UNIT 10: COST OF CAPITAL

Question 1

Which of the following is not considered a capital component for thepurpose of calculating the weighted average cost of capital (WACC) as itapplies to capital budgeting?

a. Long-term debt.
b. Common stock.
c. Accounts payable and accruals.
d. Preferred stock.

Answer 1

C

Question 2

For a typical firm with a given capital structure, which of the followingis correct? (Note: All rates are after taxes.)

a. kd > ke > ks > WACC.
b. ks > ke > kd > WACC.
c. WACC > ke > ks > kd.
d. ke > ks > WACC > kd.
e. None of the statements above is correct.

Answer 2

D

Question 3

Which of the following statements is most correct?

a. If a company’s tax rate increases but the yield to maturity of its noncallable bonds remains the same, the company’s marginal cost of debt capital used to calculate its weighted average cost of capital will fall.
b. All else equal, an increase in a company’s stock price will increasethe marginal cost of retained earnings, ks.
c. All else equal, an increase in a company’s stock price will increasethe marginal cost of issuing new common equity, ke.
d. Statements a and b are correct.
e. Statements b and c are correct.

Answer 3

A

Question 4

Which of the following statements is most correct?

a. Since the money is readily available, the cost of retained earnings isusually a lot cheaper than the cost of debt financing.
b. When calculating the cost of preferred stock, a company needs to adjustfor taxes, because preferred stock dividends are tax deductible.
c. When calculating the cost of debt, a company needs to adjust for taxes,because interest payments are tax deductible.
d. Statements a and b are correct.
e. Statements b and c are correct.

Answer 4

C

Question 5

Which of the following factors in the discounted cash flow (DCF) approachto estimating the cost of common equity is the least difficult to estimate?

a. Expected growth rate, g.
b. Dividend yield, D1/P0.
c. Required return, ks.
d. Expected rate of return, ˆks .
e. All of the above are equally difficult to estimate.

Answer 5

B

Question 6

Which of the following statements is most correct?

a. The WACC measures the after-tax cost of capital.
b. The WACC measures the marginal cost of capital.
c. There is no cost associated with using retained earnings.
d. Statements a and b are correct.
e. All of the statements above are correct.

Answer 6

D

Question 7

Which of the following statements about the cost of capital is incorrect?

a. A company’s target capital structure affects its weighted average costof capital.
b. Weighted average cost of capital calculations should be based on theafter-tax costs of all the individual capital components.
c. If a company’s tax rate increases, then, all else equal, its weightedaverage cost of capital will increase.
d. Flotation costs can increase the weighted average cost of capital.
e. An increase in the risk-free rate is likely to increase the marginalcosts of both debt and equity financing.

Answer 7

C

Question 8

Campbell Co. is trying to estimate its weighted average cost of capital(WACC). Which of the following statements is most correct?

a. The after-tax cost of debt is generally cheaper than the after-tax costof preferred stock.
b. Since retained earnings are readily available, the cost of retainedearnings is generally lower than the cost of debt.
c. If the company’s beta increases, this will increase the cost of equityfinancing, even if the company is able to rely on only retainedearnings for its equity financing.
d. Statements a and b are correct.
e. Statements a and c are correct.

Answer 8

E

Question 9

Wyden Brothers has no retained earnings. The company uses the CAPM to calculate the cost of equity capital. The company’s capital structure consists of common stock, preferred stock, and debt. Which of the following events will reduce the company’s WACC?

a. A reduction in the market risk premium.
b. An increase in the flotation costs associated with issuing new commonstock.
c. An increase in the company’s beta.
d. An increase in expected inflation.
e. An increase in the flotation costs associated with issuing preferredstock

Answer 9

A

Question 10

Which of the following statements is most correct?

a. The WACC is a measure of the before-tax cost of capital.
b. Typically the after-tax cost of debt financing exceeds the after-taxcost of equity financing.
c. The WACC measures the marginal after-tax cost of capital.
d. Statements a and b are correct.
e. Statements b and c are correct.

Answer 10

C

Question 11

A company has a capital structure that consists of 50 percent debt and 50 percent equity. Which of the following statements is most correct?

a. The cost of equity financing is greater than or equal to the cost ofdebt financing.
b. The WACC exceeds the cost of equity financing.
c. The WACC is calculated on a before-tax basis.
d. The WACC represents the cost of capital based on historical averages.In that sense, it does not represent the marginal cost of capital.
e. The cost of retained earnings exceeds the cost of issuing new commonstock.

