Chapter 11

Cost of Capital

True / False Questions

1. It is standard practice to evaluate investment decisions using the cost of the specific financing
method involved.

True False

2. The calculation of the cost of capital depends upon the historical cost of funds.

True False

3. The cost of capital for each source of funds is dependent on current market conditions and
expected rates of return.

True False

4. In determining the cost of debt, yields and prices of the firm's outstanding bonds could be used.

True False

5. The cost of debt is equal to the current bond yield on bonds of similar risk class, adjusted for the
corporate tax rate.

True False

6. The amount of debt capital used by a corporation is not related to the availability of equity funds
from retained earnings and new common stock.

True False

7. A firm's cost of preferred stock is equal to the preferred dividend divided by the net price after
flotation costs.

True False

8. A firm's cost of preferred stock is equal to the preferred dividend divided by market price plus the
dividend growth rate (Kp = D/P0 + g).

True False

11-1
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
9. The cost of new common stock is greater than the cost of outstanding common stock.

True False

10. In determining the cost of preferred stock, the earnings on outstanding preferred stock may be
used as a proxy.

True False

11. The out-of-pocket cost of common stock is a good approximation of the cost of common stock
equity.

True False

12. The discount rate that equates a future stream of expected dividends to the current price is a good
approximation of the cost of common stock.

True False

13. Ke represents an expected return to stockholders as well as a cost to the firm.

True False

14. The cost of retained earnings is considered to be equal to the required rate of return on a firm's
outstanding common stock.

True False

15. Retained earnings represent an internal source of funds that is raised without the payment of
interest or cost to the firm's stockholders.

True False

16. The only difference in the cost of retained earnings (Ke) and the cost of new common stock (Kn) is
the flotation cost on new common stock.

True False

17. Regardless of the particular source of funds utilized for a project, the required rate of return, or
discount rate, will be the weighted average cost of capital.

True False

18. The use of common stock equity in the weighted average cost of capital is always (Ke) and not
(Kn), the cost of new common stock.

True False

11-2
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
19. The use of the optimum capital structure minimizes the cost of capital.

True False

20. All firms within particular industries have similar optimum capital structures.

True False

21. A firm should always be at a single optimum debt-to-equity ratio to minimize its cost of capital.

True False

22. Weights used to calculate the weighted average cost of capital Ka are derived from the optimum
capital structure.

True False

23. Taking on additional debt will reduce the cost of equity.

True False

24. Firms in stable industries are advised to keep debt levels very low so that shareholders, rather
than creditors, receive the benefits of steady cash flows.

True False

25. Most firms are able to use 60% to 70% debt in their capital structure without exceeding norms
acceptable to most creditors and investors.

True False

26. Although the after-tax cost of debt is below the cost of equity, firms cannot increase their use of
debt without limit.

True False

27. According to traditional financial theory, the cost of capital curve is U-shaped over the range of
debt-equity mixes.

True False

28. A firm that does not earn the cost of capital in the short run will probably be in bankruptcy.

True False

29. A firm that does not earn the cost of capital in the long run will not maximize shareholder wealth.

True False

11-3
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
30. Companies prefer to maintain some financing flexibility in order to choose the lowest-cost source
of funds at a single point in time.

True False

31. The use of the weighted average cost of capital assumes that the firm is in its optimum capital
structure range and the cost of each component stays constant over the range of financing.

True False

32. Larger bond issues can lower "liquidity risk," or the possibility that an investor will not be able to
sell a bond quickly and easily.

True False

33. Market values rather than book values should be used for determining the optimal capital
structure; however, in practice, book value is commonly used.

True False

34. In determining the optimum capital structure, it is assumed that the firm will raise capital in the
optimum proportions every year.

True False

35. The pretax cost of debt is generally less than the pretax cost of equity.

True False

36. The capital asset pricing model (CAPM) relates the risk-return tradeoffs of individual assets to
market returns.

True False

37. In the capital asset pricing model (CAPM), beta measures the volatility of the market.

True False

38. Per the capital asset pricing model, the slope of the security market line (SML) must be 1.0.

True False

39. The financial managers of the firm decide on its cost of capital for financing projects.

True False

40. The cost of debt, preferred stock, and common equity must all be adjusted for tax implications.

True False

11-4
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
41. Although debt financing is generally cheaper than equity financing, financial managers should not
use debt financing significantly above the industry standard because it can increase the firm's
overall cost of capital.

True False

42. The cost of capital generally varies inversely with the size of the capital structure.

True False

43. As the risk-free rate increases, the required rate of return for common stock decreases.

True False

44. A firm with a higher beta than another firm will have a higher required rate of return.

True False

45. The slope of the security market line (SML) will often increase when the economy is in a boom
period.

True False

Multiple Choice Questions

46. Each project should be judged against

A. the specific means of financing used to support its implementation.

B. the exiting interest rate at that point in time.
C. the cost of new common stock equity.
D. None of these options

47. Financial capital does not include

A. stocks.
B. bonds.
C. preferred stocks.
D. working capital.

11-5
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
48. The overall weighted average cost of capital is used instead of costs for specific sources of funds
because

A. use of the cost for specific sources of capital would make investment decisions inconsistent.
B. a project with the highest return would always be accepted under the specific cost criteria.
C. investments funded by low-cost debt would have an advantage over other investments.
D. use of the cost for specific sources of capital would make investment decisions inconsistent,
and investments funded by low-cost debt would have an advantage over other investments.

49. Debreu Beverages has an optimal capital structure that is 70% common equity, 20% debt, and
10% preferred stock. Debreu's pretax cost of equity is 9%. Its pretax cost of preferred equity is
7%, and its pretax cost of debt is also 5%. If the corporate tax rate is 35%, what is the weighed
average cost of capital?

