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THEORY D. The cost the company is charged by investment bankers who handle the issuance of equity or long-
Risk & Return term debt securities.
1. All of the following statements are correct except:
A. The matching of assets and liability maturities lowers default risk. 6. All of the following are examples of imputed costs except
B. Default risk refers to the inability of the firm to pay off its maturing obligations. A. Decelerated depreciation.
C. An increase in the payables deferral period will lead to a reduction in the need to non-spontaneous B. The stated interest paid on a bank loan.
funding. C. Assets that are considered obsolete that maintain a net book value.
D. The matching of asset and liability maturities is considered desirable because this strategy minimizes D. Lending funds to a supplier at a lower-than-market rate in exchange for receiving the supplier’s
interest rate risk. products at a discount.

2. Which of the following would increase risk? 7. The theory underlying the cost of capital is primarily concerned with the cost of
A. Increase the level of working capital. A. Long-term funds and old funds.
B. Increase the amount of equity financing. B. Short-term funds and new funds.
C. Increase the amount of short-term borrowing. C. Long-term funds and new funds.
D. Change the composition of working capital to include more liquid assets. D. Any combination of old or new, short-term or long-term funds.

3. A firm’s financial risk is a function of how it manages and maintains its debt. Which one of the following sets 8. Management knowledge of the cost of capital is useful for each of the following except
of ratios characterizes the firm with the greatest amount of financial risk? A. Evaluating performance.
A. High debt-to-equity ratio, high interest coverage ratio, stable return on equity. B. Managing working capital.
B. High debt-to-equity ratio, low interest coverage ratio, volatile return on equity. C. Making capital investment decisions.
C. Low debt-to-equity ratio, low interest coverage ratio, volatile return on equity. D. Setting the maximum rate of return on new investments.
D. Low debt-to-equity ratio, high interest coverage ratio, stable return on equity.
Cost of Debt
Marketable Securities Management
9. The explicit cost of debt financing is the interest expense. The implicit cost(s) of debt financing is (are) the
4. Which of the following classes of securities are listed in order from lowest risk/opportunity for return to
A. Increase in the cost of debt as the debt-to-equity ratio increases.
highest risk/opportunity for return?
B. Increase in the cost of equity as the debt-to-equity ratio decreases.
A. Preferred stock; common stock; corporate mortgage bonds; corporate debentures.
C. Increases in the cost of debt and equity as the debt-to-equity ratio increases.
B. U.S. Treasury bonds; corporate first mortgage bonds; corporate income bonds; preferred stock.
D. Decrease in the weighted-average cost of capital as the debt-to-equity ratio increases.
C. Corporate income bonds; corporate mortgage bonds; convertible preferred stock; subordinated
debentures.
10. In computing the cost of capital, the cost of debt capital is determined by
D. Common stock; corporate first mortgage bonds; corporate second mortgage bonds; corporate income
A. Interest rate times (1 – the firm’s tax rate)
bonds.
B. The capital asset pricing model.
C. Annual interest payment divided by the book value of the debt.
Cost of Capital - Basic Concepts
D. Annual interest payment divided by the proceeds from debt issuance.
5. Cost of capital is
A. The amount the company must pay for its plant assets.
11. The interest rate on the bonds is greater for the second alternative consisting of pure debt than it is for the
B. The dividends a company must pay on its equity securities.
first alternative consisting of both debt and equity because
C. The cost the company must incur to obtain its capital resources.
A. The pure debt alternative would flood the market and be more difficult to sell.
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B. The pure debt alternative carries the risk of increasing the probability of default. A. Standard deviation of the market returns.
C. The diversity of the combination alternative creates greater risk for the investor. B. Interest rate for the safest possible investment.
D. The combination alternative carries the risk of increasing dividend payments. C. Expected rate of return on the market portfolio.
D. Expected risk premium on the portfolio of stocks.
12. If a $1,000 bond sells for $1,125, which of the following statements are correct?
I. The market rate of interest is greater than the coupon rate on the bond. 17. If the return on the market portfolio is 10% and the risk-free rate is 5%, what is the effect on a company's
II. The coupon rate on the bond is greater than the market rate of interest. required rate of return on its stock of an increase in the beta coefficient from 1.2 to 1.5?
