Chapter 9 - The Cost of Capital PDF

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Financial Management: Theory And Practice, Canadian Edition, 3rd ed.
By Nelson Education...

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CHAPTER 9 - THE COST OF CAPITAL 1. The cost of preferred stock to a firm must be adjusted to an after-tax figure because dividends received by a corporation may be excluded from the receiving corporation’s taxable income. a. True b. Fals e ANSWER: Fals e 2. The cost of common stock is the rate of return the marginal shareholder requires on the firm’s common stock. a. True b. Fals e ANSWER: True 3. For capital budgeting and cost of capital purposes, the firm should always consider retained earnings as the first source of capital, i.e., use these funds first, because retained earnings have no cost to the firm. a. True b. Fals e ANSWER: Fals e 4. Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new common shares or bonds does have a cost. a. True b. Fals e ANSWER: Fals e 5. The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors. a. True b. Fals e ANSWER: Fals e 6. The firm’s cost of external equity raised by issuing new stock is the same as the required rate of return on the firm’s outstanding common stock. a. True b. Fals e ANSWER: Fals Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 9 - THE COST OF CAPITAL e 7. The cost of external equity capital raised by issuing new common stock (r e) is defined as follows, in words: “The cost of external equity equals the cost of equity capital from retaining earnings (r s), divided by 1 minus the percentage flotation cost required to sell the new stock (1 – F).” a. True b. Fals e ANSWER: Fals e 8. If the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common stock (re) is equal to the cost of equity capital from retaining earnings (r s) divided by 1 minus the percentage flotation cost required to sell the new stock, (1 – F). If the expected growth rate is not zero, then the cost of external equity must be found using a different procedure. a. True b. Fals e ANSWER: True 9. Suppose you are the president of a small, publicly traded corporation. Since you believe that your firm’s share price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. Thus, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt. a. True b. Fals e ANSWER: Fals e 10. The higher the firm’s flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and retained earnings, whose cost is the average return on assets. a. True b. Fals e ANSWER: Fals e 11. If a firm’s marginal tax rate is increased, and other things held constant, this would lower the cost of debt used to calculate its WACC. a. True b. Fals e ANSWER: True 12. In general, firms should use their WACC to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 9 - THE COST OF CAPITAL to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project. a. True b. Fals e ANSWER: Fals e 13. Suppose the debt ratio (D/TA) is 10%, the current cost of debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 20% would have to decrease the WACC. a. True b. Fals e ANSWER: Fals e 14. The cost of debt, rd, is normally less than rs, so rd(1 – T) will normally be less than rs. Therefore, as long as the firm is not completely debt financed, the WACC will normally be greater than r d(1 – T). a. True b. Fals e ANSWER: True 15. The lower the firm’s tax rate, the lower its after-tax cost of debt and WACC will be, other things held constant. a. True b. Fals e ANSWER: Fals e 16. Given that Firms X and Y are two separate entities, the cost of debt for X can be greater than the cost of equity for Y. a. True b. Fals e ANSWER: True 17. If expectations for long-term inflation rose, but the slope of the SML remained constant, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Therefore, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt. a. True b. Fals e ANSWER: Fals e 18. To estimate the required rate of return on common equity, the DCF method can be used only for constant growth Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 9 - THE COST OF CAPITAL stocks. a. True b. Fals e ANSWER: Fals e 19. The component costs of capital are based on embedded costs. a. True b. Fals e ANSWER: Fals e 20. If investors’ aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the required rate of return on equity, r s, than on the interest rate on long-term debt, r d, for most firms. Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity. However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit the shift toward debt. a. True b. Fals e ANSWER: True 21. Which of the following is not a capital component when calculating the WACC? a. long-term debt b. accounts payable c. retained earnings d. preferred stock ANSWER: b 22. Among various sources of financing, which one will receive favourable tax treatments by issuers? a. long-term debt b. common stock c. retained earnings d. preferred stock ANSWER: a 23. For a typical firm, which sequence is correct? All rates are after taxes, and assume the firm operates at its target capital structure. a. re > rs > WACC > rd b. rs > re > rd > WACC Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 9 - THE COST OF CAPITAL c. WACC > re > rs > rd d. rd > re > rs > WACC ANSWER: a 24. Bankston Corporation forecasts that if all of its existing financial policies are adhered to, its proposed capital budget would be so large that it would have to issue new common stock. Since new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock. Which action would reduce its need to issue new common stock? a. increasing the percentage of debt in the target capital