Chapter 11 - The Cost of Cap

Chapter 11--The Cost of Capital
Student: ___________________________________________________________________________
1. Capital refers to items on the right-hand side of a firm's balance sheet.

True False
2. The component costs of capital are market-determined variables in as much as they

are based on investors' required returns.
True False
3. The cost of debt is equal to one minus the marginal tax rate multiplied by the coupon
rate on outstanding debt.
True False
4. The cost of issuing preferred stock by a corporation must be adjusted to an after-tax

figure because of the 70 percent dividend exclusion provision for corporations holding
other corporations' preferred stock.
True False
5. The firm's cost of external equity capital is the same as the required rate of return on
the firm's outstanding common stock.
True False
6. The cost of equity raised by retaining earnings can be less than, equal to, or greater
than the cost of equity raised by selling new issues of common stock, depending on tax
rates, flotation costs, the attitude of investors, and other factors.
True False
7. The cost of equity capital from the sale of new common stock (ke) is generally equal to
the cost of equity capital from retention of earnings (rs), divided by one minus the
flotation cost as a percentage of sales price (1 - F).
True False
8. Funds acquired by the firm through retaining earnings have no cost because there are
no dividend or interest payments associated with them, but capital raised by selling new
stock or bonds does have a cost.
True False
9. The weighted average cost of capital increases if the total funds required call for an
amount of equity in excess of what can be obtained as retained earnings.
True False
10. The marginal cost of capital (MCC) is the cost of the last dollar of new capital that the
firm raises, and the marginal cost declines as more and more of a specific type of capital
is raised during a given period.
True False
11. Even if a firm obtains all of its common equity from retained earnings, its MCC
schedule might still increase if very large amounts of new capital are needed.
True False
12. There is a jump, or break, in a firm's MCC schedule each time the firm runs out of a
particular source of capital at a particular cost. For example, a firm may use up its 10
percent debt and can then issue more debt only if it offers a higher rate to investors.
True False
13. The correct discount rate for a firm to use in capital budgeting, assuming that new
investments are of the same degree of risk as the firm's existing assets, is its marginal
cost of capital.
True False
14. The firm's cost of capital represents the maximum rate of return that a firm can earn
from its capital budgeting projects to ensure that the value of the firm increases.
True False
15. The cost of capital is the firm's average cost funds given what the market demands
be paid to attract the funds.
True False
16. The cost of capital used in capital budgeting must be determined using the specific
financing used to fund that particular project.
True False
17. A firm's capital structure has no impact on the firm's weighted average cost of
capital.
True False
18. Each component cost of particular types of capital is identical for each source of
funds found in a firm's capital structure.
True False
19. The after tax cost of debt is used to calculate the weighted average cost of capital
since we are concerned with the after-tax cash flows of the firm.
True False
20. Tax adjustments to the cost of preferred stock must be made when determining the
cost of capital since dividend expenses on preferred stocks are tax deductible.
True False
21. If a firm cannot invest retained earnings and earn at least the cost of equity, it should
pay these funds to shareholders and let them invest directly in other assets that do
provide this return.
True False
22. Long-term capital gains are taxed at a lower rate than dividends for most
stockholders leading companies to pay out dividends rather than use retained earnings
to fund capital projects.
True False
23. Flotation costs associated with issuing new equity cause the cost of external equity
to be lower than the cost of retained earnings.
True False
24. If expectations for long-term inflation rose, but the slope of the SML remained
constant, this would have a greater impact on the required rate of return on equity, rs,
than on the interest rate on long-term debt, rd, for most firms. In other words, the
percentage point increase in the cost of equity would be greater than the increase in the
interest rate on long-term debt.
True False
25. A firm going from a lower to a higher tax bracket could increase its use of debt, yet
actually wind up with a lower after-tax cost of debt.
True False
26. Since 70 percent of preferred dividends received by a corporation is excluded from

taxable income, the component cost of equity for a company which pays half of its
earnings out as common dividends and half as preferred dividends should, theoretically,
be
Cost of equity = rs(0.30)(0.50) + rs(1 - T)(0.70)(0.50).

True False
27. The steeper the demand curve for a firm's stock, the closer the values of rs and re are
to one another, other things held constant.
True False
28. In general, it is not possible for re, the cost of new equity, to be lower than rs, the cost
of retained earnings. However, an exception to this rule occurs when the stock price
increases just prior to the firm issuing new equity such that it more than offsets the
flotation costs and thus, re becomes less than rs.
True False
29. The cost of debt, rd, is always less than rs, so rd(1 - T) will certainly be less than rs.
Therefore, since a firm cannot be 100% debt financed, the weighted average cost of
capital will always be greater than rd(1 - T).
True False
30. Firms should use their weighted average cost of capital (WACC) when they are
funding their capital projects with a variety of sources. However, when the firm plans on
using only debt or only equity to fund a particular project, it should use the after-tax cost
of the specific source of capital to evaluate that project.
True False
31. Which of the following is not considered a capital component for the purpose of
calculating the weighted average cost of capital as it applies to capital budgeting?
A. Long-term debt.
B. Common stock.
C. Short-term debt.
D. Preferred stock.
E. All of the above are considered capital components for WACC and capital budgeting
purposes.
32. Which of the following statements is most correct?

A. If a company's tax rate increases but the yield to maturity of its noncallable bonds
remains the same, the company's marginal cost of debt capital used to calculate its
weighted average cost of capital will fall.
B. All else equal, an increase in a company's stock price will increase the marginal cost of
retained earnings.
C. All else equal, an increase in a company's stock price will increase the marginal cost of
issuing new common equity.
D. Answers a and b are both correct.
E. Answers b and c are both correct.
33. Which of the following factors in the discounted cash flow (DCF) approach to
estimating the cost of common equity is the least difficult to estimate?
A. Expected growth rate, g
B. Dividend yield,
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C. Required return, rs
D. Expected rate of return,
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E. All of the above are equally difficult to estimate.
34. If a firm can shift its capital structure so as to change its weighted average cost of
capital (WACC), which of the following results would be preferred?
A. The firm should try to decrease the WACC because such an action will increase the
value of the firm.
B. The firm should try to increase the WACC because such an action will increase the
value of the firm.
C. The firm should try to decrease the WACC because such an action will decrease the
value of the firm.
D. The firm should try to increase the WACC because such an action will decrease the
value of the firm.
E. The firm should not try to change the WACC because changing the WACC will not
change the value of the firm.
35. The firm's weighted average cost of capital (WACC) is

A. set by the board of directors of the firm because it is the benchmark they use to
evaluate upper management.
B. regulated by the Internal Revenue Service (IRS) because tax-deductible debt is
included in the computation.
C. determined by the financial markets because investors provide the funds used by
firms and these funds have costs, which are the returns demanded by investors.
D. the same as the firm's internal rate of return (IRR).
E. the total net present value (NPV) of all the capital budgeting projects in which the firm
invests in any year.
36. The before-tax cost of debt, rd, is the same as the

