Question 1

Which of the following statements is CORRECT?

Accepted Answer

A)   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.
B)   A cost should be assigned to retained 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 paid out rather than retained and reinvested.
C)   No cost should be assigned to retained 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."
D)   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.
E)   If a firm has enough retained 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.F) B) and C)
G) D) and E)

Question 2

You were hired as a consultant to Giambono Company,whose 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 retained earnings is 11.50%.The firm will not be issuing any new stock.What is its WACC?

Accepted Answer

A)   8.70%
B)   8.87%
C)   7.92%
D)   7.66%
E)   6.70%F) All of the above
G) B) and C)

Question 3

"Capital" is sometimes defined as funds supplied to a firm by investors.

Accepted Answer

A) True 
 B)False

Question 4

Safeco Company and Risco Inc are identical in size and capital structure.However,the riskiness of their assets and cash flows are somewhat different,resulting in Safeco having a WACC of 10% and Risco a WACC of 12%.Safeco is considering Project X,which has an IRR of 10.5% and is of the same risk as a typical Safeco project.Risco is considering Project Y,which has an IRR of 11.5% and is of the same risk as a typical Risco project. Now assume that the two companies merge and form a new company,Safeco/Risco Inc.Moreover,the new company's market risk is an average of the pre-merger companies' market risks,and the merger has no impact on either the cash flows or the risks of Projects X and Y.Which of the following statements is CORRECT?

Accepted Answer

A)   If the firm evaluates these projects and all other projects at the new overall corporate WACC,it will probably become riskier over time.
B)   If evaluated using the correct post-merger WACC,Project X would have a negative NPV.
C)   After the merger,Safeco/Risco would have a corporate WACC of 11%.Therefore,it should reject Project X but accept Project Y.
D)   Safeco/Risco's WACC,as a result of the merger,would be 10%.
E)   After the merger,Safeco/Risco should select Project Y but reject Project X.If the firm does this,its corporate WACC will fall to 10.5%.F) A) and B)
G) C) and E)

Question 5

For a company whose target capital structure calls for 50% debt and 50% common equity,which of the following statements is CORRECT?

Accepted Answer

A)   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.
B)   The WACC is calculated on a before-tax basis.
C)   The WACC exceeds the cost of equity.
D)   The cost of equity is always equal to or greater than the cost of debt.
E)   The cost of retained earnings typically exceeds the cost of new common stock.F) D) and E)
G) C) and E)

Question 6

Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets.They then provide funds to their different divisions for investment in capital projects.The divisions may vary in risk,and the projects within the divisions may also vary in risk.Therefore,it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.

Accepted Answer

A) True 
 B)False

Question 7

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.

Accepted Answer

A) True 
 B)False

Question 8

Which of the following statements is CORRECT?

Accepted Answer

A)   The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital.
B)   The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt.
C)   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.
D)   There is an "opportunity cost" associated with using retained earnings,hence they are not "free."
E)   The WACC as used in capital budgeting would be simply the before-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year.F) A) and D)
G) B) and C)

Question 9

O'Brien Inc.has the following data: rRF = 5.00%;RPM = 6.00%;and b = 1.50.What is the firm's cost of equity from retained earnings based on the CAPM?

Accepted Answer

A)   10.92%
B)   12.46%
C)   14.98%
D)   15.54%
E)   14.00%F) B) and E)
G) A) and E)

Question 10

Which of the following statements is CORRECT?

Accepted Answer

A)   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.
B)   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.
C)   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.
D)   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.
E)   The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm's cost of equity capital.F) None of the above
G) A) and E)

Question 11

The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

Accepted Answer

A) True 
 B)False

Question 12

The before-tax cost of debt,which is lower than the after-tax cost,is used as the component cost of debt for purposes of developing the firm's WACC.

Accepted Answer

A) True 
 B)False

Question 13

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

Accepted Answer

A)   Long-term debt.
B)   Accounts payable.
C)   Retained earnings.
D)   Common stock.
E)   Preferred stock.F) A) and B)
G) A) and E)

Question 14

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.

Accepted Answer

A) True 
 B)False

Question 15

Which of the following statements is CORRECT?

Accepted Answer

A)   The WACC is calculated using before-tax costs for all components.
B)   The after-tax cost of debt usually exceeds the after-tax cost of equity.
C)   For a given firm,the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock.
D)   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.
E)   The WACC that should be used in capital budgeting is the firm's marginal,after-tax cost of capital.F) A) and B)
G) A) and C)

Question 16

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them,and no flotation costs are required to raise them,but capital raised by selling new stock or bonds does have a cost.

