70) A company is going to issue a $1,000 par value bond that pays a 7% annual coupon. The
company expects investors to pay $942 for the 20-year bond. The expected flotation cost per
bond is $42, and the firm is in the 34% tax bracket. Compute the following:
a. The yield to maturity on the firm’s bonds
b. The firm’s after-tax cost of existing debt
c. The firm’s after-tax cost of new debt
71) Toto and Associates’ preferred stock is selling for $27.50 a share. The firm nets $25.60 after
issuance costs. The stock pays an annual dividend of $3.00 per share. What is the cost of
existing, and new, preferred stock respectively?
72) Sutter Corporation’s common stock is selling for $16.80 a share. Last year Sutter paid a
dividend of $.80. Investors are expecting Sutter’s dividends to grow at an annual rate of 5% per
year. What is the cost of internal equity?
73) Gibson Industries is issuing a $1,000 par value bond with an 8% annual interest coupon rate
that matures in 11 years. Investors are willing to pay $972, and flotation costs will be 9%.
Gibson is in the 34% tax bracket. What will be the after-tax cost of new debt for the bond?
74) The preferred stock of Wells Co. sells for $17 and pays a $1.75 dividend. The net price of the
stock after issuance costs is $15.30. What is the cost of capital for new preferred stock?
75) Glenna Gayle common stock sells for $55, and dividends paid last year were $1.35. Flotation
costs on issuing stock will be 8% of the market price. The dividends are predicted to have a 10%
growth rate. What is the cost of internal equity, and new equity, respectively for Glenna Gayle?
76) Toombes, Inc. is issuing new common stock at a market price of $55. Dividends last year
were $3.30 per share and are expected to grow at a rate of 6%. Flotation costs will be 5% of the
market price. What is Toombes’ cost of retained earnings, and new equity, respectively?
9.3 Learning Objective 3
1) A company’s cost of capital is equal to a weighted average of its investors’ required returns.
2) A corporation may lower its cost of capital by shifting a portion of its total financing from a
higher cost source of capital, such as common equity, to a lower cost source of capital, such as
debt.
3) The best financial structure is determined by finding the debt and equity mix that maximizes
the firm’s cost of capital.
4) If a firm were to earn exactly its cost of capital, we would expect the price of its common
stock to remain unchanged.
5) If a firm’s tax rate increases then its weighted average cost of capital increases also.
6) The average cost of capital is the appropriate rate to use when evaluating new investments,
even though the new investments may be in a higher risk class.
7) Once the weighted average cost of capital (WACC) is determined then all projects of average
risk will be compared to the original WACC regardless of the size of the capital budget.
8) The mixture of financing sources used by a firm will vary from year to year, so many firms
use target capital structure proportions when calculating the firm’s weighted average cost of
capital.
9) Using the weighted cost of capital as a cutoff rate assumes that the riskiness of the project
being evaluated is similar to the riskiness of the company’s existing assets.
10) Using the weighted cost of capital as a cutoff rate assumes that future investments will be
financed so as to maintain the firm’s target degree of financial leverage.
11) The market value weights are preferred when calculating a firm’s weighted average cost of
capital.
12) A firm’s weighted average cost of capital is a function of (1) the individual costs of capital,
(2) the capital structure mix, and (3) the level of financing necessary to make the investment.
13) A company’s capital structure mix is based on the proportion of fixed versus variable costs in
its optimal production process.
14) A firm’s weighted average cost of capital is determined using all of the following inputs
except:
A) the firm’s capital structure.
B) the amount of capital necessary to make the investment.
C) the firm’s after tax cost of debt.
D) the probability distribution of expected returns.
15) Cost of capital is
A) the coupon rate of debt.
B) a hurdle rate set by the board of directors.
C) the rate of return that must be earned on additional investment if firm value is to remain
unchanged.
D) the average cost of the firm’s assets.
16) Cost of capital is commonly used interchangeably with all of the following terms except:
A) the firm’s required rate of return.
B) the hurdle rate for new investments.
C) the internal rate of return for new investments.
D) the firm’s opportunity cost of funds.
17) Jones Company has a target capital structure of 30% debt, 15% preferred stock, and 55%
common equity. The company’s after-tax cost of debt is 7%, its cost of preferred stock is 11%, its
cost of retained earnings is 15%, and its cost of new common stock is 16%. The company stock
has a beta of 1.5 and the company’s marginal tax rate is 35%. What is the company’s weighted
average cost of capital if retained earnings are used to fund the common equity portion?