Answer 11

A

Question 12

A firm estimates that its proposed capital budget will force it to issue new common stock, which has a greater cost than the cost of retainedearnings. The firm, however, would like to avoid issuing costly new commonstock. Which of the following steps would mitigate the firm’s need to raise new common stock?

a. Increasing the company’s dividend payout ratio for the upcoming year.
b. Reducing the company’s debt ratio for the upcoming year.
c. Increasing the company’s proposed capital budget.
d. All of the statements above are correct.
e. None of the statements above is correct.

Answer 12

E

Question 13

Dick Boe Enterprises, an all-equity firm, has a corporate beta coefficient of 1.5. The financial manager is evaluating a project with an expected return of 21 percent, before any risk adjustment. The risk-free rate is 10 percent, and the required rate of return on the market is 16 percent. The project being evaluated is riskier than Boe’s average project, in terms of both beta risk and total risk.Which of the following statements is most correct?

a. The project should be accepted since its expected return (before riskadjustment) is greater than its required return.
b. The project should be rejected since its expected return (before riskadjustment) is less than its required return.
c. The accept/reject decision depends on the risk-adjustment policy of thefirm. If the firm’s policy were to reduce a riskier-than-averageproject’s expected return by 1 percentage point, then the project should be accepted.
d. Riskier-than-average projects should have their expected returns increased to reflect their added riskiness. Clearly, this would make the project acceptable regardless of the amount of the adjustment.
e. Projects should be evaluated on the basis of their total risk alone.Thus, there is insufficient information in the problem to make an accept/reject decision.

Answer 13

C

Question 14

A company estimates that an average-risk project has a WACC of 10 percent,a below-average risk project has a WACC of 8 percent, and an above-average risk project has a WACC of 12 percent. Which of the following independent projects should the company accept?

a. Project A has average risk and a return of 9 percent.
b. Project B has below-average risk and a return of 8.5 percent.
c. Project C has above-average risk and a return of 11 percent.
d. All of the projects above should be accepted.
e. None of the projects above should be accepted.

Answer 14

B

Question 15

Conglomerate Inc. consists of 2 divisions of equal size, and Conglomerate is 100 percent equity financed. Division A’s cost of equity capital is 9.8 percent, while Division B’s cost of equity capital is 14 percent. Conglomerate’s composite WACC is 11.9 percent. Assume that all Division A projects have the same risk and that all Division B projects have the same risk. However, the projects in Division A are not the same risk as those in Division B. Which of the following projects should Conglomerate accept?

a. Division A project with an 11 percent return.
b. Division B project with a 12 percent return.
c. Division B project with a 13 percent return.
d. Statements a and c are correct.
e. Statements b and d are correct.

Answer 15

A

Question 16

Which of the following will increase a company’s retained earnings breakpoint?

a. An increase in its net income.
b. An increase in its dividend payout.
c. An increase in the amount of equity in its capital structure.
d. An increase in its capital budget.
e. All of the statements above are correct.

Answer 16

A

Question 17

Which of the following actions will increase the retained earnings breakpoint?

a. An increase in the dividend payout ratio.
b. An increase in the debt ratio.
c. An increase in the capital budget.
d. An increase in flotation costs.
e. All of the statements above are correct.

Answer 17

B

Question 18

Which of the following statements is most correct?

a. Since debt capital is riskier than equity capital, the cost of debt is always greater than the WACC.
b. Because of the risk of bankruptcy, the cost of debt capital is always higher than the cost of equity capital.
c. If a company assigns the same cost of capital to all of its projects regardless of the project’s risk, then it follows that the company will generally reject too many safe projects and accept too many risky projects.
d. Because you are able to avoid flotation costs, the cost of retained earnings is generally lower than the cost of debt.
e. Higher flotation costs tend to reduce the cost of equity capital.

Answer 18

C

Question 19

Which of the following statements is most correct?

a. Higher flotation costs reduce investor returns, and therefore reduce acompany’s WACC.
b. The WACC represents the historical cost of capital and is usually calculated on a before-tax basis.
c. The cost of retained earnings is zero because retained earnings arereadily available and do not require the payment of flotation costs.
d. All of the statements above are correct.
e. None of the statements above is correct.