III. The coupon rate and the market rate are equal. A. No change C. 1.5% increase
IV. The bond sells at a premium. B. 1.5% decrease. D. 3% increase
V. The bond sells at a discount.
Weighted-Average Cost of Capital
A. I and IV. C. II and IV. 18. The weighted average cost of capital represents the
B. I and V. D. II and V. A. equivalent units of capital used by the organization.
B. overall cost of capital from all organization financing sources.
Cost of Preferred Stock C. overall cost of dividends plus interest paid by the organization.
13. The basis for measuring the cost of capital derived from bonds and preferred stock, respectively, is the D. cost of bonds, preferred stock, and common stock divided by the three sources.
A. after-tax rate of interest for bonds and stated annual dividend rate for preferred stock
B. pretax rate of interest for bonds and stated annual dividend rate for preferred stock 19. The overall cost of capital is the
C. pretax rate of interest for bonds and stated annual dividend rate less the expected earnings per share A. Average rate of return a firm earns on its assets.
for preferred stock B. Minimum rate a firm must earn on high-risk projects.
D. after-tax rate of interest for bonds and stated annual dividend rate less the expected earnings per share C. Rate of return on assets that covers the costs associated with the funds employed.
for preferred stock D. Cost of the firm's equity capital at which the market value of the firm will remain unchanged.

Dividend Growth Model 20. The three elements needed to estimate the cost of equity capital for use in determining a firm's weighted-
14. When calculating the cost of capital, the cost assigned to retained earnings should be average cost of capital are
A. Zero. A. Current dividends per share, expected growth rate in dividends per share, and current book value per
B. Equal to the cost of external common equity. share of common stock.
C. Lower than the cost of external common equity. B. Current earnings per share, expected growth rate in earnings per share, and current book value per
D. Higher than the cost of external common equity. share of common stock.
C. Current earnings per share, expected growth rate in dividends per share, and current market price per
Capital Asset Pricing Model share of common stock.
15. According to the capital asset pricing model (CAPM), the relevant risk of a security is its D. Current dividends per share, expected growth rate in dividends per share, and current market price per
A. Company-specific risk. C. Systematic risk. share of common stock.
B. Diversifiable risk. D. Total risk.
21. Which of the following is not considered a capital component for the purpose of calculating the weighted
16. An investor uses the capital asset pricing model (CAPM) to evaluate the risk-return relationship on a average cost of capital as it applies to capital budgeting?
portfolio of stocks held as an investment. Which of the following would not be used to estimate the portfolio's A. Common stock. C. Preferred stock.
expected rate of return? B. Long-term debt. D. Short-term debt.
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22. The weighted-average cost of capital approach to decision making is not directly affected by the: DOL + DFL = DTL
A. cost of debt outstanding 28. Which class of leverage causes earnings before interest and taxes to be more sensitive to changes in
B. value of the common stock sales?
C. current budget for expansion. A. Credit. C. Intrinsic.
D. proposed mix of debt, equity, and existing funds used to implement the project B. Financial. D. Operating.

23. The pre-tax cost of capital is higher than the after-tax cost of capital because 29. Companies experience changes in interest expenses, variable cost per unit, quantity of units sold, and fixed
A. interest expense is deductible for tax purposes. costs. Their degree of operating leverage is not affected by the change in
B. the cost of capital is a deductible expense for tax purposes. A. Interest expenses. C. Quantity of units sold.
C. principal payments on debt are deductible for tax purposes. B. Fixed costs. D. Variable cost per unit.
D. dividend payments to stockholders are deductible for tax purposes.
24. A company has made the decision to finance next year's capital projects through debt rather than additional 30. A firm with a higher degree of operating leverage when compared to the industry average implies that the
equity. The benchmark cost of capital for these projects should be A. Firm is less risky.
