Deck 9: The Cost of Capital

Question 1

The cost of capital reflects the cost of funds ________.

A) that makes the net present value of a project equal zero
B) at a given point in time
C) over a long-run time period
D) at current book values

Answer 1

over a long-run time period

Question 2

A firm's flotation cost can be calculated by weighting the cost of each source of financing by its relative proportion in a firm's target capital structure.

Answer 2

False

Question 3

The cost of capital reflects the cost of funds over the long run measured at a given point in time, based on the best information available.

Answer 3

True

Question 4

The cost of capital is the rate of return a firm must earn on investments in order to increase the firm's value.

Question 5

The ________ is the firm's desired optimal mix of debt and equity financing.

A) book value
B) market value
C) cost of capital
D) target capital structure

Question 6

The cost of capital is a static concept and it is not affected by economic and firm-specific factors such as business risk and financial risk.

Question 7

The cost of capital is a dynamic concept and it is affected by economic and firm-specific factors such as business risk and financial risk.

Question 8

The ________ is the rate of return required by the market suppliers of capital in order to attract their funds to the firm.

A) yield to maturity
B) internal rate of return
C) cost of capital
D) modified internal rate of return

Question 9

The cost to a firm of each type of capital is dependent upon ________.

A) the risk-free rate of bonds plus the business risk of the firm
B) the risk-free rate of each type of capital plus the business risk of the firm
C) the risk-free rate of each type of capital plus the financial risk of the firm
D) the risk-free rate of each type of capital plus the business risk and the financial risk of the firm

Question 10

In using the cost of capital, it is important that it reflects the historical cost of raising funds over the long run.

Question 11

Holding risk constant, the implementation of projects with a rate of return above the cost of capital will decrease the value of a firm, and vice versa.

Question 12

The target capital structure is the desired optimal mix of debt and equity financing that most firms attempt to achieve and maintain.

Question 13

The cost of common stock equity refers to the cost of the next dollar of financing necessary to finance a new investment opportunity.

Question 14

The cost of capital is used to decide whether a proposed corporate investment will increase or decrease a firm's stock price.

Question 15

Although a firm's existing mix of financing sources may reflect its target capital structure, it is ultimately ________.

A) the internal rate of return that is relevant for evaluating the firm's future investment opportunities
B) the marginal cost of capital that is relevant for evaluating the firm's future investment opportunities
C) the risk-free rate of return that is relevant for evaluating the firm's future investment opportunities
D) the risk-free rate of return that is relevant for evaluating the firm's future financing opportunities

Question 16

The ________ is the rate of return that a firm must earn on its investments in order to maintain the market value of its stock.

A) yield to maturity
B) cost of capital
C) internal rate of return
D) modified internal rate of return

Question 17

The ________ is a weighted average of the cost of funds which reflects the interrelationship of financing decisions.

A) internal rate of return
B) sunk cost
C) cost of capital
D) risk-free rate

Question 18

The cost of capital is described as the rate of return required by the market suppliers of capital in order to attract their funds to the firm.

Question 19

The cost of capital of each source of financing is the after-tax cost of obtaining the financing using the historically based cost reflected by the existing financing on the firm's books.

Question 20

The cost of capital acts as a major link between a firm's long-term investment decisions and the wealth of the firm's owners as determined by the market value of their shares.

Question 21

The marginal cost of capital is a relevant cost of capital for evaluating a firm's future investment opportunities.

Question 22

The approximate before-tax cost of debt for a 15-year, 10 percent, $1,000 par value bond selling at $950 is ________.

A) 10 percent
B) 10.7 percent
C) 12 percent
D) 15.4 percent

Question 23

The weighted average cost of capital represents the annual before-tax percentage cost of the debt.

Question 24

Which of the following is a source of long-term funds?

A) commercial paper
B) retained earnings
C) factoring
D) money market instruments

Question 25

Generally the least expensive source of long-term capital is ________.

A) retained earnings
B) preferred stock
C) long-term debt
D) common stock

Question 26

A tax adjustment must be made in determining the cost of ________.

A) long-term debt
B) common stock
C) preferred stock
D) retained earnings

Question 27

The ________ from the sale of a security are the funds actually received from the sale after ________.

A) gross proceeds; adding the after-tax costs
B) gross proceeds; reducing the flotation costs
C) net proceeds; reducing the flotation costs
D) net proceeds; adding the after-tax costs

Question 28

Generally, the order of cost, from the least expensive to the most expensive, for long-term capital of a corporation is ________.

A) new common stock, retained earnings, preferred stock, long-term debt
B) common stock, preferred stock, long-term debt, short-term debt
C) preferred stock, new common stocks, common stock, retained earnings
D) long-term debt, preferred stock, retained earnings, new common stock

Question 29

When the net proceeds from sale of a bond equal its par value, the before-tax cost would just equal the coupon interest rate.

