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Chapter 11 – The Cost of Capital
58. Which of the following statements is correct?
a. Because we often need to make comparisons among firms that are in different income tax brackets, it is best
to calculate the WACC on a before-tax basis.
b. If a firm has been suffering accounting losses and is expected to continue suffering such losses (and we then
assume that its tax rate going forward is zero), it is possible that its after-tax component cost of preferred
stock as used to calculate the WACC will be less than its after-tax component cost of debt.
c. Due to the way the MCC is constructed, the first break point in the MCC schedule must be associated with
using up all available retained earnings and having to issue common stock.
d. Normally, the cost of external equity raised by issuing new common stock is above the cost of retained
earnings. Moreover, the higher the growth rate relative to the dividend yield, the more the cost of external
equity will exceed the cost of retained earnings.
e. None of the above is a correct statement.
59. Bouchard Company’s stock sells for $20 per share, its last dividend (D0) was $1.00, its growth rate is a constant 6
percent, and the company would incur a flotation cost of 20 percent if it sold new common stock. Retained earnings
for the coming year are expected to be $1,000,000, and the common equity ratio is 60 percent. If Bouchard has a
capital budget of $2,000,000, what component cost of common equity will be built into the WACC for the last dollar
of capital the company raises?
a. 11.30%
b. 11.45%
c. 11.80%
d. 12.15%
e. 12.63%
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Chapter 11 – The Cost of Capital
60. Diggin Tools just issued new preferred stock, which sold for $85 in the stock markets. Holders of the stock will
receive an annual dividend equal to $9.35. The flotation costs associated with the new issue were 6 percent and
Diggin’s marginal tax rate is 30 percent. What is Diggin’s cost of preferred stock, rps?
a. 11.0%
b. 7.7%
c. 8.2%
d. 11.7%
e. 10.3%
61. Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent common
equity. The firm expects to earn $600 in after–tax income during the coming year, and it will retain 40 percent of
those earnings. The current market price of the firm’s stock is P0 = $28; its last dividend was D0 = $2.20, and its
expected dividend growth rate is 6 percent. Allison can issue new common stock at a 15 percent flotation cost. What
will Allison‘s marginal cost of equity capital (not the WACC) be if it must fund a capital budget requiring $600 in total
new capital?
a. 15.8%
b. 13.9%
c. 7.9%
d. 14.3%
e. 9.7%
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Chapter 11 – The Cost of Capital
62. Your company’s stock sells for $50 per share, its last dividend (D0) was $2.00, its growth rate is a constant 5
percent, and the company would incur a flotation cost of 15 percent if it sold new common stock. Net income for the
coming year is expected to be $500,000 and the firm’s payout ratio is 60 percent. The firm’s common equity ratio is
30 percent and it has no preferred stock outstanding. The firm can borrow up to $300,000 at an interest rate of 7
percent; any additional debt will have an interest rate of 9 percent. Your company‘s tax rate is 40 percent. If the firm
has a capital budget of $1,000,000, what is the WACC for the last dollar of capital the company raises?
a. 3.78%
b. 6.76%
c. 9.94%
d. 11.81%
e. 13.25%
63. SW Ink’s preferred stock, which pays a $5 dividend each year, currently sells for $62.50. The company’s marginal
tax rate is 40 percent. What is the cost of preferred stock, rp s, that should be included in the computation of the SW
Ink’s weighted average cost of capital (WACC)?
a. 8.0%
b. 4.8%
c. 3.2%
d. The dividend growth rate is needed to compute rp s; so not enough information is given to answer this question.
e. None of the above is correct.
64. Tapley Inc.’s current (target) capital structure has a target debt ratio (D/TA) of 60 percent. The firm can raise up to
$5 million in new debt at a before-tax cost of 8 percent. If more debt is required, the initial cost will be 8.5 percent,
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Chapter 11 – The Cost of Capital
and if more than $10 million of debt is required, the cost will be 9 percent. Net income for the previous year was $10
million, and it is expected to increase by 10 percent this year. The firm expects to maintain its dividend payout ratio
of 40 percent on the 1 million shares of common stock outstanding. If it must sell new common stock, it would
encounter a 10 percent flotation cost on the first $2 million, a 15 percent cost if more than $2 million but less than $4
million is needed, and a 20 percent cost if more than $4 million of new outside equity is required. Tapley’s tax rate is
30 percent, and its current stock price is $88 per share. If the firm has an unlimited number of projects which will
earn a 10.25 percent return, what is the maximum capital budget that can be adopted without adversely affecting
stockholder wealth?
