COSTS of CAPITAL, CAPITAL STRUCTURE & LEVERAGE

Question 1

1. Which of the following is NOT a component used in calculating the cost of capital?
   a. Cost of long-term debt
   b. Cost of short-term debt
   c. Cost of common stock
   d. Cost of retained earnings

Answer 1

b. Cost of short-term debt

Question 2

2. A company believes that it can sell long-term bonds with a 6% coupon, but a price that gives a yield-to-maturity of 9%. If such bonds are part of next year’s financing plans, which of the following should be used for bonds in the
   after-tax (40%) cost-of-capital calculation?
   a. 3.6%
   b. 5.4%
   c. 4.2%
   d. 6.0%

Answer 2

b. 5.4%
Solution: Cost of debt: yield rate (100% – tax rate) = 9% (100% – 40%)

Question 3

3. Blink Company sold 12%, non-convertible preferred stock with a par value of P 50. The stock sold for P 55, and
   flotation costs were 6% of the market price. Tax rate is 30%. What is Blink’s cost of preferred stock?
   a. 11.61%
   b. 10.91%
   c. 8.12%
   d. 7.64%

Answer 3

a. 11.61%
Solution: Cost of preferred stock: dividend yield = expected dividend ÷ net price = [50 (12%)] ÷ [55 (94%)]
NOTE: Flotation cost is considered in computing cost of debts/shares, NOT in computing cost of retained earnings.

Question 4

4. Generally, the most expensive source of financing for a firm is:
   a. Debt
   b. Preferred stock
   c. Retained earnings
   d. New common stock

Answer 4

d. New common stock

Question 5

5. A firm is expected to pay a dividend of P 5.00 per share this year. Dividend is expected to grow at a rate of 6%. If
   the current market price of the stock is P 60 per share, what is the estimated cost of equity?
   a. 6%
   b. 8.3%
   c. 12%
   d. 14.3%

Answer 5

Solution: Cost of equity (Gordon model): dividend yield + growth rate = (5 ÷ 60) + 6%

Question 6

6. The Gordon model (Dividend Growth model) assumes that the return on share of common stock is comprised of a:
   a. Dividend yield and dividends growth rate
   b. Dividend yield and expected price next year
   c. Capital gains yield and dividend growth rate
   d. Capital gains growth rate and dividend growth rate

Answer 6

a. Dividend yield and dividends growth rate

Question 7

7. The value of the stock increases as the
   a. Value of the debt decreases
   b. Dividend growth rate decreases
   c. Required rate of return increases
   d. Required rate of return decreases

Answer 7

d. Required rate of return decreases

Question 8

8. Bangkok Corporation carries no debt in its capital structure. Its beta is 0.8. The risk-free rate is 9 percent and the
   expected return on the market is 15 percent. The company has an opportunity to invest in a project that earns 12%.
   What is Bangkok’s required rate of return (i.e., cost of capital)?
   a. 4.8%
   b. 9%
   c. 12%
   d. 13.8%

Answer 8

Solution: Cost of capital (CAPM): risk-free rate + beta-adjusted risk premium = 9% + 0.8 (15% - 9%)

Question 9

9. Under CAPM, “beta” can best be described as the
   a. Weighted-average return of an investment portfolio
   b. Variability of standard deviation of the investment returns
   c. Investment return’s sensitivity to changes in interest rates
   d. Investment return’s sensitivity to changes in the market’s returns

Answer 9

d. Investment return’s sensitivity to changes in the market’s returns

Question 10

10. The additional return one must expect to receive for assuming risk?
    a. Risk discount
    b. Risk premium
    c. Risk-free rate of return
    d. Expected rate of return

Answer 10

b. Risk premium

Question 12

12. When establishing optimal capital structure, firms should strive to
    a. Maximize the marginal cost of capital
    b. Maximize the amount of equity financing
    c. Minimize the amount of debt financing used
    d. Minimize the weighted average cost of capital

Answer 12

d. Minimize the weighted average cost of capital

Question 13

13. If a high percentage of an entity’s total costs is fixed, the entity’s operating leverage will be
    a. Low
    b. High
    c. Unchanged
    d. Unable to be determined

Answer 13

b. High

Question 13

14. Positive financial leverage is an indication of:
    Ca. Liquidity and solvency are expressed as a single measure
    b. Yield that shareholders can expect on their investment
    c. The benefit obtained from the use of borrowed funds
    d. The rate at which the earnings of a company are expected to grow

Answer 13

c. The benefit obtained from the use of borrowed funds

NOTE: The positive financial leverage results when a business borrows funds and then invests the funds at a rate of
return higher than the rate at which they were borrowed (i.e., return on equity > return on assets > cost of debt)

Question 14

15. Because the degree of total leverage is multiplicative and not additive, when a firm has very high operating leverage
    it can moderate its total risk by
    a. Increasing EBIT
    b. Increasing Sales
    c. Using more financial leverage
    d. Using a lower level of financial leverage

Answer 14

d. Using a lower level of financial leverage
NOTE: Total Leverage = Operating Leverage x Financial Leverage