A) 11.20%
B) 12.00%
C) 13.80%
D) 14.45%
18) J & B Corp. is investing in a major capital budgeting project that will require the expenditure
of $16 million. The money will be raised by issuing $2 million of bonds, $4 million of preferred
stock, and $10 million of new common stock. The company estimates is after-tax cost of debt to
be 7%, its cost of preferred stock to be 9%, the cost of retained earnings to be 14%, and the cost
of new common stock to be 17%. What is the weighted average cost of capital for this project?
A) 12.20%
B) 13.12%
C) 13.75%
D) 14.23%
19) Acme Conglomerate Corporation operates three divisions. One division involves significant
research and development, and thus has a high-risk cost of capital of 15%. The second division
operates in business segments related to Acme’s core business, and this division has a cost of
capital of 10% based upon its risk. Acme’s core business is the least risky segment, with a cost of
capital of 8%. The firm’s overall weighted average cost of capital of 11% has been used to
evaluate capital budgeting projects for all three divisions. This approach will
A) favor projects in the core business division because that division is the least risky.
B) favor projects in the related businesses division because the cost of capital for this division is
the closest to the firm’s weighted average cost of capital.
C) favor projects in the research and development division because the higher risk projects look
more favorable if a lower cost of capital is used to evaluate them.
D) not favor any division over the other because they all use the same company-wide weighted
average cost of capital.
20) Joe’s Discount Club currently has a weighted average cost of capital of 12%. Joe’s has been
growing rapidly over the past several years, selling common stock in each year to finance its
growth. However, due to difficult economic times this year, Joe’s decides to cut its dividend and
increase its retained earnings so that the common equity portion of its capital structure will
include only retained earnings and no new common stock will be sold. Joe’s weighted average
cost of capital this year should be
A) zero, since no new stock will be sold.
B) less than 12%.
C) equal to 12%.
D) greater than 12%.
21) Higgins Office Corp. plans to maintain its optimal capital structure of 40 percent debt, 10
percent preferred stock, and 50 percent common equity indefinitely. The required return on each
component source of capital is as follows: debt—8 percent; preferred stock—12 percent; common
equity—16 percent. Assuming a 40 percent marginal tax rate, what after-tax rate of return must
Higgins Office Corp. earn on its investments if the value of the firm is to remain unchanged?
A) 12.40 percent
B) 12.00 percent
C) 11.12 percent
D) 10.64 percent
22) SkyHigh Airlines has five possible investment projects for the coming year. Each project is
indivisible. They are:
Project Investment (million) IRR
A $ 6 18%
B $10 15%
C $ 9 20%
D $ 4 12%
E $ 3 24%
SkyHigh’s weighted marginal cost of capital schedule is 12 percent for up to $6 million of
investment; 16 percent for between $6 million and $18 million of investment; and above $18
million the weighted cost of capital is 18 percent. The optimal capital budget is:
A) $12 million.
B) $18 million.
C) $23 million.
D) $28 million.
23) The ABC Company is planning a $64 million expansion. The expansion is to be financed by
selling $25.6 million in new debt and $38.4 million in new common stock. The before-tax
required rate of return on debt is 9 percent and the required rate of return on equity is 14 percent.
If the company is in the 35 percent tax bracket, what is the firm’s cost of capital?
A) 8.92%
B) 9.89%
C) 11.50%
D) 10.74%
24) Burns and Nuble is considering an investment in a project which would require an initial
outlay of $350,000 and produce expected cash flows in years 1-5 of $95,450 per year. You have
determined that the current after-tax cost of the firm’s capital (required rate of return) for each
source of financing is as follows:
Cost of Long-Term Debt 7%
Cost of Preferred Stock 11%
Cost of Common Stock 15%
Long term debt currently makes up 25% of the capital structure, preferred stock 15%, and
common stock 60%. What is the net present value of this project?
A) -$9,306
B) $2,149
C) $5,983
D) $11,568
25) For a typical corporation, which of the following capital structures will result in the lowest
weighted average cost of capital?
A) 40% debt, 20% preferred stock, 40% common equity
B) 50% debt, 10% preferred stock, 40% common equity
C) 60% debt, 10% preferred stock, 30% common equity
D) 60% debt, 15% preferred stock, 25% common equity
26) Given the following information on S & G Inc.’s capital structure, compute the company’s
weighted average cost of capital.
Type of Percent of Before-Tax
Capital Capital Structure Component Cost
Bonds 40% 7.5%
Preferred Stock 5% 11%
Common Stock (Internal Only) 55% 15%
The company’s marginal tax rate is 40%.
A) 13.3%
B) 7.1%
C) 10.6%
D) 10%
27) Which of the following causes a firm’s cost of capital (WACC) to differ from an investor’s
required rate of return on the company’s common stock?
