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Chapter 9: The Cost of Capital

1. The cost of capital used to evaluate a project should be the cost of the specific type of
financing used to fund that project.
a. True
Incorrect. Most firms have a target capital structure, or preferred mix of funds. If the firm uses
one type of funds to finance current projects, it must use the other types of funds for future
financing to return to its preferred capital structure. Thus, focus should not be placed on where
the funds will come from for specific projects, but instead the cost of capital must reflect the
average cost of the various sources of funds.
b. False
Correct. Most firms have a target capital structure, or preferred mix of funds. If the firm uses
one type of funds to finance current projects, it must use the other types of funds for future
financing to return to its preferred capital structure. Thus, focus should not be placed on where
the funds will come from for specific projects, but instead the cost of capital must reflect the
average cost of the various sources of funds.
2. When calculating the component cost of debt for capital budgeting purposes for profitable,
tax-paying firms, the tax adjustment:
a. reduces the component cost of debt
Correct. Interest payments are tax deductible. So the cost of debt must be adjusted to reflect
lower taxes due to interest payments.
b. does not affect the component cost of debt
Incorrect. Interest payments are tax deductible. So the cost of debt must be adjusted to reflect
lower taxes due to interest payments.
c. increases the component cost of debt
Incorrect. Interest payments are tax deductible. So the cost of debt must be adjusted to reflect
lower taxes due to interest payments.
3. The coupon rate on existing debt is usually:
a. a good estimate of the before-tax cost of new debt.
Incorrect. The yield-to-maturity on existing debt is a good estimate of the before-tax costs of
debt, not the coupon rate.
b. always higher than the before-tax cost of new debt
Incorrect. The yield-to-maturity on existing debt is a good estimate of the before-tax costs of
debt, not the coupon rate. The yield-to-maturity may be higher or lower than coupon rates on
existing debt.
c. always lower than the before-tax cost of new debt
Incorrect. The yield-to-maturity on existing debt is a good estimate of the before-tax costs of
debt, not the coupon rate. The yield-to-maturity may be higher or lower than coupon rates on
existing debt.
d. none of the above statements are true

Correct. The yield-to-maturity on existing debt is a good estimate of the before-tax costs of debt,
not the coupon rate.
4. There is no tax effect to consider when calculating the component cost of preferred stock for
capital budgeting purposes.
a. True
Correct. Preferred stock dividends are not tax deductible, so there is no tax effect.
b. False
Incorrect. Preferred stock dividends are not tax deductible, so there is no tax effect.
5. Since retained earnings are generated by the firm:
a. there is no component cost for these funds.
Incorrect. The cost of retained earnings is the rate of return stockholders require on a firms
common stock since stockholders could have received this money as dividends and invested it.
b. the funds have a positive cost that is more than new equity issues.
Incorrect. The cost of retained earnings is the rate of return stockholders require on a firms
common stock since stockholders could have received this money as dividends and invested it.
Retained earnings cost less than new equity issues since there are no flotation costs.
c. the funds have a positive cost that is less than new equity issues.
Correct. The cost of retained earnings is the rate of return stockholders require on a firms
common stock since stockholders could have received this money as dividends and invested it.
Retained earnings cost less than new equity issues since there are no flotation costs.
6. Which of the following statements is correct?
a. Although some methods of estimating the cost of equity capital encounter severe difficulties,
the CAPM is a simple and reliable model that provides great accuracy and consistency in
estimating the cost of equity capital.
Incorrect. The firms beta and the market risk premium are difficult to accurately estimate.
b. The DCF model is preferred over other models to estimate the cost of equity because of the
ease with which a firms growth rate is obtained.
Incorrect. The growth rate is the most difficult input for the DCF model.
c. The bond-yield-plus-risk-premium approach to estimating the cost of equity is not always
accurate but its advantages are that it is a standardized and objective model.
Incorrect. The bond-yield-plus-risk-premium model is a subjective, ad hoc procedure.
d. None of the statements above is correct.
Correct. The firms beta and the market risk premium are difficult to accurately estimate. The
growth rate is the most difficult input for the DCF model. The bond-yield-plus-risk-premium
model is a subjective, ad hoc procedure.
7. Which of the following is NOT considered a capital component for the purpose of calculating
the weighted average cost of capital (WACC) as it applies to capital budgeting?
a. Long-term debt.

