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MULTIPLE CHOICE
2. Studies analyzing the historical returns earned by common stock investors have found that the returns
from average risk common stock investments over the years have averaged (arithmetically) _______
percentage points _______ than the returns on Treasury bills.
a. 6 to 8, higher
b. 1 to 2, lower
c. 3 to 4, higher
d. 8 to 9, higher
ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return
TOP: Capital asset pricing model approach
3. The cost of equity capital for non-dividend paying stocks can be determined by
a. using the Capital Asset Pricing Model
b. estimating ke for comparable dividend-paying stocks in their industry
c. forecasting the liquidation proceeds from the sale of the company's assets.
d. using the CAPM and by estimating ke for comparable dividend-paying stocks in their
industry
ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return
TOP: Risk premium on debt & other approaches for estimating...
4. For a company that is not planning to change its target capital structure, the proportions of debt and
equity used in calculating the weighted cost of capital should be based on the current _______ weights
of the individual components.
a. book value
b. market value
c. replacement value
d. accounting value
ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Determining the weighted cost of capital schedule
6. A firm can raise up to $700 million for investment from a mixture of debt, preferred stock and retained
equity. Above $700 million, the firm must issue new common stock. Assuming that debt costs and
preferred stock costs remain unchanged, the marginal cost of capital for amounts up to $700 million
will be _______ the marginal cost of capital for amounts over $700 million.
a. less than
b. equal to
c. greater than
d. cannot be determined from the information given
ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Determining the weighted marginal cost of capital schedule
7. The CAPM assumes that the only risk of concern to the investor is _______, which is measured by
_______.
a. Unsystematic risk, beta
b. Systematic risk, the return to the market portfolio
c. Systematic risk, beta
d. Unsystematic risk, the return to the market portfolio
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Understand risk and return TOP: Capital asset pricing model approach | p. 462
8. If a firm adopts a large proportion of above-average-risk investment projects that are not offset by
below-average-risk investment projects
a. its cost of capital will rise
b. the average risk premium for the firm will decline
c. the risk-free rate will increase as more risk is added
d. its cost of capital will fall
ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital TOP: Divisional costs of capital
9. The most appropriate weights to use in calculating a firm's cost of capital are the proportions of the
components in the firm's _______ capital structure.
a. historical average
b. long-range target
c. current
d. industry average
ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: The problem of lumpy capital
10. For firms subject to the 34% marginal tax rate, the after-tax cost of _______ is roughly two-thirds the
cost of preferred stock.
a. retained earnings
b. new common stock
c. long-term debt
d. retained earnings and new common stock
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of debt
11. There are four major components that determine the risk premium. They include all the following
except
a. interest rate risk
b. business risk
c. reinvestment rate risk
d. financial risk
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return
TOP: Nature of risk premiums
14. Break points can be determined by dividing the amount of funds available from each financing source
at a fixed cost by the _____ proportion for that financing source.
a. weighted capital structure
b. target capital structure
c. economic capital structure
d. divisional capital structure
ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Determining the weighted cost of capital structure
15. If a preferred stock is callable, then the calculation of the cost of preferred stock financing is
a. similar to that for bonds
b. equal to Dp/Pn
c. equal to Dp less flotation costs
d. less than Dp/Pn
ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of preferred stock
16. The constant growth valuation model approach to calculating the cost of equity assumes that
a. earnings and dividends grow at a constant rate, but stock price growth is indeterminate
b. the growth rate is greater than or equal to ke
c. dividends are constant
d. earnings, dividends, and stock price will grow at a constant rate
ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Dividend valuation model approach
19. The historic beta of a firm is of little use as a forecast of the firm's future systematic risk characteristics
when
a. the firm is growing at a rate of 7-10 percent a year
b. the firm is expanding an existing product line
c. the firm is expanding into a new product line
d. all of these answers are correct
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return
TOP: The capital asset pricing model approach
20. All of the following methods may be used to determine the cost of equity capital (k e) for a non-
dividend-paying stock except
a. the risk premium on debt approach
b. the Capital Asset Pricing Model approach
c. comparing with similar dividend-paying stocks in the industry
d. the simulation with growth expectations approach
ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return
TOP: Risk premium on debt & other approaches for estimating...
