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11 Chapter - Cost of Capital Chapter 11 Cost of Capital True / False Questions 1. It is standard practice to evaluate investment decisions using the cost of the specific financing method involved. True False 2. The calculation of the cost of capital depends upon historical costs of funds. True False 3. The cost of capital for each source of funds is dependent on current market conditions and expected rates of return. True False 4. In determining the cost of debt, yields and prices of outstanding bonds are used. True False 5. The cost of debt is equal to the current bond yield on bonds of similar risk class and adjusted for the corporate tax rate. True False 6. The amount of debt capital used by a corporation is not related to the availability of equity funds from retained earnings and new common stock. True False 7. A firm's cost of preferred stock is equal to the preferred dividend divided by the net price after flotation costs. True False 11-1 Chapter 11 - Cost of Capital 8. A firm's cost of preferred stock is equal to the preferred dividend divided by market price plus the dividend growth rate (Kp= D/Po+ g). True False 9. The cost of new common stock is greater than the cost of outstanding common stock. True False 10. In determining the cost of preferred stock, the earnings on outstanding preferred stock may be used as a proxy. True False 11. The out-of-pocket cost of common stock is a good approximation of the cost of common stock equity. True False 12. The discount rate that equates a future stream of expected dividends to the current price is a good approximation of the cost of common stock. True False 13. Kerepresents an expected return to stockholders as well as a cost to the firm. True False 14. The cost of retained earnings is equal to the required rate of return on a firm's outstanding common stock. True False 11-2 Chapter 11 - Cost of Capital 15. Retained earnings represent an internal source of funds that is raised without the payment of interest, or cost to the firm's stockholders. True False 16. The only difference in the cost of retained earnings (Ke) and the cost of new common stock (Kn) is the flotation cost on new common stock. True False 17. Regardless of the particular source of funds utilized for a project, the required rate of return, or discount rate, will be the weighted average cost of capital. True False 18. The use of common stock equity in the weighted average cost of capital is always (Ke) and not (Kn), the cost of new common stock. True False 19. The use of the optimum capital structure minimizes the cost of capital. True False 20. All firms within particular industries have similar optimum capital structures. True False 21. A firm should always be at a single optimum debt to equity ratio to minimize its cost of capital. True False 11-3 Chapter 11 - Cost of Capital 22. Weights used to calculate the weighted average cost of capital Kaare derived from the optimum capital structure. True False 23. Taking on additional debt will reduce the cost of equity. True False 24. Firms in stable industries are advised to keep debt levels very low so that shareholders, rather than creditors, receive the benefits of steady cash flows. True False 25. Most firms are able to use 60%-70% debt in their capital structure without exceeding norms acceptable to most creditors and investors. True False 26. Although the after-tax cost of debt is below the cost of equity, firms cannot increase their use of debt without limit. True False 27. According to traditional financial theory, the cost of capital curve is U-shaped over the range of debt-equity mixes. True False 28. A firm that does not earn the cost of capital in the short run will probably be in bankruptcy. True False 11-4 Chapter 11 - Cost of Capital 29. A firm that does not earn the cost of capital in the long run will not maximize shareholder wealth. True False 30. Companies prefer to maintain some financing flexibility in order to choose the lowest cost source of funds at a single point in time. True False 31. The use of the weighted average cost of capital assumes that the firm is in its optimum capital structure range and the cost of each component stays constant over the range of financing. True False 32. Market values rather than book values should be used for determining the optimal capital structure, though in practice, book value is commonly used. True False 33. In determining the optimum capital structure it is assumed that the firm will raise capital in the optimum proportions every year. True False 34. The pretax cost of debt is less than the pretax cost of equity. True False 35. The capital asset pricing model (CAPM) relates the risk-return tradeoffs of individual assets to market returns. True False 11-5 Chapter 11 - Cost of Capital 36. Individual common stocks' betas have a tendency to move toward 1.0 over time. True False 37. In the capital asset pricing model (CAPM), beta measures the volatility of the market. True False 38. Per the capital asset pricing model, the slope of the security market line (SML) must be 1.0. True False 39. The financial managers of the firm decide on its cost of capital for financing projects. True False 40. The cost of debt, preferred stock, and common equity must all be adjusted for tax implications. True False 41. Although debt financing is generally cheaper than equity financing, financial managers should not use debt financing significantly above the industry standard because it can increase the firm's overall cost of capital. True False 42. The cost of capital generally varies inversely with the size of the capital structure. True False 43. As the risk-free rate increases, the required rate of return for common stock decreases. True False 11-6 Chapter 11 - Cost of Capital 44. A firm with a higher beta than another firm will have a higher required rate of return. True False 45. The slope of the security market line (SML) will often increase when the economy is in a boom period. True False Multiple Choice Questions 46. Each project should be judged against A. the specific means of financing used to support its implementation. B. the going interest rate at that point in time. C. the cost of new common stock equity. D. none of these. 47. Financial capital does not include A. stock. B. bonds. C. preferred stock. D. working capital. 48. The overall weighted average cost of capital is used instead of costs for specific sources of funds because A. use of the cost for specific sources of capital would make investment decisions inconsistent. B. a project with the highest return would always be accepted under the specific cost criteria. C. investments funded by low cost debt would have an advantage over other investments. D. both a and c are correct. 