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La Consolacion College Tanauan Unified La Consolacion College

– South Luzon

Cost of Capital

Name: _______________________________________________ Score:

Date: ______________________

SEATWORK

"Success is not final; failure is not fatal: It is the courage to continue that counts." – Anonymous

1. Which of the following is not considered a capital component for the purpose of calculating the weighted average
cost of capital (WACC) as it applies to capital budgeting?
a. Long-term debt.
b. Common stock.
c. Accounts payable and accruals.
d. Preferred stock.

2. For a typical firm with a given capital structure, which of the following is correct? (Note: All rates are after taxes.)
a. kd > ke > ks > WACC.
b. ks > ke > kd > WACC.
c. WACC > ke > ks > kd.
d. ke > ks > WACC > kd.
e. None of the statements above is correct.

3. Which of the following statements is most correct?

a. If a company’s tax rate increases but the yield to maturity of its noncallable bonds remains the same, the com-
pany’s marginal cost of debt capital used to calculate its weighted average cost of capital will fall.
b. All else equal, an increase in a company’s stock price will increase the marginal cost of retained earnings, ks.
c. All else equal, an increase in a company’s stock price will increase the marginal cost of issuing new common eq-
uity, ke.
d. Statements a and b are correct.
e. Statements b and c are correct.

4. Which of the following statements is most correct?

a. Since the money is readily available, the cost of retained earnings is usually a lot cheaper than the cost of debt
financing.
b. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock divi-
dends are tax deductible.
c. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are tax de-
ductible.
d. Statements a and b are correct.
e. Statements b and c are correct.

5. Which of the following factors in the discounted cash flow (DCF) approach to estimating the cost of common equity
is the least difficult to estimate?
a. Expected growth rate, g.
b. Dividend yield, D1/P0.
c. Required return, ks.
d. Expected rate of return, k̂s .

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 e. All of the above are equally difficult to estimate.

6. Which of the following statements is most correct?

a. The WACC measures the after-tax cost of capital.
b. The WACC measures the marginal cost of capital.
c. There is no cost associated with using retained earnings.
d. Statements a and b are correct.
e. All of the statements above are correct.

7. Which of the following statements about the cost of capital is incorrect?

a. A company’s target capital structure affects its weighted average cost of capital.
b. Weighted average cost of capital calculations should be based on the after-tax costs of all the individual capital
components.
c. If a company’s tax rate increases, then, all else equal, its weighted average cost of capital will increase.
d. Flotation costs can increase the weighted average cost of capital.
e. An increase in the risk-free rate is likely to increase the marginal costs of both debt and equity financing.

8. Campbell Co. is trying to estimate its weighted average cost of capital (WACC). Which of the following statements is
most correct?
a. The after-tax cost of debt is generally cheaper than the after-tax cost of preferred stock.
b. Since retained earnings are readily available, the cost of retained earnings is generally lower than the cost of
debt.
c. If the company’s beta increases, this will increase the cost of equity financing, even if the company is able to rely
on only retained earnings for its equity financing.
d. Statements a and b are correct.
e. Statements a and c are correct.

9. Wyden Brothers has no retained earnings. The company uses the CAPM to calculate the cost of equity capital. The
company’s capital structure consists of common stock, preferred stock, and debt. Which of the following events will
reduce the company’s WACC?
a. A reduction in the market risk premium.
b. An increase in the flotation costs associated with issuing new common stock.
c. An increase in the company’s beta.
d. An increase in expected inflation.
e. An increase in the flotation costs associated with issuing preferred stock.

10. Which of the following statements is most correct?

a. The WACC is a measure of the before-tax cost of capital.
b. Typically the after-tax cost of debt financing exceeds the after-tax cost of equity financing.
c. The WACC measures the marginal after-tax cost of capital.
d. Statements a and b are correct.
e. Statements b and c are correct.

11. A company has a capital structure that consists of 50 percent debt and 50 percent equity. Which of the following
statements is most correct?
a. The cost of equity financing is greater than or equal to the cost of debt financing.
b. The WACC exceeds the cost of equity financing.
c. The WACC is calculated on a before-tax basis.
d. The WACC represents the cost of capital based on historical averages. In that sense, it does not represent the
marginal cost of capital.
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 e. The cost of retained earnings exceeds the cost of issuing new common stock.

12. A firm estimates that its proposed capital budget will force it to issue new common stock, which has a greater cost
than the cost of retained earnings. The firm, however, would like to avoid issuing costly new common stock. Which
of the following steps would mitigate the firm’s need to raise new common stock?
a. Increasing the company’s dividend payout ratio for the upcoming year.
b. Reducing the company’s debt ratio for the upcoming year.
c. Increasing the company’s proposed capital budget.
d. All of the statements above are correct.
e. None of the statements above is correct.

13. Dick Boe Enterprises, an all-equity firm, has a corporate beta coefficient of 1.5. The financial manager is evaluating a
project with an expected return of 21 percent, before any risk adjustment. The risk-free rate is 10 percent, and the
required rate of return on the market is 16 percent. The project being evaluated is riskier than Boe’s average project,
in terms of both beta risk and total risk. Which of the following statements is most correct?
a. The project should be accepted since its expected return (before risk adjustment) is greater than its required re-
turn.
b. The project should be rejected since its expected return (before risk adjustment) is less than its required return.
c. The accept/reject decision depends on the risk-adjustment policy of the firm. If the firm’s policy were to reduce
a riskier-than-average project’s expected return by 1 percentage point, then the project should be accepted.
d. Riskier-than-average projects should have their expected returns increased to reflect their added riskiness.
Clearly, this would make the project acceptable regardless of the amount of the adjustment.
e. Projects should be evaluated on the basis of their total risk alone. Thus, there is insufficient information in the
problem to make an accept/reject decision.

14. A company estimates that an average-risk project has a WACC of 10 percent, a below-average risk project has a
WACC of 8 percent, and an above-average risk project has a WACC of 12 percent. Which of the following independ-
ent projects should the company accept?
a. Project A has average risk and a return of 9 percent.
b. Project B has below-average risk and a return of 8.5 percent.
c. Project C has above-average risk and a return of 11 percent.
d. All of the projects above should be accepted.
e. None of the projects above should be accepted.

15. Conglomerate Inc. consists of 2 divisions of equal size, and Conglomerate is 100 percent equity financed. Division A’s
cost of equity capital is 9.8 percent, while Division B’s cost of equity capital is 14 percent. Conglomerate’s composite
WACC is 11.9 percent. Assume that all Division A projects have the same risk and that all Division B projects have the
same risk. However, the projects in Division A are not the same risk as those in Division B. Which of the following
projects should Conglomerate accept?
a. Division A project with an 11 percent return.
b. Division B project with a 12 percent return.
c. Division B project with a 13 percent return.
d. Statements a and c are correct.
e. Statements b and d are correct.

16. Which of the following will increase a company’s retained earnings break point?
a. An increase in its net income.
b. An increase in its dividend payout.
c. An increase in the amount of equity in its capital structure.
d. An increase in its capital budget.
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 e. All of the statements above are correct.

17. Which of the following actions will increase the retained earnings break point?
a. An increase in the dividend payout ratio.
b. An increase in the debt ratio.
c. An increase in the capital budget.
d. An increase in flotation costs.
e. All of the statements above are correct.

18. Which of the following statements is most correct?

a. Since debt capital is riskier than equity capital, the cost of debt is always greater than the WACC.
b. Because of the risk of bankruptcy, the cost of debt capital is always higher than the cost of equity capital.
c. If a company assigns the same cost of capital to all of its projects regardless of the project’s risk, then it follows
that the company will generally reject too many safe projects and accept too many risky projects.
d. Because you are able to avoid flotation costs, the cost of retained earnings is generally lower than the cost of
debt.
e. Higher flotation costs tend to reduce the cost of equity capital.

19. Which of the following statements is most correct?

a. Higher flotation costs reduce investor returns, and therefore reduce a company’s WACC.
b. The WACC represents the historical cost of capital and is usually calculated on a before-tax basis.
c. The cost of retained earnings is zero because retained earnings are readily available and do not require the
payment of flotation costs.
d. All of the statements above are correct.
e. None of the statements above is correct.

20. Which of the following statements is most correct?

a. In the weighted average cost of capital calculation, we must adjust the cost of preferred stock for the tax exclu-
sion of 70 percent of dividend income.
b. We ideally would like to use historical measures of the component costs from prior financings in estimating the
appropriate weighted average cost of capital.
c. The cost of a new equity issuance (ke) could possibly be lower than the cost of retained earnings (ks) if the mar-
ket risk premium and risk-free rate decline by a substantial amount.
d. Statements b and c are correct.
e. None of the statements above is correct.

21. Which of the following statements is most correct?

a. The cost of retained earnings is the rate of return stockholders require on a firm’s common stock.
b. The component cost of preferred stock is expressed as kp(1 - T), because preferred stock dividends are treated
as fixed charges, similar to the treatment of debt interest.
c. The bond-yield-plus-risk-premium approach to estimating a firm’s cost of common equity involves adding a sub-
jectively determined risk premium to the market risk-free bond rate.
d. The higher the firm’s flotation cost for new common stock, the more likely the firm is to use preferred stock,
which has no flotation cost.
e. None of the statements above is correct.

