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Chapter 11 – The Cost of Capital
1. Capital refers to items on the right-hand side of a firm’s balance sheet.
a. True
b. False
2. The component costs of capital are market-determined variables in as much as they are based on investors‘ required
returns.
a. True
b. False
3. The cost of debt is equal to one minus the marginal tax rate multiplied by the coupon rate on outstanding debt.
a. True
b. False
4. The cost of issuing preferred stock by a corporation must be adjusted to an after–tax figure because of the 70
percent dividend exclusion provision for corporations holding other corporations’ preferred stock.
a. True
b. False
5. The firm’s cost of external equity capital is the same as the required rate of return on the firm’s outstanding common
stock.
a. True
b. False
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Chapter 11 – The Cost of Capital
6. The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of 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
7. The cost of equity capital from the sale of new common stock (ke) is generally equal to the cost of equity capital
from retention of earnings (rs), divided by one minus the flotation cost as a percentage of sales price (1 − F).
a. True
b. False
8. Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest
payments associated with them, but capital raised by selling new stock or bonds does have a cost.
a. True
b. False
9. The weighted average cost of capital increases if the total funds required call for an amount of equity in excess of
what can be obtained as retained earnings.
a. True
b. False
10. The marginal cost of capital (MCC) is the cost of the last dollar of new capital that the firm raises, and the marginal
cost declines as more and more of a specific type of capital is raised during a given period.
a. True
b. False
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Chapter 11 – The Cost of Capital
11. Even if a firm obtains all of its common equity from retained earnings, its MCC schedule might still increase if very
large amounts of new capital are needed.
a. True
b. False
12. There is a jump, or break, in a firm’s MCC schedule each time the firm runs out of a particular source of capital at a
particular cost. For example, a firm may use up its 10 percent debt and can then issue more debt only if it offers a
higher rate to investors.
a. True
b. False
13. The correct discount rate for a firm to use in capital budgeting, assuming that new investments are of the same
degree of risk as the firm’s existing assets, is its marginal cost of capital.
a. True
b. False
14. The firm’s cost of capital represents the maximum rate of return that a firm can earn from its capital budgeting
projects to ensure that the value of the firm increases.
a. True
b. False
15. The cost of capital is the firm’s average cost funds given what the market demands be paid to attract the funds.
a. True
b. False
16. The cost of capital used in capital budgeting must be determined using the specific financing used to fund that
particular project.
a. True
b. False
17. A firm’s capital structure has no impact on the firm’s weighted average cost of capital.
a. True
b. False
18. Each component cost of particular types of capital is identical for each source of funds found in a firm‘s capital
structure.
a. True
b. False
19. The after tax cost of debt is used to calculate the weighted average cost of capital since we are concerned with the
after-tax cash flows of the firm.
a. True
b. False
20. Tax adjustments to the cost of preferred stock must be made when determining the cost of capital since dividend
expenses on preferred stocks are tax deductible.
a. True
b. False
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Chapter 11 – The Cost of Capital
21. If a firm cannot invest retained earnings and earn at least the cost of equity, it should pay these funds to shareholders
and let them invest directly in other assets that do provide this return.
a. True
b. False
22. Long-term capital gains are taxed at a lower rate than dividends for most stockholders leading companies to pay out
dividends rather than use retained earnings to fund capital projects.
a. True
b. False
23. Flotation costs associated with issuing new equity cause the cost of external equity to be lower than the cost of
retained earnings.
a. True
b. False
24. 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. In
other words, 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
CFIN4
Chapter 11 – The Cost of Capital
25. A firm going from a lower to a higher tax bracket could increase its use of debt, yet actually wind up with a lower
after-tax cost of debt.
a. True
b. False
26. Since 70 percent of preferred dividends received by a corporation is excluded from taxable income, the component
cost of equity for a company which 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) + rs(1 − T)(0.70)(0.50).
a. True
b. False
27. The steeper the demand curve for a firm’s stock, the closer the values of rs and re are to one another, other things
held constant.
a. True
b. False
28. In general, it is not possible for re, the cost of new equity, to be lower than rs, the cost of retained earnings.
However, an exception to this rule occurs when the stock price increases just prior to the firm issuing new equity
such that it more than offsets the flotation costs and thus, re becomes less than rs.
a. True
b. False
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Chapter 11 – The Cost of Capital
29. The cost of debt, rd, is always less than rs, so rd(1 − T) will certainly be less than rs. Therefore, since a firm cannot
be 100% debt financed, the weighted average cost of capital will always be greater than rd(1 − T).
a. True
b. False
30. Firms should use their weighted average cost of capital (WACC) when they are funding their capital projects with a
variety of sources. However, when the firm plans on using only debt or only equity to fund a particular project, it
should use the after–tax cost of the specific source of capital to evaluate that project.
a. True
b. False
31. Which of the following is not considered a capital component for the purpose of calculating the weighted average
cost of capital as it applies to capital budgeting?
a. Long-term debt.
b. Common stock.
c. Short-term debt.
d. Preferred stock.
e. All of the above are considered capital components for WACC and capital budgeting purposes.
