Exam 10: The Cost of Capital

A) 11.15%
B) 11.73%
C) 12.35%
D) 13.00%
E) 13.65%

Correct Answer

verified

Show Answer

A) Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.
B) The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes.
C) If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.
D) Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt.
E) Higher flotation costs tend to reduce the cost of equity capital.

Correct Answer

verified

Show Answer

Correct Answer

verified

Show Answer

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, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity.
B) The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average after-tax cost of all the firm's outstanding debt.
C) Suppose some of a publicly-traded firm's stockholders are not diversified; they hold only the one firm's stock. In this case, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firm's intrinsic value.
D) The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity.
E) The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm's cost of equity capital.

Correct Answer

verified

Show Answer

A) Long-term debt.
B) Accounts payable.
C) Retained earnings.
D) Common stock.
E) Preferred stock.

Correct Answer

verified

Show Answer

Correct Answer

verified

Show Answer

Correct Answer

verified

True

A) When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation.
B) All else equal, an increase in a company's stock price will increase its marginal cost of retained earnings, rs.
C) All else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re.
D) Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt.
E) If a company's tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall.

Correct Answer

verified

Show Answer

A) Project B, which is of below-average risk and has a return of 8.5%.
B) Project C, which is of above-average risk and has a return of 11%.
C) Project A, which is of average risk and has a return of 9%.
D) None of the projects should be accepted.
E) All of the projects should be accepted.

Correct Answer

verified

Show Answer

A) Since the costs of internal and external equity are related, an increase in the flotation cost required to sell a new issue of stock will increase the cost of retained earnings.
B) Since its stockholders are not directly responsible for paying a corporation's income taxes, corporations should focus on before-tax cash flows when calculating the WACC.
C) An increase in a firm's tax rate will increase the component cost of debt, provided the YTM on the firm's bonds is not affected by the change in the tax rate.
D) When the WACC is calculated, it should reflect the costs of new common stock, retained earnings, preferred stock, long-term debt, short-term bank loans if the firm normally finances with bank debt, and accounts payable if the firm normally has accounts payable on its balance sheet.
E) If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the after-tax cost of debt.

Correct Answer

verified

Show Answer

A) 4.35%
B) 4.58%
C) 4.83%
D) 5.08%
E) 5.33%

Correct Answer

verified

D

Correct Answer

verified

Show Answer

Correct Answer

verified

False

A) 8.98%
B) 9.26%
C) 9.54%
D) 9.83%
E) 10.12%

Correct Answer

verified

Show Answer

A) 9.42%
B) 9.91%
C) 10.44%
D) 10.96%
E) 11.51%

Correct Answer

verified

Show Answer

A) The WACC is calculated using before-tax costs for all components.
B) The after-tax cost of debt usually exceeds the after-tax cost of equity.
C) For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock.
D) Retained earnings that were generated in the past and are reported on the firm's balance sheet are available to finance the firm's capital budget during the coming year.
E) The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital.

Correct Answer

verified

Show Answer

Correct Answer

verified

Show 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.

Correct Answer

verified

Show Answer