21. The cost of external equity is greater than the cost of internal equity because
a. it decreases the earnings per share
b. it increases the market price of the stock
c. of the flotation costs
d. dividends are increased
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of external equity capital
22. Retained earnings are a cheaper source of funds than the sale of new equity because
a. retention defers the payment of taxable dividends to shareholders
b. there are no flotation costs
c. new shares are usually priced below current market price
d. all the above
ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of external equity capital
23. Historic average capital costs are _______ new (marginal) resource allocation decisions.
a. not relevant for making
b. very useful when making
c. necessary for making
d. the relevant costs for making
ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital TOP: Marginal costs
24. Which of the following is not a typical source of debt funds for a small firm?
a. investment banking firms
b. commercial finance companies
c. Small Business Administration
d. leasing companies
ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Entrepreneurial finance issues: The cost of capital
25. If a firm will use only equity funds during the current capital budgeting period then the _______ is the
correct capital cost to use for computing the cost of funds for the firm.
a. cost of equity capital
b. weighted cost of funds
c. historical cost of funds
d. all of these answers are correct
ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: The problem of lumpy capital
26. The optimal capital budget is determined by comparing the expected project returns to the company's
a. computed break points
b. cost of equity schedule
c. marginal cost of capital schedule
d. optimal opportunity curve
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Determining the optimal capital budget
29. The major components that determine the risk premium on a specific security at any point in time
include all of the following except
a. business risk
b. financial risk
c. interest rate risk
d. real rate of return risk
ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return
TOP: Nature of risk premiums
30. Rank in ascending order (lowest to highest) the relative riskiness of the various types of corporate and
government securities.
a. common stock, preferred stock, corporate debt, long-term government debt
b. corporate debt, long-term government debt, preferred stock, common stock
c. long-term government debt, corporate debt, preferred stock, common stock
d. corporate debt, preferred stock, long-term government debt, common stock
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital; Understand risk and return
TOP: Relative costs of capital
31. Rank in ascending order (lowest to highest) investors' required rates of return on the various types of
corporate securities.
a. preferred stock, corporate debt, common stock
b. common stock, preferred stock, corporate debt
c. preferred stock, common stock, corporate debt
d. corporate debt, preferred stock, common stock
ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital TOP: Relative costs of capital
32. Which of the following statements (if any) is (are) true concerning companies that do not pay
dividends?
a. The cost of equity capital can be estimated using the Capital Asset Pricing Model.
b. The cost of equity capital is equal to the growth short-term rate of earnings per share.
c. The dividend capitalization model can be used to determine an accurate cost of equity
capital.
d. The cost of equity capital cannot be determined by using the CAPM, the risk premium on
debt approach, or by estimating ke for comparable dividend-paying stocks in their
industry.
33. The optimal capital budget is indicated by the point at which the __________ and the __________
intersect.
a. depreciation schedule; investment opportunity schedule
b. investment opportunity curve; marginal cost of capital curve
c. investment opportunity curve; average cost of capital curve
d. efficient portfolio curve; marginal cost of capital curve
ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Determining the optimal capital budget
34. During the 1980s, the cost of capital for U.S. firms averaged about 3.3 percentage points higher than
Japanese firms. During 1990 this disadvantage may have disappeared due to:
a. higher exports to the U.S.
b. higher real interest rates in Japan
c. larger shareholder interest
d. higher Japanese stock market
ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Multicultural understanding
LOC: Knowledge of financial markets and interest rates TOP: International issues
35. If a firm sells assets, generating cash flows, the cost of these funds is ______.
a. the firm's cost of equity
b. the firm's cost of cash flows
c. the firm's weighted cost of capital
d. zero
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of depreciation generated funds
36. Small firms are reluctant to obtain capital through the sale of common stock because of:
a. potential loss of voting control
b. high issuance costs
c. high cost of debt
d. both the potential loss of voting control and the high issuance costs
ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Understand the role of the finance function
TOP: Entrepreneurial finance issues
37. Determine the (after-tax) percentage cost of a $50 million debt issue that the Mattingly Corporation is
planning to place privately with a large insurance company. Assume that the company has a 40%
marginal tax rate. This long-term debt issue will yield 12% to the insurance company.
a. 4.8%
b. 7.2%
c. 12.0%
d. 10.6%
ANS: B
Solution:
ki = kd(1 - T) = 12%( 1- 0.40) = 7.2%
38. Calculate the after-tax cost of preferred stock for Ohio Valley Power Company, which is planning to
sell $100 million of $3.25 cumulative preferred stock to the public at a price of $25 per share.
