Part 7 Long-Term Valuation
CHAPTER 20
COST OF CAPITAL
CHAPTER LEARNING OBJECTIVES
20.1 Explain how the three major problem areas in finance—valuation, cost of
capital, and determining cash flows—are related.
20.2 Calculate the weighted average cost of capital (WACC) and explain its
20.3 Estimate the cost of capital and its non-equity components.
20.4 Explain how operating leverage and financial leverage affect a firm’s risk.
20.5 Use the discounted cash flow model to estimate the cost of equity.
20.6 Estimate the cost of equity using risk-based models and describe the
20.7 Explain how WACC interacts with the investment decision framework
introduced in chapters 13 to 17.
Cost of Capital 20 – 2
MULTIPLE CHOICE QUESTIONS
1. Which of the following is the least permanent source of capital for a firm?
a) A 10% coupon bond purchased 3 years ago
b) Preferred shares
c) 10% coupon bonds issued 10 years ago
d) Accounts payable
2. Argus Mining Company is financed by $2 million in debt (yield of 8%) and $1 million in equity
(returning a rate of 22%). If we assume no taxes and perpetual cash flows, what level of
earnings must Argus Mining Company earn in order to be considered a value-creating
company?
a) $0.38 million
b) $0.40 million
c) $0.52 million
d) $0.63 million
3. Which of the following statements is incorrect regarding the equity portion of the WACC?
a) Preferred equity is separate from common equity
b) Market values rather than book values should be used
c) Retained earnings is not included
d) Equity has a tax shield as well as debt
4. Using the following information, determine the debt-to-equity ratio for Montreal Computing
Power Company.
Balance sheet of Montreal Computing Power Company:
Cash and marketable securities 75 Accruals 100
Inventory 350 Accounts payable 350
Prepaid expenses 150 Short-term debt 250
Other current assets 1,500 Other current liabilities 500
Net fixed assets 3,925 Long-term debt 2,800
Shareholders’ equity 2,000
Total assets 6,000 Total liabilities and shareholders’ equity 6,000
a) 1.400
b) 1.525
c) 1.775
d) 1.950
5. Using the following information, determine the market-to-book ratio for Montreal Computing
Power Company.
Balance sheet of Montreal Computing Power Company:
Cash and marketable securities 75 Accruals 100
Inventory 350 Accounts payable 350
Prepaid expenses 150 Short-term debt 250
Other current assets 1,500 Other current liabilities 500
Net fixed assets 3,925 Long-term debt 2,800
Shareholders’ equity 2,000
Total assets 6,000 Total liabilities and shareholders’ equity 6,000
Montreal Computing Power Company has 1,000 common shares outstanding. The shares were
issued 10 years ago at $4 per share and currently trade at a price of $3.
a) 0.667
b) 0.933
c) 1.400
d) 1.500
6. The required rate of return on Montreal Computing Power’s equity is 15 percent and the yield
on their debt is 7 percent. There are no taxes and all cash flows are perpetuities. If the value of
the debt is $1,000 and value of the equity is $1,000, what level of earnings must Montreal
Computing Power earn in order to support the current valuation?
a) $290
b) $300
c) $330
d) $220
7. Use the following statements to answer this question:
I. Regulated industries offer their shareholders a limited required rate of return.
II. Regulated industries have a very low level of debt.
a) I and II are correct.
b) I and II are incorrect.
c) I is correct and II is incorrect.
d) I is incorrect and II is correct.
8. Which one of the following is true about book and market values?
a) Book-to-market values provide information about the efficient use of assets.
b) A high book to market ratio is well perceived by the market.
c) If the return on equity is lower than the required rate of return, the market-to-book ratio will
decrease.
20 – 5 Test Bank for Introduction to Corporate Finance, Fourth Canadian Edition
d) Determining prices in regulated industries depends on the market value of assets.
9. Which of the following is not needed to determine a firm’s WACC?
a) The book value of the equity.
b) The market value of the debt.
c) The current share price.
d) The current yield on preferred shares.
