Cost of Capital & WACC

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Test your proficiency of cost of capital concepts, cost of debt, cost of preferred stock, cost of equity, cost of retained earnings, dividend discount models, capital asset pricing model, and weighted average cost of capital.

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What is the overall (weighted average) cost of capital in the following situation? The firm has $10 million in long-term debt, $2 million in preferred stock, and $8 million in common equity -- all at market values. The before-tax cost for debt, preferred stock, and common equity forms of capital are 8%, 9%, and 15%, respectively. Assume a 40% tax rate.

2 points

6.40%

6.54%

9.30%

10.90%

Clear selection

The cost of retained earnings is equal to:

1 point

the return on new common stock

the return on preferred stock

It does not have a cost.

the return on existing common stock

Clear selection

Tidewater Fishing has a current beta of 1.48. The market risk premium is 8.9 percent and the risk-free rate of return is 3.2 percent. By how much will the cost of equity increase if the company expands its operations such that the company beta rises to 1.60?

2 points

0.88 percent

1.07 percent

1.50 percent

2.10 percent

Clear selection

In calculating the proportional amount of equity financing employed by a firm, we should use:

2 points

the common stock equity account on the firm's balance sheet.

the sum of common stock and preferred stock on the balance sheet.

the current market price per share of common stock times the number of shares outstanding.

the book value of the firm.

Clear selection

The cost of equity capital is all of the following EXCEPT:

2 points

the minimum rate that a firm should earn on the equity-financed part of an investment.

a return on the equity-financed portion of an investment that, at worst, leaves the market price of the stock unchanged.

by far the most difficult component cost to estimate.

generally lower than the before-tax cost of debt.

Clear selection

Lei-Feng, Inc.'s $100 par value preferred stock just paid its $10 per share annual dividend. The preferred stock has a current market price of $96 a share. The firm's marginal tax rate (combined federal and state) is 40 percent, and the firm plans to maintain its current capital structure relationship into the future. The component cost of preferred stock to Lei-Feng, Inc. would be closest to .

2 points

6 percent

6.25 percent

10 percent

10.4 percent

Clear selection

The least expensive form of financing for the firm is:

1 point

existing common stock

preferred stock

debt

new common stock

Clear selection

A single, overall cost of capital is often used to evaluate projects because:

2 points

it avoids the problem of computing the required rate of return for each investment proposal.

it is the only way to measure a firm's required return.

it acknowledges that most new investment projects have about the same degree of risk.

it acknowledges that most new investment projects offer about the same expected return.

Clear selection

Jacques Fauxpas is attempting to determine his company's weighted-average cost of capital. His first step was to determine the required rates of return for his company's long-term debt, preferred stock, and common stock. He then adjusted these required rates of return by multiplying each return by one minus the company's marginal tax rate. Jacques is planning on using these three adjusted required return figures as his component costs of capital. How is Jacques doing so far?

2 points

All three of Jacques' component cost figures are

All three component cost figures are

Only the required return (yield) on preferred stock and debt should have been adjusted for taxes.

Only the required return (yield) on debt should have been adjusted for taxes.

Clear selection

Chelsea Fashions is expected to pay an annual dividend of $0.80 a share next year. The market price of the stock is $22.40 and the growth rate is 5 percent. What is the firm's cost of equity?

2 points

7.58 percent

7.91 percent

8.24 percent

8.57 percent

Clear selection

Regardless of the type of asset being acquired, the appropriate discount rate is:

1 point

the aftertax cost of debt

the weighted average cost of capital

the required rate of return

the cost of equity capital

Clear selection

For an all-equity financed firm, a project whose expected rate of return plots-----------should be rejected.

1 point

above the characteristic line

above the security market line

below the security market line

below the characteristic line

Clear selection

Market values are often used in computing the weighted average cost of capital because

1 point

this is the simplest way to do the calculation.

this is consistent with the goal of maximizing shareholder value.

this is required by regulators.

this is a very common mistake.

Clear selection

The cost of preferred stock is computed the same as the:

1 point

pre-tax cost of debt.

return on an annuity.

aftertax cost of debt.

return on a perpetuity.

Clear selection

Socks-N-Shoes, Inc., used a proxy company to calculate an unlevered beta of 0.90 for its Socks Division. The firm's corporate cost of debt is 5% on an after-tax basis. Sock-N-Shoes finances its projects with a roughly 80%/20% mix of debt and equity. The market has an expected rate of return of 16% and the risk-free rate is 6%. The required rate of return (divisional cost of capital) for the Socks Division should be closest to which of the following four answers?

2 points

15%

16%

Clear selection

The cost of debt is measured by:

1 point

the weighted average cost of capital

the coupon rate on the firm's bonds

the yield to maturity on the firm's bonds

the marginal cost of capital

Clear selection

The cost of capital is best calculated with:

1 point

market value weightings

book value weightings

Modigliani and Miller weightings

It doesn't matter.

Clear selection

To compute the required rate of return for equity in a company using the CAPM, it is necessary to know all of the following EXCEPT:

1 point

the risk-free rate.

the earnings for the next time period.

the beta for the firm.

the market return expected for the time period.

Clear selection

Grill Works and More has 8 percent preferred stock outstanding that is currently selling for $49 a share. The market rate of return is 14 percent and the firm's tax rate is 37 percent. What is the firm's cost of preferred stock?

2 points

14.77 percent

16.33 percent

15.67 percent

15.29 percent

Clear selection

The overall (weighted average) cost of capital is composed of a weighted average of __________.

1 point

the cost of common equity and the cost of debt

the cost of common equity and the cost of preferred stock

the cost of preferred stock and the cost of debt

the cost of common equity, the cost of preferred stock, and the cost of debt

Clear selection

The common stock of a company must provide a higher expected return than the debt of the same company because

1 point

there is less demand for stock than for bonds.

there is greater demand for stock than for bonds.

there is more systematic risk involved for the common stock.

there is a market premium required for bonds.

Clear selection

For which of the following costs is it generally necessary to apply a tax adjustment to a yield measure?

1 point

Cost of debt.

Cost of preferred stock.

Cost of common equity.

Cost of retained earnings.

Clear selection

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