Incorrect. The WACC includes all investor supplied capital which includes long-term debt,
preferred stock, and common stock.
b. Common stock.
Incorrect. The WACC includes all investor supplied capital which includes long-term debt,
preferred stock, and common stock.
c. Accounts payable and accruals.
Correct. The WACC includes all investor supplied capital which includes long-term debt,
preferred stock, and common stock.
d. Preferred stock.
Incorrect. The WACC includes all investor supplied capital which includes long-term debt,
preferred stock, and common stock.
8. Which of the following statements is correct?
a. If a companys tax rate increases, but the yield to maturity of its noncallable bonds remains the
same, the companys marginal cost of debt capital used to calculate its weighted average cost of
capital will likely fall.
Correct. The higher tax rate results in a bigger tax reduction due to interest payment tax
deductibility.
b. All else equal, an increase in a companys stock price will increase the marginal cost of
retained earnings.
Incorrect. An increased price (all else equal) means a lower rate of return on equity.
c. All else equal, a decrease in a companys stock price will decrease the marginal cost of issuing
new common equity.
Incorrect. A decreased price (all else equal) means a higher rate of return on equity.
9. A firms capital structure policy affects its weighted average cost of capital.
a. True
Correct. The capital structure policy sets the proportions of capital components used in the
WACC formula. The capital structure policy (by setting the level of debt) also directly affects
the default risk for the company which affects rates of return.
b. False
Incorrect. The capital structure policy sets the proportions of capital components used in the
WACC formula. The capital structure policy (by setting the level of debt) also directly affects
the default risk for the company which affects rates of return.

10. A company estimates that an average-risk project has a WACC of 10 percent, a belowaverage risk project has a WACC of 8 percent, and an above-average risk project has a WACC of
12 percent. Which of the following independent projects should the company accept?
a. Project A has average risk and a return of 9 percent.
Incorrect. Project As return of 9% is less than the 10% required for an average risk project.
b. Project B has below-average risk and a return of 8.5 percent.

Correct. Project Bs return of 8.5% is greater than the 8% required for an average risk project.
c. Project C has above-average risk and a return of 11 percent.
Incorrect. Project Cs return of 11% is less than the 12% required for an average risk project.
d. All of the projects above should be accepted.
Incorrect. Project As return of 9% is less than the 10% required for an average risk project.
Project Bs return of 8.5% is greater than the 8% required for an average risk project. Project Cs
return of 11% is less than the 12% required for an average risk project.
11. The Barabas Company has an equal amount of low-risk projects, average-risk projects, and
high-risk projects. Barabas estimates that the overall companys WACC is 12 percent. This is
also the correct cost of capital for the companys average-risk projects. The companys CFO
argues that, even though the companys projects have different risks, the cost of capital for each
project should be the same because the company obtains its capital from the same sources. If the
company follows the CFOs advice, what is likely to happen over time?
a. The company will take on too many low-risk projects and reject too many high-risk projects.
Incorrect. The company will take on too many high-risk projects since the return for the high risk
projects will generally exceed the average WACC that is based on a mixture of all three types of
projects. The company will reject too many low-risk projects since the return for the low risk
project will generally be less than the average WACC that is based on a mixture of all three types
of projects.
b. The company will take on too many high-risk projects since the return for the high risk
projects will generally exceed the average WACC that is based on a mixture of all three types of
projects. The company will reject too many low-risk projects since the return for the low risk
project will generally be less than the average WACC that is based on a mixture of all three types
of projects.
Correct.
c. Things will generally even out over time, and therefore, the risk of the firm should remain
constant over time.
Incorrect. The company will take on too many high-risk projects since the return for the high risk
projects will generally exceed the average WACC that is based on a mixture of all three types of
projects. The company will reject too many low-risk projects since the return for the low risk
project will generally be less than the average WACC that is based on a mixture of all three types
of projects.
12. Of the three measures of project risk (stand-alone, corporate, and market), market risk is
theoretically the most relevant measure.
a. True
Correct. Of the three measures of project risk (stand-alone, corporate, and market), market risk is
theoretically the most relevant measure.
b. False
Incorrect. Of the three measures of project risk (stand-alone, corporate, and market), market risk
is theoretically the most relevant measure.