Answer 19

E

Question 20

Which of the following statements is most correct?

a. In the weighted average cost of capital calculation, we must adjust the cost of preferred stock for the tax exclusion of 70 percent of dividend income.
b. We ideally would like to use historical measures of the component costs from prior financings in estimating the appropriate weighted average cost of capital.
c. The cost of a new equity issuance (ke) could possibly be lower than the cost of retained earnings (ks) if the market risk premium and risk-freerate decline by a substantial amount.
d. Statements b and c are correct.
e. None of the statements above is correct.

Answer 20

E

Question 21

Which of the following statements is most correct?

a. The cost of retained earnings is the rate of return stockholdersrequire on a firm’s common stock.
b. The component cost of preferred stock is expressed as kp(1 - T), because preferred stock dividends are treated as fixed charges, similar to thetreatment of debt interest.
c. The bond-yield-plus-risk-premium approach to estimating a firm’s costof common equity involves adding a subjectively determined risk premiumto the market risk-free bond rate.
d. The higher the firm’s flotation cost for new common stock, the morelikely the firm is to use preferred stock, which has no flotation cost.
e. None of the statements above is correct.

Answer 21

A

Question 22

Which of the following statements is correct?

a. The cost of capital used to evaluate a project should be the cost ofthe specific type of financing used to fund that project.
b. The cost of debt used to calculate the weighted average cost of capitalis based on an average of the cost of debt already issued by the firmand the cost of new debt.
c. One problem with the CAPM approach in estimating the cost of equitycapital is that if a firm’s stockholders are, in fact, not welldiversified, beta may be a poor measure of the firm’s true investmentrisk.
d. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method of estimating a firm’s cost of equity capital.
e. The cost of equity capital is generally easier to measure than the cost of debt, which varies daily with interest rates, or the cost ofpreferred stock since preferred stock is issued infrequently.

Answer 22

C

Question 23

Which of the following statements is correct?

a. Although some methods of estimating the cost of equity capitalencounter severe difficulties, the CAPM is a simple and reliable modelthat provides great accuracy and consistency in estimating the cost ofequity capital.
b. The DCF model is preferred over other models to estimate the cost ofequity because of the ease with which a firm’s growth rate is obtained.
c. The bond-yield-plus-risk-premium approach to estimating the cost ofequity is not always accurate but its advantages are that it is astandardized and objective model.
d. Depreciation-generated funds are an additional source of capital and,in fact, represent the largest single source of funds for some firms.
e. None of the statements above is correct

Answer 23

D

Question 24

In applying the CAPM to estimate the cost of equity capital, which of thefollowing elements is not subject to dispute or controversy?

a. The expected rate of return on the market, kM.
b. The stock’s beta coefficient, bi.
c. The risk-free rate, kRF.
d. The market risk premium (RPM).
e. All of the above are subject to dispute.

Answer 24

E

Question 25

Which of the following statements is most correct?

a. Beta measures market risk, but if a firm’s stockholders are not welldiversified, beta may not accurately measure stand-alone risk.
b. If the calculated beta underestimates the firm’s true investment risk,then the CAPM method will overestimate ks.
c. The discounted cash flow method of estimating the cost of equity can’tbe used unless the growth component, g, is constant during the analysisperiod.
d. An advantage shared by both the DCF and CAPM methods of estimating thecost of equity capital, is that they yield precise estimates andrequire little or no judgement.
e. None of the statements above is correct.

Answer 25

A

Question 26

Which of the following statements is most correct?

a. The weighted average cost of capital for a given capital budget levelis a weighted average of the marginal cost of each relevant capitalcomponent that makes up the firm’s target capital structure.
b. The weighted average cost of capital is calculated on a before-tax basis.
c. An increase in the risk-free rate is likely to increase the marginalcosts of both debt and equity financing.
d. Statements a and c are correct.
e. All of the statements above are correct.