A. Between 7% and 8%
B. Between 8% and 9%
C. Between 9% and 10%
D. Between 10% and 12%

50. Given an optimal capital structure that is 50% debt and 50% common stock, calculate the
weighted average cost of capital for Stone Corp. given the following additional information:

Bond coupon rate………………..8%

Bond yield to maturity…………..6%
Dividend, expected……………..$5
Price, common………………….$80
Growth rate…………………….5%
Corporate tax rate………………30%

A. Less than 5.0%.

B. More than 5.0% and less than 6.25%.
C. More than 6.25% and less than 7.5%.
D. More than 7.5%.

51. For a firm paying 5% for new debt, the higher the firm's tax rate

A. the higher the after-tax cost of debt.

B. the lower the after-tax cost of debt.
C. the after-tax cost is unchanged.
D. Not enough information to judge.

11-6
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
52. If a firm's bonds are currently yielding 6% in the marketplace, why would the firm's cost of debt be
lower?

A. Interest rates have changed.

B. Additional debt can be issued more cheaply than the original debt.
C. There should be no difference; the cost of debt is the same as the bond's market yield.
D. Interest is tax-deductible.

53. The cost of a firm's debt is determined by taking the

A. present value of the interest payments and principal times one minus the tax rate.
B. historical yield on bonds times one minus the tax rate.
C. estimated yield on new bond issues of the same risk times one minus the shareholder's
marginal tax rate.
D. None of these options

54. The coupon rate on a debt issue is 6%. If the yield to maturity on the debt is 9%, what is the after-
tax cost of debt in the weighted average cost of capital if the firm's tax rate is 34%?

A. 3.96%
B. 4.08%
C. 5.94%
D. 7.92%

55. The coupon rate on an issue of debt is 8%. The yield to maturity on this issue is 10%. The
corporate tax rate is 31%. What would be the approximate after-tax cost of debt for a new issue of
bonds?

A. 5.28%
B. 2.48%
C. 6.90%
D. 3.14%

56. A firm's cost of financing, in an overall sense, is equal to its

A. weighted average cost of capital.

B. required yield that investors seek for various kinds of securities.
C. required rate of return that investors seek for various kinds of securities.
D. All of these options

11-7
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
57. A firm has $50 million in assets and its optimal capital structure is 60% equity. If the firm has $12
million in retained earnings, at what asset level will the firm need to issue additional stock?
(Assume no growth in retained earnings.)

A. The firm should have already issued additional stock.

B. The firm can increase assets to $30 million.
C. The firm can increase assets to $20 million.
D. There is insufficient information to determine an answer.

58. Tobin's Barbeque has a bank loan at 8% interest and an after-tax cost of debt of 6%. What will the
after-tax cost of debt be when the loan is due if a new loan is taken out yielding 11%.

A. 7.52%
B. 8.25%
C. 13.33%
D. None of these options

59. The pre-tax cost of debt for a new issue of debt is determined by

A. the investor's required rate of return on issued stock.

B. the coupon rate of existing debt.
C. the yield to maturity of outstanding or comparable bonds.
D. All of these options

60. Lewis, Schultz, and Nobel Development Corp. has an after-tax cost of debt of 4.5%. With a tax
rate of 30%, what is the yield on the debt?

A. 4.41%
B. 9.0%
C. 1.89%
D. 6.43%

61. The after-tax cost of preferred stock to the issuing corporation

A. is the same as the before-tax cost.

B. is usually lower than the cost of debt.
C. is dependent on the firm's tax bracket.
D. None of these options

11-8
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
62. A firm is paying an annual dividend of $2.65 for its preferred stock that is selling for $57.00. There
is a selling cost of $3.30. What is the after-tax cost of preferred stock if the firm's tax rate is 33%?

A. 2.02%
B. 4.93%
C. 5.79%
D. 6.11%

63. Firm X has a tax rate of 30%. The price of its new preferred stock is $75 and its flotation cost is
$3.15. The cost of new preferred stock is 8%. What is the firm's dividend?

A. $7.18
B. $5.75
C. $7.56
D. None of these options

64. The cost of equity capital in the form of new common stock will be higher than the cost of retained
earnings because of

A. the existence of taxes.

B. the existence of flotation costs.
C. investors' unwillingness to purchase additional shares of common stock.
D. the existence of financial leverage.

65. If the flotation cost goes up, the cost of retained earnings will

A. go up.
B. go down.
C. stay the same.
D. slowly increase.

66. Why is the cost of debt normally lower than the cost of preferred stock?

A. Preferred stock dividends are tax deductions.

B. Interest on debt is tax deductible.
C. Preferred stock dividends must be paid before common stock dividends.
D. Common stock dividends are not tax-deductible.

11-9
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
67. If flotation costs go down, the cost of new preferred stock will

A. go up.
B. go down.
C. stay the same.
D. slowly increase.

68. A firm's preferred stock pays an annual dividend of $2, and the stock sells for $65. Flotation costs
for new issuances of preferred stock are 5% of the stock value. What is the after-tax cost of
preferred stock if the firm's tax rate is 30%?

A. 1.2%
B. 1.58%
C. 3.20%
D. 5.26%

69. Ten years ago, Stigler Company issued $100 par value preferred stock yielding 6%. The preferred
stock is now selling for $102 per share. What is the approximate current yield or cost of the
preferred stock? (Disregard flotation costs.)

A. 7.76%
B. 8%
C. 5.9%
D. There is not enough information to answer the question.

70. A firm's debt-to-equity ratio varies at times because

A. a firm will want to sell common stock when prices are high and bonds when interest rates are
low.
B. a firm will want to take advantage of timing its fund-raising in order to minimize costs over the
long run.
C. the market allows some leeway in the debt-to-equity ratio before penalizing the firm with a
higher cost of capital.
D. All of these are accurate statements.

71. Using the constant dividend growth model for common stock, if P0 goes up,

A. the assumed cost goes up.

B. the assumed cost goes down.
C. the assumed cost remains unchanged.
D. Further information is needed to answer the question.

