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Principles of Managerial Finance, 15e (Zutter)
Chapter 9 The Cost of Capital
9.1 Overview of the cost of capital
1) Holding risk constant, the implementation of projects with a rate of return above the cost of capital will
decrease the value of a firm, and vice versa.
2) The cost of common stock equity refers to the cost of the next dollar of financing necessary to finance a
new investment opportunity.
3) The target capital structure is the desired optimal mix of debt and equity financing that firms attempt
to achieve and maintain.
4) The cost of capital is the rate of return a firm must meet or exceed on investments to increase the firm's
value.
5) The cost of capital is used to decide whether a proposed corporate investment will increase or decrease
a firm's stock price.
6) The cost of capital reflects the cost of financing and is the minimum rate of return that a project must
earn to increase firm value.
7) The cost of capital acts as a major link between a firm's long-term investment decisions and the wealth
of the firm's owners as determined by the market value of their shares.
8) The cost of capital of each source of financing is the after-tax cost of obtaining the financing using the
historically based cost reflected by the existing financing on the firm's books.
9) A firm's flotation cost can be calculated by weighting the cost of each source of financing by its relative
proportion in a firm's target capital structure.
10) The cost of capital is a static concept and it is not affected by economic and firm-specific factors such
as business risk and financial risk.
11) The cost of capital is a dynamic concept and it is affected by economic and firm-specific factors such
as business risk and financial risk.
12) In using the cost of capital, it is important that it reflects the historical cost of raising funds over the
long run.
13) The ________ is the rate of return that a firm must earn on its investments in order to maintain the
market value of its stock.
A) yield to maturity
B) cost of capital
C) internal rate of return
D) modified internal rate of return
14) The ________ is the rate of return required by the market suppliers of capital in order to attract their
funds to the firm.
A) yield to maturity
B) internal rate of return
C) cost of capital
D) modified internal rate of return
15) Although a firm's existing mix of financing sources may reflect its target capital structure, it is
ultimately ________.
A) the internal rate of return that is relevant for evaluating the firm's future investment opportunities
B) the marginal cost of capital that is relevant for evaluating the firm's future investment opportunities
C) the risk-free rate of return that is relevant for evaluating the firm's future investment opportunities
D) the risk-free rate of return that is relevant for evaluating the firm's future financing opportunities
16) The ________ is a weighted average of the cost of funds which reflects the interrelationship of
financing decisions.
A) internal rate of return
B) sunk cost
C) cost of capital
D) risk-free rate
17) The ________ is the firm's desired optimal mix of debt and equity financing.
A) book value
B) market value
C) cost of capital
D) target capital structure
18) In order to recognize the interrelationship between financing and investments, a firm should use
________ when evaluating an investment.
A) the least costly source of financing
B) the most costly source of financing
C) the weighted average cost of all financing sources
D) the current opportunity cost
19) The four basic sources of long-term funds for a firm are ________.
A) current liabilities, long-term debt, common stock, and preferred stock
B) current liabilities, long-term debt, common stock, and retained earnings
C) long-term debt, paid-in capital in excess of par, common stock, and retained earnings
D) long-term debt, common stock, preferred stock, and retained earnings
20) Most firms finance their activities with a blend of debt and equity.
21) If you purchased the same percentage of each type of security that a firm issued, the expected return
on that portfolio of securities would equal the firm's weighted average cost of capital.
22) Which of the following is true of long-term funds?
A) They provide an easy way to reduce financing costs because they are relatively cheaper than short-
term funds.
B) They are a type of investment fund which invests in money market investments of high quality and
low risk.
C) They are the sources that supply the financing necessary to support a firm's capital budgeting
activities.
D) They are the funds available to a business on the basis of inventory held and require detailed
inventory tracking.
23) Which type of long-term funding is used by the fewest number of firms in the United States?
A) long-term debt
B) preferred stock
C) retained earnings
D) common stock
24) A firm finances its activities with both debt (that costs 8%) and equity (that costs 14%). The firm can
borrow additional funds at 8% if it so desires. A financial analyst at this firm argues that the firm should
undertake any investment that earns a return of at least 8% because such investments will enable the firm
to pay debtholders what they desire, and any earnings above 8% will go to stockholders. If a firm decides
to make investments based on this logic it will ________.
A) decline to make investments that it should undertake
B) undertake investments that it should decline
C) make only those investment decisions that increase shareholder value
D) have exorbitant interest expenses
25) Which of the following is a source of long-term funds?
A) commercial paper
B) retained earnings
C) factoring
D) money market instruments
26) A firm finances its activities with both debt (that costs 8%) and equity (that costs 14%). The firm can
borrow additional funds at 8% if it so desires. A financial analyst at this firm argues that the firm should
undertake only those investments that earn a return of at least 14% because only those investments will
increase shareholder value If a firm decides to make investments based on this logic it will ________.
A) decline to make investments that it should undertake
B) undertake investments that it should decline
C) make only those investment decisions that increase shareholder value
D) maximize its stock price
1) The marginal cost of capital is a relevant cost of capital for evaluating a firm's future investment
opportunities.