Accepted Answer

A) True 
 B)False

Question 17

S.Bouchard and Company hired you as a consultant to help estimate its cost of capital.You have obtained the following data: D0 = $0.85;P0 = $22.00;and g = 6.00% (constant) .The CEO thinks,however,that the stock price is temporarily depressed,and that it will soon rise to $37.00.Based on the DCF approach,by how much would the cost of equity from retained earnings change if the stock price changes as the CEO expects? Do not round your intermediate calculations.

Accepted Answer

A)   -1.66%
B)   -1.39%
C)   -1.79%
D)   -1.73%
E)   -1.81%F) A) and D)
G) A) and C)

Question 18

When working with the CAPM,which of the following factors can be determined with the most precision?

Accepted Answer

A)   The market risk premium (RPM) .
B)   The beta coefficient,bi,of a relatively safe stock.
C)   The most appropriate risk-free rate,rRF.
D)   The expected rate of return on the market,rM.
E)   The beta coefficient of "the market," which is the same as the beta of an average stock.F) A) and B)
G) D) and E)

Question 19

A.Butcher Timber Company hired your consulting firm to help them estimate the cost of equity.The yield on the firm's bonds is 12.00%,and your firm's economists believe that the cost of equity 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 equity from retained earnings?

Accepted Answer

A)   15.85%
B)   14.74%
C)   12.52%
D)   13.31%
E)   14.58%F) None of the above
G) A) and E)

Question 20

Duval Inc.uses only equity capital,and it has two equally-sized divisions.Division A's cost of capital is 10.0%,Division B's cost is 14.0%,and the corporate (composite) WACC is 12.0%.All of Division A's projects are equally risky,as are all of Division B's projects.However,the projects of Division A are less risky than those of Division B.Which of the following projects should the firm accept?

Accepted Answer

A)   A Division B project with a 13% return.
B)   A Division B project with a 12% return.
C)   A Division A project with an 11% return.
D)   A Division A project with a 9% return.
E)   A Division B project with an 11% return.F) C) and E)
G) C) and D)

Exam 11: The Cost of Capital

Which of the following statements is CORRECT?

Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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O'Brien Inc.has the following data: r_RF = 5.00%;RP_M = 6.00%;and b = 1.50.What is the firm's cost of equity from retained earnings based on the CAPM?

Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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Correct Answer
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Correct Answer
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Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them,and no flotation costs are required to raise them,but capital raised by selling new stock or bonds does have a cost.

Correct Answer
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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.

Correct Answer
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Correct Answer
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Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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When working with the CAPM,which of the following factors can be determined with the most precision?

Correct Answer
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The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

Correct Answer
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The before-tax cost of debt,which is lower than the after-tax cost,is used as the component cost of debt for purposes of developing the firm's WACC.

Correct Answer
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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.

Correct Answer
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Correct Answer
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For a company whose target capital structure calls for 50% debt and 50% common equity,which of the following statements is CORRECT?

Correct Answer
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Correct Answer
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Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

Correct Answer
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"Capital" is sometimes defined as funds supplied to a firm by investors.

Correct Answer
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Exam 11: The Cost of Capital

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

O'Brien Inc.has the following data: rRF = 5.00%;RPM = 6.00%;and b = 1.50.What is the firm's cost of equity from retained earnings based on the CAPM?

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them,and no flotation costs are required to raise them,but capital raised by selling new stock or bonds does have a cost.

Correct AnswerverifiedShow Answer

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.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

When working with the CAPM,which of the following factors can be determined with the most precision?

Correct AnswerverifiedShow Answer

The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

Correct AnswerverifiedShow Answer

The before-tax cost of debt,which is lower than the after-tax cost,is used as the component cost of debt for purposes of developing the firm's WACC.

Correct AnswerverifiedShow Answer

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.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

For a company whose target capital structure calls for 50% debt and 50% common equity,which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

Correct AnswerverifiedShow Answer

"Capital" is sometimes defined as funds supplied to a firm by investors.

Correct AnswerverifiedShow Answer

Correct Answer
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Correct Answer
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O'Brien Inc.has the following data: r_RF = 5.00%;RP_M = 6.00%;and b = 1.50.What is the firm's cost of equity from retained earnings based on the CAPM?

Correct Answer
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