Answer 26

D

Question 27

Which of the following statements is correct?

a. The WACC should include only after-tax component costs. Therefore, therequired rates of return (or “market rates”) on debt, preferred, andcommon equity (kd, kp, and ks) must be adjusted to an after-tax basisbefore they are used in the WACC equation.
b. The cost of retained earnings is generally higher than the cost of newcommon stock.
c. Preferred stock is riskier to investors than is debt. Therefore, ifsomeone told you that the market rates showed kd company, that person must have made a mistake.> kp for a given
d. If a company with a debt ratio of 50 percent were suddenly exemptedfrom all future income taxes, then, all other things held constant,this would cause its WACC to increase.
e. None of the statements above is correct

Answer 27

D

Question 28

Which of the following statements is most correct?

a. An increase in flotation costs incurred in selling new stock willincrease the cost of retained earnings.
b. The WACC should include only after-tax component costs. Therefore, therequired rates of return (or “market rates”) on debt, preferred, andcommon equity (kd, kp, and ks) must be adjusted to an after-tax basisbefore they are used in the WACC equation.
c. An increase in a firm’s corporate tax rate will increase the firm’scost of debt capital, as long as the yield to maturity on the company’sbonds remains constant or falls.
d. Statements b and c are correct.
e. None of the statements above is correct.

Answer 28

E

Question 29

Which of the following statements is most correct?

a. Since stockholders do not generally pay corporate taxes, corporationsshould focus on before-tax cash flows when calculating the weightedaverage cost of capital (WACC).
b. All else equal, an increase in flotation costs will increase the costof retained earnings.
c. When calculating the weighted average cost of capital, firms shouldrely on historical costs rather than marginal costs of capital.
d. Statements a and b are correct.
e. None of the statements above is correct.

Answer 29

E

Question 30

Which of the following statements is correct?

a. Because we often need to make comparisons among firms that are indifferent income tax brackets, it is best to calculate the WACC on abefore-tax basis.
b. If a firm has been suffering accounting losses and is expected tocontinue suffering such losses, and therefore its tax rate is zero, itis possible that its after-tax component cost of preferred stock asused to calculate the WACC will be less than its after-tax componentcost of debt.
c. Normally, the cost of external equity raised by issuing new commonstock is above the cost of retained earnings. Moreover, the higher thegrowth rate is relative to the dividend yield, the more the cost ofexternal equity will exceed the cost of retained earnings.
d. The lower a company’s tax rate, the greater the advantage of using debtin terms of lowering its WACC.
e. None of the statements above is correct.

Answer 30

B

Question 31

Kemp Consolidated has two divisions of equal size: a computer division anda restaurant division. Stand-alone restaurant companies typically have acost of capital of 8 percent, while stand-alone computer companiestypically have a 12 percent cost of capital. Kemp’s restaurant divisionhas the same risk as a typical restaurant company, and its computerdivision has the same risk as a typical computer company. Consequently,Kemp estimates that its composite corporate cost of capital is 10 percent.The company’s consultant has suggested that they use an 8 percent hurdlerate for the restaurant division and a 12 percent hurdle rate for thecomputer division. However, Kemp has chosen to ignore its consultant, andinstead, chooses to assign a 10 percent cost of capital to all projects inboth divisions. Which of the following statements is most correct?

a. While Kemp’s decision to not risk adjust its cost of capital will leadit to accept more projects in its computer division and fewer projectsin its restaurant division, this should not affect the overall value ofthe company.
b. Kemp’s decision to not risk adjust means that it is effectivelysubsidizing its restaurant division, which means that its restaurantdivision is likely to become a larger part of the overall company overtime.
c. Kemp’s decision to not risk adjust means that the company will accepttoo many projects in the computer business and too few projects in therestaurant business. This will lead to a reduction in the overallvalue of the company.
d. Statements a and b are correct.
e. Statements b and c are correct.

Answer 31

C

Question 32

The Barabas Company has an equal amount of low-risk projects, average-riskprojects, and high-risk projects. Barabas estimates that the overallcompany’s WACC is 12 percent. This is also the correct cost of capital forthe company’s average-risk projects. The company’s CFO argues that, eventhough the company’s projects have different risks, the cost of capital foreach project should be the same because the company obtains its capitalfrom the same sources. If the company follows the CFO’s advice, what islikely to happen over time?

a. The company will take on too many low-risk projects and reject too manyhigh-risk projects.
b. The company will take on too many high-risk projects and reject toomany low-risk projects.
c. Things will generally even out over time, and therefore, the risk ofthe firm should remain constant over time.
d. Statements a and c are correct.
e. Statements b and c are correct.