2) Generally the least expensive source of long-term capital is ________.
A) retained earnings
B) preferred stock
C) long-term debt
D) common stock
3) In general, floatation costs include two components, underwriting costs and administrative costs.
4) Flotation costs reduce the net proceeds from the sale of a bond whether sold at a premium, at a
discount, or at its par value.
5) The net proceeds used in calculation of the cost of long-term debt are funds actually received from the
sale after paying for flotation costs and taxes.
6) When the net proceeds from sale of a bond equal its par value, the before-tax cost would just equal the
coupon interest rate.
7) From a bond issuer's perspective, the IRR on a bond's cash flows is its yield to maturity (YTM); from
the investor's perspective, the IRR on a bond's cash flows is the cost to maturity.
8) The cost to maturity that a firm pays on its existing bonds equals the rate of return required by the
market.
9) The weighted average cost of capital represents the annual before-tax percentage cost of the debt.
10) A tax adjustment must be made in determining the cost of ________.
A) long-term debt
B) common stock
C) preferred stock
D) retained earnings
11) The ________ from the sale of a security are the funds actually received from the sale after ________.
A) gross proceeds; adding the after-tax costs
B) gross proceeds; reducing the flotation costs
C) net proceeds; reducing the flotation costs
D) net proceeds; adding the after-tax costs
12) The before-tax cost of debt for a 15-year, 10 percent, $1,000 par value bond selling at $950 is ________.
A) 10 percent
B) 10.7 percent
C) 12 percent
D) 15.4 percent
13) The before-tax cost of debt for a 10-year, 8 percent, $1,000 par value bond selling at $1,150 is ________.
A) 5.97 percent
B) 8.33 percent
C) 8.82 percent
D) 9 percent
14) The before-tax cost of debt for a firm, which has a marginal tax rate of 21 percent, is 12 percent. The
after-tax cost of debt is ________.
A) 12.00 percent
B) 2.52 percent
C) 9.48 percent
D) 7.20 percent
15) The specific cost of each source of long-term financing is based on ________ and ________ costs.
A) before-tax; historical
B) after-tax; historical
C) before-tax; book value
D) after-tax; current
16) When determining the after-tax cost of a bond, the face value of the issue must be adjusted to the net
proceeds amounts by considering ________.
A) the risks
B) the flotation costs
C) the approximate returns
D) the taxes
17) If a corporation faces a tax rate of 21 percent, the after-tax cost of debt for a 15-year, 12 percent, $1,000
par value bond, selling at $950 is ________.
A) 2.68 percent
B) 12.76 percent
C) 10.08 percent
D) 5.11 percent
18) If a corporation pays a tax rate of 21 percent, the after-tax cost of debt for a 10-year, 8 percent, $1,000
par value bond selling at $1,150 is ________.
A) 4.71 percent
B) 3.58 percent
C) 1.25 percent
D) 6.32 percent
19) The after-tax cost of debt for a 20-year, 7 percent, $1,000 par value bond selling at $960 (assume a
marginal tax rate of 40 percent) is ________.
A) 5.84 percent
B) 4.43 percent
C) 1.55 percent
D) 5.53 percent
20) Debt is generally the least expensive source of capital. This is primarily due to ________.
A) debt's fixed interest payments and finite maturity
B) the tax deductibility of dividends paid to shareholders
C) debt being less risky than equity and interest payments being tax deductible
D) the secured nature of a debt obligation
21) Nico Trading Corporation is considering issuing long-term debt. The debt would have a 30-year
maturity and a 10 percent coupon rate. In order to sell the issue, the bonds must be underpriced at a
discount of 5 percent of face value. In addition, the firm would have to pay flotation costs of 5 percent of
face value. The firm's tax rate is 21 percent. Given this information, the after-tax cost of debt for Nico
Trading would be ________.
A) 7.26%
B) 8.82%
C) 2.34%
D) 11.17%
22) Recently the corporate tax law in the U.S. changed so that firms that previously faced a marginal tax
rate of close to 40% now pay tax at a flat rate of 21%. Holding everything else constant, this reduction in
the tax rate faced by corporations ________.
A) increased the after-tax cost of debt
B) decreased the after-tax cost of debt
C) did not change the after-tax cost of debt
D) increased the value of the deduction for interest expense
23) Tangshan Mining is considering issuing long-term debt. The debt would have a 30 year maturity and
a 6 percent coupon rate and make semiannual coupon payments. In order to sell the issue, the bonds
must be underpriced at a discount of 1 percent of face value. In addition, the firm would have to pay
flotation costs of 1 percent of face value. The firm's tax rate is 21 percent. Given this information, the after-
tax cost of debt for Tangshan Mining would be ________.
A) 4.74%
B) 1.29%
C) 2.43%
D) 4.86%
9.3 Cost of preferred stock
1) Since preferred stock is a form of ownership, it has no maturity date.
