Chapter 10: Cost of Capital True/False Page 353
(Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard)
Note that there is some overlap between the T/F and the multiple choice questions, as some T/F
statements are used in the MC questions. See the preface for information on the AACSB letter
indicators (F, M, etc.) on the subject lines.
Multiple Choice: True/False
1. “Capital” is sometimes defined as funds supplied to a firm by investors.
a. True
b. False
2. The cost of capital used in capital budgeting should reflect the average
cost of the various sources of investor-supplied funds a firm uses to
acquire assets.
a. True
b. False
3. Suppose you are the president of a small, publicly-traded corporation.
Since you believe that your firm’s stock price is temporarily depressed,
all additional capital funds required during the current year will be
raised using debt. In this case, the appropriate marginal cost of
capital for use in capital budgeting during the current year is the
after-tax cost of debt.
a. True
b. False
4. The component costs of capital are market-determined variables in the
sense that they are based on investors’ required returns.
a. True
b. False
5. The before-tax cost of debt, which is lower than the after-tax cost, is
used as the component cost of debt for purposes of developing the
firm’s WACC.
a. True
b. False
CHAPTER 10
THE COST OF CAPITAL
Page 354 True/False Chapter 10: Cost of Capital
6. The cost of debt is equal to one minus the marginal tax rate multiplied
by the average coupon rate on all outstanding debt.
a. True
b. False
7. The cost of debt is equal to one minus the marginal tax rate multiplied
by the interest rate on new debt.
a. True
b. False
8. The cost of preferred stock to a firm must be adjusted to an after-tax
figure because 70% of dividends received by a corporation may be
excluded from the receiving corporation’s taxable income.
a. True
b. False
9. The cost of perpetual preferred stock is found as the preferred’s
annual dividend divided by the market price of the preferred stock. No
adjustment is needed for taxes because preferred dividends, unlike
interest on debt, are not deductable by the issuing firm.
a. True
b. False
10. The cost of common equity obtained by retaining earnings is the rate of
return the marginal stockholder requires on the firm’s common stock.
a. True
b. False
11. For capital budgeting and cost of capital purposes, the firm should
always consider retained earnings as the first source of capital–i.e.,
use these funds first–because retained earnings have no cost to the
firm.
a. True
b. False
12. Funds acquired by the firm through retaining earnings have no cost
because there are no dividend or interest payments associated with
them, and no flotation costs are required to raise them, but capital
raised by selling new stock or bonds does have a cost.
a. True
b. False
Chapter 10: Cost of Capital True/False Page 355
13. The cost of equity raised by retaining earnings can be less than, equal
to, or greater than the cost of external equity raised by selling new
issues of common stock, depending on tax rates, flotation costs, the
attitude of investors, and other factors.
a. True
b. False
14. The firm’s cost of external equity raised by issuing new stock is the
same as the required rate of return on the firm’s outstanding common
stock.
a. True
b. False
15. For capital budgeting and cost of capital purposes, the firm should
assume that each dollar of capital is obtained in accordance with its
target capital structure, which for many firms means partly as debt,
partly as preferred stock, and partly common equity.
a. True
b. False
16. The higher the firm’s flotation cost for new common equity, the more
likely the firm is to use preferred stock, which has no flotation cost,
and retained earnings, whose cost is the average return on the assets
that are acquired.
a. True
b. False
17. In general, firms should use their weighted average cost of capital
(WACC) to evaluate capital budgeting projects because most projects are
funded with general corporate funds, which come from a variety of
sources. However, if the firm plans to use only debt or only equity to
fund a particular project, it should use the after-tax cost of that
specific type of capital to evaluate that project.
a. True
b. False
18. If a firm’s marginal tax rate is increased, this would, other things
held constant, lower the cost of debt used to calculate its WACC.
a. True
b. False
Page 356 True/False Chapter 10: Cost of Capital
19. The reason why retained earnings have a cost equal to rs is because
investors think they can (i.e., expect to) earn rs on investments with
the same risk as the firm’s common stock, and if the firm does not
think that it can earn rs on the earnings that it retains, it should pay
those earnings out to its investors. Thus, the cost of retained
earnings is based on the opportunity cost principle.
