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# Corporate Finance Study Set 2

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## Quiz 9 : The Cost of Capital

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.
Free
True False
Westbrook's Painting Co.plans to issue a $1,000 par value, 20-year noncallable bond with a 7.00% annual coupon, paid semiannually.The company's marginal tax rate is 25%, but Congress is considering a change in the corporate tax rate to 15%.By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted? Free Multiple Choice Answer: Answer: C The cost of capital used in capital budgeting should reflect the average after-tax cost of providing required returns to investors. Free True False Answer: Answer: True Which of the following statements is CORRECT? Multiple Choice Answer: "Capital" is sometimes defined as funds supplied to a firm by investors. True False Answer: The Lincoln Company sold a$1,000 par value, noncallable bond several years ago that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually.The bond currently sells for $925 and the company's tax rate is 25%.What is the component cost of debt for use in the WACC calculation? Multiple Choice Answer: The component costs of capital are market-determined variables in the sense that they are based on investors' required returns. True False Answer: If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC. True False Answer: The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt. True False Answer: The cost of preferred stock to a firm must be adjusted to an after-tax figure because 50% of dividends received by a corporation may be excluded from the receiving corporation's taxable income. True False Answer: Which of the following statements is CORRECT? Multiple Choice Answer: The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt. True False Answer: The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock.No adjustment is needed for taxes because preferred dividends, unlike interest on debt, is not deductible by the issuing firm. True False Answer: Because 50% of the preferred dividends received by a corporation are excluded from taxable income, the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be ​ Cost of equity = rs(0.30)(0.50) + rps(1 − T)(0.50)(0.50). True False Answer: The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock. True False Answer: Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting? Multiple Choice Answer: Kenny Electric Company's noncallable bonds were issued several years ago and now have 20 years to maturity.These bonds have a 9.25% annual coupon, paid semiannually, sells at a price of$1,075, and has a par value of $1,000.If the firm's tax rate is 25%, what is the component cost of debt for use in the WACC calculation? Multiple Choice Answer: Perpetual preferred stock from Franklin Inc.sells for$97.50 per share, and it pays an $8.50 annual dividend.If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors.What is the company's cost of preferred stock for use in calculating the WACC? Multiple Choice Answer: A company's perpetual preferred stock currently sells for$92.50 per share, and it pays an $8.00 annual dividend.If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price.What is the firm's cost of preferred stock? Multiple Choice Answer: Collins Group The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below. The stock is currently selling for$15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for$875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 25%. -Refer to the data for the Collins Group.What is the best estimate of the after-tax cost of debt?