11-7 Chapter 11 - Cost of Capital 49. Debreu Beverages has an optimal capital structure that is 70% common equity, 20% debt, and 10% preferred stock. Debreu's pretax cost of equity is 9%. Its pretax cost of preferred equity is 7%, and its pretax cost of debt is also 5%. If the corporate tax rate is 35%, what is the weighed average cost of capital? A. Between 7% and 8% B. Between 8% and 9% C. Between 9% and 10% D. Between 10% and 12% 50. Given an optimal capital structure that is 50% debt and 50% common stock, calculate the weighted average cost of capital for Stone Corp given the following additional information: Bond coupon rate..8% Bond yield to maturity..6% Dividend, expected..$5 Price, common.$80 Growth rate.5% Corporate tax rate30% A. less than 5.0%. B. more than 5.0% and less than 6.25%. C. more than 6.25% and less than 7.5%. D. more than 7.5%. 51. For a firm paying 5% for new debt, the higher the firm's tax rate A. the higher the after-tax cost of debt. B. the lower the after-tax cost of debt. C. after-tax cost is unchanged. D. Not enough information to judge. 52. If a firm's bonds are currently yielding 6% in the marketplace, why would the firm's cost of debt be lower? A. Interest rates have changed. B. Additional debt can be issued more cheaply than the original debt. C. There should be no difference; cost of debt is the same as the bond's market yield. D. Interest is tax-deductible. 11-8 Chapter 11 - Cost of Capital 53. The cost of debt is determined by taking the A. present value of the interest payments and principal times one minus the tax rate. B. historical yield on bonds times one minus the tax rate. C. estimated yield on new bond issues of the same risk times one minus the shareholder marginal tax rate. D. none of these. 54. The coupon rate on a debt issue is 6%. If the yield to maturity on the debt is 9%, what is the after-tax cost of debt in the weighted average cost of capital if the firm's tax rate is 34%? A. 3.96% B. 4.08% C. 5.94% D. 7.92% 55. The coupon rate on an issue of debt is 8%. The yield to maturity on this issue is 10%. The corporate tax rate is 31%. What would be the approximate after-tax cost of debt for a new issue of bonds? A. 5.28% B. 2.48% C. 6.90% D. 3.14% 56. A firm's cost of financing, in an overall sense, is equal to its A. weighted average cost of capital. B. required yield that investors seek for various kinds of securities. C. required rate of return that investors seek for various kinds of securities. D. all of these. 11-9 Chapter 11 - Cost of Capital 57. A firm has $50 million in assets and its optimal capital structure is 60% equity. If the firm has $12 million in retained earnings, at what asset level will the firm need to issue additional stock? (Assume no growth in retained earnings.) A. The firm should have already issued additional stock. B. The firm can increase assets to $30 million. C. The firm can increase assets to $20 million. D. There is insufficient information to determine an answer. 58. Klein Corp. can issue $1,000 par value bond that pays $90 per year in interest at a price of $980. The bond will have a 10-year life. The firm is in a 35% tax bracket. What is the aftertax cost of debt? A. 9.14% B. 9.30% C. 5.87% D. 6.8% 59. Tobin's Barbeque has a bank loan at 8% interest and an after-tax cost of debt of 6%. What will the after-tax cost of debt be when the loan is due if a new loan is taken out yielding 11%. A. 7.52% B. 8.25% C. 13.33% D. none of these 60. The pre-tax cost of debt for a new issue of debt is determined by A. the investor's required rate of return on issued stock. B. the coupon rate of existing debt. C. the yield to maturity of outstanding bonds. D. all of these. 11-10 Chapter 11 - Cost of Capital 61. Lewis, Schultz and Nobel Development Corp. has an after-tax cost of debt of 4.5 percent. With a tax rate of 30 percent, what is the yield on the debt? A. 4.41% B. 9.0% C. 1.89% D. 6.43% 62. The after-tax cost of preferred stock to the issuing corporation A. is the same as the before-tax cost. B. is usually lower than the cost of debt. C. is dependent on the firm's tax bracket. D. none of these. 63. A firm is paying an annual dividend of $2.65 for its preferred stock which is selling for $57.00. There is a selling cost of $3.30. What is the after-tax cost of preferred stock if the firm's tax rate is 33%? A. 2.02% B. 4.93% C. 5.79% D. 6.11% 64. Firm X has a tax rate of 30%. The price of its new preferred stock is $75 and its flotation cost is $3.15. The cost of new preferred stock is 8%. What is the firm's dividend? A. $7.18 B. $5.75 C. $7.56 D. none of these. 65. The cost of equity capital in the form of new common stock will be higher than the cost of retained earnings because of A. the existence of taxes. B. the existence of flotation costs. C. investors' unwillingness to purchase additional shares of common stock. D. the existence of financial leverage. 11-11 Chapter 11 - Cost of Capital 66. If the flotation cost goes up, the cost of retained earnings will A. go up. B. go down. C. stay the same. D. slowly increase. 67. Why is the cost of debt normally lower than the cost of preferred stock? A. Preferred stock dividends are tax deductions. B. Interest is tax deductible. C. Preferred stock dividends must be paid before common stock dividends. D. Common stock dividends are not tax deductible. 68. If flotation costs go down, the cost of new preferred stock will A. go up. B. go down. C. stay the same. D. slowly increase. 69. A firm's preferred stock pays an annual dividend of $2, and the stock sells for $65. Flotation costs for new issuances of preferred stock are 5% of the stock value. What is the after-tax cost of preferred stock if the firm's tax rate is 30%? A. 1.2% B. 1.58% C. 3.20% D. 5.26% 70. Ten years ago, Stigler Company issued $100 par value preferred stock yielding 6 percent. The preferred stock is now selling for $102 per share. What is the current yield or cost of the preferred stock? (Disregard flotation costs.) A. 7.76%. B. 8%. C. 5.9%. D. There is not enough information to answer the question. 11-12 Chapter 11 - Cost of Capital 71. A firm's debt to equity ratio varies at times because A. a firm will want to sell common stock when prices are high and bonds when interest rates are low. B. a firm will want to take advantage of timing its fund raising in order to minimize costs over the long run. C. the market allows some leeway in the debt to equity ratio before penalizing the firm with a higher cost of capital. D. all of these are accurate statements. 72. Using the constant dividend growth model for common stock, if Po goes up A. the assumed cost goes up. B. the assumed cost goes down. C. the assumed cost remains unchanged. D. Need further information. 73. New common stock is more expensive than Ke A. to compensate for risk. B. to compensate for more dividends. C. to compensate for expansionary problems. D. to cover distribution costs. 74. In computing the cost of common equity, if D1 goes downward and Po goes up, Ke will A. go up. B. go down. C. stay the same. D. slowly increase. 