Question: 1 This year, Nelson Industries increased earnings before interest and taxes (EBIT) by

17%. During the same period, earnings per share increased by 42%. The degree of
financial leverage that existed during the year is

A. 1.70

B. 5.90

C. 4.20

D. 2.47
Answer (D) is correct.
If earnings before interest and taxes increased by 17%, and earnings per share income
was up 42%, the firm is using leverage effectively. The degree of financial leverage is
the percentage change in earnings per share divided by the percentage change in
EBIT. Accordingly, Nelson’s degree of financial leverage is 2.47 (.42 ÷ .17).

Question: 2 Short-term interest rates are

A. Usually lower than long-term rates.

Answer (A) is correct.
Historically, a facet of the term structure of interest rates (the relationship of yield and
time to maturity) is that short-term interest rates ordinarily have been lower than long-
term rates. One reason is that less risk is involved in the short run. Moreover, future
expectations about interest rates affect the term structure. Most economists believe
that a long-term interest rate is an average of future expected short-term interest rates.
For this reason, the yield curve will (1) slope upward if future rates are expected to
rise, (2) slope downward if interest rates are anticipated to fall, and (3) remain flat if
investors think the rate is stable. Future inflation is incorporated into this relationship.
Another consideration is liquidity preference. Investors in an uncertain world accept
lower rates on short-term investments because of their greater liquidity.

B. Lower than long-term rates during periods of high inflation only.

C. Not significantly related to long-term rates.

D. Usually higher than long-term rates.

Question: 3 What would be the primary reason for a company to agree to a debt covenant limiting
the percentage of its long-term debt?

A. To reduce the risk for existing bondholders.

B. To lower the company’s bond rating.

C. To cause the price of the company’s stock to rise.

D. To reduce the interest rate on the bonds being sold.

 Answer (D) is correct.
The bond indenture is the contractual arrangement between the issuer and the
bondholders. It contains restrictive covenants intended to prevent the issuer from
taking actions contrary to the interests of the bondholders. A trustee, often a bank, is
appointed to ensure compliance. For example, the issuer may be required to (1)
maintain its financial ratios, e.g., the ratio of total long-term debt to equity or times-
interest-earned, at specified levels; (2) limit dividends if earnings do not meet
specified requirements; or (3) restrict the amount of new bonds issued to a percentage
of bondable property (fixed assets). The undertakings in the debt covenant reduce the
risk for holders of the new debt and the default risk premium included in the interest
rate.

Question: 4 Larson Corp. issued $20 million of long-term debt in the current year. What is a major
advantage to Larson with regards to the debt issuance?

A. The reduced earnings per share made possible through financial leverage.

B. The relatively low after-tax cost due to the interest deduction.

Answer (B) is correct.
The most significant advantage of debt is that interest paid on debt is tax deductible.
For a corporation facing a high marginal tax rate, tax savings from the interest
deduction can be substantial.

C. The increased financial risk resulting from the use of the debt.

D. The reduction of Larson’s control over the company.

Question: 5 If Brewer Corporation’s bonds are currently yielding 8% in the marketplace, why is the
firm’s cost of debt lower?

A. Interest is deductible for tax purposes.

Answer (A) is correct.
Because interest is deductible for tax purposes, the actual cost of debt capital is the
net effect of the interest payment and the offsetting tax deduction. The actual cost of
debt equals the interest rate times the difference of 1 minus the marginal tax rate.
Thus, if a firm with an 8% market rate is in a 40% tax bracket, the net cost of the debt
capital is 4.8% [8% × (1.0 – .40)].

B. There should be no difference; cost of debt is the same as the bonds’ market yield.

C. Market interest rates have increased.

D. Additional debt can be issued more cheaply than the original debt.

Question: 6 The term structure of interest rates is the relationship of

A. The maturity dates of an issuance of bonds.

B. Interest rates over different structures of securities.

 C. Interest rates over different structures of bonds.

D. Interest rates over time.

Answer (D) is correct.
The term structure of interest rates is the relationship of interest rates and years to
maturity. Corporate CFOs use the term structure to decide whether to borrow short-
term debt or long-term debt. Investors use the term structure to decide whether to buy
short-term or long-term bonds.

