Chapter 12 Cost of Capital

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1 Chapter 12 Cost of Capital 1. The return that shareholders require on their investment in the firm is called the: A) Dividend yield. B) Cost of equity. C) Capital gains yield. D) Cost of capital. E) Income return. 2. The proportions of the market value of the firm's assets financed via debt, common stock, and preferred stock are called the firm's. A) financing costs B) portfolio weights C) beta coefficients D) capital structure weights E) costs of capital 3. When firms develop a WACC for individual projects based on the cost of capital for other firms in similar lines of business as the project, the firm is utilizing a. A) subjective risk approach B) pure play approach C) divisional cost of capital approach D) capital adjustment approach E) security market line approach 4. Which of the following is FALSE regarding the use of the dividend growth model for estimating the cost of equity capital? A) A key advantage to this model is its high degree of simplicity. B) The results from this model are not sensitive to changes in the dividend growth rate. C) One method of estimating future growth rates is the use of historical growth rates. D) The model works particularly well for companies that maintain a mostly steady dividend growth rate. E) The model does not explicitly consider risk. Page 1

2 5. You need to calculate the cost of equity capital for a dividend-paying stock that is traded on the New York Stock Exchange. Which of the following would likely be least helpful to you? A) The rate of return on stocks of similar risk. B) Knowledge of the stock's price six months ago. C) The stock's current market-to-book ratio. D) An investment survey that projects future dividend growth rates for the firm. E) A data set containing dividends paid for the past ten years. 6. Which of the following is true regarding a firm's cost of debt? A) The cost of debt must be adjusted higher due to the firm's tax deductibility of interest expense. B) The firm's cost of debt based on its past borrowing is known as its structural debt cost. C) It is possible to determine a firm's cost of debt by using the SML. D) The coupon rate on outstanding debt is the firm's current cost of debt. E) A firm's cost of equity is generally easier to calculate than a firm's cost of debt. 7. All else the same, a higher corporate tax rate. A) will decrease the WACC of a firm with some debt in its capital structure B) will increase the WACC of a firm with some debt in its capital structure C) will not affect the WACC of a firm with some debt in its capital structure D) will decrease the WACC of a firm with no debt in its capital structure E) will change the WACC of a firm with some debt in its capital structure, but the direction is unclear. 8. A firm that uses its WACC as a cutoff without consideration of project risk: A) Tends to become less risky over time. B) Tends to reject more negative NPV projects over time. C) Likely will see its WACC rise over time. D) Will only accept projects where the IRR is equal to the WACC. E) Ignores the capital structure of the firm. 9. Suppose a firm uses a constant WACC in determining the value of capital budgeting projects rather than using the security market line. The firm will tend to. A) accept profitable, low risk projects and reject unprofitable, high risk projects B) accept profitable, low risk projects and accept unprofitable, high risk projects C) reject profitable, low risk projects and accept unprofitable, high risk projects D) reject profitable, low risk projects and reject unprofitable, high risk projects E) become less risky over time Page 2

3 10. To estimate the cost of equity for a firm, which of the following variables would NOT be needed? A) The current dividend payment. B) The risk-free interest rate. C) The debt/equity ratio. D) The beta coefficient. E) The market price of the stock. 11. The long-term debt of your firm is currently selling for 109% of its face value. The issue matures in 12 years and pays an annual coupon of 7.5%. What is the cost of debt? A) 5.60% B) 6.40% C) 7.50% D) 8.90% E) 9.30% 12. Suppose that your firm has a cost of equity of 18% and a cost of debt of 8%. If the target debt/equity ratio is 0.60, and the tax rate is 35%, what is the firm's weighted average cost of capital (WACC)? A) 7.4% B) 9.9% C) 11.8% D) 13.2% E) 14.3% 13. Given the following information, what is the average annual dividend growth rate? Dividend $1.80 $1.90 $2.15 $2.28 $2.49 $2.75 A) 4.9% B) 6.2% C) 8.8% D) 9.7% E) 10.3% 14. A company has preferred stock outstanding which pays a dividend of $6 per share a year. The current stock price is $75 per share. What is the cost of preferred stock? A) 6% B) 7% C) 10% D) 9% E) 8% Page 3

4 15. Given the following information, what is the firm's weighted average cost of capital? Market value of equity = $30 million; market value of debt = $20 million; cost of equity = 15%; cost of debt = 9%; equity beta = 1.4; tax rate = 35%. A) 11.34% B) 12.60% C) 12.97% D) 13.32% E) 14.08% 16. The market value of debt is $425 million and the total market value of the firm is $925 million. The cost of equity is 17%, the cost of debt is 10%, and the tax rate is 35%. What is the WACC? A) 11.01% B) 12.18% C) 13.78% D) 14.17% E) 15.64% 17. Bonds will be issued for a new project. Bonds in the same risk class issued by another firm are currently priced at $1,068.55, have 15 years remaining to maturity, and pay coupons of $90 every year. If this firm's marginal tax rate is 35%, what is the project's pretax cost of debt? A) 8.19% B) 7.47% C) 5.32% D) 6.12% E) 9.00% 18. A firm is considering a project that will generate perpetual cash flows of $25,000 per year beginning next year. The project has the same risk as the firm's overall operations and must be financed externally. Equity costs 15% and debt costs 6% on an aftertax basis. The firm's D/E ratio is 1.2. What is the most the firm can pay for the project and still earn its required return? A) $212,250 B) $247,750 C) $276,500 D) $366,250 E) $412,750 Page 4

5 19. Your firm has 8 million shares of common stock outstanding with a market price of $7.00 per share. The company also has outstanding preferred stock with a market value of $20 million, and 35,000 bonds outstanding, each with face value $1,000 and selling at 92% of par value. The cost of equity is 16%, the cost of preferred is 10%, and the cost of debt is 7%. If the tax rate is 35%, what is the WACC? A) 10.06% B) 13.21% C) 14.52% D) 12.79% E) 11.48% Page 5

CHAPTER 15 COST OF CAPITAL

CHAPTER 15 COST OF CAPITAL Answers to Concepts Review and Critical Thinking Questions 1. It is the minimum rate of return the firm must earn overall on its existing assets. If it earns more than this,