11-10
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
72. New common stock is more expensive than Ke

A. to compensate for risk.

B. to compensate for more dividends.
C. to compensate for expansionary problems.
D. to cover distribution costs.

73. In computing the cost of common equity, if D1 goes downward and P0 goes up, Ke will

A. go up.
B. go down.
C. stay the same.
D. slowly increase.

74. In determining the cost of retained earnings

A. the dividend valuation model is inappropriate.

B. flotation costs are included.
C. growth is not considered.
D. the capital asset pricing model can be used.

75. Within the capital asset pricing model

A. the risk-free rate is usually higher than the return in the market.
B. the higher the beta, the lower the required rate of return.
C. beta measures the volatility of an individual stock relative to a stock market index.
D. Two of the options.

76. Using the constant growth model, a firm's expected (D1) dividend yield is 4% of the stock price,
and its growth rate is 5%. If the tax rate is .35%, what is the firm's cost of equity?

A. 10%
B. 6.65%
C. 9.0%
D. More information is required to answer the question.

11-11
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
77. Expected cash dividends are $3.00, the dividend yield is 4%, flotation costs are 4% of price, and
the growth rate is 3%. Compute the approximate cost of new common stock.

A. 7.00%
B. 7.2%
C. 6.9%
D. 4.2%

78. A firm's stock is selling for $65. The dividend yield is 6%. A 7% growth rate is expected for the
common stock. The firm's tax rate is 40%. What is the firm's cost of retained earnings?

A. 8.16%
B. 13.00%
C. 12.35%
D. The retained earnings cannot be determined from this information.

79. A firm's stock is selling for $62. The next annual dividend is expected to be $3.00. The growth rate
is 9%. The flotation cost is $5.00. What is the cost of retained earnings?

A. 13.84%
B. 12.46%
C. 12.7%
D. None of these options

80. For many firms, the cheapest and most important source of equity capital is in the form of

A. debt.
B. common stock.
C. preferred stock.
D. retained earnings.

81. Retained earnings has a cost associated with it because

A. new funds must be raised.

B. there is an opportunity cost associated with stockholder funds.
C. Ke > g.
D. flotation costs increase the cost of funding.

11-12
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
82. There may be a change in the marginal cost of capital curve because

A. the tax rate charged to investors changes.

B. the firm has exhausted its supply of retained earnings.
C. the firm is limited in the amount of depreciation it can take.
D. the tax rate charged to investors changes and the firm has exhausted its supply of retained
earnings.

83. The after-tax cost of debt will almost always be below

A. the before-tax cost of debt.

B. the weighted average cost of capital.
C. the cost of equity.
D. All of these options

84. The optimal capital structure for firms in cyclical industries should contain ________________
than firms in stable industries.

A. more debt
B. less debt
C. an equal amount of debt
D. None of these options is valid. There is no relationship between the cyclical nature of an
industry and optimal capital structure.

85. The component parts of the cost of capital should be weighted by their proportion in the firm's

A. current capital structure.

B. historical capital structure.
C. optimum capital structure.
D. expected capital structure.

86. Which of the following is not true about debt financing and the weighted average cost of capital?

A. Debt is usually the cheapest source of financing.

B. As the level of debt increases beyond the optimum capital structure, the cost of capital
increases.
C. No debt in the firm's capital structure will minimize the firm's weighted average cost of capital.
D. None of these options

11-13
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
87. A firm in a stable industry should use

A. a large amount of debt to lower the cost of capital.

B. no debt at all.
C. preferred stock in place of debt.
D. a limited amount of debt to lower the cost of capital.

88. Although debt financing is usually the cheapest component of capital, it cannot be used in excess
because

A. interest rates may change.

B. the firm's stock price will increase and raise the cost of equity financing.
C. the financial risk of the firm may increase and thus drive up the cost of all sources of financing.
D. underwriting costs may change.

89. A firm in a cyclical industry should use

A. a large amount of debt to lower the cost of capital.

B. no debt at all.
C. preferred stock in place of debt.
D. a limited amount of debt to lower the cost of capital.

90. Most firms are able to use ______% debt in their capital structure without exceeding norms
acceptable to creditors and investors.

A. 30-50
B. 40-60
C. 50-70
D. 60-80

91. Marginal cost of capital

A. recognizes that cost of capital does not stay constant as more funds are raised.
B. usually provides the same capital budgeting choices as the use of weighted average cost of
capital.
C. can be defined as the cost of capital when no retained earnings are available for expansion.
D. None of these options apply.

11-14
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
92. The weighted average cost of capital is used as a discount rate because

A. it is an indication of how much the firm is earning overall.

B. as long as the cost of capital is earned, the common stock value of the firm will be maintained.
C. it is comparable to the prevailing market interest rates.
D. returns below the cost of capital will cover all fixed costs associated with capital and provide an
excess return to stockholders.

93. Use of the marginal cost of capital

A. acknowledges that when retained earnings are used up as a source of equity, the cost of
capital rises as new common stock is sold to support more growth.
B. recognizes that the return from the last dollar of funds generated should be greater than or
equal to the cost of the last dollar of funds raised.
C. acknowledges that when retained earnings are used up as a source of equity, the cost of
capital rises as new common stock is sold to support more growth and recognizes that the
return from the last dollar of funds generated should be greater than or equal to the cost of the
last dollar of funds raised.
D. None of these options are correct.

94. The general rule for using the weighted average cost of capital (WACC) in capital budgeting
decisions is to accept all projects with

A. rates of return greater than or equal to the WACC.

B. rates of return less than the WACC.
C. rates of return equal to or less than the WACC.
D. positive rates of return.

95. Oak Enterprises has a beta of 1.2, the market return is 8%, and the T-bill rate is 4%. What is their
expected required return of common equity?