Flotation costs are $1.00 per share. Ohio Valley has a marginal income tax rate of 40%.
a. 13.0%
b. 7.8%
c. 8.12%
d. 13.54%
ANS: D
Solution:
kp = $3.25/($25 - $1) = 13.54%
39. The Allegheny Valley Power Company common stock has a beta of 0.80. If the current risk-free rate is
6.5% and the expected return on the stock market as a whole is 16%, determine the cost of equity
capital for the firm (using the CAPM).
a. 14.1%
b. 7.6%
c. 6.5%
d. 13.0%
ANS: A
Solution:
ke = rf + (km - rf) = 6.5% + 0.80(16% - 6.5%) = 14.1%
Rawls can issue new common stock to net the company $44 per share. Determine the cost of internal
equity capital using the dividend capitalization model approach. (Compute answer to the nearest
0.1%).
a. 12.3%
b. 13.4%
c. 13.0%
d. 12.7%
ANS: D
Solution:
ke = $3.50(1.05)/$48 + 0.05 = 0.1266 (or 12.7%)
Rawls can issue new common stock to net the company $44 per share. Determine the cost of internal
equity capital using the capital asset pricing model approach. (Compute answer to the nearest 0.1%).
a. 12.9%
b. 12.6%
c. 13.0%
d. 11.8%
ANS: B
Solution:
ke = rf + (km- rf) = 0.06 + 1.1(0.12 - 0.06) = 0.126 = 12.6%
Rawls can issue new common stock to net the company $44 per share. Determine the cost of external
equity capital using the dividend capitalization model approach. (Compute answer to the nearest
0.1%).
a. 12.7%
b. 14.4%
c. 12.6%
d. 13.35%
ANS: D
Solution:
ke' = (D1/Pnet) + g = [$3.50(1.05)/$44] + 0.05 = 0.1335 or 13.4%
43. Determine the weighted cost of capital for the Mills Company that will finance its optimal capital
budget with $120 million of long-term debt (kd = 12.5%) and $180 million in retained earnings (ke =
16.0%). Mills' present capital structure is considered optimal. The company's marginal tax rate is 40%.
(Compute answer to nearest .1%).
a. 14.3%
b. 12.6%
c. 14.6%
d. 11.9%
ANS: B
Solution:
ka = 0.40 x 12.5%(1 - 0.4) + 0.60 x 16.0% = 12.6%
44. What is the cost of a preferred stock with a $100 par value that pays a $9.60 dividend per year? The
security has a flotation cost of $3.37 and will be retired at its par value in 20 years.
a. 9.6%
b. 9.9%
c. 10.0%
d. 10.6%
ANS: C
Solution:
Try kp = 10%
$9.60(8.514) + $100(0.149) = $96.63
45. What is the cost of equity for East Roon, if the firm is expected to always pay a constant dividend of
$2.22? The firm's common stock is presently selling for $18.50.
a. 8.3%
b. 12.0%
c. 10.2%
d. cannot be determined from the information given
ANS: B
Solution:
ke = $2.22/$18.50 = 0.12 or 12%
46. According to Value Line, Bestway has a beta of 1.15. If 3-month Treasury bills currently yield 7.9
percent and the market risk premium is estimated to be 8.3 percent, what is Bestway's cost of equity
capital?
a. 17.45%
b. 8.36%
c. 9.55%
d. 16.2%
ANS: A
Solution:
ke = 7.9% + 1.15(8.3%) = 17.45%
47. Northeast Airlines (NA) has a current dividend of $1.80. Dividends are expected to grow at a rate of 7
percent a year into the foreseeable future. What is NA's cost of external equity if its stock can be sold
to net $46 a share?
a. 10.9%
b. 11.2%
c. 7.2%
d. 21.0%
ANS: B
Solution:
ke = $1.80(1.07)/$46 + 0.07 = 0.112 or 11.2%
48. A firm with a 40 percent marginal tax rate has a capital structure of $60,000,000 in debt and
$140,000,000 in equity. What is the firm's weighted cost of capital if the marginal pretax cost of debt is
12 percent, the firm's average pretax cost of debt outstanding is 8%, and the cost of equity is 14.5
percent?