22. Which of the following statements is correct?

a. The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund
that project.
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 b. The cost of debt used to calculate the weighted average cost of capital is based on an average of the cost of debt
already issued by the firm and the cost of new debt.
c. One problem with the CAPM approach in estimating the cost of equity capital is that if a firm’s stockholders are,
in fact, not well diversified, beta may be a poor measure of the firm’s true investment risk.
d. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method of estimating a
firm’s cost of equity capital.
e. The cost of equity capital is generally easier to measure than the cost of debt, which varies daily with interest
rates, or the cost of preferred stock since preferred stock is issued infrequently.

23. Which of the following statements is correct?

a. Although some methods of estimating the cost of equity capital encounter severe difficulties, the CAPM is a
simple and reliable model that provides great accuracy and consistency in estimating the cost of equity capital.
b. The DCF model is preferred over other models to estimate the cost of equity because of the ease with which a
firm’s growth rate is obtained.
c. The bond-yield-plus-risk-premium approach to estimating the cost of equity is not always accurate but its ad-
vantages are that it is a standardized and objective model.
d. Depreciation-generated funds are an additional source of capital and, in fact, represent the largest single source
of funds for some firms.
e. None of the statements above is correct.

24. In applying the CAPM to estimate the cost of equity capital, which of the following elements is not subject to dispute
or controversy?
a. The expected rate of return on the market, kM.
b. The stock’s beta coefficient, bi.
c. The risk-free rate, kRF.
d. The market risk premium (RPM).
e. All of the above are subject to dispute.

25. Which of the following statements is most correct?

a. Beta measures market risk, but if a firm’s stockholders are not well diversified, beta may not accurately measure
stand-alone risk.
b. If the calculated beta underestimates the firm’s true investment risk, then the CAPM method will overestimate
ks.
c. The discounted cash flow method of estimating the cost of equity can’t be used unless the growth component,
g, is constant during the analysis period.
d. An advantage shared by both the DCF and CAPM methods of estimating the cost of equity capital, is that they
yield precise estimates and require little or no judgement.
e. None of the statements above is correct.

26. Which of the following statements is most correct?

a. The weighted average cost of capital for a given capital budget level is a weighted average of the marginal cost
of each relevant capital component that makes up the firm’s target capital structure.
b. The weighted average cost of capital is calculated on a before-tax basis.
c. An increase in the risk-free rate is likely to increase the marginal costs of both debt and equity financing.
d. Statements a and c are correct.
e. All of the statements above are correct.

27. Which of the following statements is correct?

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 a. The WACC should include only after-tax component costs. Therefore, the required rates of return (or “market
rates”) on debt, preferred, and common equity (kd, kp, and ks) must be adjusted to an after-tax basis before
they are used in the WACC equation.
b. The cost of retained earnings is generally higher than the cost of new common stock.
c. Preferred stock is riskier to investors than is debt. Therefore, if someone told you that the market rates showed
kd > kp for a given company, that person must have made a mistake.
d. If a company with a debt ratio of 50 percent were suddenly exempted from all future income taxes, then, all
other things held constant, this would cause its WACC to increase.
e. None of the statements above is correct.

28. Which of the following statements is most correct?

a. An increase in flotation costs incurred in selling new stock will increase the cost of retained earnings.
b. The WACC should include only after-tax component costs. Therefore, the required rates of return (or “market
rates”) on debt, preferred, and common equity (kd, kp, and ks) must be adjusted to an after-tax basis before
they are used in the WACC equation.
c. An increase in a firm’s corporate tax rate will increase the firm’s cost of debt capital, as long as the yield to ma-
turity on the company’s bonds remains constant or falls.
d. Statements b and c are correct.
e. None of the statements above is correct.

29. Which of the following statements is most correct?

a. Since stockholders do not generally pay corporate taxes, corporations should focus on before-tax cash flows
when calculating the weighted average cost of capital (WACC).
b. All else equal, an increase in flotation costs will increase the cost of retained earnings.
c. When calculating the weighted average cost of capital, firms should rely on historical costs rather than marginal
costs of capital.
d. Statements a and b are correct.
e. None of the statements above is correct.

30. Which of the following statements is correct?

a. Because we often need to make comparisons among firms that are in different income tax brackets, it is best to
calculate the WACC on a before-tax basis.
b. If a firm has been suffering accounting losses and is expected to continue suffering such losses, and therefore its
tax rate is zero, it is possible that its after-tax component cost of preferred stock as used to calculate the WACC
will be less than its after-tax component cost of debt.
c. Normally, the cost of external equity raised by issuing new common stock is above the cost of retained earnings.
Moreover, the higher the growth rate is relative to the dividend yield, the more the cost of external equity will
exceed the cost of retained earnings.
d. The lower a company’s tax rate, the greater the advantage of using debt in terms of lowering its WACC.
e. None of the statements above is correct.

31. Kemp Consolidated has two divisions of equal size: a computer division and a restaurant division. Stand-alone res-
taurant companies typically have a cost of capital of 8 percent, while stand-alone computer companies typically have
a 12 percent cost of capital. Kemp’s restaurant division has the same risk as a typical restaurant company, and its
computer division has the same risk as a typical computer company. Consequently, Kemp estimates that its compo-
site corporate cost of capital is 10 percent. The company’s consultant has suggested that they use an 8 percent hur-
dle rate for the restaurant division and a 12 percent hurdle rate for the computer division. However, Kemp has cho-
sen to ignore its consultant, and instead, chooses to assign a 10 percent cost of capital to all projects in both divi-
sions. Which of the following statements is most correct?

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 a. While Kemp’s decision to not risk adjust its cost of capital will lead it to accept more projects in its computer di-
vision and fewer projects in its restaurant division, this should not affect the overall value of the company.
b. Kemp’s decision to not risk adjust means that it is effectively subsidizing its restaurant division, which means
that its restaurant division is likely to become a larger part of the overall company over time.
c. Kemp’s decision to not risk adjust means that the company will accept too many projects in the computer busi-
ness and too few projects in the restaurant business. This will lead to a reduction in the overall value of the
company.
d. Statements a and b are correct.
e. Statements b and c are correct.

32. The Barabas Company has an equal amount of low-risk projects, average-risk projects, and high-risk projects. Barab-
as estimates that the overall company’s WACC is 12 percent. This is also the correct cost of capital for the company’s
average-risk projects. The company’s CFO argues that, even though the company’s projects have different risks, the
cost of capital for each project should be the same because the company obtains its capital from the same sources.
If the company follows the CFO’s advice, what is likely to happen over time?
a. The company will take on too many low-risk projects and reject too many high-risk projects.
b. The company will take on too many high-risk projects and reject too many low-risk projects.
c. Things will generally even out over time, and therefore, the risk of the firm should remain constant over time.
d. Statements a and c are correct.
e. Statements b and c are correct.

33. If a company uses the same cost of capital for evaluating all projects, which of the following results is likely?

a. Accepting poor, high-risk projects.

b. Rejecting good, low-risk projects.
c. Accepting only good, low-risk projects.
d. Accepting no projects.
e. Answers a and b are correct.

34. If a typical U.S. company uses the same cost of capital to evaluate all projects, the firm will most likely become
a. Riskier over time, and its value will decline.
b. Riskier over time, and its value will rise.
c. Less risky over time, and its value will rise.
d. Less risky over time, and its value will decline.
e. There is no reason to expect its risk position or value to change over time as a result of its use of a single dis-
count rate.

35. Pearson Plastics has two equal-sized divisions, Division A and Division B. The company estimates that if the divisions
operated as independent companies Division A would have a cost of capital of 8 percent, while Division B would have a
cost of capital of 12 percent. Since the two divisions are the same size, Pearson’s composite weighted average cost of
capital (WACC) is 10 percent. In the past, Pearson has assigned separate hurdle rates to each division based on their rel-
ative risk. Now, however, Pearson has chosen to use the corporate WACC, which is currently 10 percent, for both divi-
sions. Which of the following is likely to occur as a result of this change? Assume that this change is likely to have no ef-
fect on the average risk of each division and market conditions remain unchanged.
a. Over time, the overall risk of the company will increase.
b. Over time, Division B will become a larger part of the overall company.
c. Over time, the company’s corporate WACC will increase.
d. Statements a and c are correct.
e. All of the statements above are correct.

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36. Smith Electric Co. and Ferdinand Water Co. are the same size and have the same capital structure. Smith Electric Co.
is riskier than Ferdinand and has a WACC of 12 percent. Ferdinand Water Co. is safer than Smith and has a WACC of
10 percent. Ferdinand Water Co. is considering Project X. Project X has an IRR of 10.5 percent, and has the same risk
as a typical project undertaken by Ferdinand Water Co. Smith Electric Co. is considering Project Y. Project Y has an
IRR of 11.5 percent, and has the same risk as a typical project undertaken by Smith Electric Co.

Now assume that Smith Electric Co. and Ferdinand Water Co. merge to form a new company, Leeds United Utilities.
The merger has no impact on the cash flows or risk of either Project X or Project Y. Leeds United Utilities’ CFO is try-
ing to establish hurdle rates for the new company’s projects that accurately reflect the risk of each project. (That is,
he is using risk-adjusted hurdle rates.) Which of the following statements is most correct?
a. Leeds United Utilities’ weighted average cost of capital is 11 percent.
b. Project X has a positive NPV.
c. After the merger, Leeds United Utilities should select Project X and reject Project Y.
d. Statements a and b are correct.
e. All of the statements above are correct.

