Unit 6 - MCQs Answers

s6: (104) Valuation Methods and Cost of Capital
1: (11) Stock Valuation Methods

2: (31) Cost of Capital – Current
3: (38) Cost of Capital – New
4: (24) Options and Derivatives
1: (11) Stock Valuation Methods
Question: 1 A financial analyst is using the two-stage model of dividend growth to value a
corporation that paid an annual dividend last year of $4 per share. The annual dividend
is assumed to grow at 10% per year for the next 3 years and then grow at 5% per year
thereafter. A 12% required return is assumed. Which change in one of the assumptions
would cause the analyst to find a higher value for the stock?
A. The 3-year assumption is changed to 5 years.

Answer (A) is correct.
This would cause the dividend growth in Years 4 and 5 to increase from 5% to 10%. The
higher future cash flows result in a higher value for the stock.
B. The 10% growth rate is changed to 8%.

Answer (B) is incorrect.
If the dividend grows at a slower rate, the value of the stock will decline because future cash
flows are lower.
C. The required return is changed from 12% to 14%.

Answer (C) is incorrect.
As the required rate of return increases, the value of the stock (present value of an
investment) decreases. Less money would be required up front to achieve the same future
value, since the returns will be higher.
D. The growth rate is changed from 5% to 4%.

Answer (D) is incorrect.
If the dividend grows at a slower rate, the value of the stock will decline because future cash
flows are lower.
Question: 2 The CFO of a publicly traded chemical manufacturer is in the process of evaluating the
company’s dividend policy in relation to shareholder value. The company’s dividend
per share has been held constant at $2.30 for the last 10 years. The CFO would like to
implement a 5% yearly dividend growth policy at the company starting next year. The
CFO has determined that the required return in the market for the company’s stock is
13%.
What is the forecasted value of the company stock in 5 years if the CFO’s dividend
growth policy is implemented?
A. $23.71
Answer (A) is incorrect.
The amount of $23.71 results from incorrectly dividing the next dividend solely by the cost of
capital, failing to subtract the growth rate from the denominator.
B. $30.19
The amount of $30.19 results from incorrectly calculating the next dividend as only $2.415
[$2.30 dividend × (1 + .05 growth rate)], failing to consider that the question asks for the
forecasted value in 5 years.
C. $38.53
Answer (C) is correct.
The dividend discount model (also known as the dividend growth model) is a method of
arriving at the value of a stock by using expected dividends per share and discounting them
back to present value. The expected dividend at the end of 5 years is calculated as
$3.08221997 [$2.30 dividend × (1 + .05 growth rate)6]. Thus, the forecasted value of one
share of stock in 5 years is calculated as $38.53 [$3.08221997 next dividend ÷ (13% cost of
capital – 5% dividend growth rate)].
D. $36.69
The amount of $36.69 results from incorrectly calculating the next dividend as only $2.935
[$2.30 dividend × (1 + .05 growth rate)5].
Question: 3 A company is projecting an annual growth rate for the foreseeable future of 9%. The
most recent dividend paid was $3.00 per share. New common stock can be issued at
$36 per share. Using the constant growth model, what is the approximate cost of
capital for retained earnings?
A. 17.33%
This percentage results from failing to multiply the previous dividend by the growth rate.
B. 19.88%
This percentage overstates the cost of capital.
C. 9.08%
This percentage is calculated by improperly multiplying the current dividend by the projected
growth rate then dividing it by the current issue price per share of common stock.
D. 18.08%
Answer (D) is correct.
The cost of capital can be found using the dividend discount model. In the calculation below,
x is the cost of capital.
Price = Next period dividend ÷ (Cost of capital – Dividend growth rate)
Price = [Current period dividend × (1 + Growth rate)] ÷

(Cost of capital – Dividend growth rate)
$36 = ($3.00 × 1.09) ÷ (x – 9%)
$36x – $3 × 1.09
$3.24 =
$36x – $3.27
$3.24 =
$36x = $6.51
x = 18.08333 or 18.08%
Question: 4 Current-year earnings are $2.00 per share. Using a discounted cash flow model, the
controller determines that the common stock is worth $14 per share. Assuming a 5%
long-term growth rate, the required rate of return is which one of the following?
A. 10%
The amount of 10% incorrectly multiplies the long-term growth rate of 5% by the earnings per
share of $2.00 to calculate the required rate of return.
B. 15%
This answer choice forgets to subtract the dividend growth rate from the cost of capital in the
denominator and thus calculates an incorrect rate of return of 15%.
C. 7%
This answer choice incorrectly multiplies the $14 common stock price times the growth rate
and the dividend of 2 times the growth rate in order to figure out the rate of return. When
those two incorrect figures are multiplied together, it calculates the 7% provided in this
answer choice.
D. 20%
The current-year earnings per share are $2.00. In order to calculate the correct dividend per
share amount when given only the amount of the last annual dividend paid, it is necessary to
adjust to the expected dividend using the growth rate of the company. Thus, the dividends
per share equal $2.10 [$2 × (1 + .05)].
back to present value. The formula is as follows:
The rate of return can now be solved for as follows:
$2.10 ÷ (x – .05) = $14

$2.10 = $14x – .70
$2.80 = $14x
x = 20%
Question: 5 By using the dividend growth model, estimate the cost of equity capital for a firm with a
stock price of $30.00, an estimated dividend at the end of the first year of $3.00 per
share, and an expected growth rate of 10%.
A. 11.0%
The growth rate (10%) plus 10% of the current dividend yield (10%) equals 11.0%.
B. 12.2%
This is a bogus percentage.
C. 20.0%
Under the dividend growth model, the cost of equity equals the expected growth rate plus the
quotient of the next dividend and the current market price. Thus, the cost of equity capital is
20% [10% + ($3 ÷ $30)]. This model assumes that the payout ratio, retention rate, and the
earnings per share growth rate are all constant.
D. 21.1%
The sum of the growth rate (10%) and the dividend incorrectly divided by the share price
discounted one year equals 21.1%.
Question: 6 An analyst is in the process of determining what the current share price should be for a
company. In early January, the analyst collected the following information
• Dividend at end of current year = $1.00

• Yearly dividend increase = 5%
• Expected investor return = 10%
Based on the data provided, the current share price should be
A. $6.67
The dividend discount model is a method of arriving at the value of a stock by using expected
dividends per share and discounting them back to present value. The formula is as follows:
dividend per share ÷ (cost of capital – dividend growth rate). The amount of $6.67 incorrectly
adds the investor return and the dividend growth rate instead of subtracting them from each
other.
B. $7.00
dividend per share ÷ (cost of capital – dividend growth rate). The amount of $7.00 incorrectly
calculates the expected dividend as $1.05 ($1 × 1.05). This is not necessary because the
problem states the dividend at the end of the current year. (NOTE: If given the dividend for
the prior year, then this discounting would apply.) In addition, this option incorrectly adds the
investor return and the dividend growth rate instead of subtracting them from each other.
C. $20.00
dividend per share ÷ (cost of capital – dividend growth rate). Because the dividend at year
end is given, the expected dividend does not need to be calculated. Therefore, the current
share price should be $20 [$1 ÷ (.10 – .05)].
D. $21.00
dividend per share ÷ (cost of capital – dividend growth rate). The amount of $21.00
incorrectly calculates the expected dividend as $1.05 (1 × 1.05). This is not necessary
because the problem states the dividend at the end of the current year. (NOTE: If given the
dividend for the prior year, then this discounting would apply.)
Question: 7 Stock A is currently trading at $50 per share. A financial analyst has collected the
following historical and current data for the stock.
Year Dividend paid during the year
20X1 $2.00
20X2 2.20
20X3 2.42
The stock has a cost of equity capital of 15% and plans to maintain a 100% dividend
payout while maintaining the dividend trend in the future as well. Using the constant
growth dividend discount valuation model, the analyst concludes that the value of
Stock A in 20X3 would be
A. $48.40
The amount of $48.40 assumes no growth in dividends beyond the third year.
B. $44.00
The amount of $44.00 assumes no growth in dividends beyond the second year.
C. $40.00
The amount of $40.00 assumes no growth in dividends.
D. $53.24
The constant growth dividend discount model is a method that arrives at the value of a stock
by using expected dividends per share and discounting them back to present value. The
formula involves dividing the expected dividends per share by the discount rate minus the
dividend growth rate. The dividends are expected to increase by 10% each year ($2.20 ÷
2.00 = 110%; $2.42 ÷ 2.20 = 110%). Accordingly, the calculation would be to divide the
expected dividend of $2.662 [$2.42 × (1 + .10)] by a rate of 5% (15% – 10%). Thus, the value
of Stock A in 20X3 is $53.24 ($2.662 ÷ .05).
Question: 8 A public company’s shareholders expect to receive a dividend 1 year from now of $20
per share. Immediately after the dividend payout, analysts are expecting that the stock
will trade at $244 per share. If the investors have a required rate of return of 20%, what
is the current value of the stock?
A. $244
The current value of the stock is not equal to the future expected value of the stock. The
dividend and the shareholders’ required rate of return must be considered.
B. $264
The current value of the stock is not found by adding the dividend amount to the expected
future value of the stock.
C. $220
One method of valuing stock is shareholder return, which measures the return on a purchase
of stock. Shareholder return is equal to the required rate of return. In this case, the current
value of the stock is equal to the beginning stock price. In the calculation below, x is the
beginning stock price.
Shareholder = (Ending stock price – Beginning stock price + Annual dividends per share) ÷
return Beginning stock price
20% = ($244 – x + $20) ÷ x
0.2x = $264 – x
1.2x = $264
x = $220
D. $224
The amount of $224 does not consider the appreciation in share price as part of the
shareholder’s return
Question: 9 A corporation just paid a dividend of $2.00 per common share. Historical data indicate
that dividends grow at a steady rate of 5% per year. The required rate of return for
investing in such stock is 18%. The current value of one share of common stock is
A. $11.67
The value of $11.67 fails to include the dividend growth rate in the calculation and divides the next
dividend by the cost of capital.
B. $16.15
Answer (B) is correct.
back to present value. The next dividend is calculated as $2.10 [$2.00 dividend × (1 + .05
growth rate)]. Thus, the current value of one share of common stock is calculated as $16.15
[$2.10 next dividend ÷ (18% cost of capital – 5% dividend growth rate)].
C. $11.11
The value of $11.11 fails to include the dividend growth rate in the calculation and divides the
dividend by the cost of capital. Furthermore, the next dividend of $2.10 must be used rather
than the most recent dividend.
D. $15.38
The value of $15.38 uses the most recent dividend rather than the next dividend of $2.10
Question: 10 The CFO of a publicly traded company is expecting to pay a dividend next year of
$1.25 and projecting that the price of the company’s stock will be $45 in 1 year. The
CFO has determined that the required rate of return for the company is 10%. Based on
the data available, what is the value of one share of stock today?
A. $51.39
The value of one share of stock today is the price of the stock at the end of the year plus the dividend
received, discounted back 1 year by the required rate of return.
B. $45.00
The value of one share of stock also includes the dividend expected to be paid. Since the
question asked for the value today, the stock price must be discounted back 1 year.
C. $46.25
This is the value of one share of stock at the end of the year. However, this amount must be
discounted back 1 year to reflect the value of one share today.
D. $42.05
The value of one share of stock today is the price of the stock at the end of the year plus the
dividend received, discounted back 1 year by the required rate of return. Thus, the value of
the stock at the end of the year is $46.25 ($45 plus the $1.25 dividend). This must be
discounted back to today to equal $42.05 ($46.25 ÷ 1.10).
Question: 11 A manufacturer of printers is attempting to determine its cost of common equity for cost
of capital purposes. The manufacturer’s long-term debt is rated AA by Standard &
Poor’s. The manufacturer’s common shares trade on the NASDAQ and the current
market price is $26.87. The most recent yearly common share dividend paid common
shareholders was $1.04. The consensus forecast of security analysts who follow the
manufacturer’s common shares is that earnings growth will average 12.5% over the
long term. The manufacturer’s marginal income tax rate is 40%. Using the dividend
discount model, what is the manufacturer’s cost of equity capital for cost of capital
purposes?
A. 10.11%
The figure of 10.11% fails to use to next dividend rather than the most recent dividend and
subtracts the dividend over the market price from the growth rate. Furthermore, the market
price should not be multiplied by 1 minus the tax rate.
B. 16.37%
The next dividend, $1.17, must be used instead of $1.04.
C. 16.85%
Under the dividend growth model, the cost of equity equals the expected growth rate plus the
quotient of the next dividend and the current market price. The next dividend is calculated as
$1.17 [$1.04 dividend × (1 + .125 growth)]. Thus, the cost of equity capital is 16.85% [12.5%
+ ($1.17 ÷ $26.87)]. This model assumes that the payout ratio, retention rate, and the
earnings per share growth rate are all constant.
D. 9.82%
The figure of 9.82% subtracts the next dividend over the market price from the growth rate.
Furthermore, the market price should not be multiplied by 1 minus the tax rate.
2: (31) Cost of Capital – Current
Question: 1 The following is an excerpt from a balance sheet:
Long-term debt (9% interest rate) $30,000,000
Preferred stock (100,000 shares, 12% dividend) 10,000,000
Common stock (5,000,000 shares outstanding) 60,000,000