75. In determining the cost of retained earnings A. the dividend valuation model is inappropriate. B. flotation costs are included. C. growth is not considered. D. the capital asset pricing model can be used. 11-13 Chapter 11 - Cost of Capital 76. Within the capital asset pricing model A. the risk-free rate is usually higher than the return in the market. B. the higher the beta the lower the required rate of return. C. beta measures the volatility of an individual stock relative to a stock market index. D. two of the above are true. 77. Using the constant growth model, a firm's expected (D1) dividend yield is 4% of the stock price, and its growth rate is 5%. If the tax rate is .35%, what is the firm's cost of equity? A. 10% B. 6.65% C. 9.0% D. More information is required 78. Expected cash dividends are $3.00, the dividend yield is 4%, flotation costs are 4% of price, and the growth rate is 3%. Compute cost of new common stock. A. 7.00% B. 7.2% C. 6.9% D. 4.2% 79. A firm's stock is selling for $65. The dividend yield is 6%. A 7% growth rate is expected for the common stock. The firm's tax rate is 40%. What is the firm's cost of retained earnings? A. 8.16% B. 13.00% C. 12.35% D. can not be determined. 80. A firm's stock is selling for $62. The next annual dividend is expected to be $3.00. The growth rate is 9%. The flotation cost is $5.00. What is the cost of retained earnings? A. 13.84% B. 12.46% C. 12.7% D. none of these 11-14 Chapter 11 - Cost of Capital 81. For many firms, the cheapest and most important source of equity capital is in the form of A. debt. B. common stock. C. preferred stock. D. retained earnings. 82. Retained earnings has a cost associated with it because: A. new funds must be raised. B. There is an opportunity cost associated with stockholder funds. C. Ke> g D. flotation costs increase the cost of funding. 83. There may be a change in the marginal cost of capital curve because A. the tax rate charged to investors changes. B. the firm has exhausted its supply of retained earnings. C. the firm is limited in the amount of depreciation it can take. D. a and b. 84. The after-tax cost of debt will almost always be below A. the before-tax cost of debt. B. the weighted average cost of capital. C. the cost of equity. D. all of these. 85. The optimal capital structure for firms in cyclical industries should contain ________________ than firms in stable industries. A. more debt B. less debt C. an equal amount of debt D. none of these. There is no relationship between the cyclical nature of an industry and optimal capital structure. 11-15 Chapter 11 - Cost of Capital 86. The component parts of the cost of capital should be weighted by their proportion in the firm's A. current capital structure. B. historical capital structure. C. optimum capital structure. D. expected capital structure. 87. Which is not true about debt financing and the weighted average cost of capital? A. Debt is usually the cheapest source of financing. B. As the level of debt increases beyond the optimum capital structure, the cost of capital increases. C. No debt in the firm's capital structure will minimize the firm's weighted-average cost of capital. D. None of these. 88. A firm in a stable industry should use A. a large amount of debt to lower the cost of capital. B. no debt at all. C. preferred stock in place of debt. D. a limited amount of debt to lower the cost of capital. 89. Although debt financing is usually the cheapest component of capital, it cannot be used in excess because A. interest rates may change. B. the firm's stock price will increase and raise the cost of equity financing. C. the financial risk of the firm may increase and thus drive up the cost of all sources of financing. D. underwriting costs may change. 90. A firm in a cyclical industry should use A. a large amount of debt to lower the cost of capital. B. no debt at all. C. preferred stock in place of debt. D. a limited amount of debt to lower the cost of capital. 11-16 Chapter 11 - Cost of Capital 91. Most firms are able to use _____ percent debt in their capital structure without exceeding norms acceptable to creditors and investors. A. 30-50 B. 40-60 C. 50-70 D. 60-80 92. Marginal cost of capital A. recognizes that cost of capital does not stay constant as more funds are raised. B. usually provides the same capital budgeting choices as the use of weighted average cost of capital. C. can be defined as the cost of capital when no retained earnings are available for expansion. D. none of these apply. 93. The weighted average cost of capital is used as a discount rate because A. it is an indication of how much the firm is earning overall. B. as long as the cost of capital is earned, the common stock value of the firm will be maintained. C. it is comparable to the prevailing market interest rates. D. returns below the cost of capital will cover all fixed costs associated with capital and provide an excess return to stockholders. 94. Use of the marginal cost of capital A. acknowledges that when retained earnings is used up as a source of equity the cost of capital rises as new common stock is sold to support more growth. B. recognizes that the return from the last dollar of funds generated should be equal to the cost of the last dollar of funds raised. C. both a and b are correct. D. none of these are correct. 11-17 Chapter 11 - Cost of Capital 95. The general rule for using the weighted average cost of capital (WACC) in capital budgeting decisions is accept all projects with A. rates of return greater than or equal to the WACC. B. rates of return less than the WACC. C. rates of return equal to or less than the WACC. D. positive rates of return. 96. Oak Enterprises has a beta of 1.2, the market return is 8%, and the T-bill rate is 4%. What is their expected required return of common equity? A. Between 11% and 12% B. Between 8% and 9% C. Between 7% and 8% D. Between 4% and 5% 97. All of the following are important considerations for minimizing the cost of capital except: A. future inflation rates B. industry debt ratios C. future economic conditions D. current coupon rates of outstanding debt 11-18 Chapter 11 - Cost of Capital Matching Questions 98. Match the following with the items below: 1. optimal capital structure The distribution expense involved in selling securities to the public. ____ The result of multiplying the cost of each item in the capital structure by its corresponding representation in the overall capital structure and summing the results. ____ Features the best possible mix of debt, preferred stock, retained earnings and new common stock. ____ 2. marginal cost of capital 3. capital asset pricing model 4. weighted average cost of Determines the value of a share of stock by taking the capital present value of the expected future stream of dividends. The cost of alternative sources of financing to the 5. cost of capital firm. 6. financial Relates the risk-return tradeoffs of individual capital securities to market returns. 7. flotation costs The cost of the most recent dollars of funds raised. 8. dividend Appears on the balance sheet under long-term valuation model liabilities and equity. 