Foundations of Finance, 7e (Keown/Martin/Petty)
Chapter 9 The Cost of Capital
9.1 Learning Objective 1
1) In order to create value a corporation must earn a rate of return on its invested capital that is
higher than the market’s required rate of return on that invested capital.
2) The cost of capital is the rate that must be earned on an investment project if the project is to
increase the value of the common shareholders’ investment.
3) The firm’s cost of capital may also be referred to as the firm’s opportunity cost of capital.
4) The firm’s cost of capital is important when evaluation the firm’s overall value, but should not
be used to evaluate individual projects which have their own unique characteristics.
5) The cost of debt increases relative to the investor’s required return due to flotation costs, but
decreases relative to the investor’s required return due to the tax deductibility of interest.
6) Higher flotation costs will result in all of the following except:
A) higher after-tax cost of debt
B) higher weighted average cost of capital
C) higher cost of retained earnings
D) higher cost of common equity when new common shares are sold
9.2 Learning Objective 2
1) Flotation costs cause a corporation’s cost of capital to be lower than its investors’ required
returns.
2) The cost of a particular source of capital (debt, preferred stock, common stock) is equal to the
investor’s required rate of return after adjusting for the effects of both flotation costs and
corporate taxes.
3) The cost of debt capital is obtained by substituting the net proceeds per bond for the bond
price in the bond valuation equation and solving for the required return.
4) The cost of preferred stock is equal to the preferred stock dividend divided by the net proceeds
per preferred share.
5) A corporation’s cost of common equity may be estimated using either a dividend valuation
model or the capital asset pricing model.
6) Corporations have two costs of common equity, one for retained earnings and one if the
company issues new common stock.
7) The Capital Asset Pricing Model may be used to estimate the cost of retained earnings.
8) A reasonable estimate of the market risk premium based on historical data and expert opinion
is between 5% and 7%.
9) The market risk premium remains constant over time because the risk free rate of return
moves inversely with beta.
10) A firm’s cost of capital is the required rate of return on the firm’s average project.
11) The firm financed completely with equity capital has a cost of capital equal to the required
return on common stock.
12) The after-tax cost of equity equals one minus the marginal tax rate times the required rate of
return on common stock.
13) If preferred stock pays a $5 annual dividend and sells for $50 the cost of preferred stock
financing is 10% since dividends are not tax deductible and preferred stock is sold without
flotation costs.
14) Other things equal, management should retain profits only if the company’s investments
within the firm are at least as attractive as the stockholders’ other investment opportunities.
15) Financing with new common stock is generally more costly than financing with retained
earnings due to increasing tax rates.
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16) The firm’s best financial structure is determined by finding the capital structure that
minimizes the firm’s cost of capital.
17) The required return of a preferred stockholder, rps, is higher than the cost of preferred stock
for the corporation because stockholder’s must pay federal taxes on their dividend income.
18) Investors require higher rates of return to compensate for purchasing power losses resulting
from inflation.
19) A security with a reasonably stable price will have a lower required rate of return than a
security with an unstable price.
20) The cost of internal common equity is already on an after-tax basis since dividends paid to
common stockholders are not tax deductible.
21) A short-term T-bill’s rate of return should be used in the CAPM formula to determine the
cost of equity capital regardless of the length of the project under consideration.
22) The capital asset pricing model uses three variables to evaluate required returns on common
equity: the risk free rate, the beta coefficient, and the market risk premium.
23) The investor’s required rate of return will equal the firm’s cost of capital if corporate
transactions costs are taken into account.
24) The cost of debt measures the cost of a bank loan, while the cost of preferred stock is used as
a proxy for the cost of a new bond issue.
25) Preferred dividends are paid with before-tax dollars because the dividend rate is known,
whereas common stock dividends are paid with after-tax dollars.
26) An increase in a corporation’s marginal tax rate will cause the corporation’s after tax cost of
debt to increase, other things remaining the same.
27) Because investors like dividends, the higher the company’s dividend growth rate, the lower
the company’s cost of common equity.
28) An increase in a corporation’s marginal tax rate will decrease the corporation’s cost of debt,
but have no impact on its cost of preferred stock or cost of common equity.
29) Two factors that cause the investor’s required rate of return to differ from the company’s cost
of capital are
A) taxes and risk.
B) transactions costs and risk.
C) taxes and transactions costs.
D) risk and opportunity cost differences.
30) Two considerations that cause a corporation’s cost of capital to be different than its investors’
required returns are
A) corporate taxes and flotation costs.
B) individual taxes and corporate taxes.
C) individual taxes and dividends.
D) corporate taxes and the earned income tax credit.
31) Due to changes in regulatory requirements, the transactions costs associated with selling
corporate securities increased by $1 per share. This change will
A) cause the cost of capital to decrease.
