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QUIZZER (DO-IT-YOURSELF DRILL)

THEORIES
1. Which of the following would increase risk?
A. Increase the level of working capital.
B. Increase the amount of equity financing.
C. Increase the amount of short-term borrowing.
D. Change the composition of working capital to include more liquid assets.
2. A firm’s financial risk is a function of how it manages and maintains its debt. Which one of the
following sets of ratios characterizes the firm with the greatest amount of financial risk?
A. High debt-to-equity ratio, high interest coverage ratio, stable return on equity.
B. High debt-to-equity ratio, low interest coverage ratio, volatile return on equity.
C. Low debt-to-equity ratio, low interest coverage ratio, volatile return on equity.
D. Low debt-to-equity ratio, high interest coverage ratio, stable return on equity.
3. Cost of capital is
A. The amount the company must pay for its plant assets.
B. The dividends a company must pay on its equity securities.
C. The cost the company must incur to obtain its capital resources.
D. The cost the company is charged by investment bankers who handle the issuance of equity or
long-term debt securities.
4. All of the following are examples of imputed costs except
A. Decelerated depreciation.
B. The stated interest paid on a bank loan.
C. Assets that are considered obsolete that maintain a net book value.
D. Lending funds to a supplier at a lower-than-market rate in exchange for receiving the supplier’s
products at a discount.
5. Management knowledge of the cost of capital is useful for each of the following except
A. Evaluating performance.
B. Managing working capital.
C. Making capital investment decisions.
D. Setting the maximum rate of return on new investments.
6. The explicit cost of debt financing is the interest expense. The implicit cost(s) of debt financing is
(are) the
A. Increase in the cost of debt as the debt-to-equity ratio increases.
B. Increase in the cost of equity as the debt-to-equity ratio decreases.
C. Increases in the cost of debt and equity as the debt-to-equity ratio increases.
D. Decrease in the weighted-average cost of capital as the debt-to-equity ratio increases.
7. The interest rate on the bonds is greater for the second alternative consisting of pure debt than it is
for the first alternative consisting of both debt and equity because
A. The pure debt alternative would flood the market and be more difficult to sell.
B. The pure debt alternative carries the risk of increasing the probability of default.
C. The diversity of the combination alternative creates greater risk for the investor.
D. The combination alternative carries the risk of increasing dividend payments.
8. If a P1,000 bond sells for P1,125, which of the following statements are correct?
I. The market rate of interest is greater than the coupon rate on the bond.
II. The coupon rate on the bond is greater than the market rate of interest.
III. The coupon rate and the market rate are equal.
IV. The bond sells at a premium.
V. The bond sells at a discount.
A. I and IV.
B. I and V.
C. II and IV.
D. II and V.
9. When calculating the cost of capital, the cost assigned to retained earnings should be
A. Zero.
B. Equal to the cost of external common equity.
C. Lower than the cost of external common equity.
D. Higher than the cost of external common equity.
10. According to the capital asset pricing model (CAPM), the relevant risk of a security is its
A. Company-specific risk. C. Systematic risk.
B. Diversifiable risk. D. Total risk.
11. An investor uses the capital asset pricing model (CAPM) to evaluate the risk-return relationship on a
portfolio of stocks held as an investment. Which of the following would not be used to estimate the
portfolio's expected rate of return?

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A. Standard deviation of the market returns.