a. True
b. False
20. The text identifies three methods for estimating the cost of common
stock from retained earnings: the CAPM method, the DCF method, and the
bond-yield-plus-risk-premium method. However, only the DCF method is
widely used in practice.
a. True
b. False
21. The text identifies three methods for estimating the cost of common
stock from retained earnings: the CAPM method, the DCF method, and the
bond-yield-plus-risk-premium method. However, only the CAPM method
always provides an accurate and reliable estimate.
a. True
b. False
22. The text identifies three methods for estimating the cost of common
stock from retained earnings: the CAPM method, the DCF method, and the
bond-yield-plus-risk-premium method. Since we cannot be sure that the
estimate obtained with any of these methods is correct, it is often
appropriate to use all three methods, then consider all three
estimates, and end up using a judgmental estimate when calculating the
WACC.
a. True
b. False
23. When estimating the cost of equity by use of the CAPM, three potential
problems are (1) whether to use long-term or short-term rates for rRF,
(2) whether or not the historical beta is the beta that investors use
when evaluating the stock, and (3) how to measure the market risk
premium, RPM. These problems leave us unsure of the true value of rs.
a. True
b. False
24. When estimating the cost of equity by use of the DCF method, the single
biggest potential problem is to determine the growth rate that investors
Chapter 10: Cost of Capital True/False Page 357
use when they estimate a stock’s expected future rate of return. This
problem leaves us unsure of the true value of rs.
a. True
b. False
25. When estimating the cost of equity by use of the bond–yield–plus-risk–
premium method, we can generally get a good idea of the interest rate
on new long-term debt, but we cannot be sure that the risk premium we
add is appropriate. This problem leaves us unsure of the true value of
rs.
a. True
b. False
26. If a firm is privately owned, and its stock is not traded in public
markets, then we cannot measure its beta for use in the CAPM model, we
cannot observe its stock price for use in the DCF model, and we don’t
know what the risk premium is for use in the bond-yield-plus-risk–
premium method. All this makes it especially difficult to estimate the
cost of equity for a private company.
a. True
b. False
27. The cost of external equity capital raised by issuing new common stock
(re) is defined as follows, in words: “The cost of external equity
equals the cost of equity capital from retaining earnings (rs), divided
by one minus the percentage flotation cost required to sell the new
stock, (1 – F).”
a. True
b. False
28. If the expected dividend growth rate is zero, then the cost of external
equity capital raised by issuing new common stock (re) is equal to the
cost of equity capital from retaining earnings (rs) divided by one minus
the percentage flotation cost required to sell the new stock, (1 – F).
If the expected growth rate is not zero, then the cost of external
equity must be found using a different formula.
a. True
b. False
29. Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is
8%, the current cost of equity is 16%, and the tax rate is 40%. An
increase in the debt ratio to 60% would have to decrease the weighted
average cost of capital (WACC).
a. True
Page 358 True/False Chapter 10: Cost of Capital
b. False
30. Firms raise capital at the total corporate level by retaining earnings
and by obtaining funds in the capital markets. They then provide funds
to their different divisions for investment in capital projects. The
divisions may vary in risk, and the projects within the divisions may
also vary in risk. Therefore, it is conceptually correct to use
different risk–adjusted costs of capital for different capital
budgeting projects.
a. True
b. False
31. The cost of debt, rd, is normally less than rs, so rd(1 – T) will
normally be much less than rs. Therefore, as long as the firm is not
completely debt financed, the weighted average cost of capital (WACC)
will normally be greater than rd(1 – T).
a. True
b. False
32. The lower the firm’s tax rate, the lower will be its after-tax cost of
debt and also its WACC, other things held constant.
a. True
b. False
33. Since 70% of the preferred dividends received by a corporation are
excluded from taxable income, the component cost of equity for a
company that pays half of its earnings out as common dividends and half
as preferred dividends should, theoretically, be
Cost of equity = rs(0.30)(0.50) + rps(1 – T)(0.70)(0.50).