A. average yield to maturity (YTM) associated with the firm's bonds.
B. dividend yield associated with the firm's common stock.
C. average coupon rate of the firm's bonds.
D. re if the firm has no preferred stock.
E. the firm's marginal tax rate.
37. Alice Stewart, who is the CFO of Meyers Foods, is teaching an upper-level course in
corporate finance at the University of Phoenix. One of the assignments Alice gave her
class was to compute the component costs of capital for Meyers Foods. Meyers Foods
uses debt and common stock (no preferred stock) to finance its investments. Students in
the class did not reach the same conclusions about the relationships among the
components costs¾that is, the after-tax cost of debt, rdT, the cost of retained earnings
(i.e., internal equity), rs, and the cost of new, or external, equity, re. Which of the
following relationships should be correct for Meyers Foods?
A. rdT < rs < re
B. rs < rdT < re
C. re < rdT < rs
D. re < rs < rdT
E. None of the above is a correct relationship.
38. Under normal circumstances, the weighted average cost of capital is used as the
firm's required rate of return because
A. as long as the firm's investments earn returns greater than the cost of capital, the
value of the firm will not decrease.
B. returns below the cost of capital will cover all the fixed costs associated with capital
and provide excess returns to the firm's stockholders.
C. it is comparable to the average of all the interest rates on debt that currently prevail
in the financial markets.
D. it is an indication of the return the firm is earning from all of its assets in combination.
39. Estimating the cost of common equity using the discounted cash flow approach may
be difficult to evaluate because
A. the dividend yield is extremely difficult to estimate.
B. the proper growth rate is difficult to establish.
C. the current price of the common equity is always changing making it difficult to
determine.
D. all of the above are difficult to estimate.
40. Although it is a subjective measure, analysts often estimate the cost of common
equity by adding a risk premium of 3 to 5 percentage points to the
A. the cost of preferred stock for the firm.
B. the risk free rate.
C. interest rate on the firm's long term debt.
D. the market return.
E. the growth rate of the firm.
41. The target capital structure of a firm is the capital structure that
A. minimizes the operating risk of the firm's assets.
B. maximizes the tax shield created by debt.
C. minimizes the default risk of long-term debt.
D. maximizes the price of the firm's stock.
E. none of the above.
42. The marginal cost of capital ____ as more capital is raised during a given period.
A. does not change
B. decreases
C. increases
D. changes in an unpredictable way
E. approaches zero
43. A graph of a firm's acceptable capital projects ranked in the order of the projects'
internal rate of return is called the firm's ____.
A. marginal cost of capital schedule
B. investment opportunity schedule
C. modified internal rate of return schedule
D. internal project classification schedule
E. optimal capital budget schedule
44. Which of the following may be true concerning debt and equity?
A. The cost of debt for Firm A is greater than the cost of equity for Firm A.
B. The cost of debt for Firm A is greater than the cost of equity for Firm B.
C. The cost of internally generated equity for Firm A is greater than the cost of externally
generated equity funds for Firm A.
D. The cost of internally generated equity for Firm A is less than the cost of debt for Firm
A.
E. None of the above could be true.
45. Which of the following statements is correct?
A. Capital components are the types of capital used by firms to raise money. All capital
comes from one of three components: long-term debt, preferred stock, and equity.
B. Preferred stock does not involve any adjustment for flotation cost since the dividend
and price are fixed.
C. The cost of debt used in calculating the WACC is an average of the after-tax cost of
new debt and of outstanding debt.
D. The opportunity cost principle implies that if the firm cannot invest retained earnings
and earn at least rs, it should pay these funds to its stockholders and let them invest
directly in other assets that do provide this return.
E. The cost of new common equity includes an adjustment for flotation costs which is
expressed as a fixed percentage of the current stock price. The flotation percentage is
determined jointly by the current price of the firm's stock and its growth rate.

A. An increase in the corporate tax rate would lower the weighted average cost of capital
for an average firm, other things held constant.
B. Depreciation-generated funds have a cost equal to the firm's lowest WACC, and hence
they have no impact on the MCC schedule.
C. As a firm's debt ratio approaches 100 percent, the after-tax cost of debt, rdT, at its
lowest level.
D. Statements a, b, and c are all true.
E. Statements a, b, and c are all false.
47. Typically, according to the text, the MCC schedule is either horizontal or rising, which
implies that the cost of capital to a firm increases as it raises larger and larger amounts
of capital. The rising section of MCC schedule
A. Is caused by economies of scale in financing.
B. Would be eliminated (that is, the MCC schedule would be horizontal) if the firm
retained all of its earnings.
C. Results from a change in the debt ratio as the firm expands.
D. Occurs because the firm must, if it is to expand, be willing to take on riskier and riskier
projects, and this causes an increase in the cost of capital.
E. Results from flotation costs associated with the sale of new common and preferred
stock, along with higher debt costs, as the firm's rate of expansion increases.
A. Under normal conditions, the CAPM approach to estimating a firm's cost of retained
earnings gives a better estimate than the DCF approach.
B. The CAPM approach is typically used to estimate a firm's flotation cost adjustment
factor, and this factor is added to the DCF cost estimate.
C. The risk premium used in the bond-yield-plus-risk-premium method is the same as the
one used in the CAPM method.
D. In practice (as opposed to theory), the DCF method and the CAPM method usually
produce exactly the same estimate for r.
E. The above statements are all false.
49. In applying the CAPM to estimate the cost of equity capital, which of the following
elements is not subject to dispute or controversy?
A. Expected rate of return on the market, rM.
B. The stock's beta coefficient, bi.
C. Risk-free rate, rRF.
D. Market risk premium (MRP).
E. All of the above are subject to dispute.

A. The cost of capital used to evaluate a project should be the cost of the specific type of
financing used to fund that project.
B. The cost of debt used to calculate the weighted average cost of capital is based on an
average of the cost of debt already issued by the firm and the cost of new debt.
C. One problem with the CAPM approach to estimating the cost of equity capital is that if
a firm's stockholders are, in fact, not well diversified, beta might be a poor measure of
the firm's true investment risk.
D. The bond-yield-plus-risk-premium approach is the most sophisticated and objective
method of estimating a firm's cost of equity capital.
E. The cost of equity capital is generally easier to measure than the cost of debt, which
varies daily with interest rates, or the cost of preferred stock which is issued infrequently.

A. Beta measures market risk, but if a firm's stockholders are not well diversified, beta
may not accurately measure the firm's total risk.
B. If the calculated beta underestimates the firm's true investment risk, then the CAPM
method will overestimate rs.
C. The discounted cash flow method of estimating the cost of equity can't be used unless
the growth component, g, is constant during the analysis period.
D. An advantage shared by both the DCF and CAPM methods of estimating the cost of
equity capital, is that they yield precise estimates and require little or no judgment.
E. None of the above is a correct statement.
52. Which of the following statements is false?
A. From a theoretical standpoint, the capital weights used to calculate the WACC should
be based on the market values of the different securities. However, if a firm's book value
weights are closest to its market value weights, book value weights can be used as
proxies.
B. Generally, only long-term debt is included in the calculation of the WACC, because the
WACC is used for capital budgeting purposes, which includes long-term assets, and those
assets are financed with long-term capital.
C. The first break point a firm encounters in capital budgeting is for retained earnings,
unless a firm has zero or negative net income.
D. The weighted average cost of capital will change whenever a break point occurs.
E. Answers a and b are both false.

A. One purpose of calculating the WACC is to have a singular cost of capital measure that
can be applied to evaluate all of the firm's projects, including those of greater than and
lesser than average risks.
B. A firm facing a steep demand curve (that is, high flotation costs) for new equity would
likely also face, at some point, a steeply upward sloping WACC curve.
C. A breakpoint is based on the dollar value used of a specific type of capital, and occurs
at the point where the cost of that capital type increases. Thus, if a firm has $100,000 in
earnings, and stockholders want $50,000 of those earnings paid as dividends, then
retained earnings will have two breakpoints.
E. All of the above are false.