A. Between 11% and 12%

B. Between 8% and 9%
C. Between 7% and 8%
D. Between 4% and 5%

11-15
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
96. All of the following are important considerations for minimizing the cost of capital except:

A. future inflation rates

B. industry debt ratios
C. future economic conditions
D. current coupon rates of outstanding debt

Matching Questions

97. Match the following with the items below:

1. capital asset The distribution expense involved in selling

pricing model securities to the public. ____
The result of multiplying the cost of each item
in the capital structure by its corresponding
2. marginal cost representation in the overall capital structure and
of capital summing the results. ____
Features the best possible mix of debt,
3. optimal capital preferred stock, retained earnings, and new
structure common stock. ____
Determines the value of a share of stock by
4. financial taking the present value of the expected future
capital stream of dividends. ____
5. weighted
average cost of The cost of alternative sources of financing to
capital the firm. ____
Relates the risk-return tradeoffs of individual
6. flotation costs securities to market returns. ____
The cost of the most recent dollars of funds
7. cost of capital raised. ____
8. dividend Appears on the balance sheet under long-
valuation model term liabilities and equity. ____

Essay Questions

11-16
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
98. Zinger Corporation manufactures industrial type sewing machines and received a very large order
from a few European countries. In order to be able to supply these countries with its products,
Zinger will have to expand its facilities. Of the required expansion, Zinger feels it can raise $75
million internally through retained earnings. The firm's optimum capital structure has been 35%
debt, 10% preferred stock, and 55% equity. The company will try to maintain this capital structure
in financing this expansion plan. Currently, Zinger's common stock is traded at a price of $28 per
share. Last year's dividend was $1.50 per share. The growth rate is 8%. The company's preferred
stock is selling at $45 and has been yielding 6% in the current market. Flotation costs have been
estimated at 8% of common stock and 3% of preferred stock. Zinger Corp. has bonds outstanding
at 6%, but its investment banker has informed the company that interest rates for bonds of equal
risk are currently yielding 5%. Zinger's tax rate is 40%.

a) Compute the cost of Kd, Kp, Ke, Kn.

b) Calculate the initial weighted average cost of capital using Ke.
c) How large of a capital budget can the firm support with "retained earnings" financing only?

99. Jury Company wants to calculate the component costs in its capital structure. Common stock
currently sells for $33, and is expected to pay a dividend of $.50. Jury's dividend growth rate is
8%, and flotation cost is $1.25. Preferred stock sells for $40, pays a dividend of $3.00, and carries
a flotation cost of $1.10. Jury Company bonds yield 7% in the market. Jury is in the 30% tax
bracket.
Calculate the cost of debt, cost of new common stock, cost of preferred stock, and cost of retained
earnings.

11-17
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
100.Given the information about Jury Co. in the previous problem, calculate the company's weighted
average cost of capital assuming that its new financing will consist of 40% debt, 10% preferred
stock, and 50% retained earnings.

11-18
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
 Chapter 11 Cost of Capital Answer Key

True / False Questions

1. It is standard practice to evaluate investment decisions using the cost of the specific financing
method involved.

FALSE

AACSB: Analytic
Blooms: Understand
Difficulty: Basic
Learning Objective: 11-02 The cost of capital is normally the discount rate to use in analyzing an investment.

2. The calculation of the cost of capital depends upon the historical cost of funds.

FALSE

Each project must be evaluated by the current cost of funds.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-01 The cost of capital represents the weighted average cost of the source of financing to the firm.

3. The cost of capital for each source of funds is dependent on current market conditions and
expected rates of return.

TRUE

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-01 The cost of capital represents the weighted average cost of the source of financing to the firm.

4. In determining the cost of debt, yields and prices of the firm's outstanding bonds could be
used.

TRUE

AACSB: Analytic
Blooms: Understand
Difficulty: Basic
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

11-19
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
5. The cost of debt is equal to the current bond yield on bonds of similar risk class, adjusted for
the corporate tax rate.

TRUE

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

6. The amount of debt capital used by a corporation is not related to the availability of equity
funds from retained earnings and new common stock.

FALSE

AACSB: Analytic
Blooms: Understand
Difficulty: Challenge
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

7. A firm's cost of preferred stock is equal to the preferred dividend divided by the net price after
flotation costs.

TRUE

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: Basic
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

8. A firm's cost of preferred stock is equal to the preferred dividend divided by market price plus
the dividend growth rate (Kp = D/P0 + g).

FALSE

The correct formula is Kp = Dp/(Pp - F).

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: Basic
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

9. The cost of new common stock is greater than the cost of outstanding common stock.

TRUE

AACSB: Analytic
Blooms: Understand
Difficulty: Basic
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to

11-20
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
 bonds; preferred stock; and common stock.

10. In determining the cost of preferred stock, the earnings on outstanding preferred stock may be
used as a proxy.

FALSE

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

11. The out-of-pocket cost of common stock is a good approximation of the cost of common stock
equity.

FALSE

Flotation costs for new stock issues must be considered in the valuation, unlike existing stock.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

12. The discount rate that equates a future stream of expected dividends to the current price is a
good approximation of the cost of common stock.

TRUE

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

13. Ke represents an expected return to stockholders as well as a cost to the firm.

TRUE

AACSB: Analytic
Blooms: Understand
Difficulty: Basic
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

14. The cost of retained earnings is considered to be equal to the required rate of return on a firm's
outstanding common stock.

TRUE

AACSB: Reflective Thinking

11-21
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
 Blooms: Remember
Difficulty: Basic
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

15. Retained earnings represent an internal source of funds that is raised without the payment of
interest or cost to the firm's stockholders.

FALSE

"Opportunity cost" must be considered since earnings could be issued to shareholders in the
form of dividends.

AACSB: Analytic
Blooms: Understand
Difficulty: Basic
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

16. The only difference in the cost of retained earnings (Ke) and the cost of new common stock (Kn)
is the flotation cost on new common stock.

TRUE

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

17. Regardless of the particular source of funds utilized for a project, the required rate of return, or
discount rate, will be the weighted average cost of capital.

TRUE

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-01 The cost of capital represents the weighted average cost of the source of financing to the firm.

18. The use of common stock equity in the weighted average cost of capital is always (Ke) and not
(Kn), the cost of new common stock.

FALSE

Either or both may be used; it is situation-dependent.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

11-22
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
19. The use of the optimum capital structure minimizes the cost of capital.

TRUE

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

20. All firms within particular industries have similar optimum capital structures.

FALSE

As seen in Table 11-3, use of debt in diverse industries can vary sharply.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-01 The cost of capital represents the weighted average cost of the source of financing to the firm.

