978-0132757089 Chapter 14 Part 2

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Principles: Principle 1: Money Has a Time Value

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

The current market price of an existing debt issue is $1,125. The bonds have a $1,000 par value,

pay interest annually at a 12% coupon rate, and mature in 10 years. The firm has a marginal tax

rate of 34%.

14) The before-tax cost of this debt issue is:

A) 12%.

B) 7.92%.

C) 9.97%.

D) 13%.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

15) The after-tax cost of this debt issue is:

A) 7.92%.

B) 6.58%.

C) 12%.

D) 3.39%.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

16) Walker & Son is issuing a 10-year, $1,000 par value bond that pays 9% interest annually. The

bond is expected to sell for $885. What is Walker & Son’s after-tax cost of debt if the firm is in

the 34% tax bracket?

A) 7.23%

B) 8.01%

C) 9.15%

D) 10.35%

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

17) Dublin International Corporation’s marginal tax rate is 40%. It can issue three-year bonds

with a coupon rate of 8.5% and par value of $1,000. The bonds can be sold now at a price of

$938.90 each. Determine the appropriate after-tax cost of debt for Dublin International to use in a

capital budgeting analysis.

A) 11.0%

B) 5.2%

C) 6.6%

D) 7.2%

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

18) Hill Town Motels 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 Hill Town Motels?

A) 5.43%

B) 11.2%

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

19) Verigreen Lawn Care products just paid a dividend of $1.85. This dividend is expected to

grow at a constant rate of 3% per year, so the next expected dividend is $1.90. The stock price is

currently $12.50. New stock can be sold at this price subject to flotation costs of 15%. The

company’s marginal tax rate is 40%. Compute the cost of common equity.

A) 18.0%

B) 17.8%

C) 18.2%

D) 15.2%

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

20) Sola Cola Corporation is undertaking a capital budgeting analysis. The rate on 10-year U.S.

Treasury bonds is 3.60%, and the return on the S & P 500 index is 11.6%. If the cost of Sola

Cola’s common equity is 19.6%, calculate their beta.

A) 1.69

B) 5.4

C) 2.0

D) 1.38

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

21) Pony Corporation is undertaking a capital budgeting analysis. The firm’s beta is 1.5. The rate

on 10-year U.S. Treasury bonds is 5%, and the return on the S & P 500 index is 12%. What is the

cost of Pony’s common equity?

A) 13.3%

B) 15.5%

C) 17.7%

D) 19.9%

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

22) The last paid dividend is $2 for a share of common stock that is currently selling for $20.

What is the cost of common equity if the long-term growth rate in dividends for the firm is

expected to be 8%?

A) 10.8%

B) 12.8%

C) 14.8%

D) 16.8%

E) 18.8%

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

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

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

24) The cost of common equity using the CAPM is:

A) 11.00%.

B) 11.20%.

C) 11.50%.

D) 11.72%.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

25) The best estimate of the cost of new common equity is:

A) 11.00%.

B) between 11.0%. and 11.2%

C) 11.50%.

D) between 10%. and 12%

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

26) XYZ Corporation is trying to determine the appropriate cost of preferred stock to use in

determining the firm’s cost of capital. This firm’s preferred stock is currently selling for $29.89

and pays a perpetual annual dividend of $2.60 per share. Compute the cost of preferred stock for

XYZ.

A) 7.2%

B) 6.2%

C) 8.7%

D) 16.7%

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

27) Many corporate finance professionals favor the CAPM for determining the cost of equity.

Which of the following is a reason for this preference?

A) The data is less expensive.

B) The variables in the model that apply to public corporations are readily available from public

sources.

C) Because the CAPM gives better treatment to flotation costs.

D) The CAPM uses data from the firm’s financial statements.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

28) In calculating the cost of capital for an average firm, which of the following statements is

true?

A) The cost of a firm’s bonds is greater than the cost of its common stock.

B) The cost of a firm’s preferred stock is greater than the cost of its common stock.

C) The cost of a firm’s retained earnings is less than the cost of its bonds.

D) The cost of a firm’s common stock is greater than the cost of its bonds.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

29) A firm has an issue of preferred stock that pays an annual dividend of $2.00 per share and

currently is selling for $18.50 per share. Finally, the firm’s marginal tax rate is 34%. This firm’s

cost of financing with new preferred stock is:

A) 10%.

B) 7.13%.

C) 10.81%.

D) 6.6%.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

30) The CAPM approach is used to determine the cost of:

A) debt.

B) preferred stock.

C) common equity.

D) long term funds.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

31) Given the following information, determine the risk-free rate.

Cost of equity = 12%

Beta = 1.50

Market risk premium = 3%

A) 8.0%

B) 7.5%

C) 7.0%

D) 6.5%

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

15.25%. What is Alpha’s cost of common equity using the CAPM approach?

A) 21.25%

B) 15.81%

C) 9.25%

D) 6.32%

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of equity

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

34) The George Company, Inc., has two issues of debt. Issue A has a maturity value of 8 million

dollars, a coupon rate of 8%, paid annually, and is selling at par. Issue B was issued as a 15 year

9.3% on this bond. The maturity value of Issue B is 6 million dollars. The George company has a

marginal tax rate of 35%. What is the company’s after tax cost of debt?

A) 4.73%

B) 5.56%

C) 7.36%

D) 8.47%

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

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

46,000 shares outstanding currently selling for $50 per share. The firm expects to pay a $5.50

dividend per share one year from now and is experiencing a 3.67% growth rate in dividends,

which it expects to continue indefinitely. The firm’s marginal tax rate is 40%. The company has

35) The current total value of the firm is:

A) $6,450,000.

B) $5,750,000.

C) $4,950,000.

D) $3,250,000.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: firm value

Principles: Principle 1: Money Has a Time Value

36) The proportion of debt in this firm’s capital structure is:

A) 40%.

B) 50%.

C) 60%.

D) 70%.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 1: Money Has a Time Value

37) The after-tax cost of debt is:

A) 6.20%.

B) 5.40%.

C) 4.60%.

D) 3.80%.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

38) The after-tax cost of common stock is:

A) 14.67%.

B) 13.23%.

C) 12.41%.

D) 11.65%.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

39) The firm’s weighted average cost of capital is:

A) 10.47%.

B) 9.29%.

C) 8.63%.

D) 7.71%.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 1: Money Has a Time Value

40) The firm financed completely with equity capital has a cost of capital equal to the required

return on common stock.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of capital

Principles: Principle 1: Money Has a Time Value

41) A bond with a Moody’s rating of Aaa and and S&P rating of AAA will have a higher required

return than a bond with an unstable price a Moody’s rating of Aa1 and and S&P rating of AA+.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

42) If the before-tax cost of debt is 9% and the firm has a 34% marginal tax rate, the after-tax

cost of debt is 5.94%.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

43) No adjustment is made in the cost of preferred stock for taxes since preferred stock dividends

are not tax-deductible.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

44) Only a small minority of bonds issued by large corporations are rated by Moody’s or S&P.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

45) The cost of debt is equal to one minus the marginal tax rate times the coupon rate of interest

on the firm’s outstanding debt.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

46) Assuming an after-tax cost of preferred stock of 12% and a corporate tax rate of 40%, a firm

must earn at least $20 before tax on every $100 invested.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

47) The cost of common equity is already on an after-tax basis since dividends paid to common

stockholders are not tax-deductible.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

48) The cost of common equity is usually higher than the firm’s WACC.

Topic: 14.3 Estimating the Cost of Individual Sources of Capital

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value