Question: 7 A curve on a graph with the rate of return on the vertical axis and time on the horizontal
axis depicts

A. The present value of future returns, discounted at the marginal cost of capital, minus
the present value of the cost.

B. A series of payments of a fixed amount for a specified number of years.

C. A yield curve showing the term structure of interest rates.

Answer (C) is correct.
The term structure of interest rates is the relationship between long- and short-term
interest rates, that is, between yield to maturity and time to maturity. It is graphically
depicted by a yield curve with a rate of return on the vertical axis and time to maturity
on the horizontal axis. In general, the longer the term of a bond, the higher the return
(yield) demanded by investors to compensate for increased risk.

D. The internal rate of return on an investment.

Question: 8 The term structure of interest rates is depicted by a yield curve. What variables are
plotted on the horizontal axis and on the vertical axis?

A. Real risk-free rate and the inflation rate, respectively.

B. Years to maturity and the interest rates, respectively.

Answer (B) is correct.
The term structure of interest rates is the relationship between long- and short-term
interest rates. The term structure is graphically depicted by a yield curve. The interest
rate is plotted on the vertical axis, and the years to maturity is plotted on the
horizontal axis. The yield curve may change in both slope and position over time.

C. Interest rates and the inflation rates, respectively.

D. Years to maturity and the real risk-free rate, respectively.

Question: 9 The yield curve depicting the term structure of interest rates

A. Is usually downward sloping.

 B. Shows the relationship between inflation and years to maturity.

C. Never changes its slope.

D. Is usually upward sloping.

Answer (D) is correct.
A normal yield curve is upward sloping, reflecting the fact that issuers of longer-term
debt must offer higher yields to compensate for increased risk.

Question: 10
The yield curve
shown implies
that the

A. Short-term interest rates have a higher annualized yield than long-term rates.

B. Credit risk premium of corporate bonds has increased.

C. Credit risk premium of municipal bonds has increased.

D. Long-term interest rates have a higher annualized yield than short-term rates.
Answer (D) is correct.
The term structure of interest rates is the relationship between yield to maturity and
time to maturity. This relationship is depicted by a yield curve. Assuming the long-
term interest rate is an average of expected future short-term rates, the curve will be
upward sloping when future short-term interest rates are expected to rise.
Furthermore, the normal expectation is for long-term investments to pay higher rates
because of their higher risk. Thus, long-term interest rates have a higher annualized
yield than short-term rates.

Question: 11 Which of the following types of bonds is most likely to maintain a constant market
value?

A. Convertible.

B. Callable.

C. Zero-coupon.
 D. Floating-rate.
Answer (D) is correct.
Floating-rate bonds are most likely to maintain their constant market value because
their return varies with market conditions.

Question: 12 Serial bonds are attractive to investors because

A. The yield to maturity is the same for all bonds in the issue.

B. The coupon rate on these bonds is adjusted to the maturity date.

C. All bonds in the issue mature on the same date.

D. Investors can choose the maturity that suits their financial needs.
Answer (D) is correct.
Serial bonds have staggered maturities. They mature over a period (series) of years.
Thus, investors can choose the maturity date that meets their investment needs. For
example, an investor who will have a child starting college in 16 years can choose
bonds that mature in 16 years.

Question: 13 Which one of the following characteristics distinguishes income bonds from other
bonds?

A. By promising a return to the bondholder, an income bond is junior to preferred and

common stock.

B. Income bonds are junior to subordinated debt but senior to preferred and common
stock.

C. The bondholder is guaranteed an income over the life of the security.

D. Income bonds pay interest only if the issuing company has earned the interest.
Answer (D) is correct.
An income bond is one that pays interest only if the issuing company has earned the
interest, although the principal must still be paid on the due date. Such bonds are
riskier than normal bonds.

