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 non-
spontaneous funding.
. !hich of the following would increase risk"
a. #ncrease the le$el of working capital.
b. %hange the composition of working capital to include more li&uid assets.
c. #ncrease the amount of short-term borrowing.
d. #ncrease the amount of e&uity financing.
'. A firm(s financial risk is a function of how it manages and maintains its debt. !hich one of
the following sets of ratios characterizes the firm with the greatest amount of financial risk"
A. )igh debt-to-e&uity ratio* high interest co$erage ratio* stable return on e&uity.
+. ,ow debt-to-e&uity ratio* low interest co$erage ratio* $olatile return on e&uity.
%. )igh debt-to-e&uity ratio* low interest co$erage ratio* $olatile return on e&uity.
D. ,ow debt-to-e&uity ratio* high interest co$erage ratio* stable return on e&uity.
-. !hich of the following classes of securities are listed in order from lowest risk.opportunity
for return to highest risk.opportunity for return" /01
A. 2.3. Treasury bonds4 corporate first mortgage bonds4 corporate income bonds4 preferred
stock.
+. %orporate income bonds4 corporate mortgage bonds4 con$ertible preferred stock4
subordinated debentures.
%. %ommon stock4 corporate first mortgage bonds4 corporate second mortgage bonds4
corporate income bonds.
D. 5referred stock4 common stock4 corporate mortgage bonds4 corporate debentures.
6. #f the return on the market portfolio is 178 and the risk-free rate is 68* what is the effect on
a company9s re&uired rate of return on its stock of an increase in the beta coefficient from 1.
to 1.6"
A. '8 increase +. 1.68 increase %. :o change D. 1.68 decrease.
;. %ost of capital is
a. The amount the company must pay for its plant assets.
b. The di$idends a company must pay on its e&uity securities.
c. The cost the company must incur to obtain its capital resources.
d. The cost the company is charged by in$estment bankers who handle the issuance of
e&uity or long-term debt securities.
<. 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 $alue.
c. Decelerated depreciation.
d. ,ending funds to a supplier at a lower-than-market rate in exchange for recei$ing the
supplier(s products at a discount.
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=. The theory underlying the cost of capital is primarily concerned with the cost of
A. ,ong-term funds and old funds.
+. 3hort-term funds and new funds.
%. ,ong-term funds and new funds.
D. Any combination of old or new* short-term or long-term funds.
>. ?anagement knowledge of the cost of capital is useful for each of the following except
a. ?aking capital in$estment decisions.
b. ?anaging working capital.
c. 3etting the maximum rate of return on new in$estments.
d. 0$aluating performance.
17. The pre-tax cost of capital is higher than the after-tax cost of capital because
a. interest expense is deductible for tax purposes.
b. principal payments on debt are deductible for tax purposes.
c. the cost of capital is a deductible expense for tax purposes.
d. di$idend payments to stockholders are deductible for tax purposes.
11. The o$erall cost of capital is the
A. @ate of return on assets that co$ers the costs associated with the funds employed.
+. A$erage rate of return a firm earns on its assets.
%. ?inimum rate a firm must earn on high-risk proAects.
D. %ost of the firm9s e&uity capital at which the market $alue of the firm will remain
unchanged.
1. The explicit cost of debt financing is the interest expense. The implicit cost/s1 of debt
financing is /are1 the
a. #ncrease in the cost of debt as the debt-to-e&uity ratio increases.
b. #ncreases in the cost of debt and e&uity as the debt-to-e&uity ratio increases.
c. #ncrease in the cost of e&uity as the debt-to-e&uity ratio decreases.
d. Decrease in the weighted-a$erage cost of capital as the debt-to-e&uity ratio increases.
1'. #n computing the cost of capital* the cost of debt capital is determined by
a. Annual interest payment di$ided by the proceeds from debt issuance.
b. #nterest rate times /1 B the firm(s tax rate1
c. Annual interest payment di$ided by the book $alue of the debt.
d. The capital asset pricing model.
1-. The interest rate on the bonds is greater for the second alternati$e consisting of pure debt
than it is for the first alternati$e consisting of both debt and e&uity because
A. The di$ersity of the combination alternati$e creates greater risk for the in$estor.
+. The pure debt alternati$e would flood the market and be more difficult to sell.
%. The pure debt alternati$e carries the risk of increasing the probability of default.
