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13 Chapter - The cost of capital
Multiple Choice
31. Companies have no way to directly estimate the discount rate that reflects the risk of
a. a publicly traded security.
b. its debt securities.
*c. the incremental cash flows from a particular project.
d. none of the above.
32. A company's overall cost of capital is
a. equal to its cost debt.
*b. a weighted average of the costs of capital for the collection of individual projects that
the company is working on.
c. best measured by the cost of capital of the riskiest projects that the company is working
on.
d. none of the above.
33. The finance balance sheet is
*a. the same as the accounting balance sheet, but it is based on market values.
b. the same as the accounting balance sheet, but it does not have to balance.
c. based on cash rather than accrual accounting.
d. profit.
34. The value of the cash flows that the assets of the company are expected to generate must
equal
*a. the value of the cash flows claimed by the equity investors.
b. the value of the cash flows claimed by the debt investors.
c. the value of the cash flows claimed by both the equity and debt investors.
d. the revenue produced by the company.
35. The beta for a company can be estimated by
a. adding up the betas of the individual projects of the company.
*b. taking the weighted average of the beta for the individual projects of the company.
c. taking the simple average of the beta for the individual projects of the company.
d. None of the above.
13.2
36. The company can be viewed as
*a. a portfolio of individual projects, each with their own risks, cost of capital, and
returns.
b. a collection of equity shares comprising it.
c. a collection of debt instruments financing it.
d. none of the above.
37. In order for a company to estimate its cost of debt capital by observing the price of its debt
instruments,
*a. the company must depend on markets being reasonably efficient.
b. the debt must be privately held.
c. the beta of the debt must be greater than the beta of the company's equity.
d. None of the above.
38. If markets are not reasonably efficient, then
*a. the estimates of expected returns are not needed.
b. the need for a discount rate to analyse project cash flows is not needed.
c. estimates of expected returns that were based on security prices will not be reliable.
d. none of the above.
39. When estimating the cost of debt capital for the company, we are primarily interested in
a. the cost of short-term debt.
*b. the cost of long-term debt.
c. the coupon rate of the debt.
d. none of the above.
40. Long-term debt typically describes
a. debt with a maturity greater than one year.
b. only coupon debt.
*c. publicly traded debt.
d. none of the above.
John Wiley & Sons Australia, Ltd
13.3
41. Which of the following need to be excluded from the calculation of the company's amount of
permanent debt?
a. Long-term debt
b. Revolving lines of credit
*c. Mortgage debt
d. None of the above
42. When analysing a company's cost of debt, we are typically interested in
*a. the cost of the debt on the date that the analysis is being completed.
b. the coupon rate on the company's bonds.
c. the risk-free rate plus half a percent.
d. none of the above.
43. If a company has bonds outstanding and the company would like to calculate the current cost
of debt for the bonds, then the company would
a. use the coupon rate of the bonds to estimate the cost.
*b. use the current yield to maturity of the bonds to estimate the cost.
c. use the current coupon yield of the bonds to estimate the cost.
d. none of the above.
44. A bond has a coupon rate of 6 percent and the bond makes semiannual coupon payments.
The dollar amount of coupon interest received every six months is
a. $60.
*b. $30.
c. $30 plus or minus the prorate portion of the discount or premium that the bond was
purchased for.
d. none of the above.
45. Bond issuance costs include
a. investment banking fees.
b. legal fees.
c. accountant fees.
*d. all of the above.
13.4
46. Income tax have the effect of
a. increasing the cost of debt.
*b. decreasing the cost of debt.
c. decreasing the cost of capital for the company.
d. both b and c are correct.
47. The appropriate risk-free rate to use when calculating the cost of equity for a company is
*a. a long-term Treasury rate.
b. a short-term Treasury rate.
