Financial Management: Core Concepts, 4e (Brooks)
Chapter 11 The Cost of Capital
1) The ________ is the cost of each financing component multiplied by that component’s percent
of the total funding amount.
A) NPV
B) IRR
C) cost of capital
D) cost of debt
2) The cost of capital is ________.
A) the cost of debt in a firm that finances with both debt and equity
B) the cost of each financing component multiplied by that component’s percent of the total
borrowed
C) another name for the IRR
D) All of the above
3) ________ refers to the way a company finances itself through some combination of loans,
bond sales, preferred stock sales, common stock sales, and retention of earnings.
A) Capital structure
B) Cost of capital
C) Working capital management
D) NPV
4) Which of the following is NOT considered a part of the firm’s capital structure?
A) Long-term debt
B) Retained earnings
C) Inventory
D) Preferred stock
5) A firm’s capital structure can be determined by examining which parts of the firm’s balance
sheet?
A) The long-term assets
B) The debt and equity
C) The short-term assets and liabilities
D) None of the above because a firm’s capital structure is best observed on the income statement.
6) Of the following, which is NOT a source of funds for a company?
A) Common shareholders
B) Commercial banks
C) Preferred stockholders
D) All are sources of funds for companies.
7) Which of the following would be classified as debt lenders for a firm?
A) Preferred shareholders, banks, and nonbank lenders
B) Nonbank lenders, common shareholders, and commercial banks
C) Preferred shareholders, common shareholders, and suppliers
D) Suppliers, nonbank lenders, and commercial banks
8) Which of the following would be classified as equity financing for a firm?
A) Preferred shareholders, banks, and nonbank lenders
B) Nonbank lenders, common shareholders, and commercial banks
C) Preferred shareholders, common shareholders, and retained earnings
D) Suppliers, nonbank lenders, and commercial banks
9) When a company borrows money from a bank or sells bonds, it is called ________.
A) capital structure financing
B) stock financing
C) equity financing
D) debt financing
10) Which of the items below is sometimes termed hybrid equity financing?
A) Retained earnings
B) Preferred stock
C) Callable bonds
D) Variable rate bonds
11) Which of the statements below is NOT true?
A) Preferred stock is a form of hybrid equity financing.
B) Retained earnings are a form of hybrid equity financing.
C) Common stock is a form of equity financing.
D) Corporate bonds are a form of debt financing.
12) The weighted average cost of capital is ________.
A) the average of the cost of each financing component, weighted by the proportion of each
component
B) the cost of capital for the firm as a whole
C) made up of three financing components: the cost of debt, the cost of preferred stock, and the
cost of equity
D) All of the above
13) Alloy Supply Co. has a new project that will require the company to borrow $3,000,000.
Acme has made an agreement with three lenders for the needed financing. First National Bank
will give $1,500,000 and wants 6% interest on the loan. Banner Bank will give $1,000,000 and
wants 9% interest on the loan. Western National Bank will give $500,000 and wants 7% interest
on the loan. What is the weighted average cost of capital to acquire the $3,000,000?
A) 8.17%
B) 11.17%
C) 7.33%
D) 7.17%
14) Dakota Drilling Inc. (DD) has a new project that will require the company to borrow
$5,000,000. MM has made an agreement with three lenders for the needed financing. First
National Bank will give $1,000,000 and wants 6% interest on the loan. Texas Bank will give
$3,000,000 and wants 7% interest on the loan. Chase Bank will give $1,000,000 and wants 8%
interest on the loan. What is the weighted average cost of capital for this $5,000,000?
A) 10.67%
B) 10.20%
C) 8.00.00%
D) 7.00%
15) The choice of the borrowing proportion makes up the capital budgeting of the firm.
16) When a company borrows from a bank or sells bonds, it is called equity financing.
17) When a company “borrows” money from the owners by selling common stock or using
internal funds, it is called equity financing.
18) When estimating the cost of debt financing from bonds, a firm can use the yield-to-maturity
as the before-tax cost of debt.
19) The textbook labels preferred stock as “hybrid equity financing.” Identify and explain the
features of preferred stock that give it the designation of “hybrid equity financing.”
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11.2 Components of the Weighted Average Cost of Capital
1) In capital budgeting, the ________ is the appropriate discount rate to use when calculating the
NPV of an average risk project.
A) WACC
B) IRR
C) cost of debt
D) cost of equity
2) In capital budgeting, the appropriate decision rule for an average-risk project is to accept if the
________ is greater than the WACC.
A) NPV
B) IRR
C) cost of equity
D) cost of debt
3) The ________ is the return that the bank or bondholder demands on new borrowing.