A) The fact that the risk free rate of interest has increased.
B) The incurrence of flotation costs when new securities are issued.
C) The market risk premium exceeds 12%.
D) None of the above — the WACC and required return are the same
28) Which of the following should not be considered when calculating a firm’s WACC?
A) Cost of preferred stock
B) After-tax cost of bonds
C) Cost of common stock
D) Cost of carrying inventory
29) Which of the following should NOT be considered when calculating a firm’s WACC?
A) After-tax YTM on a firm’s bonds
B) After-tax cost of accounts payable
C) Cost of newly issued preferred stock
D) Cost of newly issued common stock
30) Clothier, Inc. has a target capital structure of 40% debt and 60% common equity, and has a
40% marginal tax rate. If Clothier’s yield to maturity on bonds is 7.5% and investors require a
15% return on Clothier’s common stock, what is the firm’s weighted average cost of capital?
A) 7.20%
B) 10.80%
C) 12.00%
D) 12.25%
31) Milton Parker has a capital structure that consists of $7 million of debt, $2 million of
preferred stock, and $11 million of common equity, based upon current market values. Parker’s
yield to maturity on its bonds is 7.4%, and investors require an 8% return on Parker’s preferred
and a 14% return on Parker’s common stock. If the tax rate is 35%, what is Parker’s WACC?
A) 7.21%
B) 8.12%
C) 10.18%
D) 12.25%
32) Meacham Corp. wants to issue bonds with a 9% coupon rate, a face value of $1,000, and 12
years to maturity. Meacham estimates that the bonds will sell for $1,090 and that flotation costs
will equal $15 per bond. Meacham Corp. common stock currently sells for $30 per share.
Meacham can sell additional shares by incurring flotation costs of $3 per share. Meacham paid a
dividend yesterday of $4.00 per share and expects the dividend to grow at a constant rate of 5%
per year. Meacham also expects to have $12 million of retained earnings available for use in
capital budgeting projects during the coming year. Meacham’s capital structure is 40% debt and
60% common equity. Meacham’s marginal tax rate is 35%.
a. Calculate the after-tax cost of debt assuming Meacham’s bonds are its only debt.
b. Calculate the cost of retained earnings.
c. Calculate the cost of new common stock.
d. Calculate the weighted average cost of capital assuming Meacham’s total capital budget is
$30 million.
33) Office Clean Corporation has a capital structure consisting of 30 percent debt and 70 percent
common equity. Assuming the capital structure is optimal, what amount of total investment can
be financed by a $35 million addition to retained earnings without selling new common stock?
9.4 Learning Objective 4
1) Calculating the cost of capital for divisions within a company is not recommended because the
data is too fragmented and all divisions are part of the same company in any case.
2) The after-tax cost of debt is equal to one minus the marginal tax rate times the yield to
maturity on the firm’s outstanding debt.
3) If the before-tax cost of debt is 7% and the firm has a 40% marginal tax rate, the after-tax cost
of debt is 2.8%.
4) A corporate bond has a face value of $1,000 and a coupon rate of 5%. The bond matures in 15
years and has a current market price of $925. If the corporation sells more bonds it will incur
flotation costs of $25 per bond. If the corporate tax rate is 35%, what is the after-tax cost of debt
capital?
A) 3.74%
B) 4.45%
C) 5.29%
D) 6.78%
5) A corporate bond has a face value of $1,000 and a coupon rate of 9%. The bond matures in 14
years and has a current market price of $946. If the corporation sells more bonds it will incur
flotation costs of $26 per bond. If the corporate tax rate is 35%, what is the after-tax cost of debt
capital?
A) 5.57%
B) 6.56%
C) 8.18%
D) 7.31%
6) Kendall, Inc. has $15 million of outstanding bonds with a coupon rate of 10 percent. The yield
to maturity on these bonds is 12.5 percent. If the firm’s tax rate is 30 percent, what is relevant
cost of debt financing to Kendall, Inc.?
A) 13.75 percent
B) 8.75 percent
C) 7.00 percent
D) 3.75 percent
7) Porky Pine Co. is issuing a $1,000 par value bond that pays 8.5% interest annually. Investors
are expected to pay $1,100 for the 12-year bond. Porky will pay $50 per bond in flotation costs.
What is the after-tax cost of new debt if the firm is in the 35% tax bracket?
A) 8.23%
B) 4.55%
C) 4.70%
D) 7.45%
8) All the following variables are used in computing the cost of debt except:
A) maturity value of the debt.
B) market price of the debt.
C) number of years to maturity.
D) risk-free rate.