a. $32.0 million
b. $15.9 million
c. $23.0 million
d. $10.6 million
e. $26.5 million
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Chapter 11 – The Cost of Capital
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Chapter 11 – The Cost of Capital
65. Anderson Company has four investment opportunities with the following costs (all costs are paid at t = 0) and
estimated internal rates of return (IRR):
Project
Cost
IRR
A
$2,000
16.0%
B
3,000
14.5
C
5,000
11.5
D
3,000
9.5
The company has a target capital structure which consists of 40 percent common equity, 40 percent debt, and 20
percent preferred stock. The company has $1,000 in retained earnings. The company expects its year–end dividend
to be $3.00 per share (i.e., = $3.00). The dividend is expected to grow at a constant rate of 5 percent a year. The
company’s stock price is currently $42.75. If the company issues new common stock, the company will pay its
investment bankers a 10 percent flotation cost. The company can issue corporate bonds with a yield to maturity of
10 percent. The company is in the 35 percent tax bracket. How large can the cost of preferred stock be (including
flotation costs) and it still be profitable for the company to invest in all four projects?
a. 7.75%
b. 8.90%
c. 10.46%
d. 11.54%
e. 12.68%
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Chapter 11 – The Cost of Capital
66. Refer to Gulf Electric Company. What is GEC‘s cost of equity from newly issued stock?
a. 13.77%
b. 12.66%
c. 13.33%
d. 12.29%
e. 10.00%
67. Refer to Gulf Electric Company. Assume now that GEC needs to raise $300 million in new capital. What is GEC‘s
marginal cost of capital for evaluating the $300 million in capital projects and any others that might arise during the
year?
a. 6.00%
b. 13.77%
c. 12.66%
d. 9.50%
e. 9.00%
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Chapter 11 – The Cost of Capital
Byron Corporation
Byron Corporation‘s present capital structure, which is also its target capital structure, is 40 percent debt and 60
percent common equity. Next year‘s net income is projected to be $21,000, and Byron’s payout ratio is 30 percent.
The company‘s earnings and dividends are growing at a constant rate of 5 percent; the last dividend (D0) was $2.00;
and the current equilibrium stock price is $21.88. Byron can raise all the debt financing it needs at 14.0 percent. If
Byron issues new common stock, a 20 percent flotation cost will be incurred. The firm’s marginal tax rate is 40
percent.
68. Refer to Byron Corporation. What is the maximum amount of new capital that can be raised at the lowest
component cost of equity? (In other words, what is the retained earnings break point?)
a. $12,600
b. $14,700
c. $17,400
d. $21,000
e. $24,500
69. Refer to Byron Corporation. What is the component cost of the equity raised by selling new common stock?
a. 17.0%
b. 16.4%
c. 15.0%
d. 14.6%
e. 12.0%
70. Refer to Byron Corporation. Assume that at one point along the marginal cost of capital schedule the component
cost of equity is 18.0 percent. What is the weighted average cost of capital at that point?
a. 10.8%
b. 13.6%
c. 14.2%
d. 16.4%
e. 18.0%
Rollins Corporation
Rollins Corporation is constructing its MCC schedule. Its target capital structure is 20 percent debt, 20 percent
preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current
maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock which pays a 12 percent
annual dividend, but flotation costs of 5 percent would be incurred. Rollins’ beta is 1.2, the risk-free rate is 10
percent, and the market risk premium is 5 percent. Rollins is a constant growth firm which just paid a dividend of
$2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm’s policy is to use a risk premium of 4
percentage points when using the bond–yield-plus-risk-premium method to find rs. The firm‘s net income is expected
to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent,
and the firm’s marginal tax rate is 40 percent.
