Principles of Managerial Finance, Brief Ed., 8e (Zutter/Smart)
Chapter 9 The Cost of Capital
9.1 Overview of the cost of capital
1) Holding risk constant, the implementation of projects with a rate of return above the cost of
capital will decrease the value of a firm, and vice versa.
2) The cost of common stock equity refers to the cost of the next dollar of financing necessary to
finance a new investment opportunity.
3) The target capital structure is the desired optimal mix of debt and equity financing that firms
attempt to achieve and maintain.
4) The cost of capital is the rate of return a firm must meet or exceed on investments to increase
the firm’s value.
5) The cost of capital is used to decide whether a proposed corporate investment will increase or
decrease a firm’s stock price.
6) The cost of capital reflects the cost of financing and is the minimum rate of return that a
project must earn to increase firm value.
7) The cost of capital acts as a major link between a firm’s long-term investment decisions and
the wealth of the firm’s owners as determined by the market value of their shares.
8) The cost of capital of each source of financing is the after-tax cost of obtaining the financing
using the historically based cost reflected by the existing financing on the firm’s books.
9) A firm’s flotation cost can be calculated by weighting the cost of each source of financing by
its relative proportion in a firm’s target capital structure.
10) The cost of capital is a static concept and it is not affected by economic and firm-specific
factors such as business risk and financial risk.
11) The cost of capital is a dynamic concept and it is affected by economic and firm-specific
factors such as business risk and financial risk.
12) In using the cost of capital, it is important that it reflects the historical cost of raising funds
over the long run.
13) The ________ is the rate of return that a firm must earn on its investments in order to
maintain the market value of its stock.
A) yield to maturity
B) cost of capital
C) internal rate of return
D) modified internal rate of return
14) The ________ is the rate of return required by the market suppliers of capital in order to
attract their funds to the firm.
A) yield to maturity
B) internal rate of return
C) cost of capital
D) modified internal rate of return
15) Although a firm’s existing mix of financing sources may reflect its target capital structure, it
is ultimately ________.
A) the internal rate of return that is relevant for evaluating the firm’s future investment
opportunities
B) the marginal cost of capital that is relevant for evaluating the firm’s future investment
opportunities
C) the risk-free rate of return that is relevant for evaluating the firm’s future investment
opportunities
D) the risk-free rate of return that is relevant for evaluating the firm’s future financing
opportunities
16) The ________ is a weighted average of the cost of funds which reflects the interrelationship
of financing decisions.
A) internal rate of return
B) sunk cost
C) cost of capital
D) risk-free rate
17) The ________ is the firm’s desired optimal mix of debt and equity financing.
A) book value
B) market value
C) cost of capital
D) target capital structure
18) In order to recognize the interrelationship between financing and investments, a firm should
use ________ when evaluating an investment.
A) the least costly source of financing
B) the most costly source of financing
C) the weighted average cost of all financing sources
D) the current opportunity cost
19) The four basic sources of long-term funds for a firm are ________.
A) current liabilities, long-term debt, common stock, and preferred stock
B) current liabilities, long-term debt, common stock, and retained earnings
C) long-term debt, paid-in capital in excess of par, common stock, and retained earnings
D) long-term debt, common stock, preferred stock, and retained earnings
20) Most firms finance their activities with a blend of debt and equity.
21) If you purchased the same percentage of each type of security that a firm issued, the expected
return on that portfolio of securities would equal the firm’s weighted average cost of capital.
22) Which of the following is TRUE of long-term funds?
A) They provide an easy way to reduce financing costs because they are relatively cheaper than
short-term funds.
B) They are a type of investment fund which invests in money market investments of high
quality and low risk.
C) They are the sources that supply the financing necessary to support a firm’s capital budgeting
activities.
D) They are the funds available to a business on the basis of inventory held and require detailed
inventory tracking.
23) Which type of long-term funding is used by the fewest number of firms in the United States?
A) long-term debt
B) preferred stock
C) retained earnings
D) common stock
24) A firm finances its activities with both debt (that costs 8%) and equity (that costs 14%). The
firm can borrow additional funds at 8% if it so desires. A financial analyst at this firm argues that
the firm should undertake any investment that earns a return of at least 8% because such
investments will enable the firm to pay debtholders what they desire, and any earnings above 8%
will go to stockholders. If a firm decides to make investments based on this logic it will
________.
A) decline to make investments that it should undertake
B) undertake investments that it should decline
C) make only those investment decisions that increase shareholder value
D) have exorbitant interest expenses
25) Which of the following is a source of long-term funds?
A) commercial paper
B) retained earnings
C) factoring
D) money market instruments
26) A firm finances its activities with both debt (that costs 8%) and equity (that costs 14%). The
firm can borrow additional funds at 8% if it so desires. A financial analyst at this firm argues that
the firm should undertake only those investments that earn a return of at least 14% because only
those investments will increase shareholder value If a firm decides to make investments based on
this logic it will ________.