Question: 14 If a $1,000 bond sells for $1,125, which of the following statements are true?

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 bond sells at a premium.
IV. The bond sells at a discount.
V.
A. I and IV.
 B. II and IV.

C. II and III.
Answer (C) is correct.
The excess of the price over the face value is a premium. A premium is paid because
the coupon rate on the bond is greater than the market rate of interest. Thus, because
the bond is paying a higher rate than other similar bonds, its price is bid up by
investors.

D. I and III.

Question: 15 Debentures are

A. Income bonds that require interest payments only when earnings permit.

B. Bonds secured by the full faith and credit of the issuing firm.
Answer (B) is correct.
Debentures are unsecured bonds. Although no assets are mortgaged as security for the
bonds, debentures are secured by the full faith and credit of the issuing firm.
Debentures are a general obligation of the borrower. Only a firm with the best credit
rating can issue debentures because only its credit rating and reputation secure the
bonds.

C. Subordinated debt and rank behind convertible bonds.

D. A form of lease financing similar to equipment trust certificates.

Question: 16 Junk bonds are

A. Securities rated at less than investment grade.

Answer (A) is correct.
Junk bonds are high-risk and therefore high-yield securities that are normally issued
when the debt ratio is very high. Thus, the bondholders have as much risk as the
holders of equity securities. Such bonds are not highly rated by credit evaluation
companies. Junk bonds have become accepted because of the tax deductibility of the
interest paid.

B. Securities that are highly risky but offer only low yields.

C. Considered illegal.

D. Worthless securities.

Question: 17 Which one of the following statements is true when comparing bond financing
alternatives?

A. A convertible bond must be converted to common stock prior to its maturity.

 B. A call provision is generally considered detrimental to the investor.
Answer (B) is correct.
A callable bond can be recalled by the issuer prior to maturity. A call provision is
detrimental to the investor because the issuer can recall the bond when market interest
rates decline. It is usually exercised only when a company wishes to refinance high-
interest debt.

C. A bond with a call provision typically has a lower yield to maturity than a similar bond
without a call provision.

D. A call premium requires the investor to pay an amount greater than par at the time of
purchase.

Question: 18 From an investor’s viewpoint, the least risky type of bond in which to invest is a(n)

A. Mortgage bond.
Answer (A) is correct.
A mortgage bond is backed by tangible property, making it the safest type for the
investor of the four listed.

B. Debenture bond.

C. Income bond.

D. Deep discount bond.

Question: 19 All of the following may allow a firm to set a lower coupon rate on a bond issued at
par except a

A. Higher rating from a bond rating agency.

B. Conversion option.

C. Call provision.
Answer (C) is correct.
A bond issued at par may carry a lower coupon rate than other similar bonds in the
market if it has some feature that makes it more attractive to investors. For example, a
sinking fund reduces default risk. Hence, investors may require a lower risk premium
and be willing to accept a lower coupon rate. Other features attractive to investors
include covenants in the bond indenture that restrict risky undertakings by the issuer
and an option to convert the debt instruments to equity securities. The opportunity to
profit from appreciation of the firm’s stock justifies a lower coupon rate. An
improvement in a bond’s rating from AA to AAA (the highest possible) also justifies
reduction in the risk premium and a lower coupon rate. However, a call provision is
usually undesirable to investors. The issuer may take advantage of a decline in
interest rates to recall the bond and stop paying interest before maturity.

D. Sinking fund.
Question: 20 If a bond sells at a premium, the

A. Bond purchase price must be lower than the face amount of the bond.

B. Stated coupon rate must be more than the required market rate.
Answer (B) is correct.
If the stated, or coupon, rate of a bond is higher (lower) than the effective, or market,
rate on the date of issue, the bonds sell at a premium (discount).

C. Nominal rate must be less than the yield rate.

D. Stated coupon rate must be less than the required market rate.

Question: 21 A company issued a 15-year, $1,000 par value bond. The coupon rate on this bond is
9% annually, with interest being paid each 6 months. The investor who purchased the
bond expects to earn a 12% nominal rate of return.

