Question 1

Which of the following statements is CORRECT?

Accepted Answer

A)   A change in a company's target capital structure cannot affect its WACC.
B)   WACC calculations should be based on the before-tax costs of all the individual capital components.
C)   Flotation costs associated with issuing new common stock normally reduce the WACC.
D)   If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline.
E)   An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.F) B) and E)
G) A) and B)

Question 2

Vang Enterprises, which is debt-free and finances only with equity from retained earnings, is considering 7 equal sized capital budgeting projects. Its CFO hired you to assist in deciding whether none, some, or all of the projects should be accepted. You have the following information: rRF = 4.50%; RPM = 5.50%; and b = 0.92. The company adds or subtracts a specified percentage to the corporate WACC when it evaluates projects that have above- or below-average risk. Data on the 7 projects are shown below. If these are the only projects under consideration, how large should the capital budget be?

Accepted Answer

A)   $100
B)   $ 75
C)   $ 50
D)   $ 25
E)   $ 0F) B) and C)
G) A) and B)

Question 3

Keys Printing 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 40.00%, but Congress is considering a change in the corporate tax rate to 30.00%. By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted?

Accepted Answer

A)   0.57%
B)   0.63%
C)   0.70%
D)   0.77%
E)   0.85%F) A) and D)
G) A) and C)

Question 4

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the DCF method is widely used in practice.

Accepted Answer

A) True 
 B)False

Question 5

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) All of the above
G) C) and D)

Question 6

O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of equity from retained earnings based on the CAPM?

Accepted Answer

A)   11.30%
B)   11.64%
C)   11.99%
D)   12.35%
E)   12.72%F) A) and B)
G) A) and C)

Question 7

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) B) and D)
G) A) and B)

Question 8

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.

Accepted Answer

A) True 
 B)False

Question 9

Which of the following statements is CORRECT?

Accepted Answer

A)   In the WACC calculation, we must adjust the cost of preferred stock (the market yield)  to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income.
B)   We should use historical measures of the component costs from prior financings that are still outstanding when estimating a company's WACC for capital budgeting purposes.
C)   The cost of new equity (re)  could possibly be lower than the cost of retained earnings (rs)  if the market risk premium, risk-free rate, and the company's beta all decline by a sufficiently large amount.
D)   Its cost of retained earnings is the rate of return stockholders require on a firm's common stock.
E)   The component cost of preferred stock is expressed as rp(1 - T) , because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt.F) B) and C)
G) C) and D)

Question 10

If the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common stock If the expected growth rate is not zero, then the cost of external equity must be found using a different formula.

Accepted Answer

A) True 
 B)False

Question 11

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 $40.00. 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?

Accepted Answer

A)   -1.49%
B)   -1.66%
C)   -1.84%
D)   -2.03%
E)   -2.23%F) C) and E)
G) B) and E)

Question 12

Since 70% 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

Accepted Answer

A) True 
 B)False

Question 13

The reason why retained earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm's common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should pay those earnings out to its investors. Thus, the cost of retained earnings is based on the opportunity cost principle.

Accepted Answer

A) True 
 B)False

Question 14

Trahan Lumber Company hired you to help estimate its cost of capital. You obtained the following data: D1 = $1.25; P0 = $27.50; g = 5.00% (constant) ; and F = 6.00%. What is the cost of equity raised by selling new common stock?

Accepted Answer

A)   9.06%
B)   9.44%
C)   9.84%
D)   10.23%
E)   10.64%F) B) and D)
G) B) and E)

Exam 10: Cost of Capital

Correct Answer
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Correct Answer
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The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the DCF method is widely used in practice.

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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Since 70% 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

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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O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of equity from retained earnings based on the CAPM?

Correct Answer
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Trahan Lumber Company hired you to help estimate its cost of capital. You obtained the following data: D1 = $1.25; P0 = $27.50; g = 5.00% (constant) ; and F = 6.00%. What is the cost of equity raised by selling new common stock?

Correct Answer
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If the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common stock If the expected growth rate is not zero, then the cost of external equity must be found using a different formula.

Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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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.

Correct Answer
verified

Exam 10: Cost of Capital

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the DCF method is widely used in practice.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Since 70% 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

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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 = 1.05. What is the firm's cost of equity from retained earnings based on the CAPM?

Correct AnswerverifiedShow Answer

Trahan Lumber Company hired you to help estimate its cost of capital. You obtained the following data: D1 = $1.25; P0 = $27.50; g = 5.00% (constant) ; and F = 6.00%. What is the cost of equity raised by selling new common stock?

Correct AnswerverifiedShow Answer

If the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common stock If the expected growth rate is not zero, then the cost of external equity must be found using a different formula.

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow 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.

Correct AnswerverifiedShow Answer

Correct Answer
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Correct Answer
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Correct Answer
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