13. High beta projects are projects with


risk and should be evaluated using a
cost of equity capital.
a. low; low
Incorrect. High beta projects have high risk and should be evaluated using a high cost of equity
capital.
b. low; high
Incorrect. High beta projects have high risk and should be evaluated using a high cost of equity
capital.
c. high; high
Incorrect. High beta projects have high risk and should be evaluated using a high cost of equity
capital.
d. high; low
Correct. High beta projects have high risk and should be evaluated using a high cost of equity
capital.
14. If the expected rate of return on a given capital project lies above the SML, the project should
be accepted even if its beta is above the beta of the firms average project.
a. True
Correct. The SML shows the required risk/return tradeoff. If the expected return for the project
lies above the SML, it means the project is expected to return more than is required on a riskadjusted basis.
b. False
Incorrect. The SML shows the required risk/return tradeoff. If the expected return for the project
lies above the SML, it means the project is expected to return more than is required on a riskadjusted basis.
15. Which of the following methods involves calculating an average beta for firms in a similar
business and then applying that beta to determine a projects beta?
a. Risk premium method.
Incorrect. The pure play method involves calculating an average beta for firms in a similar
business and then applying that beta to determine a projects beta.
b. Pure play method.
Correct. The pure play method involves calculating an average beta for firms in a similar
business and then applying that beta to determine a projects beta.
c. Accounting beta method.
Incorrect. The pure play method involves calculating an average beta for firms in a similar
business and then applying that beta to determine a projects beta.
d. CAPM method.
Incorrect. The pure play method involves calculating an average beta for firms in a similar
business and then applying that beta to determine a projects beta.
16. The cost of new common stock (external equity) is generally higher than the cost of retained
earnings (internal equity) because of:

a. tax effects.
Incorrect. Retained earnings do not incur flotation costs, while new common stock does. Thus,
the cost of new common stock is higher than the cost of retained earnings. There is no tax effect
when computing the cost of equity.
b. investors required returns.
Incorrect. Retained earnings do not incur flotation costs, while new common stock does. Thus,
the cost of new common stock is higher than the cost of retained earnings. Since both are equity,
the investors required return would be the same for internal or external equity.
c. flotation costs.
Correct. Retained earnings do not incur flotation costs, while new common stock does. Thus,
the cost of new common stock is higher than the cost of retained earnings. There is no tax effect
when computing the cost of equity.
d. coupon payments
Incorrect. Retained earnings do not incur flotation costs, while new common stock does. Thus,
the cost of new common stock is higher than the cost of retained earnings. There are no coupon
payments for equity.
17. A firm estimates that its proposed capital budget will force it to issue new common stock,
which has a greater cost than the cost of retained earnings. The firm, however, would like to
avoid issuing costly new common stock. Which of the following steps would mitigate the firms
need to raise new common stock?
a. Increasing the companys dividend payout ratio for the upcoming year.
Incorrect. A higher dividend payout will make it more likely that the firm will need to issue new
common stock since it will have less retained earnings.
b. Reducing the companys debt ratio for the upcoming year.
Incorrect. A larger required portion of funds from equity will make it more likely that the firm
will need to issue new common stock.
c. Increasing the companys proposed capital budget.
Incorrect. A higher capital budget means a larger amount of equity capital is needed which will
make it more likely that the firm will need to issue new common stock.
d. None of the statements above is correct.
Correct. A higher dividend payout will make it more likely that the firm will need to issue new
common stock since it will have less retained earnings. A larger required portion of funds from
equity will make it more likely that the firm will need to issue new common stock. A higher
capital budget means a larger amount of equity capital is needed which will make it more likely
that the firm will need to issue new common stock.
18. Which of the following will increase a companys retained earnings break point?
a. An increase in its net income.
Correct. Higher net income translates to more funds available as retained earnings and increases
the total amount of financing that can be raised before the firm is forced to sell new common
stock.
b. An increase in its dividend payout.