D. The combination alternati$e carries the risk of increasing di$idend payments.
16. #f a C1*777 bond sells for C1*16* which of the following statements are correct"
#. The market rate of interest is greater than the coupon rate on the bond.
##. The coupon rate on the bond is greater than the market rate of interest.
###. The coupon rate and the market rate are e&ual.
#D. The bond sells at a premium.
D. The bond sells at a discount.
a. # and #D. b. # and D. c. ## and #D. d. ## and D.
1;. %ompanies experience changes in interest expenses* $ariable cost per unit* &uantity of units
sold* and fixed costs. Their degree of operating le$erage is not affected by the change in
A. #nterest expenses. %. Euantity of units sold.
+. Dariable cost per unit. D. Fixed costs.
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1<. #f the return on total assets is 178 and if the return on common stockholders( e&uity is 18
then
a. The after-tax cost of long-term debt is probably greater than 178.
b. The after-tax cost of long-term debt is 18.
c. ,e$erage is negati$e.
d. The after-tax cost of long-term debt is probably less than 178.
1=. The basis for measuring the cost of capital deri$ed from bonds and preferred stock*
respecti$ely* is the
A. after-tax rate of interest for bonds and stated annual di$idend rate for preferred stock
+. pretax rate of interest for bonds and stated annual di$idend rate less the expected earnings
per share for preferred stock
%. pretax rate of interest for bonds and stated annual di$idend rate for preferred stock
D. after-tax rate of interest for bonds and stated annual di$idend rate less the expected
earnings per share for preferred stock
1>. The market $alue of a firm(s outstanding common shares will be higher* e$erything else
e&ual* if
a. #n$estors ha$e a lower re&uired return on e&uity.
b. #n$estors expect lower di$idend growth.
c. #n$estors ha$e longer expected holding periods.
d. #n$estors ha$e shorter expected holding periods.
7. !hen calculating the cost of capital* the cost assigned to retained earnings should be
A. Gero.
+. ,ower than the cost of external common e&uity.
%. 0&ual to the cost of external common e&uity.
D. )igher than the cost of external common e&uity.
1. The three elements needed to estimate the cost of e&uity capital for use in determining a
firm9s weighted-a$erage cost of capital are
A. %urrent di$idends per share* expected growth rate in di$idends per share* and current
book $alue per share of common stock.
+. %urrent earnings per share* expected growth rate in di$idends per share* and current
market price per share of common stock.
%. %urrent earnings pers share* expected growth rate in earnings per share* and current book
$alue per share of common stock.
D. %urrent di$idends per share* expected growth rate in di$idends per share* and current
market price per share of common stock.
. An in$estor uses the capital asset pricing model /%A5?1 to e$aluate the risk-return
relationship on a portfolio of stocks held as an in$estment. !hich of the following would not
be used to estimate the portfolio9s expected rate of return"
A. 0xpected risk premium on the portfolio of stocks.
+. #nterest rate for the safest possible in$estment.
%. 0xpected rate of return on the market portfolio.
D. 3tandard de$iation of the market returns.
'. According to the capital asset pricing model /%A5?1* the rele$ant risk of a security is its
A. %ompany-specific risk. %. 3ystematic risk.
+. Di$ersifiable risk. D. Total risk.
-. The weighted a$erage cost of capital represents the
a. cost of bonds* preferred stock* and common stock di$ided by the three sources.
b. e&ui$alent units of capital used by the organization.
c. o$erall cost of capital from all organization financing sources.
d. o$erall cost of di$idends plus interest paid by the organization.
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6. !hich of the following is not considered a capital component for the purpose of calculating
the weighted a$erage cost of capital as it applies to capital budgeting"
a. ,ong-term debt. b. %ommon stock. c. 3hort-term debt. d. 5referred stock.
;. !hen calculating a firm9s cost of capital* all of the following are true except that
A. The cost of capital of a firm is the weighted a$erage cost of its $arious financing
components.
+. The calculation of the cost of capital should focus on the historical costs of alternati$e
forms of financing rather than market or current costs.
%. All costs should be expressed as after-tax costs.
D. The time $alue of money should be incorporated into the calculations.
<. A company has made the decision to finance next year9s capital proAects through debt rather
than additional e&uity. The benchmark cost of capital for these proAects should be
A. The before-tax cost of new-debt financing.
+. The after-tax cost of new-debt financing.