Present Value of an Ordinary Annuity Present Value of a Single Amount

% 15 Periods 30 Periods 15 Periods 30 Periods

4.5 10.740 16.289 0.517 0.267

6 9.712 13.765 0.417 0.174

9 8.061 10.274 0.275 0.075

12 6.811 8.055 0.183 0.033

The cash proceeds received by the company from the investor totaled

A. $796.00

B. $619.43

C. $793.43
Answer (C) is correct.
The cash flows consist of interest of $45 [($1,000 × 9%) × 0.5] every 6 months for 15
years (30 periods), and $1,000 at the end of the 30th interest period. The 12%
discount rate translates to 6% every 6 months. Thus, the calculation is
Periodic interest ($45 × 13.765) $619.43
 Maturity ($1,000 × .174) 174.00
amount

Total proceeds $793.43

D. $950.75

Question: 22 What is the price of a 10-year, 10% coupon bond with a $1,000 face value if investors
require a 12% return? Assume annual coupon payments.

Present Value of an Ordinary Annuity

% 10 Periods

10 6.14

12 5.65

Present Value of $1
% 10 Periods
10 .386
12 .322

A. $322.00

B. $604.50

C. $887.00
Answer (C) is correct.
The price of the bond is equal to the sum of present value of the face value of the
bond and the present value of the interest payments. Thus, the price is $887.00
[($1,000 × .322 PV factor) + ($100 × 5.65 PV factor)].

D. $565.00

Question: 23 Which one of the following factors might cause a firm to increase the portion of debt in
its financial structure?
 A. Increased economic uncertainty.

B. An increase in the federal funds rate.

C. A decrease in the firm’s cost of equity.

D. An increase in the corporate income tax rate.

Answer (D) is correct.
An increase in the corporate income tax rate might encourage a company to borrow
because interest on debt is tax deductible, whereas dividends are not. Accordingly, an
increase in the tax rate means that the after-tax cost of debt capital will decrease.
Given equal interest rates, a firm with a high tax rate will have a lower after-tax cost
of debt capital than a firm with a low tax rate.

Question: 24 Which of the following observations regarding the valuation of bonds is correct?

A. The market value of a discount bond is greater than its face value during a period of
rising interest rates.

B. For a given change in the required return, the shorter its maturity, the greater the change
in the market value of the bond.

C. When interest rates rise so that the required rate of return increases, the market value of
the bond will increase.

D. When the market rate of return is less than the stated coupon rate, the market value of
the bond will be more than its face value, and the bond will be selling at a premium.
Answer (D) is correct.
When the bonds’ stated rate is higher than the market rate, investors are willing to pay
more for the bonds since their periodic interest payments are higher than those
currently available in the market. In this case, the issuer receives more cash than the
par value and the bonds are said to be sold at a premium.

Question: 25 An individual holds a 10-year fixed-rate bond as an investment. Three years of its life
remain. When the bond was issued, interest rates were much higher than they are now.
Interest rates are expected to be stable for the next 3 years. Which of the following
statements is correct regarding the bond?

A. The bond will increase in value during the next 3 years.

B. The bond will become more sensitive to changes in interest rates during the next
3 years.

C. The bond is currently selling at a discount.

D. The bond is currently selling at a premium.

Answer (D) is correct.
When the bonds’ stated rate is higher than the market rate, investors are willing to pay
 more for the bond since their periodic interest payments are higher than those
currently available in the market. In this case, the issuer receives more cash than the
par value and the bonds are said to be sold at a premium.

Question: 26 Future payments must be discounted in a bond valuation in order to take into account
the

A. Fact that the bond was sold at a premium.

B. Expected interest rate on the coupon payments.

C. Difference between the market rate of interest and the coupon rate.

D. Time value of money.

Answer (D) is correct.
Determining the value of a bond is performed by calculating the present value of a
bond’s future principal and interest payments using the market rate of interest as a
discount factor. Discounting assumes that the present value of the payments today will
be invested at the market interest rate to return the amounts specified by the bond in
the future as the bond matures. Therefore, the purpose of discounting future payments
is to consider the time value of money.

