Chapter 9
12) The approximate before-tax cost of debt for a 10-year, 8 percent, $1,000 par value bond selling at $1,150 is ________. A) 5.97 percent B) 8.33 percent C) 8.82 percent D) 9 percent
Answer: A
17) If a corporation has an average tax rate of 40 percent, the approximate annual, after-tax cost of debt for a 10-year, 8 percent, $1,000 par value bond selling at $1,150 is ________. A) 3.6 percent B) 4.8 percent C) 6 percent D) 8 percent
Answer: A
18) The approximate after-tax cost of debt for a 20-year, 7 percent, $1,000 par value bond selling at $960 (assume a marginal tax rate of 40 percent) is ________. A) 4.43 percent B) 5.15 percent C) 7 percent D) 7.35 percent
Answer: A
20) The cost of retained earnings will always equal the cost of preferred stock.
Answer: FALSE
18) When discussing weighing schemes for calculating the weighted average cost of capital, ________. A) market value weights are preferred over book value weights and target weights are preferred over historical weights B) book value weights are preferred over market value weights and target weights are preferred over historical weights C) book value weights are preferred over market value weights and historical weights are preferred over target weights D) market value weights are preferred over book value weights and historical weights are preferred over target weights
Answer: A
20) Nico Trading Corporation is considering issuing long-term debt. The debt would have a 30-year maturity and a 10 percent coupon rate. In order to sell the issue, the bonds must be underpriced at a discount of 5 percent of face value. In addition, the firm would have to pay flotation costs of 5 percent of face value. The firm's tax rate is 35 percent. Given this information, the after-tax cost of debt for Nico Trading would be ________. A) 7.26% B) 11.17% C) 10.00% D) 9.00%
Answer: A
38) What would be the cost of new common stock equity for Tangshan Mining if the firm just paid a dividend of $4.25, the stock price is $55.00, dividends are expected to grow at 8.5 percent indefinitely, and flotation costs are $6.25 per share? A) 17.22% B) 16.88% C) 9.46% D) 12.57%
Answer: A
40) The cost of new common stock financing is higher than the cost of retained earnings due to ________. A) flotation costs and underpricing B) flotation costs and overpricing C) flotation costs and commission costs D) commission costs and overpricing
Answer: A
41) Since retained earnings are viewed as a fully subscribed issue of additional common stock, the cost of retained earnings is ________. A) less than the cost of new common stock equity B) equal to the cost of new common stock equity C) greater than the cost of new common stock equity D) not related to the cost of new common stock equity
Answer: A
9) A tax adjustment must be made in determining the cost of ________. A) long-term debt B) common stock C) preferred stock D) retained earnings
Answer: A
11) The approximate before-tax cost of debt for a 15-year, 10 percent, $1,000 par value bond selling at $950 is ________. A) 10 percent B) 10.7 percent C) 12 percent D) 15.4 percent
Answer: B
13) The weights used in weighted average cost of capital must be ________. A) greater than 50% B) nonnegative C) less than zero D) zero
Answer: B
14) The ________ is the rate of return that a firm must earn on its investments in order to maintain the market value of its stock. A) yield to maturity B) cost of capital C) internal rate of return D) modified internal rate of return
Answer: B
15) When determining the after-tax cost of a bond, the face value of the issue must be adjusted to the net proceeds amounts by considering ________. A) the risks B) the flotation costs C) the approximate returns D) the taxes
Answer: B
17) Although a firm's existing mix of financing sources may reflect its target capital structure, it is ultimately ________. A) the internal rate of return that is relevant for evaluating the firm's future investment opportunities B) the marginal cost of capital that is relevant for evaluating the firm's future investment opportunities C) the risk-free rate of return that is relevant for evaluating the firm's future investment opportunities D) the risk-free rate of return that is relevant for evaluating the firm's future financing opportunities
Answer: B
17) As the need for capital increases beyond the optimum capital structure, the cost of debt financing will ________ the firm's weighted average cost of capital. A) increase, lowering B) increase, raising C) decrease, lowering D) decrease, raising
Answer: B
21) The cost of common stock equity is ________. A) the cost of the guaranteed stated dividend expected by the stockholders B) the rate at which investors discount the expected dividends of the firm to determine its share value C) the after-tax cost of the interest obligations D) the historical cost of floating the stock issue
Answer: B
23) The cost of common stock equity may be estimated by using the ________. A) yield curve B) capital asset pricing model C) break-even analysis D) DuPont analysis
Answer: B
24) Which of the following is a source of long-term funds? A) commercial paper B) retained earnings C) factoring D) money market instruments
Answer: B
35) In comparing the constant-growth model and the capital asset pricing model (CAPM) to calculate the cost of common stock equity, ________. A) the CAPM ignores risk, while the constant-growth model directly considers risk as reflected in the beta B) the CAPM directly considers risk as reflected in the beta, while the constant-growth model uses the market price as a reflection of the expected risk-return preference of investors C) the CAPM directly considers risk as reflected in the beta, while the constant growth model uses dividend expectations as a reflection of risk D) the CAPM indirectly considers risk as reflected in the market return, while the constant growth model uses dividend expectations as a reflection of risk
Answer: B
39) What would be the cost of retained earnings equity for Tangshan Mining if the expected return on U.S. Treasury Bills is 5.00%, the market risk premium is 10.00 percent, and the firm's beta is 1.3? A) 11.5% B) 18.0% C) 10.0% D) 19.5%
Answer: B
10) A firm has determined it can issue preferred stock at $115 per share par value. The stock will pay a $12 annual dividend. The cost of issuing and selling the stock is $3 per share. The cost of the preferred stock is ________. A) 6.4 percent. B) 10.4 percent. C) 10.7 percent. D) 12 percent.
