978-0134083285 Chapter 9 Part 1

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Foundations of Finance, 9e (Keown/Martin/Petty)

Chapter 9 The Cost of Capital

Learning Objective 9.1

1) In order to create value, a corporation must earn a rate of return on its invested capital that is higher

than the market’s required rate of return on that invested capital.

Keywords: Required Rate of Return, Invested Capital

Learning Obj.: L.O. 9.1

AACSB: Reflective Thinking

2) The cost of capital is the rate that must be earned on an investment project if the project is to increase

the value of the common shareholders’ investment.

Keywords: Cost of Capital, Shareholder Value

Learning Obj.: L.O. 9.1

AACSB: Reflective Thinking

3) The firm’s cost of capital may also be referred to as the firm’s opportunity cost of capital.

Keywords: Cost of Capital, Opportunity Cost of Capital

Learning Obj.: L.O. 9.1

AACSB: Reflective Thinking

4) The firm’s cost of capital is important when evaluating the firm’s overall value, but it should not be

used to evaluate individual projects which have their own unique characteristics.

Keywords: Cost of Capital

Learning Obj.: L.O. 9.1

AACSB: Reflective Thinking

5) The cost of debt increases relative to the investor’s required return due to flotation costs, but decreases

relative to the investor’s required return due to the tax deductibility of interest.

Keywords: Cost of Debt, Flotation Costs, Taxes, Interest

Learning Obj.: L.O. 9.1

AACSB: Analytical Thinking

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

common stock.

Keywords: Cost of Capital, Required Return on Common Stock

Learning Obj.: L.O. 9.1

AACSB: Reflective Thinking

7) The investor’s required rate of return will equal the firm‘s cost of capital if corporate transactions costs

are taken into account.

Keywords: Cost of Capital, Required Rate of Return

Learning Obj.: L.O. 9.1

AACSB: Analytical Thinking

8) If a firm were to earn exactly its cost of capital, we would expect the price of its common stock to

remain unchanged.

Keywords: Cost of Capital, Firm Value

Learning Obj.: L.O. 9.1

AACSB: Reflective Thinking

9) Higher flotation costs will result in all of the following EXCEPT

A) higher after-tax cost of debt.

B) higher weighted average cost of capital.

C) higher cost of retained earnings.

D) higher cost of common equity when new common shares are sold.

Keywords: Flotation Costs, Cost of Retained Earnings

Learning Obj.: L.O. 9.1

AACSB: Analytical Thinking

10) Two considerations that cause a corporation‘s cost of capital to be different than its investors’ required

returns are

A) corporate taxes and flotation costs.

B) individual taxes and corporate taxes.

C) individual taxes and dividends.

D) corporate taxes and the earned income tax credit.

Keywords: Cost of Capital, Required Rate of Return, Taxes, Flotation Costs

Learning Obj.: L.O. 9.1

AACSB: Reflective Thinking

11) A firm‘s cost of capital is influenced by

A) the current ratio.

B) par value of common stock.

C) capital structure.

D) net income.

Keywords: Cost of Capital

Learning Obj.: L.O. 9.1

AACSB: Reflective Thinking

12) Which of the following statements is MOST correct?

A) Because the cost of debt is lower than the cost of equity, value-maximizing firms maintain debt ratios

of close to 100%.

B) Corporations that are 100% equity financed will have a much lower weighted average cost of capital

because the lack of debt lowers their risk of bankruptcy.

C) The source of capital with the lowest after-tax cost is preferred stock, because it is a hybrid security,

part debt and part equity.

D) The cost of a particular source of capital is equal to the investor’s required rate of return after adjusting

for the effects of both flotation costs and corporate taxes.

Keywords: Cost of Capital, Flotation Costs, Transactions Costs

Learning Obj.: L.O. 9.1

AACSB: Reflective Thinking

13) Cost of capital is

A) the coupon rate of debt.

B) a hurdle rate 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.