Question: 27 Company ABC and Company XYZ have the same income-generating capacity and
amount of assets, and their average tax rate is 30%. Only their capital structures differ.
ABC is fully equity-financed, but XYZ is financed by permanent debt and equity. ABC
has a value of $5,000,000, and its equity is $2,000,000 greater than XYZ’s. If XYZ has
an incremental borrowing rate of 6% and an interest rate on debt of 5%, its value is

A. $3,000,000

B. $7,000,000

C. $5,000,000

D. $5,600,000
Answer (D) is correct.
The value of a levered firm is the value of an unlevered firm plus the present value of
the tax savings from deductions of interest. ABC is unlevered because it is fully
equity-financed. Given that ABC is unlevered, its value of $5,000,000 equals its
equity (assets – $0 liabilities = equity). Given also that ABC’s equity is $2,000,000
greater than XYZ’s, and the two companies have the same amount of assets
($5,000,000), XYZ must have $2,000,000 of permanent debt. For permanent debt, the
present value of tax savings is the product of the amount of debt and the tax rate. The
value of the tax savings therefore is $600,000 ($2,000,000 × 30%). The value of XYZ
is $5,600,000 ($5,000,000 value of ABC + $600,000).

Question: 28 In the current year, Company A has a degree of total leverage (DTL) of 8 and a degree
of financial leverage (DFL) of 2. If sales in dollars are twice that of the previous year,
what is the percentage change in EBIT in the current year?
 A. 400%
Answer (A) is correct.
The DTL (8) is the product of the degree of operating leverage (DOL) and the DFL
(2). The DOL therefore is 4 (8 ÷ 2). The DOL is the ratio that measures the effect that
given fixed operating costs have on earnings. It equals the percentage change in
earnings before interest and taxes (EBIT) divided by the percentage change in sales.
Thus, the percentage change in EBIT in the current year is 400% (DOL of 4 × 100%
change in sales).

B. 200%

C. 800%

D. 100%

Question: 29 The stock of Fargo Co. is selling for $85. The next annual dividend is expected to be
$4.25 and is expected to grow at a rate of 7%. The corporate tax rate is 30%. What
percentage represents the firm’s cost of common equity?

A. 12.0%
Answer (A) is correct.
The cost of common stock may be calculated using a form of the dividend growth
model. It is based on the assumption that common shareholders demand dividends
that increase at a constant rate.
Percentage=(Net dividend ÷ Net issue proceeds) + Dividend growth rate
cost

=($4.25 ÷ $85) + 7%

=5% + 7%

=12%

B. 5.0%

C. 7.0%

D. 8.4%

Question: 30 The benefits of debt financing over equity financing are likely to be highest in which of
the following situations?

A. High marginal tax rates and few noninterest tax benefits.

Answer (A) is correct.
Interest paid on debt is tax deductible. Thus, debt financing decreases taxable income,
and higher marginal tax rates are avoided. In contrast, dividends paid are not
deductible. Consequently, they do not reduce taxable income, and higher marginal tax
rates are not avoided. Moreover, when the benefits of equity financing (e.g., lack of
 fixed payments) are few, debt is more attractive.

B. Low marginal tax rates and few noninterest tax benefits.

C. Low marginal tax rates and many noninterest tax benefits.

D. High marginal tax rates and many noninterest tax benefits.

Question: 31Each share of nonparticipating, 8%, cumulative preferred stock in a company that meets its dividend
obligations has all of the following characteristics except

A. Voting rights in corporate elections.

Answer (A) is correct.
Dividends on cumulative preferred stock accrue until declared. That is, the carrying amount of the
preferred stock increases by the amount of any undeclared dividends. Participating preferred stock
participates with common shareholders in excess earnings of the firm. Accordingly, 8% participating
preferred stock might pay a dividend each year greater than 8% when the corporation is extremely
profitable. Thus, nonparticipating preferred stock will receive no more than what is stated on the face of
the stock. Preferred shareholders rarely have voting rights. Voting rights are exchanged for preferences
regarding dividends and liquidation of assets.

