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PRACTICE
QUESTIONS
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COST OF CAPITAL PRACTICE QUESTIONS
PRACTICE QUESTIONS:
1. The optimal capital budget is the amount of capital determined by the:
a. point of tangency between the marginal cost of capital curve and the
investment opportunity schedule.
b. downward sloping marginal cost of capital curve's intersection with a
upward sloping investment opportunity schedule.
c. upward sloping marginal cost of capital curve's intersection with a
downward sloping investment opportunity schedule.
Answer- c
The marginal cost of capital increases as additional capital is raised, which means the curve
is upward sloping. The investment
opportunity schedule slopes downward, representing the diminishing returns of additional
capital invested. The point where the
two curves intersect is the firm's optimal capital budget, the amount of capital that will
finance all the projects that have positive
net present values.
2. Julius, Inc., is in a 40% marginal tax bracket. The firm can raise as much capital as
needed in the bond market at a cost of 10%. The preferred stock has a fixed
dividend of $4.00. The price of preferred stock is $31.50. The after-tax costs of debt
and preferred stock are closest to:
Debt Preferred stock
A 6% 7.6%
B 10% 7.6%
C 6% 12.7%
Answer- c
After-tax cost of debt = 10% × (1 - 0.4) = 6%.
Cost of preferred stock = $4 / $31.50 = 12.7%.
3. The after-tax cost of preferred stock is always:
a. less than the before-tax cost of preferred stock.
b. equal to the before-tax cost of preferred stock.
c. higher than the cost of common shares.
Answer- b
The after-tax cost of preferred stock is equal to the before-tax cost of preferred stock,
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because preferred stock dividends are not
tax deductible. The cost of preferred shares is usually higher than the cost of debt, but less
than the cost of common shares.
4. The following data is regarding the Link Company:
a. A target debt/equity ratio of 0.5
b. Bonds are currently yielding 10%
c. Link is a constant growth firm that just paid a dividend of $3.00
d. Stock sells for $31.50 per share, and has a growth rate of 5%
e. Marginal tax rate is 40%
What is Link's after-tax cost of capital?
A. 12.0%.
B. 12.5%
C. 10.5%
D. 10%
Answer- A
Use the revised form of the constant growth model to determine the cost of equity. Use
algebra to determine the weights for the target capital structure realizing that debt is 50%
of equity. Substitute 0.5E for D in the formula below.
k = D ÷ P + growth = (3)(1.05) ÷ (31.50) + 0.05 = 0.15 or 15%
V = debt + equity = 0.5 + 1 = 1.5
WACC = (E ÷ V)(k ) + (D ÷ V)(k )(1 − t)
WACC = (1 ÷ 1.5)(0.15) + (0.5 ÷ 1.5)(0.10)(1 − 0.4) = 0.1 + 0.02 = 0.12 or 12%
5. Ferryville Radar Technologies has five-year, 7.5% notes outstanding that trade at a
yield to maturity of 6.8%. The company's marginal tax rate is 35%. Ferryville plans
to issue new five-year notes to finance an expansion. Ferryville's cost of debt capital
is closest to:
a. 4.9%.
b. 2.4%.
c. 4.4%.
Answer- c
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Ferryville's cost of debt capital is k (1 - t) = 6.8% × (1 - 0.35) = 4.42%. Note that the before-
tax cost of debt is the yield to maturity on the company's outstanding notes, not their
coupon rate. If the expected yield on new par debt were known, we would use that.
Since it is not, the yield to maturity on existing debt is the best approximation.
6. Nippon Post Corporation (NPC), a Japanese software development firm, has a
capital structure that is comprised of 60% common equity and 40% debt. In order
to finance several capital projects, NPC will raise USD1.6 million by issuing common
equity and debt in proportion to its current capital structure. The debt will be
issued at par with a 9% coupon and flotation costs on the equity issue will be 3.5%.
NPC's common stock is currently selling for USD21.40 per share, and its last
dividend was USD1.80 and is expected to grow at 7% forever. The company's tax
rate is 40%. NPC's WACC based on the cost of new capital is closest to:
a. 9.6%
b. 11.8%
c. 13.1%
d. 12.1%
Answer- b
k = 0.09(1 - 0.4) = 0.054 = 5.4%
k = [(1.80 × 1.07) / 21.40] + 0.07 = 0.16 = 16.0%
WACC = 0.6(16.0%) + 0.4(5.4%) = 11.76%
Flotation costs, treated correctly, have no effect on the cost of equity component of the
WACC.