11-19 ____ ____ ____ ____ ____ Chapter 11 - Cost of Capital Essay Questions 99. Zinger Corporation manufactures industrial type sewing machines. Zinger Corp. received a very large order from a few European countries. In order to be able to supply these countries with its products, Zinger will have to expand its facilities. Of the required expansion, Zinger feels it can raise $75 million internally, through retained earnings. The firm's optimum capital structure has been 35% debt, 10% preferred stock and 55% equity. The company will try to maintain this capital structure in financing this expansion plan. Currently Zinger's common stock is traded at a price of $28 per share. Last year's dividend was $1.50 per share. The growth rate is 8%. The company's preferred stock is selling at $45 and has been yielding 6% in the current market. Flotation costs have been estimated at 8% of common stock and 3% of preferred stock. Zinger Corp. has bonds outstanding at 6%, but its investment banker has informed the company that interest rates for bonds of equal risk are currently yielding 5%. Zinger's tax rate is 40%. a) Compute the cost of Kd, Kp, Ke, Kn. b) Calculate the initial weighted average cost of capital using Ke. c) How large a capital budget can the firm support with retained earnings financing? 11-20 Chapter 11 - Cost of Capital 100. The Accidental Petroleum Company is trying to determine its weighted average cost of capital for use in making a number of investment decisions. The firm's bonds were issued 6 years ago and have 14 years left until maturity. They carried an 8% coupon rate, and are currently selling for $910.00. The firm's preferred stock carries a $3.10 dividend and is currently selling at $42.50 per share. Accidental's investment banker has stated that issue costs for new preferred will be 50 cents per share. The firm has significant retained earnings, but will also need to sell new common stock to finance the projects it is now considering. Accidental Petroleum common stock is expected to pay a $1.75 per share dividend next year, and is expected to maintain an 8% growth rate for the foreseeable future. The stock is currently priced at $50 per share, but new common stock will have flotation costs of 70 cents per share. Calculate the costs of the various components of Accidental Petroleum's capital (Kd, Kp, Ke, Kn). The firm's tax rate is 30%. 101. Jury Company wants to calculate the component costs in its capital structure. Common stock currently sells for $33, and is expected to pay a dividend of $.40. Jury's dividend growth rate is 8%, and flotation cost is $1.25. Preferred stock sells for $40, pays a dividend of $3.00, and carries a flotation cost of $1.10. Jury Company bonds yield 7% in the market. Jury is in the 30% tax bracket. Calculate cost of debt, cost of new common stock, cost of preferred stock and cost of retained earnings. 11-21 Chapter 11 - Cost of Capital 102. Given the information about Jury Co. in the previous problem, calculate the company's weighted average cost of capital assuming that its new financing will consist of 40% debt, 10% preferred stock, and 50% retained earnings. Chapter 11 Cost of Capital Answer Key True / False Questions 1. It is standard practice to evaluate investment decisions using the cost of the specific financing method involved. FALSE Bloom's: Understand Difficulty: Basic Learning Objective: 11-02 The cost of capital is normally the discount rate to use in analyzing an investment. 2. The calculation of the cost of capital depends upon historical costs of funds. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-01 The cost of capital represents the weighted 11-22 Chapter 11 - Cost of Capital 3. The cost of capital for each source of funds is dependent on current market conditions and expected rates of return. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-01 The cost of capital represents the weighted 4. In determining the cost of debt, yields and prices of outstanding bonds are used. TRUE Bloom's: Understand Difficulty: Basic Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 5. The cost of debt is equal to the current bond yield on bonds of similar risk class and adjusted for the corporate tax rate. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 6. The amount of debt capital used by a corporation is not related to the availability of equity funds from retained earnings and new common stock. FALSE Bloom's: Understand Difficulty: Challenge Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. 11-23 Chapter 11 - Cost of Capital 7. A firm's cost of preferred stock is equal to the preferred dividend divided by the net price after flotation costs. TRUE Bloom's: Remember Difficulty: Basic Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 8. A firm's cost of preferred stock is equal to the preferred dividend divided by market price plus the dividend growth rate (Kp= D/Po+ g). FALSE Bloom's: Remember Difficulty: Basic Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 9. The cost of new common stock is greater than the cost of outstanding common stock. TRUE Bloom's: Understand Difficulty: Basic Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 10. In determining the cost of preferred stock, the earnings on outstanding preferred stock may be used as a proxy. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 11-24 Chapter 11 - Cost of Capital 11. The out-of-pocket cost of common stock is a good approximation of the cost of common stock equity. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 12. The discount rate that equates a future stream of expected dividends to the current price is a good approximation of the cost of common stock. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 13. Kerepresents an expected return to stockholders as well as a cost to the firm. TRUE Bloom's: Understand Difficulty: Basic Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 14. The cost of retained earnings is equal to the required rate of return on a firm's outstanding common stock. TRUE Bloom's: Remember Difficulty: Basic Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 11-25 Chapter 11 - Cost of Capital 15. Retained earnings represent an internal source of funds that is raised without the payment of interest, or cost to the firm's stockholders. FALSE Bloom's: Understand Difficulty: Basic Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 16. The only difference in the cost of retained earnings (Ke) and the cost of new common stock (Kn) is the flotation cost on new common stock. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 17. Regardless of the particular source of funds utilized for a project, the required rate of return, or discount rate, will be the weighted average cost of capital. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-01 The cost of capital represents the weighted 18. The use of common stock equity in the weighted average cost of capital is always (Ke) and not (Kn), the cost of new common stock. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 11-26 Chapter 11 - Cost of Capital 19. The use of the optimum capital structure minimizes the cost of capital. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. 20. All firms within particular industries have similar optimum capital structures. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-01 The cost of capital represents the weighted 21. A firm should always be at a single optimum debt to equity ratio to minimize its cost of capital. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. 22. Weights used to calculate the weighted average cost of capital Kaare derived from the optimum capital structure. TRUE Bloom's: Remember Difficulty: Basic Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. 23. Taking on additional debt will reduce the cost of equity. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. 11-27 Chapter 11 - Cost of Capital 24. Firms in stable industries are advised to keep debt levels very low so that shareholders, rather than creditors, receive the benefits of steady cash flows. FALSE Bloom's: Understand Difficulty: Basic Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. 25. Most firms are able to use 60%-70% debt in their capital structure without exceeding norms acceptable to most creditors and investors. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. 26. Although the after-tax cost of debt is below the cost of equity, firms cannot increase their use of debt without limit. TRUE AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. 27. According to traditional financial theory, the cost of capital curve is U-shaped over the range of debt-equity mixes. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. 11-28 Chapter 11 - Cost of Capital 28. A firm that does not earn the cost of capital in the short run will probably be in bankruptcy. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. 29. A firm that does not earn the cost of capital in the long run will not maximize shareholder wealth. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. 30. Companies prefer to maintain some financing flexibility in order to choose the lowest cost source of funds at a single point in time. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. 31. The use of the weighted average cost of capital assumes that the firm is in its optimum capital structure range and the cost of each component stays constant over the range of financing. TRUE Bloom's: Understand Difficulty: Challenge Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. 11-29 Chapter 11 - Cost of Capital 32. Market values rather than book values should be used for determining the optimal capital structure, though in practice, book value is commonly used. TRUE Bloom's: Remember Difficulty: Intermediate Learning Objective: 11-01 The cost of capital represents weighted 33. the In determining the optimum capital structure it is assumed that the firm will raise capital in the optimum proportions every year. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. 34. The pretax cost of debt is less than the pretax cost of equity. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 35. The capital asset pricing model (CAPM) relates the risk-return tradeoffs of individual assets to market returns. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 11-30 Chapter 11 - Cost of Capital 36. Individual common stocks' betas have a tendency to move toward 1.0 over time. TRUE Bloom's: Remember Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 37. In the capital asset pricing model (CAPM), beta measures the volatility of the market. FALSE Bloom's: Remember Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 38. Per the capital asset pricing model, the slope of the security market line (SML) must be 1.0. FALSE Bloom's: Remember Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 39. The financial managers of the firm decide on its cost of capital for financing projects. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-01 The cost of capital represents the weighted 11-31 Chapter 11 - Cost of Capital 40. The cost of debt, preferred stock, and common equity must all be adjusted for tax implications. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 41. Although debt financing is generally cheaper than equity financing, financial managers should not use debt financing significantly above the industry standard because it can increase the firm's overall cost of capital. TRUE AACSB: Analytic Bloom's: Evaluate Difficulty: Intermediate Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. 42. The cost of capital generally varies inversely with the size of the capital structure. FALSE AACSB: Analytic Bloom's: Evaluate Difficulty: Intermediate Learning Objective: 11-05 The cost of capital may eventually increase as larger amounts of financing are utilized. 43. As the risk-free rate increases, the required rate of return for common stock decreases. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 11-32 Chapter 11 - Cost of Capital 44. A firm with a higher beta than another firm will have a higher required rate of return. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 45. The slope of the security market line (SML) will often increase when the economy is in a boom period. FALSE AACSB: Analytic Bloom's: Evaluate Difficulty: Challenge Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. Multiple Choice Questions 46. Each project should be judged against A. the specific means of financing used to support its implementation. B. the going interest rate at that point in time. C. the cost of new common stock equity. D. none of these. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-02 The cost of capital is normally the discount rate to use in analyzing an investment. 47. Financial capital does not include A. stock. B. bonds. C. preferred stock. D. working capital. Bloom's: Remember Difficulty: Basic Learning Objective: 11-01 The cost of capital represents the weighted 11-33 Chapter 11 - Cost of Capital 48. The overall weighted average cost of capital is used instead of costs for specific sources of funds because A. use of the cost for specific sources of capital would make investment decisions inconsistent. B. a project with the highest return would always be accepted under the specific cost criteria. C. investments funded by low cost debt would have an advantage over other investments. D. both a and c are correct. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-02 The cost of capital is normally the discount rate to use in analyzing an investment. 49. Debreu Beverages has an optimal capital structure that is 70% common equity, 20% debt, and 10% preferred stock. Debreu's pretax cost of equity is 9%. Its pretax cost of preferred equity is 7%, and its pretax cost of debt is also 5%. If the corporate tax rate is 35%, what is the weighed average cost of capital? A. Between 7% and 8% B. Between 8% and 9% C. Between 9% and 10% D. Between 10% and 12% AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 11-34 Chapter 11 - Cost of Capital 50. Given an optimal capital structure that is 50% debt and 50% common stock, calculate the weighted average cost of capital for Stone Corp given the following additional information: Bond coupon rate..8% Bond yield to maturity..6% Dividend, expected..$5 Price, common.