Question 1

Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A's cost of capital is 10.0%, Division B's cost is 14.0%, and the corporate (composite)  WACC is 12.0%. All of Division A's projects are equally risky, as are all of Division B's projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept?

Accepted Answer

A)   A Division B project with a 13% return.
B)   A Division B project with a 12% return.
C)   A Division A project with an 11% return.
D)   A Division A project with a 9% return.
E)   A Division B project with an 11% return.F) A) and D)
G) C) and E)

Question 2

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

Accepted Answer

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

Question 3

When estimating the cost of equity by use of the DCF method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return. This problem leaves us unsure of the true value of rs.

Accepted Answer

A) True 
 B)False

Question 4

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

Accepted Answer

A) True 
 B)False

Question 5

You were recently hired by Scheuer Media Inc. to estimate its cost of common equity. You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.00% (constant) ; and F = 5.00%. What is the cost of equity raised by selling new common stock?

Accepted Answer

A)   10.77%
B)   11.33%
C)   11.90%
D)   12.50%
E)   13.12%F) B) and D)
G) A) and C)

Question 6

Safeco Company and Risco Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Safeco having a WACC of 10% and Risco a WACC of 12%. Safeco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Safeco project. Risco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Risco project. Now assume that the two companies merge and form a new company, Safeco/Risco Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is CORRECT?

Accepted Answer

A)   If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.
B)   If evaluated using the correct post-merger WACC, Project X would have a negative NPV.
C)   After the merger, Safeco/Risco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y.
D)   Safeco/Risco's WACC, as a result of the merger, would be 10%.
E)   After the merger, Safeco/Risco should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%.F) D) and E)
G) None of the above

Question 7

Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.

Accepted Answer

A)   If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms' assets.
B)   If a firm's managers want to maximize the value of their firm's stock, they should, in theory, concentrate on project risk as measured by the standard deviation of the project's expected future cash flows.
C)   If a firm evaluates all projects using the same cost of capital, and the CAPM is used to help determine that cost, then its risk as measured by beta will probably decline over time.
D)   Projects with above-average risk typically have higher than average expected returns. Therefore, to maximize a firm's intrinsic value, its managers should favor high-beta projects over those with lower betas.
E)   Project A has a standard deviation of expected returns of 20%, while Project B's standard deviation is only 10%. A's returns are negatively correlated with both the firm's other assets and the returns on most stocks in the economy, while B's returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital.F) A) and E)
G) D) and E)

Question 8

Teall Development Company hired you as a consultant to help them estimate its cost of capital. You have been provided with the following data: D1 = $1.45; P0 = $22.50; and g = 6.50% (constant) . Based on the DCF approach, what is the cost of common from retained earnings?

Accepted Answer

A)   11.10%
B)   11.68%
C)   12.30%
D)   12.94%
E)   13.59%F) A) and C)
G) A) and B)

Question 9

Which of the following statements is CORRECT?

Accepted Answer

A)   A change in a company's target capital structure cannot affect its WACC.
B)   WACC calculations should be based on the before-tax costs of all the individual capital components.
C)   Flotation costs associated with issuing new common stock normally reduce the WACC.
D)   If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline.
E)   An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.F) None of the above
G) A) and C)

Question 10

Sorensen Systems Inc. is expected to pay a $2.50 dividend at year end (D1 = $2.50) , the dividend is expected to grow at a constant rate of 5.50% a year, and the common stock currently sells for $52.50 a share. The before-tax cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of 45% debt and 55% common equity. What is the company's WACC if all the equity used is from retained earnings?

Accepted Answer

A)   7.07%
B)   7.36%
C)   7.67%
D)   7.98%
E)   8.29%F) A) and D)
G) B) and C)

Question 11

The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

Accepted Answer

A) True 
 B)False

Question 12

Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant) . What is the cost of common from retained earnings based on the DCF approach?

Accepted Answer

A)   9.42%
B)   9.91%
C)   10.44%
D)   10.96%
E)   11.51%F) C) and D)
G) None of the above

Question 13

Which of the following statements is CORRECT?

Accepted Answer

A)   When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.
B)   When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.
C)   Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM.
D)   If a company's beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence must issue new stock.
E)   Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC.F) B) and D)
G) B) and C)

Question 14

Assume that Kish Inc. hired you as a consultant to help estimate its cost of common equity. You have obtained the following data: D0 = $0.90; P0 = $27.50; and g = 7.00% (constant) . Based on the DCF approach, what is the cost of common from retained earnings?

