COST OF CAPITAL

PRACTICE QUESTIONS
1. An analyst gathered the following information about a company:
Capital Structure Required Rate of Return
25% debt 12%
35% preferred stock 14%
40% common stock 17%
Assuming a tax rate of 30%, the company’s cost of capital is closest to:
A) 14.7%
B) 13.8%
C) 12.6%
2. Which of the following statements is least accurate?
A) The cost of preferred stock is calculated as preferred stock dividend per share divided by current
market price of preferred shares.
B) The cost of equity may be estimated through different methods, which may produce different results.
C) In the calculation of cost of debt, an adjustment is made for taxes because interest on debt is not tax
deductible.
3. An analyst gathered the following information about a company:
Risk-free rate: 8%
Equity market risk premium: 6%
Firm’s beta: 1.2
Cost of debt: 10%
Tax rate: 30%
Assuming a target debt to equity ratio of 0.3, calculate the firm’s WACC.
A) 13.31%
B) 14%
C) 12.74%
4. Assuming that a firm has equal amounts of debt and common stock outstanding, which of the following
statements is most accurate?
A) An increase in the firm’s tax rate will cause its weighted average cost of capital (WACC) to rise.
B) A decrease in the firm’s tax rate will cause its WACC to fall.
C) An increase in the firm’s tax rate will cause its WACC to fall.
5. Which of the following is most likely to cause a reduction in the firm’s WACC?
A) An increase in the market risk premium
B) A decrease in the firm’s tax rate
C) A decrease in the company’s equity beta
6. An analyst gathered the following information for a company:
Stock price: $45
Last year’s dividend per share: $5
Dividend growth rate: 8%
Cost of debt: 9%
Tax rate: 35%
Target debt to equity ratio: 0.4
The firm’s WACC is closest to:
A) 14.34%
B) 15.96%
230

Page 25 of 112
 C) 16.86%
7. A firm is considering investing in a project that requires an initial investment of $150,000 and will last
for 4 years. The following data is available to the management:
Expected annual after-tax cash flows: $60,000
Target debt to equity ratio: 0.3
Cost of equity: 14%
Cost of debt: 10%
Tax rate: 25%
The project’s NPV is closest to:
A) $29,212
B) $32,049
C) $30,338
8. Consider the following statements:
Statement 1: A potential supplier of capital will provide capital to a company if the return offered by the
company is equal to the return that could be earned elsewhere at a lower risk.
Statement 2: The marginal cost of capital is the expected rate of return that investors demand for
financing an average risk investment of the company.
Which of the following is most likely?
A) Only Statement 1 is incorrect.
B) Only Statement 2 is incorrect.
C) Both statements are correct.
9. Jason Corporations has the following capital structure:
Equity = 65%
Debt = 25%
Preferred stock = 10%
The company’s before-tax cost of debt is 10%, cost of common equity is 12%, and cost of preferred
equity is 13%. Given that the company’s marginal tax rate is 35%, its weighted average cost of capital is
closest to:
A) 12.48%
B) 11.60%
C) 10.73%
10. An analyst gathered the following information regarding Alpha Associates:
Source of Capital Book Value ($ millions) Market Value ($ millions)
Common stock 37.5 52.8
Preferred stock 30 31.68
Bonds outstanding 7.5 11.52
Total capital 75 96
The company’s before-tax cost of debt and the cost of common equity are 9% and the cost of preferred
equity is 11%. Given that the company’s marginal tax rate is 30%, its weighted average cost of capital is
closest to:
A) 9.66%
B) 9.48%
C) 9.34%
11. Sun Corporations has the following capital structure:
Equity = 50%
Debt = 45%
Preferred stock = 5%
The company’s after-tax cost of debt is 14% and the cost of equity is 16%. Given that the company’s
weighted average cost of capital is 14.5%, its cost of preferred equity is closest to:
A) 4.5%

231

Page 26 of 112
 B) 3.5%
C) 4.0%
12. Which of the following statements is most accurate?
A) Dividend payments provide a tax shield and, therefore, should be adjusted for tax savings in the
WACC formula.
B) A company’s marginal cost of capital increases as it raises additional capital.
C) The profitability of the company’s investment opportunities increases as the company makes
additional investments.
13. Alton Technologies is planning to set up a new plant in a foreign country. The company has the
following capital structure:
Capital Structure Required Rate of Return
45% common stock 8%
35% debt 7%
20% preferred stock 9%
The company’s directors have estimated the cost of the investment to be $55 million and plan to finance
$33 million by issuing common stock and $22 million by issuing debt. Given that the company’s
marginal tax rate is 40%, its weighted average cost of capital is closest to:
A) 20.10%
B) 7.60%
C) 6.48%
14. Which of the following statements is least accurate?
A) A company should raise capital and undertake all projects as long as the investment opportunity
schedule is below the marginal cost of capital.
B) If a project has less risk than the firm’s existing projects, the WACC is adjusted downward.
C) Yield-to-maturity is the yield that equates the present value of the bond’s expected future cash flows
to its current market price.
15. An analyst gathered the following information regarding Star Traders Inc.:
Current market share price = $42
Market price of preferred stock = $52
Common stock (issued 300,000 common shares) = $3,000,000
Preferred stock (issued 40,000 preferred shares) = $800,000
The company pays dividends of $3.40 per share and $5.60 per share on its common and preferred stock
respectively. The company’s cost of preferred stock is closest to:
A) 9.48%
B) 10.77%
C) 11.63%
16. JB Associates earned net income of $4.5 million in 2009. The company announced dividends of $0.818
per share which will grow at a constant rate forever. Given that the weighted average number of common
shares outstanding in 2009 is 2.2 million and that the company’s book value of equity in 2008 and 2009
is $22 million and $28 million respectively, its annual growth rate in dividends is closest to:
A) 10.8%
B) 10.4%
C) 10.6%
17. An analyst gathered the following information regarding MT Technologies:
Current market share price = $42
Current dividend = $1.02 per share
Earnings retention rate = 70%
Return on equity = 22%
After-tax cost of debt = 9%
Marginal tax rate = 35%
232

Page 27 of 112
 Target debt-to-equity ratio = 0.3
The company’s weighted average cost of capital is closest to:
A) 16.08%
B) 15.35%
C) 15.44%
18. Which of the following is least likely a method for calculating the cost of debt?
A) Yield-to-maturity approach
B) Bond yield plus risk premium approach
C) Debt rating approach
19. Dolphin Inc. has a return on equity of 15%. Its next year’s dividend is forecasted to be $1.52 per share and the
current stock price is $43. Given that the company’s cost of equity is 16%, its earnings retention rate is closest
to:
A) 15.50%
B) 83.10%
C) 60.43%
20. An analyst gathered the following information regarding Moon Traders:
Current market share price = $55
Risk-free rate = 6%
Current market risk premium = 7%
Beta of stock = 1.4
Target debt-to-equity ratio = 0.4
The company has a capital structure that includes BB-rated bonds with 5 years to maturity. The yield-to-
maturity on a comparable BB-rated bond with a similar term to maturity is 8%. Given that the company’s
marginal tax rate is 40%, its weighted average cost of capital is closest to:
A) 12.66%
B) 13.57%
C) 11.40%
21. Which of the following is least likely an issue in estimating the cost of debt?
A) The company’s currently outstanding bonds contain embedded options.
B) The company uses leases as a source of finance.
C) The company uses fixed rate debt.
22. The yield-to-maturity on Capital One’s long-term debt is 8%. The risk premium is estimated to be 5.5%.
Given that the company’s marginal tax rate is 40%, its cost of equity and debt are closest to:
Cost of Equity Cost of Debt
A 10.3% 8.0%
B 13.5% 4.8%
C 10.3% 4.8%
23. Which of the following is least likely an assumption when using WACC as the discount rate to evaluate a
particular project?
A) The project will have a constant capital structure throughout its life.
B) The company’s market values of debt and equity are available.
C) The project under consideration is an average risk project.
24. Which of the following statements regarding a stock’s beta is least accurate?
A) It is believed to revert toward 1 over time.
B) It is calculated by regressing market returns against the company’s stock’s returns over a given
period.
C) Some experts argue that the betas of small companies should be adjusted upward to reflect greater
risk.

233

Page 28 of 112
25. Pluto Inc. issues a semi-annual pay bond to finance a new project. The bond has a 20-year term, a par
value of $1,000, and offers a 7% coupon rate. Given that the bond is issued at $984.5 and that the
company’s marginal tax rate is 40%, the after-tax cost of debt is closest to:
A) 3.57%
B) 4.29%
C) 7.15%
26. Beta estimates are least likely sensitive to:
A) The choice of the market index against which stock returns are regressed.
B) The capital structure of the company.
C) The length of the estimation period.
27. Donald Investments has a target debt-to-equity ratio of 0.8. Given that the after-tax cost of debt is 5.6%
and that the company’s weighted average cost of capital is 10.8%, its cost of equity is closest to:
A) 14.96%
B) 31.60%
C) 4.62%
28. Gamma Corporations has a target debt-to-equity ratio of 0.4. The company’s equity beta is 0.9, risk-free
rate is 7%, and expected return on the market is 12%. Given that the company’s marginal tax rate is 35%
and that its weighted average cost of capital is 10.5%, its before-tax cost of debt is closest to:
A) 12.31%
B) 8.00%
C) 4.92%
29. Venus Inc. is considering investing in the hotel business. The company has a D/E ratio of 1.3, a before-
tax cost of debt of 8%, and a marginal tax rate of 40%.
Luxury Hotels is a publicly traded company that operates only in the hotel industry. The company has a
D/E ratio of 1.8, an equity beta of 0.9, and marginal tax rate of 35%.
The risk-free rate is 6% and expected market risk premium is 7%. The weighted average cost of capital
that Venus Inc should use to evaluate the risk of entering the hotel industry is closest to:
A) 7.57%
B) 9.70%
C) 7.96%
30. Consider the following statements:
Statement 1: A company’s existing debt covenants that restrict it from issuing debt with similar seniority
causes its marginal cost of capital to increase as additional capital is raised.
Statement 2: Deviation from its target capital structure over the short term causes the marginal cost of
capital to increase as additional capital is raised.
Which of the following is most likely?
A) Only Statement 1 is incorrect.
B) Only Statement 2 is incorrect.
C) Both statements are correct.
31. Mega Associates wants to invest in a project in Elantica, an emerging country. It gathered the following
information:
A) Yield on Elantica’s dollar-denominated 10-year government bond = 12%
B) Yield on a 10-year U.S. Treasury bond = 3.5%
C) Annualized standard deviation of Elantica’s stock market = 34%
D) Annualized standard deviation of Elantica’s dollar-denominated 10-year government bond = 25%
E) Project’s beta = 1.3
F) Expected return on the Elantican equity market = 11%
G) Risk-free rate = 6%
The country risk premium and the cost of equity for the project in Elantica are closest to:
Country Risk Premium Cost of Equity
A 11.56% 27.53%
234

Page 29 of 112
 B 11.56% 24.06%
C 16.32% 28.82%
32. Beta Inc. wants to raise capital amounting to $550 million. It has a target debt-to-equity ratio of 1.2. The
following table illustrates the company’s marginal cost of capital schedule:
Amount of New Debt After-Tax Cost of Amount of New Equity Cost of
($ millions) Debt ($ millions) Equity
0 – 100 3.5% 0 – 200 6.5%
100 – 250 4.5% 200 – 400 7.5%
250 – 450 5.5% 400 – 600 8.5%
The company’s weighted average cost of capital is closest to:
A) 6.41%
B) 5.86%
C) 13.4%
33. Jupiter Inc. is planning to invest $142,000 in a new project. The company’s directors have been provided
with the following information:
Expected future cash flows = $25,000 every year for the next 6 years
Before-tax cost of debt = 7.5%
Current market share price = $37.5
Expected market risk premium = 5%
Risk-free rate = 6%
Beta of the stock = 1.4
Target debt-to-equity ratio = 0.5
Marginal tax rate = 30%
Flotation costs for equity = 3.5%
The net present value of the project is closest to:
A) −$39,405
B) −$34,435
C) −$37,749
34. A company has $5 million in debt outstanding with a coupon rate of 12%. Currently, the yield to maturity
(YTM) on these bonds is 14%. If the firm's tax rate is 40%, what is the company's after-tax cost of debt?
A. 5.6%.
B. 8.4%.
C. 14.0%.
35. The cost of preferred stock is equal to:
A. the preferred stock dividend divided by its par value.
B. [(1 - tax rate) times the preferred stock dividend] divided by price.
C. the preferred stock dividend divided by its market price.
36. A company's $100, 8% preferred is currently selling for $85. What is the company's cost of preferred
equity?
A. 8.0%.
B. 9.4%.
C. 10.8%.
37. The expected dividend is $2.50 for a share of stock priced at $25. What is the cost of equity if the long-
term growth in dividends is projected to be 8%?
A. 15%.
B. 16%.
C. 18%.

