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23) A corporation that uses both debt and equity in its capital structure has concluded that the risk
premium it must pay on its common stock is too high. To decrease this, the firm can ________.
A) increase the proportion of long-term debt to decrease the cost of capital
B) increase the proportion of short-term debt to decrease the cost of capital
C) decrease the proportion of common stock equity to decrease financial risk
D) increase the proportion of common stock equity to decrease financial risk
24) The constant-growth valuation model is based on the premise that the value of a share of common
stock is ________.
A) the sum of the dividends and expected capital appreciation
B) determined based on an industry standard P/E multiple
C) determined by using a measure of relative risk called correlation coefficient
D) equal to the present value of all expected future dividends
25) In calculating the cost of common stock equity, the model which describes the relationship between
the required return and the nondiversifiable risk of the firm is ________.
A) the constant-growth model
B) the NPV model
C) the variable growth model
D) the capital asset pricing model
26) A firm has a beta of 1.2. The market return equals 14 percent and the risk-free rate of return equals 6
percent. The estimated cost of common stock equity is ________.
A) 6 percent
B) 7.2 percent
C) 14 percent
D) 15.6 percent
27) One major expense associated with issuing new shares of common stock is ________.
A) coupon payment
B) sunk cost
C) overvaluation
D) underpricing
28) One of the circumstances in which the Gordon growth valuation model for estimating the value of a
share of stock should be used is ________.
A) declining dividends
B) an erratic dividend stream
C) the lack of data on dividend payments
D) a steady growth rate in dividends
29) A firm has common stock with a market price of $25 per share and an expected dividend of $2 per
share at the end of the coming year. The growth rate in dividends has been 5 percent. The cost of the
firm's common stock equity is ________.
A) 5 percent
B) 8 percent
C) 10 percent
D) 13 percent
30) A firm has common stock with a market price of $55 per share and an expected dividend of $2.81 per
share at the end of the coming year. The dividends paid on the outstanding stock over the past five years
are as follows:
The cost of the firm's common stock equity is ________.
A) 4.1 percent
B) 5.1 percent
C) 12.1 percent
D) 15.4 percent
31) Using the capital asset pricing model, the cost of common stock equity is the return required by
investors as compensation for ________.
A) the specific risk of a firm
B) a firm's unsystematic risk
C) price volatility of the stock
D) a firm's nondiversifiable risk
32) A firm has common stock with a market price of $100 per share and an expected dividend of $5.61 per
share at the end of the coming year. A new issue of stock is expected to be sold for $98, with $2 per share
representing the underpricing necessary in the competitive capital market. Flotation costs are expected to
total $1 per share. The dividends paid on the outstanding stock over the past five years are as follows:
The cost of this new issue of common stock is ________.
A) 5.8 percent
B) 7.7 percent
C) 10.8 percent
D) 12.8 percent
33) In comparing the constant-growth model and the capital asset pricing model (CAPM) to calculate the
cost of common stock equity, ________.
A) the CAPM ignores risk, while the constant-growth model directly considers risk as reflected in the
beta
B) the CAPM directly considers risk as reflected in the beta, while the constant-growth model uses the
market price as a reflection of the expected risk-return preference of investors
C) the CAPM directly considers risk as reflected in the beta, while the constant growth model uses
dividend expectations as a reflection of risk
D) the CAPM indirectly considers risk as reflected in the market return, while the constant growth model
uses dividend expectations as a reflection of risk
34) Given that the cost of common stock is 9 percent, dividends are $0.75 per share and the price of the
stock is $12.50 per share, what is the annual growth rate of dividends?
A) 2 percent
B) 4 percent
C) 3 percent
D) 5 percent
35) What would be the cost of new common stock equity for Tangshan Mining if the firm just paid a
dividend of $4.25, the stock price is $55.00, dividends are expected to grow at 8.5 percent indefinitely, and
flotation costs are $6.25 per share?
A) 17.22%
B) 16.88%
C) 17.96%
D) 12.57%
36) What would be the cost of retained earnings equity for Tangshan Mining if the expected return on
U.S. Treasury Bills is 5.00%, the market risk premium is 10.00 percent, and the firm's beta is 1.3?
A) 11.5%
B) 18.0%
C) 10.0%
D) 19.5%
37) The cost of new common stock financing is higher than the cost of retained earnings due to ________.