a. True
b. False
34. If expectations for long-term inflation rose, but the slope of the SML
remained constant, this would have a greater impact on the required
rate of return on equity, rs, than on the interest rate on long-term
debt, rd, for most firms. Therefore, the percentage point increase in
the cost of equity would be greater than the increase in the interest
rate on long-term debt.
a. True
b. False
Chapter 10: Cost of Capital Conceptual M/C Page 359
35. If investors’ aversion to risk rose, causing the slope of the SML to
increase, this would have a greater impact on the required rate of
return on equity, rs, than on the interest rate on long-term debt, rd,
for most firms. Other things held constant, this would lead to an
increase in the use of debt and a decrease in the use of equity.
However, other things would not stay constant if firms used a lot more
debt, as that would increase the riskiness of both debt and equity and
thus limit the shift toward debt.
a. True
b. False
Multiple Choice: Conceptual
36. Which of the following is NOT a capital component when calculating the
weighted average cost of capital (WACC) for use in capital budgeting?
a. Long–term debt.
b. Accounts payable.
c. Retained earnings.
d. Common stock.
e. Preferred stock.
37. Bankston Corporation forecasts that if all of its existing financial
policies are followed, its proposed capital budget would be so large
that it would have to issue new common stock. Since new stock has a
higher cost than retained earnings, Bankston would like to avoid issuing
new stock. Which of the following actions would REDUCE its need to
issue new common stock?
a. Increase the dividend payout ratio for the upcoming year.
b. Increase the percentage of debt in the target capital structure.
c. Increase the proposed capital budget.
d. Reduce the amount of short–term bank debt in order to increase the
current ratio.
e. Reduce the percentage of debt in the target capital structure.
38. Schalheim Sisters Inc. has always paid out all of its earnings as
dividends, hence the firm has no retained earnings. This same
situation is expected to persist in the future. The company uses the
CAPM to calculate its cost of equity, its target capital structure
consists of common stock, preferred stock, and debt. Which of the
following events would REDUCE its WACC?
a. The market risk premium declines.
b. The flotation costs associated with issuing new common stock
increase.
c. The company’s beta increases.
d. Expected inflation increases.
e. The flotation costs associated with issuing preferred stock increase.
Page 360 Conceptual M/C Chapter 10: Cost of Capital
39. For a typical firm, which of the following sequences is CORRECT? All
rates are after taxes, and assume that the firm operates at its target
capital structure.
a. rs > re > rd > WACC.
b. re > rs > WACC > rd.
c. WACC > re > rs > rd.
d. rd > re > rs > WACC.
e. WACC > rd > rs > re.
40. When working with the CAPM, which of the following factors can be
determined with the most precision?
a. The market risk premium (RPM).
b. The beta coefficient, bi, of a relatively safe stock.
c. The most appropriate risk-free rate, rRF.
d. The expected rate of return on the market, rM.
e. The beta coefficient of “the market,” which is the same as the beta
of an average stock.
41. Duval Inc. uses only equity capital, and it has two equally-sized
divisions. Division A’s cost of capital is 10.0%, Division B’s cost is
14.0%, and the corporate (composite) WACC is 12.0%. All of Division
A’s projects are equally risky, as are all of Division B’s projects.
However, the projects of Division A are less risky than those of
Division B. Which of the following projects should the firm accept?
a. A Division B project with a 13% return.
b. A Division B project with a 12% return.
c. A Division A project with an 11% return.
d. A Division A project with a 9% return.
e. A Division B project with an 11% return.
42. LaPango Inc. estimates that its average-risk projects have a WACC of
10%, its below–average risk projects have a WACC of 8%, and its above–
average risk projects have a WACC of 12%. Which of the following
projects (A, B, and C) should the company accept?
a. Project B, which is of below-average risk and has a return of 8.5%.
b. Project C, which is of above-average risk and has a return of 11%.
c. Project A, which is of average risk and has a return of 9%.
d. None of the projects should be accepted.
e. All of the projects should be accepted.