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Chapter 11 – The Cost of Capital
32. Which of the following statements is most correct?
a. If a company’s tax rate increases but the yield to maturity of its noncallable bonds remains the same, the
company’s marginal cost of debt capital used to calculate its weighted average cost of capital will fall.
b. All else equal, an increase in a company’s stock price will increase the marginal cost of retained earnings.
c. All else equal, an increase in a company’s stock price will increase the marginal cost of issuing new common
equity.
d. Answers a and b are both correct.
e. Answers b and c are both correct.
33. Which of the following factors in the discounted cash flow (DCF) approach to estimating the cost of common equity
is the least difficult to estimate?
a. Expected growth rate, g
b. Dividend yield,
c. Required return, rs
d. Expected rate of return,
e. All of the above are equally difficult to estimate.
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Chapter 11 – The Cost of Capital
34. If a firm can shift its capital structure so as to change its weighted average cost of capital (WACC), which of the
following results would be preferred?
a. The firm should try to decrease the WACC because such an action will increase the value of the firm.
b. The firm should try to increase the WACC because such an action will increase the value of the firm.
c. The firm should try to decrease the WACC because such an action will decrease the value of the firm.
d. The firm should try to increase the WACC because such an action will decrease the value of the firm.
e. The firm should not try to change the WACC because changing the WACC will not change the value of the
firm.
35. The firm’s weighted average cost of capital (WACC) is
a. set by the board of directors of the firm because it is the benchmark they use to evaluate upper management.
b. regulated by the Internal Revenue Service (IRS) because tax-deductible debt is included in the computation.
c. determined by the financial markets because investors provide the funds used by firms and these funds have
costs, which are the returns demanded by investors.
d. the same as the firm’s internal rate of return (IRR).
e. the total net present value (NPV) of all the capital budgeting projects in which the firm invests in any year.
36. The before-tax cost of debt, rd, is the same as the
a. average yield to maturity (YTM) associated with the firm‘s bonds.
b. dividend yield associated with the firm‘s common stock.
c. average coupon rate of the firm’s bonds.
d. re if the firm has no preferred stock.
e. the firm’s marginal tax rate.
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Chapter 11 – The Cost of Capital
37. Alice Stewart, who is the CFO of Meyers Foods, is teaching an upper-level course in corporate finance at the
University of Phoenix. One of the assignments Alice gave her class was to compute the component costs of capital
for Meyers Foods. Meyers Foods uses debt and common stock (no preferred stock) to finance its investments.
Students in the class did not reach the same conclusions about the relationships among the components costs that is,
the after-tax cost of debt, rdT, the cost of retained earnings (i.e., internal equity), rs, and the cost of new, or external,
equity, re. Which of the following relationships should be correct for Meyers Foods?
a. rdT < rs < re
b. rs < rdT < re
c. re < rdT < rs
d. re < rs < rdT
e. None of the above is a correct relationship.
38. Under normal circumstances, the weighted average cost of capital is used as the firm’s required rate of return
because
a. as long as the firm‘s investments earn returns greater than the cost of capital, the value of the firm will not
decrease.
b. returns below the cost of capital will cover all the fixed costs associated with capital and provide excess
returns to the firm’s stockholders.
c. it is comparable to the average of all the interest rates on debt that currently prevail in the financial markets.
d. it is an indication of the return the firm is earning from all of its assets in combination.
39. Estimating the cost of common equity using the discounted cash flow approach may be difficult to evaluate because
a. the dividend yield is extremely difficult to estimate.
b. the proper growth rate is difficult to establish.
c. the current price of the common equity is always changing making it difficult to determine.
d. all of the above are difficult to estimate.