A. The cost of equity financing. B. Firm is more profitable.
B. The weighted-average cost of capital. C. Firm has higher variable costs.
C. The after-tax cost of new-debt financing. D. Firm's profits are more sensitive to changes in sales volume.
D. The before-tax cost of new-debt financing.
31. The purchase of treasury stock with a firm's surplus cash
25. If the return on total assets is 10% and if the return on common stockholders’ equity is 12% then A. Increases a firm's assets.
A. Leverage is negative. B. Dilutes a firm's earnings per share.
B. The after-tax cost of long-term debt is 12%. C. Increases a firm's financial leverage.
C. The after-tax cost of long-term debt is probably less than 10%. D. Increases a firm's interest coverage ratio.
D. The after-tax cost of long-term debt is probably greater than 10%.
32. Which of the changes in leverage would apply to a company that substantially increases its investment in
26. When calculating a firm's cost of capital, all of the following are true except that fixed assets as a proportion of total assets and replaces some of its long-term debt with equity?
A. All costs should be expressed as after-tax costs. A. B. C. D.
B. The time value of money should be incorporated into the calculations. Financial Leverage Increase Decrease Increase Decrease
C. The cost of capital of a firm is the weighted average cost of its various financing components. Operating Leverage Decrease Increase Increase Decrease
D. The calculation of the cost of capital should focus on the historical costs of alternative forms of financing
rather than market or current costs. Problems
Cost of Debt
Securities Valuation 1. What is the yield to maturity on Fox Inc.'s bonds if its after-tax cost of debt is 9% and its tax rate is 34%?
27. The market value of a firm’s outstanding common shares will be higher, everything else equal, if A. 5.94% C. 13.64%
A. Investors expect lower dividend growth. B. 9% D. 26.47%
B. Investors have a lower required return on equity.
C. Investors have longer expected holding periods. 2. Maylar Corporation has sold $50 million of $1,000 par value, 12% coupon bonds. The bonds were sold at a
D. Investors have shorter expected holding periods. discount and the corporation received $985 per bond. If the corporate tax rate is 40%, the after-tax cost of
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these bonds for the first year (rounded to the nearest hundredth percent) is A. B. C. D.
A. 4.87%. C. 7.31%. ABC 9.6% 12.5% 13.8% 16.2%
B. 7.09%. D. 12.00%. DEF 8.6% 16.7% 15.4% 18.2%

3. The MNO Company believes that it can sell long-term bonds with a 6% coupon but at a price that gives a Cost of Common Stock – Dividend Growth Model
yield-to-maturity of 9%. If such bonds are part of next year’s financing plans, which of the following should 8. What return on equity do investors seem to expect for a firm with a $50 share price, an expected dividend of
be used for bonds in their after-tax (40%) cost-of-capital calculation? $5.50, a beta of .9, and a constant growth rate of 4.5%?
A. 3.6% C. 5.4% A. 15.05% C. 15.95%
B. 4.2% D. 6% B. 15.50% D. 16.72%
Cost of Preferred Stock 9. Frostfell Airlines is expected to pay an upcoming dividend of $3.29. The company's dividend is expected to
4. Doris Corporation's stock has a market price of $20.00 and pays a constant dividend of $2.50. What is the grow at a steady, constant rate of 5% well into the future. Frostfell currently has 1,600,000 shares of
required rate of return on its stock? common stock outstanding. If the required rate of return for Frostfell is 12%, what is the best estimate for the
A. 11.5% C. 12.5% current price of Frostfell's common stock?
B. 12.0% D. 13.0% A. $27.41 C. $62.51
5. Ambry Inc. is going to use an underwriter to sell its preferred stock. Four underwriters have given estimates B. $47.00 D. $65.80
(below) on their fees and the selling price of the stock, as well as the expected dividend for each:
Fees Selling Price Dividends 10. Newmass, Inc. paid a cash dividend to its common shareholders over the past 12 months of $2.20 per
Underwriter 1 $5 $101 $10 share. The current market value of the common stock is $40 per share, and investors are anticipating the
Underwriter 2 7 102 11 common dividend to grow at a rate of 6% annually. The cost to issue new common stock will be 5% of the
Underwriter 3 3 97 7 market value. The cost of a new common stock issue will be
Underwriter 4 3 98 8 A. 11.50% C. 11.83%
Which underwriter will produce the lowest cost of funds for the preferred stock? B. 11.79% D. 12.14%