A) decline to make investments that it should undertake
B) undertake investments that it should decline
C) make only those investment decisions that increase shareholder value
D) maximize its stock price
9.2 Cost of long-term debt
1) The marginal cost of capital is a relevant cost of capital for evaluating a firm’s future
investment opportunities.
2) Generally the least expensive source of long-term capital is ________.
A) retained earnings
B) preferred stock
C) long-term debt
D) common stock
3) In general, floatation costs include two components, underwriting costs and administrative
costs.
4) Flotation costs reduce the net proceeds from the sale of a bond whether sold at a premium, at a
discount, or at its par value.
5) The net proceeds used in calculation of the cost of long-term debt are funds actually received
from the sale after paying for flotation costs and taxes.
6) When the net proceeds from sale of a bond equal its par value, the before-tax cost would just
equal the coupon interest rate.
7) From a bond issuer’s perspective, the IRR on a bond’s cash flows is its yield to maturity
(YTM); from the investor’s perspective, the IRR on a bond’s cash flows is the cost to maturity.
8) The cost to maturity that a firm pays on its existing bonds equals the rate of return required by
the market.
9) The weighted average cost of capital represents the annual before-tax percentage cost of the
debt.
10) A tax adjustment must be made in determining the cost of ________.
A) long-term debt
B) common stock
C) preferred stock
D) retained earnings
11) The ________ from the sale of a security are the funds actually received from the sale after
________.
A) gross proceeds; adding the after-tax costs
B) gross proceeds; reducing the flotation costs
C) net proceeds; reducing the flotation costs
D) net proceeds; adding the after-tax costs
12) The before-tax cost of debt for a 15-year, 10 percent, $1,000 par value bond selling at $950
is ________.
A) 10 percent
B) 10.7 percent
C) 12 percent
D) 15.4 percent
13) The before-tax cost of debt for a 10-year, 8 percent, $1,000 par value bond selling at $1,150
is ________.
A) 5.97 percent
B) 8.33 percent
C) 8.82 percent
D) 9 percent
14) The before-tax cost of debt for a firm, which has a marginal tax rate of 21 percent, is 12
percent. The after-tax cost of debt is ________.
A) 12.00 percent
B) 2.52 percent
C) 9.48 percent
D) 7.20 percent
15) The specific cost of each source of long-term financing is based on ________ and ________
costs.
A) before-tax; historical
B) after-tax; historical
C) before-tax; book value
D) after-tax; current
16) When determining the after-tax cost of a bond, the face value of the issue must be adjusted to
the net proceeds amounts by considering ________.
A) the risks
B) the flotation costs
C) the approximate returns
D) the taxes
17) If a corporation faces a tax rate of 21 percent, the after-tax cost of debt for a 15-year, 12
percent, $1,000 par value bond, selling at $950 is ________.
A) 2.68 percent
B) 12.76 percent
C) 10.08 percent
D) 5.11 percent
18) If a corporation pays a tax rate of 21 percent, the after-tax cost of debt for a 10-year, 8
percent, $1,000 par value bond selling at $1,150 is ________.
A) 4.71 percent
B) 3.58 percent
C) 1.25 percent
D) 6.32 percent
19) The after-tax cost of debt for a 20-year, 7 percent, $1,000 par value bond selling at $960
(assume a marginal tax rate of 21 percent) is ________.
A) 5.84 percent
B) 4.43 percent
C) 1.55 percent
D) 5.53 percent
20) Debt is generally the least expensive source of capital. This is primarily due to ________.
A) debt’s fixed interest payments and finite maturity
B) the tax deductibility of dividends paid to shareholders
C) debt being less risky than equity and interest payments being tax deductible
D) the secured nature of a debt obligation
21) Nico Trading Corporation is considering issuing long-term debt. The debt would have a 30-
year maturity and a 10 percent coupon rate. In order to sell the issue, the bonds must be
underpriced at a discount of 5 percent of face value. In addition, the firm would have to pay
flotation costs of 5 percent of face value. The firm’s tax rate is 21 percent. Given this
information, the after-tax cost of debt for Nico Trading would be ________.
A) 7.26%
B) 8.82%
C) 2.34%
D) 11.17%
22) Recently the corporate tax law in the U.S. changed so that firms that previously faced a
marginal tax rate of close to 40% now pay tax at a flat rate of 21%. Holding everything else
constant, this reduction in the tax rate faced by corporations ________.