A. Suppose a firm is losing money and thus, is not paying taxes, and that this situation is
expected to persist for a few years whether or not the firm uses debt financing. Then the
firm's after-tax cost of debt will equal its before-tax cost of debt.
B. The component cost of preferred stock is expressed as rps(1 - T), because preferred
stock dividends are treated as fixed charges, similar to the treatment of debt interest.
C. The reason that a cost of capital is assigned to retained earnings is because these
funds are already earning a return in the business, the reason does not involve the
opportunity cost principle.
D. The bond-yield-plus-risk-premium approach to estimating a firm's cost of common
equity involves adding a subjectively determined risk-premium to the market risk-free
bond rate.
55. Consider the discussions concerning the cost of common equity. What is the
relationship between the cost of retained earnings (internal equity), rs, and the cost of
new common equity (external equity), re?
A. rs > re, because new stockholders are willing to accept a lower return and "pay their
dues" before they start receiving the higher returns that existing, loyal stockholders
receive.
B. 0 = rs < re, because there is no "real" cost to the income that the firm decides to retain
to reinvest in assets rather than payout to common stockholders as dividends.
C. 0 < rs < re, because there is a real cost to retaining income (earnings) for
reinvestment, but the firm has to pay flotation costs when issuing new common stock.
D. rs = re, because they both represent essentially the same source of funds, so they
must have the same cost.
E. None of the above is a correct answer.
56. Which of the following is least likely to lead to a break point in the marginal cost of
capital schedule?
A. an increase in the required return demanded by investors for a new bond issue.
B. increased flotation costs associated with seasoned equity offerings.
C. decreased liquidity in money markets leading to lower selling prices for commercial
paper.
D. using retained earnings to fund new projects for the firm.
E. issuing preferred stock to institutional investors.
57. Which of the following steps is not necessary for calculating the marginal cost of
capital schedule?
A. Determine each point at which a break in the marginal cost of capital schedule occurs.
B. Make a list of all the break points.
C. Determine the cost of capital for each component in the intervals between the breaks.
D. Estimate the change in the cost of capital within each interval.
E. Calculate the weighted averages of these component costs to obtain the WACCs in
each interval.
A. Because we often need to make comparisons among firms that are in different income
tax brackets, it is best to calculate the WACC on a before-tax basis.
B. If a firm has been suffering accounting losses and is expected to continue suffering
such losses (and therefore its tax rate is zero), it is possible that its after-tax component
cost of preferred stock as used to calculate the WACC will be less than its after-tax
component cost of debt.
C. Due to the way the MCC is constructed, the first break point in the MCC schedule must
be associated with using up all available retained earnings and having to issue common
stock.
D. Normally, the cost of external equity raised by issuing new common stock is above the
cost of retained earnings. Moreover, the higher the growth rate relative to the dividend
yield, the more the cost of external equity will exceed the cost of retained earnings.
59. Bouchard Company's stock sells for $20 per share, its last dividend (D0) was $1.00,
its growth rate is a constant 6 percent, and the company would incur a flotation cost of
20 percent if it sold new common stock. Retained earnings for the coming year are
expected to be $1,000,000, and the common equity ratio is 60 percent. If Bouchard has
a capital budget of $2,000,000, what component cost of common equity will be built into
the WACC for the last dollar of capital the company raises?
A. 11.30%
B. 11.45%
C. 11.80%
D. 12.15%
E. 12.63%
60. Diggin Tools just issued new preferred stock, which sold for $85 in the stock markets.
Holders of the stock will receive an annual dividend equal to $9.35. The flotation costs
associated with the new issue were 6 percent and Diggin's marginal tax rate is 30
percent. What is Diggin's cost of preferred stock, rps?
A. 11.0%
B. 7.7%
C. 8.2%
D. 11.7%
E. 10.3%
61. Allison Engines Corporation has established a target capital structure of 40 percent
debt and 60 percent common equity. The firm expects to earn $600 in after-tax income
during the coming year, and it will retain 40 percent of those earnings. The current
market price of the firm's stock is P0 = $28; its last dividend was D0 = $2.20, and its
expected dividend growth rate is 6 percent. Allison can issue new common stock at a 15
percent flotation cost. What will Allison's marginal cost of equity capital (not the WACC)
be if it must fund a capital budget requiring $600 in total new capital?
A. 15.8%
B. 13.9%
C. 7.9%
D. 14.3%
E. 9.7%
62. Your company's stock sells for $50 per share, its last dividend (D0) was $2.00, its
growth rate is a constant 5 percent, and the company would incur a flotation cost of 15
percent if it sold new common stock. Net income for the coming year is expected to be
$500,000 and the firm's payout ratio is 60 percent. The firm's common equity ratio is 30
percent and it has no preferred stock outstanding. The firm can borrow up to $300,000 at
an interest rate of 7 percent; any additional debt will have an interest rate of 9 percent.
Your company's tax rate is 40 percent. If the firm has a capital budget of $1,000,000,
what is the WACC for the last dollar of capital the company raises?
A. 3.78%
B. 6.76%
C. 9.94%
D. 11.81%
E. 13.25%
63. SW Ink's preferred stock, which pays a $5 dividend each year, currently sells for
$62.50. The company's marginal tax rate is 40 percent. What is the cost of preferred
stock, rps, that should be included in the computation of the SW Ink's weighted average
cost of capital (WACC)?
A. 8.0%
B. 4.8%
C. 3.2%
D. The dividend growth rate is needed to compute rps; so not enough information is given
to answer this question.
E. None of the above is correct.
64. Tapley Inc.'s current (target) capital structure has a target debt ratio (D/TA) of 60
percent. The firm can raise up to $5 million in new debt at a before-tax cost of 8 percent.
If more debt is required, the initial cost will be 8.5 percent, and if more than $10 million
of debt is required, the cost will be 9 percent. Net income for the previous year was $10
million, and it is expected to increase by 10 percent this year. The firm expects to
maintain its dividend payout ratio of 40 percent on the 1 million shares of common stock
outstanding. If it must sell new common stock, it would encounter a 10 percent flotation
cost on the first $2 million, a 15 percent cost if more than $2 million but less than $4
million is needed, and a 20 percent cost if more than $4 million of new outside equity is
required. Tapley's tax rate is 30 percent, and its current stock price is $88 per share. If
the firm has an unlimited number of projects which will earn a 10.25 percent return, what
is the maximum capital budget that can be adopted without adversely affecting
stockholder wealth?
A. $32.0 million
B. $15.9 million
C. $23.0 million
D. $10.6 million
E. $26.5 million
65. Anderson Company has four investment opportunities with the following costs (all
costs are paid at t = 0) and estimated internal rates of return (IRR):
Project Cost IRR

A $2,000 16.0%
B 3,000 14.5
C 5,000 11.5
D 3,000 9.5
The company has a target capital structure which consists of 40 percent common equity, 40 percent debt, and 20
percent preferred stock. The company has $1,000 in retained earnings. The company expects its year-end dividend to
be $3.00 per share (i.e.,
010009000003e40300000000bd03000000000400000003010800050000000b0200000000050000000c022100120004
00000004010d00040000000701030005000000140200000000bd030000410b2000cc00210012000000000021001200
0000000028000000120000002100000001001800000000003807000000000000000000000000000000000000ffffffffff
ffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffff0000ffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffff
ffffffffffffffffffffffffffffffffffffffff0000ffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffff0000ffffffffff
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fdfffefffffffffffffffdfffffffffdfffeffffffffffff0000fffffffffffffffffffffffffffffffffffffffffffffffffefefefffffffefefefffffffefefefffffffefefeffffffffffffff
ffff0000fffffffffffffffffffffffffffffffffffffffffffffffffffffffefefefffffffffffffefefeffffffffffffffffffffffffffffff0000ffffffffffffffffffffffffffffffffffffffffff
fffffffffffffefefefdfdfdffffffffffff000000010101000000ffffffffffff0000fffffffffffffffffffffffffffffffffffffffffffffffffdfdfdfdfdfdfffffffdfdfd
ffffffffffff000000ffffffffffffffffff0000fffffffffffffffffffffffffffffffffffffffffffffffffdfffefffffffffdfffffffffcfcfcfcfffd000000fffeffffffffffffff000
0fffffffffffffffffffffffffffffffffffffffffffffffffbfefcfefefefffefffffffffffffffdfffe000000fffeffffffffffffff0000fffeff02000103000200000000
0000000301000100fdfffefffefffefefefefefefefefefefefeffffff000000fdfffeffffffffffff0000fffffffefefe020202fffffffffffffefefeffffff
000000fffdfffffffffffffffffffffefefeffffff000000fdfffeffffffffffff0000fefefeffffff000000ffffffffffffffffffffffffffffff030002fffffffdfdfdfdf
dfdffffff000000010101fdfffeffffffffffff0000ffffffffffff010101fffffffdfdfdfffffffefefeffffffffffff000000fffffffffffffffffffffffffefefeffffff
ffffffffffff0000fffffffbfbfb010101fefefefffffffffffffefefeffffffffffff000000fffffffffffffffffffefefeffffffffffffffffffffffff0000ffffffffffff0101
01fffffffcfcfcfffffffffffffffffffdfffe000000fffffffffffffffffffffffffffffffffdffffffffffffff0000fefefeffffff000000fefefefffffffffffffffffffffffffdff
fe000000fefefefffffffffffffffffffdfdfdfffeffffffffffffff0000fbfefcfdfffe000100fffffffffffffffdfffffefffffeff000100fffffffffffffefefeffffffff
fffffffffffffeffffffffffffff0000ffffffffffff000000fffffffefefeffffffffffff000000ffffffffffffffffffffffffffffffffffffffffffffffffffffffffffff0000ffffff00
0000020202000000010101000000000000ffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffff0000fffffffffffffefefeffffffffffffffff
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ffffffffffffffffff000000000000fcfcfcffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffff0000fffffffffffffffffffdfdfdffffffffffffffffffffffffff
ffffffffffffffffffffffffffffffffffffffffffffffffffffffffff0000fefefefffffffefefefffffffffffffffffffefefeffffffffffffffffffffffffffffffffffffffffffffffffffffffffff
ffffffff0000030000000000 = $3.00). The dividend is expected to grow at a constant rate of 5 percent a year. The
company's stock price is currently $42.75. If the company issues new common stock, the company will pay its
investment bankers a 10 percent flotation cost. The company can issue corporate bonds with a yield to maturity of 10
percent. The company is in the 35 percent tax bracket. How large can the cost of preferred stock be (including flotation
costs) and it still be profitable for the company to invest in all four projects?
A. 7.75%
B. 8.90%
C. 10.46%
D. 11.54%
E. 12.68%
66. Gulf Electric Company
Gulf Electric Company (GEC) uses only debt and equity in its capital structure. It can
borrow unlimited amounts at an interest rate of 10 percent so long as it finances at its
target capital structure, which calls for 55 percent debt and 45 percent common equity.
Its last dividend was $2.20; its expected constant growth rate is 6 percent; its stock sells
on the NYSE at a price of $35; and new stock would net the company $30 per share after
flotation costs. GEC's tax rate is 40 percent, and it expects to have $100 million of
retained earnings this year. GEC has two projects available: Project A has a cost of $200
million and a rate of return of 13 percent, while Project B has a cost of $125 million and a
rate of return of 10 percent. All of the company's potential projects are equally risky.
Refer to Gulf Electric Company. What is GEC's cost of equity from newly issued
stock?
A. 13.77%
B. 12.66%
C. 13.33%
D. 12.29%
E. 10.00%