10. MinMax Corp has the following capital structure: 55% equity (giving a return of 9%), 10%
preferred shares (with a yield of 6%), and 35% debt (with a coupon rate of 10% and yield to
maturity of 6.5%). If there are no taxes, what is the firm’s WACC?
a) 10.333%
b) 9.050%
c) 7.825%
d) 6.915%
11. In the same question above, what would be the WACC if taxes are included at a corporate
tax rate of 40%?
a) 10.333%
b) 9.050%
c) 7.825%
Cost of Capital 20 – 6
d) 6.915%
12. A firm has a capital structure that uses 45 percent equity, 20 percent preferred shares, and
35 percent debt. The preferred shares have a current yield of 5.5 percent. The debt has a
coupon rate of 10 percent and a current yield to maturity of 6.5 percent. The common shares
have a yield of 8 percent. There are no taxes. What is the firm’s WACC?
a) 6.575%
b) 6.975%
c) 7.275%
d) 8.200%
13. Use the following statements to answer this question:
I. Without taxes, the benefit of having debt on the WACC largely vanishes.
II. Preferred shares cost the same as common equity financing.
a) I and II are correct.
b) I and II are incorrect.
c) I is correct and II is incorrect.
d) I is incorrect and II is correct.
14. A firm has a capital structure that uses 45 percent equity, 20 percent preferred shares, and
35 percent debt. The preferred shares have a current yield of 5.5 percent. The debt has a
coupon rate of 10 percent and a current yield to maturity of 6.5 percent. The common shares
20 – 7 Test Bank for Introduction to Corporate Finance, Fourth Canadian Edition
have a yield of 8 percent. The tax rate is 25 percent. What is the firm’s WACC?
a) 5.231%
b) 6.700%
c) 6.406%
d) 6.975%
15. An analyst has obtained the following information about Maudite Brewers Co.: Book value of
assets $25,000; book value of common equity $10,000; book value of preferred shares $5,000.
The company has 4,000 common shares outstanding which are currently trading at $5 per
share. The company has 3,000 preferred shares outstanding which are currently trading at $2
per share. The yield on the debt equals the coupon rate. The weights used to determine the
weighted average cost of capital are:
Common Equity: Preferred Equity: Debt:
a) 55.56% 16.67% 27.77%
b) 40% 20% 40%
c) 80% 10% 10%
d) Cannot be determined because we need the market value of debt.
16. A firm has 2 million shares outstanding, which are currently trading at $45 per share and
have a dividend yield of 10 percent. The firm also has $40 million of 6 percent bonds
outstanding that are currently trading at 110, with a yield to maturity of 3 percent. There are no
preferred shares and no taxes. What is the WACC?
a) 7.70%
b) 7.85%
c) 8.69%
d) 8.77%
17. A firm has 2 million shares outstanding, which are currently trading at $45 per share and
have a dividend yield of 10 percent. The firm also has $40 million of 6 percent bonds
outstanding that are currently trading at 110 with a 5-year maturity. There are no preferred
shares and no taxes. What is the WACC?
a) 7.70%
b) 7.85%
c) 7.95%
d) 8.77%
18. A firm’s cost of debt can best be estimated:
a) by adding a risk premium to the coupon rate.
b) using the yield–to-maturity on newly issued debt of other firms.
c) using the firm’s borrowing rate on short-term loans.
d) using the yield–to–maturity on the firm’s outstanding debt.
19. In estimating a firm’s cost of debt, which of the following should be used?
a) The yield to maturity when the bonds were issued.
b) The yield to maturity of the bonds based on current bond prices.
c) The coupon rate payable on the bonds.
d) None of the above.
20. Greengrocer Foods will pay a dividend of $3.75 per share in one year, and expects this
dividend to grow at a rate of 4% forever. If its common shares are currently trading at $50, what
is the cost of Greengrocer Foods’ equity?
a) 7.50%
b) 11.50%
c) 12.25%
d) 15.75%
21. Which of the following statements is/are true about the marginal cost of capital?
a) It is the weighted average cost of the next dollar of financing raised.
b) For most levels of financing, it equals the weighted average cost of capital.
c) It exceeds the weighted average cost of capital due to flotation costs.
d) All of the above are true.
