CHAPTER 15
Cost of Capital
I. DEFINITIONS
COST OF CAPITAL
a 1. The opportunity cost associated with the firm’s capital investment in a project is
called
its:
a. cost of capital.
b. beta coefficient.
c. capital gains yield.
d. sunk cost.
e. internal rate of return.
COST OF EQUITY
b 2. The return that shareholders require on their investment in the firm is called the:
a. dividend yield.
b. cost of equity.
c. capital gains yield.
d. cost of capital.
e. income return.
COST OF DEBT
c 3. The return that lenders require on their loaned funds to the firm is called the:
a. coupon rate.
b. current yield.
c. cost of debt.
d. capital gains yield.
e. cost of capital.
CAPITAL STRUCTURE WEIGHTS
d 4. The proportions of the market value of the firm’s assets financed via debt, common
stock, and preferred stock are called the firm’s:
a. financing costs.
b. portfolio weights.
c. beta coefficients.
d. capital structure weights.
e. costs of capital.
WACC
e 5. The weighted average of the firm’s costs of equity, preferred stock, and aftertax debt
is
the:
a. reward to risk ratio for the firm.
b. expected capital gains yield for the stock.
c. expected capital gains yield for the firm.
d. portfolio beta for the firm.
e. weighted average cost of capital (WACC).
DIVISIONAL COST OF CAPITAL
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a 6. For a firm with multiple business units, the cost of capital developed for each unit is
called a:
a. divisional cost of capital.
b. pure play approach.
c. subjective risk adjustment.
d. stratified beta coefficient.
e. fundamental beta coefficient.
PURE PLAY APPROACH
b 7. When firms develop a WACC for individual projects based on the cost of capital for
other firms in similar lines of business as the project, the firm is utilizing a _____
approach.
a. subjective risk
b. pure play
c. divisional cost of capital
d. capital adjustment
e. security market line
FLOTATION COSTS
c 8. The costs incurred by the firm when new issues of stocks or bonds are sold are
called:
a. required rates of return.
b. costs of capital.
c. flotation costs.
d. capital structure weights.
e. costs of equity and debt.
II. CONCEPTS
COST OF CAPITAL
e 9. The cost of capital:
a. will decrease as the risk level of a firm increases.
b. is primarily dependent on the source of the funds used in a project.
c. implies that a project will produce a positive net present value only when the rate of
return on the project is less than the cost of capital.
d. remains constant for all projects sponsored by the same firm.
e. depends on how the funds are going to be utilized.
COST OF CAPITAL
c 10. The overall cost of capital for a retail store:
a. is equivalent to the after-tax cost of the firm’s liabilities.
b. should be used as the required return when analyzing a potential acquisition of a
wholesale distributor.
c. reflects the return investors require on the total assets of the firm.
d. remains constant even when the debt-equity ratio changes.
e. is unaffected by changes in corporate tax rates.
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COST OF EQUITY
d 11. A firm’s overall cost of equity is:
I. directly observable in the financial markets.
II. unaffected by changes in the market risk premium.
III. highly dependent upon the growth rate and risk level of a firm.
IV. an estimate only.
a. I and III only
b. II and IV only
c. I and II only
d. III and IV only
e. I and IV only
COST OF EQUITY
b 12. The cost of equity for a firm is:
a. determined by directly observing the rate of return required by equity investors.
b. based on estimates derived from financial models.
c. equivalent to a leveraged firm’s cost of capital.
d. equal to the risk-free rate of return plus the market risk premium.
e. equal to the risk-free rate of return plus the dividend growth rate.
DIVIDEND GROWTH MODEL
c 13. The dividend growth model:
a. can be used to estimate the cost of equity for any corporation.
b. is applicable only to firms that pay a constant dividend.
c. is highly dependent upon the estimated rate of growth.
d. is considered quite complex.
e. considers the risk of the firm.
DIVIDEND GROWTH MODEL
c 14. The dividend growth model:
a. generally produces the same estimated cost of equity for a firm regardless of the
source
of information used to predict the rate of growth.
b. can only be used if historical dividend information is available.
c. ignores the risk that future dividends may vary from their estimated values.
d. assumes that both the dividend amount and the stock price are not constant over time.
e. uses beta to measure the systematic risk of the firm.
SECURITY MARKET LINE APPROACH
a 15. The market risk premium:
a. varies over time as both the risk-free rate of return and the market rate of return vary.
b. plus the risk-free rate of return equals the cost of capital for any firm with a beta of
zero.
c. is equal to one percent for a risk-free asset.
d. is equal to the risk-free rate of return multiplied by the beta of a firm.
e. is modified by the standard deviation when computing the cost of equity.
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SECURITY MARKET LINE APPROACH
e 16. Which of the following statements are correct concerning the security market line
(SML) approach?
I. The SML approach considers the amount of systematic risk associated with an
individual firm.
II. The SML approach can be applied to more firms than the dividend growth model can.
III. The SML approach generally relies on the past to predict the future.
IV. The SML approach generally assumes that the reward-to-risk ratio is constant.
a. I and III only
b. II and IV only
c. III and IV only
d. I, II, and III only
e. I, II, III, and IV
COST OF DEBT
a 17. The pre-tax cost of debt for a firm:
a. is equal to the yield to maturity on the outstanding bonds of the firm.
b. is equal to the coupon rate of the outstanding bonds of the firm.
c. is equivalent to the current yield on the outstanding bonds of the firm.
d. is based on the yield to maturity that existed when the currently outstanding bonds
were originally issued.
e. has to be estimated as it cannot be directly observed in the market.
COST OF DEBT
d 18. The after-tax cost of debt generally increases when:
I. a firm’s bond rating increases.
II. the market rate of interest increases.
III. tax rates decrease.
IV. bond prices decline.
a. I and III only
b. II and III only
c. I, II, and III only
d. II, III, and IV only
e. I, II, III, and IV
COST OF PREFERRED STOCK
d 19. The cost of preferred stock is computed the same as:
a. the pre-tax cost of debt.
b. an annuity.
c. the after-tax cost of debt.
d. a perpetuity.
e. an irregular growth common stock.
COST OF PREFERRED STOCK
a 20. The cost of preferred stock:
a. is equal to the dividend yield on the stock.
b. is equal to the yield to maturity.
c. is highly dependent on the growth rate.
d. varies directly with the stock’s price.
e. is difficult to determine.
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CAPITAL STRUCTURE WEIGHTS
d 21. The capital structure weights used in computing the weighted average cost of capital
are:
a. constant over time provided that the debt-equity ratio changes in unison with the
market values.
b. based on the face value of the firm’s debt.
c. computed using the book value of the long-term debt and the shareholder’s equity.
d. based on the market value of the firm’s debt and equity securities.
e. limited to the firm’s debt and common stock.
CAPITAL STRUCTURE WEIGHTS
c 22. Your firm uses both preferred and common stock as well as long-term debt to finance
its operations. Which one of the following will increase the capital structure weight
of the debt, all else equal?
a. an increase in the market price of the common stock
b. an increase in the number of shares of preferred stock outstanding
c. an increase in the quoted price of the firm’s bonds as a percentage of face value
d. the exercise of warrants by company employees
e. the conversion of convertible bonds into equity shares
WEIGHTED AVERAGE COST OF CAPITAL
e 23. The weighted average cost of capital for a firm is dependent upon the firm’s:
I. tax rate.
II. debt-equity ratio.
III. coupon rate on the preferred stock.
IV. level of risk.
a. I and III only
b. II and IV only
c. I, II, and IV only
d. I, III, and IV only
e. I, II, III, and IV
WEIGHTED AVERAGE COST OF CAPITAL
b 24. The weighted average cost of capital for a firm is the:
a. discount rate which the firm should apply to all of the projects it undertakes.
b. overall rate which the firm must earn on its existing assets to maintain the value
of its stock.
c. rate the firm should expect to pay on its next bond issue.
d. maximum rate which the firm should require on any projects it undertakes.
e. rate of return that the firm’s preferred stockholders should expect to earn over the
long
term.
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WEIGHTED AVERAGE COST OF CAPITAL
e 25. Which one of the following statements is correct concerning the weighted average
cost
of capital (WACC)?
a. The pre-tax rate of return on the debt is the rate that is relevant to the computation of
the WACC.
b. When computing the WACC, the weight assigned to the preferred stock is equal to
the
coupon rate multiplied by the par value assigned to the preferred stock.
c. A firm’s WACC will decrease as their corporate tax rate decreases.
d. The weight of the common stock used in the computation of the WACC is based on
the
number of shares outstanding multiplied by the book value per share.
e. The weight of the debt can be based on the face value of the bond issue(s)
