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(Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard)

Note that there is some overlap between the T/F and the multiple choice questions, as some T/F
statements are used in the MC questions. See the preface for information on the AACS letter
indicators !F, M, etc." on the sub#ect lines.
Multiple Choice: True/alse
(11-1) Capital F I Answer: a EASY
1
. Capital is sometimes defined as funds supplied to a firm by investors.
a. True
b. False
(11-1) Cost of capital F I Answer: a EASY
2
. The cost of capital used in capital budgeting should reflect the average
cost of the various sources of investor-supplied funds a firm uses to
acquire assets.
a. True
b. False
(11-1) Specific capital cost F I Answer: b EASY

. !uppose you are the president of a small" publicly-traded corporation.


!ince you believe that your firm#s stoc$ price is temporarily depressed"
all additional capital funds required during the current year %ill be
raised using debt. &n this case" the appropriate marginal cost of
capital for use in capital budgeting during the current year is the
after-ta' cost of debt.
a. True
b. False
(11-2) Component capital costs F I Answer: a EASY
(
. The component costs of capital are mar$et-determined variables in the
sense that they are based on investors# required returns.
a. True
b. False
(11-3) Cost of debt F I Answer: b EASY
)
. The before-ta' cost of debt" %hich is lo%er than the after-ta' cost" is
used as the component cost of debt for purposes of developing the firm#s
*+CC.
a. True
b. False
Chapter 11: Cost of Capital True/False Page 95
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CH!"TE# $$
THE C%&T % C!"'T!L
(11-3) Cost of debt F I Answer: b EASY
,
. The cost of debt is equal to one minus the marginal ta' rate multiplied
by the average coupon rate on all outstanding debt.
a. True
b. False
(11-3) Cost of debt F I Answer: a EASY
-
. The cost of debt is equal to one minus the marginal ta' rate multiplied
by the interest rate on ne% debt.
a. True
b. False
(11-) Cost of preferred F I Answer: b EASY
.
. The cost of preferred stoc$ to a firm must be ad/usted to an after-ta'
figure because -01 of dividends received by a corporation may be
e'cluded from the receiving corporation#s ta'able income.
a. True
b. False
(11-) Cost of preferred F I Answer: a EASY
2
. The cost of perpetual preferred stoc$ is found as the preferred#s annual
dividend divided by the mar$et price of the preferred stoc$. 3o
ad/ustment is needed for ta'es because preferred dividends" unli$e
interest on debt" are not deductable by the issuing firm.
a. True
b. False
(11-!) Cost of common F I Answer: a EASY
10
. The cost of common equity obtained by retaining earnings is the rate of
return the marginal stoc$holder requires on the firm#s common stoc$.
a. True
b. False
(11-!) Cost of retained earnin"s F I Answer: b EASY
11
. For capital budgeting and cost of capital purposes" the firm should
al%ays consider retained earnings as the first source of capital--i.e."
use these funds first--because retained earnings have no cost to the
firm.
a. True
b. False
(11-!) Cost of retained earnin"s F I Answer: b EASY
12
. Funds acquired by the firm through retaining earnings have no cost
because there are no dividend or interest payments associated %ith them"
and no flotation costs are required to raise them" but capital raised by
selling ne% stoc$ or bonds does have a cost.
Page 9, True/False Chapter 11: Cost of Capital
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a. True
b. False
(11-!) Cost of retained earnin"s F I Answer: b EASY
1
. The cost of equity raised by retaining earnings can be less than" equal
to" or greater than the cost of e'ternal equity raised by selling ne%
issues of common stoc$" depending on ta' rates" flotation costs" the
attitude of investors" and other factors.
a. True
b. False
(11-#) Cost of new common F I Answer: b EASY
1(
. The firm#s cost of e'ternal equity raised by issuing ne% stoc$ is the
same as the required rate of return on the firm#s outstanding common
stoc$.
a. True
b. False
(11-$) %ACC F I Answer: a EASY
1)
. For capital budgeting and cost of capital purposes" the firm should
assume that each dollar of capital is obtained in accordance %ith its
target capital structure" %hich for many firms means partly as debt"
partly as preferred stoc$" and partly common equity.
a. True
b. False
(Comp&) Flotation and capital F I Answer: b EASY
1,
. The higher the firm#s flotation cost for ne% common equity" the more
li$ely the firm is to use preferred stoc$" %hich has no flotation cost"
and retained earnings" %hose cost is the average return on the assets
that are acquired.
a. True
b. False
(11-1) Specific capital cost F I Answer: b 'E(I)'
1-
. &n general" firms should use their %eighted average cost of capital
4*+CC5 to evaluate capital budgeting pro/ects because most pro/ects are
funded %ith general corporate funds" %hich come from a variety of
sources. 6o%ever" if the firm plans to use only debt or only equity to
fund a particular pro/ect" it should use the after-ta' cost of that
specific type of capital to evaluate that pro/ect.
a. True
b. False
(11-3) After-ta* cost of debt F I Answer: a 'E(I)'
1.
. &f a firm#s marginal ta' rate is increased" this %ould" other things
held constant" lo%er the cost of debt used to calculate its *+CC.
a. True
Chapter 11: Cost of Capital True/False Page 9-
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b. False
Page 9. True/False Chapter 11: Cost of Capital
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(11-!) +etained earnin"s F I Answer: a 'E(I)'
12
. The reason %hy retained earnings have a cost equal to r
s
is because
investors thin$ they can 4i.e." e'pect to5 earn r
s
on investments %ith
the same ris$ as the firm#s common stoc$" and if the firm does not thin$
that it can earn r
s
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.
a. True
b. False
(11-!) Cost of e,-it. estimates F I Answer: b 'E(I)'
20
. The te't identifies three methods for estimating the cost of common
stoc$ from retained earnings7 the C+89 method" the :CF method" and the
bond-yield-plus-ris$-premium method. 6o%ever" only the :CF method is
%idely used in practice.
a. True
b. False
(11-!) Cost of e,-it. estimates F I Answer: b 'E(I)'
21
. The te't identifies three methods for estimating the cost of common
stoc$ from retained earnings7 the C+89 method" the :CF method" and the
bond-yield-plus-ris$-premium method. 6o%ever" only the C+89 method
al%ays provides an accurate and reliable estimate.
a. True
b. False
(11-!) Cost of e,-it. estimates F I Answer: a 'E(I)'
22
. The te't identifies three methods for estimating the cost of common
stoc$ from retained earnings7 the C+89 method" the :CF method" and the
bond-yield-plus-ris$-premium method. !ince %e cannot be sure that the
estimate obtained %ith any of these methods is correct" it is often
appropriate to use all three methods" then consider all three estimates"
and end up using a /udgmental estimate %hen calculating the *+CC.
a. True
b. False
(11-!) Cost of e,-it. estimates F I Answer: a 'E(I)'
2
. *hen estimating the cost of equity by use of the C+89" three potential
problems are 415 %hether to use long-term or short-term rates for r
;F
"
425 %hether or not the historical beta is the beta that investors use
%hen evaluating the stoc$" and 45 ho% to measure the mar$et ris$
premium" ;8
9
. These problems leave us unsure of the true value of r
s
.
a. True
b. False
(11-!) Cost of e,-it. estimates F I Answer: a 'E(I)'
2(
. *hen estimating the cost of equity by use of the :CF method" the single
biggest potential problem is to determine the gro%th rate that investors
Chapter 11: Cost of Capital True/False Page 99
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use %hen they estimate a stoc$#s e'pected future rate of return. This
problem leaves us unsure of the true value of r
s
.
a. True
b. False
(11-!) Cost of e,-it. estimates F I Answer: a 'E(I)'
2)
. *hen estimating the cost of equity by use of the bond-yield-plus-ris$-
premium method" %e can generally get a good idea of the interest rate on
ne% long-term debt" but %e cannot be sure that the ris$ premium %e add
is appropriate. This problem leaves us unsure of the true value of r
s
.
a. True
b. False
(11-!) Cost of e,-it. estimates F I Answer: a 'E(I)'
2,
. &f a firm is privately o%ned" and its stoc$ is not traded in public
mar$ets" then %e cannot measure its beta for use in the C+89 model" %e
cannot observe its stoc$ price for use in the :CF model" and %e don#t
$no% %hat the ris$ premium is for use in the bond-yield-plus-ris$-
premium method. +ll this ma$es it especially difficult to estimate the
cost of equity for a private company.
a. True
b. False
(11-#) Cost of new common F I Answer: b 'E(I)'
2-
. The cost of e'ternal equity capital raised by issuing ne% common stoc$
4r
e
5 is defined as follo%s" in %ords7 The cost of e'ternal equity
equals the cost of equity capital from retaining earnings 4r
s
5" divided
by one minus the percentage flotation cost required to sell the ne%
stoc$" 41 - F5.
a. True
b. False
(11-#) Cost of new common F I Answer: a 'E(I)'
2.
. &f the e'pected dividend gro%th rate is <ero" then the cost of e'ternal
equity capital raised by issuing ne% common stoc$ 4r
e
5 is equal to the
cost of equity capital from retaining earnings 4r
s
5 divided by one minus
the percentage flotation cost required to sell the ne% stoc$" 41 - F5.
