Principles of Managerial Finance, Brief, 7e (Gitman)
Chapter 9 The Cost of Capital
9.1 Understand the basic concept and the sources of capital associated with the cost of capital.
1) Holding risk constant, the implementation of projects with a rate of return above the cost of
capital will decrease the value of a firm, and vice versa.
2) The cost of common stock equity refers to the cost of the next dollar of financing necessary to
finance a new investment opportunity.
3) The cost of capital is described as the rate of return required by the market suppliers of capital
in order to attract their funds to the firm.
4) The target capital structure is the desired optimal mix of debt and equity financing that most
firms attempt to achieve and maintain.
5) The cost of capital is the rate of return a firm must earn on investments in order to increase the
firm’s value.
6) The cost of capital is used to decide whether a proposed corporate investment will increase or
decrease a firm’s stock price.
7) The cost of capital reflects the cost of funds over the long-run measured at a given point in
time, based on the best information available.
8) The cost of capital acts as a major link between a firm’s long-term investment decisions and
the wealth of the firm’s owners as determined by the market value of their shares.
9) The cost of capital of each source of financing is the after-tax cost of obtaining the financing
using the historically based cost reflected by the existing financing on the firm’s books.
10) A firm’s flotation cost can be calculated by weighting the cost of each source of financing by
its relative proportion in a firm’s target capital structure.
11) The cost of capital is a static concept and it is not affected by economic and firm-specific
factors such as business risk and financial risk.
12) The cost of capital is a dynamic concept and it is affected by economic and firm-specific
factors such as business risk and financial risk.
13) In using the cost of capital, it is important that it reflects the historical cost of raising funds
over the long run.
14) The ________ is the rate of return that a firm must earn on its investments in order to
maintain the market value of its stock.
A) yield to maturity
B) cost of capital
C) internal rate of return
D) modified internal rate of return
15) The ________ is the rate of return required by the market suppliers of capital in order to
attract their funds to the firm.
A) yield to maturity
B) internal rate of return
C) cost of capital
D) modified internal rate of return
16) The cost of capital reflects the cost of funds ________.
A) that makes the net present value of a project equal zero
B) at a given point in time
C) over a long-run time period
D) at current book values
17) Although a firm’s existing mix of financing sources may reflect its target capital structure, it
is ultimately ________.
A) the internal rate of return that is relevant for evaluating the firm’s future investment
opportunities
B) the marginal cost of capital that is relevant for evaluating the firm’s future investment
opportunities
C) the risk-free rate of return that is relevant for evaluating the firm’s future investment
opportunities
D) the risk-free rate of return that is relevant for evaluating the firm’s future financing
opportunities
18) The ________ is a weighted average of the cost of funds which reflects the interrelationship
of financing decisions.
A) internal rate of return
B) sunk cost
C) cost of capital
D) risk-free rate
19) The ________ is the firm’s desired optimal mix of debt and equity financing.
A) book value
B) market value
C) cost of capital
D) target capital structure
20) The cost to a firm of each type of capital is dependent upon ________.
A) the risk-free rate of bonds plus the business risk of the firm
B) the risk-free rate of each type of capital plus the business risk of the firm
C) the risk-free rate of each type of capital plus the financial risk of the firm
D) the risk-free rate of each type of capital plus the business risk and the financial risk of the
firm
21) In order to recognize the interrelationship between financing and investments, a firm should
use ________ when evaluating an investment.
A) the least costly source of financing
B) the most costly source of financing
C) the weighted average cost of all financing sources
D) the current opportunity cost
22) The four basic sources of long-term funds for a firm are ________.
A) current liabilities, long-term debt, common stock, and preferred stock
B) current liabilities, long-term debt, common stock, and retained earnings
C) long-term debt, paid-in capital in excess of par, common stock, and retained earnings
D) long-term debt, common stock, preferred stock, and retained earnings
23) Which of the following is true of long-term funds?
A) They provide an easy way to reduce financing costs because they are relatively cheaper than
short-term funds.
B) They are a type of investment fund which invests in money market investments of high
quality and low risk.
C) They are the sources that supply the financing necessary to support a firm’s capital budgeting
activities.
D) They are the funds available to a business on the basis of inventory held and require detailed
inventory tracking.