7. A company is planning a $50 million expansion. The expansion is to be financed by
selling $20 million in new debt and $30 million in new common stock. The before-
tax required return on debt is 9% and the required return for equity is 14%. If the
company is in the 40% tax bracket, the marginal weighted average cost of capital is
closest to:
a. 10.6%.
b. 9.0%.
c. 10.0%
Answer- a
(0.4)(9%)(1 - 0.4) + (0.6)(14%) = 10.56%
8. BPM Ltd. has the following capital structure: 40% debt and 60% equity. The cost of
equity is 16%. Its before tax cost of debt is 8%, and its corporate tax rate is 40%.
BPM is considering between two mutually exclusive projects that have the
following cash flows:
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Today Year 1 Year 2 Year 3
Project X Cost = 100 50 m 30 m 50 m
million
Project Y Cost = 150 50 m 60 m 80 m
million
Which project should BPM choose?
a. Project X because its NPV is $16 million.
b. Project X because its NPV is $5 million.
c. Project Y because its NPV is $22 million.
Answer- b
Use the WACC as the discount rate to calculate NPV.
WACC = (w × (k × (1 - T))) + (w × k ) = [0.4 × 0.08 × (1 - 0.4)] + [0.6 × 0.16] = 11.52%
NPV of project X = -100 + 50 / (1.1152) + 30 / (1.1152 ) + 50 / (1.1152 ) = +5.01
NPV of project Y = -150 + 50 / (1.1152) + 60 / (1.1152 ) + 80 / (1.1152 ) = +0.76
9. Hans Klein, CFA, is responsible for capital projects at Vertex Corporation. Klein and
his assistant, Karl Schwartz, were discussing various issues about capital budgeting
and Schwartz made a comment that Klein believed to be incorrect. Which of the
following is most likely the incorrect statement made by Schwartz?
a. "Net present value (NPV) and internal rate of return (IRR) result in the
same rankings of potential capital projects."
b. "It is not always appropriate to use the firm's marginal cost of capital when
determining the net present value of a capital project."
c. "The weighted average cost of capital (WACC) should be based on market
values for the firm's outstanding securities."
Answer- a
It is possible that the NPV and IRR methods will give different rankings. This often occurs
when there is a significant difference in the timing of the cash flows between two projects.
A firm's marginal cost of capital, or WACC, is only appropriate for computing a project's
NPV if the project has the same risk as the firm.
10. Cullen Casket Company is considering a project that requires a $175,000 cash
outlay and is expected to produce cash flows of $65,000 per year for the next four
years. Cullen's tax rate is 40% and the before-tax cost of debt is 9%. The current
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share price for Cullen stock is $32 per share and the expected dividend next year is
$1.50 per share. Cullen's expected growth rate is 5%. Cullen finances the project
with 70% newly issued equity and 30% debt, and the flotation costs for equity are
4.5%. What is the dollar amount of the flotation costs attributable to the project,
and that is the NPV for the project, assuming that flotation costs are accounted for
correctly?
Dollar amount of flotation NPV
cost
A. $ 5513 $ 32872
B. $ 7875 $ 30510
C. $ 5513 $ 30510
Answer- a
In order to determine the discount rate, we need to calculate the WACC.
After-tax cost of debt = 9.0% (1 - 0.40) = 5.40%
Cost of equity = ($1.50 / $32.00) + 0.05 = 0.0469 + 0.05 = 0.0969, or 9.69%
WACC = 0.70(9.69%) + 0.30(5.40%) = 8.40%
Since the project is financed with 70% newly issued equity, the amount of equity capital
raised is 0.70 × $175,000 = $122,500
Flotation costs are 4.5 percent, which equates to a dollar flotation cost of $122,500 × 0.045
= $5,512.50.
NPV = - (175000 + 5513) + 65000 / 1.084 + 65000 / (1.084) 2 - 4 = 32872
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