A) IRR
B) WACC
C) cost of equity
D) cost of debt
4) The cost of debt could be which of the following?
A) The required return on money borrowed as a long-term loan from a bank
B) The required return on money borrowed from a venture capitalist
C) The yield-to-maturity on money raised by selling bonds
D) All of the choices above could be considered the cost of debt.
5) Which of the following would NOT be considered a cost of debt financing?
A) The required return on a bank loan
B) The required return on preferred stock
C) The yield-to-maturity of a bond issue
D) The required return on money borrowed from a venture capitalist
6) Your firm has just issued a 15-year $1,000.00 par value, 10% annual coupon bond for a net
price of $964.00. What is the yield to maturity? Use a financial calculator to determine your
answer.
A) 10.60%
B) 10.49%
C) 10.44%
D) 10.16%
7) Your firm has just issued a 10-year $1,000.00 par value, 6% coupon semiannual bond for a net
price of $964.00. What is the yield to maturity? Use a financial calculator to determine your
answer.
A) 3.16%
B) 6.50%
C) 6.32%
D) 6.00%
8) Your firm has issued a 20-year $1,000.00 par value semiannual 10% coupon bond that sells
for $1,000 in the market place. The proceeds from the sale of the bond issue are $975.00 per
bond. What is your firm’s yield to maturity on this new bond issue? Use a financial calculator to
determine your answer.
A) 5.15%
B) 10.16%
C) 10.30%
D) 10.41%
9) A/An ________ facilitates the issuing and sale of bonds and for this service is paid a fee.
A) commercial banker
B) investment banker
C) dealer
D) broker
10) An investment banker’s fees are part of the ________ realized for issuing new debt or equity.
A) flotation costs
B) opportunity costs
C) revenues
D) benefits
11) Pricing preferred stock is most similar to pricing ________.
A) constant growth common stock
B) a perpetuity
C) a zero-coupon bond
D) a three-month Treasury bill
12) Your firm has preferred stock outstanding that pays a current dividend of $3.00 per year and
has a current price of $35.90. You anticipate that the economy will grow steadily at a rate of
2.00% per year for the foreseeable future. What is the market required rate of return on your
firm’s preferred stock?
A) 10.82%
B) 8.36%
C) 7.59%
D) There is not enough information to answer this question.
13) Your firm has preferred stock outstanding that pays a current dividend of $2.50 per year and
has a current price of $25.00. Currently, preferred stock makes up approximately 5% of your
firm’s long-term financing. What is the market required rate of return on your firm’s preferred
stock?
A) 8.36%
B) 9.00%
C) 9.30%
D) 10.00%
14) The riskiness of a future cash flow is measured by ________, and these are all components
of the SML.
A) the firm’s standard deviation, correlation, and the market risk premium
B) beta, the market risk premium, and the firm’s standard deviation
C) the market risk premium, beta, and correlation
D) beta, the market risk premium, and the risk-free rate
15) Use the security market line to determine the required rate of return for the following firm’s
stock. The firm has a beta of 1.05, the required return in the market place is 11.50%, the standard
deviation of returns for the market portfolio is 20.00%, and the standard deviation of returns for
your firm is also 20.00%.
A) 13.13%
B) 10.50%
C) 31.25%
D) There is not enough information to answer this question.
16) Use the security market line to determine the required rate of return for the following firm’s
stock. The firm has a beta of 1.20, the required return in the market place is 10.00%, and the risk-
free rate of return is 1.50%.
A) 11.70%
B) 10.70%
C) 7.20%
D) 2.80%
17) Which of the following is an advantage of the dividend growth approach over the SML in
estimating the required return on equity?
A) The dividend growth model uses market information but the SML does not.
B) Dividend growth is known, whereas estimating beta for the SML is an art form.
C) It is easy to fit flotation costs into the dividend growth model but not the SML.
D) All are advantages of the dividend growth model for estimating the required return on equity.
18) Use the dividend growth model to determine the required rate of return for equity. Yesterday
your firm paid a dividend of $1.50 per share. Further, the recent stock price is $31.82 per share,
and you anticipate a growth rate in dividends of 4.00% per year for the foreseeable future.
A) 8.90%
B) 8.71%
C) 9.09%
D) There is not enough information to answer this question.
