47968043 MSQ 10 Cost of Capital PDF

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MANAGEMENT ADVISORY SERVICESCOST OF CAPITALTHEORY All of the following statements are correct except: a. The matching of asset and liability maturities is considered desirable because this strategyminimizes interest rate risk. b. Default risk refers to the inability of the firm to pay off its maturi...

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MANAGEMENT ADVISORY SERVICES COST OF CAPITAL

THEORY 1. All of the following statements are correct except: a. The matching of asset and liability maturities is considered desirable because this strategy minimizes interest rate risk. b. Default risk refers to the inability of the firm to pay off its maturing obligations. c. The matching of assets and liability maturities lowers default risk. d. An increase in the payables deferral period will lead to a reduction in the need to nonspontaneous funding. 2. Which of the following would increase risk? a. Increase the level of working capital. b. Change the composition of working capital to include more liquid assets. c. Increase the amount of short-term borrowing. d. Increase the amount of equity financing. 3. A firm’s financial risk is a function of how it manages and maintains its debt. Which one of the following sets of ratios characterizes the firm with the greatest amount of financial risk? A. High debt-to-equity ratio, high interest coverage ratio, stable return on equity. B. Low debt-to-equity ratio, low interest coverage ratio, volatile return on equity. C. High debt-to-equity ratio, low interest coverage ratio, volatile return on equity. D. Low debt-to-equity ratio, high interest coverage ratio, stable return on equity. 4. Which of the following classes of securities are listed in order from lowest risk/opportunity for return to highest risk/opportunity for return? (E) A. U.S. Treasury bonds; corporate first mortgage bonds; corporate income bonds; preferred stock. B. Corporate income bonds; corporate mortgage bonds; convertible preferred stock; subordinated debentures. C. Common stock; corporate first mortgage bonds; corporate second mortgage bonds; corporate income bonds. D. Preferred stock; common stock; corporate mortgage bonds; corporate debentures. 5. If the return on the market portfolio is 10% and the risk-free rate is 5%, what is the effect on a company's required rate of return on its stock of an increase in the beta coefficient from 1.2 to 1.5? A. 3% increase B. 1.5% increase C. No change D. 1.5% decrease. 6. Cost of capital is a. The amount the company must pay for its plant assets. b. The dividends a company must pay on its equity securities. c. The cost the company must incur to obtain its capital resources. d. The cost the company is charged by investment bankers who handle the issuance of equity or long-term debt securities. 7. All of the following are examples of imputed costs except a. The stated interest paid on a bank loan. b. Assets that are considered obsolete that maintain a net book value. c. Decelerated depreciation. d. Lending funds to a supplier at a lower-than-market rate in exchange for receiving the supplier’s products at a discount.

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8. The theory underlying the cost of capital is primarily concerned with the cost of A. Long-term funds and old funds. B. Short-term funds and new funds. C. Long-term funds and new funds. D. Any combination of old or new, short-term or long-term funds. 9. Management knowledge of the cost of capital is useful for each of the following except a. Making capital investment decisions. b. Managing working capital. c. Setting the maximum rate of return on new investments. d. Evaluating performance. 10. The pre-tax cost of capital is higher than the after-tax cost of capital because a. interest expense is deductible for tax purposes. b. principal payments on debt are deductible for tax purposes. c. the cost of capital is a deductible expense for tax purposes. d. dividend payments to stockholders are deductible for tax purposes. 11. The overall cost of capital is the A. Rate of return on assets that covers the costs associated with the funds employed. B. Average rate of return a firm earns on its assets. C. Minimum rate a firm must earn on high-risk projects. D. Cost of the firm's equity capital at which the market value of the firm will remain unchanged. 12. The explicit cost of debt financing is the interest expense. The implicit cost(s) of debt financing is (are) the a. Increase in the cost of debt as the debt-to-equity ratio increases. b. Increases in the cost of debt and equity as the debt-to-equity ratio increases. c. Increase in the cost of equity as the debt-to-equity ratio decreases. d. Decrease in the weighted-average cost of capital as the debt-to-equity ratio increases. 13. In computing the cost of capital, the cost of debt capital is determined by a. Annual interest payment divided by the proceeds from debt issuance. b. Interest rate times (1 – the firm’s tax rate) c. Annual interest payment divided by the book value of the debt. d. The capital asset pricing model. 14. The interest rate on the bonds is greater for the second alternative consisting of pure debt than it is for the first alternative consisting of both debt and equity because A. The diversity of the combination alternative creates greater risk for the investor. B. The pure debt alternative would flood the market and be more difficult to sell. C. The pure debt alternative carries the risk of increasing the probability of default. D. The combination alternative carries the risk of increasing dividend payments. 15. If a $1,000 bond sells for $1,125, which of the following statements are correct? I. The market rate of interest is greater than the coupon rate on the bond. II. The coupon rate on the bond is greater than the market rate of interest. III. The coupon rate and the market rate are equal. IV. The bond sells at a premium. V. The bond sells at a discount. a. I and IV. b. I and V. c. II and IV. d. II and V. 16. Companies experience changes in interest expenses, variable cost per unit, quantity of units sold, and fixed costs. Their degree of operating leverage is not affected by the change in A. Interest expenses. C. Quantity of units sold. B. Variable cost per unit. D. Fixed costs.

