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Chapter 14

Cost of Capital

Multiple Choice Questions

1. A group of individuals got together and purchased all of the outstanding

shares of common stock of DL Smith, Inc. What is the return that these

individuals reuire on this investment called!

A. dividend

"ield

#. cost of

euit"

C. capital gains

"ield

D. cost of

capital

$. income

return

%. &e'tile (ills )orro*s mone" at a rate of 1+. percent. &his interest rate

is referred to as the-

A. compound

rate.

#. current

"ield.

C. cost ofde)t.

D. capital gains

"ield.

$. cost of

capital.



+. &he average of a rm/s cost of euit" and afterta' cost of de)t that is

*eighted )ased on the rm/s capital structure is called the-

A. re*ard to risk

ratio.

#. *eighted capital gains

rate.

C. structured cost of

capital.

D. su)0ective cost of

capital.

$. *eighted average cost of

capital.

4. When a manager develops a cost of capital for a specic pro0ect )ased

on the cost of capital for another rm *hich has a similar line of

)usiness as the pro0ect, the manager is utiliing the 22222 approach.

A. su)0ective

risk

#. pure

pla"

C. divisional cost ofcapital

D. capital

ad0ustment

$. securit" market

line



. A rm/s cost of capital-

A. *ill decrease as the risk level of the rm

increases.

#. for a specic pro0ect is primaril" dependent upon the source of the

funds used for the pro0ect.

C. is independent of the rm/s capital

structure.

D. should )e applied as the discount rate for an" pro0ect considered

)" the rm.

$. depends upon ho* the funds raised are going to

)e spent.

3. &he *eighted average cost of capital for a *holesaler-

A. is euivalent to the afterta' cost of the rm/s

lia)ilities.

#. should )e used as the reuired return *hen anal"ing a potential

acuisition of a retail outlet.

C. is the return investors reuire on the total assets of

the rm.

D. remains constant *hen the de)teuit" ratio

changes.

$. is una5ected )" changes in corporate ta'

rates.



6. Which one of the follo*ing is the primar" determinant of a rm/s cost of

capital!

A. de)teuit"

ratio

#. applica)le ta'

rate

C. cost of

euit"

D. cost of

de)t

$. use of the

funds

7. Scholastic &o"s is considering developing and distri)uting a ne* )oard

game for children. &he pro0ect is similar in risk to the rm/s current

operations. &he rm maintains a de)teuit" ratio of 8.48 and retains

all prots to fund the rm/s rapid gro*th. 9o* should the rm

determine its cost of euit"!

A. )" adding the market risk premium to the afterta'

cost of de)t

#. )" multipl"ing the market risk premium )":1 8.48;

C. )" using the dividend gro*th

model

D. )" using the capital asset pricing

model

$. )" averaging the costs )ased on the dividend gro*th model and the

capital asset pricing model



<. All else constant, *hich one of the follo*ing *ill increase a rm/s cost of

euit" if the rm computes that cost using the securit" market line

approach! Assume the rm currentl" pa"s an annual dividend of =1 a

share and has a )eta of 1.%.

A. a reduction in the dividend

amount

#. an increase in the dividend

amount

C. a reduction in the market rate of

return

D. a reduction in the rm/s

)eta

$. a reduction in the riskfreerate

18

.

A rm/s overall cost of euit" is-

A. is generall" less that the rm/s WACC given a

leveraged rm.

#. una5ected )" changes in the market risk

premium.

C. highl" dependent upon the gro*th rate and risk level of the rm.

D. generall" less than the rm/s afterta' cost

of de)t.

$. inversel" related to changes in the rm/s

ta' rate.



11

.

&he cost of euit" for a rm-

A. tends to remain static for rms *ith increasing

levels of risk.

#. increases as the uns"stematic risk of the rm

increases.

C. ignores the rm/s risks *hen that cost is )ased on the dividend

gro*th model.

D. euals the riskfree rate plus the market risk

premium.

$. euals the rm/s preta' *eighted average cost of

capital.

1%

.

&he dividend gro*th model can )e used to compute the cost of euit"

for a rm in *hich of the follo*ing situations!

I. rms that have a 188 percent retention ratio

II. rms that pa" a constant dividend

III. rms that pa" an increasing dividend

I>. rms that pa" a decreasing dividend

A. I and II

onl"#. I and III

onl"

C. II and III

onl"

D. I, II, and III

onl"

$. II, III, and I>

onl"



1+

.

&he dividend gro*th model-

A. is onl" as relia)le as the estimated rate of

gro*th.

#. can onl" )e used if historical dividend information is

availa)le.

C. considers the risk that future dividends ma" var" from their

estimated values.

D. applies onl" *hen a rm is currentl" pa"ing

dividends.

$. uses )eta to measure the s"stematic risk of

a rm.

14

.

Which one of the follo*ing statements related to the S(L approach to

euit" valuation is correct! Assume the rm uses de)t in its capital

structure.

A. &his model considers a rm/s rate of

gro*th.

#. &he model applies onl" to nondividend

pa"ing rms.

C. &he model is dependent upon a relia)le estimate of the market risk

premium.D. &he model generall" produces the same cost of euit" as the

dividend gro*th model.

$. &his approach generall" produces a cost of euit" that euals the

rm/s overall cost of capital.



1

.

Which of the follo*ing statements are correct!

I. &he S(L approach is dependent upon a relia)le measure of a rm/s

uns"stematic risk.

II. &he S(L approach can )e applied to rms that retain all of their

earnings.

III. &he S(L approach assumes a rm/s future risks are similar to its

past risks.

I>. &he S(L approach assumes the re*ardtorisk ratio is constant.

A. I and III

onl"

#. II and I>

onl"C. III and I>

onl"

D. I, II, and III

onl"

$. II, III, and I>

onl"

13

.

&he preta' cost of de)t-

A. is )ased on the current "ield to maturit" of the rm/s

outstanding )onds.

#. is eual to the coupon rate on the latest )onds issued

)" a rm.

C. is euivalent to the average current "ield on all of a rm/s

outstanding )onds.

D. is )ased on the original "ield to maturit" on the latest )onds

issued )" a rm.

$. has to )e estimated as it cannot )e directl" o)served in

the market.



16

.

&he afterta' cost of de)t generall" increases *hen-

I. a rm/s )ond rating increases.

II. the market rate of interest increases.

III. ta' rates decrease.

I>. )ond prices rise.

A. I and III

onl"

#. II and III

onl"

C. I, II, and III

onl"

D. II, III, and I>onl"

$. I, II, III, and

I>

17

.

&he cost of preferred stock is computed the same as the-

A. preta' cost of

de)t.

#. return on anannuit".

C. afterta' cost of

de)t.

D. return on a

perpetuit".

$. cost of an irregular gro*th common

stock.



1<

.

&he cost of preferred stock-

A. is eual to the dividend

"ield.

#. is eual to the "ield to

maturit".

C. is highl" dependent on the dividend

gro*th rate.

D. is independent of the stock/s

price.

$. decreases *hen ta' rates

increase.

%8

.

&he capital structure *eights used in computing the *eighted average

cost of capital-

A. are )ased on the )ook values of total de)t and

total euit".

#. are )ased on the market value of the rm/s de)t and euit"

securities.

C. are computed using the )ook value of the longterm de)t and the

)ook value of euit".

D. remain constant over time unless the rm issues ne*

securities.

$. are restricted to the rm/s de)t and

common stock.



%1

.

(orris Industries has a capital structure of percent common stock,

18 percent preferred stock, and 4 percent de)t. &he rm has a 38

percent dividend pa"out ratio, a )eta of 8.7<, and a ta' rate of +7

percent. ?iven this, *hich one of the follo*ing statements is correct!

A. &he afterta' cost of de)t *ill )e greater than the current "ieldto

maturit" on the rm/s )onds.

#. &he rm/s cost of preferred is most likel" less than the rm/s actual

cost of de)t.

C. &he rm/s cost of euit" is una5ected )" a change in the

rm/s ta' rate.

D. &he cost of euit" can onl" )e estimated using the S(L

approach.

$. &he rm/s *eighted average cost of capital *ill remain constant aslong as the capital structure remains constant.

%%

.

&he afterta' cost of de)t-

A. varies inversel" to changes in market

interest rates.

#. *ill generall" e'ceed the cost of euit" if the relevant ta'

rate is ero.

C. *ill generall" eual the cost of preferred if the ta'rate is ero.

D. is una5ected )" changes in the market rate of

interest.

$. has a greater e5ect on a rm/s cost of capital *hen the de)teuit"

ratio increases.



%+

.

&he *eighted average cost of capital for a rm ma" )e dependent upon

the rm/s-

I. rate of gro*th.

II. de)teuit" ratio.

III. preferred dividend pa"ment.

I>. retention ratio.

A. I and III

onl"

#. II and I>

onl"

C. I, II, and I>

onl"D. I, III, and I>

onl"

$. I, II, III, and

I>

%4

.

&he *eighted average cost of capital for a rm is the-

A. discount rate *hich the rm should appl" to all of the pro0ects it

undertakes.#. rate of return a rm must earn on its e'isting assets to maintain the

current value of its stock.

C. coupon rate the rm should e'pect to pa" on its ne't

)ond issue.

D. minimum discount rate the rm should reuire on an"

ne* pro0ect.

$. rate of return shareholders should e'pect to earn on their investment

in this rm.



%

.

Which one of the follo*ing statements is correct for a rm that uses

de)t in its capital structure!

A. &he WACC should decrease as the rm/s de)teuit" ratio

increases.

#. When computing the WACC, the *eight assigned to the preferred

stock is )ased on the coupon rate multiplied )" the par value of the

preferred.

C. &he rm/s WACC *ill decrease as the corporate ta' rate

decreases.

D. &he *eight of the common stock used in the computation of the

WACC is )ased on the num)er of shares outstanding multiplied )"

the )ook value per share.

$. &he WACC *ill remain constant unless a rm retires some ofits de)t.

%3

.

If a rm uses its WACC as the discount rate for all of the pro0ects it

undertakes then the rm *ill tend to-

I. re0ect some positive net present value pro0ects.

II. accept some negative net present value pro0ects.

III. favor high risk pro0ects over lo* risk pro0ects.

I>. increase its overall level of risk over time.

A. I and III

onl"

#. III and I>

onl"

C. I, II, and III

onl"

D. I, II, and I>

onl"

$. I, II, III, andI>



%6

.

@reston Industries has t*o separate divisions. $ach division is in a

separate line of )usiness. Division A is the largest division and

represents 68 percent of the rm/s overall sales. Division A is also the

riskier of the t*o divisions. Division # is the smaller and least risk" of

the t*o. When management is deciding *hich of the various divisional

pro0ects should )e accepted, the managers should-

A. allocate more funds to Division A since it is the largest of the t*o

divisions.

#. fund all of Division #/s pro0ects rst since the" tend to )e less risk"

and then allocate the remaining funds to the Division A pro0ects that

have the highest net present values.

C. allocate the compan"/s funds to the pro0ects *ith the highest net

present values )ased on the rm/s *eighted average cost of capital.D. assign appropriate, )ut di5ering, discount rates to each pro0ect and

then select the pro0ects *ith the highest net present values.

$. fund the highest net present value pro0ects from each division )ased

on an allocation of 68 percent of the funds to Division A and +8

percent of the funds to Division #.

%7

.

(arkle" and Stearns is a multidivisional rm that uses its WACC as the

discount rate for all proposed pro0ects. $ach division is in a separate

line of )usiness and each presents risks uniue to those lines. ?iven

this, a division *ithin the rm *ill tend to-

A. receive less pro0ect funding if its line of )usiness is riskier than that

of the other divisions.

#. avoid risk" pro0ects so it can receive more pro0ect

funding.

C. )ecome less risk" over time )ased on the pro0ects that are

accepted.

D. have eual pro)a)ilit" of receiving funding as compared to the

other divisions.$. prefer higher risk pro0ects over lo*er risk

pro0ects.



%<

.

&he discount rate assigned to an individual pro0ect should )e )ased on-

A. the rm/s *eighted average cost of

capital.

#. the actual sources of funding used for the

pro0ect.

C. an average of the rm/s overall cost of capital for the past

ve "ears.

D. the current risk level of the

overall rm.

$. the risks associated *ith the use of the funds reuired )"

the pro0ect.

+8

.

Assigning discount rates to individual pro0ects )ased on the risk level of

each pro0ect-

A. ma" cause the rm/s overall *eighted average cost of capital to

either increase or decrease over time.

#. *ill prevent the rm/s overall cost of capital from changing

over time.

C. *ill cause the rm/s overall cost of capital to decrease

over time.

D. decreases the value of the rm over

time.

$. negates the rm/s goal of creating the most value for the

shareholders.



+1

.

Which one of the follo*ing statements is correct!

A. irms should accept lo* risk pro0ects prior to funding high risk

pro0ects.

#. (aking su)0ective ad0ustments to a rm/s WACC *hen determining

pro0ect discount rates unfairl" punishes lo*risk divisions *ithin a

rm.

C. A pro0ect that is unaccepta)le toda" might )e accepta)le tomorro*

given a change in market returns.

D. &he pure pla" method is most freuentl" used for pro0ects involving

the e'pansion of a rm/s current operations.

$. irms that elect to use the pure pla" method for determining a

discount rate for a pro0ect cannot su)0ectivel" ad0ust the pure pla"

rate.

+%

.

@hil/s is a sitdo*n restaurant that specialies in homecooked meals.