B. Dividend payments that are not tax deductible by the company.

C. No principal repayments.

D. A superior claim to common stock equity in the case of liquidation.

Question: 32 Which of the following factors is inherent in a firm’s operations if it utilizes only equity
financing?

A. Marginal risk.

B. Financial risk.

C. Interest rate risk.

D. Business risk.
Answer (D) is correct.
Business risk is the risk inherent in ongoing operations. It depends on general
economic factors, such as demand variability, input price variability, and phase of the
business cycle, and the level of operating leverage. It specifically excludes the effects
of the financial risk encountered when using financial leverage.

Question: 33 In general, it is more expensive for a company to finance with equity capital than with
debt capital because

A. Long-term bonds have a maturity date and must therefore be repaid in the future.
 B. Investors are exposed to greater risk with equity capital.
Answer (B) is correct.
Providers of equity capital are exposed to more risk than are lenders because the firm
is not obligated to pay them a return. Also, in case of liquidation, creditors are paid
before equity investors. Thus, equity financing is more expensive than debt because
equity investors require a higher return to compensate for the greater risk assumed.

C. Equity capital is in greater demand than debt capital.

D. Dividends fluctuate to a greater extent than interest rates.

Question: 34 Which of the following statements is (are) correct regarding corporate debt and equity
securities?

I. Both debt and equity security holders have an ownership interest in the
corporation.
II. Both debt and equity securities have an obligation to pay income.

A. I only.

B. Both I and II.

C. Neither I nor II.

Answer (C) is correct.
Debt holders have no ownership interest in the corporation. A legal obligation to
provide income (pay interest) only exists for debt holders.

D. II only.

Question: 35Bander Co. is determining how to finance some long-term projects. Bander has decided it prefers the
benefits of no fixed charges, no fixed maturity date, and an increase in the credit-worthiness of the company. Which
of the following would best meet Bander’s financing requirements?

A. Common stock.
Answer (A) is correct.
The greatest disadvantage of debt financing is increased risk. Payments on debt must be made at fixed
times, whether or not the debtor is profitable, and must be fully repaid by a fixed maturity date. Equity
financing avoids this risk. It benefits companies that want to raise a large amount of capital and enhance
creditworthiness.

B. Long-term debt.

C. Short-term debt.

D. Bonds.
Question: 36 Which of the following is considered a corporate equity security?

A. A shareholder’s appraisal right.

B. A share of callable preferred stock.

Answer (B) is correct.
Preferred stock is a form of equity security that has attributes of both debt and equity.
It has a fixed charge, but payment of dividends is not an obligation.

C. A shareholder’s preemptive right.

D. A callable bond.

Question: 37 Preferred and common stock differ in that

A. Common stock dividends are a fixed amount, while preferred stock dividends are not.

B. Preferred stock has a higher priority than common stock with regard to earnings and
assets in the event of bankruptcy.
Answer (B) is correct.
In the event of bankruptcy, the claims of preferred shareholders must be satisfied
before common shareholders receive anything. The interests of common shareholders
are secondary to those of all other claimants.

C. Preferred stock dividends are deductible as an expense for tax purposes, while common
stock dividends are not.

D. Failure to pay dividends on common stock will not force the firm into bankruptcy,
while failure to pay dividends on preferred stock will force the firm into bankruptcy.

Question: 38 Unless the shares are specifically restricted, a holder of common stock with a
preemptive right may share proportionately in all of the following except

A. The vote for directors.

B. Cumulative dividends.
Answer (B) is correct.
Common stock does not have the right to accumulate unpaid dividends. This right
often is attached to preferred stock.

C. New issues of stock of the same class.

D. Corporate assets upon liquidation.

Question: 39 The following excerpt was taken from a company’s financial statements: “ . . . 10%
convertible participating . . . $10,000,000.” What is most likely being referred to?
 A. Stock options.