B. Interest rate for the safest possible investment.
C. Expected rate of return on the market portfolio.
D. Expected risk premium on the portfolio of stocks.
12. If the return on the market portfolio is 10% and the risk-free rate is 5%, what is the effect on a
company's required rate of return on its stock of an increase in the beta coefficient from 1.2 to 1.5?
A. No change C. 1.5% increase
B. 1.5% decrease. D. 3% increase
13. The overall cost of capital is the
A. Average rate of return a firm earns on its assets.
B. Minimum rate a firm must earn on high-risk projects.
C. Rate of return on assets that covers the costs associated with the funds employed.
D. Cost of the firm's equity capital at which the market value of the firm will remain unchanged.
14. The three elements needed to estimate the cost of equity capital for use in determining a firm's
weighted-average cost of capital are
A. Current dividends per share, expected growth rate in dividends per share, and current book
value per share of common stock.
B. Current earnings per share, expected growth rate in earnings per share, and current book value
per share of common stock.
C. Current earnings per share, expected growth rate in dividends per share, and current market
price per share of common stock.
D. Current dividends per share, expected growth rate in dividends per share, and current market
price per share of common stock.
15. Which of the following is not considered a capital component for the purpose of calculating the
weighted average cost of capital as it applies to capital budgeting?
A. Common stock. C. Preferred stock.
B. Long-term debt. D. Short-term debt.
16. The weighted-average cost of capital approach to decision making is not directly affected by the:
A. cost of debt outstanding
B. value of the common stock
C. current budget for expansion.
D. proposed mix of debt, equity, and existing funds used to implement the project
17. The pre-tax cost of capital is higher than the after-tax cost of capital because
A. interest expense is deductible for tax purposes.
B. the cost of capital is a deductible expense for tax purposes.
C. principal payments on debt are deductible for tax purposes.
D. dividend payments to stockholders are deductible for tax purposes.
18. The market value of a firm’s outstanding common shares will be higher, everything else equal, if
A. Investors expect lower dividend growth.
B. Investors have a lower required return on equity.
C. Investors have longer expected holding periods.
D. Investors have shorter expected holding periods.
19. Companies experience changes in interest expenses, variable cost per unit, quantity of units sold, and
fixed costs. Their degree of operating leverage is not affected by the change in
A. Interest expenses. C. Quantity of units sold.
B. Fixed costs. D. Variable cost per unit.
20. A firm with a higher degree of operating leverage when compared to the industry average implies that
the
A. Firm is less risky.
B. Firm is more profitable.
C. Firm has higher variable costs.
D. Firm's profits are more sensitive to changes in sales volume.
21. The purchase of treasury stock with a firm's surplus cash
A. Increases a firm's assets.
B. Dilutes a firm's earnings per share.
C. Increases a firm's financial leverage.
D. Increases a firm's interest coverage ratio.

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PROBLEMS
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%?
A. 5.94% C. 13.64%
B. 9% D. 26.47%
2. Maylar Corporation has sold P50 million of P1,000 par value, 12% coupon bonds. The bonds were sold
at a discount and the corporation received P985 per bond. If the corporate tax rate is 40%, the after-
tax cost of these bonds for the first year (rounded to the nearest hundredth percent) is
A. 4.87%. C. 7.31%.
B. 7.09%. D. 12.00%.
3. The MNO Company believes that it can sell long-term bonds with a 6% coupon but at a price that
gives a yield-to-maturity of 9%. If such bonds are part of next year’s financing plans, which of the
following should be used for bonds in their after-tax (40%) cost-of-capital calculation?
A. 3.6% C. 5.4%
B. 4.2% D. 6%
4. Doris Corporation's stock has a market price of P20.00 and pays a constant dividend of P2.50. What is
the required rate of return on its stock?
A. 11.5% C. 12.5%
B. 12.0% D. 13.0%
5. Allison Engines Corporation has established a target capital structure of 40 percent debt and 60
percent common equity. The current market price of the firm’s stock is P0 = P28; its last dividend was
D0 = P2.20, and its expected dividend growth rate is 6 percent. What will Allison’s marginal cost of
retained earnings, ks, be?
A. 7.9% C. 14.3%
B. 13.9% D. 15.8%
6. The ABC Company is expected to have a constant annual growth rate of 5 percent. It has a price per
share of P32 and pays an expected dividend of P2.40. Its competitor, the DEF Company is expected
to have a growth rate of 10%, has a price per share of P72, and pays an expected P4.80/share
dividend. The required rates of return on equity for the two companies are:
A. B. C. D.
ABC 9.6% 12.5% 13.8% 16.2%
DEF 8.6% 16.7% 15.4% 18.2%
7. What return on equity do investors seem to expect for a firm with a P50 share price, an expected
dividend of P5.50, a beta of .9, and a constant growth rate of 4.5%?
A. 15.05% C. 15.95%
B. 15.50% D. 16.72%
8. Frostfell Airlines is expected to pay an upcoming dividend of P3.29. The company's dividend is
expected to grow at a steady, constant rate of 5% well into the future. Frostfell currently has
1,600,000 shares of common stock outstanding. If the required rate of return for Frostfell is 12%,
what is the best estimate for the current price of Frostfell's common stock?
A. P27.41 C. P62.51
B. P47.00 D. P65.80
9. Newmass, Inc. paid a cash dividend to its common shareholders over the past 12 months of P2.20
per share. The current market value of the common stock is P40 per share, and investors are
anticipating the common dividend to grow at a rate of 6% annually. The cost to issue new common
stock will be 5% of the market value. The cost of a new common stock issue will be
A. 11.50% C. 11.83%
B. 11.79% D. 12.14%
10. Blair Brothers’ stock currently has a price of P50 per share and is expected to pay a year-end dividend
of P2.50 per share (D1 = P2.50). The dividend is expected to grow at a constant rate of 4 percent per
year. The company has insufficient retained earnings to fund capital projects and must, therefore,
issue new common stock. The new stock has an estimated flotation cost of P3 per share. What is the
company’s cost of equity capital?
A. 9.21% C. 9.45%
B. 9.32% D. 10.14%
11. 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 estimated. The following information for DCL Corporation is provided.
• Market price of common stock is P50 per share.
• The dividend next year is expected to be P2.50 per share.
• Expected growth in dividends is a constant 10%.
• New bonds can be issued at face value with a 13% coupon rate.