Answer: C
10) The ________ from the sale of a security are the funds actually received from the sale after ________. A) gross proceeds, adding the after-tax costs B) gross proceeds, reducing the flotation costs C) net proceeds, reducing the flotation costs D) net proceeds, adding the after-tax costs
Answer: C
13) The before-tax cost of debt for a firm, which has a marginal tax rate of 40 percent, is 12 percent. The after-tax cost of debt is ________. A) 4.8 percent B) 6.0 percent C) 7.2 percent D) 12 percent
Answer: C
15) The ________ is the rate of return required by the market suppliers of capital in order to attract their funds to the firm. A) yield to maturity B) internal rate of return C) cost of capital D) modified internal rate of return
Answer: C
16) If a corporation has an average tax rate of 40 percent, the approximate, annual, after-tax cost of debt for a 15-year, 12 percent, $1,000 par value bond, selling at $950 is ________. A) 10 percent B) 10.6 percent C) 7.7 percent D) 6.0 percent
Answer: C
16) The cost of capital reflects the cost of funds ________. A) that makes the net present value of a project equal zero B) at a given point in time C) over a long-run time period D) at current book values
Answer: C
18) The ________ is a weighted average of the cost of funds which reflects the interrelationship of financing decisions. A) internal rate of return B) sunk cost C) cost of capital D) risk-free rate
Answer: C
19) Debt is generally the least expensive source of capital. This is primarily due to ________. A) the fixed interest payments B) the priority of claims on assets and earnings in the event of liquidation C) the tax deductibility of interest payments D) the secured nature of a debt obligation
Answer: C
21) In order to recognize the interrelationship between financing and investments, a firm should use ________ when evaluating an investment. A) the least costly source of financing B) the most costly source of financing C) the weighted average cost of all financing sources D) the current opportunity cost
Answer: C
22) The cost of common stock equity may be estimated by using the ________. A) yield curve B) break-even analysis C) Gordon model D) DuPont analysis
Answer: C
23) Which of the following is true of long-term funds? A) They provide an easy way to reduce financing costs because they are relatively cheaper than short-term funds. B) They are a type of investment fund which invests in money market investments of high quality and low risk. C) They are the sources that supply the financing necessary to support a firm's capital budgeting activities. D) They are the funds available to a business on the basis of inventory held and require detailed inventory tracking.
