Cost of Capital 20 – 14
35. If a company increases the proportion of debt in a firm’s capital structure, then:
a) the increased debt is not covered by the tax shield.
b) holders of common shares will expect a higher rate of return
c) the company’s equity beta will decrease
d) the firm’s WACC remains unchanged.
36. Use the following statements to answer this question:
I. The source of volatility in operating income is caused by fixed costs.
II. Operating leverage does not necessarily increase with increases in the volatility of net
income.
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.
37. Toronto Skaters Co. has a return on equity of 8 percent and pays out 20 percent of its
earnings in dividends. The expected growth in dividends is:
a) 1.6%
b) 6.4%
c) 8%
d) 20%
20 – 15 Test Bank for Introduction to Corporate Finance, Fourth Canadian Edition
38. According to The Boston Consulting Group, a star is characterized by:
a) High present value of operations now and low present value of growth opportunities
b) High present value of operations now and high present value of growth opportunities
c) Low present value of operations now and low present value of growth opportunities
d) Low present value of operations now and high present value of growth opportunities
39. The return on equity of KillerApps Inc. is 20 percent of which it pays out 30 percent as
dividends, and reinvests the rest in the company. The company is expected to pay a dividend of
$1.50 next year and the current stock price is $30. The cost of equity of KillerApps is:
a) 15%
b) 17%
c) 19%
d) 21%
40. According to The Boston Consulting Group, a firm with a low present value of existing
operations but a high present value of growth opportunities would be classified as:
a) A dog
b) A cash cow
c) A star
d) A turnaround firm
41. According to The Boston Consulting Group, a cash cow is characterized by:
a) High present value of existing operations and low present value of growth opportunities
b) High present value of existing operations and high present value of growth opportunities
c) Low present value of existing operations and low present value of growth opportunities
d) Low present value of existing operations and high present value of growth opportunities
42. The manager of Montreal Trustco has noticed that as he increases the dividend payout
ratio, the value of the firm’s equity declines. This is most likely due to:
a) The firm’s return on equity is lower than the required return on equity
b) The firm’s return on equity is higher than the required return on equity
c) The firm’s return on equity is equal to the required return on equity
d) None of the above is a likely explanation
43. The manager of Montreal Trustco has noticed that as he increases the dividend payout
ratio, the value of the firm’s equity increases. This is most likely due to:
a) The firm’s return on equity is lower than the required return on equity
b) The firm’s return on equity is higher than the required return on equity
c) The firm’s return on equity is equal to the required return on equity
d) None of the above is a likely explanation.
44. Use the following statements to answer this question:
I. A firm’s growth depends on its reinvestment opportunities.
II. Increasing the firm’s retention ratio does not always increase the value of the firm.
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.
45. Montreal Trustco expects to pay a dividend of $5 next year. Dividends are expected to grow
at 3 percent forever and the market requires a rate of return of 7 percent on its stock. Montreal
Trustco can issue new stock at $125 per share with flotation costs of $20 per share. The tax
rate is zero. The cost of issuing new equity to Montreal Trustco is:
a) 3.00%
b) 7.00%
c) 7.76%
d) 11.76%
46. The Third Cup Company has a return on equity of 10 percent and pays out 30 percent of its
earnings as dividends. The company is expected to pay a dividend of $2 next year and the
current stock price is $20. The cost of equity of The Third Cup Company is:
a) 17%
b) 13%
c) 10%
d) 7%
47. The Third Cup Company has just paid a dividend of $3 per share. The dividends are
expected to grow at a rate of 4 percent per year forever. The current stock price is $25 per
share. The firm faces a tax rate of 40 percent and flotation costs of 5 percent on new stock
issues. The cost of equity for internal funds is:
a) 9.89%
b) 10.12%
c) 16.48%
d) 16.87%
48. The Third Cup Company has just paid a dividend of $3 per share. The dividends are
expected to grow at a rate of 4 percent per year forever. The current stock price is $25 per
share. The firm faces a tax rate of 40 percent and flotation costs of 5 percent on new stock
issues. The cost of equity for new funds is:
a) 9.89%
b) 10.12%
c) 16.48%
d) 16.87%
49. The Montreal Film Festival Company has a book value per share of $10 and a current return
on equity of 7 percent. The firm expects to invest $100 next year and earn a return of 10 percent
on that investment. The market requires a rate of return of 5 percent on the firm’s equity. The
present value of existing opportunities and the present value of growth opportunities are:
a) PVEO = $95.24; PVGO = $14.00
20 – 19 Test Bank for Introduction to Corporate Finance, Fourth Canadian Edition
b) PVEO = $14.00; PVGO = $95.24
c) PVEO = $10.00; PVGO = $100.00
d) PVEO = $100.00; PVGO = $10.00
50. The Saguenay Tourism Company has a beta of 1.30, the risk-free rate is 3 percent, and the
return on the market is 4 percent. The required return on the firm’s equity is:
a) 3.9%
b) 6.5%
c) 4.30%
d) 9.50%
51. The current T-Bill rate is 3%, and the market risk premium is 9%. If Arabica Coffee
Company has a beta of 1.75, its required return on equity is:
a) 9.0%
b) 13.50%
c) 15.75%
d) 18.75%
52. Activa Sports Gyms is considering a project that is virtually risk-free. It has a beta of 1.5 and
a D/E ratio of 0.6. The appropriate discount rate to use in analyzing this project is:
a) The cost of equity computed from its beta.
