BFM 113 Financial Management Part 1 Cost of Capital

Multiple Choice
Identify the choice that best completes the statement or answers the question.

____ 1. Studies analyzing the historical returns earned by common stock investors have found that the returns
from average risk common stock investments over the years have averaged (arithmetically) ____
percentage points ____ than the returns on Treasury bills.
a. 6 to 8, higher c. 3 to 4, higher
b. 1 to 2, lower d. 8 to 9, higher
____ 2. The cost of equity capital for non-dividend paying stocks can be determined by
a. using the Capital Asset Pricing Model
b. estimating ke for comparable dividend-paying stocks in their industry
c. forecasting the liquidation proceeds from the sale of the company's assets.
d. using the CAPM and by estimating ke for comparable dividend-paying stocks in their
industry
____ 3. For a company that is not planning to change its target capital structure, the proportions of debt and equity
used in calculating the weighted cost of capital should be based on the current ____ weights of the
individual components.
a. book value c. replacement value
b. market value d. accounting value
____ 4. The cost of capital is
a. the rate of return required by investors in the firm's securities
b. the minimum rate of return required on new investments of high risk undertaken by the
firm
c. approximately 10 percent for most firms
d. concerned with plant and equipment only
____ 5. A firm can raise up to $700 million for investment from a mixture of debt, preferred stock and retained
equity. Above $700 million, the firm must issue new common stock. Assuming that debt costs and
preferred stock costs remain unchanged, the marginal cost of capital for amounts up to $700 million will
be ____ the marginal cost of capital for amounts over $700 million.
a. less than
b. equal to
c. greater than
d. cannot be determined from the information given
____ 6. The required rate of return on any security consists of a
a. risk premium plus an expected inflation rate
b. risk free rate plus a risk premium
c. inflation rate plus a marketability premium
d. risk free rate plus an inflation premium
____ 7. The total return to stockholders, ke, is composed of the
a. opportunity cost plus a risk premium
b. dividend yield plus the price appreciation of the security
c. opportunity cost plus an inflation premium
d. dividend yield minus the risk premium
____ 8. If a firm is losing money then the after-tax cost of debt is
a. equal to kd (1 - T) c. equal to the pretax cost of debt
b. found by trial and error d. equal to the yield to first call date
____ 9. The cost of external equity is greater than the cost of internal equity because
a. it decreases the earnings per share c. of the flotation costs
b. it increases the market price of the stock d. dividends are increased
____ 10. Historic average capital costs are ____ new (marginal) resource allocation decisions.
a. not relevant for making c. necessary for making
b. very useful when making d. the relevant costs for making
____ 11. Which of the following statements (if any) is (are) true concerning companies that do not pay dividends?
a. The cost of equity capital can be estimated using the Capital Asset Pricing Model.
b. The cost of equity capital is equal to the growth short-term rate of earnings per share.
c. The dividend capitalization model can be used to determine an accurate cost of equity
capital.
d. The cost of equity capital cannot be determined by using the CAPM, the risk premium on
debt approach, or by estimating ke for comparable dividend-paying stocks in their
industry.
____ 12. If a firm sells assets, generating cash flows, the cost of these funds is ____.
a. the firm's cost of equity c. the firm's weighted cost of capital
b. the firm's cost of cash flows d. zero
____ 13. Small firms are reluctant to obtain capital through the sale of common stock because of:
a. potential loss of voting control
b. high issuance costs
c. high cost of debt
d. both the potential loss of voting control and the high issuance costs
____ 14. Calculate the after-tax cost of preferred stock for Ohio Valley Power Company, which is planning to sell
$100 million of $3.25 cumulative preferred stock to the public at a price of $25 per share. Flotation costs
are $1.00 per share. Ohio Valley has a marginal income tax rate of 40%.
a. 13.0% c. 8.12%
b. 7.8% d. 13.54%
____ 15. The Allegheny Valley Power Company common stock has a beta of 0.80. If the current risk-free rate is
6.5% and the expected return on the stock market as a whole is 16%, determine the cost of equity capital
for the firm (using the CAPM).
a. 14.1% c. 6.5%
b. 7.6% d. 13.0%
____ 16. The following financial information is available on Rawls Manufacturing Company:

Current per share market price $48.00

Beta 1.1
Expected rate of return on market 12.0%
Risk-free rate 6.0%

Rawls can issue new common stock to net the company $44 per share. Determine the cost of internal
equity capital using the capital asset pricing model approach. (Compute answer to the nearest 0.1%).
a. 12.9% c. 13.0%
 b. 12.6% d. 11.8%
____ 17. What is the cost of a preferred stock with a $100 par value that pays a $9.60 dividend per year? The
security has a flotation cost of $3.37 and will be retired at its par value in 20 years.
a. 9.6% c. 10.0%
b. 9.9% d. 10.6%
____ 18. According to Value Line, Bestway has a beta of 1.15. If 3-month Treasury bills currently yield 7.9 percent
and the market risk premium is estimated to be 8.3 percent, what is Bestway's cost of equity capital?
a. 17.45% c. 9.55%
b. 8.36% d. 16.2%
____ 19. Easy Slider Inc. sold a 15 year $1,000 face value bond with a 10 percent coupon rate. Interest is paid
annually. After flotation costs, Easy Slider received $928 per bond. Compute the after-tax cost of debt for
these bonds if the firm's marginal tax rate is 40 percent.
a. 6.0% c. 7.8%
b. 7.2% d. 6.6%
____ 20. Mid-South Utilities will sell $10 million of $100 par value preferred stock that will pay an annual
dividend of $9.75. Mid-South will receive $93.98 per share after flotation costs. If the issue must be
retired in 20 years, what is the cost of the preferred issue?
a. 10.37% c. 10.23%
b. 10.50% d. 9.75%
____ 21. Witin's stock price is currently $34.25 and the current quarterly dividend is $0.25. Consensus estimates
for Witin indicate a growth rate in earnings of 10% into the foreseeable future. If Witin plans to sell 1
million shares to raise new capital for expansion, what is the cost of new equity if the issuance costs are
8%?
a. 13.49% c. 13.21%
b. 10.87% d. 13.17%
____ 22. Pluega Inc. issued a $100 million 8.27% coupon debenture bond due in the next 20 years. The bonds each
sold for $996. If the bonds pay interest semi-annually, what is Pluega's after cash cost of debt? Assume
40% tax rate.
a. 4.96% c. 4.99%
b. 8.30% d. 3.32%
____ 23. Haulsee Inc. pays no dividend currently but is expected to start paying a small dividend next year. The
5-year old firm has a beta of 1.25 and current earnings of $0.90 per share. The current Treasury bill rate is
6.10% and the market risk premium is 8.8%. Determine Haulsee's cost of equity if the firm's tax rate is
40%.
a. 9.48%
b. 17.1%
c. 14.9%
d. cannot determined from the information provided
____ 24. American Dental Laser is selling a 10 year $1,000 face value bond with a 8% coupon rate. Interest is paid
annually. The price to the public is $820 and the issue costs per bond are $10 each. Compute the pretax
cost of debt for these bonds.
a. 11.1% c. 11.5%
b. 11.3% d. 11.8%
____ 25. Wright Express(WE) has a capital structure of 30% debt and 70% equity. WE is considering a project that
requires an investment of $2.6 million. To finance this project, WE plans to issue 10-year bonds with a
coupon interest rate of 12%. Each of these bonds has a $1,000 face value and will be sold to net WE $980.
If the current risk-free rate is 7% and the expected market return is 14.5%, what is the weighted cost of
capital for WE? Assume WE has a beta of 1.20 and a marginal tax rate of 40%.
a. 14.9% c. 13.4%
b. 12.4% d. 16.0%
____ 26. California Best (CB), a sport shoe store, expects an operating income of $2.3 million this year. CB has no
long-term debt. The firm is considering as expansion project. The current risk-free rate of return is 7% and
the current market risk premium is 8.3%. If CB's beta is 20% greater than the overall market, what is the
firm's cost of capital? Assume that CB has a marginal tax rate of 40%.
a. 8.3% c. 9.96%
b. 16.96% d. 15.3%
____ 27. Columbia Gas Company's(CG) current capital structure is 35% debt and 65% equity. This year CG has
earnings after tax of $5.31 million and is paying $1.6 million in dividends. To finance a transmission pipe
line, CG can borrow $2 million at a cost of 10%, the same rate that CG is currently paying on a total of
$15 million long-term debt. CG has 1,000,000 shares outstanding and its current market price is $31. If
CG's long-term growth rate of dividends is expected to be 8%, what is the weighted cost of capital for the
firm? Assume a marginal tax rate of 40%.
a. 10.9% c. 19.6%
b. 13.6% d. 16.9%
____ 28. Heleveton Industries is 100% equity financed. Its current beta is 1.1. The expected market risk premium is
8.5% and the risk-free rate is 4.2%. If Heleveton changes its capital structure to 25% debt, it estimates its
beta will increase to 1.2. If the after-tax cost of debt will be 6%, should Heleveton make the capital
structure change?
a. Yes, cost of capital decreases by 2.52%
b. Yes, cost of capital decreases 1.67%.
c. No, stock price would decrease due to increased risk
d. No, cost of capital increases by 0.85%.
____ 29. Bay State Technology has determined that its cost of equity is 15% and its after-tax cost of debt is 7.2%.
Bay State expects to earn $14 million after taxes next year and, as a new firm, does not pay any dividends.
The stock sells for $24. Bonds are currently selling at par value. Compute Bay State's weighted cost of
capital. A partial balance sheet is shown below:

Current liabilities $ 300,000

Long-term debt 1,000,000
Common stock at $1 par 100,000
Paid in capital 900,000
Retained earnings 3,000,000
Total liabilities and stockholders' equity $5,300,000

a. 13.4% c. 11.6%
b. 13.1% d. 12.7%
____ 30. There are two primary ways that capital is raised. Which of the following statements is/are correct?
I. Capital is raised internally by using retained earnings.
II. Capital is raised externally by selling fixed assets.
a. I only c. Both I and II
 b. II only d. Neither I nor II
____ 31. Investors can form earnings growth expectations from various sources, including
a. potential sales growth. c. assumed product development.
b. current earnings and retention rates. d. investors’ required rate of return.
____ 32. What is the weighted average cost of capital for Mud Bug Corporation?
Source of Capital Capital Components Cost
Long Term Debt $60,000 5.6%
Preferred Stock $15,000 10.6%
Common Stock $75,000 13.0%

a. 6.9% c. 10.2%
b. 8.5% d. 9.8%
____ 33. What is the cost of preferred stock if the stock is selling for $208, the dividend is $35 and flotation costs
are 5% of the selling price?
a. 17.7% c. 12.5%
b. 25.2% d. 10.8%
____ 34. A firm is determining its cost of common stock equity. It last paid a divided of $.52, the dividends are
growing at 5%, flotation costs are $2 per share and the firm will net $72 per share upon the sale of the
stock. What is the firm’s cost of common equity?
a. 3.49% c. 6.11%
b. 8.22% d. 5.76%
____ 35. Surfin’ Bubba Surfboard Shop is currently selling for $34.25 a share with a current dividend of $1.00. It is
estimated that Surfin’ Bubba will have a growth rate in earnings of 10% into the foreseeable future. If
Surfin’ Bubba plans to raise new capital for expansion, what is the cost of new equity if flotation costs are
8% of the price.
a. 13.49% c. 12.21%
b. 11.57% d. 10.87%
____ 36. What is the cost of equity for Fat Rat Laboratories, Inc.? The stock has the following dividends, the
stock sells for $70 with flotation costs of $6 and it expects to pay a dividend of $3.20 next year (rounded).
YEARS DIVIDENDS
2010 $2.94
2009 2.70
2008 2.49
2007 2.29

a. 14.00% c. 12.26%
b. 13.57% d. 10.00%
____ 37. What is the cost of debt for Foggy Futures Weather Forecasters? The firm is in the 40% tax bracket.
The optimal capital structure is listed below:
Source of Capital Weight
Long-Term Debt 25%
Preferred Stock 20%
Common Stock 55%

Debt: The firm can issue $1000 par value, 8% coupon interest bonds with a 20 year
 maturity date. The bond has an average discount of $30 and flotation costs of
$30 per bond. The selling price is $1000.
Preferred The firm can sell preferred stock with a dividend that is 8% of the current
Stock price. The stock costs $95. The cost of issuing and selling the stock is
expected to be $5 per share.
Common The firm’s common stock is currently selling for $90 per share. The firm
Stock: expects to pay cash dividends of $7 per share next year. The dividends have
been growing at 6%. The stock must be discounted by $7 and flotation costs
are expected to amount to $5 per share.
Retained The firm expects to have enough retained earnings in the coming year to be
Earnings: used in place of any new stock being issued.

a. 5.18% c. 7.5%
b. 3.6% d. 12.2%
____ 38. What is the cost of preferred stock for Foggy Futures Weather Forecasters? The firm is in the 40% tax
bracket. The optimal capital structure is listed below:
Source of Capital Weight
Long-Term Debt 25%
Preferred Stock 20%
Common Stock 55%

Debt: The firm can issue $1000 par value, 8% coupon interest bonds with a 20 year
maturity date. The bond has an average discount of $30 and flotation costs of
$30 per bond. The selling price is $1000.
Preferred The firm can sell preferred stock with a dividend that is 8% of the current
Stock price. The stock costs $95. The cost of issuing and selling the stock is
expected to be $5 per share.
Common The firm’s common stock is currently selling for $90 per share. The firm
Stock: expects to pay cash dividends of $7 per share next year. The dividends have
been growing at 6%. The stock must be discounted by $7 and flotation costs
are expected to amount to $5 per share.
Retained The firm expects to have enough retained earnings in the coming year to be
Earnings: used in place of any new stock being issued.

a. 4.9% c. 7.88%
b. 11.55% d. 8.44%
____ 39. What is the cost of common stock for Foggy Futures Weather Forecasters? The firm is in the 40% tax
bracket. The optimal capital structure is listed below:
Source of Capital Weight
Long-Term Debt 25%
Preferred Stock 20%
Common Stock 55%

Debt: The firm can issue $1000 par value, 8% coupon interest bonds with a 20 year
maturity date. The bond has an average discount of $30 and flotation costs of
$30 per bond. The selling price is $1000.
Preferred The firm can sell preferred stock with a dividend that is 8% of the current
Stock price. The stock costs $95. The cost of issuing and selling the stock is
 expected to be $5 per share.
Common The firm’s common stock is currently selling for $90 per share. The firm
Stock: expects to pay cash dividends of $7 per share next year. The dividends have
been growing at 6%. The stock must be discounted by $7 and flotation costs
are expected to amount to $5 per share.
Retained The firm expects to have enough retained earnings in the coming year to be
Earnings: used in place of any new stock being issued.

a. 12.25% c. 14.97%
b. 19.75% d. 13.22%
____ 40. Using rounded whole percents for the various costs and weighted costs, what is the weighted average cost
of capital for Foggy Futures Weather Forecasters? The firm is in the 40% tax bracket. The optimal
capital structure is listed below:
Source of Capital Weight
Long-Term Debt 25%
Preferred Stock 20%
Common Stock 55%

Debt: The firm can issue $1000 par value, 8% coupon interest bonds with a 20 year
maturity date. The bond has an average discount of $30 and flotation costs of
$30 per bond. The selling price is $1000.
Preferred The firm can sell preferred stock with a dividend that is 8% of the current
Stock price. The stock costs $95. The cost of issuing and selling the stock is
expected to be $5 per share.
Common The firm’s common stock is currently selling for $90 per share. The firm
Stock: expects to pay cash dividends of $7 per share next year. The dividends have
been growing at 6%. The stock must be discounted by $7 and flotation costs
are expected to amount to $5 per share.
Retained The firm expects to have enough retained earnings in the coming year to be
Earnings: used in place of any new stock being issued.

a. 12% c. 15%
b. 8% d. 18%