&heresa/s is a *alkin deli that specialies in specialt" soups and

sand*iches. #oth rms are currentl" considering e'panding their

operations during the summer months )" o5ering pre*rapped donuts,

sand*iches, and *raps at a local )each. @hil/s currentl" has a WACC of

14 percent *hile &heresa/s WACC is 18 percent. &he e'pansion pro0ect

has a pro0ected net present value of =1%,388 at a 18 percent discount

rate and a net present value of =%,878 at a 14 percent discount rate.

Which rm or rms should e'pand and o5er food at the local )eachduring the summer months!

A. @hil/s

onl"

#. &heresa/s

onl"

C. )oth @hil/s and

&heresa/s

D. neither @hil/s nor &heresa/s

$. cannot )e determined from the information

provided



++

.

Wilderness Adventures specialies in )ackcountr" tours and resort

management. &ravel $'citement specialies in making travel

reservations and promoting vacation travel. Wilderness Adventures has

an afterta' cost of capital of 1+ percent and &ravel $'citement has an

afterta' cost of capital of 11 percent. #oth rms are considering

)uilding *ilderness campgrounds complete *ith manmade lakes and

hiking trails. &he estimated net present value of such a pro0ect is

estimated at =76,888 at a discount rate of 11 percent and =1%,88 at a

1+ percent discount rate. Which rm or rms, if either, should accept

this pro0ect!

A. Wilderness Adventures

onl"

#. &ravel $'citementonl"

C. )oth Wilderness Adventures and &ravel

$'citement

D. neither Wilderness Adventures nor &ravel

$'citement

$. cannot )e determined *ithout further

information

+4

.

&he su)0ective approach to pro0ect anal"sis-

A. is used onl" *hen a rm has an alleuit" capital

structure.

#. uses the WACC of rm B as the )asis for the discount rate for a

pro0ect under consideration )" rm .

C. assigns discount rates to pro0ects )ased on the discretion of the

senior managers of a rm.

D. allo*s managers to randoml" ad0ust the discount rate assigned to a

pro0ect once the pro0ect/s )eta has )een determined.

$. applies a lo*er discount rate to pro0ects that are nanced totall" *itheuit" as compared to those that are partiall" nanced *ith de)t.



+

.

Which one of the follo*ing statements is correct!

A. &he su)0ective approach assesses the risks of each pro0ect and

assigns an ad0ustment factor that is uniue 0ust for that pro0ect.

#. verall, a rm makes )etter decisions *hen it uses the su)0ective

approach than *hen it uses its WACC as the discount rate for all

pro0ects.

C. irms *ill correctl" accept or re0ect ever" pro0ect if the" adopt the

su)0ective approach.

D. (andator" pro0ects should onl" )e accepted if the" produce a

positive E@> *hen the rm/s WACC is used as the discount rate.

$. &he pure pla" approach should onl" )e used *ith lo*risk

pro0ects.

+3

.

When a rm has Fotation costs eual to 6 percent of the funding need,

pro0ect anal"sts should-

A. increase the pro0ect/s discount rate to o5set these e'penses )"

multipl"ing the rm/s WACC )" 1.86.

#. increase the pro0ect/s discount rate to o5set these e'penses )"

dividing the rm/s WACC )" :1 8.86;.

C. add 6 percent to the rm/s WACC to get the discount rate for

the pro0ect.D. increase the initial pro0ect cost )" multipl"ing that

cost )" 1.86.

$. increase the initial pro0ect cost )" dividing that cost )"

:1 8.86;.



+6

.

&he Fotation cost for a rm is computed as-

A. the arithmetic average of the Fotation costs of )oth de)t

and euit".

#. the *eighted average of the Fotation costs associated *ith each

form of nancing.

C. the geometric average of the Fotation costs associated *ith each

form of nancing.

D. onehalf of the Fotation cost of de)t plus onehalf of the Fotation

cost of euit".

$. a *eighted average )ased on the )ook values of the rm/s de)t

and euit".

+7

.

Incorporating Fotation costs into the anal"sis of a pro0ect *ill-

A. cause the pro0ect to )e improperl"

evaluated.

#. increase the net present value of the

pro0ect.

C. increase the pro0ect/s rate of

return.

D. increase the initial cash outFo* of the

pro0ect.

$. have no e5ect on the present value of the

pro0ect.

+<

.

lotation costs for a levered rm should-

A. )e ignored *hen anal"ing a pro0ect )ecause the" are not an actual

pro0ect cost.

#. )e spread over the life of a pro0ect there)" reducing the cash Fo*s

for each "ear of the pro0ect.

C. onl" )e considered *hen t*o pro0ects are mutuall"

e'clusive.

D. )e *eighted and included in the initial

cash Fo*.

$. )e totall" ignored *hen internal euit" funding is

utilied.



48

.

Chelsea ashions is e'pected to pa" an annual dividend of =8.78 a

share ne't "ear. &he market price of the stock is =1<.38 and the gro*th

rate is percent. What is the rm/s cost of euit"!

A. 6.7

percent

#. 6.<1

percent

C. 7.%4

percent

D. <.87

percent

$. 18.88

percent

41

.

&he Shoe utlet has paid annual dividends of =8.3, =8.68, =8.6%, and

=8.6 per share over the last four "ears, respectivel". &he stock is

currentl" selling for =%3 a share. What is this rm/s cost of euit"!

A. 6.3

percent

#. 6.<+

percentC. 18.+7

percent

D. 18.+

percent

$. 11.6<

percent



4%

.

S*eet &reats common stock is currentl" priced at =17.+ a share. &he

compan" 0ust paid =1.% per share as its annual dividend. &he

dividends have )een increasing )" %. percent annuall" and are

e'pected to continue doing the same. What is this rm/s cost of

euit"!

A. 3.8+

percent

#. 3.17

percent

C. 7.46

percent

D. <.41

percent$. <.7%

percent

4+

.

&he common stock of (etal (olds has a negative gro*th rate of 1.

percent and a reuired return of 17 percent. &he current stock price is

=11.48. What *as the amount of the last dividend paid!

A. =%.8

6#. =%.1

1

C. =%.1

<

D. =%.%

%

$. =%.%

3



44

.

9igh*a" $'press has paid annual dividends of =1.8, =1.%8, =1.%,

=1.1, and =8.< over the past ve "ears, respectivel". What is the

average dividend gro*th rate!

A. 1.64

percent

#. +.38

percent

C. %.%7

percent

D. %.46

percent

$. 4.+<

percent

4

.

Southern 9ome Cookin/ 0ust paid its annual dividend of =8.3 a share.

&he stock has a market price of =1+ and a )eta of 1.1%. &he return on

the G.S. &reasur" )ill is %. percent and the market risk premium is 3.7

percent. What is the cost of euit"!

A. <.<7

percent

#. 18.84percent

C. 18.1%

percent

D. 18.+6

percent

$. 18.4

percent



43

.

Eational 9ome Hentals has a )eta of 1.%4, a stock price of =%%, and

recentl" paid an annual dividend of =8.<4 a share. &he dividend gro*th

rate is 4. percent. &he market has a 18.3 percent rate of return and a

risk premium of 6. percent. What is the rm/s cost of euit"!

A. 6.8

percent

#. 7.36

percent

C. <.1+

percent

D. 18.+8

percent

$. 18.37percent

46

.

9enesse" (arkets has a gro*th rate of 4.7 percent and is euall" as

risk" as the market. &he stock is currentl" selling for =16 a share. &he

overall stock market has a 18.3 percent rate of return and a risk

premium of 7.6 percent. What is the e'pected rate of return on this

stock!

A. 7.6percent

#. <.%

percent

C. 18.3

percent

D. 11.+

percent

$. 11.6

percent



47

.

&ide*ater ishing has a current )eta of 1.%1. &he market risk premium

is 7.< percent and the riskfree rate of return is +.% percent. #" ho*

much *ill the cost of euit" increase if the compan" e'pands its

operations such that the compan" )eta rises to 1.8!

A. 1.77

percent

#. %.7

percent

C. %.38

percent

D. +.18

percent

$. +.%3percent

4<

.

Wind @o*er S"stems has %8"ear, semiannual )onds outstanding *ith

a percent coupon. &he face amount of each )ond is =1,888. &hese

)onds are currentl" selling for 114 percent of face value. What is the

compan"/s preta' cost of de)t!

A. +.<7

percent#. 4.4%

percent

C. 4.61

percent

D. .+3

percent

$. .

percent



8

.

#oulder urniture has )onds outstanding that mature in 1 "ears, have

a 3 percent coupon, and pa" interest annuall". &hese )onds have a face

value of =1,888 and a current market price of =1,86. What is the

compan"/s afterta' cost of de)t if its ta' rate is +% percent!

A. %.<6

percent

#. +.%4

percent

C. +.7

percent

D. .%1

percent

$. .+percent

1

.

9and" (an, Inc. has ero coupon )onds outstanding that mature in 7

"ears. &he )onds have a face value of =1,888 and a current market

price of =348. What is the compan"/s preta' cost of de)t!

A. %.

percent

#. .8<percent

C. .33

percent

D. 6.+1

percent

$. 6.47

percent



%

.

Dog ?one ?ood $ngines has a )ond issue outstanding *ith 16 "ears to

maturit". &hese )onds have a =1,888 face value, a < percent coupon,

and pa" interest semiannuall". &he )onds are currentl" uoted at 7%

percent of face value. What is the compan"/s preta' cost of de)t if the

ta' rate is +7 percent!

A. 4.18

percent

#. 4.4%

percent

C. 3.31

percent

D. 7.<8

percent$. 11.4%

percent

+

.

&he Corner #aker" has a )ond issue outstanding that matures in 6

"ears. &he )onds pa" interest semiannuall". Currentl", the )onds are

uoted at 181.4 percent of face value and carr" a < percent coupon.

What is the rm/s afterta' cost of de)t if the ta' rate is +8 percent!

A. 4.77percent

#. .+3

percent

C. .4

percent

D. 3.11

percent

$. 7.64

percent



4

.

&he outstanding )onds of &ech $'press are priced at =<7< and mature

in 18 "ears. &hese )onds have a 3 percent coupon and pa" interest

annuall". &he rm/s ta' rate is + percent. What is the rm/s afterta'

cost of de)t!

A. +.81

percent

#. +.%%

percent

C. +.+

percent

D. 4.88

percent

$. 4.41percent

.

Simple oods has a ero coupon )ond issue outstanding that matures in

< "ears. &he )onds are selling at 4% percent of par value. What is the

compan"/s afterta' cost of de)t if the ta' rate is +7 percent!

A. .47

percent

#. .6+percent

C. 3.1%

percent

D. 6.6+

percent

$. <.77

percent



3

.

?rill Works and (ore has 6 percent preferred stock outstanding that is

currentl" selling for =4< a share. &he market rate of return is 14 percent

and the rm/s ta' rate is +6 percent. What is the rm/s cost of preferred

stock!

A. 1+.66

percent

#. 1+.%<

percent

C. 1+.36

percent

D. 14.%<

percent

$. 14.4percent

6

.

Samuelson @lastics has 6. percent preferred stock outstanding.

Currentl", this stock has a market value per share of =% and a )ook

value per share of =+7. What is the cost of preferred stock!

A. 6.8

percent

#. 1+.77percent

C. 14.4%

percent

D. 1<.%<

percent

$. 1<.64

percent



7

.

Ee* ork Deli has 6 percent preferred stock outstanding that sells for

=+4 a share. &his stock *as originall" issued at =4 per share. What is

the cost of preferred stock!

A. 1+.37

percent

#. 14.88

percent

C. 17.%<

percent

D. %8.<

percent

$. %8.78

percent

<

.

Eelson/s Landscaping has 1,%88 )onds outstanding that are selling for

=<<8 each. &he compan" also has %,88 shares of preferred stock at a

market price of =%7 a share. &he common stock is priced at =+6 a share

and there are %7,888 shares outstanding. What is the *eight of the

common stock as it relates to the rm/s *eighted average cost of

capital!

A. 4+.87percent

#. 4.13

percent

C. 46.11

percent

D. 4.88

percent

$. .4

percent



38

.

(angrove ruit arms has a =%8,888 )ond issue outstanding that is

selling at <% percent of face value. &he rm also has 1,88 shares of

preferred stock and 1,888 shares of common stock outstanding. &he

preferred stock has a market price of =+ a share compared to a price

of =%4 a share for the common stock. What is the *eight of the

preferred stock as it relates to the rm/s *eighted average cost of

capital!

A. 3.6

percent

#. 6.%8

percent

C. 6.6

percentD. 7.8+

percent

$. 7.16

percent

31

.

$lectronics ?alore has <8,888 shares of common stock outstanding at

a market price of =+7 a share. &he compan" also has 48,888 )onds

outstanding that are uoted at 183 percent of face value. What *eight

should )e given to the de)t *hen the rm computes its *eighted

average cost of capital!

A. 4%

percent

#. 43

percent

C. 8

percent

D. 4

percent$. 7

percent



3%

.

@hillips $uipment has 78,888 )onds outstanding that are selling at par.

#onds *ith similar characteristics are "ielding 6. percent. &he

compan" also has 68,888 shares of 6 percent preferred stock and %.

million shares of common stock outstanding. &he preferred stock sells

for =3 a share. &he common stock has a )eta of 1.+4 and sells for =4%

a share. &he G.S. &reasur" )ill is "ielding %.7 percent and the return on

the market is 11.% percent. &he corporate ta' rate is +7 percent. What

is the rm/s *eighted average cost of capital!

A. 18.1

percent

#. 18.34

percent

C. 11.17percent

D. 11.+8

percent

$. 11.3

percent

3+

.