c. a 50/50 mix of short-term and long-term Treasury rates.
d. none of the above.
48. The average risk-premium for the Australian market from 1974 to 2009 was
a. 8.00%.
*b. 4.20%.
c. 6.51%.
d. 6.51% + the Treasury rate.
49. The recommended model to estimate the cost of ordinary shares for a company is
a. a one-stage constant growth model.
b. a multistage growth model.
*c. the CAPM.
d. none of the above.
50. In order to use the WACC to evaluate a future project's flows, which of the following must
hold?
a. The project will be financed with the same proportion of debt and equity as the
company.
b. The systematic risk of the project is the same as the overall systematic risk of the
company.
c. The project must be viable.
*d. a and b above.
John Wiley & Sons Australia, Ltd
13.5
51. Overall cost of capital: If the market risk premium is currently 6 percent and the risk-free rate
of return is 4 percent, then what is the expected return on a common share with a beta equal to 2?
a. 8.0%
b. 10.0%
c. 12.0%
*d. 16.0%
52. Overall cost of capital: What is the beta of a company whose equity has an expected return of
21.3 percent when the risk-free rate of return is 7.0 percent and the expected return on the market
is 18.0 percent?
a. 0.79
*b. 1.30
c. 1.57
d. none of the above
53. Overall cost of capital: Stryder, Ltd., has 3 million shares outstanding at a current price of
$15 per share. The book value of the shares is $10 per share. The company also has $30 million
in par value of bonds outstanding. The bonds are selling at a price equal to 101 percent of par.
What is the market value of the company?
a. $30.0 million
b. $45.0 million
c. $75.0 million
*d. $75.3 million
54. How companies estimate their cost of capital: The Diverse Co. has invested 40 percent of
the company's assets in a project with a beta of 0.4 and the remaining assets in a project with a
beta of 1.8. What is the beta of the company?
a. 0.96
*b. 1.24
c. 1.28
d. None of the above
13.6
55. How companies estimate their cost of capital: You are analysing the cost of capital for a
company that is financed with 65 percent equity and 35 percent debt. The cost of debt capital is 8
percent, while the cost of equity capital is 20 percent for the company. What is the overall cost of
capital for the company?
a. 12.2%
b. 14.0%
*c. 15.8%
d. 20.0%
56. How companies estimate their cost of capital: You are analysing the cost of capital for a
company that is financed with $300 million of equity and $200 million of debt. The cost of debt
capital for the company is 9 percent, while the cost of equity capital is 19 percent . What is the
overall cost of capital for the company?
a. 13.0%
b. 14.0%
*c. 15.0%
d. 16.0%
57. How companies estimate their cost of capital: The WACC for a company is 19.75 percent.
You know that the company is financed with $75 million of equity and $25 million of debt. The
cost of debt capital is 7 percent. What is the cost of equity for the company?
a. 19.75%
*b. 24.00%
c. 32.50%
d. 58.00%
58. How companies estimate their cost of capital: The WACC for a company is 13.00 percent.
You know that the company's cost of debt capital is 10 percent and the cost of equity capital is
20%. What proportion of the company is financed with debt?
a. 30%
b. 33%
*c. 50%
d. 70%
John Wiley & Sons Australia, Ltd
13.7
59. The cost of debt: Bellamee, Ltd., has bonds outstanding with five years to maturity and are
priced at $920.87. If the bonds have a coupon rate of 7 percent, then what is the YTM for the
bonds?
a. 4.5%
b. 7.0%
*c. 9.0%
d. 9.2%
60. The cost of debt: Dynamo company has bonds outstanding with 12 years to maturity and are
currently priced at $1,080.29. If the bonds have a coupon rate of 8 percent, then what is the
equivalent annual return (EAR) to the investor for purchasing the bonds at the described price?
a. 3.5%
b. 7.00%
*c. 7.12%
d. 8.00%
61. The cost of debt: Beckham company has bonds outstanding with 13 years to maturity and are
currently priced at $746.16. If the bonds have a coupon rate of 8.5 percent, then what is the aftertax cost of debt for Beckham if its company tax rate is 35%?
a. 6.250%
*b. 8.125%
c. 12.500%
d. 12.890%
62. The cost of debt: PackMan company has bonds outstanding with nine years to maturity and
are currently priced at $754.08. If the bonds have a coupon rate of 7.25 percent, then what is the