Answer: C
24) The cost of retained earnings is ________. A) less than the cost of debt B) equal to the cost of a new issue of common stock C) equal to the cost of common stock equity D) irrelevant to the investment/financing decision
Answer: C
36) In calculating the cost of common stock equity, ________. A) the use of the capital asset pricing model (CAPM) is often preferred, because the data required are more readily available B) the use of the CAPM is preferred, because it directly considers risk and the effect of inflation on the stock prices C) the use of the constant-growth valuation model is often preferred, because the data required are more readily available D) the use of the constant-growth valuation model is often preferred, because it has a stronger theoretical foundation
Answer: C
37) Given that the cost of common stock is 18 percent, dividends are $1.50 per share and the price of the stock is $12.50 per share, what is the annual growth rate of dividends? A) 4 percent B) 5 percent C) 6 percent D) 8 percent
Answer: C
4) Generally the least expensive source of long-term capital is ________. A) retained earnings B) preferred stock C) long-term debt D) common stock
Answer: C
7) What is the dividend on an 8 percent preferred stock that currently sells for $45 and has a face value of $50 per share? A) $3.33 B) $3.60 C) $4.00 D) $5.00
Answer: C
9) A firm has issued preferred stock at its $125 per share par value. The stock will pay a $15 annual dividend. The cost of issuing and selling the stock was $4 per share. The cost of the preferred stock is ________. A) 7.2 percent B) 12 percent C) 12.4 percent D) 15 percent
Answer: C
11) Tangshan Mining is considering issuing preferred stock. The preferred stock would have a par value of $75 and a 5.50 percent dividend. What is the cost of preferred stock for Tangshan if flotation costs would amount to 5.5 percent of par value? A) 5.50% B) 5.27% C) 7.73% D) 5.82%
Answer: D
14) The preferred capital structure weights to be used in the weighted average cost of capital are ________. A) book value weights B) nominal weights C) historic weights D) target weights
Answer: D
14) The specific cost of each source of long-term financing is based on ________ and ________ costs. A) before-tax, historical B) after-tax, historical C) before-tax, book value D) after-tax, current
Answer: D
19) The ________ is the firm's desired optimal mix of debt and equity financing. A) book value B) market value C) cost of capital D) target capital structure
Answer: D
20) The cost to a firm of each type of capital is dependent upon ________. A) the risk-free rate of bonds plus the business risk of the firm B) the risk-free rate of each type of capital plus the business risk of the firm C) the risk-free rate of each type of capital plus the financial risk of the firm D) the risk-free rate of each type of capital plus the business risk and the financial risk of the firm
Answer: D
21) Tangshan Mining is considering issuing long-term debt. The debt would have a 30 year maturity and a 12 percent coupon rate and make semiannual coupon payments. In order to sell the issue, the bonds must be underpriced at a discount of 2.5 percent of face value. In addition, the firm would have to pay flotation costs of 2.5 percent of face value. The firm's tax rate is 33 percent. Given this information, the after-tax cost of debt for Tangshan Mining would be ________. A) 6.38% B) 12.76% C) 4.98% D) 8.48%
Answer: D
22) The four basic sources of long-term funds for a firm are ________. A) current liabilities, long-term debt, common stock, and preferred stock B) current liabilities, long-term debt, common stock, and retained earnings C) long-term debt, paid-in capital in excess of par, common stock, and retained earnings D) long-term debt, common stock, preferred stock, and retained earnings
Answer: D
25) A corporation has concluded that its financial risk premium is too high. In order to decrease this, the firm can ________. A) increase the proportion of long-term debt to decrease the cost of capital B) increase the proportion of short-term debt to decrease the cost of capital C) decrease the proportion of common stock equity to decrease financial risk D) increase the proportion of common stock equity to decrease financial risk
Answer: D
26) The constant-growth valuation model is based on the premise that the value of a share of common stock is ________. A) the sum of the dividends and expected capital appreciation B) determined based on an industry standard P/E multiple C) determined by using a measure of relative risk called correlation coefficient D) equal to the present value of all expected future dividends
Answer: D
27) In calculating the cost of common stock equity, the model which describes the relationship between the required return and the nondiversifiable risk of the firm is ________. A) the constant-growth model B) the NPV model C) the variable growth model D) the capital asset pricing model
Answer: D
28) A firm has a beta of 1.2. The market return equals 14 percent and the risk-free rate of return equals 6 percent. The estimated cost of common stock equity is ________. A) 6 percent B) 7.2 percent C) 14 percent D) 15.6 percent
Answer: D
29) One major expense associated with issuing new shares of common stock is ________. A) coupon payment B) sunk cost C) overvaluation D) underpricing
Answer: D
3) Generally, the order of cost, from the least expensive to the most expensive, for long-term capital of a corporation is ________. A) new common stock, retained earnings, preferred stock, long-term debt B) common stock, preferred stock, long-term debt, short-term debt C) preferred stock, new common stocks, common stock, retained earnings D) long-term debt, preferred stock, retained earnings, new common stock
Answer: D
30) One of the circumstances in which the Gordon growth valuation model for estimating the value of a share of stock should be used is ________. A) declining dividends B) an erratic dividend stream C) the lack of data on dividend payments D) a steady growth rate in dividends
Answer: D
31) A firm has common stock with a market price of $25 per share and an expected dividend of $2 per share at the end of the coming year. The growth rate in dividends has been 5 percent. The cost of the firm's common stock equity is ________. A) 5 percent B) 8 percent C) 10 percent D) 13 percent
Answer: D
33) Using the capital asset pricing model, the cost of common stock equity is the return required by investors as compensation for ________. A) the specific risk of a firm B) a firm's unsystematic risk C) price volatility of the stock D) a firm's nondiversifiable risk
Answer: D
42) Which of the following is a reason for a firm to underprice new issues? A) When the market is in equilibrium, additional demand for shares can be achieved only at a higher price. B) When additional shares are issued, each share's percent of ownership in a firm is diluted, thereby justifying a higher share value. C) When additional shares are issued, each share's percent of ownership in a firm is concentrated, thereby justifying a lower share value. D) When the market is in equilibrium, additional demand for shares can be achieved only at a lower price.
