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Chapter 11: Determining the Cost of Capital
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Page 21
is the cost of common from reinvested earnings?
a.
10.69%
b.
11.25%
c.
11.84%
d.
12.43%
e.
13.05%
POINTS:
1
37. The CEO of Harding Media Inc. as asked you to help estimate its cost of common equity. You have obtained the
following data: D0 = $0.85; P0 = $22.00; and gL = 6.00% (constant). The CEO thinks, however, that the stock price is
temporarily depressed, and that it will soon rise to $40.00. Based on the dividend growth model, by how much would the
cost of common from reinvested earnings change if the stock price changes as the CEO expects?
a.
−1.49%
b.
−1.66%
c.
−1.84%
d.
−2.03%
e.
−2.23%
POINTS:
1
38. Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is
temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case,
the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt.
a.
True
b.
False
ANSWER:
False
39. For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in
accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and
partly common equity.
a.
True
b.
False
ANSWER:
True
40. In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects
because most projects are funded with general corporate funds, which come from a variety of sources. However, if the
firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type
of capital to evaluate that project.
a.
True
b.
False
ANSWER:
False
41. When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good
idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This
problem leaves us unsure of the true value of rs.
a.
True
b.
False
ANSWER:
True
42. The cost of debt, rd, is normally less than rs, so rd(1 − T) will normally be much less than rs. Therefore, as long as the
firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 −
T).
a.
True
b.
False
ANSWER:
True
43. The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant.
a.
True
b.
False
ANSWER:
False
44. For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm
operates at its target capital structure.
a.
re > rs > WACC > rd.
b.
WACC > re > rs > rd.
c.
rd > re > rs > WACC.
d.
WACC > rd > rs > re.
e.
rs > re > rd > WACC.
ANSWER:
a
45. Which of the following statements is CORRECT?
a.
When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on
preferred stock are deductible by the paying corporation.
b.
Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt
than on the cost of common stock as measured by the CAPM.
c.
If a company's beta increases, this will increase the cost of equity used to calculate the WACC, but only if the
company does not have enough reinvested earnings to take care of its equity financing and hence must issue
new stock.
d.
Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC.
e.
When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are
deductible by the paying corporation.
ANSWER:
e
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Page 26
46. Which of the following statements is CORRECT?
a.
We should use historical measures of the component costs from prior financings that are still outstanding when
estimating a company's WACC for capital budgeting purposes.
b.
The cost of new equity (re) could possibly be lower than the cost of reinvested earnings (rs) if the market risk
premium, risk-free rate, and the company's beta all decline by a sufficiently large amount.
c.
A firm's cost of reinvesting earnings is the rate of return stockholders require on a firm's common stock.
d.
The component cost of preferred stock is expressed as rp(1 − T), because preferred stock dividends are treated
as fixed charges, similar to the treatment of interest on debt.
e.
In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that
70% of the dividends received by corporate investors are excluded from their taxable income.
ANSWER:
c
47. Which of the following statements is CORRECT?
a.
The percentage flotation cost associated with issuing new common equity is typically smaller than the
flotation cost for new debt.
b.
The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to
acquire its assets.
Chapter 11: Determining the Cost of Capital
c.
There is an "opportunity cost" associated with using reinvested earnings, hence they are not "free."
d.
The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only
debt to finance its capital budget during the coming year.
e.
The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital.
ANSWER:
c
48. Which of the following statements is CORRECT?
a.
WACC calculations should be based on the before-tax costs of all the individual capital components.
b.
Flotation costs associated with issuing new common stock normally reduce the WACC.
c.
If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline.
d.
An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.
e.
A change in a company's target capital structure cannot affect its WACC.
ANSWER:
c
49. Which of the following statements is CORRECT?
a.
The after-tax cost of debt usually exceeds the after-tax cost of equity.
b.
For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible
preferred stock.
c.
Retained earnings that were generated in the past and are reported on the firm's balance sheet are available to
finance the firm's capital budget during the coming year.
d.
The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital.
e.
The WACC is calculated using before-tax costs for all components.
ANSWER:
d
50. Which of the following statements is CORRECT? Assume a company's target capital structure is 50% debt and 50%
common equity.
a.
The WACC is calculated on a before-tax basis.
b.
The WACC exceeds the cost of equity.
c.
The cost of equity is always equal to or greater than the cost of debt.
d.
The cost of reinvested earnings typically exceeds the cost of new common stock.
e.
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.
ANSWER:
c
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51. Which of the following statements is CORRECT?
a.
The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in
fact pay taxes.
b.
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.
c.
Because no flotation costs are required to obtain capital as reinvested earnings, the cost of reinvested earnings
is generally lower than the after-tax cost of debt.
d.
Higher flotation costs tend to reduce the cost of equity capital.
e.
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.
ANSWER:
b
52. Which of the following statements is CORRECT?
a.
A cost should be assigned to reinvested 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 distributed rather
than retained and reinvested.
b.
No cost should be assigned to reinvested 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."
c.
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.
d.
If a firm has enough reinvested 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.
e.
The component cost of preferred stock is expressed as rp(1 − T). This follows because preferred stock
Chapter 11: Determining the Cost of Capital
dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes.
ANSWER:
a
53. Which of the following statements is CORRECT?
a.
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.
b.
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.
c.
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.
d.
The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a
firm's cost of equity capital.
e.
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.
ANSWER:
c
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Page 31
54. Which of the following statements is CORRECT?
a.