A. Underwriter 1. C. Underwriter 3.
B. Underwriter 2. D. Underwriter 4. 11. Blair Brothers’ stock currently has a price of $50 per share and is expected to pay a year-end dividend of
$2.50 per share (D1 = $2.50). The dividend is expected to grow at a constant rate of 4 percent per year. The
Cost of Retained Earnings – Dividend Growth Model company has insufficient retained earnings to fund capital projects and must, therefore, issue new common
6. Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent stock. The new stock has an estimated flotation cost of $3 per share. What is the company’s cost of equity
common equity. The current market price of the firm’s stock is P 0 = $28; its last dividend was D0 = $2.20, capital?
and its expected dividend growth rate is 6 percent. What will Allison’s marginal cost of retained earnings, k s, A. 9.21% C. 9.45%
be? B. 9.32% D. 10.14%
A. 7.9% C. 14.3%
B. 13.9% D. 15.8% 12. The DCL Corporation is preparing to evaluate the capital expenditure proposals for the coming year.
Because the firm employs discounted cash flow methods of analyses, the cost of capital for the firm must be
7. The ABC Company is expected to have a constant annual growth rate of 5 percent. It has a price per share estimated. The following information for DCL Corporation is provided.
of P32 and pays an expected dividend of P2.40. Its competitor, the DEF Company is expected to have a  Market price of common stock is $50 per share.
growth rate of 10%, has a price per share of P72, and pays an expected P4.80/share dividend. The  The dividend next year is expected to be $2.50 per share.
required rates of return on equity for the two companies are:  Expected growth in dividends is a constant 10%.
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 New bonds can be issued at face value with a 13% coupon rate. the Capital Asset Pricing Model (CAPM) equation [R = RF + ß(RM - RF)], the cost of using retained
 The current capital structure of 40% long-term debt and 60% equity is considered to be optimal. earnings to finance the capital expenditures is
 Anticipated earnings to be retained in the coming year are $3 million. A. 12.40% C. 13.21%
 The firm has a 40% marginal tax rate. B. 12.99% D. 14.26%

If the firm must assume a 10% flotation cost on new stock issuances, what is the cost of new common 17. Stock J has a beta of 1.2 and an expected return of 15.6%, and stock K has a beta of 0.8 and an expected
stock? return of 12.4%. What must be the expected return on the market and the risk-free rate of return, to be
A. 14.50%. C. 15.50%. consistent with the capital asset pricing model?
B. 15.32%. D. 15.56%. A. Market is 12.4%; risk-free is 0%. C. Market is 14%; risk-free is 4%.
B. Market is 14%; risk-free is 1.6%. D. Market is 14%; risk-free is 6%.
13. Fitzgerald is interested in investing in a corporation with a low cost of equity capital. By using the dividend
growth model, which of the following corporations has the lowest cost of equity capital? 18. If the return on the market portfolio is 10% and the risk-free rate is 5%, what is the effect on a company's
Stock Price Dividend Growth Rate required rate of return on its stock of an increase in the beta coefficient from 1.2 to 1.5?
C.S. Inc. $25 $5 8% A. No change C. 1.5% increase
Lewis Corp. 30 3 10% B. 1.5% decrease D. 3% increase
Screwtape Inc. 20 4 6%
Wormwood Corp. 28 7 7% 19. An investor was expecting a 15% return on his portfolio with beta of 1.25 before the market risk premium
A. C.S. Inc. C. Screwtape Inc. increased from 6% to 9%. Based on this change, what return will now be expected on the portfolio?
B. Lewis Corp. D. Wormwood Corp. A. 15.00% C. 18.75%
B. 18.00% D. 22.50%
Cost of Common Stock – Capital Asset Pricing Model 20. What happens to expected portfolio return if the portfolio beta increases from 1.0 to 2.0, the risk-free rate
14. Based on the following information about stock price increases and decreases, make an estimate of the decreases from 5% to 4%, and the market risk premium remains at 8%?
stock's beta: Month 1 = Stock +1.5%, Market +1.1%; Month 2 = Stock +2.0%, Market +1.4%; Month 3 = A. It remains unchanged. C. It increases from 13% to 20%.