A) flotation costs and underpricing
B) flotation costs and overpricing
C) flotation costs and commission costs
D) commission costs and overpricing
38) Since retained earnings are viewed as a fully subscribed issue of additional common stock, the cost of
retained earnings is ________.
A) less than the cost of new common stock equity
B) equal to the cost of new common stock equity
C) greater than the cost of new common stock equity
D) not related to the cost of new common stock equity
9.5 Weighted average cost of capital
1) The weighted average cost that reflects the interrelationship of financing decisions can be obtained by
weighing the cost of each source of financing by the target proportion in a firm's capital structure.
2) The weighted average cost of capital (WACC) reflects the expected average cost of the different forms
of capital that a firm uses.
3) Since retained earnings is a more expensive source of financing than debt and preferred stock, the
weighted average cost of capital will fall once retained earnings have been exhausted.
4) In computing the weighted average cost of capital, the weights are either book value or market value
weights based on actual capital structure proportions.
5) In computing the weighted average cost of capital the preferred weighting scheme is generally based
on the market values of each source of capital.
6) Weights that use accounting values to measure the proportion of each type of capital in a firm's
financial structure are called market value weights.
7) Weights that use accounting values to measure the proportion of each type of capital in a firm's
financial structure are called book value weights.
8) A company's target weights refer to the desired mix of debt and equity, based on market values of each
capital source, rather than the current mix of debt and equity.
9) The weights used in weighted average cost of capital must be ________.
A) greater than 50%
B) nonnegative
C) less than zero
D) zero
10) When the market values of a firm's securities have been changing dramatically, the firm may want to
calculate its WACC based on ________.
A) book value weights
B) nominal weights
C) historic weights
D) target weights
11) A firm has determined its cost of each source of capital and the percentage of each source making up
the firm's capital structure:
The weighted average cost of capital is ________.
A) 6 percent
B) 10.7 percent
C) 11 percent
D) 15 percent
12) When discussing weighing schemes for calculating the weighted average cost of capital, ________.
A) market value weights are preferred over book value weights and target weights are preferred over
historical weights
B) book value weights are preferred over market value weights and target weights are preferred over
historical weights
C) book value weights are preferred over market value weights and historical weights are preferred over
target weights
D) market value weights are preferred over book value weights and historical weights are preferred over
target weights
Table 9.1
A firm has determined its optimal capital structure which is composed of the following sources and
target market value proportions.
Debt: The firm can sell a 12-year, $1,000 par value, 7 percent bond for $960. A flotation cost of
2 percent of the face value would be required in addition to the discount of $40.
Preferred Stock: The firm has determined it can issue preferred stock at $75 per share par value. The
stock will pay a $10 annual dividend. The cost of issuing and selling the stock is $3 per share.
Common Stock: A firm's common stock is currently selling for $18 per share. The dividend expected to
be paid at the end of the coming year is $1.74. Its dividend payments have been growing at a constant
rate for the last four years. Four years ago, the dividend was $1.50. It is expected that to sell, a new
common stock issue must be underpriced $1 per share in floatation costs. Additionally, the firm's
marginal tax rate is 40 percent.
13) The firm's before-tax cost of debt is ________. (See Table 9.1)
A) 7.8 percent
B) 10.6 percent
C) 11.2 percent
D) 12.7 percent
14) The firm's after-tax cost of debt is ________. (See Table 9.1)
A) 3.25 percent
B) 4.67 percent
C) 8 percent
D) 8.13 percent
15) The firm's cost of preferred stock is ________. (See Table 9.1)
A) 7.2 percent
B) 8.3 percent
C) 13.3 percent
D) 13.9 percent
16) The firm's cost of a new issue of common stock is ________. (See Table 9.1)
A) 7 percent
B) 9.08 percent
C) 14.2 percent
D) 13.4 percent
17) The firm's cost of retained earnings is ________. (See Table 9.1)
A) 10.2 percent
B) 13.9 percent
C) 12.7 percent
D) 13.6 percent
18) The weighted average cost of capital up to the point when retained earnings are exhausted is
________. (See Table 9.1)
A) 7.5 percent
B) 8.65 percent
C) 10.4 percent
D) 11.9 percent
19) If the target market proportion of long-term debt is reduced to 15 percent – increasing the proportion
of common stock equity to 75 percent, what will be the revised weighted average cost of capital? (See
Table 9.1)
A) 13.6 percent
B) 11.0 percent
C) 12.34 percent
D) 10.4 percent
Table 9.2
A firm has determined its optimal structure which is composed of the following sources and target
market value proportions.
