978-0133423822 Chapter 14 Part 2

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14.3 Estimating the Cost of Individual Sources of Capital

1) PVE, Inc. has $15 million of debt outstanding with a coupon rate of 9%. Currently, the

yield to maturity on these bonds is 7%. If the irm’s tax rate is 35%, what is the after-tax

cost of debt to J & B?

A) 10.76%

B) 5.85%

C) 4.55%

D) 5.4%

Question Status: New question

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

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 4%?

A) 10%

B) 8%

C) 14%

D) 18%

Question Status: Revised

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

3) Sonderson Corporation is undertaking a capital budgeting analysis. The irm’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 irm’s cost of capital?

A) 13.1%

B) 15.5%

C) 17.7%

D) 19.9%

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

4) Most irms 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

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

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.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

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.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

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

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

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

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

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.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

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) the dividend

D) both A and B

Question Status: Revised

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

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 irm is in the 34% tax bracket?

A) 6.83%

B) 9.00%

C) 10.35%

D) 15.68%

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of debt

Principles: Principle 1: Money Has a Time Value

12) MTD Inc. has a new bond issue that will net the irm $1,603,500. The bonds have a

$1,500,000 par value, pay interest annually at a 6% coupon rate, and mature in 10 years.

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

A) 5.1%.

B) 3.37%.

C) 5.6%.

D) 6.58%.

Question Status: New question

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

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 irm’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%

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of debt

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 irm 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%.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

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%.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

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 irm is in the 34% tax bracket?

A) 7.23%

B) 8.01%

C) 9.15%

D) 10.35%

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

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%

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

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 irm’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%

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

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 lotation 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%

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

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

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

21) Pony Corporation is undertaking a capital budgeting analysis. The irm’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%

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

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

irm is expected to be 8%?

A) 10.8%

B) 12.8%

C) 14.8%

D) 16.8%

E) 18.8%

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

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

Berlioz Inc. is trying to estimate its cost of common equity, and it has the following

information. The irm has a beta of 0.90, the before-tax cost of the irm’s debt is 7.75%, and

the irm estimates that the risk-free rate is 4% while the current market return is 12%.

Berlioz stock currently sells for $35.00 per share. The irm pays dividends annually and

expects dividends to grow at a constant rate of 5% indeinitely. The most recent dividend

per share, paid yesterday, is $2.00. Finally, the irm has a marginal tax rate of 34%.

23) The cost of common equity using the dividend-growth model is

A) 11.00%.

B) 11.32%.

C) 11.50%.

D) 11.72%.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

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%.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

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%.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

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 irm’s cost of capital. This irm’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%

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of preferred equity

Principles: Principle 1: Money Has a Time Value

27) Many corporate inance 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 lotation costs.

D) The CAPM uses data from the irm’s inancial statements.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

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

is true?

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

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

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

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

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value

29) A irm 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 irm’s marginal tax rate is 34%.

This irm’s cost of inancing with new preferred stock is

A) 10%.

B) 7.13%.

C) 10.81%.

D) 6.6%.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

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.

Question Status: Previous edition

Objective: 14.3 Calculate the after-tax cost of debt, preferred stock and common equity.

Keywords: cost of equity

Principles: Principle 1: Money Has a Time Value