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• The current capital structure of 40% long-term debt and 60% equity is considered to be
optimal.
• Anticipated earnings to be retained in the coming year are P3 million.
• The firm has a 40% marginal tax rate.
If the firm must assume a 10% flotation cost on new stock issuances, what is the cost of new
common stock?
A. 14.50%. C. 15.50%.
B. 15.32%. D. 15.56%.
12. 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?
Stock Price Dividend Growth Rate
C.S. Inc. P25 P5 8%
Lewis Corp. 30 3 10%
Screwtape Inc. 20 4 6%
Wormwood Corp. 28 7 7%
A. C.S. Inc. C. Screwtape Inc.
B. Lewis Corp. D. Wormwood Corp.
13. Based on the following information about stock price increases and decreases, make an estimate of
the stock's beta: Month 1 = Stock +1.5%, Market +1.1%; Month 2 = Stock +2.0%, Market +1.4%;
Month 3 = Stock -2.5%, Market -2.0%.
A. Beta equals 1.0
B. Beta is less than 1.0.
C. Beta is greater than 1.0.
D. There is no consistent pattern of returns.
14. The common stock of Anthony Steel has a beta of 1.20. The risk-free rate is 5 percent and the market
risk premium (kM - kRF) is 6 percent. Assume the firm will be able to use retained earnings to fund
the equity portion of its capital budget. What is the company’s cost of retained earnings, ks?
A. 7.0% C. 11.0%
B. 7.2% D. 12.2%
15. Colt, Inc. is planning to use retained earnings to finance anticipated capital expenditures. The beta
coefficient for Colt's stock is 1.15, the risk-free rate of interest is 8.5%, and the market return is
estimated at 12.4%. If a new issue of common stock were used in this model, the flotation costs
would be 7%. By using the Capital Asset Pricing Model (CAPM) equation [R = RF + ß(RM - RF)], the
cost of using retained earnings to finance the capital expenditures is
A. 12.40% C. 13.21%
B. 12.99% D. 14.26%
16. 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 return of 12.4%. What must be the expected return on the market and the risk-free rate of
return, to be consistent with the capital asset pricing model?
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%.
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 required rate of return on its stock of an increase in the beta coefficient from 1.2 to 1.5?
A. No change C. 1.5% increase
B. 1.5% decrease D. 3% increase
18. An investor was expecting a 15% return on his portfolio with beta of 1.25 before the market risk
premium increased from 6% to 9%. Based on this change, what return will now be expected on the
portfolio?
A. 15.00% C. 18.75%
B. 18.00% D. 22.50%
19. What happens to expected portfolio return if the portfolio beta increases from 1.0 to 2.0, the risk-free
rate decreases from 5% to 4%, and the market risk premium remains at 8%?
A. It remains unchanged. C. It increases from 13% to 20%.
B. It increases from 12% to 19%. D. It increases from 13% to 16%.
20. The expected returns, standard deviations, and beta coefficients of four stocks are given below:
Expected Return Standard Deviation Beta Coefficient
M 18% .65 .9
N 20% .9 1.2
O 20% .4 1.5
Q 21% 1.2 1.7
Given an expected return on the market portfolio of 18% and a risk-free rate of 12%, which stock(s)
is(are) overvalued or undervalued?