&f the e'pected gro%th rate is not <ero" then the cost of e'ternal
equity must be found using a different formula.
a. True
b. False
(11-/) Factors affectin" %ACC F I Answer: b 'E(I)'
22
. !uppose the debt ratio 4:=T+5 is )01" the interest rate on ne% debt is
.1" the current cost of equity is 1,1" and the ta' rate is (01. +n
increase in the debt ratio to ,01 %ould have to decrease the %eighted
average cost of capital 4*+CC5.
a. True
Page 100 True/False Chapter 11: Cost of Capital
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b. False
Chapter 11: Cost of Capital True/False Page 101
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(11-0) +is1-ad2-sted capital costs F I Answer: a 'E(I)'
0
. Firms raise capital at the total corporate level by retaining earnings
and by obtaining funds in the capital mar$ets. They then provide funds
to their different divisions for investment in capital pro/ects. The
divisions may vary in ris$" and the pro/ects %ithin the divisions may
also vary in ris$. Therefore" it is conceptually correct to use
different ris$-ad/usted costs of capital for different capital budgeting
pro/ects.
a. True
b. False
(Comp&) %ACC F I Answer: a 'E(I)'
1
. The cost of debt" r
d
" is normally less than r
s
" so r
d
41 - T5 %ill
normally be much less than r
s
. Therefore" as long as the firm is not
completely debt financed" the %eighted average cost of capital 4*+CC5
%ill normally be greater than r
d
41 - T5.
a. True
b. False
(Comp&) 3a*es4 r
d
(1 - 3)4 and %ACC F I Answer: b 'E(I)'
2
. The lo%er the firm#s ta' rate" the lo%er %ill be its after-ta' cost of
debt and also its *+CC" other things held constant.
a. True
b. False
(Comp&) Cost of e,-it. F I Answer: b 'E(I)'

. !ince -01 of the preferred dividends received by a corporation are


e'cluded from ta'able 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 > r
s
40.0540.)05 ? r
ps
41 - T540.-0540.)05.
a. True
b. False
(Comp&) Inflation effects F I Answer: b 'E(I)'
(
. &f e'pectations for long-term inflation rose" but the slope of the !9@
remained constant" this %ould have a greater impact on the required rate
of return on equity" r
s
" than on the interest rate on long-term debt"
r
d
" for most firms. Therefore" the percentage point increase in the
cost of equity %ould be greater than the increase in the interest rate
on long-term debt.
a. True
b. False
Page 102 True/False Chapter 11: Cost of Capital
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(Comp&) Inflation effects F I Answer: a 'E(I)'
)
. &f investors# aversion to ris$ rose" causing the slope of the !9@ to
increase" this %ould have a greater impact on the required rate of
return on equity" r
s
" than on the interest rate on long-term debt" r
d
"
for most firms. Ather things held constant" this %ould lead to an
increase in the use of debt and a decrease in the use of equity.
6o%ever" other things %ould not stay constant if firms used a lot more
debt" as that %ould increase the ris$iness of both debt and equity and
thus limit the shift to%ard debt.
a. True
b. False
Multiple Choice: Conceptual
(11-2) Capital components C I Answer: b EASY
,
. *hich of the follo%ing is 3AT a capital component %hen calculating the
%eighted average cost of capital 4*+CC5 for use in capital budgetingB
a. @ong-term debt.
b. +ccounts payable.
c. ;etained earnings.
d. Common stoc$.
e. 8referred stoc$.
(11-#) Internal 5s& e*ternal common C I Answer: b EASY
-
. Can$ston Corporation forecasts that if all of its e'isting financial
policies are follo%ed" its proposed capital budget %ould be so large
that it %ould have to issue ne% common stoc$. !ince ne% stoc$ has a
higher cost than retained earnings" Can$ston %ould li$e to avoid issuing
ne% stoc$. *hich of the follo%ing actions %ould ;D:ECD its need to
issue ne% common stoc$B
a. &ncrease the dividend payout ratio for the upcoming year.
b. &ncrease the percentage of debt in the target capital structure.
c. &ncrease the proposed capital budget.
d. ;educe the amount of short-term ban$ debt in order to increase the
current ratio.
e. ;educe the percentage of debt in the target capital structure.
(11-/) Factors affectin" %ACC C I Answer: a EASY
.
. !chalheim !isters &nc. has al%ays paid out all of its earnings as
dividends" hence the firm has no retained earnings. This same situation
is e'pected to persist in the future. The company uses the C+89 to
calculate its cost of equity" its target capital structure consists of
common stoc$" preferred stoc$" and debt. *hich of the follo%ing events
%ould ;D:ECD its *+CCB
a. The mar$et ris$ premium declines.
b. The flotation costs associated %ith issuing ne% common stoc$
increase.
c. The companyFs beta increases.
d. D'pected inflation increases.
Chapter 11: Cost of Capital Con&eptual #/C Page 103
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e. The flotation costs associated %ith issuing preferred stoc$ increase.
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(Comp&) Capital components C I Answer: b EASY
2
. For a typical firm" %hich of the follo%ing sequences is CA;;DCTB +ll
rates are after ta'es" and assume that the firm operates at its target
capital structure.
a. r
s
G r
e
G r
d
G *+CC.
b. r
e
G r
s
G *+CC G r
d
.
c. *+CC G r
e
G r
s
G r
d
.
d. r
d
G r
e
G r
s
G *+CC.
e. *+CC G r
d
G r
s
G r
e
.
(11-!) Cost of e,-it.: CA6' C I Answer: e 'E(I)'
(0
. *hen %or$ing %ith the C+89" %hich of the follo%ing factors can be
determined %ith the most precisionB
a. The mar$et ris$ premium 4;8
9
5.
b. The beta coefficient" b
i
" of a relatively safe stoc$.
c. The most appropriate ris$-free rate" r
;F
.
d. The e'pected rate of return on the mar$et" r
9
.
e. The beta coefficient of the mar$et" %hich is the same as the beta
of an average stoc$.
(11-0) (i5isional ris1 C I Answer: c 'E(I)'
(1
. :uval &nc. uses only equity capital" and it has t%o equally-si<ed
divisions. :ivision +Fs cost of capital is 10.01" :ivision CFs cost is
1(.01" and the corporate 4composite5 *+CC is 12.01. +ll of :ivision +Fs
pro/ects are equally ris$y" as are all of :ivision C#s pro/ects.
6o%ever" the pro/ects of :ivision + are less ris$y than those of
:ivision C. *hich of the follo%ing pro/ects should the firm acceptB
a. + :ivision C pro/ect %ith a 11 return.
b. + :ivision C pro/ect %ith a 121 return.
c. + :ivision + pro/ect %ith an 111 return.
d. + :ivision + pro/ect %ith a 21 return.
e. + :ivision C pro/ect %ith an 111 return.
(11-0) +is1 and pro2ects C I Answer: a 'E(I)'
(2
. @a8ango &nc. estimates that its average-ris$ pro/ects have a *+CC of
101" its belo%-average ris$ pro/ects have a *+CC of .1" and its above-
average ris$ pro/ects have a *+CC of 121. *hich of the follo%ing
pro/ects 4+" C" and C5 should the company acceptB
a. 8ro/ect C" %hich is of belo%-average ris$ and has a return of ..)1.
b. 8ro/ect C" %hich is of above-average ris$ and has a return of 111.
c. 8ro/ect +" %hich is of average ris$ and has a return of 21.
d. 3one of the pro/ects should be accepted.
e. +ll of the pro/ects should be accepted.
Chapter 11: Cost of Capital Con&eptual #/C Page 105
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(11-0) +is1 and pro2ects C I Answer: d 'E(I)'
(
. 3orris Dnterprises" an all-equity firm" has a beta of 2.0. The chief
financial officer is evaluating a pro/ect %ith an e'pected return of
1(1" before any ris$ ad/ustment. The ris$-free rate is )1" and the
mar$et ris$ premium is (1. The pro/ect being evaluated is ris$ier than
the firmFs average pro/ect" in terms of both its beta ris$ and its total
ris$. *hich of the follo%ing statements is CA;;DCTB
a. The pro/ect should definitely be accepted because its e'pected return
4before any ris$ ad/ustments5 is greater than its required return.
b. The pro/ect should definitely be re/ected because its e'pected return
4before ris$ ad/ustment5 is less than its required return.
c. ;is$ier-than-average pro/ects should have their e'pected returns
increased to reflect their higher ris$. Clearly" this %ould ma$e the
pro/ect acceptable regardless of the amount of the ad/ustment.
d. The accept=re/ect decision depends on the firm#s ris$-ad/ustment policy.
&f 3orris# policy is to increase the required return on a ris$ier-than-
average pro/ect to 1 over r
!
" then it should re/ect the pro/ect.
e. Capital budgeting pro/ects should be evaluated solely on the basis of
their total ris$. Thus" insufficient information has been provided
to ma$e the accept=re/ect decision.
(11-0) +is1-ad2-sted capital cost C I Answer: a 'E(I)'
((
. The 9ac9illen Company has equal amounts of lo%-ris$" average-ris$" and
high-ris$ pro/ects. The firm#s overall *+CC is 121. The CFA believes
that this is the correct *+CC for the companyFs average-ris$ pro/ects"
but that a lo%er rate should be used for lo%er-ris$ pro/ects and a
higher rate for higher-ris$ pro/ects. The CDA disagrees" on the grounds
that even though pro/ects have different ris$s" the *+CC used to
evaluate each pro/ect should be the same because the company obtains
capital for all pro/ects from the same sources. &f the CDAFs position
is accepted" %hat is li$ely to happen over timeB
a. The company %ill ta$e on too many high-ris$ pro/ects and re/ect too
many lo%-ris$ pro/ects.
b. The company %ill ta$e on too many lo%-ris$ pro/ects and re/ect too
many high-ris$ pro/ects.
c. Things %ill generally even out over time" and" therefore" the firmFs
ris$ should remain constant over time.
d. The companyFs overall *+CC should decrease over time because its
stoc$ price should be increasing.
e. The CDAFs recommendation %ould ma'imi<e the firmFs intrinsic value.
(11-0) +is1-ad2-sted capital cost C I Answer: d 'E(I)'
()
. &f a typical E.!. company correctly estimates its *+CC at a given point
in time and then uses that same cost of capital to evaluate all pro/ects
for the ne't 10 years" then the firm %ill most li$ely
a. become ris$ier over time" but its intrinsic value %ill be ma'imi<ed.
b. become less ris$y over time" and this %ill ma'imi<e its intrinsic
value.
c. accept too many lo%-ris$ pro/ects and too fe% high-ris$ pro/ects.
d. become more ris$y and also have an increasing *+CC. &ts intrinsic
value %ill not be ma'imi<ed.
Page 10, Con&eptual #/C Chapter 11: Cost of Capital
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e. continue as before" because there is no reason to e'pect its ris$
position or value to change over time as a result of its use of a
single cost of capital.
(Comp&) Capital components C I Answer: e 'E(I)'
(,
. *hich of the follo%ing statements is CA;;DCTB
a. *hen calculating the cost of preferred stoc$" a company needs to
ad/ust for ta'es" because preferred stoc$ dividends are deductible by
the paying corporation.
b. +ll else equal" an increase in a companyFs stoc$ price %ill increase
its marginal cost of retained earnings" r
s
.
c. +ll else equal" an increase in a companyFs stoc$ price %ill increase
its marginal cost of ne% common equity" r
e
.
d. !ince the money is readily available" the after-ta' cost of retained
earnings is usually much lo%er than the after-ta' cost of debt.
e. &f a companyFs ta' rate increases but the HT9 on its noncallable
bonds remains the same" the after-ta' cost of its debt %ill fall.
(Comp&) Capital components C I Answer: a 'E(I)'
(-
. *hich of the follo%ing statements is CA;;DCTB
a. *hen calculating the cost of debt" a company needs to ad/ust for
ta'es" because interest payments are deductible by the paying
corporation.
b. *hen calculating the cost of preferred stoc$" companies must ad/ust
for ta'es" because dividends paid on preferred stoc$ are deductible
by the paying corporation.
c. Cecause of ta' effects" an increase in the ris$-free rate %ill have a
greater effect on the after-ta' cost of debt than on the cost of
common stoc$ as measured by the C+89.
d. &f a companyFs beta increases" this %ill increase the cost of equity
used to calculate the *+CC" but only if the company does not have
enough retained earnings to ta$e care of its equity financing and
hence must issue ne% stoc$.
e. 6igher flotation costs reduce investors# e'pected returns" and that
leads to a reduction in a companyFs *+CC.
(Comp&) Capital components C I Answer: d 'E(I)'
(.
. *hich of the follo%ing statements is CA;;DCTB
a. &n the *+CC calculation" %e must ad/ust the cost of preferred stoc$
4the mar$et yield5 to reflect the fact that -01 of the dividends
received by corporate investors are e'cluded from their ta'able
income.
b. *e should use historical measures of the component costs from prior
financings that are still outstanding %hen estimating a companyFs
*+CC for capital budgeting purposes.
c. The cost of ne% equity 4r
e
5 could possibly be lo%er than the cost of
retained earnings 4r
s
5 if the mar$et ris$ premium" ris$-free rate"
and the companyFs beta all decline by a sufficiently large amount.
d. &ts cost of retained earnings is the rate of return stoc$holders
require on a firmFs common stoc$.
Chapter 11: Cost of Capital Con&eptual #/C Page 10-
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e. The component cost of preferred stoc$ is e'pressed as r
p
41 - T5"
because preferred stoc$ dividends are treated as fi'ed charges"
similar to the treatment of interest on debt.
Page 10. Con&eptual #/C Chapter 11: Cost of Capital
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(Comp&) %ACC C I Answer: d 'E(I)'
(2
. *hich of the follo%ing statements is CA;;DCTB
a. The *+CC as used in capital budgeting is an estimate of a companyFs
before-ta' cost of capital.
b. The percentage flotation cost associated %ith issuing ne% common
equity is typically smaller than the flotation cost for ne% debt.
c. The *+CC as used in capital budgeting is an estimate of the cost of
all the capital a company has raised to acquire its assets.
d. There is an opportunity cost associated %ith using retained
earnings" hence they are not free.
e. The *+CC as used in capital budgeting %ould be simply the after-ta'
cost of debt if the firm plans to use only debt to finance its
capital budget during the coming year.
(Comp&) %ACC C I Answer: d 'E(I)'
)0
. *hich of the follo%ing statements is CA;;DCTB
a. + change in a companyFs target capital structure cannot affect its
*+CC.
b. *+CC calculations should be based on the before-ta' costs of all the
individual capital components.
c. Flotation costs associated %ith issuing ne% common stoc$ normally
reduce the *+CC.
d. &f a companyFs ta' rate increases" then" all else equal" its %eighted
average cost of capital %ill decline.
e. +n increase in the ris$-free rate %ill normally lo%er the marginal
costs of both debt and equity financing.
(Comp&) %ACC and cap& components C I Answer: e 'E(I)'
)1
. *hich of the follo%ing statements is CA;;DCTB
a. The *+CC is calculated using before-ta' costs for all components.
b. The after-ta' cost of debt usually e'ceeds the after-ta' cost of
equity.
c. For a given firm" the after-ta' cost of debt is al%ays more e'pensive
than the after-ta' cost of non-convertible preferred stoc$.
d. ;etained earnings that %ere generated in the past and are reported on
the firmFs balance sheet are available to finance the firmFs capital
budget during the coming year.
e. The *+CC that should be used in capital budgeting is the firmFs
marginal" after-ta' cost of capital.
(Comp&) %ACC and cap& components C I Answer: d 'E(I)'
)2
. For a company %hose target capital structure calls for )01 debt and )01
common equity" %hich of the follo%ing statements is CA;;DCTB
a. The interest rate used to calculate the *+CC is the average after-ta'
cost of all the company#s outstanding debt as sho%n on its balance
sheet.
b. The *+CC is calculated on a before-ta' basis.
c. The *+CC e'ceeds the cost of equity.
d. The cost of equity is al%ays equal to or greater than the cost of
debt.
Chapter 11: Cost of Capital Con&eptual #/C Page 109
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e. The cost of retained earnings typically e'ceeds the cost of ne%
common stoc$.
(Comp&) Cost of capital concepts C I Answer: c 'E(I)'
)
. *hich of the follo%ing statements is CA;;DCTB
a. !ince debt capital can cause a company to go ban$rupt but equity
capital cannot" debt is ris$ier than equity" and thus the after-ta'
cost of debt is al%ays greater than the cost of equity.
b. The ta'-ad/usted cost of debt is al%ays greater than the interest
rate on debt" provided the company does in fact pay ta'es.
c. &f a company assigns the same cost of capital to all of its pro/ects
regardless of each pro/ectFs ris$" then the company is li$ely to
re/ect some safe pro/ects that it actually should accept and to
accept some ris$y pro/ects that it should re/ect.
d. Cecause no flotation costs are required to obtain capital as retained
earnings" the cost of retained earnings is generally lo%er than the
after-ta' cost of debt.
e. 6igher flotation costs tend to reduce the cost of equity capital.
(Comp&) 'CC brea1 points C I Answer: d 'E(I)'
)(
. *hich of the follo%ing statements is CA;;DCTB
a. The brea$ point as discussed in the te't refers to the point %here
the firm#s ta' rate increases.
b. The brea$ point as discussed in the te't refers to the point %here
the firm has raised so much capital that it is simply unable to
borro% any more money.
c. The brea$ point as discussed in the te't refers to the point %here
the firm is ta$ing on investments that are so ris$y the firm is in
serious danger of going ban$rupt if things do not go e'actly as
planned.
d. The brea$ point as discussed in the te't refers to the point %here
the firm has raised so much capital that it has e'hausted its supply
of ne% retained earnings and thus must raise equity by issuing stoc$.
e. The brea$ point as discussed in the te't refers to the point %here
the firm has e'hausted its supply of ne% retained earnings and thus
must begin to finance %ith preferred stoc$.
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(11-0) +is1-ad2-sted capital cost C I Answer: c 7A+(
))
. Cranberry Corp. has t%o divisions of equal si<e7 a computer
manufacturing division and a data processing division. &ts CFA believes
that stand-alone data processor companies typically have a *+CC of .1"
%hile stand-alone computer manufacturers typically have a 121 *+CC. 6e
also believes that the data processing and manufacturing divisions have
the same ris$ as their typical peers. Consequently" he estimates that
the composite" or corporate" *+CC is 101. + consultant has suggested
using an .1 hurdle rate for the data processing division and a 121
hurdle rate for the manufacturing division. 6o%ever" the CFA disagrees"
and he has assigned a 101 *+CC to all pro/ects in both divisions. *hich
of the follo%ing statements is CA;;DCTB
a. *hile the decision to use /ust one *+CC %ill result in its accepting
more pro/ects in the manufacturing division and fe%er pro/ects in its
data processing division than if it follo%ed the consultantFs
recommendation" this should not affect the firmFs intrinsic value.
b. The decision not to ad/ust for ris$ means" in effect" that it is
favoring the data processing division. Therefore" that division is
li$ely to become a larger part of the consolidated company over time.
c. The decision not to ad/ust for ris$ means that the company %ill
accept too many pro/ects in the manufacturing division and too fe% in
the data processing division. This %ill lead to a reduction in the
firmFs intrinsic value over time.
d. The decision not to ris$-ad/ust means that the company %ill accept
too many pro/ects in the data processing business and too fe%
pro/ects in the manufacturing business. This %ill lead to a
reduction in its intrinsic value over time.
e. The decision not to ris$ ad/ust means that the company %ill accept
too many pro/ects in the manufacturing business and too fe% pro/ects
in the data processing business. This may affect the firmFs capital
structure but it %ill not affect its intrinsic value.
(11-0) (i5& ris1 and pro2ects C I Answer: a 7A+(
),
. !afeco Company and ;isco &nc are identical in si<e and capital
structure. 6o%ever" the ris$iness of their assets and cash flo%s are
some%hat different" resulting in !afeco having a *+CC of 101 and ;isco a
*+CC of 121. !afeco is considering 8ro/ect I" %hich has an &;; of 10.)1
and is of the same ris$ as a typical !afeco pro/ect. ;isco is
considering 8ro/ect H" %hich has an &;; of 11.)1 and is of the same ris$
as a typical ;isco pro/ect.
3o% assume that the t%o companies merge and form a ne% company"
!afeco=;isco &nc. 9oreover" the ne% company#s mar$et ris$ is an average
of the pre-merger companies# mar$et ris$s" and the merger has no impact
on either the cash flo%s or the ris$s of 8ro/ects I and H. *hich of the
follo%ing statements is CA;;DCTB
a. &f the firm evaluates these pro/ects and all other pro/ects at the
ne% overall corporate *+CC" it %ill probably become ris$ier over
time.
b. &f evaluated using the correct post-merger *+CC" 8ro/ect I %ould have
a negative 38J.
c. +fter the merger" !afeco=;isco %ould have a corporate *+CC of 111.
Therefore" it should re/ect 8ro/ect I but accept 8ro/ect H.
d. !afeco=;iscoFs *+CC" as a result of the merger" %ould be 101.
Chapter 11: Cost of Capital Con&eptual #/C Page 111
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e. +fter the merger" !afeco=;isco should select 8ro/ect H but re/ect
8ro/ect I. &f the firm does this" its corporate *+CC %ill fall to
10.)1.
(Comp&) Capital components C I Answer: b 7A+(
)-
. *hich of the follo%ing statements is CA;;DCTB
a. The component cost of preferred stoc$ is e'pressed as r
p
41 - T5.
This follo%s because preferred stoc$ dividends are treated as fi'ed
charges" and as such they can be deducted by the issuer for ta'
purposes.
b. + cost should be assigned to retained earnings due to the opportunity
cost principle" %hich refers to the fact that the firmFs stoc$holders
%ould themselves e'pect to earn a return on earnings that %ere paid
out rather than retained and reinvested.
c. 3o cost should be assigned to retained earnings because the firm does
not have to pay anything to raise them. They are generated as cash
flo%s by operating assets that %ere raised in the past" hence they
are free.
d. !uppose a firm has been losing money and thus is not paying ta'es"
and this situation is e'pected to persist into the foreseeable
future. &n this case" the firmFs before-ta' and after-ta' costs of
debt for purposes of calculating the *+CC %ill both be equal to the
interest rate on the firmFs currently outstanding debt" provided that
debt %as issued during the past ) years.
e. &f a firm has enough retained earnings to fund its capital budget for
the coming year" then there is no need to estimate either a cost of
equity or a *+CC.
(Comp&) Cost of capital C I Answer: d 7A+(
).
. *hich of the follo%ing statements is CA;;DCTB
a. The cost of capital used to evaluate a pro/ect should be the cost of
the specific type of financing used to fund that pro/ect" i.e." it is
the after-ta' cost of debt if debt is to be used to finance the
pro/ect or the cost of equity if the pro/ect %ill be financed %ith
equity.
b. The after-ta' cost of debt that should be used as the component cost
%hen calculating the *+CC is the average after-ta' cost of all the
firmFs outstanding debt.
c. !uppose some of a publicly-traded firmFs stoc$holders are not
diversifiedK they hold only the one firmFs stoc$. &n this case" the
C+89 approach %ill result in an estimated cost of equity that is too
lo% in the sense that if it is used in capital budgeting" pro/ects
%ill be accepted that %ill reduce the firmFs intrinsic value.
d. The cost of equity is generally harder to measure than the cost of
debt because there is no stated" contractual cost number on %hich to
base the cost of equity.
e. The bond-yield-plus-ris$-premium approach is the most sophisticated
and ob/ective method for estimating a firmFs cost of equity capital.
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(Comp&) Cost of e,-it. C I Answer: d 7A+(
)2
. *hich of the follo%ing statements is CA;;DCTB
a. +lthough some methods used to estimate the cost of equity are sub/ect
to severe limitations" the C+89 is a simple" straightfor%ard" and
reliable model that consistently produces accurate cost of equity
estimates. &n particular" academics and corporate finance people
generally agree that its $ey inputs--beta" the ris$-free rate" and
the mar$et ris$ premium--can be estimated %ith little error.
b. The :CF model is generally preferred by academics and financial
e'ecutives over other models for estimating the cost of equity. This
is because of the :CF modelFs logical appeal and also because
accurate estimates for its $ey inputs" the dividend yield and the
gro%th rate" are easy to obtain.
c. The bond-yield-plus-ris$-premium approach to estimating the cost of
equity may not al%ays be accurate" but it has the advantage that its
t%o $ey inputs" the firmFs o%n cost of debt and its ris$ premium" can
be found by using standardi<ed and ob/ective procedures.
d. !urveys indicate that the C+89 is the most %idely used method for
estimating the cost of equity. 6o%ever" other methods are also used
because C+89 estimates may be sub/ect to error" and people li$e to
use different methods as chec$s on one another. &f all of the
methods produce similar results" this increases the decision ma$er#s
confidence in the estimated cost of equity.
e. The :CF model is preferred by academics and finance practitioners
over other cost of capital models because it correctly recogni<es
that the e'pected return on a stoc$ consists of a dividend yield plus
an e'pected capital gains yield.
(Comp&) CA6' and (CF C I Answer: c 7A+(
,0
. *hich of the follo%ing statements is CA;;DCTB
a. The discounted cash flo% method of estimating the cost of equity
cannot be used unless the gro%th rate" g" is e'pected to be constant
forever.
b. &f the calculated beta underestimates the firmFs true investment
ris$--i.e." if the for%ard-loo$ing beta that investors thin$ e'ists
e'ceeds the historical beta--then the C+89 method based on the
historical beta %ill produce an estimate of r
s
and thus *+CC that is
too high.
c. Ceta measures mar$et ris$" %hich is" theoretically" the most relevant
ris$ measure for a publicly-o%ned firm that see$s to ma'imi<e its
intrinsic value. This is true even if not all of the firmFs
stoc$holders are %ell diversified.
d. +n advantage shared by both the :CF and C+89 methods %hen they are
used to estimate the cost of equity is that they are both ob/ective
as opposed to sub/ective" hence little or no /udgment is required.
e. The specific ris$ premium used in the C+89 is the same as the ris$
premium used in the bond-yield-plus-ris$-premium approach.
Chapter 11: Cost of Capital Con&eptual #/C Page 113
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(Comp&) %ACC C I Answer: d 7A+(
,1
. *hich of the follo%ing statements is CA;;DCTB
a. The bond-yield-plus-ris$-premium approach to estimating the cost of
common equity involves adding a ris$ premium to the interest rate on
the companyFs o%n long-term bonds. The si<e of the ris$ premium for
bonds %ith different ratings is published daily in The Wall Street
Journal.
b. The *+CC is calculated using a before-ta' cost for debt that is equal
to the interest rate that must be paid on ne% debt" along %ith the
after-ta' costs for common stoc$ and for preferred stoc$ if it is
used.
c. +n increase in the ris$-free rate is li$ely to reduce the marginal
costs of both debt and equity.
d. The relevant *+CC can change depending on the amount of funds a firm
raises during a given year. 9oreover" the *+CC at each level of
funds raised is a %eighted average of the marginal costs of each
capital component" %ith the %eights based on the firmFs target
capital structure.
e. Ceta measures mar$et ris$" %hich is generally the most relevant ris$
measure for a publicly-o%ned firm that see$s to ma'imi<e its
intrinsic value. 6o%ever" this is not true unless all of the firmFs
stoc$holders are %ell diversified.
(Comp&) %ACC C I Answer: e 7A+(
,2
. *hich of the follo%ing statements is CA;;DCTB
a. !ince the costs of internal and e'ternal equity are related" an
increase in the flotation cost required to sell a ne% issue of stoc$
%ill increase the cost of retained earnings.
b. !ince its stoc$holders are not directly responsible for paying a
corporationFs income ta'es" corporations should focus on before-ta'
cash flo%s %hen calculating the *+CC.
c. +n increase in a firmFs ta' rate %ill increase the component cost of
debt" provided the HT9 on the firmFs bonds is not affected by the
change in the ta' rate.
d. *hen the *+CC is calculated" it should reflect the costs of ne%
common stoc$" retained earnings" preferred stoc$" long-term debt"
short-term ban$ loans if the firm normally finances %ith ban$ debt"
and accounts payable if the firm normally has accounts payable on its
balance sheet.
e. &f a firm has been suffering accounting losses that are e'pected to
continue into the foreseeable future" and therefore its ta' rate is
<ero" then it is possible for the after-ta' cost of preferred stoc$
to be less than the after-ta' cost of debt.
Page 11/ Con&eptual #/C Chapter 11: Cost of Capital
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(Comp&) 8eta and pro2ect ris1 C I Answer: e 7A+(
,
. *hich of the follo%ing statements is CA;;DCTB +ssume that the firm is a
publicly-o%ned corporation and is see$ing to ma'imi<e shareholder
%ealth.
a. &f a firm has a beta that is less than 1.0" say 0.2" this %ould
suggest that the e'pected returns on its assets are negatively
correlated %ith the returns on most other firmsF assets.
b. &f a firmFs managers %ant to ma'imi<e the value of the stoc$" they
should" in theory" concentrate on pro/ect ris$ as measured by the
standard deviation of the pro/ectFs e'pected future cash flo%s.
c. &f a firm evaluates all pro/ects using the same cost of capital" and
the C+89 is used to help determine that cost" then its ris$ as
measured by beta %ill probably decline over time.
d. 8ro/ects %ith above-average ris$ typically have higher-than-average
e'pected returns. Therefore" to ma'imi<e a firmFs intrinsic value"
its managers should favor high-beta pro/ects over those %ith lo%er
betas.
e. 8ro/ect + has a standard deviation of e'pected returns of 201" %hile
8ro/ect CFs standard deviation is only 101. +Fs returns are
negatively correlated %ith both the firmFs other assets and the
returns on most stoc$s in the economy" %hile CFs returns are
positively correlated. Therefore" 8ro/ect + is less ris$y to a firm
and should be evaluated %ith a lo%er cost of capital.
(Comp&) 'CC brea1 points C I Answer: c 7A+(
,(
. Firm 9#s earnings and stoc$ price tend to move up and do%n %ith other
firms in the !L8 )00" %hile Firm *#s earnings and stoc$ price move
counter cyclically %ith 9 and other !L8 companies. Coth 9 and *
estimate their costs of equity using the C+89" they have identical
mar$et values" their standard deviations of returns are identical" and
they both finance only %ith common equity. *hich of the follo%ing
statements is CA;;DCTB
a. 9 should have the lo%er *+CC because it is li$e most other companies"
and investors li$e that fact.
b. 9 and * should have identical *+CCs because their ris$s as measured
by the standard deviation of returns are identical.
c. &f 9 and * merge" then the merged firm 9* should have a *+CC that is
a simple average of 9#s and *#s *+CCs.
d. *ithout additional information" it is impossible to predict %hat the
merged firm#s *+CC %ould be if 9 and * merged.
e. !ince 9 and * move counter cyclically to one another" if they merged"
the merged firm#s *+CC %ould be less than the simple average of the
t%o firms# *+CCs.
Chapter 11: Cost of Capital Con&eptual #/C Page 115
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Multiple Choice: "ro(lems
(11-) Cost of preferred C I Answer: b EASY
,)
. Cosio &nc.#s perpetual preferred stoc$ sells for M2-.)0 per share" and
it pays an M..)0 annual dividend. &f the company %ere to sell a ne%
preferred issue" it %ould incur a flotation cost of (.001 of the price
paid by investors. *hat is the company#s cost of preferred stoc$ for
use in calculating the *+CCB
a. ..-21
b. 2.0.1
c. 2.((1
d. 2..21
e. 10.221
(11-) Cost of preferred C I Answer: d EASY
,,
. + companyFs perpetual preferred stoc$ currently sells for M22.)0 per
share" and it pays an M..00 annual dividend. &f the company %ere to
sell a ne% preferred issue" it %ould incur a flotation cost of ).001 of
the issue price. *hat is the firm#s cost of preferred stoc$B
a. -..11
b. ..221
c. ..,)1
d. 2.101
e. 2.),1
(11-!) Cost of +E: CA6' C I Answer: a EASY
,-
. A#Crien &nc. has the follo%ing data7 r
;F
> ).001K ;8
9
> ,.001K and b >
1.0). *hat is the firm#s cost of equity from retained earnings based on
the C+89B
a. 11.01
b. 11.,(1
c. 11.221
d. 12.)1
e. 12.-21
(11-!) Cost of +E: CA6' C I Answer: e EASY
,.
. !canlon &nc.#s CFA hired you as a consultant to help her estimate the
cost of capital. Hou have been provided %ith the follo%ing data7 r
;F
>
(.101K ;8
9
> ).2)1K and b > 1.0. Cased on the C+89 approach" %hat is
the cost of equity from retained earningsB
a. 2.,-1
b. 2.2-1
c. 10.2.1
d. 10.,01
e. 10.21
Page 11, #/C Pro%le*s Chapter 11: Cost of Capital
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(11-!) Cost of +E: (CF C I Answer: c EASY
,2
. +ssume that you are a consultant to Cros$e &nc." and you have been
provided %ith the follo%ing data7 :
1
> M0.,-K 8
0
> M2-.)0K and g >
..001 4constant5. *hat is the cost of equity from retained earnings
based on the :CF approachB
a. 2.(21
b. 2.211
c. 10.((1
d. 10.2,1
e. 11.)11
(11-!) Cost of +E: (CF C I Answer: d EASY
-0
. Teall :evelopment Company hired you as a consultant to help them
estimate its cost of capital. Hou have been provided %ith the follo%ing
data7 :
1
> M1.()K 8
0
> M22.)0K and g > ,.)01 4constant5. Cased on the
:CF approach" %hat is the cost of equity from retained earningsB
a. 11.101
b. 11.,.1
c. 12.01
d. 12.2(1
e. 1.)21
(11-!) 8ond-.ield-pl-s-ris1 premi-m C I Answer: a EASY
-1
. +. Cutcher Timber Company hired your consulting firm to help them
estimate the cost of equity. The yield on the firm#s bonds is ..-)1"
and your firm#s economists believe that the cost of equity can be
estimated using a ris$ premium of ..)1 over a firm#s o%n cost of debt.
*hat is an estimate of the firm#s cost of equity from retained earningsB
a. 12.,01
b. 1.101
c. 1.,1
d. 1(.1-1
e. 1(.-(1
(11-$) %ACC C I Answer: b EASY
-2
. Hou %ere hired as a consultant to Niambono Company" %hose target capital
structure is (01 debt" 1)1 preferred" and ()1 common equity. The after-
ta' cost of debt is ,.001" the cost of preferred is -.)01" and the cost
of retained earnings is 12.-)1. The firm %ill not be issuing any ne%
stoc$. *hat is its *+CCB
a. ..2.1
b. 2.2,1
c. 2.)(1
d. 2..1
e. 10.121
Chapter 11: Cost of Capital #/C Pro%le*s Page 11-
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a li&ense "istri%ute" (ith a &ertain pro"u&t or ser!i&e or other(ise on a pass(or"+prote&te" (e%site for &lassroo* use.
(11-3) Cost of debt C I Answer: d 'E(I)'
-
. To help finance a ma/or e'pansion" Castro Chemical Company sold a
noncallable bond several years ago that no% has 20 years to maturity.
This bond has a 2.2)1 annual coupon" paid semiannually" sells at a price
of M1"0-)" and has a par value of M1"000. &f the firm#s ta' rate is
(01" %hat is the component cost of debt for use in the *+CC calculationB
a. (.)1
b. (.).1
c. (..1
d. ).0.1
e. ).1
(11-3) Cost of debt C I Answer: c 'E(I)'
-(
. !everal years ago the Oa$ob Company sold a M1"000 par value" noncallable
bond that no% has 20 years to maturity and a -.001 annual coupon that is
paid semiannually. The bond currently sells for M22)" and the companyFs
ta' rate is (01. *hat is the component cost of debt for use in the *+CC
calculationB
a. (.2.1
b. (.(,1
c. (.,)1
d. (..1
e. ).01
(11-!) Cost of +E: (CF C I Answer: d 'E(I)'
-)
. +ssume that Pish &nc. hired you as a consultant to help estimate its
cost of capital. Hou have obtained the follo%ing data7 :
0
> M0.20K 8
0

> M2-.)0K and g > -.001 4constant5. Cased on the :CF approach" %hat is
the cost of equity from retained earningsB
a. 2.221
b. 2.,.1
c. 10.0.1
d. 10.)01
e. 10.221
(11-!) Cost of +E: (CF C I Answer: c 'E(I)'
-,
. ;ivoli &nc. hired you as a consultant to help estimate its cost of
capital. Hou have been provided %ith the follo%ing data7 :
0
> M0..0K
8
0
> M22.)0K and g > ..001 4constant5. Cased on the :CF approach" %hat
is the cost of equity from retained earningsB
a. 10.,21
b. 11.2)1
c. 11..(1
d. 12.(1
e. 1.0)1
Page 11. #/C Pro%le*s Chapter 11: Cost of Capital
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a li&ense "istri%ute" (ith a &ertain pro"u&t or ser!i&e or other(ise on a pass(or"+prote&te" (e%site for &lassroo* use.
(11-#) r
e
based on (CF4 (
1
C I Answer: c 'E(I)'
--
. Trahan @umber Company hired you to help estimate its cost of capital.
Hou obtained the follo%ing data7 :
1
> M1.2)K 8
0
> M2-.)0K g > ).001
4constant5K and F > ,.001. *hat is the cost of equity raised by selling
ne% common stoc$B
a. 2.0,1
b. 2.((1
c. 2..(1
d. 10.21
e. 10.,(1
(11-#) r
e
based on (CF4 (
1
C I Answer: b 'E(I)'
-.
. Hou %ere recently hired by !cheuer 9edia &nc. to estimate its cost of
capital. Hou obtained the follo%ing data7 :
1
> M1.-)K 8
0
> M(2.)0K g >
-.001 4constant5K and F > ).001. *hat is the cost of equity raised by
selling ne% common stoc$B
a. 10.--1
b. 11.1
c. 11.201
d. 12.)01
e. 1.121
(11-#) Cost of new common C I Answer: b 'E(I)'
-2
. *eaver Chocolate Co. e'pects to earn M.)0 per share during the current
year" its e'pected dividend payout ratio is ,)1" its e'pected constant
dividend gro%th rate is ,.01" and its common stoc$ currently sells for
M2.)0 per share. 3e% stoc$ can be sold to the public at the current
price" but a flotation cost of )1 %ould be incurred. *hat %ould be the
cost of equity from ne% common stoc$B
a. 12.-01
b. 1.-1
c. 1(.0(1
d. 1(.-(1
e. 1).(.1
(11-$) %ACC C I Answer: c 'E(I)'
.0
. !orensen !ystems &nc. is e'pected to pay a M2.)0 dividend at year end
4:
1
> M2.)05" the dividend is e'pected to gro% at a constant rate of
).)01 a year" and the common stoc$ currently sells for M)2.)0 a share.
The before-ta' cost of debt is -.)01" and the ta' rate is (01. The
target capital structure consists of ()1 debt and ))1 common equity.
*hat is the companyFs *+CC if all the equity used is from retained
earningsB
a. -.0-1
b. -.,1
c. -.,-1
d. -.2.1
e. ..221
Chapter 11: Cost of Capital #/C Pro%le*s Page 119
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(11-$) %ACC and tar"et cap& str-c& C I Answer: a 'E(I)'
.1
. Hou %ere hired as a consultant to Quigley Company" %hose target capital
structure is )1 debt" 101 preferred" and ))1 common equity. The
interest rate on ne% debt is ,.)01" the yield on the preferred is ,.001"
the cost of retained earnings is 11.2)1" and the ta' rate is (01. The
firm %ill not be issuing any ne% stoc$. *hat is Quigley#s *+CCB
a. ..1)1
b. ..(.1
c. ...21
d. 2.1-1
e. 2.)(1
(11-3) 3a*es and cost of debt C I Answer: c 'E(I)'97A+(
.2
. Peys 8rinting plans to issue a M1"000 par value" 20-year noncallable
bond %ith a -.001 annual coupon" paid semiannually. The company#s
marginal ta' rate is (0.001" but Congress is considering a change in the
corporate ta' rate to 0.001. Cy ho% much %ould the component cost of
debt used to calculate the *+CC change if the ne% ta' rate %as adoptedB
a. 0.)-1
b. 0.,1
c. 0.-01
d. 0.--1
e. 0..)1
(11-!) Cost of +E: (CF C I Answer: c 'E(I)'97A+(
.
. !. Couchard and Company hired you as a consultant to help estimate its
cost of capital. Hou have obtained the follo%ing data7 :
0
> M0..)K 8
0

> M22.00K and g > ,.001 4constant5. The CDA thin$s" ho%ever" that the
stoc$ price is temporarily depressed" and that it %ill soon rise to
M(0.00. Cased on the :CF approach" by ho% much %ould the cost of equity
from retained earnings change if the stoc$ price changes as the CDA
e'pectsB
a. -1.(21
b. -1.,,1
c. -1..(1
d. -2.01
e. -2.21
(11-$) %ACC and mar1et cap& str-c& C I Answer: e 'E(I)'97A+(
.(
. !app Truc$ingFs balance sheet sho%s a total of noncallable M() million
long-term debt %ith a coupon rate of -.001 and a yield to maturity of
,.001. This debt currently has a mar$et value of M)0 million. The
balance sheet also sho%s that the company has 10 million shares of
common stoc$" and the boo$ value of the common equity 4common stoc$ plus
retained earnings5 is M,) million. The current stoc$ price is M22.)0
per shareK stoc$holders# required return" r
s
" is 1(.001K and the firm#s
ta' rate is (01. The CFA thin$s the *+CC should be based on mar$et
value %eights" but the president thin$s boo$ %eights are more
appropriate. *hat is the difference bet%een these t%o *+CCsB
a. 1.))1
Page 120 #/C Pro%le*s Chapter 11: Cost of Capital
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a li&ense "istri%ute" (ith a &ertain pro"u&t or ser!i&e or other(ise on a pass(or"+prote&te" (e%site for &lassroo* use.
b. 1.-21
c. 1.211
d. 2.11
e. 2.,1
(11-!) +is1 premi-m4 CA6'4 and (CF C I Answer: b 7A+(
.)