%. The cost of e&uity financing.
D. The weighted-a$erage cost of capital.
=. The weighted-a$erage cost of capital approach to decision making is not directly affected by
the:
A. proposed mix of debt* e&uity* and existing funds used to implement the proAect
+. $alue of the common stock
%. cost of debt outstanding
D. current budget for expansion.
>. !hich class of le$erage causes earnings before interest and taxes to be more sensiti$e to
changes in sales"
A. %redit. +. Financial. %. Hperating. D. #ntrinsic.
'7. A firm with a higher degree of operating le$erage when compared to the industry a$erage
implies that the
A. Firm has higher $ariable costs.
+. Firm9s profits are more sensiti$e to changes in sales $olume.
%. Firm is more profitable.
D. Firm is less risky.
'1. The purchase of treasury stock with a firm9s surplus cash
A. #ncreases a firm9s assets. %. #ncreases a firm9s interest co$erage ratio.
+. #ncreases a firm9s financial le$erage. D. Dilutes a firm9s earnings per share.
'. !hich of the changes in le$erage would apply to a company that substantially increases its
in$estment in fixed assets as a proportion of total assets and replaces some of its long-term
debt with e&uity"
A. +. %. D.
Financial ,e$erage #ncrease Decrease #ncrease Decrease
Hperating ,e$erage Decrease #ncrease #ncrease Decrease
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Problems
1. +ased on the following information about stock price increases and decreases* make an
estimate of the stock9s beta: ?onth 1 I 3tock J1.68* ?arket J1.184 ?onth I 3tock
J.78* ?arket J1.-84 ?onth ' I 3tock -.68* ?arket -.78.
A. +eta is greater than 1.7. %. +eta e&uals 1.7
+. +eta is less than 1.7. D. There is no consistent pattern of returns.
. !hat is the yield to maturity on Fox #nc.9s bonds if its after-tax cost of debt is >8 and its tax
rate is '-8"
A. 6.>-8 +. >8 %. 1'.;-8 D. ;.-<8
'. ?aylar %orporation has sold C67 million of C1*777 par $alue* 18 coupon bonds. The bonds
were sold at a discount and the corporation recei$ed C>=6 per bond. #f the corporate tax rate
is -78* the after-tax cost of these bonds for the first year /rounded to the nearest hundredth
percent1 is
A. <.'18. +. -.=<8. %. 1.778. D. <.7>8.
-. The ?:H %ompany belie$es that it can sell long-term bonds with a ;8 coupon but at a price
that gi$es a yield-to-maturity of >8. #f such bonds are part of next year(s financing plans*
which of the following should be used for bonds in their after-tax /-781 cost-of-capital
calculation"
A. '.;8 +. 6.-8 %. -.8 D. ;8
6. Ambry #nc. is going to use an underwriter to sell its preferred stock. Four underwriters ha$e
gi$en estimates /below1 on their fees and the selling price of the stock* as well as the
expected di$idend for each:
Fees 3elling 5rice Di$idends
2nderwriter 1 C6 C171 C17
2nderwriter < 17 11
2nderwriter ' ' >< <
2nderwriter - ' >= =
!hich underwriter will produce the lowest cost of funds for the preferred stock"
A. 2nderwriter 1. +. 2nderwriter . %. 2nderwriter '. D. 2nderwriter -.
;. Kra$y %ompany expects earnings of 5'7 million next year. #ts di$idend payout ratio is -78*
and its debt.e&uity ratio is 1.67. Kra$y uses no preferred stock.
At what amount of financing will there be a break point in Kra$y(s marginal cost of capital"
A. 5-6 million. +. 5'7 million. %. 57 million. D. 51= million.
<. Allison 0ngines %orporation has established a target capital structure of -7 percent debt and
;7 percent common e&uity. The current market price of the firm(s stock is 57 I C=4 its last
di$idend was D7 I C.7* and its expected di$idend growth rate is ; percent. !hat will
Allison(s marginal cost of retained earnings* ks* be"
a. 16.=8 b. 1'.>8 c. <.>8 d. 1-.'8
=. Doris %orporation9s stock has a market price of C7.77 and pays a constant di$idend of
C.67. !hat is the re&uired rate of return on its stock"
A. 1'.78 +. 1.68 %. 1.78 D. 11.68
>. The A+% %ompany is expected to ha$e a constant annual growth rate of 6 percent. #t has a
price per share of 5' and pays an expected di$idend of 5.-7. #ts competitor* the D0F
%ompany is expected to ha$e a growth rate of 178* has a price per share of 5<* and pays an
expected 5-.=7.share di$idend. The re&uired rates of return on e&uity for the two companies
are:
A. +. %. D.
A+% 1'.=8 >.;8 1.68 1;.8
D0F 16.-8 =.;8 1;.<8 1=.8
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17. Frostfell Airlines is expected to pay an upcoming di$idend of C'.>. The company9s di$idend
is expected to grow at a steady* constant rate of 68 well into the future. Frostfell currently
has 1*;77*777 shares of common stock outstanding. #f the re&uired rate of return for Frostfell
is 18* what is the best estimate for the current price of Frostfell9s common stock"
A. C;6.=7 +. C;.61 %. C-<.77 D. C<.-1
11. :ewmass* #nc. paid a cash di$idend to its common shareholders o$er the past 1 months of
C.7 per share. The current market $alue of the common stock is C-7 per share* and
in$estors are anticipating the common di$idend to grow at a rate of ;8 annually. The cost to
issue new common stock will be 68 of the market $alue. The cost of a new common stock
issue will be
A. 11.678 +. 11.<>8 %. 11.='8 D. 1.1-8
1. !hat return on e&uity do in$estors seem to expect for a firm with a C67 share price* an
expected di$idend of C6.67* a beta of .>* and a constant growth rate of -.68"
A. 16.768 +. 16.678 %. 16.>68 D. 1;.<8
1'. +lair +rothers( stock currently has a price of C67 per share and is expected to pay a year-end
di$idend of C.67 per share /D1 I C.671. The di$idend is expected to grow at a constant rate
of - percent per year. The company has insufficient retained earnings to fund capital proAects
and must* therefore* issue new common stock. The new stock has an estimated flotation cost
of C' per share. !hat is the company(s cost of e&uity capital"
a. 17.1-8 b. >.18 c. >.-68 d. >.'8
1-. The D%, %orporation is preparing to e$aluate the capital expenditure proposals for the
coming year. +ecause the firm employs discounted cash flow methods of analyses* the cost
of capital for the firm must be estimated. The following information for D%, %orporation is
pro$ided.
?arket price of common stock is C67 per share.
The di$idend next year is expected to be C.67 per share.
0xpected growth in di$idends is a constant 178.
:ew bonds can be issued at face $alue with a 1'8 coupon rate.
The current capital structure of -78 long-term debt and ;78 e&uity is considered to be
optimal.
Anticipated earnings to be retained in the coming year are C' million.
The firm has a -78 marginal tax rate.
#f the firm must assume a 178 flotation cost on new stock issuances* what is the cost of new
common stock"
A. 1-.678. +. 16.6;8. %. 16.'8. D. 16.678.
16. Fitzgerald is interested in in$esting in a corporation with a low cost of e&uity capital. +y
using the di$idend growth model* which of the following corporations has the lowest cost of
e&uity capital"
3tock 5rice Di$idend Krowth @ate
%.3. #nc. C6 C6 =8
,ewis %orp. '7 ' 178
3crewtape #nc. 7 - ;8
!ormwood %orp. = < <8
A. %.3. #nc. %. 3crewtape #nc.
+. ,ewis %orp. D. !ormwood %orp.
1;. The common stock of Anthony 3teel has a beta of 1.7. The risk-free rate is 6 percent and the
market risk premium /k? - k@F1 is ; percent. Assume the firm will be able to use retained
earnings to fund the e&uity portion of its capital budget. !hat is the company(s cost of
retained earnings* ks"
a. <.78 b. <.8 c. 11.78 d. 1.8
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1<. %olt* #nc. is planning to use retained earnings to finance anticipated capital expenditures. The
beta coefficient for %olt9s stock is 1.16* the risk-free rate of interest is =.68* and the market
return is estimated at 1.-8. #f a new issue of common stock were used in this model* the
flotation costs would be <8. +y using the %apital Asset 5ricing ?odel /%A5?1 e&uation L@
I @F J M/@? - @F1N* the cost of using retained earnings to finance the capital expenditures is
A. 1'.18 +. 1.>>8 %. 1.-78 D. 1-.;8
1=. 3tock O has a beta of 1. and an expected return of 16.;8* and stock P has a beta of 7.= and
an expected return of 1.-8. !hat must be the expected return on the market and the risk-
free rate of return* to be consistent with the capital asset pricing model"
A. ?arket is 1-84 risk-free is ;8. %. ?arket is 1-84 risk-free is -8.
+. ?arket is 1.-84 risk-free is 78. D. ?arket is 1-84 risk-free is 1.;8.