235

Page 30 of 112
38. An analyst gathered the following data about a company:
Capital structure Required rate of return
30% debt 10% for debt
20% preferred stock 11% for preferred stock
50% common stock 18% for common stock
Assuming a 40% tax rate, what after-tax rate of return must the company earn on its investments?
A. 13.0%.
B. 14.2%.
C. 18.0%.
39. 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
14% for equity. If the company is in the 40% tax bracket, the company's marginal cost of capital is
closest to:
A. 7.2%.
B. 10.6%.
C. 12.0%.
Use the following data to answer Questions 7 through 10.
 A company has a target capital structure of 40% debt and 60% equity.
 The company's bonds with face value of $1,000 pay a 10% coupon (semiannual), mature in 20 years,
and sell for $849.54 with a yield to maturity of 12%.
 The company stock beta is 1.2.
 Risk-free rate is 10%, and market risk premium is 5%.
 The company is a constant-growth firm that just paid a dividend of $2, sells for $27 per share, and
has a growth rate of 8%.
 The company's marginal tax rate is 40%.
40. The company's after-tax cost of debt is:
A. 7.2%.
B. 8.0%.
C. 9.1%.
41. The company's cost of equity using the capital asset pricing model (CAPM) approach is:
A. 16.0%.
B. 16.6%.
C. 16.9%.
42. The company's cost of equity using the dividend discount model is:
A. 15.4%.
B. 16.0%.
C. 16.6%.
43. The company's weighted average cost of capital (using the cost of equity from CAPM) is closest to:
A. 12.5%.
B. 13.0%.
C. 13.5%.
44. What happens to a company's weighted average cost of capital (WACC) if the firm's corporate tax rate
increases and if the Federal Reserve causes an increase inthe risk-free rate, respectively? (Consider the
events independently and assume a beta of less than one.)
Tax rate increase Increase in risk-free rate
A. Decrease WACC Increase WACC
B. Decrease WACC Decrease WACC
C. Increase WACC Increase WACC
45. Given the following information on a company's capital structure, what is the company's weighted
average cost of capital? The marginal tax rate is 40%.
236

Page 31 of 112
 Type of capital Percent of capital structure Before-tax component cost
Bonds 40% 7.5%
Preferred stock 5% 11%
Common stock 55% 15%
A. 10.0%.
B. 10.6%.
C. 11.8%.
46. Derek Ramsey is an analyst with Bullseye Corporation, a major U.s.-based discount retailer. Bullseye is
considering opening new stores in Brazil and wants to estimate its cost of equity capital for this
investment. Ramsey has found that:
 The appropriate beta to use for the project is 1.3.
 The market risk premium is 6%.
 The risk-free interest rate is 4.5%.
 The country risk premium for Brazil is 3.1%.
Which of the following is closest to the cost of equity that Ramsey should use in his analysis?
A. 10.5%.
B. 15.6%.
C. 16.3%.
47. Manigault Industries currently has assets on its balance sheet of $200 million that are financed with 70%
equity and 30% debt. The executive management team at Manigault is considering a major expansion
that would require raising additional capital. Rosannna Stallworth, the CFO of Manigault, has put
together the following schedule for the costs of debt and equity:
Amount of New After- Tax Cost of Amount of New Cost of Equity
Debt (in millions) Debt Equity (in millions)
$0 to $49 4.0% $0 to $99 7.0%
$50 to $99 4.2% $100 to $199 8.0%
$100 to $149 4.5% $200 to $299 9.0%
In a presentation to Manigault's Board of Directors, Stallworth makes the following statements:
Statement 1: If we maintain our target capital structure of70% equity and 30% debt, the break point at
which our cost of equity will increase to 8.0% is $185 million in new capital.
Statement 2: If we want to finance total assets of $450 million, our marginal cost of capital will increase to
7.56%.
Are Stallworth's Statements 1 and 2 most likely correct or incorrect?
Statement 1 Statement 2
A. Correct Correct
B. Incorrect Correct
C. Incorrect Incorrect
48. Black Pearl Yachts is considering a project that requires a $180,000 cash outlay and is expected to
produce cash flows of $50,000 per year for the next five years. Black Pearl's tax rate is 25%, and the
before-tax cost of debt is 8%. The current share price for Black Pearl's stock is $56 and the expected
dividend next year is $2.80 per share. Black Pearl's expected growth rate is 5%. Assume that Black Pearl
finances the project with 60% equity and 40% debt, and the flotation cost for equity is 4.0%. The
appropriate discount rate is the weighted average cost of capital (WACC). Which of the following
choices is closest to the dollar amount of the flotation costs and the NPV for the project, assuming that
flotation costs are accounted for properly?
Dollar amount of flotation costs NPV of
project
A. $4,320 $17,548
B. $4,320 $13,228
C. $7,200 $17,548

237

Page 32 of 112
49. Jay Company has a debt-to-equity ratio of 2.0. Jay is evaluating the cost of equity for a project in the
same line of business as Cass Company and will use the pure-play method with Cass as the comparable
firm. Cass has a beta of 1.2 and a debt-to-equity ratio of 1.6. The project beta most likely:
A. will be less than Jay Company's beta.
B. will be greater than Jay Company's beta.
C. could be greater than or less than Jay Company's beta.
50. The cost of equity is equal to the:
A. expected market return.
B. rate of return required by stockholders.
C. cost of retained earnings plus dividends.
51. Which of the following statements is correct?
A. The appropriate tax rate to use in the adjustment of the before-tax cost of debt to determine the after-
tax cost of debt is the average tax rate because interest is deductible against the company's entire
taxable income.
B. For a given company, the after-tax cost of debt is generally less than both the cost of preferred equity
and the cost of common equity.
C. For a given company, the investment opportunity schedule is upward sloping because as a company
invests more in capital projects, the returns from investing increase.
52. Using the dividend discount model, what is the cost of equity capital for Zeller Mining if the company
will pay a dividend of C$2.30 next year, has a payout ratio of 30 percent, a return on equity (ROE) of 15
percent, and a stock price of C$45?
A. 9.61 percent.
B. 10.50 percent.
C. 15.61 percent.
53. Dot.Com has determined that it could issue $1,000 face value bonds with an 8 percent coupon paid semi-
annually and a five-year maturity at $900 per bond. If Dot.Com’s marginal tax rate is 38 percent, its
after-tax cost of debt is closest to:
A. 6.2 percent.
B. 6.4 percent.
C. 6.6 percent.
54. The cost of debt can be determined using the yield-to-maturity and the bond rating approaches. If the
bond rating approach is used, the:
A. coupon is the yield.
B. yield is based on the interest coverage ratio.
C. company is rated and the rating can be used to assess the credit default spread of the company's debt.
55. Morgan Insurance Ltd. issued a fixed-rate perpetual preferred stock three years ago and placed it
privately with institutional investors. The stock was issued at $25 per share with a $1.75 dividend. If the
company were to issue preferred stock today, the yield would be 6.5 percent. The stock's current value is:
A. $25.00.
B. $26.92.
C. $37.31.
56. A financial analyst at Buckco Ltd. wants to compute the company's weighted average cost of capital
(WACC) using the dividend discount model. The analyst has gathered the following data:
Before-tax cost of new debt 8 percent
Tax rate 40 percent
Target debt-to-equity ratio 0.8033
Stock price $30
Next year's dividend $1.50
Estimated growth rate 7 percent
238

Page 33 of 112
 Buckco’s WACC is closest to:
A. 8 percent.
B. 9 percent.
C. 12 percent.
57. The Gearing Company has an after-tax cost of debt capital of 4 percent, a cost of preferred stock of 8
percent, a cost of equity capital of 10 percent, and a weighted average cost of capital of 7 percent.
Gearing intends to maintain its current capital structure as it raises additional capital. In making its
capital-budgeting decisions for the average-risk project, the relevant cost of capital is:
A. 4 percent.
B. 7 percent.
C. 8 percent.
58. Fran McClure of Alba Advisers is estimating the cost of capital of Frontier Corporation as part of her
valuation analysis of Frontier. McClure will be using this estimate, along with projected cash flows from
Frontier's new projects, to estimate the effect of these new projects on the value of Frontier. McClure has
gathered the following information on Frontier Corporation:
Current Year ($) Forecasted for Next Year ($)
Book value of debt 50 50
Market value of debt 62 63
Book value of shareholders' equity 55 58
Market value of shareholders' equity 210 220
The weights that McClure should apply in estimating Frontier's cost of capital for debt and equity are,
respectively:
A. WD = 0.200; WE = 0.800.
B. wd = 0.185; we = 0.815.
C. wd = 0.223; we = 0.777.
59. Wang Securities had a long-term stable debt-to-equity ratio of 0.65. Recent bank borrowing for
expansion into South America raised the ratio to 0.75. The increased leverage has what effect on the asset
beta and equity beta of the company?
A. The asset beta and the equity beta will both rise.
B. The asset beta will remain the same and the equity beta will rise.
C. The asset beta will remain the same and the equity beta will decline.
60. Brandon Wiene is a financial analyst covering the beverage industry. He is evaluating the impact of DEF
Beverage’s new product line of flavored waters. DEF currently has a debt-to-equity ratio of 0.6. The new
product line would be financed with $50 million of debt and $100 million of equity. In estimating the
valuation impact of this new product line on DEF's value, Wiene has estimated the equity beta and asset
beta of comparable companies. In calculating the equity beta for the product line, Wiene is intending to
use DEF's existing capital structure when converting the asset beta into a project beta. Which of the
following statements is correct?
A. Using DEF’s debt-to-equity ratio of 0.6 is appropriate in calculating the new product line's equity
beta.
B. Using DEF’s debt-to-equity ratio of 0.6 is not appropriate, but rather the debt-to-equity ratio of the
new product, 0.5, is appropriate to use in calculating the new product line’s equity beta.
C. Wiene should use the new debt-to-equity ratio of DEF that would result from the additional $50
million debt and $100 million equity in calculating the new product line's equity beta.
61. Trumpit Resorts Company currently has 1.2 million common shares of stock outstanding and the stock
has a beta of 2.2. It also has $10 million face value of bonds that have five years remaining to maturity
and 8 percent coupon with semi-annual payments, and are priced to yield 13.65 percent. If Trumpit issues
up to $2.5 million of new bonds, the bonds will be priced at par and have a yield of 13.65 percent; if it
issues bonds beyond $2.5 million, the expected yield on the entire issuance will be 16 percent. Trumpit
has learned that it can issue new common stock at $10 a share. The current risk-free rate of interest is 3
239

Page 34 of 112
 percent and the expected market return is 10 percent. Trumpit’s marginal tax rate is 30 percent. If
Trumpit raises $7.5 million of new capital while maintaining the same debt-to-equity ratio, its weighted
average cost of capital is closest to:
A. 14.5 percent.
B. 15.5 percent.
C. 16.5 percent.
The following information relates to Questions 62–67
Jurgen Knudsen has been hired to provide industry expertise to Henrik Sandell, CFA, an analyst for a
pension plan managing a global large-cap fund internally. Sandell is concerned about one of the fund's
larger holdings, auto parts manufacturer Kruspa AB. Kruspa currently operates in 80 countries, with the
previous year's global revenues at €5.6 billion. Recently, Kruspa’s CFO announced plans for expansion
into China. Sandell worries that this expansion will change the company's risk profile and wonders if he
should recommend a sale of the position.
Sandell provides Knudsen with the basic information. Kruspa’s global annual free cash flow to the firm
is €500 million and earnings are €400 million. Sandell estimates that cash flow will level off at a 2
percent rate of growth. Sandell also estimates that Kruspa’s after-tax free cash flow to the firm on the
China project for next three years is, respectively, €48 million, €52 million, and €54.4 million. Kruspa
recently announced a dividend of €4.00 per share of stock. For the initial analysis, Sandell requests that
Knudsen ignore possible currency fluctuations. He expects the Chinese plant to sell only to customers
within China for the first three years. Knudsen is asked to evaluate Kruspa’s planned financing of the
required €100 million with a €80 public offering of 10-year debt in Sweden and the remainder with an
equity offering.
Additional information:
Equity risk premium, Sweden 4.82 percent
Risk-free rate of interest, Sweden 4.25 percent
Industry debt-to-equity ratio 0.3
Market value of Kruspa’s debt €900 million
Market value of Kruspa’s equity €2.4 billion
Kruspa’s equity beta 1.3
Kruspa’s before-tax cost of debt 9.25 percent
China credit A2 country risk premium 1.88 percent
Corporate tax rate 37.5 percent
Interest payments each year Level
62. Using the capital asset pricing model, Kruspa’s cost of equity capital for its typical project is closestto:
A. 7.62 percent.
B. 10.52 percent.
C. 12.40 percent.
63. Sandell is interested in the weighted average cost of capital of Kruspa AB prior to its investing in the
China project. This weighted average cost of capital (WACC) is closest to:
A. 7.65 percent.
B. 9.23 percent.
C. 10.17 percent.
64. In his estimation of the project's cost of capital, Sandell would like to use the asset beta of Kruspa as a
base in his calculations. The estimated asset beta of Kruspa prior to the China project is closest to:
A. 1.053.
B. 1.110.
C. 1.327.

240

Page 35 of 112
65. Sandell is performing a sensitivity analysis of the effect of the new project on the company's cost of
capital. If the China project has the same asset risk as Kruspa, the estimated project beta for the China
project, if it is financed 80 percent with debt, is closest to:
A. 1.300.
B. 2.635.
C. 3.686.
66. As part of the sensitivity analysis of the effect of the new project on the company's cost of capital,
Sandell is estimating the cost of equity of the China project considering that the China project requires a
country equity premium to capture the risk of the project. The cost of equity for the project in this case
is closest to:
A. 10.52 percent.
B. 19.91 percent.
C. 28.95 percent.
67. In his report, Sandell would like to discuss the sensitivity of the project's net present value to the
estimation of the cost of equity. The China project's net present value calculated using the equity beta
without and with the country risk premium are, respectively:
A. €26 million and €24 million.
B. €28 million and €25 million.
C. €30 million and €27 million.
The following information relates to Questions 68–71
Boris Duarte, CFA, covers initial public offerings for Zellweger Analytics, an independent research firm
specializing in global small-cap equities. He has been asked to evaluate the upcoming new issue of
TagOn, a US-based business intelligence software company. The industry has grown at 26 percent per
year for the previous three years. Large companies dominate the market, but sizable “pure-play”
companies such as Relevant, Ltd., ABJ, Inc., and Opus Software Pvt. Ltd also compete. Each of these
competitors is domiciled in a different country, but they all have shares of stock that trade on the US
NASDAQ. The debt ratio of the industry has risen slightly in recent years.
Market
Value Equity Market Value Share
Sales in in Millions Debt in Equity Tax Price
Company Millions ($) ($) Millions ($) Beta Rate ($)
Relevant Ltd. 752 3,800 0.0 1.702 23 42
percent
ABJ, Inc. 843 2,150 6.5 2.800 23 24
percent
Opus Software Pvt. 211 972 13.0 3.400 23 13
Ltd. percent
Duarte uses the information from the preliminary prospectus for TagOn’s initial offering. The company
intends to issue 1 million new shares. In his conversation with the investment bankers for the deal, he
concludes the offering price will be between $7 and $12. The current capital structure of TagOn consists
of a $2.4 million five-year non-callable bond issue and 1 million common shares. Other information that
Duarte has gathered:
Currently outstanding bonds $2.4 million five-year bonds, coupon of 12.5 percent, with a
market value of $2.156 million
Risk-free rate of interest 5.25 percent
Estimated equity risk premium 7 percent
Tax rate 23 percent
68. The asset betas for Relevant, ABJ, and Opus, respectively, are:
A. 1.70, 2.52, and 2.73.
B. 1.70, 2.79, and 3.37.
241