Question 30

Flotation costs reduce the net proceeds from the sale of a bond whether sold at a premium, at a discount, or at its par value.

Question 31

The approximate before-tax cost of debt for a 10-year, 8 percent, $1,000 par value bond selling at $1,150 is ________.

A) 5.97 percent
B) 8.33 percent
C) 8.82 percent
D) 9 percent

Question 32

The cost to maturity of existing bonds reflects the rate of return required by the market.

Question 33

The weighted average cost of capital refers to the cost of capital required for one additional dollar of financing.

Question 34

From a bond issuer's perspective, the IRR on a bond's cash flows is its yield to maturity (YTM); from the investor's perspective, the IRR on a bond's cash flows is the cost to maturity.

Question 35

In order to recognize the interrelationship between financing and investments, a firm should use ________ when evaluating an investment.

A) the least costly source of financing
B) the most costly source of financing
C) the weighted average cost of all financing sources
D) the current opportunity cost

Question 36

From a bond issuer's perspective, the IRR on a bond's cash flows is its cost to maturity; from the investor's perspective, the IRR on a bond's cash flows is the yield to maturity (YTM).

Question 37

The four basic sources of long-term funds for a firm are ________.

A) current liabilities, long-term debt, common stock, and preferred stock
B) current liabilities, long-term debt, common stock, and retained earnings
C) long-term debt, paid-in capital in excess of par, common stock, and retained earnings
D) long-term debt, common stock, preferred stock, and retained earnings

Question 38

Which of the following is true of long-term funds?

A) They provide an easy way to reduce financing costs because they are relatively cheaper than short-term funds.
B) They are a type of investment fund which invests in money market investments of high quality and low risk.
C) They are the sources that supply the financing necessary to support a firm's capital budgeting activities.
D) They are the funds available to a business on the basis of inventory held and require detailed inventory tracking.

Question 39

The net proceeds used in calculation of the cost of long-term debt are funds actually received from the sale after paying for flotation costs and taxes.

Question 40

In general, floatation costs include two components, underwriting costs and administrative costs.

Question 41

If a corporation has an average tax rate of 40 percent, the approximate annual, after-tax cost of debt for a 10-year, 8 percent, $1,000 par value bond selling at $1,150 is ________.

A) 3.6 percent
B) 4.8 percent
C) 6 percent
D) 8 percent

Question 42

The cost of preferred stock is the ratio of the preferred stock dividend to a firm's total earnings.

Question 43

The before-tax cost of debt for a firm, which has a marginal tax rate of 40 percent, is 12 percent. The after-tax cost of debt is ________.

A) 4.8 percent
B) 6.0 percent
C) 7.2 percent
D) 12 percent

Question 44

If a corporation has an average tax rate of 40 percent, the approximate, annual, after-tax cost of debt for a 15-year, 12 percent, $1,000 par value bond, selling at $950 is ________.

A) 10 percent
B) 10.6 percent
C) 7.7 percent
D) 6.0 percent

Question 45

When determining the after-tax cost of a bond, the face value of the issue must be adjusted to the net proceeds amounts by considering ________.

A) the risks
B) the flotation costs
C) the approximate returns
D) the taxes

Question 46

Nico Trading Corporation is considering issuing long-term debt. The debt would have a 30-year maturity and a 10 percent coupon rate. In order to sell the issue, the bonds must be underpriced at a discount of 5 percent of face value. In addition, the firm would have to pay flotation costs of 5 percent of face value. The firm's tax rate is 35 percent. Given this information, the after-tax cost of debt for Nico Trading would be ________.

A) 7.26%
B) 11.17%
C) 10.00%
D) 9.00%

Question 47

The cost of preferred stock is the ratio of the preferred stock dividend to a firm's net proceeds from the sale of the preferred stock.

Question 48

What is the dividend on an 8 percent preferred stock that currently sells for $45 and has a face value of $50 per share?

A) $3.33
B) $3.60
C) $4.00
D) $5.00

Question 49

Since preferred stock is a form of ownership, it has no maturity date.

Question 50

The approximate after-tax cost of debt for a 20-year, 7 percent, $1,000 par value bond selling at $960 (assume a marginal tax rate of 40 percent) is ________.

A) 4.43 percent
B) 5.15 percent
C) 7 percent
D) 7.35 percent

Question 51

Preferred stockholders must receive their stated dividends prior to the distribution of any earnings to common stockholders and bondholders.

Question 52

Tangshan Mining is considering issuing long-term debt. The debt would have a 30 year maturity and a 12 percent coupon rate and make semiannual coupon payments. In order to sell the issue, the bonds must be underpriced at a discount of 2.5 percent of face value. In addition, the firm would have to pay flotation costs of 2.5 percent of face value. The firm's tax rate is 33 percent. Given this information, the after-tax cost of debt for Tangshan Mining would be ________.