a. 13.75%
b. 11.59%
c. 12.31%
d. 10.45%
ANS: C
Solution:
ka = 0.3(0.12)(1 - 0.4) + 0.7(0.145) = 0.1231 or 12.31%
49. Crickentree has a target capital structure of 30 percent debt and 70 percent equity. If the firm expects
to have a net income of $1.7 million and a dividend payout ratio of 40 percent, what will be its equity
break point?
a. $2,428,571
b. $1,457,143
c. $3,400,000
d. $ 971,429
ANS: B
Solution:
x = $1.7(1 - 0.4)/0.7 = $1.457 or $1,457,143
PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills
LOC: Knowledge of capital budgeting and cost of capital TOP: Break point calculation
50. Easy Slider Inc. sold a 15 year $1,000 face value bond with a 10 percent coupon rate. Interest is paid
annually. After flotation costs, Easy Slider received $928 per bond. Compute the after-tax cost of debt
for these bonds if the firm's marginal tax rate is 40 percent.
a. 6.0%
b. 7.2%
c. 7.8%
d. 6.6%
ANS: D
Solution:
(try 11%) ki = 11%(0.6) = 6.6%
$928 = $100(7.191) + $1000(0.209) $928
so kd = 11%
ki = 11%(0.6) = 6.6%
51. Easy Slider recently sold a 15 year $1,000 face value bond at a discount for $700 that net the firm
$692 after flotation costs. The low coupon bond has a 6% coupon with interest paid semiannually. If
Easy Slider has a marginal tax rate of 40 percent, what is its after-tax cost of debt for these bonds?
a. 10.0%
b. 6.0%
c. 9.2%
d. 7.8%
ANS: B
Solution:
(Try 5% semiannually ): $692 = $30(15.373) + $1,000(0.231) = $692
Therefore kd = 10% and ki = 10%(1 - 0.4) = 6%
52. Alpha Products maintains a capital structure of 40 percent debt and 60 percent common equity. To
finance its capital budget for next year, the firm will sell $50 million of 11 percent debentures at par
and finance the balance of its $125 million capital budget with retained earnings. Next year Alpha
expects net income to grow 7 percent to $140 million, and dividends also are expected to increase 7
percent to $1.40 per share and to continue growing at that rate for the foreseeable future. The current
market value of Alpha's stock is $30. If the firm has a marginal tax rate of 40 percent, what is its
weighted cost of capital for the coming year?
a. 9.64%
b. 8.63%
c. 9.84%
d. 11.67%
ANS: A
Solution:
ke = $1.40/$30 + 0.07 = 0.1167
ka = 0.6(0.1167) + 0.4(0.11)(1 - 0.4) = 0.0964 or 9.64%
PTS: 1 OBJ: TYPE: E. Prob. NAT: Analytic skills
LOC: Knowledge of capital budgeting and cost of capital TOP: Weighted cost of capital
53. Wellington Gas has a target capital structure of 50 percent common equity, 40 percent debt, and 10
percent preferred stock. The cost of retained earnings is 16 percent, and the cost of new equity
(external) is 16.7 percent. Wellington can sell debentures that will have an after-tax cost of 8.3 percent
and the after-tax cost of preferred stock will be 11.9 percent. What is the marginal cost of capital
before and after the break point?
a. 12.51% and 12.86%
b. 11.18% and 11.53%
c. 14.23% and 14.68%
d. 12.51% and 11.53%
ANS: A
Solution:
ka1 = 0.5(0.16) + 0.4(0.083) + 0.1(0.119) = 0.1251
ka2 = 0.5(0.167) + 0.4(0.083) + 0.1(0.119) = 0.1286
54. GQ earned $740,000 before taxes this year. The firm has a debt ratio of 30 percent, a marginal tax rate
of 35 percent, and a dividend payout ratio of 40 percent. GQ has no preferred stock. What is GQ's
break point for equity?
