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Chapter10CostofCapitalSolutions - Cost of Capital Solutions...

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Cost of Capital - Solutions 1. When calculating a WACC for a company with preferred stock, there is no need to adjust the cost of the preferred stock to reflect the tax exclusion of 70% of the preferred stock dividend. * A. True B. False 2. A firm can only have one break point in its marginal cost of capital curve, which will occur when they deplete their additions to retained earnings and must switch over to new issues of equity. A. True * B. False 3. Because creditors can foresee, to at least some extent, the costs of bankruptcy, they charge a higher rate of interest to compensate for the present value of bankruptcy costs. * A. True B. False 4. Increasing a company’s debt ratio will typically reduce the marginal cost of both debt and equity financing; however, it still may raise the company’s WACC. A. True * B. False 5. Although quite rare, the mathematics is such that the after-tax component cost of debt financing can be greater than the after-tax component cost of equity financing. A. True * B. False 6. The cost to the firm of retained earnings is zero, since they are generated from the current earnings of the firm and there are no flotation costs associated with their retention. A. True * B. False Old Exam Questions - Cost of Capital - Solutions Page 1 of 42 Pages
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7. If we assume that the stock market is efficient, and if we assume that Stock A has a beta of 1.20, while Stock B has a beta of 1.40 (that is, B has higher risk than A), then we must also assume that the required rate of return on Stock B exceeds the required rate of return on Stock A. * A. True B. False 8. If a firm must pay flotation expense when issuing a security, then the firm’s required rate of return on that security will be greater than the investor’s required rate of return for that security. * 9. The easiest way to correctly calculate the firm’s cost of debt is simply to multiply the coupon rate on the debt times one minus the firm’s tax rate. * 10. 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). A. True * B. False 11. If expectations for long-term inflation rose, but the slope of the SML remained constant, this, for most firms, would have a greater impact on the required rate of return on equity, r s , than on the interest rate on long-term debt, r d . In other words, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt. (Hint: play with some numbers and see what happens.) * 12. If the tax laws stated that $0.50 out of every $1.00 of interest paid by a corporation was allowed as a tax-deductible expense, it would probably encourage companies to use more debt financing than they presently do, other things held constant.
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