21. A firm should always be at a single optimum debt-to-equity ratio to minimize its cost of capital.

FALSE

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

22. Weights used to calculate the weighted average cost of capital Ka are derived from the
optimum capital structure.

TRUE

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: Basic
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

23. Taking on additional debt will reduce the cost of equity.

FALSE

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

11-23
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
24. Firms in stable industries are advised to keep debt levels very low so that shareholders, rather
than creditors, receive the benefits of steady cash flows.

FALSE

Firms in a stable industry are more apt to use financial leverage (greater proportionate debt) to
amplify their earnings per common share.

AACSB: Analytic
Blooms: Understand
Difficulty: Basic
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

25. Most firms are able to use 60% to 70% debt in their capital structure without exceeding norms
acceptable to most creditors and investors.

FALSE

Lenders and investors generally become concerned when debt exceeds 50% of the overall
capital structure.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

26. Although the after-tax cost of debt is below the cost of equity, firms cannot increase their use of
debt without limit.

TRUE

AACSB: Analytic
Blooms: Apply
Difficulty: Intermediate
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

27. According to traditional financial theory, the cost of capital curve is U-shaped over the range of
debt-equity mixes.

TRUE

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

11-24
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
28. A firm that does not earn the cost of capital in the short run will probably be in bankruptcy.

FALSE

Proper management of the sources of capital can allow a firm to survive short-term
interruptions in its income stream.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

29. A firm that does not earn the cost of capital in the long run will not maximize shareholder
wealth.

TRUE

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

30. Companies prefer to maintain some financing flexibility in order to choose the lowest-cost
source of funds at a single point in time.

TRUE

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

31. The use of the weighted average cost of capital assumes that the firm is in its optimum capital
structure range and the cost of each component stays constant over the range of financing.

TRUE

AACSB: Analytic
Blooms: Understand
Difficulty: Challenge
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

32. Larger bond issues can lower "liquidity risk," or the possibility that an investor will not be able to
sell a bond quickly and easily.

TRUE

AACSB: Analytic
Blooms: Understand
Difficulty: Challenge
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

11-25
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
33. Market values rather than book values should be used for determining the optimal capital
structure; however, in practice, book value is commonly used.

TRUE

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: Intermediate
Learning Objective: 11-01 The cost of capital represents the weighted average cost of the source of financing to the firm.

34. In determining the optimum capital structure, it is assumed that the firm will raise capital in the
optimum proportions every year.

FALSE

The firm must constantly reevaluate its capital structure for changes, in order to allow them to
change their approach in their next round of financing.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

35. The pretax cost of debt is generally less than the pretax cost of equity.

TRUE

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

36. The capital asset pricing model (CAPM) relates the risk-return tradeoffs of individual assets to
market returns.

TRUE

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

37. In the capital asset pricing model (CAPM), beta measures the volatility of the market.

FALSE

Beta represents the volatility of one particular stock against an index of the overall market.

AACSB: Reflective Thinking

11-26
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
 Blooms: Remember
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

38. Per the capital asset pricing model, the slope of the security market line (SML) must be 1.0.

FALSE

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

39. The financial managers of the firm decide on its cost of capital for financing projects.

FALSE

Managers will consistently analyze alternatives and select the optimum, but they cannot dictate
the actual cost itself.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-01 The cost of capital represents the weighted average cost of the source of financing to the firm.

40. The cost of debt, preferred stock, and common equity must all be adjusted for tax implications.

FALSE

The cost of debt financing has direct tax implications; equity financing does not.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

41. Although debt financing is generally cheaper than equity financing, financial managers should
not use debt financing significantly above the industry standard because it can increase the
firm's overall cost of capital.

TRUE

AACSB: Analytic
Blooms: Evaluate
Difficulty: Intermediate
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

11-27
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
42. The cost of capital generally varies inversely with the size of the capital structure.

FALSE

AACSB: Analytic
Blooms: Evaluate
Difficulty: Intermediate
Learning Objective: 11-05 The cost of capital may eventually increase as larger amounts of financing are utilized.

43. As the risk-free rate increases, the required rate of return for common stock decreases.

FALSE

"K" is utilized in all cost of capital decisions and bears a direct relationship to increases and
decreases in Rf.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

44. A firm with a higher beta than another firm will have a higher required rate of return.

TRUE

Beta is a direct measure of risk, so Kj must be higher.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

45. The slope of the security market line (SML) will often increase when the economy is in a boom
period.

FALSE

AACSB: Analytic
Blooms: Evaluate
Difficulty: Challenge
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

Multiple Choice Questions

11-28
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
46. Each project should be judged against

A. the specific means of financing used to support its implementation.

B. the exiting interest rate at that point in time.
C. the cost of new common stock equity.
D. None of these options

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-02 The cost of capital is normally the discount rate to use in analyzing an investment.

47. Financial capital does not include

A. stocks.
B. bonds.
C. preferred stocks.
D. working capital.

AACSB: Reflective Thinking

Blooms: Remember
Difficulty: Basic
Learning Objective: 11-01 The cost of capital represents the weighted average cost of the source of financing to the firm.

48. The overall weighted average cost of capital is used instead of costs for specific sources of
funds because

A. use of the cost for specific sources of capital would make investment decisions inconsistent.
B. a project with the highest return would always be accepted under the specific cost criteria.
C. investments funded by low-cost debt would have an advantage over other investments.
D. use of the cost for specific sources of capital would make investment decisions inconsistent,
and investments funded by low-cost debt would have an advantage over other investments.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-02 The cost of capital is normally the discount rate to use in analyzing an investment.

11-29
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
49. Debreu Beverages has an optimal capital structure that is 70% common equity, 20% debt, and
10% preferred stock. Debreu's pretax cost of equity is 9%. Its pretax cost of preferred equity is
7%, and its pretax cost of debt is also 5%. If the corporate tax rate is 35%, what is the weighed
average cost of capital?