Chapter 10: Cost of Capital Conceptual M/C Page 361
43. Norris Enterprises, an all-equity firm, has a beta of 2.0. The chief
financial officer is evaluating a project with an expected return of
14%, before any risk adjustment. The risk-free rate is 5%, and the
market risk premium is 4%. The project being evaluated is riskier than
the firm’s average project, in terms of both its beta risk and its
total risk. Which of the following statements is CORRECT?
a. The project should definitely be accepted because its expected return
(before any risk adjustments) is greater than its required return.
b. The project should definitely be rejected because its expected return
(before risk adjustment) is less than its required return.
c. Riskier-than-average projects should have their expected returns
increased to reflect their higher risk. Clearly, this would make
the project acceptable regardless of the amount of the adjustment.
d. The accept/reject decision depends on the firm’s risk-adjustment policy.
If Norris‘ policy is to increase the required return on a riskier-than–
average project to 3% over rS, then it should reject the project.
e. Capital budgeting projects should be evaluated solely on the basis
of their total risk. Thus, insufficient information has been
provided to make the accept/reject decision.
44. The MacMillen Company has equal amounts of low-risk, average-risk, and
high-risk projects. The firm’s overall WACC is 12%. The CFO believes
that this is the correct WACC for the company’s average-risk projects,
but that a lower rate should be used for lower-risk projects and a
higher rate for higher-risk projects. The CEO disagrees, on the
grounds that even though projects have different risks, the WACC used to
evaluate each project should be the same because the company obtains
capital for all projects from the same sources. If the CEO’s position
is accepted, what is likely to happen over time?
a. The company will take on too many high-risk projects and reject too
many low-risk projects.
b. The company will take on too many low-risk projects and reject too
many high-risk projects.
c. Things will generally even out over time, and, therefore, the firm’s
risk should remain constant over time.
d. The company’s overall WACC should decrease over time because its
stock price should be increasing.
e. The CEO’s recommendation would maximize the firm’s intrinsic value.
45. If a typical U.S. company correctly estimates its WACC at a given point
in time and then uses that same cost of capital to evaluate all
projects for the next 10 years, then the firm will most likely
a. become riskier over time, but its intrinsic value will be maximized.
b. become less risky over time, and this will maximize its intrinsic
value.
c. accept too many low-risk projects and too few high-risk projects.
d. become more risky and also have an increasing WACC. Its intrinsic
value will not be maximized.
Page 362 Conceptual M/C Chapter 10: Cost of Capital
e. continue as before, because there is no reason to expect its risk
position or value to change over time as a result of its use of a
single cost of capital.
46. Which of the following statements is CORRECT?
a. When calculating the cost of preferred stock, a company needs to
adjust for taxes, because preferred stock dividends are deductible
by the paying corporation.
b. All else equal, an increase in a company’s stock price will increase
its marginal cost of retained earnings, rs.
c. All else equal, an increase in a company’s stock price will increase
its marginal cost of new common equity, re.
d. Since the money is readily available, the after-tax cost of retained
earnings is usually much lower than the after-tax cost of debt.
e. If a company’s tax rate increases but the YTM on its noncallable
bonds remains the same, the after-tax cost of its debt will fall.
47. Which of the following statements is CORRECT?
a. When calculating the cost of debt, a company needs to adjust for
taxes, because interest payments are deductible by the paying
corporation.
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.
Chapter 10: Cost of Capital Conceptual M/C Page 363
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.
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 after-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.
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.
Page 364 Conceptual M/C Chapter 10: Cost of Capital
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.
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 new 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 new retained earnings and thus
must begin to finance with preferred stock.