Wa"co Industrial Suppl" has a preta' cost of de)t of 6.3 percent, a cost

of euit" of 14.+ percent, and a cost of preferred stock of 7. percent.

&he rm has %%8,888 shares of common stock outstanding at a market

price of =%6 a share. &here are %,888 shares of preferred stockoutstanding at a market price of =41 a share. &he )ond issue has a face

value of =8,888 and a market uote of 181.%. &he compan"/s ta' rate

is +6 percent. What is the rm/s *eighted average cost of capital!

A. 18.17

percent

#. 18.74

percent

C. 11.+%percent

D. 1%.38

percent

$. 1%.71

percent



34

.

Central S"stems, Inc. desires a *eighted average cost of capital of 7

percent. &he rm has an afterta' cost of de)t of .4 percent and a cost

of euit" of 1.% percent. What de)teuit" ratio is needed for the rm

to achieve its targeted *eighted average cost of capital!

A. 8.+

7

#. 8.4

4

C. 1.8

%

D. %.6

6

$. +.3+

3

.

H.S. ?reen has %8,888 shares of common stock outstanding at a

market price of =%7 a share. Ee't "ear/s annual dividend is e'pected to

)e =1. a share. &he dividend gro*th rate is % percent. &he rm also

has 6,88 )onds outstanding *ith a face value of =1,888 per )ond. &he

)onds carr" a 6 percent coupon, pa" interest semiannuall", and mature

in 6. "ears. &he )onds are selling at <7 percent of face value. &he

compan"/s ta' rate is +4 percent. What is the rm/s *eighted average

cost of capital!

A. .4

percent

#. 3.%

percent

C. 6.

percent

D. 7.

percent$. <.3

percent



33

.

elso/s has a de)teuit" ratio of 8.3 and a ta' rate of + percent. &he

rm does not issue preferred stock. &he cost of euit" is 14. percent

and the afterta' cost of de)t is 4.7 percent. What is the *eighted


A. 18.43

percent

#. 18.36

percent

C. 18.73

percent

D. 11.+7

percent

$. 11.6percent

36

.

?ranite Works maintains a de)teuit" ratio of 8.3 and has a ta' rate

of +% percent. &he rm does not issue preferred stock. &he preta' cost

of de)t is <.7 percent. &here are %,888 shares of stock outstanding

*ith a )eta of 1.% and a market price of =1< a share. &he current

market risk premium is 7. percent and the current riskfree rate is +.3

percent. &his "ear, the rm paid an annual dividend of =1.18 a share

and e'pects to increase that amount )" % percent each "ear. Gsing an

average e'pected cost of euit", *hat is the *eighted average cost ofcapital!

A. 7.44

percent

#. 7.67

percent

C. 7.<3

percent

D. <.1+percent

$. <.%8

percent



37

.

Delta Lighting has +8,888 shares of common stock outstanding at a

market price of =1.88 a share. &his stock *as originall" issued at =+1

per share. &he rm also has a )ond issue outstanding *ith a total face

value of =%78,888 *hich is selling for 73 percent of par. &he cost of

euit" is 1+ percent *hile the afterta' cost of de)t is 3.< percent. &he

rm has a )eta of 1.47 and a ta' rate of +8 percent. What is the

*eighted average cost of capital!

A. 18.86

percent

#. 18.76

percent

C. 1%.+3

percentD. 1+.%<

percent

$. 1+.46

percent

3<

.

&he (arket utlet has a )eta of 1.+7 and a cost of euit" of 14.<4

percent. &he riskfree rate of return is 4.% percent. What discount rate

should the rm assign to a ne* pro0ect that has a )eta of 1.%!

A. 1+.4

percent.

#. 1+.6%

percent.

C. 1+.<4

percent.

D. 14.14

percent.

$. 14.+3

percent.



68

.

Silo (ills has a )eta of 8.< and a cost of euit" of 11.< percent. &he

riskfree rate of return is %.7 percent. &he rm is currentl" considering a

pro0ect that has a )eta of 1.8+ and a pro0ect life of 3 "ears. What

discount rate should )e assigned to this pro0ect!

A. 1+.++

percent.

#. 1%.36

percent.

C. 1+.3%

percent.

D. 1+.74

percent.

$. 14.8<percent.

61

.

&ravis J Sons has a capital structure *hich is )ased on 48 percent de)t,

percent preferred stock, and percent common stock. &he preta'

cost of de)t is 6. percent, the cost of preferred is < percent, and the

cost of common stock is 1+ percent. &he compan"/s ta' rate is +<

percent. &he compan" is considering a pro0ect that is euall" as risk" as

the overall rm. &his pro0ect has initial costs of =+%,888 and annual

cash inFo*s of =76,888, =%6<,888, and =113,888 over the ne't three

"ears, respectivel". What is the pro0ected net present value of thispro0ect!

A. =37,%11.

84

#. =37,76<.

<6

C. =3<,+31.

87

D. =64,%87.17

$. =63,811.

%+



6%

.

@anelli/s is anal"ing a pro0ect *ith an initial cost of =118,888 and cash

inFo*s of =3,888 in "ear one and =64,888 in "ear t*o. &his pro0ect is

an e'tension of the rm/s current operations and thus is euall" as risk"

as the current rm. &he rm uses onl" de)t and common stock to

nance its operations and maintains a de)teuit" ratio of 8.4. &he

afterta' cost of de)t is 4.7 percent, the cost of euit" is 1%.6 percent,

and the ta' rate is + percent. What is the pro0ected net present value

of this pro0ect!

A. =6,41

1

#. =6,78

<

C. =7,+++

D. =7,<+

7

$. =<,74

8

6+

.

Carson $lectronics uses 68 percent common stock and +8 percent de)t

to nance its operations. &he afterta' cost of de)t is .4 percent and

the cost of euit" is 1.4 percent. (anagement is considering a pro0ect

that *ill produce a cash inFo* of =+3,888 in the rst "ear. &he cashinFo*s *ill then gro* at + percent per "ear forever. What is the

ma'imum amount the rm can initiall" invest in this pro0ect to avoid a

negative net present value for the pro0ect!

A. =%<<,8+

%

#. =+7%,<6

<

C. =411,483

D. =4+4,87

3

$. =441,41

4



64

.

&he #aker" is considering a ne* pro0ect it considers to )e a little riskier

than its current operations. &hus, management has decided to add an

additional 1. percent to the compan"/s overall cost of capital *hen

evaluating this pro0ect. &he pro0ect has an initial cash outla" of =7,888

and pro0ected cash inFo*s of =16,888 in "ear one, =%7,888 in "ear t*o,

and =+8,888 in "ear three. &he rm uses % percent de)t and 6

percent common stock as its capital structure. &he compan"/s cost of

euit" is 1. percent *hile the afterta' cost of de)t for the rm is 3.1

percent. What is the pro0ected net present value of the ne* pro0ect!

A.

=3,%8

7

#. =1,<3

4

C.

=+87

D. =1,4%

6

$. =1,6

+

6.

&he il Derrick has an overall cost of euit" of 1+.3 percent and a )etaof 1.%7. &he rm is nanced solel" *ith common stock. &he riskfree

rate of return is +.4 percent. What is an appropriate cost of capital for a

division *ithin the rm that has an estimated )eta of 1.17!

A. 1%.+6

percent

#. 1%.41

percent

C. 1%.4percent

D. 1%.36

percent

$. 1%.78

percent



63

.

(iller Sisters has an overall )eta of 8.6< and a cost of euit" of 11.%

percent for the rm overall. &he rm is 188 percent nanced *ith

common stock. Division A *ithin the rm has an estimated )eta of 1.87

and is the riskiest of all of the rm/s operations. What is an appropriate

cost of capital for division A if the market risk premium is <. percent!

A. 1+.1%

percent

#. 1+.<3

percent

C. 14.3+

percent

D. 1.66

percent$. 13.81

percent

66

.

Deep (ining and @recious (etals are separate rms that are )oth

considering a silver e'ploration pro0ect. Deep (ining is in the actual

mining )usiness and has an afterta' cost of capital of 1%.7 percent.

@recious (etals is in the precious gem retail )usiness and has an

afterta' cost of capital of 18.3 percent. &he pro0ect under consideration

has initial costs of =6,888 and anticipated annual cash inFo*s of

=18%,888 a "ear for ten "ears. Which rm:s;, if either, should acceptthis pro0ect!

A. Compan" A

onl"

#. Compan" #

onl"

C. )oth Compan" A and

Compan" #

D. neither Compan" A orCompan" #


information



67

.

Sister @ools sells outdoor s*imming pools and currentl" has an afterta'

cost of capital of 11.3 percent. Al/s Construction )uilds and sells *ater

features and fountains and has an afterta' cost of capital of 18.+

percent. Sister @ools is considering )uilding and selling its o*n *ater

features and fountains. &he sales manager of Sister @ools estimates

that the *ater features and fountains *ould produce %8 percent of the

rm/s future total sales. &he initial cash outla" for this pro0ect *ould )e

=7,888. &he e'pected net cash inFo*s are =16,888 a "ear for 6 "ears.

What is the net present value of the Sister @ools pro0ect!

A.

=11,84

4

#. =+,84

7

C.

=%,%3

%

D.

=1,8

7

$. =1,%1

<



6<

.

Decker/s is a chain of furniture retail stores. urniture ashions is a

furniture maker and a supplier to Decker/s. Decker/s has a )eta of 1.+7

as compared to urniture ashion/s )eta of 1.1%. &he riskfree rate of

return is +. percent and the market risk premium is 7 percent. What

discount rate should Decker/s use if it considers a pro0ect that involves

the manufacturing of furniture!

A. 1%.43

percent

#. 1%.<%

percent

C. 1+.8

percent

D. 14.87percent

$. 14.4

percent

78

.

#leakl" $nterprises has a capital structure of 48 percent common stock,

18 percent preferred stock, and 8 percent de)t. &he Fotation costs are

4. percent for de)t, 6 percent for preferred stock, and <. percent for

common stock. &he corporate ta' rate is +4 percent. What is the

*eighted average Fotation cost!

A. .7

percent

#. 3.%

percent

C. 3.4

percent

D. 3.3

percent

$. 3.7percent



71

.

Kustice, Inc. has a capital structure *hich is )ased on +8 percent de)t,

percent preferred stock, and 3 percent common stock. &he Fotation

costs are 11 percent for common stock, 18 percent for preferred stock,

and 6 percent for de)t. &he corporate ta' rate is +6 percent. What is

the *eighted average Fotation cost!

A. 7.<6

percent

#. <.47

percent

C. <.3%

percent

D. <.6

percent$. 18.88

percent

7%

.

&he Dail" #re* has a de)teuit" ratio of 8.34. &he rm is anal"ing a

ne* pro0ect *hich reuires an initial cash outla" of =4%8,888 for

euipment. &he Fotation cost is <.3 percent for euit" and .4 percent

for de)t. What is the initial cost of the pro0ect including the Fotation

costs!

A. =+8%,48

8

#. =+37,<%

4

C. =43,+%

7

D. =43,68

8

$. =7+,++

+



7+

.

ou are evaluating a pro0ect *hich reuires =%+8,888 in e'ternal

nancing. &he Fotation cost of euit" is 11.3 percent and the Fotation

cost of de)t is .4 percent. What is the initial cost of the pro0ect

including the Fotation costs if "ou maintain a de)teuit" ratio of 8.4!

A. =%47,4<

4

#. =%4<,8%

1

C. =%4,3+

7

D. =%,

1

$. =%,343

74

.

Western Wear is considering a pro0ect that reuires an initial investment

of =%64,888. &he rm maintains a de)teuit" ratio of 8.48 and has a

Fotation cost of de)t of 7 percent and a Fotation cost of euit" of 18.

percent. &he rm has sucient internall" generated euit" to cover the

euit" portion of this pro0ect. What is the initial cost of the pro0ect

including the Fotation costs!

A. =%78,48

<

#. =%71,48

3

C. =%77,88

D. =%<6,64

6

$. =+8%,63

%



7

.

ester"ear @roductions is considering a pro0ect *ith an initial start up

cost of =<38,888. &he rm maintains a de)teuit" ratio of 8.8 and has

a Fotation cost of de)t of 3.7 percent and a Fotation cost of euit" of

11.4 percent. &he rm has sucient internall" generated euit" to

cover the euit" cost of this pro0ect. What is the initial cost of the

pro0ect including the Fotation costs!

A. =<6<,41

6

#. =<7%,%3

C. =<<%,+7

3

D. =1,8+7,1+

$. =1,83,8

7<

73

.

&he Cit" Street Corporation/s common stock has a )eta of 1.%. &he risk

free rate is +. percent and the e'pected return on the market is 1+

percent. What is the rm/s cost of euit"!

A. 11.4percent

#. 1%.7

percent

C. 14.<

percent

D. 16.3

percent

$. 1<.1

percent



76

.

Stock in Countr" Hoad Industries has a )eta of 8.<6. &he market risk

premium is 18 percent *hile &)ills are currentl" "ielding . percent.

Countr" Hoad/s most recent dividend *as =1. per share, and

dividends are e'pected to gro* at a 6 percent annual rate indenitel".

&he stock sells for =+% a share. What is the estimated cost of euit"

using the average of the CA@( approach and the dividend discount

approach!

A. 1+.3<

percent

#. 14.83

percent

C. 14.%1

percentD. 14.+7

percent

$. 14.8

percent

77

.

9oldup #ank has an issue of preferred stock *ith a = stated dividend

that 0ust sold for =<% per share. What is the )ank/s cost of preferred!