37. Which of the following statements is correct?

a. A relatively risky future cash outflow should be evaluated using a relatively low discount rate.
b. If a firm’s managers want to maximize the value of the stock, they should concentrate exclusively on projects’
market, or beta, risk.
c. If a firm evaluates all projects using the same cost of capital, then the riskiness of the firm as measured by its be-
ta will probably decline over time.
d. If a firm has a beta that is less than 1.0, say 0.9, this would suggest that its assets’ returns are negatively corre-
lated with the returns of most other firms’ assets.
e. None of the statements above is correct.
38. Which of the following statements is most correct?
a. Suppose a firm is losing money and thus, is not paying taxes, and that this situation is expected to persist for a
few years whether or not the firm uses debt financing. Then the firm’s after-tax cost of debt will equal its be-
fore-tax cost of debt.
b. The component cost of preferred stock is expressed as kp(1 - T), because preferred stock dividends are treated
as fixed charges, similar to the treatment of debt interest.
c. The reason that a cost is assigned to retained earnings is because these funds are already earning a return in the
business; the reason does not involve the opportunity cost principle.
d. The bond-yield-plus-risk-premium approach to estimating a firm’s cost of common equity involves adding a sub-
jectively determined risk premium to the market risk-free bond rate.
e. None of the statements above is correct.

39. Your company’s stock sells for $50 per share, its last dividend (D0) was $2.00, its growth rate is a constant 5 percent,
and the company will incur a flotation cost of 15 percent if it sells new common stock. What is the firm’s cost of new
equity, ke?
a. 9.20%
b. 9.94%
c. 10.50%
d. 11.75%
e. 12.30%

40. Blair Brothers’ stock currently has a price of $50 per share and is expected to pay a year-end dividend of $2.50 per
share (D1 = $2.50). The dividend is expected to grow at a constant rate of 4 percent per year. The company has in-
sufficient retained earnings to fund capital projects and must, therefore, issue new common stock. The new stock
has an estimated flotation cost of $3 per share. What is the company’s cost of equity capital?
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 a. 10.14%
b. 9.21%
c. 9.45%
d. 9.32%
e. 9.00%

41. Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent common
equity. The current market price of the firm’s stock is P0 = $28; its last dividend was D0 = $2.20, and its expected div-
idend growth rate is 6 percent. What will Allison’s marginal cost of retained earnings, ks, be?
a. 15.8%
b. 13.9%
c. 7.9%
d. 14.3%
e. 9.7%

42. An analyst has collected the following information regarding Christopher Co.:
 The company’s capital structure is 70 percent equity and 30 percent debt.
 The yield to maturity on the company’s bonds is 9 percent.
 The company’s year-end dividend is forecasted to be $0.80 a share.
 The company expects that its dividend will grow at a constant rate of 9 percent a year.
 The company’s stock price is $25.
 The company’s tax rate is 40 percent.
 The company anticipates that it will need to raise new common stock this year, and total flotation costs will
equal 10 percent of the amount issued.

Assume the company accounts for flotation costs by adjusting the cost of capital. Given this information, calculate
the company’s WACC.
a. 10.41%
b. 12.56%
c. 10.78%
d. 13.55%
e. 9.29%

43. Flaherty Electric has a capital structure that consists of 70 percent equity and 30 percent debt. The company’s long-
term bonds have a before-tax yield to maturity of 8.4 percent. The company uses the DCF approach to determine the
cost of equity. Flaherty’s common stock currently trades at $45 per share. The year-end dividend (D1) is expected to be
$2.50 per share, and the dividend is expected to grow forever at a constant rate of 7 percent a year. The company es-
timates that it will have to issue new common stock to help fund this year’s projects. The flotation cost on new com-
mon stock issued is 10 percent, and the company’s tax rate is 40 percent. What is the company’s weighted average cost
of capital, WACC?
a. 10.73%
b. 10.30%
c. 11.31%
d. 7.48%
e. 9.89%

44. Billick Brothers is estimating its WACC. The company has collected the following information:
 Its capital structure consists of 40 percent debt and 60 percent common equity.
 The company has 20-year bonds outstanding with a 9 percent annual coupon that are trading at par.
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  The company’s tax rate is 40 percent.
 The risk-free rate is 5.5 percent.
 The market risk premium is 5 percent.
 The stock’s beta is 1.4.

What is the company’s WACC?

a. 9.71%
b. 9.66%
c. 8.31%
d. 11.18%
e. 11.10%

45. Dandy Product’s overall weighted average required rate of return is 10 percent. Its yogurt division is riskier than av-
erage, its fresh produce division has average risk, and its institutional foods division has below-average risk. Dandy
adjusts for both divisional and project risk by adding or subtracting 2 percentage points. Thus, the maximum ad-
justment is 4 percentage points. What is the risk-adjusted required rate of return for a low-risk project in the yogurt
division?
a. 6%
b. 8%
c. 10%
d. 12%
e. 14%

46. Stephenson & Sons has a capital structure that consists of 20 percent equity and 80 percent debt. The company ex-
pects to report $3 million in net income this year, and 60 percent of the net income will be paid out as dividends.
How large must the firm’s capital budget be this year without it having to issue any new common stock?
a. $ 1.20 million
b. $13.00 million
c. $ 1.50 million
d. $ 0.24 million
e. $ 6.00 million
47. The common stock of Anthony Steel has a beta of 1.20. The risk-free rate is 5 percent and the market risk premium (kM
- kRF) is 6 percent. Assume the firm will be able to use retained earnings to fund the equity portion of its capital budget.
What is the company’s cost of retained earnings, ks?
a. 7.0%
b. 7.2%
c. 11.0%
d. 12.2%
e. 12.4%

48. A company just paid a $2.00 per share dividend on its common stock (D0 = $2.00). The dividend is expected to grow
at a constant rate of 7 percent per year. The stock currently sells for $42 a share. If the company issues additional
stock, it must pay its investment banker a flotation cost of $1.00 per share. What is the cost of external equity, ke?
a. 11.76%
b. 11.88%
c. 11.98%
d. 12.22%
e. 12.30%

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49. Hamilton Company’s 8 percent coupon rate, quarterly payment, $1,000 par value bond, which matures in 20 years,
currently sells at a price of $686.86. The company’s tax rate is 40 percent. Based on the nominal interest rate, not
the EAR, what is the firm’s component cost of debt for purposes of calculating the WACC?
a. 3.05%
b. 7.32%
c. 7.36%
d. 12.20%
e. 12.26%

50. Trojan Services’ CFO is interested in estimating the company’s WACC and has collected the following information:
 The company has bonds outstanding that mature in 26 years with an annual coupon of 7.5 percent. The bonds
have a face value of $1,000 and sell in the market today for $920.
 The risk-free rate is 6 percent.
 The market risk premium is 5 percent.
 The stock’s beta is 1.2.
 The company’s tax rate is 40 percent.
 The company’s target capital structure consists of 70 percent equity and 30 percent debt.
 The company uses the CAPM to estimate the cost of equity and does not include flotation costs as part of its
cost of capital.

What is Trojan’s WACC?

a. 9.75%
b. 9.39%
c. 10.87%
d. 9.30%
e. 9.89%

51. A company has determined that its optimal capital structure consists of 40 percent debt and 60 percent equity. As-
sume the firm will not have enough retained earnings to fund the equity portion of its capital budget. Also, assume
the firm accounts for flotation costs by adjusting the cost of capital. Given the following information, calculate the
firm’s weighted average cost of capital.
 kd = 8%.
 Net income = $40,000.
 Payout ratio = 50%.
 Tax rate = 40%.
 P0 = $25.
 Growth = 0%.
 Shares outstanding = 10,000.
 Flotation cost on additional equity = 15%.

a. 7.60%
b. 8.05%
c. 11.81%
d. 13.69%
e. 14.28%

52. Hatch Corporation’s target capital structure is 40 percent debt, 50 percent common stock, and 10 percent 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 percent.
 The company’s preferred stock sells for $42 a share and pays an annual dividend of $4 a share.
Page 11 of 36
  The company’s common stock sells for $28 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 percent a year.
 The firm will be able to use retained earnings to fund the equity portion of its capital budget.
 The company’s tax rate is 40 percent.

What is the company’s weighted average cost of capital (WACC)?

a. 9.25%
b. 9.70%
c. 10.03%
d. 10.59%
e. 11.30%

53. Hilliard Corp. wants to calculate its weighted average cost of capital (WACC). The company’s CFO has collected the
following information:
 The company’s long-term bonds currently offer a yield to maturity of 8 percent.
 The company’s stock price is $32 a share (P0 = $32).
 The company recently paid a dividend of $2 a share (D0 = $2.00).
 The dividend is expected to grow at a constant rate of 6 percent a year (g = 6%).
 The company pays a 10 percent flotation cost whenever it issues new common stock (F = 10 percent).
 The company’s target capital structure is 75 percent equity and 25 percent debt.
 The company’s tax rate is 40 percent.
 The firm will be able to use retained earnings to fund the equity portion of its capital budget.