Page 36 of 112
 C. 1.70, 2.81, and 3.44.
69. The average asset beta for the pure players in this industry, Relevant, ABJ, and Opus, weighted by
market value of equity is closest to:
A. 1.67.
B. 1.97.
C. 2.27.
70. Using the capital asset pricing model, the cost of equity capital for a company in this industry with a
debt-to-equity ratio of 0.01, asset beta of 2.27, and a marginal tax rate of 23 percent is closest to:
A. 17 percent.
B. 21 percent.
C. 24 percent.
71. The marginal cost of capital for TagOn, based on an average asset beta of 2.27 for the industry and
assuming that new stock can be issued at $8 per share, is closest to:
A. 20.5 percent.
B. 21.0 percent.
C. 21.5 percent.
72. Two years ago, a company issued $20 million in long-term bonds at par value with a coupon rate of 9
percent. The company has decided to issue an additional $20 million in bonds and expects the new issue
to be priced at par value with a coupon rate of 7 percent. The company has no other debt outstanding and
has a tax rate of 40 percent. To compute the company's weighted average cost of capital, the appropriate
after-tax cost of debt is closest to:
A. 4.2%.
B. 4.8%.
C. 5.4%.
73. An analyst gathered the following information about a company and the market:
Current market price per share of common stock $28.00
Most recent dividend per share paid on common stock (D0) $2.00
Expected dividend payout rate 40%
Expected return on equity (ROE) 15%
Beta for the common stock 1.3
Expected rate of return on the market portfolio 13%
Risk-free rate of return 4%
Using the discounted cash flow (DCF) approach, the cost of retained earnings for the company
isclosest to:
A. 15.7%.
B. 16.1%.
C. 16.8%.
74. An analyst gathered the following information about a company and the market:
Current market price per share of common stock $28.00
Most recent dividend per share paid on common stock (D0) $2.00
Expected dividend payout rate 40%
Expected return on equity (ROE) 15%
Beta for the common stock 1.3
Expected rate of return on the market portfolio 13%
Risk-free rate of return 4%
Using the Capital Asset Pricing Model (CAPM) approach, the cost of retained earnings for the company
is closest to:
242

Page 37 of 112
 A. 13.6%.
B. 15.7%.
C. 16.1%.
75. An analyst gathered the following information about a private company and its publicly traded
competitor:
Comparable Companies Tax Rate (%) Debt/Equity Equity Beta
Private company 30.0 1.00 N.A.
Public company 35.0 0.90 1.75
Using the pure-play method, the estimated equity beta for the private company is closest to:
A. 1.029.
B. 1.104.
C. 1.877.
76. An analyst gathered the following information about the capital markets in the United States and in
Paragon, a developing country.
Selected Market Information (%)
Yield on US 10-year Treasury bond 4.5
Yield on Paragon 10-year government bond 10.5
Annualized standard deviation of Paragon stock index 35.0
Annualized standard deviation of Paragon dollar-denominated government bond 25.0

Based on the analyst’s data, the estimated country equity premium for Paragon is closest to:
A. 4.29%.
B. 6.00%.
C. 8.40%.
77. The 6% semiannual coupon, 7-year notes of Foodbine Transportation, Inc. trade for a price of 94.54.
What is the company's after-tax cost of debt capital if its marginal tax rate is 30%?
A. 4.2%.
B. 4.9%.
C. 2.1%.
78. 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.
79. In order to more accurately estimate the cost of equity for a company situated in a developing market,
an analyst should:
A. add a country risk premium to the risk-free rate when using the capital asset pricing model
(CAPM).
B. use the yield on the sovereign debt of the developing country instead of the risk free rate when
using the capital asset pricing model (CAPM).
C. add a country risk premium to the market risk premium when using the capital asset pricing model
(CAPM).
80. Sung, 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. 6.0% 7.6%
243

Page 38 of 112
 B. 10.0% 7.6%
C. 6.0% 12.7%
81. 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.
82. Jolly Cruz, CFA, is the Chief Financial Officer of Waterbury Corporation. Cruz has just been informed
that the U.S. Internal Revenue Code may be revised such that the maximum marginal corporate tax
rate will be increased. Since Waterbury's taxable income is routinely in the highest marginal tax
bracket, Cruz is concerned about the potential impact of the proposed change. Assuming that
Waterbury maintains its target capital structure, which of the following is least likely to be affected by
the proposed tax change?
A. Waterbury's after-tax cost of corporate debt.
B. Waterbury's return on equity (ROE).
C. Waterbury's after-tax cost of noncallable, nonconvertible preferred stock.
83. Affluence Inc. is considering whether to expand its recreational sports division by embarking on a
new project. Affluence's capital structure consists of 75% debt and 25% equity and its marginal tax
rate is 30%. Aspire Brands is a publicly traded firm that specializes in recreational sports products.
Aspire has a debt-to-equity ratio of 1.7, a beta of 0.8, and a marginal tax rate of 35%. Using the pure-
play method with Aspire as the comparable firm, the project beta Affluence should use to calculate
the cost of equity capital for this project is closest to:
A. 0.58.
B. 1.18.
C. 0.38.
84. The following data is regarding the Continue Company:
 A target debt/equity ratio of 0.5
 Bonds are currently yielding 10%
 Continue is a constant growth firm that just paid a dividend of $3.00
 Stock sells for $31.50 per share, and has a growth rate of 5%
 Marginal tax rate is 40%
What is Continue's after-tax cost of capital?
A. 12.0%.
B. 12.5%.
C. 10.5%.
85. Rox 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%. Rox plans to issue new five-year notes to finance an
expansion. Rox's cost of debt capital is closest to:
A. 4.9%.
B. 2.4%.
C. 4.4%.
86. Until Co. is looking to expand its appliances division. It currently has a beta of 0.9, a D/E ratio of 2.5,
a marginal tax rate of 30%, and its debt is currently yielding 7%. JF Black, Inc. is a publicly traded
appliance firm with a beta of 0.7, a D/E ratio of 3, a marginal tax rate of 40%, and its debt is currently
yielding 6.8%. The risk-free rate is currently 5% and the expected return on the market portfolio is
9%. Using this data, calculate Until's weighted average cost of capital for this potential expansion.
A. 4.2%.
B. 5.7%.
C. 7.1%.

244

Page 39 of 112
87. To finance a proposed project, Youth Corporation would need to issue £25 million in common equity.
Youth would receive £23 million in net proceeds from the equity issuance. When analyzing the
project, analysts at Youth should:
A. increase the cost of equity capital to account for the 8% flotation cost.
B. not consider the flotation cost because it is a sunk cost.
C. add the £2 million flotation cost to the project's initial cash outflow.
88. Nicon 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%.
89. Which one of the following statements about the marginal cost of capital (MCC) is most accurate?
A. The MCC falls as more and more capital is raised in a given period.
B. A breakpoint on the MCC curve occurs when one of the components in the weighted average cost
of capital changes in cost.
C. The MCC is the cost of the last dollar obtained from bondholders.
90. Hue Fox, manager at a large U.S. firm, has just been assigned to the capital budgeting area to replace
a person who left suddenly. One of Fox's first tasks is to calculate the company's weighted average
cost of capital (WACC) - and fast! The CEO is scheduled to present to the board in half an hour and
needs the WACC - now! Luckily, Fox finds clear notes on the target capital component weights.
Unfortunately, all he can find for the cost of capital components is some handwritten notes. He can
make out the numbers, but not the corresponding capital component. As time runs out, he has to
guess.
Here is what Fox deciphered:
 Target weights: wd = 30%, wps = 20%, wce = 50%, where wd, wps, and wce are the weights used
for debt, preferred stock, and common equity.
 Cost of components (in no particular order): 6.0%, 15.0%, and 8.5%.
 The cost of debt is the after-tax cost.
If Fox guesses correctly, the WACC is:
A. 9.0%.
B. 11.0%.
C. 9.2%.
91. 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%
92. Dragon Company is considering a project in the commercial printing business. Its debt currently has a
yield of 12%. Dragon has a leverage ratio of 2.3 and a marginal tax rate of 30%. Hockin Inc., a
publicly traded firm that operates only in the commercial printing business, has a marginal tax rate of
25%, a debt-to-equity ratio of 2.0, and an equity beta of 1.3. The risk-free rate is 3% and the expected
return on the market portfolio is 9%. The appropriate WACC to use in evaluating Dragon's project is
closest to:
A. 8.6%.

245

Page 40 of 112
 B. 8.9%.
C. 9.2%.
93. Flow Technologies has a target capital structure of 60% equity and 40% debt. The schedule of
financing costs for the Flow is shown in the table below:
Amount of New Debt After-tax Cost of Amount of New Equity Cost of
(in millions) Debt (in millions) Equity
$0 to $199 4.5% $0 to $299 7.5%
$200 to $399 5.0% $300 to $699 8.5%
$400 to $599 5.5% $700 to $999 9.5%
Flow Technologies has breakpoints for raising additional financing at both:
A. $400 million and $700 million.
B. $500 million and $1,000 million.
C. $500 million and $700 million.
94. DFG 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%. DFG is considering between two
mutually exclusive projects that have the following cash flows:
Today Year 1 Year 2 Year 3
Project X Cost = 100 million + 50 million + 30 million + 50 million
Project Y Cost = 150 million + 50 million + 60 million + 80 million
Which project should DFG 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.
95. Hudd Kan, CFA, is responsible for capital projects at Vertex Corporation. Kan and his assistant, Karl
Schwartz, were discussing various issues about capital budgeting and Schwartz made a comment that
Kan 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."
96. Lolz Corp. pays 40% of its earnings out in dividends. The return on equity (ROE) is 15%. Last year's
earnings were $5.00 per share and the dividend was just paid to shareholders. The current price of
shares is $42.00. The firm's tax rate is 30%. The cost of common equity is closest to:
A. 14.2%.
B. 16.1%.
C. 13.8%.
97. The most accurate way to account for flotation costs when issuing new equity to finance a project is
to:
A. increase the cost of equity capital by multiplying it by (1 + flotation cost).
B. increase the cost of equity capital by dividing it by (1 - flotation cost).
C. adjust cash flows in the computation of the project NPV by the dollar amount of the flotation costs.
98. A company has the following data associated with it:
 A target capital structure of 10% preferred stock, 50% common equity and 40% debt.
 Outstanding 20-year annual pay 6% coupon bonds selling for $894.
 Common stock selling for $45 per share that is expected to grow at 8% and expected to pay a $2
dividend one year from today.
 Their $100 par preferred stock currently sells for $90 and is earning 5%.
 The company's tax rate is 40%.
246

Page 41 of 112
 What is the weighted average cost of capital (WACC)?
A. 8.5%.
B. 9.2%.
C. 10.3%.
99. Cluff 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. Cluff's tax rate is 40% and the before-
tax cost of debt is 9%. The current share price for Cluff stock is $32 per share and the expected
dividend next year is $1.50 per share. Cluff's expected growth rate is 5%. Cluff 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 floatation costs NPV of project
A. $5,513 $32,872
B. $7,875 $30,510
C. $5,513 $30,510
100. The following is a schedule of Lion Company's new debt and equity capital costs ($ millions):
Amount of New Debt After-tax Cost of Debt Amount of New Cost of Equity
Equity
< $30 3.5% < $60 8.5%
$30 - $60 4.0% $60 - $90 10.3%
> $60 4.7% > $90 12.5%
The company has a target capital structure of 30% debt and 70% equity. Lion needs to raise an
additional $135.0 million of capital for a new project while maintaining its target capital structure. The
company's second debt break point and its marginal
cost of capital (MCC) are closest to:
Debt Break Point #2 MCC
A. $100 million 8.4%
B. $200 million 10.0%
C. $200 million 8.4%
101. A company has the following capital structure:
 Target weightings: 30% debt, 20% preferred stock, 50% common equity.
 Tax Rate: 35%.
 The firm can issue $1,000 face value, 7% semi-annual coupon debt with a 15-year maturity for a
price of $1,047.46.
 A preferred stock issue that pays a dividend of $2.80 has a value of $35 per share. The company's
growth rate is estimated at 6%.
 The company's common shares have a value of $40 and a dividend in year 0 of D0 = $3.00.
 The company's weighted average cost of capital is closest to:
A. 9.84%.
B. 9.28%.
C. 10.53%.
102. Tony Green, operations manager of Phisco Inc., is exploring a proposed product line expansion. Green
explains that he estimates the beta for the project by seeking out a publicly traded firm that is engaged
exclusively in the same business as the proposed Phisco product line expansion. The beta of the
proposed project is estimated from the beta of that firm after appropriate adjustments for capital
structure differences. The method that Green uses is known as the:
A. build-up method.
B. pure-play method.
C. accounting method.

247

Page 42 of 112
103. A company primarily engaged in the production of cement has the following characteristics:
 Beta = 0.8.
 Market value debt = $180 million.
 Market value equity = $540 million.
 Effective tax rate = 25%.
 Marginal tax rate = 34%.
The asset beta that should be used by a company considering entering into cement production is closest
to:
A. 0.640.
B. 0.656.
C. 0.725.
104. A company's outstanding 20-year, annual-pay 6% coupon bonds are selling for $894. At a tax rate of
40%, the company's after-tax cost of debt capital is closest to:
A. 7.0%
B. 4.2%.
C. 5.1%
105. An analyst gathered the following data about a company:
Capital Structure Required Rate of Return
30% debt 10% for debt
20% preferred stock 11% for preferred stock
50% common stock 18% for common stock
Assuming a 40% tax rate, what after-tax rate of return must the company earn on its investments?
A. 13.0%.
B. 14.2%.
C. 10.0%.
106. Worldy Industries has the following capital structure on December 31, 2006:
Book Value Market Value
Debt outstanding $8 million $10.5 million
Preferred stock outstanding $2 million $1.5 million
Common stock outstanding $10 million $13.7 million
Total capital $20 million $25.7 million
What is the firm's target debt and preferred stock portion of the capital structure based on existing
capital structure?
Debt Preferred Stock
A. 0.40 0.10
B. 0.41 0.06
C. 0.41 0.10
107. Axsis Corporation earned £3.00 per share and paid a dividend of £2.40 on its common stock last year.
Its common stock is trading at £40 per share. Axsis is expected to have a return on equity of 15%, an
effective tax rate of 34%, and to maintain its historic payout ratio going forward. In estimating Axsis's
after-tax cost of capital, an analyst's estimate of Axsis's cost of common equity would be closest to:
A. 9.2%.
B. 8.8%.
C. 9.0%.