19) Use the dividend growth model to determine the required rate of return for equity. Your firm
intends to pay a dividend of $2.25 per share one year from now, has a recent price of $40.20 per
share, and anticipates a growth rate in dividends of 3.00% per year for the foreseeable future.
A) 8.76%
B) 8.60%
C) 8.44%
D) There is not enough information to answer this question.
20) Use the dividend growth model to determine the required rate of return for equity. Your firm
intends to issue new common stock. Your investment bankers have determined that the stock
should be offered at a price of $45.00 per share and that you should anticipate paying a dividend
of $1.50 in one year. If you anticipate a constant growth in dividends of 3.00% per year and the
investment banking firm will take 5.00% per share as flotation costs, what is the required rate of
return for this issue of new common stock?
A) 6.51%
B) 6.83%
C) 7.08%
D) There is not enough information to answer this question.
21) Use the dividend growth model to determine the required rate of return for equity. Your firm
intends to issue new common stock. Your investment bankers have determined that the stock
should be offered at a price of $20.00 per share and that you should anticipate paying a dividend
of $0.50 in one year. If you anticipate a constant growth in dividends of 4.00% per year and the
investment banking firm will take 10.00% per share as flotation costs, what is the required rate of
return for this issue of new common stock?
A) 6.78%
B) 7.08%
C) 7.19%
D) 10.20%
22) The cost of retained earnings ________.
A) is the loss of the dividend option for the owners
B) is the cost of issuing new common stock without the flotation costs
C) is the appropriate cost of capital for the shareholders
D) All of the above
23) When calculating the after-tax weighted average cost of capital (WACC), which of the
following costs is adjusted for taxes in the equation?
A) The before-tax cost of equity
B) The before-tax cost of debt
C) The before-tax cost of preferred stock
D) The after-tax cost of debt
24) Which of the following are tax-deductible expenses for corporations?
A) Interest expenses
B) Preferred stock dividends
C) Common stock dividends
D) All are tax-deductible for corporations.
25) Which of the following is the proper way to adjust the cost of debt to estimate the after-tax
cost of debt?
A) Rd ÷ (1 + Tc)
B) Rd ÷ (1 – Tc)
C) Rd × (1 – Tc)
D) Rd × (1 + Tc)
26) For estimating NPV, the IRR is the appropriate discount rate to use for an average-risk
project.
27) When evaluating an average-risk project using IRR, a firm should use the WACC as the
hurdle rate.
28) Flotation costs reduce the cost of borrowing funds for the firms.
29) When determining the cost of bond financing a firm must determine the net proceeds from
the sale of the bond less the flotation cost charged by the investment banker to estimate the yield-
to-maturity.
30) Two techniques for determining the cost of equity include using:
1. The Security Market Line, and 2. The Internal Rate of Return.
31) It is easier to incorporate the impact of flotation costs on the cost of equity capital in using
the dividend growth model rather than the Security Market Line.
32) The cost of retained earnings is the cost of issuing new common stock without flotation
costs.
33) To find the after-tax cost of debt for a corporation, one needs to multiply the before-tax cost
of debt by (1 + Tc), where Tc = the corporate tax rate.
34) Theo has been assigned the task of determining the cost of capital for his division of the firm.
His first step is to determine the cost of debt. The firm has $1,000 par value bonds outstanding
that have an annual coupon rate of 8.00% and make semiannual payments. These bonds have
twenty-three years remaining to maturity and currently sell for $1,133.42. What is the yield-to–
maturity on these bonds? Use a financial calculator to determine your answer.
35) Define flotation costs and explain how they are used when estimating a firm’s yield-to–
maturity.
36) Phillip Enterprises Inc. needs to determine its cost of equity capital. Use the following
information to estimate the firm’s cost of equity using both the security market line and the
dividend growth model. The current market price of stock is $22.89, the risk-free rate is 4.00%,
the required return on the market portfolio is 13.50%, the firm has a constant growth rate in
dividends of 3.00% per year, current dividends are $2.00, and the firm’s beta is 0.90.
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11.3 Weighting the Components: Book Value or Market Value?
1) The ________ of an asset or liability is its cost carried on the balance sheet.
A) market value
B) book value
C) hybrid value
D) theoretical value
2) Rogue Drafting has debt with a market value of $450,000, preferred stock with a market value
of $150,000, and common stock with a market value of $350,000. If debt has a cost of 8%,
preferred stock a cost of 10%, common stock a cost of 12%, and the firm has a tax rate of 30%,
what is the WACC?
A) 8.65%
B) 9.12%
C) 9.33%
D) 9.46%