Chapter eleven: the cost of capital

true

A firm should continue to invest in capital budgeting projects to the point where the marginal cost of capital (MCC) equals the marginal return (internal rate of return, IRR) generated by the last project that is purchased. True or False

marginal return (internal rate of return, IRR) generated by the last project purchased

A firm should continue to invest in capital budgeting projects until its marginal cost of capital is equal to the: a. net present value (NPV) of the last project purchased. b. internal rate of return (IRR) of the first project purchased. c. marginal return (internal rate of return, IRR) generated by the last project purchased. d. combined cost of all of the projects purchased. e. weighted average cost of capital for all of the projects purchased.

false

A firm's cost of capital (WACC) represents the maximum rate of return that a firm can earn from its capital budgeting projects to ensure that the value of the firm does not decrease. True or False

false

A firm's cost of external equity capital (cost of issuing new stock) is equal to the rate of return that stockholders demand (require) to invest in the firm's outstanding common stock. True or False

determined by participants in the financial markets, because investors set the minimum returns they require (demand) to provide the funds the firm invests in capital budgeting projects

A firm's weighted average cost of capital (WACC) is: a. set by the board of directors of the firm, because it is the benchmark they use to evaluate members of the senior management team. b. regulated by the Internal Revenue Service (IRS), because tax-deductible debt is included in the computation. c. determined by participants in the financial markets, because investors set the minimum return they require (demand) to provide the funds the firm invests in capital budgeting projects. d. the same as the average internal rate of return (IRR) the firm earns on its assets. e. the combined net present value (NPV) of all the capital budgeting projects in which the firm invests.

its before-tax interest cost of debt, rs.

According to the bond-yield-plus-risk-premium approach, a firm's cost of retained earnings, rs, can be estimated by adding a risk premium of 3 to 5 percentage points to: a. its cost of preferred stock, rps. b. the risk free rate of return. c. its before-tax interest cost of debt, rs. d. its return on equity (ROE). e. its after-tax interest cost of debt, rsT.

$75,000

Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent common equity. The firm expects to earn $150,000 in after-tax income during the coming year, and it will retain 30 percent of those earnings. What is the break point of retained earnings? a. $175,000 b. $75,00 c. $112,500 d. $500,000 e. $250,000

the area that is above the MCC schedule but below the IOS schedule when the IOS line is above the MCC line

Alpha Inc. combines the marginal cost of capital (MCC) schedule with the investment opportunity schedule (IOS) on a single graph. Which of the following areas on the MCC/IOS graph shows the maximum excess of marginal returns over marginal costs? a. The area that is below the marginal weighted average cost of capital (MCC) schedule b. The area that is above the IOS schedule c. The point of intersection of the MCC schedule and the IOS schedule d. The point of intersection of weighted average cost of capital (WACC) schedule and y-axis e. The area that is above the MCC schedule but below the IOS schedule when the IOS line is above the MCC line

16%

Alpha Inc.'s beta coefficient is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Based on the capital asset pricing model (CAPM), what should be Alpha's cost of retained earnings? a. 11% b. 17% c. 12% d. 18% e. 16%

true

Because the value of a firm's stock depends on the after-tax cash flows it generates during its life, after-tax component costs of capital (i.e., the after-tax cost of debt) are used when computing a firm's weighted average cost of capital (WACC). True or False

all of the projects whose internal rates of return (IRRs) are greater than the firm's weighted average cost of capital WACC).

Beige Inc. is evaluating three capital budgeting projects whose internal rates of return (IRRs) are greater than the firm's marginal cost of capital (MCC). Beige should choose: a. the projects that minimize its marginal cost of capital. b. all of the projects whose internal rates of return (IRRs) are greater than the firm's weighted average cost of capital WACC). c. the projects that maximize its dividend payout. d. the projects that generate the greatest combination of cash inflows. e. the one (single) project that has the highest net present value (NPV).

