Ch 09 The Cost of Capital
a.
11.15%
b.
11.73%
c.
12.35%
d.
13.00%
e.
13.65%
ANSWER:
d
RATIONALE:
rRF
5.50%
Expected rM
11.50%
RPM = Expected return on Market − rRF =
6.00%
b
1.25
rs = rRF + rRF(RPM × b)
13.00%
POINTS:
1
DIFFICULTY:
False
TOPICS:
KEYWORDS:
OTHER:
NOTES:
JFND-GO4G-EO5U-QPJO
GCID-3c40b4d2540c-a67a-f1e4-5168-6ba5ad08
32. When estimating the cost of equity by use of the dividend growth method, the single biggest potential problem is to
determine the growth rate that investors use when they estimate a stock’s expected future rate of return. This problem
leaves us unsure of the true value of rs.
a.
True
b.
False
ANSWER:
True
RATIONALE:
DIFFICULTY:
Ch 09 The Cost of Capital
33. As a consultant to Basso Inc., you have been provided with the following data: D1 = $0.67; P0 = $27.50; and gL =
8.00% (constant). What is the cost of common from reinvested earnings based on the dividend growth approach?
a.
9.42%
b.
9.91%
c.
10.44%
d.
10.96%
e.
11.51%
c
False
JFND-GO4G-EO5U-QPNF
GCID-E7BW-1TBP-GY3U-QCDG-GPOS-RPBI-GWAN-4PMD-CEHN-4CB1-CO4N-4QB1-
False
JFND-GO4G-EO5U-QCKR
Ch 09 The Cost of Capital
34. To help them estimate the company’s cost of capital, Smithco has hired you as a consultant. You have been provided
with the following data: D1 = $1.45; P0 = $22.50; and gL = 6.50% (constant). Based on the dividend growth approach,
what is the cost of common from reinvested earnings?
a.
11.10%
b.
11.68%
c.
12.30%
d.
12.94%
e.
13.59%
False
JFND-GO4G-EO5U-QPNR
35. To help estimate its cost of common equity, Maxwell and Associates recently hired you. You have obtained the
following data: D0 = $0.90; P0 = $27.50; and gL = 7.00% (constant). Based on the dividend growth model, what is the
cost of common from reinvested earnings?
a.
9.29%
b.
9.68%
c.
10.08%
d.
10.50%
e.
10.92%
GO4W-NQNBEE
Ch 09 The Cost of Capital
36. As the assistant to the CFO of Johnstone Inc., you must estimate its cost of common equity. You have been provided
with the following data: D0 = $0.80; P0 = $22.50; and gL = 8.00% (constant). Based on the dividend growth model, what
is the cost of common from reinvested earnings?
a.
10.69%
b.
11.25%
c.
11.84%
d.
12.43%
e.
13.05%
c
QUESTION TYPE:
HAS VARIABLES:
False
QUESTION TYPE:
HAS VARIABLES:
False
LEARNING OBJECTIVES:
NATIONAL STANDARDS:
LOCAL STANDARDS:
DATE CREATED:
DATE MODIFIED:
QUESTION ID:
JFND-GO4G-EO5U-QPBO
Ch 09 The Cost of Capital
37. 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%
ANSWER:
POINTS:
DIFFICULTY:
Difficulty: Challenging
Multiple Choice
FMTP.EHRH.17.09.07 – LO: 9-7
United States – BUSPROG: Analytic
United States – OH – Default City – TBA
TOPICS:
Cost of common: Dividend growth model, discounted cash flow, DCF
KEYWORDS:
OTHER:
TYPE: Multiple Choice: Problem
FMTP.EHRH.17.09.07 – LO: 9-7
United States – BUSPROG: Analytic
United States – OH – Default City – TBA
TOPICS:
Cost of common: Dividend growth model, discounted cash flow, DCF
KEYWORDS:
OTHER:
TYPE: Multiple Choice: Problem
8/26/2015 10:46 AM
8/27/2015 6:21 PM
Ch 09 The Cost of Capital
38. 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
False
False
capital
JFND-GO4G-EO5U-QCNF
39. 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
True
False
JFND-GO4G-EO5U-QPJA
Ch 09 The Cost of Capital
40. 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
False
False
capital
JFND-GO4G-EO5U-QCJ3
41. When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good
idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This
problem leaves us unsure of the true value of rs.
capital
WACC
JFND-GO4G-EO5U-QCKB
4OTI-GO4W-NQNBEE
Ch 09 The Cost of Capital
a.
True
b.
False
True
Unfortunately, this is true.
False
JFND-GO4G-EO5U-QCKD
GO4W-NQNBEE
42. 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
True
False
WACC
JFND-GO4G-EO5U-QCJS
GCID-E7BW-1TBP-GY3U-QCDG-GPOS-RPBI-GWAN-4PMD-CEHN-4CB1-CO4N-4QB1-
Ch 09 The Cost of Capital
43. 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
False
False
JFND-GO4G-EO5U-QCJI
44. For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm
operates at its target capital structure.
a.
re > rs > WACC > rd.
b.