Chapter 10: Cost of Capital Conceptual M/C Page 365
55. Cranberry Corp. has two divisions of equal size: a computer
manufacturing division and a data processing division. Its CFO
believes that stand-alone data processor companies typically have a
WACC of 8%, while stand-alone computer manufacturers typically have a
12% WACC. He also believes that the data processing and manufacturing
divisions have the same risk as their typical peers. Consequently, he
estimates that the composite, or corporate, WACC is 10%. A consultant
has suggested using an 8% hurdle rate for the data processing division
and a 12% hurdle rate for the manufacturing division. However, the CFO
disagrees, and he has assigned a 10% WACC to all projects in both
divisions. Which of the following statements is CORRECT?
a. While the decision to use just one WACC will result in its accepting
more projects in the manufacturing division and fewer projects in
its data processing division than if it followed the consultant’s
recommendation, this should not affect the firm’s intrinsic value.
b. The decision not to adjust for risk means, in effect, that it is
favoring the data processing division. Therefore, that division is
likely to become a larger part of the consolidated company over
time.
c. The decision not to adjust for risk means that the company will
accept too many projects in the manufacturing division and too few in
the data processing division. This will lead to a reduction in the
firm’s intrinsic value over time.
d. The decision not to risk-adjust means that the company will accept
too many projects in the data processing business and too few
projects in the manufacturing business. This will lead to a
reduction in its intrinsic value over time.
e. The decision not to risk adjust means that the company will accept
too many projects in the manufacturing business and too few projects
in the data processing business. This may affect the firm’s capital
structure but it will not affect its intrinsic value.
56. Safeco Company and Risco Inc are identical in size and capital
structure. However, the riskiness of their assets and cash flows are
somewhat different, resulting in Safeco having a WACC of 10% and Risco
a WACC of 12%. Safeco is considering Project X, which has an IRR of
10.5% and is of the same risk as a typical Safeco project. Risco is
considering Project Y, which has an IRR of 11.5% and is of the same
risk as a typical Risco project.
Now assume that the two companies merge and form a new company,
Safeco/Risco Inc. Moreover, the new company’s market risk is an
average of the pre-merger companies’ market risks, and the merger has
no impact on either the cash flows or the risks of Projects X and Y.
Which of the following statements is CORRECT?
a. If the firm evaluates these projects and all other projects at the
new overall corporate WACC, it will probably become riskier over
time.
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%.
Page 366 Conceptual M/C Chapter 10: Cost of Capital
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.
58. Which of the following statements is CORRECT?
a. The cost of capital used to evaluate a project should be the cost of
the specific type of financing used to fund that project, i.e., it
is the after-tax cost of debt if debt is to be used to finance the
project or the cost of equity if the project will be financed with
equity.
b. The after-tax cost of debt that should be used as the component cost
when calculating the WACC is the average after-tax cost of all the
firm’s outstanding debt.
c. Suppose some of a publicly-traded firm’s stockholders are not
diversified; they hold only the one firm’s stock. In this case, the
CAPM approach will result in an estimated cost of equity that is too
low in the sense that if it is used in capital budgeting, projects
will be accepted that will reduce the firm’s intrinsic value.
d. The cost of equity is generally harder to measure than the cost of
debt because there is no stated, contractual cost number on which to
base the cost of equity.
e. The bond-yield-plus-risk-premium approach is the most sophisticated
and objective method for estimating a firm’s cost of equity capital.
Chapter 10: Cost of Capital Conceptual M/C Page 367
59. Which of the following statements is CORRECT?
a. Although some methods used to estimate the cost of equity are
subject to severe limitations, the CAPM is a simple,
straightforward, and reliable model that consistently produces
accurate cost of equity estimates. In particular, academics and
corporate finance people generally agree that its key inputs–beta,
the risk-free rate, and the market risk premium–can be estimated
with little error.
b. The DCF model is generally preferred by academics and financial
executives over other models for estimating the cost of equity.
This is because of the DCF model’s logical appeal and also because
accurate estimates for its key inputs, the dividend yield and the
growth rate, are easy to obtain.
c. The bond-yield-plus-risk-premium approach to estimating the cost of
equity may not always be accurate, but it has the advantage that its
two key inputs, the firm’s own cost of debt and its risk premium,
can be found by using standardized and objective procedures.
d. Surveys indicate that the CAPM is the most widely used method for
estimating the cost of equity. However, other methods are also used
because CAPM estimates may be subject to error, and people like to
use different methods as checks on one another. If all of the
methods produce similar results, this increases the decision maker’s
confidence in the estimated cost of equity.
e. The DCF model is preferred by academics and finance practitioners
over other cost of capital models because it correctly recognizes
that the expected return on a stock consists of a dividend yield
plus an expected capital gains yield.