10.0%

Beige Inc. plans to issue preferred stock that pays a dividend equal to $11.52 per share and sells for $120 per share to raise funds to support future growth. It will cost 4 percent, or $4.80 per share, to issue the new preferred stock, which means that Beige will net $115.20 per share. What is the cost of preferred stock Beige should use when computing its weighted average cost of capital (WACC)? a. 14.0% b. 10.4% c. 13.6% d. 9.6% e. 10.0%

12.63%

Bouchard Company's stock sells for $20 per share, its last dividend (D0) was $1.00, its growth rate is a constant 6 percent, and the company must pay flotation cost equal to 20 percent when it issues new common stock. What is Bouchard's cost of issuing new common stock? a. 11.00% b. 12.25% c. 12.63% d. 11.30% e. 11.56%

$24,500

Byron Corporation forecasts that its income will be $21,000 next year. The firm pays out 30 percent of earnings as dividends to common stockholders. Its target capital structure is 40 percent debt and 60 percent common equity. What Byron's retained earnings break point? a. $35,000 b. $24,500 c. $6,300 d. $36,750 e. $10,500

12.50%

Coral Inc.'s preferred stock currently sells for $90 a share and pays a dividend of $10 per share. However, the firm will net only $80 per share if it issues new preferred stock. What is Coral's cost of preferred stock? Coral's marginal tax rate is 35 percent. a. 8.13% b. 12.50% c. 11.11% d. 7.22% e. 11.76%

11.70%

Diggin Tools plans to issue new preferred stock, which has a market value of $85 per share. Holders of the stock will receive an annual dividend equal to $9.35. The flotation costs associated with the new issue were 6 percent and Diggin's marginal tax rate is 30 percent. What Diggin's component cost of preferred stock, rps? a. 17.00% b. 11.66% c. 10.38% d. 11.70% e. 11.00%

11.60%

Following is information about Seasonal Products (SP) Corporation. The company has no preferred stock. Type of Proportion of the Type of Capital After-Tax Cost Capital Capital Structure Debt, rdT 6.5% Debt 40.0% Common equity Equity 60.0 Retained earnings, rs 12.0 New issue, re 15.0 The firm expects to retain $300,000 in earnings this year to invest in capital budgeting projects. If the SP's capital budget is expected to equal $550,000, what required rate of return, or marginal cost of capital, should be used when evaluating capital budgeting projects? a. 9.80% b. 11.60% c. 9.25% d. 11.17% e. 9.90%

11.9%

Following is information about Sleek Pleats (SP) Corporation. The company has no preferred stock. Type of Proportion of the Type of Capital After-Tax Cost Capital Capital Structure Debt, rdT 7.0% Debt 30.0% Common equity Equity 70.0 Retained earnings, rs 14.0 New issue, re 16.0 The firm expects to retain $210,000 in earnings this year to invest in capital budgeting projects. If the SP's capital budget is expected to equal $290,000, what required rate of return, or marginal cost of capital, should be used when evaluating capital budgeting projects? a. 11.9% b. 13.3% c. 10.5% d. 11.5% e. 12.3%

false

For a particular firm, depending on tax rates, flotation costs, and the attitude of investors, the cost of new common equity, re, can be less than, equal to, or greater than its before-tax cost of debt, rd. True or False

15.50%

J. Ross and Sons Inc. has a target capital structure that calls for 40 percent debt, 10 percent preferred stock, and 50 percent common equity. Ross' common stock currently sells for $40 per share. The firm recently paid a dividend equal to $2 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year. If it issues new common stock, the firm will incur flotation costs equal to 7 percent. What is the firm's cost of retained earnings? a. 15.00% b. 15.91% c. 15.50% d. 14.54% e. 16.50%

Projects D and E should be purchased.

Luxury Production Materials (LPM) generated the following information for its capital budgeting manager: Capital Structure Project Cost IRR Type of Capital Proportion D $70,000 18.0% Debt 60.0% E 65,000 15.0 Common equity 40.0 F 75,000 14.0 G 72,000 12.0 LPM's weighted average cost of capital (WACC) is 13 percent if the firm does not have to issue new common equity; if new common equity is needed, its WACC is 16 percent. If LPM expects to generate $80,000 in retained earnings this year, which project(s) should be purchased? Assume that the projects are independent and indivisible. a. Only Project D should be purchased. b. Project D and E should be purchased c. Projects D, E, and F should be purchased. d. All of the projects should be purchased. e. None of the projects should be purchased.

