Fundamentals of Corporate Finance, 3e (Berk/DeMarzo/Harford)
Chapter 13 The Cost of Capital
13.1 A First Look at the Weighted Average Cost of Capital
1) Financial managers must determine their irm’s overall cost of capital based on all
sources of inancing.
AACSB Objective: Analytic Skills
Author: KB
Question Status: Revised
2) To attract capital from outside investors, a irm must ofer potential investors an
expected return that is commensurate with the level of risk that they can bear.
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
3) One should use accounting-based book values rather than market values of debt and
equity to determine the weights for the diferent sources of capital.
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
4) A irm’s sources of inancing, which usually consists of debt and equity, represent its
________.
A) total assets
B) capital
C) total liabilities
D) current liabilities
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
1
5) The relative proportion of debt, equity, and other securities that a irm has outstanding
constitute its ________.
A) asset ratio
B) current ratio
C) capital structure
D) retained earnings
AACSB Objective: Analytic Skills
Author: KB
Question Status: Revised
6) A irm’s overall cost of capital that is a blend of the costs of the diferent sources of
capital is known as the irm’s ________.
A) weighted average cost of capital
B) cost of equity infusion
C) cost of debt
D) cost of preferred stock
AACSB Objective: Analytic Skills
Author: KB
Question Status: Revised
7) The book value of a irm’s equity is $100 million and its market value of equity is $200
million. The face value of its debt is $50 million and its market value of debt is $60 million.
What is the market value of assets of the irm?
A) $150 million
B) $160 million
C) $260 million
D) $250 million
AACSB Objective: Analytic Skills
Author: KB
Question Status: Revised
2
8) A irm raised all its capital via equity rather than debt. Such a irm is also referred to as
a(n) ________ irm.
A) levered
B) margined
C) risk less
D) unlevered
AACSB Objective: Analytic Skills
Author: KB
Question Status: Revised
9) A levered irm is one that has ________ outstanding.
A) debt
B) equity
C) preferred stock
D) equity options
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
10) Leverage is the amount of ________ on a irm’s balance sheet.
A) equity
B) debt
C) preferred stock
D) retained earnings
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
11) For an unlevered irm, the cost of capital can be determined by using the ________.
A) yield on the traded debt
B) Capital Asset Pricing Model
C) dividend yield
D) preferred stock yield
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
12) Assume Lavender Corporation has a market value of $4 billion of equity and a market
value of $19.8 billion of debt. What are the weights in equity and debt that are used for
calculating the WACC?
A) 0.10, 0.90
B) 0.832, 0.168
C) 0.168, 0.832
D) 0.90, 0.10
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AACSB Objective: Analytic Skills
Author: KB
Question Status: Revised
13) Assume Bismuth Electronics has a book value of $6 billion of equity and a face value of
$19.7 billion of debt. The market values of equity and debt are $2.5 billion and $18.5
billion. A Wall Street inancial analyst determines values of equity and debt as $3 billion
and $20 billion. Which of the following values should be used for calculating the irm’s
WACC?
A) $6 billion of equity and $19.7 billion of debt
B) $2.5 billion of equity and $20 billion of debt
C) $3 billion of equity and $19.9 billion of debt
D) $2.5 billion of equity and $18.5 billion of debt
AACSB Objective: Analytic Skills
Author: KB
Question Status: Revised
14) Assume the total market value of General Motors (GM) is $10 billion. GM has a market
value of $6 billion of equity and a face value of $12 billion of debt. What are the weights in
equity and debt that are used for calculating the WACC?
A) 0.30, 0.70
B) 0.60, 0.40
C) 0.40, 0.60
D) cannot be determined
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
15) A irm incurs $40,000 in interest expenses each year. If the tax rate of the irm is 30%,
what is the efective after-tax interest rate expense for the irm?
A) $21,000.00
B) $22,400.00
C) $23,800.00
D) $28,000.00
Dif: 1 Var: 14
AACSB Objective: Analytic Skills
Author: KB
Question Status: Revised
16) A irm incurs $35,000 in interest expenses each year. If the tax rate of the irm is 30%,
what is the efective after-tax interest rate expense for the irm?
