Chapter 09: The Cost of Capital
40. The CEO of Harding Media Inc. as asked you to help estimate its cost of common equity. You have obtained the
following data: D0 = $0.85; P0 = $22.00; and gL = 6.00% (constant). The CEO thinks, however, that the stock price is
temporarily depressed, and that it will soon rise to $40.00. Based on the dividend growth model, by how much would the
cost of common from reinvested earnings change if the stock price changes as the CEO expects?
a. −1.49%
b. −1.66%
c. −1.84%
d. −2.03%
e. −2.23%
41. Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm’s stock price is
temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case,
the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt.
a. True
b. False
Chapter 09: The Cost of Capital
42. For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in
accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and
partly common equity.
a. True
b. False
43. In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects
because most projects are funded with general corporate funds, which come from a variety of sources. However, if the
firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type
of capital to evaluate that project.
a. True
b. False
Chapter 09: The Cost of Capital
44. The cost of debt, rd, is normally less than rs, so rd(1 − T) will normally be much less than rs. Therefore, as long as the
firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 −
T).
a. True
b. False
45. The lower the firm’s tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant.
a. True
b. False
46. Which of the following statements is CORRECT?
a. When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on
preferred stock are deductible by the paying corporation.
b. Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than
on the cost of common stock as measured by the CAPM.
c. If a company’s beta increases, this will increase the cost of equity used to calculate the WACC, but only if the
company does not have enough reinvested earnings to take care of its equity financing and hence must issue new stock.
d. Higher flotation costs reduce investors’ expected returns, and that leads to a reduction in a company’s WACC.
Chapter 09: The Cost of Capital
e. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible
by the paying corporation.
47. Which of the following statements is CORRECT?
a. We should use historical measures of the component costs from prior financings that are still outstanding when
estimating a company’s WACC for capital budgeting purposes.
b. The cost of new equity (re) could possibly be lower than the cost of reinvested earnings (rs) if the market risk
premium, risk-free rate, and the company’s beta all decline by a sufficiently large amount.
c. A company must try to adjust its current actual market value weights toward its target weights.
d. The component cost of preferred stock is expressed as rp(1 − T), because preferred stock dividends are treated as
fixed charges, similar to the treatment of interest on debt.
e. In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 50%
of the dividends received by corporate investors are excluded from their taxable income.
48. Which of the following statements is CORRECT?
a. The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation
cost for new debt.
b. The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to
acquire its assets.
c. There is an “opportunity cost” associated with using reinvested earnings, hence they are not “free.”
Chapter 09: The Cost of Capital
d. The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only
debt to finance its capital budget during the coming year.
e. The WACC as used in capital budgeting is an estimate of a company’s before-tax cost of capital.
49. Which of the following statements is CORRECT?
a. WACC calculations should be based on the before-tax costs of all the individual capital components.
b. Flotation costs associated with issuing new common stock normally reduce the WACC.
c. If a company’s tax rate increases, then, all else equal, its weighted average cost of capital will decline.
d. An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.
e. A change in a company’s target capital structure cannot affect its WACC.
50. Which of the following statements is CORRECT?
a. The after-tax cost of debt usually exceeds the after-tax cost of equity.
b. For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible
preferred stock.
c. Retained earnings that were generated in the past and are reported on the firm’s balance sheet are available to
finance the firm’s capital budget during the coming year.
d. The required return on debt used in calculating a firm’s WACC should be based on the debt’s current required
return even if it is higher than the debt’s coupon rate.
Chapter 09: The Cost of Capital
e. The WACC is calculated using before-tax costs for all components.
51. Which of the following statements is CORRECT? Assume a company’s target capital structure is 50% debt and 50%
common equity.
a. The WACC is calculated on a before-tax basis.
b. The WACC exceeds the cost of equity.
c. The cost of equity is always equal to or greater than the cost of debt.
d. The cost of reinvested earnings typically exceeds the cost of new common stock.
e. The interest rate used to calculate the WACC is the average after-tax cost of all the company’s outstanding debt as
shown on its balance sheet.
52. Which of the following statements is CORRECT?
a. A cost should be assigned to reinvested earnings due to the opportunity cost principle, which refers to the fact that
the firm’s stockholders would themselves expect to earn a return on earnings that were distributed rather than retained and
reinvested.
b. No cost should be assigned to reinvested earnings because the firm does not have to pay anything to raise them.
They are generated as cash flows by operating assets that were raised in the past; hence, they are “free.”
c. Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into
the foreseeable future. In this case, the firm’s before-tax and after-tax costs of debt for purposes of calculating the WACC
Chapter 09: The Cost of Capital
will both be equal to the interest rate on the firm‘s currently outstanding debt, provided that debt was issued during the
past 5 years.
d. If a firm has enough reinvested earnings to fund its capital budget for the coming year, then there is no need to
estimate either a cost of equity or a WACC.
e. The component cost of preferred stock is expressed as rp(1 − T). This follows because preferred stock dividends
are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes.
53. Which of the following statements is CORRECT?
a. The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average
after-tax cost of all the firm’s outstanding debt.
b. Suppose some of a publicly-traded firm’s stockholders are not diversified; they hold only the one firm’s stock. In
this case, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in
capital budgeting, projects will be accepted that will reduce the firm’s intrinsic value.
c. Whether shareholders are already equity holders or are brand-new equity holders, they all have the same
required rate of return on stock.
d. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm’s
cost of equity capital.
e. The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that
project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will
be financed with equity.