Bonds are currently trading at $1,083.34, reflecting a yield to maturity of 8%. The
preferred stock is trading at $125 per share. Common stock is selling at $16 per share,
and the treasurer estimates that the firm’s cost of equity is 17%. If the effective income
tax rate is 40%, what is the firm’s cost of capital?
A. 13.09%
The effective rate for the debt is the after-tax cost [8% yield × (1.0 – .40 tax rate) = 4.8%].
The component cost of preferred stock equals the cash dividend divided by the market price
[($100 × 12%) ÷ $125 = 9.6%]. Thus, the weighted-average cost of capital (WACC) is
calculated as follows:
Market Value Weight Cost of Capital Weighted Cost
Long-term debt $ 32,500,2001 26% × 4.8% = 1.25%
Preferred stock 12,500,0002 10% × 9.6% = .96%
Common stock 80,000,0003 64% × 17.0% = 10.88%
Totals $125,000,200 100% 13.09%
1 ($1,083.34 market ÷ $1,000 carrying amount) × $30,000,000 = $32,500,200
2 $125 market price × 100,000 shares outstanding = $12,500,000
3 $16 market price × 5,000,000 shares outstanding = $80,000,000
B. 14.18%
The percentage of 14.18% results from improperly using the bonds’ nominal rate.
C. 12.67%
The percentage of 12.67% results from calculating a simple average of the rate of the bonds,
the rate of the preferred stock, and the estimated cost of equity.
D. 13.86%
The percentage of 13.86% results from using the bonds’ yield rather than the after-tax
interest cost.
Question: 2 An accountant must calculate the weighted average cost of capital of the corporation
using the following information.
Component
Cost
Accounts payable $35,000,000 -0-
Long-term debt 10,000,000 8%
Common stock 10,000,000 15%
Retained earnings 5,000,000 18%

What is the weighted average cost of capital?
A. 12.80%

Since the effect of income taxes is ignored in this situation, the stated rate on long-term debt is
considered to be its effective rate. The weighted-average cost of capital (WACC) can thus be calculated
as follows:
Carrying Amount Weight Cost of Capital Weighted Cost
Long-term debt $10,000,000 40% × 8% = 3.2%
Common stock 10,000,000 40% × 15% = 6.0%
Retained earnings 5,000,000 20% × 18% = 3.6%
Totals $25,000,000 100% 12.8%

B. 10.25%
This percentage results from improperly performing a simple average on the four balance
sheet items listed.
C. 8.00%
This percentage is the component cost of debt.
D. 6.88%
This percentage results from improperly ignoring the weighted cost of common stock.
Question: 3 The cost of debt most frequently is measured as
A. Actual interest rate minus tax savings.

The cost of debt most frequently is measured as the after-tax interest rate on the debt.
Therefore, the component cost is equal to the effective rate multiplied by 1 minus the
marginal tax rate.
B. Actual interest rate plus a risk premium.

The risk premium is applicable when calculating the cost of retained earnings, not the cost of
debt.
C. Actual interest rate adjusted for inflation.

The effective rate already takes inflation into consideration. The actual interest rate does not
have to be adjusted periodically for inflation. In addition, the tax savings are ignored in this
option.
D. Actual interest rate.
The cost of debt takes into account the deductibility of interest by subtracting the tax savings
from the actual interest rate.
Question: 4 In calculating the component costs of long-term funds, the appropriate cost of retained
earnings, ignoring flotation costs, is equal to
A. The cost of common stock.

Common shareholders expect retained earnings to be paid out in the form of dividends. Thus, the cost
of retained earnings is an opportunity cost, i.e., the rate that investors can earn elsewhere on
investments of comparable risk.
B. The weighted average cost of capital for the firm.

The weighted-average cost of capital is an average of all sources of long-term funds.
C. Zero, or no cost.
All sources of funds have a cost to the corporation.
D. The same as the cost of preferred stock.

The cost of preferred stock is based on its stated dividend rate, regardless of the amount of
retained earnings available.
Question: 5 A firm needs to raise $50,000,000 for expansion. The two available options are to sell
7%, 10-year bonds at face value or to sell 5% preferred stock at par for which annual
dividends would be paid. The firm’s effective income tax rate is 30%. Which one of the
following best describes the difference in the firm’s cash flow for the second year after
issue?
A. Cash flow with the stock issue is $700,000 higher.
Cash flows do not vary this much between the two options.
B. Cash flow with the stock issue is $525,000 higher.

Cash flow with the stock issue is not higher than the bond issue.
C. Cash flow with the bond issue is $225,000 higher.

The amount of $225,000 results from finding a rate difference of .45%.
D. Cash flow with the bond issue is $50,000 higher.

Under the bond issue option, cash flows will consist of interest payments as well as the tax
shield effect of debt. Therefore, cash outflows will be $2,450,000 {$50,000,000 × [.07 × (1 –
.3)]}. Under the preferred stock option, cash flows will consist of payments of dividends, with
no tax shield effect. Therefore, cash outflows will be $2,500,000 ($50,000,000 × .05).
Therefore, cash flow is $50,000 higher under the bond issue option.
Question: 6 What is the weighted average cost of capital for a firm using 65% common equity with
a return of 15%, 25% debt with a return of 6%, 10% preferred stock with a return of
10%, and a tax rate of 35%?
A. 12.250%
The amount of 12.250% ignores the tax savings on debt capital.
B. 11.275%
Using the complement of the tax rate instead of the tax rate to calculate the tax shield results
in 11.275%.
C. 10.333%
The amount of 10.333% is an unweighted average of the three costs and ignores the tax
shield.
D. 11.725%

The cost for equity capital is given as 15%, and preferred stock is 10%. The before-tax rate for debt is
given as 6%, which translates to an after-tax cost of 3.9% [6% × (1.0 – .35)]. The rates are weighted as
follows:
Component Weighted
Component Weight Cost Cost
Long-term debt 25% × 3.9% = .975%
Preferred stock 10% × 10.0% = 1.000%
Common stock 65% × 15.0% = 9.750%
11.725%
Question: 7 A firm’s target or optimal capital structure is consistent with which one of the following?
A. Minimum weighted-average cost of capital.

Ideally, a firm will have a capital structure that minimizes its weighted-average cost of capital.
This requires a balancing of both debt and equity capital and their associated risk levels.
B. Minimum risk.
The minimum risk may be associated with high costs.
C. Minimum cost of debt.

The cost of equity capital must also be considered when optimizing capital structure.
D. Maximum earnings per share.

EPS is based on the relationship between costs and revenues, whereas the capital structure
is related only to the cost of capital.
Question: 8 A company is in the process of considering various methods of raising additional

capital to grow the company. The current capital structure is 25% debt totaling $5
million with a pre-tax cost of 10%, and 75% equity with a current cost of equity of 10%.
The marginal income tax rate is 40%. The company’s policy is to allow a total debt to
total capital ratio of up to 50% and a maximum weighted-average cost of capital
(WACC) of 10%. The company has the following options.
1. Option 1: Issue debt of $15 million with a pre-tax cost of 10%.

2. Option 2: Offer shares to the public to generate $15 million. The cost of equity
is 10%.
Which option should the company select?
A. Option 2 because the equity to total capital ratio will be 86%.

Before considering any options, the total capital is $20 million ($5 million ÷ 25%) and equity is
$15 million ($20 million total capital – $5 million debt). If the company issues $15 million in
debt, the capital structure will consist of 57% debt and 43% equity, which exceeds the 50%
debt to total equity limit. If the company issues $15 million in stock, the capital structure will
consist of 14% debt and 86% equity with a WACC of 9.44% {[14% × 10% × (1 – 40%)] +
[86% × 10%]}. Thus, the company should choose Option 2 because it meets all requirements.
B. Option 1 because the equity to total capital ratio will be 43%.

The company cannot choose Option 1 because Option 1’s debt to total capital ratio is 57%.
C. Option 1 because it has the lower WACC of 7.72%.

The company cannot choose Option 1 because Option 1’s debt to total capital ratio exceeds
50%.
D. Either Option 1 or 2 because both will yield a WACC of 10%.
The company can only choose Option 2 because Option 1’s debt to total capital ratio exceeds 50%.
Question: 9 If k is the cost of debt and t is the marginal tax rate, the after-tax cost of debt, ki,
is best represented by the formula
A. ki = k(t)
The cost of debt times the marginal tax rate equals the tax savings from issuing
debt
B. ki= k ÷ (1 – t)
The after-tax cost of debt is the cost of debt times the quantity one minus the tax rate.
C. ki = k(1 – t)
The after-tax cost of debt is the cost of debt times the quantity one minus the tax rate. For
example, the after-tax cost of a 10% bond is 7% [10% × (1 – 30%)] if the tax rate is 30%.
D. ki= k ÷ t
The after-tax cost of debt is the cost of debt times the quantity one minus the tax rate.
Question: 10 A company with a combined federal and state tax rate of 30% has the following capital
structure:
Cost of
Weight Instrument Capital
40% Bonds 10%

50% Common stock 10%
10% Preferred stock 20%

What is the weighted-average after-tax cost of capital for this company?
A. 9.8%
The company’s weighted-average cost of capital can be calculated as follows:
Cost of Tax Weighted
Weight Capital Effect Cost
Bonds 40% × 10% × 70% = 2.8%
Common equity 50% × 10% = 5.0%
Preferred stock 10% × 20% = 2.0%
Totals 100% 9.8%
B. 7.7%
There is no tax savings associated with common stock and preferred stock.
C. 8.2%
To calculate the after-tax cost of capital, the component should be multiplied by 1 minus the
tax rate, not the tax rate itself.
D. 3.3%
To calculate the after-tax cost of capital, the component should be multiplied by 1 minus the
tax rate, not the tax rate itself. Additionally, there is no tax savings associated with common
and preferred stock.
Question: 11 A firm issued $100,000, 15-year term bonds with a coupon rate of 8% at par. Interest is
paid annually to bondholders. The firm’s effective income tax rate is 35%. The firm
used the proceeds to complete the purchase of a supplier whose effective income tax
rate is 20%. What is the after-tax cost of debt?
A. 8%
The figure of 8% is the before-tax cost of debt.
B. 5.2%
Since the bond is issued at par, the coupon rate is equal to the effective rate. The after-tax
cost of debt is found by multiplying the effective rate by 1 minus the effective tax rate.
Therefore, the answer is 5.2% [8% × (1 – .35)].
C. 6.4%
The firm’s effective income tax rate should be used, not the supplier’s.
D. 3.6%
The tax rates should not be added together; only the firm’s effective income tax rate should
be used.
Question: 12 What is the after-tax cost of preferred stock that sells for $5 per share and offers a
$0.75 dividend when the tax rate is 35%?
A. 5.25%
Using the complement of the tax rate to reduce the effective cost results in 5.25%.
B. 9.75%
This percentage reduces the cost by the tax rate, which is not appropriate since preferred
dividends are not deductible for tax purposes.
C. 10.50%
This percentage assumes a 30% tax rate and deductibility of dividends.
D. 15%
The component cost of preferred stock is the dividend yield, i.e., the cash dividend divided by
the market price of the stock ($.75 ÷ $5.00 = 15%). Preferred dividends are not deductible for
tax purposes.
Question: 13 A firm’s $1,000 par value preferred stock paid its $100 per share annual dividend on
April 4 of the current year. The preferred stock’s current market price is $960 a share
on the date of the dividend distribution. The firm’s marginal tax rate (combined federal
and state) is 40%, and the firm plans to maintain its current capital structure
relationship. The component cost of preferred stock to the firm would be closest to
A. 6.25%
There is no tax deductibility of preferred dividend
B. 10.4%
The component cost of preferred stock is equal to the dividend yield, i.e., the cash dividend
divided by the market price of the stock. (Dividends on preferred stock are not deductible for
tax purposes; therefore, there is no adjustment for tax savings.) The annual dividend on
preferred stock is $100 when the price of the stock is $960. This results in a cost of capital of
about 10.4% ($100 ÷ $960).
C. 10%
The denominator is the current market price, not the par value.
D. 6%
There is no tax deductibility of preferred dividends and the denominator is the current market
price, not the par value.
Question: 14 In referring to the graph of a firm’s cost of capital, if e is the optimal position, which one
of the following statements best explains the saucer or U-shaped curve?
A. The cost of capital is almost always negatively influenced by increases in financial leverage.
Increased leverage is initially favorable.
B. Use of at least some debt financing will enhance the value of the firm.
The U-shaped curve indicates that the cost of capital is quite high when the debt-to-equity
ratio is quite low. As debt increases, the cost of capital declines as long as the cost of debt is
less than that of equity. Eventually, the decline in the cost of capital levels off because the
cost of debt ultimately rises as more debt is used. Additional increases in debt (relative to
equity) will then increase the cost of capital. The implication is that some debt is present in
the optimal capital structure because the cost of capital initially declines when debt is added.
However, a point is reached (e) at which debt becomes excessive and the cost of capital
begins to rise.
C. The composition of debt and equity does not affect the firm’s cost of capital.
The composition of the capital structure affects the cost of capital since the components have
different costs.
D. The cost of capital is almost always favorably influenced by increases in financial leverage.
The cost of debt does not remain constant as financial leverage increases. Eventually, that
cost also increases.
Question: 15 A firm has $10 million in equity and $30 million in long-term debt to finance its
operations. The firm’s beta is 1.125, the risk-free rate is 6%, and the expected market
return is 14%. The firm issued long-term debt at the market rate of 9%. Assume the
firm is at its optimal capital structure. The firm’s effective income tax rate is 40%. What
is the firm’s weighted average cost of capital?
A. 10.5%
Failing to take the tax effect of debt into account results in 10.5%.
B. 9.5%
The WACC is determined by multiplying the cost of each component of capital by its
proportion.
C. 7.8%
Using the Capital Asset Pricing Model, the cost of equity is calculated as follows.
Required rate of return = Risk-free return + beta × (Market return – Risk-free return)
= 6% + 1.125 × (14% – 6%)
= 15%
The firm calculates its WACC as follows:
Component Weight Component Cost Weighted Cost
Debt 75% × 9% × (1.0 – .4) = 4.05%

Equity 25% × 15% = 3.75%
7.80%
D. 8.6%
Using the wrong weights results in 8.6%. Total capital consists of 75%, not 66.6%, of debt
and 25%, not 33.3%, of equity.
Question: 16 A company has the following financial information:
Proportion of
Source of capital capital structure Cost of capital
Long-term debt 60% 7.1%
Preferred stock 20% 10.5%
Common stock 20% 14.2%

To maximize shareholder wealth, the company should accept projects with returns
greater than what percent?
A. 7.1%
The threshold for accepting projects should be the weighted-average cost of all sources of
capital, not just debt.
B. 10.6%
The WACC is determined by multiplying the cost of each component of capital by its
proportion, not by taking their average.
C. 14.2%
The threshold for accepting projects should be the weighted-average cost of all sources of
capital, not just common stock.
D. 9.2%

The company should not accept projects that have a lower return than the after-tax weighted-average
cost of capital, calculated as follows:
Cost of Weighted
Weight Capital Cost
Long-term debt 60% × 7.1% = 4.26%
Preferred stock 20% × 10.5% = 2.10%
Common equity 20% × 14.2% = 2.84%
Totals 100% 9.20%
Question: 17 The capital structure of an airline company is comprised of 50% common stock, 30%
preferred stock, and 20% debt. The company’s cost of common stock is 12%, and the
cost of preferred stock is 10%. The company’s pretax cost of debt is 5%. The company
has an effective income tax rate of 30%. What is the company’s weighted average cost
of capital?
A. 18.9%
The amount of 18.9% is not meaningful in this context because it is higher than
any of the component parts.
B. 8.8%
The amount of 8.8% incorrectly attributes a tax benefit to preferred, which is not available.
C. 10.0%
A WACC of 10% is found by failing to apply the effective income tax rate to the debt
component of capital.
D. 9.7%
A firm’s weighted-average cost of capital is a single, composite rate of return on its combined
components of capital. The company’s weighted average cost of capital (WACC) can be
found as follows:
WACC = (50% × 12%) + (30% × 10%) + (20% × 5%) × (1 – 30%) = .097 = 9.7%
Question: 18 When calculating the cost of capital, the cost assigned to retained earnings should be
A. Lower than the cost of external common equity.

Newly issued or external common equity is more costly than retained earnings. The company
incurs issuance costs when raising new, outside funds.
B. Zero.
The cost of retained earnings is the rate of return shareholders require on equity capital the
firm obtains by retaining earnings. The opportunity cost of retained funds will be positive.
C. Equal to the cost of external common equity.

Retained earnings will always be less costly than external equity financing. Earnings retention
does not require the payment of issuance costs.
D. Higher than the cost of external common equity.

Retained earnings will always be less costly than external equity financing. Earnings retention
does not require the payment of issuance costs.
Question: 19 The weighted-average cost of capital is equal to the
A. Average rate of return a firm earns on its assets.

The weighted-average cost of capital is neither a cost nor a required return: it is a weighted
average of a cost and a required return.
B. Rate of return on assets that covers the costs associated with the funds employed.
The weighted-average cost of capital represents the minimum rate of return at which a
company produces value for its investors. Therefore, it is the return on assets that covers the
company’s costs.
C. Cost of the firm’s equity capital at which the market value of the firm will remain unchanged.
Weighted-average cost of capital takes the cost of debt into consideration as well.
D. Minimum rate a firm must earn on high-risk projects.

This is the internal rate of return for high-risk projects.
Question: 20 A company is planning an expansion program estimated to cost $100 million. The company is going to raise fun
shown below.
Debt .30
Preferred stock .24
Equity .46
The company had net income available to common shareholders of $184 million last year of which 75% was pa
marginal tax rate of 40%.
Additional data:
• The before-tax cost of debt is estimated to be 11%.

• The market yield of preferred stock is estimated to be 12%.
• The after-tax cost of common stock is estimated to be 16%.
What is the company’s weighted average cost of capital?
A. 13.54%
This percentage results from improperly using the before-tax cost of debt.
B. 13.00%
This percentage results from performing a simple average cost calculation on the individual
components of capital.
C. 12.22%
The effective rate for the company’s debt is the after-tax cost [11% × (1.0 – .40 tax rate) =
6.6%] The weighted average cost of capital (WACC) can thus be calculated as follows:
Carrying Amount Weight Cost of Capital Weighted Cost
Debt $ 30,000,000 30% × 6.6% = 1.98%
Preferred stock 24,000,000 24% × 12.0% = 2.88%
Common equity 46,000,000 46% × 16.0% = 7.36%
Totals $100,000,000 100% 12.22%

D. 14.00%
This percentage results from performing a simple average on just the preferred stock and
common equity components.
Question: 21 A company’s capital structure consists of 30% long-term debt, 25% preferred stock,
and 45% common equity. The cost of capital for each component is shown below.
Long-term debt 8%
Preferred stock 11%
Common equity 15%

If the company pays taxes at the rate of 40%, what is the company’s after-tax weighted
average cost of capital?
A. 10.94%

The effective rate for debt is the after-tax cost [8% × (1.0 – .40 tax rate) = 4.8%]. The weighted-average
cost of capital (WACC) can thus be calculated as follows:
Weight Cost of Capital Weighted Cost
Long-term debt 30% × 4.8% = 1.44%
Common equity 45% × 15.0% = 6.75%
Totals 100% 10.94%
B. 9.84%
This percentage results from improperly applying the tax effect to the rate on preferred stock
C. 11.90%
This percentage results from failing to adjust the rate on debt for the tax effect.
D. 7.14%
This percentage results from improperly applying the tax effect to the rates on preferred stock
and common equity.
Question: 22 A company has a weighted-average cost of capital of 12.8%. If the after-tax cost of
debt is 8%, and the weight on debt is 20%, what is the company’s cost of equity?
Assume the company has no preferred stock.
A. 26.0%
The company’s cost of equity calculated using the WACC formula equals 14%.
B. 14.0%
The company’s cost of equity can be calculated using the WACC formula.
WACC = Weight on equity × Cost of equity + Weight on debt × Cost of debt
12.8% = 80% × Cost of equity + 20% × 8%
12.8% = 80% × Cost of equity + 1.6%
11.2% = 80% × Cost of equity
14% = Cost of equity
C. 18.0%
D. 11.2%
This amount must be divided by the weight on equity of 80% (100% – 20% weight on debt).
Question: 23 Which of the following, when considered individually, would generally have the effect of
increasing a firm’s cost of capital?
I. The firm reduces its operating leverage.

II. The corporate tax rate is increased.
III. The firm pays off its only outstanding debt.
IV. The Treasury Bond yield increases.
V.
A. I, III and IV.

Reducing operating leverage means reducing the amount of fixed costs used in the
organization’s production process would lower the cost of capital.
B. III and IV.

Debt generally has a lower initial cost than equity. By removing debt from the firm’s financing
structure, the cost of capital is thereby increased. Similarly, the increase in yield on Treasury
bonds, a risk-free rate, would cause the yield on all other bonds to also increase.
C. I and III.
Reducing operating leverage means reducing the amount of fixed costs used in the
organization’s production process; this would make the firm less risky and therefore lower the
cost of capital.
D. II and IV.
Interest is paid before the calculation of taxes but dividends are paid from after-tax income; a
rise in the corporate tax rate thus would lower the firm’s cost of capital because the firm
would receive a higher tax shield.
Question: 24 Joint Products, Inc., a corporation with a 40% marginal tax rate, plans to issue
$1,000,000 of 8% preferred stock in exchange for $1,000,000 of its 8% bonds currently
outstanding. The firm’s total liabilities and equity are equal to $10,000,000. The effect
of this exchange on the firm’s weighted average cost of capital is likely to be
A. A decrease, since preferred stock payments do not need to be made each year, whereas debt
payments must be made.
The preferred stock has a higher effective rate, leading to an increase in the cost of capital.
B. A decrease, since a portion of the debt payments are tax deductible.

The cost of capital will increase (debt is being replaced by preferred stock, not the other way
around).
C. An increase, since a portion of the debt payments are tax deductible.

The payment of interest on bonds is tax-deductible, whereas dividends on preferred stock
must be paid out of after-tax earnings. Thus, when bonds are replaced in the capital structure
with preferred stock, an increase in the cost of capital is likely because there is no longer a
tax shield.
D. No change, since it involves equal amounts of capital in the exchange and both instruments
have the same rate.
While the dollar amounts may be equal, the different effective rates on the two instruments
will cause a change in the cost of capital.
Question: 25 A company’s capital structure consists entirely of long-term debt and common equity.
The cost of capital for each component is shown below.
Long-term debt 8%
Common equity 15%

The company pays taxes at a rate of 40%. If the weighted-average cost of capital is
10.41%, what proportion of the company’s capital structure is in the form of long-term
debt?
A. 45%
The effective rate for debt (8%) is a pre-tax rate. But the component cost of debt used to calculate the
weighted-average cost of capital (WACC) is an after-tax rate. The effective rate for debt is given as
8%. The component cost of debt is the after-tax cost, or .048 [(1.0 – .40 tax rate) × .08]. The formula
for the WACC is solved as follows:
(Debt weight × Cost of debt) + (Equity weight × Cost of equity) = WACC
(Debt weight × .048) + (Equity weight × .15) = .1041
[(1 – Equity weight) × .048] + (Equity weight × .15) = .1041
.048 – (.048 × Equity weight) + (Equity weight × .15) = .1041
– (.048 × Equity weight) + (Equity weight × .15) = .0561
Equity weight × .102 = .0561
Equity weight = .55

Equity is 55% of the capital structure and debt is 45%
B. 66%
This percentage results from improperly subtracting the percentage of common equity rather
than the tax rate [8% × (1.0 – .15) = 6.8%] and (6.8 ÷ 10.41) = 65.32%.
C. 55%
This percentage is the proportion of WACC in the form of common equity.
D. 34%
This percentage results from simply dividing the 8% pre-tax cost of debt by the 15% cost of
common stock.
Question: 26 A company has $150 par value preferred stock with a market price of $120 a share.
The organization pays a $15 per share annual dividend. The company’s current
marginal tax rate is 40%. Looking to the future, the company anticipates maintaining its
current capital structure. What is the component cost of preferred stock to the
company?
A. 7.5%
The preferred stock dividend is not deductible for tax purposes
B. 12.5%
The component cost of preferred stock is the dividend divided by the market price (also called
the dividend yield). No tax adjustment is necessary because dividends are not deductible.
Since the market price is $120 when the dividend is $15, the component cost of preferred
capital is 12.5% ($15 ÷ $120).
C. 10%
The denominator is the market price, not the par value.
D. 6%
The preferred stock dividend is not deductible for tax purposes and the denominator is the
market price, not the par value.
Question: 27 A firm has determined that it can minimize its weighted average cost of capital (WACC)
by using a debt-equity ratio of 2/3. If the firm’s cost of debt is 9% before taxes, the cost
of equity is estimated to be 12% before taxes, and the tax rate is 40%, what is the
firm’s WACC?
A. 10.80%
Improperly using the before-tax cost of debt results in 10.80%.
B. 9.36%
A firm’s weighted-average cost of capital (WACC) is derived by weighting the (after-tax) cost
of each component of the financing structure by its proportion of the financing structure as a
whole. The firm’s WACC can be calculated as follows:
Component
Component Weight Cost Totals
Debt 40% × 5.4% = 2.16%

Equity 60% × 12.0% = 7.20%
9.36%
C. 7.92%
Improperly subtracting the effect of taxes from equity, but not from debt, results in 7.92%.
D. 6.48%
Improperly subtracting the effect of taxes from the cost of equity results in 6.48%
Question: 28 What is the weighted average cost of capital for a firm with 40% long-term debt, 20%
preferred stock, and 40% common equity if the respective before-tax costs for these
components are 8%, 13%, and 17%? The firm’s tax rate is 35%.
A. 10.22%
This percentage assumes that dividends on common equity (instead of debt) are tax deductible, which
is incorrect.
B. 8.5%
Simply averaging the unweighted costs of debt and equity results in 8.5%.
C. 8.7%

The firm’s cost of capital can be calculated as follows:
Market Component Weighted
Value Weight Cost Cost
Debt $1,000,000 33.33% × 8% = 2.67%
Equity 2,000,000 66.67% × 9% = 6.00%
Totals $3,000,000 100.00% 8.67%
D. 8.0%
The cost of debt financing only is 8.0%.
Question: 30 What is the weighted average cost of capital for a firm with equal amounts of debt and
equity financing, a 15% before-tax company cost of equity capital, a 35% tax rate, and
a 12% coupon rate on its debt that is selling at par value?
A. 11.40%
The 12% debt coupon rate is reduced by the 35% tax shield, resulting in a cost of debt of
7.8% [12% × (1.0 – .35)]. The average of the 15% equity capital and 7.8% debt is 11.4%.
B. 8.775%
This percentage assumes that dividends on equity capital are tax deductible.
C. 13.50%
This percentage overlooks the tax shield on the debt capital.
D. 9.60%
Using the complement of the tax rate instead of the tax rate results in 9.60%.
Question: 31 A firm has announced that it plans to finance future investments so that the firm will
achieve an optimum capital structure. Which one of the following corporate objectives
is consistent with this announcement?
A. Maximize earnings per share.

The maximization of EPS may not always suggest the best capital structure.
B. Minimize the cost of equity.

Minimizing the cost of equity may signify overly conservative management.
C. Minimize the cost of debt.

The minimization of debt cost may not be optimal; as long as the firm can earn more on debt
capital than it pays in interest, debt financing may be indicated.
D. Maximize the net worth of the firm.

Financial structure is the composition of the financing sources of the assets of a firm.
Traditionally, the financial structure consists of current liabilities, long-term debt, retained
earnings, and stock. For most firms, the optimum structure includes a combination of debt
and equity. Debt is cheaper than equity, but excessive use of debt increases the firm’s risk
and drives up the weighted-average cost of capital.
3: (38) Cost of Capital – New
Question: 1 The marginal cost of capital (MCC) curve for an entity rises twice, first when the entity
has raised US $75 million and again when US $175 million of new funds has been
raised. These increases in the MCC are caused by
A. Decreases in the cost of at least one of the financing sources.

As additional funds are raised, an increase in the cost of a source of financing, not a
decrease, will result in an increase in the MCC.
B. Increases in the cost of at least one of the financing sources.

The MCC is a weighted average of the costs of various new financing sources. If the cost of
any source of new financing increases, the MCC curve will rise. The curve shifts upward with
each incremental increase in financing cost because the lowest-cost sources are assumed to
be used first.
C. Decreases in the returns on the additional investments undertaken.

Financing costs do not directly depend on rates of return on investment.
D. Increases in the returns on the additional investments undertaken.

Financing costs do not directly depend on rates of return on investment.
Fact Pattern: DQZ Telecom is considering a project for the coming year that will cost $50 million. DQZ
plans to use the following combination of debt and equity to finance the investment.
• Issue $15 million of 20-year bonds at a price of $101, with a coupon rate of 8%, and
flotation costs of 2% of par.
• Use $35 million of funds generated from earnings.
• The equity market is expected to earn 12%. U.S. Treasury bonds are currently yielding
5%. The beta coefficient for DQZ is estimated as .60. DQZ is subject to an effective corporate
income tax rate of 40%.
Question: 2 Assume that the after-tax cost of debt is 7% and the cost of equity is 12%. Determine
the weighted-average cost of capital to DQZ.
A. 6.30%
The amount of 6.30% assumes that 7% is the before-tax cost of debt and that equity is tax deductible.
B. 8.50%
The amount of 8.50% reverses the weights.
C. 9.50%
The amount of 9.50% assumes debt and equity are equally weighted.
D. 10.50%
The 7% debt cost and the 12% equity cost should be weighted by the proportions of the total
investment represented by each source of capital. The total project costs $50 million, of
which debt is $15 million, or 30% of the total. Equity capital is the other 70%. Consequently,
the weighted-average cost of capital is 10.5% [(30% × 7%) + (70% × 12%)].
Question: 3 A corporation has sold $50 million of $1,000 par value, 12% coupon bonds. The bonds
were sold at a discount and the corporation received $985 per bond. If the corporate
tax rate is 40%, the after-tax cost of these bonds for the first year (rounded to the
nearest hundredth percent) is
A. 7.09%
The after-tax cost of the bonds equals the effective rate times the tax effect.
B. 4.87%
Multiplying the pretax effective rate 12.18% ($120 ÷ $985) by the tax rate of .40 instead of by
(1 – .40) results in 4.87%.
C. 7.31%
Interest is 12%, and the annual interest payment on one bond is $120. Thus, the effective
rate is 12.18% ($120 ÷ $985). Reducing this rate by the 40% tax savings lowers the cost to
7.31%.
D. 12.00%
The nominal interest rate is 12%.
Question: 4 A company, which has no current debt, has a beta of .95 for its common stock.
Management is considering a change in the capital structure to 30% debt and 70%
equity. This change would increase the beta on the stock to 1.05, and the after-tax cost
of debt will be 7.5%. The expected return on equity is 16%, and the risk-free rate is 6%.
Should the company’s management proceed with the capital structure change?
A. Yes, because the cost of equity capital will decrease.

The average cost of capital needs to be considered.
B. No, because the weighted-average cost of capital will increase.

The weighted average cost of capital will decrease.
C. Yes, because the weighted-average cost of capital will decrease.

The important consideration is whether the overall cost of capital will be lower for a given
proposal. According to the Capital Asset Pricing Model, the change will result in a lower
average cost of capital. For the existing structure, the cost of equity capital is 15.5% [6% +
.95 (16% – 6%)]. Because the company has no debt, the average cost of capital is also
15.5%. Under the proposal, the cost of equity capital is 16.5% [6% + 1.05 (16% – 6%)], and
the weighted average cost of capital is 13.8% [.3(.075) + .7(.165)]. Hence, the proposal of
13.8% should be accepted.
D. No, because the cost of equity capital will increase.
The average cost of capital needs to be considered.
Question: 5 A firm has total capital of $100 million, and its weighted-average cost of capital is 12%.
A new project has been proposed that will require additional capital of $10 million. The
firm estimates that the additional capital can be raised at a pre-tax cost of 10%. The
marginal income tax rate is 36%. What discount rate should the firm use in evaluating
the new project?
A. 12.00%
The weighted-average cost of capital should be used if it is known. A lower marginal rate for
debt will lead to greater risk to shareholders, which will lead to a higher cost for common
equity. Thus, the firm should invest in projects that have an expected return that is greater
than the 12% weighted-average cost of capital.
B. 7.56%
The discount rate used in evaluating the new project should be the weighted-average cost of
the additional capital. This answer choice incorrectly adds the average of the current cost of
capital and the additional cost of capital (11%) to the new cost of capital (10%) in order to get
a pre-tax rate of 21%. This number is then incorrectly multiplied by the tax rate instead of 1
minus the tax rate.
C. 10.00%
the additional capital. The amount of 10.00% fails to account for the effects of the tax rate.
D. 6.40%
the additional capital. Therefore, the discount rate to be used by the firm in evaluating its new
project should be 12%. The weighted-average cost of capital should be used if it is known.
Question: 6 A company has made the decision to finance next year’s capital projects through debt
rather than additional equity. The benchmark cost of capital for these projects should
be
A. The before-tax cost of new-debt financing.

The cost of capital is a composite, or weighted average, of all financing sources in their usual
proportions. The cost of capital should also be calculated on an after-tax basis.
B. The weighted-average cost of capital.

A weighted average of the costs of all financing sources should be used, with the weights
determined by the usual financing proportions. The terms of any financing raised at the time
of initiating a particular project do not represent the cost of capital for the firm. When a firm
achieves its optimal capital structure, the weighted-average cost of capital is minimized.
C. The after-tax cost of new-debt financing.

D. The cost of equity financing.

Question: 7 A company’s current capital structure is optimal, and the company wishes to maintain
it.
Debt 25%
Preferred equity 5
Common equity 70
Management is planning to build a $75 million facility that will be financed according to
this desired capital structure. Currently, $15 million of cash is available for capital
expansion. The percentage of the $75 million that will come from a new issue of
common stock is
A. 56.00%
Because $15 million is already available, the company must finance $60 million ($75 million – $15
million). Of this amount, 70%, or $42 million, should come from the issuance of common stock to
maintain the current capital structure. The $42 million represents 56% of the total $75 million.
B. 52.50%
The 70% desired common stock percentage multiplied by the original $75 million is $52.5
million.
C. 70.00%
The new issue of common stock will fund 70% of the financed amount, not 70% of the total
project cost. The financed amount is $60 million ($75 million – $15 million cash).
D. 50.00%
This is a nonsense percentage in this context.
Question: 8 Which one of a firm’s sources of new capital usually has the lowest after-tax cost?
A. Common stock.
Common stock has a higher after-tax cost than debt.
B. Retained earnings.
The cost to the company of equity instruments is in the form of dividends. Because dividends
are not deductible for tax purposes, equity sources of capital have a higher after-tax cost than
debt sources.
C. Bonds.
Debt financing, such as bonds, normally has a lower after-tax cost than does equity financing.
The interest on debt is tax deductible, whereas the dividends on equity are not. Also, bonds
are slightly less risky than stock because the bond holders have a first right to assets at
liquidation.
D. Preferred stock.
Preferred stock has a higher after-tax cost than debt.
Question: 9 A firm has sold 1,000 shares of $100 par, 8% preferred stock at an issue price of $92
per share. Stock issue costs were $5 per share. The firm pays taxes at the rate of 40%.
What is the firm’s cost of preferred stock capital?
A. 8.25%
This percentage results from adding the issue costs rather than subtracting them.
B. 8.70%
This percentage results from failing to subtract the issue costs.
C. 8.00%
This percentage results from using the par value rather than the selling price and failing to
subtract the issue costs.
D. 9.20%
Because the dividends on preferred stock are not deductible for tax purposes, the effect of
income taxes is ignored. Thus, the relevant calculation is to divide the $8 annual dividend by
the quantity of funds received from the issuance. In this case, the funds received equal $87
($92 proceeds – $5 issue costs). Thus, the cost of capital is 9.2% ($8 ÷ $87).
Question: 10 A profitable firm is reviewing alternatives to raise additional capital. It estimates that it
can issue debt at a yield of 6% or, alternately, issue preferred shares at a yield of 7%.
If the firm’s marginal income tax rate is 37%, what would be the cost for each
alternative?
A. Debt: 6.00%, preferred shares: 7.00%.

The debt and preferred shares yield must be multiplied by 1 minus the tax rate.
B. Debt: 3.78%, preferred shares: 4.41%.

The preferred shares should not be multiplied by 1 minus the tax rate
C. Debt: 3.78%, preferred shares: 7.00%.

The cost of the debt would be 3.78% [6% × (1 – .37)] since interest payments are tax-
deductible by the firm. The preferred shares would cost 7%.
D. Debt: 6.00%, preferred shares: 4.41%.

The debt yield of 6% must be multiplied by 1 minus the tax rate, while the preferred shares
yield should not be multiplied by 1 minus the tax rate.
Question: 11 Vivid, Inc., has determined that it needs $10,000,000 of funding to expand its
operations into a foreign country. Its capital structure consists of 10% long-term debt,
20% preferred stock, 40% common stock, and 30% retained earnings. New debt can
be issued at a cost of 15% and new preferred stock at a cost of 10%. Common stock is
currently trading at $76 per share with a flotation cost of $8 per share. In addition, Vivid
will pay a $6 dividend that it expects to grow 1.5% annually. What is the weighted-
average cost of new capital? (Round numbers to three decimal places, e.g., 0.1547 =
15.5%).
A. 11.4%
A cost of 11.4% is derived by using a weight of 40% for retained earnings.
B. 10.4%
The cost of new capital is the ratio of what a firm must pay to what it receives. The cost of
new capital is calculated as follows:
Component Weight Cost of Capital Weighted Cost
Long-term debt 10% × 15.0% = 1.5%
Common stock 40% × 10.3% (A) = 4.1%
Retained earnings 30% × 9.4% (B) = 2.8%
10.4%
(A) [$6 dividend ÷ ($76 stock price – $8 flotation cost)] + 1.5% = 10.3%
(B) ($6 dividend ÷ $76 stock price) + 1.5% = 9.4%
C. 10%
A cost of 10% is the cost of new preferred stock.
D. 11.9%
A cost of 11.9% is derived by using a weight of 20% for long-term debt.
Question: 12 The theory underlying the cost of capital is primarily concerned with the cost of
A. Short-term funds and old funds.
The cost of old funds is a sunk cost and of no relevance for decision-making purposes.
Similarly, short-term funds are used for working capital or other temporary purposes, and
there is less concern with the cost of capital and the way it compares with the return earned
on the assets borrowed.
B. Long-term funds and old funds.

The concern is with the cost of new funds; the cost of old funds is a sunk cost and of no
relevance for decision-making purposes.
C. Long-term funds and new funds.

The theory underlying the cost of capital is based primarily on the cost of long-term funds and
the acquisition of new funds. The reason is that long-term funds are used to finance long-
term investments. For an investment alternative to be viable, the return on the investment
must be greater than the cost of the funds used. The objective in short-term borrowing is
different. Short-term loans are used to meet working capital needs and not to finance long-
term investments
D. Short-term funds and new funds.