248

Page 43 of 112
108. A financial analyst is estimating the effect on the cost of capital for a company of a decrease in the
marginal tax rate. The company is financed with debt and common equity. A decrease in the firm's
marginal tax rate would:
A. increase the cost of capital because of a higher after-tax cost of debt.
B. decrease the cost of capital because of a lower after-tax cost of debt and equity.
C. increase the cost of capital because of a higher after-tax cost of debt and equity.
109. A firm has $3 million in outstanding 10-year bonds, with a fixed rate of 8% (assume annual
payments). The bonds trade at a price of $92 per $100 par in the open market. The firm's marginal tax
rate is 35%. What is the after-tax component cost of debt to be used in the weighted average cost of
capital (WACC) calculations?
A. 9.26%.
B. 6.02%.
C. 5.40%.
110. When calculating the weighted average cost of capital (WACC) an adjustment is made for taxes
because:
A. the interest on debt is tax deductible.
B. equity earns higher return than debt.
C. equity is risky.
111. Jonson Aluminum, Inc. is considering whether to build a mill based around a new rolling technology
the company has been developing. Management views this project as being riskier than the average
project the company undertakes. Based on their analysis of the projected cash flows, management
determines that the project's internal rate of return is equal to the company's marginal cost of capital. If
the project goes forward, the company will finance it with newly issued debt with an after-tax cost
less than the project's IRR. Should management accept or reject this project?
A. Accept, because the project returns the company's cost of capital.
B. Reject, because the project reduces the value of the company when its risk is taken into account.
C. Accept, because the marginal cost of the new debt is less than the project's internal rate of return.
112. A company has the following data associated with it:
 A target capital structure of 10% preferred stock, 50% common equity and 40% debt.
 Outstanding 20-year annual pay 6% coupon bonds selling for $894.
 Common stock selling for $45 per share that is expected to grow at 8% and expected to pay a $2
dividend one year from today.
 Their $100 par preferred stock currently sells for $90 and is earning 5%.
 The company's tax rate is 40%.
What is the after-tax cost of debt capital and after-tax cost of preferred stock?
Debt capital Preferred stock
A. 4.2% 5.6%
B. 4.5% 3.3%
C. 4.2% 3.3%
113. Simoco Financial is considering raising additional capital to finance a takeover of one of the firm's
major competitors. Reuben Mellum, an analyst with Simoco, has put together the following schedule
of costs related to raising new capital:
Amount of New After-tax Cost of Debt Amount of New Cost of Equity
Debt (in millions0 Equity (in millions)
$0 to $149 4.2% $0 to $399 7.5%
$150 to $349 5.0% $400 to $799 8.5%
Assuming that Simoco has a target debt to equity ratio of 65% equity and 35% debt, what are the
marginal cost of capital schedule breakpoints for raising additional debt capital and equity capital,
respectively?

249

Page 44 of 112
 Breakpoint for new debt capital Breakpoint for new equity
capital
A. $428.6 million $615.4 million
B. $375.0 million $615.4 million
C. $428.6 million $533.3 million
114. The expected annual dividend one year from today is $2.50 for a share of stock priced at $25. What is
the cost of equity if the constant long-term growth in dividends is projected to be 8%?
A. 18%.
B. 19%.
C. 15%.
115. An analyst gathered the following information for DFR Company, which has a target capital structure
of 70% common equity and 30% debt:
Dividend yield 3.50%
Expected market return 9.00%
Risk-free rate 4.00%
Tax rate 40%
Beta 0.90
Bond yield-to-maturity 8.00%
DFR's weighted-average cost of capital is closest to:
A. 8.4%.
B. 6.9%.
C. 7.4%.
116. Airton Machinery currently has assets on its balance sheet of $300 million that is financed with 70%
equity and 30% debt. The executive management team at Airton is considering a major expansion that
would require raising additional capital. Jubin Marian, an analyst with Airton Machinery, has put
together the following schedule for the costs of debt and equity:
Amount of New Debt After-tax Amount of New Equity Cost of Equity
(in millions) Cost of Debt (in millions)
$0 to $49 4.0% $0 to $99 7.0%
$50 to $99 4.2% $100 to $199 8.0%
$100 to $149 4.5% $200 to $299 9.0%
In a presentation to Airton's executive management team, Marian makes the following statements:
Statement 1: If we maintain our target capital structure of 70% equity and 30% debt, the breakpoint at
which our cost of equity will increase to 9.0% is approximately $286 million in new capital.
Statement 2: If we want to finance total assets of $600 million, our weighted average cost of capital
(WACC) for the additional financing needed will be 7.56%.
Marian's statements are:
Statement 1 Statement 2
A. Incorrect Incorrect
B. Correct Incorrect
C. Correct Correct
117. A firm has $4 million in outstanding bonds that mature in four years, with a fixed rate of 7.5%
(assume annual payments). The bonds trade at a price of $98 in the open market. The firm's marginal
tax rate is 35%. Using the bond-yield plus method, what is the firm's cost of equity risk assuming an
add-on of 4%?
A. 13.34%.
B. 12.11%.
C. 11.50%.

250

Page 45 of 112
118. Which of the following statements is least accurate regarding the marginal cost of capital's role in
determining the net present value (NPV) of a project?
A. The NPVs of potential projects of above-average risk should be calculated using the marginal cost
of capital for the firm.
B. Projects for which the present value of the after-tax cash inflows is greater than the present value
of the after-tax cash outflows should be undertaken by the firm.
C. When using a firm's marginal cost of capital to evaluate a specific project, there is an implicit
assumption that the capital structure of the firm will remain at the target capital structure over the
life of the project.
119. The debt of Sumana Equipment, Inc. has an average maturity of ten years and a BBB rating. A market
yield to maturity is not available because the debt is not publicly traded, but the market yield on debt
with similar characteristics is 8.33%. Sumana is planning to issue new ten-year notes that would be
subordinate to the firm's existing debt. The company's marginal tax rate i 40%. The most appropriate
estimate of the after-tax cost of this new debt is:
A. More than 5.0%.
B. Between 3.3% and 5.0%.
C. 5.0%.
120. A new project is expected to be less risky than the average risk of existing projects. The appropriate
discount rate to use when evaluating this project is:
A. less than the firm's marginal cost of capital.
B. greater than the firm's marginal cost of capital.
C. the firm's marginal cost of capital.
121. Which of the following statements is most accurate regarding a firm's cost of preferred shares? A
firm's cost of preferred stock is:
A. approximately equal to the market price of the firm's debt as a percentage of the market price of
its common shares.
B. the dividend yield on the firm's newly-issued preferred stock.
C. the market price of the preferred shares as a percentage of its issuance price.
122. A $100 par, 8% preferred stock is currently selling for $80. What is the cost of preferred equity?
A. 10.0%.
B. 10.8%.
C. 8.0%.
123. An analyst gathered the following information about a capital budgeting project:
 The proposed project cost $10,000.
 The project is expected to increase pretax net income and cash flow by $3,000 in each of the next
eight years.
 The company has 50% of its capital in equity at a cost of 12%.
 The pretax cost of debt capital is 6%.
 The company's tax rate is 33%.
The project's net present value is closest to:
A. $1,551.
B. $7,240.
C. $6,604.
124. The following information applies to a corporation:
 The company has $200 million of equity and $100 million of debt.
 The company recently issued bonds at 9%.
 The corporate tax rate is 30%.
 The company's beta is 1.125.
If the risk-free rate is 6% and the expected return on the market portfolio is 14%, the company's after-
tax weighted average cost of capital is closest to:
A. 11.2%.
251

Page 46 of 112
 B. 10.5%.
C. 12.1%.
125. Which of the following is least likely to be useful to an analyst who is estimating the pretax cost of a
firm's fixed-rate debt?
A. Seniority and any special covenants of the firm's anticipated debt.
B. The yield to maturity of the firm's existing debt.
C. The coupon rate on the firm's existing debt.
126. Which of the following events will reduce a company's weighted average cost of capital (WACC)?
A. A reduction in the market risk premium.
B. A reduction in the company's bond rating.
C. An increase in expected inflation.
127. Which of the following statements about the role of the marginal cost of capital in determining the net
present value of a project is most accurate? The marginal cost of capital should be used to discount the
cash flows:
A. of all projects the firm is considering.
B. if the firm's capital structure is expected to change during the project's life.
C. for potential projects that have a level of risk near that of the firm's average project.
128. Tomson Industries has 200,000 bonds outstanding. The par value of each corporate bond is $1,000,
and the current market price of the bonds is $965. Tomson also has 6 million common shares
outstanding, with a book value of $35 per share and a market price of $28 per share. At a recent board
of directors meeting, Tomson board members decided not to change the company's capital structure in
a material way for the future. To calculate the weighted average cost of Tomson's capital, what
weights should be assigned to debt and to equity?
Debt Equity
A. 56.55% 43.45%
B. 53.46% 46.54%
C. 48.85% 51.15%
129. If central bank actions caused the risk-free rate to increase, what is the most likely change to cost of
debt and equity capital?
A. Both increase.
B. Both decrease.
C. One increase and one decrease.
130. Given the following information about capital structure, compute the WACC. The marginal tax rate is
40%.
Type of Percent of Before-Tax
Capital Capital Structure Component Cost
Bonds 40% 7.5%
Preferred Stock 5% 11.0%
Common Stock 55% 15.0%
A. 10.6%.
B. 13.3%.
C. 7.1%.
131. Which of the following is least likely to be useful to an analyst when estimating the cost of raising
capital through the issuance of non-callable, nonconvertible preferred stock?
A. The firm's corporate tax rate.
B. The preferred stock's dividend rate.
C. The stated par value of the preferred issue.
132. The following information applies to World Turn Company:
 10% rate of interest on newly issued bonds.
 7% growth rate in earnings and dividends.
252

Page 47 of 112
  The last dividend paid was $0.93.
 Shares sell for $16.
 Stock's beta is 1.5.
 Market risk premium is 6%.
 Risk-free rate of interest is 5%.
 The firm is in a 40% marginal tax bracket.
If the appropriate risk premium relative to the bond yield is 4%, World Turn's equity cost of capital
using the dividend discount model is closest to:
A. 13.2%.
B. 12.8%.
C. 14.0%.
133. Assume a firm uses a constant WACC to select investment projects rather than adjusting the projects
for risk. If so, the firm will tend to:
A. reject profitable, low-risk projects and accept unprofitable, high-risk projects.
B. accept profitable, low-risk projects and accept unprofitable, high-risk projects.
C. accept profitable, low-risk projects and reject unprofitable, high-risk projects.
134. The cost of preferred stock is equal to the preferred stock dividend:
A. divided by its par value.
B. divided by the market price.
C. multiplied by the market price.
135. A company has a target capital structure of 40% debt and 60% equity. The company is a constant
growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8%.
 The company's bonds pay 10% coupon (semi-annual payout), mature in 20 years, and sell for
$849.54.
 The company's stock beta is 1.2.
 The company's marginal tax rate is 40%.
 The risk-free rate is 10%.
 The market risk premium is 5%.
The cost of equity using the capital asset pricing model (CAPM) approach and the discounted cash
flow approach is:
CAPM Discounted cash flow
A. 16.0% 16.0%
B. 16.6% 15.4%
C. 16.0% 15.4%
136. A publicly traded company has a beta of 1.2, a debt/equity ratio of 1.5, ROE of 8.1%, and a marginal
tax rate of 40%. The unlevered beta for this company is closest to:
A. 1.071.
B. 0.632.
C. 0.832.
137. A company has $5 million in debt outstanding with a coupon rate of 12%. Currently the YTM on these
bonds is 14%. If the tax rate is 40%, what is the after tax cost of debt?
A. 8.4%.
B. 5.6%.
C. 7.2%.
138. The marginal cost of capital is:
A. the cost of the last dollar raised by the firm.
B. equal to the firm's weighted cost of funds.
C. tied solely to the specific source of financing.
139. Which of the following choices best describes the role of taxes on the after-tax cost of capital in the
U.S. from the different capital sources?
253

Page 48 of 112
 Common Preferred Debt
equity equity
A. Decrease Decrease No effect
B. No effect Decrease Decrease
C. No effect No effect Decrease
140. Carlon Frez, CFA, and Regine Davis, CFA, were recently discussing the relationships between capital
structure, capital budgets, and net present value (NPV) analysis. Which of the following comments
made by these two individuals is least accurate?
A) "For projects with more risk than the average firm project, NPV computations should be based on
the marginal cost of capital instead of the weighted average cost of capital."
B) "A break point occurs at a level of capital expenditure where one of the component costs of capital
increases."
C) "The optimal capital budget is determined by the intersection of a firm's marginal cost of capital
curve and its investment opportunity schedule."
141. Jubin Marian, an analyst with Airton Machinery, is estimating a country risk premium to include in
his estimate of the cost of equity for a project Airton is starting in India. Marian has compiled the
following information for his analysis:
 Indian 10-year government bond yield = 7.20%
 10-year U.S. Treasury bond yield = 4.60%
 Annualized standard deviation of the Bombay Sensex stock index = 40%.
 Annualized standard deviation of Indian dollar denominated 10-year government bond = 24%
 Annualized standard deviation of the S&P 500 Index = 18%.
The estimated country risk premium for India based on Marian's research is closest to:
A) 2.6%.
B) 4.3%.
C) 5.8%.
142. The before-tax cost of debt for Hard Industries, Inc. is currently 8.0%, but it will increase to 8.25%
when debt levels reach $600 million. The debt-to-total assets ratio for Hard is 40% and its capital
structure is composed of debt and common equity only. If Hard changes its target capital structure to
50% debt / 50% equity, which of the following describes the effect on the level of new investment at
which the cost of debt will increase? The level will:
A) decrease.
B) increase.
C) change, but can either increase or decrease.
143. A firm has $100 in equity and $300 in debt. The firm recently issued bonds at the market required rate
of 9%. The firm's beta is 1.125, the risk-free rate is 6%, and the expected return in the market is 14%.
Assume the firm is at their optimal capital structure and the firm's tax rate is 40%. What is the firm's
weighted average cost of capital (WACC)?
A) 8.6%.
B) 5.4%.
C) 7.8%.
144. The Garden and Home Store recently issued preferred stock paying $2 annual dividends. The price of
its preferred stock is $20. The after-tax cost of fixed-rate debt capital is 6% and the cost of common
stock equity is 12%. The cost of preferred stock is closest to:
A) 10%.
B) 9%.
C) 11%.
145. A company has a target capital structure of 40% debt and 60% equity. The company is a constant
growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8%.