after-tax cost of debt for Beckham its if company tax rate is 30 percent?
*a. 7.050%
b. 8.225%
c. 11.750%
d. 12.095%
13.8
63. The cost of equity: Jacque Ewing Drilling, Ltd., has a beta of 1.3 and is trying to calculate its
cost of equity capital. If the risk-free rate of return is 8 percent and the expected return on the
market is 12 percent, then what is the company's after-tax cost of equity capital if the company's
company tax rate is 40 percent?
a. 7.92%
*b. 13.20%
c. 15.57%
d. 23.60%
64. The cost of equity: TeleNyckel, Ltd., has a beta of 1.4 and is trying to calculate its cost of
equity capital. If the risk-free rate of return is 9 percent and the market risk premium is 5 percent,
then what is the company's after-tax cost of equity capital if the company's company tax rate is
30 percent?
a. 11.20%
b. 10.60%
c. 15.14%
*d. 16.00%
65. The cost of equity: RadicalVenOil, Ltd., has a cost of equity capital equal to 22.8 percent. If
the risk-free rate of return is 10 percent and the expected return on the market is 18 percent, then
what is the company's beta if the company's company tax rate is 35 percent?
a. 1.0
b. 1.28
*c. 1.60
d. 4.10
66. The cost of equity: Gangland Water Guns, Ltd., is expected to pay a dividend of $2.10 one
year from today. If the company's growth in dividends is expected to remain at a flat 3 percent
forever, then what is the cost of equity capital for Gangland if the price of its ordinary shares is
currently $17.50?
a. 12.00%
b. 14.65%
*c. 15.00%
d. 15.36%
John Wiley & Sons Australia, Ltd
13.9
67. The cost of equity: UltraFlex Diving Boards, Ltd., just paid a dividend of $1.50. If the
company's growth in dividends is expected to remain at a flat 4 percent forever, then what is the
cost of equity capital for Ultra Flex Diving Boards if the price of its ordinary shares is currently
$26.00?
a. 5.77%
b. 6.00%
c. 9.77%
*d. 10.00%
68. The cost of equity: Rubber Chicken, Ltd., was paid a dividend of $1.87 last year. If the
company's growth in dividends is expected to be 10 percent next year and then zero thereafter,
then what is the cost of equity capital for Rubber Chicken if the price of its ordinary shares is
currently $25.71?
a. 7.27%
*b. 8.00%
c. 18.00%
d. The problem is not solvable with the information that is given.
69. The cost of equity: The Dedus Shoes, Ltd., has common shares with a price of $28.76 per
share. The company paid a dividend of $1.00 yesterday, and dividends are expected to grow at
10 percent for two years and then at 5 percent thereafter. What is the implied cost of ordinary
shares for Dedus?
a. 7.00%
b. 8.00%
*c. 9.00%
d. 10.00%
70. The cost of equity: Tranquility, Ltd., has common shares with a price of $18.37 per share.
The company paid a dividend of $1.50 yesterday, and dividends are expected to grow at 9
percent for three years and then at 2 percent thereafter. What is the implied cost of ordinary
shares for Tranquility?
a. 9%
b. 10%
c. 11%
*d. 12%
13.10
71. The cost of equity: Oasis, Ltd., has common shares with a price of $21.12 per share. The
company is expected to pay a dividend of $1.75 one year from today, and dividends are expected
to grow at 10 percent for two years after that and then at 5 percent thereafter. What is the implied
cost of ordinary shares for Oasis?
a. 13%
*b. 14%
c. 15%
d. 16%
72. The cost of preference shares: Billy's Goat Coats has a preference share issue outstanding
with a current price of $38.89. The company last paid a dividend on the issue of $3.50 per share.
What is the company's cost of preference shares?
a. 7%
b. 8%
*c. 9%
d. 10%
73. The cost of equity: Wally's War Duds has a preference share issue outstanding with a current
price of $26.57. The company is expected to pay a dividend of $1.86 per share a year from today.
What is the company's cost of preference shares?
a. 6.50%
*b. 7.00%
c. 7.50%
d. 8.00%
74. The cost of equity: Melba's Toast has a preference share issue outstanding with a current
price of $19.50. The company is expected to pay a dividend of $2.34 per share a year from today.
What is the company's cost of preference shares?
a. 11.50%
b. 11.75%
*c. 12.00%
d. 12.25%
John Wiley & Sons Australia, Ltd
13.11
75. Using the WACC in practice: Swirlpool, Ltd., has found that its cost of equity capital is 18
percent, and its cost of debt capital is 8 percent. If the company is financed with 60 percent