16.47%

Marigold Inc.'s common stock currently sells for $40 per share, but the firm will net only $34 per share if it issues new common stock. The firm recently paid a dividend equal to $2 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year. What is Marigold's cost of new common equity? a. 15.00% b. 15.88% c. 15.50% d. 16.47% e. 6.47%

project w and x should be purchased

Marvelous Manufacturing (MM) generated the following information for its capital budgeting manager: ​ Capital Structure Project Cost IRR Type of Capital Proportion W $65,000 15% Debt 30% X 70,000 13 Common equity 70 Y 75,000 12 Z 70,000 11 ​ MM's weighted average cost of capital (WACC) is 12 percent if the firm does not have to issue new common equity; if new common equity is needed, its WACC is 16 percent. If MM expects to generate $70,000 in retained earnings this year, which project(s) should be purchased? Assume that the projects are independent and indivisible. a. Only Project W should be purchased. b. Projects W and X should be purchased. c. Projects W, X, and Y should be purchased. d. All of the projects should be purchased. e. None of the projects should be purchased.

$700,000

Omega Inc. expects its net income to be $525,000 this year. The firm's dividend payout ratio is 60 percent. The firm is financed with 30 percent debt, and it has no preferred stock outstanding. What is the retained earnings break point for Omega Inc.? a. $315,000 b. $450,000 c. $210,000 d. $300,000 e. $700,000

14.60%

Oval Inc. just paid a dividend equal to $1.50 per share on its common stock, and it expects this dividend to grow by 4 percent per year indefinitely. The firm plans to issue common stock, which has a $16 per share market price, to raise funds to support operations. Oval's investment bankers estimate that the flotation costs for new issues of common stock will be equal to 8 percent of the issue (market) price. What is Oval's cost of new common equity, re? a. 14.60% b. 13.38% c. 10.60% d. 8.76% e. 18.55%

7.2%

Rollins Corporation is constructing its marginal cost of capital (MCC) schedule. Its target capital structure is 30 percent debt, 20 percent preferred stock, and 50 percent common equity. Its bonds have a 12 percent coupon rate of interest, semiannual interest payments, a current maturity of 20 years, and a market value equal to their par value of $1,000. The firm's marginal tax rate is 40 percent. What is Rollins' after-tax cost of debt? a. 8.4% b. 7.2% c. 4.8% d. 12.0% e. 3.6%

9.13%

SW Inc.'s preferred stock, which pays a $5.25 dividend each year, currently sells for $62.50. The company's marginal tax rate is 40 percent. When it issues preferred stock, SW normally incurs flotation costs equal to 8 percent. What is the cost of preferred stock, rps, that should be included in the computation of the SW Inc.'s weighted average cost of capital (WACC)? a. 7.73% b. 9.07% c. 8.40% d. 9.13% e. 7.78%

$30,000

Smith and Sons Inc. has a target capital structure that calls for 40 percent debt, 10 percent preferred stock, and 50 percent common equity. The firm's current after-tax cost of debt is 6 percent, and it can sell as much debt as it wishes at this rate. The firm's cost of preferred stock is 11 percent and its cost of retained earnings is 14 percent. The firm expects to generate $15,000 in retained earnings this year. Compute the weighted average cost of capital (WACC) break point associated with issuing new common stock. a. $17,500 b. $15,000 c. $30,000 d. $37,500 e. $150,000

15.64%

Super Solutions Inc. just paid a dividend equal to $3.00 per share. Its stock sells for $33.00 per share, it is growing at an annual rate equal to 6 percent, which is expected to continue long into the future. What is Super's cost of retained earnings? a. 9.09% b. 15.64% c. 15.09% d. 9.64% e. 14.58%

16.0%

Tangerine Inc.'s target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon rate, semiannual interest payments, a current maturity of 20 years, and a market value equal to their par value of $1,000. The firm's marginal tax rate is 40 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to determine its cost of retained earnings. What is Tangerine's component cost of retained earnings? a. 8.0% b. 9.6% c. 11.2% d. 14.4% e. 16.0%