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17. If the return on total assets is 10% and if the return on common stockholders’ equity is 12% then a. The after-tax cost of long-term debt is probably greater than 10%. b. The after-tax cost of long-term debt is 12%. c. Leverage is negative. d. The after-tax cost of long-term debt is probably less than 10%. 18. The basis for measuring the cost of capital derived from bonds and preferred stock, respectively, is the A. after-tax rate of interest for bonds and stated annual dividend rate for preferred stock B. pretax rate of interest for bonds and stated annual dividend rate less the expected earnings per share for preferred stock C. pretax rate of interest for bonds and stated annual dividend rate for preferred stock D. after-tax rate of interest for bonds and stated annual dividend rate less the expected earnings per share for preferred stock 19. The market value of a firm’s outstanding common shares will be higher, everything else equal, if a. Investors have a lower required return on equity. b. Investors expect lower dividend growth. c. Investors have longer expected holding periods. d. Investors have shorter expected holding periods. 20. When calculating the cost of capital, the cost assigned to retained earnings should be A. Zero. B. Lower than the cost of external common equity. C. Equal to the cost of external common equity. D. Higher than the cost of external common equity. 21. The three elements needed to estimate the cost of equity capital for use in determining a firm's weighted-average cost of capital are A. Current dividends per share, expected growth rate in dividends per share, and current book value per share of common stock. B. Current earnings per share, expected growth rate in dividends per share, and current market price per share of common stock. C. Current earnings pers share, expected growth rate in earnings per share, and current book value per share of common stock. D. Current dividends per share, expected growth rate in dividends per share, and current market price per share of common stock. 22. An investor uses the capital asset pricing model (CAPM) to evaluate the risk-return relationship on a portfolio of stocks held as an investment. Which of the following would not be used to estimate the portfolio's expected rate of return? A. Expected risk premium on the portfolio of stocks. B. Interest rate for the safest possible investment. C. Expected rate of return on the market portfolio. D. Standard deviation of the market returns. 23. According to the capital asset pricing model (CAPM), the relevant risk of a security is its A. Company-specific risk. C. Systematic risk. B. Diversifiable risk. D. Total risk. 24. The weighted average cost of capital represents the a. cost of bonds, preferred stock, and common stock divided by the three sources. b. equivalent units of capital used by the organization. c. overall cost of capital from all organization financing sources. d. overall cost of dividends plus interest paid by the organization.