ordinary shares and 40 percent debt, then what is the after-tax weighted average cost of capital
for Swirlpool if it is subject to a 40 percent company tax rate?
a. 10.37%
b. 12.00%
*c. 12.72%
d. 14.00%
76. Using the WACC in practice: Maloney's, Ltd., has found that its cost of equity capital is 17
percent and its cost of debt capital is 6 percent. If the company is financed with $3,000,000 of
ordinary shares (market value) and $2,000,000 of debt, then what is the after-tax weighted
average cost of capital for Maloney's if it is subject to a 40 percent company tax rate?
a. 8.96%
b. 11.16%
*c. 11.64%
d. 12.60%
77. Using the WACC in practice: Ronnie's Comics has found that its cost of equity capital is 15
percent and its cost of debt capital is 12 percent. If the company is financed with $250,000,000
of ordinary shares (market value) and $750,000,000 of debt, then what is the after-tax weighted
average cost of capital for Ronnie's if it is subject to a 35 percent company tax rate?
a. 6.05%
*b. 6.95%
c. 8.75%
d. 13.65%
78. Using the WACC in practice: Poly's Parrot Shops has found that its cost of equity capital is
17 percent. It has 7-year maturity bonds outstanding with a price of $767.03 that have a coupon
rate of 7 percent. If the company is financed with $120,000,000 of ordinary shares (market
value) and $80,000,000 of debt, then what is the after-tax weighted average cost of capital for
Poly's if it is subject to a 35 percent company tax rate?
a. 10.20%
b. 11.76%
c. 11.88%
*d. 13.32%
13.12
79. Using the WACC in practice: Marley's Pipe Shops has found that its equity capital shares
have a beta equal to 1.5 while the risk-free return is 8 percent and the expected return on the
market is 14 percent. Its cost of debt financing is 12 percent. If the company is financed with
$120,000,000 of ordinary shares (market value) and $80,000,000 of debt, then what is the aftertax weighted average cost of capital for Marley's if it is subject to a 35 percent company tax rate?
a. 10.20%
b. 11.76%
c. 11.88%
*d. 13.32%
80. Using the WACC in practice: Droz's Hiking Gear, Ltd., has found that its equity capital
shares have a beta equal to 1.5 while the risk-free return is 8 percent and the expected return on
the market is 14 percent. It has 7-year maturity bonds outstanding with a price of $767.03 that
have a coupon rate of 7 percent.. If the company is financed with $120,000,000 of ordinary
shares (market value) and $80,000,000 of debt, then what is the after-tax weighted average cost
of capital for Droz's if it is subject to a 35 percent company tax rate?
a. 10.20%
b. 11.76%
c. 11.88%
*d. 13.32%
John Wiley & Sons Australia, Ltd
13.13
Essay Questions
81. Briefly explain why the book value of debt might not reflect the current cost of debt for the
company, with respect to a single issuance of debt?
Correct Answer:
The book value of debt (or bonds) will be reflective of the market and company risks at the time
the bonds were issued. If market or company conditions have changed materially since that time,
then the market price of the bonds will reflect the current cost of debt equity for the company
rather than the book value of that debt.
82. Explain the conditions under which the constant-growth dividend formula for the cost of
ordinary shares can be used to find the cost of equity capital for the company.
Correct Answer:
The first condition that must hold is that the growth rate in dividends must be constant for the
foreseeable future of the company. This condition does not generally hold for growing or
contracting companies. The second condition is that the growth rate in dividends must be less
than the cost of equity capital for the company.
83. Discuss the two major conditions for when the company may use its current weighted
average cost of capital to evaluate a new project's cash flows.
Correct Answer:
The first condition is that the proportions of capital (debt, ordinary shares, preference shares) that
the company is relying on to finance the company must also be utilised to finance the new
project. Any material deviation from that mix will alter the individual cost of each type of
financing. The second condition is that the level of systematic risk inherent in the overall
portfolio of projects the company is currently taking on must be the same as the level of
systematic risk for the new project.
13.14

