978-0132757089 Chapter 14 Part 1

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Financial Management: Principles and Applications, 11e (Titman)

Chapter 14 The Cost of Capital

1) In order to maximize firm value, management should invest in new assets when cash flows

from the assets are discounted at the firm’s ________ and result in a positive NPV.

A) cost of capital

B) cost of debt used to finance the project

C) rate of return on equity

D) internal rate of return

Topic: 14.1 The Cost of Capital: An Overview

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 1: Money Has a Time Value

2) The investor’s required rate of return differs from the firm’s cost of capital due to the:

A) firm’s beta.

B) tax deductibility of interest.

C) CAPM.

D) time value of money.

Topic: 14.1 The Cost of Capital: An Overview

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

3) The weights used to determine the relative importance of the firm’s sources of capital should

reflect:

A) book values in accord with generally accepted accounting principles.

B) current market values for bonds, common stock, and preferred stock and book values for

retained earnings.

C) current market values.

D) subjective adjustments for firm risk.

Topic: 14.1 The Cost of Capital: An Overview

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 1: Money Has a Time Value

4) Which of the following best describes a firm’s cost of capital?

A) The average yield to maturity on debt

B) The average cost of the firm’s assets

C) The rate of return that must be earned on its investments in order to satisfy the firm’s investors

D) The coupon rate on preferred stock

Topic: 14.1 The Cost of Capital: An Overview

Keywords: cost of capital

Principles: Principle 1: Money Has a Time Value

5) A firm’s capital structure consists of which of the following?

A) Common stock

B) Preferred stock

C) Bonds

D) All of the above

Topic: 14.1 The Cost of Capital: An Overview

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 1: Money Has a Time Value

6) Which of the following must be adjusted for the firm’s tax rate when estimating the weighted

average cost of capital WACC?

A) Cost of common equity

B) Cost of preferred stock

C) Cost of debt

D) All of the above

Topic: 14.1 The Cost of Capital: An Overview

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

7) Which of the following would NOT be considered in calculating a firm’s cost of capital?

A) Bonds

B) Accounts payable

C) Preferred Stock

D) common stock

Topic: 14.1 The Cost of Capital: An Overview

Keywords: cost of capital

Principles: Principle 1: Money Has a Time Value

8) Which of the following reasons causes bonds to be a less expensive form of capital for a

public firm than the issuance of common stock? Bondholders:

A) bear less risk than common stockholders bear.

B) have prior voting rights over common stockholders.

C) receive greater returns than common stockholders.

D) investors pay a lower tax rate on bond interest

Topic: 14.1 The Cost of Capital: An Overview

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

9) The cost of capital is:

A) the opportunity cost of using funds to invest in new projects.

B) the rate of return the firm must earn on its investments in order to satisfy the required rate of

return of the firm’s investors.

C) the required rate of return for new capital investments which have typical or average risk.

D) all of the above.

Topic: 14.1 The Cost of Capital: An Overview

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

10) Cost of capital is:

A) the coupon rate of debt.

B) a minimum rate of return set by the board of directors.

C) the rate of return that must be earned on additional investment if firm value is to remain

unchanged.

D) the average cost of the firm’s assets.

Topic: 14.1 The Cost of Capital: An Overview

Keywords: cost of capital

Principles: Principle 1: Money Has a Time Value

11) Which of the following is a correct formula for calculating the cost of capital?

A) WACC = weighted after-tax cost of debt + weighted cost of preferred stock + weighted cost

of common stock

B) WACC = weighted after-tax cost of debt + weighted after-tax cost of preferred stock +

weighted after–tax cost of common stock

C) WACC = (after-tax cost of debt + cost of preferred stock + cost of common stock )/3

D) WACC = weighted cost of debt + weighted cost of preferred stock + weighted cost of

common stock

Topic: 14.1 The Cost of Capital: An Overview

Keywords: cost of capital

Principles: Principle 1: Money Has a Time Value

12) The minimum rate of return necessary to attract an investor to purchase or hold a security is

called the cost of capital.

Topic: 14.1 The Cost of Capital: An Overview

Keywords: cost of capital

Principles: Principle 1: Money Has a Time Value

13) The weighted average cost of capital is computed using before-tax costs of each of the

sources of financing that a firm uses to finance a project.

Topic: 14.1 The Cost of Capital: An Overview

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 1: Money Has a Time Value

14) When investors increase their required rate of return, the cost of capital increases

simultaneously.

Topic: 14.1 The Cost of Capital: An Overview

Keywords: cost of capital

Principles: Principle 1: Money Has a Time Value

15) The firm should continue to invest in new projects up to the point where the marginal rate of

return earned on a new investment equals the marginal cost of new capital.

Topic: 14.1 The Cost of Capital: An Overview

Keywords: cost of capital

Principles: Principle 1: Money Has a Time Value

16) Business risk reflects the added variability in earnings available to a firm’s shareholders.

Topic: 14.1 The Cost of Capital: An Overview

Keywords: cost of capital

Principles: Principle 1: Money Has a Time Value

17) Briefly identify and describe some important uses of a firm’s weighted average cost of

capital.

Topic: 14.1 The Cost of Capital: An Overview

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 1: Money Has a Time Value

14.2 Determining the Firm’s Capital Structure Weights

Use the following information to answer the following question(s).

The following data concerning Grafton Computer Peripherals’ capital structure is available.

$ millions Book Values Market Values

Accounts

Payable &

Accruals $100

Short-term

notes 50 50

Long-term

debt 150 200

Preferred

Stock 25 50

Common

Stock 200 500

1) The percentage of common stock in Grafton’s weighted average cost of capital is:

A) 38.1%.