Keywords: Cost of Capital

Learning Obj.: L.O. 9.1

AACSB: Reflective Thinking

14) Which of the following causes a firm’s cost of capital (WACC) to differ from an investor’s required

rate of return on the company‘s common stock?

A) the fact that the risk-free rate of interest has increased

B) the incurrence of flotation costs when new securities are issued

C) The market risk premium exceeds 12%.

D) None of the above — the WACC and required return are the same.

Keywords: Weighted Average Cost of Capital, Taxes, Flotation Costs

Learning Obj.: L.O. 9.1

AACSB: Reflective Thinking

Learning Objective 9.2

1) Flotation costs cause a corporation‘s cost of capital to be lower than its investors’ required returns.

Keywords: Flotation Costs, Cost of Capital, Required Returns

Learning Obj.: L.O. 9.2

AACSB: Reflective Thinking

2) The cost of a particular source of capital (debt, preferred stock, common stock) is equal to the investor’s

required rate of return after adjusting for the effects of both flotation costs and corporate taxes.

Keywords: Cost of Capital, Flotation Costs, Corporate Taxes

Learning Obj.: L.O. 9.2

AACSB: Reflective Thinking

3) The cost of debt capital is obtained by substituting the net proceeds per bond for the bond price in the

bond valuation equation and solving for the required return.

Keywords: Cost of Debt

Learning Obj.: L.O. 9.2

AACSB: Reflective Thinking

4) The cost of preferred stock is equal to the preferred stock dividend divided by the net proceeds per

preferred share.

Keywords: Cost of Preferred Stock, Net Proceeds, Flotation Costs

Learning Obj.: L.O. 9.2

AACSB: Reflective Thinking

5) A corporation’s cost of common equity may be estimated using either a dividend valuation model or

the capital asset pricing model.

Keywords: Cost of Common Equity, Dividend Growth Model, Capital Asset Pricing Model

Learning Obj.: L.O. 9.2

AACSB: Reflective Thinking

6) Corporations have two costs of common equity, one for retained earnings and one if the company

issues new common stock.

Keywords: Cost of Common Equity, Retained Earnings

Learning Obj.: L.O. 9.2

AACSB: Reflective Thinking

7) The Capital Asset Pricing Model may be used to estimate the cost of retained earnings.

Keywords: Capital Asset Pricing Model, Cost of Retained Earnings

Learning Obj.: L.O. 9.2

AACSB: Reflective Thinking

8) A reasonable estimate of the market risk premium based on historical data and expert opinion is

between 5% and 7%.

Keywords: Market Risk Premium, Capital Asset Pricing Model

Learning Obj.: L.O. 9.2

AACSB: Reflective Thinking

9) The market risk premium remains constant over time because the risk-free rate of return moves

inversely with beta.

Keywords: Market Risk Premium, Capital Asset Pricing Model

Learning Obj.: L.O. 9.2

AACSB: Reflective Thinking

10) The after-tax cost of equity equals one minus the marginal tax rate times the required rate of return on

common stock.

Keywords: Cost of Common Equity

Learning Obj.: L.O. 9.2

AACSB: Reflective Thinking

11) If preferred stock pays a $5 annual dividend and sells for $50, the cost of preferred stock financing is

10% since dividends are not tax deductible and preferred stock is sold without flotation costs.

Keywords: Cost of Preferred Stock, Flotation Costs

Learning Obj.: L.O. 9.2

AACSB: Analytical Thinking

12) Other things equal, management should retain profits only if the company‘s investments within the

firm are at least as attractive as the stockholders’ other investment opportunities.

Keywords: Cost of Retained Earnings, Shareholder Value

Learning Obj.: L.O. 9.2

AACSB: Analytical Thinking

13) Financing with new common stock is generally more costly than financing with retained earnings due

to increasing tax rates.