A) $22,050.00
B) $24,500.00
C) $28,175.00
D) $29,400.00
AACSB Objective: Analytic Skills
Author: KB
Question Status: Revised
17) A irm incurs $70,000 in interest expenses each year. If the tax rate of the irm is 30%,
what is the efective after-tax interest rate expense for the irm?
A) $34,300.00
B) $39,200.00
C) $49,000.00
D) $56,350.00
AACSB Objective: Analytic Skills
Author: KB
Question Status: Revised
5
18) The fact that the after-tax cost of debt is lower than the pretax cost of debt implicitly
assumes that interest expense can be ________.
A) expensed
B) margined
C) reinanced
D) capitalized
AACSB Objective: Analytic Skills
Author: KB
Question Status: Revised
19) The after-tax cost of equity is ________ the pretax cost of equity.
A) higher than
B) lower than
C) the same as
D) less than or equal to
AACSB Objective: Analytic Skills
Author: KB
Question Status: Revised
20) Epiphany is an all-equity irm with an estimated market value of $400,000. The irm
sells $225,000 of debt and uses the proceeds to purchase outstanding equity. Compute the
weight in equity and the weight in debt after the proposed inancing and repurchase of
equity.
A) 0.28, 0.72
B) 0.44, 0.56
C) 0.39, 0.61
D) 0.56, 0.44
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
6
21) Epiphany is an all-equity irm with an estimated market value of $300,000. The irm
sells $250,000 of debt and uses the proceeds to purchase outstanding equity. Compute the
weight in equity and the weight in debt after the proposed inancing and repurchase of
equity.
A) 0.42, 0.58
B) 0.50, 0.50
C) 0.17, 0.83
D) 0.58, 0.42
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
22) Epiphany is an all-equity irm with an estimated market value of $500,000. The irm
sells $150,000 of debt and uses the proceeds to purchase outstanding equity. Compute the
weight in equity and the weight in debt after the proposed inancing and repurchase of
equity.
A) 0.15, 0.85
B) 0.18, 0.82
C) 0.30, 0.70
D) 0.70, 0.30
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
7
23) Assume JUP has debt with a book value of $24 million, trading at 120% of par value.
The irm has book equity of $28 million, and 2 million shares trading at $20 per share.
What weights should JUP use in calculating its WACC?
A) 41.86% for debt, 58.14% for equity
B) 37.67% for debt, 62.33% for equity
C) 33.49% for debt, 66.51% for equity
D) 29.30% for debt, 70.70% for equity
AACSB Objective: Analytic Skills
Author: WC
Question Status: New
24) As a irm increases its level of debt relative to its level of equity, the irm is ________.
A) increasing the fraction of its equity
B) decreasing the fraction of its debt
C) decreasing its leverage
D) increasing its leverage
AACSB Objective: Analytic Skills
Author: WC
Question Status: Previous Edition
25) Why do we use market values rather than book values in calculation of WACC?
AACSB Objective: Analytic Skills
Author: SS
Question Status: Previous Edition
8
26) Why do we use leverage if it increases the risk of a irm?
AACSB Objective: Analytic Skills
Author: SS
Question Status: Previous Edition
13.2 The Firm’s Costs of Debt and Equity Capital
1) A irm’s cost of debt is the rate of interest it would have to pay to reinance its existing
debt.
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
2) The fact that the interest paid on debt is a tax-deductible expense increases the cost of
debt inancing.
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
3) The ________ of a irm’s debt can be used as the irm’s current cost of debt.
A) current yield
B) coupon rate
C) yield to maturity
D) discount yield
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
9
4) Outstanding debt of Home Depot trades with a yield to maturity of 8%. The tax rate of
Home Depot is 30%. What is the efective cost of debt of Home Depot?
A) 5.88%
B) 8%
C) 6.44%
D) 5.60%
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
5) Outstanding debt of Home Depot trades with a yield to maturity of 5%. The tax rate of
Home Depot is 40%. What is the efective cost of debt of Home Depot?
A) 4.50%
B) 4.65%
C) 3.60%
D) 3.00%
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
6) Outstanding debt of Home Depot trades with a yield to maturity of 7%. The tax rate of
Home Depot is 35%. What is the efective cost of debt of Home Depot?
A) 4.55%
B) 5.01%
C) 5.46%
D) 5.69%
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
10