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.

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

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