Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
Chapter 20: Cost of Capital
Multiple Choice Questions
1. Section: 20.1 Financing Sources
Learning Objective: 20.1
Level of difficulty: Intermediate
2. Section: 20.1 Financing Sources
Learning Objective: 20.1
Level of difficulty: Basic
3. Section: 20.1 Financing Sources
Learning Objective: 20.1
Level of difficulty: Intermediate
4. Section: 20.1 Financing Sources
Learning Objective: 20.1
Level of difficulty: Intermediate
5. Section: 20.1 Financing Sources
Learning Objective: 20.1
Level of difficulty: Intermediate
6. Section: The Cost of Capital
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
Learning Objective: 20.2
Level of difficulty: Intermediate
7. Section: 20.5 Growth Models and the Cost of Common Equity
Learning Objective: 20.5
Level of difficulty: Intermediate
8. Section: 20.5 Growth Models and the Cost of Common Equity
Learning Objective: 20.5
Level of difficulty: Challenging
9. Section: 20.5 Growth Models and the Cost of Common Equity
Learning Objective: 20.5
Level of difficulty: Intermediate
A growth firm is the one that adds value to the firm and has growth opportunities: ROE > ke.
10. Section: 20.5 Growth Models and the Cost of Common Equity
Learning Objective: 20.5
Level of difficulty: Intermediate
Practice Problems
Intermediate
11. Section: 20.6 Risk-Based Models and the Cost of Common Equity
Learning Objective: 20.6
Level of difficulty: Intermediate
12. Section: 20.5 Growth Models and the Cost of Common Equity
Level of difficulty: Intermediate
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
Learning Objective: 20.5
Solution:
13. Section: 20.1 Financing Sources
Learning Objective: 20.1
Level of difficulty: Intermediate
Solution:
14. Section: 20.3 Estimating the Non-Equity Component Costs
Learning Objective: 20.3
Level of difficulty: Intermediate
Solution:
i) Flotation costs: Issuing expenses on new securities have to be paid from the gross proceeds of
15. Section: 20.2 The Cost of Capital
Learning Objective: 20.2
Level of difficulty: Intermediate
Solution:
16. Section: 20.5 Growth Models and the Cost of Common Equity
Level of difficulty: Intermediate
Learning Objective: 20.5
Solution:
17. Section: 20.5 Growth Models and the Cost of Common Equity
Learning Objective: 20.5
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
Level of difficulty: Intermediate
Solution:
18. Section: 20.5 Growth Models and the Cost of Common Equity
Learning Objective: 20.5
Level of difficulty: Intermediate
Solution:
19. Section: 20.5 Growth Models and the Cost of Common Equity
Learning Objective: 20.5
Level of difficulty: Intermediate
Solution:
20. Section: 20.5 Growth Models and the Cost of Common Equity
Learning Objective: 20.5
Level of difficulty: Intermediate
Topic: Growth Models and the Cost of Common Equity
Solution:
21. Section: 20.5 Growth Models and the Cost of Common Equity
Learning Objective: 20.5
Level of difficulty: Intermediate
Solution:
22. Section: 20.5 Growth Models and the Cost of Common Equity
Learning Objective: 20.5
Level of difficulty: Intermediate
Solution:
23. Section: 20.7 The Cost of Capital and Investment
Learning Objective: 20.7
Level of difficulty: Intermediate
Solution: The statement is false. The cost of capital for a new project depends on the use of
24. Section: 20.7 The Cost of Capital and Investment
Learning Objective: 20.7
Level of difficulty: Intermediate
Solution:
The appropriate discount rate should be based on the risk of the project, not on the risk of the
individual companies undertaking the project. In this case, the development of a software
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
25. Section: 20.7 The Cost of Capital and Investment
Learning Objective: 20.7
Level of difficulty: Intermediate
Solution:
Challenging
26. Section: 20.7 The Cost of Capital and Investment
Learning Objective: 20.5, 20.6 and 20.7
Level of difficulty: Challenging
Solution:
We must first determine the firm’s cost of equity. We have enough information to estimate ke
using either the CAPM or the constant dividend growth model.
