Question 1

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

Accepted Answer

The answer of The cost of retained earnings is generally...

Question 2

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.

Accepted Answer

This statement is true. The constant growth valuation model includes a built-in adjustment for flotation costs, which are the costs associated with issuing new shares of equity. On the other hand, the CAPM does not have a simple adjustment mechanism for factoring in flotation costs.

Question 3

The cost of retained earnings for Tangshan Mining would be 16.64 percent if the firm just paid a dividend of $4.00, the stock price is $50.00, dividends are expected to grow at 8 percent indefinitely, and flotation costs are $5.00 per share.

Accepted Answer

The cost of retained earnings is the rate of return that shareholders require on their investment in the company. It is calculated as the dividend yield plus the expected growth rate of dividends. In this case, the dividend yield is 4.00 / 50.00 = 8.00%. The expected growth rate of dividends is 8.00%. Therefore, the cost of retained earnings is 8.00% + 8.00% = 16.00%.

Question 4

The cost of common stock equity capital represents the return required by existing shareholders on their investment in order to leave the market price of the firm's outstanding share unchanged.

Accepted Answer

The statement is true. The cost of common stock equity capital, also known as the cost of equity, is the return that shareholders require on their investment in order to maintain the current market value of the firm's shares. This is often estimated using the capital asset pricing model (CAPM) or other similar models.

Question 5

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

Accepted Answer

The constant growth model assumes that the market price is influenced by investors' risk-return preferences and that the expected future cash flows from the investment will grow at a constant rate indefinitely. This is used to estimate the intrinsic value of a stock or other asset.

Question 6

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 the firm as measured by the beta coefficient.

Accepted Answer

The capital asset pricing model (CAPM) describes the relationship between the required return and the systematic risk of the firm, not the nonsystematic risk, as measured by the beta coefficient.

Question 7

The cost of common stock equity is

Accepted Answer

The cost of common stock equity is the rate at which investors discount the expected dividends of the firm. It represents the return that shareholders require to invest in the stock. The other options do not accurately describe the cost of common stock equity.

Question 8

The cost of retained earnings for Tangshan Mining would be 17.60 percent if the firm just paid a dividend of $4.00, the stock price is $50.00, dividends are expected to grow at 8 percent indefinitely, and flotation costs are $5.00 per share.

Accepted Answer

The cost of retained earnings (k) can be calculated as follows:

k = (D / (P - F)) + g

Where: 
D = dividend per share = $4.00 
P = stock price = $50.00 
F = flotation costs = $5.00 
g = expected dividend growth rate = 8%

Plugging in the values, we get:

k = ($4.00 / ($50.00 - $5.00)) + 0.08 
k = 0.0918 or 9.18%

Therefore, the statement is false. The cost of retained earnings for Tangshan Mining is 9.18%, not 17.60%.

Question 9

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

Accepted Answer

Net proceeds represent the total amount of money raised through an offering, including any underpricing or flotation costs. The cost of retained earnings is generally considered to be the opportunity cost of utilizing that capital for alternative investments, rather than the actual cost of raising the funds.

Question 10

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

Accepted Answer

This measure is known as the cost of equity or the required rate of return on equity, and it is calculated using the dividend discount model or other methods to estimate the expected future cash flows from owning the stock. This rate reflects the risk and opportunity cost associated with investing in the company's equity, and it is used to evaluate the attractiveness of different investment opportunities or to estimate the cost of capital for the firm.

Question 11

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

Accepted Answer

This is because common stock represents ownership in the company and therefore involves higher risk for investors compared to debt financing, which has a fixed interest rate and maturity date. This higher risk results in a higher expected rate of return for investors, making the cost of new common stock typically higher than other long-term financing options.

Question 12

The cost of retained earnings 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.

Accepted Answer

The cost of retained earnings equity can be calculated using the Capital Asset Pricing Model (CAPM) as follows:

Cost of Retained Earnings Equity = Risk-Free Rate + Beta x Market Risk Premium

= 5.00% + 1.3 x 10.00%

= 18.00%

Therefore, the statement is true.

Question 13

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.

Accepted Answer

This is true because if stockholders believe that the firm will earn the required return on reinvested funds, they will be more likely to allow the firm to retain those funds instead of demanding higher dividends or selling their shares. This allows the firm to use those retained earnings for future investment and growth opportunities.

Question 14

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.

Accepted Answer

The statement is false. The cost of new issues is often higher than the cost of existing issues due to additional fees and underwriting costs associated with the issuance of new securities.

Question 15

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.

Accepted Answer

The answer of The Gordon model is based on the...

Question 16

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.

Accepted Answer

Retained earnings refer to profits that a company has kept aside for reinvestment, rather than distributing as dividends. Since there are no costs associated with issuing new shares or hiring an underwriter when using retained earnings, the cost of retained earnings is lower than that of a new issue of common stock.

Question 17

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

Accepted Answer

The statement correctly describes the CAPM, which is a widely used financial model for calculating the expected return on an investment, based on the risk-free rate, market risk premium, and beta of the asset. The cost of common stock equity, or the required rate of return, is typically derived from the CAPM by adding the risk premium for the stock to the risk-free rate. The nondiversifiable risk in this context refers to the risk of the stock relative to the market as a whole, which cannot be eliminated through diversification.

Question 18

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

Accepted Answer

The cost of retained earnings equity is calculated using the Capital Asset Pricing Model (CAPM): Cost of Equity = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate). Plugging in the values: 5% + 1.3 * (10% - 5%) = 11.5%, not 18.00%.

Question 19

The cost of new common stock equity for Tangshan Mining would be 17.60 percent if the firm just paid a dividend of $4.00, the stock price is $50.00, dividends are expected to grow at 8 percent indefinitely, and flotation costs are $5.00 per share.

Accepted Answer

The cost of new common stock equity can be calculated using the formula: Cost of Equity = (D1 / (P0 - F)) + g, where D1 is the expected dividend next year, P0 is the current stock price, F is the flotation cost, and g is the growth rate. Here, D1 = $4.00 * (1 + 0.08) = $4.32, P0 = $50.00, F = $5.00, and g = 0.08. Thus, Cost of Equity = ($4.32 / ($50.00 - $5.00)) + 0.08 = 0.176 or 17.60%.

Question 20

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.

Accepted Answer

The statement is true. The CAPM takes into account the firm's risk (as reflected by beta) in calculating the cost of common stock equity, whereas the constant growth valuation model assumes a constant growth rate and does not directly consider the firm's risk.

Quiz 9: The Cost of Capital