a. $634,286
b. $962,000
c. $412,286
d. $288,600
ANS: C
Solution:
Retained earnings = $740,000(1 - 0.35)(1 - 0.4) = $288,600
Break point =$288,600/0.7 = $412,286
55. Groves, Inc. pays an annual dividend of $1.22. This dividend is expected to continue growing at a rate
of about 5 percent each year. The firm is in a fairly risky business and has a beta of 1.45. The expected
market rate of return is 13.5 percent, and the risk-free rate is 9.3 percent. What is the cost of equity for
Groves?
a. 19.6%
b. 13.5%
c. 15.4%
d. 6.1%
ANS: C
Solution:
ke = 0.093 + 1.45(0.135 - 0.093) = 0.154
56. PDQ Inc. has a weighted cost of capital of 14.6 percent and has an opportunity to invest in the
following average risk projects:
Project Cost Annual Cost Flow Project life
1 $10,000 $1,992.43 10 years
2 $21,000 $4,526.84 8 years
3 $18,500 $4,580.34 7 years
57. Mid-South Utilities will sell $10 million of $100 par value preferred stock that will pay an annual
dividend of $9.75. Mid-South will receive $93.98 per share after flotation costs. If the issue must be
retired in 20 years, what is the cost of the preferred issue?
a. 10.37%
b. 10.50%
c. 10.23%
d. 9.75%
ANS: B
Solution:
10.5 % (by calculator)
58. Witin's stock price is currently $34.25 and the current quarterly dividend is $0.25. Consensus estimates
for Witin indicate a growth rate in earnings of 10% into the foreseeable future. If Witin plans to sell 1
million shares to raise new capital for expansion, what is the cost of new equity if the issuance costs
are 8%?
a. 13.49%
b. 10.87%
c. 13.21%
d. 13.17%
ANS: A
Solution:
ke = 1.00(1.10) + .10 = .1349 or 13.49%
31.51
60. Pluega Inc. issued a $100 million 8.27% coupon debenture bond due in the next 20 years. The bonds
each sold for $996. If the bonds pay interest semi-annually, what is Pluega's after cash cost of debt?
Assume 40% tax rate.
a. 4.96%
b. 8.30%
c. 4.99%
d. 3.32%
ANS: C
Solution:
8.31(1-.4) = 4.986 or 4.99% (by calculator)
61. Haulsee Inc. pays no dividend currently but is expected to start paying a small dividend next year. The
5-year old firm has a beta of 1.25 and current earnings of $0.90 per share. The current Treasury bill
rate is 6.10% and the market risk premium is 8.8%. Determine Haulsee's cost of equity if the firm's tax
rate is 40%.
a. 9.48%
b. 17.1%
c. 14.9%
d. cannot determined from the information provided
ANS: B
Solution:
ke = 6.10 + 1.25(8.8) = 17.1%
a. 1 and 2
b. 1 and 3
c. 1, 2, and 3
d. cannot be determined from the information provided
ANS: A
Solution:
Equity break point = $3,000,000/0.6 = $5,000,000
Debt break point = $2,000,000/0.35 = $5,714,286
ke = $2.15/$36 + 0.08 = 0.140
ki = 0.106(1 - 0.4) = 0.0636
k'e = $2.15/$34.50 + 0.08 = 0.142
ka1 = 0.6(0.140) + 0.35(0.0636) + 0.05(0.115) = 0.112
ka2 = 0.6(0.142) + 0.35(0.0636) + 0.05(0.115) = 0.113
ka3 = 0.6(.142) + 0.35(0.114)(0.6) + 0.05(0.115) = 0.115
63. Far Out Tech (FOT) has a debt ratio of 0.3 and it considers this to be its optimal capital structure. FOT
has no preferred stock. FOT has analyzed four capital projects for the coming year as follows:
64. Temple Company's common stock dividends have grown over the past 5-year period from $0.60 per
share to $0.89 (today). Assume that Temple's dividends are expected to grow at this rate for the
foreseeable future. Temple's stock is currently selling for $12 per share. New common stock can be
sold to net the company $11 per share. Determine the costs of internal and external equity to Temple.
