Question 1

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

Accepted Answer

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

Question 2

To estimate the required rate of return on common equity, the DCF method can be used only for constant growth stocks.

Accepted Answer

A) True 
 B)False

Question 3

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) B) and C)
F) A) and C)

Question 4

If a firm's marginal tax rate is increased, and other things held constant, this would lower the cost of debt used to calculate its WACC.

Accepted Answer

A) True 
 B)False

Question 5

Grunewald Co.'s common stock currently sells for $60.00 per share, the company expects to earn $3.00 per share during the current year, its expected payout ratio is 40%, and its expected constant growth rate is 7.00%. New stock can be sold to the public at the current price, but a flotation cost of 9% would be incurred. By how much would the cost of new stock exceed the cost of retained earnings?

Accepted Answer

A)   0.05%
B)   0.10%
C)   0.20%
D)   0.30%E) C) and D)
F) B) and D)

Question 6

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) B) and D)
F) A) and D)

Question 7

What is the best estimate of the WACC for CGT?

Accepted Answer

A)   9.88%
B)   10.18%
C)   10.50%
D)   11.14%E) B) and C)
F) A) and D)

Question 8

Suppose you are the president of a small, publicly traded corporation. Since you believe that your firm's share price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. Thus, 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 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

Which of the following statements is correct?

Accepted Answer

A)   The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the interest rate on the company's own long-term bonds. The size of the risk premium for bonds with different ratings is published daily in The Wall Street Journal.
B)   The WACC is calculated using a before-tax cost for debt equal to the interest rate that must be paid on new debt, along with the after-tax costs for common stock and for preferred stock if it is used.
C)   An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity.
D)   The WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm's target capital structure.E) A) and B)
F) A) and C)

Question 11

Which of the following statements is correct?

Accepted Answer

A)   The discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever.
B)   If the calculated beta underestimates the firm's true investment risk, i.e., if the forward-looking beta that investors think exists exceeds the historical beta, then the CAPM method based on the historical beta will produce an estimate of rs and thus a WACC that is too high.
C)   Beta measures market risk, which is the most relevant risk measure for a publicly owned firm that seeks to maximize its intrinsic value. This is true even if not all of the firm's stockholders are well diversified.
D)   The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach.E) All of the above
F) A) and B)

Question 12

If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity. However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit the shift toward debt.

Accepted Answer

A) True 
 B)False

Question 13

What will happen if a typical company uses the same cost of capital to evaluate all projects?

Accepted Answer

A)   The firm will likely become riskier over time, but its intrinsic value will be maximized.
B)   The firm will likely become riskier over time, and its intrinsic value will not be maximized.
C)   The firm will likely become less risky over time, and its intrinsic value will not be maximized.
D)   The firm will likely become less risky over time, and its intrinsic value will be maximized.E) B) and C)
F) C) and D)

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) All of the above
F) C) and D)

Question 15

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) B) and C)
F) C) and D)

Question 16

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 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) None of the above
F) A) and B)

Question 18

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 19

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) A) and C)

Question 20

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 project (A, B, C, or D)  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)   Project A has a below-average risk and has a return of 7.5%.E) All of the above
F) None of the above

Exam 9: The Cost of Capital

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 project (A, B, C, or D) should the company accept?

Correct Answer
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To estimate the required rate of return on common equity, the DCF method can be used only for constant growth stocks.

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

Correct Answer
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Correct Answer
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Among various sources of financing, which one will receive favourable tax treatments by issuers?

Correct Answer
verified

Which of the following statements is correct?

Correct Answer
verified

If a firm's marginal tax rate is increased, and other things held constant, this would lower the cost of debt used to calculate its WACC.

Correct Answer
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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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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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What will happen if a typical company uses the same cost of capital to evaluate all projects?

Correct Answer
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Which of the following statements is correct?

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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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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Correct Answer
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What is the best estimate of the WACC for CGT?

Correct Answer
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Which of the following statements is correct?

Correct Answer
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Exam 9: The Cost of Capital

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 project (A, B, C, or D) should the company accept?

Correct AnswerverifiedShow Answer

To estimate the required rate of return on common equity, the DCF method can be used only for constant growth stocks.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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

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

Correct AnswerverifiedShow Answer

Which of the following statements is correct?

Correct AnswerverifiedShow Answer

If a firm's marginal tax rate is increased, and other things held constant, this would lower the cost of debt used to calculate its WACC.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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

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

What will happen if a typical company uses the same cost of capital to evaluate all projects?

Correct AnswerverifiedShow Answer

Which of the following statements is correct?

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

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

Correct AnswerverifiedShow Answer

What is the best estimate of the WACC for CGT?

Correct AnswerverifiedShow Answer

Which of the following statements is correct?

Correct AnswerverifiedShow Answer

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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Correct Answer
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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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Correct Answer
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Correct Answer
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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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Correct Answer
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Correct Answer
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Correct Answer
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