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Chapter 12: The Cost of Capital
Multiple Choice
1. The cost of internal common equity is represented in financial formulas as ____.
a.
ki
b.
kd
c.
k’e
d.
ke
2. Studies analyzing the historical returns earned by common stock investors have found that the returns from average risk
common stock investments over very long time periods have averaged approximately ____ percentage points ____ than
holding period returns on corporate debt issues.
a.
7.5; higher
b.
7.5; lower
c.
5.7; lower
d.
5.7; higher
3. The cost of equity capital for non-dividend paying stocks can be determined by ____.
I. using the Capital Asset Pricing Model
II. estimating ke for comparable dividend-paying stocks in their industry
a.
Only statement I is correct.
b.
Only statement II is correct.
c.
Both statements I and II are correct.
d.
Neither statement I nor II is correct.
4. For a company that is not planning to change its target capital structure, the proportions of debt and equity used in
calculating the weighted cost of capital should be based on the current ____ value weights of the individual components.
a.
book
b.
market
c.
replacement
d.
accounting
5. The cost of capital is ____.
a.
the rate of return required by investors in the firm’s securities
b.
the minimum rate of return required on new investments of high risk undertaken by the firm
c.
approximately 10 percent for most firms
d.
concerned with plant and equipment only
a
6. A firm can raise up to $700 million for investment from a mixture of debt, preferred stock and retained equity. Above
$700 million, the firm must issue new common stock. Assuming that debt costs and preferred stock costs remain
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Chapter 12: The Cost of Capital
unchanged, the marginal cost of capital for amounts up to $700 million will be ____ the marginal cost of capital for
amounts over $700 million.
a.
less than
b.
equal to
c.
greater than
d.
Cannot be determined from the information given
a
7. The CAPM assumes that the only risk of concern to the investor is ____, which is measured by ____.
a.
unsystematic risk; beta
b.
systematic risk; the return to the market portfolio
c.
systematic risk; beta
d.
unsystematic risk; the return to the market portfolio
c
8. If a firm adopts a large proportion of above-average-risk investment projects that are not offset by below-average-risk
investment projects, ____.
a.
its cost of capital will rise
b.
the average risk premium for the firm will decline
c.
the risk-free rate will increase as more risk is added
d.
its cost of capital will fall
a
9. The most appropriate weights to use in calculating a firm’s cost of capital are the proportions of the components in the
firm’s ____ capital structure.
a.
historical average
b.
long-range target
c.
current
d.
industry average
10. For firms subject to the 40% marginal tax rate, the after-tax cost of ____ is roughly three-fifths the cost of preferred
stock.
a.
retained earnings
b.
new common stock
c.
long-term debt
d.
None of these are correct
c
11. There are four major components that determine the risk premium. They include all of the following EXCEPT ____
risk.
a.
marketability
b.
business
c.
reinvestment rate
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Chapter 12: The Cost of Capital
d.
financial
c
12. The required rate of return on any security consists of a(n) ____.
a.
risk premium plus an expected inflation rate
b.
risk free rate plus a risk premium
c.
inflation rate plus a marketability premium
d.
risk free rate plus an inflation premium
13. The cost of external common equity is represented in financial formulas as ____.
a.
ki
b.
kd
c.
k’e
d.
ke
c
14. Break points can be determined by dividing the amount of funds available from each financing source at a fixed cost
by the ____ capital structure proportion for that financing source.
a.
weighted
b.
target
c.
economic
d.
divisional
15. If a preferred stock is callable, then the calculation of the cost of preferred stock financing is ____.
a.
similar to that for bonds
b.
equal to Dp/Pn
c.
equal to Dp less flotation costs
d.
less than Dp/Pn
a
16. The constant growth valuation model approach to calculating the cost of equity assumes that ____.
a.
earnings and dividends grow at a constant rate, but stock price growth is indeterminate
b.
the growth rate is greater than or equal to ke
c.