A. 4.38percent

#. 4.34

percent

C. .+<

percent

D. .4+

percent

$. .4

percent



7<

.

Decline, Inc. is tr"ing to determine its cost of de)t. &he rm has a de)t

issue outstanding *ith 1 "ears to maturit" that is uoted at 186

percent of face value. &he issue makes semiannual pa"ments and has

an em)edded cost of < percent annuall". What is the afterta' cost of

de)t if the ta' rate is +< percent!

A. 4.<<

percent

#. .<8

percent

C. 3.16

percent

D. 6.+6

percent$. 6.4%

percent

<8

.

Kimin"/s Cricket arm issued a +8"ear, 7 percent, semiannual )ond 3

"ears ago. &he )ond currentl" sells for 114 percent of its face value.

What is the afterta' cost of de)t if the compan"/s ta' rate is +1

percent!

A. 4.3+percent

#. 4.68

percent

C. 4.6

percent

D. 4.7%

percent

$. 4.73

percent



<1

.

(ullineau' Corporation has a target capital structure of 41 percent

common stock, 4 percent preferred stock, and percent de)t. Its cost

of euit" is 17 percent, the cost of preferred stock is 3. percent, and

the preta' cost of de)t is 7. percent. What is the rm/s WACC given a

ta' rate of +< percent!

A. <.76

percent

#. 18.4+

percent

C. 18.4<

percent

D. 1+.+7

percent$. 1.16

percent

<%

.

Cookie Dough (anufacturing has a target de)teuit" ratio of 8.. Its

cost of euit" is 1 percent, and its cost of de)t is 11 percent. What is

the rm/s WACC given a ta' rate of +1 percent!

A. 1%.+

percent#. 1%.67

percent

C. 1+.11

percent

D. 1+.47

percent

$. 1+.36

percent



<+

.

ama/s Llamas has a *eighted average cost of capital of <. percent.

&he compan"/s cost of euit" is 1. percent, and its preta' cost of

de)t is 7. percent. &he ta' rate is +4 percent. What is the compan"/s

target de)teuit" ratio!

A. 8.7

<

#. 8.<

%

C. 8.<

7

D. 1.8

1

$. 1.4

<4

.

Kungle, Inc. has a target de)teuit" ratio of 8.6%. Its WACC is 11.

percent and the ta' rate is +4 percent. What is the cost of euit" if the

afterta' cost of de)t is . percent!

A. 1+.6

percent

#. 1+.74percent

C. 14.41

percent

D. 14.6<

percent

$. 1.7%

percent



<

.

&itan (ining Corporation has 14 million shares of common stock

outstanding, <88,888 shares of < percent preferred stock outstanding

and %%8,888 ten percent semiannual )onds outstanding, par value

=1,888 each. &he common stock currentl" sells for =4% per share and

has a )eta of 1.1, the preferred stock currentl" sells for =78 per share,

and the )onds have 16 "ears to maturit" and sell for <1 percent of par.

&he market risk premium is 11. percent, &)ills are "ielding 6.

percent, and the rm/s ta' rate is +% percent. What discount rate

should the rm appl" to a ne* pro0ect/s cash Fo*s if the pro0ect has the

same risk as the rm/s t"pical pro0ect!

A. 14.<

percent

#. 14.6%percent

C. 1.16

percent

D. 1.4

percent

$. 13.77

percent

<3

.

Suppose "our compan" needs =14 million to )uild a ne* assem)l" line.

our target de)teuit" ratio is 8.74. &he Fotation cost for ne* euit" is<. percent, )ut the Foatation cost for de)t is onl" %. percent. What is

the true cost of )uilding the ne* assem)l" line after taking Fotation

costs into account!

A. 14.7%

million

#. 14.<4

million

C. 1.86million

D. 1.1%

million

$. 1.%+

million



Essay Questions

<6

.

What role does the *eighted average cost of capital pla" *hen

determining a pro0ect/s cost of capital!

<7

.

What are some advantages of the su)0ective approach to determining

the cost of capital and *h" do "ou think that approach is utilied!

<<

.

?ive an e'ample of a situation *here a rm should adopt the pure pla"

approach for determining the cost of capital for a pro0ect.



188

.

Suppose "our )oss comes to "ou and asks "ou to reevaluate a capital

)udgeting pro0ect. &he rst evaluation *as in error, he e'plains,

)ecause it ignored Fotation costs. &o correct for this, he asks "ou to

evaluate the pro0ect using a higher cost of capital *hich incorporates

these costs. Is "our )oss/ approach correct! Wh" or *h" not!

181.

$'plain ho* the use of internal euit" rather than e'ternal euit"a5ects the anal"sis of a pro0ect.



Chapter 14 Cost of Capital Ans*er e"

Multiple Choice Questions

1. A group of individuals got together and purchased all of the

outstanding shares of common stock of DL Smith, Inc. What is the

return that these individuals reuire on this investment called!

A. dividend

"ield

B. cost of

euit"

C. capital gains

"ield

D. cost of

capital

$. income

return

Hefer to section 14.%

AACSB: Analytic

Blooms: Remember

Difculty: 1 Easy

Learning Objective: 14!1 "o# to $etermine a %rm&s cost o' e(uity ca)ital*

Section: 14*+

,o)ic: Cost o' e(uity



%. &e'tile (ills )orro*s mone" at a rate of 1+. percent. &his interest

rate is referred to as the-

A. compound

rate.

#. current

"ield.

C. cost of

de)t.

D. capital gains

"ield.

$. cost of

capital.

Hefer to section 14.+

AACSB: Analytic

Blooms: Remember

Difculty: 1 Easy

Learning Objective: 14!+ "o# to $etermine a %rm&s cost o' $ebt*

Section: 14*-

,o)ic: Cost o' $ebt

+. &he average of a rm/s cost of euit" and afterta' cost of de)t that is

*eighted )ased on the rm/s capital structure is called the-

A. re*ard to risk

ratio.

#. *eighted capital gains

rate.

C. structured cost of

capital.

D. su)0ective cost of

capital.E. *eighted average cost of

capital.

Hefer to section 14.4

AACSB: Analytic



Blooms: Remember

Difculty: 1 Easy

Learning Objective: 14!- "o# to $etermine a %rm&s overall cost o' ca)ital*

Section: 14*4

,o)ic: .eig/te$ average cost o' ca)ital

4. When a manager develops a cost of capital for a specic pro0ect

)ased on the cost of capital for another rm *hich has a similar line

of )usiness as the pro0ect, the manager is utiliing the 22222

approach.

A. su)0ective

risk

B. pure

pla"

C. divisional cost ofcapital

D. capital

ad0ustment

$. securit" market

line

Hefer to section 14.

AACSB: Analytic

Blooms: Remember Difculty: 1 Easy

Learning Objective: 14!0 Some o' t/e )it'alls associate$ #it/ a %rm&s overall cost o' ca)ital an$ #/at to $o

about t/em*

Section: 14*0

,o)ic: ure lay



. A rm/s cost of capital-

A. *ill decrease as the risk level of the rm

increases.

#. for a specic pro0ect is primaril" dependent upon the source of the

funds used for the pro0ect.

C. is independent of the rm/s capital

structure.

D. should )e applied as the discount rate for an" pro0ect considered

)" the rm.

E. depends upon ho* the funds raised are going to

)e spent.


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: 1 Easy


Section: 14*1

,o)ic: Cost o' ca)ital

3. &he *eighted average cost of capital for a *holesaler-

A. is euivalent to the afterta' cost of the rm/s

lia)ilities.

#. should )e used as the reuired return *hen anal"ing a potential

acuisition of a retail outlet.

C. is the return investors reuire on the total assets of

the rm.

D. remains constant *hen the de)teuit" ratio

changes.

$. is una5ected )" changes in corporate ta'

rates.


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: 1 Easy




Section: 14*1

,o)ic: .ACC

6. Which one of the follo*ing is the primar" determinant of a rm/s cost

of capital!

A. de)teuit"

ratio

#. applica)le ta'

rate

C. cost of

euit"

D. cost of

de)t

E. use of thefunds


AACSB: Analytic

Blooms: Remember

Difculty: 1 Easy


Section: 14*1




7. Scholastic &o"s is considering developing and distri)uting a ne*

)oard game for children. &he pro0ect is similar in risk to the rm/s

current operations. &he rm maintains a de)teuit" ratio of 8.48 and

retains all prots to fund the rm/s rapid gro*th. 9o* should the rm

determine its cost of euit"!

A. )" adding the market risk premium to the afterta'

cost of de)t

#. )" multipl"ing the market risk premium )"

:1 8.48;

C. )" using the dividend gro*th

model

D. )" using the capital asset pricing

model$. )" averaging the costs )ased on the dividend gro*th model and

the capital asset pricing model


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: 1 Easy


Section: 14*+




<. All else constant, *hich one of the follo*ing *ill increase a rm/s cost

of euit" if the rm computes that cost using the securit" market line

approach! Assume the rm currentl" pa"s an annual dividend of =1 a

share and has a )eta of 1.%.

A. a reduction in the dividend

amount

#. an increase in the dividend

amount

C. a reduction in the market rate of

return

D. a reduction in the rm/s

)eta

E. a reduction in the riskfreerate


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: + 3e$ium


Section: 14*+

,o)ic: CA3



18. A rm/s overall cost of euit" is-

A. is generall" less that the rm/s WACC given a

leveraged rm.

#. una5ected )" changes in the market risk

premium.

C. highl" dependent upon the gro*th rate and risk level of

the rm.

D. generall" less than the rm/s afterta' cost

of de)t.

$. inversel" related to changes in the rm/s

ta' rate.


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: 1 Easy


Section: 14*+


11. &he cost of euit" for a rm-

A. tends to remain static for rms *ith increasing

levels of risk.

#. increases as the uns"stematic risk of the rm

increases.

C. ignores the rm/s risks *hen that cost is )ased on the dividend

gro*th model.

D. euals the riskfree rate plus the market risk

premium.

$. euals the rm/s preta' *eighted average cost of

capital.


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: 1 Easy




1+. &he dividend gro*th model-

A. is onl" as relia)le as the estimated rate of

gro*th.

#. can onl" )e used if historical dividend information is

availa)le.

C. considers the risk that future dividends ma" var" from their

estimated values.

D. applies onl" *hen a rm is currentl" pa"ing

dividends.

$. uses )eta to measure the s"stematic risk of

a rm.


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: 1 Easy


Section: 14*+

,o)ic: Divi$en$ gro#t/ mo$el

14. Which one of the follo*ing statements related to the S(L approach to

euit" valuation is correct! Assume the rm uses de)t in its capital

structure.

A. &his model considers a rm/s rate of

gro*th.

#. &he model applies onl" to nondividend

pa"ing rms.

C. &he model is dependent upon a relia)le estimate of the market risk

premium.

D. &he model generall" produces the same cost of euit" as the

dividend gro*th model.$. &his approach generall" produces a cost of euit" that euals the

rm/s overall cost of capital.


AACSB: Analytic



Blooms: 2n$erstan$

Difculty: 1 Easy


Section: 14*+

,o)ic: S3L a))roac/

1. Which of the follo*ing statements are correct!

I. &he S(L approach is dependent upon a relia)le measure of a rm/s

uns"stematic risk.

II. &he S(L approach can )e applied to rms that retain all of their

earnings.

III. &he S(L approach assumes a rm/s future risks are similar to its

past risks.

I>. &he S(L approach assumes the re*ardtorisk ratio is constant.

A. I and III

onl"

#. II and I>

onl"

C. III and I>

onl"

D. I, II, and III

onl"

E. II, III, and I>

onl"


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: + 3e$ium


Section: 14*+

,o)ic: S3L a))roac/



13. &he preta' cost of de)t-

A. is )ased on the current "ield to maturit" of the rm/s

outstanding )onds.

#. is eual to the coupon rate on the latest )onds issued

)" a rm.

C. is euivalent to the average current "ield on all of a rm/s

outstanding )onds.

D. is )ased on the original "ield to maturit" on the latest )onds

issued )" a rm.

$. has to )e estimated as it cannot )e directl" o)served in

the market.


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: 1 Easy


Section: 14*-

,o)ic: Cost o' $ebt



16. &he afterta' cost of de)t generall" increases *hen-

I. a rm/s )ond rating increases.

II. the market rate of interest increases.

III. ta' rates decrease.

I>. )ond prices rise.

A. I and III

onl"

B. II and III

onl"

C. I, II, and III

onl"

D. II, III, and I>onl"

$. I, II, III, and

I>


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: + 3e$ium


Section: 14*-

,o)ic: Cost o' $ebt



17. &he cost of preferred stock is computed the same as the-

A. preta' cost of

de)t.

#. return on an

annuit".

C. afterta' cost of

de)t.

D. return on a

perpetuit".

$. cost of an irregular gro*th common

stock.


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: 1 Easy


Section: 14*-

,o)ic: Cost o' )re'erre$

1<. &he cost of preferred stock-

A. is eual to the dividend

"ield.

#. is eual to the "ield to

maturit".

C. is highl" dependent on the dividend

gro*th rate.

D. is independent of the stock/s

price.

$. decreases *hen ta' rates

increase.


AACSB: Analytic

Blooms: Remember

Difculty: 1 Easy




Section: 14*-


%8. &he capital structure *eights used in computing the *eighted

average cost of capital-

A. are )ased on the )ook values of total de)t and

total euit".

B. are )ased on the market value of the rm/s de)t and euit"

securities.

C. are computed using the )ook value of the longterm de)t and the

)ook value of euit".

