Deck 11: Cost of Capital

Question 1

A firm's cost of preferred stock is equal to the preferred dividend divided by the net price after flotation costs.

Answer 1

True

Question 2

It is standard practice to evaluate investment decisions using the cost of the specific financing method involved.

Answer 2

False

Question 3

The out-of-pocket cost of common stock is a good approximation of the cost of common stock equity.

Answer 3

False

Question 4

The cost of retained earnings is equal to the required rate of return on a firm's outstanding common stock.

Question 5

The calculation of the cost of capital depends upon historical costs of funds.

Question 6

Retained earnings represent an internal source of funds that is raised without the payment of interest, or cost to the firm's stockholders.

Question 7

The amount of debt capital used by a corporation is not related to the availability of equity funds from retained earnings and new common stock.

Question 8

In determining the cost of preferred stock, the earnings on outstanding preferred stock may be used as a proxy.

Question 9

The use of the optimum capital structure minimizes the cost of capital.

Question 10

The discount rate that equates a future stream of expected dividends to the current price is a good approximation of the cost of common stock.

Question 11

The only difference in the cost of retained earnings (K_e) and the cost of new common stock (K_n) is the flotation cost on new common stock.

Question 12

The cost of new common stock is greater than the cost of outstanding common stock.

Question 13

The cost of capital for each source of funds is dependent on current market conditions and expected rates of return.

Question 14

K_erepresents an expected return to stockholders as well as a cost to the firm.

Question 15

In determining the cost of debt, yields and prices of outstanding bonds are used.

Question 16

The cost of debt is equal to the current bond yield on bonds of similar risk class and adjusted for the corporate tax rate.

Question 17

All firms within particular industries have similar optimum capital structures.

Question 18

The use of common stock equity in the weighted average cost of capital is always (K_e) and not (K_n), the cost of new common stock.

Question 19

A firm's cost of preferred stock is equal to the preferred dividend divided by market price plus the dividend growth rate (K_p= D/P_o+ g).

Question 20

Regardless of the particular source of funds utilized for a project, the required rate of return, or discount rate, will be the weighted average cost of capital.

Question 21

The pretax cost of debt is less than the pretax cost of equity.

Question 22

In the capital asset pricing model (CAPM), beta measures the volatility of the market.

Question 23

A firm that does not earn the cost of capital in the long run will not maximize shareholder wealth.

Question 24

Although the after-tax cost of debt is below the cost of equity, firms cannot increase their use of debt without limit.

Question 25

Companies prefer to maintain some financing flexibility in order to choose the lowest cost source of funds at a single point in time.

Question 26

A firm that does not earn the cost of capital in the short run will probably be in bankruptcy.

Question 27

Taking on additional debt will reduce the cost of equity.

Question 28

The capital asset pricing model (CAPM) relates the risk-return tradeoffs of individual assets to market returns.

Question 29

The cost of debt, preferred stock, and common equity must all be adjusted for tax implications.

Question 30

Individual common stocks' betas have a tendency to move toward 1.0 over time.

Question 31

Market values rather than book values should be used for determining the optimal capital structure, though in practice, book value is commonly used.

Question 32

Firms in stable industries are advised to keep debt levels very low so that shareholders, rather than creditors, receive the benefits of steady cash flows.

Question 33

The use of the weighted average cost of capital assumes that the firm is in its optimum capital structure range and the cost of each component stays constant over the range of financing.

Question 34

Most firms are able to use 60%-70% debt in their capital structure without exceeding norms acceptable to most creditors and investors.

Question 35

Weights used to calculate the weighted average cost of capital K_aare derived from the optimum capital structure.

Question 36

Per the capital asset pricing model, the slope of the security market line (SML) must be 1.0.

Question 37

A firm should always be at a single optimum debt to equity ratio to minimize its cost of capital.

Question 38

According to traditional financial theory, the cost of capital curve is U-shaped over the range of debt-equity mixes.

Question 39

The financial managers of the firm decide on its cost of capital for financing projects.

Question 40

In determining the optimum capital structure it is assumed that the firm will raise capital in the optimum proportions every year.

Question 41

Tobin's Barbeque has a bank loan at 8% interest and an after-tax cost of debt of 6%. What will the after-tax cost of debt be when the loan is due if a new loan is taken out yielding 11%.

A) 7.52%
B) 8.25%
C) 13.33%
D) none of these

Question 42

As the risk-free rate increases, the required rate of return for common stock decreases.