A. Between 7% and 8%
B. Between 8% and 9%
C. Between 9% and 10%
D. Between 10% and 12%

AACSB: Analytic
Blooms: Apply
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

11-30
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
50. Given an optimal capital structure that is 50% debt and 50% common stock, calculate the
weighted average cost of capital for Stone Corp. given the following additional information:

Bond coupon rate………………..8%

Bond yield to maturity…………..6%
Dividend, expected……………..$5
Price, common………………….$80
Growth rate…………………….5%
Corporate tax rate………………30%

A. Less than 5.0%.

B. More than 5.0% and less than 6.25%.
C. More than 6.25% and less than 7.5%.
D. More than 7.5%.

AACSB: Analytic
Blooms: Apply
Difficulty: Challenge
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

51. For a firm paying 5% for new debt, the higher the firm's tax rate

A. the higher the after-tax cost of debt.

B. the lower the after-tax cost of debt.
C. the after-tax cost is unchanged.
D. Not enough information to judge.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

11-31
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
52. If a firm's bonds are currently yielding 6% in the marketplace, why would the firm's cost of debt
be lower?

A. Interest rates have changed.

B. Additional debt can be issued more cheaply than the original debt.
C. There should be no difference; the cost of debt is the same as the bond's market yield.
D. Interest is tax-deductible.

AACSB: Analytic
Blooms: Understand
Difficulty: Basic
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

53. The cost of a firm's debt is determined by taking the

A. present value of the interest payments and principal times one minus the tax rate.
B. historical yield on bonds times one minus the tax rate.
C. estimated yield on new bond issues of the same risk times one minus the shareholder's
marginal tax rate.
D. None of these options

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

54. The coupon rate on a debt issue is 6%. If the yield to maturity on the debt is 9%, what is the
after-tax cost of debt in the weighted average cost of capital if the firm's tax rate is 34%?

A. 3.96%
B. 4.08%
C. 5.94%
D. 7.92%

AACSB: Analytic
Blooms: Apply
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

11-32
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
55. The coupon rate on an issue of debt is 8%. The yield to maturity on this issue is 10%. The
corporate tax rate is 31%. What would be the approximate after-tax cost of debt for a new issue
of bonds?

A. 5.28%
B. 2.48%
C. 6.90%
D. 3.14%

AACSB: Analytic
Blooms: Apply
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

56. A firm's cost of financing, in an overall sense, is equal to its

A. weighted average cost of capital.

B. required yield that investors seek for various kinds of securities.
C. required rate of return that investors seek for various kinds of securities.
D. All of these options

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-01 The cost of capital represents the weighted average cost of the source of financing to the firm.

57. A firm has $50 million in assets and its optimal capital structure is 60% equity. If the firm has
$12 million in retained earnings, at what asset level will the firm need to issue additional stock?
(Assume no growth in retained earnings.)

A. The firm should have already issued additional stock.

B. The firm can increase assets to $30 million.
C. The firm can increase assets to $20 million.
D. There is insufficient information to determine an answer.

AACSB: Analytic

11-33
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
 Blooms: Apply
Difficulty: Intermediate
Learning Objective: 11-05 The cost of capital may eventually increase as larger amounts of financing are utilized.

58. Tobin's Barbeque has a bank loan at 8% interest and an after-tax cost of debt of 6%. What will
the after-tax cost of debt be when the loan is due if a new loan is taken out yielding 11%.

A. 7.52%
B. 8.25%
C. 13.33%
D. None of these options

Since the after-tax cost of debt on preexisting loans is 6% on an 8% pretax interest rate, the
company's tax rate must be 25% ([8 - 6]/8).

AACSB: Analytic
Blooms: Apply
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

59. The pre-tax cost of debt for a new issue of debt is determined by

A. the investor's required rate of return on issued stock.

B. the coupon rate of existing debt.
C. the yield to maturity of outstanding or comparable bonds.
D. All of these options

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

11-34
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
60. Lewis, Schultz, and Nobel Development Corp. has an after-tax cost of debt of 4.5%. With a tax
rate of 30%, what is the yield on the debt?

A. 4.41%
B. 9.0%
C. 1.89%
D. 6.43%

AACSB: Analytic
Blooms: Apply
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

61. The after-tax cost of preferred stock to the issuing corporation

A. is the same as the before-tax cost.

B. is usually lower than the cost of debt.
C. is dependent on the firm's tax bracket.
D. None of these options

AACSB: Analytic
Blooms: Understand
Difficulty: Basic
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

11-35
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
62. A firm is paying an annual dividend of $2.65 for its preferred stock that is selling for $57.00.
There is a selling cost of $3.30. What is the after-tax cost of preferred stock if the firm's tax rate
is 33%?

A. 2.02%
B. 4.93%
C. 5.79%
D. 6.11%

AACSB: Analytic
Blooms: Apply
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

63. Firm X has a tax rate of 30%. The price of its new preferred stock is $75 and its flotation cost is
$3.15. The cost of new preferred stock is 8%. What is the firm's dividend?

A. $7.18
B. $5.75
C. $7.56
D. None of these options

AACSB: Analytic
Blooms: Apply
Difficulty: Challenge
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

11-36
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
64. The cost of equity capital in the form of new common stock will be higher than the cost of
retained earnings because of

A. the existence of taxes.

B. the existence of flotation costs.
C. investors' unwillingness to purchase additional shares of common stock.
D. the existence of financial leverage.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

65. If the flotation cost goes up, the cost of retained earnings will

A. go up.
B. go down.
C. stay the same.
D. slowly increase.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

66. Why is the cost of debt normally lower than the cost of preferred stock?

A. Preferred stock dividends are tax deductions.

B. Interest on debt is tax deductible.
C. Preferred stock dividends must be paid before common stock dividends.
D. Common stock dividends are not tax-deductible.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

11-37
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
67. If flotation costs go down, the cost of new preferred stock will

A. go up.
B. go down.
C. stay the same.
D. slowly increase.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

68. A firm's preferred stock pays an annual dividend of $2, and the stock sells for $65. Flotation
costs for new issuances of preferred stock are 5% of the stock value. What is the after-tax cost
of preferred stock if the firm's tax rate is 30%?