D. remain constant over time unless the rm issues ne*

securities.

$. are restricted to the rm/s de)t andcommon stock.


AACSB: Analytic

Blooms: Remember

Difculty: 1 Easy


Section: 14*4

,o)ic: .ACC



%1. (orris Industries has a capital structure of percent common stock,

18 percent preferred stock, and 4 percent de)t. &he rm has a 38

percent dividend pa"out ratio, a )eta of 8.7<, and a ta' rate of +7

percent. ?iven this, *hich one of the follo*ing statements is correct!

A. &he afterta' cost of de)t *ill )e greater than the current "ieldto

maturit" on the rm/s )onds.

#. &he rm/s cost of preferred is most likel" less than the rm/s actual

cost of de)t.

C. &he rm/s cost of euit" is una5ected )" a change in the

rm/s ta' rate.

D. &he cost of euit" can onl" )e estimated using the S(L

approach.

$. &he rm/s *eighted average cost of capital *ill remain constant aslong as the capital structure remains constant.


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: + 3e$ium


Section: 14*4

,o)ic: .ACC



%%. &he afterta' cost of de)t-

A. varies inversel" to changes in market

interest rates.

#. *ill generall" e'ceed the cost of euit" if the relevant ta'

rate is ero.

C. *ill generall" eual the cost of preferred if the ta'

rate is ero.

D. is una5ected )" changes in the market rate of

interest.

E. has a greater e5ect on a rm/s cost of capital *hen the de)t

euit" ratio increases.


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: + 3e$ium


Section: 14*-

,o)ic: Cost o' $ebt



%+. &he *eighted average cost of capital for a rm ma" )e dependent

upon the rm/s-

I. rate of gro*th.

II. de)teuit" ratio.

III. preferred dividend pa"ment.

I>. retention ratio.

A. I and III

onl"

#. II and I>

onl"

C. I, II, and I>

onl"D. I, III, and I>

onl"

E. I, II, III, and

I>


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: + 3e$iumLearning Objective: 14!- "o# to $etermine a %rm&s overall cost o' ca)ital*

Section: 14*4

,o)ic: .ACC



%4. &he *eighted average cost of capital for a rm is the-

A. discount rate *hich the rm should appl" to all of the pro0ects it

undertakes.

B. rate of return a rm must earn on its e'isting assets to maintain

the current value of its stock.

C. coupon rate the rm should e'pect to pa" on its ne't

)ond issue.

D. minimum discount rate the rm should reuire on an"

ne* pro0ect.

$. rate of return shareholders should e'pect to earn on their

investment in this rm.


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: 1 Easy


Section: 14*4

,o)ic: .ACC



%. Which one of the follo*ing statements is correct for a rm that uses

de)t in its capital structure!

A. &he WACC should decrease as the rm/s de)teuit" ratio

increases.

#. When computing the WACC, the *eight assigned to the preferred

stock is )ased on the coupon rate multiplied )" the par value of

the preferred.

C. &he rm/s WACC *ill decrease as the corporate ta' rate

decreases.

D. &he *eight of the common stock used in the computation of the

WACC is )ased on the num)er of shares outstanding multiplied )"

the )ook value per share.

$. &he WACC *ill remain constant unless a rm retires some ofits de)t.


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: + 3e$ium


Section: 14*4

,o)ic: .ACC



%3. If a rm uses its WACC as the discount rate for all of the pro0ects it

undertakes then the rm *ill tend to-

I. re0ect some positive net present value pro0ects.

II. accept some negative net present value pro0ects.

III. favor high risk pro0ects over lo* risk pro0ects.

I>. increase its overall level of risk over time.

A. I and III

onl"

#. III and I>

onl"

C. I, II, and III

onl"D. I, II, and I>

onl"

E. I, II, III, and

I>


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: 1 Easy Learning Objective: 14!0 Some o' t/e )it'alls associate$ #it/ a %rm&s overall cost o' ca)ital an$ #/at to $o

about t/em*

Section: 14*0

,o)ic: .ACC



%6. @reston Industries has t*o separate divisions. $ach division is in a

separate line of )usiness. Division A is the largest division and

represents 68 percent of the rm/s overall sales. Division A is also the

riskier of the t*o divisions. Division # is the smaller and least risk" of

the t*o. When management is deciding *hich of the various

divisional pro0ects should )e accepted, the managers should-

A. allocate more funds to Division A since it is the largest of the t*o

divisions.

#. fund all of Division #/s pro0ects rst since the" tend to )e less risk"

and then allocate the remaining funds to the Division A pro0ects

that have the highest net present values.

C. allocate the compan"/s funds to the pro0ects *ith the highest net

present values )ased on the rm/s *eighted average cost ofcapital.

D. assign appropriate, )ut di5ering, discount rates to each pro0ect

and then select the pro0ects *ith the highest net present values.

$. fund the highest net present value pro0ects from each division

)ased on an allocation of 68 percent of the funds to Division A and

+8 percent of the funds to Division #.


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: 1 Easy


about t/em*

Section: 14*0

,o)ic: Divisional cost o' ca)ital



%7. (arkle" and Stearns is a multidivisional rm that uses its WACC as

the discount rate for all proposed pro0ects. $ach division is in a

separate line of )usiness and each presents risks uniue to those

lines. ?iven this, a division *ithin the rm *ill tend to-

A. receive less pro0ect funding if its line of )usiness is riskier than that

of the other divisions.

#. avoid risk" pro0ects so it can receive more pro0ect

funding.

C. )ecome less risk" over time )ased on the pro0ects that are

accepted.

D. have eual pro)a)ilit" of receiving funding as compared to the

other divisions.

E. prefer higher risk pro0ects over lo*er riskpro0ects.


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: 1 Easy


about t/em*

Section: 14*0




%<. &he discount rate assigned to an individual pro0ect should )e )ased

on-

A. the rm/s *eighted average cost of

capital.

#. the actual sources of funding used for the

pro0ect.

C. an average of the rm/s overall cost of capital for the past

ve "ears.

D. the current risk level of the

overall rm.

E. the risks associated *ith the use of the funds reuired )"

the pro0ect.


AACSB: Analytic

Blooms: Remember

Difculty: 1 Easy


about t/em*

Section: 14*0




+8. Assigning discount rates to individual pro0ects )ased on the risk level

of each pro0ect-

A. ma" cause the rm/s overall *eighted average cost of capital to

either increase or decrease over time.

#. *ill prevent the rm/s overall cost of capital from changing

over time.

C. *ill cause the rm/s overall cost of capital to decrease

over time.

D. decreases the value of the rm over

time.

$. negates the rm/s goal of creating the most value for the

shareholders.


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: 1 Easy


about t/em*

Section: 14*0

,o)ic: roject cost o' ca)ital



+1. Which one of the follo*ing statements is correct!

A. irms should accept lo* risk pro0ects prior to funding high risk

pro0ects.

#. (aking su)0ective ad0ustments to a rm/s WACC *hen determining

pro0ect discount rates unfairl" punishes lo*risk divisions *ithin a

rm.

C. A pro0ect that is unaccepta)le toda" might )e accepta)le

tomorro* given a change in market returns.

D. &he pure pla" method is most freuentl" used for pro0ects

involving the e'pansion of a rm/s current operations.

$. irms that elect to use the pure pla" method for determining a

discount rate for a pro0ect cannot su)0ectivel" ad0ust the pure pla"

rate.


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: + 3e$ium


about t/em*

Section: 14*0




+%. @hil/s is a sitdo*n restaurant that specialies in homecooked meals.

&heresa/s is a *alkin deli that specialies in specialt" soups and

sand*iches. #oth rms are currentl" considering e'panding their

operations during the summer months )" o5ering pre*rapped

donuts, sand*iches, and *raps at a local )each. @hil/s currentl" has a

WACC of 14 percent *hile &heresa/s WACC is 18 percent. &he

e'pansion pro0ect has a pro0ected net present value of =1%,388 at a

18 percent discount rate and a net present value of =%,878 at a 14

percent discount rate. Which rm or rms should e'pand and o5er

food at the local )each during the summer months!

A. @hil/s

onl"

#. &heresa/sonl"

C. )oth @hil/s and

&heresa/s

D. neither @hil/s nor

&heresa/s

$. cannot )e determined from the information

provided


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: 1 Easy


about t/em*

Section: 14*0




++. Wilderness Adventures specialies in )ackcountr" tours and resort

management. &ravel $'citement specialies in making travel

reservations and promoting vacation travel. Wilderness Adventures

has an afterta' cost of capital of 1+ percent and &ravel $'citement

has an afterta' cost of capital of 11 percent. #oth rms are

considering )uilding *ilderness campgrounds complete *ith man

made lakes and hiking trails. &he estimated net present value of such

a pro0ect is estimated at =76,888 at a discount rate of 11 percent and

=1%,88 at a 1+ percent discount rate. Which rm or rms, if either,

should accept this pro0ect!

A. Wilderness Adventures

onl"

#. &ravel $'citementonl"

C. )oth Wilderness Adventures and &ravel

$'citement

D. neither Wilderness Adventures nor &ravel

$'citement


information


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: 1 Easy


about t/em*

Section: 14*0




+4. &he su)0ective approach to pro0ect anal"sis-

A. is used onl" *hen a rm has an alleuit" capital

structure.

#. uses the WACC of rm B as the )asis for the discount rate for a

pro0ect under consideration )" rm .

C. assigns discount rates to pro0ects )ased on the discretion of the

senior managers of a rm.

D. allo*s managers to randoml" ad0ust the discount rate assigned to

a pro0ect once the pro0ect/s )eta has )een determined.

$. applies a lo*er discount rate to pro0ects that are nanced totall"

*ith euit" as compared to those that are partiall" nanced *ith

de)t.


AACSB: Analytic

Blooms: Remember

Difculty: 1 Easy


about t/em*

Section: 14*0




+. Which one of the follo*ing statements is correct!

A. &he su)0ective approach assesses the risks of each pro0ect and

assigns an ad0ustment factor that is uniue 0ust for that pro0ect.

B. verall, a rm makes )etter decisions *hen it uses the su)0ective

approach than *hen it uses its WACC as the discount rate for all

pro0ects.

C. irms *ill correctl" accept or re0ect ever" pro0ect if the" adopt the

su)0ective approach.

D. (andator" pro0ects should onl" )e accepted if the" produce a

positive E@> *hen the rm/s WACC is used as the discount rate.

$. &he pure pla" approach should onl" )e used *ith lo*risk

pro0ects.


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: 1 Easy


about t/em*

Section: 14*0

,o)ic: Subjective a))roac/



+3. When a rm has Fotation costs eual to 6 percent of the funding

need, pro0ect anal"sts should-

A. increase the pro0ect/s discount rate to o5set these e'penses )"

multipl"ing the rm/s WACC )" 1.86.

#. increase the pro0ect/s discount rate to o5set these e'penses )"

dividing the rm/s WACC )" :1 8.86;.

C. add 6 percent to the rm/s WACC to get the discount rate for

the pro0ect.

D. increase the initial pro0ect cost )" multipl"ing that

cost )" 1.86.

E. increase the initial pro0ect cost )" dividing that cost )"

:1 8.86;.


AACSB: Analytic

Blooms: Remember

Difculty: 1 Easy

Learning Objective: 14!4 "o# to correctly inclu$e otation costs in ca)ital bu$geting )rojects*

Section: 14*5

,o)ic: 6lotation costs

+6. &he Fotation cost for a rm is computed as-

A. the arithmetic average of the Fotation costs of )oth de)t

and euit".

B. the *eighted average of the Fotation costs associated *ith each

form of nancing.

C. the geometric average of the Fotation costs associated *ith each

form of nancing.

D. onehalf of the Fotation cost of de)t plus onehalf of the Fotation

cost of euit".

$. a *eighted average )ased on the )ook values of the rm/s de)tand euit".


AACSB: Analytic

Blooms: Remember

Difculty: 1 Easy




Section: 14*5


+7. Incorporating Fotation costs into the anal"sis of a pro0ect *ill-

A. cause the pro0ect to )e improperl"

evaluated.

#. increase the net present value of the

pro0ect.

C. increase the pro0ect/s rate of

return.

D. increase the initial cash outFo* of the

pro0ect.

$. have no e5ect on the present value of the

pro0ect.


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: 1 Easy


Section: 14*5




+<. lotation costs for a levered rm should-

A. )e ignored *hen anal"ing a pro0ect )ecause the" are not an

actual pro0ect cost.

#. )e spread over the life of a pro0ect there)" reducing the cash Fo*s

for each "ear of the pro0ect.

C. onl" )e considered *hen t*o pro0ects are mutuall"

e'clusive.

D. )e *eighted and included in the initial

cash Fo*.

$. )e totall" ignored *hen internal euit" funding is

utilied.


AACSB: Analytic

Blooms: 2n$erstan$

Difculty: 1 Easy


Section: 14*5


48. Chelsea ashions is e'pected to pa" an annual dividend of =8.78 a

share ne't "ear. &he market price of the stock is =1<.38 and the

gro*th rate is percent. What is the rm/s cost of euit"!

A. 6.7

percent

#. 6.<1

percent

C. 7.%4

percent

D. <.87

percent$. 18.88

percent

H M :.78N1<.38; O .8 M <.87 percent

AACSB: Analytic



Blooms: A))ly

Difculty: 1 Easy


Section: 14*+


41. &he Shoe utlet has paid annual dividends of =8.3, =8.68, =8.6%,

and =8.6 per share over the last four "ears, respectivel". &he stock

is currentl" selling for =%3 a share. What is this rm/s cost of euit"!