What is the company’s WACC?

a. 10.67%
b. 11.22%
c. 11.47%
d. 12.02%
e. 12.56%

54. Johnson Industries finances its projects with 40 percent debt, 10 percent preferred stock, and 50 percent common
stock.
 The company can issue bonds at a yield to maturity of 8.4 percent.
 The cost of preferred stock is 9 percent.
 The risk-free rate is 6.57 percent.
 The market risk premium is 5 percent.
 Johnson Industries’ beta is equal to 1.3.
 Assume that the firm will be able to use retained earnings to fund the equity portion of its capital budget.
 The company’s tax rate is 30 percent.

What is the company’s weighted average cost of capital (WACC)?

a. 8.33%
b. 8.95%
c. 9.79%
d. 10.92%
e. 13.15%

55. Helms Aircraft has a capital structure that consists of 60 percent debt and 40 percent common stock. The firm will be
able to use retained earnings to fund the equity portion of its capital budget. The company recently issued bonds
with a yield to maturity of 9 percent. The risk-free rate is 6 percent, the market risk premium is 6 percent, and
Page 12 of 36
 Helms’ beta is equal to 1.5. If the company’s tax rate is 35 percent, what is the company’s weighted average cost of
capital (WACC)?
a. 8.33%
b. 9.51%
c. 9.95%
d. 10.98%
e. 11.84%

56. Dobson Dairies has a capital structure that consists of 60 percent long-term debt and 40 percent common stock. The
company’s CFO has obtained the following information:
 The before-tax yield to maturity on the company’s bonds is 8 percent.
 The company’s common stock is expected to pay a $3.00 dividend at year end (D1 = $3.00), and the dividend is
expected to grow at a constant rate of 7 percent a year. The common stock currently sells for $60 a share.
 Assume the firm will be able to use retained earnings to fund the equity portion of its capital budget.
 The company’s tax rate is 40 percent.

What is the company’s weighted average cost of capital (WACC)?

a. 12.00%
b. 8.03%
c. 9.34%
d. 8.00%
e. 7.68%

57. Longstreet Corporation has a target capital structure that consists of 30 percent debt, 50 percent common equity,
and 20 percent preferred stock. The tax rate is 30 percent. The company has projects in which it would like to invest
with costs that total $1,500,000. Longstreet will retain $500,000 of net income this year. The last dividend was $5,
the current stock price is $75, and the growth rate of the company is 10 percent. If the company raises capital
through a new equity issuance, the flotation costs are 10 percent. The cost of preferred stock is
9 percent and the cost of debt is 7 percent. (Assume debt and preferred stock have no flotation costs.) What is the
weighted average cost of capital at the firm’s optimal capital budget?
a. 12.58%
b. 18.15%
c. 12.18%
d. 12.34%
e. 11.94%

58. A stock analyst has obtained the following information about J-Mart, a large retail chain:
 The company has noncallable bonds with 20 years maturity remaining and a maturity value of $1,000. The
bonds have a 12 percent annual coupon and currently sell at a price of $1,273.8564.
 Over the past four years, the returns on the market and on J-Mart were as follows:

Year Market J-Mart

1999 12.0% 14.5%
2000 17.2 22.2
2001 -3.8 -7.5
2002 20.0 24.0

 The current risk-free rate is 6.35 percent, and the expected return on the market is 11.35 percent. The compa-
ny’s tax rate is 35 percent. The company anticipates that its proposed investment projects will be financed with
70 percent debt and 30 percent equity.

Page 13 of 36
 What is the company’s estimated weighted average cost of capital (WACC)?
a. 8.04%
b. 9.00%
c. 10.25%
d. 12.33%
e. 13.14%

59. Clark Communications has a capital structure that consists of 70 percent common stock and 30 percent long-term
debt. In order to calculate Clark’s weighted average cost of capital (WACC), an analyst has accumulated the following
information:
 The company currently has 15-year bonds outstanding with annual coupon payments of 8 percent. The bonds
have a face value of $1,000 and sell for $1,075.
 The risk-free rate is 5 percent.
 The market risk premium is 4 percent.
 The beta on Clark’s common stock is 1.1.
 The company’s retained earnings are sufficient so that they do not have to issue any new common stock to fund
capital projects.
 The company’s tax rate is 38 percent.

Given this information, what is Clark’s WACC?

a. 5.93%
b. 7.40%
c. 7.91%
d. 8.07%
e. 8.73%

60. Reading Foods is interested in calculating its weighted average cost of capital (WACC). The company’s CFO has col-
lected the following information:
 The target capital structure consists of 40 percent debt and 60 percent common stock.
 The company has 20-year noncallable bonds with a par value of $1,000, a 9 percent annual coupon, and a price
of $1,075.
 Equity flotation costs are 2 percent.
 The company’s common stock has a beta of 0.8.
 The risk-free rate is 5 percent.
 The market risk premium is 4 percent.
 The company’s tax rate is 40 percent.
 The company plans to use retained earnings to finance the equity portion of its capital structure, so it does not
intend to issue any new common stock.

What is the company’s WACC?

a. 13.13%
b. 6.24%
c. 8.21%
d. 6.89%
e. 6.57%

61. Financial analysts for Naulls Industries have revealed the following information about the company:
 Naulls Industries currently has a capital structure that consists of 75 percent common equity and 25 percent
debt.
Page 14 of 36
  The risk-free rate, kRF, is 5 percent.
 The market risk premium , kM - kRF, is 6 percent.
 Naulls’s common stock has a beta of 1.2.
 Naulls has 20-year bonds outstanding with an annual coupon rate of 12 percent and a face value of $1,000. The
bonds sell today for $1,200.
 The company’s tax rate is 40 percent.

What is the company’s current WACC?

a. 7.41%
b. 9.17%
c. 10.61%
d. 10.99%
e. 11.57%

62. Grateway Inc. has a weighted average cost of capital of 11.5 percent. Its target capital structure is 55 percent equity and
45 percent debt. The company has sufficient retained earnings to fund the equity portion of its capital budget. The be-
fore-tax cost of debt is 9 percent, and the company’s tax rate is 30 percent. If the expected dividend next period (D1) is
$5 and the current stock price is $45, what is the company’s growth rate?
a. 2.68%
b. 3.44%
c. 4.64%
d. 6.75%
e. 8.16%

63. The managers of Kenforest Grocers are trying to determine the company’s optimal capital budget for the upcoming
year. Kenforest is considering the following projects:
Rate of
Project Size Return Risk
A $200,000 16% High
B 500,000 14 Average
C 400,000 12 Low
D 300,000 11 High
E 100,000 10 Average
F 200,000 10 Low
G 400,000 7 Low
The company estimates that its WACC is 11 percent. All projects are independent. The company adjusts for risk by add-
ing 2 percentage points to the WACC for high-risk projects and subtracting 2 percentage points from the WACC for low-
risk projects. Which of the projects will the company accept?
a. A, B, C, E, F
b. B, D, F, G
c. A, B, C, E
d, A, B, C, D, E
e. A, B, C, F

64. Bradshaw Steel has a capital structure with 30 percent debt (all long-term bonds) and 70 percent common equity.
The yield to maturity on the company’s long-term bonds is 8 percent, and the firm estimates that its overall compo-
site WACC is 10 percent. The risk-free rate of interest is 5.5 percent, the market risk premium is 5 percent, and the
company’s tax rate is 40 percent. Bradshaw uses the CAPM to determine its cost of equity. What is the beta on
Bradshaw’s stock?
a. 1.07
b. 1.48
Page 15 of 36
 c. 1.31
d. 0.10
e. 1.35

65. Arizona Rock, an all-equity firm, currently has a beta of 1.25. The risk-free rate, kRF, is 7 percent and kM is 14 per-
cent. Suppose the firm sells 10 percent of its assets with beta equal to 1.25 and purchases the same proportion of
new assets with a beta of 1.1. What will be the firm’s new overall required rate of return, and what rate of return
must the new assets produce in order to leave the stock price unchanged?
a. 15.645%; 15.645%
b. 15.750%; 14.700%
c. 15.645%; 14.700%
d. 15.750%; 15.645%
e. 14.750%; 15.750%

66. Sun State Mining Inc., an all-equity firm, is considering the formation of a new division that will increase the assets of
the firm by 50 percent. Sun State currently has a required rate of return of 18 percent, U.S. Treasury bonds yield 7
percent, and the market risk premium is 5 percent. If Sun State wants to reduce its required rate of return to 16 per-
cent, what is the maximum beta coefficient the new division could have?
a. 2.2
b. 1.0
c. 1.8
d. 1.6
e. 2.0

67. Heavy Metal Corp. is a steel manufacturer that finances its operations with 40 percent debt, 10 percent preferred
stock, and 50 percent equity. The interest rate on the company’s debt is 11 percent. The preferred stock pays an an-
nual dividend of $2 and sells for $20 a share. The company’s common stock trades at $30 a share, and its current
dividend (D0) of $2 a share is expected to grow at a constant rate of 8 percent per year. The flotation cost of external
equity is 15 percent of the dollar amount issued, while the flotation cost on preferred stock is 10 percent. The com-
pany estimates that its WACC is 12.30 percent. Assume that the firm will not have enough retained earnings to fund
the equity portion of its capital budget. What is the company’s tax rate?
a. 30.33%
b. 32.86%
c. 35.75%
d. 38.12%
e. 40.98%

68. Anderson Company has four investment opportunities with the following costs (paid at t = 0) and expected returns:
Expected
Project Cost Return
A $2,000 16.0%
B 3,000 14.5
C 5,000 11.5
D 3,000 9.5

The company has a target capital structure that consists of 40 percent common equity, 40 percent debt, and 20 per-
cent preferred stock. The company has $1,000 in retained earnings. The company expects its year-end dividend to
be $3.00 per share (D1 = $3.00). The dividend is expected to grow at a constant rate of 5 percent a year. The com-
pany’s stock price is currently $42.75. If the company issues new common stock, the company will pay its invest-
ment bankers a 10 percent flotation cost.
Page 16 of 36
 The company can issue corporate bonds with a yield to maturity of 10 percent. The company is in the 35 percent tax
bracket. How large can the cost of preferred stock be (including flotation costs) and it still be profitable for the com-
pany to invest in all four projects?
a. 7.75%
b. 8.90%
c. 10.46%
d. 11.54%
e. 12.68%

(The following information applies to the next three problems.)