2) Preferred stockholders must receive their stated dividends prior to the distribution of any earnings to
common stockholders and bondholders.
3) The amount of preferred stock dividends that must be paid each year may be stated in dollars or as a
percentage of the firm's earnings.
4) The cost of preferred stock is typically higher than the cost of long-term debt (bonds) because the cost
of long-term debt (interest) is tax deductible.
5) The cost of preferred stock is the ratio of the preferred stock dividend to a firm's net proceeds from the
sale of the preferred stock.
6) The cost of preferred stock is the ratio of the preferred stock dividend to a firm's total earnings.
7) What is the dividend on an 8 percent preferred stock that currently sells for $45 and has a face value of
$50 per share?
A) $3.33
B) $3.60
C) $4.00
D) $5.00
8) A firm has issued 10 percent preferred stock, which sold for $100 per share par value. The cost of
issuing and selling the stock was $2 per share. The firm's marginal tax rate is 40 percent. The cost of the
preferred stock is ________.
A) 3.9 percent
B) 6.1 percent
C) 9.8 percent
D) 10.2 percent
9) A firm has issued preferred stock at its $125 per share par value. The stock will pay a $15 annual
dividend. The cost of issuing and selling the stock was $4 per share. The cost of the preferred stock is
________.
A) 7.2 percent
B) 12 percent
C) 12.4 percent
D) 15 percent
10) A firm has determined it can issue preferred stock at $115 per share par value. The stock will pay a
$12 annual dividend. The cost of issuing and selling the stock is $3 per share. The cost of the preferred
stock is ________.
A) 6.4 percent
B) 10.4 percent
C) 10.7 percent
D) 12 percent
11) Tangshan Mining is considering issuing preferred stock. The preferred stock would have a par value
of $75 and a 5.50 percent dividend. What is the cost of preferred stock for Tangshan if flotation costs
would amount to 5.5 percent of par value?
A) 5.50%
B) 5.27%
C) 7.73%
D) 5.82%
1) The cost of common stock equity may be measured using either the constant-growth valuation model
or the capital asset pricing model.
2) The constant-growth model uses the market price as a reflection of the expected risk-return preference
of investors in the marketplace.
3) The cost of common stock equity capital represents the return required by existing shareholders on
their investment.
4) The cost of retained earnings is always lower than the cost of a new issue of common stock due to the
absence of flotation costs when financing projects with retained earnings.
5) In computing the cost of retained earnings, the net proceeds represents the amount of money retained
net of any underpricing and/or flotation costs.
6) The cost of retained earnings is generally higher than both the cost of debt and cost of preferred stock.
7) One measure of the cost of common stock equity is the rate at which investors discount the expected
common stock dividends of the firm to determine its share value.
8) The Gordon model is based on the premise that the value of a share of stock is equal to the sum of all
future dividends it is expected to provide over an infinite time horizon.
9) Using the Capital Asset Pricing Model (CAPM), the cost of common stock equity is the return required
by investors as compensation for a firm's nondiversifiable risk.
10) Use of the capital asset pricing model (CAPM) in measuring the cost of common stock equity differs
from the constant-growth valuation model in that it directly considers the firm's risk as reflected by beta.
11) When the constant-growth valuation model is used to find the cost of common stock equity capital, it
can easily be adjusted for flotation costs to find the cost of new common stock; the capital asset pricing
model (CAPM) does not provide a simple adjustment mechanism.
12) The cost of new common stock is normally greater than any other long-term financing cost.
13) The capital asset pricing model describes the relationship between the required return, or the cost of
common stock equity capital, and the nonsystematic risk of a firm as measured by the beta coefficient.
14) The capital asset pricing model is used to calculate the effect of increase in prices of capital assets due
to inflation.
15) The Gordon model assumes that the value of a share of stock equals the future value of the current
price of share that it is expected to remain constant over an infinite time horizon.
16) According to the CAPM, the required return of an asset is the sum of risk-free rate of return and beta
times the risk premium.
17) The cost of equity for Tangshan Mining would be roughly 10 percent if the expected return on U.S.
Treasury Bills is 2 percent, the market risk premium is 6 percent, and the firm's beta is 1.33.
18) The cost of retained earnings will always equal the cost of preferred stock.
19) The cost of common stock equity is ________.
A) the cost of the guaranteed stated dividend expected by the stockholders
B) the rate at which investors discount the expected dividends of the firm to determine its share value
C) the after-tax cost of the interest obligations
D) the historical cost of floating the stock issue
20) The cost of common stock equity may be estimated by using the ________.
A) yield curve
B) break-even analysis
C) Gordon model
D) DuPont analysis
21) The cost of common stock equity may be estimated by using the ________.
A) yield curve
B) capital asset pricing model
C) break-even analysis
D) DuPont analysis
22) The cost of retained earnings is ________.
A) less than the cost of debt
B) equal to the cost of a new issue of common stock
C) equal to the cost of common stock equity
D) irrelevant to the investment/financing decision