Incorrect. A higher dividend payout means less funds are available as retained earnings and
decreases the total amount of financing that can be raised before the firm is forced to sell new
common stock.
c. An increase in the amount of equity in its capital structure.
Incorrect. An increase in the amount of equity in the capital structure means that of the total
financing raised, equity must represent a larger proportion. This decreases the total amount of
financing that can be raised before the firm is forced to sell new common stock.
d. All of the statements above are correct.
Incorrect. Higher net income translates to more funds available as retained earnings and
increases the total amount of financing that can be raised before the firm is forced to sell new
common stock. A higher dividend payout means less funds are available as retained earnings and
decreases the total amount of financing that can be raised before the firm is forced to sell new
common stock. An increase in the amount of equity in the capital structure means that of the
total financing raised, equity must represent a larger proportion. This decreases the total amount
of financing that can be raised before the firm is forced to sell new common stock.
19. Depreciation-generated funds are an additional source of capital and, in fact, represent the
largest single source of funds for some firms.
a. True
Correct. Depreciation-generated funds are an additional source of capital and, in fact, represent
the largest single source of funds for some firms.
b. False
Incorrect. Depreciation-generated funds are an additional source of capital and, in fact, represent
the largest single source of funds for some firms.
20. There are many practical measurement difficulties encountered when estimating the cost of
capital.
a. True
Correct. There are many practical measurement difficulties encountered when estimating the cost
of capital.
b. False
Incorrect. There are many practical measurement difficulties encountered when estimating the
cost of capital.
21. Average Corporation's currently outstanding 19.0% coupon bonds have a yield-to-maturity
of 16.86%. Average believes it could issue at par new bonds that would provide a similar yieldto-maturity. If its marginal tax rate is 30%, what is the firm's component cost of debt for
purposes of calculating the WACC (ignore flotation costs)?
a. 11.80%
Correct. The yield-to-maturity on new debt adjusted for the tax deductibility of interest is the
correct cost of debt for purposes of calculating the WACC [kd(1-t)].
b. 13.30%