dividends are constant
d.
earnings, dividends, and stock price will grow at a constant rate
17. The total return to stockholders, ke, is composed of the ____.
a.
opportunity cost plus a risk premium
b.
dividend yield plus the price appreciation of the security
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Chapter 12: The Cost of Capital
c.
opportunity cost plus an inflation premium
d.
dividend yield minus the risk premium
18. If a firm is losing money then the after-tax cost of debt is ____.
a.
equal to kd(1 – T)
b.
found by trial and error
c.
equal to the pretax cost of debt
d.
equal to the yield to first call date
19. The historic beta of a firm is of little use as a forecast of the firm’s future systematic risk characteristics when the firm
is ____.
a.
growing at a rate of 7-10 percent a year
b.
expanding an existing product line
c.
expanding into a new product line
d.
All of these are correct
20. All of the following methods may be used to determine the cost of equity capital (ke) for a non-dividend-paying stock
EXCEPT ____.
a.
the risk premium on debt approach
b.
the Capital Asset Pricing Model approach
c.
comparing with similar dividend-paying stocks in the industry
d.
the simulation with growth expectations approach
21. The cost of external equity is greater than the cost of internal equity because ____.
a.
it decreases the earnings per share
b.
it increases the market price of the stock
c.
of the flotation costs
d.
dividends are increased
22. Retained earnings are a cheaper source of funds than the sale of new equity because ____.
a.
retention defers the payment of taxable dividends to shareholders
b.
there are no flotation costs
c.
new shares are usually priced below current market price
d.
All of these are correct
23. Historic average capital costs are ____ making new (marginal) resource allocation decisions.
a.
not relevant for
b.
very useful when
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Chapter 12: The Cost of Capital
c.
necessary for
d.
the relevant costs for
24. Which of the following is NOT a typical source of debt funds for a small firm?
a.
investment banking firms
b.
commercial finance companies
c.
Small Business Administration
d.
leasing companies
25. The after-tax cost of debt is represented in financial formulas as ____.
a.
ki
b.
kd
c.
k’e
d.
ke
26. The optimal capital budget is determined by comparing the expected project returns to the company’s ____.
a.
computed break points
b.
cost of equity schedule
c.
marginal cost of capital schedule
d.
optimal opportunity curve
27. The cost of depreciation-generated funds is equal to ____.
a.
the cost of equity capital
b.
zero, because depreciation is a non–cash expense
c.
the investment opportunity cost
d.
the weighted cost of capital
28. The pretax cost of debt is represented in financial formulas as ____.
a.
ki
b.
kd
c.
k’e
d.
ke
29. It is difficult for small firms to apply for the dividend valuation model because ____.
a.
the dividend valuation model depends on the Capital Asset Pricing Model, which small firms cannot use
b.
of limited access to the capital markets for new equity
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Chapter 12: The Cost of Capital
c.
of prohibitively high common stock issuance costs
d.
small firms often pay little or no dividends
30. Rank in ascending order (lowest to highest) the relative riskiness of the various types of corporate and government
securities.
a.
common stock, preferred stock, corporate debt, long-term government debt
b.
corporate debt, long-term government debt, preferred stock, common stock
c.
long-term government debt, corporate debt, preferred stock, common stock
d.
corporate debt, preferred stock, long-term government debt, common stock
31. Rank in ascending order (lowest to highest) investors’ required rates of return on the various types of corporate
securities.
a.
preferred stock, corporate debt, common stock
b.
common stock, preferred stock, corporate debt
c.
preferred stock, common stock, corporate debt
d.
corporate debt, preferred stock, common stock
32. Which of the following statements is true concerning companies that do not pay dividends?
a.
The cost of equity capital can be estimated using the Capital Asset Pricing Model.
b.
The cost of equity capital is equal to the growth short-term rate of earnings per share.
c.
The dividend capitalization model can be used to determine an accurate cost of equity capital.
d.