1>. #f the return on the market portfolio is 178 and the risk-free rate is 68* what is the effect on
a company9s re&uired rate of return on its stock of an increase in the beta coefficient from 1.
to 1.6"
A. '8 increase +. 1.68 increase %. :o change D. 1.68 decrease
7. An in$estor was expecting a 168 return on his portfolio with beta of 1.6 before the market
risk premium increased from ;8 to >8. +ased on this change* what return will now be
expected on the portfolio"
A. 16.778 +. 1=.778 %. 1=.<68 D. .678
1. !hat happens to expected portfolio return if the portfolio beta increases from 1.7 to .7* the
risk-free rate decreases from 68 to -8* and the market risk premium remains at =8"
A. #t increases from 18 to 1>8. %. #t increases from 1'8 to 78.
+. #t increases from 1'8 to 1;8. D. #t remains unchanged.
. %omputechs is an all-e&uity firm that is analyzing a potential mass communications proAect
which will re&uire an initial* after-tax cash outlay of C177*777* and will produce after-tax
cash inflows of C1*777 per year for 17 years. #n addition* this proAect will ha$e an after-tax
sal$age $alue of C7*777 at the end of Qear 17. #f the risk-free rate is 6 percent* the return on
an a$erage stock is 17 percent* and the beta of this proAect is 1.=7* then what is the proAect9s
:5D"
A. C17*;66 +. C'*'- %. -C'<*-7< D. -C'*71
'. The expected returns* standard de$iations* and beta coefficients of four stocks are gi$en
below:
0xpected @eturn 3tandard De$iation +eta %oefficient
? 1=8 .;6 .>
: 78 .> 1.
H 78 .- 1.6
E 18 1. 1.<
Ki$en an expected return on the market portfolio of 1=8 and a risk-free rate of 18* which
stock/s1 is/are1 o$er$alued or under$alued"
A. ? and : are under$alued4 H and E are o$er$alued.
+. ? is under$alued4 :* H* and E are o$er$alued.
%. ?* :* H* and E are o$er$alued.
D. ?* :* H* and E are under$alued.
-. Krateway #nc. has a weighted a$erage cost of capital of 11.6 percent. #ts target capital
structure is 66 percent e&uity and -6 percent debt. The company has sufficient retained
earnings to fund the e&uity portion of its capital budget. The before-tax cost of debt is >
percent* and the company(s tax rate is '7 percent. #f the expected di$idend next period /D11 is
C6 and the current stock price is C-6* what is the company(s growth rate"
a. .;=8 b. '.--8 c. -.;-8 d. ;.<68
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6. A company has C;67*777 of 178 debt outstanding and C677*777 of e&uity financing. The
re&uired return of the e&uity holders is 168* and there are no retained earnings currently
a$ailable for in$estment purposes. #f new outside e&uity is raised* it will cost the firm 1;8.
:ew debt would ha$e a before-tax cost of >8* and the corporate tax rate is 678. !hen
calculating the marginal cost of capital* the company should assign a cost of R,ist AS to
e&uity capital and R,ist +S to the after-tax cost of debt financing.
A. +. %. D.
,ist A 168 168 1;8 1;8
,ist + -.68 6.78 -.68 6.78
;. A company has C1 million in shareholders9 e&uity and C million in debt e&uity /=8 bonds1.
#ts after-tax weighted-a$erage cost of capital is 18* but it uses 168 as the hurdle rate in
capital budgeting decisions. During the past year* its operating income before tax and interest
was C677*777. #ts tax rate is -78. !hat is the company9s cost of e&uity capital"
A. =8 +. 18 %. 168 D. ;.-8
<. !hat is the weighted a$erage cost of capital for a firm with -78 debt* 78 preferred stock*
and -78 common e&uity if the respecti$e costs for these components are =8 after-tax* 1'8
after-tax* and 1<8 before-tax" The firm9s tax rate is '68.