Keywords: Cost of Retained Earnings, Cost of New Common Stock

Learning Obj.: L.O. 9.2

AACSB: Reflective Thinking

14) The required return of a preferred stockholder, rps, is higher than the cost of preferred stock for the

corporation because stockholders must pay federal taxes on their dividend income.

Keywords: Required Return on Preferred Stock, Cost of Preferred Stock

Learning Obj.: L.O. 9.2

AACSB: Analytical Thinking

15) A security with a reasonably stable price will have a lower required rate of return than a security with

an unstable price.

Keywords: Required Return, Variability of Returns

Learning Obj.: L.O. 9.2

AACSB: Analytical Thinking

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

stockholders are not tax deductible.

Keywords: Cost of Retained Earnings

Learning Obj.: L.O. 9.2

AACSB: Reflective Thinking

17) A short-term T-bill’s rate of return should be used in the CAPM formula to determine the cost of

equity capital regardless of the length of the project under consideration.

Keywords: Capital Asset Pricing Model, Risk-free Rate of Return

Learning Obj.: L.O. 9.2

AACSB: Reflective Thinking

18) The capital asset pricing model uses three variables to evaluate required returns on common equity:

the risk-free rate, the beta coefficient, and the market risk premium.

Keywords: CAPM

Learning Obj.: L.O. 9.2

AACSB: Reflective Thinking

19) The cost of debt measures the cost of a bank loan, while the cost of preferred stock is used as a proxy

for the cost of a new bond issue.

Keywords: Cost of Debt, Cost of Preferred Stock, Bonds

Learning Obj.: L.O. 9.2

AACSB: Reflective Thinking

20) Preferred dividends are paid with before-tax dollars because the dividend rate is known, whereas

common stock dividends are paid with after-tax dollars.

Keywords: Preferred Dividends, Common Dividends, Taxes

Learning Obj.: L.O. 9.2

AACSB: Reflective Thinking

21) An increase in a corporation’s marginal tax rate will cause the corporation‘s after-tax cost of debt to

increase, other things remaining the same.

Keywords: Cost of Debt, Taxes

Learning Obj.: L.O. 9.2

AACSB: Analytical Thinking

22) Because investors like dividends, the higher the company‘s dividend growth rate, the lower the

company‘s cost of common equity.

Keywords: Cost of Common Equity, Dividend Growth Rate

Learning Obj.: L.O. 9.2

AACSB: Analytical Thinking

23) An increase in a corporation’s marginal tax rate will decrease the corporation’s cost of debt, but have

no impact on its cost of preferred stock or cost of common equity.

Keywords: Cost of Debt, Cost of Preferred Stock, Cost of Common Equity, Marginal Tax Rate

Learning Obj.: L.O. 9.2

AACSB: Analytical Thinking

24) Due to changes in regulatory requirements, the transactions costs associated with selling corporate

securities increased by $1 per share. This change will

A) cause the cost of capital to decrease.

B) cause the cost of capital to increase.

C) have no effect on the cost of capital because transactions costs are expensed immediately.

D) cause the cost of capital to decrease only if investors may be billed for part of the increase in

transactions costs.

Keywords: Flotation Costs, Cost of Capital

Learning Obj.: L.O. 9.2

AACSB: Analytical Thinking

25) Adventure Outfitter Corp. can sell common stock for $27 per share and its investors require a 17%

return. However, the administrative or flotation costs associated with selling the stock amount to $2.70

per share. What is the cost of capital for Adventure Outfitter if the corporation raises money by selling

common stock?

A) 27.00%

B) 18.89%

C) 18.33%

D) 17.00%

Keywords: Cost of Capital, Flotation Costs

Learning Obj.: L.O. 9.2

AACSB: Analytical Thinking

26) A company has preferred stock that can be sold for $21 per share. The preferred stock pays an annual

dividend of 3.5% based on a par value of $100. Flotation costs associated with the sale of preferred stock

equal $1.25 per share. The company‘s marginal tax rate is 35%. Therefore, the cost of preferred stock is

A) 18.87%.