. The CFA of @eno' &ndustries hired you as a consultant to help estimate
its cost of capital. Hou have obtained the follo%ing data7 415 r
d
>
yield on the firmFs bonds > -.001 and the ris$ premium over its o%n debt
cost > (.001. 425 r
;F
> ).001" ;8
9
> ,.001" and b > 1.2). 45 :
1
>
M1.20" 8
0
> M).00" and g > ..001 4constant5. Hou %ere as$ed to
estimate the cost of equity based on the three most commonly used
methods and then to indicate the difference bet%een the highest and
lo%est of these estimates. *hat is that differenceB
a. 1.11
b. 1.)01
c. 1...1
d. 2.(1
e. 2.).1
(11-#) r
s
5s& r
e
C I Answer: c 7A+(
.,
. Da$ins &nc.Fs common stoc$ currently sells for M().00 per share" the
company e'pects to earn M2.-) per share during the current year" its
e'pected payout ratio is -01" and its e'pected constant gro%th rate is
,.001. 3e% stoc$ can be sold to the public at the current price" but a
flotation cost of .1 %ould be incurred. Cy ho% much %ould the cost of
ne% stoc$ e'ceed the cost of retained earningsB
a. 0.021
b. 0.121
c. 0.-1
d. 0.),1
e. 0..(1
(11-$) %ACC and capital str-ct-re C I Answer: c 7A+(
.-
. Colster FoodsF 4CF5 balance sheet sho%s a total of M2) million long-term
debt %ith a coupon rate of ..)01. The yield to maturity on this debt is
..001" and the debt has a total current mar$et value of M2- million.
The balance sheet also sho%s that the company has 10 million shares of
stoc$" and the stoc$ has a boo$ value per share of M).00. The current
stoc$ price is M20.00 per share" and stoc$holders# required rate of
return" r
s
" is 12.2)1. The company recently decided that its target
capital structure should have )1 debt" %ith the balance being common
equity. The ta' rate is (01. Calculate *+CCs based on boo$" mar$et"
and target capital structures" and then find the sum of these three
*+CCs.
a. 2..,1
b. 22.)(1
c. 0.--1
d. 2.001
e. .2.1
Chapter 11: Cost of Capital #/C Pro%le*s Page 121
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(11-$) %ACC and e,-it. from +E C I Answer: e 7A+(
..
. :aves &nc. recently hired you as a consultant to estimate the companyFs
*+CC. Hou have obtained the follo%ing information. 415 The firm#s
noncallable bonds mature in 20 years" have an ..001 annual coupon" a par
value of M1"000" and a mar$et price of M1"0)0.00. 425 The companyFs ta'
rate is (01. 45 The ris$-free rate is (.)01" the mar$et ris$ premium
is ).)01" and the stoc$Fs beta is 1.20. 4(5 The target capital
structure consists of )1 debt and the balance is common equity. The
firm uses the C+89 to estimate the cost of equity" and it does not
e'pect to issue any ne% common stoc$. *hat is its *+CCB
a. -.1,1
b. -.)(1
c. -.21
d. ..)1
e. ..-21
(11-$) %ACC and e,-it. from +E C I Answer: d 7A+(
.2
. +ssume that you are on the financial staff of Janderheiden &nc." and you
have collected the follo%ing data7 The yield on the companyFs outstanding
bonds is -.-)1" its ta' rate is (01" the ne't e'pected dividend is M0.,) a
share" the dividend is e'pected to gro% at a constant rate of ,.001 a
year" the price of the stoc$ is M1).00 per share" the flotation cost for
selling ne% shares is F > 101" and the target capital structure is ()1
debt and ))1 common equity. *hat is the firm#s *+CC" assuming it must
issue ne% stoc$ to finance its capital budgetB
a. ,..21
b. -.2,1
c. -.,(1
d. ..0(1
e. ..((1
(11-0) 6ro2ect ris1 C I Answer: a 7A+(
20
. Jang Dnterprises" %hich is debt-free and finances only %ith equity from
retained earnings" is considering - equal si<ed capital budgeting
pro/ects. &ts CFA hired you to assist in deciding %hether none" some" or
all of the pro/ects should be accepted. Hou have the follo%ing
information7 r
;F
> (.)01K ;8
9
> ).)01K and b > 0.22. The company adds or
subtracts a specified percentage to the corporate *+CC %hen it evaluates
pro/ects that have above- or belo%-average ris$. :ata on the - pro/ects
are sho%n belo%. &f these are the only pro/ects under consideration" ho%
large should the capital budget beB
;is$ D'pected Cost
8ro/ect ;is$ Factor ;eturn 49illions5
1 Jery lo% -2.001 -.,01 M2).0
2 @o% -1.001 2.1)1 M2).0
+verage 0.001 10.101 M2).0
( 6igh 1.001 10.(01 M2).0
) Jery high 2.001 10..01 M2).0
, Jery high 2.001 10.201 M2).0
- Jery high 2.001 1.001 M2).0
Page 122 #/C Pro%le*s Chapter 11: Cost of Capital
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a. M100
b. M -)
c. M )0
d. M 2)
e. M 0
Multiple Part:
(The following information applies to Problems 91, 92, 93, and 94!
+ssume that you have been hired as a consultant by CNT" a ma/or producer of
chemicals and plastics" including plastic grocery bags" styrofoam cups" and
fertili<ers" to estimate the firm#s %eighted average cost of capital. The
balance sheet and some other information are provided belo%.
+ssets
Current assets M ."000"000
3et plant" property" and equipment 101"000"000
Total assets M12"000"000
@iabilities and Dquity
+ccounts payable M 10"000"000
+ccruals 2"000"000
Current liabilities M 12"000"000
@ong-term debt 4(0"000 bonds" M1"000 par value5 (0"000"000
Total liabilities M )2"000"000
Common stoc$ 410"000"000 shares5 0"000"000
;etained earnings )0"000"000
Total shareholders# equity .0"000"000
Total liabilities and shareholders# equity M12"000"000
The stoc$ is currently selling for M1).2) per share" and its noncallable
M1"000 par value" 20-year" -.2)1 bonds %ith semiannual payments are selling
for M.-).00. The beta is 1.2)" the yield on a ,-month Treasury bill is .)01"
and the yield on a 20-year Treasury bond is ).)01. The required return on the
stoc$ mar$et is 11.)01" but the mar$et has had an average annual return of
1(.)01 during the past ) years. The firm#s ta' rate is (01.
(11-2) After-ta* cost of debt C I Answer: c 'E(I)'
21
. *hat is the best estimate of the after-ta' cost of debtB
a. (.,(1
b. (...1
c. ).1(1
d. ).(01
e. ).,-1
(11-!) CA6' cost of e,-it. C I Answer: d 'E(I)'
22
. Cased on the C+89" %hat is the firm#s cost of equityB
a. 11.1)1
b. 11.-1
c. 12.)1
d. 1.001
Chapter 11: Cost of Capital #/C Pro%le*s Page 123
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e. 1.,)1
(11-$) %ei":ts for %ACC C I Answer: a 'E(I)'
2
. *hich of the follo%ing is the best estimate for the %eight of debt for
use in calculating the *+CCB
a. 1..,-1
b. 12.,01
c. 20.).1
d. 21.,11
e. 22.,21
(11-$) %ACC C I Answer: c 'E(I)'
2(
. *hat is the best estimate of the firm#s *+CCB
a. 10..)1
b. 11.121
c. 11.)1
d. 11...1
e. 12.2(1
Page 12/ #/C Pro%le*s Chapter 11: Cost of Capital
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Chapter 11: Cost of Capital Ans(ers Page 125
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CH!"TE# $$
!)&*E#& !)D &%L+T'%)&
1& (11-1) Capital F I Answer: a EASY
2& (11-1) Cost of capital F I Answer: a EASY
& (11-1) Specific capital cost F I Answer: b EASY
(& (11-2) Component capital costs F I Answer: a EASY
)& (11-3) Cost of debt F I Answer: b EASY
,& (11-3) Cost of debt F I Answer: b EASY
-& (11-3) Cost of debt F I Answer: a EASY
.& (11-) Cost of preferred F I Answer: b EASY
2& (11-) Cost of preferred F I Answer: a EASY
10& (11-!) Cost of common F I Answer: a EASY
11& (11-!) Cost of retained earnin"s F I Answer: b EASY
12& (11-!) Cost of retained earnin"s F I Answer: b EASY
1& (11-!) Cost of retained earnin"s F I Answer: b EASY
1(& (11-#) Cost of new common F I Answer: b EASY
1)& (11-$) %ACC F I Answer: a EASY
1,& (Comp&) Flotation and capital F I Answer: b EASY
1-& (11-1) Specific capital cost F I Answer: b 'E(I)'
In general, this statement is false, because the firm should be viewed as an ongoing entity, and using debt (or
equity) to fund a given project will change the capital structure, and this factor should be recognized by basing the
cost of capital for all projects on a target capital structure. Under some special circumstances, where a project is
set up as a separate entity, then project financing! may be used, and only the project"s specific situation is
considered. #his is a specific situation, however, and not the in general! case.
1.& (11-3) After-ta* cost of debt F I Answer: a 'E(I)'
12& (11-!) +etained earnin"s F I Answer: a 'E(I)'
20& (11-!) Cost of e,-it. estimates F I Answer: b 'E(I)'
21& (11-!) Cost of e,-it. estimates F I Answer: b 'E(I)'
$one of the methods always provides accurate and reliable estimates. %ith the &'(), we don"t *now the beta
that investors are using, we are not totally sure of what r+, to use, and we don"t *now if the &'() is truly correct.
22& (11-!) Cost of e,-it. estimates F I Answer: a 'E(I)'
Unfortunately, this is true.
