Exam
Name___________________________________
TRUE/FALSE. Write ‘T’ if the statement is true and ‘F‘ if the statement is false.
1) Financial managers do not need to use all sources of financing in order to determine the cost of capital.
2) To attract capital from outside investors, a firm must offer potential investors an expected return that is
commensurate with the level of risk that they can bear.
3) One should use accounting–based book values rather than market values of debt and equity to determine the
weights for the different sources of capital.
MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.
4) A firm’s sources of financing, which usually consists of debt and equity, represent its
A) total assets.
B) capital.
C) total liabilities.
D) current liabilities.
5) The relative proportion of debt, equity, and other securities that a firm has outstanding constitute its
A) asset ratio.
B) current ratio.
C) capital structure.
D) none of the above
6) The firm’s overall cost of capital that is a blend of the costs of the different sources of capital is known as the
firm’s
A) weighted average cost of capital.
B) cost of equity infusion.
C) cost of debt.
D) cost of preferred stock.
7) The book value of equity of a firm is $100 million and the market value of equity is $200 million. The face
value of debt of the firm is $50 million and the market value of debt is $60 million. What is the market value
of assets of the firm?
A) $150 million
B) $160 million
C) $260 million
D) $250 million
8) Apple computers has raised all its capital via equity rather than debt. Such a firm is also referred to as an
________ firm.
A) levered
B) margined
C) risk less
D) unlevered
9) A levered firm is one that has ________ outstanding.
A) debt
B) equity
C) preferred stock
D) equity options
10) Leverage is the amount of ________ on a firm’s balance sheet.
A) equity
B) debt
C) preferred stock
D) none of the above
11) For an unlevered firm, the cost of capital of the firm can be determined by using the
A) yield on the traded debt.
B) Capital Asset Pricing Model.
C) dividend yield.
D) preferred stock yield.
12) GM has a market value of $8 billion of equity and a market value of $12 billion of debt. What are the
weights in equity and debt that are used for calculating the WACC?
A) 0.5, 0.5
B) 0.6, 0.4
C) 0.4, 0.6
D) 0.8, 0.2
13) GM has a book value of $8 billion of equity and a face value of $12 billion of debt. What are the weights in
debt and equity that are used for calculating the WACC?
A) 0.4, 0.6
B) 0.6, 0.4
C) 0.5, 0.5
D) cannot be determined
14) The total market value of General Motors (GM) is $10 billion. GM has a market value of $7 billion of equity
and a face value of $10 billion of debt. What are the weights in equity and debt that are used for calculating
the WACC?
A) 0.6, 0.4
B) 0.7, 0.3
C) 0.3, 0.7
D) cannot be determined
SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.
15) Why do we use market values rather than book values in calculation of WACC?
16) Why do we use leverage if it increases the risk of a firm?
MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.
17) A firm incurs $50,000 in interest expenses each year. If the tax rate of the firm is 30%, what is the effective
after–tax interest rate expense for the firm?
A) $27,000
B) $29,000
C) $32,000
D) $35,000
18) A firm incurs $40,000 in interest expenses each year. If the tax rate of the firm is 40%, what is the effective
after–tax interest rate expense for the firm?
A) $22,000
B) $24,000
C) $27,000
D) $29,000
19) A firm incurs $70,000 in interest expenses each year. If the tax rate of the firm is 20%, what is the effective
after–tax interest rate expense for the firm?
A) $37,000
B) $49,000
C) $56,000
D) $65,000
20) The fact that the after–tax cost of debt is lower than the pretax cost of debt implicitly assumes that interest
expense can be
A) expensed.
B) margined.
C) refinanced.
D) none of the above
21) The after–tax cost of equity is ________ the pretax cost of equity.
A) higher than
B) lower than
C) the same as
D) none of the above
22) Epiphany is an all–equity firm with an estimated market value of $400,000. The firm sells $300,000 of debt
and uses the proceeds to purchase outstanding equity. Compute the weight in equity and the weight in
debt after the proposed financing and repurchase of equity.
A) 0.2, 0.8
B) 0.25, 0.75
C) 0.4, 0.6
D) 0.5, 0.5
23) Epiphany is an all–equity firm with an estimated market value of $300,000. The firm sells $100,000 of debt
and uses the proceeds to purchase outstanding equity. Compute the weight in equity and the weight in
debt after the proposed financing and repurchase of equity.