None of these are correct
33. The optimal capital budget is indicated by the point at which the ____ and the ____ intersect.
a.
depreciation schedule; investment opportunity schedule
b.
investment opportunity curve; marginal cost of capital curve
c.
investment opportunity curve; average cost of capital curve
d.
efficient portfolio curve; marginal cost of capital curve
34. During the 1980s, the cost of capital for U.S. firms averaged about 3.3 percentage points higher than Japanese firms.
During 1990 this disadvantage may have disappeared due to ____.
a.
higher exports to the United States
b.
higher real interest rates in Japan
c.
larger shareholder interest
d.
higher Japanese stock market
35. If a firm sells assets, generating cash flows, the cost of these funds is ____.
a.
the firm’s cost of equity
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Chapter 12: The Cost of Capital
b.
the firm’s cost of cash flows
c.
the firm’s weighted cost of capital
d.
zero
c
36. Small firms are reluctant to obtain capital through the sale of common stock because of ____.
a.
potential loss of voting control
b.
high issuance costs
c.
high cost of debt
d.
All of these are correct
37. Determine the (after-tax) percentage cost of a $50 million debt issue that the Mattingly Corporation is planning to
place privately with a large insurance company. Assume that the company has a 40% marginal tax rate. This long-term
debt issue will yield 12% to the insurance company.
a.
4.8%
b.
7.2%
c.
12.0%
d.
10.6%
38. Calculate the after-tax cost of preferred stock for Ohio Valley Power Company, which is planning to sell $100 million
of $3.25 cumulative preferred stock to the public at a price of $25 per share. Flotation costs are $1.00 per share. Ohio
Valley has a marginal income tax rate of 40%.
a.
13.0%
b.
7.8%
c.
8.12%
d.
13.54%
39. The Allegheny Valley Power Company common stock has a beta of 0.80. Assume the current risk-free rate is 6.5%
and the expected return on the stock market as a whole is 16%, determine the cost of equity capital for the firm (using the
CAPM).
a.
14.1%
b.
7.6%
c.
6.5%
d.
13.0%
a
40. The following financial information is available on Rawls Manufacturing Company:
Current per share market price
$48.00
Current (t = 0) per share dividend
$3.50
Expected long-term growth rate
5.0%
Rawls can issue new common stock to net the company $44 per share. Determine the cost of internal equity capital using
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Chapter 12: The Cost of Capital
the dividend capitalization model approach. (Compute answer to the nearest 0.1%.)
a.
12.3%
b.
13.4%
c.
13.0%
d.
12.7%
41. The following financial information is available on Rawls Manufacturing Company:
Current per share market price
$48.00
Beta
1.1
Expected rate of return on market
12.0%
Risk-free rate
6.0%
Rawls can issue new common stock to net the company $44 per share. Determine the cost of internal equity capital using
the capital asset pricing model approach. (Compute answer to the nearest 0.1%.)
a.
12.9%
b.
12.6%
c.
13.0%
d.
11.8%
42. The following financial information is available on Rawls Manufacturing Company:
Current per share market price
$48.00
Current per share dividend
$3.50
Current per share earnings
$6.00
Beta
1.1
Expected rate of return on market
12.0%
Risk-free rate
6.0%
Expected long-term growth rate
5.0%
Rawls can issue new common stock to net the company $44 per share. Determine the cost of external equity capital using
the dividend capitalization model approach. (Compute answer to the nearest 0.1%.)
a.
12.7%
b.
14.4%
c.
12.6%
d.
13.4%
43. Determine the weighted cost of capital for the Mills Company that will finance its optimal capital budget with $120
million of long-term debt (kd = 12.5%) and $180 million in retained earnings (ke = 16.0%). Mills’ present capital structure
is considered optimal. The company’s marginal tax rate is 40%. (Compute answer to nearest 0.1%.)
a.
14.3%
b.
12.6%
c.
14.6%
d.