The Global Advertising Company has a marginal tax rate of 40 percent. The company can raise debt at a 12 percent in-
terest rate and the last dividend paid by Global was $0.90. Global’s common stock is selling for $8.59 per share, and its
expected growth rate in earnings and dividends is 5 percent. If Global issues new common stock, the flotation cost in-
curred will be 10 percent. Global plans to finance all capital expenditures with 30 percent debt and 70 percent equity.
69. What is Global’s cost of retained earnings if it can use retained earnings rather than issue new common stock?

a. 12.22%
b. 17.22%
c. 10.33%
d. 9.66%
e. 16.00%

70. What is the cost of common equity raised by selling new stock?
a. 12.22%
b. 17.22%
c. 10.33%
d. 9.66%
e. 16.00%

71. What is the firm’s weighted average cost of capital if the firm has sufficient retained earnings to fund the equity por-
tion of its capital budget?
a. 11.95%
b. 12.22%
c. 12.88%
d. 13.36%
e. 14.21%

(The following information applies to the next two problems.)

Byron Corporation’s present capital structure, which is also its target capital structure, is 40 percent debt and 60 percent
common equity. Assume that the firm has no retained earnings. The company’s earnings and dividends are growing at a con-
stant rate of 5 percent; the last dividend (D0) was $2.00; and the current equilibrium stock price is $21.88. Byron can raise all
the debt financing it needs at 14 percent. If Byron issues new common stock, a 20 percent flotation cost will be incurred. The
firm’s marginal tax rate is 40 percent.

72. What is the component cost of the equity raised by selling new common stock?
a. 17.0%

Page 17 of 36
 b. 16.4%
c. 15.0%
d. 14.6%
e. 12.0%

73. What is the firm’s weighted average cost of capital?

a. 10.8%
b. 13.6%
c. 14.2%
d. 16.4%
e. 18.0%
(The following information applies to the next six problems.)

Rollins Corporation has a target capital structure consisting of 20 percent debt, 20 percent preferred stock, and 60 percent
common equity. Assume the firm has insufficient retained earnings to fund the equity portion of its capital budget. Its bonds
have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par,
$100 preferred stock that pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins’ beta
is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins 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 percent. The firm’s policy is to use a risk premium of
4 percentage points when using the bond-yield-plus-risk-premium method to find ks. Flotation costs on new common stock
total 10 percent, and the firm’s marginal tax rate is 40 percent.

74. What is Rollins’ component cost of debt?

a. 10.0%
b. 9.1%
c. 8.6%
d. 8.0%
e. 7.2%

75. What is Rollins’ cost of preferred stock?

a. 10.0%
b. 11.0%
c. 12.0%
d. 12.6%
e. 13.2%

76. What is Rollins’ cost of retained earnings using the CAPM approach?
a. 13.6%
b. 14.1%
c. 16.0%
d. 16.6%
e. 16.9%

77. What is the firm’s cost of retained earnings using the DCF approach?
a. 13.6%
b. 14.1%
c. 16.0%
d. 16.6%
e. 16.9%

Page 18 of 36
78. What is Rollins’ cost of retained earnings using the bond-yield-plus-risk-premium approach?
a. 13.6%
b. 14.1%
c. 16.0%
d. 16.6%
e. 16.9%

WACC Answer: b Diff: E

79. What is Rollins’ WACC, if the firm has insufficient retained earnings to fund the equity portion of its capital budget?

a. 13.6%
b. 14.1%
c. 16.0%
d. 16.6%
e. 16.9%

(The following information applies to the next two problems.)

The Jackson Company has just paid a dividend of $3.00 per share on its common stock, and it expects this dividend to grow by
10 percent per year, indefinitely. The firm has a beta of 1.50; the risk-free rate is 10 percent; and the expected return on the
market is 14 percent. The firm’s investment bankers believe that new issues of common stock would have a flotation cost
equal to 5 percent of the current market price.

Stock price--constant growth Answer: d Diff: E

80. How much should an investor be willing to pay for this stock today?

a. $62.81
b. $70.00
c. $43.75
d. $55.00
e. $30.00

Cost of external equity Answer: b Diff: E

81. What will be Jackson’s cost of new common stock if it issues new stock in the marketplace today?

a. 15.25%
b. 16.32%
c. 17.00%
d. 12.47%
e. 9.85%

(The following information applies to the next two problems.)

Becker Glass Corporation expects to have earnings before interest and taxes during the coming year of $1,000,000, and
it expects its earnings and dividends to grow indefinitely at a constant annual rate of 12.5 percent. The firm has
$5,000,000 of debt outstanding bearing a coupon interest rate of 8 percent, and it has 100,000 shares of common stock
outstanding. Historically, Becker has paid 50 percent of net earnings to common shareholders in the form of dividends.

Page 19 of 36
The current price of Becker’s common stock is $40, but it would incur a 10 percent flotation cost if it were to sell new
stock. The firm’s tax rate is 40 percent.

Cost of retained earnings Answer: e Diff: M

82. What is the firm’s cost of retained earnings?

a. 15.0%
b. 15.5%
c. 16.0%
d. 16.5%
e. 17.0%

83. What is Becker’s cost of newly issued stock?

a. 16.0%
b. 16.5%
c. 17.0%
d. 17.5%
e. 18.0%

(The following information applies to the next four problems.)

J. Ross and Sons Inc. has a target capital structure that calls for 40 percent debt, 10 percent preferred stock, and 50 percent
common equity. The firm’s current after-tax cost of debt is 6 percent, and it can sell as much debt as it wishes at this rate. The
firm’s preferred stock currently sells for $90 a share and pays a dividend of $10 per share; however, the firm will net only $80
per share from the sale of new preferred stock. Ross’ common stock currently sells for $40 per share, but the firm will net
only $34 per share from the sale of new common stock. The firm recently paid a dividend of $2 per share on its common
stock, and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year. Assume the firm has
sufficient retained earnings to fund the equity portion of its capital budget.

84. What is the firm’s cost of retained earnings?

a. 10.0%
b. 12.5%
c. 15.5%
d. 16.5%
e. 18.0%

85. What is the firm’s cost of newly issued common stock?

a. 10.0%
b. 12.5%
c. 15.5%
d. 16.5%
e. 18.0%

86. What is the firm’s cost of newly issued preferred stock?

a. 10.0%
b. 12.5%
c. 15.5%
d. 16.5%
e. 18.0%
Page 20 of 36
87. What is the firm’s weighted average cost of capital?
a. 9.5%
b. 10.3%
c. 10.8%
d. 11.4%
e. 11.9%

(The following information applies to the next three problems.)

The following information applies to the Coetzer Company:

 Coetzer has a target capital structure of 40 percent debt and 60 percent common equity.
 Coetzer has $1,000 par value bonds outstanding with a 15-year maturity, a 12 percent annual coupon, and a current price
of $1,150.
 The risk-free rate is 5 percent. The market risk premium (kM – kRF) is also 5 percent.
 Coetzer’s common stock has a beta of 1.4.
 Coetzer’s tax rate is 40 percent.

88. What is the company’s after-tax cost of debt?

a. 3.6%
b. 6.0%
c. 7.2%
d. 10.0%
e. 12.0%

89. What is the company’s after-tax cost of common equity?

a. 6.0%
b. 8.4%
c. 9.6%
d. 10.0%
e. 12.0%

90. What is the company’s WACC?

a. 6.0%
b. 7.4%
c. 9.6%
d. 10.8%
e. 12.2%

(The following information applies to the next four problems.)

Viduka Construction’s CFO wants to estimate the company’s WACC. She has collected the following information:

 The company currently has 20-year bonds outstanding. The bonds have an 8.5 percent annual coupon, a face value of $1,000, and
they currently sell for $945.
 The company’s stock has a beta = 1.20.
 The market risk premium, kM – kRF, equals 5 percent.
 The risk-free rate is 6 percent.

Page 21 of 36
 The company has outstanding preferred stock that pays a $2.00 annual dividend. The preferred stock sells for $25 a
share.
 The company’s tax rate is 40 percent.
 The company’s capital structure consists of 40 percent long-term debt, 40 percent common stock, and 20 percent pre-
ferred stock.

91. What is the company’s after-tax cost of debt?

a. 5.10%
b. 5.46%
c. 6.46%
d. 8.50%
e. 9.11%

92. What is the company’s after-tax cost of preferred stock?

a. 4.80%
b. 5.60%
c. 7.10%
d. 8.00%
e. 8.40%

93. What is the company’s after-tax cost of common equity?

a. 7.20%
b. 7.32%
c. 7.94%
d. 12.00%
e. 12.20%

94. What is the company’s WACC?

a. 7.95%
b. 8.12%
c. 8.59%
d. 8.67%
e. 10.04%

(The following information applies to the next three problems.)

