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Fundamentals of Corporate Finance, 12e (Ross)
Chapter 14 Cost of Capital
1) The cost of capital for a new project:
A) is determined by the overall risk level of the firm.
B) is dependent upon the source of the funds obtained to fund that project.
C) is dependent upon the firm's overall capital structure.
D) should be applied as the discount rate for all other projects considered by the firm.
E) depends upon how the funds raised for that project are going to be spent.
2) Which one of the following is the primary determinant of a firm's cost of capital?
A) Debt-equity ratio of any new funds raised
B) Marginal tax rate
C) Pretax cost of equity
D) Aftertax cost of equity
E) Use of the funds raised
3) A company's current cost of capital is based on:
A) only the return required by the company's current shareholders.
B) the current market rate of return on equity shares.
C) the weighted costs of all future funding sources.
D) both the returns currently required by its debtholders and stockholders.
E) the company's original debt-equity ratio.
4) All else constant, which one of the following will increase a company's cost of equity if the
company computes that cost using the security market line approach? Assume the firm currently
pays an annual dividend of $1 a share and has a beta of 1.2.
A) A reduction in the dividend amount
B) An increase in the dividend amount
C) A reduction in the market rate of return
D) A reduction in the firm's beta
E) A reduction in the risk-free rate
5) A company's overall cost of equity is:
A) generally less than its WACC given a debt-equity ratio of .5.
B) unaffected by changes in the market risk premium.
C) directly related to the risk level of the firm.
D) generally less than the firm's aftertax cost of debt.
E) inversely related to changes in the level of inflation.
6) The cost of equity for a company with a debt-equity ratio of .41:
A) tends to remain static even as the company's level of risk increases.
B) increases as the unsystematic risk of the company's stock increases.
C) is affected by either a change in the company's beta or its projected rate of growth.
D) equals the risk-free rate plus the market risk premium.
E) equals the company's pretax weighted average cost of capital.
7) The primary advantage of using the dividend growth model to estimate a company's cost of
equity is:
A) the ability to apply either current or future tax rates.
B) the model's applicability to all corporations.
C) is the model's consideration of risk.
D) the stability of the computed cost of equity over time.
E) the simplicity of the model.
8) The dividend growth model:
A) is only as reliable as the estimated rate of growth.
B) can only be used if historical dividend information is available.
C) considers the risk that future dividends may vary from their estimated values.
D) applies only when a company is currently paying dividends.
E) is based solely on historical dividend information.
9) Assume Russo's has a debt-equity ratio of .4 and uses the capital asset pricing model to
determine its cost of equity. As a result, the company's cost of equity:
A) is affected by the firm's rate of growth projections.
B) implies that the firm pays out all of its earnings to its shareholders.
C) is dependent upon a reliable estimate of the market risk premium.
D) would be unaffected if the dividend discount model were applied instead.
E) will be unaffected by changes in overall market risks.
10) The capital asset pricing model approach to equity valuation:
A) is dependent upon the unsystematic risk of a security.
B) assumes the reward-to-risk ratio increases as beta increases.
C) can only be applied to dividend-paying firms.
D) assumes a firm's future risks will be higher than its current risks.
E) assumes the reward-to-risk ratio is constant.
11) A group of individuals got together and purchased all of the outstanding shares of common
stock of DL Smith Inc. What is the return that these individuals require on this investment
called?
A) Dividend yield
B) Cost of equity
C) Capital gains yield
D) Cost of capital
E) Income return
12) Textile Mills borrows money at a rate of 8.7 percent. This interest rate is referred to as the:
A) compound rate.
B) current yield.
C) cost of debt.
D) capital gains yield.
E) cost of capital.
13) A company's pretax cost of debt:
A) is based on the current yield to maturity of the company's outstanding bonds.
B) is equal to the coupon rate on the latest bonds issued by the company.
C) is equivalent to the average current yield on all of a company's outstanding bonds.
D) is based on the original yield to maturity on the latest bonds issued by a company.
E) has to be estimated as it cannot be directly observed in the market.
14) Which one of these will increase a company's aftertax cost of debt?
A) A decrease in the company's debt-equity ratio
B) A decrease in the company's tax rate
C) An increase in the credit rating of the company's bonds
D) An increase in the company's beta
E) A decrease in the market rate of interest
15) The cost of preferred stock is computed the same as the:
A) pretax cost of debt.
B) rate of return on an annuity.
C) aftertax cost of debt.
D) rate of return on a perpetuity.
E) cost of an irregular growth common stock.
16) The cost of preferred stock:
A) is equal to the dividend yield.
B) is equal to the yield to maturity.
C) is highly dependent on the dividend growth rate.
D) is independent of the stock's price.
E) decreases when tax rates increase.
17) The aftertax cost of debt:
A) varies inversely to changes in market interest rates.
B) will generally exceed the cost of equity if the relevant tax rate is zero.
C) will generally equal the cost of preferred if the tax rate is zero.
D) is unaffected by changes in the market rate of interest.
E) is highly dependent upon a company's tax rate.
18) The capital structure weights used in computing a company's weighted average cost of
capital:
A) are based on the book values of debt and equity.