The cost of short-term funds is not usually a concern for investment purposes.
Fact Pattern: Rogers, Inc., operates a chain of restaurants located in the Southeast. The company has
steadily grown to its present size of 48 restaurants. The board of directors recently approved a large-
scale remodeling of the restaurants, and the company is now considering two financing alternatives.
• The first alternative would consist of
▪ Bonds that would have a 9% coupon rate and reissued at their base amount would net $19.2
million after a 4% flotation cost
▪ Preferred stock with a stated rate of 6% that would yield $4.8 million after a 4% flotation cost
▪ Common stock that would yield $24 million after a 5% flotation cost
• The second alternative would consist of a public offering of bonds that would have a 9% coupon rate and
an 11% market rate and would net $48 million after a 4% flotation cost.
Rogers’ current capital structure, which is considered optimal, consists of 40% long-term debt, 10%
preferred stock, and 50% common stock. The current market value of the common stock is $30 per
share, and the common stock dividend during the past 12 months was $3 per share. Investors are
expecting the growth rate of dividends to equal the historical rate of 6%. Rogers is subject to an effective
income tax rate of 40%.
Question: 13 The after-tax weighted marginal cost of capital for Rogers’ second financing alternative
consisting solely of bonds would be
A. 5.40%
This percentage (5.40%) is 60% of 9%.
B. 5.13%
This percentage (5.13%) is 5.40% reduced by the 5% stock flotation costs.
C. 6.60%
This percentage (6.60%) is the market interest rate times one minus the tax rate.
D. 5.63%
Annual cash interest is $4,500,000 {[$48,000,000 ÷ (1.0 – .04 flotation cost)] × .09}. The cost
of the new bonds equals the annual cash interest divided by the net issue proceeds, times
one minus the tax rate, or 5.63% [($4,500,000 ÷ $48,000,000) × (100% – 40%)].
Question: 14 A corporation is preparing to evaluate the capital expenditure proposals for the coming
year. Because the firm employs discounted cash flow methods of analyses, the cost of
capital for the firm must be estimated. The following information for the corporation is
provided.
• Market price of common stock is $50 per share.

• The dividend next year is expected to be $2.50 per share.
• Expected growth in dividends is a constant 10%.
• New bonds can be issued at face value with a 13% coupon rate.
• The current capital structure of 40% long-term debt and 60% equity is
considered to be optimal.
• Anticipated earnings to be retained in the coming year are $3 million.
• The firm has a 40% marginal tax rate.
If the firm must assume a 10% flotation cost on new stock issuances, what is the cost
of new common stock?
A. 15.00%
This percentage did not take into account flotation costs
B. 16.11%
Assuming next year’s dividend grew by 10% results in 16.11%
C. 15.56%
Because of flotation costs, the corporation will only receive $45 from each new common
share issued ($50 × 90%). The cost of this new common equity issue can thus be calculated
as follows:
Cost of new common stock = (Next dividend ÷ Net issue proceeds) + Dividend growth rate
= ($2.50 ÷ $45.00) + 0.1
= 0.0556 + 0.1
= 0.1556
D. 15.05%
Using the present value of the dividend to be received next year results in 15.05%
Question: 15 A corporation is selling $25 million of cumulative, non-participating preferred stock. The
issue will have a par value of $65 per share with a dividend rate of 6%. The issue will
be sold to investors for $68 per share, and issuance costs will be $4 per share. The
cost of preferred stock to the corporation is
A. 6.09%
Cost of capital for its new preferred stock is calculated as follows:
Cost of new preferred stock = Dividend ÷ Net issue proceeds
= ($65 × 6%) ÷ ($68 – $4)
= $3.90 ÷ $64
= 6.09%
B. 5.42%
Improperly dividing the annual dividend by the sum of the issue price and the issue costs
results in 5.42%.
C. 5.74%
Improperly dividing the annual dividend by the issue price results in 5.74%.
D. 6.00%
Improperly dividing the annual dividend by the par value results in 6.00%.
Fact Pattern: The FLF Corporation is preparing to evaluate capital expenditure proposals for the coming
year. Because the firm employs discounted cash flow methods, the cost of capital for the firm must be
estimated. The following information for FLF Corporation is provided:
• The market price of common stock •• The current capital structure of 40% long-term debt
is $60 per share. and 60% equity is considered to be optimal.
• The dividend next year is expected • Anticipated earnings to be retained in the coming
to be $3 per share. year are $3 million.
• Expected growth in dividends is a • The firm has a 40% marginal tax rate.
constant 10%.
• New bonds can be issued at face
value with a 10% coupon rate.
Question: 16 Without prejudice to your answers from any other questions, assume that the after-tax
cost of debt financing is 10%, the cost of retained earnings is 14%, and the cost of new
common stock is 16%. If capital expansion needs to be $7 million for the coming year,
what is the after-tax weighted-average cost of capital to FLF Corporation?
A. 16%
This figure is the cost of new common stock.
B. 12.74%

To maintain a capital structure of 40% debt and 60% equity, the $7 million total must consist of $2.8
million of debt and $4.2 million of equity. The equity will consist of $3 million of retained earnings and
$1.2 million of new stock. The weighted-average cost of the three sources of new capital is determined
as follows:
Debt $2,800,000 ÷ $7,000,000 × 10% = 4.00%
Common stock $1,200,000 ÷ $7,000,000 × 16% = 2.74%
Retained earnings $3,000,000 ÷ $7,000,000 × 14% = 6.00%
12.74%
C. 11.14%
This figure assumes a tax adjustment for the cost of debt, but the 10% rate is an after-tax
amount.
D. 13.6%
This figure assumes the equity consists solely of new common stock.
• The market price of common stock is •• The current capital structure of 40% long-term debt and
$60 per share. 60% equity is considered to be optimal.
• The dividend next year is expected to • Anticipated earnings to be retained in the coming year
be $3 per share. are $3 million.
constant 10%.
• New bonds can be issued at face value
with a 10% coupon rate.
Question: 17 If FLF Corporation must assume a 20% flotation cost on new stock issuances, what is
the cost of new common stock?
A. 15%
This figure results from ignoring the flotation costs.
B. 10%
This figure is the dividend growth rate
C. 6.25%
This figure results from failing to add the dividend growth rate.
D. 16.25%
The company will receive only 80% of the $60 market price, or $48. Consequently, the
dividend yield is 6.25% ($3 ÷ $48). Adding the 10% growth rate produces a cost of new
common equity of 16.25%.
constant 10%.
Question: 18 The after-tax cost to FLF Corporation of the new bond issue is
A. 10%
This figure is the before-tax rate.
B. 4%
This figure results from using a 60% tax rate.
C. 6%
Because the bonds are issued at their face value, the pretax effective rate is 10%. However,
interest is deductible for tax purposes, so the government absorbs 40% of the cost, leaving a
6% after-tax cost.
D. 14%
The after-tax cost will be less than the effective before-tax rate
Question: 19 A preferred stock is sold for $101 per share, has a face value of $100 per share,
underwriting fees of $5 per share, and annual dividends of $10 per share. If the tax rate
is 40%, the cost of funds (capital) for the preferred stock is
A. 10.0%
The amount of 10.0% results from improperly basing the calculation on par value funds
received.
B. 10.4%
The cost of capital for new preferred stock is equal to the dividend on the stock divided by the
net issue proceeds [$10 ÷ ($101 – $5) = 10.4%]. Because dividends on preferred stock are
not deductible for tax purposes, the income tax rate is irrelevant.
C. 6.25%
The amount of 6.25% results from improperly multiplying the dividends by the tax rate.
D. 4.2%
The amount of 4.2% results from improperly multiplying the dividends by the tax rate
Question: 20 The management of a company has been reviewing the company’s financing
arrangements. The current financing mix is $750,000 of common stock, $200,000 of
preferred stock ($50 par) and $300,000 of debt. The company currently pays a
common stock cash dividend of $2. The common stock sells for $38, and dividends
have been growing at about 10% per year. Debt currently provides a yield to maturity
to the investor of 12%, and preferred stock pays a dividend of 9% to yield 11%. Any
new issue of securities will have a flotation cost of approximately 3%. The company
has retained earnings available for the equity requirement. The company’s effective
income tax rate is 40%. Based on this information, the cost of capital for retained
earnings is
A. 15.8%
The cost of new common stock is the next dividend ($2.20) divided by the net proceeds of the stock. If
this were to involve a new sale of stock, the flotation costs would be deducted from the selling price to
get the net proceeds. However, this was for retained earnings, so there is no deduction. The calculation
is to divide the $2.20 dividend by the $38 selling price to get 5.8%. Add the 10% growth rate and the
answer is 15.8%.
B. 9.5%
This percentage results from failing to consider the growth rate on dividends.
C. 16.0%
This percentage is based on an amount that erroneously deducted flotation costs from the
selling price.
D. 14.2%
This percentage results from failing to consider the next dividend.
Question: 21 On January 1, Year 1, XYZ organization issued 1,000 shares of common stock in
return for $30,000. The flotation costs associated with the issuance totaled $750. In
addition, XYZ issued new bonds which raised $100,000. The interest rate associated
with these bonds is 10%. What formula should XYZ use to calculate the cost of new
debt?
A. Cash dividend on common stock ÷ Market price of common stock

The formula to calculate the component cost of common stock is
Cash dividend on common stock ÷ Market price of common stock
B. (Next dividend ÷ Net issue proceeds) + Dividend growth rate

The cost of new common stock is commonly calculated using the dividend growth model,
which equates to cost of capital of new common stock; thus, the formula for cost of common
stock is
(Next dividend ÷ Net issue proceeds) + Dividend growth rate
C. Next dividend ÷ Net issue proceeds

All new issues of equity securities involve the payment of flotation costs, which reduce the
proceeds received, thereby raising the cost of capital. The cost of new preferred stock is thus
calculated as
Next dividend ÷ Net issue proceeds
D. Annual interest ÷ Net issue proceeds

The formula to calculate the cost of new debt is
Annual interest ÷ Net issue proceeds
Fact Pattern:
Williams, Inc., is interested in measuring its •• Williams’ common stock is currently selling for $100
overall cost of capital and has gathered the per share. The firm expects to pay cash dividends of
following data. Under the terms described as $7 per share next year, and the dividends are
follows, the company can sell unlimited amounts
expected to remain constant. The stock will have to
of all instruments.
be underpriced by $3 per share, and flotation costs
are expected to amount to $5 per share.
• Williams can raise cash by selling
$1,000, 8%, 20-year bonds with annual • Williams expects to have available $100,000 of
interest payments. In selling the issue, an retained earnings in the coming year; once these
average premium of $30 per bond would retained earnings are exhausted, the firm will use new
be received, and the firm must pay common stock as the form of common stock equity
flotation costs of $30 per bond. The financing.
after-tax cost of funds is estimated to be • Williams’ preferred capital structure is
4.8%.
Long-term debt 30%
• Williams can sell 8% preferred stock
with a par value of $100 for $105 per Preferred stock 20%
share. The cost of issuing and selling the
• Common stock 50%
preferred stock is expected to be $5 per
share.
Question: 22 If Williams, Inc., needs a total of $1,000,000, the firm’s weighted-average cost of
capital would be
A. 4.8%
This percentage is the cost of the long-term debt alone.
B. 27.4%
This percentage is the unweighted total of each of the four elements of capital.
C. 6.8%

Because Williams can sell unlimited amounts of all of its instruments, it can maintain its preferred
capital structure. The cost of new debt is given as 4.8%. The cost of new preferred stock is 8.0% ($8
dividend ÷ $100 net issue proceeds). The common equity component will amount to $500,000
($1,000,000 capital needed × 50% common stock). Retained earnings are available to cover $100,000
(10% of the total), so new common stock will have to be issued to cover the other 40%. The cost of new
common stock is 7.6% ($7 dividend ÷ $92 net issue proceeds).
Cost of Weighted
Component Weight Capital Cost
New long-term debt 30% × 4.8% = 1.44%
New preferred stock 20% × 8.0% = 1.60%
New common stock 40% × 7.6% = 3.04%
Retained earnings 10% × 7.0% = .70%
Total 6.78%
D. 6.5%
This percentage would be correct only if the equity capital were obtained totally from retained
earnings. Because only $100,000 of retained earnings is available, the remainder of equity
capital must come from sales of new common stock.
Question: 23 The firm’s marginal cost of capital
A. Should be the same as the firm’s rate of return on equity.

If the cost of capital were the same as the rate of return on equity (which is usually higher
than that of debt capital), there would be no incentive to invest.
B. Is inversely related to the firm’s required rate of return used in capital budgeting.
The rate of return used for capital budgeting purposes should be at least as high as the
marginal cost of capital.
C. Is a weighted average of the investors’ required returns on debt and equity.

The marginal cost of capital is the cost of the next dollar of capital. The marginal cost
continually increases because the lower cost sources of funds are used first. The marginal
cost represents a weighted average of both debt and equity capital.
D. Is unaffected by the firm’s capital structure.

The marginal cost of capital is affected by the degree of debt in the firm’s capital structure.
Financial risk plays a role in the returns desired by investors.
constant 10%.
Question: 24 The cost of using FLF Corporation retained earnings for financing is
A. 9%
This figure would be the after-tax cost if dividends were deductible.
B. 5%
This figure results from failing to add the dividend growth rate.
C. 10%
This figure is the dividend growth rate.
D. 15%
The cost of using retained earnings equals the dividend yield (dividends per share ÷ market
price) plus the dividend growth rate. Dividing the $3 dividend by the $60 market price results
in a yield of 5%. Adding the 10% dividend growth rate produces a cost of 15% for retained
earnings. No adjustment is made for taxes because dividends are not tax deductible.
• The firm has a 40% marginal tax rate.
• Expected growth in dividends is a
constant 10%.
Question: 25 The maximum capital expansion that FLF Corporation can support in the coming year
without resorting to external equity financing is
A. Cannot determine from the information given.

The amount of $5 million can be calculated.
B. $5 million.
The current optimal capital structure is 40% debt and 60% equity. The $3 million to be
retained from earnings in the coming year represents the equity portion of the maximum new
capital outlay. To retain the optimal capital structure, $2 million of debt must be added to the
$3 million of retained earnings. Hence, the maximum capital expansion is $5 million.
C. $3 million.
Three million is the amount of earnings retained.
D. $2 million.
Two million is the amount of debt that must be added to maintain the optimal structure.
Question: 26 A company is planning to issue additional shares of common stock in a public offering.
The current market price of the company’s stock is $38, and the dividend for the past
year was $2.25. A well-known investment advisory firm forecasts dividend growth of
8%, and an investment banker estimates that the flotation costs would be 6% of the
issue price. What cost of equity should the company use in its cost of capital
calculation?
A. 14.3%
The amount of $38 is the current market price, so it is not subject to growth.
B. 14.0%
Adding the dividend growth rate and the flotation costs does not result in the cost of capital.
C. 14.8%
The next dividend that the company will pay is $2.43 ($2.25 × 1.08). The net issue proceeds
are $35.72 [$38 × (1 – .06)] after taking the flotation costs into account. Therefore, the cost of
capital is 14.8% [($2.43 ÷ $35.72) + .08].
D. 13.9%
The formula of Cash dividend on common stock ÷ Market price of common stock results in
the cost of capital for current common stock. The problem is looking for the cost of capital for
new common stock.
Fact Pattern:
Williams, Inc., is interested in measuring its •• Williams’ common stock is currently selling for $100
overall cost of capital and has gathered the per share. The firm expects to pay cash dividends of
following data. Under the terms described as $7 per share next year, and the dividends are
follows, the company can sell unlimited amounts
expected to remain constant. The stock will have to
of all instruments.
be underpriced by $3 per share, and flotation costs
are expected to amount to $5 per share.
$1,000, 8%, 20-year bonds with annual • Williams expects to have available $100,000 of
interest payments. In selling the issue, an retained earnings in the coming year; once these
average premium of $30 per bond would retained earnings are exhausted, the firm will use new
be received, and the firm must pay common stock as the form of common stock equity
flotation costs of $30 per bond. The financing.
after-tax cost of funds is estimated to be • Williams’ preferred capital structure is
4.8%.
Long-term debt 30%
with a par value of $100 for $105 per Preferred stock 20%
share. The cost of issuing and selling the • Common stock 50%
preferred stock is expected to be $5 per
share.
Question: 27 The cost of funds from retained earnings for Williams, Inc., is
A. 8.1%
Dividing the $7 dividend by the $100 market price of the stock produces a ratio of 7%, not
8.1%.
B. 7.0%
Because retained earnings is internally generated (that is, no issue costs are involved), its
cost is simply the component cost of common stock, i.e., the next dividend divided by the
market price ($7 ÷ $100 = 7.0%).
C. 7.6%
This figure is the cost of new common stock.
D. 7.4%
This figure is the cost of new common stock after failing to subtract the discount.
Question: 28 Kenia, the CFO of an organization, is looking to raise capital. She is concerned
because she knows that if she issues new debt, the debtholders will demand a higher
interest rate to compensate for the increased risk. Which of the following scenarios will
persuade Kenia to issue new debt?
A. The organization expects a higher tax rate this year.

As tax rates rise, the deductibility of interest makes debt a more attractive financing option.
Therefore, because the organization expects a higher tax rate, it will be able to deduct more
of the interest associated with debt.
B. The CEO of the organization has approved the issuance of new debt.
Even though the CEO has approved the issuance, Kenia must still diligently examine other
financing options.
C. The cost of the new bond is 11%, and the cost of the new capital is 9%.
The cost of the new capital is 2% less than the cost of the new bond (11% cost of new bond –
9% cost of new capital); thus, the new capital costs less and would be more advantageous
than the debt scenario.
D. The organization expects a decreased tax rate this year.

Kenia would be persuaded to issue new debt as tax rates increase, not decrease
Fact Pattern:
Williams, Inc., is interested in measuring its •• Williams’ common stock is currently selling for
overall cost of capital and has gathered the $100 per share. The firm expects to pay cash
following data. Under the terms described as dividends of $7 per share next year, and the
follows, the company can sell unlimited
dividends are expected to remain constant. The
amounts of all instruments.
stock will have to be underpriced by $3 per
share, and flotation costs are expected to
amount to $5 per share.
$1,000, 8%, 20-year bonds with
annual interest payments. In selling • Williams expects to have available $100,000 of
the issue, an average premium of retained earnings in the coming year; once
$30 per bond would be received, and these retained earnings are exhausted, the firm
the firm must pay flotation costs of will use new common stock as the form of
$30 per bond. The after-tax cost of common stock equity financing.
funds is estimated to be 4.8%. • Williams’ preferred capital structure is
Long-term debt 30%
with a par value of $100 for $105 per
share. The cost of issuing and selling Preferred stock 20%
the preferred stock is expected to be
• Common stock 50%
$5 per share.
Question: 29 The cost of funds from the sale of common stock for Williams, Inc., is
A. 7.4%
This figure results from failing to subtract the discount.
B. 7.6%
According to the dividend growth model, the cost of new (external) common equity is the next
dividend divided by the net issue proceeds plus the dividend growth rate. Since flotation costs
are incurred when issuing new stock, they must be deducted from the market price to arrive
at the amount of capital the corporation will actually receive. Accordingly, the $100 selling
price is reduced by the $3 discount and the $5 flotation costs to arrive at the $92 to be
received for the stock. Because the dividend is not expected to increase in future years, no
growth factor is included in the calculation. Thus, the cost of the common stock is 7.6%
($7 dividend ÷ $92 net issue proceeds).
C. 7.0%
This figure results from failing to subtract the discount and flotation costs.
D. 8.1%
This figure would be correct only if the amount received were about $86 or if some growth
factor were assumed.
Question: 30 How is a firm’s cost of new capital calculated?
A. Ratio of what a firm must pay to what it expects to pay.

The cost of new capital for preferred stock is calculated as
Next dividend ÷ Net issue proceeds
The cost of new capital for common stock is calculated as
(Next dividend ÷ Net issue proceeds) + Dividend growth rate
B. Annual interest divided by net issue proceeds.

Annual interest divided by net issue proceeds is the formula for calculating the cost of new
debt.
C. Ratio of what a firm must pay to what a firm gets.

The cost of new capital (also called external capital) is the ratio of what the firm must pay to
what the firm gets. Examples of the cost of capital are interest rates on debt and flotation
costs on the issuance of new securities.
D. Common stock plus annual interest.

Annual interest is a component of the cost of new debt formula and is not a component of the
cost of new capital formula.
▪ Bonds that would have a 9% coupon rate and reissued at their base amount would net
$19.2 million after a 4% flotation cost
▪ Preferred stock with a stated rate of 6% that would yield $4.8 million after a 4% flotation
cost
• The second alternative would consist of a public offering of bonds that would have a 9% coupon
rate and an 11% market rate and would net $48 million after a 4% flotation cost.
preferred stock, and 50% common stock. The current market value of the common stock is $30 per share,
and the common stock dividend during the past 12 months was $3 per share. Investors are expecting the
growth rate of dividends to equal the historical rate of 6%. Rogers is subject to an effective income tax
rate of 40%.
Question: 31 Assuming the after-tax cost of common stock is 15%, the after-tax weighted marginal
cost of capital for Rogers’ first financing alternative consisting of bonds, preferred
stock, and common stock would be
A. 8.725%
They do not appear to be the result of a common error.
B. 11.700%
C. 7.285%
D. 10.375%

Since the bonds would incur a 4% flotation cost, their face amount must be $20,000,000 ($19,200,000 ÷
.96). The before-tax rate of return on the debt is therefore .09375 [($20,000,000 × 9%) ÷ $19,200,000].
The preferred stock will yield $4,800,000 after subtracting the 4% flotation cost, so it must sell for
$5,000,000 ($4,800,000 ÷ .96). The annual dividend on the preferred stock is $300,000 ($5,000,000 ×
6%). Consequently, the cost of capital raised by issuing preferred stock is 6.25% ($300,000 dividend ÷
$4,800,000 net issuance price). The after-tax weighted marginal cost of capital for Rogers’ first
financing alternative is therefore calculated as follows:
Weighted
Weight Cost of Capital Cost
Long-term debt 40% × 9.375% × (1.0 – .40) = 2.250%
Preferred stock 10% × 6.25% = .625%
Common stock 50% × 15% = 7.500%
10.375%
▪ Bonds that would have a 9% coupon rate and reissued at their base amount would net
$19.2 million after a 4% flotation cost
▪ Preferred stock with a stated rate of 6% that would yield $4.8 million after a 4% flotation
cost
• The second alternative would consist of a public offering of bonds that would have a 9% coupon
rate and an 11% market rate and would net $48 million after a 4% flotation cost.
preferred stock, and 50% common stock. The current market value of the common stock is $30 per share,
and the common stock dividend during the past 12 months was $3 per share. Investors are expecting the
growth rate of dividends to equal the historical rate of 6%. Rogers is subject to an effective income tax
rate of 40%.
Question: 32 The after-tax cost of the common stock proposed in Rogers’ first financing alternative
would be
A. 17.16%
To determine the cost of new common stock, the dividend growth model is used.
(Next dividend ÷ Net issue proceeds) + Dividend
Cost of new common =
growth rate
stock
= [($3.00 × 1.06) ÷ ($30.00 × .95)] + .06
= ($3.18 ÷ $28.50) + .06
= .1116 + .06
= 17.16%
B. 16.60%
This percentage ignores the flotation costs.
C. 16.00%
This percentage ignores the increase in dividends and flotation costs.
D. 16.53%
This percentage ignores the increase in the next dividend.
Fact Pattern:
Williams, Inc., is interested in measuring its •• Williams’ common stock is currently selling for
overall cost of capital and has gathered the $100 per share. The firm expects to pay cash
following data. Under the terms described as dividends of $7 per share next year, and the
follows, the company can sell unlimited
dividends are expected to remain constant. The
amounts of all instruments.
stock will have to be underpriced by $3 per
share, and flotation costs are expected to
amount to $5 per share.
$1,000, 8%, 20-year bonds with
annual interest payments. In selling • Williams expects to have available $100,000 of
the issue, an average premium of retained earnings in the coming year; once
$30 per bond would be received, and these retained earnings are exhausted, the firm
the firm must pay flotation costs of will use new common stock as the form of
$30 per bond. The after-tax cost of common stock equity financing.
funds is estimated to be 4.8%. • Williams’ preferred capital structure is
Long-term debt 30%
with a par value of $100 for $105 per
share. The cost of issuing and selling Preferred stock 20%
the preferred stock is expected to be • Common stock 50%
$5 per share.
Question: 33 If Williams, Inc., needs a total of $200,000, the firm’s weighted-average cost of capital
would be
A. 19.8%
This figure is the unweighted sum of each of the three elements of capital.
B. 6.5%

Because Williams can sell unlimited amounts of all of its instruments, it can maintain its preferred
capital structure. The cost of new debt is given as 4.8%. The cost of new preferred stock is 8.0%. No
new common stock needs to be issued since sufficient retained earnings are available ($200,000 capital
needed × 50% common stock = $100,000). Thus, the component cost of retained earnings can be used
for the common stock component of the WACC calculation:
Cost of Weighted
Component Weight Capital Cost
New long-term debt 30% × 4.8% = 1.44%
New preferred stock 20% × 8.0% = 1.60%
Retained earnings 50% × 7.0% = 3.50%
Total 6.54%
C. 6.8%
This figure can only be obtained if new common stock is sold. New common stock will not be
sold because the retained earnings can be used at a lower cost, and there is no need to sell
stock when the total capital required is only $200,000.
D. 4.8%
This figure is the cost of long-term debt alone. The firm wants to maintain a capital structure
in which debt represents only 30% of the total capital.
Question: 34 Vivid, Inc., has determined that it needs $10,000,000 of funding to expand its
operations into a foreign country. Its capital structure consists of 10% long-term debt,
20% preferred stock, 40% common stock, and 30% retained earnings. Vivid issued
new debt and collected $40,000 of proceeds. The yearly interest rate is 12%. The cost
of retained earnings is expected to be 13.5%, and the cost of new common stock is
expected to be 17%. Vivid also can sell $200 par value preferred stock that pays a
15% dividend and has a $10 flotation cost. What is the weighted-average cost of new
capital? (Round numbers to three decimal places, e.g., 0.1547 = 15.5%).
A. 15.3%
The cost of new capital is the ratio of what a firm must pay to what it receives. The cost of
new capital is calculated as follows:
Component Weight Cost of Capital Weighted Cost
Long-term debt 10% × 12.0% (A) = 1.2%