B) cause the cost of capital to increase.
C) have no effect on the cost of capital because transactions costs are expensed immediately.
D) cause the cost of capital to decrease only if investors may be billed for part of the increase in
transactions costs.
32) Jones Distributing Corp. can sell common stock for $27 per share and its investors require a
17% return. However, the administrative or flotation costs associated with selling the stock
amount to $2.70 per share. What is the cost of capital for Jones Distributing if the corporation
raises money by selling common stock?
A) 27.00%
B) 18.89%
C) 18.33%
D) 17.00%
33) A company has preferred stock that can be sold for $21 per share. The preferred stock pays
an annual dividend of 3.5% based on a par value of $100. Flotation costs associated with the sale
of preferred stock equal $1.25 per share. The company’s marginal tax rate is 35%. Therefore, the
cost of preferred stock is:
A) 18.87%.
B) 17.72%.
C) 14.26%.
D) 12.94%.
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34) Asian Trading Company paid a dividend yesterday of $5 per share (D0 = $4). The dividend
is expected to grow at a constant rate of 8% per year. The price of Asian Trading Company’s
stock today is $29 per share. If Asian Trading Company decides to issue new common stock,
flotation costs will equal $2.50 per share. Asian Trading Company’s marginal tax rate is 35%.
Based on the above information, the cost of retained earnings is
A) 28.38%.
B) 24.12%.
C) 26.62%.
D) 31.40%.
35) Asian Trading Company paid a dividend yesterday of $5 per share (D0 = $4). The dividend
is expected to grow at a constant rate of 8% per year. The price of Asian Trading Company’s
stock today is $29 per share. If Asian Trading Company decides to issue new common stock,
flotation costs will equal $2.50 per share. Asian Trading Company’s marginal tax rate is 35%.
Based on the above information, the cost of new common stock is
A) 28.38%.
B) 24.12%.
C) 26.62%.
D) 31.40%.
36) In general, which of the following rankings, from highest to lowest cost, is most accurate?
A) cost of new common stock, cost of preferred stock, cost of debt, cost of retained earnings
B) cost of debt, cost of preferred stock, cost of new common stock, cost of retained earnings
C) cost of new common stock, cost of retained earnings, cost of preferred stock, cost of debt
D) cost of preferred stock, cost of new common stock, cost of retained earnings, cost of debt
37) The risk free rate of return is 2.5% and the market risk premium is 8%. Penn Trucking has a
beta of 2.2 and a standard deviation of returns of 28%. Penn Trucking’s marginal tax rate is 35%.
Analysts expect Penn Trucking’s dividends to grow by 6% per year for the foreseeable future.
Using the capital asset pricing model, what is Penn Trucking’s cost of retained earnings?
A) 16.4%
B) 17.7%
C) 19.6%
D) 20.1%
38) A company has preferred stock with a current market price of $18 per share. The preferred
stock pays an annual dividend of 4% based on a par value of $100. Flotation costs associated
with the sale of preferred stock equal $1.50 per share. The company’s marginal tax rate is 40%.
Therefore, the cost of preferred stock is
A) 28.80%.
B) 24.24%.
C) 22.22%.
D) 14.55%.
39) KayCee Manufacturing Company paid a dividend yesterday of $3.50 per share. The dividend
is expected to grow at a constant rate of 10% per year. The price of KayCee’s common stock
today is $40 per share. If KayCee decides to issue new common stock, flotation costs will equal
$4.00 per share. Kaycee’s marginal tax rate is 35%. Based on the above information, the cost of
retained earnings is
A) 26.41%.
B) 20.09%.
C) 19.63%.
D) 17.55%.
40) KayCee Manufacturing Company paid a dividend yesterday of $3.50 per share. The dividend
is expected to grow at a constant rate of 10% per year. The price of KayCee’s common stock
today is $40 per share. If Kaycee decides to issue new common stock, flotation costs will equal
$4.00 per share. Kaycee’s marginal tax rate is 35%. Based on the above information, the cost of
new common stock is
A) 26.41%.
B) 20.09%.
C) 19.63%.
D) 17.55%.
41) The risk free rate of return is 3% and the expected return on the market portfolio is 14%.
Starship Enterprises has a beta of 2.0 and a standard deviation of returns of 26%. Starship’s
marginal tax rate is 35%. Analysts expect Starship’s net income to grow by 12% per year for the
next 5 years. Using the capital asset pricing model, what is Starship Enterprises’ cost of retained
earnings?
A) 18.6%
B) 21.2%
C) 22.8%
D) 25.0%
42) Jiffy Co. expects to pay a dividend of $3.00 per share in one year. The current price of Jiffy
common stock is $60 per share. Flotation costs are $3.00 per share when Jiffy issues new stock.