$80 Growth rate.5% Corporate tax rate30% A. less than 5.0%. B. more than 5.0% and less than 6.25%. C. more than 6.25% and less than 7.5%. D. more than 7.5%. AACSB: Analytic Bloom's: Apply Difficulty: Challenge Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 51. For a firm paying 5% for new debt, the higher the firm's tax rate A. the higher the after-tax cost of debt. B. the lower the after-tax cost of debt. C. after-tax cost is unchanged. D. Not enough information to judge. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 11-35 Chapter 11 - Cost of Capital 52. If a firm's bonds are currently yielding 6% in the marketplace, why would the firm's cost of debt be lower? A. Interest rates have changed. B. Additional debt can be issued more cheaply than the original debt. C. There should be no difference; cost of debt is the same as the bond's market yield. D. Interest is tax-deductible. Bloom's: Understand Difficulty: Basic Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 53. The cost of debt is determined by taking the A. present value of the interest payments and principal times one minus the tax rate. B. historical yield on bonds times one minus the tax rate. C. estimated yield on new bond issues of the same risk times one minus the shareholder marginal tax rate. D. none of these. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 54. The coupon rate on a debt issue is 6%. If the yield to maturity on the debt is 9%, what is the after-tax cost of debt in the weighted average cost of capital if the firm's tax rate is 34%? A. 3.96% B. 4.08% C. 5.94% D. 7.92% AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 11-36 Chapter 11 - Cost of Capital 55. The coupon rate on an issue of debt is 8%. The yield to maturity on this issue is 10%. The corporate tax rate is 31%. What would be the approximate after-tax cost of debt for a new issue of bonds? A. 5.28% B. 2.48% C. 6.90% D. 3.14% AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 56. A firm's cost of financing, in an overall sense, is equal to its A. weighted average cost of capital. B. required yield that investors seek for various kinds of securities. C. required rate of return that investors seek for various kinds of securities. D. all of these. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-01 The cost of capital represents the weighted 11-37 Chapter 11 - Cost of Capital 57. A firm has $50 million in assets and its optimal capital structure is 60% equity. If the firm has $12 million in retained earnings, at what asset level will the firm need to issue additional stock? (Assume no growth in retained earnings.) A. The firm should have already issued additional stock. B. The firm can increase assets to $30 million. C. The firm can increase assets to $20 million. D. There is insufficient information to determine an answer. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Learning Objective: 11-05 The cost of capital may eventually increase as larger amounts of financing are utilized. 58. Klein Corp. can issue $1,000 par value bond that pays $90 per year in interest at a price of $980. The bond will have a 10-year life. The firm is in a 35% tax bracket. What is the aftertax cost of debt? A. 9.14% B. 9.30% C. 5.87% D. 6.8% AACSB: Analytic Bloom's: Apply Difficulty: Challenge Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 11-38 Chapter 11 - Cost of Capital 59. Tobin's Barbeque has a bank loan at 8% interest and an after-tax cost of debt of 6%. What will the after-tax cost of debt be when the loan is due if a new loan is taken out yielding 11%. A. 7.52% B. 8.25% C. 13.33% D. none of these AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 60. The pre-tax cost of debt for a new issue of debt is determined by A. the investor's required rate of return on issued stock. B. the coupon rate of existing debt. C. the yield to maturity of outstanding bonds. D. all of these. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 11-39 Chapter 11 - Cost of Capital 61. Lewis, Schultz and Nobel Development Corp. has an after-tax cost of debt of 4.5 percent. With a tax rate of 30 percent, what is the yield on the debt? A. 4.41% B. 9.0% C. 1.89% D. 6.43% AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 62. The after-tax cost of preferred stock to the issuing corporation A. is the same as the before-tax cost. B. is usually lower than the cost of debt. C. is dependent on the firm's tax bracket. D. none of these. Bloom's: Understand Difficulty: Basic Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 11-40 Chapter 11 - Cost of Capital 63. A firm is paying an annual dividend of $2.65 for its preferred stock which is selling for $57.00. There is a selling cost of $3.30. What is the after-tax cost of preferred stock if the firm's tax rate is 33%? A. 2.02% B. 4.93% C. 5.79% D. 6.11% AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 64. Firm X has a tax rate of 30%. The price of its new preferred stock is $75 and its flotation cost is $3.15. The cost of new preferred stock is 8%. What is the firm's dividend? A. $7.18 B. $5.75 C. $7.56 D. none of these. AACSB: Analytic Bloom's: Apply Difficulty: Challenge Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 11-41 Chapter 11 - Cost of Capital 65. The cost of equity capital in the form of new common stock will be higher than the cost of retained earnings because of A. the existence of taxes. B. the existence of flotation costs. C. investors' unwillingness to purchase additional shares of common stock. D. the existence of financial leverage. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 66. If the flotation cost goes up, the cost of retained earnings will A. go up. B. go down. C. stay the same. D. slowly increase. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 67. Why is the cost of debt normally lower than the cost of preferred stock? A. Preferred stock dividends are tax deductions. B. Interest is tax deductible. C. Preferred stock dividends must be paid before common stock dividends. D. Common stock dividends are not tax deductible. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 11-42 Chapter 11 - Cost of Capital 68. If flotation costs go down, the cost of new preferred stock will A. go up. B. go down. C. stay the same. D. slowly increase. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 69. A firm's preferred stock pays an annual dividend of $2, and the stock sells for $65. Flotation costs for new issuances of preferred stock are 5% of the stock value. What is the after-tax cost of preferred stock if the firm's tax rate is 30%? A. 1.2% B. 1.58% C. 3.20% D. 5.26% AACSB: Analytic Bloom's: Apply Difficulty: Challenge Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 11-43 Chapter 11 - Cost of Capital 70. Ten years ago, Stigler Company issued $100 par value preferred stock yielding 6 percent. The preferred stock is now selling for $102 per share. What is the current yield or cost of the preferred stock? (Disregard flotation costs.) A. 7.76%. B. 8%. C. 5.9%. D. There is not enough information to answer the question. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 71. A firm's debt to equity ratio varies at times because A. a firm will want to sell common stock when prices are high and bonds when interest rates are low. B. a firm will want to take advantage of timing its fund raising in order to minimize costs over the long run. C. the market allows some leeway in the debt to equity ratio before penalizing the firm with a higher cost of capital. D. all of these are accurate statements. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. 11-44 Chapter 11 - Cost of Capital 72. Using the constant dividend growth model for common stock, if Po goes up A. the assumed cost goes up. B. the assumed cost goes down. C. the assumed cost remains unchanged. D. Need further information. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 73. New common stock is more expensive than Ke A. to compensate for risk. B. to compensate for more dividends. C. to compensate for expansionary problems. D. to cover distribution costs. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 74. In computing the cost of common equity, if D1 goes downward and Po goes up, Ke will A. go up. B. go down. C. stay the same. D. slowly increase. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 11-45 Chapter 11 - Cost of Capital 75. In determining the cost of retained earnings A. the dividend valuation model is inappropriate. B. flotation costs are included. C. growth is not considered. D. the capital asset pricing model can be used. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 76. Within the capital asset pricing model A. the risk-free rate is usually higher than the return in the market. B. the higher the beta the lower the required rate of return. C. beta measures the volatility of an individual stock relative to a stock market index. D. two of the above are true. Bloom's: Understand Difficulty: Basic Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 77. Using the constant growth model, a firm's expected (D1) dividend yield is 4% of the stock price, and its growth rate is 5%. If the tax rate is .35%, what is the firm's cost of equity? A. 10% B. 6.65% C. 9.0% D. More information is required AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 11-46 Chapter 11 - Cost of Capital 78. Expected cash dividends are $3.00, the dividend yield is 4%, flotation costs are 4% of price, and the growth rate is 3%. Compute cost of new common stock. A. 7.00% B. 7.2% C. 6.9% D. 4.2% AACSB: Analytic Bloom's: Apply Difficulty: Challenge Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 79. A firm's stock is selling for $65. The dividend yield is 6%. A 7% growth rate is expected for the common stock. The firm's tax rate is 40%. What is the firm's cost of retained earnings? A. 8.16% B. 13.00% C. 12.35% D. can not be determined. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 11-47 Chapter 11 - Cost of Capital 80. A firm's stock is selling for $62. The next annual dividend is expected to be $3.00. The growth rate is 9%. The flotation cost is $5.00. What is the cost of retained earnings? A. 13.84% B. 12.46% C. 12.7% D. none of these AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 81. For many firms, the cheapest and most important source of equity capital is in the form of A. debt. B. common stock. C. preferred stock. D. retained earnings. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 82. Retained earnings has a cost associated with it because: A. new funds must be raised. B. There is an opportunity cost associated with stockholder funds. C. Ke> g D. flotation costs increase the cost of funding. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 11-48 Chapter 11 - Cost of Capital 83. There may be a change in the marginal cost of capital curve because A. the tax rate charged to investors changes. B. the firm has exhausted its supply of retained earnings. C. the firm is limited in the amount of depreciation it can take. D. a and b. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-05 The cost of capital may eventually increase as larger amounts of financing are utilized. 84. The after-tax cost of debt will almost always be below A. the before-tax cost of debt. B. the weighted average cost of capital. C. the cost of equity. D. all of these. Bloom's: Understand Difficulty: Basic Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 85. The optimal capital structure for firms in cyclical industries should contain ________________ than firms in stable industries. A. more debt B. less debt C. an equal amount of debt D. none of these. There is no relationship between the cyclical nature of an industry and optimal capital structure. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. 11-49 Chapter 11 - Cost of Capital 86. The component parts of the cost of capital should be weighted by their proportion in the firm's A. current capital structure. B. historical capital structure. C. optimum capital structure. D. expected capital structure. Bloom's: Understand Difficulty: Basic Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. 87. Which is not true about debt financing and the weighted average cost of capital? A. Debt is usually the cheapest source of financing. B. As the level of debt increases beyond the optimum capital structure, the cost of capital increases. C. No debt in the firm's capital structure will minimize the firm's weighted-average cost of capital. D. None of these. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. 88. A firm in a stable industry should use A. a large amount of debt to lower the cost of capital. B. no debt at all. C. preferred stock in place of debt. D. a limited amount of debt to lower the cost of capital. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. 11-50 Chapter 11 - Cost of Capital 89. Although debt financing is usually the cheapest component of capital, it cannot be used in excess because A. interest rates may change. B. the firm's stock price will increase and raise the cost of equity financing. C. the financial risk of the firm may increase and thus drive up the cost of all sources of financing. D. underwriting costs may change. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-05 The cost of capital may eventually increase as larger amounts of financing are utilized. 90. A firm in a cyclical industry should use A. a large amount of debt to lower the cost of capital. B. no debt at all. C. preferred stock in place of debt. D. a limited amount of debt to lower the cost of capital. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. 91. Most firms are able to use _____ percent debt in their capital structure without exceeding norms acceptable to creditors and investors. A. 30-50 B. 40-60 C. 50-70 D. 60-80 Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. 11-51 Chapter 11 - Cost of Capital 92. Marginal cost of capital A. recognizes that cost of capital does not stay constant as more funds are raised. B. usually provides the same capital budgeting choices as the use of weighted average cost of capital. C. can be defined as the cost of capital when no retained earnings are available for expansion. D. none of these apply. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-05 The cost of capital may eventually increase as larger amounts of financing are utilized. 