Chapter 10: The Cost of Capital
Chapter 10: The Cost of Capital
Copyright Cengage Learning. Powered by Cognero.
Page 22
b. When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on
preferred stock are deductible by the paying corporation.
c. Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than
on the cost of common stock as measured by the CAPM.
d. If a company’s beta increases, this will increase the cost of equity used to calculate the WACC, but only if the
company does not have enough retained earnings to take care of its equity financing and hence must issue new stock.
e. Higher flotation costs reduce investors’ expected returns, and that leads to a reduction in a company’s WACC.
48. Which of the following statements is CORRECT?
a. In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 70%
of the dividends received by corporate investors are excluded from their taxable income.
b. We should use historical measures of the component costs from prior financings that are still outstanding when
estimating a company’s WACC for capital budgeting purposes.
c. The cost of new equity (re) could possibly be lower than the cost of retained earnings (rs) if the market risk
premium, risk-free rate, and the company’s beta all decline by a sufficiently large amount.
d. Its cost of retained earnings is the rate of return stockholders require on a firm’s common stock.
e. The component cost of preferred stock is expressed as rp(1 – T), because preferred stock dividends are treated as
fixed charges, similar to the treatment of interest on debt.
Copyright Cengage Learning. Powered by Cognero.
Page 23
49. Which of the following statements is CORRECT?
a. The WACC as used in capital budgeting is an estimate of a company’s before-tax cost of capital.
b. The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation
cost for new debt.
c. The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to
acquire its assets.
d. There is an “opportunity cost” associated with using retained earnings, hence they are not “free.”
e. The WACC as used in capital budgeting would be simply the before-tax cost of debt if the firm plans to use only
debt to finance its capital budget during the coming year.
50. Which of the following statements is CORRECT?
a. A change in a company’s target capital structure cannot affect its WACC.
b. WACC calculations should be based on the before-tax costs of all the individual capital components.
c. Flotation costs associated with issuing new common stock normally reduce the WACC.
d. If a company’s tax rate increases, then, all else equal, its weighted average cost of capital will decline.
e. An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.
Copyright Cengage Learning. Powered by Cognero.
Page 24
51. Which of the following statements is CORRECT?
a. The WACC is calculated using before-tax costs for all components.
b. The after-tax cost of debt usually exceeds the after-tax cost of equity.
c. For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible
preferred stock.
d. Retained earnings that were generated in the past and are reported on the firm’s balance sheet are available to
finance the firm’s capital budget during the coming year.
e. The WACC that should be used in capital budgeting is the firm’s marginal, after-tax cost of capital.
52. For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following
statements is CORRECT?
a. The interest rate used to calculate the WACC is the average after-tax cost of all the company’s outstanding debt as
shown on its balance sheet.
b. The WACC is calculated on a before-tax basis.
c. The WACC exceeds the cost of equity.
d. The cost of equity is always equal to or greater than the cost of debt.
e. The cost of retained earnings typically exceeds the cost of new common stock.
Copyright Cengage Learning. Powered by Cognero.
Page 25
53. Which of the following statements is CORRECT?
a. Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and
thus the after-tax cost of debt is always greater than the cost of equity.
b. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact
pay taxes.
c. If a company assigns the same cost of capital to all of its projects regardless of each project’s risk, then the
company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should
reject.
d. Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is
generally lower than the after-tax cost of debt.
e. Higher flotation costs tend to reduce the cost of equity capital.
54. Which of the following statements is CORRECT?
a. The “break point” as discussed in the text refers to the point where the firm’s tax rate increases.
b. The “break point” as discussed in the text refers to the point where the firm has raised so much capital that it is
simply unable to borrow any more money.
c. The “break point” as discussed in the text refers to the point where the firm is taking on investments that are so
risky the firm is in serious danger of going bankrupt if things do not go exactly as planned.
d. The “break point” as discussed in the text refers to the point where the firm has raised so much capital that it has
exhausted its supply of additions to retained earnings and thus must raise equity by issuing stock.
e. The “break point” as discussed in the text refers to the point where the firm has exhausted its supply of additions
to retained earnings and thus must begin to finance with preferred stock.
Chapter 10: The Cost of Capital
Copyright Cengage Learning. Powered by Cognero.
Page 27
b. If evaluated using the correct post-merger WACC, Project X would have a negative NPV.
c. After the merger, Safeco/Risco would have a corporate WACC of 11%. Therefore, it should reject Project X but
accept Project Y.
d. Safeco/Risco’s WACC, as a result of the merger, would be 10%.
e. After the merger, Safeco/Risco should select Project Y but reject Project X. If the firm does this, its corporate
WACC will fall to 10.5%.
57. Which of the following statements is CORRECT?
a. The component cost of preferred stock is expressed as rp(1 – T). This follows because preferred stock dividends
are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes.
b. A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that
the firm’s stockholders would themselves expect to earn a return on earnings that were paid out rather than retained and
reinvested.
c. No cost should be assigned to retained earnings because the firm does not have to pay anything to raise them.