What is the cost of internal common equity (retained earnings) if the long-term growth in
dividends is projected to be 8 percent indefinitely?
A) 13 percent
B) 14 percent
C) 15 percent
D) 16 percent
43) The average cost associated with each additional dollar of financing for investment projects
is
A) the incremental return.
B) the marginal cost of capital.
C) CAPM required return.
D) the component cost of capital.
44) A firm’s cost of capital is influenced by
A) the current ratio.
B) par value of common stock.
C) capital structure.
D) net income.
45) Clanton Company is financed 75 percent by equity and 25 percent by debt. If the firm
expects to earn $30 million in net income next year and retain 40% of it, how large can the
capital budget be before common stock must be sold?
A) $7.5 million
B) $12.0 million
C) $15.5 million
D) $16.0 million
46) The cost of new preferred stock is equal to
A) the preferred stock dividend divided by the market price.
B) the preferred stock dividend divided by its par value.
C) (1 – tax rate) times the preferred stock dividend divided by net price.
D) preferred stock dividend divided by the net selling price of preferred.
47) In general, the least expensive source of capital is
A) debt.
B) new common stock.
C) preferred stock
D) retained earnings.
48) The cost of external equity capital is greater than the cost of retained earnings because of:
A) flotation costs on new equity.
B) increasing marginal tax rates.
C) higher dividends.
D) greater risk for shareholders.
49) Seafood Products Corp. is expected to pay a dividend of $2.60 next year. Dividends are
expected to grow at a constant rate of 8% per year, and the stock price is currently $20.00. New
stock can be sold at this price subject to flotation costs of 15%. The company’s marginal tax rate
is 35%. Compute the cost of internal equity (retained earnings) and the cost of external equity
(new common stock), respectively.
A) 0, 21.00%
B) 8.00%, 23.29%
C) 21.00%, 23.29%
D) 23.00%, 25.48%
50) DEF Company’s preferred stock is currently selling for $28.00, and pays a perpetual annual
dividend of $2.00 per share. Underwriters of a new issue of preferred stock would charge $3 per
share in flotation costs. The firm’s tax rate is 40%. Compute the cost of new preferred stock for
DEF.
A) 4.80%
B) 7.14%
C) 8.00%
D) 9.15%
51) Atlas Corporation wishes to estimate its cost of retained earnings. The firm’s beta is 1.3. The
rate on 6-month T-bills is 2%, and the return on the S&P 500 index is 15%. What is the
appropriate cost for retained earnings in determining the firm’s cost of capital?
A) 17.0%
B) 19.5%
C) 18.9%
D) 22.1%
52) In capital budgeting analysis, when computing the weighted average cost of capital, the
CAPM approach is typically used to find which of the following?
A) Market value weight of equity
B) Pretax component cost of debt
C) After-tax component cost of debt
D) Component cost of internal equity
53) The cost of retained earnings is less than the cost of new common stock because
A) marginal tax brackets increase.
B) flotation costs are incurred when new stock is issued.
C) dividends are not tax deductible.
D) accounting rules allow a deduction when using retained earnings.
54) Which of the following differentiates the cost of retained earnings from the cost of newly-
issued common stock?
A) The cost of the pre-emptive rights held by existing shareholders.
B) The greater marginal tax rate faced by the now-larger firm.
C) The flotation costs incurred when issuing new securities.
D) The larger dividends paid to the new common stockholders.
55) Five Rivers Casino is undergoing a major expansion. The expansion will be financed by
issuing new 15-year, $1,000 par, 9% annual coupon bonds. The market price of the bonds is
$1,070 each.Five Rivers flotation expense on the new bonds will be $50 per bond. Five Rivers
marginal tax rate is 35%. What is the yield to maturity on the newly-issued bonds?
A) 6.95%
B) 7.99%
C) 8.17%
D) 9.82%
56) Five Rivers Casino is undergoing a major expansion. The expansion will be financed by
issuing new 15-year, $1,000 par, 9% annual coupon bonds. The market price of the bonds is
$1,070 each. Gamblers flotation expense on the new bonds will be $50 per bond. Gamblers
marginal tax rate is 35%. What is the pre-tax cost of debt for the newly-issued bonds?
A) 8.76%
B) 8.12%
C) 7.49%
D) 10.25%
57) General Bill’s will issue preferred stock to finance a new artillery line. The firm’s existing
preferred stock pays a dividend of $4.00 per share and is selling for $40 per share. Investment
bankers have advised General Bill that flotation costs on the new preferred issue would be 5% of
the selling price. The General’s marginal tax rate is 30%. What is the relevant cost of new
preferred stock?
