18) The cost of retained earnings will always equal the cost of preferred stock.
19) The cost of common stock equity is ________.
A) the cost of the guaranteed stated dividend expected by the stockholders
B) the rate at which investors discount the expected dividends of the firm to determine its share
value
C) the after-tax cost of the interest obligations
D) the historical cost of floating the stock issue
20) The cost of common stock equity may be estimated by using the ________.
A) yield curve
B) break-even analysis
C) Gordon model
D) DuPont analysis
21) The cost of common stock equity may be estimated by using the ________.
A) yield curve
B) capital asset pricing model
C) break-even analysis
D) DuPont analysis
22) The cost of retained earnings is ________.
A) less than the cost of debt
B) equal to the cost of a new issue of common stock
C) equal to the cost of common stock equity
D) irrelevant to the investment/financing decision
23) A corporation that uses both debt and equity in its capital structure has concluded that the
risk premium it must pay on its common stock is too high. To decrease this, the firm can
________.
A) increase the proportion of long-term debt to decrease the cost of capital
B) increase the proportion of short-term debt to decrease the cost of capital
C) decrease the proportion of common stock equity to decrease financial risk
D) increase the proportion of common stock equity to decrease financial risk
24) The constant-growth valuation model is based on the premise that the value of a share of
common stock is ________.
A) the sum of the dividends and expected capital appreciation
B) determined based on an industry standard P/E multiple
C) determined by using a measure of relative risk called correlation coefficient
D) equal to the present value of all expected future dividends
25) In calculating the cost of common stock equity, the model which describes the relationship
between the required return and the nondiversifiable risk of the firm is ________.
A) the constant-growth model
B) the NPV model
C) the variable growth model
D) the capital asset pricing model
26) A firm has a beta of 1.2. The market return equals 14 percent and the risk-free rate of return
equals 6 percent. The estimated cost of common stock equity is ________.
A) 6 percent
B) 7.2 percent
C) 14 percent
D) 15.6 percent
27) One major expense associated with issuing new shares of common stock is ________.
A) coupon payment
B) sunk cost
C) overvaluation
D) underpricing
24
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28) One of the circumstances in which the Gordon growth valuation model for estimating the
value of a share of stock should be used is ________.
A) declining dividends
B) an erratic dividend stream
C) the lack of data on dividend payments
D) a steady growth rate in dividends
Answer: D
Diff: 2
Topic: Finding the Cost of Common Stock Equity
Learning Obj.: LG 5
Learning Outcome: F-14
AACSB: Reflective Thinking
29) A firm has common stock with a market price of $25 per share and an expected dividend of
$2 per share at the end of the coming year. The growth rate in dividends has been 5 percent. The
cost of the firm’s common stock equity is ________.
A) 5 percent
B) 8 percent
C) 10 percent
D) 13 percent
Answer: D
Diff: 1
Topic: Finding the Cost of Common Stock Equity
Learning Obj.: LG 5
Learning Outcome: F-14
AACSB: Analytical Thinking
30) A firm has common stock with a market price of $55 per share and an expected dividend of
$2.81 per share at the end of the coming year. The dividends paid on the outstanding stock over
the past five years are as follows:
The cost of the firm’s common stock equity is ________.
A) 4.1 percent
B) 5.1 percent
C) 12.1 percent
D) 15.4 percent
31) Using the capital asset pricing model, the cost of common stock equity is the return required
by investors as compensation for ________.
A) the specific risk of a firm
B) a firm’s unsystematic risk
C) price volatility of the stock
D) a firm’s nondiversifiable risk
32) A firm has common stock with a market price of $100 per share and an expected dividend of
$5.61 per share at the end of the coming year. A new issue of stock is expected to be sold for
$98, with $2 per share representing the underpricing necessary in the competitive capital market.
Flotation costs are expected to total $1 per share. The dividends paid on the outstanding stock
over the past five years are as follows:
The cost of this new issue of common stock is ________.