a. 18.1%; 18.9%
b. 15.9%; 16.6%
c. 16.2%; 16.9%
d. 15.9%; 18.9%
ANS: C
Solution:
$0.89 = $0.60 (FVIFg, 5 )
g = 8.2% by calculator or interpolation
ke = $0.96/$12 + 0.082 = 0.162 or 16.2%
k'e = $0.96/$11 + 0.082 = 0.169 or 16.9%
65. Whipple Industries, Inc. is in the process of determining its optimal capital budget for next year. The
following investment projects are under consideration:
Amount of
Funds Raised Cost
$0 - $6 million 12.0%
$6 million - $12 million 12.5%
$12 million - $18 million 13.5%
Over $18 million 15.0%
Determine Whipple's optimal capital budget (in dollars) for the coming year.
a. $11 million
b. $10 million
c. $5 million
d. $14 million
ANS: A
Solution:
66. American Dental Laser is selling a 10 year $1,000 face value bond with a 8% coupon rate. Interest is
paid annually. The price to the public is $820 and the issue costs per bond are $10 each. Compute the
pretax cost of debt for these bonds.
a. 11.1%
b. 11.3%
c. 11.5%
d. 11.8%
ANS: B
Solution:
$810 = $80(PVIFAkd,10) + $1000(PVIFkd,10)
try 11%: $80(5.889) + $1000(0.352) = $823.12
try 12%: $80(5.650) + $1000(0.322) = $774.00
kd = 11% + $13.12 (12% - 11%) = 11.3%
$13.12 + $36
67. Mid-States Utility Company just issued at $3.20 cumulative preferred stock at a price to the public of
$30 a share. The flotation costs were $1.50 a share and the issue will be retired in 20 years at its $30
par value. What is the cost of this preferred issue?
a. 11.3%
b. 10.3%
c. 10.7%
d. 11.6%
ANS: A
Solution:
$28.50 = $3.20(PVIFAkp,20) + $30(PVIFkp,20)
try 11%: $3.20(7.963) + $30(0.124) = $29.20
try 12%: $3.20(7.469) + $30(0.104) =$27.02
$0.70
kp = 11% + (12% - 11%) = 11.3%
$0.70 + $1.48
68. Wright Express(WE) has a capital structure of 30% debt and 70% equity. WE is considering a project
that requires an investment of $2.6 million. To finance this project, WE plans to issue 10-year bonds
with a coupon interest rate of 12%. Each of these bonds has a $1,000 face value and will be sold to net
WE $980. If the current risk-free rate is 7% and the expected market return is 14.5%, what is the
weighted cost of capital for WE? Assume WE has a beta of 1.20 and a marginal tax rate of 40%.
a. 14.9%
b. 12.4%
c. 13.4%
d. 16.0%
ANS: C
Solution:
try 12%: $120(5.650) + $10000(.322) = $1,000
try 13%: $120(5.426) + $1000(0.295) = $946.12
$20
kd = 12% + (13% - 12%) = 12.4%
$20 + $33.88
70. Columbia Gas Company's(CG) current capital structure is 35% debt and 65% equity. This year CG has
earnings after tax of $5.31 million and is paying $1.6 million in dividends. To finance a transmission
pipe line, CG can borrow $2 million at a cost of 10%, the same rate that CG is currently paying on a
total of $15 million long-term debt. CG has 1,000,000 shares outstanding and its current market price
is $31. If CG's long-term growth rate of dividends is expected to be 8%, what is the weighted cost of
capital for the firm? Assume a marginal tax rate of 40%.
a. 10.9%
b. 13.6%
c. 19.6%
d. 16.9%
ANS: A
Solution:
kd = 10%(1 - 0.4) = 6%
ke = $1.6(1.08)/$31 + 0.08 = .136 or 13.6%
ka = 0.35(6%) + 0.65(13.6%) = 10.9%
71. Heleveton Industries is 100% equity financed. Its current beta is 1.1. The expected market risk
premium is 8.5% and the risk-free rate is 4.2%. If Heleveton changes its capital structure to 25% debt,
it estimates its beta will increase to 1.2. If the after-tax cost of debt will be 6%, should Heleveton make
the capital structure change?
a. Yes, cost of capital decreases by 2.52%
b. Yes, cost of capital decreases 1.67%.
c. No, stock price would decrease due to increased risk
d. No, cost of capital increases by 0.85%.
ANS: B
Solution:
Old ke = 4.2 + 1.1(8.5) = 13.55% = ka
New ke = 4.2 + 1.2(8.5) = 14.4%
New ka = .7(14.4) + .3(6) = 11.88%
Stock price is maximized where the cost of capital is minimized.