11.9%
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Chapter 12: The Cost of Capital
44. What is the cost of a preferred stock with a $100 par value that pays a $9.60 dividend per year? The security has a
flotation cost of $3.37 and will be retired at its par value in 20 years.
a.
9.6%
b.
9.9%
c.
10.0%
d.
10.6%
c
45. What is the cost of equity for East Roon if the firm is expected to always pay a constant dividend of $2.22? The firm’s
common stock is presently selling for $18.50.
a.
8.3%
b.
12.0%
c.
10.2%
d.
Cannot be determined from the information given
46. According to Value Line, Bestway has a beta of 1.15. If 3-month Treasury bills currently yield 7.9% and the market
risk premium is estimated to be 8.3%, what is Bestway’s cost of equity capital?
a.
17.45%
b.
8.36%
c.
9.55%
d.
16.2%
a
47. Northeast Airlines (NA) has a current dividend of $1.80. Dividends are expected to grow at a rate of 7% a year into
the foreseeable future. What is NA’s cost of external equity if its stock can be sold to net $46 a share?
a.
10.9%
b.
11.2%
c.
7.2%
d.
21.0%
48. A firm with a 40% marginal tax rate has a capital structure of $60,000,000 in debt and $140,000,000 in equity. What
is the firm’s weighted cost of capital if the marginal pretax cost of debt is 12%, the firm’s average pretax cost of debt
outstanding is 8%, and the cost of equity is 14.5%?
a.
13.75%
b.
11.59%
c.
12.31%
d.
10.45%
c
49. Crickentree has a target capital structure of 30% debt and 70% equity. If the firm expects to have a net income of $1.7
million and a dividend payout ratio of 40%, what will be its equity break point?
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Chapter 12: The Cost of Capital
a.
$2,428,571
b.
$1,457,143
c.
$3,400,000
d.
$971,429
50. Easy Slider Inc. sold a 15-year $1,000 face value bond with a 10% coupon rate. Interest is paid annually. After
flotation costs, Easy Slider received $928 per bond. Compute the after-tax cost of debt for these bonds if the firm’s
marginal tax rate is 40%.
a.
6.0%
b.
7.2%
c.
7.8%
d.
6.6%
51. Alpha Products maintains a capital structure of 40% debt and 60% common equity. To finance its capital budget for
next year, the firm will sell $50 million of 11% debentures at par and finance the balance of its $125 million capital
budget with retained earnings. Next year Alpha expects net income to grow 7% to $140 million, and dividends also are
expected to increase 7% to $1.40 per share and to continue growing at that rate for the foreseeable future. The current
market value of Alpha’s stock is $30. If the firm has a marginal tax rate of 40%, what is its weighted cost of capital for the
coming year?
a.
9.64%
b.
8.63%
c.
9.84%
d.
11.67%
a
52. Wellington Gas has a target capital structure of 50% common equity, 40% debt, and 10% preferred stock. The cost of
retained earnings is 16%, and the cost of new equity (external) is 16.7%. Wellington can sell debentures that will have an
after-tax cost of 8.3% and the after-tax cost of preferred stock will be 11.9%. What is the marginal cost of capital before
and after the break point?
a.
12.51% and 12.86%
b.
11.18% and 11.53%
c.
14.23% and 14.68%
d.
12.51% and 11.53%
a
53. GQ earned $740,000 before taxes this year. The firm has a debt ratio of 30%, a marginal tax rate of 35%, and a
dividend payout ratio of 40%. GQ has no preferred stock. What is GQ’s break point for equity?
a.
$634,286
b.
$962,000
c.
$412,286
d.
$288,600
c
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Chapter 12: The Cost of Capital
54. Groves Inc. pays an annual dividend of $1.22. This dividend is expected to continue growing at a rate of about 5%
each year. The firm is in a fairly risky business and has a beta of 1.45. The expected market rate of return is 13.5%, and
the risk-free rate is 9.3%. What is the cost of equity for Groves?
a.