Chapter 09: The Cost of Capital
54. Which of the following statements is CORRECT?
a. The dividend growth model is generally preferred by academics and financial executives over other models for
estimating the cost of equity. This is because of the dividend growth model’s logical appeal and also because accurate
estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain.
b. The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it
has the advantage that its two key inputs, the firm’s own cost of debt and its risk premium, can be found by using
standardized and objective procedures.
c. Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other
methods are also used because CAPM estimates may be subject to error, and people like to use different methods as
checks on one another. If all of the methods produce similar results, this increases the decision maker’s confidence in the
estimated cost of equity.
d. The dividend growth model model is preferred by academics and finance practitioners over other cost of capital
models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected
capital gains yield.
e. Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a
simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular,
academics and corporate finance people generally agree that its key inputs⎯beta, the risk-free rate, and the market risk
premium⎯can be estimated with little error.
55. Bartlett Company’s target capital structure is 40% debt, 15% preferred, and 45% common equity. The after-tax cost of
debt is 6.00%, the cost of preferred is 7.50%, and the cost of common using reinvested earnings is 12.75%. The firm will
not be issuing any new stock. You were hired as a consultant to help determine their cost of capital. What is its WACC?
a. 8.98%
b. 9.26%
c. 9.54%
d. 9.83%
e. 10.12%
Chapter 09: The Cost of Capital
56. Quinlan Enterprises stock trades for $52.50 per share. It is expected to pay a $2.50 dividend at year end (D1 = $2.50),
and the dividend is expected to grow at a constant rate of 5.50% a year. The before-tax cost of debt is 7.50%, and the tax
rate is 25%. The target capital structure consists of 45% debt and 55% common equity. What is the company’s WACC if
all the equity used is from reinvested earnings?
a. 7.53%
b. 7.85%
c. 8.18%
d. 8.50%
e. 8.84%
Chapter 09: The Cost of Capital
57. Avery Corporation’s target capital structure is 35% debt, 10% preferred, and 55% common equity. The interest rate on
new debt is 6.50%, the yield on the preferred is 6.00%, the cost of common from reinvested earnings is 11.25%, and the
tax rate is 25%. The firm will not be issuing any new common stock. What is Avery’s WACC?
a. 8.49%
b. 8.83%
c. 9.19%
d. 9.55%
e. 9.94%
58. The president and CFO of Spellman Transportation are having a disagreement about whether to use market value or
book value weights in calculating the WACC. Spellman’s balance sheet shows a total of noncallable $45 million long-
term debt with a coupon rate of 7.00% and a yield to maturity of 6.00%. This debt currently has a market value of $50
million. The company has 10 million shares of common stock, and the book value of the common equity (common stock
plus retained earnings) is $65 million. The current stock price is $22.50 per share; stockholders’ required return, rs, is
14.00%; and the firm’s tax rate is 25%. The CFO thinks the WACC should be based on market value weights, but the
president thinks book weights are more appropriate. What is the difference between these two WACCs?
a. 1.42%
b. 1.57%
c. 1.75%
d. 1.94%
e. 2.16%
Chapter 09: The Cost of Capital
59. To estimate the company’s WACC, Marshall Inc. recently hired you as a consultant. You have obtained the following
information. (1) The firm’s noncallable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $1,000,
and a market price of $1,050.00. (2) The company’s tax rate is 25%. (3) The risk-free rate is 4.50%, the market risk
premium is 5.50%, and the stock’s beta is 1.20. (4) The target capital structure consists of 35% debt and the balance is
common equity. The firm uses the CAPM to estimate the cost of common stock, and it does not expect to issue any new
shares. What is its WACC?
a. 7.48%
b. 7.88%
c. 8.29%
d. 8.73%
e. 9.19%
Chapter 09: The Cost of Capital
Collins Group
The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm’s weighted
average cost of capital. The balance sheet and some other information are provided below.
Assets
Current assets $ 38,000,000
Net plant, property, and equipment 101,000,000
Total assets $139,000,000
Liabilities and Equity
Accounts payable $ 10,000,000
Accruals 9,000,000
Current liabilities $ 19,000,000
Long-term debt (40,000 bonds, $1,000 par value) 40,000,000
Total liabilities $ 59,000,000
Common stock (10,000,000 shares) 30,000,000
Retained earnings 50,000,000
Total shareholders’ equity 80,000,000
Total liabilities and shareholders’ equity $139,000,000
The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with
semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the
yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an
average annual return of 14.50% during the past 5 years. The firm’s tax rate is 25%.
60. Refer to the data for the Collins Group. Which of the following is the best estimate for the weight of debt for use in
calculating the firm’s WACC?
a. 18.67%
b. 19.60%
c. 20.58%
Chapter 09: The Cost of Capital
d. 21.61%
e. 22.69%
61. Refer to the data for the Collins Group. What is the best estimate of the firm’s WACC?
a. 11.08%
b. 11.42%
c. 11.77%
d. 12.13%
e. 12.49%
Chapter 09: The Cost of Capital
62. The higher the firm’s flotation cost for new common equity, the more likely the firm is to use preferred stock, which
has no flotation cost, and reinvested earnings, whose cost is the average return on the assets that are acquired.
a. True
b. False
63. The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: “The cost
of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage
flotation cost required to sell the new stock, (1 − F).”
a. True
b. False