A) 0.2, 0.8
B) 0.25, 0.75
C) 0.67, 0.33
D) 0.5, 0.5
24) Epiphany is an all–equity firm with an estimated market value of $500,000. The firm sells $200,000 of debt
and uses the proceeds to purchase outstanding equity. Compute the weight in equity and the weight in
debt after the proposed financing and repurchase of equity.
A) 0.2, 0.8
B) 0.25, 0.75
C) 0.4, 0.6
D) 0.6, 0.4
25) Assume JUP has debt with a book value of $20 million, trading at 120% of par value. The firm has book
equity of $20 million, and 2 million shares trading at $18 per share. What weights should JUP use in
calculating its WACC?
A) 40% for debt, 60% for equity
B) 50% for debt, 50% for equity
C) 36% for debt, 64%% for equity
D) 45% for debt, 55% for equity
26) As a firm increases its level of debt relative to its level of equity, the firm is:
A) increasing the fraction of the firm financed with equity.
B) decreasing the fraction of the firm financed with debt.
C) decreasing its leverage.
D) increasing its leverage.
TRUE/FALSE. Write ‘T’ if the statement is true and ‘F‘ if the statement is false.
27) A firm’s cost of debt is the rate of interest it would have to pay to refinance its existing debt.
28) The fact that the interest paid on debt is a tax–deductible expense increases the cost of debt financing.
MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.
29) The ________ of a firm’s debt can be used as the firm’s current cost of debt.
A) current yield
B) coupon rate
C) yield to maturity
D) discount yield
30) Outstanding debt of Home Depot trades with a yield to maturity of 7%. The tax rate of Home Depot is 30%.
What is the effective cost of debt of Home Depot?
A) 5.2%
B) 7%
C) 6.3%
D) 4.9%
31) Outstanding debt of Home Depot trades with a yield to maturity of 6%. The tax rate of Home Depot is 40%.
What is the effective cost of debt of Home Depot?
A) 5.3%
B) 5.7%
C) 4.5%
D) 3.6%
32) Outstanding debt of Home Depot trades with a yield to maturity of 8%. The tax rate of Home Depot is 35%.
What is the effective cost of debt of Home Depot?
A) 5.2%
B) 5.8%
C) 6.2%
D) 6.5%
33) Preferred stock of Ford Motors pays a dividend of $4 each year and trades at a price of $30. What is the cost
of preferred stock capital for Ford?
A) 13.3%
B) 14.5%
C) 15.5%
D) 16.2%
34) Preferred stock of Ford Motors pays a dividend of $3.5 each year and trades at a price of $25. What is the
cost of preferred stock capital for Ford?
A) 12.6%
B) 14.0%
C) 13.5%
D) 12.8%
35) Preferred stock of Ford Motors pays a dividend of $2.5 each year and trades at a price of $25. What is the
cost of preferred stock capital for Ford?
A) 8%
B) 9%
C) 10%
D) 11%
36) IBM expects to pay a dividend of $4 next year and expects these dividends to grow at 7% a year. The price
of IBM is $90 per share. What is IBM’s cost of equity capital?
A) 9.65%
B) 10.23%
C) 10.89%
D) 11.44%
37) IBM expects to pay a dividend of $3 next year and expects these dividends to grow at 8% a year. The price
of IBM is $95 per share. What is IBM’s cost of equity capital?
A) 3.16%
B) 4.84%
C) 8%
D) 11.16%
38) IBM just paid a dividend of $3.5 and expects these dividends to grow at 9% a year. The price of IBM is $100
per share. What is IBM’s cost of equity capital?
A) 3.5%
B) 9%
C) 12.5%
D) 12.82%
39) Your estimate of the market risk premium is 6%. The risk–free rate of return is 5% and General Motors has a
beta of 1.2. What is General Motors’ cost of equity capital?
A) 12.2%
B) 11.8%
C) 12.9%
D) 11.4%
40) Your estimate of the market risk premium is 7%. The risk–free rate of return is 4% and General Motors has a
beta of 1.5. What is General Motors’ cost of equity capital?
