Chapter 11 Test Bank – Static Key
1. It is standard practice to evaluate investment decisions using the cost of the specific financing method
involved.
2. The calculation of the cost of capital depends upon the historical cost of funds.
3. The cost of capital for each source of funds is dependent on current market conditions and expected
rates of return.
4. The cost of capital refers to the cost that a company takes on to purchase a big project.
5. In determining the cost of debt, a firm could use its yields and prices of outstanding bonds.
6. The cost of debt is equal to the current bond yield on bonds of similar risk class, adjusted for the
corporate tax rate.
7. The cost of debt needs to consider tax, while the cost of stock does not need to consider tax.
8. The amount of debt capital used by a corporation is not related to the availability of equity funds from
retained earnings and new common stock.
9. A firm’s cost of preferred stock is equal to the preferred dividend divided by the net price after flotation
costs.
10. A firm’s cost of preferred stock is equal to the preferred dividend divided by market price plus the
dividend growth rate (Kp = D/P0 + g).
11. The cost of new common stock is greater than the cost of outstanding common stock.
12. In determining the cost of preferred stock, the earnings on outstanding preferred stock may be used as
a proxy.
13. The out-of-pocket cost of common stock is a good approximation of the cost of common stock equity.
14. The discount rate that equates a future stream of expected dividends to the current price is a good
approximation of the cost of common stock.
15. Ke represents an expected return to stockholders as well as a cost to the firm.
16. The cost of retained earnings is considered to be equal to the required rate of return on a firm’s
outstanding common stock.
17. Retained earnings represent an internal source of funds that is raised without the payment of interest or
cost to the firm’s stockholders.
18. The only difference in the cost of retained earnings (Ke) and the cost of new common stock (Kn) is the
flotation cost on new common stock.
19. Regardless of the particular source of funds utilized for a project, the required rate of return, or discount
rate, will be the weighted average cost of capital.
20. The measurement of common stock equity in weighted average cost of capital uses the cost of retained
earnings (Ke) ,but not the cost of new common stock (Kn).
21. The use of the optimum capital structure minimizes the cost of capital.
22. All firms within particular industries have similar optimum capital structures.
23. A firm should always be at a single optimum debt–to-equity ratio to minimize its cost of capital.
24. Weights used to calculate the weighted average cost of capital Ka are derived from the optimum capital
structure.
25. Taking on additional debt will reduce the cost of equity.
26. Firms in stable industries are advised to keep debt levels very low so that shareholders, rather than
creditors, receive the benefits of steady cash flows.
27. Most firms are able to use 60% to 70% debt in their capital structure without exceeding norms
acceptable to most creditors and investors.
28. Although the after-tax cost of debt is below the cost of equity, firms cannot increase their use of debt to
endless amounts.
29. According to traditional financial theory, the cost of capital curve is U-shaped over the range of debt-
equity mixes.
30. A firm that does not earn the cost of capital in the short run will probably be in bankruptcy.
31. A firm that does not earn the cost of capital in the long run will not maximize shareholder wealth.
33. The use of the weighted average cost of capital assumes that the firm is in its optimum capital structure
range and the cost of each component stays constant over the range of financing.
34. The weighted average cost of capital calculates the average cost of issued or new issuance of debt and
equity for a firm.
35. Larger bond issues can lower “liquidity risk,” or the possibility that an investor will not be able to sell a
bond quickly and easily.
36. Market values rather than book values should be used for determining the optimal capital structure;
however, in practice, book value is commonly used.
37. In determining the optimum capital structure, it is assumed that the firm will raise capital in the optimum
proportions every year.
38. The pretax cost of debt is generally less than the pretax cost of equity.
39. The capital asset pricing model (CAPM) relates the risk-return tradeoffs of individual assets to market
returns.
40. In the capital asset pricing model (CAPM), beta measures the volatility of the market.
41. Per the capital asset pricing model, the slope of the security market line (SML) must be 1.0.
42. The financial managers of the firm decide on its cost of capital for financing projects.
43. The cost of debt, preferred stock, and common equity must all be adjusted for tax implications.
44. Although debt financing is generally cheaper than equity financing, financial managers should not use
debt financing significantly above the industry standard because it can increase the firm’s overall cost of
capital.
45. The cost of capital generally varies inversely with the size of the capital structure.
46. As the risk-free rate increases, the required rate of return for common stock decreases.
47. A firm with a higher beta than another firm will have a higher required rate of return.
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48. The slope of the security market line (SML) will often increase when the economy is in a boom period.
49. Each project should be judged against
50. Financial capital does not include
51. The overall weighted average cost of capital is used instead of costs for individual sources of funds
because
52. Debreu Beverages has an optimal capital structure that is 70% common equity, 20% debt, and 10%
preferred stock. Debreu’s pretax cost of equity is 9%. Its pretax cost of preferred equity is 7%, and its
pretax cost of debt is also 5%. If the corporate tax rate is 35%, what is the weighted average cost of
capital?
53. Debreu Beverages has an optimal capital structure that is 70% common equity, 10% preferred stock,
and 20% debt. Debreu’s pretax cost of equity is 9%. Its pretax cost of preferred equity is 7%, and its pretax
cost of debt is also 5%. If the corporate tax rate is 35%, what is the weighted average cost of capital?
54. Given an optimal capital structure that is 50% debt and 50% common stock, calculate the weighted
average cost of capital for the company given the following additional information:
55. For a firm paying 5% for new debt, the higher the firm’s tax rate
56. If a firm’s bonds are currently yielding 6% in the marketplace, why would the firm’s cost of debt be
lower?
57. The cost of a firm’s debt is determined by taking the
58. The coupon rate on a debt issue is 6%. If the yield to maturity on the debt is 9%, what is the after-tax
cost of debt in the weighted average cost of capital if the firm’s tax rate is 34%?
59. The coupon rate on an issue of debt is 8%. The yield to maturity on this issue is 10%. The corporate tax
rate is 31%. What would be the approximate after-tax cost of debt for a new issue of bonds?
60. A firm’s cost of financing, in an overall sense, is equal to its
61. A firm has $50 million in assets and its optimal capital structure is 60% equity. If the firm has $12 million
in retained earnings available to invest, at what asset level will the firm need to issue additional stock?
(Assume no growth in retained earnings.)
62. Tobin’s Barbeque has a bank loan at 8% interest and an after-tax cost of debt of 6%. What will the
after-tax cost of debt be if a new loan is taken out yielding 11%.