B) are based on the market values of the outstanding securities.
C) depend upon the financing obtained to fund each specific project.
D) remain constant over time unless new securities are issued or outstanding securities are
redeemed.
E) are restricted to debt and common stock.
19) A company's weighted average cost of capital:
A) is equivalent to the aftertax cost of the outstanding liabilities.
B) should be used as the required return when analyzing any new project.
C) is the return investors require on the total assets of the firm.
D) remains constant when the debt-equity ratio changes.
E) is unaffected by changes in corporate tax rates.
20) Black River Tours has a capital structure of 60 percent common stock, 5 percent preferred
stock, and 35 percent debt. The dividend payout ratio is 30 percent, the company's beta is 1.21,
and the tax rate is 21 percent. Given this, which one of the following statements is correct?
A) The aftertax cost of debt will be greater than the current yield-to-maturity on the company's
outstanding bonds.
B) The company's cost of preferred is most likely less than the company's actual cost of debt.
C) The cost of equity is unaffected by a change in the company's tax rate.
D) The cost of equity can only be estimated using the capital asset pricing model.
E) The weighted average cost of capital will remain constant as long as the company's capital
structure remains constant.
21) The average of a company's cost of equity, cost of preferred, and aftertax cost of debt that is
weighted based on the company's capital structure is called the:
A) reward-to-risk ratio.
B) weighted capital gains rate.
C) structured cost of capital.
D) subjective cost of capital.
E) weighted average cost of capital.
22) The weighted average cost of capital for a company is least dependent upon the:
A) company's beta.
B) coupon rate of the company's outstanding bonds.
C) growth rate of the company's dividends.
D) company's marginal tax rate.
E) standard deviation of the company's common stock.
23) The weighted average cost of capital for a firm with debt is the:
A) discount rate that the firm should apply to all of the projects it undertakes.
B) rate of return a company must earn on its existing assets to maintain the current value of its
stock.
C) coupon rate the firm should expect to pay on its next bond issue.
D) minimum discount rate the firm should require on any new project.
E) rate of return debtholders should expect to earn on their investment in this firm.
24) Which one of the following statements related to WACC is correct for a company that uses
debt in its capital structure?
A) The WACC would most likely decrease if the firm replaced its preferred stock with debt.
B) The weight assigned to preferred stock decreases as the market value of the preferred stock
increases.
C) The WACC will decrease as the corporate tax rate decreases.
D) The weight of equity is based on the number of shares outstanding and the book value per
share.
E) The WACC will remain constant unless a company retires some of its debt.
25) If a company uses its WACC as the discount rate for all of the projects it undertakes then the
company will tend to:
A) accept all positive net present value projects.
B) increase the average risk level of the company over time.
C) reject all high-risk projects.
D) reject all negative net present value projects.
E) favor low-risk projects over high-risk projects.
26) Preston Industries has two separate divisions. Each division is in a separate line of business.
Division A is the largest division and represents 65 percent of the company's overall sales.
Division A is also the riskier of the two divisions. When management is deciding which of the
various divisional projects should be accepted, the managers should:
A) allocate more funds to Division A since it is the larger of the two divisions.
B) fund all of Division B's projects first since they tend to be less risky and then allocate the
remaining funds to the Division A projects that have the highest net present values.
C) allocate the company's funds to the projects with the highest net present values based on the
company's weighted average cost of capital.
D) assign appropriate, but differing, discount rates to each project and then select the projects
with the highest net present values.
E) fund the highest net present value projects from each division based on an allocation of 65
percent of the funds to Division A and 35 percent of the funds to Division B.
27) Jenner's is a multi-division firm that uses its overall WACC as the discount rate for all
proposed projects. Each division is in a separate line of business and each presents risks unique
to those lines. Given this, a division within the firm will tend to:
A) receive less project funding if its line of business is riskier than that of the other divisions.
B) avoid risky projects so it can receive more project funding.
C) become less risky over time based on the projects that are accepted.
D) have an equal probability with all the other divisions of receiving funding.
E) prefer higher risk projects over lower risk projects.
28) The discount rate assigned to an individual project should be based on:
A) the company's overall weighted average cost of capital.
B) the actual sources of funding used for the project.
C) an average of the company's overall cost of capital for the past five years.
D) the current risk level of the overall firm.
E) the risks associated with the use of the funds required by the project.
29) Assigning discount rates to individual projects based on the risk level of each project:
A) may cause the company's overall weighted average cost of capital to either increase or
decrease over time.
B) will prevent the company's overall cost of capital from changing over time.
C) will cause the company's overall cost of capital to decrease over time.
D) decreases the value of the company over time.
E) negates the company's goal of creating the most value for its shareholders.
30) Which one of the following statements is correct?
A) Firms should accept low-risk projects prior to funding high-risk projects.
B) Making subjective adjustments to a company's WACC when determining project discount
rates unfairly punishes low-risk divisions within the company.
C) A project that is unacceptable today might be acceptable tomorrow given a change in market
returns.
D) The pure play method is most frequently used for projects involving the expansion of a
company's current operations.
E) Companies that elect to use the pure play method for determining a discount rate for a project
cannot subjectively adjust the pure play rate.