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Chapter 11 – The Cost of Capital
40. Although it is a subjective measure, analysts often estimate the cost of common equity by adding a risk premium of 3
to 5 percentage points to the
a. the cost of preferred stock for the firm.
b. the risk free rate.
c. interest rate on the firm’s long term debt.
d. the market return.
e. the growth rate of the firm.
41. The target capital structure of a firm is the capital structure that
a. minimizes the operating risk of the firm’s assets.
b. maximizes the tax shield created by debt.
c. minimizes the default risk of long-term debt.
d. maximizes the price of the firm’s stock.
e. none of the above.
42. The marginal cost of capital as more capital is raised during a given period.
a. does not change
b. decreases
c. increases
d. changes in an unpredictable way
e. approaches zero
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Chapter 11 – The Cost of Capital
43. A graph of a firm’s acceptable capital projects ranked in the order of the projects’ internal rate of return is called the
firm‘s .
a. marginal cost of capital schedule
b. investment opportunity schedule
c. modified internal rate of return schedule
d. internal project classification schedule
e. optimal capital budget schedule
44. Which of the following may be true concerning debt and equity?
a. The cost of debt for Firm A is greater than the cost of equity for Firm A.
b. The cost of debt for Firm A is greater than the cost of equity for Firm B.
c. The cost of internally generated equity for Firm A is greater than the cost of externally generated equity funds
for Firm A.
d. The cost of internally generated equity for Firm A is less than the cost of debt for Firm A.
e. None of the above could be true.
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Chapter 11 – The Cost of Capital
45. Which of the following statements is correct?
a. Capital components are the types of capital used by firms to raise money. All capital comes from one of three
components: long-term debt, preferred stock, and equity.
b. Preferred stock does not involve any adjustment for flotation cost since the dividend and price are fixed.
c. The cost of debt used in calculating the WACC is an average of the after-tax cost of new debt and of
outstanding debt.
d. The opportunity cost principle implies that if the firm cannot invest retained earnings and earn at least rs, it
should pay these funds to its stockholders and let them invest directly in other assets that do provide this
return.
e. The cost of new common equity includes an adjustment for flotation costs which is expressed as a fixed
percentage of the current stock price. The flotation percentage is determined jointly by the current price of the
firm’s stock and its growth rate.
46. Which of the following statements is most correct?
a. An increase in the corporate tax rate would lower the weighted average cost of capital for an average firm,
other things held constant.
b. Depreciation-generated funds have a cost equal to the firm‘s lowest WACC, and hence they have no impact
on the MCC schedule.
c. As a firm’s debt ratio approaches 100 percent, the after-tax cost of debt, rdT, at its lowest level.
d. Statements a, b, and c are all true.
e. Statements a, b, and c are all false.
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Chapter 11 – The Cost of Capital
47. Typically, according to the text, the MCC schedule is either horizontal or rising, which implies that the cost of capital
to a firm increases as it raises larger and larger amounts of capital. The rising section of MCC schedule
a. Is caused by economies of scale in financing.
b. Would be eliminated (that is, the MCC schedule would be horizontal) if the firm retained all of its earnings.
c. Results from a change in the debt ratio as the firm expands.
d. Occurs because the firm must, if it is to expand, be willing to take on riskier and riskier projects, and this
causes an increase in the cost of capital.
e. Results from flotation costs associated with the sale of new common and preferred stock, along with higher
debt costs, as the firm’s rate of expansion increases.
48. Which of the following statements is correct?
a. Under normal conditions, the CAPM approach to estimating a firm’s cost of retained earnings gives a better
estimate than the DCF approach.
b. The CAPM approach is typically used to estimate a firm’s flotation cost adjustment factor, and this factor is
added to the DCF cost estimate.
c. The risk premium used in the bond-yield-plus-risk-premium method is the same as the one used in the CAPM
method.
d. In practice (as opposed to theory), the DCF method and the CAPM method usually produce exactly the same
estimate for r.
e. The above statements are all false.
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Chapter 11 – The Cost of Capital
49. In applying the CAPM to estimate the cost of equity capital, which of the following elements is not subject to dispute
or controversy?
a. Expected rate of return on the market, rM
.
b. The stock’s beta coefficient, βi.
c. Risk-free rate, rRF.
d. Market risk premium (MRP).
e. All of the above are subject to dispute.
50. 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.
b. The cost of debt used to calculate the weighted average cost of capital is based on an average of the cost of
debt already issued by the firm and the cost of new debt.
c. One problem with the CAPM approach to estimating the cost of equity capital is that if a firm’s stockholders
are, in fact, not well diversified, beta might be a poor measure of the firm’s true investment risk.
d. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method of estimating a
firm‘s cost of equity capital.
e. The cost of equity capital is generally easier to measure than the cost of debt, which varies daily with interest
rates, or the cost of preferred stock which is issued infrequently.