Stock -2.5%, Market -2.0%. B. It increases from 12% to 19%. D. It increases from 13% to 16%.
A. Beta equals 1.0
B. Beta is less than 1.0. 21. The expected returns, standard deviations, and beta coefficients of four stocks are given below:
C. Beta is greater than 1.0. Expected Return Standard Deviation Beta Coefficient
D. There is no consistent pattern of returns. M 18% .65 .9
N 20% .9 1.2
15. The common stock of Anthony Steel has a beta of 1.20. The risk-free rate is 5 percent and the market risk O 20% .4 1.5
premium (kM - kRF) is 6 percent. Assume the firm will be able to use retained earnings to fund the equity Q 21% 1.2 1.7
portion of its capital budget. What is the company’s cost of retained earnings, ks? Given an expected return on the market portfolio of 18% and a risk-free rate of 12%, which stock(s) is(are)
A. 7.0% C. 11.0% overvalued or undervalued?
B. 7.2% D. 12.2% A. M, N, O, and Q are overvalued.
B. M, N, O, and Q are undervalued.
16. Colt, Inc. is planning to use retained earnings to finance anticipated capital expenditures. The beta C. M is undervalued; N, O, and Q are overvalued.
coefficient for Colt's stock is 1.15, the risk-free rate of interest is 8.5%, and the market return is estimated at D. M and N are undervalued; O and Q are overvalued.
12.4%. If a new issue of common stock were used in this model, the flotation costs would be 7%. By using
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Weighted-Average Cost of Capital Payout ratio = 50% Shares outstanding = 10,000

22. What is the weighted average cost of capital for a firm with 40% debt, 20% preferred stock, and 40% Tax rate = 40% Flotation cost on additional equity = 15%
common equity if the respective costs for these components are 8% after-tax, 13% after-tax, and 17% A. 7.60% C. 11.81%
before-tax? The firm's tax rate is 35%. B. 8.05% D. 13.69%
A. 10.22% C. 11.48%
B. 10.52% D. 12.60% 26. Company X is interested in calculating it weighted-average cost of capital. Company X has a current
financial structure that is composed of 50% debt, 40% common stock, and 10% preferred stock. Ignore the
23. Wiley’s new financing will be in proportion to the market value of its present financing, shown below. effects of cost of retained earnings. The beta of Company X stock is 0.7, and the current risk-free rate of
Book Value ($000 Omitted) return is 4%. The market risk premium is 6%. The preferred dividend on Company X preferred stock is set
Long-term debt $7,000 at $2.25, and the net issuance price per share (which happens to be the same as the current price per
Preferred stock (100 shares) 1,000 share) of preferred stock is $30. Debt issued by Company X yields an 11% stated interest rate to investors.
Common stock (200 shares) 7,000 The marginal tax rate for Company X is 40%. What is the weighted-average cost of capital for Company X?
The firms’ bonds are currently selling at 80% of par, generating a current market yield of 9%, and the A. 0.0660 C. 0.0743
corporation has a 40% tax rate. The preferred stock is selling at its par value and pays a 6% dividend. The B. 0.0733 D. 0.0820
common stock has a current market value of $40 and is expected to pay a $1.20 per share dividend this
fiscal year. Dividend growth is expected to be 10% per year. Wiley’s weighted-average cost of capital is 27. Grateway Inc. has a weighted average cost of capital of 11.5 percent. Its target capital structure is 55
(round your calculations to tenths of a percent) percent equity and 45 percent debt. The company has sufficient retained earnings to fund the equity portion
A. 8.3% C. 9.6% of its capital budget. The before-tax cost of debt is 9 percent, and the company’s tax rate is 30 percent. If
B. 9.0% D. 13.0% the expected dividend next period (D1) is $5 and the current stock price is $45, what’s the growth rate?