A. 17.8 +. 17.68 %. 11.-=8 D. 1.;78
=. Datacomp #ndustries* which has no current debt* has a beta of .>6 for its common stock.
?anagement is considering a change in the capital structure to '78 debt and <78 e&uity.
This change would increase the beta on the stock to 1.76* and the after-tax cost of debt will
be <.68. The expected return on e&uity is 1;8* and the risk-free rate is ;8. 3hould
Datacomp9s management proceed with the capital structure change"
A. :o* because the cost of e&uity capital will increase.
+. Qes* because the cost of e&uity capital will decrease.
%. Qes* because the weighted-a$erage cost of capital will decrease.
D. :o* because the weighted-a$erage cost of capital will increase.
>. )ea$y ?etal %orp. is a steel manufacturer that finances its operations with -7 percent debt*
17 percent preferred stock* and 67 percent e&uity. The interest rate on the company(s debt is
11 percent. The preferred stock pays an annual di$idend of C and sells for C7 a share. The
company(s common stock trades at C'7 a share* and its current di$idend /D71 of C a share is
expected to grow at a constant rate of = percent per year. The flotation cost of external e&uity
is 16 percent of the dollar amount issued* while the flotation cost on preferred stock is 17
percent. The company estimates that its !A%% is 1.'7 percent. Assume that the firm will
not ha$e enough retained earnings to fund the e&uity portion of its capital budget. !hat is
the company(s tax rate"
a. '7.''8 b. '.=<8 c. '6.<68 d. '=.18
'7. !iley(s new financing will be in proportion to the market $alue of its present financing*
shown below.
+ook Dalue /C777 Hmitted1
,ong-term debt C<*777
5referred stock /177 shares1 1*777
%ommon stock /77 shares1 <*777
The firms( bonds are currently selling at =78 of par* generating a current market yield of >8*
and the corporation has a -78 tax rate. The preferred stock is selling at its par $alue and
pays a ;8 di$idend. The common stock has a current market $alue of C-7 and is expected to
pay a C1.7 per share di$idend this fiscal year. Di$idend growth is expected to be 178 per
year. !iley(s weighted-a$erage cost of capital is /round your calculations to tenths of a
percent1
a. 1'.78 b. =.'8 c. >.;8 d. >.78
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'1. A company has determined that its optimal capital structure consists of -7 percent debt and
;7 percent e&uity. Assume the firm will not ha$e enough retained earnings to fund the e&uity
portion of its capital budget. Also* assume the firm accounts for flotation costs by adAusting
the cost of capital. Ki$en the following information* calculate the firm(s weighted a$erage
cost of capital.
kd I =8 57 I C6
:et income I C-7*777 Krowth I 78
5ayout ratio I 678 3hares outstanding I 17*777
Tax rate I -78 Flotation cost on additional e&uity I 168
a. <.;78 b. =.768 c. 11.=18 d. 1'.;>8
'. Dobson Dairies has a capital structure that consists of ;7 percent long-term debt and -7
percent common stock. The company(s %FH has obtained the following information:
The before-tax yield to maturity on the company(s bonds is = percent.
The company(s common stock is expected to pay a C'.77 di$idend at year end /D1 I
C'.771* and the di$idend is expected to grow at a constant rate of < percent a year. The
common stock currently sells for C;7 a share.
Assume the firm will be able to use retained earnings to fund the e&uity portion of its
capital budget.
The company(s tax rate is -7 percent.
!hat is the company(s weighted a$erage cost of capital /!A%%1"
a. 1.778 b. =.7'8 c. >.'-8 d. <.;=8
''. +radshaw 3teel has a capital structure with '7 percent debt /all long-term bonds1 and <7
percent common e&uity. The yield to maturity on the company(s long-term bonds is =
percent* and the firm estimates that its o$erall composite !A%% is 17 percent. The risk-free
rate of interest is 6.6 percent* the market risk premium is 6 percent* and the company(s tax
rate is -7 percent. +radshaw uses the %A5? to determine its cost of e&uity. !hat is the beta
on +radshaw(s stock"
a. 1.7< b. 1.-= c. 7.17 d. 1.'6
'-. %ompany T is interested in calculating it weighted-a$erage cost of capital. %ompany T has a
current financial structure that is composed of 678 debt* -78 common stock* and 178
preferred stock. #gnore the effects of cost of retained earnings. The beta of %ompany T
stock is 7.<* and the current risk-free rate of return is -8. The market risk premium is ;8.