16%

The Jackson Company just paid a dividend equal to $3.00 per share on its common stock, and it expects this dividend to grow by 7 percent per year indefinitely. The firm has a beta coefficient equal to 1.50, the risk-free rate is 10 percent, and the expected return on the market is 14 percent. According to the capital asset pricing model, what is Jackson's cost of retained earnings, rs? a. 23% b. 11% c. 7% d. 16% e. 21%

yield to maturity (YTM)

The _____ on a bond is the cost to the firm for using bondholders' funds. a. coupon rate b. market-to-face value c. yield to maturity (YTM) d. maturity value e. risk-free rate of return

its growth rate (g) is not stable, which makes it difficult to estimate

The annual growth of Omega Inc's operations fluctuates substantially. As a result, using the dividend discount model (DDM) to estimate Omega's cost of retained earnings, rs, is difficult because: a. the stock's dividend yield is extremely difficult to estimate. b. its growth rate (g) is not stable, which makes it difficult to estimate. c. the market price of its common stock is very volatile. d. the firm's growth rate might be negative for an extended period of time. e. its net income is difficult to compute.

yield to maturity (YTM) associated with the firm's bonds.

The before-tax cost of debt, rd, is the same as the: a. yield to maturity (YTM) associated with the firm's bonds. b. dividend yield associated with the firm's common stock. c. average coupon rate on the firm's bonds. d. return on equity if the firm has no preferred stock. e. the firm's marginal tax rate.

true

The component costs of capital are market-determined variables in as much as they are based on investors' required returns. True or False

false

The cost of issuing preferred stock must be adjusted for taxes because preferred stock dividend payments represent a tax-deductible expense for the firm. True or False

total funds required to invest in capital budgeting projects the firm is evaluating for possible purchase

The investment opportunity schedule (IOS) shows the: a. costs of the capital components included in a firm's financing arrangements. b. total funds required to invest in capital budgeting projects the firm is evaluating for possible purchase. c. net present values of different projects the firm is evaluating. d. firm's average cost of capital. e. marginal increase in the weighted average cost of capital that results from changes in the capital components that the firm uses to finance new capital budgeting projects.

false

The marginal cost of capital (MCC) is the weighted average cost of the last dollar of new capital that the firm raises. The MCC generally declines as greater amounts of a specific type of capital are raised during a given period. True or False

cash flow expected to be generated by the asset; the rate of return required by investors

The value of any asset—real or financial—is based on the _____ and the _____. a. weighted average cost of the investment; rate of return achieved by the firm b. cash flow expected to be generated by the asset; the rate of return required by investors c. marginal return an investor expects to earn from the investment; additional cash flow generated by the asset d. rate of return achieved by the investment firm; investors' weighted average cost of investing their money e. rate of return earned by the firm; cash flow expected to be generated by the asset

cost of debt, which is measured as the debt's yield to maturity (YTM)

Which of the following cost of capital measures must be adjusted to account for tax savings? a. Cost of preferred stock b. Cost of debt, which is measured as the debt's yield to maturity (YTM) c. Cost of retained earnings d. Cost of new common equity e. Dividend yield

all investors are well diversified

Which of the following is a major assumption that is embedded in the capital asset pricing model (CAPM), which is often used to estimate the cost of retained earnings, rs? a. All investors are well diversified. b. The firm's dividends and earnings grow at a constant rate far into the future. c. The firm's cost of equity and its cost of debt are always equal. d. The firm's cost of retained earnings must be less than its cost of preferred stock for the CAPM to provide a reasonable estimate for rs. e. Investors primarily purchase stocks with beta coefficients equal to zero.

rs < re

Which of the following is the correct relationship between different capital components of a firm? rd = before-tax cost of debt; rs = cost of retained earnings; re = cost of new common equity a. rs < re b. rd = rs c. rs = re d. rs < rd e. re = re + rd

rdT = Bondholders' required rate of return (YTM) - Tax savings

Which of the following mathematical expressions is used to calculate the after-tax cost of debt, rdT? a. rdT = Firm's internal rate of return - Tax payments b. rdT = Firm's internal rate of return - Tax savings c. rdT = Bondholders' required rate of return (YTM) - Tax savings d. rdT = Firm's internal rate of return - Dividend payments e. rdT = Bondholders' required rate of return (YTM) - Interest payments

The capital asset pricing model (CAPM) assumes investors are well diversified, whereas the discounted cash flow (DCF) approach assumes the firm grows at a constant growth rate.