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25. Which of the following is not considered a capital component for the purpose of calculating the weighted average cost of capital as it applies to capital budgeting? a. Long-term debt. b. Common stock. c. Short-term debt. d. Preferred stock. 26. When calculating a firm's cost of capital, all of the following are true except that A. The cost of capital of a firm is the weighted average cost of its various financing components. B. The calculation of the cost of capital should focus on the historical costs of alternative forms of financing rather than market or current costs. C. All costs should be expressed as after-tax costs. D. The time value of money should be incorporated into the calculations. 27. 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. B. The after-tax cost of new-debt financing. C. The cost of equity financing. D. The weighted-average cost of capital. 28. The weighted-average cost of capital approach to decision making is not directly affected by the: A. proposed mix of debt, equity, and existing funds used to implement the project B. value of the common stock C. cost of debt outstanding D. current budget for expansion. 29. Which class of leverage causes earnings before interest and taxes to be more sensitive to changes in sales? A. Credit. B. Financial. C. Operating. D. Intrinsic. 30. A firm with a higher degree of operating leverage when compared to the industry average implies that the A. Firm has higher variable costs. B. Firm's profits are more sensitive to changes in sales volume. C. Firm is more profitable. D. Firm is less risky. 31. The purchase of treasury stock with a firm's surplus cash A. Increases a firm's assets. C. Increases a firm's interest coverage ratio. B. Increases a firm's financial leverage. D. Dilutes a firm's earnings per share. 32. Which of the changes in leverage would apply to a company that substantially increases its investment in fixed assets as a proportion of total assets and replaces some of its long-term debt with equity? A. B. C. D. Financial Leverage Increase Decrease Increase Decrease Operating Leverage Decrease Increase Increase Decrease Problems 1. Based on the following information about stock price increases and decreases, make an estimate of the stock's beta: Month 1 = Stock +1.5%, Market +1.1%; Month 2 = Stock +2.0%, Market +1.4%; Month 3 = Stock -2.5%, Market -2.0%. A. Beta is greater than 1.0. C. Beta equals 1.0 B. Beta is less than 1.0. D. There is no consistent pattern of returns. 2. What is the yield to maturity on Fox Inc.'s bonds if its after-tax cost of debt is 9% and its tax rate is 34%?

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A. 5.94%

B. 9%

C. 13.64%

D. 26.47%

3. Maylar 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. 7.31%. B. 4.87%. C. 12.00%. D. 7.09%. 4. The MNO Company believes that it can sell long-term bonds with a 6% coupon but at a price that gives a yield-to-maturity of 9%. If such bonds are part of next year’s financing plans, which of the following should be used for bonds in their after-tax (40%) cost-of-capital calculation? A. 3.6% B. 5.4% C. 4.2% D. 6% 5. Ambry Inc. is going to use an underwriter to sell its preferred stock. Four underwriters have given estimates (below) on their fees and the selling price of the stock, as well as the expected dividend for each: Fees Selling Price Dividends Underwriter 1 $5 $101 $10 Underwriter 2 7 102 11 Underwriter 3 3 97 7 Underwriter 4 3 98 8 Which underwriter will produce the lowest cost of funds for the preferred stock? A. Underwriter 1. B. Underwriter 2. C. Underwriter 3. D. Underwriter 4. 6. Gravy Company expects earnings of P30 million next year. Its dividend payout ratio is 40%, and its debt/equity ratio is 1.50. Gravy uses no preferred stock. At what amount of financing will there be a break point in Gravy’s marginal cost of capital? A. P45 million. B. P30 million. C. P20 million. D. P18 million. 7. Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent common equity. The current market price of the firm’s stock is P 0 = $28; its last dividend was D0 = $2.20, and its expected dividend growth rate is 6 percent. What will Allison’s marginal cost of retained earnings, ks, be? a. 15.8% b. 13.9% c. 7.9% d. 14.3% 8. Doris Corporation's stock has a market price of $20.00 and pays a constant dividend of $2.50. What is the required rate of return on its stock? A. 13.0% B. 12.5% C. 12.0% D. 11.5% 9. The ABC Company is expected to have a constant annual growth rate of 5 percent. It has a price per share of P32 and pays an expected dividend of P2.40. Its competitor, the DEF Company is expected to have a growth rate of 10%, has a price per share of P72, and pays an expected P4.80/share dividend. The required rates of return on equity for the two companies are: A. B. C. D. ABC 13.8% 9.6% 12.5% 16.2% DEF 15.4% 8.6% 16.7% 18.2% 10. Frostfell Airlines is expected to pay an upcoming dividend of $3.29. The company's dividend is expected to grow at a steady, constant rate of 5% well into the future. Frostfell currently has 1,600,000 shares of common stock outstanding. If the required rate of return for Frostfell is 12%, what is the best estimate for the current price of Frostfell's common stock? A. $65.80 B. $62.51 C. $47.00 D. $27.41 11. Newmass, Inc. paid a cash dividend to its common shareholders over the past 12 months of $2.20 per share. The current market value of the common stock is $40 per share, and investors are anticipating the common dividend to grow at a rate of 6% annually. The cost to

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