A. 2.68% C. 4.64%
24. Dobson Dairies has a capital structure that consists of 60 percent long-term debt and 40 percent common B. 3.44% D. 6.75%
stock. The company’s CFO has obtained the following information:
 The before-tax yield to maturity on the company’s bonds is 8 percent. 28. A company has $1 million in shareholders' equity and $2 million in debt equity (8% bonds). Its after-tax
 The company’s common stock is expected to pay a $3.00 dividend at year end (D 1 = $3.00), and the weighted-average cost of capital is 12%, but it uses 15% as the hurdle rate in capital budgeting decisions.
dividend is expected to grow at a constant rate of 7 percent a year. The common stock currently sells During the past year, its operating income before tax and interest was $500,000. Its tax rate is 40%. What is
the company's cost of equity capital?
for $60 a share.
A. 8% C. 15%
 Assume the firm will be able to use retained earnings to fund the equity portion of its capital budget.
B. 12% D. 26.4%
 The company’s tax rate is 40 percent.
What is the company’s weighted average cost of capital (WACC)? 29. Bradshaw Steel has a capital structure with 30 percent debt (all long-term bonds) and 70 percent common
A. 8.03% C. 9.34% equity. The yield to maturity on the company’s long-term bonds is 8 percent, and the firm estimates that its
B. 7.68% D. 12.00% overall composite WACC is 10 percent. The risk-free rate of interest is 5.5 percent, the market risk premium
25. A company has determined that its optimal capital structure consists of 40 percent debt and 60 percent is 5 percent, and the company’s tax rate is 40 percent. Bradshaw uses the CAPM to determine its cost of
equity. Assume the firm will not have enough retained earnings to fund the equity portion of its capital equity.
budget. Also, assume the firm accounts for flotation costs by adjusting the cost of capital. Given the
following information, calculate the firm’s weighted average cost of capital. What is the beta on Bradshaw’s stock?
kd = 8% P0 = $25 A. 0.10 C. 1.35
Net income = $40,000 Growth = 0% B. 1.07 D. 1.48
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30. Heavy Metal Corp. is a steel manufacturer that finances its operations with 40 percent debt, 10 percent year for 10 years. In addition, this project will have an after-tax salvage value of $20,000 at the end of Year
preferred stock, and 50 percent equity. The interest rate on the company’s debt is 11 percent. The preferred 10. If the risk-free rate is 5 percent, the return on an average stock is 10 percent, and the beta of this project
stock pays an annual dividend of $2 and sells for $20 a share. The company’s common stock trades at $30 is 1.80, then what is the project's NPV?
a share, and its current dividend (D0) of $2 a share is expected to grow at a constant rate of 8 percent per A. $3,234 C. -$32,012
year. The flotation cost of external equity is 15 percent of the dollar amount issued, while the flotation cost B. $10,655 D. -$37,407
on preferred stock is 10 percent. The company estimates that its WACC is 12.30 percent. Assume that the
firm will not have enough retained earnings to fund the equity portion of its capital budget. What is the DOL + DFL = DTL
company’s tax rate? 35. In its first year of operations, a firm had $50,000 of fixed operating costs. It sold 10,000 units at a $10 unit
A. 30.33% C. 35.75% price and incurred variable costs of $4 per unit. If all prices and costs will be the same in the second year
B. 32.87% D. 38.12% and sales are projected to rise to 25,000 units, what will the degree of operating leverage (the extent to
which fixed costs are used in the firm’s operations) be in the second year?
31. Datacomp Industries, which has no current debt, has a beta of .95 for its common stock. Management is A. 1.25 C. 2.0
considering a change in the capital structure to 30% debt and 70% equity. This change would increase the B. 1.50 D. 6.0
beta on the stock to 1.05, and the after-tax cost of debt will be 7.5%. The expected return on equity is 16%,
and the risk-free rate is 6%. Should Datacomp's management proceed with the capital structure change? 36. For a firm with a degree of operating leverage of 3.5, an increase in sales of 6% will
A. No, because the cost of equity capital will increase. A. Decrease pre-tax profits by 3.5%. C. Increase pre-tax profits by 3.5%.
B. Yes, because the cost of equity capital will decrease. B. Increase pre-tax profits by 1.71%. D. Increase pre-tax profits by 21%.