Which of the following statements is correct about using the capital asset pricing model (CAPM) to determine a firm's component costs of capital? a. The capital asset pricing model (CAPM) gives a better estimate than the discounted cash flow (DCF) approach of a firm's cost of retained earnings. b. The capital asset pricing model (CAPM) approach is typically used to estimate the flotation costs associated with issuing new common equity. c. The beta coefficient used in the capital asset pricing model (CAPM) is equal to the growth rate used in the discounted cash flow (DCF) method. d. The capital asset pricing model (CAPM) and the discounted cash flow (DCF) approach provide the same estimate for the firm's cost of retained earnings, rs. e. The capital asset pricing model (CAPM) assumes investors

investment opportunity schedule (IOS)

a graph of the capital budgeting projects a firm is evaluating ranked in the order of their internal rates of return is called a(n) _____. a. marginal cost of capital graph b. investment opportunity schedule (IOS) c. modified internal rate of return (MIRR) graph d. internal project classification schedule e. optimal capital budget (OCB) schedule

true

even if a firm obtains all of its common equity financing from retained earnings, its marginal cost of capital (MCC) schedule could still increase if very large amounts of new capital are raised. True or False

inversely related to the rate of return investors require to purchase

everything else equal, an asset's value is: a. inversely related to the rate of return investors require to purchase it. b. directly proportional to the cost of debt used in the capital budgeting process of the firm. c. not related to the cash flows that the asset is expected to generate during its life. d. inversely related to the cost of debt used in the capital budgeting process of the firm. e. directly proportional to the rate of return investors require to purchase it.

internal rate of return (IRR)

if a project's _____ exceeds the firm's weighted average cost of capital (WACC), its net present value (NPV) will be positive. a. marginal cost of capital b. incremental operating cash flows c. inflation premium d. internal rate of return (IRR) e. initial investment outlay

average yield to maturity (YTM) on the firm's bonds

the average rate of return that investors require to provide funds to the firm in the form of debt is the ________. a. average coupon rate on the firm's bonds b. average yield to maturity (YTM) on the firm's bonds c. average maturity value of the firm's bonds d. firm's required rate of return e. average internal rate of return (IRR) the firm earns on its assets

generally increases because the firm incurs higher floatation costs and higher financial risk as it raises more funds through new debt and new equity issues

the marginal cost of capital (MCC) schedule generally rises, which implies that the weighted average cost of capital: a. increases as the firm achieves economies of scale in its financing arrangements. b. decreases as the firm uses more retrained earnings to finance capital budgeting projects. c. decreases as the firm uses a greater proportion of cheaper debt and a lower proportion of more expensive common stock. d. increases as the firm pays more taxes on higher levels of taxable income. e. generally increase because the firm incurs higher flotation costs and higher financial risk as it raises more funds through new debt and new equity issues.

increases

the marginal cost of capital generally _____ as more capital is raise during a given period. a. remains constant b. decreases c. increases d. changes in an unpredictable way e. approaches zero

investors who purchase the firm's stocks and bonds in the financial markets

the rates of return, or costs, that a firm must pay to raise funds to invest in capital budgeting projects are determined by the: a. marginal revenue generated by projects in which the firm invests. b. investors who purchase the firm's stock and bonds in the financial markets. c. internal rate of return the firm earns on its investments. d. cash flows generated by the investment in capital budgeting projects. e. firm's dividend payout ratio.

maximizes the price of the firm's stock

the target capital structure of a firm is the capital structure that: a. minimizes the operating risk of the firm's assets. b. maximizes the tax shield created by debt. c. minimizes the default risk of long-term debt. d. maximizes the price of the firm's stock. e. maximizes the dividends paid to common stockholders.

minimum rate of return a firm must earn on average-risk investments to maintain its current value

the weighted average cost of capital of a firm represents the: a. minimum rate of return a firm must earn on average-risk investments to maintain its current value. b. maximum rate of return a firm can expect to earn on its investments. c. maximum interest rate a firm should pay on the debt it uses. d. minimum dividend yield a firm must pay to its preferred stockholders. e. required rate of return that should be used to evaluate capital budgeting projects that have above-average risk.