31) The Road Stop is a national hotel chain with a cost of capital of 12.4 percent. This chain is
considering opening a high-end resort that is expected to have a cost of capital that is at least 13
percent. The estimated net present value of the resort project is $500 when discounted at 12.4
percent. The best representation of this situation is that the resort project should:
A) be accepted immediately.
B) be financed solely with debt in order for the project to have a positive NPV.
C) probably be put on hold until its cost of capital can be lowered.
D) be permanently rejected.
E) probably be expanded.
32) The subjective approach to project analysis:
A) is used only when a firm has an all-equity capital structure.
B) uses the WACC of Firm X as the basis for the discount rate for a project under consideration
by Firm Y.
C) assigns discount rates to projects based on the discretion of the senior managers of a firm.
D) allows managers to randomly adjust the discount rate assigned to a project once the project's
standard deviation has been determined.
E) applies a lower discount rate to projects that are financed totally with equity as compared to
those that are partially financed with debt.
33) Which one of the following statements is correct?
A) The subjective approach assigns a discount rate to each project based on other companies in
the same category as the project.
B) Overall, a company makes better decisions when it uses the subjective approach than when it
uses its WACC as the discount rate for all projects.
C) Companies will correctly accept or reject every project if they adopt the subjective approach.
D) Mandatory projects should only be accepted if they produce a positive NPV when the overall
company WACC is used as the discount rate.
E) The pure play approach should only be used with low-risk projects.
34) When a manager develops a cost of capital for a specific project based on the cost of capital
for another firm that has a similar line of business as the project, the manager is utilizing the
________ approach.
A) subjective risk
B) pure play
C) divisional cost of capital
D) capital adjustment
E) security market line
35) When computing the adjusted cash flow from assets, the tax amount is calculated as:
A) EBT(TC).
B) (EBT − Depreciation)(TC).
C) (EBIT + Depreciation − Change in NWC − Capital spending)(TC).
D) EBIT(TC).
E) (EBIT − Depreciation − Change in NWC − Capital spending)(TC).
36) Why does the tax amount need to be adjusted when valuing a firm using the cash flow from
assets approach?
A) The tax effect of the dividend payments must be eliminated.
B) Only straight-line depreciation can be used when computing taxes for valuation purposes.
C) Taxes must be computed for valuation purposes based solely on the marginal tax rate.
D) The tax effect of the interest expense must be removed.
E) The taxes must be computed for valuation purposes based on the average tax rate for the past
ten years.
37) When a firm has flotation costs equal to 8.3 percent of the funding need, project analysts
should:
A) increase the project's discount rate to offset these expenses by multiplying the company's
WACC by 1.083.
B) increase the project's discount rate to offset these expenses by dividing the company's WACC
by (1 − .083).
C) add 8.3 percent to the company's firm's WACC to determine the discount rate for the project.
D) increase the initial project cost by multiplying that cost by 1.083.
E) increase the initial project cost by dividing that cost by (1 − .083).
38) The flotation cost for a company is computed as:
A) the arithmetic average of the flotation costs of both debt and equity.
B) the weighted average of the flotation costs associated with each form of financing.
C) the geometric average of the flotation costs associated with each form of financing.
D) one-half of the flotation cost of debt plus one-half of the flotation cost of equity.
E) a weighted average based on the book values of the company's outstanding securities.
39) Incorporating flotation costs into the analysis of a project will:
A) cause the project to be improperly evaluated.
B) increase the net present value of the project.
C) increase the project's rate of return.
D) increase the initial cash outflow of the project.
E) have no effect on the present value of the project.
40) Flotation costs for a levered firm should be:
A) ignored when analyzing a project because they are a sunk cost.
B) spread over the life of a project thereby reducing the cash flows for each year of the project.
C) considered only when two projects are mutually exclusive.
D) weighted and included in the initial cash flow.
E) totally ignored when internal equity funding is utilized.
41) Chelsea Fashions is expected to pay an annual dividend of $1.26 a share next year. The
market price of the stock is $24.09 and the growth rate is 2.6 percent. What is the cost of equity?
A) 9.77 percent
B) 7.91 percent
C) 9.24 percent
D) 7.83 percent
E) 7.54 percent
42) The Shoe Outlet has paid annual dividends of $.58, $.66, $.72, and $.75 per share over the
last four years, respectively. The stock is currently selling for $10.08 a share. What is the cost of
equity?
A) 18.74 percent
B) 17.13 percent
C) 10.38 percent
D) 19.53 percent
E) 11.79 percent
43) Sweet Treats common stock is currently priced at $36.72 a share. The company just paid
$2.18 per share as its annual dividend. The dividends have been increasing by 2.2 percent
annually and are expected to continue doing the same. What is the cost of equity?
A) 9.41 percent
B) 9.51 percent
C) 8.47 percent
D) 8.27 percent
E) 8.82 percent
44) The common stock of Metal Molds has a negative growth rate of 1.63 percent and a required
return of 18.21 percent. The current stock price is $9.82. What was the amount of the last
dividend paid?
A) $1.07
B) $2.11
C) $1.64
D) $1.73
E) $1.98