A) increased the after-tax cost of debt
B) decreased the after-tax cost of debt
C) did not change the after-tax cost of debt
D) increased the value of the deduction for interest expense
23) Tangshan Mining is considering issuing long-term debt. The debt would have a 30 year
maturity and a 6 percent coupon rate and make semiannual coupon payments. In order to sell the
issue, the bonds must be underpriced at a discount of 1 percent of face value. In addition, the
firm would have to pay flotation costs of 1 percent of face value. The firm’s tax rate is 21
percent. Given this information, the after-tax cost of debt for Tangshan Mining would be
________.
A) 4.74%
B) 1.29%
C) 2.43%
D) 4.86%
9.3 Cost of preferred stock
1) Since preferred stock is a form of ownership, it has no maturity date.
2) Preferred stockholders must receive their stated dividends prior to the distribution of any
earnings to common stockholders and bondholders.
3) The amount of preferred stock dividends that must be paid each year may be stated in dollars
or as a percentage of the firm’s earnings.
4) The cost of preferred stock is typically higher than the cost of long-term debt (bonds) because
the cost of long-term debt (interest) is tax deductible.
5) The cost of preferred stock is the ratio of the preferred stock dividend to a firm’s net proceeds
from the sale of the preferred stock.
6) The cost of preferred stock is the ratio of the preferred stock dividend to a firm’s total
earnings.
7) What is the dividend on an 8 percent preferred stock that currently sells for $45 and has a face
value of $50 per share?
A) $3.33
B) $3.60
C) $4.00
D) $5.00
8) A firm has issued 10 percent preferred stock, which sold for $100 per share par value. The
cost of issuing and selling the stock was $2 per share. The firm’s marginal tax rate is 40 percent.
The cost of the preferred stock is ________.
A) 3.9 percent
B) 6.1 percent
C) 9.8 percent
D) 10.2 percent
9) A firm has issued preferred stock at its $125 per share par value. The stock will pay a $15
annual dividend. The cost of issuing and selling the stock was $4 per share. The cost of the
preferred stock is ________.
A) 7.2 percent
B) 12 percent
C) 12.4 percent
D) 15 percent
10) A firm has determined it can issue preferred stock at $115 per share par value. The stock will
pay a $12 annual dividend. The cost of issuing and selling the stock is $3 per share. The cost of
the preferred stock is ________.
A) 6.4 percent.
B) 10.4 percent.
C) 10.7 percent.
D) 12 percent.
11) Tangshan Mining is considering issuing preferred stock. The preferred stock would have a
par value of $75 and a 5.50 percent dividend. What is the cost of preferred stock for Tangshan if
flotation costs would amount to 5.5 percent of par value?
A) 5.50%
B) 5.27%
C) 7.73%
D) 5.82%
1) The cost of common stock equity may be measured using either the constant-growth valuation
model or the capital asset pricing model.
2) The constant-growth model uses the market price as a reflection of the expected risk-return
preference of investors in the marketplace.
3) The cost of common stock equity capital represents the return required by existing
shareholders on their investment.
4) The cost of retained earnings is always lower than the cost of a new issue of common stock
due to the absence of flotation costs when financing projects with retained earnings.
5) In computing the cost of retained earnings, the net proceeds represents the amount of money
retained net of any underpricing and/or flotation costs.
6) The cost of retained earnings is generally higher than both the cost of debt and cost of
preferred stock.
7) One measure of the cost of common stock equity is the rate at which investors discount the
expected common stock dividends of the firm to determine its share value.
8) The Gordon model is based on the premise that the value of a share of stock is equal to the
sum of all future dividends it is expected to provide over an infinite time horizon.
9) Using the Capital Asset Pricing Model (CAPM), the cost of common stock equity is the return
required by investors as compensation for a firm’s nondiversifiable risk.
10) Use of the capital asset pricing model (CAPM) in measuring the cost of common stock
equity differs from the constant-growth valuation model in that it directly considers the firm’s
risk as reflected by beta.
11) When the constant-growth valuation model is used to find the cost of common stock equity
capital, it can easily be adjusted for flotation costs to find the cost of new common stock; the
capital asset pricing model (CAPM) does not provide a simple adjustment mechanism.
12) The cost of new common stock is normally greater than any other long-term financing cost.
13) The capital asset pricing model describes the relationship between the required return, or the
cost of common stock equity capital, and the nonsystematic risk of a firm as measured by the
beta coefficient.
14) The capital asset pricing model is used to calculate the effect of increase in prices of capital
assets due to inflation.
15) The Gordon model assumes that the value of a share of stock equals the future value of the
current price of share that it is expected to remain constant over an infinite time horizon.
16) According to the CAPM, the required return of an asset is the sum of risk-free rate of return
and beta times the risk premium.
17) The cost of equity for Tangshan Mining would be roughly 10 percent if the expected return
on U.S. Treasury Bills is 2 percent, the market risk premium is 6 percent, and the firm’s beta is
1.33.