

Correct Answer
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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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Correct Answer
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Correct Answer
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C

Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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False

Trahan Lumber Company hired you to help estimate its cost of capital.You obtained the following data: D₁ = $1.25;P₀ = $20.00;g = 5.00% (constant) ;and F = 6.00%.What is the cost of equity raised by selling new common stock?

Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
verified

Teall Development Company hired you as a consultant to help them estimate its cost of capital.You have been provided with the following data: D₁ = $1.45;P₀ = $28.00;and g = 6.50% (constant) .Based on the DCF approach,what is the cost of equity from retained earnings?

Correct Answer
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Correct Answer
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Correct Answer
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A