Question 1

The reason why reinvested 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 reinvested earnings is based on the opportunity cost principle.

Accepted Answer

A) True 
 B)False

Question 2

The cost of equity raised by retaining earnings can be less than,equal to,or greater than the cost of external equity raised by selling new issues of common stock,depending on tax rates,flotation costs,the attitude of investors,and other factors.

Accepted Answer

A) True 
 B)False

Question 3

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.

Accepted Answer

A) True 
 B)False

Question 4

To help estimate its cost of common equity,Maxwell and Associates recently hired you.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 reinvested earnings?

Accepted Answer

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

Question 5

Which of the following statements is CORRECT?

Accepted Answer

A)  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.
B)  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.
C)  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.
D)  The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm's cost of equity capital.
E)  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.F) A) and B)
G) C) and E)

Question 6

For capital budgeting and cost of capital purposes,the firm should always consider reinvested earnings as the first source of capital⎯i.e.,use these funds first⎯because reinvested earnings have no cost to the firm.

Accepted Answer

A) True 
 B)False

Question 7

Burnham Brothers Inc.has no retained earnings since it has always paid out all of its earnings as dividends.This same situation is expected to persist in the future.The company uses the CAPM to calculate its cost of equity,and its target capital structure consists of common stock,preferred stock,and debt.Which of the following events would REDUCE its WACC?

Accepted Answer

A)  The flotation costs associated with issuing new common stock increase.
B)  The company's beta increases.
C)  Expected inflation increases.
D)  The flotation costs associated with issuing preferred stock increase.
E)  The market risk premium declines.F) B) and C)
G) A) and B)

Question 8

The cost of debt,rd,is normally less than rs,so rd(1 − T)will normally be much less than rs.Therefore,as long as the firm is not completely debt financed,the weighted average cost of capital (WACC)will normally be greater than rd(1 − T).

Accepted Answer

A) True 
 B)False

Question 9

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method,the DCF method,and the bond-yield-plus-risk-premium method.However,only the CAPM method always provides an accurate and reliable estimate.

Accepted Answer

A) True 
 B)False

Question 10

Suppose the debt ratio (D/TA)is 50%,the interest rate on new debt is 8%,the current cost of equity is 16%,and the tax rate is 40%.An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

Accepted Answer

A) True 
 B)False

Question 11

As the winner of a contest,you are now CFO for the day for Maguire Inc.and your day's job involves raising capital for expansion.Maguire's common stock currently sells for $45.00 per share,the company expects to earn $2.75 per share during the current year,its expected payout ratio is 70%,and its expected constant growth rate is 6.00%.New stock can be sold to the public at the current price,but a flotation cost of 8% would be incurred.By how much would the cost of new stock exceed the cost of common from reinvested earnings?

Accepted Answer

A)  0.09%
B)  0.19%
C)  0.37%
D)  0.56%
E)  0.84%F) A) and E)
G) A) and D)

Question 12

If a firm is privately owned,and its stock is not traded in public markets,then we cannot measure its beta for use in the CAPM model,we cannot observe its stock price for use in the DCF model,and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method.All this makes it especially difficult to estimate the cost of equity for a private company.

Accepted Answer

A) True 
 B)False

Question 13

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them,and no flotation costs are required to raise them,but capital raised by selling new stock or bonds does have a cost.

Accepted Answer

A) True 
 B)False

Question 14

The CEO of Harding Media Inc.as asked you to help estimate its cost of common equity.You have obtained the following data: D0 = $0.85; P0 = $22.00; and g = 6.00% (constant) .The CEO thinks,however,that the stock price is temporarily depressed,and that it will soon rise to $40.00.Based on the DCF approach,by how much would the cost of common from reinvested earnings change if the stock price changes as the CEO expects?

Accepted Answer

A)  −1.49%
B)  −1.66%
C)  −1.84%
D)  −2.03%
E)  −2.23%F) A) and D)
G) B) and E)

Question 15

The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

Accepted Answer

A) True 
 B)False

Question 16

You are a finance intern at Chambers and Sons and they have asked you to help estimate the company's cost of common equity.You obtained the following data: D1 = $1.25; P0 = $27.50; g = 5.00% (constant) ; and F = 6.00%.What is the cost of equity raised by selling new common stock?

Accepted Answer

A)  9.06%
B)  9.44%
C)  9.84%
D)  10.23%
E)  10.64%F) A) and B)
G) None of the above

Question 17

Quinlan Enterprises stock trades for $52.50 per share.It is expected to pay a $2.50 dividend at year end (D1 = $2.50) ,and the dividend is expected to grow at a constant rate of 5.50% a year.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 reinvested earnings?

Accepted Answer

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

Question 18

Bloom and Co.has no debt or preferred stock⎯it uses only equity capital,and has two equally-sized divisions.Division X's cost of capital is 10.0%,Division Y's cost is 14.0%,and the corporate (composite) WACC is 12.0%.All of Division X's projects are equally risky,as are all of Division Y's projects.However,the projects of Division X are less risky than those of Division Y.Which of the following projects should the firm accept?