A. 6.3

percent

B. 6.<+

percent

C. 18.+7

percentD. 18.+

percent

$. 11.6<

percent

:=8.68 =8.3;N=8.3 M 8.863<%+

:=8.6% =8.68;N=8.68 M 8.8%761

:=8.6 =8.6%;N=8.6% M 8.841336

g M :8.863<%+ O 8.8%761 O 8.841336;N+ M .84<84

He M P:=8.6 Q 1.84<84;N=%3R O .84<84 M 6.<+ percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*+




4%. S*eet &reats common stock is currentl" priced at =17.+ a share. &he

compan" 0ust paid =1.% per share as its annual dividend. &he

dividends have )een increasing )" %. percent annuall" and are

e'pected to continue doing the same. What is this rm/s cost of

euit"!

A. 3.8+

percent

#. 3.17

percent

C. 7.46

percent

D. <.41

percent$. <.7%

percent

e M P:=1.% Q 1.8%;N=17.+R O 8.8% M <.41 percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*+




4+. &he common stock of (etal (olds has a negative gro*th rate of 1.

percent and a reuired return of 17 percent. &he current stock price

is =11.48. What *as the amount of the last dividend paid!

A. =%.8

6

#. =%.1

1

C. =%.1

<

D. =%.%

%

E. =%.%

3

D1 M P:8.17 :8.81;; Q =11.48R M =%.%%+ D8 M =%.%%+N:1 8.81; M

=%.%3

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*+

,o)ic: Divi$en$ gro#t/



44. 9igh*a" $'press has paid annual dividends of =1.8, =1.%8, =1.%,

=1.1, and =8.< over the past ve "ears, respectivel". What is the

average dividend gro*th rate!

A. 1.64

percent

#. +.38

percent

C. %.%7

percent

D. %.46

percent

$. 4.+<

percent

:=1.%8 =1.8;N=1.8 M 8.14%76

:=1.% =1.%8;N=1.%8 M 8.841336

:=1.1 =1.%;N=1.% M 8.87

:=8.< =1.1;N=1.1 M 8.16+<1

g M :8.14%76 O 8.841336 8.87 8.16+<1;N4 M 1.64 percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy Learning Objective: 14!1 "o# to $etermine a %rm&s cost o' e(uity ca)ital*

Section: 14*+

,o)ic: Divi$en$ gro#t/



4. Southern 9ome Cookin/ 0ust paid its annual dividend of =8.3 a share.

&he stock has a market price of =1+ and a )eta of 1.1%. &he return on

the G.S. &reasur" )ill is %. percent and the market risk premium is

3.7 percent. What is the cost of euit"!

A. <.<7

percent

#. 18.84

percent

C. 18.1%

percent

D. 18.+6

percent

$. 18.4percent

He M 8.8% O :1.1% Q 8.837; M 18.1% percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*+




43. Eational 9ome Hentals has a )eta of 1.%4, a stock price of =%%, and

recentl" paid an annual dividend of =8.<4 a share. &he dividend

gro*th rate is 4. percent. &he market has a 18.3 percent rate of

return and a risk premium of 6. percent. What is the rm/s cost of

euit"!

A. 6.8

percent

#. 7.36

percent

C. <.1+

percent

D. 18.+8

percentE. 18.37

percent

He M :8.183 8.86; O :1.%4 Q 8.86; M 8.1%4

He M P:=8.<4 Q 1.84;N=%%R O 8.84 M 8.87<3

He Average M :8.1%4 O 8.87<3;N% M 18.37 percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy Learning Objective: 14!1 "o# to $etermine a %rm&s cost o' e(uity ca)ital*

Section: 14*+




46. 9enesse" (arkets has a gro*th rate of 4.7 percent and is euall" as

risk" as the market. &he stock is currentl" selling for =16 a share. &he

overall stock market has a 18.3 percent rate of return and a risk

premium of 7.6 percent. What is the e'pected rate of return on this

stock!

A. 7.6

percent

#. <.%

percent

C. 18.3

percent

D. 11.+

percent$. 11.6

percent

He M :8.183 8.876; O :1.88 Q 8.876; M 18.3 percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*+




47. &ide*ater ishing has a current )eta of 1.%1. &he market risk

premium is 7.< percent and the riskfree rate of return is +.% percent.

#" ho* much *ill the cost of euit" increase if the compan" e'pands

its operations such that the compan" )eta rises to 1.8!

A. 1.77

percent

B. %.7

percent

C. %.38

percent

D. +.18

percent

$. +.%3percent

Increase in cost of euit" M :1.8 1.%1; Q 8.87< M %.7 percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*+




4<. Wind @o*er S"stems has %8"ear, semiannual )onds outstanding

*ith a percent coupon. &he face amount of each )ond is =1,888.

&hese )onds are currentl" selling for 114 percent of face value. What

is the compan"/s preta' cost of de)t!

A. +.<7

percent

#. 4.4%

percent

C. 4.61

percent

D. .+3

percent

$. .percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*-

,o)ic: Cost o' $ebt



8. #oulder urniture has )onds outstanding that mature in 1 "ears,

have a 3 percent coupon, and pa" interest annuall". &hese )onds

have a face value of =1,888 and a current market price of =1,86.

What is the compan"/s afterta' cost of de)t if its ta' rate is +%

percent!

A. %.<6

percent

#. +.%4

percent

C. +.7

percent

D. .%1

percent$. .+

percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*-

,o)ic: Cost o' $ebt



1. 9and" (an, Inc. has ero coupon )onds outstanding that mature in 7

"ears. &he )onds have a face value of =1,888 and a current market

price of =348. What is the compan"/s preta' cost of de)t!

A. %.

percent

#. .8<

percent

C. .33

percent

D. 6.+1

percent

$. 6.47

percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*-

,o)ic: Cost o' $ebt



%. Dog ?one ?ood $ngines has a )ond issue outstanding *ith 16 "ears

to maturit". &hese )onds have a =1,888 face value, a < percent

coupon, and pa" interest semiannuall". &he )onds are currentl"

uoted at 7% percent of face value. What is the compan"/s preta'

cost of de)t if the ta' rate is +7 percent!

A. 4.18

percent

#. 4.4%

percent

C. 3.31

percent

D. 7.<8

percentE. 11.4%

percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*-

,o)ic: Cost o' $ebt



+. &he Corner #aker" has a )ond issue outstanding that matures in 6

"ears. &he )onds pa" interest semiannuall". Currentl", the )onds are

uoted at 181.4 percent of face value and carr" a < percent coupon.

What is the rm/s afterta' cost of de)t if the ta' rate is +8 percent!

A. 4.77

percent

#. .+3

percent

C. .4

percent

D. 3.11

percent

$. 7.64percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*-

,o)ic: Cost o' $ebt



4. &he outstanding )onds of &ech $'press are priced at =<7< and

mature in 18 "ears. &hese )onds have a 3 percent coupon and pa"

interest annuall". &he rm/s ta' rate is + percent. What is the rm/s

afterta' cost of de)t!

A. +.81

percent

#. +.%%

percent

C. +.+

percent

D. 4.88

percent

$. 4.41percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*-

,o)ic: Cost o' $ebt



. Simple oods has a ero coupon )ond issue outstanding that matures

in < "ears. &he )onds are selling at 4% percent of par value. What is

the compan"/s afterta' cost of de)t if the ta' rate is +7 percent!

A. .47

percent

#. .6+

percent

C. 3.1%

percent

D. 6.6+

percent

$. <.77

percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*-

,o)ic: Cost o' $ebt



3. ?rill Works and (ore has 6 percent preferred stock outstanding that

is currentl" selling for =4< a share. &he market rate of return is 14

percent and the rm/s ta' rate is +6 percent. What is the rm/s cost

of preferred stock!

A. 1+.66

percent

#. 1+.%<

percent

C. 1+.36

percent

D. 14.%<

percent

$. 14.4percent

Hp M :8.86 Q =188;N=4< M 14.%< percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*-




6. Samuelson @lastics has 6. percent preferred stock outstanding.

Currentl", this stock has a market value per share of =% and a )ook

value per share of =+7. What is the cost of preferred stock!

A. 6.8

percent

#. 1+.77

percent

C. 14.4%

percent

D. 1<.%<

percent

$. 1<.64

percent

Hp M :8.86 Q =188;N=% M 14.4% percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*-




7. Ee* ork Deli has 6 percent preferred stock outstanding that sells for

=+4 a share. &his stock *as originall" issued at =4 per share. What

is the cost of preferred stock!

A. 1+.37

percent

#. 14.88

percent

C. 17.%<

percent

D. %8.<

percent

$. %8.78

percent

Hp M :8.86 Q =188;N=+4 M %8.< percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*-




<. Eelson/s Landscaping has 1,%88 )onds outstanding that are selling

for =<<8 each. &he compan" also has %,88 shares of preferred stock

at a market price of =%7 a share. &he common stock is priced at =+6

a share and there are %7,888 shares outstanding. What is the *eight

of the common stock as it relates to the rm/s *eighted average cost

of capital!

A. 4+.87

percent

B. 4.13

percent

C. 46.11

percent

D. 4.88percent

$. .4

percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*4

,o)ic: .eig/te$ average



38. (angrove ruit arms has a =%8,888 )ond issue outstanding that is

selling at <% percent of face value. &he rm also has 1,88 shares of

preferred stock and 1,888 shares of common stock outstanding. &he

preferred stock has a market price of =+ a share compared to a

price of =%4 a share for the common stock. What is the *eight of the

preferred stock as it relates to the rm/s *eighted average cost of

capital!

A. 3.6

percent

#. 6.%8

percent

C. 6.6

percentD. 7.8+

percent

E. 7.16

percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*4

,o)ic: .eig/t o' )re'erre$



31. $lectronics ?alore has <8,888 shares of common stock outstanding

at a market price of =+7 a share. &he compan" also has 48,888

)onds outstanding that are uoted at 183 percent of face value.

What *eight should )e given to the de)t *hen the rm computes its


A. 4%

percent

#. 43

percent

C. 8

percent

D. 4

percent$. 7

percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*4

,o)ic: .eig/t o' $ebt



3%. @hillips $uipment has 78,888 )onds outstanding that are selling at

par. #onds *ith similar characteristics are "ielding 6. percent. &he

compan" also has 68,888 shares of 6 percent preferred stock and

%. million shares of common stock outstanding. &he preferred stock

sells for =3 a share. &he common stock has a )eta of 1.+4 and sells

for =4% a share. &he G.S. &reasur" )ill is "ielding %.7 percent and the

return on the market is 11.% percent. &he corporate ta' rate is +7

percent. What is the rm/s *eighted average cost of capital!

A. 18.1

percent

#. 18.34

percent

C. 11.17percent

D. 11.+8

percent

$. 11.3

percent

He M 8.8%7 O 1.+4 :8.11% 8.8%7; M 8.1483

Hp M :8.86 Q =188;N=3 M 8.1863<

WACC M :=18mN=%++.6m; :8.1483; O :=47.6mN=%++.6m;

:8.1863<; O :=78mN=%++.6m; :8.86; :1 8.+7; M 18.1 percent

AACSB: Analytic

Blooms: Analy7e

Difculty: 1 Easy


Section: 14*4

,o)ic: .ACC



3+. Wa"co Industrial Suppl" has a preta' cost of de)t of 6.3 percent, a

cost of euit" of 14.+ percent, and a cost of preferred stock of 7.

percent. &he rm has %%8,888 shares of common stock outstanding

at a market price of =%6 a share. &here are %,888 shares of

preferred stock outstanding at a market price of =41 a share. &he

)ond issue has a face value of =8,888 and a market uote of

181.%. &he compan"/s ta' rate is +6 percent. What is the rm/s


A. 18.17

percent

#. 18.74

percent

C. 11.+%percent

D. 1%.38

percent

E. 1%.71

percent

WACC M :=,<48,888N=6,%1,388; :8.14+; O :=1,8%,888N=6,%1,388;

:8.87; O :=3,388N=6,%1,388; :8.863; :1 8.+6; M 1%.71 percent

AACSB: Analytic

Blooms: Analy7eDifculty: 1 Easy


Section: 14*4

,o)ic: .ACC



34. Central S"stems, Inc. desires a *eighted average cost of capital of 7

percent. &he rm has an afterta' cost of de)t of .4 percent and a

cost of euit" of 1.% percent. What de)teuit" ratio is needed for

the rm to achieve its targeted *eighted average cost of capital!

A. 8.+

7

#. 8.4

4

C. 1.8

%

D. %.6

6

$. +.3+

WACC M 8.87 M PWe Q 8.1%R O P:1 We; Q 8.84;R

We M 8.%3+ Wd M 1 We M 8.6+46

De)teuit" ratio M 8.6+46N8.%3+ M %.66

AACSB: Analytic

Blooms: Analy7e

Difculty: 1 Easy


Section: 14*4

,o)ic: Debte(uity ratio



3. H.S. ?reen has %8,888 shares of common stock outstanding at a

market price of =%7 a share. Ee't "ear/s annual dividend is e'pected

to )e =1. a share. &he dividend gro*th rate is % percent. &he rm

also has 6,88 )onds outstanding *ith a face value of =1,888 per

)ond. &he )onds carr" a 6 percent coupon, pa" interest

semiannuall", and mature in 6. "ears. &he )onds are selling at <7

percent of face value. &he compan"/s ta' rate is +4 percent. What is

the rm/s *eighted average cost of capital!