254

Page 49 of 112
  The company's bonds pay 10% coupon (semi-annual payout), mature in 20 years, and sell for
$849.54.
 The company's stock beta is 1.2.
 The company's marginal tax rate is 40%.
 The risk-free rate is 10%.
 The market risk premium is 5%.
The company's after-tax cost of debt is:
A) 12.0%.
B) 7.2%.
C) 4.8%.
146. A North American investment society held a panel discussion on the topics of capital costs and capital
budgeting. Which of the following comments made during this discussion is the least accurate?
A) A project's internal rate of return decreases when a breakpoint is reached.
B) An increase in the after-tax cost of debt may occur at a break point.
C) Any given project's NPV will decline when a breakpoint is reached.
147. Advance Systems Inc. has the following capital structure and cost of new capital:
Book Value Market Value Cost of
Issuing
Debt $50 million $58 million 5.3%
Preferred stock $25 million $28 million 7.2%
Common stock $200 million $525 million 8.0%
Total capital $275 million $611 million
What is Advance's weighted-average cost of capital if its marginal tax rate is 40%?
A) 7.50%.
B) 6.23%.
C) 8.02%.
148. At a recent Haggerty Semiconductors Board of Directors meeting, Merle Haggerty was asked to
discuss the topic of the company's weighted average cost of capital (WACC).
At the meeting Haggerty made the following statements about the company's WACC:
Statement 1: A company creates value by producing a higher return on its assets than the cost of
financing those assets. As such, the WACC is the cost of financing a firm's assets and can be viewed
as the firm's opportunity cost of financing its assets.
Statement 2: Since a firm's WACC reflects the average risk of the projects that make up the firm, it is
not appropriate for evaluating all new projects. It should be adjusted upward for projects with greater-
than-average risk and downward for projects with less-than-average risk.
Are Statement 1 and Statement 2, as made by Haggerty CORRECT?
Statement 1 Statement 2
A. Correct Correct
B. Incorrect Correct
C. Correct Incorrect
149. Which of the following is used to illustrate a firm's weighted average cost of capital (WACC) at
different levels of capital?
A) Schedule of marginal capital break points.
B) Marginal cost of capital schedule.
C) Cost of capital component schedule.

255

Page 50 of 112
150. JKL Corp. 8% coupon bonds have a yield to maturity of 7.5%. The firm's tax rate is 30%. The after-
tax cost of debt is closest to:
A) 5.3%.
B) 7.5%.
C) 5.6%.
151. Which of the following is most accurate regarding the component costs and component weights in a
firm's weighted average cost of capital (WACC)?
A) The weights in the WACC should be based on the book values of the individual capital
components.
B) Taxes reduce the cost of debt for firms in countries in which interest payments are tax deductible.
C) The appropriate pre-tax cost of a firm's new debt is the average coupon rate on the firm's existing
debt.
152. A company has the following information:
A target capital structure of 40% debt and 60% equity.
$1,000 par value bonds pay 10% coupon (semi-annual payments), mature in 20 years, and sell for
$849.54.
The company stock beta is 1.2.
Risk-free rate is 10%, and market risk premium is 5%.
The company's marginal tax rate is 40%.
The weighted average cost of capital (WACC) is closest to:
A) 13.5%.
B) 13.0%.
C) 12.5%.
153. Ravencroft Supplies is estimating its weighted average cost of capital (WACC). Ravencroft's optimal
capital structure includes 10% preferred stock, 30% debt, and 60% equity. They can sell additional
bonds at a rate of 8%. The cost of issuing new preferred stock is 12%. The firm can issue new shares
of common stock at a cost of 14.5%. The firm's marginal tax rate is 35%. Ravencroft's WACC is
closest to:
A) 12.3%.
B) 13.3%.
C) 11.5%.
154. Voda Corporation's target capital structure is 40% debt, 50% common stock, and 10% preferred stock.
Information regarding the company's cost of capital can be summarized as follows:
 The company's bonds have a nominal yield to maturity of 7%.
 The company's preferred stock sells for $40 a share and pays an annual dividend of $4 a share.
 The company's common stock sells for $25 a share and is expected to pay a dividend of $2 a share
at the end of the year (i.e., D1 = $2.00). The dividend is expected to grow at a constant rate of 7%
a year.
 The company has no retained earnings.
 The company's tax rate is 40%.
What is the company's weighted average cost of capital (WACC)?
A) 10.18%.
B) 10.03%.
C) 10.59%.
155. Assume that a company has equal amounts of debt, common stock, and preferred stock. An increase
in the corporate tax rate of a firm will cause its weighted average cost of capital (WACC) to:
A) more information is needed.
B) rise.
C) fall.
156. Enamel Manufacturing (EM) is considering investing in a new vehicle. EM finances new projects
using retained earnings and bank loans. This new vehicle is expected to have the same level of risk as
256

Page 51 of 112
 the typical investment made by EM. Which one of the following should the firm use in making its
decision?
A) Marginal cost of capital.
B) After-tax cost of debt.
C) Cost of retained earnings.
157. A firm is planning a $25 million expansion project. The project will be financed with $10 million in
debt and $15 million in equity stock (equal to the company's current capital structure). The before-tax
required return on debt is 10% and 15% for equity. If the company is in the 35% tax bracket, what
cost of capital should the firm use to determine the project's net present value (NPV)?
A) 9.6%.
B) 12.5%.
C) 11.6%.
158. The expected dividend one year from today is $2.50 for a share of stock priced at $22.50. The long-
term growth in dividends is projected at 8%. The cost of common equity is closest to:
A) 15.6%.
B) 18.0%.
C) 19.1%.
159. Meredith Suresh, an analyst with Torch Electric, is evaluating two capital projects. Project 1 has an
initial cost of $200,000 and is expected to produce cash flows of $55,000 per year for the next eight
years. Project 2 has an initial cost of $100,000 and is expected to produce cash flows of $40,000 per
year for the next four years. Both projects should be financed at Torch's weighted average cost of
capital. Torch's current stock price is $40 per share, and next year's expected dividend is $1.80. The
firm's growth rate is 5%, the current tax rate is 30%, and the pre-tax cost of debt is 8%. Torch has a
target capital structure of 50% equity and 50% debt. If Torch takes on either project, it will need to be
financed with externally generated equity which has flotation costs of 4%.
Suresh is aware that there are two common methods for accounting for flotation costs. The first
method, commonly used in textbooks, is to incorporate flotation costs directly into the cost of equity.
The second, and more correct approach, is to subtract the dollar value of the flotation costs from the
project NPV. If Suresh uses the cost of equity adjustment approach to account for flotation costs rather
than the correct cash flow adjustment approach, will the NPV for each project be overstated or
understated?
Project 1 NPV Project 2 NPV
A. Overstated Overstated
B. Understated Overstated
C. Understated Understated
160. Jamal Winfield is an analyst with Flow Technologies, a major computer services company based in
the U.S. Flow's management team is considering opening new stores in Mexico, and wants to estimate
the cost of equity capital for Flow's investment in Mexico. Winfield has researched bond yields in
Mexico and found that the yield on a Mexican government 10-year bond is 7.7%. A similar maturity
U.S. Treasury bond has a yield of 4.6%. In the most recent year, the standard deviation of Mexico's
All Share Index stock index and the S&P 500 index was 38% and 20% respectively. The annualized
standard deviation of the Mexican dollar-denominated 10-year government bond over the last year was
26%. Winfield has also determined that the appropriate beta to use for the project is 1.25, and the
market risk premium is 6%. The risk free interest rate is 4.2%. What is the appropriate country risk
premium for Mexico and what is the cost of equity that Winfield should use in his analysis?
Country Risk Premium for Cost of Equity for
Mexico Project
A. 5.89% 17.36%
B. 4.53% 19.06%
C. 4.53% 17.36%

257

Page 52 of 112
161. In calculating the weighted average cost of capital (WACC), which of the following statements is
least accurate?
A) The cost of preferred equity capital is the preferred dividend divided by the price of preferred
shares.
B) The cost of debt is equal to one minus the marginal tax rate multiplied by the coupon rate on
outstanding debt.
C) Different methods for estimating the cost of common equity might produce different results.
162. Elenore Rice, CFA, is asked to determine the appropriate weighted average cost of capital for Samson
Brick Company. Rice is provided with the following data:
Debt outstanding, market value $10 million
Common stock outstanding, market value $30 million
Marginal tax rate 40%
Cost of common equity 12%
Cost of debt 8%
Samson has no preferred stock. Assuming Samson's ratios reflect the firm's target capital structure,
Samson's weighted average cost of capital is closest to:
A) 10.2%.
B) 10.4%.
C) 9.8%.

258

Page 53 of 112
 ANSWERS
1. Answer: B
WACC = (0.25) (0.12) (1 – 0.3) + (0.35)(0.14) + (0.4)(0.17) = 13.8%
2. Answer: C
An adjustment is made for taxes because interest on debt is tax deductible.
3. Answer: A
Cost of equity = 0.08 + (1.2) (0.06) = 15.2%
After-tax cost of debt = 0.1 (1 – 0.3) = 7%
WACC = 15.2% (1/1.3) + 7% (0.3/1.3) = 13.31%
4. Answer: C
An increase in the firm’s tax rate causes its after-tax cost of debt to fall, reducing the firm’s WACC.
5. Answer: C
A decrease in the risk company’s equity beta reduces its cost of equity and therefore its WACC.
6. Answer: B
We use the Gordon growth model to estimate the company’s WACC.
Cost of equity = [5 (1 + 0.08)/45] + 0.08 = 20%
After-tax cost of debt = 0.09 (1 – 0.35) = 5.85%
WACC = 20% (1/1.4) + 5.85% (0.4/1.4) = 15.96%
7. Answer: C
After-tax cost of debt = 0.1 (1 – 0.25) = 7.5%
WACC = 14% (1/1.3) + 7.5% (0.3/1.3) = 12.5%
[CF][2ND][CE|C]
150000 [+/−] [ENTER]
[↓] 60000 [ENTER]
[↓] 4 [ENTER]
[NPV] 12.5 [ENTER]
[↓] [CPT]
NPV = 30,338.36
8. Answer: A
A potential supplier of capital will not provide capital to a company if the return offered by the company
is equal to the return that could be earned elsewhere at a lower risk.
9. Answer: C
WACC = (0.65 × 0.12) + [0.25 × 0.1 × (1 – 0.35)] + (0.1 × 0.13) = 10.725%
10. Answer: C
Percentage of equity in the capital structure = 52.8 / 96 = 55%
Percentage of debt in the capital structure = 11.52 / 96 = 12%
Percentage of preferred stock in the capital structure = 31.68 / 96 = 33%
WACC = (0.55 × 0.09) + [0.12 × 0.09 × (1 – 0.3)] + (0.33 × 0.11) = 9.336%
11. Answer: C
0.145 = (0.5 × 0.16) + (0.45 × 0.14) + (0.05 × Cost of preferred equity)
Cost of preferred equity = (0.145 – 0.143) / 0.05 = 4%
12. Answer: B
Interest payments provide a tax shield and, therefore, should be adjusted for tax savings in the WACC
formula.
The profitability of the company’s investment opportunities decreases as the company makes additional
investments.
13. Answer: C
Percentage of equity in the capital structure = 33 / 55 = 60%
259

Page 54 of 112
 Percentage of debt in the capital structure = 22 / 55 = 40%
WACC = (0.6 × 0.08) + (0.4 × 0.07 × 0.6) = 6.48%
14. Answer: A
A company should raise capital and undertake all projects as long as the investment opportunity schedule
is above the marginal cost of capital (i.e., to the left of the intersection point).
15. Answer: B
Cost of preferred stock = 5.6 / 52 = 10.769%
16. Answer: A
EPS in 2009 = Net income / Weighted average number of common shares
EPS in 2009 = 4.5 / 2.2 = $2.045
Dividend payout ratio = 0.818 / 2.045 = 40%
Return on equity = 4.5 / [(22 + 28) / 2] = 18%
Dividend growth rate = (1 – 0.4) × 0.18 = 10.8%
17. Answer: A
Dividend growth rate = 0.7 × 0.22 = 15.4%
Next year’s expected dividend = 1.02 × 1.154 = $1.17708
Cost of equity = (1.17708 / 42) + 0.154 = 18.2026%
WACC = (0.182026 × 1/1.3) + (0.09 × 0.3/1.3) = 16.08%
18. Answer: B
Bond yield plus risk premium approach is used to calculate the cost of equity.
19. Answer: B
0.16 = (1.52 / 43) + Dividend growth rate
Dividend growth rate = 12.4651%
0.124651 = Retention rate × 0.15
Retention rate = 83.10%
20. Answer: A
Cost of equity = 0.06 + (1.4 × 0.07) = 15.8%
After-tax cost of debt = 0.08 × (1 – 0.4) = 4.8%
WACC = (0.158 × 1/1.4) + (0.048 × 0.4/1.4) = 12.66%
21. Answer: C
A company using fixed rate debt is not an issue in calculating the cost of equity. However, floating rate
debt is an issue because floating rate is reset periodically based on a reference rate and is, therefore, more
difficult to estimate than the cost of fixed rate debt.
22. Answer: B
Cost of equity = 0.08 + 0.055 = 13.5%
After-tax cost of debt = 0.08 (1 – 0.4) = 4.8%
23. Answer: B
Statement B is not an assumption when using WACC as the discount rate to evaluate a particular project.
24. Answer: B
Beta can be calculated by regressing the company’s stock’s returns against market returns over a given
period.
25. Answer: B
N = 40; PV = −$984.5; FV = $1,000; PMT = $35; CPT I/Y; I/Y = 3.5734%
Before-tax cost of debt = 3.5734 × 2 = 7.1468%
After-tax cost of debt = 0.071468 × (1 – 0.4) = 4.29%
26. Answer: B
Beta estimates are not affected by the capital structure of the company.
27. Answer: A
0.108 = (1/1.8 × Cost of equity) + (0.8/1.8 × 0.056)
260