Preferred stock 20% × 15.8% (B) = 3.2%
Common stock 40% × 17.0% = 6.8%
Retained earnings 30% × 13.5% = 4.1%
15.3%
(A) (1) $40,000 proceeds × .12 interest rate = $4,800 annual interest
(2) $4,800 annual interest ÷ $40,000 net proceeds = 12%
(B) (1) $200 par value × .15 dividend rate = $30 dividend
(2) $30 dividend ÷ ($200 par value – $10 flotation cost) = 15.8%
B. 17%
A cost of 17% is derived by using a weight of 50% for common stock.
C. 15.8%
A cost of 15.8% is the cost of new preferred stock.
D. 14.1%
A cost of 14.1% does not consider the weighted-average cost of new debt (1.2%).
Question: 35 A firm seeking to optimize its capital budget has calculated its marginal cost of capital
and projected rates of return on several potential projects. The optimal capital budget is
determined by
A. Accepting all potential projects with projected rates of return exceeding the lowest marginal cost
of capital.
The optimal capital budget may exclude profitable projects as lower-cost capital goes first to
projects with higher rates of return.
B. Calculating the point at which marginal cost of capital meets the projected rate of return,
assuming that the most profitable projects are accepted first.
In economics, a basic principle is that a firm should increase output until marginal cost equals
marginal revenue. Similarly, the optimal capital budget is determined by calculating the point
at which marginal cost of capital (which increases as capital requirements increase) and
marginal efficiency of investment (which decreases if the most profitable projects are
accepted first) intersect.
C. Calculating the point at which average marginal cost meets average projected rate of return,
assuming the largest projects are accepted first.
The intersection of average marginal cost with average projected rates of return when the
largest (not most profitable) projects are accepted first offers no meaningful capital budgeting
conclusion.
D. Accepting all potential projects with projected rates of return lower than the highest marginal
cost of capital.
Accepting projects with rates of return lower than the cost of capital is not rational.
Question: 36 A firm’s new financing will be in proportion to the market value of its current financing
shown below.
Carrying Amount
($000 Omitted)
Long-term debt $7,000
Preferred stock (100,000 shares) 1,000
Common stock (200,000 shares) 7,000

The firm’s bonds are currently selling at 80% of par, generating a current market yield
of 9%, and the corporation has a 40% tax rate. The preferred stock is selling at its par
value and pays a 6% dividend. The common stock has a current market value of $40
and is expected to pay a $1.20 per share dividend this fiscal year. Dividend growth is
expected to be 10% per year, and flotation costs are negligible. The firm’s weighted-
average cost of capital is (round calculations to tenths of a percent)
A. 9.6%
The first step is to determine the component costs of each form of capital. Multiplying the
current yield of 9% times one minus the tax rate (1.0 – .40 = .60) results in an after-tax cost of
debt of 5.4% (9% × .60). Since the preferred stock is trading at par, the component cost is 6%
(the annual dividend rate). The component cost of common equity is calculated using the
dividend growth model, which combines the dividend yield with the growth rate. Dividing the
$1.20 dividend by the $40 market price produces a dividend yield of 3%. Adding the 3%
dividend yield and the 10% growth rate gives a 13% component cost of common equity.
Once the costs of the three types of capital have been computed, the next step is to weight
them according to their current market values. The market value of the long-term debt is 80%
of its carrying amount, or $5,600,000 ($7,000,000 × 80%). The $1,000,000 of preferred stock
is selling at par. The common stock has a current market value of $8,000,000 (200,000
shares × $40).
Long-term debt $ 5,600,000 × 5.4% = $ 302,400
Preferred stock 1,000,000 × 6.0% = 60,000
Common stock 8,000,000 × 13.0% = 1,040,000
Totals $14,600,000 $1,402,400
Thus, the weighted-average cost of capital is 9.6% ($1,402,000 ÷ $14,600,000).
B. 8.13%
The amount of 8.13% is the simple average.
C. 9.0%
The amount of 9.0% is based on carrying amoun
D. 13.0%
The amount of 13.0% is the cost of equity.
Fact Pattern: DQZ Telecom is considering a project for the coming year that will cost $50 million. DQZ
plans to use the following combination of debt and equity to finance the investment.
• Issue $15 million of 20-year bonds at a price of $101, with a coupon rate of 8%, and flotation
costs of 2% of par.
• Use $35 million of funds generated from earnings.
• The equity market is expected to earn 12%. U.S. Treasury bonds are currently yielding 5%. The
beta coefficient for DQZ is estimated as .60. DQZ is subject to an effective corporate income tax rate of
40%.
Question: 37 The before-tax cost of DQZ’s planned debt financing, net of flotation costs, in the first
year is
A. 7.92%
The amount of 7.92% ignores the 2% flotation costs.
B. 10.00%
The amount of 10.0% is the sum of the coupon rate and the flotation rate.
C. 8.08%
The cost of new debt equals the annual interest divided by the net issue proceeds. The
annual interest is $1.2 million ($15,000,000 × .08 coupon rate). The proceeds amount to
$14,850,000 [($15,000,000 × 1.01) market price – ($15,000,000 × .02) flotation costs]. Thus,
the company is paying $1.2 million annually for the use of $14,850,000, a cost of 8.08%
($1,200,000 ÷ $14,850,000).
D. 11.80%
The coupon rate is 8% annually.
constant 10%.
Question: 38 Without prejudice to your answers from any other questions, assume that the after-tax
cost of debt financing is 10%, the cost of retained earnings is 14%, and the cost of new
common stock is 16%. What is the marginal cost of capital to FLF Corporation for any
projected capital expansion in excess of $7 million?
A. 13.6%
For this calculation, the weighted-average cost of capital is based on the 16% cost of new
common stock and the 10% cost of debt. Retained earnings will not be considered because
the amount available has been exhausted. Thus, the weighted average of any additional
capital required will be 13.6% [(60% × 16% cost of new equity) + (40% × 10% cost of new
debt)].
B. 16%
This percentage is the cost of new common stock.
C. 12.74%
This percentage is the weighted-average cost of capital calculated for a $7 million budget.
D. 10%
This percentage is the cost of debt capital.
4: (24) Options and Derivatives
Question: 1 A forward contract involves a commitment today to purchase a product
A. On a specific future date at a price to be determined some time in the future.

The price of a future contract is determined on the day of commitment, not some time in the future.
B. On a specific future date at a price determined today.

A forward contract is an executory contract in which the parties involved agree to the terms of
a purchase and a sale, but performance is deferred. Accordingly, a forward contract involves
a commitment today to purchase a product on a specific future date at a price determined
today.
C. At some time during the current day at its present price.

Performance is deferred in a future contract, and the price of the product is not necessarily its
present price. The price can be any price determined on the day of commitment.
D. Only when its price increases above its current exercise price.
A forward contract is a firm commitment to purchase a product. It is not based on a
contingency. Also, a forward contract does not involve an exercise price (exercise price is in
an option contract).
Question: 2 A company has recently purchased some stock of a competitor as part of a long-term
plan to acquire the competitor. However, it is somewhat concerned that the market
price of this stock could decrease over the short run. The company could hedge
against the possible decline in the stock’s market price by
A. Purchasing a put option on that stock.

A put option is the right to sell stock at a given price within a certain period. If the market price
falls, the put option may allow the sale of stock at a price above market, and the profit of the
option holder will be the difference between the price stated in the put option and the market
price, minus the cost of the option, commissions, and taxes. The company that issues the
stock has nothing to do with put (and call) options.
B. Selling a put option on that stock.

Selling a put option could force the company to purchase additional stock if the option is
exercised.
C. Obtaining a warrant option on that stock.

A warrant gives the holder a right to purchase stock from the issuer at a given price (it is
usually distributed along with debt).
D. Purchasing a call option on that stock.

A call option is the right to purchase shares at a given price within a specified period.
Question: 3 An automobile company that uses the futures market to set the price of steel to protect
a profit against price increases is an example of
A. Selling futures to protect the company from loss.

The automobile company needs to purchase futures in order to protect itself from
loss, not sell futures. Selling futures protects against price declines.
B. A short hedge.
A short hedge is a futures contract that is sold to protect against price declines. The
automobile company wishes to protect itself against price increases.
C. A long hedge.
A change in prices can be minimized or avoided by hedging. Hedging is the process of using
offsetting commitments to minimize or avoid the impact of adverse price movements. The
automobile company desires to stabilize the price of steel so that its cost to the company will
not rise and cut into profits. Accordingly, the automobile company uses the futures market to
create a long hedge, which is a futures contract that is purchased to protect against price
increases.
D. Selling futures to protect against price declines.

It is the definition of a short hedge, which is used for avoiding price declines. The automobile
company wants to protect itself against price increases.
Question: 4 You are currently holding a call option on a stock with an exercise price of $100. If the
current stock price is $90, the intrinsic value of this option is
A. $90
Exercising a stock that is “out-of-the-money” results in a loss.
B. $(10)
The intrinsic value of an option cannot be less than zero.
C. $10
Exercising a stock that is “out-of-the-money” results in a loss
D. $0
The intrinsic value of a call option is the price of the underlying asset less the exercise price.
If the value of the underlying is less than the exercise price of the option, the option is “out-of-
the-money,” or not worth exercising. Intrinsic value cannot be less than zero. The intrinsic
value of an out-of-the-money option is zero.
Question: 5 An investor wrote a $45 call option and bought a $50 put option, both of which had the
same time to expiration. On the transaction date, the stock price was $45, and the
prices for the call and put options were $8 and $10, respectively. Subsequently, the
stock price fell by $10, where it remained through the option expiration date. As of the
expiration date, the total profit on the combined option position, ignoring commissions
and other transactions, is
A. $13
The amount of gain and loss on a call option for the writer is calculated as the option price
minus the excess of the market price over the exercise price, if any. Thus, the call option
provides the investor a gain of $8 ($8 – $0). The amount of gain and loss on a put option for
the buyer is calculated as the excess of the exercise price over the market price minus the
option price. Thus, the put option provides the investor a gain of $5 [($50 – $35) – $10)]. The
total profit on the combined option position is $13 ($8 gain + $5 gain).
B. $3
The put option yields a gain, not a loss.
C. $17

The option price for the call option is $8, while the option price for the put option is $10.
D. $7
The put option yields a gain, not a loss. The option price for the call option is $8, while the
option price for the put option is $10.
Question: 6 If a corporation’s stock price experiences increased volatility, what would happen to the
value of the call options and the put options on the corporation’s stock?
A. The call options would decrease in value, and the put options would increase in value.
Both options increase in value, since they protect against volatility.
B. Both the call options and the put options would decrease in value.
Since options protect against volatility in the stock price, the more volatile a stock is, the more
owning the options becomes valuable.
C. The call options would increase in value, and the put options would decrease in value.
Both options increase in value, since they protect against volatility.
D. Both the call options and the put options would increase in value.
Since options protect against volatility in the stock price, the more volatile a stock is, the more
owning the options becomes valuable.
Question: 7 A distinguishing feature of a futures contract is that
A. Performance is delayed.
Both a forward contract and a futures contract are executory.
B. Delivery is to be on a specific day.

A futures contract is for delivery during a given month.
C. The price is marked to market each day.

A distinguishing feature of futures contracts is that their prices are marked to market every
day at the close of the day. Thus, the market price is posted at the close of business each
day. A mark-to-market provision minimizes a futures contract’s chance of default because
profits and losses on the contracts must be received or paid each day through a
clearinghouse.
D. It is a hedge, not a speculation.
A futures contract may be speculative.
Question: 8 When a firm finances each asset with a financial instrument of the same approximate
maturity as the life of the asset, it is applying
A. A hedging approach.
Maturity matching, or equalizing the life of an asset and the debt instrument used to finance
that asset, is a hedging approach. The basic concept is that the company has the entire life of
the asset to recover the amount invested before having to pay the lender.
B. Working capital management.

Working capital management is short-term asset management.
C. Financial leverage.
Financial leverage is the relationship between debt and equity financing.
D. Return maximization.
Return maximization is more aggressive than maturity matching. It entails using the lowest
cost forms of financing.
Question: 9 An example of a hedging approach to financing is
A. Matching assets with liabilities of the same maturity.

Maturity matching equalizes the life of an acquired asset with the debt instrument used to
finance it. Because it mitigates financial risk, maturity matching is a hedging approach to
financing.
B. Using 5-year bonds to finance inventory acquisition.

Inventory is a current asset that is expected to be sold within 1 year. Thus, financing
inventory with a 5-year bond is not an example of maturity matching, which is a hedging
approach to financing.
C. Financing building projects with accounts payable.

Accounts payable is a current liability. However, a building project should be financed using a
long-term liability because the life of the building is greater than 1 year. If a building is
financed with a long-term liability, maturity matching has taken place.
D. Increasing earnings by purchasing stock puts.

