CHAPTER 10—THE COST OF CAPITAL
United States – OH – DISC.FOFM.BRIG.16.03 – Capital budgeting and cost of capital
WACC and cap. components
Bloom’s: Analysis
Multiple Choice: Conceptual
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.
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.
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WACC and cap. components
Bloom’s: Analysis
Multiple Choice: Conceptual
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.
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CHAPTER 10—THE COST OF 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 additions to 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
additions to retained earnings and thus must begin to finance with preferred stock.
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MCC break points
Bloom’s: Analysis
Multiple Choice: Conceptual
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.
Cost of capital concepts
Bloom’s: Analysis
Multiple Choice: Conceptual
CHAPTER 10—THE COST OF CAPITAL
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%.
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%.
10-9 Adjusting the Cost of Capital for Risk
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Div. risk and projects
Multiple Choice: Conceptual
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
10-9 Adjusting the Cost of Capital for Risk
FOFM.BRIG.16.10.09 – Adjusting the Cost of Capital for Risk
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Risk-adjusted capital cost
Multiple Choice: Conceptual
CHAPTER 10—THE COST OF CAPITAL
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.
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Capital components
Bloom’s: Analysis
Multiple Choice: Conceptual
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.
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Cost of capital
Bloom’s: Analysis
Multiple Choice: Conceptual
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
CHAPTER 10—THE COST OF CAPITAL
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.
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Cost of equity
Bloom’s: Analysis
Multiple Choice: Conceptual
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.
FOFM.BRIG.16.10.00 – Comprehensive
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CHAPTER 10—THE 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 or is available online.
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.
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Bloom’s: Analysis
Multiple Choice: Conceptual
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.
United States – OH – DISC.FOFM.BRIG.16.03 – Capital budgeting and cost of capital
CAPM and DCF
Bloom’s: Analysis
Multiple Choice: Conceptual
CHAPTER 10—THE COST OF CAPITAL
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.
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Beta and project risk
Bloom’s: Analysis
Multiple Choice: Conceptual
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
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Bloom’s: Analysis
Multiple Choice: Conceptual
CHAPTER 10—THE COST OF CAPITAL
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.
c
CHALLENGING
Comprehensive
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MCC break points
Multiple Choice: Conceptual
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.
b.
c.
d.
e.
EASY
10-4 Cost of Preferred Stock, rp
FOFM.BRIG.16.10.04 – Cost of Preferred Stock, rp
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Cost of preferred
Bloom’s: Analysis
CHAPTER 10—THE COST OF CAPITAL
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%
EASY
10-4 Cost of Preferred Stock, rp
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.
b.
c.
d.
e.
a
EASY
10-5 The Cost of Retained Earnings, rs
CHAPTER 10—THE COST OF CAPITAL
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.
b.
c.
d.
e.
e
EASY
10-5 The Cost of Retained Earnings, rs
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.
b.
c.
d.
e.
c
EASY
10-5 The Cost of Retained Earnings, rs
CHAPTER 10—THE COST OF CAPITAL
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.
b.
c.
d.
e.
EASY
10-5 The Cost of Retained Earnings, rs
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.
b.
c.
d.
e.
a
EASY
10-5 The Cost of Retained Earnings, rs
CHAPTER 10—THE COST OF CAPITAL
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.
b.
c.
d.
e.
EASY
10-7 Composite, or Weighted Average, Cost of Capital, WACC
WACC
73. To help finance a major expansion, Castro Chemical Company sold a noncallable bond several years ago that now has
20 years to maturity. This bond has a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par
value of $1,000. If the firm’s tax rate is 40%, what is the component cost of debt for use in the WACC calculation?
a.
4.35%
b.
4.58%
c.
4.83%
d.
5.08%
e.
5.33%
CHAPTER 10—THE COST OF CAPITAL
74. Several years ago the Jakob Company sold a $1,000 par value, noncallable bond that now has 20 years to maturity and
a 7.00% annual coupon that is paid semiannually. The bond currently sells for $925, and the company’s tax rate is 40%.
What is the component cost of debt for use in the WACC calculation?
a.
4.28%
b.
4.46%
c.
4.65%
d.
4.83%
e.
5.03%
c
MODERATE
10-3 Cost of Debt rd(1 – T)
75. Assume that Kish Inc. hired you as a consultant to help estimate its cost of capital. You have obtained the following
MODERATE
10-3 Cost of Debt rd(1 – T)
CHAPTER 10—THE COST OF CAPITAL
data: D0 = $0.90; P0 = $27.50; and g = 7.00% (constant). Based on the DCF approach, what is the cost of equity from
retained earnings?
a.
b.
c.
d.
e.
MODERATE
10-5 The Cost of Retained Earnings, rs
76. Rivoli Inc. hired you as a consultant to help estimate its cost of capital. You have been provided with the following
data: D0 = $0.80; P0 = $22.50; and g = 8.00% (constant). Based on the DCF approach, what is the cost of equity from
retained earnings?
a.
b.
c.
d.
e.
c
MODERATE
10-5 The Cost of Retained Earnings, rs