WACC > re > rs > rd.
c.
rd > re > rs > WACC.
d.
WACC > rd > rs > re.
e.
rs > re > rd > WACC.
a
False
capital
GO4W-NQNBEE
Ch 09 The Cost of Capital
45. 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.
e.
When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are
deductible by the paying corporation.
Difficulty: Moderate
Multiple Choice
FMTP.EHRH.17.09.08 – LO: 9-8
United States – BUSPROG: Analytic
United States – AK – DISC: Capital budgeting and cost – DISC: Capital budgeting and cost of
United States – OH – Default City – TBA
Capital components
TYPE: Multiple Choice: Conceptual
8/26/2015 10:45 AM
8/26/2015 10:45 AM
46. Which of the following statements is CORRECT?
Capital components
TYPE: Multiple Choice: Conceptual
8/26/2015 10:45 AM
8/26/2015 10:45 AM
Ch 09 The Cost of Capital
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 firm’s cost of reinvesting earnings is the rate of return stockholders require on a firm’s common stock.
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
70% of the dividends received by corporate investors are excluded from their taxable income.
Difficulty: Moderate
Multiple Choice
FMTP.EHRH.17.09.08 – LO: 9-8
United States – BUSPROG: Analytic
United States – AK – DISC: Capital budgeting and cost – DISC: Capital budgeting and cost of
United States – OH – Default City – TBA
Capital components
TYPE: Multiple Choice: Conceptual
8/26/2015 10:45 AM
8/26/2015 10:45 AM
47. 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.”
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.
Difficulty: Moderate
Multiple Choice
FMTP.EHRH.17.09.08 – LO: 9-8
Ch 09 The Cost of Capital
48. 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.
1
Difficulty: Moderate
Multiple Choice
FMTP.EHRH.17.09.08 – LO: 9-8
United States – BUSPROG: Analytic
United States – OH – Default City – TBA
TYPE: Multiple Choice: Conceptual
8/26/2015 10:45 AM
8/26/2015 10:45 AM
49. Which of the following statements is CORRECT?
United States – BUSPROG: Analytic
United States – OH – Default City – TBA
TYPE: Multiple Choice: Conceptual
8/26/2015 10:45 AM
Ch 09 The Cost of Capital
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 WACC that should be used in capital budgeting is the firm’s marginal, after-tax cost of capital.
e.
The WACC is calculated using before-tax costs for all components.
Difficulty: Moderate
Multiple Choice
FMTP.EHRH.17.09.08 – LO: 9-8
United States – BUSPROG: Analytic
United States – AK – DISC: Capital budgeting and cost – DISC: Capital budgeting and cost of
United States – OH – Default City – TBA
WACC and cap. components
TYPE: Multiple Choice: Conceptual
8/26/2015 10:45 AM
8/26/2015 10:45 AM
50. 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.
Difficulty: Moderate
Multiple Choice
FMTP.EHRH.17.09.08 – LO: 9-8
Ch 09 The Cost of Capital
51. Which of the following statements is CORRECT?
a.
The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in
fact pay taxes.
b.
If a company assigns the same cost of capital to all of its projects regardless of each project’s risk, then the
company is likely to reject some safe projects that it actually should accept and to accept some risky projects
that it should reject.
c.
Because no flotation costs are required to obtain capital as reinvested earnings, the cost of reinvested earnings
is generally lower than the after-tax cost of debt.
d.
Higher flotation costs tend to reduce the cost of equity capital.
e.
Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity,
and thus the after-tax cost of debt is always greater than the cost of equity.
Difficulty: Moderate
Multiple Choice
FMTP.EHRH.17.09.08 – LO: 9-8
United States – BUSPROG: Analytic
United States – AK – DISC: Capital budgeting and cost – DISC: Capital budgeting and cost of
United States – OH – Default City – TBA
Cost of capital concepts
TYPE: Multiple Choice: Conceptual
8/26/2015 10:46 AM
8/26/2015 10:46 AM
United States – BUSPROG: Analytic
United States – AK – DISC: Capital budgeting and cost – DISC: Capital budgeting and cost of
United States – OH – Default City – TBA
WACC and cap. components
TYPE: Multiple Choice: Conceptual
8/26/2015 10:46 AM
8/26/2015 10:46 AM
Ch 09 The Cost of Capital
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 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.
Difficulty: Challenging
Multiple Choice
FMTP.EHRH.17.09.08 – LO: 9-8
United States – BUSPROG: Analytic
United States – AK – DISC: Capital budgeting and cost – DISC: Capital budgeting and cost of
Capital components
TYPE: Multiple Choice: Conceptual
8/26/2015 10:46 AM
8/26/2015 10:46 AM
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.
The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual
cost number on which to base the cost of equity.
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
Ch 09 The Cost of Capital
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.