A) 5.8 percent
B) 7.7 percent
C) 10.8 percent
D) 12.8 percent
33) In comparing the constant-growth model and the capital asset pricing model (CAPM) to
calculate the cost of common stock equity, ________.
A) the CAPM ignores risk, while the constant-growth model directly considers risk as reflected
in the beta
B) the CAPM directly considers risk as reflected in the beta, while the constant-growth model
uses the market price as a reflection of the expected risk-return preference of investors
C) the CAPM directly considers risk as reflected in the beta, while the constant growth model
uses dividend expectations as a reflection of risk
D) the CAPM indirectly considers risk as reflected in the market return, while the constant
growth model uses dividend expectations as a reflection of risk
34) Given that the cost of common stock is 9 percent, dividends are $0.75 per share and the price
of the stock is $12.50 per share, what is the annual growth rate of dividends?
A) 2 percent
B) 4 percent
C) 3 percent
D) 5 percent
35) What would be the cost of new common stock equity for Tangshan Mining if the firm just
paid a dividend of $4.25, the stock price is $55.00, dividends are expected to grow at 8.5 percent
indefinitely, and flotation costs are $6.25 per share?
A) 17.22%
B) 16.88%
C) 17.96%
D) 12.57%
36) What would be the cost of retained earnings equity for Tangshan Mining if the expected
return on U.S. Treasury Bills is 5.00%, the market risk premium is 10.00 percent, and the firm’s
beta is 1.3?
A) 11.5%
B) 18.0%
C) 10.0%
D) 19.5%
37) The cost of new common stock financing is higher than the cost of retained earnings due to
________.
A) flotation costs and underpricing
B) flotation costs and overpricing
C) flotation costs and commission costs
D) commission costs and overpricing
38) Since retained earnings are viewed as a fully subscribed issue of additional common stock,
the cost of retained earnings is ________.
A) less than the cost of new common stock equity
B) equal to the cost of new common stock equity
C) greater than the cost of new common stock equity
D) not related to the cost of new common stock equity
1) The weighted average cost that reflects the interrelationship of financing decisions can be
obtained by weighing the cost of each source of financing by the target proportion in a firm’s
capital structure.
2) The weighted average cost of capital (WACC) reflects the expected average cost of the
different forms of capital that a firm uses.
3) Since retained earnings is a more expensive source of financing than debt and preferred stock,
the weighted average cost of capital will fall once retained earnings have been exhausted.
4) In computing the weighted average cost of capital, the weights are either book value or market
value weights based on actual capital structure proportions.
5) In computing the weighted average cost of capital the preferred weighting scheme is generally
based on the market values of each source of capital.
6) Weights that use accounting values to measure the proportion of each type of capital in a
firm’s financial structure are called market value weights.
7) Weights that use accounting values to measure the proportion of each type of capital in a
firm’s financial structure are called book value weights.
8) A company’s target weights refer to the desired mix of debt and equity, based on market
values of each capital source, rather than the current mix of debt and equity.
9) The weights used in weighted average cost of capital must be ________.
A) greater than 50%
B) nonnegative
C) less than zero
D) zero
10) When the market values of a firm’s securities have been changing dramatically, the firm may
want to calculate its WACC based on ________.
A) book value weights
B) nominal weights
C) historic weights
D) target weights
11) A firm has determined its cost of each source of capital and the percentage of each source
making up the firm’s capital structure:
The weighted average cost of capital is ________.
A) 6 percent
B) 10.7 percent
C) 11 percent
D) 15 percent
12) When discussing weighing schemes for calculating the weighted average cost of capital,
________.
A) market value weights are preferred over book value weights and target weights are preferred
over historical weights
B) book value weights are preferred over market value weights and target weights are preferred
over historical weights
C) book value weights are preferred over market value weights and historical weights are
preferred over target weights
D) market value weights are preferred over book value weights and historical weights are
preferred over target weights