interest payments on debt represent a tax deductible expense to the firm

to determine the actual cost of using debt, a firm must adjust its bonds' average yield to maturity for the fact that _____. a. interest payments on debt represent taxable income to the firm b. interest payments on debt represent a tax deductible expense to the firm c. the average yield to maturity on its debt is a positive return that the firm receives (earns) d. the average yield to maturity on the firm's debt determines the tax rate that it pays on its operating income e. the firm's bondholders do not have to pay taxes on the interest they receive from the firm

as long as the firm's investments earn returns greater than its WACC, the value of the firm will not decrease

under normal circumstances, the weighted average cost of capital (WACC) is used as the firm's required rate of return because: a. as long as the firm's investments earn returns greater than its WACC, the value of the firm will not decrease. b. any returns less than the WACC will cover the fixed costs associated with the capital and provide excess returns to the firm's stockholders. c. it is the average of all the interest rates on the firm's existing debt. d. it is an indication of the returns the firm expects to earn in the future from investing in capital budgeting projects. e. it represents the average return the firm currently earns on the funds it has invested in assets.

a break point (BP) is defined as the last dollar of new total capital that can be raised before an increase in the firm's weighted average costs of capital (WACC) occurs

which of the following is true of a break point on a firm's marginal cost of capital (MCC) schedule? a. A break point (BP) is defined as the last dollar of new total capital that can be raised before an increase in the firm's weighted average cost of capital (WACC) occurs. b. A break point (BP) is defined as the weighted average cost of capital (WACC) of the last dollar of new capital that a firm raises. c. A break point denotes the cost of obtaining an additional dollar of new capital that is required to meet the firm's capital budgeting needs. d. At the break point, the marginal cost of raising new capital equals the marginal revenues generated from investing the new capital. e. A break point shows the point at which the yield to maturity (YTM) on debt is equal to the firm's required rate of return.

an increase in the tax rate will decrease a firm's marginal cost of debt

which of the following statements about the marginal cost of capital is correct? assume everything else is equal. a. An increase in the tax rate will decrease a firm's marginal cost of debt. b. An increase in a company's stock price will increase its marginal cost of debt. c. An increase in a company's stock price will increase its marginal cost of issuing new common equity. d. An increase in the total capital raised during a particular period will decrease a firm's marginal cost of debt. e. A decrease in the weighted cost of capital (WACC) will decrease a firm's marginal cost of retained earnings.

all else equal, an increase in the corporate tax rate will result in a decrease in the firm's weighted average cost of capital

which of the following statements concerning the effect of taxes on a firm's cost of capital is correct? a. All else equal, an increase in the corporate tax rate will result in a decrease in the firm's weighted average cost of capital. b. For a particular firm, the before-tax cost of debt is less than the after-tax cost of debt because the firm must pay taxes on the interest its bondholders receive. c. A firm's after-tax cost of debt is always greater than its cost of retained earnings. d. Because preferred stock dividends are tax deductible to the firm, its cost of preferred stock is greater than its before-tax cost of debt. e. All else equal, a firm's cost of retained earnings is less than its cost of new common equity because any earnings retained by the firm are not double taxed (i.e., taxed twice) like the dividends that are paid to new common stockholders.

floatation costs increase the cost of using funds; e.g., the cost of issuing new common stock is greater than the cost of retained earnings because the firm must pay flotation costs to issue new equity

which of the following statements is true about the flotation costs that are incurred when a firm issues new securities to raise funds? a. The higher the flotation costs associated with a preferred stock issue, the lower the firm's cost of preferred stock, rps. b. Flotation costs should be added to the per share price of a preferred stock issue to compute the cost of preferred stock, rps. c. Floatation costs should be added to the before-tax weighted average cost of capital to determine the firm's overall net weighted average cost of capital after taxes. d. When it incurs flotation costs, the firm normally receives a higher amount of net proceeds from a security issue than when there are no flotation costs. e. Floatation costs increase the cost of using funds; e.g., the cost of issuing new common stock is greater than the cost of retained earnings because the firm must pay flotation costs to issue new equity