B. Bonds.

C. Common stock.

D. Preferred stock.
Answer (D) is correct.
Preferred shareholders have priority over common shareholders in the assets and
earnings of the enterprise. If preferred dividends are cumulative, any past preferred
dividends must be paid before any common dividends. Preferred stock also may be
convertible into common stock, and it may be participating. For example, 10% fully
participating preferred stock will receive additional distributions at the same rates as
other shareholders if dividends paid to all shareholders exceed 10%.

Question: 40 Which of the following is usually not a feature of cumulative preferred stock?

A. Has priority over common stock with regard to assets.

B. Has priority over common stock with regard to earnings.

C. Has voting rights.

Answer (C) is correct.
Preferred stock usually does not have voting rights. Preferred shareholders have the
right to vote for directors only if the firm has not paid the preferred dividend for a
specified period of time, such as ten quarters. This provision is an incentive for
management to pay preferred dividends.

D. Has the right to receive dividends in arrears before common stock dividends can be
paid.

Question: 41 Which one of the following statements is correct regarding the effect preferred stock has
on a company?

A. Control of the firm is now shared by the common and preferred shareholders, with
preferred shareholders having greater control.

B. Nonpayment of preferred dividends places the firm in default, as does nonpayment of

interest on debt.

C. Preferred shareholders’ claims take precedence over the claims of common

shareholders in the event of liquidation.
Answer (C) is correct.
Preferred shareholders have priority over common shareholders in relation to
dividend and liquidation rights, but payment of preferred dividends, unlike bond
interest, is not mandatory. In exchange for these preferences, the preferred
shareholders give up the right to vote. Consequently, preferred stock is a hybrid of
debt and equity.
 D. The firm’s after-tax profits are shared equally by common and preferred shareholders.

Question: 42 Which of the following corporate characteristics would favor debt financing versus
equity financing?

A. A high tax rate.

Answer (A) is correct.
One of the significant advantages of debt financing is that interest paid on debt is tax
deductible. For a corporation that has a high tax rate, tax savings from the interest
deduction can be substantial.

B. Below average stock issuing costs.

C. Low aversion to risk.

D. A high debt-to-equity ratio.

Question: 43 What is the maximum amount Alpha Co. can raise through crowdfunding in a 12-month
period?

A. $200,000

B. $500,000

C. $100,000

D. $1,070,000
Answer (D) is correct.
According to the SEC’s Regulation Crowdfunding, a company may raise a maximum
aggregate amount of $1,070,000 through crowdfunding offerings in a 12-month
period.

Question: 44 Kevin has a $900,000 annual income and wants to make his first crowdfunding
investment. In a 12-month period, Kevin may invest up to

A. The greater of $2,200 or 5% of the lesser of his annual income or net worth.

B. 10% of the lesser of his annual income or net worth.

Answer (B) is correct.
According to the SEC’s Regulation Crowdfunding, individual investments in all
crowdfunding issuers over a 12-month period are limited as follows: (1) if the
investor’s annual income or net worth is less than $107,000, investment is limited to
the greater of $2,200 or 5% of the lesser of annual income or net worth; (2) if the
investor’s annual income and net worth is $107,000 or more, investment is limited to
10% of the lesser of annual income or net worth. Because Kevin’s annual income is
$900,000, his investment is limited to 10% of the lesser of annual income or net
worth.
 C. 20% of the lesser of his annual income or net worth.

D. 5% of the lesser of his annual income or net worth.

Question: 45 Talon has $80,000 in annual income and a net worth of $500,000. In order to comply
with the SEC’s investment limitation in Regulation Crowdfunding, how much may Talon
invest through crowdfunding in a 12-month period?

A. $2,200

B. $25,000

C. $4,000
Answer (C) is correct.
According to the SEC’s Regulation Crowdfunding, individual investments in all
crowdfunding issuers over a 12-month period for an investor whose annual income or
net worth is less than $107,000 are limited to the greater of $2,200 or 5% of the lesser
of annual income or net worth. The lesser of Talon’s annual income or net worth is
$80,000. Five percent of that is $4,000, which is greater than $2,200. Thus, Talon’s
investment is limited to $4,000.

