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Unformatted text preview: CHAPTER 10 DETERMINING THE COST OF CAPITAL (Difficulty: E = Easy, M = Medium, and T = Tough) True-False Easy: (10.1) Cost of capital Answer: a Diff: E 1 . The cost of capital should reflect the average cost of the various sources of long-term funds a firm uses to support its assets. a. True b. False (10.1) Capital Answer: a Diff: E 2 . Capital can be defined as the funds supplied by investors. a. True b. False (10.1) Component costs of capital Answer: a Diff: E 3 . The component costs of capital are market-determined variables in as much as they are based on investors' required returns. a. True b. False (10.2) Cost of debt Answer: b Diff: E 4 . The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC. a. True b. False (10.2) Cost of debt Answer: b Diff: E 5 . The cost of debt is equal to one minus the marginal tax rate multiplied by the coupon rate on outstanding debt. a. True b. False (10.3) Cost of preferred stock Answer: b Diff: E 6 . The cost of issuing preferred stock by a corporation must be adjusted to an after-tax figure because of the 70 percent dividend exclusion provision for corporations holding other corporations' preferred stock. a. True b. False Chapter 10: Determining the Cost of Capital Page 1 (10.4) Cost of common stock Answer: a Diff: E 7 . The cost of common stock is the rate of return stockholders require on the firm's common stock. a. True b. False (10.4) Retained earnings Answer: b Diff: E 8 . In capital budgeting and cost of capital analyses, the firm should always consider retained earnings as the first source of capital, since this is a free source of funding to the firm. a. True b. False (10.4) Retained earnings Answer: b Diff: E 9 . Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, but capital raised by selling new stock or bonds does have a cost. a. True b. False (10.4) Cost of internal equity Answer: b Diff: E 10 . 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. a. True b. False (10.4) Cost of external equity Answer: b Diff: E 11 . The firm's cost of external equity capital is the same as the required rate of return on the firm's outstanding common stock. a. True b. False (10.4) Cost of external equity Answer: b Diff: E 12 . The cost of equity capital from the sale of new common stock (r e ) is generally equal to the cost of equity capital from retention of earnings (r s ), divided by one minus the flotation cost as a percentage of sales price (1 - F)....
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