B) 17.72%.

C) 14.26%.

D) 12.94%.

Keywords: Cost of Preferred Stock, Net Proceeds, Flotation Costs

Learning Obj.: L.O. 9.2

AACSB: Analytical Thinking

27) Sentry Manufacturing paid a dividend yesterday of $5 per share (D0 = $5). The dividend is expected

to grow at a constant rate of 8% per year. The price of Sentry Manufacturing’s stock today is $29 per

share. If Sentry Manufacturing decides to issue new common stock, flotation costs will equal $2.50 per

share. Sentry Manufacturing’s marginal tax rate is 35%. Based on the above information, the cost of

retained earnings is

A) 28.38%.

B) 24.12%.

C) 26.62%.

D) 31.40%.

Keywords: Cost of Retained Earnings

Learning Obj.: L.O. 9.2

AACSB: Analytical Thinking

28) Sentry Manufacturing paid a dividend yesterday of $5 per share (D0 = $5). The dividend is expected

to grow at a constant rate of 8% per year. The price of Sentry Manufacturing’s stock today is $29 per

share. If Sentry Manufacturing decides to issue new common stock, flotation costs will equal $2.50 per

share. Sentry Manufacturing’s marginal tax rate is 35%. Based on the above information, the cost of new

common stock is

A) 28.38%.

B) 24.12%.

C) 26.62%.

D) 31.40%.

Keywords: Cost of New Common Stock

Learning Obj.: L.O. 9.2

AACSB: Analytical Thinking

29) In general, which of the following rankings, from highest to lowest cost, is most accurate?

A) cost of new common stock, cost of preferred stock, cost of debt, cost of retained earnings

B) cost of debt, cost of preferred stock, cost of new common stock, cost of retained earnings

C) cost of new common stock, cost of retained earnings, cost of preferred stock, cost of debt

D) cost of preferred stock, cost of new common stock, cost of retained earnings, cost of debt

Keywords: Cost of New Common Stock, Cost of Retained Earnings, Cost of Preferred Stock, Cost of Debt

Learning Obj.: L.O. 9.2

AACSB: Reflective Thinking

30) The risk-free rate of return is 2.5% and the market risk premium is 8%. Rogue Transport has a beta of

2.2 and a standard deviation of returns of 28%. Rogue Transport‘s marginal tax rate is 35%. Analysts

expect Rogue Transport’s dividends to grow by 6% per year for the foreseeable future. Using the capital

asset pricing model, what is Rogue Transport’s cost of retained earnings?

A) 16.4%

B) 17.7%

C) 19.6%

D) 20.1%

Keywords: Capital Asset Pricing Model, Cost of Retained Earnings

Learning Obj.: L.O. 9.2

AACSB: Analytical Thinking

31) A company has preferred stock with a current market price of $18 per share. The preferred stock pays

an annual dividend of 4% based on a par value of $100. Flotation costs associated with the sale of

preferred stock equal $1.50 per share. The company‘s marginal tax rate is 40%. Therefore, the cost of

preferred stock is

A) 28.80%.

B) 24.24%.

C) 22.22%.

D) 14.55%.

Keywords: Cost of Preferred Stock, Net Proceeds, Flotation Costs

Learning Obj.: L.O. 9.2

AACSB: Analytical Thinking

32) Johnson Production Company paid a dividend yesterday of $3.50 per share. The dividend is expected

to grow at a constant rate of 10% per year. The price of KayCee’s common stock today is $40 per share. If

KayCee decides to issue new common stock, flotation costs will equal $4.00 per share. KayCee’s marginal

tax rate is 35%. Based on the above information, the cost of retained earnings is

A) 26.41%.

B) 20.09%.

C) 19.63%.

D) 17.55%.

Keywords: Cost of Retained Earnings

Learning Obj.: L.O. 9.2

AACSB: Analytical Thinking