Page 55 of 112
 Cost of equity = 14.96%
28. Answer: A
Cost of equity = 0.07 + [0.9 × (0.12 – 0.07)] = 11.5%
0.105 = (0.115 × 1/1.4) + (0.4/1.4 × After-tax cost of debt)
After-tax cost of debt = 8%
Before-tax cost of debt = 0.08 / (1 – 0.35) = 12.3077%
29. Answer: A
β Asset = β Equity × [1 / {1 + [(1 – t) × D/E]}]
β Asset = 0.9 × [1 / {1 + [(1 – 0.35) × 1.8]}]
β Asset = 0.4147
β Project = β Asset × {1 + [(1 – t) × D/E]}
β Project = 0.4147 × {1 + [(1 – 0.4) × 1.3]}
β Project = 0.7382
Cost of equity = 0.06 + (0.7382 × 0.07) = 11.17%
After-tax cost of debt = 0.08 × (1 – 0.4) = 4.8%
WACC = (0.1117 × 1/2.3) + (0.048 × 1.3/2.3) = 7.57%
30. Answer: C
Both statements are correct.
31. Answer: A
Country risk premium = (0.12 – 0.035) × (0.34 / 0.25) = 11.56%
Cost of equity = 0.06 + [1.3 × (0.11 – 0.06 + 0.1156)] = 27.528%
32. Answer: A
Proportion of new debt raised = 550 × (1.2 / 2.2) = $300
Proportion of new equity raised = 550 (1 / 2.2) = $250
WACC = (0.055 × 1.2/2.2) + (0.075 × 1/2.2) = 6.4091%
33. Answer: C
After-tax cost of debt = 0.075 × (1 – 0.3) = 5.25%
Cost of equity = 0.06 + (1.4 × 0.05) = 13%
WACC = (0.13 × 1/1.5) + (0.0525 × 0.5/1.5) = 10.4167%
Dollar amount of flotation costs = 142,000 × 1/1.5 × 0.035 = $3,313.3333
Therefore, initial investment = 142,000 + 3,313.3333 = $145,313.3333
Use the following keystrokes to calculate the NPV of the project:
[CF] [2ND] [CE|C]
145,313.3333 [+|−] [ENTER] [↓]
25,000 [ENTER] [↓]
6 [ENTER]
[NPV] 10.4167 [ENTER] [↓] [CPT]
NPV = −$37,748.64
34. Answer: B
kd(1 - t) = (0.14)(1 - 0.4) = 8.4%
35. Answer: C
Cost of preferred stock = kps = Dps / P
36. Answer: B
kps = Dps / Pps , Dps = $100 x 8% = $8, kps = 8 / 85 = 9.4%
37. Answer: C
Using the dividend yield plus growth rate approach: kce = (D] / Po) + g = (2.50/25.00) + 8% = 18%.
38. Answer: A
WACC = (wd)(kd)(1- t) + (wp)(kp) + (wce)(kce)= (0.3)(0.1)(1- 0.4) + (0.2)(0.11) + (0.5)(0.18) = 13%

261

Page 56 of 112
39. Answer: B
wd = 20 / (20 + 30) = 0.4, wce = 30 / (20 + 30) = 0.6
WACC = (wd)(kd)(1 - t) + (wce)(kce)= (0.4)(9)(1- 0.4) + (0.6)(14) = 10.56% = MCC
40. Answer: A
kd(1 - t) = 12(1 - 0.4) = 7.2%
41. Answer: A
Using the CAPM formula, kce = RFR + [E(Rmkt) - RFRJ = 10 + 1.2(5) = 16%.
42. Answer: B
D] = Do (1 + g) = 2(1.08) = 2.16; kce = (D] / Po) + g = (2.16/27) + 0.08 = 16%
43. Answer: A
WACC = (wd)(kd)(l - t) + (wee)(kce)= (0.4)(7.2) + (0.6)(16) = 12.48%
44. Answer: A
An increase in the corporate tax rate will reduce the after-tax cost of debt, causing the WACC to fall.
More specifically, because the after-tax cost of debt = (kd)(l - t), the term (1 - t) decreases, decreasing the
after-tax cost of debt. If the risk-free rate were to increase, the costs of debt and equity would both
increase, thus causing the firm's cost of capital to increase.
45. Answer: B
WACC = (wd)(kd)(1- t) + (wps)(kps) + (wce)(kce)= (0.4)(7.5)(1- 0.4) + (0.05)(11) + (0.55)(15) = 10.6%
46. Answer: C
ke=Rp+[E(RMKT)-RF+CRP]
= 0.045 + 1.3[0.06 + 0.031]
= 0.163, or 16.3%
Note that the "market risk premium" refers to the quantity [E(RMKT)- RpJ.
47. Answer: C
Statement 1 is incorrect. The break point at which the cost of equity changes to 8.0% is:
amount of capital at which the component's of capital changes
break point 
weight of the component in the WACC
$ 100 million
=  $ 142.86 million
0.70
Statement 2 is also incorrect. If Manigault wants to finance $450 million of total assets, that means that
the firm will need to raise $450 - $200 = $250 million in additional capital. Using the target capital
structure of 70% equity, 30% debt, the firm will need to raise 0.70 x $250 = $175 million in new equity
and 0.30 x $250 = $75 in new debt. Looking at the capital schedule, the cost associated with $75 million
in new debt is 4.2%, and the cost associated with $175 million in new equity is 8.0%. The marginal cost
of capital at that point will be (0.3 x 4.2%) + (0.7 x 8.0%) = 6.86%.
48. Answer: B
Because the project is financed with 60% equity, the amount of equity capital raised is 0.60 x $180,000 =
$108,000.
Flotation costs are 4.0%, which equates to a dollar cost of $108,000 x 0.04 = $4,320.
After-tax cost of debt = 8.0% (1 - 0.25) = 6.0%
 $2.80 
Cost 0 equity =   + 0.05 = 0.10, or 10.0%
 $56.00 
WACC = 0.60(0.10) + 0.40(0.06) = 8.4%
$50,000 $50,000 $50,000 $50,000 $50,000
NPV= -$180,000-$4,320+      $13,228
1.084 1.084 2 1.084 3 1.084 4 1.084 5

262

Page 57 of 112
49. Answer: C
The project beta calculated using the pure-play method is not necessarily related in a predictable way to
the beta of the firm that is performing the project.
50. Answer: B is correct. The cost of equity is defined as the rate of return required by stockholders.
51. Answer: B is correct. Debt is generally less costly than preferred or common stock. The cost of debt is
further reduced if interest expense is tax deductible.
52. Answer: C is correct. First calculate the growth rate using the sustainable growth calculation, and then
calculate the cost of equity using the rearranged dividend discount model:
g = (1 – Dividend payout ratio)(Return on equity) = (1 – 0.30)(15%) = 10.5%
re = (D1 / P0) + g = ($2.30 / $45) + 10.50% = 15.61%
53. Answer: C is correct. FV = $1,000; PMT = $40; N = 10; PV = $900
Solve for i. The six-month yield, i, is 5.3149%
YTM = 5.3149% × 2 = 10.62985%
rd(1 − t) = 10.62985%(1 − 0.38) = 6.5905%
54. Answer: C is correct. The bond rating approach depends on knowledge of the company's rating and can
be compared with yields on bonds in the public market.
55. Answer: B is correct. The company can issue preferred stock at 6.5%.
Pp = $1.75/0.065 = $26.92
56. Answer: B is correct.
Cost of equity = D1/P0 + g = $1.50 / $30 + 7% = 5% + 7% = 12%
D / (D + E) = 0.8033 / 1.8033 = 0.445
WACC = [(0.445) (0.08)(1 − 0.4)] + [(0.555)(0.12)] = 8.8%
57. Answer: B is correct. The weighted average cost of capital, using weights derived from the current
capital structure, is the best estimate of the cost of capital for the average-risk project of a company.
58. Answer: C is correct.
wd = $63/($220 + 63) = 0.223
we = $220/($220 + 63) = 0.777
59. Answer: B is correct. Asset risk does not change with a higher debt-to-equity ratio. Equity risk rises with
higher debt.
60. Answer: B is correct. The debt-to-equity ratio of the new product should be used when making the
adjustment from the asset beta, derived from the comparables, to the equity beta of the new product.
61. Answer: B is correct.
Capital structure:
Market value of debt: FV = $10,000,000, PMT = $400,000, N = 10,
I/YR = 13.65%. Solving for PV gives the answer $7,999,688.
Market value of equity: 1.2 million shares outstanding at $10 = $12,000,000
Market value of debt $7,999,688 40%
Market value of equity 12,000,000 60%
Total capital $19,999,688 100%
To raise $7.5 million of new capital while maintaining the same capital structure, the company would
issue $7.5 million × 40% = $3.0 million in bonds, which results in a before-tax rate of 16 percent.
rd(1 − t) = 0.16(1 − 0.3) = 0.112 or 11.2%
re = 0.03 + 2.2 (0.10 − 0.03) = 0.184 or 18.4%
WACC = [0.40(0.112)] + [0.6(0.184)] = 0.0448 + 0.1104 = 0.1552 or 15.52%
62. Answer: B is correct.
re = 0.0425 + (1.3)(0.0482) = 0.1052 or 10.52%
63. Answer: B is correct.
WACC = [(€900/€3300) .0925 (1 − 0.375)] + [(€2400/€3300)(0.1052)] = 0.0923 or 9.23%
263

Page 58 of 112
64. Answer: A is correct.
Asset beta = Unlevered beta = 1.3/(1 + [(1−0.375)(€900/€2400)] = 1.053
65. Answer: C is correct.
Project beta = 1.053 {1 + [(1 − 0.375)(€80/€20)]} = 1.053 {3.5} = 3.686
66. Answer: C is correct.
re = 0.0425 + 3.686(0.0482 + 0.0188) = 0.2895 or 28.95%
67. Answer: C is correct.
Cost of equity without the country risk premium:
re = 0.0425 + 3.686 (0.0482) = 0.2202 or 22.02%
Cost of equity with the country risk premium:
re = 0.0425 + 3.686 (0.0482 + 0.0188) = 0.2895 or 28.95%
Weighted average cost of capital without the country risk premium:
WACC = [0.80 (0.0925) (1 − 0.375) ] + [0.20 (0.2202)] = 0.04625 + 0.04404 = 0.09038 or 9.03 percent
Weighted average cost of capital with the country risk premium:
WACC = [0.80 (0.0925) (1 − 0.375) ] + [0.20 (0.2895)] = 0.04625 + 0.0579 = 0.1042 or 10.42 percent
NPV without the country risk premium:
NPV=€48million(1+0.0903)1+€52million(1+0.0903)2+€54.4million(1+0.0903)3− €100million=
€44.03million+43.74million+41.97million− €100million= €29.74million
€48million €52million €54.4million
NPV = + + - €100million
1 2 3
(1 + 0.0903) (1 + 0.0903) (1 + 0.0903)
= €44.03million + 43.74million + 41.97million - €100million
= €29.74million
NPV with the country risk premium:
NPV=€48million(1+0.1042)1+€52million(1+0.1042)2+€54.4million(1+0.1042)3− €100million=
€43.47million+42.65million+40.41million− €100million= €26.53million
€48million €52million €54.4million
NPV = + + - €100million
1 2 3
(1 + 0.1042) (1 + 0.1042) (1 + 0.1042)
= €43.47million + 42.65million + 40.41million - €100million
= €26.53million
68. Answer: B is correct.
Asset betas: βequity/[1 + (1 − t)(D/E)]
Relevant = 1.702/[1 + (0.77)(0)] = 1.702
ABJ = 2.8/[1 + (0.77)(0.003)] = 2.7918
Opus = 3.4/1 + [(0.77)(0.013)] = 3.3663
69. Answer: C is correct.
Weights are determined based on relative market values:
Pure-Play Market Value of Equity in Millions Proportion of Total
Relevant $3,800 0.5490
ABJ 2,150 0.3106
Opus 972 0.1404
Total $6,922 1.0000
Weighted average beta (0.5490)(1.702) + (0.3106)(2.7918) + (0.1404)(3.3572) = 2.27.
70. Answer: B is correct.
Asset beta = 2.27
Levered beta = 2.27 {1 + [(1 − 0.23)(0.01)]} = 2.2875

264

Page 59 of 112
 Cost of equity capital = 0.0525 + (2.2875)(0.07) = 0.2126 or 21.26%
71. Answer: C is correct.
For debt: FV = 2,400,000; PV = 2,156,000; n = 10; PMT = 150,000
Solve for i. i = 0.07748. YTM = 15.5%
Before-tax cost of debt = 15.5%
Market value of equity = 1 million shares outstanding + 1 million newly issued shares = 2 million shares
at $8 = $16 million
Total market capitalization = $2.156 million + $16 million = $18.156 million
Levered beta = 2.27 {1 + [(1 − 0.23)(2.156/16)]} = 2.27 (1.1038) = 2.5055
Cost of equity = 0.0525 + 2.5055 (0.07) = 0.2279 or 22.79%
Debt weight = $2.156/$18.156 = 0.1187
Equity weight = $16/$18.156 = 0.8813
TagOn’s MCC = [(0.1187)(0.155)(1 − 0.23)] + [(0.8813)(0.2279)]
= 0.01417 + 0.20083
= 0.2150 or 21.50%
72. Answer: A is correct. The relevant cost is the marginal cost of debt. The before-tax marginal cost of debt
can be estimated by the yield to maturity on a comparable outstanding. After adjusting for tax, the after-
tax cost is 7(1 − 0.4) = 7(0.6) = 4.2%.
73. Answer: C is correct. The expected return is the sum of the expected dividend yield plus expected
growth. The expected growth is (1 − 0.4)15% = 9%. The expected dividend yield is $2.18/$28 = 7.8%.
The sum is 16.8%.
74. Answer: B is correct. Using the CAPM approach, 4% + 1.3(9%) = 15.7%.
75. Answer: C is correct. Inferring the asset beta for the public company: unlevered beta = 1.75/[1 + (1 −
0.35) (0.90)] = 1.104. Relevering to reflect the target debt ratio of the private firm: levered beta = 1.104 ×
[1 + (1 − 0.30) (1.00)] = 1.877.
76. Answer: C is correct. The country equity premium can be estimated as the sovereign yield spread times
the volatility of the country’s stock market relative to its bond market. Paragon’s equity premium is
(10.5% – 4.5%) × (35%/25%) = 6% × 1.4 = 8.40%.
77. Answer B
To determine Foodbine's before-tax cost of debt, find the yield to maturity on its outstanding notes:
PV = -94.54; FV = 100; PMT = 6 / 2 = 3; N = 14; CPT → I/Y = 3.50 × 2 = 7%
Foodbine's after-tax cost of debt is kd(1 - t) = 7%(1 - 0.3) = 4.9%
78. 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.
79. Answer C
In order to reflect the increased risk when investing in a developing country, a country risk premium is
added to the market risk premium when using the CAPM.
80. Answer C
After-tax cost of debt = 10% × (1 - 0.4) = 6%. Cost of preferred stock = $4 / $31.50 = 12.7%.
81. Answer B
The after-tax cost of preferred stock is equal to the before-tax cost of preferred stock, 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.