Answer 32

B

Question 33

If a company uses the same cost of capital for evaluating all projects,which of the following results is likely?

a. Accepting poor, high-risk projects.
b. Rejecting good, low-risk projects.
c. Accepting only good, low-risk projects.
d. Accepting no projects.
e. Answers a and b are correct.

Answer 33

E

Question 34

If a typical U.S. company uses the same cost of capital to evaluate allprojects, the firm will most likely become

a. Riskier over time, and its value will decline.
b. Riskier over time, and its value will rise.
c. Less risky over time, and its value will rise.
d. Less risky over time, and its value will decline.
e. There is no reason to expect its risk position or value to change overtime as a result of its use of a single discount rate.

Answer 34

A

Question 35

Pearson Plastics has two equal-sized divisions, Division A and Division B.The company estimates that if the divisions operated as independentcompanies Division A would have a cost of capital of 8 percent, whileDivision B would have a cost of capital of 12 percent. Since the twodivisions are the same size, Pearson’s composite weighted average cost ofcapital (WACC) is 10 percent. In the past, Pearson has assigned separatehurdle rates to each division based on their relative risk. Now, however,Pearson has chosen to use the corporate WACC, which is currently 10 percent,for both divisions. Which of the following is likely to occur as a resultof this change? Assume that this change is likely to have no effect on theaverage risk of each division and market conditions remain unchanged.

a. Over time, the overall risk of the company will increase.
b. Over time, Division B will become a larger part of the overall company.
c. Over time, the company’s corporate WACC will increase.
d. Statements a and c are correct.
e. All of the statements above are correct.

Answer 35

E

Question 36

Smith Electric Co. and Ferdinand Water Co. are the same size and have thesame capital structure. Smith Electric co. Is riskier than ferdinand and has a WACC of 12 percent. Ferdinand Water Co. is safer than Smith and has a WACC of 10% . Ferdinand Water Co. is considering Project X. Project X has an IRR of 10.5 percent, and has the same risk as a typical project undertaken by Ferdinand Water Co. Smith Electric Co. isconsidering Project Y. Project Y has an IRR of 11.5 percent, and has thesame risk as a typical project undertaken by Smith Electric Co.

Now assume that Smith Electric Co. and Ferdinand Water Co. merge to form anew company, Leeds United Utilities. The merger has no impact on the cashflows or risk of either Project X or Project Y. Leeds United Utilities’CFO is trying to establish hurdle rates for the new company’s projects thataccurately reflect the risk of each project. (That is, he is using riskadjusted hurdle rates.) Which of the following statements is most correct?

a. Leeds United Utilities’ weighted average cost of capital is 11 percent.
b. Project X has a positive NPV.
c. After the merger, Leeds United Utilities should select Project X andreject Project Y.
d. Statements a and b are correct.
e. All of the statements above are correct.

Answer 36

E

Question 37

Which of the following statements is correct?

a. A relatively risky future cash outflow should be evaluated using arelatively low discount rate.
b. If a firm’s managers want to maximize the value of the stock, theyshould concentrate exclusively on projects’ market, or beta, risk.
c. If a firm evaluates all projects using the same cost of capital, thenthe riskiness of the firm as measured by its beta will probably declineover time.
d. If a firm has a beta that is less than 1.0, say 0.9, this would suggestthat its assets’ returns are negatively correlated with the returns ofmost other firms’ assets.
e. None of the statements above is correct.

Answer 37

A

Question 38

Which of the following statements is most correct?

a. Suppose a firm is losing money and thus, is not paying taxes, and thatthis situation is expected to persist for a few years whether or notthe firm uses debt financing. Then the firm’s after-tax cost of debtwill equal its before-tax cost of debt.
b. The component cost of preferred stock is expressed as kp(1 - T), becausepreferred stock dividends are treated as fixed charges, similar to thetreatment of debt interest.
c. The reason that a cost is assigned to retained earnings is becausethese funds are already earning a return in the business; the reasondoes not involve the opportunity cost principle.
d. The bond-yield-plus-risk-premium approach to estimating a firm’s costof common equity involves adding a subjectively determined risk premiumto the market risk-free bond rate.
e. None of the statements above is correct.

Answer 38

A