Question 43

Although debt financing is generally cheaper than equity financing, financial managers should not use debt financing significantly above the industry standard because it can increase the firm's overall cost of capital.

Question 44

Financial capital does not include

A) stock.
B) bonds.
C) preferred stock.
D) working capital.

Question 45

The cost of capital generally varies inversely with the size of the capital structure.

Question 46

A firm's cost of financing, in an overall sense, is equal to its

A) weighted average cost of capital.
B) required yield that investors seek for various kinds of securities.
C) required rate of return that investors seek for various kinds of securities.
D) all of these.

Question 47

The coupon rate on a debt issue is 6%. If the yield to maturity on the debt is 9%, what is the after-tax cost of debt in the weighted average cost of capital if the firm's tax rate is 34%?

A) 3.96%
B) 4.08%
C) 5.94%
D) 7.92%

Question 48

The slope of the security market line (SML) will often increase when the economy is in a boom period.

Question 49

The coupon rate on an issue of debt is 8%. The yield to maturity on this issue is 10%. The corporate tax rate is 31%. What would be the approximate after-tax cost of debt for a new issue of bonds?

A) 5.28%
B) 2.48%
C) 6.90%
D) 3.14%

Question 50

A firm with a higher beta than another firm will have a higher required rate of return.

Question 51

The cost of debt is determined by taking the

A) present value of the interest payments and principal times one minus the tax rate.
B) historical yield on bonds times one minus the tax rate.
C) estimated yield on new bond issues of the same risk times one minus the shareholder marginal tax rate.
D) none of these.

Question 52

The overall weighted average cost of capital is used instead of costs for specific sources of funds because

A) use of the cost for specific sources of capital would make investment decisions inconsistent.
B) a project with the highest return would always be accepted under the specific cost criteria.
C) investments funded by low cost debt would have an advantage over other investments.
D) both a and c are correct.

Question 53

Each project should be judged against

A) the specific means of financing used to support its implementation.
B) the going interest rate at that point in time.
C) the cost of new common stock equity.
D) none of these.

Question 54

If a firm's bonds are currently yielding 6% in the marketplace, why would the firm's cost of debt be lower?

A) Interest rates have changed.
B) Additional debt can be issued more cheaply than the original debt.
C) There should be no difference; cost of debt is the same as the bond's market yield.
D) Interest is tax-deductible.

Question 55

Lewis, Schultz and Nobel Development Corp. has an after-tax cost of debt of 4.5 percent. With a tax rate of 30 percent, what is the yield on the debt?

A) 4.41%
B) 9.0%
C) 1.89%
D) 6.43%

Question 56

Debreu Beverages has an optimal capital structure that is 70% common equity, 20% debt, and 10% preferred stock. Debreu's pretax cost of equity is 9%. Its pretax cost of preferred equity is 7%, and its pretax cost of debt is also 5%. If the corporate tax rate is 35%, what is the weighed average cost of capital?

A) Between 7% and 8%
B) Between 8% and 9%
C) Between 9% and 10%
D) Between 10% and 12%

Question 57

A firm has $50 million in assets and its optimal capital structure is 60% equity. If the firm has $12 million in retained earnings, at what asset level will the firm need to issue additional stock? (Assume no growth in retained earnings.)

A) The firm should have already issued additional stock.
B) The firm can increase assets to $30 million.
C) The firm can increase assets to $20 million.
D) There is insufficient information to determine an answer.

Question 58

Klein Corp. can issue $1,000 par value bond that pays $90 per year in interest at a price of $980. The bond will have a 10-year life. The firm is in a 35% tax bracket. What is the after-tax cost of debt?

A) 9.14%
B) 9.30%
C) 5.87%
D) 6.8%

Question 59

The pre-tax cost of debt for a new issue of debt is determined by

A) the investor's required rate of return on issued stock.
B) the coupon rate of existing debt.
C) the yield to maturity of outstanding bonds.
D) all of these.

Question 60

For a firm paying 5% for new debt, the higher the firm's tax rate

A) the higher the after-tax cost of debt.
B) the lower the after-tax cost of debt.
C) after-tax cost is unchanged.
D) Not enough information to judge.

Question 61

In computing the cost of common equity, if D₁ goes downward and P_o goes up, K_e will

A) go up.
B) go down.
C) stay the same.
D) slowly increase.

Question 62

Expected cash dividends are $3.00, the dividend yield is 4%, flotation costs are 4% of price, and the growth rate is 3%. Compute cost of new common stock.