The dividend growth model is generally preferred by academics and financial executives over other models for
estimating the cost of equity. This is because of the dividend growth model's logical appeal and also because
accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain.
b.
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.
c.
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.
d.
The dividend growth model 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.
e.
Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a
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.
ANSWER:
c
55. Which of the following statements is CORRECT?
a.
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.
b.
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.
c.
An advantage shared by both the dividend growth model 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.
d.
The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-
premium approach.
Chapter 11: Determining the Cost of Capital
e.
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.
ANSWER:
b
56. Which of the following statements is CORRECT?
a.
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.
b.
An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity.
c.
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.
d.
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.
e.
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.
ANSWER:
c
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Page 33
57. Which of the following statements is CORRECT?
a.
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.
b.
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.
c.
When the WACC is calculated, it should reflect the costs of new common stock, reinvested 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.
d.
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.
e.
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 reinvested earnings.
ANSWER:
d
58. Firm J's earnings and stock price tend to move up and down with other firms in the S&P 500, while Firm F's earnings
and stock price move counter cyclically with J and other S&P companies. Both J and F estimate their costs of equity using
the CAPM, they have identical market values, their standard deviations of returns are identical, and they both finance only
with common equity. Which of the following statements is CORRECT?
a.
J and F should have identical WACCs because their risks as measured by the standard deviation of returns are
identical.
b.
If J and F merge, then the merged firm MW should have a WACC that is a simple average of J's and F's
WACCs.
Chapter 11: Determining the Cost of Capital
c.
Without additional information, it is impossible to predict what the merged firm's WACC would be if J and F
merged.
d.
Since J and F 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.
e.
J should have the lower WACC because it is like most other companies, and investors like that fact.
ANSWER:
b
59. Your consultant firm has been hired by Eco Brothers Inc. to help them estimate the cost of common equity. The yield
on the firm's bonds is 8.75%, and your firm's economists believe that the cost of common 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 common from reinvested
earnings?
a.
12.60%
b.
13.10%
c.
13.63%
d.
14.17%
e.
14.74%
POINTS:
1
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Page 35
60. Bartlett Company's 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 common using reinvested earnings is 12.75%. The firm will
not be issuing any new stock. You were hired as a consultant to help determine their cost of capital. What is its WACC?
a.
8.98%
b.
9.26%
c.
9.54%
d.
9.83%
e.
10.12%
POINTS:
1
61. Quinlan Enterprises stock trades for $52.50 per share. It is expected to pay a $2.50 dividend at year end (D1 = $2.50),
and the dividend is expected to grow at a constant rate of 5.50% a year. The before-tax cost of debt is 7.50%, and the tax
rate is 40%. The target capital structure consists of 45% debt and 55% common equity. What is the company's WACC if
all the equity used is from reinvested earnings?
a.
7.07%
b.
7.36%
c.
7.67%
d.
7.98%
Chapter 11: Determining the Cost of Capital
e.
8.29%
POINTS:
1
62. Avery Corporation's target capital structure is 35% debt, 10% preferred, and 55% common equity. The interest rate on
new debt is 6.50%, the yield on the preferred is 6.00%, the cost of common from reinvested earnings is 11.25%, and the
tax rate is 40%. The firm will not be issuing any new common stock. What is Avery's WACC?
a.
8.15%
b.
8.48%
c.
8.82%
d.
9.17%
e.
9.54%
ANSWER:
a
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Page 37
63. The president and CFO of Spellman Transportation are having a disagreement about whether to use market value or
book value weights in calculating the WACC. Spellman's balance sheet shows a total of noncallable $45 million long-
term debt with a coupon rate of 7.00% and a yield to maturity of 6.00%. This debt currently has a market value of $50
million. The company has 10 million shares of common stock, and the book value of the common equity (common stock
plus retained earnings) is $65 million. The current stock price is $22.50 per share; stockholders' required return, rs, is
14.00%; and the firm's tax rate is 40%. The CFO thinks the WACC should be based on market value weights, but the
president thinks book weights are more appropriate. What is the difference between these two WACCs?
a.
1.55%
b.
1.72%
c.
1.91%
d.
2.13%
e.
2.36%
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Page 38
POINTS:
1
64. Granby Foods' (GF) balance sheet shows a total of $25 million long-term debt with a coupon rate of 8.50%. The yield
to maturity on this debt is 8.00%, and the debt has a total current market value of $27 million. The company has 10
million shares of stock, and the stock has a book value per share of $5.00. The current stock price is $20.00 per share, and
stockholders' required rate of return, rs, is 12.25%. The company recently decided that its target capital structure should
have 35% debt, with the balance being common equity. The tax rate is 40%. Calculate WACCs based on book, market,
and target capital structures. What is the sum of these three WACCs?
a.
28.36%
b.
29.54%
c.
30.77%
d.
32.00%
e.
33.28%
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Page 39
POINTS:
1
65. To estimate the company's WACC, Marshall Inc. recently hired you as a consultant. You have obtained the following
information. (1) The firm's noncallable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $1,000,
and a market price of $1,050.00. (2) The company's tax rate is 40%. (3) The risk-free rate is 4.50%, the market risk
premium is 5.50%, and the stock's beta is 1.20. (4) The target capital structure consists of 35% debt and the balance is
common equity. The firm uses the CAPM to estimate the cost of common stock, and it does not expect to issue any new
shares. What is its WACC?
a.
7.16%
b.
7.54%
c.
7.93%
d.
8.35%
e.
8.79%