60. Which of the following statements is CORRECT?
a. The discounted cash flow method of estimating the cost of equity
cannot be used unless the growth rate, g, is expected to be constant
forever.
b. If the calculated beta underestimates the firm’s true investment
risk–i.e., if the forward-looking beta that investors think exists
exceeds the historical beta–then the CAPM method based on the
historical beta will produce an estimate of rs and thus WACC that is
too high.
c. Beta measures market risk, which is, theoretically, the most
relevant risk measure for a publicly-owned firm that seeks to
maximize its intrinsic value. This is true even if not all of the
firm’s stockholders are well diversified.
d. An advantage shared by both the DCF and CAPM methods when they are
used to estimate the cost of equity is that they are both “objective”
as opposed to “subjective,” hence little or no judgment is required.
e. The specific risk premium used in the CAPM is the same as the risk
premium used in the bond-yield-plus-risk-premium approach.
Page 368 Conceptual M/C Chapter 10: Cost of Capital
61. Which of the following statements is CORRECT?
a. The bond-yield-plus-risk-premium approach to estimating the cost of
common equity involves adding a risk premium to the interest rate on
the company’s own long-term bonds. The size of the risk premium for
bonds with different ratings is published daily in The Wall Street
Journal.
b. The WACC is calculated using a before-tax cost for debt that is
equal to the interest rate that must be paid on new debt, along with
the after-tax costs for common stock and for preferred stock if it
is used.
c. An increase in the risk-free rate is likely to reduce the marginal
costs of both debt and equity.
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.
Chapter 10: Cost of Capital Conceptual M/C Page 369
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.
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.
Page 370 M/C Problems Chapter 10: Cost of Capital
Multiple Choice: Problems
65. Bosio Inc.’s perpetual preferred stock sells for $97.50 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. 8.72%
b. 9.08%
c. 9.44%
d. 9.82%
e. 10.22%
66. A company’s perpetual preferred stock currently sells for $92.50 per
share, and it pays an $8.00 annual dividend. If the company were to
sell a new preferred issue, it would incur a flotation cost of 5.00% of
the issue price. What is the firm’s cost of preferred stock?
a. 7.81%
b. 8.22%
c. 8.65%
d. 9.10%
e. 9.56%
67. O’Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b =
1.05. What is the firm’s cost of equity from retained earnings based
on the CAPM?
a. 11.30%
b. 11.64%
c. 11.99%
d. 12.35%
e. 12.72%
68. Scanlon Inc.’s CFO hired you as a consultant to help her estimate the
cost of capital. You have been provided with the following data: rRF =
4.10%; RPM = 5.25%; and b = 1.30. Based on the CAPM approach, what is
the cost of equity from retained earnings?
a. 9.67%
b. 9.97%
c. 10.28%
d. 10.60%
e. 10.93%
Chapter 10: Cost of Capital M/C Problems Page 371
69. Assume that you are a consultant to Broske Inc., and you have been
provided with the following data: D1 = $0.67; P0 = $27.50; and g =
8.00% (constant). What is the cost of equity from retained earnings
based on the DCF approach?
a. 9.42%
b. 9.91%
c. 10.44%
d. 10.96%
e. 11.51%
70. Teall Development Company hired you as a consultant to help them
estimate its cost of capital. You have been provided with the
following data: D1 = $1.45; P0 = $22.50; and g = 6.50% (constant).
Based on the DCF approach, what is the cost of equity from retained
earnings?
a. 11.10%
b. 11.68%
c. 12.30%
d. 12.94%
e. 13.59%
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 8.75%,
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. 12.60%
b. 13.10%
c. 13.63%
d. 14.17%
e. 14.74%
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 12.75%. The firm will not be issuing
any new stock. What is its WACC?
a. 8.98%
b. 9.26%
c. 9.54%
d. 9.83%
e. 10.12%