The cost of capital exercise PDF

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Cost of Capital...

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THE COST OF CAPITAL CHAPTER 11

(Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard)

Note that there is some overlap between the T/F and the multiple choice questions, as some T/F statements are used in the MC questions. See the preface for information on the AACSB letter indicators (F, M, etc.) on the subject lines. Multiple Choice: True/False (11-1) Capital 1

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F I

Answer: a

EASY

“Capital” is sometimes defined as funds supplied to a firm by investors. a. True b. False

(11-1) Cost of capital 2

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F I

Answer: a

EASY

The cost of capital used in capital budgeting should reflect the average cost of the various sources of investor-supplied funds a firm uses to acquire assets. a. True b. False

(11-1) Specific capital cost 3

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F I

Answer: b

EASY

Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case, 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. False

(11-2) Component capital costs 4

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F I

Answer: a

EASY

The component costs of capital are market-determined variables in the sense that they are based on investors' required returns. a. True b. False

(11-3) Cost of debt 5

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F I

Answer: b

EASY

The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC. a. True b. False

Chapter 11: Cost of Capital

True/False

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(11-3) Cost of debt 6

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F I

Answer: b

EASY

The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt. a. True b. False

(11-3) Cost of debt 7

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F I

Answer: a

EASY

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt. a. True b. False

(11-4) Cost of preferred 8

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F I

Answer: b

EASY

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income. a. True b. False

(11-4) Cost of preferred 9

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F I

Answer: a

EASY

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, are not deductable by the issuing firm. a. True b. False

(11-5) Cost of common 10

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F I

Answer: a

EASY

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock. a. True b. False

(11-5) Cost of retained earnings 11

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F I

Answer: b

EASY

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. False

(11-5) Cost of retained earnings 12

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F I

Answer: b

EASY

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 stock or bonds does have a cost.

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True/False

Chapter 11: Cost of Capital

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a. True b. False (11-5) Cost of retained earnings 13

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F I

Answer: b

EASY

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. False

(11-6) Cost of new common 14

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F I

Answer: b

EASY

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. False

(11-7) WACC 15

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F I

Answer: a

EASY

For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity. a. True b. False

(Comp.) Flotation and capital 16

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F I

Answer: b

EASY

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 the assets that are acquired. a. True b. False

(11-1) Specific capital cost 17

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F I

Answer: b

MEDIUM

In general, firms should use their weighted average cost of capital (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 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. False

(11-3) After-tax cost of debt 18

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F I

Answer: a

MEDIUM

If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC. a. True

Chapter 11: Cost of Capital

True/False

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b. False

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True/False

Chapter 11: Cost of Capital

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(11-5) Retained earnings 19

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F I

Answer: a

MEDIUM

The reason why retained earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm's common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should pay those earnings out to its investors. Thus, the cost of retained earnings is based on the opportunity cost principle. a. True b. False

(11-5) Cost of equity estimates 20

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F I

Answer: b

MEDIUM

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the DCF method is widely used in practice. a. True b. False

(11-5) Cost of equity estimates 21

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F I

Answer: b

MEDIUM

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the CAPM method always provides an accurate and reliable estimate. a. True b. False

(11-5) Cost of equity estimates 22

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F I

Answer: a

MEDIUM

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. Since we cannot be sure that the estimate obtained with any of these methods is correct, it is often appropriate to use all three methods, then consider all three estimates, and end up using a judgmental estimate when calculating the WACC. a. True b. False

(11-5) Cost of equity estimates 23

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F I

Answer: a

MEDIUM

When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to use long-term or short-term rates for rRF, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and (3) how to measure the market risk premium, RPM. These problems leave us unsure of the true value of rs. a. True b. False

(11-5) Cost of equity estimates 24

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F I

Answer: a

MEDIUM

When estimating the cost of equity by use of the DCF method, the single biggest potential problem is to determine the growth rate that investors

Chapter 11: Cost of Capital

True/False

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use when they estimate a stock's expected future rate of return. problem leaves us unsure of the true value of rs.

This

a. True b. False (11-5) Cost of equity estimates 25

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F I

Answer: a

MEDIUM

When estimating the cost of equity by use of the bond-yield-plus-riskpremium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs. a. True b. False

(11-5) Cost of equity estimates 26

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F I

Answer: a

MEDIUM

If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the DCF model, and we don't know what the risk premium is for use in the bond-yield-plus-riskpremium method. All this makes it especially difficult to estimate the cost of equity for a private company. a. True b. False

(11-6) Cost of new common 27

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F I

Answer: b

MEDIUM

The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: “The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 - F).” a. True b. False

(11-6) Cost of new common 28

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F I

Answer: a

MEDIUM

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 (rs) divided by one 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 formula. a. True b. False

(11-8) Factors affecting WACC 29

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F I

Answer: b

MEDIUM

Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC). a. True

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True/False

Chapter 11: Cost of Capital

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b. False

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True/False

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(11-9) Risk-adjusted capital costs 30

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F I

Answer: a

MEDIUM

Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets. They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects. a. True b. False

(Comp.) WACC 31

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F I

Answer: a

MEDIUM

The cost of debt, rd, is normally less than rs, so rd(1 - T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 - T). a. True b. False

(Comp.) Taxes, rd(1 - T), and WACC 32

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F I

Answer: b

MEDIUM

The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant. a. True b. False

(Comp.) Cost of equity 33

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F I

Answer: b

MEDIUM

Since 70% of the preferred dividends received by a corporation are excluded from taxable income, the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be Cost of equity = rs(0.30)(0.50) + rps(1 - T)(0.70)(0.50). a. True b. False

(Comp.) Inflation effects 34

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F I

Answer: b

MEDIUM

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. False

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True/False

Chapter 11: Cost of Capital

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(Comp.) Inflation effects 35

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F I

Answer: a

MEDIUM

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, rs, than on the interest rate on long-term debt, rd, 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. False

Multiple Choice: Conceptual (11-2) Capital components 36

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C I

Long-term debt. Accounts payable. Retained earnings. Common stock. Preferred stock.

(11-6) Internal vs. external common .

EASY

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting? a. b. c. d. e.

37

Answer: b

C I

Answer: b

EASY

Bankston Corporation forecasts that if all of its existing financial policies are followed, 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 of the following actions would REDUCE its need to issue new common stock? a. b. c. d.

Increase the dividend payout ratio for the upcoming year. Increase the percentage of debt in the target capital structure. Increase the proposed capital budget. Reduce the amount of short-term bank debt in order to increase the current ratio. e. Reduce the percentage of debt in the target capital structure. (11-8) Factors affecting WACC 38

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C I

Answer: a

EASY

Schalheim Sisters Inc. has always paid out all of its earnings as dividends, hence the firm 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 of the following events would REDUCE its 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.

Chapter 11: Cost of Capital

Conceptual M/C

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e. The flotation costs associated with issuing preferred stock increase.

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Conceptual M/C

Chapter 11: Cost of Capital

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

(Comp.) Capital components 39

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C I

rs > re > WACC rd > WACC

re rs > re >

> > re > rd
<...