Accepted Answer

A)  A Division Y project with a 12% return.
B)  A Division X project with an 11% return.
C)  A Division X project with a 9% return.
D)  A Division Y project with an 11% return.
E)  A Division Y project with a 13% return.F) A) and E)
G) None of the above

Question 19

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'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.
B)  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.
C)  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.
D)  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.
E)  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.F) All of the above
G) B) and C)

Question 20

Which of the following statements is CORRECT?

Accepted Answer

A)  If the calculated beta underestimates the firm's true investment risk⎯i.e., if the forward-looking beta that investors think exists exceeds the historical beta⎯then the CAPM method based on the historical beta will produce an estimate of rs and thus WACC that is too high.
B)  Beta measures market risk, which is, theoretically, the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. This is true even if not all of the firm's stockholders are well diversified.
C)  An advantage shared by both the DCF and CAPM methods when they are used to estimate the cost of equity is that they are both "objective" as opposed to "subjective," hence little or no judgment is required.
D)  The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach.
E)  The discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever.F) B) and E)
G) C) and D)

Exam 11: Determining the Cost of Capital

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.

Correct Answer
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Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them,and no flotation costs are required to raise them,but capital raised by selling new stock or bonds does have a cost.

Correct Answer
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The cost of equity raised by retaining earnings can be less than,equal to,or greater than the cost of external equity raised by selling new issues of common stock,depending on tax rates,flotation costs,the attitude of investors,and other factors.

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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The cost of debt,r_d,is normally less than r_s,so r_d(1 − T)will normally be much less than r_s.Therefore,as long as the firm is not completely debt financed,the weighted average cost of capital (WACC)will normally be greater than r_d(1 − T).

Correct Answer
verified

To help estimate its cost of common equity,Maxwell and Associates recently hired you.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 reinvested earnings?

Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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You are a finance intern at Chambers and Sons and they have asked you to help estimate the company's cost of common equity.You obtained the following data: D₁ = $1.25; P₀ = $27.50; g = 5.00% (constant) ; and F = 6.00%.What is the cost of equity raised by selling new common stock?

Correct Answer
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Correct Answer
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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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The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method,the DCF method,and the bond-yield-plus-risk-premium method.However,only the CAPM method always provides an accurate and reliable estimate.

Correct Answer
verified

For capital budgeting and cost of capital purposes,the firm should always consider reinvested earnings as the first source of capital⎯i.e.,use these funds first⎯because reinvested earnings have no cost to the firm.

Correct Answer
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Correct Answer
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Correct Answer
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The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

Correct Answer
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Correct Answer
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Correct Answer
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Suppose the debt ratio (D/TA)is 50%,the interest rate on new debt is 8%,the current cost of equity is 16%,and the tax rate is 40%.An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

Correct Answer
verified

Correct Answer
verified

Exam 11: Determining the Cost of Capital

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.

Correct AnswerverifiedShow Answer

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them,and no flotation costs are required to raise them,but capital raised by selling new stock or bonds does have a cost.

Correct AnswerverifiedShow Answer

The cost of equity raised by retaining earnings can be less than,equal to,or greater than the cost of external equity raised by selling new issues of common stock,depending on tax rates,flotation costs,the attitude of investors,and other factors.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

The cost of debt,rd,is normally less than rs,so rd(1 − T)will normally be much less than rs.Therefore,as long as the firm is not completely debt financed,the weighted average cost of capital (WACC)will normally be greater than rd(1 − T).

Correct AnswerverifiedShow Answer

To help estimate its cost of common equity,Maxwell and Associates recently hired you.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 reinvested earnings?

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

You are a finance intern at Chambers and Sons and they have asked you to help estimate the company's cost of common equity.You obtained the following data: D1 = $1.25; P0 = $27.50; g = 5.00% (constant) ; and F = 6.00%.What is the cost of equity raised by selling new common stock?

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

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method,the DCF method,and the bond-yield-plus-risk-premium method.However,only the CAPM method always provides an accurate and reliable estimate.

Correct AnswerverifiedShow Answer

For capital budgeting and cost of capital purposes,the firm should always consider reinvested earnings as the first source of capital⎯i.e.,use these funds first⎯because reinvested earnings have no cost to the firm.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Suppose the debt ratio (D/TA)is 50%,the interest rate on new debt is 8%,the current cost of equity is 16%,and the tax rate is 40%.An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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The cost of debt,r_d,is normally less than r_s,so r_d(1 − T)will normally be much less than r_s.Therefore,as long as the firm is not completely debt financed,the weighted average cost of capital (WACC)will normally be greater than r_d(1 − T).

Correct Answer
verified

To help estimate its cost of common equity,Maxwell and Associates recently hired you.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 reinvested earnings?

Correct Answer
verified

Correct Answer
verified

You are a finance intern at Chambers and Sons and they have asked you to help estimate the company's cost of common equity.You obtained the following data: D₁ = $1.25; P₀ = $27.50; g = 5.00% (constant) ; and F = 6.00%.What is the cost of equity raised by selling new common stock?

Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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