Answer: D
8) A firm has issued 10 percent preferred stock, which sold for $100 per share par value. The cost of issuing and selling the stock was $2 per share. The firm's marginal tax rate is 40 percent. The cost of the preferred stock is ________. A) 3.9 percent B) 6.1 percent C) 9.8 percent D) 10.2 percent
Answer: D
1) Holding risk constant, the implementation of projects with a rate of return above the cost of capital will decrease the value of a firm, and vice versa.
Answer: FALSE
1) The weighted average cost of capital refers to the cost of capital required for one additional dollar of financing.
Answer: FALSE
10) A firm's flotation cost can be calculated by weighting the cost of each source of financing by its relative proportion in a firm's target capital structure.
Answer: FALSE
10) Historical weights are the present value of market price based on the actual historical capital structure proportions.
Answer: FALSE
10) The Gordon model is based on the premise that the value of a share of stock is equal to sum of all future dividends it is expected to provide over an infinite time horizon.
Answer: FALSE
11) The cost of capital is a static concept and it is not affected by economic and firm-specific factors such as business risk and financial risk.
Answer: FALSE
12) Target weights are either book value or market value weights based on actual historical capital structure proportions.
Answer: FALSE
13) In using the cost of capital, it is important that it reflects the historical cost of raising funds over the long run.
Answer: FALSE
15) The capital asset pricing model describes the relationship between the required return, or the cost of common stock equity capital, and the nonsystematic risk of a firm as measured by the beta coefficient.
Answer: FALSE
16) The capital asset pricing model is used to calculate the effect of increase in prices of capital assets due to inflation.
Answer: FALSE
17) The Gordon model assumes that the value of a share of stock equals the future value of the current price of share that it is expected to remain constant over an infinite time horizon.
Answer: FALSE
2) Preferred stockholders must receive their stated dividends prior to the distribution of any earnings to common stockholders and bondholders.
Answer: FALSE
2) The cost of common stock equity refers to the cost of the next dollar of financing necessary to finance a new investment opportunity.
Answer: FALSE
3) Since retained earnings is a more expensive source of financing than debt and preferred stock, the weighted average cost of capital will fall once retained earnings have been exhausted.
Answer: FALSE
3) The amount of preferred stock dividends that must be paid each year may be stated in dollars or as a percentage of the firm's earnings.
Answer: FALSE
3) The cost of capital is described as the rate of return required by the market suppliers of capital in order to attract their funds to the firm.
Answer: FALSE
6) From a bond issuer's perspective, the IRR on a bond's cash flows is its yield to maturity (YTM), from the investor's perspective, the IRR on a bond's cash flows is the cost to maturity.
Answer: FALSE
6) In computing the cost of retained earnings, the net proceeds represents the amount of money retained net of any underpricing and/or flotation costs.
Answer: FALSE
6) In computing the weighted average cost of capital, the target weights are either book value or historical value weights based on actual capital structure proportions.
Answer: FALSE
6) The cost of preferred stock is the ratio of the preferred stock dividend to a firm's total earnings.
Answer: FALSE
7) The cost to maturity of existing bonds reflects the rate of return required by the market.
Answer: FALSE
8) The weighted average cost of capital represents the annual before-tax percentage cost of the debt.
Answer: FALSE
8) Weights that use accounting values to measure the proportion of each type of capital in a firm's financial structure are called market value weights.
Answer: FALSE
9) Since the net proceeds from sale of new common stock will be less than the current market price, the cost of new issues will always be less than the cost of existing issues.
Answer: FALSE
9) The cost of capital of each source of financing is the after-tax cost of obtaining the financing using the historically based cost reflected by the existing financing on the firm's books.
Answer: FALSE
1) In general, floatation costs include two components, underwriting costs and administrative costs.
Answer: TRUE
1) Since preferred stock is a form of ownership, it has no maturity date.
Answer: TRUE
1) The cost of common stock equity may be measured using either the constant-growth valuation model or the capital asset pricing model.