Burlees Inc.’s CFO is interested in calculating the cost of capital. In order to calculate the cost of capital, the company
has collected the following information:
 The company’s capital structure consists of 40 percent debt and 60 percent common stock.
 The company has bonds outstanding with 25 years to maturity. The bonds have a 12 percent annual coupon, a face value
of $1,000, and a current price of $1,252.
 The company uses the CAPM to calculate the cost of common stock. Currently, the risk-free rate is 5 percent and the
market risk premium, (kM - kRF), equals 6 percent. The company’s common stock has a beta of 1.6.
 The company’s tax rate is 40 percent.

95. What is the company’s after-tax cost of debt?

a. 3.74%
b. 4.80%
c. 5.62%

Page 22 of 36
 d. 7.20%
e. 8.33%

96. What is the company’s cost of common equity?

a. 9.65%
b. 14.00%
c. 14.60%
d. 17.60%
e. 18.91%

97. What is the company’s weighted average cost of capital (WACC)?

a. 10.5%
b. 11.0%
c. 11.5%
d. 12.0%
e. 12.5%

Page 23 of 36
13
. Risk and project selection Answer: c Diff: E

ks = 10% + (16% - 10%)1.5 = 10% + 9% = 19%.

Expected return = 21%. 21% - Risk adjustment 1% = 20%.
Risk-adjusted return = 20% > ks = 19%. Thus, the project should be selected.
14
. Risk and project selection Answer: b Diff: E

The project whose return is greater than its risk-adjusted cost of capital
should be selected. Only Project B meets this criteria.
15
. Divisional risk Answer: a Diff: E N

The correct answer is statement a. Division A should accept only projects

with a return greater than 9.8 percent, and Division B should accept only
projects with a return greater than 14 percent. Only statement a fits this
criteria. The company’s composite WACC is irrelevant in the decision.
16
. Retained earnings break point Answer: a Diff: E

Statement a is true; an increase in net income will increase the retained

earnings break point. Statements b and c will serve to lower the break
point. Statement b will result in less earnings being retained, so the re-
tained earnings break point will be reduced. Statement c will result in more
earnings being needed, so the retained earnings break point will be reduced.
Statement d will have no effect on the retained earnings break point.

17
. Retained earnings break point Answer: b Diff: E

Statement a is false; increasing the dividend payout will result in the firm running out of retained
earnings earlier. Statement b is true; a higher debt ratio means that retained earnings are a small-
er portion of the funding mix and, therefore, retained earnings will go further. Statement c will
have no effect on the retained earnings break point, as is the case for statement d.
18
. Miscellaneous cost of capital concepts Answer: c Diff: E N

Page 1 of 36
 The correct answer is statement c. Debt is usually safer than equity because it has promised
payments over the life of the debt. So, the cost of debt is typically below the WACC. So, state-
ment a is incorrect. If bankruptcy occurs, debt holders may get something. Equity holders will
get nothing! So, the cost of debt is again typically below the cost of equity. So, statement b is in-
correct. Statement c is correct. Statement d is incorrect. The cost of retained earnings is general-
ly equal to the required return on equity, which exceeds the cost of debt. Higher flotation costs
increase the cost of equity. So statement e is incorrect.
19
. Miscellaneous concepts Answer: e Diff: E

Flotation costs do not reduce investor returns; they reduce the amount of the
company’s proceeds. This drives the company’s cost of equity, and thus its
WACC, higher. Therefore, statement a is false. The WACC is based on margin-
al costs and incorporates taxes. Consequently, statement b is false. Re-
tained earnings have no flotation costs but the company still must earn a re-
turn on them, so they are not without a cost. Investors expect a required
rate of return, and if they don’t receive it, they would prefer that the com-
pany pay out retained earnings as dividends, so that they can then invest in
something that does give them their expected return. Thus, retained earnings
have a cost. Therefore, statement c is false. Since statements a, b, and c
are false, the correct choice is statement e.

20
. Capital components Answer: e Diff: M

Statement e is the correct answer. Unlike interest expense on debt, pre-

ferred dividends are not deductible, hence there are no tax savings associat-
ed with the use of preferred stock. The component costs of WACC should re-
flect the costs of new financing, not historical measures. The cost of issu-
ing new equity is always greater than the cost of retained earnings.
21
. Capital components Answer: a Diff: M

Statement a is true; the other statements are false. Preferred stock divi-
dends are not tax deductible; therefore, the cost of preferred stock is only
kp. The risk premium in the bond-yield-plus-risk premium approach would be
added to the firm’s cost of debt, not the risk-free rate. Preferred stock
also has flotation costs.
22
. Cost of capital estimation Answer: c Diff: M
23
. Cost of equity estimation Answer: d Diff: M
24
. CAPM cost of equity estimation Answer: e Diff: M
25
. CAPM and DCF estimation Answer: a Diff: M
26
. WACC Answer: d Diff: M

Both statements a and c are true; therefore, statement d is the correct

choice. Statement a recites the definition of the weighted average cost of
capital. Statement c is correct because kd = kRF + LP + MRP + DRP while
ks = kRF + (kM - kRF)b. If kRF increases then the values for kd and ks will in-
crease.
27
. WACC Answer: d Diff: M

Page 2 of 36
 If a firm paid no income taxes, its cost of debt would not be adjusted down-
ward, hence the component cost of debt would be higher than if T were greater
than 0. With a higher component cost of debt, the WACC would increase. Of
course, the company would have higher earnings, and its cash flows from a
given project would be high, so the higher WACC would not impede its invest-
ments, that is, its capital budget would be larger than if it were taxed.
28
. WACC Answer: e Diff: M

Statement e is the correct answer. An increase in flotation costs has no ef-

fect on the cost of retained earnings. Since interest is tax deductible,
while preferred and common dividends are not, only the cost of debt used in
the WACC equation must be adjusted by multiplying by (1 - T). An increase in
the firm’s corporate tax rate reduces the after-tax component cost of debt.

29
. WACC Answer: e Diff: M

Statement e is the correct answer. After-tax cash flows must be considered in

order to account for the tax deductibility of interest payments on cor-porate
debt. An increase in flotation costs will leave the cost of retained earnings
unchanged, but will raise the cost of new equity issues. The marginal, not the
embedded, cost of capital is the relevant cost of capital.
30. WACC and capital components Answer: b Diff: M

Because corporations can exclude dividends for tax purposes, preferred stock
often has a before-tax market return that is less than the issuing company’s
before-tax cost of debt. Then, if the issuer’s tax rate is zero, its compo-
nent cost of preferred would be less than its after-tax cost of debt.
31
. Risk-adjusted cost of capital Answer: c Diff: M

By Kemp not making the risk adjustment, it is true that the company will ac-
cept more projects in the computer division, and fewer projects in the res-
taurant division. However, this will make the company riskier overall, rais-
ing its cost of equity. Investors will discount their cash flows at a higher
rate, and the company’s value will fall. In addition, some of the computer
projects might not exceed the appropriate risk-adjusted hurdle rate, and will
actually be negative NPV projects, further destroying value. Therefore,
statement a is false. Because fewer of the restaurant projects will be ac-
cepted, the restaurant division will become a smaller part of the overall
company. Therefore, statement b is false. As explained above, statement c
is true.
32
. Risk-adjusted cost of capital Answer: b Diff: M

By not risk adjusting the cost of capital, the firm will tend to reject low-
risk projects since their returns will be lower than the average cost of cap-
ital, and it will take on high-risk projects since their returns will be
higher than the average cost of capital.
33
. Risk-adjusted cost of capital Answer: e Diff: M
34
. Risk-adjusted cost of capital Answer: a Diff: M

Page 3 of 36
35
. Division WACCs and risk Answer: e Diff: M

If the company uses the 10 percent WACC, it will turn down all projects with
a return of less than 10 percent but more than 8 percent. Thus, these “saf-
er” projects will no longer be taken, and the company will increase the pro-
portion of risky projects it undertakes. Therefore, statement a is true. If
Division A’s projects have lower returns than Division B’s because they have
less risk, fewer and fewer projects will be accepted from Division A and more
projects will be accepted from Division B. Therefore, Division B will grow
and Division A will shrink. Therefore, statement b is true. If the company
becomes riskier, then its cost of equity will increase causing WACC to in-
crease. Therefore, statement c is true. Because all of the statements are
true, the correct choice is statement e.
36
. Divisional risk and project selection Answer: e Diff: M N
The correct answer is statement e. Statement a is correct; the firms have
the same size and capital structure, so the WACC of the merged company is
just a simple average of their separate WACCs. Statement b is correct; Pro-
ject X has an IRR of 10.5% and its appropriate cost of capital is 10%, there-
fore, the project has a positive net present value. Statement c is also cor-
rect; Project X should be accepted because of the previous argument. Project
Y should be rejected because it has an 11.5% return and its appropriate cost
of capital is 12%. Therefore, statement e is the correct choice.
37
. Beta and project risk Answer: a Diff: M
38
. Miscellaneous concepts Answer: a Diff: M
39
. Cost of new equity Answer: b Diff: E

ke = + 5% = 9.94%.
40
. Cost of new equity Answer: d Diff: E

The firm must issue new equity to fund its capital projects, so we need to find the cost of new eq-
uity capital, ke:
ke = D1/(P0 - F) + g
= $2.50/($50 - $3) + 4%
= $2.50/$47 + 4%
= 5.32% + 4%
= 9.32%.
41
. Cost of retained earnings Answer: d Diff: E

Use the dividend growth model to calculate ks:

ks = + g = + 0.06
= 0.0833 + 0.06 = 0.1433  14.3%.
42
. WACC Answer: a Diff: E

WACC = wdkd(1 - T) + wcke. kd is given = 9%. Find ke:

ke = D1/[P0(1 - F)] + g
= $0.8/[$25(1 - 0.1)] + 0.09
= 0.125556.