265

Page 60 of 112
82. Answer C
Corporate taxes do not affect the cost of preferred stock to the issuing firm. Waterbury's after-tax cost
of debt, and consequently, its weighted average cost of capital will decrease because the tax savings on
interest will increase. Also, since taxes impact net income, Waterbury's ROE will be affected by the
change.
83. Answer B
The unlevered asset beta is:
 1 
 Aspire asset  0.8    0.380
 1  1  0.35 1.7 
Affluence"s debt-to-equity ratio = 0.75/0.25 = 3. To calculate the project beta, re-lever the asset beta
using Affluence"s debt-to- equity ratio and marginal tax rate:
 Affluence project  0.380 1  1  0.33   1.178  1.18
84. 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.
ks = D1 ÷ P0 + growth = (3)(1.05) ÷ (31.50) + 0.05 = 0.15 or 15% V = debt + equity = 0.5 + 1 = 1.5
WACC = (E ÷ V)(ks) + (D ÷ V)(kdebt)(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%
85. Answer C
Rox's cost of debt capital is kd(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.
86. Answer B
 1 
JF Black asset  0.7    0.25
 1  1  0.40  3.0 
Utilitarian project  0.25 1  1  0.32.5   0.6875
project cost of equity=5%+0.6875  9%  5%   7.75%
1 2.5
WACCproject  7.75  7% 1  0.3  5.71%
3.5 3.5
87. Answer C
The recommended method is to treat flotation costs as a cash outflow at project initiation rather than as
a component of the cost of equity.
88. Answer B
kd = 0.09(1 - 0.4) = 0.054 = 5.4%
kce = [(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.
89. Answer B
A breakpoint is calculated by dividing the amount of capital at which a component's cost of capital
changes by the weight of that component in the capital structure.
The marginal cost of capital (MCC) is defined as the weighted average cost of the last dollar raised by
the company. Typically, the marginal cost of capital will increase as more capital is raised by the firm.
The marginal cost of capital is the weighted average rate across all sources of long-term financings—

266

Page 61 of 112
 bonds, preferred stock, and common stock—when the final dollar was obtained, regardless of its
specific source.
90. Answer B
If Fox remembers to order the capital components from cheapest to most expensive, he can calculate
WACC. The order from cheapest to most expensive is: debt, preferred stock (which acts like a hybrid
of debt and equity), and common equity.
Then, using the formula for WACC = (wd)(kd) + (wps)(kps) + (wce)(kce)
where wd, wps, and we are the weights used for debt, preferred stock, and common equity.
WACC = (0.30 × 6.0%) + (0.20 × 8.5%) + (0.50 × 15.00%) = 11.0%.
91. Answer A
(0.4)(9%)(1 - 0.4) + (0.6)(14%) = 10.56%
92. Answer A
Hockin' asset beta:
 1 
 ASSET  1.3    0.52
 1  1  0.25 2.0 
We are given Dragon"s leverage ratio (assets-to-equity) as equal to 2.3. If we assign the value of 1 to
equity (A/E = 2.3/1), then debt (and the debt-to-equity ratio) must be 2.3 − 1 = 1.3.
Equity beta for the project:
 PROJECT = 0.52[1 + (1 − 0.3)(1.3)] = 0.9932
Project cost of equity = 3% + 0.9932(9% − 3%) = 8.96%
Dragon"s capital structure weight for debt is 1.3/2.3 = 56.5%, and its weight for equity is 1/2.3 =
43.5%. The appropriate WACC for the project is therefore:
0.565(12%)(1 − 0.3) + 0.435(8.96%) = 8.64%.
93. Answer B
Flow will have a break point each time a component cost of capital changes, for a total of three
marginal cost of capital schedule breakpoints.
Break pointDebt > $200mm = ($200 million ÷ 0.4) = $500 million
Break pointDebt > $400mm = ($400 million ÷ 0.4) = $1,000 million
Break pointEquity > $300mm = ($300 million ÷ 0.6) = $500 million
Break pointEquity > $700mm = ($700 million ÷ 0.6) = $1,167 million
94. Answer B
Use the WACC as the discount rate to calculate NPV.
WACC = (wd × (kd × (1 - T))) + (we × ke)
= [0.4 × 0.08 × (1 - 0.4)] + [0.6 × 0.16] = 11.52%
NPV of project X = -100 + 50 / (1.1152) + 30 / (1.11522) + 50 / (1.11523) = +5.01
NPV of project Y = -150 + 50 / (1.1152) + 60 / (1.11522) + 80 / (1.11523) = +0.76
95. 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.
96. Answer A
ROE × retention ratio = growth rate
15% × (1 - 0.40) = 9%
D0 = $5.00 × 0.40 = $2.00
[$2.00(1.09) / $42.00] + 0.09 = 14.19%

267

Page 62 of 112
97. Answer C
Adjusting the cost of equity for flotation costs is incorrect because doing so entails adjusting the
present value of cash flows by a fixed percentage over the life of the project. In reality, flotation costs
are a cash outflow that occurs at the initiation of a project. Therefore, the correct way to account for
flotation costs is to adjust the cash flows in the computation of project NPV, not the cost of equity. The
dollar amount of the flotation cost should be considered an additional cash outflow at initiation of the
project.
98. Answer A
After-tax cost of debt:
N = 20; FV = 1,000; PMT = 60; PV = -894; CPT I/Y = 7%
kd = (7%)(1 − 0.4) = 4.2%
Cost of preferred stock:
kps = Dps / P = 5 / 90 = 5.56%
Cost of common equity:
kce = (D1 / P0) + g
kce = 2 / 45 + 0.08 = 0.1244 = 12.44%
WACC = (0.4)(4.2) + (0.1)(5.6) + (0.5)(12.4) = 8.5%
99. 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.
$65,000 $65,000 $65,000 $65,000
NPV  $175,000  $5,513      $32,872
1.084 1.084 2 1.084 3 1.084 4
100. Answer B
Debt break point #2 = $60 million / 0.30 = $200 million.
$135 million × 30% = $40.5 million new debt
$135 million × 70% = $94.5 million new equity
MCC = 4.0%(0.30) + 12.5%(0.70) = 9.95%.
101. Answer A
Step 1: Determine the after-tax cost of debt:
The after-tax cost of debt [kd (1 - t)] is used to compute the weighted average cost of capital. It is the
interest rate on new debt (kd) less the tax savings due to the deductibility of interest (kdt).
Here, we are given the inputs needed to calculate kd: N = 15 × 2 = 30; PMT = (1,000 × 0.07) / 2 = 35;
FV = 1,000; PV = -1,047.46; CPT → I = 3.25, multiply by 2 = 6.50%. Thus, kd (1 - t) = 6.50% × (1 -
0.35) = 4.22%
Step 2: Determine the cost of preferred stock:
Preferred stock is a perpetuity that pays a fixed dividend (Dps) forever. The cost of preferred stock (kps)
= Dps / P
where: Dps = preferred dividends.
P = price
Here, kps = Dps / P = $2.80 / $35 = 0.08, or 8.0%.

268

Page 63 of 112
 Step 3: Determine the cost of common equity:
kce = (D1 / P0) + g
where: D1 = Dividend in next year
P0 = Current stock price g = Dividend growth rate
Here, D1 = D0 × (1 + g) = $3.00 × (1 + 0.06) = $3.18. kce = (3.18 / 40) + 0.06 = 0.1395 or 13.95%.
Step 4: Calculate WACC:
WACC = (wd)(kd) + (wps)(kps) + (wce)(kce)
where wd, wps, and wce are the weights used for debt, preferred stock, and common equity. Here,
WACC = (0.30 × 4.22%) + (0.20 × 8.0%) + (0.50 × 13.95%) = 9.84%.
Note: Your calculation may differ slightly, depending on whether you carry all calculations in your
calculator, or round to two decimals and then calculate.
102. Answer B
The method used by Green is known as the pure-play method. The method entails selection of the
pure-play equity beta, unlevering it using the pure-play company's capital structure, and re-levering
using the subject company's capital structure.
103. Answer B
The unlevered (asset) beta is 0.8{1 / [1 + (1 - 0.34)(180 / 540)]} = 0.656.
104. Answer B
Pretax cost of debt: N = 20; FV = 1000; PV = −894; PMT = 60; CPT → I/Y = 7% After-tax cost of
debt: kd = (7%)(1−0.4) = 4.2%
105. Answer A
(0.3)(0.1)(1 - 0.4) + (0.2)(0.11) + (0.5)(0.18) = 0.13
106. Answer B
The weights in the calculation of WACC should be based on the firm's target capital structure, that is,
the proportions (based on market values) of debt, preferred stock, and equity that the firm expects to
achieve over time. Book values should not be used. As such, the weight of debt is 41% ($10.5 ÷ $25.7),
the weight of preferred stock is 6% ($1.5 ÷ $25.7) and the weight of common
stock is 53% ($13.7 ÷ $25.7).
107. Answer A
We can estimate the company's expected growth rate as ROE × (1 − payout ratio): g = 15% × (1 −
2.40/3.00) = 3%
The expected dividend next period is then £2.40(1.03) = £2.47. Based on dividend discount model
pricing, the required return on equity is 2.47 / 40 + 3% = 9.18%.
108. Answer A
The cost of debt capital is affected by the marginal tax rate because interest costs are tax-deductible. A
lower marginal tax rate decreases the value to the firm of the tax deduction for interest and therefore
increases the after-tax cost of debt capital. Cost of equity capital is not affected by the marginal tax
rate.
109. Answer B
If the bonds are trading at $92 per $100 par, the required yield is 9.26% (N = 10; PV = -92; FV = 100;
PMT = 8; CPT I/Y = 9.26). The equivalent after-tax cost of this financing is: 9.26% (1 - 0.35) = 6.02%.
110. Answer A
Equity and preferred stock are not adjusted for taxes because dividends are not deductible for corporate
taxes. Only interest expense is deductible for corporate taxes.
111. Answer B
The marginal (or weighted average) cost of capital is the appropriate discount rate for projects that
have the same level of risk as the firm's existing projects. For a project with a higher degree of risk,
cash flows should be discounted at a rate higher than the firm's WACC. Since this project's IRR is
269

Page 64 of 112
 equal to the company's WACC, its NPV must be zero if the cash flows are discounted at the WACC. If
the cash flows are discounted at a rate higher than the WACC to account for the project's higher risk,
the NPV must be negative. Therefore, the project would reduce the value of the company, so
management should reject it. A company considers its capital raising and budgeting decisions
independently. Each investment decision must be made assuming a WACC which includes each of the
different sources of capital and is based on the long-run target weights.
112. Answer A
Debt:
N = 20; FV = 1,000; PMT = 60; PV = -894; CPT I/Y = 7%
kd = (7%)(1 − 0.4) = 4.2% Preferred stock:
kps = Dps / P = 5 / 90 = 5.56%
Note that the cost of preferred stock is not adjusted for taxes because preferred dividends are usually
not tax-deductible.
113. Answer A
A breakpoint is calculated as the amount of capital where component cost changes / weight of
component in the WACC. The breakpoint for raising new debt capital occurs at ($150 / 0.35) = $428.6
million, and the breakpoint for raising new equity capital
occurs at ($400 / 0.65) = $615.4 million.
114. Answer A
Ks = (D1 / P0) + g = (2.5/25) + 0.08 = 0.18 or 18%.
115. Answer C
The problem must be solved in two steps. First, calculate the cost of equity:
rCE = Rf + β(RM - Rf)
= 0.04 + 0.9(0.09 - 0.04)
= 0.085 = 8.5%
Next, calculate the WACC.
WACC = wDrD(1 - t) + wPrP + wCErCE
= (0.30)(0.08)(1 - 0.40) + 0 + (0.70)(0.085)
= 0.0739 or 7.39%
116. Answer C
Marian's first statement is correct. A breakpoint calculated as (amount of capital where component cost
changes / weight of component in the WACC). The component cost of equity for Airton will increase
when the amount of new equity raised is $200 million, which will occur at ($200 million / 0.70) =
$285.71 million, or $286 million of new capital.
Marian's second statement is also correct. If Airton wants to finance $600 million of total assets, the
firm will need to raise $600 − $300 = $300 million of additional capital. Using the target capital
structure of 70% equity and 30% debt, Airton will need to raise $300 × 0.70 = $210 million in new
equity and $300 × 0.30 = $90 million in new debt. Looking at the capital schedules, these levels of new
financing correspond with rates of 9.0% and 4.2% for costs of equity and debt respectively, and the
WACC is equal to (9.0% × 0.70) + (4.2% × 0.30) = 7.56%.
117. Answer B
If the bonds are trading at $98, the required yield is 8.11%, and the market value of the issue is $3.92
million. To calculate this rate using a financial calculator (and figuring the rate assuming a $100 face
value for each bond), N = 4; PMT = 7.5 = (0.075 × 100); FV = 100; PV = -98; CPT → I/Y = 8.11. By
adding the equity risk factor of 4%, we compute the cost of equity as 12.11%.
118. Answer A
The WACC is the appropriate discount rate for projects that have approximately the same level of risk
as the firm's existing projects. This is because the component costs of capital used to calculate the