A. 1.2%
B. 1.58%
C. 3.20%
D. 5.26%

AACSB: Analytic
Blooms: Apply
Difficulty: Challenge
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

11-38
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
69. Ten years ago, Stigler Company issued $100 par value preferred stock yielding 6%. The
preferred stock is now selling for $102 per share. What is the approximate current yield or cost
of the preferred stock? (Disregard flotation costs.)

A. 7.76%
B. 8%
C. 5.9%
D. There is not enough information to answer the question.

AACSB: Analytic
Blooms: Apply
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

70. A firm's debt-to-equity ratio varies at times because

A. a firm will want to sell common stock when prices are high and bonds when interest rates
are low.
B. a firm will want to take advantage of timing its fund-raising in order to minimize costs over
the long run.
C. the market allows some leeway in the debt-to-equity ratio before penalizing the firm with a
higher cost of capital.
D. All of these are accurate statements.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

71. Using the constant dividend growth model for common stock, if P0 goes up,

A. the assumed cost goes up.

B. the assumed cost goes down.
C. the assumed cost remains unchanged.
D. Further information is needed to answer the question.

AACSB: Analytic
Blooms: Apply
Difficulty: Intermediate

11-39
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
 Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

72. New common stock is more expensive than Ke

A. to compensate for risk.

B. to compensate for more dividends.
C. to compensate for expansionary problems.
D. to cover distribution costs.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

73. In computing the cost of common equity, if D1 goes downward and P0 goes up, Ke will

A. go up.
B. go down.
C. stay the same.
D. slowly increase.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

74. In determining the cost of retained earnings

A. the dividend valuation model is inappropriate.

B. flotation costs are included.
C. growth is not considered.
D. the capital asset pricing model can be used.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

11-40
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
75. Within the capital asset pricing model

A. the risk-free rate is usually higher than the return in the market.
B. the higher the beta, the lower the required rate of return.
C. beta measures the volatility of an individual stock relative to a stock market index.
D. Two of the options.

AACSB: Analytic
Blooms: Understand
Difficulty: Basic
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

76. Using the constant growth model, a firm's expected (D1) dividend yield is 4% of the stock price,
and its growth rate is 5%. If the tax rate is .35%, what is the firm's cost of equity?

A. 10%
B. 6.65%
C. 9.0%
D. More information is required to answer the question.

AACSB: Analytic
Blooms: Apply
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

11-41
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
77. Expected cash dividends are $3.00, the dividend yield is 4%, flotation costs are 4% of price,
and the growth rate is 3%. Compute the approximate cost of new common stock.

A. 7.00%
B. 7.2%
C. 6.9%
D. 4.2%

AACSB: Analytic
Blooms: Apply
Difficulty: Challenge
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

78. A firm's stock is selling for $65. The dividend yield is 6%. A 7% growth rate is expected for the
common stock. The firm's tax rate is 40%. What is the firm's cost of retained earnings?

A. 8.16%
B. 13.00%
C. 12.35%
D. The retained earnings cannot be determined from this information.

AACSB: Analytic
Blooms: Apply
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

11-42
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
79. A firm's stock is selling for $62. The next annual dividend is expected to be $3.00. The growth
rate is 9%. The flotation cost is $5.00. What is the cost of retained earnings?

A. 13.84%
B. 12.46%
C. 12.7%
D. None of these options

AACSB: Analytic
Blooms: Apply
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

80. For many firms, the cheapest and most important source of equity capital is in the form of

A. debt.
B. common stock.
C. preferred stock.
D. retained earnings.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

81. Retained earnings has a cost associated with it because

A. new funds must be raised.

B. there is an opportunity cost associated with stockholder funds.
C. Ke > g.
D. flotation costs increase the cost of funding.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

11-43
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
82. There may be a change in the marginal cost of capital curve because

A. the tax rate charged to investors changes.

B. the firm has exhausted its supply of retained earnings.
C. the firm is limited in the amount of depreciation it can take.
D. the tax rate charged to investors changes and the firm has exhausted its supply of retained
earnings.

AACSB: Analytic
Blooms: Understand
Difficulty: Challenge
Learning Objective: 11-05 The cost of capital may eventually increase as larger amounts of financing are utilized.

83. The after-tax cost of debt will almost always be below

A. the before-tax cost of debt.

B. the weighted average cost of capital.
C. the cost of equity.
D. All of these options

AACSB: Analytic
Blooms: Understand
Difficulty: Basic
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

84. The optimal capital structure for firms in cyclical industries should contain ________________
than firms in stable industries.

A. more debt
B. less debt
C. an equal amount of debt
D. None of these options is valid. There is no relationship between the cyclical nature of an
industry and optimal capital structure.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

11-44
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
85. The component parts of the cost of capital should be weighted by their proportion in the firm's

A. current capital structure.

B. historical capital structure.
C. optimum capital structure.
D. expected capital structure.

AACSB: Analytic
Blooms: Understand
Difficulty: Basic
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

86. Which of the following is not true about debt financing and the weighted average cost of
capital?

A. Debt is usually the cheapest source of financing.

B. As the level of debt increases beyond the optimum capital structure, the cost of capital
increases.
C. No debt in the firm's capital structure will minimize the firm's weighted average cost of
capital.
D. None of these options

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

87. A firm in a stable industry should use

A. a large amount of debt to lower the cost of capital.

B. no debt at all.
C. preferred stock in place of debt.
D. a limited amount of debt to lower the cost of capital.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

11-45
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
88. Although debt financing is usually the cheapest component of capital, it cannot be used in
excess because

A. interest rates may change.

B. the firm's stock price will increase and raise the cost of equity financing.
C. the financial risk of the firm may increase and thus drive up the cost of all sources of
financing.
D. underwriting costs may change.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-05 The cost of capital may eventually increase as larger amounts of financing are utilized.