A) 7.00%
B) 7.37%
C) 10.00%
D) 10.53%
E) 15.00%
58) Kelly Corporation will issue new common stock to finance an expansion. The existing
common stock just paid a $1.50 dividend, and dividends are expected to grow at a constant rate
8% indefinitely. The stock sells for $45, and flotation expenses of 5% of the selling price will be
incurred on new shares. What is the cost of new common stock be for Kelly Corp.?
A) 11.33%
B) 11.51%
C) 11.60%
D) 11.79%
E) 12.53%
59) Kelly Corporation will issue new common stock to finance an expansion. The existing
common stock just paid a $1.50 dividend, and dividends are expected to grow at a constant rate
8% indefinitely. The stock sells for $45, and flotation expenses of 5% of the selling price will be
incurred on new shares. What is the cost of retained earnings for Kelly Corp.?
A) 11.33%
B) 11.51%
C) 11.60%
D) 11.79%
E) 12.53%
60) Which of the following statements is most correct?
A) Because the cost of debt is lower than the cost of equity, value-maximizing firms maintain
debt ratios of close to 100%.
B) Corporations that are 100% equity financed will have a much lower weighted average cost of
capital because the lack of debt lowers their risk of bankruptcy.
C) The source of capital with the lowest after-tax cost is preferred stock, because it is a hybrid
security, part debt and part equity.
D) The cost of a particular source of capital is equal to the investor’s required rate of return after
adjusting for the effects of both flotation costs and corporate taxes.
61) All else equal, an increase in beta results in
A) an increase in the cost of retained earnings.
B) an increase in the cost of newly issued common stock .
C) an increase in the after-tax cost of debt.
D) an increase in the cost of common equity, whether or not the funds come from retained
earnings or newly issued common stock.
62) Royal Mediterranean Cruise Line’s common stock is selling for $22 per share. The last
dividend was $1.20, and dividends are expected to grow at a 6% annual rate. Flotation costs on
new stock sales are 5% of the selling price. What is the cost of Royal’s retained earnings?
A) 5.73%
B) 11.45%
C) 11.78%
D) 12.09%
63) Royal Mediterranean Cruise Line’s common stock is selling for $22 per share. The last
dividend was $1.20, and dividends are expected to grow at a 6% annual rate. Flotation costs on
new stock sales are 5% of the selling price. What is the cost of Royal’s new common stock?
A) 5.73%
B) 11.45%
C) 11.78%
D) 12.09%
64) New Jet Airlines plans to issue 14-year bonds with a par value of $1,000 that will pay $60
every six months. The bonds have a market price of $1,220. Flotation costs on new debt will be
4% of the selling price. If the firm has a 35% marginal tax bracket, compute the following:
a. Yield to maturity of debt
b. After-tax cost of existing debt
c. After-tax cost of new debt
65) Alarm Systems Corporation’s preferred stock pays a dividend of $3.60 and sells for $28.00.
Alarm Systems Corporation has a marginal tax rate of 35%. What is the cost of preferred
financing?
66) NewLinePhone Corp. is very risky, with a beta equal to 2.8 and a standard deviation of
returns of 32%. The risk free rate of return is 3% and the market risk premium is 8%.
NewLinePhone’s marginal tax rate is 35%. Use the capital asset pricing model to estimate
NewLinePhone’s cost of retained earnings.
67) Dickerson Corporation’s common stock is currently selling for $38. Last year’s dividend was
$4.00 per share. Investors expect dividends to grow at an annual rate of 7 percent indefinitely.
Flotation costs of 4% will be incurred when new stock is sold.
a. What is the cost of internal common equity?
b. What is the cost of new common equity?
68) Last year Gator Getters, Inc. had $50 million in total assets. Management desires to increase
its plant and equipment during the coming year by $12 million. The company plans to finance 40
percent of the expansion with debt and the remaining 60 percent with equity capital. Bond
financing will be at a 9 percent rate and will be sold at its par value. Common stock is currently
selling for $50 per share, and flotation costs for new common stock will amount to $5 per share.
The expected dividend next year for Gator is $2.50. Furthermore, dividends are expected to grow
at a 6 percent rate far into the future. The marginal corporate tax rate is 34 percent. Internal
funding available from additions to retained earnings is $4,000,000.
a. What amount of new common stock must be sold if the existing capital structure is to be
maintained?
b. Calculate the weighted marginal cost of capital at an investment level of $12 million.
69) The common stock for El Viss Company currently sells for $20 per share. The firm just paid
a dividend of $1.50, and the dividend three years ago was $1.30. Dividends per share are
anticipated to grow at the same rate in the future as they have over the past three years. Flotation
costs for new shares will be 6% of the selling price. Calculate the following:
a. the cost of retained earnings
b. the cost of external equity capital