19.6%
b.
13.5%
c.
15.4%
d.
6.1%
c
55. PDQ Inc. has a weighted cost of capital of 14.6% and has an opportunity to invest in the following average risk
projects:
Project
Cost
Annual Cost Flow
Project life
1
$10,000
$1,992.43
10 years
2
$21,000
$4,526.84
8 years
3
$18,500
$4,580.34
7 years
In which projects should PDQ invest? Assume no capital rationing.
a.
1 and 2 only
b.
2 and 3 only
c.
1 and 3 only
d.
Cannot be determined from the information provided
c
56. Mid-South Utilities will sell $10 million of $100 par value preferred stock that will pay an annual dividend of $9.75.
Mid-South will receive $93.98 per share after flotation costs. If the issue must be retired in 20 years, what is the cost of
the preferred issue?
a.
10.37%
b.
10.50%
c.
10.23%
d.
9.75%
b
57. Witin’s stock price is currently $34.25, and the current quarterly dividend is $0.25. Consensus estimates for Witin
indicate a growth rate in earnings of 10% into the foreseeable future. If Witin plans to sell 1 million shares to raise new
capital for expansion, what is the cost of new equity if the issuance costs are 8%?
a.
13.49%
b.
10.87%
c.
13.21%
d.
13.17%
a
58. Weltron has a target capital structure of 35% debt and 65% equity. If the firm expects net income of $12.3 million and
an annual dividend of $0.12 per share, what is the expected equity break point? There are 12 million shares outstanding.
a.
$18,923,076
b.
$16,707,692
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Chapter 12: The Cost of Capital
c.
$10,061,538
d.
$2,215,385
b
59. Pluega Inc. issued a $100 million 8.27% coupon debenture bond due in the next 20 years. The bonds each sold for
$996. If the bonds pay interest semi-annually, what is Pluega’s after cash cost of debt? Assume 40% tax rate.
a.
4.96%
b.
8.30%
c.
4.99%
d.
3.32%
c
60. Haulsee Inc. pays no dividend currently but is expected to start paying a small dividend next year. The 5-year-old firm
has a beta of 1.25 and current earnings of $0.90 per share. The current Treasury bill rate is 6.10%, and the market risk
premium is 8.8%. Determine Haulsee’s cost of equity if the firm’s tax rate is 40%.
a.
9.48%
b.
17.1%
c.
14.9%
d.
Cannot determined from the information provided
b
61. Sharp’s current capital structure of 60% equity, 35% debt, and 5% preferred stock is considered optimal. This year
Sharp expects to have earnings after tax of $3.6 million and to pay out $600,000 in dividends. Sharp can also raise up to
$2 million in long-term debt at a pretax interest rate of 10.6% (all debt over $2 million will cost 11.4% pretax), and sell
preferred stock at a cost of 11.5%. Sharp’s marginal tax rate is 40%. The current value of Sharp’s common stock is $36
and a dividend of $2.15 is expected to be paid during the coming year. Dividends have been growing at an annual
compound rate of 8% a year and are expected to continue growing at that rate. New shares can be sold to net the firm
$34.50. Sharp has an opportunity to invest in the following capital projects. Which one(s) should be accepted?
Project
Cost
Annual Cash Flow
Project Life
1
$3.0 million
$552,893
10 years
2
$2.5 million
$693,481
5 years
3
$2.0 million
$345,220
10 years
a.
1 and 2 only
b.
1 and 3 only
c.
1, 2, and 3
d.
Cannot be determined from the information provided
a
62. Far Out Tech (FOT) has a debt ratio of 0.3, and it considers this to be its optimal capital structure. FOT has no
preferred stock. FOT has analyzed four capital projects for the coming year as follows:
Project
Net Investment
IRR
1
$3,000,000
13.5%
2
$1,500,000
18.0%
3
$2,000,000
12.6%
4
$1,600,000
16.0%