Page 4 of 36
 Now you can calculate WACC:
WACC = (0.3)(0.09)(0.6) + (0.7)(0.125556) = 10.41%.
43
. WACC Answer: a Diff: E

WACC = [0.3  0.084  (1 - 0.4)] + [0.7  ($2.5/($45  (1 - 0.1)) + 0.07)]

= 10.73%.
44
. WACC Answer: b Diff: E

WACC = wdkd(1 - T) + wcks.

ks = kRF + RPM(b)
ks = 5.5% + 5%(1.4)
ks = 5.5% + 7% = 12.5%.
WACC = wdkd(1 - T) + wcks
WACC = 0.4(9%)(1 - 0.4) + (0.6)12.5%
WACC = 9.66%.
45
. Divisional risk Answer: c Diff: E

kYD = 10% + 2% = 12%.

However, for a low-risk project, Dandy Product subtracts 2 percentage points.
Therefore, the required rate of return is 10 percent.
kYD,Low-risk project = 10% + 2% - 2% = 10%.

46. Retained earnings break point Answer: e Diff: E

Additions to retained earnings will be: $3.0 million  0.4 = $1.2 million.
The retained earnings breakpoint is $1.2 million/0.2 = $6 million.
47
. Cost of retained earnings Answer: d Diff: M

The cost of retained earnings as calculated from the CAPM is

ks = kRF + (kM - kRF)b
= 5% + (6%)1.2
= 12.2%.
48
. Cost of external equity Answer: d Diff: M

D0 = $2; D1 = $2(1.07) = $2.14.

ke = D1/[P0(1 - F)] + g
= $2.14/($42 - $1) + 7% = 12.22%.
49
. Component cost of debt Answer: b Diff: M

Financial calculator solution:

Calculate the nominal YTM of bond:
Inputs: N = 80; PV = -686.86; PMT = 20; FV = 1000.
Output: I = 3.05% periodic rate.
Nominal annual rate = 3.05%  4 = 12.20%.
Calculate kd after-tax: kd,AT = 12.20(1 - T) = 12.20(1 - 0.4) = 7.32%.

Page 5 of 36
50. WACC Answer: e Diff: M N

Data given:
kRF = 6%; RPM = 5%; b = 1.2; T = 40%; wd = 0.3; wc = 0.7.
WACC = wdkd(1 - T) + wcks.
Step 1: Determine the firm’s costs of debt and equity:
Enter the following data as inputs in your calculator:
N = 26; PV = -920; PMT = 75; FV = 1000; and then solve for I = kd = 8.2567%.

ks = kRF + (RPM)b
= 6% + (5%)1.2
= 12%.

Step 2: Given the firm’s component costs of capital, calculate the firm’s WACC:
WACC = wdkd(1 - T) + wcks
= 0.3(8.2567%)(1 - 0.4) + 0.7(12%)
= 1.4862% + 8.4%
= 9.8862%  9.89%.
51
. WACC Answer: a Diff: M

Find the dividend, D1 = [(0.5)$40,000]/# of Shares = $20,000/10,000 = $2.00.

Since the firm will not have enough retained earnings to fund the equity por-
tion of its capital budget, the firm will have to issue new common stock.

Find the cost of new common stock:

ke = D1/[P0(1 - F)] + g = $2.00/[$25(1 - 0.15)] + 0% = 0.0941 = 9.41%.

Finally, calculate WACC, using ke = 0.0941, and kd = 0.08, so

WACC = (D/A)(1 - Tax rate)kd + (E/A)ke
= 0.4(0.08)(1 - 0.4) + 0.6(0.0941) = 0.0757  7.6%.
52
. WACC Answer: b Diff: M

AT cost of debt = 0.07(1 - 0.40) = 0.042 = 4.2%.

Cost of preferred stock = $4/$42 = 0.0952 = 9.52%.
Cost of retained earnings = $2/$28 + 0.07 = 0.1414 = 14.14%.
WACC = 0.40(0.042) + 0.10(0.0952) + 0.50(0.1414) = 0.0970 = 9.70%.
53
. WACC Answer: a Diff: M

AT cost of debt = 0.08(1 - 0.40) = 0.048 = 4.80%.

Cost of retained earnings = $2.12/$32 + 0.06 = 0.1263 = 12.63%.
WACC = 0.75(0.1263) + 0.25(0.048) = 10.67%.

54
. WACC Answer: c Diff: M

Cost of debt = 0.084(1 - 0.30) = 0.0588 = 5.88%.

Cost of preferred stock = 0.09 = 9%.
Cost of retained earnings = kRF + (RPM)b = 6.57% + (5%)1.3 = 13.07%.

Page 6 of 36
 WACC = 0.4(0.0588) + 0.10(0.09) + 0.50(0.1307) = 9.79%.
55
. WACC Answer: b Diff: M

Cost of debt = 0.09(1 - 0.35) = 0.0585 = 5.85%.

Cost of retained earnings = kRF + (RPM)b = 6% + 6%(1.5) = 15%.
WACC = 0.60(0.0585) + 0.40(0.1500) = 0.0951 = 9.51%.
56
. WACC Answer: e Diff: M

The firm will not be issuing new equity because there are adequate retained
earnings available to fund available projects. Therefore, WACC should be
calculated using ks rather than ke.

ks = D1/P0 + g
= $3.00/$60.00 + 0.07
= 0.12 = 12%.

WACC = wdkd(1 - T) + wcks

= (0.6)(0.08)(1 - 0.4) + (0.4)(0.12)
= 0.0768 = 7.68%.
57
. WACC Answer: d Diff: M

AT cost of debt = 7%(1 - 0.3) = 4.9%.

Retained earnings breakpoint = $500,000/0.5 = $1,000,000.

Thus, to finance its optimal capital budget, Longstreet must issue some new
equity and flotation costs of 10% will be incurred.

Cost of new equity = [$5(1.10)/$75(1 - 0.1)] + 10% = 8.15% + 10% = 18.15%.

WACC = 4.9%(0.3) + 9%(0.2) + 18.15%(0.5) = 12.34%.

58
. WACC Answer: a Diff: M

WACC = [(0.7)(kd)(1 - T)] + [(0.3)(ks)].

Use bond information to solve for kd:

N = 20; PV = -1273.8564; PMT = 120; FV = 1000; and then solve for kd = 9%.

To solve for ks, we can use the SML equation, but we need to find beta. Using
Market and J-Mart return information and a calculator’s regression feature we
find b = 1.3585.

ks = 0.0635 + (0.1135 - 0.0635)(1.3585) = 0.1314 = 13.14%.

Plug these values into the WACC equation and solve:

WACC = [(0.7)(0.09)(1 - 0.35)] + [(0.3)(0.1314)] = 0.0804 = 8.04%.
59
. WACC Answer: c Diff: M

Step 1: Find the cost of debt:

Enter the following input data in the calculator:
N = 15; PV = -1075; PMT = 80; FV = 1000; and then solve for I = kd = 7.1678%.
Step 2: Find the cost of equity:
ks = kRF + (kM - kRF)b
Page 7 of 36
 = 5% + 4%(1.1)
= 5% + 4.4%
= 9.4%.
Step 3: Calculate the firm’s WACC:
WACC = wdkd(1 - T) + wcks
= (0.3)(7.1678%)(1 - 0.38) + (0.7)(9.4%)
= 1.3332% + 6.58%
= 7.9132%  7.91%.
60
. WACC Answer: d Diff: M

wd = 0.4; wc = 0.6.
Step 1: Calculate kd:
Use the information about the company’s existing bonds to enter the following input
data in the calculator:
N = 20; PV = -1075; PMT = 90; FV = 1000; and then solve for I = 8.2234%.
Step 2: Calculate ks:
kRF = 5%; kM - kRF = 4%; b = 0.8.
ks = kRF + (kM - kRF)b
= 5% + (4%)0.8
= 8.2%.
Step 3: Calculate WACC:
WACC = wdkd(1 - T) + wcks
= (0.4)(8.2234%)(1 - 0.4) + (0.6)(8.2%)
= 6.89%.
61
. WACC Answer: c Diff: M N

WACC = wdkd(1 - T) + wcks.