A) 13.5%
B) 14.5%
C) 13.9%
D) 14.8%
41) Your estimate of the market risk premium is 6%. The risk–free rate of return is 4.5% and General Motors has
a beta of 1.6. What is General Motors’ cost of equity capital?
A) 14.1%
B) 13.5%
C) 13.9%
D) 14.4%
SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.
42) Is it incorrect to use the coupon rate of debt toward cost of debt?
43) What is the difference between the effective cost of debt and the cost of debt?
44) Should a firm with high retained earnings have a lower cost of equity?
45) Among the two models Constant Dividend Growth Model (CDGM) and Capital Asset Pricing Model
(CAPM), which is a better method for computation of the cost of equity?
46) Which of the three costs debt, preferred stock and common equity is most difficult to estimate?
MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.
47) A firm has outstanding debt with a coupon rate of 7%, seven years maturity, and a price of $1000 per $1000
face value. What is the after–tax cost of debt if the marginal tax rate of the firm is 30%?
A) 4.9%
B) 5.2%
C) 5.5%
D) 5.9%
48) A firm has outstanding debt with a coupon rate of 9%, nine years maturity, and a price of $1000 per $1000
face value. What is the after–tax cost of debt if the marginal tax rate of the firm is 30%?
A) 4.9%
B) 6.3%
C) 5.8%
D) 5.9%
49) A firm has outstanding debt with a coupon rate of 6%, ten years maturity, and a price of $1000 per $1000 face
value. What is the after–tax cost of debt if the marginal tax rate of the firm is 40%?
A) 2.9%
B) 3.2%
C) 3.6%
D) 3.9%
50) A firm has $1 million market value and it sells preferred stock with a par value of $100. If the coupon rate
on the preferred stock is 7% and the preferred stock trades at $95, what is the cost of preferred stock
financing?
A) 6.75%
B) 7.15%
C) 7.21%
D) 7.37%
51) A firm has $2 million market value and it sells preferred stock with a par value of $100. If the coupon rate
on the preferred stock is 8% and the preferred stock trades at $90, what is the cost of preferred stock
financing?
A) 8.75%
B) 8.89%
C) 9.21%
D) 9.35%
52) A firm has $3 million market value and it sells preferred stock with a par value of $100. If the coupon rate
on the preferred stock is 9% and the preferred stock trades at $95, what is the cost of preferred stock
financing?
A) 8.75%
B) 9.47%
C) 10.21%
D) 10.41%
53) An all–equity firm produced a dividend flow of $30,000 last year. The market value of the firm is $875,000
and the dividend is expected to increase at 3% each year. What is the cost of equity capital for this firm?
A) 6.53%
B) 6.91%
C) 7.45%
D) 7.89%
54) An all–equity firm produced a dividend flow of $20,000 last year. The market value of the firm is $650,000
and the dividend is expected to increase at 4% each year. What is the cost of equity capital for this firm?
A) 5.5%
B) 6.2%
C) 7.2%
D) 7.8%
55) An all–equity firm produced a dividend flow of $40,000 last year. The market value of the firm is $800,000
and the dividend is expected to increase at 5% each year. What is the cost of equity capital for this firm?
A) 9.18%
B) 9.75%
C) 10.25%
D) 11.89%
56) The outstanding debt of Berstin Corp. has ten years to maturity, a current yield of 7%, and a price of $95.
What is the pretax cost of debt if the tax rate is 30%.
A) 4.9%
B) 6.5%
C) 7.0%
D) 7.37%
57) The outstanding debt of Berstin Corp. has five years to maturity, a current yield of 6%, and a price of $95.
What is the pretax cost of debt if the tax rate is 30%.
A) 4.2%
B) 4.8%
C) 6.9%
D) more information needed
58) The outstanding debt of Berstin Corp. has eight years to maturity, a current yield of 8%, and a price of $95.
What is the pretax cost of debt if the tax rate is 30%.
A) 5.6%
B) 6.5%
C) 8.5%
D) more information needed
59) SIROM Scientific Solutions has $10 million of outstanding equity and $5 million of bank debt. The bank
debt costs 5% per year. The estimated equity beta is 2. If the market risk premium is 7% and the risk–free
rate is 4%, compute the weighted average cost of capital if the firm’s tax rate is 30%.
A) 13.16%
B) 13.52%
C) 13.76%
D) 14.21%