Incorrect. It is not the coupon rate on the outstanding bonds that matters. Hint: The yield-tomaturity on new debt adjusted for the tax deductibility of interest is the correct cost of debt for
purposes of calculating the WACC [kd(1-t)].
c. 16.86%
Incorrect. You need to adjust for the tax deductibility of interest. Hint: The yield-to-maturity on
new debt adjusted for the tax deductibility of interest is the correct cost of debt for purposes of
calculating the WACC [kd(1-t)].
d. 19.00%
Incorrect. It is not the coupon rate on the outstanding bonds that matters. Hint: The yield-tomaturity on new debt adjusted for the tax deductibility of interest is the correct cost of debt for
purposes of calculating the WACC [kd(1-t)].
22. Average Corporation could sell at par, $200 preferred stock that pays a 10.0% annual
dividend, but flotation costs of $8.00 per share would be incurred, so the net price the firm would
receive is $192. The firm's tax rate is 20%. What is the company's cost of preferred stock?
a. 8.00%
Incorrect. Preferred stock dividends are not tax deductible. Also, the correct price to use to
calculate the cost of preferred is the net price received. kp=Dp/Pp
b. 8.34%
Incorrect. Preferred stock dividends are not tax deductible.
c. 10.00%
Incorrect. The correct price to use to calculate the cost of preferred is the net price received.
kp=Dp/Pp
d. 10.42%
Correct. The correct price to use to calculate the cost of preferred is the net price received.
kp=Dp/Pp
23. Average Corporation's stock currently sells for $67.00 per share, its last dividend was $5.50,
its growth rate is a constant 4.0%, and the company will incur a flotation cost of 13.0% of the
market value if it sells new common stock. The firm's tax is 40%. What is the firm's cost of
retained earnings?
a. 13.81%
Incorrect. There are no flotation costs for retained earnings. Hint: You are given the past
dividend, so you first must multiply it time one plus the growth rate to get the next expected
dividend. There are no flotation costs for retained earnings (internal equity). ks = (D1/P0)+g
b. 13.44%
Incorrect. You are not given the expected dividend and there are no flotation costs for retained
earnings. Hint: You are given the past dividend, so you first must multiply it time one plus the
growth rate to get the next expected dividend. There are no flotation costs for retained earnings
(internal equity). ks = (D1/P0)+g
c. 12.54%
Correct. You are given the past dividend, so you first must multiply it time one plus the growth
rate to get the next expected dividend. There are no flotation costs for retained earnings (internal
equity). ks = (D1/P0)+g

d. 12.21%
Incorrect. You are not given the expected dividend. Hint: You are given the past dividend, so you
first must multiply it time one plus the growth rate to get the next expected dividend. There are
no flotation costs for retained earnings (internal equity). ks = (D1/P0)+g
e. 7.52%
Incorrect. Common stock dividends are not tax deductible. Hint: You are given the past dividend,
so you first must multiply it time one plus the growth rate to get the next expected dividend.
There are no flotation costs for retained earnings (internal equity). ks = (D1/P0)+g
24. Average Corporation's stock currently sells for $42.00 per share, its last dividend was $5.10,
its growth rate is a constant 4.0%, and the company will incur a flotation cost of 11.0% of the
market value if it sells new common stock. The firm's tax is 40%. What is the firm's cost of
common equity if it must issue new stock?
a. 10.91%
Incorrect. Common stock dividends are tax deductible. Hint: You are given the past dividend, so
you first must multiply it time one plus the growth rate to get the next expected dividend. There
are flotation costs for new stock (external equity). ks = D1/[P0(1-F)]+g
b. 18.19%
Correct. You are given the past dividend, so you first must multiply it time one plus the growth
rate to get the next expected dividend. There are flotation costs for new stock (external equity). ks
= D1/[P0(1-F)]+g
c. 17.64%
Incorrect. You are given the past dividend, not the expected dividend. Hint: You are given the
past dividend, so you first must multiply it time one plus the growth rate to get the next expected
dividend. There are flotation costs for new stock (external equity). ks = D1/[P0(1-F)]+g
d. 16.63%
Incorrect. You must consider flotation costs for new stock (external equity). Hint: You are given
the past dividend, so you first must multiply it time one plus the growth rate to get the next
expected dividend. There are flotation costs for new stock (external equity). ks = D1/[P0(1-F)]+g
e. 16.14%
Incorrect. You are given the past dividend, not the expected dividend. Also, you must consider
flotation costs for new stock (external equity). Hint: You are given the past dividend, so you first
must multiply it time one plus the growth rate to get the next expected dividend. There are
flotation costs for new stock (external equity). ks = D1/[P0(1-F)]+g
25. Average Corporation's stock currently sells for $45.00 per share, it is expected to pay a
dividend of $3.10 next year, its growth rate is a constant 7.0%, and the company will incur a
flotation cost of 12.0% of the market value if it sells new common stock. The firm's tax is 40%.
What is the firm's cost of retained earnings?
a. 13.89%
Correct. You are given the next expected dividend. There are no flotation costs for retained
earnings (internal equity). ks = (D1/P0)+g
b. 14.37%