24) Which of the following is a source of long-term funds?
A) commercial paper
B) retained earnings
C) factoring
D) money market instruments
9.2 Explain what is meant by marginal cost of capital.
1) The weighted average cost of capital refers to the cost of capital required for one additional
dollar of financing.
2) The marginal cost of capital is a relevant cost of capital for evaluating a firm’s future
investment opportunities.
3) Generally, the order of cost, from the least expensive to the most expensive, for long-term
capital of a corporation is ________.
A) new common stock, retained earnings, preferred stock, long-term debt
B) common stock, preferred stock, long-term debt, short-term debt
C) preferred stock, new common stocks, common stock, retained earnings
D) long-term debt, preferred stock, retained earnings, new common stock
4) Generally the least expensive source of long-term capital is ________.
A) retained earnings
B) preferred stock
C) long-term debt
D) common stock
9.3 Determine the cost of long-term debt, and explain why the after-tax cost of debt is the
relevant cost of debt.
1) In general, floatation costs include two components, underwriting costs and administrative
costs.
2) Flotation costs reduce the net proceeds from the sale of a bond whether sold at a premium, at a
discount, or at its par value.
3) The net proceeds used in calculation of the cost of long-term debt are funds actually received
from the sale after paying for flotation costs and taxes.
4) When the net proceeds from sale of a bond equal its par value, the before-tax cost would just
equal the coupon interest rate.
5) From a bond issuer’s perspective, the IRR on a bond’s cash flows is its cost to maturity; from
the investor’s perspective, the IRR on a bond’s cash flows is the yield to maturity (YTM).
6) From a bond issuer’s perspective, the IRR on a bond’s cash flows is its yield to maturity
(YTM); from the investor’s perspective, the IRR on a bond’s cash flows is the cost to maturity.
7) The cost to maturity of existing bonds reflects the rate of return required by the market.
8) The weighted average cost of capital represents the annual before-tax percentage cost of the
debt.
9) A tax adjustment must be made in determining the cost of ________.
A) long-term debt
B) common stock
C) preferred stock
D) retained earnings
10) The ________ from the sale of a security are the funds actually received from the sale after
________.
A) gross proceeds; adding the after-tax costs
B) gross proceeds; reducing the flotation costs
C) net proceeds; reducing the flotation costs
D) net proceeds; adding the after-tax costs
11) The approximate before-tax cost of debt for a 15-year, 10 percent, $1,000 par value bond
selling at $950 is ________.
A) 10 percent
B) 10.7 percent
C) 12 percent
D) 15.4 percent
12) The approximate before-tax cost of debt for a 10-year, 8 percent, $1,000 par value bond
selling at $1,150 is ________.
A) 5.97 percent
B) 8.33 percent
C) 8.82 percent
D) 9 percent
13) The before-tax cost of debt for a firm, which has a marginal tax rate of 40 percent, is 12
percent. The after-tax cost of debt is ________.
A) 4.8 percent
B) 6.0 percent
C) 7.2 percent
D) 12 percent
14) The specific cost of each source of long-term financing is based on ________ and ________
costs.
A) before-tax; historical
B) after-tax; historical
C) before-tax; book value
D) after-tax; current
15) When determining the after-tax cost of a bond, the face value of the issue must be adjusted to
the net proceeds amounts by considering ________.
A) the risks
B) the flotation costs
C) the approximate returns
D) the taxes
16) If a corporation has an average tax rate of 40 percent, the approximate, annual, after-tax cost
of debt for a 15-year, 12 percent, $1,000 par value bond, selling at $950 is ________.
A) 10 percent
B) 10.6 percent
C) 7.7 percent
D) 6.0 percent
17) If a corporation has an average tax rate of 40 percent, the approximate annual, after-tax cost
of debt for a 10-year, 8 percent, $1,000 par value bond selling at $1,150 is ________.
A) 3.6 percent
B) 4.8 percent
C) 6 percent
D) 8 percent
18) The approximate after-tax cost of debt for a 20-year, 7 percent, $1,000 par value bond selling
at $960 (assume a marginal tax rate of 40 percent) is ________.