Refer to Gulf Electric Company. Assume now that GEC needs to raise $300 million in
new capital. What is GEC's marginal cost of capital for evaluating the $300 million in
capital projects and any others that might arise during the year?
A. 6.00%
B. 13.77%
C. 12.66%
D. 9.50%
E. 9.00%
68. Byron Corporation
Byron Corporation's present capital structure, which is also its target capital structure, is
40 percent debt and 60 percent common equity. Next year's net income is projected to
be $21,000, and Byron's payout ratio is 30 percent. The company's earnings and
dividends are growing at a constant rate of 5 percent; the last dividend (D0) was $2.00;
and the current equilibrium stock price is $21.88. Byron can raise all the debt financing it
needs at 14.0 percent. If Byron issues new common stock, a 20 percent flotation cost will
be incurred. The firm's marginal tax rate is 40 percent.
Refer to Byron Corporation. What is the maximum amount of new capital that can be
raised at the lowest component cost of equity? (In other words, what is the retained
earnings break point?)
A. $12,600
B. $14,700
C. $17,400
D. $21,000
E. $24,500

Refer to Byron Corporation. What is the component cost of the equity raised by selling
new common stock?
A. 17.0%
B. 16.4%
C. 15.0%
D. 14.6%
E. 12.0%
Refer to Byron Corporation. Assume that at one point along the marginal cost of
capital schedule the component cost of equity is 18.0 percent. What is the weighted
average cost of capital at that point?
A. 10.8%
B. 13.6%
C. 14.2%
D. 16.4%
E. 18.0%
71. Rollins Corporation

Rollins Corporation is constructing its MCC schedule. Its target capital structure is 20
percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have
a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for
$1,000. The firm could sell, at par, $100 preferred stock which pays a 12 percent annual
dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-
free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant
growth firm which just paid a dividend of $2.00, sells for $27.00 per share, and has a
growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage
points when using the bond-yield-plus-risk-premium method to find rs. The firm's net
income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation
costs on new common stock total 10 percent, and the firm's marginal tax rate is 40
percent.
Refer to Rollins Corporation. What is Rollins' component cost of debt?

A. 10.0%
B. 9.1%
C. 8.6%
D. 8.0%
E. 7.2%
percent.
Refer to Rollins Corporation. What is Rollins' cost of preferred stock?

A. 10.0%
B. 11.0%
C. 12.0%
D. 12.6%
E. 13.2%

percent.
Refer to Rollins Corporation. What is Rollins' cost of retained earnings using the CAPM
approach?
A. 13.6%
B. 14.1%
C. 16.0%
D. 16.6%
E. 16.9%
percent.
Refer to Rollins Corporation. What is the firm's cost of retained earnings using the
DCF approach?
A. 13.6%
B. 14.1%
C. 16.0%
D. 16.6%
E. 16.9%

percent.
Refer to Rollins Corporation. What is Rollins' cost of retained earnings using the bond-
yield-plus-risk-premium approach?
A. 13.6%
B. 14.1%
C. 16.0%
D. 16.6%
E. 16.9%
percent.
Refer to Rollins Corporation. What is Rollins' lowest WACC?

A. 13.6%
B. 14.1%
C. 16.0%
D. 16.6%
E. 16.9%

percent.
Refer to Rollins Corporation. What is Rollins' retained earnings break point?

A. $600,000
B. $800,000
C. $1,000,000
D. $1,200,000
E. $1,400,000
percent.
Refer to Rollins Corporation. What is Rollins' WACC once it starts using new common
stock financing?
A. 13.6%
B. 14.1%
C. 16.0%
D. 16.6%
E. 16.9%
79. Jackson Company

The Jackson Company has just paid a dividend of $3.00 per share on its common stock,
and it expects this dividend to grow by 10 percent per year, indefinitely. The firm has a
beta of 1.50; the risk-free rate is 10 percent; and the expected return on the market is 14
percent. The firm's investment bankers believe that new issues of common stock would
have a flotation cost equal to 5 percent of the current market price.
Refer to Jackson Company. How much should an investor be willing to pay for this
stock today?
A. $62.81
B. $70.00
C. $43.75
D. $55.00
E. $30.00
80. Jackson Company
Refer to Jackson Company. What will be Jackson's cost of new common stock if it
issues new stock in the marketplace today?
A. 15.25%
B. 16.32%
C. 17.00%
D. 12.47%
E. 9.85%
81. J. Ross and Sons Inc.

J. Ross and Sons Inc. has a target capital structure that calls for 40 percent debt, 10
percent preferred stock, and 50 percent common equity. The firm's current after-tax cost
of debt is 6 percent, and it can sell as much debt as it wishes at this rate. The firm's
preferred stock currently sells for $90 a share and pays a dividend of $10 per share;
however, the firm will net only $80 per share from the sale of new preferred stock. Ross
expects to retain $15,000 in earnings over the next year. Ross' common stock currently
sells for $40 per share, but the firm will net only $34 per share from the sale of new
common stock. The firm recently paid a dividend of $2 per share on its common stock,
and investors expect the dividend to grow indefinitely at a constant rate of 10 percent
per year.
Refer to J. Ross and Sons Inc. What is the firm's cost of retained earnings?
A. 10.0%
B. 12.5%
C. 15.5%
D. 16.5%
E. 18.0%
per year.
Refer to J. Ross and Sons Inc. What is the firm's cost of newly issued common stock?
A. 10.0%
B. 12.5%
C. 15.5%
D. 16.5%
E. 18.0%

per year.
Refer to J. Ross and Sons Inc. What is the firm's cost of newly issued preferred stock?
A. 10.0%
B. 12.5%
C. 15.5%
D. 16.5%
E. 18.0%
per year.
Refer to J. Ross and Sons Inc. Where will a break in the WACC curve occur?
A. $30,000
B. $20,000
C. $10,000
D. $42,000
E. There will be no breaks in the WACC curve.

per year.
Refer to J. Ross and Sons Inc. What will be the WACC above this break point?
A. 12.5%
B. 8.3%
C. 10.6%
D. 11.9%
E. 14.1%
86. Financial Calculator Section
The following question(s) may require the use of a financial calculator.
Hamilton Company's 8 percent coupon rate, quarterly payment, $1,000 par value bond,
which matures in 20 years, currently sells at a price of $686.86. The company's tax rate
is 40 percent. Based on the simple interest rate, not the EAR, what is the firm's
component cost of debt for purposes of calculating the WACC?
A. 3.05%
B. 7.32%
C. 7.36%
D. 12.20%
E. 12.26%
Chapter 11--The Cost of Capital Key
1. Capital refers to items on the right-hand side of a firm's balance sheet.