Purchasing stock puts does not necessarily increase earnings.
Question: 10 Which of the following is exercisable only at the expiration date?
A. Call option.
A call option may be a European option or an American option
B. American option.
An American option is exercisable at any time up to its expiration.
C. European option.
An American option is a contractual arrangement that gives the owner the right to buy or sell
an asset at a fixed price at any moment in time before or on a specified date. A European
option is exercisable only at the expiration date.
D. Put option.
A put option may be a European option or an American option.
Question: 11 An entity is planning on issuing at par, £5 million of 10-year, non-prepayable debt at

9% interest. The entity wants to convert its fixed-rate interest payments to floating-rate
interest payments based on the London interbank offered rate. Which one of the
following contracts should the entity consider?
A. Options.
Options are the most common form of derivative. As the name implies, the party who buys the option
has bought the right to demand that the counterparty (the seller) perform some action on or before a
specified date. The exercise of the option is at the discretion of the option holder (the buyer).
B. Forwards.
In a forward contract, two parties (often a wholesaler and a retailer) agree on a sale in
advance of delivery, with the price and quantities finalized in advance.
C. Futures.
A futures contract involves exchanging specific merchandise, such as grains, metals, fossil
fuels, or foreign currencies. It is a commitment to buy or sell an asset at a fixed price.
D. Swaps.
Swaps are contracts by which the parties exchange cash flows. Interest rate swaps are
agreements to exchange interest payments based on one interest structure for payments
based on another structure. For example, a company with fixed debt service charges may
enter into a swap with a counterparty who agrees to supply the first party with interest
payments based on a floating rate that more closely tracks the first party’s revenues.
Question: 12 A gold-mining company expects to sell 10,000 ounces of gold 6 months from today.
The revenue risk of selling the gold can be hedged by
A. Buying a gold futures contract for 10,000 ounces today that expires in 6 months.
Buying a gold futures contract for 10,000 ounces today that expires in 6 months will not
hedge the revenue risk of selling the gold. By buying a gold futures contract, the company is
buying gold at a pre-determined rate. Because it wants to sell gold, not buy it, this hedge
would not achieve its objectives.
B. Selling the gold in the spot market 6 months from today.

Selling the gold in the spot market 6 months from today will not hedge the revenue risk. The
spot rate 6 months from now could be less or more than the spot rate today. The company
could potentially lose revenue if the spot rate is less in 6 months. This transaction does not
hedge risk.
C. Selling a gold futures contract for 10,000 ounces today that expires in 6 months.
Selling a gold futures contract for 10,000 ounces today that expires in 6 months would allow
the gold-mining company to lock in a selling price today for the sale of the 10,000 ounces in 6
months when the contract expires. This will hedge the revenue risk as the company pre-
determined what it will get for the contract in 6 months.
D. Buying a gold futures contract for 5,000 ounces today that expires in 6 months and selling a
gold futures contract for 5,000 ounces today that expires in 6 months.
Buying a gold futures contract for 5,000 ounces today that expires in 6 months and selling a
gold futures contract for 5,000 ounces today that expires in 6 months will not effectively
hedge the company’s revenue risk. By buying a gold futures contract, the company is buying
gold at a pre-determined rate. Because it wants to sell gold, not buy it, this hedge would not
achieve its objectives. Even though the company would want to sell a gold futures contract, it
would not be for 5,000. By only selling a gold futures contract for 5,000 ounces, it is hedging
half its risk.
Question: 13 Which one of the following is not a determinant in valuing a call option?
A. Interest rate.
The risk-free interest rate is one of the determinants of the value of a call option.
B. Exercise price.
Exercise price is one of the determinants on which the value of a call option is based.
C. Forward contract price.

The exercise price, the expiration date, and the interest rate are all determinants in valuing a
call option.
D. Expiration date.
The call option’s expiration date is used in determining the call option’s value.
Question: 14 A contractual arrangement that gives the owner the right to buy or sell an asset at a
fixed price at any moment in time before or on a specified date is a(n)
A. Future option.
Although an option can be exercised in the future, it is not called a future option.
B. European option.
A European option is exercisable only at the expiration date.
C. American option.
An American option is a contractual arrangement that gives the owner the right to buy or sell
an asset at a fixed price at any moment in time before or on a specified date.
D. Foreign option.
A foreign option is a nonsense term.
Question: 15 A U.S. company has accounts receivable from a Swiss company for 100,000 Swiss
Francs (CHF) due in 3 months. At the time of contract, the exchange rate was 1.0 CHF
= 1.0 USD. The U.S. company wishes to manage its foreign exchange exposure and
therefore
A. Sells U.S. Dollar futures.

The company should buy, not sell, U.S. Dollars
B. Sells a Swiss Francs interest rate swap.

Interest rate swaps are agreements to exchange interest payments based on one interest
structure for payments based on another structure.
C. Buys U.S. Dollar futures.

A forward contract like the one described in this question is appropriate for a retailer and a
wholesaler, who are exchanging very specific merchandise and can take the time to address
all the facets of the contract. Buying a U.S. Dollar futures contract allows the company to buy
U.S. Dollars at a stated rate when receiving accounts receivable in 3 months. This will hedge
the future fluctuation of a U.S. Dollar.
D. Buys a currency swap.

Swaps are contracts by which the parties exchange cash flows. Currency swaps are
agreements to exchange cash flows denominated in one currency for cash flows
denominated in another.
Question: 16 How much must the stock be worth at expiration in order for a call holder to break even
if the exercise price is $60 and the call premium was $3?
A. $60.00
The amount of $60 is the result of failing to consider the impact of the call premium.
B. $57.00
The amount of $57 is the result of deducting the call premium from the exercise price.
C. $61.50
The full call premium must be added to the exercise price.
D. $63.00
Because the call premium is $3, the stock price must be at least $63 ($60 exercise price + $3
call premium).
Question: 17 A major homebuilder will use lumber to build a large development of homes next year.
If the homebuilder plans to buy the lumber next year, it can hedge its future costs if it
A. Buys a lumber futures contract next year.
Buying the futures contract next year does not help because it hedges its future costs farther
down the road, not when the homebuilder actually needs the lumber.
B. Sells a lumber futures contract today that expires next year.

Selling the futures contract would mean that the homebuilder would have to sell the lumber
next, which is not the goal since the homebuilder needs to build with the lumber.
C. Buys and sells lumber futures contracts today that expire next year.

These two actions would offset each other and thus would not hedge against price fluctuations.
D. Buys a lumber futures contract today that expires next year.

Buying the futures contract allows the homebuilder to buy the lumber next year at a stated
rate. This will hedge the future costs.
Question: 18 The use of derivatives to either hedge or speculate results in
A. Offsetting risk when hedging and increased risk when speculating.

Derivatives, including options and futures, are contracts between the parties who contract.
Unlike stocks and bonds, they are not claims on business assets. A futures contract is
entered into as either a speculation or a hedge. Speculation involves the assumption of risk in
the hope of gaining from price movements. Hedging is the process of using offsetting
commitments to minimize or avoid the impact of adverse price movements.
B. Increased risk regardless of motive.

Hedging decreases risk by using offsetting commitments that avoid the impact of adverse
price movements
C. Decreased risk regardless of motive.

Speculation involves the assumption of risk in the hope of gaining from price movements.
D. Offsetting risk when speculating and increased risk when hedging.

Speculating increases risk while hedging offsets risk.
Question: 19 The type of option that does not have the backing of stock is called a(n)
A. Unsecured option.
An unsecured option is a nonsense term.
B. Naked option.
A naked or uncovered option is a call option that does not have the backing of stock. Thus,
the option writer will have to purchase the underlying stock if the call option is exercised.
C. Covered option.
A covered option is one that is written against stock held in the option writer’s portfolio.
D. Put option.
A put option is an option that gives the owner the right to sell the underlying asset for a fixed
price.
Question: 20 The owner of a call option wants to know the respective effects on the call’s price of a
decrease in stock-return volatility and a decrease in time to expiration. The respective
effects on the call’s price are which of the following?
Decrease in Stock-Return Volatility Decrease in Time to Expiration
A. Increase Increase

Both a decrease in stock-return volatility and a decrease in time to expiration will cause the
call’s price to decrease, not increase.
B. Decrease Decrease

A decrease in stock-return volatility will cause the call’s price to decrease. A decrease in the
time to expiration will also cause the call’s price to decrease. Thus, both of these effects will
cause a decrease in the call’s price.
C. Increase Decrease

A decrease in stock-return volatility will cause the call’s price to decrease, not increase.
D. Decrease Increase

A decrease in time to expiration will cause the call’s price to decrease, not increase.
Question: 21 Buying a wheat futures contract to protect against price fluctuation of wheat would be
classified as a
A. Fair value hedge.

A fair value hedge is an instrument designed as hedging the exposure to changes in fair
value of an asset or liability or an identified portion thereof that is attributed to a particular
risk.
B. Foreign currency hedge.
A foreign currency hedge is an instrument designated as hedging the exposure to variability
in foreign currency.
C. Cash flow hedge.

A cash flow hedge is an instrument designated as hedging the exposure to variability in
expected future cash flows attributed to a particular risk.
D. Swap.
A swap is a contract between two parties in which the parties promise to make payments to
one another on scheduled dates in the future and use different criteria or formulas to
determine their respective payments.
Question: 22 If a corporation holds a forward contract for the delivery of U.S. Treasury bonds in
6 months and, during those 6 months, interest rates decline, at the end of the 6 months
the value of the forward contract will have
A. Decreased.
The value of the forward contract will increase when interest rates decrease.
B. Remained constant.
The value of the forward contract will increase when interest rates decrease.
C. Increased.
Interest rate futures contracts involve risk-free bonds, such as U.S. Treasury bonds. When
interest rates decrease over the period of a forward contract, the value of the bonds and the
forward contract increase.
D. Any of the answers may be correct, depending on the extent of the decline in interest rates.
Any decline in interest rates increases the value of the bonds.
Question: 23 Which one of the following is not correct regarding the value of options?
A. The higher the strike price, the lower the value of a call option and the higher the value of a put
option.
The strike price is the price at which the owner can purchase or sell the asset underlying the
option contract. The higher the strike price, the cheaper the call option will be. Conversely,
the higher the strike price, the more expensive the put option will be.
B. The value of a put option is adversely related to the risk-free interest rate, and the value of a call
is positively related to the risk-free interest rate.
A rise in interest rates will result in a rise in the value of a call option and a fall in the value of
a put option.
C. Volatility of the underlying stock increases the value of a call option but decreases the value of
a put option.
An increase in the volatility of the price of the underlying will result in an increase in the value
of both call options and put options.
D. As the stock price increases, the value of a put option decreases but the value of a call option
increases.
When the stock price goes up, a call option will gain in value and a put option will decrease in
value.
Question: 24 If a call option is “out of the money,”
A. The option no longer exists.

The option does exist; it is just not worth exercising.
B. The value of the underlying asset is less than the exercise price.
Although the value of the underlying asset is less than the exercise price, it is also not worth
exercising.
C. It is not worth exercising.

Although the call option is not worth exercising, the value of the underlying asset is also less
than the exercise price.
D. It is not worth exercising, and the value of the underlying asset is less than the exercise price.
When the value of the asset underlying a call option is less than the exercise price of the
option, the option is “out of the money,” which means it is not worth exercising.

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s6: (104) Valuation Methods and Cost of Capital

1: (11) Stock Valuation Methods

1: (11) Stock Valuation Methods

A. The 3-year assumption is changed to 5 years.

B. The 10% growth rate is changed to 8%.

C. The required return is changed from 12% to 14%.

D. The growth rate is changed from 5% to 4%.

Price = [Current period dividend × (1 + Growth rate)] ÷

$36 = ($3.00 × 1.09) ÷ (x – 9%)

The rate of return can now be solved for as follows:

$2.10 ÷ (x – .05) = $14

• Dividend at end of current year = $1.00

Year Dividend paid during the year

20% = ($244 – x + $20) ÷ x

Question: 1 The following is an excerpt from a balance sheet:

Long-term debt (9% interest rate) $30,000,000

Preferred stock (100,000 shares, 12% dividend) 10,000,000

Common stock (5,000,000 shares outstanding) 60,000,000

Long-term debt $ 32,500,2001 26% × 4.8% = 1.25%

Preferred stock 12,500,0002 10% × 9.6% = .96%

Common stock 80,000,0003 64% × 17.0% = 10.88%

Totals $125,000,200 100% 13.09%

1 ($1,083.34 market ÷ $1,000 carrying amount) × $30,000,000 = $32,500,200

2 $125 market price × 100,000 shares outstanding = $12,500,000

3 $16 market price × 5,000,000 shares outstanding = $80,000,000

Accounts payable $35,000,000 -0-

Long-term debt 10,000,000 8%

Common stock 10,000,000 15%

Retained earnings 5,000,000 18%

Answer (A) is correct.

Carrying Amount Weight Cost of Capital Weighted Cost

Long-term debt $10,000,000 40% × 8% = 3.2%

Common stock 10,000,000 40% × 15% = 6.0%

Retained earnings 5,000,000 20% × 18% = 3.6%

Totals $25,000,000 100% 12.8%

Question: 3 The cost of debt most frequently is measured as

A. Actual interest rate minus tax savings.

B. Actual interest rate plus a risk premium.

C. Actual interest rate adjusted for inflation.

A. The cost of common stock.

B. The weighted average cost of capital for the firm.

D. The same as the cost of preferred stock.

B. Cash flow with the stock issue is $525,000 higher.

C. Cash flow with the bond issue is $225,000 higher.

D. Cash flow with the bond issue is $50,000 higher.

Answer (D) is correct.

Component Weight Cost Cost

Long-term debt 25% × 3.9% = .975%

Preferred stock 10% × 10.0% = 1.000%

Common stock 65% × 15.0% = 9.750%

A. Minimum weighted-average cost of capital.

C. Minimum cost of debt.

D. Maximum earnings per share.

Question: 8 A company is in the process of considering various methods of raising additional

1. Option 1: Issue debt of $15 million with a pre-tax cost of 10%.

A. Option 2 because the equity to total capital ratio will be 86%.

B. Option 1 because the equity to total capital ratio will be 43%.

C. Option 1 because it has the lower WACC of 7.72%.

Weight Instrument Capital

40% Bonds 10%