B) 20%.

C) 6.25%.

D) 62.5%.

Topic: 14.2 Determining the Firm’s Capital Structure Weights

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 4: Market Prices Reflect Information

2) The percentage of debt in Grafton’s weighted average cost of capital is:

A) 38.1%.

B) 25%.

C) 31.25%.

D) 57.14%.

Topic: 14.2 Determining the Firm’s Capital Structure Weights

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 4: Market Prices Reflect Information

3) The percentage of preferred stock in Grafton’s weighted average cost of capital is:

A) 5.9%.

B) 6.25%.

C) 4.76%.

D) 62.5%.

Topic: 14.2 Determining the Firm’s Capital Structure Weights

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 4: Market Prices Reflect Information

4) The total capital that should be used in computing the weights for Grafton’s WACC is:

A) $800.

B) $525.

C) $750.

D) $425.

Topic: 14.2 Determining the Firm’s Capital Structure Weights

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 4: Market Prices Reflect Information

5) Which of the following statements is true?

A) The level of general economic conditions will determine whether a firm should utilize an

arithmetic average cost of capital or a weighted average cost of capital.

B) A firm should utilize a weighted average cost of capital for evaluating investment decisions

rather than an arithmetic average cost of capital.

C) For an average firm that is capitalized with 65% equity, usage of an arithmetic average cost of

capital will usually overstate the true cost of capital.

D) All of the above are true.

E) None of the above are true.

Topic: 14.2 Determining the Firm’s Capital Structure Weights

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 4: Market Prices Reflect Information

6) A firm’s weighted marginal cost of capital increases when internal equity financing is

exhausted but is unaffected by an increase in the cost of other financing sources.

Topic: 14.2 Determining the Firm’s Capital Structure Weights

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 4: Market Prices Reflect Information

7) Capital structure represents the mix of long-term sources of funds used by a firm.

Topic: 14.2 Determining the Firm’s Capital Structure Weights

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 4: Market Prices Reflect Information

8) Why are market values preferred to book (balance sheet) values when computing a firm’s

weighted average cost of capital.

Topic: 14.2 Determining the Firm’s Capital Structure Weights

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 4: Market Prices Reflect Information

1) J & B, Inc. has $5 million of debt outstanding with a coupon rate of 12%. Currently, the yield

to maturity on these bonds is 14%. If the firm’s tax rate is 40%, what is the after-tax cost of debt

to J & B?

A) 12.0%

B) 14.0%

C) 8.4%

D) 5.6%

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

2) The expected dividend is $2.50 for a share of stock priced at $25. What is the cost of common

equity if the long-term growth in dividends is projected to be 8%?

A) 10%

B) 8%

C) 25%

D) 18%

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

3) Sonderson Corporation is undertaking a capital budgeting analysis. The firm’s beta is 1.5. The

rate on six-month T-bills is 5%, and the return on the S&P 500 index is 12%. What is the

appropriate cost of common equity in determining the firm’s cost of capital?

A) 13.1%

B) 15.5%

C) 17.7%

D) 19.9%

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

4) Most firms use Treasury securities with maturities of ________ to determine the appropriate

risk-free rate to use in the CAPM.

A) 90 days

B) 180 days

C) 10 years

D) 30 years

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

5) The cost of preferred stock is equal to:

A) the preferred stock dividend divided by market price.

B) the preferred stock dividend divided by its par value.

C) (1 – tax rate) times the preferred stock dividend divided by net price.

D) the preferred stock dividend divided by the net market price.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

6) The most expensive source of capital is usually:

A) preferred stock.

B) new common stock.

C) debt.

D) retained earnings.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

7) When calculating the weighted average cost of capital, which of the following has to be

adjusted for taxes?

A) Common stock

B) Retained earnings

C) Debt

D) Preferred stock

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

8) Which of the following is NOT used to calculate the cost of debt?

A) Face value of the debt

B) Market price of the debt

C) Number of years to maturity

D) Risk-free rate

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

9) Which of the following is a valid issue in implementing the dividend growth model? The

model:

A) is too complex to be used to estimate value.

B) does not require an accurate estimate of the rate of growth in future dividends.

C) is based upon the assumption that dividends are expected to grow at a constant rate forever.

D) both A and C.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

10) An increase in ________ will increase the cost of common equity.

A) the expected growth rate of dividends

B) the risk-free rate

C) a drop in the stock price

D) both A and B

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

11) Bender and Co. is issuing a $1,000 par value bond that pays 9% interest annually. Investors

are expected to pay $918 for the 10-year bond. What is the after-tax cost of debt if the firm is in

the 34% tax bracket?

A) 6.83%

B) 9.00%

C) 10.35%

D) 15.68%

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

12) Busing Manufacturing has a new bond issue that will net the firm $1,069,000. The bonds

have a $1,000,000 par value, pay interest annually at a 12% coupon rate, and mature in 10 years.

The firm has a marginal tax rate of 34%. The after-tax cost of the debt issue is:

A) 7.15%.

B) 3.68%.

C) 7.92%.

D) 6.58%.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

13) Alpha has an outstanding bond issue that has a 7.75% semiannual coupon, a current maturity

of 20 years, and sells for $967.97. The firm’s income tax rate is 40%. What should Alpha use as

an after-tax cost of debt for cost of capital purposes?

A) 2.42%

B) 4.04%

C) 4.85%

D) 8.08%

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of debt