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A. M, N, O, and Q are overvalued.

B. M, N, O, and Q are undervalued.
C. M is undervalued; N, O, and Q are overvalued.
D. M and N are undervalued; O and Q are overvalued.
21. What is the weighted average cost of capital for a firm with 40% debt, 20% preferred stock, and 40%
common equity if the respective costs for these components are 8% after-tax, 13% after-tax, and
17% before-tax? The firm's tax rate is 35%.
A. 10.22% C. 11.48%
B. 10.52% D. 12.60%
22. Wiley’s new financing will be in proportion to the market value of its present financing, shown below.
Book Value (P000 Omitted)
Long-term debt P7,000
Preferred stock (100 shares) 1,000
Common stock (200 shares) 7,000
The firms’ bonds are currently selling at 80% of par, generating a current market yield of 9%, and the
corporation has a 40% tax rate. The preferred stock is selling at its par value and pays a 6%
dividend. The common stock has a current market value of P40 and is expected to pay a P1.20 per
share dividend this fiscal year. Dividend growth is expected to be 10% per year. Wiley’s weighted-
average cost of capital is (round your calculations to tenths of a percent)
A. 8.3% C. 9.6%
B. 9.0% D. 13.0%
23. Dobson Dairies has a capital structure that consists of 60 percent long-term debt and 40 percent
common stock. The company’s CFO has obtained the following information:
• The before-tax yield to maturity on the company’s bonds is 8 percent.
• The company’s common stock is expected to pay a P3.00 dividend at year end (D1 = P3.00),
and the dividend is expected to grow at a constant rate of 7 percent a year. The common stock
currently sells for P60 a share.
• Assume the firm will be able to use retained earnings to fund the equity portion of its capital
budget.
• The company’s tax rate is 40 percent.
What is the company’s weighted average cost of capital (WACC)?
A. 8.03% C. 9.34%
B. 7.68% D. 12.00%
24. A company has determined that its optimal capital structure consists of 40 percent debt and 60
percent equity. Assume the firm will not have enough retained earnings to fund the equity portion of
its capital 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.
kd = 8% P0 = P25
Net income = P40,000 Growth = 0%
Payout ratio = 50% Shares outstanding = 10,000
Tax rate = 40% Flotation cost on additional equity = 15%
A. 7.60% C. 11.81%
B. 8.05% D. 13.69%
25. 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 effects of cost of retained earnings. The beta of Company X stock is 0.7, and the current
risk-free rate of return is 4%. The market risk premium is 6%. The preferred dividend on Company
X preferred stock is set at P2.25, and the net issuance price per share (which happens to be the same
as the current price per share) of preferred stock is P30. Debt issued by Company X yields an 11%
stated interest rate to investors. The marginal tax rate for Company X is 40%. What is the
weighted-average cost of capital for Company X?
A. 0.0660 C. 0.0743
B. 0.0733 D. 0.0820
26. Grateway Inc. has a weighted average cost of capital of 11.5 percent. Its target capital structure is 55
percent equity and 45 percent debt. The company has sufficient retained earnings to fund the equity
portion of its capital budget. The before-tax cost of debt is 9 percent, and the company’s tax rate is
30 percent. If the expected dividend next period (D1) is P5 and the current stock price is P45, what is
the company’s growth rate?
A. 2.68% C. 4.64%
B. 3.44% D. 6.75%
27. A company has P1 million in shareholders' equity and P2 million in debt equity (8% bonds). Its after-
tax weighted-average cost of capital is 12%, but it uses 15% as the hurdle rate in capital budgeting
decisions. During the past year, its operating income before tax and interest was P500,000. Its tax
rate is 40%. What is the company's cost of equity capital?