TRUE
2. The component costs of capital are market-determined variables in as much as they

are based on investors' required returns.
TRUE
3. The cost of debt is equal to one minus the marginal tax rate multiplied by the coupon
rate on outstanding debt.
FALSE
4. The cost of issuing preferred stock by a corporation must be adjusted to an after-tax

figure because of the 70 percent dividend exclusion provision for corporations holding
other corporations' preferred stock.
FALSE
5. The firm's cost of external equity capital is the same as the required rate of return on
the firm's outstanding common stock.
FALSE
6. The cost of equity raised by retaining earnings can be less than, equal to, or greater
than the cost of equity raised by selling new issues of common stock, depending on tax
rates, flotation costs, the attitude of investors, and other factors.
FALSE
7. The cost of equity capital from the sale of new common stock (ke) is generally equal to
the cost of equity capital from retention of earnings (rs), divided by one minus the
flotation cost as a percentage of sales price (1 - F).
FALSE
8. Funds acquired by the firm through retaining earnings have no cost because there are
no dividend or interest payments associated with them, but capital raised by selling new
stock or bonds does have a cost.
FALSE
9. The weighted average cost of capital increases if the total funds required call for an
amount of equity in excess of what can be obtained as retained earnings.
TRUE
10. The marginal cost of capital (MCC) is the cost of the last dollar of new capital that the
firm raises, and the marginal cost declines as more and more of a specific type of capital
is raised during a given period.
FALSE
11. Even if a firm obtains all of its common equity from retained earnings, its MCC
schedule might still increase if very large amounts of new capital are needed.
TRUE
12. There is a jump, or break, in a firm's MCC schedule each time the firm runs out of a
particular source of capital at a particular cost. For example, a firm may use up its 10
percent debt and can then issue more debt only if it offers a higher rate to investors.
TRUE
13. The correct discount rate for a firm to use in capital budgeting, assuming that new
investments are of the same degree of risk as the firm's existing assets, is its marginal
cost of capital.
TRUE
14. The firm's cost of capital represents the maximum rate of return that a firm can earn
from its capital budgeting projects to ensure that the value of the firm increases.
FALSE
15. The cost of capital is the firm's average cost funds given what the market demands
be paid to attract the funds.
TRUE
16. The cost of capital used in capital budgeting must be determined using the specific
financing used to fund that particular project.
FALSE
17. A firm's capital structure has no impact on the firm's weighted average cost of
capital.
FALSE
18. Each component cost of particular types of capital is identical for each source of
funds found in a firm's capital structure.
FALSE
19. The after tax cost of debt is used to calculate the weighted average cost of capital
since we are concerned with the after-tax cash flows of the firm.
TRUE
20. Tax adjustments to the cost of preferred stock must be made when determining the
cost of capital since dividend expenses on preferred stocks are tax deductible.
FALSE
21. If a firm cannot invest retained earnings and earn at least the cost of equity, it should
pay these funds to shareholders and let them invest directly in other assets that do
provide this return.
TRUE
22. Long-term capital gains are taxed at a lower rate than dividends for most
stockholders leading companies to pay out dividends rather than use retained earnings
to fund capital projects.
FALSE
23. Flotation costs associated with issuing new equity cause the cost of external equity
to be lower than the cost of retained earnings.
FALSE
24. If expectations for long-term inflation rose, but the slope of the SML remained
constant, this would have a greater impact on the required rate of return on equity, rs,
than on the interest rate on long-term debt, rd, for most firms. In other words, the
percentage point increase in the cost of equity would be greater than the increase in the
interest rate on long-term debt.
FALSE
25. A firm going from a lower to a higher tax bracket could increase its use of debt, yet
actually wind up with a lower after-tax cost of debt.
TRUE
26. Since 70 percent of preferred dividends received by a corporation is excluded from

taxable income, the component cost of equity for a company which pays half of its
earnings out as common dividends and half as preferred dividends should, theoretically,
be
Cost of equity = rs(0.30)(0.50) + rs(1 - T)(0.70)(0.50).

FALSE
27. The steeper the demand curve for a firm's stock, the closer the values of rs and re are
to one another, other things held constant.
FALSE
28. In general, it is not possible for re, the cost of new equity, to be lower than rs, the cost
of retained earnings. However, an exception to this rule occurs when the stock price
increases just prior to the firm issuing new equity such that it more than offsets the
flotation costs and thus, re becomes less than rs.
FALSE
29. The cost of debt, rd, is always less than rs, so rd(1 - T) will certainly be less than rs.
Therefore, since a firm cannot be 100% debt financed, the weighted average cost of
capital will always be greater than rd(1 - T).
TRUE
30. Firms should use their weighted average cost of capital (WACC) when they are
funding their capital projects with a variety of sources. However, when the firm plans on
using only debt or only equity to fund a particular project, it should use the after-tax cost
of the specific source of capital to evaluate that project.
FALSE
31. Which of the following is not considered a capital component for the purpose of
calculating the weighted average cost of capital as it applies to capital budgeting?
A. Long-term debt.
B. Common stock.
C. Short-term debt.
D. Preferred stock.
E. All of the above are considered capital components for WACC and capital budgeting
purposes.

A. If a company's tax rate increases but the yield to maturity of its noncallable bonds
remains the same, the company's marginal cost of debt capital used to calculate its
weighted average cost of capital will fall.
B. All else equal, an increase in a company's stock price will increase the marginal cost of
retained earnings.
C. All else equal, an increase in a company's stock price will increase the marginal cost of
issuing new common equity.
E. Answers b and c are both correct.
33. Which of the following factors in the discounted cash flow (DCF) approach to
estimating the cost of common equity is the least difficult to estimate?
A. Expected growth rate, g
B. Dividend yield,
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ffffffffffffffffffffffffffffffffffffffffff0000030000000000
C. Required return, rs
D. Expected rate of return,
0100090000031c0200000000f501000000000400000003010800050000000b020000000
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000f5010000410b2000cc001a000b00000000001a000b0000000000280000000b000000
1a0000000100180000000000a803000000000000000000000000000000000000ffffffffffff
ffffffffffffffffffffffffffffffffffffffffffffffffffffff000000ffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffff
ff000000fffffffdfdfdfffffffffffffdfdfdfdfdfdfffffffdfdfdffffffffffffffffff000000fdfdfdfffffffefefeffffff
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000000fffffffffffffdfdfdfdfdfdffffffffffffffffffffffffffffffffffffffffff000000fffffffffffffffffffffffffefefefef
efefdfdfdfefefeffffffffffffffffff000000fffffffffffffffffffffffffefefeffffffffffffffffffffffffffffffffffff000000
fefefefffffffffffffffffffefefefffffffefefeffffffffffffffffffffffff000000fdfdfdffffffffffffffffffffffffffffff0101
01010101ffffffffffffffffff000000fffffffffffffffffffffffffffffffffffffefefeffffff010101ffffffffffff000000ff
fffffffffffdfdfdffffffffffffffffff000000000000fffffffffffffefefe000000fffffffefefefffffffffffffdfdfdffff
ff010101ffffffffffffffffffffffff000000000000000000000000fefefefffffffffffffefefe00000000000
0ffffffffffff000000ffffff010101fefefefffffffffffffffffffffffffffffffffffffefefeffffff000000ffffff000000
fffffffffffffdfdfdffffffffffffffffffffffffffffffffffff000000ffffff000000fffffffefefeffffffffffffffffffffffffffffff
ffffffffffff000000fcfcfc010101fffffffffffffffffffffffffffffffffffffefefefdfdfdffffff0000000300020303
03000000fffffffffffffefefefefefefcfffdffffffffffffffffff000000fffeff000000fdfdfd010101000000
fffffffffffffdfffeffffffffffffffffff000000fffefffffffffffffffefefefffffffffffffffffffdfffeffffffffffffffffff00000
0fefefefefefefffffffdfdfdffffffffffffffffffffffffffffffffffffffffff000000020202fffffffcfcfc0202020000
00fffffffffffffefefeffffffffffffffffff000000fcfffd000000020202fffffffffffffefefefffffffffeffffffffffffffff
ffff000000fdfffefefefefffffffffffffffffffffffffefefefffeffffffffffffffffffff000000f9fcfaffffffffffffffffffffff
fffffffffffffffffeffffffffffffffffffff000000030000000000
E. All of the above are equally difficult to estimate.
34. If a firm can shift its capital structure so as to change its weighted average cost of
capital (WACC), which of the following results would be preferred?
A. The firm should try to decrease the WACC because such an action will increase the
value of the firm.
B. The firm should try to increase the WACC because such an action will increase the
value of the firm.
C. The firm should try to decrease the WACC because such an action will decrease the
value of the firm.
D. The firm should try to increase the WACC because such an action will decrease the
value of the firm.
E. The firm should not try to change the WACC because changing the WACC will not
change the value of the firm.
35. The firm's weighted average cost of capital (WACC) is

A. set by the board of directors of the firm because it is the benchmark they use to
evaluate upper management.
B. regulated by the Internal Revenue Service (IRS) because tax-deductible debt is
included in the computation.
C. determined by the financial markets because investors provide the funds used by
firms and these funds have costs, which are the returns demanded by investors.
D. the same as the firm's internal rate of return (IRR).
E. the total net present value (NPV) of all the capital budgeting projects in which the firm
invests in any year.
36. The before-tax cost of debt, rd, is the same as the

A. average yield to maturity (YTM) associated with the firm's bonds.
B. dividend yield associated with the firm's common stock.
C. average coupon rate of the firm's bonds.
D. re if the firm has no preferred stock.
E. the firm's marginal tax rate.
37. Alice Stewart, who is the CFO of Meyers Foods, is teaching an upper-level course in
corporate finance at the University of Phoenix. One of the assignments Alice gave her
class was to compute the component costs of capital for Meyers Foods. Meyers Foods
uses debt and common stock (no preferred stock) to finance its investments. Students in
the class did not reach the same conclusions about the relationships among the
components costs¾that is, the after-tax cost of debt, rdT, the cost of retained earnings
(i.e., internal equity), rs, and the cost of new, or external, equity, re. Which of the
following relationships should be correct for Meyers Foods?
A. rdT < rs < re
B. rs < rdT < re
C. re < rdT < rs
D. re < rs < rdT
E. None of the above is a correct relationship.
38. Under normal circumstances, the weighted average cost of capital is used as the
firm's required rate of return because
A. as long as the firm's investments earn returns greater than the cost of capital, the
value of the firm will not decrease.
B. returns below the cost of capital will cover all the fixed costs associated with capital
and provide excess returns to the firm's stockholders.
C. it is comparable to the average of all the interest rates on debt that currently prevail
in the financial markets.
D. it is an indication of the return the firm is earning from all of its assets in combination.
39. Estimating the cost of common equity using the discounted cash flow approach may
be difficult to evaluate because
A. the dividend yield is extremely difficult to estimate.
B. the proper growth rate is difficult to establish.
C. the current price of the common equity is always changing making it difficult to
determine.
D. all of the above are difficult to estimate.
40. Although it is a subjective measure, analysts often estimate the cost of common
equity by adding a risk premium of 3 to 5 percentage points to the
A. the cost of preferred stock for the firm.
B. the risk free rate.
C. interest rate on the firm's long term debt.
D. the market return.
E. the growth rate of the firm.
41. The target capital structure of a firm is the capital structure that
A. minimizes the operating risk of the firm's assets.
B. maximizes the tax shield created by debt.
C. minimizes the default risk of long-term debt.
D. maximizes the price of the firm's stock.
E. none of the above.
42. The marginal cost of capital ____ as more capital is raised during a given period.
A. does not change
B. decreases
C. increases
D. changes in an unpredictable way
E. approaches zero
43. A graph of a firm's acceptable capital projects ranked in the order of the projects'
internal rate of return is called the firm's ____.
A. marginal cost of capital schedule
B. investment opportunity schedule
C. modified internal rate of return schedule
D. internal project classification schedule
E. optimal capital budget schedule
44. Which of the following may be true concerning debt and equity?
A. The cost of debt for Firm A is greater than the cost of equity for Firm A.
B. The cost of debt for Firm A is greater than the cost of equity for Firm B.
C. The cost of internally generated equity for Firm A is greater than the cost of externally
generated equity funds for Firm A.
D. The cost of internally generated equity for Firm A is less than the cost of debt for Firm
A.
E. None of the above could be true.
A. Capital components are the types of capital used by firms to raise money. All capital
comes from one of three components: long-term debt, preferred stock, and equity.
B. Preferred stock does not involve any adjustment for flotation cost since the dividend
and price are fixed.
C. The cost of debt used in calculating the WACC is an average of the after-tax cost of
new debt and of outstanding debt.
D. The opportunity cost principle implies that if the firm cannot invest retained earnings
and earn at least rs, it should pay these funds to its stockholders and let them invest
directly in other assets that do provide this return.
E. The cost of new common equity includes an adjustment for flotation costs which is
expressed as a fixed percentage of the current stock price. The flotation percentage is
determined jointly by the current price of the firm's stock and its growth rate.

A. An increase in the corporate tax rate would lower the weighted average cost of capital
for an average firm, other things held constant.
B. Depreciation-generated funds have a cost equal to the firm's lowest WACC, and hence
they have no impact on the MCC schedule.
C. As a firm's debt ratio approaches 100 percent, the after-tax cost of debt, rdT, at its
lowest level.
D. Statements a, b, and c are all true.
E. Statements a, b, and c are all false.
47. Typically, according to the text, the MCC schedule is either horizontal or rising, which
implies that the cost of capital to a firm increases as it raises larger and larger amounts
of capital. The rising section of MCC schedule
A. Is caused by economies of scale in financing.
B. Would be eliminated (that is, the MCC schedule would be horizontal) if the firm
retained all of its earnings.
C. Results from a change in the debt ratio as the firm expands.
D. Occurs because the firm must, if it is to expand, be willing to take on riskier and riskier
projects, and this causes an increase in the cost of capital.
E. Results from flotation costs associated with the sale of new common and preferred
stock, along with higher debt costs, as the firm's rate of expansion increases.
A. Under normal conditions, the CAPM approach to estimating a firm's cost of retained
earnings gives a better estimate than the DCF approach.
B. The CAPM approach is typically used to estimate a firm's flotation cost adjustment
factor, and this factor is added to the DCF cost estimate.
C. The risk premium used in the bond-yield-plus-risk-premium method is the same as the
one used in the CAPM method.
D. In practice (as opposed to theory), the DCF method and the CAPM method usually
produce exactly the same estimate for r.
E. The above statements are all false.
49. In applying the CAPM to estimate the cost of equity capital, which of the following
elements is not subject to dispute or controversy?
A. Expected rate of return on the market, rM.
B. The stock's beta coefficient, bi.
C. Risk-free rate, rRF.
D. Market risk premium (MRP).
E. All of the above are subject to dispute.

A. The cost of capital used to evaluate a project should be the cost of the specific type of
financing used to fund that project.
B. The cost of debt used to calculate the weighted average cost of capital is based on an
average of the cost of debt already issued by the firm and the cost of new debt.
C. One problem with the CAPM approach to estimating the cost of equity capital is that if
a firm's stockholders are, in fact, not well diversified, beta might be a poor measure of
the firm's true investment risk.
D. The bond-yield-plus-risk-premium approach is the most sophisticated and objective
method of estimating a firm's cost of equity capital.
E. The cost of equity capital is generally easier to measure than the cost of debt, which
varies daily with interest rates, or the cost of preferred stock which is issued infrequently.

A. Beta measures market risk, but if a firm's stockholders are not well diversified, beta
may not accurately measure the firm's total risk.
B. If the calculated beta underestimates the firm's true investment risk, then the CAPM
method will overestimate rs.
C. The discounted cash flow method of estimating the cost of equity can't be used unless
the growth component, g, is constant during the analysis period.
D. An advantage shared by both the DCF and CAPM methods of estimating the cost of
equity capital, is that they yield precise estimates and require little or no judgment.
52. Which of the following statements is false?
A. From a theoretical standpoint, the capital weights used to calculate the WACC should
be based on the market values of the different securities. However, if a firm's book value
weights are closest to its market value weights, book value weights can be used as
proxies.
B. Generally, only long-term debt is included in the calculation of the WACC, because the
WACC is used for capital budgeting purposes, which includes long-term assets, and those
assets are financed with long-term capital.
C. The first break point a firm encounters in capital budgeting is for retained earnings,
unless a firm has zero or negative net income.
D. The weighted average cost of capital will change whenever a break point occurs.
E. Answers a and b are both false.

A. One purpose of calculating the WACC is to have a singular cost of capital measure that
can be applied to evaluate all of the firm's projects, including those of greater than and
lesser than average risks.
B. A firm facing a steep demand curve (that is, high flotation costs) for new equity would
likely also face, at some point, a steeply upward sloping WACC curve.
C. A breakpoint is based on the dollar value used of a specific type of capital, and occurs
at the point where the cost of that capital type increases. Thus, if a firm has $100,000 in
earnings, and stockholders want $50,000 of those earnings paid as dividends, then
retained earnings will have two breakpoints.
E. All of the above are false.

A. Suppose a firm is losing money and thus, is not paying taxes, and that this situation is
expected to persist for a few years whether or not the firm uses debt financing. Then the
firm's after-tax cost of debt will equal its before-tax cost of debt.
B. The component cost of preferred stock is expressed as rps(1 - T), because preferred
stock dividends are treated as fixed charges, similar to the treatment of debt interest.
C. The reason that a cost of capital is assigned to retained earnings is because these
funds are already earning a return in the business, the reason does not involve the
opportunity cost principle.
D. The bond-yield-plus-risk-premium approach to estimating a firm's cost of common
equity involves adding a subjectively determined risk-premium to the market risk-free
bond rate.
55. Consider the discussions concerning the cost of common equity. What is the
relationship between the cost of retained earnings (internal equity), rs, and the cost of
new common equity (external equity), re?
A. rs > re, because new stockholders are willing to accept a lower return and "pay their
dues" before they start receiving the higher returns that existing, loyal stockholders
receive.
B. 0 = rs < re, because there is no "real" cost to the income that the firm decides to retain
to reinvest in assets rather than payout to common stockholders as dividends.
C. 0 < rs < re, because there is a real cost to retaining income (earnings) for
reinvestment, but the firm has to pay flotation costs when issuing new common stock.
D. rs = re, because they both represent essentially the same source of funds, so they
must have the same cost.
E. None of the above is a correct answer.
56. Which of the following is least likely to lead to a break point in the marginal cost of
capital schedule?
A. an increase in the required return demanded by investors for a new bond issue.
B. increased flotation costs associated with seasoned equity offerings.
C. decreased liquidity in money markets leading to lower selling prices for commercial
paper.
D. using retained earnings to fund new projects for the firm.
E. issuing preferred stock to institutional investors.
57. Which of the following steps is not necessary for calculating the marginal cost of
capital schedule?
A. Determine each point at which a break in the marginal cost of capital schedule occurs.
B. Make a list of all the break points.
C. Determine the cost of capital for each component in the intervals between the breaks.
D. Estimate the change in the cost of capital within each interval.
E. Calculate the weighted averages of these component costs to obtain the WACCs in
each interval.
A. Because we often need to make comparisons among firms that are in different income
tax brackets, it is best to calculate the WACC on a before-tax basis.
B. If a firm has been suffering accounting losses and is expected to continue suffering
such losses (and therefore its tax rate is zero), it is possible that its after-tax component
cost of preferred stock as used to calculate the WACC will be less than its after-tax
component cost of debt.
C. Due to the way the MCC is constructed, the first break point in the MCC schedule must
be associated with using up all available retained earnings and having to issue common
stock.
D. Normally, the cost of external equity raised by issuing new common stock is above the
cost of retained earnings. Moreover, the higher the growth rate relative to the dividend
yield, the more the cost of external equity will exceed the cost of retained earnings.
59. Bouchard Company's stock sells for $20 per share, its last dividend (D0) was $1.00,
its growth rate is a constant 6 percent, and the company would incur a flotation cost of
20 percent if it sold new common stock. Retained earnings for the coming year are
expected to be $1,000,000, and the common equity ratio is 60 percent. If Bouchard has
a capital budget of $2,000,000, what component cost of common equity will be built into
the WACC for the last dollar of capital the company raises?
A. 11.30%
B. 11.45%
C. 11.80%
D. 12.15%
E. 12.63%
60. Diggin Tools just issued new preferred stock, which sold for $85 in the stock markets.
Holders of the stock will receive an annual dividend equal to $9.35. The flotation costs
associated with the new issue were 6 percent and Diggin's marginal tax rate is 30
percent. What is Diggin's cost of preferred stock, rps?
A. 11.0%
B. 7.7%
C. 8.2%
D. 11.7%
E. 10.3%
61. Allison Engines Corporation has established a target capital structure of 40 percent
debt and 60 percent common equity. The firm expects to earn $600 in after-tax income
during the coming year, and it will retain 40 percent of those earnings. The current
market price of the firm's stock is P0 = $28; its last dividend was D0 = $2.20, and its
expected dividend growth rate is 6 percent. Allison can issue new common stock at a 15
percent flotation cost. What will Allison's marginal cost of equity capital (not the WACC)
be if it must fund a capital budget requiring $600 in total new capital?
A. 15.8%
B. 13.9%
C. 7.9%
D. 14.3%
E. 9.7%
62. Your company's stock sells for $50 per share, its last dividend (D0) was $2.00, its
growth rate is a constant 5 percent, and the company would incur a flotation cost of 15
percent if it sold new common stock. Net income for the coming year is expected to be
$500,000 and the firm's payout ratio is 60 percent. The firm's common equity ratio is 30
percent and it has no preferred stock outstanding. The firm can borrow up to $300,000 at
an interest rate of 7 percent; any additional debt will have an interest rate of 9 percent.
Your company's tax rate is 40 percent. If the firm has a capital budget of $1,000,000,
what is the WACC for the last dollar of capital the company raises?
A. 3.78%
B. 6.76%
C. 9.94%
D. 11.81%
E. 13.25%
63. SW Ink's preferred stock, which pays a $5 dividend each year, currently sells for
$62.50. The company's marginal tax rate is 40 percent. What is the cost of preferred
stock, rps, that should be included in the computation of the SW Ink's weighted average
cost of capital (WACC)?
A. 8.0%
B. 4.8%
C. 3.2%
D. The dividend growth rate is needed to compute rps; so not enough information is given
to answer this question.
E. None of the above is correct.
64. Tapley Inc.'s current (target) capital structure has a target debt ratio (D/TA) of 60
percent. The firm can raise up to $5 million in new debt at a before-tax cost of 8 percent.
If more debt is required, the initial cost will be 8.5 percent, and if more than $10 million
of debt is required, the cost will be 9 percent. Net income for the previous year was $10
million, and it is expected to increase by 10 percent this year. The firm expects to
maintain its dividend payout ratio of 40 percent on the 1 million shares of common stock
outstanding. If it must sell new common stock, it would encounter a 10 percent flotation
cost on the first $2 million, a 15 percent cost if more than $2 million but less than $4
million is needed, and a 20 percent cost if more than $4 million of new outside equity is
required. Tapley's tax rate is 30 percent, and its current stock price is $88 per share. If
the firm has an unlimited number of projects which will earn a 10.25 percent return, what
is the maximum capital budget that can be adopted without adversely affecting
stockholder wealth?
A. $32.0 million
B. $15.9 million
C. $23.0 million
D. $10.6 million
E. $26.5 million
65. Anderson Company has four investment opportunities with the following costs (all
costs are paid at t = 0) and estimated internal rates of return (IRR):
Project Cost IRR

A $2,000 16.0%
B 3,000 14.5
C 5,000 11.5
D 3,000 9.5
The company has a target capital structure which consists of 40 percent common equity, 40 percent debt, and 20
percent preferred stock. The company has $1,000 in retained earnings. The company expects its year-end dividend to
be $3.00 per share (i.e.,
010009000003e40300000000bd03000000000400000003010800050000000b0200000000050000000c022100120004
00000004010d00040000000701030005000000140200000000bd030000410b2000cc00210012000000000021001200
0000000028000000120000002100000001001800000000003807000000000000000000000000000000000000ffffffffff
fffffffffffffffffffffffffffffffffffffffffefffffffffdfffefefefefffffffffefffffffffdfffeffffffffffff0000fffffffffffffffffffffffffffffffffffffffffffffffffffcfeffffff
fdfffefffffffffffffffdfffffffffdfffeffffffffffff0000fffffffffffffffffffffffffffffffffffffffffffffffffefefefffffffefefefffffffefefefffffffefefeffffffffffffff
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fffffffffffffefefefdfdfdffffffffffff000000010101000000ffffffffffff0000fffffffffffffffffffffffffffffffffffffffffffffffffdfdfdfdfdfdfffffffdfdfd
ffffffffffff000000ffffffffffffffffff0000fffffffffffffffffffffffffffffffffffffffffffffffffdfffefffffffffdfffffffffcfcfcfcfffd000000fffeffffffffffffff000
0fffffffffffffffffffffffffffffffffffffffffffffffffbfefcfefefefffefffffffffffffffdfffe000000fffeffffffffffffff0000fffeff02000103000200000000
0000000301000100fdfffefffefffefefefefefefefefefefefeffffff000000fdfffeffffffffffff0000fffffffefefe020202fffffffffffffefefeffffff
000000fffdfffffffffffffffffffffefefeffffff000000fdfffeffffffffffff0000fefefeffffff000000ffffffffffffffffffffffffffffff030002fffffffdfdfdfdf
dfdffffff000000010101fdfffeffffffffffff0000ffffffffffff010101fffffffdfdfdfffffffefefeffffffffffff000000fffffffffffffffffffffffffefefeffffff
ffffffffffff0000fffffffbfbfb010101fefefefffffffffffffefefeffffffffffff000000fffffffffffffffffffefefeffffffffffffffffffffffff0000ffffffffffff0101
01fffffffcfcfcfffffffffffffffffffdfffe000000fffffffffffffffffffffffffffffffffdffffffffffffff0000fefefeffffff000000fefefefffffffffffffffffffffffffdff
fe000000fefefefffffffffffffffffffdfdfdfffeffffffffffffff0000fbfefcfdfffe000100fffffffffffffffdfffffefffffeff000100fffffffffffffefefeffffffff
fffffffffffffeffffffffffffff0000ffffffffffff000000fffffffefefeffffffffffff000000ffffffffffffffffffffffffffffffffffffffffffffffffffffffffffff0000ffffff00
0000020202000000010101000000000000ffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffff0000fffffffffffffefefeffffffffffffffff
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ffffffff0000030000000000 = $3.00). The dividend is expected to grow at a constant rate of 5 percent a year. The
company's stock price is currently $42.75. If the company issues new common stock, the company will pay its
investment bankers a 10 percent flotation cost. The company can issue corporate bonds with a yield to maturity of 10
percent. The company is in the 35 percent tax bracket. How large can the cost of preferred stock be (including flotation
costs) and it still be profitable for the company to invest in all four projects?
A. 7.75%
B. 8.90%
C. 10.46%
D. 11.54%
E. 12.68%
Refer to Gulf Electric Company. What is GEC's cost of equity from newly issued
stock?
A. 13.77%
B. 12.66%
C. 13.33%
D. 12.29%
E. 10.00%