Accepted Answer

A)   9.29%
B)   9.68%
C)   10.08%
D)   10.50%
E)   10.92%F) A) and C)
G) D) and E)

Question 15

If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.

Accepted Answer

A) True 
 B)False

Question 16

Which of the following statements is CORRECT?

Accepted Answer

A)   The component cost of preferred stock is expressed as rp(1 - T) . This follows because preferred stock dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes.
B)   A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firm's stockholders would themselves expect to earn a return on earnings that were distributed rather than retained and reinvested.
C)   No cost should be assigned to retained earnings because the firm does not have to pay anything to raise them. They are generated as cash flows by operating assets that were raised in the past; hence, they are "free."
D)   Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into the foreseeable future. In this case, the firm's before-tax and after-tax costs of debt for purposes of calculating the WACC will both be equal to the interest rate on the firm's currently outstanding debt, provided that debt was issued during the past 5 years.
E)   If 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 WACC.F) C) and D)
G) A) and B)

Question 17

When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs.

Accepted Answer

A) True 
 B)False

Question 18

For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is CORRECT?

Accepted Answer

A)   The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet.
B)   The WACC is calculated on a before-tax basis.
C)   The WACC exceeds the cost of equity.
D)   The cost of equity is always equal to or greater than the cost of debt.
E)   The cost of retained earnings typically exceeds the cost of new common stock.F) B) and D)
G) D) and E)

Question 19

The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant.

Accepted Answer

A) True 
 B)False

Question 20

When working with the CAPM, which of the following factors can be determined with the most precision?

Accepted Answer

A)   The market risk premium (RPM) .
B)   The beta coefficient, bi, of a relatively safe stock.
C)   The most appropriate risk-free rate, rRF.
D)   The expected rate of return on the market, rM.
E)   The beta coefficient of "the market," which is the same as the beta of an average stock.F) None of the above
G) A) and B)

Exam 9: The Cost of Capital

Assume that Kish Inc. hired you as a consultant to help estimate its cost of common equity. You have obtained the following data: D0 = $0.90; P0 = $27.50; and g = 7.00% (constant) . Based on the DCF approach, what is the cost of common from retained earnings?

Correct Answer
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Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.

Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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Teall Development Company hired you as a consultant to help them estimate its cost of capital. You have been provided with the following data: D1 = $1.45; P0 = $22.50; and g = 6.50% (constant) . Based on the DCF approach, what is the cost of common from retained earnings?

Correct Answer
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The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

Correct Answer
verified

When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs.

Correct Answer
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Correct Answer
verified

The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant.

Correct Answer
verified

Correct Answer
verified

Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.

Correct Answer
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When working with the CAPM, which of the following factors can be determined with the most precision?

Correct Answer
verified

For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is CORRECT?

Correct Answer
verified

When estimating the cost of equity by use of the DCF method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return. This problem leaves us unsure of the true value of rs.

Correct Answer
verified

Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant) . What is the cost of common from retained earnings based on the DCF approach?

Correct Answer
verified

Correct Answer
verified

You were recently hired by Scheuer Media Inc. to estimate its cost of common equity. You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.00% (constant) ; and F = 5.00%. What is the cost of equity raised by selling new common stock?

Correct Answer
verified

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

Correct Answer
verified

Exam 9: The Cost of Capital

Assume that Kish Inc. hired you as a consultant to help estimate its cost of common equity. You have obtained the following data: D0 = $0.90; P0 = $27.50; and g = 7.00% (constant) . Based on the DCF approach, what is the cost of common from retained earnings?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Teall Development Company hired you as a consultant to help them estimate its cost of capital. You have been provided with the following data: D1 = $1.45; P0 = $22.50; and g = 6.50% (constant) . Based on the DCF approach, what is the cost of common from retained earnings?

Correct AnswerverifiedShow Answer

The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

Correct AnswerverifiedShow Answer

When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.

Correct AnswerverifiedShow Answer

When working with the CAPM, which of the following factors can be determined with the most precision?

Correct AnswerverifiedShow Answer

For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

When estimating the cost of equity by use of the DCF method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return. This problem leaves us unsure of the true value of rs.

Correct AnswerverifiedShow Answer

Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant) . What is the cost of common from retained earnings based on the DCF approach?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

You were recently hired by Scheuer Media Inc. to estimate its cost of common equity. You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.00% (constant) ; and F = 5.00%. What is the cost of equity raised by selling new common stock?

Correct AnswerverifiedShow Answer

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

Correct AnswerverifiedShow Answer

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