We can now estimate the after-tax cost of debt from the information given.
kb = (1 – T) × (RF + 3%) = (1 – 0.3)*(3% + 3%) = 4.2%
27. Section: 20.7 The Cost of Capital and Investment
Learning Objective: 20.5, 20.6 and 20.7
Level of difficulty: Challenging
Solution:
We first compute the costs of each source of funds:
So we have:
By financial calculator:
Preferred: The market value is the total dividend payments divided by the market capitalization
rate.
P = 0.06 × ($1,500,000)/0.055 = $1,636,364
Equity: Shares are currently trading at 10/(1 – 0.12)= $11.36
28. Section: 20.7 The Cost of Capital and Investment
Learning Objective: 20.5, 20.6 and 20.7
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
Level of difficulty: Challenging
Solution:
a. Cost of Debt:
b. Since they need $5m in total financing, all of the common equity financing ($5m*0.5 =
c. Since they need $8m in total financing, the common equity financing needed ($8m*0.5 = $4m)
29. Section: 20.7 The Cost of Capital and Investment
Learning Objective: 20.5, 20.6 and 20.7
Level of difficulty: Challenging
Solution:
a. Cost of LT debt:
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
b. Cost of Preferred Shares:
c. and d.
Cost of Common Equity Financing:
(i) Dividend Growth Model Approach:
30. Section: 20.7 The Cost of Capital and Investment
Learning Objective: 20.7
Level of difficulty: Challenging
Solution:
a. Using ke, we get:
b.
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
Answers to Concept Review Questions
20.1 Financing Sources
Concept review questions
1. Why is the earnings yield not usually an adequate measure of the investor’s required return on
equity?
Since most firms have some expectation for growth, so the stock price reflects these growth
2. How are the ROE and Ke related to a firm’s growth opportunities and its M/B ratio?
20.2 The Cost of Capital
Concept review questions
1. Why is the weighted average cost of capital (WACC) so important?
2. What are the steps involved in estimating a firm’s WACC?
There are three steps involved in estimating the WACC:
i. Estimate market values for the sources of capital, since our focus is on how to increase the
3. How can we estimate the market value of common equity, preferred equity, and long-term
debt?
The market value of common equity is simply price per share multiplied by the number of shares
20.3 Estimating the Non-Equity Component Costs
Concept review questions
1. How do flotation costs affect the cost of capital sources for a firm?
One complication that arises with respect to all sources of capital, except for internally generated
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
2. Explain how to estimate the cost of debt and preferred equity for a firm.
The cost of debt is obtained by using Equation 20-13. The left-hand side is the after-tax after-
flotation proceeds of debt. The right-hand side is the present value of the after tax interest
20.4 The Effects of Operating and Financial Leverage
Concept review questions
1. Distinguish between operating and financial leverage.
2. Why do we say that equity holders bear the brunt of the effects of leverage?
20.5 Growth Models and the Cost of Common Equity
Concept review questions
1. Explain how we can use the constant growth DDM to estimate the cost of firms’ internal
common equity, as well as the cost of new common share issues.
The cost of firms’ internal common equity is the dividend yield plus the growth rate of
2. Explain the relationship among ROE, retention rates, and firm growth.
3. How can we relate the existence of multiple growth stages to four commonly used firm
classifications?
Assume that a firm earns current earnings in the first stage and starts to grow with a constant rate
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
4. Describe the Fed model and how it may be used to estimate the required rate of return of the
market as a whole.
The Fed model was used to estimate whether the stock market was over- or undervalued and
20.6 Risk-Based Models and the Cost of Common Equity
Concept review questions
1. Explain how we can use the CAPM to estimate the cost of common equity.
DCF performs poorly when applied to growth stocks, which pay low dividends and/or display
2. Explain why beta estimates are “period specific” and outline the potential problems that may
arise. Allude to problems with recent beta estimates.
The beta estimation is time varying. In the past ten years, one sub index shows rapidly increasing
20.7 The Cost of Capital and Investment
Concept review questions
1. Explain the importance of using the WACC as a hurdle rate for making investment decisions.
If investors want an overall WACC, this suggests that this firm should not reinvest funds within
2. Why does the MCC suddenly jump up and become expensive?
When the common equity portion of financing comes entirely from reinvested earnings, the
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita