Principles of Managerial Finance, 15e (Zutter)

Chapter 9 The Cost of Capital

9.1 Overview of the cost of capital

1) Holding risk constant, the implementation of projects with a rate of return above the cost of capital will
decrease the value of a firm, and vice versa.
Answer: FALSE

2) The cost of common stock equity refers to the cost of the next dollar of financing necessary to finance a
new investment opportunity.
Answer: FALSE

3) The target capital structure is the desired optimal mix of debt and equity financing that firms attempt
to achieve and maintain.
Answer: TRUE

4) The cost of capital is the rate of return a firm must meet or exceed on investments to increase the firm's
value.
Answer: TRUE

5) The cost of capital is used to decide whether a proposed corporate investment will increase or decrease
a firm's stock price.
Answer: TRUE

6) The cost of capital reflects the cost of financing and is the minimum rate of return that a project must
earn to increase firm value.
Answer: TRUE

7) The cost of capital acts as a major link between a firm's long-term investment decisions and the wealth
of the firm's owners as determined by the market value of their shares.
Answer: TRUE

8) The cost of capital of each source of financing is the after-tax cost of obtaining the financing using the
historically based cost reflected by the existing financing on the firm's books.
Answer: FALSE

9) A firm's flotation cost can be calculated by weighting the cost of each source of financing by its relative
proportion in a firm's target capital structure.
Answer: FALSE

10) The cost of capital is a static concept and it is not affected by economic and firm-specific factors such
as business risk and financial risk.
Answer: FALSE

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11) The cost of capital is a dynamic concept and it is affected by economic and firm-specific factors such
as business risk and financial risk.
Answer: TRUE

12) In using the cost of capital, it is important that it reflects the historical cost of raising funds over the
long run.
Answer: FALSE

13) The ________ is the rate of return that a firm must earn on its investments in order to maintain the
market value of its stock.
A) yield to maturity
B) cost of capital
C) internal rate of return
D) modified internal rate of return
Answer: B

14) The ________ is the rate of return required by the market suppliers of capital in order to attract their
funds to the firm.
A) yield to maturity
B) internal rate of return
C) cost of capital
D) modified internal rate of return
Answer: C

15) Although a firm's existing mix of financing sources may reflect its target capital structure, it is
ultimately ________.
A) the internal rate of return that is relevant for evaluating the firm's future investment opportunities
B) the marginal cost of capital that is relevant for evaluating the firm's future investment opportunities
C) the risk-free rate of return that is relevant for evaluating the firm's future investment opportunities
D) the risk-free rate of return that is relevant for evaluating the firm's future financing opportunities
Answer: B

16) The ________ is a weighted average of the cost of funds which reflects the interrelationship of
financing decisions.
A) internal rate of return
B) sunk cost
C) cost of capital
D) risk-free rate
Answer: C

17) The ________ is the firm's desired optimal mix of debt and equity financing.
A) book value
B) market value
C) cost of capital
D) target capital structure
Answer: D

18) In order to recognize the interrelationship between financing and investments, a firm should use
________ when evaluating an investment.
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A) the least costly source of financing
B) the most costly source of financing
C) the weighted average cost of all financing sources
D) the current opportunity cost
Answer: C

19) The four basic sources of long-term funds for a firm are ________.
A) current liabilities, long-term debt, common stock, and preferred stock
B) current liabilities, long-term debt, common stock, and retained earnings
C) long-term debt, paid-in capital in excess of par, common stock, and retained earnings
D) long-term debt, common stock, preferred stock, and retained earnings
Answer: D

20) Most firms finance their activities with a blend of debt and equity.
Answer: TRUE

21) If you purchased the same percentage of each type of security that a firm issued, the expected return
on that portfolio of securities would equal the firm's weighted average cost of capital.
Answer: TRUE

22) Which of the following is true of long-term funds?

A) They provide an easy way to reduce financing costs because they are relatively cheaper than short-
term funds.
B) They are a type of investment fund which invests in money market investments of high quality and
low risk.
C) They are the sources that supply the financing necessary to support a firm's capital budgeting
activities.
D) They are the funds available to a business on the basis of inventory held and require detailed
inventory tracking.
Answer: C

23) Which type of long-term funding is used by the fewest number of firms in the United States?
A) long-term debt
B) preferred stock
C) retained earnings
D) common stock
Answer: D

24) A firm finances its activities with both debt (that costs 8%) and equity (that costs 14%). The firm can
borrow additional funds at 8% if it so desires. A financial analyst at this firm argues that the firm should
undertake any investment that earns a return of at least 8% because such investments will enable the firm
to pay debtholders what they desire, and any earnings above 8% will go to stockholders. If a firm decides
to make investments based on this logic it will ________.
A) decline to make investments that it should undertake
B) undertake investments that it should decline
C) make only those investment decisions that increase shareholder value
D) have exorbitant interest expenses
Answer: B

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25) Which of the following is a source of long-term funds?
A) commercial paper
B) retained earnings
C) factoring
D) money market instruments
Answer: B

26) A firm finances its activities with both debt (that costs 8%) and equity (that costs 14%). The firm can
borrow additional funds at 8% if it so desires. A financial analyst at this firm argues that the firm should
undertake only those investments that earn a return of at least 14% because only those investments will
increase shareholder value If a firm decides to make investments based on this logic it will ________.
A) decline to make investments that it should undertake
B) undertake investments that it should decline
C) make only those investment decisions that increase shareholder value
D) maximize its stock price
Answer: A

9.2 Cost of long-term debt

1) The marginal cost of capital is a relevant cost of capital for evaluating a firm's future investment
opportunities.
Answer: TRUE

2) Generally the least expensive source of long-term capital is ________.

A) retained earnings
B) preferred stock
C) long-term debt
D) common stock
Answer: C

3) In general, floatation costs include two components, underwriting costs and administrative costs.
Answer: TRUE

4) Flotation costs reduce the net proceeds from the sale of a bond whether sold at a premium, at a
discount, or at its par value.
Answer: TRUE

5) The net proceeds used in calculation of the cost of long-term debt are funds actually received from the
sale after paying for flotation costs and taxes.
Answer: TRUE

6) When the net proceeds from sale of a bond equal its par value, the before-tax cost would just equal the
coupon interest rate.
Answer: TRUE

7) From a bond issuer's perspective, the IRR on a bond's cash flows is its yield to maturity (YTM); from
the investor's perspective, the IRR on a bond's cash flows is the cost to maturity.
Answer: FALSE

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8) The cost to maturity that a firm pays on its existing bonds equals the rate of return required by the
market.
Answer: FALSE

9) The weighted average cost of capital represents the annual before-tax percentage cost of the debt.
Answer: FALSE

10) A tax adjustment must be made in determining the cost of ________.

A) long-term debt
B) common stock
C) preferred stock
D) retained earnings
Answer: A

11) The ________ from the sale of a security are the funds actually received from the sale after ________.
A) gross proceeds; adding the after-tax costs
B) gross proceeds; reducing the flotation costs
C) net proceeds; reducing the flotation costs
D) net proceeds; adding the after-tax costs
Answer: C

12) The before-tax cost of debt for a 15-year, 10 percent, $1,000 par value bond selling at $950 is ________.
A) 10 percent
B) 10.7 percent
C) 12 percent
D) 15.4 percent
Answer: B

13) The before-tax cost of debt for a 10-year, 8 percent, $1,000 par value bond selling at $1,150 is ________.
A) 5.97 percent
B) 8.33 percent
C) 8.82 percent
D) 9 percent
Answer: A

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14) The before-tax cost of debt for a firm, which has a marginal tax rate of 21 percent, is 12 percent. The
after-tax cost of debt is ________.
A) 12.00 percent
B) 2.52 percent
C) 9.48 percent
D) 7.20 percent
Answer: C

15) The specific cost of each source of long-term financing is based on ________ and ________ costs.
A) before-tax; historical
B) after-tax; historical
C) before-tax; book value
D) after-tax; current
Answer: D

16) When determining the after-tax cost of a bond, the face value of the issue must be adjusted to the net
proceeds amounts by considering ________.
A) the risks
B) the flotation costs
C) the approximate returns
D) the taxes
Answer: B

17) If a corporation faces a tax rate of 21 percent, the after-tax cost of debt for a 15-year, 12 percent, $1,000
par value bond, selling at $950 is ________.
A) 2.68 percent
B) 12.76 percent
C) 10.08 percent
D) 5.11 percent
Answer: C

18) If a corporation pays a tax rate of 21 percent, the after-tax cost of debt for a 10-year, 8 percent, $1,000
par value bond selling at $1,150 is ________.
A) 4.71 percent
B) 3.58 percent
C) 1.25 percent
D) 6.32 percent
Answer: A

19) The after-tax cost of debt for a 20-year, 7 percent, $1,000 par value bond selling at $960 (assume a
marginal tax rate of 21 percent) is ________.
A) 5.84 percent
B) 4.43 percent
C) 1.55 percent
D) 5.53 percent
Answer: A

20) Debt is generally the least expensive source of capital. This is primarily due to ________.
A) debt's fixed interest payments and finite maturity
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B) the tax deductibility of dividends paid to shareholders
C) debt being less risky than equity and interest payments being tax deductible
D) the secured nature of a debt obligation
Answer: C

21) Nico Trading Corporation is considering issuing long-term debt. The debt would have a 30-year
maturity and a 10 percent coupon rate. In order to sell the issue, the bonds must be underpriced at a
discount of 5 percent of face value. In addition, the firm would have to pay flotation costs of 5 percent of
face value. The firm's tax rate is 21 percent. Given this information, the after-tax cost of debt for Nico
Trading would be ________.
A) 7.26%
B) 8.82%
C) 2.34%
D) 11.17%
Answer: A

22) Recently the corporate tax law in the U.S. changed so that firms that previously faced a marginal tax
rate of close to 40% now pay tax at a flat rate of 21%. Holding everything else constant, this reduction in
the tax rate faced by corporations ________.
A) increased the after-tax cost of debt
B) decreased the after-tax cost of debt
C) did not change the after-tax cost of debt
D) increased the value of the deduction for interest expense
Answer: A

23) Tangshan Mining is considering issuing long-term debt. The debt would have a 30 year maturity and
a 6 percent coupon rate and make semiannual coupon payments. In order to sell the issue, the bonds
must be underpriced at a discount of 1 percent of face value. In addition, the firm would have to pay
flotation costs of 1 percent of face value. The firm's tax rate is 21 percent. Given this information, the after-
tax cost of debt for Tangshan Mining would be ________.
A) 4.74%
B) 1.29%
C) 2.43%
D) 4.86%
Answer: D

9.3 Cost of preferred stock

1) Since preferred stock is a form of ownership, it has no maturity date.
Answer: TRUE

2) Preferred stockholders must receive their stated dividends prior to the distribution of any earnings to
common stockholders and bondholders.
Answer: FALSE

3) The amount of preferred stock dividends that must be paid each year may be stated in dollars or as a
percentage of the firm's earnings.
Answer: FALSE

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4) The cost of preferred stock is typically higher than the cost of long-term debt (bonds) because the cost
of long-term debt (interest) is tax deductible.
Answer: TRUE

5) The cost of preferred stock is the ratio of the preferred stock dividend to a firm's net proceeds from the
sale of the preferred stock.
Answer: TRUE

6) The cost of preferred stock is the ratio of the preferred stock dividend to a firm's total earnings.
Answer: FALSE

7) What is the dividend on an 8 percent preferred stock that currently sells for $45 and has a face value of
$50 per share?
A) $3.33
B) $3.60
C) $4.00
D) $5.00
Answer: C

8) A firm has issued 10 percent preferred stock, which sold for $100 per share par value. The cost of
issuing and selling the stock was $2 per share. The firm's marginal tax rate is 40 percent. The cost of the
preferred stock is ________.
A) 3.9 percent
B) 6.1 percent
C) 9.8 percent
D) 10.2 percent
Answer: D

9) A firm has issued preferred stock at its $125 per share par value. The stock will pay a $15 annual
dividend. The cost of issuing and selling the stock was $4 per share. The cost of the preferred stock is
________.
A) 7.2 percent
B) 12 percent
C) 12.4 percent
D) 15 percent
Answer: C

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10) A firm has determined it can issue preferred stock at $115 per share par value. The stock will pay a
$12 annual dividend. The cost of issuing and selling the stock is $3 per share. The cost of the preferred
stock is ________.
A) 6.4 percent
B) 10.4 percent
C) 10.7 percent
D) 12 percent
Answer: C

11) Tangshan Mining is considering issuing preferred stock. The preferred stock would have a par value
of $75 and a 5.50 percent dividend. What is the cost of preferred stock for Tangshan if flotation costs
would amount to 5.5 percent of par value?
A) 5.50%
B) 5.27%
C) 7.73%
D) 5.82%
Answer: D

9.4 Cost of common stock

1) The cost of common stock equity may be measured using either the constant-growth valuation model
or the capital asset pricing model.
Answer: TRUE

2) The constant-growth model uses the market price as a reflection of the expected risk-return preference
of investors in the marketplace.
Answer: TRUE

3) The cost of common stock equity capital represents the return required by existing shareholders on
their investment.
Answer: TRUE

4) The cost of retained earnings is always lower than the cost of a new issue of common stock due to the
absence of flotation costs when financing projects with retained earnings.
Answer: TRUE

5) In computing the cost of retained earnings, the net proceeds represents the amount of money retained
net of any underpricing and/or flotation costs.
Answer: FALSE

6) The cost of retained earnings is generally higher than both the cost of debt and cost of preferred stock.
Answer: TRUE

7) One measure of the cost of common stock equity is the rate at which investors discount the expected
common stock dividends of the firm to determine its share value.
Answer: TRUE

8) The Gordon model is based on the premise that the value of a share of stock is equal to the sum of all
future dividends it is expected to provide over an infinite time horizon.
Answer: FALSE
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9) Using the Capital Asset Pricing Model (CAPM), the cost of common stock equity is the return required
by investors as compensation for a firm's nondiversifiable risk.
Answer: TRUE

10) Use of the capital asset pricing model (CAPM) in measuring the cost of common stock equity differs
from the constant-growth valuation model in that it directly considers the firm's risk as reflected by beta.
Answer: TRUE

11) When the constant-growth valuation model is used to find the cost of common stock equity capital, it
can easily be adjusted for flotation costs to find the cost of new common stock; the capital asset pricing
model (CAPM) does not provide a simple adjustment mechanism.
Answer: TRUE

12) The cost of new common stock is normally greater than any other long-term financing cost.
Answer: TRUE

13) The capital asset pricing model describes the relationship between the required return, or the cost of
common stock equity capital, and the nonsystematic risk of a firm as measured by the beta coefficient.
Answer: FALSE

14) The capital asset pricing model is used to calculate the effect of increase in prices of capital assets due
to inflation.
Answer: FALSE

15) The Gordon model assumes that the value of a share of stock equals the future value of the current
price of share that it is expected to remain constant over an infinite time horizon.
Answer: FALSE

16) According to the CAPM, the required return of an asset is the sum of risk-free rate of return and beta
times the risk premium.
Answer: TRUE

17) The cost of equity for Tangshan Mining would be roughly 10 percent if the expected return on U.S.
Treasury Bills is 2 percent, the market risk premium is 6 percent, and the firm's beta is 1.33.
Answer: TRUE

18) The cost of retained earnings will always equal the cost of preferred stock.
Answer: FALSE

19) The cost of common stock equity is ________.

A) the cost of the guaranteed stated dividend expected by the stockholders
B) the rate at which investors discount the expected dividends of the firm to determine its share value
C) the after-tax cost of the interest obligations
D) the historical cost of floating the stock issue
Answer: B

20) The cost of common stock equity may be estimated by using the ________.
A) yield curve

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B) break-even analysis
C) Gordon model
D) DuPont analysis
Answer: C

21) The cost of common stock equity may be estimated by using the ________.
A) yield curve
B) capital asset pricing model
C) break-even analysis
D) DuPont analysis
Answer: B

22) The cost of retained earnings is ________.

A) less than the cost of debt
B) equal to the cost of a new issue of common stock
C) equal to the cost of common stock equity
D) irrelevant to the investment/financing decision
Answer: C

23) A corporation that uses both debt and equity in its capital structure has concluded that the risk
premium it must pay on its common stock is too high. To decrease this, the firm can ________.
A) increase the proportion of long-term debt to decrease the cost of capital
B) increase the proportion of short-term debt to decrease the cost of capital
C) decrease the proportion of common stock equity to decrease financial risk
D) increase the proportion of common stock equity to decrease financial risk
Answer: D

24) The constant-growth valuation model is based on the premise that the value of a share of common
stock is ________.
A) the sum of the dividends and expected capital appreciation
B) determined based on an industry standard P/E multiple
C) determined by using a measure of relative risk called correlation coefficient
D) equal to the present value of all expected future dividends
Answer: D

25) In calculating the cost of common stock equity, the model which describes the relationship between
the required return and the nondiversifiable risk of the firm is ________.
A) the constant-growth model
B) the NPV model
C) the variable growth model
D) the capital asset pricing model
Answer: D

26) A firm has a beta of 1.2. The market return equals 14 percent and the risk-free rate of return equals 6
percent. The estimated cost of common stock equity is ________.
A) 6 percent
B) 7.2 percent
C) 14 percent
D) 15.6 percent
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Answer: D

27) One major expense associated with issuing new shares of common stock is ________.
A) coupon payment
B) sunk cost
C) overvaluation
D) underpricing
Answer: D

28) One of the circumstances in which the Gordon growth valuation model for estimating the value of a
share of stock should be used is ________.
A) declining dividends
B) an erratic dividend stream
C) the lack of data on dividend payments
D) a steady growth rate in dividends
Answer: D

29) A firm has common stock with a market price of $25 per share and an expected dividend of $2 per
share at the end of the coming year. The growth rate in dividends has been 5 percent. The cost of the
firm's common stock equity is ________.
A) 5 percent
B) 8 percent
C) 10 percent
D) 13 percent
Answer: D

30) A firm has common stock with a market price of $55 per share and an expected dividend of $2.81 per
share at the end of the coming year. The dividends paid on the outstanding stock over the past five years
are as follows:

The cost of the firm's common stock equity is ________.

A) 4.1 percent
B) 5.1 percent
C) 12.1 percent
D) 15.4 percent
Answer: C

31) Using the capital asset pricing model, the cost of common stock equity is the return required by
investors as compensation for ________.
A) the specific risk of a firm
B) a firm's unsystematic risk
C) price volatility of the stock
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D) a firm's nondiversifiable risk
Answer: D

32) A firm has common stock with a market price of $100 per share and an expected dividend of $5.61 per
share at the end of the coming year. A new issue of stock is expected to be sold for $98, with $2 per share
representing the underpricing necessary in the competitive capital market. Flotation costs are expected to
total $1 per share. The dividends paid on the outstanding stock over the past five years are as follows:

The cost of this new issue of common stock is ________.

A) 5.8 percent
B) 7.7 percent
C) 10.8 percent
D) 12.8 percent
Answer: D

33) In comparing the constant-growth model and the capital asset pricing model (CAPM) to calculate the
cost of common stock equity, ________.
A) the CAPM ignores risk, while the constant-growth model directly considers risk as reflected in the
beta
B) the CAPM directly considers risk as reflected in the beta, while the constant-growth model uses the
market price as a reflection of the expected risk-return preference of investors
C) the CAPM directly considers risk as reflected in the beta, while the constant growth model uses
dividend expectations as a reflection of risk
D) the CAPM indirectly considers risk as reflected in the market return, while the constant growth model
uses dividend expectations as a reflection of risk
Answer: B

34) Given that the cost of common stock is 9 percent, dividends are $0.75 per share and the price of the
stock is $12.50 per share, what is the annual growth rate of dividends?
A) 2 percent
B) 4 percent
C) 3 percent
D) 5 percent
Answer: C

35) What would be the cost of new common stock equity for Tangshan Mining if the firm just paid a
dividend of $4.25, the stock price is $55.00, dividends are expected to grow at 8.5 percent indefinitely, and
flotation costs are $6.25 per share?
A) 17.22%
B) 16.88%
C) 17.96%
D) 12.57%
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Answer: C

36) What would be the cost of retained earnings equity for Tangshan Mining if the expected return on
U.S. Treasury Bills is 5.00%, the market risk premium is 10.00 percent, and the firm's beta is 1.3?
A) 11.5%
B) 18.0%
C) 10.0%
D) 19.5%
Answer: B

37) The cost of new common stock financing is higher than the cost of retained earnings due to ________.
A) flotation costs and underpricing
B) flotation costs and overpricing
C) flotation costs and commission costs
D) commission costs and overpricing
Answer: A

38) Since retained earnings are viewed as a fully subscribed issue of additional common stock, the cost of
retained earnings is ________.
A) less than the cost of new common stock equity
B) equal to the cost of new common stock equity
C) greater than the cost of new common stock equity
D) not related to the cost of new common stock equity
Answer: A

9.5 Weighted average cost of capital

1) The weighted average cost that reflects the interrelationship of financing decisions can be obtained by
weighing the cost of each source of financing by the target proportion in a firm's capital structure.
Answer: TRUE

2) The weighted average cost of capital (WACC) reflects the expected average cost of the different forms
of capital that a firm uses.
Answer: TRUE

3) Since retained earnings is a more expensive source of financing than debt and preferred stock, the
weighted average cost of capital will fall once retained earnings have been exhausted.
Answer: FALSE

4) In computing the weighted average cost of capital, the weights are either book value or market value
weights based on actual capital structure proportions.
Answer: FALSE

5) In computing the weighted average cost of capital the preferred weighting scheme is generally based
on the market values of each source of capital.
Answer: TRUE

6) Weights that use accounting values to measure the proportion of each type of capital in a firm's
financial structure are called market value weights.
Answer: FALSE
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7) Weights that use accounting values to measure the proportion of each type of capital in a firm's
financial structure are called book value weights.
Answer: TRUE

8) A company's target weights refer to the desired mix of debt and equity, based on market values of each
capital source, rather than the current mix of debt and equity.
Answer: TRUE

9) The weights used in weighted average cost of capital must be ________.

A) greater than 50%
B) nonnegative
C) less than zero
D) zero
Answer: B

10) When the market values of a firm's securities have been changing dramatically, the firm may want to
calculate its WACC based on ________.
A) book value weights
B) nominal weights
C) historic weights
D) target weights
Answer: D

11) A firm has determined its cost of each source of capital and the percentage of each source making up
the firm's capital structure:

The weighted average cost of capital is ________.

A) 6 percent
B) 10.7 percent
C) 11 percent
D) 15 percent
Answer: C

12) When discussing weighing schemes for calculating the weighted average cost of capital, ________.
A) market value weights are preferred over book value weights and target weights are preferred over
historical weights
B) book value weights are preferred over market value weights and target weights are preferred over
historical weights
C) book value weights are preferred over market value weights and historical weights are preferred over
target weights
D) market value weights are preferred over book value weights and historical weights are preferred over
target weights
Answer: A
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Table 9.1
A firm has determined its optimal capital structure which is composed of the following sources and
target market value proportions.

Debt: The firm can sell a 12-year, $1,000 par value, 7 percent bond for $960. A flotation cost of
2 percent of the face value would be required in addition to the discount of $40.
Preferred Stock: The firm has determined it can issue preferred stock at $75 per share par value. The
stock will pay a $10 annual dividend. The cost of issuing and selling the stock is $3 per share.
Common Stock: A firm's common stock is currently selling for $18 per share. The dividend expected to
be paid at the end of the coming year is $1.74. Its dividend payments have been growing at a constant
rate for the last four years. Four years ago, the dividend was $1.50. It is expected that to sell, a new
common stock issue must be underpriced $1 per share in floatation costs. Additionally, the firm's
marginal tax rate is 40 percent.

13) The firm's before-tax cost of debt is ________. (See Table 9.1)
A) 7.8 percent
B) 10.6 percent
C) 11.2 percent
D) 12.7 percent
Answer: A

14) The firm's after-tax cost of debt is ________. (See Table 9.1)
A) 3.25 percent
B) 4.67 percent
C) 8 percent
D) 8.13 percent
Answer: B

15) The firm's cost of preferred stock is ________. (See Table 9.1)
A) 7.2 percent
B) 8.3 percent
C) 13.3 percent
D) 13.9 percent
Answer: D

16) The firm's cost of a new issue of common stock is ________. (See Table 9.1)
A) 7 percent
B) 9.08 percent
C) 14.2 percent
D) 13.4 percent
Answer: C

17) The firm's cost of retained earnings is ________. (See Table 9.1)
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A) 10.2 percent
B) 13.9 percent
C) 12.7 percent
D) 13.6 percent
Answer: C

18) The weighted average cost of capital up to the point when retained earnings are exhausted is
________. (See Table 9.1)
A) 7.5 percent
B) 8.65 percent
C) 10.4 percent
D) 11.9 percent
Answer: D

19) If the target market proportion of long-term debt is reduced to 15 percent – increasing the proportion
of common stock equity to 75 percent, what will be the revised weighted average cost of capital? (See
Table 9.1)
A) 13.6 percent
B) 11.0 percent
C) 12.34 percent
D) 10.4 percent
Answer: C

Table 9.2
A firm has determined its optimal structure which is composed of the following sources and target
market value proportions.

Debt: The firm can sell a 15-year, $1,000 par value, 8 percent bond for $1,050. A flotation cost of 2 percent
of the face value would be required in addition to the premium of $50.
Common Stock: A firm's common stock is currently selling for $75 per share. The dividend expected to
be paid at the end of the coming year is $5. Its dividend payments have been growing at a constant rate
for the last five years. Five years ago, the dividend was $3.10. It is expected that to sell, a new common
stock issue must be underpriced $2 per share and the firm must pay $1 per share in flotation costs.
Additionally, the firm has a marginal tax rate of 40 percent.

20) The firm's before-tax cost of debt is ________. (See Table 9.2)
A) 7.7 percent
B) 10.6 percent
C) 11.2 percent
D) 12.7 percent
Answer: A

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21) The firm's after-tax cost of debt is ________. (See Table 9.2)
A) 4.6 percent
B) 6 percent
C) 7 percent
D) 7.7 percent
Answer: A

22) The firm's cost of a new issue of common stock is ________. (See Table 9.2)
A) 10.2 percent
B) 14.3 percent
C) 16.7 percent
D) 15.2 percent
Answer: D

23) The firm's cost of retained earnings is ________. (See Table 9.2)
A) 10.2 percent
B) 14.3 percent
C) 18.9 percent
D) 15.0 percent
Answer: D

24) The weighted average cost of capital up to the point when retained earnings are exhausted is
________. (See Table 9.2)
A) 6.8 percent
B) 7.7 percent
C) 8.7 percent
D) 11.29 percent
Answer: C

25) Assuming the firm plans to pay out all of its earnings as dividends, the weighted average cost of
capital is ________. (See Table 9.2)
A) 10.44 percent
B) 8.9 percent
C) 11.6 percent
D) 12.1 percent
Answer: B

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Table 9.3
Balance Sheet
General Talc Mines
December 31, 2019

26)

Given this after-tax cost of each source of capital, the weighted average cost of capital using book weights
for General Talc Mines is ________. (See Table 9.3)
A) 11.6 percent
B) 15.5 percent
C) 16.6 percent
D) 17.5 percent
Answer: B

27) General Talc Mines has compiled the following data regarding the market value and cost of the
specific sources of capital.

Market price per share of common stock $50

Market value of long-term debt $980 per bond
The weighted average cost of capital using market value weights is ________. (See Table 9.3)
A) 11.7 percent
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B) 13.5 percent
C) 15.8 percent
D) 17.5 percent
Answer: C

28) A firm has determined its optimal capital structure, which is composed of the following sources and
target market value proportions:

Debt: The firm can sell a 20-year, $1,000 par value, 9 percent bond for $980. A flotation cost of 2 percent of
the face value would be required in addition to the discount of $20.
Preferred Stock: The firm has determined it can issue preferred stock at $65 per share par value. The
stock will pay an $8.00 annual dividend. The cost of issuing and selling the stock is $3 per share.
Common Stock: The firm's common stock is currently selling for $40 per share. The dividend expected to
be paid at the end of the coming year is $5.07. Its dividend payments have been growing at a constant
rate for the last five years. Five years ago, the dividend was $3.45. It is expected that to sell, a new
common stock issue must be underpriced at $1 per share and the firm must pay $1 per share in flotation
costs. Additionally, the firm's marginal tax rate is 40 percent.
Calculate the firm's weighted average cost of capital assuming the firm has exhausted all retained
earnings.

Answer: Interest on debt = $1,000 × 9% = $90

Net Proceeds = $1,000 - $20 - ($1,000 × 2%) = $960
Before-tax cost of debt = 9.45% (using financial calculator)
ri = 9.45% × (1-40%) = 5.67%
rp = $8 ÷ ($65 - $3) = 12.9%

Growth = $5.07 = $3.45 × (1 + g)6

- 1 = g = 0.066264 = 6.6264%

Net Proceeds = $40 - 1 - 1 = $38

rn = ($5.07 ÷ $38) + 6.6264% = 19.97%

ra = (0.3) × ($5.67) + (0.05) × (12.9) + (0.65) × (19.97) = 15.30%

0%

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29) Promo Pak has compiled the following financial data:

(a) Calculate the weighted average cost of capital using book value weights.
(b) Calculate the weighted average cost of capital using market value weights.
Answer:
(a)

ra = (0.5) × (5) + (0.05) × (14) + (0.45) × (20) = 2.5 + 0.7 + 9 = 12.2%

(b)

ra = (0.34) × (5) + (0.06) × (14) + (0.60) × (20) = 1.7 + 0.84 + 12 = 14.5%

30) A certain firm originally had capital structure weights of 50% debt and 50% common equity. Since
establishing those weights, the firm's stock price has risen dramatically. The firm has done no additional
borrowing. Assume that nothing else in the economy has changed (e.g., interest rates, tax rates, and other
macroeconomic factors remain constant). Because the firm's stock price has increased a great deal,
________.
A) the firm's cost of equity has increased
B) the firm's cost of debt has increased
C) the firm's WACC has decreased
D) the firm's cost of equity has decreased
Answer: D

31) If a firm's stock price increases and everything else remains constant, the proportion of debt in the
firm's capital structure will fall.
Answer: TRUE

32) Debt is nearly always a less costly source of financing than equity. Does it follow then that most firms
could decrease their WACC if they simply used more debt and less equity in their capital structure?
Answer: Using more debt could possibly lower the WACC, but it is not certain that this will be the
outcome. Debt is less costly than equity, but using more debt increases the cost of the equity that remains
in the firm. Therefore, there is a tradeoff here. Think about a firm that borrows money to repurchase some
of its outstanding stock. The cost of the new debt will be lower than the cost of the equity retired, but the
cost of the equity that remains will be higher than it was before. It is unclear whether the net effect of this
will be to increase or decrease the WACC, or even leave it unchanged.
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