2& (11-!) Cost of e,-it. estimates F I Answer: a 'E(I)'
Unfortunately, this is true.
2(& (11-!) Cost of e,-it. estimates F I Answer: a 'E(I)'
Unfortunately, this is true.
2)& (11-!) Cost of e,-it. estimates F I Answer: a 'E(I)'
Unfortunately, this is true.
2,& (11-!) Cost of e,-it. estimates F I Answer: a 'E(I)'
#rue, but data on comparable publicly owned firms can often be obtained and used as pro-ies for private firms.
2-& (11-#) Cost of new common F I Answer: b 'E(I)'
#his statement is true only if the e-pected growth rate is zero. .ere are some illustrative numbers that show that
the statement is true if g / 0 but false otherwise.
(ositive g 1ero g
(rice 230.00 230.00
4ividend 20.50 20.50
6rowth 7.008 0.008
,lotation 5.008 5.008
rs / 439(0 : g 33.008 5.008
re / 439(0(3 ; ,) : g 33.<7=8 5.<7=8 >qual only if g / zero.
rs9(3 ; ,) 33.5?@8 5.<7=8
2.& (11-#) Cost of new common F I Answer: a 'E(I)'
#his statement is true. .ere are some illustrative numbers to demonstrate this point.
(ositive g 1ero g
(rice 230.00 230.00
4ividend 20.50 20.50
6rowth 7.008 0.008
,lotation 5.008 5.008
rs / 439(0 : g 33.008 5.008
re / 439(0(3 ; ,) : g 33.<7=8 5.<7=8 >qual only if g / zero.
rs9(3 ; ,) 33.5?@8 5.<7=8
22& (11-/) Factors affectin" %ACC F I Answer: b 'E(I)'
0& (11-0) +is1-ad2-sted capital costs F I Answer: a 'E(I)'
1& (Comp&) %ACC F I Answer: a 'E(I)'
2& (Comp&) 3a*es4 r
d
(1 - 3)4 and %ACC F I Answer: b 'E(I)'
& (Comp&) Cost of e,-it. F I Answer: b 'E(I)'
#he preferred dividend e-clusion is a benefit to the holder of the preferred, not the issuer, hence this statement is
not true. It actually is just nonsense anywayA
(& (Comp&) Inflation effects F I Answer: b 'E(I)'
Increased inflation results in a parallel upward shift in the B)C, which means equal percentage increases in the
required returns on debt and equity.
)& (Comp&) Inflation effects F I Answer: a 'E(I)'
,& (11-2) Capital components C I Answer: b EASY
-& (11-#) Internal 5s& e*ternal common C I Answer: b EASY
Btatement b is correct, because if more debt is used, then less equity will be needed to fund the capital budget, so
the need for a stoc* issue would be reduced.
.& (11-/) Factors affectin" %ACC C I Answer: a EASY
2& (Comp&) Capital components C I Answer: b EASY
(0& (11-!) Cost of e,-it.: CA6' C I Answer: e 'E(I)'
Dy definition, both the mar*et and an average stoc* have betas of 3.0. Bince we *now this to be the case, we can
obviously determine beta for the mar*et or an average stoc* with precision.
(1& (11-0) (i5isional ris1 C I Answer: c 'E(I)'
#he correct answer is statement c. 4ivision ' should accept only projects with returns greater than 308, and
4ivision D should accept only projects with returns greater than 3E8. Fnly statement c meets this criterion.
(2& (11-0) +is1 and pro2ects C I Answer: a 'E(I)'
(roject D has a return greater than its ris*Gadjusted cost of capital, so it should be accepted.
(& (11-0) +is1 and pro2ects C I Answer: d 'E(I)'
Btatement d is correct. .ere is the proofH
rs / 58 : E8(<.0) / 58 : I8 / 3=8.
+equired return for ris*y projects / 3=8 : =8 / 378.
(roject return / 3E8 J adjusted rs / 378. #hus, the project should be rejected.
((& (11-0) +is1-ad2-sted capital cost C I Answer: a 'E(I)'
CowGris* projects will tend to have low e-pected returns and vice versa for highGris* projects due to competition
in the economy. Dy not adjusting the cost of capital for project ris*, the firm will tend to reject lowGris* projects
even though they earn higher returns than their ris*Gadjusted costs of capital, and vice versa for highGris*
projects. In addition, as the firm ta*es on more highGris* projects, its correct %'&& will increase over time.
#herefore, statement a is correct.
()& (11-0) +is1-ad2-sted capital cost C I Answer: d 'E(I)'
CowGris* projects will tend to have low e-pected returns and vice versa for highGris* projects due to competition
in the economy. Dy not adjusting the cost of capital for project ris*, the firm will tend to reject lowGris* projects
even though they earn higher returns than their ris*Gadjusted costs of capital, and vice versa for highGris*
projects. 's the firm ta*es on more highGris* projects, its true %'&& will increase over time. Ff course, the true
%'&& might change over time due to changes in mar*et conditions, but that could cause the true %'&& to
either rise or decline. #herefore, statement d is correct.
(,& (Comp&) Capital components C I Answer: e 'E(I)'
Btatement e is true, because the afterGta- cost of debt is rd(3 ; #). Bo, if rd remains constant but # increases, rd(3 ;
#) will decline. #he other statements are all false.
(-& (Comp&) Capital components C I Answer: a 'E(I)'
Btatement a is true, because interest payments on debt are ta- deductible. #he other statements are false.
(.& (Comp&) Capital components C I Answer: d 'E(I)'
(2& (Comp&) %ACC C I Answer: d 'E(I)'
)0& (Comp&) %ACC C I Answer: d 'E(I)'
Btatement d is true, because the cost of debt for %'&& purposes / rd(3 ; #), so if # increases, then
rd(3 ; #) declines.
)1& (Comp&) %ACC and cap& components C I Answer: e 'E(I)'
)2& (Comp&) %ACC and cap& components C I Answer: d 'E(I)'
Btatement d is true, because equity is more ris*y than debt and hence investors require a higher return on equity.
'lso, interest on debt is deductible, and this further reduces the cost of debt. #he other statements are false.
)& (Comp&) Cost of capital concepts C I Answer: c 'E(I)'
)(& (Comp&) 'CC brea1 points C I Answer: d 'E(I)'
))& (11-0) +is1-ad2-sted capital cost C I Answer: c 7A+(
Dy not ma*ing the ris* adjustment, the firm will accept too many projects in the manufacturing division and too
few in the data processing division. 's a result, the company will become ris*ier overall, raising its cost of
capital. Investors will discount the firm"s cash flows at a higher rate, and the firmKs intrinsic value will fall.
#herefore, statement c is true and all other statements are false.
),& (11-0) (i5& ris1 and pro2ects C I Answer: a 7A+(
)-& (Comp&) Capital components C I Answer: b 7A+(
).& (Comp&) Cost of capital C I Answer: d 7A+(
)2& (Comp&) Cost of e,-it. C I Answer: d 7A+(
,0& (Comp&) CA6' and (CF C I Answer: c 7A+(
,1& (Comp&) %ACC C I Answer: d 7A+(
Btatement d is trueLthe %'&& will increase if the firm raises more funds than can be supported by retained
earnings.
,2& (Comp&) %ACC C I Answer: e 7A+(
Btatement e is true. #he firm would get no ta- savings on interest, so its cost of debt would not be reduced by the
ta- factor. .owever, corporate investors would get to deduct ?08 of the preferred dividends they receive, which
would ma*e them willing to accept a lower beforeGta- yield on preferred stoc* than on bonds. (ut another way,
the mar*et yield on its preferred could be lower than the interest rate on its debt because of the ?08 e-clusion,
and with a zero ta- rate, there is no reduction in the cost of debt.
,& (Comp&) 8eta and pro2ect ris1 C I Answer: e 7A+(
#he fact that 'Ks returns are negatively correlated means that it serves as a sort of insurance policy to the firm.
#he fact that its B4 is high is actually good, because the negative correlation will cause the projectKs beta versus
the mar*et and also with the firmKs other assets to be relatively low, denoting a low ris* and thus justifying a
relatively low cost of capital. #his answer is theoretically always true, and it is especially true if the firm is large,
has many projects, and (roject ' is not a bet the company! project.
,(& (Comp&) 'CC brea1 points C I Answer: c 7A+(
Btatement c is true. #he merged firm would have a beta that is a simple average of )"s and %"s betas, and that
would result in a cost of equity that is an average of the two firmsK costs of equity. Bince they are financed only
with equity, their %'&&s could also be averaged to find the merged firm"s %'&&.
,)& (11-) Cost of preferred C I Answer: b EASY
(referred stoc* price 2@?.50
(referred dividend 2I.50
,lotation cost E.008
rp / 4p9((p(3 ,)) @.0I8
,,& (11-) Cost of preferred C I Answer: d EASY
(referred stoc* price 2@<.50
(referred dividend 2I.00
,lotation cost 5.008
rp / 4p9((p(3 ,)) @.308
,-& (11-!) Cost of +E: CA6' C I Answer: a EASY
r+, 5.008
+() 7.008
b 3.05
rs / r+, : b(+()) 33.=08
,.& (11-!) Cost of +E: CA6' C I Answer: e EASY
r+, E.308
+() 5.<58
b 3.=0
rs / r+, : b(+()) 30.@<58
,2& (11-!) Cost of +E: (CF C I Answer: c EASY
43 20.7?