89. A firm in a cyclical industry should use

A. a large amount of debt to lower the cost of capital.

B. no debt at all.
C. preferred stock in place of debt.
D. a limited amount of debt to lower the cost of capital.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

90. Most firms are able to use ______% debt in their capital structure without exceeding norms
acceptable to creditors and investors.

A. 30-50
B. 40-60
C. 50-70
D. 60-80

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

11-46
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
91. Marginal cost of capital

A. recognizes that cost of capital does not stay constant as more funds are raised.
B. usually provides the same capital budgeting choices as the use of weighted average cost of
capital.
C. can be defined as the cost of capital when no retained earnings are available for expansion.
D. None of these options apply.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-05 The cost of capital may eventually increase as larger amounts of financing are utilized.

92. The weighted average cost of capital is used as a discount rate because

A. it is an indication of how much the firm is earning overall.

B. as long as the cost of capital is earned, the common stock value of the firm will be
maintained.
C. it is comparable to the prevailing market interest rates.
D. returns below the cost of capital will cover all fixed costs associated with capital and provide
an excess return to stockholders.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-01 The cost of capital represents the weighted average cost of the source of financing to the firm.

93. Use of the marginal cost of capital

A. acknowledges that when retained earnings are used up as a source of equity, the cost of
capital rises as new common stock is sold to support more growth.
B. recognizes that the return from the last dollar of funds generated should be greater than or
equal to the cost of the last dollar of funds raised.
C. acknowledges that when retained earnings are used up as a source of equity, the cost of
capital rises as new common stock is sold to support more growth and recognizes that the
return from the last dollar of funds generated should be greater than or equal to the cost of
the last dollar of funds raised.
D. None of these options are correct.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-05 The cost of capital may eventually increase as larger amounts of financing are utilized.

11-47
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
94. The general rule for using the weighted average cost of capital (WACC) in capital budgeting
decisions is to accept all projects with

A. rates of return greater than or equal to the WACC.

B. rates of return less than the WACC.
C. rates of return equal to or less than the WACC.
D. positive rates of return.

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-02 The cost of capital is normally the discount rate to use in analyzing an investment.

95. Oak Enterprises has a beta of 1.2, the market return is 8%, and the T-bill rate is 4%. What is
their expected required return of common equity?

A. Between 11% and 12%

B. Between 8% and 9%
C. Between 7% and 8%
D. Between 4% and 5%

AACSB: Analytic
Blooms: Apply
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

96. All of the following are important considerations for minimizing the cost of capital except:

A. future inflation rates

B. industry debt ratios
C. future economic conditions
D. current coupon rates of outstanding debt

AACSB: Analytic
Blooms: Analyze
Difficulty: Intermediate
Learning Objective: 11-04 A firm attempts to find a minimum cost of capital through varying the mix of its sources of financing.

11-48
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Matching Questions

97. Match the following with the items below:

1. capital asset The distribution expense involved in selling
pricing model securities to the public. 6
The result of multiplying the cost of each item
in the capital structure by its corresponding
2. marginal cost representation in the overall capital structure and
of capital summing the results. 5
Features the best possible mix of debt,
3. optimal capital preferred stock, retained earnings, and new
structure common stock. 3
Determines the value of a share of stock by
4. financial taking the present value of the expected future
capital stream of dividends. 8
5. weighted
average cost of The cost of alternative sources of financing to
capital the firm. 7
Relates the risk-return tradeoffs of individual
6. flotation costs securities to market returns. 1
The cost of the most recent dollars of funds
7. cost of capital raised. 2
8. dividend Appears on the balance sheet under long-term
valuation model liabilities and equity. 4

AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Learning Objective: 11-01 The cost of capital represents the weighted average cost of the source of financing to the firm.
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.
Learning Objective: 11-05 The cost of capital may eventually increase as larger amounts of financing are utilized.

Essay Questions

11-49
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
98. Zinger Corporation manufactures industrial type sewing machines and received a very large
order from a few European countries. In order to be able to supply these countries with its
products, Zinger will have to expand its facilities. Of the required expansion, Zinger feels it can
raise $75 million internally through retained earnings. The firm's optimum capital structure has
been 35% debt, 10% preferred stock, and 55% equity. The company will try to maintain this
capital structure in financing this expansion plan. Currently, Zinger's common stock is traded at
a price of $28 per share. Last year's dividend was $1.50 per share. The growth rate is 8%. The
company's preferred stock is selling at $45 and has been yielding 6% in the current market.
Flotation costs have been estimated at 8% of common stock and 3% of preferred stock. Zinger
Corp. has bonds outstanding at 6%, but its investment banker has informed the company that
interest rates for bonds of equal risk are currently yielding 5%. Zinger's tax rate is 40%.

a) Compute the cost of Kd, Kp, Ke, Kn.

b) Calculate the initial weighted average cost of capital using Ke.
c) How large of a capital budget can the firm support with "retained earnings" financing only?

AACSB: Analytic
Blooms: Apply
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

11-50
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
 Learning Objective: 11-05 The cost of capital may eventually increase as larger amounts of financing are utilized.

99. Jury Company wants to calculate the component costs in its capital structure. Common stock
currently sells for $33, and is expected to pay a dividend of $.50. Jury's dividend growth rate is
8%, and flotation cost is $1.25. Preferred stock sells for $40, pays a dividend of $3.00, and
carries a flotation cost of $1.10. Jury Company bonds yield 7% in the market. Jury is in the
30% tax bracket.
Calculate the cost of debt, cost of new common stock, cost of preferred stock, and cost of
retained earnings.

AACSB: Analytic
Blooms: Apply
Difficulty: Intermediate
Learning Objective: 11-03 The cost of capital is based on the valuation techniques from the previous chapter and is applied to
bonds; preferred stock; and common stock.

100. Given the information about Jury Co. in the previous problem, calculate the company's
weighted average cost of capital assuming that its new financing will consist of 40% debt, 10%
preferred stock, and 50% retained earnings.

AACSB: Analytic
Blooms: Apply
Difficulty: Intermediate
Learning Objective: 11-01 The cost of capital represents the weighted average cost of the source of financing to the firm.

11-51
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
 11-52
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.