The preferred di$idend on %ompany T preferred stock is set at C.6* and the net issuance
price per share /which happens to be the same as the current price per share1 of preferred
stock is C'7. Debt issued by %ompany T yields an 118 stated interest rate to in$estors. The
marginal tax rate for %ompany T is -78. !hat is the weighted-a$erage cost of capital for
%ompany T"
a. 7.7<-' b. 7.7=7 c. 7.7;;7 d. 7.7<''
'6. For a firm with a degree of operating le$erage of '.6* an increase in sales of ;8 will
A. #ncrease pre-tax profits by '.68. %. #ncrease pre-tax profits by 18.
+. Decrease pre-tax profits by '.68. D. #ncrease pre-tax profits by 1.<18.
';. #n its first year of operations* a firm had C67*777 of fixed operating costs. #t sold 17*777
units at a C17 unit price and incurred $ariable costs of C- per unit. #f all prices and costs will
be the same in the second year and sales are proAected to rise to 6*777 units* what will the
degree of operating le$erage /the extent to which fixed costs are used in the firm(s
operations1 be in the second year"
a. 1.6 b. 1.67 c. .7 d. ;.7
'<. This year* :elson #ndustries increased earnings before interest and taxes /0+#T1 by 1<8.
During the same period* net income after tax increased by -8. The degree of financial
le$erage that existed during the year is
A. 1.<7. +. -.7. %. .-<. D. 6.>7.
MSQ-10
5age >
'=. A company has unit sales of '77*777* the unit $ariable cost is C1.67* the unit sales price is
C.77* and the annual fixed costs are C67*777. Furthermore* the annual interest expense is
C7*777* and the company has no preferred stock. Accordingly* the degree of total le$erage is
A. 1.=<6 +. 1.67 %. 1.6 D. 1.7
Euestions '> through - are based on the following information. %#A 11>- #D-'6 to '=
A new company re&uires C1 million of financing and is considering two arrangements as shown
in the table below:
Arrangement
Amount of
0&uity @aised
Amount of
Debt Financing
+efore-Tax
%ost of Debt
U1 C<77*777 C'77*777 =8 per annum
U C'77*777 C<77*777 178 per annum
#n the first year of operations* the company is expected to ha$e sales re$enues of C677*777* cost
of sales of C77*777* and general and administrati$e expenses of C177*777. The tax rate is '78*
and there are no other items on the income statement. All earnings are paid out as di$idends at
year-end.
'>. #f the cost of e&uity is 18* the weighted-a$erage cost of capital under arrangement U1* to
the nearest full percentage point* would be
A. =8 +. 178 %. 118 D. 18
-7. !hich of the following statements comparing the two financing arrangements is true"
A. The company will ha$e a higher expected gross margin under arrangement U1.
+. The company will ha$e a higher degree of operating le$erage under arrangement U.
%. The company will ha$e higher interest expense under arrangement U1.
D. The company will ha$e higher expected tax expense under arrangement U1.
-1. 2nder financing arrangement U* the degree of financial le$erage /DF,1* rounded to two
decimal places* would be
A. 1.7> +. 1.1- %. 1.' D. 1.6-
-. The return on e&uity will be R,ist AS and the debt ratio will be R,ist +S under arrangement
U* as compared with arrangement U1.
A. +. %. D.
,ist A )igher )igher ,ower ,ower
,ist + )igher ,ower )igher ,ower
MSQ-10
5age 17
ANSWER SHEET
Teor! Problem
1. A 1;. A '1. + 1. A 1;. D '1. A
. % 1<. D '. + . % 1<. + '. D
'. % 1=. A '. A 1=. A ''. D
-. A 1>. A -. + 1>. + '-. D
6. + 7. + 6. % 7. % '6. %
;. % 1. D ;. A 1. % ';. +
<. A . A <. D . D '<. %
=. % '. % =. + '. A '=. A
>. % -. % >. % -. % '>. +
17. A 6. % 17. % 6. % -7. D
11. A ;. + 11. D ;. D -1. D
1. + <. D 1. + <. D -. A
1'. + =. D 1'. D =. %
1-. % >. % 1-. + >. +
16. % '7. + 16. + '7. %
MSQ-10
5age 11