(0 2<?.50
g I.008
rs / 439(0 : g 30.EE8
-0& (11-!) Cost of +E: (CF C I Answer: d EASY
43 23.E5
(0 2<<.50
g 7.508
rs / 439(0 : g 3<.@E8
-1& (11-!) 8ond-.ield-pl-s-ris1 premi-m C I Answer: a EASY
Dond yield I.?58
+is* premium =.I58
rs / rd : +is* premium 3<.708
-2& (11-$) %ACC C I Answer: b EASY
%eights &osts
4ebt E08 7.008
(referred 358 ?.508
&ommon E58 3<.?58
%'&& / wd M rd M (3 ; #) : wp M rp : wc M rs @.<78
-& (11-3) Cost of debt C I Answer: d 'E(I)'
&oupon rate @.<58
(eriods9year <
)aturity (yr) <0
Dond price 23,0?5.00
(ar value 23,000
#a- rate E08
&alculator inputsH
$ / < M <0 E0
(N / Dond"s price G23,0?5.00
()# / &oupon rate M (ar9< 2E7.<5
,N / (ar / )aturity value 23,000
&alculator outputH I9O+, semiannual rate E.<=8
'nnual rate / < M (I9O+) / DeforeGta- cost of debt I.E?8
'fterGta- cost of debt / rd(3 P #) 5.0I8
-(& (11-3) Cost of debt C I Answer: c 'E(I)'
&oupon rate ?.008
(eriods9year <
)aturity (yr) <0
Dond price 2@<5.00
(ar value 23,000
#a- rate E08
&alculator inputsH
$ / < M <0 E0
(N / Dond"s price G2@<5.00
()# / &oupon rate M (ar9< 2=5
,N / (ar / )aturity value 23,000
I9O+ =.I?8
#imes periods9yr / beforeGta- cost of debt ?.?E8
'fterGta- cost of debt / rd(3 P #) E.758
-)& (11-!) Cost of +E: (CF C I Answer: d 'E(I)'
40 20.@0
(0 2<?.50
g ?.008
43 / 40 M (3 : g) 20.@7=
rs / 439(0 : g 30.508
-,& (11-!) Cost of +E: (CF C I Answer: c 'E(I)'
40 20.I0
(0 2<<.50
g I.008
43 / 40 M (3 : g) 20.I7E
rs / 439(0 : g 33.IE8
--& (11-#) r
e
based on (CF4 (
1
C I Answer: c 'E(I)'
43 23.<5
(0 2<?.50
g 5.008
, 7.008
re / 439((0 M (3 ; ,)) : g / @.IE8
-.& (11-#) r
e
based on (CF4 (
1
C I Answer: b 'E(I)'
43 23.?5
(0 2E<.50
g ?.008
, 5.008
re / 439((0 M (3 ; ,)) : g 33.==8
-2& (11-#) Cost of new common C I Answer: b 'E(I)'
>-pected >(B3 2=.50
(ayout ratio 758
>-pected dividend, 43 / >(B M (ayout 2<.<?5
&urrent stoc* price 2=<.50
g 7.008
, 5.008
re / 439((0 M (3 ; ,)) : g 3=.=?8
.0& (11-$) %ACC C I Answer: c 'E(I)'
43 2<.50
g 5.508
(0 25<.50
rd ?.508
#a- rate E08
%eight debt E58
%eight equity 558
rd(3 ; #) E.508
rs / 439(0 : g 30.<78
%'&& / wd(rd)(3 ; #) : wc(rs) / ?.7?8
.1& (11-$) %ACC and tar"et cap& str-c& C I Answer: a 'E(I)'
#a- rate / E08
%eights rd '# &osts
4ebt =58 7.508 =.@08
(referred 308 7.008
&ommon 558 33.<58
%'&& 3008 I.358
.2& (11-3) 3a*es and cost of debt C I Answer: c 'E(I)'97A+(
#a- +ate
Fld rate, E08 $ew rate
&oupon rate ?.008 ?.008
(eriods9year < <
)aturity (yr) <0 <0
Dond price / (ar value 23,000.00 23,000.00
Fld and $ew ta- rates E08 =08
&alculator inputsH
$ / < M <0 E0 E0
(N / Dond"s price G23,000.00 G23,000.00
()# / &oupon rate M (ar9< 2=5.00 2=5
,N / (ar / )aturity value G23,000 G23,000
I9O+ =.508 =.508
#imes periods9yr / beforeGta- cost of debt ?.008 ?.008
'fterGta- cost of debt / rd(3 P #) E.<08 E.@08
4ifference / &ost at new rate &ost at old rate / 0.?08
.& (11-!) Cost of +E: (CF C I Answer: c 'E(I)'97A+(
Fld (rice $ew (rice
40 20.I5 20.I5
(0 2<<.00 2E0.00
g 7.008 7.008
43 / 40 M (3 : g) 20.@03 20.@03
rs / 439(0 : g 30.308 I.<58
4ifference, rs0 ; rs3 G3.IE8
.(& (11-$) %ACC and mar1et cap& str-c& C I Answer: e 'E(I)'97A+(
(0 2<<.50 Doo* value weightsG%+F$6AAA
Bhares outstanding (millions) 30 &apital %eights &ost rates (roduct
bond coupon rate (not used) ?.008 4ebt 2E5.00 E0.@38 =.708 3.E?8
O#) / rd 7.008 >quity 275.00 5@.0@8 3E.008 I.<?8
rs 3E.008 #otal 2330.00 300.008 %'&& / @.?58
#a- rate E08
DN debt (millions) 2E5.00 )ar*et value weightsGG+I6.#AAA
DN equity (millions) 275.00 &apital %eights &ost rates (roduct
)N debt (millions) 250.00 4ebt 250.00 3I.3I8 =.708 0.758
)N equity (millions) / Q sh (0 / 2<<5.00 >quity 2<<5.00 I3.I<8 3E.008 33.E58
'# cost of debt / rd(3#) =.708 #otal 2<?5.00 300.008 %'&& / 3<.338
4ifference / <.=78
.)& (11-!) +is1 premi-m4 CA6'4 and (CF C I Answer: b 7A+(
Dond yield ?.008
+is* premium E.008
rs 33.008
r+, 5.008
+() 7.008
b 3.<5
rs 3<.508
43 23.<0
(0 2=5.00
g I.008
rs 33.E=8
)a- 3<.508
)in 33.008
4ifference 3.508
.,& (11-#) r
s
5s& r
e
C I Answer: c 7A+(
>-pected >(B3 2<.?5
(ayout ratio ?08
&urrent st* price 2E5.00
g 7.008
, I.008
43 23.@<5
rs / 439(0 : g 30.<I8
re / 439((0 M (3 ; ,)) : g 30.758
4ifference / re P rs 0.=?8
.-& (11-$) %ACC and capital str-ct-re C I Answer: c 7A+(
DFFR N'CU> %>I6.#B
&apital %eights &ost rates (roduct
4ebt 2<5.00 ==.==8 E.I08 3.708
#a- rate E08 >quity 250.00 77.7?8 3<.<58 I.3?8
#arget wd =5.008 #otal capital 2?5.00 300.008 %'&& / @.??8
#arget wce 75.008
&oupon rate I.508 )'+R># N'CU> %>I6.#B
O#) / rd I.008 &apital %eights &ost rates (roduct
rd(3 P #) E.I08 4ebt 2<?.00 33.I@8 E.I08 0.5?8
rs 3<.<58 >quity 2<00.00 II.338 3<.<58 30.?@8
$umber of shares (millions) 30 #otal capital 2<<?.00 300.008 %'&& / 33.=78

(rice per share 2<0.00 #'+6># %>I6.#B
DN per share 25.00 &apital %eights &ost rates (roduct
Doo* equity / DN9sh M $o. Bhs 250.00 4ebt $' =5.008 E.I08 3.7I8
)ar*et equity / (0 M $o. Bhs 2<00.00 >quity $' 75.008 3<.<58 ?.@78
Doo* value of debt (millions) 2<5.00 #otal capital $' 300.008 %'&& / @.7E8
)ar*et value of debt (millions) 2<?.00
Bum of the = %'&&B / =0.??8
..& (11-$) %ACC and e,-it. from +E C I Answer: e 7A+(
&oupon rate I.008
)aturity <0
Dond price 23,050.00
(ar value 23,000
#a- rate E08
r+, E.508
+() 5.508
b 3.<0
%eight debt =58
%eight equity 758
Dond yield ?.538
'fterGta- cost of debt / rd(3 P #) E.538
&ost of equity, rs / r+, : b(+()) 33.308
%'&& / wd(rd)(3 P #) : wc(rs) / I.?@8
.2& (11-$) %ACC and e,-it. from +E C I Answer: d 7A+(
O#) ?.?58
#a- rate E08
43 20.75
g 7.008
(0 235.00
, 30.08
%eight debt E58
%eight equity 558
'fterGta- cost of debt / rd(3 P #) E.758
re / 439((0 M (3 ; ,)) : g 30.I38
%'&& / wd(rd)(3 P #) : wc(rs) / I.0E8
20& (11-0) 6ro2ect ris1 C I Answer: a 7A+(
r+, E.508
+() 5.508
b 0.@<
&ost of equity, rs / r+, : b(+()) @.578
(roject cost of capital / rs : factor varies
(rojects" cost 2<5.00
+is* 'dder &ap cost >-p. return 'mt Invested
' G<.08 ?.578 ?.708 2<5
D G3.08 I.578 @.358 2<5
& 0.08 @.578 30.308 2<5
4 3.08 30.578 30.E08 20
> <.08 33.578 30.I08 20
, <.08 33.578 30.@08 20
6 <.08 33.578 3=.008 2<5
#otal capital budgetH 2300
21& (11-2) After-ta* cost of debt C I Answer: c 'E(I)'
&oupon rate ?.<58 &alculator inputsH
(eriods9year < $ / < M Oears / E0
)aturity (yr) <0 (N / GDond (rice / G2I?5.00
Dond price 2I?5 ()# / (&oupon rate M (ar)9< / 2=7.<5
(ar value 23,000 ,N / (ar value / 23,000
#a- rate E08 Oield / I9O+, which we solve for / E.<I8
DeforeGta- cost of debt / rd / yield M < / I.5?8
'fterGta- cost of debt / rd(3 ; #) / 5.3E8
22& (11-!) CA6' cost of e,-it. C I Answer: d 'E(I)'
r+, 5.508
>-pected r) 33.508
+() / r) ; r+, / 7.008
b 3.<5
rs / r+, : b(+()) 3=.008
2& (11-$) %ei":ts for %ACC C I Answer: a 'E(I)'
Dond price 2I?5.00
$umber of bonds E0,000
)N of debt / 4 2=5,000,000
Btoc* price / (0 235.<5
Bhares outstanding 30,000,000
)N of equity / > 235<,500,000
#otal )N / 4 : > 23I?,500,000
%eight debt / wd / 49#otal )N 3I.7?8
2(& (11-$) %ACC C I Answer: c 'E(I)'
wd 3I.7?8
rd(3 P #) 5.3E8
wc / 300.008 P wd / I3.==8
rs 3=.008
%'&& / wd(rd)(3 P #) : wc(rs) / 33.5=8