A. .4

percent

B. 3.%

percent

C. 6.percent

D. 7.

percent

$. <.3

percent

AACSB: Analytic

Blooms: Analy7e

Difculty: 1 Easy


Section: 14*4

,o)ic: .ACC



33. elso/s has a de)teuit" ratio of 8.3 and a ta' rate of + percent.

&he rm does not issue preferred stock. &he cost of euit" is 14.

percent and the afterta' cost of de)t is 4.7 percent. What is the


A. 18.43

percent

#. 18.36

percent

C. 18.73

percent

D. 11.+7

percent

$. 11.6percent

WACC M :1N1.3; :8.14; O :8.3N1.3; :8.847; M 18.73 percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*4

,o)ic: .ACC



36. ?ranite Works maintains a de)teuit" ratio of 8.3 and has a ta'

rate of +% percent. &he rm does not issue preferred stock. &he pre

ta' cost of de)t is <.7 percent. &here are %,888 shares of stock

outstanding *ith a )eta of 1.% and a market price of =1< a share. &he

current market risk premium is 7. percent and the current riskfree

rate is +.3 percent. &his "ear, the rm paid an annual dividend of

=1.18 a share and e'pects to increase that amount )" % percent each

"ear. Gsing an average e'pected cost of euit", *hat is the *eighted


A. 7.44

percent

#. 7.67

percentC. 7.<3

percent

D. <.1+

percent

E. <.%8

percent

He M 8.8+3 O 1.%:8.87; M 8.1+7He M P:=1.18 Q 1.8%;N=1<R O 8.8% M 8.86<8%3

He Average M :8.1+7 O 8.86<8%3;N% M 8.187%3

WACC M :1N1.3; :8.187%3; O :8.3N1.3; :8.8<7; :1 8.+%; M <.%8

percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*4,o)ic: .ACC



37. Delta Lighting has +8,888 shares of common stock outstanding at a

market price of =1.88 a share. &his stock *as originall" issued at

=+1 per share. &he rm also has a )ond issue outstanding *ith a total

face value of =%78,888 *hich is selling for 73 percent of par. &he cost

of euit" is 1+ percent *hile the afterta' cost of de)t is 3.< percent.

&he rm has a )eta of 1.47 and a ta' rate of +8 percent. What is the


A. 18.86

percent

B. 18.76

percent

C. 1%.+3

percentD. 1+.%<

percent

$. 1+.46

percent

WACC M :48,888N3<8,788 T .1+; O :%48,788N3<8,788 T .83<; M 18.76

percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*4,o)ic: .ACC



3<. &he (arket utlet has a )eta of 1.+7 and a cost of euit" of 14.<4

percent. &he riskfree rate of return is 4.% percent. What discount

rate should the rm assign to a ne* pro0ect that has a )eta of 1.%!

A. 1+.4

percent.

#. 1+.6%

percent.

C. 1+.<4

percent.

D. 14.14

percent.

$. 14.+3

percent.

H$ M 8.14<4 M 8.84% O :1.+7 Q mrp; mrp M 8.866

H@ro0ect M 8.84% O :1.% Q 8.866; M 1+.<4 percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*0

,o)ic: Discount rate



68. Silo (ills has a )eta of 8.< and a cost of euit" of 11.< percent. &he

riskfree rate of return is %.7 percent. &he rm is currentl" considering

a pro0ect that has a )eta of 1.8+ and a pro0ect life of 3 "ears. What

discount rate should )e assigned to this pro0ect!

A. 1+.++

percent.

B. 1%.36

percent.

C. 1+.3%

percent.

D. 1+.74

percent.

$. 14.8<percent.

H$ M 8.11< M 8.8%7 O :8.< Q mrp; mrp M 8.8<7

H@ro0ect M 8.8%7 O :1.8+ Q 8.8<7; M 1%.36 percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*0

,o)ic: Discount rate



61. &ravis J Sons has a capital structure *hich is )ased on 48 percent

de)t, percent preferred stock, and percent common stock. &he

preta' cost of de)t is 6. percent, the cost of preferred is < percent,

and the cost of common stock is 1+ percent. &he compan"/s ta' rate

is +< percent. &he compan" is considering a pro0ect that is euall" as

risk" as the overall rm. &his pro0ect has initial costs of =+%,888 and

annual cash inFo*s of =76,888, =%6<,888, and =113,888 over the

ne't three "ears, respectivel". What is the pro0ected net present

value of this pro0ect!

A. =37,%11.

84

#. =37,76<.

<6C. =3<,+31.

87

D. =64,%87.

17

E. =63,811.

%+

WACC M :8. Q 8.1+; O :8.8 Q 8.8<; O P8.48 Q 8.86 Q :1 8.+<;R

M8.8<4+

E@> =+%,888 O :=76,888N1.8<4+; O :=%6<,888N1.8<4+%; O:=113,888N1.8<4++; M =63,811.%+

AACSB: Analytic

Blooms: Analy7e

Difculty: 1 Easy


Section: 14*0

,o)ic: roject 89



6%. @anelli/s is anal"ing a pro0ect *ith an initial cost of =118,888 and

cash inFo*s of =3,888 in "ear one and =64,888 in "ear t*o. &his

pro0ect is an e'tension of the rm/s current operations and thus is

euall" as risk" as the current rm. &he rm uses onl" de)t and

common stock to nance its operations and maintains a de)teuit"

ratio of 8.4. &he afterta' cost of de)t is 4.7 percent, the cost of

euit" is 1%.6 percent, and the ta' rate is + percent. What is the

pro0ected net present value of this pro0ect!

A. =6,41

1

#. =6,78

<

C. =7,+++

D. =7,<+

7

E. =<,74

8

WACC M :1N1.4; :8.1%6; O :8.4N1.4; :8.847; M 8.18%47+

E@> M =118,888 O :=3,888N1.18%47+; O :=64,888N1.18%47+%; M

=<,748

AACSB: Analytic

Blooms: Analy7e

Difculty: 1 Easy


Section: 14*0

,o)ic: roject 89



6+. Carson $lectronics uses 68 percent common stock and +8 percent

de)t to nance its operations. &he afterta' cost of de)t is .4 percent

and the cost of euit" is 1.4 percent. (anagement is considering a

pro0ect that *ill produce a cash inFo* of =+3,888 in the rst "ear.

&he cash inFo*s *ill then gro* at + percent per "ear forever. What is

the ma'imum amount the rm can initiall" invest in this pro0ect to

avoid a negative net present value for the pro0ect!

A. =%<<,8+

%

B. =+7%,<6

<

C. =411,48

3D. =4+4,87

3

$. =441,41

4

WACC M 8.68:8.14; O 8.+8:8.84; M 8.1%4

@> M =+3,888N:8.1%4 8.8+; M =+7%,<6<

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*0

,o)ic: roject 89



64. &he #aker" is considering a ne* pro0ect it considers to )e a little

riskier than its current operations. &hus, management has decided to

add an additional 1. percent to the compan"/s overall cost of capital

*hen evaluating this pro0ect. &he pro0ect has an initial cash outla" of

=7,888 and pro0ected cash inFo*s of =16,888 in "ear one, =%7,888

in "ear t*o, and =+8,888 in "ear three. &he rm uses % percent de)t

and 6 percent common stock as its capital structure. &he compan"/s

cost of euit" is 1. percent *hile the afterta' cost of de)t for the

rm is 3.1 percent. What is the pro0ected net present value of the

ne* pro0ect!

A.

=3,%8

7B.

=1,<3

4

C.

=+87

D. =1,4%

6

$. =1,6

+

WACCirm M :8.6 Q 8.1; O :8.% Q 8.831; M 8.1+1

WACC@ro0ect M 8.1+1 O 8.81 M 8.143

E@> M =7,888 O :=16,888N1.143; O :=%7,888N1.143%; O

:=+8,888N1.143+; M =1,<34

AACSB: Analytic

Blooms: Analy7e

Difculty: 1 Easy


about t/em*Section: 14*0

,o)ic: roject 89



6. &he il Derrick has an overall cost of euit" of 1+.3 percent and a

)eta of 1.%7. &he rm is nanced solel" *ith common stock. &he risk

free rate of return is +.4 percent. What is an appropriate cost of

capital for a division *ithin the rm that has an estimated )eta of

1.17!

A. 1%.+6

percent

#. 1%.41

percent

C. 1%.4

percent

D. 1%.36

percentE. 1%.78

percent

8.1+3 M 8.8+4 O 1.%7mrp mrp M 8.86<376

HeDivision M 8.8+4 O 1.17:8.86<376; M 1%.78 percent

AACSB: Analytic

Blooms: Analy7e

Difculty: 1 Easy


about t/em*

Section: 14*0




63. (iller Sisters has an overall )eta of 8.6< and a cost of euit" of 11.%

percent for the rm overall. &he rm is 188 percent nanced *ith

common stock. Division A *ithin the rm has an estimated )eta of

1.87 and is the riskiest of all of the rm/s operations. What is an

appropriate cost of capital for division A if the market risk premium is

<. percent!

A. 1+.1%

percent

B. 1+.<3

percent

C. 14.3+

percent

D. 1.66percent

$. 13.81

percent

8.11% M rf O 8.6<:8.8<; rf M 8.8+3<

HeDivision M 8.8+3< O 1.87:8.8<; M 1+.<3 percent

AACSB: Analytic

Blooms: Analy7e

Difculty: 1 Easy Learning Objective: 14!0 Some o' t/e )it'alls associate$ #it/ a %rm&s overall cost o' ca)ital an$ #/at to $o

about t/em*

Section: 14*0




66. Deep (ining and @recious (etals are separate rms that are )oth

considering a silver e'ploration pro0ect. Deep (ining is in the actual

mining )usiness and has an afterta' cost of capital of 1%.7 percent.

@recious (etals is in the precious gem retail )usiness and has an

afterta' cost of capital of 18.3 percent. &he pro0ect under

consideration has initial costs of =6,888 and anticipated annual

cash inFo*s of =18%,888 a "ear for ten "ears. Which rm:s;, if either,

should accept this pro0ect!

A. Compan" A

onl"

#. Compan" #

onl"

C. )oth Compan" A andCompan" #

D. neither Compan" A or

Compan" #


information

Eeither compan" should accept this pro0ect as the applica)le

discount rate for )oth rms is 1%.7 percent and the E@> is negative

at this discount rate.

AACSB: Analytic

Blooms: A))ly Difculty: 1 Easy


about t/em*

Section: 14*0

,o)ic: ure lay



67. Sister @ools sells outdoor s*imming pools and currentl" has an

afterta' cost of capital of 11.3 percent. Al/s Construction )uilds and

sells *ater features and fountains and has an afterta' cost of capital

of 18.+ percent. Sister @ools is considering )uilding and selling its

o*n *ater features and fountains. &he sales manager of Sister @ools

estimates that the *ater features and fountains *ould produce %8

percent of the rm/s future total sales. &he initial cash outla" for this

pro0ect *ould )e =7,888. &he e'pected net cash inFo*s are =16,888

a "ear for 6 "ears. What is the net present value of the Sister @ools

pro0ect!

A.

=11,84

4B.

=+,84

7

C.

=%,%3

%

D.

=1,8

7

$. =1,%1<

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


about t/em*

Section: 14*0

,o)ic: ure lay



6<. Decker/s is a chain of furniture retail stores. urniture ashions is a

furniture maker and a supplier to Decker/s. Decker/s has a )eta of

1.+7 as compared to urniture ashion/s )eta of 1.1%. &he riskfree

rate of return is +. percent and the market risk premium is 7

percent. What discount rate should Decker/s use if it considers a

pro0ect that involves the manufacturing of furniture!

A. 1%.43

percent

#. 1%.<%

percent

C. 1+.8

percent

D. 14.87percent

$. 14.4

percent

He M 8.8+ O 1.1%:8.87; M 1%.43 percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


about t/em*

Section: 14*0

,o)ic: ure lay



78. #leakl" $nterprises has a capital structure of 48 percent common

stock, 18 percent preferred stock, and 8 percent de)t. &he Fotation

costs are 4. percent for de)t, 6 percent for preferred stock, and <.

percent for common stock. &he corporate ta' rate is +4 percent.

What is the *eighted average Fotation cost!

A. .7

percent

#. 3.%

percent

C. 3.4

percent

D. 3.3

percentE. 3.7

percent

Average Fotation cost M :8.48 Q 8.8<; O :8.18 Q 8.86; O :8.8 Q

8.84; M 3.7 percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*5




71. Kustice, Inc. has a capital structure *hich is )ased on +8 percent

de)t, percent preferred stock, and 3 percent common stock. &he

Fotation costs are 11 percent for common stock, 18 percent for

preferred stock, and 6 percent for de)t. &he corporate ta' rate is +6

percent. What is the *eighted average Fotation cost!

A. 7.<6

percent

#. <.47

percent

C. <.3%

percent

D. <.6

percent$. 18.88

percent

Average Fotation cost M :8.3 Q 8.11; O :8.8 Q 8.18; O :8.+8 Q

8.86; M <.6 percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*5




7%. &he Dail" #re* has a de)teuit" ratio of 8.34. &he rm is anal"ing a

ne* pro0ect *hich reuires an initial cash outla" of =4%8,888 for

euipment. &he Fotation cost is <.3 percent for euit" and .4

percent for de)t. What is the initial cost of the pro0ect including the

Fotation costs!