Answer: TRUE
1) The weighted average cost that reflects the interrelationship of financing decisions can be obtained by weighing the cost of each source of financing by the target proportion in a firm's capital structure.
Answer: TRUE
11) Target weights are either book value or market value weights based on a firm's desired capital structure proportions.
Answer: TRUE
11) Using the Capital Asset Pricing Model (CAPM), the cost of common stock equity is the return required by investors as compensation for a firm's nondiversifiable risk.
Answer: TRUE
12) The cost of capital is a dynamic concept and it is affected by economic and firm-specific factors such as business risk and financial risk.
Answer: TRUE
12) Use of the capital asset pricing model (CAPM) in measuring the cost of common stock equity differs from the constant-growth valuation model in that it directly considers the firm's risk as reflected by beta.
Answer: TRUE
13) When the constant-growth valuation model is used to find the cost of common stock equity capital, it can easily be adjusted for flotation costs to find the cost of new common stock, the capital asset pricing model (CAPM) does not provide a simple adjustment mechanism.
Answer: TRUE
14) The cost of new common stock is normally greater than any other long-term financing cost.
Answer: TRUE
18) According to the CAPM, the required return of an asset is the sum of risk-free rate of return and beta times the risk premium.
Answer: TRUE
19) The cost of equity for Tangshan Mining would be 18.00 percent if the expected return on U.S. Treasury Bills is 5.00 percent, the market risk premium is 10.00 percent, and the firm's beta is 1.3.
Answer: TRUE
2) Flotation costs reduce the net proceeds from the sale of a bond whether sold at a premium, at a discount, or at its par value.
Answer: TRUE
2) The constant-growth model uses the market price as a reflection of the expected risk-return preference of investors in the market place.
Answer: TRUE
2) The marginal cost of capital is a relevant cost of capital for evaluating a firm's future investment opportunities.
Answer: TRUE
2) The weighted average cost of capital (WACC) reflects the expected average future cost of capital over the long run.
Answer: TRUE
3) The cost of common stock equity capital represents the return required by existing shareholders on their investment.
Answer: TRUE
3) The net proceeds used in calculation of the cost of long-term debt are funds actually received from the sale after paying for flotation costs and taxes.
Answer: TRUE
4) A firm may face increase in the weighted average cost of capital either when retained earnings have been exhausted or due to increases in debt, preferred stock, and common equity costs as additional new funds are required.
Answer: TRUE
4) The cost of preferred stock is typically higher than the cost of long-term debt (bonds) because the cost of long-term debt (interest) is tax deductible.
Answer: TRUE
4) The cost of retained earnings is always lower than the cost of a new issue of common stock due to the absence of flotation costs when financing projects with retained earnings.
Answer: TRUE
4) The target capital structure is the desired optimal mix of debt and equity financing that most firms attempt to achieve and maintain.
Answer: TRUE
4) When the net proceeds from sale of a bond equal its par value, the before-tax cost would just equal the coupon interest rate.
Answer: TRUE
5) A firm can retain more of its earnings if it can convince its stockholders that it will earn at least their required return on the reinvested funds.
Answer: TRUE
5) From a bond issuer's perspective, the IRR on a bond's cash flows is its cost to maturity, from the investor's perspective, the IRR on a bond's cash flows is the yield to maturity (YTM).
Answer: TRUE
5) In computing the weighted average cost of capital, the historical weights are either book value or market value weights based on actual capital structure proportions.
Answer: TRUE
5) The cost of capital is the rate of return a firm must earn on investments in order to increase the firm's value.
Answer: TRUE
5) The cost of preferred stock is the ratio of the preferred stock dividend to a firm's net proceeds from the sale of the preferred stock.
Answer: TRUE
6) The cost of capital is used to decide whether a proposed corporate investment will increase or decrease a firm's stock price.
Answer: TRUE
7) In computing the weighted average cost of capital, from a strictly theoretical point of view, the preferred weighing scheme is target market value proportions.
Answer: TRUE
7) The cost of capital reflects the cost of funds over the long run measured at a given point in time, based on the best information available.
Answer: TRUE
7) The cost of retained earnings is generally higher than both the cost of debt and cost of preferred stock.
Answer: TRUE
8) One measure of the cost of common stock equity is the rate at which investors discount the expected common stock dividends of the firm to determine its share value.
Answer: TRUE
8) The cost of capital acts as a major link between a firm's long-term investment decisions and the wealth of the firm's owners as determined by the market value of their shares.
Answer: TRUE
9) Weights that use accounting values to measure the proportion of each type of capital in a firm's financial structure are called book value weights.
Answer: TRUE