A) 4.43 percent
B) 5.15 percent
C) 7 percent
D) 7.35 percent
19) Debt is generally the least expensive source of capital. This is primarily due to ________.
A) the fixed interest payments
B) the priority of claims on assets and earnings in the event of liquidation
C) the tax deductibility of interest payments
D) the secured nature of a debt obligation
20) Nico Trading Corporation is considering issuing long-term debt. The debt would have a 30-
year maturity and a 10 percent coupon rate. In order to sell the issue, the bonds must be
underpriced at a discount of 5 percent of face value. In addition, the firm would have to pay
flotation costs of 5 percent of face value. The firm’s tax rate is 35 percent. Given this
information, the after-tax cost of debt for Nico Trading would be ________.
A) 7.26%
B) 11.17%
C) 10.00%
D) 9.00%
21) Tangshan Mining is considering issuing long-term debt. The debt would have a 30 year
maturity and a 12 percent coupon rate and make semiannual coupon payments. In order to sell
the issue, the bonds must be underpriced at a discount of 2.5 percent of face value. In addition,
the firm would have to pay flotation costs of 2.5 percent of face value. The firm’s tax rate is 33
percent. Given this information, the after-tax cost of debt for Tangshan Mining would be
________.
A) 6.38%
B) 12.76%
C) 4.98%
D) 8.48%
9.4 Determine the cost of preferred stock
1) Since preferred stock is a form of ownership, it has no maturity date.
2) Preferred stockholders must receive their stated dividends prior to the distribution of any
earnings to common stockholders and bondholders.
3) The amount of preferred stock dividends that must be paid each year may be stated in dollars
or as a percentage of the firm’s earnings.
4) The cost of preferred stock is typically higher than the cost of long-term debt (bonds) because
the cost of long-term debt (interest) is tax deductible.
5) The cost of preferred stock is the ratio of the preferred stock dividend to a firm’s net proceeds
from the sale of the preferred stock.
6) The cost of preferred stock is the ratio of the preferred stock dividend to a firm’s total
earnings.
7) What is the dividend on an 8 percent preferred stock that currently sells for $45 and has a face
value of $50 per share?
A) $3.33
B) $3.60
C) $4.00
D) $5.00
8) A firm has issued 10 percent preferred stock, which sold for $100 per share par value. The
cost of issuing and selling the stock was $2 per share. The firm’s marginal tax rate is 40 percent.
The cost of the preferred stock is ________.
A) 3.9 percent
B) 6.1 percent
C) 9.8 percent
D) 10.2 percent
9) A firm has issued preferred stock at its $125 per share par value. The stock will pay a $15
annual dividend. The cost of issuing and selling the stock was $4 per share. The cost of the
preferred stock is ________.
A) 7.2 percent
B) 12 percent
C) 12.4 percent
D) 15 percent
10) A firm has determined it can issue preferred stock at $115 per share par value. The stock will
pay a $12 annual dividend. The cost of issuing and selling the stock is $3 per share. The cost of
the preferred stock is ________.
A) 6.4 percent.
B) 10.4 percent.
C) 10.7 percent.
D) 12 percent.
11) Tangshan Mining is considering issuing preferred stock. The preferred stock would have a
par value of $75 and a 5.50 percent dividend. What is the cost of preferred stock for Tangshan if
flotation costs would amount to 5.5 percent of par value?
A) 5.50%
B) 5.27%
C) 7.73%
D) 5.82%
9.5 Calculate the cost of common stock equity, and convert it into the cost of retained earnings
and the cost of new issues of common stock.
1) The cost of common stock equity may be measured using either the constant-growth valuation
model or the capital asset pricing model.
2) The constant-growth model uses the market price as a reflection of the expected risk-return
preference of investors in the market place.
3) The cost of common stock equity capital represents the return required by existing
shareholders on their investment.
4) The cost of retained earnings is always lower than the cost of a new issue of common stock
due to the absence of flotation costs when financing projects with retained earnings.
5) A firm can retain more of its earnings if it can convince its stockholders that it will earn at
least their required return on the reinvested funds.
6) In computing the cost of retained earnings, the net proceeds represents the amount of money
retained net of any underpricing and/or flotation costs.
7) The cost of retained earnings is generally higher than both the cost of debt and cost of
preferred stock.