A. =+8%,48

8

#. =+37,<%

4

C. =43,+%

7

D. =43,68

8$. =7+,++

+

Average Fotation cost M :1N1.34; :8.8<3; O :8.34N1.34; :8.84; M

8.86<38<7

Initial cost M =4%8,888N:1 8.86<38<7; M =43,+%7

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy Learning Objective: 14!4 "o# to correctly inclu$e otation costs in ca)ital bu$geting )rojects*

Section: 14*5

,o)ic: roject otation costs



7+. ou are evaluating a pro0ect *hich reuires =%+8,888 in e'ternal

nancing. &he Fotation cost of euit" is 11.3 percent and the

Fotation cost of de)t is .4 percent. What is the initial cost of the

pro0ect including the Fotation costs if "ou maintain a de)teuit"

ratio of 8.4!

A. =%47,4<

4

#. =%4<,8%

1

C. =%4,3+

7

D. =%,

1$. =%,34

3

Average Fotation cost M :1N1.4; :8.113; O :8.4N1.4; :8.84; M

8.8<3673

Initial cost M =%+8,888N:1 8.8<3673; M =%4,3+7

AACSB: Analytic

Blooms: A))ly


Section: 14*5




74. Western Wear is considering a pro0ect that reuires an initial

investment of =%64,888. &he rm maintains a de)teuit" ratio of

8.48 and has a Fotation cost of de)t of 7 percent and a Fotation cost

of euit" of 18. percent. &he rm has sucient internall" generated

euit" to cover the euit" portion of this pro0ect. What is the initial

cost of the pro0ect including the Fotation costs!

A. =%78,48

<

#. =%71,48

3

C. =%77,88

D. =%<6,646

$. =+8%,63

%

Average Fotation cost M :1N1.48; :8; O :8.48N1.48; :8.87; M

8.8%%761

Initial cost M =%64,888N:1 8.8%%761; M =%78,48<

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy


Section: 14*5




7. ester"ear @roductions is considering a pro0ect *ith an initial start up

cost of =<38,888. &he rm maintains a de)teuit" ratio of 8.8 and

has a Fotation cost of de)t of 3.7 percent and a Fotation cost of

euit" of 11.4 percent. &he rm has sucient internall" generated

euit" to cover the euit" cost of this pro0ect. What is the initial cost

of the pro0ect including the Fotation costs!

A. =<6<,41

6

B. =<7%,%3

C. =<<%,+7

3

D. =1,8+7,1+

$. =1,83,8

7<

Average Fotation cost M :1N1.; :8.8; O :8.N1.; :8.837; M 8.8%%3336

Initial cost M =<38,888N:1 8.8%%3336; M =<7%,%3

AACSB: Analytic

Blooms: A))ly


Section: 14*5




73. &he Cit" Street Corporation/s common stock has a )eta of 1.%. &he

riskfree rate is +. percent and the e'pected return on the market is

1+ percent. What is the rm/s cost of euit"!

A. 11.4

percent

#. 1%.7

percent

C. 14.<

percent

D. 16.3

percent

$. 1<.1

percent

H$ M 8.8+ O 1.%:8.1+ 8.8+; M 14.< percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy

EOC: 14+


Section: 14*+




76. Stock in Countr" Hoad Industries has a )eta of 8.<6. &he market risk

premium is 18 percent *hile &)ills are currentl" "ielding . percent.

Countr" Hoad/s most recent dividend *as =1. per share, and

dividends are e'pected to gro* at a 6 percent annual rate

indenitel". &he stock sells for =+% a share. What is the estimated

cost of euit" using the average of the CA@( approach and the

dividend discount approach!

A. 1+.3<

percent

#. 14.83

percent

C. 14.%1

percentD. 14.+7

percent

$. 14.8

percent

H$ M 8.8 O 8.<6:8.18; M 8.1%

H$ M P:=1. Q 1.86;N=+%R O 8.86 M 8.1%17%71

H$ Average M :8.1% O 8.1%17%71;N% M 1+.3< percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy

EOC: 14-


Section: 14*+




77. 9oldup #ank has an issue of preferred stock *ith a = stated

dividend that 0ust sold for =<% per share. What is the )ank/s cost of

preferred!

A. 4.38

percent

#. 4.34

percent

C. .+<

percent

D. .4+

percent

$. .4

percent

H@ M =N=<% M .4+ percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy

EOC: 140


Section: 14*-




7<. Decline, Inc. is tr"ing to determine its cost of de)t. &he rm has a

de)t issue outstanding *ith 1 "ears to maturit" that is uoted at

186 percent of face value. &he issue makes semiannual pa"ments

and has an em)edded cost of < percent annuall". What is the afterta'

cost of de)t if the ta' rate is +< percent!

A. 4.<<

percent

#. .<8

percent

C. 3.16

percent

D. 6.+6

percent$. 6.4%

percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy

EOC: 145


Section: 14*-

,o)ic: Cost o' $ebt



<8. Kimin"/s Cricket arm issued a +8"ear, 7 percent, semiannual )ond 3

"ears ago. &he )ond currentl" sells for 114 percent of its face value.

What is the afterta' cost of de)t if the compan"/s ta' rate is +1

percent!

A. 4.3+

percent

B. 4.68

percent

C. 4.6

percent

D. 4.7%

percent

$. 4.73percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy

EOC: 14


Section: 14*-

,o)ic: Cost o' $ebt



<1. (ullineau' Corporation has a target capital structure of 41 percent

common stock, 4 percent preferred stock, and percent de)t. Its

cost of euit" is 17 percent, the cost of preferred stock is 3. percent,

and the preta' cost of de)t is 7. percent. What is the rm/s WACC

given a ta' rate of +< percent!

A. <.76

percent

#. 18.4+

percent

C. 18.4<

percent

D. 1+.+7

percent$. 1.16

percent

WACC M 8.41:8.17; O :8.84;:.83; O :8.;:.87;:1 8.+<; M 18.4<

percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy

EOC: 14;


Section: 14*4

,o)ic: .ACC



<%. Cookie Dough (anufacturing has a target de)teuit" ratio of 8.. Its

cost of euit" is 1 percent, and its cost of de)t is 11 percent. What

is the rm/s WACC given a ta' rate of +1 percent!

A. 1%.+

percent

#. 1%.67

percent

C. 1+.11

percent

D. 1+.47

percent

$. 1+.36

percent

WACC M :1N1.;:8.1; O :8.N1.;:8.11;:1 8.+1; M 1%.+ percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy

EOC: 141!


Section: 14*4

,o)ic: .ACC



<+. ama/s Llamas has a *eighted average cost of capital of <. percent.

&he compan"/s cost of euit" is 1. percent, and its preta' cost of

de)t is 7. percent. &he ta' rate is +4 percent. What is the compan"/s

target de)teuit" ratio!

A. 8.7

<

#. 8.<

%

C. 8.<

7

D. 1.8

1

E. 1.4

WACC M 8.8< M 8.1:$N>; O :8.87; :DN>; :1 8.+4;

8.8<:>N$; M 8.1 O 8.87:8.33; :DN$;

8.8<:1 O DN$; M 8.1 O 8.831:DN$;

DN$ M 1.4

AACSB: Analytic

Blooms: Analy7e

Difculty: 1 Easy EOC: 1411


Section: 14*4

,o)ic: ,arget ca)ital structure



<4. Kungle, Inc. has a target de)teuit" ratio of 8.6%. Its WACC is 11.

percent and the ta' rate is +4 percent. What is the cost of euit" if

the afterta' cost of de)t is . percent!

A. 1+.6

percent

#. 1+.74

percent

C. 14.41

percent

D. 14.6<

percent

E. 1.7%

percent

WACC M 8.11 M :1N1.6%; H$ O :8.6%N1.6%;:8.8; H$ M 1.7% percent

AACSB: Analytic

Blooms: A))ly

Difculty: 1 Easy

EOC: 1414


Section: 14*4

,o)ic: .ACC



<. &itan (ining Corporation has 14 million shares of common stock

outstanding, <88,888 shares of < percent preferred stock outstanding

and %%8,888 ten percent semiannual )onds outstanding, par value

=1,888 each. &he common stock currentl" sells for =4% per share and

has a )eta of 1.1, the preferred stock currentl" sells for =78 per

share, and the )onds have 16 "ears to maturit" and sell for <1

percent of par. &he market risk premium is 11. percent, &)ills are

"ielding 6. percent, and the rm/s ta' rate is +% percent. What

discount rate should the rm appl" to a ne* pro0ect/s cash Fo*s if

the pro0ect has the same risk as the rm/s t"pical pro0ect!

A. 14.<

percent

#. 14.6%percent

C. 1.16

percent

D. 1.4

percent

E. 13.77

percent

(>D M %%8,888 :=1,888; :8.<1; M =%88,%88,888

(>$ M 14,888,888 :=4%; M =77,888,888(>@ M <88,888 :=78; M =6%,888,888

> M =%88,%88,888 O =77,888,888 O =6%,888,888 M =738,%88,888

DN> M =%88,%88,888N=738,%88,888 M 8.%+%6+6

$N> M =77,888,888N=738,%88,888 M 8.37+3%

@N> M =6%,888,888N=738,%88,888 M 8.87+681

H$ M 8.86 O 1.1:8.11; M 8.%86%

H@ M =<N=78 M 8.11%

HD Afterta' M 8.111<14 :1 8.+%; M 8.8631%6



WACC M 8.37+3%:8.%86%; O 8.87+681 :8.11%; O 8.%+%6+6

:8.8631%6; M 13.77 percent

AACSB: AnalyticBlooms: Analy7e

Difculty: 1 Easy

EOC: 1415


Section: 14*4

,o)ic: .ACC

<3. Suppose "our compan" needs =14 million to )uild a ne* assem)l"

line. our target de)teuit" ratio is 8.74. &he Fotation cost for ne*

euit" is <. percent, )ut the Foatation cost for de)t is onl" %.

percent. What is the true cost of )uilding the ne* assem)l" line after

taking Fotation costs into account!

A. 14.7%

million

B. 14.<4

million

C. 1.86

million

D. 1.1%

million$. 1.%+

million

f A M :1N1.74;:8.8<; O :8.74N1.74; :8.8%; M 8.83+84+

Amount raised M =14mN:1 8.83+84+; M =14.<4 million

AACSB: Analytic

Blooms: Analy7e

Difculty: 1 Easy

EOC: 141<Learning Objective: 14!4 "o# to correctly inclu$e otation costs in ca)ital bu$geting )rojects*

Section: 14*5




Essay Questions

<6. What role does the *eighted average cost of capital pla" *hen

determining a pro0ect/s cost of capital!

Assuming a pro0ect is euall" as risk" as a rm/s current operations,

WACC *ill )e used as the discount rate *hen computing the E@> of

the pro0ect. &herefore, having an accurate WACC is essential to

correctl" evaluating the pro0ect. If a pro0ect has a di5erent risk level

than the rm/s current operations, then the rm/s WACC should )e

ad0usted in accordance *ith the pro0ect/s risk or in some instances, a

di5erent rm/s WACC should )e applied as the discount rate for the

pro0ect.

eed)ack- Hefer to section 14.

AACSB: Reective ,/in=ing

Blooms: A))ly

Difculty: 1 Easy


about t/em*

Section: 14*0,o)ic: roject cost o' ca)ital



<7. What are some advantages of the su)0ective approach to

determining the cost of capital and *h" do "ou think that approach is

utilied!

&he su)0ective approach allo*s management to ad0ust a rm/s

overall cost of capital for individual divisions )ased upon its

evaluation of the risks associated *ith each division as compared to

the overall risk level of the rm. &his risk ad0ustment is )ased on the

*isdom, kno*ledge, and e'periences of the managers. &o tr" and

determine a more accurate estimate of the appropriate discount rate

might encounter costs that *ould out*eigh an" potential )enet.

&hus, the su)0ective approach is useful )ecause it ad0usts discount

rates in a cost e5ective and ecient manner.



Blooms: A))ly

Difculty: + 3e$ium


about t/em*

Section: 14*0

,o)ic: Subjective a))roac/

<<. ?ive an e'ample of a situation *here a rm should adopt the pure

pla" approach for determining the cost of capital for a pro0ect.

Student e'amples *ill var" )ut should illustrate a pro0ect that is

unrelated to the current operations of irm A. &he e'ample should

e'plain *h" the WACC of irm #, *hich is engaged in the t"pe of

operations irm A is considering, should )e used as the )asis for

setting the discount rate for the proposed pro0ect.



Blooms: Create

Difculty: + 3e$ium




about t/em*

Section: 14*0

,o)ic: ure lay

188. Suppose "our )oss comes to "ou and asks "ou to reevaluate a

capital )udgeting pro0ect. &he rst evaluation *as in error, he

e'plains, )ecause it ignored Fotation costs. &o correct for this, heasks "ou to evaluate the pro0ect using a higher cost of capital *hich

incorporates these costs. Is "our )oss/ approach correct! Wh" or *h"

not!

our )oss is confused since it is the use of funds, and not the source

of funds, that determines the cost of capital. lotation costs should

)e included in the initial cash Fo* of a pro0ect and not in the cost of

capital.

eed)ack- Hefer to section 14.3


Blooms: Analy7e

Difculty: + 3e$ium


Section: 14*5


181. $'plain ho* the use of internal euit" rather than e'ternal euit"

a5ects the anal"sis of a pro0ect.

Internal euit" avoids the Fotation costs associated *ith raising

e'ternal euit". &herefore, )" utiliing internal euit" rather than

e'ternal euit", the initial cost of the pro0ect is decreased.

Decreasing the initial cost increases the E@> of the pro0ect.

eed)ack- Hefer to section 14.3


Blooms: Analy7e

Difculty: + 3e$ium


Section: 14*5

debt and equity

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