22. Which of the following is most relevant for estimating a firm’s cost of debt?
a) The yield to maturity at issuance.
b) The return bondholders would demand for new debt.
c) The coupon rate on existing debt.
d) None of the above is relevant.
23. Use the following statements to answer this question:
I. The cost of debt of the firm is always constant.
II. The estimation of the cost of debt using the yield to maturity requires the price of the bonds
now.
a) I and II are correct.
b) I and II are incorrect.
c) I is correct and II is incorrect.
d) I is incorrect and II is correct.
24. If a firm’s debt–to-equity ratio is 3, what is the weighted average cost of capital for the firm if
the required rate of return is 12.4 percent and cost of debt is 8.4 percent?
a) 11.4%
b) 11.06%
c) 9.73%
d) 9.4%
25. When determining the costs of each component of a firm’s capital structure, the firm must
evaluate the:
a) marginal cost of new funds
b) total cost of new funds
c) average cost of new funds
d) average cost of old and new funds
26. The cost of a security to a company may differ from the security’s yield in the capital
20 – 11 Test Bank for Introduction to Corporate Finance, Fourth Canadian Edition
markets due to:
I. Flotation costs
II. Agency costs
III. Taxes
a) I only
b) I and II only
c) I and III only
d) I and II and III
27. Toronto Skaters Company is an all-equity company and is able to fund a $1 million
investment using cash. The company has a beta of 1.4, the risk-free rate is 3 percent, and the
return on the market is 8 percent. Flotation costs for new equity are 3 percent. The tax rate is
zero. The appropriate cost of capital is:
a) 0% as the firm is using cash.
b) 0% as the firm is using funds that have already been raised from the capital markets.
c) The required return on the outstanding equity.
d) The cost of equity taking into account the flotation costs.
28. Toronto Skaters Company is an all-equity company and is able to fund a $1 million
investment using cash. The company has a beta of 1.4, the risk-free rate is 3 percent, and the
return on the market is 8 percent. Flotation costs for new equity are 2 percent. The tax rate is 40
percent. What is the WACC of the investment?
a) 14.2%
b) 10%
c) 8%
d) 6.6%
29. Laurentide Union Bank is expected to pay a dividend of $4.20 per share in one year. The
dividend is expected to grow at a rate of 5 percent forever. If the current market price for a share
of Laurentide Union Bank is $40, what is the cost of equity?
a) 5.00%
b) 9.52%
c) 10.50%
d) 15.50%
30. The long-term debt of Laurentide Union Bank is currently selling for 103 percent of its face
value. The issue matures in 20 years and pays an annual coupon of 8 percent of face. The
corporate tax rate is 40 percent. What is the after-tax cost of debt for Laurentide Union?
a) 3.08%
b) 4.62%
c) 4.80%
d) 7.70%
31. James Bay Water Park Company’s preferred shares pay an annual dividend of $3 per
share. What is the cost of preferred stock if the current price is $80 per share and after-tax
flotation costs are $6 per share?
a) 4.05%
b) 3.75%
c) 7.50%
d) 7.79%
32. Poutine Company is considering offering long-term contracts to many of its non-contract
employees (a switch to fixed labour costs from variable labour costs). What is the impact of this
decision?
a) The increase in operating leverage results in greater variability in operating income.
b) The increase in operating leverage results in less variability in operating income.
c) The decrease in operating leverage results in greater variability in operating income.
d) The decrease in operating leverage results in less variability in operating income.
33. The management of James Bay Water Park is concerned about the volatility of the firm’s net
income. In order to reduce this volatility, they are planning on issuing new shares to repurchase
debt and to enter into more fixed contracts with suppliers. The effect of these actions is likely to
be:
a) A reduction of volatility of net income due to the reduction in financial leverage.
b) An increase in volatility of net income due to the reduction in financial leverage.
c) A reduction of volatility of net income due to the reduction in financial leverage and increase
in operating leverage.
d) The impact on the volatility of net income is unclear as the effects of the reduction in financial
leverage and increase in operating leverage are opposite.
34. A company with a capital structure having a D/E ratio of 0.5 has:
a) 66.66% debt
b) 66.66% equity
c) 33.33% equity
d) 50.00% debt