A) 7.00%
B) 7.2%
C) 6.9%
D) 4.2%

Question 63

A firm's debt to equity ratio varies at times because

A) a firm will want to sell common stock when prices are high and bonds when interest rates are low.
B) a firm will want to take advantage of timing its fund raising in order to minimize costs over the long run.
C) the market allows some leeway in the debt to equity ratio before penalizing the firm with a higher cost of capital.
D) all of these are accurate statements.

Question 64

For many firms, the cheapest and most important source of equity capital is in the form of

A) debt.
B) common stock.
C) preferred stock.
D) retained earnings.

Question 65

A firm's preferred stock pays an annual dividend of $2, and the stock sells for $65. Flotation costs for new issuances of preferred stock are 5% of the stock value. What is the after-tax cost of preferred stock if the firm's tax rate is 30%?

A) 1.2%
B) 1.58%
C) 3.20%
D) 5.26%

Question 66

Firm X has a tax rate of 30%. The price of its new preferred stock is $75 and its flotation cost is $3.15. The cost of new preferred stock is 8%. What is the firm's dividend?

A) $7.18
B) $5.75
C) $7.56
D) none of these.

Question 67

A firm is paying an annual dividend of $2.65 for its preferred stock which is selling for $57.00. There is a selling cost of $3.30. What is the after-tax cost of preferred stock if the firm's tax rate is 33%?

A) 2.02%
B) 4.93%
C) 5.79%
D) 6.11%

Question 68

In determining the cost of retained earnings

A) the dividend valuation model is inappropriate.
B) flotation costs are included.
C) growth is not considered.
D) the capital asset pricing model can be used.

Question 69

Within the capital asset pricing model

A) the risk-free rate is usually higher than the return in the market.
B) the higher the beta the lower the required rate of return.
C) beta measures the volatility of an individual stock relative to a stock market index.
D) two of the above are true.

Question 70

New common stock is more expensive than K_e

A) to compensate for risk.
B) to compensate for more dividends.
C) to compensate for expansionary problems.
D) to cover distribution costs.

Question 71

The after-tax cost of preferred stock to the issuing corporation

A) is the same as the before-tax cost.
B) is usually lower than the cost of debt.
C) is dependent on the firm's tax bracket.
D) none of these.

Question 72

Ten years ago, Stigler Company issued $100 par value preferred stock yielding 6 percent. The preferred stock is now selling for $102 per share. What is the current yield or cost of the preferred stock? (Disregard flotation costs.)

A) 7.76%.
B) 8%.
C) 5.9%.
D) There is not enough information to answer the question.

Question 73

Using the constant dividend growth model for common stock, if P_o goes up

A) the assumed cost goes up.
B) the assumed cost goes down.
C) the assumed cost remains unchanged.
D) Need further information.

Question 74

Using the constant growth model, a firm's expected (D₁) dividend yield is 4% of the stock price, and its growth rate is 5%. If the tax rate is .35%, what is the firm's cost of equity?

A) 10%
B) 6.65%
C) 9.0%
D) More information is required

Question 75

Why is the cost of debt normally lower than the cost of preferred stock?

A) Preferred stock dividends are tax deductions.
B) Interest is tax deductible.
C) Preferred stock dividends must be paid before common stock dividends.
D) Common stock dividends are not tax deductible.

Question 76

If the flotation cost goes up, the cost of retained earnings will

A) go up.
B) go down.
C) stay the same.
D) slowly increase.

Question 77

If flotation costs go down, the cost of new preferred stock will

A) go up.
B) go down.
C) stay the same.
D) slowly increase.

Question 78

A firm's stock is selling for $65. The dividend yield is 6%. A 7% growth rate is expected for the common stock. The firm's tax rate is 40%. What is the firm's cost of retained earnings?

A) 8.16%
B) 13.00%
C) 12.35%
D) can not be determined.

Question 79

A firm's stock is selling for $62. The next annual dividend is expected to be $3.00. The growth rate is 9%. The flotation cost is $5.00. What is the cost of retained earnings?

A) 13.84%
B) 12.46%
C) 12.7%
D) none of these

Question 80

The cost of equity capital in the form of new common stock will be higher than the cost of retained earnings because of

A) the existence of taxes.
B) the existence of flotation costs.
C) investors' unwillingness to purchase additional shares of common stock.
D) the existence of financial leverage.