73. Bay State Technology has determined that its cost of equity is 15% and its after-tax cost of debt is
7.2%. Bay State expects to earn $14 million after taxes next year and, as a new firm, does not pay any
dividends. The stock sells for $24. Bonds are currently selling at par value. Compute Bay State's
weighted cost of capital. A partial balance sheet is shown below:
a. 13.4%
b. 13.1%
c. 11.6%
d. 12.7%
ANS: D
Solution:
Capital structure: Debt = $1,000,000
Market value of Equity: 100,000 shares($24) = 2,400,000
Total $3,400,000
75. Which of the following statements regarding the cost of capital is/are correct?
I. The weighted cost of capital is the discount rate used when computing the net present value.
II. The after-tax cost of capital is weighted by the proportions of the capital components in the firm’s
long-range target capital structure.
a. I only
b. II only
c. Both I and II
d. Neither I nor II
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital TOP: Weighted cost of capital
76. The cost of debt must account for all of the following inputs EXCEPT:
a. Bond ratings.
b. Issuance costs.
c. flotation costs.
d. The tax rate.
ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of debt
77. There are two primary ways that capital is raised. Which of the following statements is/are correct?
I. Capital is raised internally by using retained earnings.
II. Capital is raised externally by selling fixed assets.
a. I only
b. II only
c. Both I and II
d. Neither I nor II
ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of equity capital
78. Investors can form earnings growth expectations from various sources, including
a. potential sales growth.
b. current earnings and retention rates.
c. assumed product development.
d. investors’ required rate of return.
ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Understand the role of the finance function TOP: Issues in implementation
79. What is the weighted average cost of capital for Mud Bug Corporation?
Source of Capital Capital Components Cost
Long Term Debt $60,000 5.6%
Preferred Stock $15,000 10.6%
Common Stock $75,000 13.0%
a. 6.9%
b. 8.5%
c. 10.2%
d. 9.8%
ANS: D PTS: 1 OBJ: TYPE: E. Prob.
NAT: Analytic skills LOC: Knowledge of capital budgeting and cost of capital
TOP: Weighted cost of capital
80. Zappin’ Skeeters Corporation needs to know its cost of retained earnings. Based on the following
information, compute the cost of retained earnings: The stock sells for $25, flotation costs are $3 and
the firm is in the 35% tax bracket.
Year Dividend
2004 $1.55
2003 $1.40
2002 $1.35
2001 $1.32
a. 15.71%
b. 9.11%
c. 12.56%
d. 10.72%
ANS: C PTS: 1 OBJ: TYPE: C. Prob.
NAT: Analytic skills LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of internal equity - constant growth dividend...
81. The cost of internal equity is cheaper than the cost of external equity. Which of the following
statements is/are correct?
I. External equity may incur expenses which are deducted from the capital received for the sale of the
security.
II. Corporations generally discount the price of the securities that are sold to the public in order to
raise capital.
a. I only
b. II only
c. Both I and II
d. Neither I nor II
ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of external equity capital
82. What is the cost of preferred stock if the stock is selling for $208, the dividend is $35 and flotation
costs are 5% of the selling price?
a. 17.7%
b. 25.2%
c. 12.5%
d. 10.8%
ANS: A PTS: 1 OBJ: TYPE: E. Prob.
NAT: Analytic skills LOC: Cost of capital
TOP: Cost of preferred calculation
83. What would be the weighted average cost of capital for Limp Linguini Noodle Makers, Inc. under the
following conditions:
*The capital structure is 40% debt and 60% equity
*The before-tax cost of debt (which includes flotation costs) is 20% and the firm is in the 40% tax
bracket.
*The firm’s beta is 1.7
*The risk-free rate is 7% and the market risk premium is 6%
a. 15.12%
b. 18.7%
c. 17.2%
d. 12%
ANS: A
Determine the cost of equity: 1.7(6%) + 7% = 17.2%
Determine the cost of debt: 20% X .60 = 12
Determine the weighted cost of capital:
17.2(.60) + 12(.40) = 15.12%
84. A firm has a beta of 1.2. The return in the market is 14% and the risk-free rate is 6%. The estimated
cost of common stock equity is:
a. 6%
b. 7.2%
c. 15.6%
d. 14%
ANS: C
Solution: 1.2 (14% - 6%) + 6% = 15.6%
85. The optimal capital budget occurs at the point where two curves intersect. Which of the following is
one of those curves?