270

Page 65 of 112
 firm's WACC are based on the existing level of firm risk. To evaluate a project with above (the firm's)
average risk, a discount rate greater than the firm's existing WACC should be used. Projects with
below-average risk should be evaluated using a discount rate less than the firm's WACC. An additional
issue to consider when using a firm's WACC (marginal cost of capital) to evaluate a specific project is
that there is an implicit assumption that the capital structure of the firm will remain at the target capital
structure over the life of the project. These complexities aside, we can still conclude that the NPVs of
potential projects of firm-average risk should be calculated using the marginal cost of capital for the
firm. Projects for which the present value of the after-tax cash inflows is greater than the present value
of the after-tax cash outflows should be undertaken by the firm.
119. Answer A
The after-tax cost of debt similar to Sumana's existing debt is kd(1 - t) = 8.33%(1 - 0.4) = 5.0%.
Because the anticipated new debt will be subordinated in the company's debt structure, investors will
demand a higher yield than the existing debt carries. Therefore, the appropriate after-tax cost of the
new debt is more than 5.0%.
120. Answer A
If the new project is less risky than the average risk of existing projects, the MCC should be adjusted
downward. A lower discount rate will increase project's the net present value.
121. Answer B
The newly-issued preferred shares of most companies generally sell at par. As such, the dividend yield
on a firm's newly-issued preferred shares is the market's required rate of return. The yield on a BBB
corporate bond reflects a pre-tax cost of debt. Both remaining choices make no sense.
122. Answer A
kps = $8 / $80 = 10%
123. Answer A
WACC = (wd)(kd)(1 - t) + (wce)(kce)
WACC = (0.5)(6%)(1 - 0.33) + (0.5)(12%) = 8.0%
The increase in after-tax cash flows for each year is 3,000 × (1 - 0.33) = $2,010.
I =8; N =8; PMT = $2,010; CPT→PV = $11,550.74
NPV = PV income - cost = $11,550.74 - $10,000 = $1,550.74
124. Answer C
ks = RFR + β(Rm − RFR)
= 6% + 1.125(14% − 6%) = 15%
WACC = [D/(D + E)] × kd(1 − t) + [E/(D + E)] × ks
= (100/300)(9%)(1 − 0.3) + (200/300)(15%) = 12.1%
125. Answer C
Ideally, an analyst would use the YTM of a firm's existing debt as the pretax cost of new debt. When a
firm's debt is not publicly traded, however, a market YTM may not be available. In this case, an analyst
may use the yield curve for debt with the same rating and maturity to estimate the market YTM. If the
anticipated debt has unique characteristics that affect YTM, these characteristics should be accounted
for when estimating the pretax cost of debt. The cost of debt is the market interest rate (YTM) on new
(marginal) debt, not the coupon rate on the firm's existing debt. If you are provided with both coupon
and YTM on the exam, you should use the YTM.
126. Answer A
An increase in either the company's beta or the market risk premium will cause the WACC to increase
using the CAPM approach. A reduction in the market risk premium will reduce the cost of equity for
WACC.

271

Page 66 of 112
127. Answer C
Net present values of projects with the average risk for the firm should be determined using the firm's
marginal cost of capital. The discount rate should be adjusted for projects with above-average or
below-average risk. Using the marginal cost of capital assumes the firm's capital structure does not
change over the life of the project.
128. Answer B
In order to calculate the weighted average cost of capital (WACC), market value weights should be
used. For the bonds = 200,000 × $965 = $193,000,000
For the stocks = 6,000,000 × $28 = $168,000,000
$361,000,000
The weight of debt would be: 193,000,000 / 361,000,000 = 0.5346 = 53.46%
The weight of common stock would be: 168,000,000 / 361,000,000 = 0.4654 = 46.54%
129. Answer A
An increase in the risk-free rate will cause the cost of equity to increase. It would also cause the cost of
debt to increase. In either case, the nominal cost of capital is the risk-free rate plus the appropriate
premium for risk.
130. Answer A
WACC = (Wd)(Kd (1 − t)) + (Wps)(Kps) + (Wce)(Ks)
WACC = 0.4(7.5%)(1 − 0.4) + 0.05(11%) + 0.55(15%) = 10.6%.
131. Answer A
The corporate tax rate is not a relevant factor when calculating the cost of preferred stock. The cost of
preferred stock, kps is expressed as:
kps = Dps / P
where:
Dps = divided per share = dividend rate × stated par value
P = market price
132. Answer A
0.93 1.07 
Ke   0.07  13.2%
16
133. Answer A
The firm will reject profitable, low-risk projects because it will use a hurdle rate that is too high. The
firm should lower the required rate of return for lower risk projects. The firm will accept unprofitable,
high-risk projects because the hurdle rate of return used will be too low relative to the risk of the
project. The firm should increase the required rate of return for high-risk projects.
134. Answer B
The cost of preferred stock, kps, is Dps ÷ price.
135. Answer A
CAPM approach:
10 + (5)(1.2) = 16%.
Discounted cash flow approach:
Next-period dividend = 2(1.08) = 2.16 (2.16 / 27) + 0.08 = 16%
136. Answer B
The unlevered beta for this company is calculated as:
 1 
unlevered  1.2    0.6316  0.632
 1  1  0.40  1.5 
137. Answer A
(0.14)(1 - 0.4)

272

Page 67 of 112
138. Answer A
The "marginal" cost refers to the last dollar of financing acquired by the firm assuming funds are
raised in the same proportion as the target capital structure. It is a percentage value based on both the
returns required by the last bondholders and stockholders to provide capital to the firm. Regardless of
whether the funding came from bondholders or stockholders, both debt and equity are needed to fund
projects.
139. Answer C
In the U.S., interest paid on corporate debt is tax deductible, so the after-tax cost of debt capital is less
than the before-tax cost of debt capital. Dividend payments are not tax deductible, so taxes do not
decrease the cost of common or preferred equity.
140. Answer A
The marginal cost of capital (MCC) and the weighted average cost of capital (WACC) are the same
thing. If a firm's capital structure remains constant, the MCC (WACC) increases as additional capital is
raised.
141. Answer B
CRP = Sovereign Yield Spread(Annualized standard deviation of equity index ÷ Annualized standard
deviation of sovereign bond market in terms of the developed market currency)
= (0.072 - 0.046)(0.40/0.24) = 0.043, or 4.3%.
142. Answer A
A break point refers to a level of new investment at which a component's cost of capital changes. The
formula for break point is:
amount of capital at which a component's cost of capital changes
break point 
weight of the component in the capital structure
As indicated, as the weight of a capital component in the capital structure increases, the break point at
which a change in the component's cost will decline. No computation is necessary, but when Hard has
40% debt, the breakpoint is $600,000,000 / 0.4 = $1.5 billion. If Hard"s debt increases to 50%, the
breakpoint will decline to $600,000,000 / 0.5 = $1.2 billion.
143. Answer C
CAPM = RE = RF + B(RM − RF) = 0.06 + (1.125)(0.14 − 0.06) = 0.15
WACC = (E ÷ V)(RE) + (D ÷ V)(RD)(1 − t)
V = 100 + 300 = 400
WACC = (1 ÷ 4)(0.15) + (3 ÷ 4)(0.09)(1 − 0.4) = 0.078
144. Answer A
Preferred stock pays constant dividends into perpetuity. The price of preferred stock equals the present
value of the preferred stock dividends: $20 = $2 / kps. Therefore, the cost of preferred stock capital
equals $2 / $20 = 0.10 = 10%.
145. Answer B
Before-tax cost of debt capital:
N = 40; PMT = 50; FV = 1,000; PV = 849.54; CPT I/Y = 6% × 2 = 12%
After-tax cost of debt capital = (12)(1 − 0.4) = 7.2%.
146. Answer A
The internal rate of return is independent of the firm's cost of capital. It is a function of the amount and
timing of a project's cash flows.
147. Answer A
WACC = (1 − t) (rd) (D ÷ A) + (rp) (P/A) + (rce) (E ÷ A)
WACC = (1 − 0.4) (0.053) (58 ÷ 611) + (0.072) (28 ÷ 611) + (0.08) (525 ÷ 611)
WACC = 0.003 + 0.0033 + 0.0687
WACC = 7.50%
273

Page 68 of 112
148. Answer A
Each statement that Haggerty has made to the board of directors regarding the weighted average cost
of capital is correct. New projects should have a return that is higher than the cost to finance those
projects.
149. Answer A
The marginal cost of capital schedule shows the WACC at different levels of capital investment. It is
usually upward sloping and is a function of a firm's capital structure and its cost of capital at different
levels of total capital investment.
150. Answer A
7.5 × (1 − 0.3) = 5.25%.
151. Answer B
The after-tax cost of debt = kd(1 - t) = kd - kd(t), where kd is the pretax cost of debt and t is the
effective corporate tax rate. So the tax savings from the tax treatment of debt is kd(t). Capital
component weights should be based on market weights, not book values. And, the appropriate pre-tax
cost of debt is the yield to maturity on the firm's existing debt.
152. Answer C
Ks = 0.10 + (0.05)(1.2) = 0.16 or 16%
Kd = Solve for i: N = 40, PMT = 50, FV = 1,000, PV = -849.54, CPT I = 6 × 2 = 12% WACC =
(0.4)(12)(1 - 0.4) + (0.6)(16)= 2.88 + 9.6 = 12.48
153. Answer C
0.10(12%) + 0.30(8%)(1 - 0.35) + 0.6(14.5%) = 11.46%.
154. Answer A
WACC = (wd)(kd)(1 − t) + (wps)(kps) + (wce)(kce)
where:
wd = 0.40 wce = 0.50 wps = 0.10 kd = 0.07
kps = Dps / P = 4.00 / 40.00 = 0.10
kce = D1 / P0 + g = 2.00 / 25.00 + 0.07 = 0.08 + 0.07 = 0.15
WACC = (0.4)(0.07)(1 − 0.4) + (0.1)(0.10) + (0.5)(0.15) = 0.0168 + 0.01 + 0.075 = 0.1018 or 10.18%
155. Answer C
Recall the WACC equation:
WACC = [wd × kd × (1 − t)] + (wps × kps) + (wce × ks)
The increase in the corporate tax rate will result in a lower cost of debt, resulting in a lower WACC for
the company.
156. Answer A
The marginal cost of capital represents the cost of raising an additional dollar of capital. The cost of
retained earnings would only be appropriate if the company avoided creditor-supplied financing or the
issuance of new common or preferred stock (and preferred stock financing). The after-tax cost of debt
is never sufficient, because a business, regardless of their size, always has a residual owner, and hence
a cost of equity.
157. Answer C
WACC = (E / V)(RE) + (D / V)(RD)(1 − TC)
WACC = (15 / 25)(0.15) + (10 / 25)(0.10)(1 − 0.35) = 0.09 + 0.026 = 0.116 or 11.6%
158. Answer C
Kce = ( D1 / P0) + g
Kce = [ 2.50 / 22.50 ] + 0.08 = 0.19111, or 19.1%

274

Page 69 of 112
159. Answer A
The incorrect method of accounting for flotation costs spreads the flotation cost out over the life of the
project by a fixed percentage that does not necessarily reflect the present value of the flotation costs.
The impact on project evaluation depends on the length of the project and magnitude of the flotation
costs, however, for most projects that are shorter, the incorrect method will overstate NPV, and that is
exactly what we see in this problem.
Correct method of accounting for flotation costs:
After-tax cost of debt = 8.0% (1-0.30) = 5.60%
Cost of equity = ($1.80 / $40.00) + 0.05 = 0.045 + 0.05 = 9.50% WACC = 0.50(5.60%) + 0.50(9.50%)
= 7.55%
Flotation costs Project 1 = $200,000 × 0.5 × 0.04 = $4,000
Flotation costs Project 2 = $100,000 × 0.5 × 0.04 = $2,000
NPV Project 1 = -$200,000 - $4,000 + (N = 8, I = 7.55%, PMT = $55,000, FV = 0 →CPT PV =
$321,535) = $117,535
NPV Project 2 = -$100,000 - $2,000 + (N = 4, I = 7.55%, PMT = $40,000, FV = 0 →CPT PV =
$133,823) = $31,823
Incorrect Adjustment for cost of equity method for accounting for flotation costs:
After-tax cost of debt = 8.0% (1-0.30) = 5.60%
Cost of equity = [$1.80 / $40.00(1-0.04)] + 0.05 = 0.0469 + 0.05 = 9.69% WACC = 0.50(5.60%) +
0.50(9.69%) = 7.65%
NPV Project 1 = -$200,000 + (N = 8, I = 7.65%, PMT = $55,000, FV = 0 →CPT PV = $320,327) =
$120,327
NPV Project 2 = -$100,000+ (N = 4, I = 7.65%, PMT = $40,000, FV = 0 →CPT PV = $133,523) =
$33,523
160. Answer C
CRP = Sovereign Yield Spread(Annualized standard deviation of equity index ÷ Annualized standard
deviation of sovereign bond market in terms of the developed market currency)
= (0.077 - 0.046)(0.38 ÷ 0.26) = 0.0453, or 4.53%
Cost of equity = RF + β[E(RMKT) - RF + CRP] = 0.042 + 1.25[0.06 + 0.0453] = 0.1736 = 17.36%
Note that you are given the market risk premium, which equals E(RMKT) - RF.
161. Answer B
After-tax cost of debt = bond yield − tax savings = kd − kdt = kd(1 − t)
162. Answer A
The capital structure ratios are:
Debt to total capital = $10 / $40 = 25% Equity to total capital = $30 / $40 = 75%
The formula for the WACC (if no preferred stock) is:
WACC = wdkd(1 - t) + wcekce
where wd is the percentage of operations financed by debt, wce is the percentage of operations
financed by equity, t is the marginal tax rate, kd is the before-tax cost of debt, and kce is the cost of
common equity.
WACC = 0.25(0.08)(0.60) + 0.75(0.12) = 0.102 = 10.2%.

275

Page 70 of 112