C. No, because the weighted-average cost of capital will increase. 37. This year, Nelson Industries increased earnings before interest and taxes (EBIT) by 17%. During the same
D. Yes, because the weighted-average cost of capital will decrease. period, net income after tax increased by 42%. The degree of financial leverage that existed during the year
is
Retained Earnings Breakpoint, Marginal Cost of Capital & Optimal Capital Budget A. 1.70. C. 4.20.
32. Gravy Company expects earnings of P30 million next year. Its dividend payout ratio is 40%, and its B. 2.47. D. 5.90.
debt/equity ratio is 1.50. Gravy uses no preferred stock.
At what amount of financing will there be a break point in Gravy’s marginal cost of capital? 38. A company has unit sales of 300,000, the unit variable cost is $1.50, the unit sales price is $2.00, and the
A. P18 million. C. P30 million. annual fixed costs are $50,000. Furthermore, the annual interest expense is $20,000, and the company has
B. P20 million. D. P45 million. no preferred stock. Accordingly, the degree of total leverage is
33. A company has $650,000 of 10% debt outstanding and $500,000 of equity financing. The required return of A. 1.20 C. 1.50
the equity holders is 15%, and there are no retained earnings currently available for investment purposes. If B. 1.25 D. 1.875
new outside equity is raised, it will cost the firm 16%. New debt would have a before-tax cost of 9%, and the
corporate tax rate is 50%. When calculating the marginal cost of capital, the company should assign a cost Comprehensive
of <List A> to equity capital and <List B> to the after-tax cost of debt financing. Questions 39 through 42 are based on the following information.
A. B. C. D. A new company requires $1 million of financing and is considering two arrangements as shown in the table
List A 15% 15% 16% 16% below:
List B 4.5% 5.0% 4.5% 5.0% Amount of Amount of Before-Tax
Arrangement Equity Raised Debt Financing Cost of Debt
Capital Budgeting #1 $700,000 $300,000 8% per annum
34. Computechs is an all-equity firm that is analyzing a potential mass communications project which will #2 $300,000 $700,000 10% per annum
require an initial, after-tax cash outlay of $100,000, and will produce after-tax cash inflows of $12,000 per In the first year of operations, the company is expected to have sales revenues of $500,000, cost of sales of
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$200,000, and general and administrative expenses of $100,000. The tax rate is 30%, and there are no other
items on the income statement. All earnings are paid out as dividends at year-end. Theory Problem
1. D 26. D 1. C 26. B
39. If the cost of equity is 12%, the weighted-average cost of capital under arrangement #1, to the nearest full 2. C 27. B 2. C 27. C
percentage point, would be 3. B 28. D 3. C 28. D
A. 8% C. 11% 4. B 29. A 4. C 29. C
B. 10% D. 12% 5. C 30. D 5. C 30. B
6. B 31. C 6. C 31. D
40. Which of the following statements comparing the two financing arrangements is true? 7. D 32. B 7. B 32. D
A. The company will have higher interest expense under arrangement #1. 8. D 8. B 33. C
B. The company will have higher expected tax expense under arrangement #1. 9. C 9. B 34. C
C. The company will have a higher expected gross margin under arrangement #1. 10. A 10. D 35. B
D. The company will have a higher degree of operating leverage under arrangement #2.
11. B 11. B 36. D
12. C 12. D 37. B
41. Under financing arrangement #2, the degree of financial leverage (DFL), rounded to two decimal places,
13. A 13. B 38. D
would be
A. 1.09 C. 1.32 14. C 14. C 39. B
B. 1.14 D. 1.54 15. C 15. D 40. B
16. D 16. B 41. D
42. The return on equity will be <List A> and the debt ratio will be <List B> under arrangement #2, as compared 17. C 17. D 42. A
with arrangement #1. 18. B 18. C
A. B. C. D. 19. C 19. C
List A Higher Higher Lower Lower 20. D 20. C
List B Higher Lower Higher Lower 21. D 21. D
22. C 22. D
23. A 23. C
24. B 24. B
25. C 25. A

MSQ-10 COST OF CAPITAL Page 8 of 8