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Chapter 11 – The Cost of Capital
51. Which of the following statements is correct?
a. Beta measures market risk, but if a firm’s stockholders are not well diversified, beta may not accurately
measure the firm‘s total risk.
b. If the calculated beta underestimates the firm’s true investment risk, then the CAPM method will overestimate
rs.
c. The discounted cash flow method of estimating the cost of equity can’t be used unless the growth component,
g, is constant during the analysis period.
d. An advantage shared by both the DCF and CAPM methods of estimating the cost of equity capital, is that
they yield precise estimates and require little or no judgment.
e. None of the above is a correct statement.
52. Which of the following statements is false?
a. From a theoretical standpoint, the capital weights used to calculate the WACC should be based on the market
values of the different securities. However, if a firm’s book value weights are closest to its market value
weights, book value weights can be used as proxies.
b. Generally, only long-term debt is included in the calculation of the WACC, because the WACC is used for
capital budgeting purposes, which includes long-term assets, and those assets are financed with long-term
capital.
c. The first break point a firm encounters in capital budgeting is for retained earnings, unless a firm has zero or
negative net income.
d. The weighted average cost of capital will change whenever a break point occurs.
e. Answers a and b are both false.
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Chapter 11 – The Cost of Capital
53. Which of the following statements is most correct?
a. One purpose of calculating the WACC is to have a singular cost of capital measure that can be applied to
evaluate all of the firm‘s projects, including those of greater than and lesser than average risks.
b. A firm facing a steep demand curve (that is, high flotation costs) for new equity would likely also face, at
some point, a steeply upward sloping WACC curve.
c. A breakpoint is based on the dollar value used of a specific type of capital, and occurs at the point where the
cost of that capital type increases. Thus, if a firm has $100,000 in earnings, and stockholders want $50,000 of
those earnings paid as dividends, then retained earnings will have two breakpoints.
d. Answers a and b are both correct.
e. All of the above are false.
54. Which of the following statements is correct?
a. Suppose a firm is losing money and thus, is not paying taxes, and that this situation is expected to persist for a
few years whether or not the firm uses debt financing. Then the firm’s after-tax cost of debt will equal its
before-tax cost of debt.
b. The component cost of preferred stock is expressed as rp s(1 − T), because preferred stock dividends are
treated as fixed charges, similar to the treatment of debt interest.
c. The reason that a cost of capital is assigned to retained earnings is because these funds are already earning a
return in the business, the reason does not involve the opportunity cost principle.
d. The bond–yield-plus-risk-premium approach to estimating a firm‘s cost of common equity involves adding a
subjectively determined risk-premium to the market risk-free bond rate.
e. None of the above is a correct statement.
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Chapter 11 – The Cost of Capital
55. Consider the discussions concerning the cost of common equity. What is the relationship between the cost of
retained earnings (internal equity), rs, and the cost of new common equity (external equity), re?
a. rs > re, because new stockholders are willing to accept a lower return and “pay their dues” before they start
receiving the higher returns that existing, loyal stockholders receive.
b. 0 = rs < re, because there is no “real” cost to the income that the firm decides to retain to reinvest in assets
rather than payout to common stockholders as dividends.
c. 0 < rs < re, because there is a real cost to retaining income (earnings) for reinvestment, but the firm has to pay
flotation costs when issuing new common stock.
d. rs = re, because they both represent essentially the same source of funds, so they must have the same cost.
e. None of the above is a correct answer.
56. Which of the following is least likely to lead to a break point in the marginal cost of capital schedule?
a. an increase in the required return demanded by investors for a new bond issue.
b. increased flotation costs associated with seasoned equity offerings.
c. decreased liquidity in money markets leading to lower selling prices for commercial paper.
d. using retained earnings to fund new projects for the firm.
e. issuing preferred stock to institutional investors.
57. Which of the following steps is not necessary for calculating the marginal cost of capital schedule?
a. Determine each point at which a break in the marginal cost of capital schedule occurs.
b. Make a list of all the break points.
c. Determine the cost of capital for each component in the intervals between the breaks.
d. Estimate the change in the cost of capital within each interval.
e. Calculate the weighted averages of these component costs to obtain the WACCs in each interval.