9) Durocorp has a target capital structure of 30% debt and 70% equity. Durocorp is planning to
invest in a project that will necessitate raising new capital. New debt will be issued at a before-
tax yield of 14%, with a coupon rate of 10%. The equity will be provided by internally generated
funds so no new outside equity will be issued. If the required rate of return on the firm’s stock is
22% and its marginal tax rate is 35%, compute the firm’s cost of capital.
A) 18.00%
B) 18.13%
C) 19.68%
D) 15.55%
10) Ewer Firm will finance a proposed investment by issuing new securities while maintaining
its optimal capital structure of 60% debt and 40% equity. The firm can issue bonds at a price of
$950.00 before $15 flotation costs. The 10-year bonds will have an annual coupon rate of 8%
and a face value of $1,000. The company can issue new equity at a before-tax cost of 16% and
its marginal tax rate is 34%. What is the appropriate cost of capital to use in analyzing this
project?
A) 3.63%
B) 8.77%
C) 9.97%
D) 11.81%
11) Triplin Corporation’s marginal tax rate is 35%. It can issue 10-year bonds with an annual
coupon rate of 7% and a par value of $1,000. After $12 per bond flotation costs, new bonds will
net the company $966 in proceeds. Determine the appropriate after-tax cost of new debt for
Triplin to use in a capital budgeting analysis.
A) 2.62%
B) 4.87%
C) 7.50%
D) 7.8%
12) Mars Car Company has a capital structure made up of 40% debt and 60% equity and a tax
rate of 30%. A new issue of $1,000 par bonds maturing in 20 years can be issued with a coupon
of 9% at a price of $1,098.18 with no flotation costs. The firm has no internal equity available
for investment at this time, but can issue new common stock at a price of $45. The next expected
dividend on the stock is $2.70. The dividend for Mars Co. is expected to grow at a constant
annual rate of 5% per year indefinitely. Flotation costs on new equity will be $7.00 per share.
The company has the following independent investment projects available:
Project Initial Outlay IRR
1 $100,000 10%
2 $ 10,000 8.5%
3 $ 50,000 12.5%
Which of the above projects should the company take on?
A) Project 3 only
B) Projects 1 and 2
C) Projects 1 and 3
D) Projects 1, 2 and 3
13) 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 relevant cost of the new bonds for capital budgeting
purposes?
A) 5.14%
B) 5.69%
C) 8.45%
D) 4.82%
9.5 Learning Objective 5
1) Using the weighted average cost of capital as the required rate of return for every project will
A) cause a firm to reject projects that should have been accepted.
B) cause a firm to accept projects that were too risky.
C) result in maximization of shareholder wealth.
D) A and B above.
2) Why should firms that own and operate multiple businesses that have different risk
characteristics use business-specific, or divisional costs of capital?
A) Not all divisions have equal risk and the firm might accept projects whose returns are higher
than are deemed appropriate.
B) Not all business divisions have equal risk and the firm will likely become less risky in the
future.
C) Not all lines of business have equal risk and it is likely that the firm will accept projects
whose returns are unacceptably low in relation to the risk involved.
D) Use of the same weighted average cost of capital for all divisions may result in too much
money being allocated to the least risky division.
9.6 Learning Objective 6
1) According to interest rate parity theory, differences in observed nominal interest rates in two
countries should equal differences in the expected rates of inflation in the two countries.
2) A U.S. company can borrow 12,000 pounds in Great Britain for 4% interest, paying back
12,480 pounds in one year. Alternatively, the U.S. company can borrow an equivalent amount of
U.S dollars in the United States and pay 8% interest. Assuming capital markets are efficient,
estimate the expected inflation rate in the United States if inflation in Great Britain is expected to
be zero.
A) 5.02%
B) 4.16%
C) 4.00%
D) 3.85%
3) The interest rate parity theorem suggests that differences in observed nominal rates of interest
in two countries should equal
A) differences in the expected rates of inflation between the two countries.
B) differences in the risk free rates of return between the two countries.
C) differences in the federal funds rates between the two countries.
D) differences in currency exchange rates between the two countries.
4) The interest rate on a one year security in the United States is 3%, while the interest rate on a
one year security in German is 8%. If the current exchange rate is 1 EURO = $1.50, then the
future exchange rate in one year, according to the international Fisher effect, is
A) $1.431.
B) $1.425.
C) $1.575.
D) $1.385.
5) Interest rate parity exists because
A) there are investors who stand ready to engage in arbitrage.
B) central banks ensure the relationship holds to protect currency values.
C) inflation is the same in all industrialized countries.
D) transactions costs and taxes make markets inefficient.