Chapter 11 – Cost of Capital
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 historical costs of funds.
Chapter 11 – Cost of Capital
3. The cost of capital for each source of funds is dependent on current market conditions and
expected rates of return.
4. In determining the cost of debt, yields and prices of outstanding bonds are used.
5. The cost of debt is equal to the current bond yield on bonds of similar risk class and
adjusted for the corporate tax rate.
6. 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.
Chapter 11 – Cost of Capital
7. A firm’s cost of preferred stock is equal to the preferred dividend divided by the net price
after flotation costs.
8. A firm’s cost of preferred stock is equal to the preferred dividend divided by market price
plus the dividend growth rate (Kp= D/Po+ g).
9. The cost of new common stock is greater than the cost of outstanding common stock.
10. In determining the cost of preferred stock, the earnings on outstanding preferred stock
may be used as a proxy.
Chapter 11 – Cost of Capital
11. The out-of-pocket cost of common stock is a good approximation of the cost of common
stock equity.
12. 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.
13. Kerepresents an expected return to stockholders as well as a cost to the firm.
14. The cost of retained earnings is equal to the required rate of return on a firm’s outstanding
common stock.
Chapter 11 – Cost of Capital
15. Retained earnings represent an internal source of funds that is raised without the payment
of interest, or cost to the firm’s stockholders.
16. 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.
17. 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.
18. The use of common stock equity in the weighted average cost of capital is always (Ke) and
not (Kn), the cost of new common stock.
Chapter 11 – Cost of Capital
19. The use of the optimum capital structure minimizes the cost of capital.
20. All firms within particular industries have similar optimum capital structures.
21. A firm should always be at a single optimum debt to equity ratio to minimize its cost of
capital.
22. Weights used to calculate the weighted average cost of capital Kaare derived from the
optimum capital structure.
23. Taking on additional debt will reduce the cost of equity.
Chapter 11 – Cost of Capital
24. 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.
25. Most firms are able to use 60%-70% debt in their capital structure without exceeding
norms acceptable to most creditors and investors.
26. Although the after-tax cost of debt is below the cost of equity, firms cannot increase their
use of debt without limit.
27. According to traditional financial theory, the cost of capital curve is U-shaped over the
range of debt-equity mixes.
Chapter 11 – Cost of Capital
28. A firm that does not earn the cost of capital in the short run will probably be in
bankruptcy.
29. A firm that does not earn the cost of capital in the long run will not maximize shareholder
wealth.
30. Companies prefer to maintain some financing flexibility in order to choose the lowest cost
source of funds at a single point in time.
31. 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.
Chapter 11 – Cost of Capital
32. Market values rather than book values should be used for determining the optimal capital
structure, though in practice, book value is commonly used.
33. In determining the optimum capital structure it is assumed that the firm will raise capital
in the optimum proportions every year.
34. The pretax cost of debt is less than the pretax cost of equity.
35. The capital asset pricing model (CAPM) relates the risk-return tradeoffs of individual
assets to market returns.
Chapter 11 – Cost of Capital
36. Individual common stocks’ betas have a tendency to move toward 1.0 over time.
37. In the capital asset pricing model (CAPM), beta measures the volatility of the market.
38. Per the capital asset pricing model, the slope of the security market line (SML) must be
1.0.
39. The financial managers of the firm decide on its cost of capital for financing projects.
Chapter 11 – Cost of Capital
40. The cost of debt, preferred stock, and common equity must all be adjusted for tax
implications.
41. 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.
42. The cost of capital generally varies inversely with the size of the capital structure.
43. As the risk-free rate increases, the required rate of return for common stock decreases.
Chapter 11 – Cost of Capital
44. A firm with a higher beta than another firm will have a higher required rate of return.
45. The slope of the security market line (SML) will often increase when the economy is in a
boom period.
46. Each project should be judged against
47. Financial capital does not include
Chapter 11 – Cost of Capital
48. The overall weighted average cost of capital is used instead of costs for specific sources of
funds because
49. 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 weighed average cost of capital?
Chapter 11 – Cost of Capital
50. Given an optimal capital structure that is 50% debt and 50% common stock, calculate the
weighted average cost of capital for Stone Corp given the following additional information:
Bond coupon rate..8%
Bond yield to maturity..6%
Dividend, expected..$5
Price, common.$80
Growth rate.5%
Corporate tax rate30%
51. For a firm paying 5% for new debt, the higher the firm’s tax rate
Chapter 11 – Cost of Capital
52. If a firm’s bonds are currently yielding 6% in the marketplace, why would the firm’s cost
of debt be lower?
53. The cost of debt is determined by taking the
54. 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%?
Chapter 11 – Cost of Capital
55. 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?
56. A firm’s cost of financing, in an overall sense, is equal to its
Chapter 11 – Cost of Capital
57. A firm has $50 million in assets and its optimal capital structure is 60% equity. If the firm
has $12 million in retained earnings, at what asset level will the firm need to issue additional
stock? (Assume no growth in retained earnings.)
58. Klein Corp. can issue $1,000 par value bond that pays $90 per year in interest at a price of
$980. The bond will have a 10-year life. The firm is in a 35% tax bracket. What is the after–
tax cost of debt?
Chapter 11 – Cost of Capital
59. 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 when the loan is due if a new loan is taken out yielding 11%.
60. The pre-tax cost of debt for a new issue of debt is determined by
Chapter 11 – Cost of Capital
61. Lewis, Schultz and Nobel Development Corp. has an after-tax cost of debt of 4.5 percent.
With a tax rate of 30 percent, what is the yield on the debt?
62. The after-tax cost of preferred stock to the issuing corporation