978-0133423822 Chapter 14 Part 1

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Financial Management, 12e (Titman/Keown/Martin)

Chapter 14 The Cost of Capital

14.1 The Cost of Capital: An Overview

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

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

A) cost of capital

B) cost of debt used to inance the project

C) rate of return on equity

D) internal rate of return

Question Status: Previous edition

Objective: 14.1 Understand the concepts underlying the irm’s overall cost of capital and the

purpose for its calculation.

Keywords: cost of capital

Principles: Principle 1: Money Has a Time Value

2) The investor’s required rate of return difers from the irm’s cost of capital due to the

A) irm’s beta.

B) tax deductibility of interest.

C) CAPM.

D) time value of money.

Question Status: Previous edition

Objective: 14.1 Understand the concepts underlying the irm’s overall cost of capital and the

purpose for its calculation.

Keywords: cost of capital

Principles: Principle 1: Money Has a Time Value

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

should relect

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 irm risk.

Question Status: Previous edition

Objective: 14.1 Understand the concepts underlying the irm’s overall cost of capital and the

purpose for its calculation.

Keywords: cost of capital

Principles: Principle 1: Money Has a Time Value

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

A) The average yield to maturity on debt

B) The average cost of the irm’s assets

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

investors

D) The coupon rate on preferred stock

Dif: 2

Question Status: Previous edition

Objective: 14.1 Understand the concepts underlying the irm’s overall cost of capital and the

purpose for its calculation.

Keywords: cost of capital

Principles: Principle 1: Money Has a Time Value

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

A) Common stock

B) Preferred stock

C) Bonds

D) All of the above

Question Status: Previous edition

Objective: 14.1 Understand the concepts underlying the irm’s overall cost of capital and the

purpose for its calculation.

Keywords: cost of capital

Principles: Principle 1: Money Has a Time Value

6) Which of the following must be adjusted for the irm’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

Question Status: Previous edition

Objective: 14.1 Understand the concepts underlying the irm’s overall cost of capital and the

purpose for its calculation.

Keywords: cost of capital

Principles: Principle 1: Money Has a Time Value

7) For tax purposes, interest on corporate debt is

A) deductible for the investor, but not for the borrower.

B) deductible for the borrower, but not for the investor.

C) fully taxable for both the borrower and the investor.

D) fully deductible for both the borrower and the investor.

Question Status: New question

Objective: 14.1 Understand the concepts underlying the irm’s overall cost of capital and the

purpose for its calculation.

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 irm 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

Question Status: Previous edition

Objective: 14.1 Understand the concepts underlying the irm’s overall cost of capital and the

purpose for its calculation.

Keywords: cost of capital

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 irm must earn on its investments in order to satisfy the required

rate of return of the irm’s investors.

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

risk.

D) all of the above.

Question Status: Previous edition

Objective: 14.1 Understand the concepts underlying the irm’s overall cost of capital and the

purpose for its calculation.

Keywords: cost of capital

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 irm value is to remain

unchanged.

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

Question Status: Previous edition

Objective: 14.1 Understand the concepts underlying the irm’s overall cost of capital and the

purpose for its calculation.

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

Question Status: Previous edition

Objective: 14.1 Understand the concepts underlying the irm’s overall cost of capital and the

purpose for its calculation.

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.

Question Status: Previous edition

Objective: 14.1 Understand the concepts underlying the irm’s overall cost of capital and the

purpose for its calculation.

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 inancing that a irm uses to inance a project.

Question Status: Previous edition

Objective: 14.1 Understand the concepts underlying the irm’s overall cost of capital and the

purpose for its calculation.

Keywords: cost of capital

Principles: Principle 1: Money Has a Time Value

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

simultaneously.

Question Status: Previous edition

Objective: 14.1 Understand the concepts underlying the irm’s overall cost of capital and the

purpose for its calculation.

Keywords: cost of capital

Principles: Principle 1: Money Has a Time Value

15) The irm 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.

Question Status: Previous edition

Objective: 14.1 Understand the concepts underlying the irm’s overall cost of capital and the

purpose for its calculation.

Keywords: cost of capital

Principles: Principle 1: Money Has a Time Value

16) Business risk relects the added variability in earnings available to a irm’s

shareholders.