I. Weighted marginal cost of capital curve
II. Investment opportunity curve
a. I only
b. II only
c. Both I and II
d. Neither I nor II
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Determining the optimal capital budget
86. The cost of common stock equity may be estimated by using which of the following?
a. Earnings curve
b. Dupont analysis
c. Capital asset pricing model
d. Price/Earnings ratio
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital
TOP: Cost of external equity capital
87. A firm is determining its cost of common stock equity. It last paid a divided of $.52, the dividends are
growing at 5%, flotation costs are $2 per share and the firm will net $72 per share upon the sale of the
stock. What is the firm’s cost of common equity?
a. 3.49%
b. 8.22%
c. 6.11%
d. 5.76%
ANS: D
Solution:
$.52 (1 + .05) = $.55
88. Surfin’ Bubba Surfboard Shop is currently selling for $34.25 a share with a current dividend of $1.00.
It is estimated that Surfin’ Bubba will have a growth rate in earnings of 10% into the foreseeable
future. If Surfin’ Bubba plans to raise new capital for expansion, what is the cost of new equity if
flotation costs are 8% of the price.
a. 13.49%
b. 11.57%
c. 12.21%
d. 10.87%
ANS: A
Solution:
89. What is Bodacious Bodywear’s weighted average cost of capital under the following conditions:
* The firm has 30% debt, 10% preferred stock, and 60% equity
*The cost of common equity is 14% and the cost of preferred stock is 9%
* The firm’s debt has a before-tax cost of debt of 10% (including flotation costs)
* The firm is in the 40% tax bracket
a. 11.1%
b. 8.5%
c. 12.3%
d. 10.5%
ANS: A
Solution:
90. In determining the cost of debt, several factors must be considered. All of the following are those
factors EXCEPT:
a. the firm’s before-tax cost of debt
b. the firm’s tax rate
c. flotation costs
d. the firm’s growth rate of dividends
ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Knowledge of capital budgeting and cost of capital TOP: Cost of debt
ESSAY
1. In considering the SML concept, the required returns for any individual security are dependent on
certain values. List and discuss those values.
ANS:
1. The risk-free rate: The 3-month or 6-month Treasury Bill rate is generally used for this
value.
2. The expected market return: This is the return that investors expect to earn on stocks with
a beta of 1.0.
3. The beta of the corporation: Beta is normally estimated by using historic values reflecting
the relationship between a security’s returns and the market returns.
2. What are the reasons that the cost of external equity is greater than the cost of internal equity?
ANS:
1. External equity has issuance costs associated with new shares. These costs are generally
significant enough that they cannot be ignored.
2. The price of the new shares being sold to the public is normally set to an amount less than
the market price of the stock before the announcement of the new issue.
3. Firms can raise capital in two ways. Why is it that internal funding does not have a zero cost?
ANS:
Firms using internal funding, or retained earnings, incur an opportunity cost. When funds are
generated through the earnings of the firm, either managers can pay out funds as dividends to common
stockholders, or the funds can be retained and reinvested in the firm. If the funds are paid out to
stockholders, they could reinvest the funds elsewhere to earn an appropriate return, given the risk of
the investment. If managers decide to retain earnings and reinvest them in the firm, there must be
investment opportunities in a firm offering a return equivalent to the returns available to stockholders
in alternative investments on a risk-adjusted basis.
4. How is the marginal cost of the various component capital sources determined?
ANS:
The marginal cost of funds is the cost of the next increments of capital raised by the firm. When
computing the marginal cost of the various component capital sources, companies typically estimate
the component costs they anticipate encountering, or paying, during the coming year. If capital costs
change significantly during the year, it may be necessary to recompute the new capital costs and use
the new estimates when evaluating projects from that time forward,
ANS:
The investment opportunity curve is the graph which illustrates the comparison between the expected
project return to the company’s marginal cost of capital schedule. It is accomplished by first plotting
the returns expected from the proposed capital expenditure projects against the cumulative funds
required. The optimal capital budget is indicated by the point at which the investment opportunity
curve and the marginal cost of capital curve intersect.