Refer to Gulf Electric Company. Assume now that GEC needs to raise $300 million in
new capital. What is GEC's marginal cost of capital for evaluating the $300 million in
capital projects and any others that might arise during the year?
A. 6.00%
B. 13.77%
C. 12.66%
D. 9.50%
E. 9.00%
Refer to Byron Corporation. What is the maximum amount of new capital that can be
raised at the lowest component cost of equity? (In other words, what is the retained
earnings break point?)
A. $12,600
B. $14,700
C. $17,400
D. $21,000
E. $24,500

Refer to Byron Corporation. What is the component cost of the equity raised by selling
new common stock?
A. 17.0%
B. 16.4%
C. 15.0%
D. 14.6%
E. 12.0%
Refer to Byron Corporation. Assume that at one point along the marginal cost of
capital schedule the component cost of equity is 18.0 percent. What is the weighted
average cost of capital at that point?
A. 10.8%
B. 13.6%
C. 14.2%
D. 16.4%
E. 18.0%

percent.
Refer to Rollins Corporation. What is Rollins' component cost of debt?

A. 10.0%
B. 9.1%
C. 8.6%
D. 8.0%
E. 7.2%
percent.
Refer to Rollins Corporation. What is Rollins' cost of preferred stock?

A. 10.0%
B. 11.0%
C. 12.0%
D. 12.6%
E. 13.2%

percent.
Refer to Rollins Corporation. What is Rollins' cost of retained earnings using the CAPM
approach?
A. 13.6%
B. 14.1%
C. 16.0%
D. 16.6%
E. 16.9%
percent.
Refer to Rollins Corporation. What is the firm's cost of retained earnings using the
DCF approach?
A. 13.6%
B. 14.1%
C. 16.0%
D. 16.6%
E. 16.9%

percent.
Refer to Rollins Corporation. What is Rollins' cost of retained earnings using the bond-
yield-plus-risk-premium approach?
A. 13.6%
B. 14.1%
C. 16.0%
D. 16.6%
E. 16.9%
percent.
Refer to Rollins Corporation. What is Rollins' lowest WACC?

A. 13.6%
B. 14.1%
C. 16.0%
D. 16.6%
E. 16.9%

percent.
Refer to Rollins Corporation. What is Rollins' retained earnings break point?

A. $600,000
B. $800,000
C. $1,000,000
D. $1,200,000
E. $1,400,000
percent.
Refer to Rollins Corporation. What is Rollins' WACC once it starts using new common
stock financing?
A. 13.6%
B. 14.1%
C. 16.0%
D. 16.6%
E. 16.9%
79. Jackson Company

Refer to Jackson Company. How much should an investor be willing to pay for this
stock today?
A. $62.81
B. $70.00
C. $43.75
D. $55.00
E. $30.00
80. Jackson Company
Refer to Jackson Company. What will be Jackson's cost of new common stock if it
issues new stock in the marketplace today?
A. 15.25%
B. 16.32%
C. 17.00%
D. 12.47%
E. 9.85%

per year.
Refer to J. Ross and Sons Inc. What is the firm's cost of retained earnings?
A. 10.0%
B. 12.5%
C. 15.5%
D. 16.5%
E. 18.0%
per year.
Refer to J. Ross and Sons Inc. What is the firm's cost of newly issued common stock?
A. 10.0%
B. 12.5%
C. 15.5%
D. 16.5%
E. 18.0%

per year.
Refer to J. Ross and Sons Inc. What is the firm's cost of newly issued preferred stock?
A. 10.0%
B. 12.5%
C. 15.5%
D. 16.5%
E. 18.0%
per year.
Refer to J. Ross and Sons Inc. Where will a break in the WACC curve occur?
A. $30,000
B. $20,000
C. $10,000
D. $42,000
E. There will be no breaks in the WACC curve.

per year.
Refer to J. Ross and Sons Inc. What will be the WACC above this break point?
A. 12.5%
B. 8.3%
C. 10.6%
D. 11.9%
E. 14.1%
86. Financial Calculator Section
The following question(s) may require the use of a financial calculator.
Hamilton Company's 8 percent coupon rate, quarterly payment, $1,000 par value bond,
which matures in 20 years, currently sells at a price of $686.86. The company's tax rate
is 40 percent. Based on the simple interest rate, not the EAR, what is the firm's
component cost of debt for purposes of calculating the WACC?
A. 3.05%
B. 7.32%
C. 7.36%
D. 12.20%
E. 12.26%

Chapter 11 - The Cost of Cap

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Chapter 11--The Cost of Capital

1. Capital refers to items on the right-hand side of a firm's balance sheet.

2. The component costs of capital are market-determined variables in as much as they

4. The cost of issuing preferred stock by a corporation must be adjusted to an after-tax

26. Since 70 percent of preferred dividends received by a corporation is excluded from

Cost of equity = rs(0.30)(0.50) + rs(1 - T)(0.70)(0.50).

32. Which of the following statements is most correct?

35. The firm's weighted average cost of capital (WACC) is

36. The before-tax cost of debt, rd, is the same as the

46. Which of the following statements is most correct?

50. Which of the following statements is correct?

51. Which of the following statements is correct?

53. Which of the following statements is most correct?

54. Which of the following statements is correct?

Project Cost IRR

67. Gulf Electric Company

69. Byron Corporation

71. Rollins Corporation

Refer to Rollins Corporation. What is Rollins' component cost of debt?

Refer to Rollins Corporation. What is Rollins' cost of preferred stock?

73. Rollins Corporation

75. Rollins Corporation

Refer to Rollins Corporation. What is Rollins' lowest WACC?

77. Rollins Corporation

Refer to Rollins Corporation. What is Rollins' retained earnings break point?

79. Jackson Company

81. J. Ross and Sons Inc.

83. J. Ross and Sons Inc.

85. J. Ross and Sons Inc.

1. Capital refers to items on the right-hand side of a firm's balance sheet.

2. The component costs of capital are market-determined variables in as much as they

4. The cost of issuing preferred stock by a corporation must be adjusted to an after-tax

26. Since 70 percent of preferred dividends received by a corporation is excluded from

Cost of equity = rs(0.30)(0.50) + rs(1 - T)(0.70)(0.50).

32. Which of the following statements is most correct?

35. The firm's weighted average cost of capital (WACC) is

36. The before-tax cost of debt, rd, is the same as the

46. Which of the following statements is most correct?

50. Which of the following statements is correct?

51. Which of the following statements is correct?

53. Which of the following statements is most correct?

54. Which of the following statements is correct?

Project Cost IRR

67. Gulf Electric Company

69. Byron Corporation

71. Rollins Corporation

Refer to Rollins Corporation. What is Rollins' component cost of debt?

Refer to Rollins Corporation. What is Rollins' cost of preferred stock?

73. Rollins Corporation

75. Rollins Corporation

Refer to Rollins Corporation. What is Rollins' lowest WACC?

77. Rollins Corporation

Refer to Rollins Corporation. What is Rollins' retained earnings break point?

79. Jackson Company

81. J. Ross and Sons Inc.

83. J. Ross and Sons Inc.

85. J. Ross and Sons Inc.

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