Cost of Capital 20 – 20
b) The adjusted WACC based on a beta of 1.0.
c) The WACC based on market values.
d) The Treasury-bill rate.
53. The Saguenay Tourism Company has a beta of .80, the risk-free rate is 4 percent, and the
market risk premium is 6 percent. The required return on the firm’s equity is:
a) 4.0%
b) 5.6%
c) 8.8%
d) 6.0%
54. The Saguenay Tourism 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 2 percent, and the
return on the market is 8 percent. Flotation costs for new equity are 5 percent. The tax rate is
zero. The appropriate cost of capital is:
a) 0.00%
b) 5.00%
c) 10.40%
d) Greater than 10.40%
55. Use the following statements to answer this question:
I. The WACC is the most appropriate rate to discount future cash flows of average risk.
20 – 21 Test Bank for Introduction to Corporate Finance, Fourth Canadian Edition
II. The investment opportunities schedule uses WACC as a threshold for investment.
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.
56. The CFO of Cynergy Inc. decides to recalculate the company’s WACC based on higher
growth expectations for the firm, thus making the new WACC:
a) Lower than the previous WACC because the cost of debt decreases.
b) Lower than the previous WACC because the cost of equity decreases.
c) Higher than the previous WACC because the cost of debt increases.
d) Higher than the previous WACC because the cost of equity increases.
57. Cynergy Inc. currently has a debt-equity ratio of 0.70, an after-tax cost of debt of 7.5%, and
a cost of equity of 14%. If the firm changes its debt-equity ratio to 0.40, it will:
a) Decrease the firm’s WACC.
b) Increase the firm’s total debt.
c) Cause the NPV of projects under consideration to decrease.
d) Not have an effect on the firm’s capital budgeting decisions.
Cost of Capital 20 – 22
PRACTICE PROBLEMS
58. Laurentide Resort has just paid a dividend of $3. The current stock price is $25. The beta of
the company is 1.3, the risk-free rate is 2 percent, and the market risk premium is 6 percent.
The firm earns a return on equity of 10%. Is this a growth firm?
59. Toronto Skaters Company has a D/E ratio of 1.5. The company has 1,000 shares
outstanding and a beta of 1.2. The risk-free rate is 3 percent and the market risk premium is 5
percent. The company has 10-year debt with a face value of $1 million and annual coupons of 4
percent. The debt is currently trading at 105. The tax rate is 35 percent. Calculate the weighted
average cost of capital for Toronto Skaters Company.
Answer:
60. A firm is going to finance a new project 100 percent with debt, through a new bond issue.
Since the firm is only using debt to finance the project, the NPV of the project should be
calculated using the cost of debt as the discount rate. Is this statement true, false, or uncertain?
Explain.
61. What is the cost of internally generated funds?
62. Explain the reasoning behind the Fed’s stock valuation model and how it estimates the
overvaluation or undervaluation of the stock market.
63. Pataty Patata Company is considering a project that costs $1 million. The project will
generate constant perpetual earnings. The firm has just paid a dividend of $5 and dividends are
expected to be constant forever. The current value of one share is $25. The firm has 100,000
shares outstanding. The firm also has perpetual debt with a market value of $3 million and
annual coupons of $300,000. The firm pays taxes at the rate of 35%. The firm will not need to
issue new securities to finance the project. Determine the minimum annual cash flows that must
be generated by the project in order for the project to be undertaken. Demonstrate that the
project will satisfy the requirements of the capital providers.
Answer:
Cost of Capital 20 – 24
64. Multiplex Entertainment has 9 million shares outstanding, 250,000 shares of 6% preferred
stock, and 105,000 semi-annual bonds at 7.5% (with par value of $1000 each). Common stock
sells at $34/share (beta 1.25), preferred stock at $91/share, and the bonds at 93% of par with
15 years to maturity. The market risk premium is 8.5%, T-Bills are yielding 5%, and the
corporate tax rate is 35%. What is the Multiplex Entertainment’s WACC?
If Multiplex Entertainment is evaluating a new investment project with the same risk as the firm’s
typical projects, what should the firm use to discount the project’s cash flows?
20 – 25 Test Bank for Introduction to Corporate Finance, Fourth Canadian Edition
Cost of Capital 20 – 26
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