Incorrect. You are given the next expected dividend so you do not need to adjust it for dividend
growth. Hint: You are given the next expected dividend. There are no flotation costs for retained
earnings (internal equity). ks = (D1/P0)+g
c. 15.38%
Incorrect. You are given the next expected dividend so you do not need to adjust it for dividend
growth. There are no flotation costs for retained earnings. Hint: You are given the next expected
dividend. There are no flotation costs for retained earnings (internal equity). ks = (D1/P0)+g
d. 14.83%
Incorrect. There are no flotation costs for retained earnings. Hint: You are given the next
expected dividend. There are no flotation costs for retained earnings (internal equity). ks =
(D1/P0)+g
e. 8.33%
Incorrect. Common stock dividends are tax deductible. Hint: You are given the next expected
dividend. There are no flotation costs for retained earnings (internal equity). ks = (D1/P0)+g
26. Average Corporation's stock currently sells for $59.00 per share, it is expected to pay a
dividend of $5.40 next year, its growth rate is a constant 6.0%, and the company will incur a
flotation cost of 14.0% of the market value if it sells new common stock. The firm's tax is 40%.
What is the firm's cost of common equity if it must issue new stock?
a. 9.98%
Incorrect. Common stock dividends are tax deductible. Hint: You are given the next expected
dividend. There are flotation costs for new stock (external equity). ks = D1/[P0(1-F)]+g
b. 15.15%
Incorrect. There are flotation costs for new stock. Hint: You are given the next expected
dividend. There are flotation costs for new stock (external equity). ks = D1/[P0(1-F)]+g
c. 15.70%
Incorrect. There are flotation costs for new stock and you are given the next expected dividend
(there is no need to adjust it for the growth rate). Hint: You are given the next expected dividend.
There are flotation costs for new stock (external equity). ks = D1/[P0(1-F)]+g
d. 16.64%
Correct. You are given the next expected dividend. There are flotation costs for new stock
(external equity). ks = D1/[P0(1-F)]+g
e. 17.28%
Incorrect. You are given the next expected dividend (there is no need to adjust it for the growth
rate). Hint: You are given the next expected dividend. There are flotation costs for new stock
(external equity). ks = D1/[P0(1-F)]+g
27. The common stock of Average Corporation has a beta of 1.2. The risk-free rate is 4% and
the market risk premium is 8%. Assume the firm will be able to use retained earnings to fund the
equity portion of the capital budget. What is the company's cost of retained earnings?
a. 8.8%
Incorrect. You are given the market risk premium, not the market return. Hint: Use the CAPM to
solve for the required return on equity. Note that you are given the market risk premium (kM-kRF)
not the market return. ks=kRF+(kM-kRF)bi

b. 9.6%
Incorrect. Do not forget to add the risk-free rate. Hint: Use the CAPM to solve for the required
return on equity. Note that you are given the market risk premium (kM-kRF) not the market return.
ks=kRF+(kM-kRF)bi
c. 13.6%
Correct. Use the CAPM to solve for the required return on equity. Note that you are given the
market risk premium (kM-kRF) not the market return. ks=kRF+(kM-kRF)bi
d. 15.8%
Incorrect. Are you guessing? Hint: Use the CAPM to solve for the required return on equity.
Note that you are given the market risk premium (kM-kRF) not the market return. ks=kRF+(kMkRF)bi
28. Average Corporation has a capital structure that consists of 65% equity and 35% debt. The
company expects to report $100 million in net income this year, and 67.5% of the net income
will be paid out as dividends. How large can the firm's capital budget be this year without it
having to include the cost of new common stock in its cost of capital analysis?
a. $103.85 million
Incorrect. You need to use the addition to retained earnings, not the dividend paid. Hint: First,
calculate the addition to retained earnings as the total net income minus dividends. Second,
calculate the retained earnings breakpoint by dividing the addition to retained earnings by the
equity fraction of the capital structure.
b. $100 million
Incorrect. This is the net income. Part of the net income will be paid as dividends. Hint: First,
calculate the addition to retained earnings as the total net income minus dividends. Second,
calculate the retained earnings breakpoint by dividing the addition to retained earnings by the
equity fraction of the capital structure.
c. $67.5 million
Incorrect. This is the amount of dividends that are expected to be paid. Hint: First, calculate the
addition to retained earnings as the total net income minus dividends. Second, calculate the
retained earnings breakpoint by dividing the addition to retained earnings by the equity fraction
of the capital structure.
d. $50 million
Correct. First, calculate the addition to retained earnings as the total net income minus dividends.
Second, calculate the retained earnings breakpoint by dividing the addition to retained earnings
by the equity fraction of the capital structure.
e. $32.5 million
Incorrect. This is the amount that is expected to be added to retained earnings. Hint: First,
calculate the addition to retained earnings as the total net income minus dividends. Second,
calculate the retained earnings breakpoint by dividing the addition to retained earnings by the
equity fraction of the capital structure.
29. Marginal Incorporated has determined that its before-tax cost of debt is 10.0%. Its cost of
preferred stock is 11.0%. Its cost of internal equity is 15.0%, and its cost of external equity is