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A. 8% C. 15%
B. 12% D. 26.4%
28. Bradshaw Steel has a capital structure with 30 percent debt (all long-term bonds) and 70 percent
common equity. The yield to maturity on the company’s long-term bonds is 8 percent, and the firm
estimates that its overall composite WACC is 10 percent. The risk-free rate of interest is 5.5 percent,
the market risk premium is 5 percent, and the company’s tax rate is 40 percent. Bradshaw uses the
CAPM to determine its cost of equity. What is the beta on Bradshaw’s stock?
A. 0.10 C. 1.35
B. 1.07 D. 1.48
29. Heavy Metal Corp. is a steel manufacturer that finances its operations with 40 percent debt, 10
percent preferred stock, and 50 percent equity. The interest rate on the company’s debt is 11 percent.
The preferred stock pays an annual dividend of P2 and sells for P20 a share. The company’s common
stock trades at P30 a share, and its current dividend (D0) of P2 a share is expected to grow at a
constant rate of 8 percent per year. The flotation cost of external equity is 15 percent of the dollar
amount issued, while the flotation cost 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 company’s tax rate?
A. 30.33% C. 35.75%
B. 32.87% D. 38.12%
30. Datacomp Industries, which has no current debt, has a beta of .95 for its common stock.
Management is considering a change in the capital structure to 30% debt and 70% equity. This
change would increase the 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?
A. No, because the cost of equity capital will increase.
B. Yes, because the cost of equity capital will decrease.
C. No, because the weighted-average cost of capital will increase.
D. Yes, because the weighted-average cost of capital will decrease.
31. Gravy Company expects earnings of P30 million next year. Its dividend payout ratio is 40%, and its
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?
A. P18 million. C. P30 million.
B. P20 million. D. P45 million.
32. A company has P650,000 of 10% debt outstanding and P500,000 of equity financing. The required
return of the equity holders is 15%, and there are no retained earnings currently available for
investment purposes. If 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 of <List A> to equity capital and <List B> to the after-tax
cost of debt financing.
A. B. C. D.
List A 15% 15% 16% 16%
List B 4.5% 5.0% 4.5% 5.0%
33. In its first year of operations, a firm had P50,000 of fixed operating costs. It sold 10,000 units at a
P10 unit price and incurred variable costs of P4 per unit. If all prices and costs will be the same in the
second year 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?
A. 1.25 C. 2.0
B. 1.50 D. 6.0
34. For a firm with a degree of operating leverage of 3.5, an increase in sales of 6% will
A. Decrease pre-tax profits by 3.5%. C. Increase pre-tax profits by 3.5%.
B. Increase pre-tax profits by 1.71%. D. Increase pre-tax profits by 21%.
35. This year, Nelson Industries increased earnings before interest and taxes (EBIT) by 17%. During the
same period, net income after tax increased by 42%. The degree of financial leverage that existed
during the year is
A. 1.70. C. 4.20.
B. 2.47. D. 5.90.
36. A company has unit sales of 300,000, the unit variable cost is P1.50, the unit sales price is P2.00, and
the annual fixed costs are P50,000. Furthermore, the annual interest expense is P20,000, and the
company has no preferred stock. Accordingly, the degree of total leverage is
A. 1.20 C. 1.50
B. 1.25 D. 1.875

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Questions 37 through 40 are based on the following information.

A new company requires P1 million of financing and is considering two arrangements as shown in the
table below:
Arrangement Amount of Amount of Before-Tax
Equity Raised Debt Financing Cost of Debt
#1 P700,000 P300,000 8% per annum
#2 P300,000 P700,000 10% per annum
In the first year of operations, the company is expected to have sales revenues of P500,000, cost of
sales of P200,000, and general and administrative expenses of P100,000. 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.
37. If the cost of equity is 12%, the weighted-average cost of capital under arrangement #1, to the
nearest full percentage point, would be
A. 8% C. 11%
B. 10% D. 12%
38. Which of the following statements comparing the two financing arrangements is true?
A. The company will have higher interest expense under arrangement #1.
B. The company will have higher expected tax expense under arrangement #1.
C. The company will have a higher expected gross margin under arrangement #1.
D. The company will have a higher degree of operating leverage under arrangement #2.
39. Under financing arrangement #2, the degree of financial leverage (DFL), rounded to two decimal
places, would be
A. 1.09 C. 1.32
B. 1.14 D. 1.54
40. The return on equity will be <List A> and the debt ratio will be <List B> under arrangement #2, as
compared with arrangement #1.
A. B. C. D.
List A Higher Higher Lower Lower
List B Higher Lower Higher Lower
- END OF HANDOUTS -

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