They are generated as cash flows by operating assets that were raised in the past, hence they are “free.”
d. Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into
the foreseeable future. In this case, the firm’s before-tax and after-tax costs of debt for purposes of calculating the WACC
will both be equal to the interest rate on the firm’s currently outstanding debt, provided that debt was issued during the
past 5 years.
e. If a firm has enough retained earnings to fund its capital budget for the coming year, then there is no need to
estimate either a cost of equity or a WACC.
Chapter 10: The Cost of Capital
Copyright Cengage Learning. Powered by Cognero.
Page 30
d. The relevant WACC can change depending on the amount of funds a firm raises during a given year. Moreover,
the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the
weights based on the firm’s target capital structure.
e. Beta measures market risk, which is generally the most relevant risk measure for a publicly-owned firm that seeks
to maximize its intrinsic value. However, this is not true unless all of the firm’s stockholders are well diversified.
62. Which of the following statements is CORRECT?
a. Since the costs of internal and external equity are related, an increase in the flotation cost required to sell a new
issue of stock will increase the cost of retained earnings.
b. Since its stockholders are not directly responsible for paying a corporation’s income taxes, corporations should
focus on before-tax cash flows when calculating the WACC.
c. An increase in a firm’s tax rate will increase the component cost of debt, provided the YTM on the firm’s bonds is
not affected by the change in the tax rate.
d. When the WACC is calculated, it should reflect the costs of new common stock, retained earnings, preferred
stock, long-term debt, short-term bank loans if the firm normally finances with bank debt, and accounts payable if the firm
normally has accounts payable on its balance sheet.
e. If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and
therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the after-tax cost of
debt.
Copyright Cengage Learning. Powered by Cognero.
Page 31
63. Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is
seeking to maximize shareholder wealth.
a. If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are
negatively correlated with the returns on most other firms’ assets.
b. If a firm’s managers want to maximize the value of the stock, they should, in theory, concentrate on project risk as
measured by the standard deviation of the project’s expected future cash flows.
c. If a firm evaluates all projects using the same cost of capital, and the CAPM is used to help determine that cost,
then its risk as measured by beta will probably decline over time.
d. Projects with above-average risk typically have higher-than-average expected returns. Therefore, to maximize a
firm’s intrinsic value, its managers should favor high-beta projects over those with lower betas.
e. Project A has a standard deviation of expected returns of 20%, while Project B’s standard deviation is only 10%.
A’s returns are negatively correlated with both the firm’s other assets and the returns on most stocks in the economy,
while B’s returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a
lower cost of capital.
64. Firm M’s earnings and stock price tend to move up and down with other firms in the S&P 500, while Firm W’s
earnings and stock price move counter cyclically with M and other S&P companies. Both M and W estimate their costs of
equity using the CAPM, they have identical market values, their standard deviations of returns are identical, and they both
finance only with common equity. Which of the following statements is CORRECT?
a. M should have the lower WACC because it is like most other companies, and investors like that fact.
b. M and W should have identical WACCs because their risks as measured by the standard deviation of returns are
identical.
Chapter 10: The Cost of Capital
Copyright Cengage Learning. Powered by Cognero.
Page 32
c. If M and W merge, then the merged firm MW should have a WACC that is a simple average of M’s and W’s
WACCs.
d. Without additional information, it is impossible to predict what the merged firm’s WACC would be if M and W
merged.
e. Since M and W move counter cyclically to one another, if they merged, the merged firm’s WACC would be less
than the simple average of the two firms’ WACCs.
65. Bosio Inc.’s perpetual preferred stock sells for $102.50 per share, and it pays an $8.50 annual dividend. If the company
were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is the
company’s cost of preferred stock for use in calculating the WACC?
a. 9.33%
b. 8.72%
c. 7.26%
d. 7.17%
e. 8.64%
Copyright Cengage Learning. Powered by Cognero.
Page 36
71. A. Butcher Timber Company hired your consulting firm to help them estimate the cost of equity. The yield on the
firm’s bonds is 12.00%, and your firm’s economists believe that the cost of equity can be estimated using a risk premium
of 3.85% over a firm’s own cost of debt. What is an estimate of the firm’s cost of equity from retained earnings?
a. 15.85%
b. 14.74%
c. 12.52%
d. 13.31%
e. 14.58%
72. You were hired as a consultant to Giambono Company, whose target capital structure is 40% debt, 15% preferred, and
45% common equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of retained earnings
is 11.50%. The firm will not be issuing any new stock. What is its WACC?
a. 8.70%
b. 8.87%
c. 7.92%
d. 7.66%
e. 6.70%
Copyright Cengage Learning. Powered by Cognero.
Page 37
73. To help finance a major expansion, Castro Chemical Company sold a noncallable bond several years ago that now has
20 years to maturity. This bond has a 9.25% annual coupon, paid semiannually, sells at a price of $875, and has a par
value of $1,000. If the firm’s tax rate is 25%, what is the component cost of debt for use in the WACC calculation? Do not
round your intermediate calculations.
a. 6.60%
b. 7.77%
c. 7.30%
d. 6.47%
e. 8.09%