16.9%. Currently, the firm's capital structure consists of 32% debt, 14% preferred stock, and
54% common equity. The firm's marginal tax rate is 39%.
What is the firm's weighted average cost of capital if it will be able to use retained earnings to
fund the equity portion of its capital budget?
a. 11.59%
Correct. Use the WACC formula to calculate the cost of capital. Adjust the before-tax cost of
debt for tax deductibility of interest, and use the cost of internal equity (retained earnings).
b. 12.62%
Incorrect. Do not use the cost of external equity (new stock). Hint: Use the WACC formula to
calculate the cost of capital. Adjust the before-tax cost of debt for tax deductibility of interest,
and use the cost of internal equity (retained earnings).
c. 12.84%
Incorrect. Do not forget to adjust the cost of debt for the tax deductibility of interest. Hint: Use
the WACC formula to calculate the cost of capital. Adjust the before-tax cost of debt for tax
deductibility of interest, and use the cost of internal equity (retained earnings).
d. 13.87%
Incorrect. Do not use the cost of external equity (new stock) and do not forget to adjust the cost
of debt for the tax deductibility of interest. Hint: Use the WACC formula to calculate the cost of
capital. Adjust the before-tax cost of debt for tax deductibility of interest, and use the cost of
internal equity (retained earnings).
30. Marginal Incorporated has determined that its before-tax cost of debt is 10.0%. Its cost of
preferred stock is 11.0%. Its cost of internal equity is 15.0%, and its cost of external equity is
16.9%. Currently, the firm's capital structure consists of 32% debt, 14% preferred stock, and
54% common equity. The firm's marginal tax rate is 39%. What is the firm's weighted average
cost of capital if it will have to issue new common stock to fund the equity portion of its capital
budget?
a. 11.59%
Incorrect. Do not use the cost of internal equity (retained earnings). Hint: Use the WACC
formula to calculate the cost of capital. Adjust the before-tax cost of debt for tax deductibility of
interest, and use the cost of external equity (new stock).
b. 12.62%
Correct. Use the WACC formula to calculate the cost of capital. Adjust the before-tax cost of
debt for tax deductibility of interest, and use the cost of external equity (new stock).
c. 12.84%
Incorrect. Do not forget to adjust the cost of debt for the tax deductibility of interest and do not
use the cost of internal equity. Hint: Use the WACC formula to calculate the cost of capital.
Adjust the before-tax cost of debt for tax deductibility of interest, and use the cost of external
equity (new stock).
d. 13.87%
Incorrect. Do forget to adjust the cost of debt for the tax deductibility of interest. Hint: Use the
WACC formula to calculate the cost of capital. Adjust the before-tax cost of debt for tax
deductibility of interest, and use the cost of external equity (new stock).