Question Status: Previous edition

Objective: 14.1 Understand the concepts underlying the irm’s overall cost of capital and the

purpose for its calculation.

Keywords: cost of capital

Principles: Principle 1: Money Has a Time Value

17) The after-tax cost of capital is computed by multiplying the before-tax cost of capital by

1 minus the tax rate.

Question Status: New question

Objective: 14.1 Understand the concepts underlying the irm’s overall cost of capital and the

purpose for its calculation.

Keywords: cost of capital

Principles: Principle 1: Money Has a Time Value

18) Briely identify and describe some important uses of a irm’s weighted average cost of

capital.

Question Status: Previous edition

Objective: 14.1 Understand the concepts underlying the irm’s overall cost of capital and the

purpose for its calculation.

Keywords: cost of capital

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

Spencer Transgenics’ capital structure is available.

$ millions Book Values

Market

Values

Accounts

Payable &

Accruals $300

Short-term

notes $150 $150

Long-term

debt $450 $600

Preferred

Stock $75 $150

Common

Stock $600 $1500

Total $1575 $2400

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

A) 62.5%.

B) 66.7%.

C) 6.25%.

D) 38.1%.

Question Status: New question

Objective: 14.2 Evaluate the irm’s capital structure and determine the relative importance (weight)

of each source of inancing.

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 4: Market Prices Relect Information

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

A) 38.1%.

B) 31.25.

C) 25%.

D) 57.14%.

Question Status: New question

Objective: 14.2 Evaluate the irm’s capital structure and determine the relative importance (weight)

of each source of inancing.

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 4: Market Prices Relect Information

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

A) 5.9%.

B) 62.5%.

C) 4.76%.

D) 6.25%.

Question Status: New question

Objective: 14.2 Evaluate the irm’s capital structure and determine the relative importance (weight)

of each source of inancing.

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 4: Market Prices Relect Information

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

A) $1,275.

B) $2,400.

C) $2,250.

D) $1,575.

Question Status: New question

Objective: 14.2 Evaluate the irm’s capital structure and determine the relative importance (weight)

of each source of inancing.

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 4: Market Prices Relect Information

5) Which of the following statements is true?

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

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

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

decisions rather than an arithmetic average cost of capital.

C) For an average irm 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 is true.

Question Status: Previous edition

Objective: 14.2 Evaluate the irm’s capital structure and determine the relative importance (weight)

of each source of inancing.

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 4: Market Prices Relect Information

6) A irm’s weighted marginal cost of capital increases when internal equity inancing is

exhausted but is unafected by an increase in the cost of other inancing sources.

Question Status: Previous edition

Objective: 14.2 Evaluate the irm’s capital structure and determine the relative importance (weight)

of each source of inancing.

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 4: Market Prices Relect Information

7) Capital structure represents the mix of equity and interest-bearing debt used by a irm.

Question Status: Revised

Objective: 14.2 Evaluate the irm’s capital structure and determine the relative importance (weight)

of each source of inancing.

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 4: Market Prices Relect Information

8) When computing a irm’s cost of capital, book values should be used be used because

they are more objective.

Question Status: New question

Objective: 14.2 Evaluate the irm’s capital structure and determine the relative importance (weight)

of each source of inancing.

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 4: Market Prices Relect Information

9) The percentage of debt in the irm’s capital structure should be adjusted by multiplying

by 1 minus the irm’s marginal tax rate.

Question Status: New question

Objective: 14.2 Evaluate the irm’s capital structure and determine the relative importance (weight)

of each source of inancing.

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 4: Market Prices Relect Information

10) The amount of debt in the irm’s capital structure should include all interest-bearing

debt, both long-term and short-term.

Question Status: New question

Objective: 14.2 Evaluate the irm’s capital structure and determine the relative importance (weight)

of each source of inancing.

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 4: Market Prices Relect Information

11) Why are market values preferred to book (balance sheet) values when computing a

irm’s weighted average cost of capital.

Question Status: Previous edition

Objective: 14.2 Evaluate the irm’s capital structure and determine the relative importance (weight)

of each source of inancing.

Keywords: Weighted Average Cost of Capital (WACC)

Principles: Principle 4: Market Prices Relect Information