A) 6.38%
B) 12.76%
C) 4.98%
D) 8.48%

Question 53

The amount of preferred stock dividends that must be paid each year may be stated in dollars or as a percentage of the firm's earnings.

Question 54

A firm has issued preferred stock at its $125 per share par value. The stock will pay a $15 annual dividend. The cost of issuing and selling the stock was $4 per share. The cost of the preferred stock is ________.

A) 7.2 percent
B) 12 percent
C) 12.4 percent
D) 15 percent

Question 55

A firm has issued 10 percent preferred stock, which sold for $100 per share par value. The cost of issuing and selling the stock was $2 per share. The firm's marginal tax rate is 40 percent. The cost of the preferred stock is ________.

A) 3.9 percent
B) 6.1 percent
C) 9.8 percent
D) 10.2 percent

Question 56

Debt is generally the least expensive source of capital. This is primarily due to ________.

A) the fixed interest payments
B) the priority of claims on assets and earnings in the event of liquidation
C) the tax deductibility of interest payments
D) the secured nature of a debt obligation

Question 57

The cost of preferred stock is typically higher than the cost of long-term debt (bonds) because the cost of long-term debt (interest) is tax deductible.

Question 58

Tangshan Mining is considering issuing preferred stock. The preferred stock would have a par value of $75 and a 5.50 percent dividend. What is the cost of preferred stock for Tangshan if flotation costs would amount to 5.5 percent of par value?

A) 5.50%
B) 5.27%
C) 7.73%
D) 5.82%

Question 59

A firm has determined it can issue preferred stock at $115 per share par value. The stock will pay a $12 annual dividend. The cost of issuing and selling the stock is $3 per share. The cost of the preferred stock is ________.

A) 6.4 percent.
B) 10.4 percent.
C) 10.7 percent.
D) 12 percent.

Question 60

The specific cost of each source of long-term financing is based on ________ and ________ costs.

A) before-tax; historical
B) after-tax; historical
C) before-tax; book value
D) after-tax; current

Question 61

One measure of the cost of common stock equity is the rate at which investors discount the expected common stock dividends of the firm to determine its share value.

Question 62

The cost of common stock equity capital represents the return required by existing shareholders on their investment.

Question 63

The capital asset pricing model describes the relationship between the required return, or the cost of common stock equity capital, and the nonsystematic risk of a firm as measured by the beta coefficient.

Question 64

The cost of new common stock is normally greater than any other long-term financing cost.

Question 65

The Gordon model assumes that the value of a share of stock equals the future value of the current price of share that it is expected to remain constant over an infinite time horizon.

Question 66

Using the Capital Asset Pricing Model (CAPM), the cost of common stock equity is the return required by investors as compensation for a firm's nondiversifiable risk.

Question 67

The cost of common stock equity may be measured using either the constant-growth valuation model or the capital asset pricing model.

Question 68

According to the CAPM, the required return of an asset is the sum of risk-free rate of return and beta times the risk premium.

Question 69

The constant-growth model uses the market price as a reflection of the expected risk-return preference of investors in the market place.

Question 70

A firm can retain more of its earnings if it can convince its stockholders that it will earn at least their required return on the reinvested funds.

Question 71

The cost of retained earnings is generally higher than both the cost of debt and cost of preferred stock.

Question 72

The cost of retained earnings is always lower than the cost of a new issue of common stock due to the absence of flotation costs when financing projects with retained earnings.

Question 73

The Gordon model is based on the premise that the value of a share of stock is equal to sum of all future dividends it is expected to provide over an infinite time horizon.

Question 74

When the constant-growth valuation model is used to find the cost of common stock equity capital, it can easily be adjusted for flotation costs to find the cost of new common stock; the capital asset pricing model (CAPM) does not provide a simple adjustment mechanism.

Question 75

The cost of retained earnings will always equal the cost of preferred stock.

Question 76

The capital asset pricing model is used to calculate the effect of increase in prices of capital assets due to inflation.

Question 77

Use of the capital asset pricing model (CAPM) in measuring the cost of common stock equity differs from the constant-growth valuation model in that it directly considers the firm's risk as reflected by beta.

Question 78

In computing the cost of retained earnings, the net proceeds represents the amount of money retained net of any underpricing and/or flotation costs.

Question 79

The cost of equity for Tangshan Mining would be 18.00 percent if the expected return on U.S. Treasury Bills is 5.00 percent, the market risk premium is 10.00 percent, and the firm's beta is 1.3.

Question 80

Since the net proceeds from sale of new common stock will be less than the current market price, the cost of new issues will always be less than the cost of existing issues.