Debt: The firm can sell a 15-year, $1,000 par value, 8 percent bond for $1,050. A flotation cost of 2 percent
of the face value would be required in addition to the premium of $50.
Common Stock: A firm's common stock is currently selling for $75 per share. The dividend expected to
be paid at the end of the coming year is $5. Its dividend payments have been growing at a constant rate
for the last five years. Five years ago, the dividend was $3.10. It is expected that to sell, a new common
stock issue must be underpriced $2 per share and the firm must pay $1 per share in flotation costs.
Additionally, the firm has a marginal tax rate of 40 percent.
20) The firm's before-tax cost of debt is ________. (See Table 9.2)
A) 7.7 percent
B) 10.6 percent
C) 11.2 percent
D) 12.7 percent
21) The firm's after-tax cost of debt is ________. (See Table 9.2)
A) 4.6 percent
B) 6 percent
C) 7 percent
D) 7.7 percent
22) The firm's cost of a new issue of common stock is ________. (See Table 9.2)
A) 10.2 percent
B) 14.3 percent
C) 16.7 percent
D) 15.2 percent
23) The firm's cost of retained earnings is ________. (See Table 9.2)
A) 10.2 percent
B) 14.3 percent
C) 18.9 percent
D) 15.0 percent
24) The weighted average cost of capital up to the point when retained earnings are exhausted is
________. (See Table 9.2)
A) 6.8 percent
B) 7.7 percent
C) 8.7 percent
D) 11.29 percent
25) Assuming the firm plans to pay out all of its earnings as dividends, the weighted average cost of
capital is ________. (See Table 9.2)
A) 10.44 percent
B) 8.9 percent
C) 11.6 percent
D) 12.1 percent
Table 9.3
Balance Sheet
General Talc Mines
December 31, 2019
26)
Given this after-tax cost of each source of capital, the weighted average cost of capital using book weights
for General Talc Mines is ________. (See Table 9.3)
A) 11.6 percent
B) 15.5 percent
C) 16.6 percent
D) 17.5 percent
27) General Talc Mines has compiled the following data regarding the market value and cost of the
specific sources of capital.
Market price per share of common stock $50
Market value of long-term debt $980 per bond
The weighted average cost of capital using market value weights is ________. (See Table 9.3)
A) 11.7 percent
B) 13.5 percent
C) 15.8 percent
D) 17.5 percent
28) A firm has determined its optimal capital structure, which is composed of the following sources and
target market value proportions:
Debt: The firm can sell a 20-year, $1,000 par value, 9 percent bond for $980. A flotation cost of 2 percent of
the face value would be required in addition to the discount of $20.
Preferred Stock: The firm has determined it can issue preferred stock at $65 per share par value. The
stock will pay an $8.00 annual dividend. The cost of issuing and selling the stock is $3 per share.
Common Stock: The firm's common stock is currently selling for $40 per share. The dividend expected to
be paid at the end of the coming year is $5.07. Its dividend payments have been growing at a constant
rate for the last five years. Five years ago, the dividend was $3.45. It is expected that to sell, a new
common stock issue must be underpriced at $1 per share and the firm must pay $1 per share in flotation
costs. Additionally, the firm's marginal tax rate is 40 percent.
Calculate the firm's weighted average cost of capital assuming the firm has exhausted all retained
earnings.
29) Promo Pak has compiled the following financial data:
(a) Calculate the weighted average cost of capital using book value weights.
(b) Calculate the weighted average cost of capital using market value weights.
30) A certain firm originally had capital structure weights of 50% debt and 50% common equity. Since
establishing those weights, the firm's stock price has risen dramatically. The firm has done no additional
borrowing. Assume that nothing else in the economy has changed (e.g., interest rates, tax rates, and other
macroeconomic factors remain constant). Because the firm's stock price has increased a great deal,
________.
A) the firm's cost of equity has increased
B) the firm's cost of debt has increased
C) the firm's WACC has decreased
D) the firm's cost of equity has decreased
31) If a firm's stock price increases and everything else remains constant, the proportion of debt in the
firm's capital structure will fall.
32) Debt is nearly always a less costly source of financing than equity. Does it follow then that most firms
could decrease their WACC if they simply used more debt and less equity in their capital structure?