93. The weighted average cost of capital is used as a discount rate because A. it is an indication of how much the firm is earning overall. B. as long as the cost of capital is earned, the common stock value of the firm will be maintained. C. it is comparable to the prevailing market interest rates. D. returns below the cost of capital will cover all fixed costs associated with capital and provide an excess return to stockholders. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-01 The cost of capital represents the weighted 94. Use of the marginal cost of capital A. acknowledges that when retained earnings is used up as a source of equity the cost of capital rises as new common stock is sold to support more growth. B. recognizes that the return from the last dollar of funds generated should be equal to the cost of the last dollar of funds raised. C. both a and b are correct. D. none of these are correct. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-05 The cost of capital may eventually increase as larger amounts of financing are utilized. 11-52 Chapter 11 - Cost of Capital 95. The general rule for using the weighted average cost of capital (WACC) in capital budgeting decisions is accept all projects with A. rates of return greater than or equal to the WACC. B. rates of return less than the WACC. C. rates of return equal to or less than the WACC. D. positive rates of return. Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-02 The cost of capital is normally the discount rate to use in analyzing an investment. 96. Oak Enterprises has a beta of 1.2, the market return is 8%, and the T-bill rate is 4%. What is their expected required return of common equity? A. Between 11% and 12% B. Between 8% and 9% C. Between 7% and 8% D. Between 4% and 5% AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 97. All of the following are important considerations for minimizing the cost of capital except: A. future inflation rates B. industry debt ratios C. future economic conditions D. current coupon rates of outstanding debt AACSB: Analytic Bloom's: Analyze Difficulty: Intermediate Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing. 11-53 Chapter 11 - Cost of Capital Matching Questions 98. Match the following with the items below: 1. optimal capital structure 2. marginal cost of capital 3. capital asset pricing model 4. weighted average cost of capital 5. cost of capital 6. financial capital 7. flotation costs 8. dividend valuation model The distribution expense involved in selling securities to the public. 7 The result of multiplying the cost of each item in the capital structure by its corresponding representation in the overall capital structure and summing the results. 4 Features the best possible mix of debt, preferred stock, retained earnings and new common stock. 1 Determines the value of a share of stock by taking the present value of the expected future stream of dividends. The cost of alternative sources of financing to the firm. Relates the risk-return tradeoffs of individual securities to market returns. The cost of the most recent dollars of funds raised. Appears on the balance sheet under long-term liabilities and equity. 8 5 3 2 6 Bloom's: Understand Difficulty: Intermediate Learning Objective: 11-01 The cost of capital represents the weighted. Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. Learning Objective: 11-05 The cost of capital may eventually increase as larger amounts of financing are utilized. 11-54 Chapter 11 - Cost of Capital Essay Questions 99. Zinger Corporation manufactures industrial type sewing machines. Zinger Corp. received a very large order from a few European countries. In order to be able to supply these countries with its products, Zinger will have to expand its facilities. Of the required expansion, Zinger feels it can raise $75 million internally, through retained earnings. The firm's optimum capital structure has been 35% debt, 10% preferred stock and 55% equity. The company will try to maintain this capital structure in financing this expansion plan. Currently Zinger's common stock is traded at a price of $28 per share. Last year's dividend was $1.50 per share. The growth rate is 8%. The company's preferred stock is selling at $45 and has been yielding 6% in the current market. Flotation costs have been estimated at 8% of common stock and 3% of preferred stock. Zinger Corp. has bonds outstanding at 6%, but its investment banker has informed the company that interest rates for bonds of equal risk are currently yielding 5%. Zinger's tax rate is 40%. a) Compute the cost of Kd, Kp, Ke, Kn. b) Calculate the initial weighted average cost of capital using Ke. c) How large a capital budget can the firm support with retained earnings financing? 11-55 Chapter 11 - Cost of Capital AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. Learning Objective: 11-05 The cost of capital may eventually increase as larger amounts of financing are utilized. 11-56 Chapter 11 - Cost of Capital 100. The Accidental Petroleum Company is trying to determine its weighted average cost of capital for use in making a number of investment decisions. The firm's bonds were issued 6 years ago and have 14 years left until maturity. They carried an 8% coupon rate, and are currently selling for $910.00. The firm's preferred stock carries a $3.10 dividend and is currently selling at $42.50 per share. Accidental's investment banker has stated that issue costs for new preferred will be 50 cents per share. The firm has significant retained earnings, but will also need to sell new common stock to finance the projects it is now considering. Accidental Petroleum common stock is expected to pay a $1.75 per share dividend next year, and is expected to maintain an 8% growth rate for the foreseeable future. The stock is currently priced at $50 per share, but new common stock will have flotation costs of 70 cents per share. Calculate the costs of the various components of Accidental Petroleum's capital (Kd, Kp, Ke, Kn). The firm's tax rate is 30%. 11-57 Chapter 11 - Cost of Capital AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 11-58 Chapter 11 - Cost of Capital 101. Jury Company wants to calculate the component costs in its capital structure. Common stock currently sells for $33, and is expected to pay a dividend of $.40. Jury's dividend growth rate is 8%, and flotation cost is $1.25. Preferred stock sells for $40, pays a dividend of $3.00, and carries a flotation cost of $1.10. Jury Company bonds yield 7% in the market. Jury is in the 30% tax bracket. Calculate cost of debt, cost of new common stock, cost of preferred stock and cost of retained earnings. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to bonds; preferred stock; and common stock. 11-59 Chapter 11 - Cost of Capital 102. Given the information about Jury Co. in the previous problem, calculate the company's weighted average cost of capital assuming that its new financing will consist of 40% debt, 10% preferred stock, and 50% retained earnings. AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Learning Objective: 11-01 The cost of capital represents the weighted 11-60 ... View Full Document

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