71. Refer to Rollins Corporation. What is Rollins‘ component cost of debt?
a. 10.0%
b. 9.1%
c. 8.6%
d. 8.0%
e. 7.2%
72. Refer to Rollins Corporation. What is Rollins’ cost of preferred stock?
a. 10.0%
b. 11.0%
c. 12.0%
d. 12.6%
e. 13.2%
73. Refer to Rollins Corporation. What is Rollins’ cost of retained earnings using the CAPM approach?
a. 13.6%
b. 14.1%
c. 16.0%
d. 16.6%
e. 16.9%
74. Refer to Rollins Corporation. What is the firm‘s cost of retained earnings using the DCF approach?
a. 13.6%
b. 14.1%
c. 16.0%
d. 16.6%
e. 16.9%
75. Refer to Rollins Corporation. What is Rollins’ cost of retained earnings using the bond–yield-plus-risk-premium
approach?
a. 13.6%
b. 14.1%
c. 16.0%
d. 16.6%
e. 16.9%
76. Refer to Rollins Corporation. What is Rollins‘ lowest WACC?
a. 13.6%
b. 14.1%
c. 16.0%
d. 16.6%
e. 16.9%
77. Refer to Rollins Corporation. What is Rollins‘ retained earnings break point?
a. $600,000
b. $800,000
c. $1,000,000
d. $1,200,000
e. $1,400,000
78. Refer to Rollins Corporation. What is Rollins’ WACC once it starts using new common stock financing?
a. 13.6%
b. 14.1%
c. 16.0%
d. 16.6%
e. 16.9%
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Chapter 11 – The Cost of Capital
Jackson Company
The Jackson Company has just paid a dividend of $3.00 per share on its common stock, and it expects this dividend
to grow by 10 percent per year, indefinitely. The firm has a beta of 1.50; the risk-free rate is 10 percent; and the
expected return on the market is 14 percent. The firm’s investment bankers believe that new issues of common
stock would have a flotation cost equal to 5 percent of the current market price.
79. Refer to Jackson Company. How much should an investor be willing to pay for this stock today?
a. $62.81
b. $70.00
c. $43.75
d. $55.00
e. $30.00
80. Refer to Jackson Company. What will be Jackson‘s cost of new common stock if it issues new stock in the
marketplace today?
a. 15.25%
b. 16.32%
c. 17.00%
d. 12.47%
e. 9.85%
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Chapter 11 – The Cost of Capital
J. Ross and Sons Inc.
J. Ross and Sons Inc. has a target capital structure that calls for 40 percent debt, 10 percent preferred stock, and 50
percent common equity. The firm’s current after-tax cost of debt is 6 percent, and it can sell as much debt as it
wishes at this rate. The firm’s preferred stock currently sells for $90 a share and pays a dividend of $10 per share;
however, the firm will net only $80 per share from the sale of new preferred stock. Ross expects to retain $15,000 in
earnings over the next year. Ross’ common stock currently sells for $40 per share, but the firm will net only $34 per
share from the sale of new common stock. The firm recently paid a dividend of $2 per share on its common stock,
and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year.
81. Refer to J. Ross and Sons Inc. What is the firm’s cost of retained earnings?
a. 10.0%
b. 12.5%
c. 15.5%
d. 16.5%
e. 18.0%
82. Refer to J. Ross and Sons Inc. What is the firm’s cost of newly issued common stock?
a. 10.0%
b. 12.5%
c. 15.5%
d. 16.5%
e. 18.0%
83. Refer to J. Ross and Sons Inc. What is the firm’s cost of newly issued preferred stock?
a. 10.0%
b. 12.5%
c. 15.5%
d. 16.5%
e. 18.0%
84. Refer to J. Ross and Sons Inc. Where will a break in the WACC curve occur?
a. $30,000
b. $20,000
c. $10,000
d. $42,000
e. There will be no breaks in the WACC curve.
85. Refer to J. Ross and Sons Inc. What will be the WACC above this break point?
a. 12.5%
b. 8.3%
c. 10.6%
d. 11.9%
e. 14.1%
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Chapter 11 – The Cost of Capital
Financial Calculator Section
The following question(s) may require the use of a financial calculator.
86. Hamilton Company’s 8 percent coupon rate, quarterly payment, $1,000 par value bond, which matures in 20 years,
currently sells at a price of $686.86. The company’s tax rate is 40 percent. Based on the simple interest rate, not the
EAR, what is the firm’s component cost of debt for purposes of calculating the WACC?
a. 3.05%
b. 7.32%
c. 7.36%
d. 12.20%
e. 12.26%