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Middle East Technical University - PHYSICS - PHYS 106

PROBLEM (1) (25 points)A parallel plate capacitor of plate separation d is half filledwith a dielectric slab of dielectric constant K = 5, as shownAird/2din the figure. With the slab in place, it is charged to aKpotential difference V and then dis

Air Force Academy - CS - 321

ECS Case IntroductionIn this section you will learn the background information that will prepare you to understand and complete each of the milestones of this case study. This information includes a history of the business, a description of the business'

Air Force Academy - CS - 321

Week 1: Milestone 1 DescriptionCase BackgroundIn this milestone, you will prepare a Request for System Services Form, which is the trigger for the Preliminary Investigation Phase. Also, you will use fact-finding techniques to extract and analyze informa

Concordia Canada - COMP - 232

Lecture Notes on DISCRETE MATHEMATICSEusebius Doedel1LOGIC Introduction. First we introduce some basic concepts needed in our discussion of logic. These will be covered in more detail later. A set is a collection of "objects" (or "elements"). Examples.

Old Dominion - FIN - 432

Chapter1AnOverviewofFinancialManagement1TopicsinChapterBasicGoal:tocreateshareholdervalueAgencyrelationships:StockholdersversusmanagersStockholdersversuscreditorsTransparencyinfinancialreportingTheCostofMoney2Whyiscorporatefinanceimportanttoa

Old Dominion - FIN - 432

Chapter1WebExtension1AACloserLookatMarkets:SecuritizationandSocialWelfare1TopicsinWebExtensionThehomemortgageindustrySecuritizationinthemortgageindustry2HomeMortgagesBeforeS&LsTheproblemsifanindividualinvestortriedtolendmoneytoanaspiringhomeow

Old Dominion - FIN - 432

CHAPTER2RiskandReturn:PartI1TopicsinChapterBasicreturnconceptsBasicriskconceptsStandaloneriskPortfolio(market)riskRiskandreturn:CAPM/SML2Whatareinvestmentreturns?Investmentreturnsmeasurethefinancialresultsofaninvestment.Returnsmaybehistorical

Old Dominion - FIN - 432

Chapter3RiskandReturn:PartII1TopicsinChapterPortfolioTheoryCapitalAssetPricingModel(CAPM)EfficientFrontierCapitalMarketLine(CML)SecurityMarketLine(SML)BetacalculationArbitragepricingtheoryFamaFrench3factormodel2PortfolioTheorySupposeAssetAha

Old Dominion - FIN - 432

Chapter4BondValuation1TopicsinChapterKeyfeaturesofbondsBondvaluationMeasuringyieldAssessingrisk2KeyFeaturesofaBondParvalue:Faceamount;paidatmaturity.Assume$1,000.Couponinterestrate:Statedinterestrate.Multiplybyparvaluetogetdollarsofinterest.

Old Dominion - FIN - 432

Chapter6FinancialOptions1TopicsinChapterFinancialOptionsTerminologyOptionPriceRelationshipsBlackScholesOptionPricingModelPutCallParity2Whatisafinancialoption?Anoptionisacontractwhichgivesitsholdertheright,butnottheobligation,tobuy(orsell)anass

Old Dominion - FIN - 432

Chapter7AccountingforFinancialManagement1TopicsinChapterIncomestatementBalancesheetStatementofcashflowsAccountingincomeversuscashflowMVAandEVACorporatetaxes2IncomeStatement20082009Sales$3,432,000$5,834,400COGS2,864,0004,980,000340,000