Difficulty: Challenging
Multiple Choice
FMTP.EHRH.17.09.08 – LO: 9-8
United States – BUSPROG: Analytic
United States – OH – Default City – TBA
Cost of capital
TYPE: Multiple Choice: Conceptual
8/26/2015 10:46 AM
8/26/2015 10:46 AM
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.
Difficulty: Challenging
Multiple Choice
Ch 09 The Cost of Capital
55. Which of the following statements is CORRECT?
a.
If the calculated beta underestimates the firm’s true investment risk⎯i.e., if the forward-looking beta that
investors think exists exceeds the historical beta⎯then the CAPM method based on the historical beta will
produce an estimate of rs and thus WACC that is too high.
b.
Beta measures market risk, which is, theoretically, the most relevant risk measure for a publicly-owned firm
that seeks to maximize its intrinsic value. This is true even if not all of the firm’s stockholders are well
diversified.
c.
An advantage shared by both the dividend growth model and CAPM methods when they are used to estimate
the cost of equity is that they are both “objective” as opposed to “subjective,” hence little or no judgment is
required.
d.
The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-
premium approach.
e.
The discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is
expected to be constant forever.
False
United States – AK – DISC: Capital budgeting and cost – DISC: Capital budgeting and cost of
United States – AK – DISC: Capital budgeting and cost – DISC: Capital budgeting and cost of
JFND-GO4G-EO5U-QP3O
Ch 09 The Cost of Capital
56. Which of the following statements is CORRECT?
a.
The WACC is calculated using a before-tax cost for debt that is equal to the interest rate that must be paid on
new debt, along with the after-tax costs for common stock and for preferred stock if it is used.
b.
An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity.
c.
The relevant WACC can change depending on the amount of funds a firm raises during a given year.
Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital
component, with the weights based on the firm’s target capital structure.
d.
Beta measures market risk, which is generally the most relevant risk measure for a publicly-owned firm that
seeks to maximize its intrinsic value. However, this is not true unless all of the firm’s stockholders are well
diversified.
e.
The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk
premium to the interest rate on the company’s own long-term bonds. The size of the risk premium for bonds
with different ratings is published daily in The Wall Street Journal.
1
Difficulty: Challenging
Multiple Choice
FMTP.EHRH.17.09.08 – LO: 9-8
United States – BUSPROG: Analytic
United States – OH – Default City – TBA
TYPE: Multiple Choice: Conceptual
8/26/2015 10:46 AM
8/26/2015 10:46 AM
57. Which of the following statements is CORRECT?
a.
Since its stockholders are not directly responsible for paying a corporation’s income taxes, corporations should
focus on before-tax cash flows when calculating the WACC.
b.
An increase in a firm’s tax rate will increase the component cost of debt, provided the YTM on the firm’s
bonds is not affected by the change in the tax rate.
Ch 09 The Cost of Capital
c.
When the WACC is calculated, it should reflect the costs of new common stock, reinvested earnings, preferred
stock, long-term debt, short-term bank loans if the firm normally finances with bank debt, and accounts
payable if the firm normally has accounts payable on its balance sheet.
d.
If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and
therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the after-
tax cost of debt.
e.
Since the costs of internal and external equity are related, an increase in the flotation cost required to sell a
new issue of stock will increase the cost of reinvested earnings.
Difficulty: Challenging
Multiple Choice
FMTP.EHRH.17.09.08 – LO: 9-8
United States – BUSPROG: Analytic
United States – AK – DISC: Capital budgeting and cost – DISC: Capital budgeting and cost of
capital
United States – OH – Default City – TBA
TYPE: Multiple Choice: Conceptual
8/26/2015 10:46 AM
8/26/2015 10:46 AM
58. Firm J’s earnings and stock price tend to move up and down with other firms in the S&P 500, while Firm F’s earnings
and stock price move counter cyclically with J and other S&P companies. Both J and F estimate their costs of equity using
the CAPM, they have identical market values, their standard deviations of returns are identical, and they both finance only
with common equity. Which of the following statements is CORRECT?
a.
J and F should have identical WACCs because their risks as measured by the standard deviation of returns are
identical.
b.
If J and F merge, then the merged firm MW should have a WACC that is a simple average of J’s and F’s
WACCs.
c.
Without additional information, it is impossible to predict what the merged firm’s WACC would be if J and F
merged.
d.
Since J and F move counter cyclically to one another, if they merged, the merged firm’s WACC would be less
than the simple average of the two firms’ WACCs.
e.
J should have the lower WACC because it is like most other companies, and investors like that fact.
Ch 09 The Cost of Capital
False
capital
WACC
JFND-GO4G-EO5U-QPNN
4OTI-GO4W-NQNBEE
59. Your consultant firm has been hired by Eco Brothers Inc. to help them estimate the cost of common equity. The yield
on the firm’s bonds is 8.75%, and your firm’s economists believe that the cost of common can be estimated using a risk
premium of 3.85% over a firm’s own cost of debt. What is an estimate of the firm’s cost of common from reinvested
earnings?
a.
12.60%
b.
13.10%
c.
13.63%
d.
14.17%
e.
14.74%
a
False