Step 1: Calculate the cost of common equity using the CAPM equation:
ks = 5% + (6%)1.2 = 12.20%.
Step 2: Calculate the cost of debt using a financial calculator by entering the following input data:
N = 20; PV = -1200; PMT = 120; FV = 1000; and then solve for I = kd = 9.7%.
Step 3: Calculate the firm’s WACC by substituting the values calculated above in the WACC equation:
WACC = (0.25)9.7%(1 - 0.40) + (0.75)12.20% = 10.61%.
62
. WACC and dividend growth rate Answer: c Diff: M

Solve for ks: WACC = wdkd(1 - T) + wcks

11.5% = 0.45(0.09)(0.70) + 0.55ks
ks = 15.75%.
Solve for g: 15.75% = D1/P0 + g
15.75% = $5/$45 + g
g = 4.64%.
63
. WACC and optimal capital budget Answer: e Diff: M

Rate of Risk-Adjusted
Project Return Cost of Capital
A 16% 13%
B 14 11
Page 8 of 36
 C 12 9
D 11 13
E 10 11
F 10 9
G 7 9

Projects A, B, and C are profitable because their returns surpass their risk-
adjusted costs of capital. D is not profitable because its return (11%) is
less than its risk-adjusted cost of capital (13%). E is not acceptable for
the same reason: Its return (10%) is less than its risk-adjusted cost of
capital (11%). F is accepted since it is low risk and its return (10%) sur-
passes the risk-adjusted cost of capital of 9%. G is rejected because its
return (7%) is less than the risk-adjusted cost of capital (9%).
64
. CAPM, beta, and WACC Answer: e Diff: M

Data given: wd = 0.3; wc = 0.7; kd = 8%; WACC = 10%; T = 40%; kRF = 5.5%,
kM - kRF = 5%.
Step 1: Determine the firm’s cost of equity using the WACC equation:
WACC = wdkd(1 - T) + wcks
10% = (0.3)(8%)(1 - 0.4) + (0.7)ks
8.56% = (0.7)ks
ks = 12.2286%.
Step 2: Calculate the firm’s beta using the CAPM equation:
ks = kRF + (kM - kRF)b
12.2286% = 5.5% + (5%)b
6.7286% = 5%b
b = 1.3457  1.35.
65
. Required rate of return Answer: c Diff: M

bOld, firm = 1.25.

kOld, firm = 0.07 + (0.14 – 0.07)1.25 = 15.75%.
bNew, firm = 0.9(1.25) + 0.1(1.1) = 1.235.
kNew, firm = 0.07 + 1.235(0.07) = 15.645%.
kNew, assets = 0.07 + 1.1(0.07) = 14.7%.
66
. Beta risk Answer: b Diff: M

Old assets = 1.0. New assets = 0.5. Total assets = 1.5.

Old required rate: New required rate:
18% = 7% + (5%)b 16% = 7% + (5%)b
beta = 2.2. beta = 1.8.

New b must not be greater than 1.8, therefore

(2.2) + (b) = 1.8
0.3333(b) = 0.3333
b = 1.0.

Therefore, beta of the new division cannot exceed 1.0.

67
. WACC Answer: b Diff: T

Capital structure: 40% D, 10% P, 50% E.

WACC = 12.30% (given).
kd = 11% (given).
Page 9 of 36
 WACC = 0.4(kd)(1 - T) + 0.1(kp) + 0.5(ke).

Because the firm has insufficient retained earnings to fund the equity por-
tion of the firm’s capital budget, use ke in the WACC calculation.

a. Calculate ke:
ke = + 8% = 8.47% + 8% = 16.47%.

b. Calculate kp:
kp = = = 11.11%.

c. Find T by substituting values for kd, kp, and ke in the WACC equation:
0.1230 = 0.4(0.11)(1 - T) + 0.1(0.1111) + 0.5(0.1647)
0.1230 = 0.044(1 - T) + 0.0111 + 0.08235
0.02954 = 0.044(1 - T)
0.671364 = 1 - T
0.328636 = T.

68
. WACC and cost of preferred stock Answer: b Diff: T

We need to find kp at the point where all 4 projects are accepted. In other words, the capital
budget = $2,000 + $3,000 + $5,000 + $3,000 = $13,000. The WACC at that point is equal to
IRRD = 9.5%.

Step 1: Find the retained earnings break point to determine whether ks or ke is used in the WACC
calculation:
BPRE = = $2,500.
Since the capital budget > the retained earnings break point, ke is used in the WACC
calculation.

Step 2: Calculate ke:

ke = + 5% = 12.80%.

Step 3: Find kp:

9.5% = 0.4(10%)(0.65) + 0.2(kp) + 0.4(12.80%)
9.5% = 2.60% + 0.2(kp) + 5.12%
1.78% = 0.2kp
8.90% = kp.
69
. Cost of retained earnings Answer: e Diff: E

ks = + 0.05 = 0.1600 = 16.00%.

70
. Cost of external equity Answer: b Diff: E
Page 10 of 36
 ke + 0.05 = 0.1722 = 17.22%.

71
. WACC Answer: d Diff: E

Since the firm can fund the equity portion of its capital budget with re-
tained earnings, use ks in WACC.

WACC = wdkd(1 - T) + wcks

= 0.3(0.12)(1 - 0.4) + 0.7(0.16)
= 0.0216 + 0.112
= 0.1336 = 13.36%.

72
. Cost of external equity Answer: a Diff: E

ke + 0.05 = 17%.

73
. WACC Answer: b Diff: E

WACC = 0.4(0.14)(1 - 0.4) + 0.6(0.17) = 0.1356 = 13.56%  13.6%.

74
. Cost of debt Answer: e Diff: E

Since the bond sells at par of $1,000, its YTM and coupon rate (12 percent)
are equal. Thus, the before-tax cost of debt to Rollins is 12.0 percent.
The after-tax cost of debt equals:
kd,After-tax = 12.0%(1 - 0.40) = 7.2%.

Financial calculator solution:

Inputs: N = 40; PV = -1000; PMT = 60; FV = 1000;
Output: I = 6.0% = kd/2.
kd = 6.0%  2 = 12%.
kd(1 - T) = 12.0%(0.6) = 7.2%.
75
. Cost of preferred stock Answer: d Diff: E

Cost of preferred stock: kp = $12/$100(0.95) = 12.6%.

76
. Cost of equity: CAPM Answer: c Diff: E

Cost of retained earnings (CAPM approach):

ks = 10% + (5%)1.2 = 16.0%.
77
. Cost of equity: DCF Answer: c Diff: E

Cost of retained earnings (DCF approach):

ks = 16.0%.

78
. Cost of equity: risk premium Answer: c Diff: E

Cost of retained earnings (bond yield-plus-risk-premium approach):

ks = 12.0% + 4.0% = 16.0%.

79
. WACC Answer: b Diff: E

Page 11 of 36
 WACC = wdkd(1 - T) + wpkp + wcke
= 0.2(12.0%)(0.6) + 0.2(12.6%) + 0.6(16.89%) = 14.09  14.1%.

80
. Stock price--constant growth Answer: d Diff: E

81
. Cost of external equity Answer: b Diff: E

Cost of new common equity:

82
. Cost of retained earnings Answer: e Diff: M

EBIT $1,000,000
Interest 400,000
EBT $ 600,000
Taxes (40%) 240,000
Net income $ 360,000

EPS1 = $360,000/100,000 = $3.60.

D1 = $3.60(0.5) = $1.80.
ks = ($1.80/$40.00) + 0.125 = 17.0%.

83
. Cost of external equity Answer: d Diff: E

0.125 = 17.5%.

0.10 = 15.5%.
85
. Cost of external equity Answer: d Diff: E

0.10 = 0.1647  16.5%.

86
.

87
. WACC Answer: d Diff: E

Since the firm has sufficient retained earnings to fund the equity portion of its capital budget, use
ks in WACC equation.

WACC = wdkd(1 - T) + wpkp + wcks

= 0.4(6%) + 0.1(12.5%) + 0.5(15.5%)
= 11.4%.

88
. Cost of debt Answer: b Diff: E N

To determine the cost of debt, use market values and the bond information
given. Enter the following data as inputs into your calculator as follows:
N = 15; PV = -1150; PMT = 120; FV = 1000; and then solve for I = kd = 10.03%. The after-tax
cost of debt is 10.03%(1 - Tax rate) = 10.03%(0.6) = 6.02%  6%.

Page 12 of 36
89
. Cost of common equity: CAPM Answer: e Diff: E N

Using the CAPM equation: ks = kRF + (kM – kRF)b

ks = 5% + (5%)1.4
ks = 12%.
Since equity costs are not tax-deductible, this is also the after-tax cost of
equity.
90
. WACC Answer: c Diff: E N

Use the target debt and equity ratios and the WACC equation as follows:
WACC = wdkd(1 – T) + wcks
= (0.40)(0.06) + (0.60)(0.12)
= 0.096, or 9.6%.
91
. Cost of debt Answer: b Diff: M N

The after-tax cost of debt is found by using the firm’s bond information to
solve for the YTM on bonds outstanding. Then, the YTM needs to be converted
to an after-tax yield.

N = 20; PV = -945; PMT = 85; FV = 1000; and then solve for kd = I = 9.11%.

AT kd = 9.11%(1 - 0.4) = 5.46%.

92
. Cost of preferred stock Answer: d Diff: E N

The after-tax cost of preferred stock can be derived by simply dividing the
preferred dividend paid by the price of preferred stock.

kp = $2/$25
kp = 8.0%.
93
. Cost of common equity: CAPM Answer: d Diff: E N

The cost of common equity can be found in a variety of ways. In this case,
we have been given information about the market risk premium and beta.
Therefore, we can use the CAPM to value the cost of common equity.

ks = kRF + (kM – kRF)b

ks = 6% + (5%)1.2
ks = 12.0%.
95
.

Page 13 of 36