structure b. increasing the dividend payout ratio for the upcoming year c. increasing the proposed capital budget d. reducing the amount of short-term bank debt in order to increase the current ratio ANSWER: a 25. Schalheim Sisters Inc. has always paid out all of its earnings as dividends, and hence has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity. Its target capital structure consists of common stock, preferred stock, and debt. Which circumstance would reduce the WACC? a. The market risk premium declines. b. The flotation costs associated with issuing new common stock increase. c. The company’s beta increases. d. Expected inflation increases. ANSWER: a 26. When working with the CAPM, which factor can be determined with the most precision? a. the market risk premium (RPM) b. the beta coefficient, bi, of a relatively safe stock c. the most appropriate risk-free rate, r RF d. the beta coefficient of “the market,” which is the same as the beta of an average stock ANSWER: d 27. Jackson Inc. uses only equity capital, and it has two equally sized divisions. Division A’s cost of capital is 10.0%, Division B’s cost is 14.0%, and the composite WACC is 12.0%. All of Division A’s projects have the same risk, as do all of Division B’s projects. However, the projects in Division A have less risk than those in Division B. Which of the following projects should Jackson accept? a. a Division B project with a 13% return b. a Division B project with a 12% return c. a Division A project with an 11% return d. a Division A project with a 9% return ANSWER: c 28. Vang Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which project (A, B, C, or D) should the company Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 9 - THE COST OF CAPITAL accept? a. Project B is of below-average risk and has a return of 8.5%. b. Project C is of above-average risk and has a return of 11%. c. Project A is of average risk and has a return of 9%. d. Project A has a below-average risk and has a return of 7.5%. ANSWER: a 29. Nelson Enterprises, an all-equity firm, has a beta of 2.0. Nelson’s chief financial officer is evaluating a project with an expected return of 21%, before any risk adjustment. The risk-free rate is 7%, and the market risk premium is 6%. The project being evaluated is riskier than Nelson’s average project, in terms of both its beta risk and its total risk. Which of the following statements is correct? a. The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return. b.The project should definitely be rejected because its expected return (before risk adjustments) is less than its required return. c. Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment. d.The accept/reject decision depends on the firm’s risk-adjustment policy. If Nelson’s policy is to increase the required return on a riskier-than-average project to 3% over r S, then it should reject the project. ANSWER: d 30. The McCue Company has equal amounts of low-risk, average-risk, and high-risk projects. McCue estimates that its overall WACC is 12%. The CFO believes that this is the correct WACC for the company’s average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees on the grounds that, even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO’s position is accepted, what is likely to happen over time? a. The company will take on too many high-risk projects and reject too many low-risk projects. b. The company will take on too many low-risk projects and reject too many high-risk projects. c. Things will generally even out over time, and therefore the firm’s risk should remain constant over time. d. The company’s overall WACC should decrease over time because its stock price should be increasing. ANSWER: a 31. What will happen if a typical company uses the same cost of capital to evaluate all projects? a. The firm will likely become riskier over time, but its intrinsic value will be maximized. b. The firm will likely become riskier over time, and its intrinsic value will not be maximized. c. The firm will likely become less risky over time, and its intrinsic value will not be maximized. Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 9 - THE COST OF CAPITAL d. The firm will likely become less risky over time, and its intrinsic value will be maximized. ANSWER: b 32. Which of the following statements is correct? a. All else being equal, an increase in a company’s stock price will increase its marginal cost of retained earnings, r s. b.All else being equal, an increase in a company’s stock price will increase its marginal cost of new common equity, r e. c. Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt. d.If a company’s tax rate increases but the YTM of its noncallable bonds remains the same, the after-tax cost of its debt will fall. ANSWER: d 33. Unless substantial amounts of capital are needed, if a firm obtains all of its common equity from retained earnings, what will happen to its marginal cost of capital curve? a. It will stay flat. b. It will rise. c. It will fall. d. It will be Ushaped. ANSWER: a 34. Which of the following statements is correct? a. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation. b.When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation. c. Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock. d.If a company’s beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence needs to issue new stock. ANSWER: a 35. Which of the following statements is correct? a. We should use historical measures of the component costs from prior financings when estimating a company’s WACC for capital budgeting purposes. b.The cost of new equity (re) could possibly be lower than the cost of retained earnings (rs) if the market risk premium, risk-free rate, and the company’s beta all decline by a sufficiently large amount. c. The cost of retained earnings is the rate of return shareholders require on a firm’s common stock. Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 9 - THE COST OF CAPITAL d.The component cost of preferred stock is expressed as r p(1 – T), because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt. ANSWER: c 36. Which of the following statements is correct? a. The WACC as used in capital budgeting is an estimate of a company’s before-tax cost of capital. b.The percentage flotation costs associated with issuing new common equity are typically smaller than the flotation costs for new debt. c. The WACC, as used in capital budgeting, is an estimate of the cost of all the capital a company has raised to acquire its assets. d.There is an opportunity cost associated with using retained earnings, hence they are not “free.” ANSWER: d 37. Which statement about WACC is true? a. A change in a company’s target capital structure cannot affect its WACC. b. WACC calculations should be based on the before-tax costs of all the individual capital components. c. Flotation costs associated with issuing new common stock normally reduce the WACC. d. If a company’s tax rate increases, then, all else equal, its WACC will decline. ANSWER: d 38. Which of the following statements is correct? a. The WACC is calculated using before-tax costs for all components. b.The after-tax cost of debt usually exceeds the after-tax cost of equity. c. Retained earnings that were generated in the past and are reflected on the firm’s balance sheet are generally available to finance the firm’s capital budget during the coming year. d.The WACC that should be used in capital budgeting is the firm’s marginal, after-tax cost of capital. ANSWER: d 39. Suppose a company’s target capital structure calls for 50% debt and 50% common equity. Which of the following statements is correct? a. The cost of equity is always equal to, or greater than, the cost of debt. b. The WACC is calculated on a before-tax basis. c. The WACC exceeds the cost of equity. d. The cost of retained earnings typically exceeds the cost of new common stock. ANSWER: a 40. What are flotation costs? Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 9 - THE COST OF CAPITAL a. They are part of the capital cost calculations for all debt and equity components. b. They are normally ignored for long-term debt. c. They are not considered for retained earnings. d. They are costs associated with the issuance of company stock to members of employee stock purchase plans. ANSWER: b 41. Suppose a firm uses a single source of capital to fund a project. Which of the following statements is correct? a. Only the cost of that source should be used to evaluate the project. b. This project should still be evaluated using the firm’s WACC. c. The average cost of all previously raised capital should be used for evaluation. d. Book values of the funding source should be used in calculating WACC. ANSWER: b 42. Which statement regarding cost of capital is true? a. If a company assigns the same cost of capital to all of its projects regardless of each project’s risk, then the company is likely to reject some safe projects that it should accept and to accept some risky projects that it should reject. b.Because of the risk of bankruptcy, the cost of debt is always higher than the cost of equity capital. c. Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt. d.Higher flotation costs tend to reduce the cost of equity capital. ANSWER: a 43. Crary Consolidated has two divisions of equal size: a computer division and a restaurant division. Its CFO believes that stand-alone restaurant companies typically have a WACC of 8%, and stand-alone computer companies typically have a 12% WACC. He also believes that Crary’s restaurant and computer divisions have the same risk as their typical peers. Consequently, Crary estimates that its composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the restaurant division and a 12% hurdle rate for the computer division. However, Crary’s CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is correct? a. While Crary’s decision not to use risk-adjusted WACCs will result in its accepting more projects in the computer division and fewer projects in its restaurant division than if it followed the consultant’s recommendation, this should not affect the firm’s intrinsic value. b.Crary’s decision not to adjust for risk means, in effect, that it is favouring the restaurant division. Therefore, that division is likely to become a larger part of the consolidated company over time. c. Crary’s decision not to adjust for risk means that the company will accept too many projects in the computer business and too few projects in the restaurant business. This will lead to a reduction in the firm’s intrinsic value over time. d.Crary’s decision to not risk adjust means that the company will accept too many projects in the restaurant business and too few projects in the computer business. This will lead to a reduction in its intrinsic value over time. ANSWER: c Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 9 - THE COST OF CAPITAL 44. Safeco Company and Risco Inc. are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Safeco having a WACC of 10% and Risco a 12% WACC. Safeco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Safeco project. Risco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Risco project. Now assume that the two companies merge and form ...