D. $8,000

Question: 46 In the current 12-month period, a wealthy angel investor has invested $55,000 in equity
funds registered under Regulation Crowdfunding. This investor’s annual income is
$4,560,000, which is less than the investor’s net worth. How much can the investor
invest in Company Y’s crowdfunding equity fund?

A. $228,000

B. $456,000

C. $107,000

D. $52,000
Answer (D) is correct.
According to the SEC’s Regulation Crowdfunding, if an investor’s annual income or
net worth is $107,000 or more, investments in all crowdfunding issuers over a 12-
month period is limited to 10% of the lesser of annual income or net worth. For the
angel investor, the investment limit is $456,000 (10% × $4,560,000). However, the
aggregate amount of securities sold to an investor through all crowdfunding offerings
may not exceed $107,000. The angel investor has already invested $55,000 in other
equity funds registered under Regulation Crowdfunding, so the investor can still
invest, at most, $52,000 ($107,000 limitation – $55,000 invested) in Company Y’s
crowdfunding equity fund.

Question: 47 Kim wants to invest in Beta Company’s crowdfunding equity fund. In the current 12-
month period, Kim has invested $25,000 in other equity funds registered under
Regulation Crowdfunding. Her annual income is $900,000, and her net worth is
 $1,500,000. How much can she invest in Beta’s crowdfunding equity fund?

A. $108,000

B. $65,000
Answer (B) is correct.
According to the SEC’s Regulation Crowdfunding, if an investor’s annual income and
net worth is $107,000 or more, individual investments in all crowdfunding issuers
over a 12-month period is limited to 10% of the lesser of annual income or net worth.
Thus, Kim is limited to $90,000 (10% × $900,000). Because she has already invested
$25,000 in other equity funds registered under Regulation Crowdfunding, she can still
invest, at most, $65,000 ($90,000 limitation – $25,000 invested) in Beta Company’s
crowdfunding equity fund.

C. $75,000

D. $90,000

Question: 48 Company Z failed to comply with the reporting requirements under Regulation
Crowdfunding. What is the maximum amount Company Z can raise through
crowdfunding securities over a 12-month period?

A. $1,070,000

B. $107,000

C. $0
Answer (C) is correct.
According to the SEC’s Regulation Crowdfunding, some companies are not eligible
to issue securities through crowdfunding. These companies include foreign
companies, certain investment companies, and companies that have failed to comply
with the reporting requirements under Regulation Crowdfunding. Company Z failed
to comply with the reporting requirements under Regulation Crowdfunding, so it is
prohibited from issuing crowdfunding securities.

D. $500,000

Question: 49 A company raising funds under Regulation Crowdfunding must disclose all of the
following except

A. Information about owners of 10% or more of the company.

Answer (A) is correct.
According to Regulation Crowdfunding, companies are required to provide certain
disclosures about the company’s financial condition. Required information includes
(1) financial statements that are based on the company’s tax returns and reviewed or
audited by an independent CPA; (2) a description of the business and the use of the
proceeds from crowdfunding; (3) information about officers, directors, and owners of
20% or more of the company; and (4) material related party transactions. Disclosure
is required for the information about owners of 20% or more of the company, not 10%
or more of the company.
 B. Material related party transactions.

C. Financial statements that are based on the company’s tax returns and reviewed or
audited by an independent CPA.

D. A description of the business and the use of the proceeds from crowdfunding.

Question: 50 A company raising funds under Regulation Crowdfunding must disclose all of the
following except

A. Information about officers, directors, and owners of 20% or more of the company.

B. The target crowdfunding amount.

C. Material related party transactions.

D. Financial statements based on the company’s tax returns that have not been reviewed or
audited by an independent CPA.
Answer (D) is correct.
According to Regulation Crowdfunding, companies are required to provide certain
disclosures including the price of the securities, the target crowdfunding amount, the
deadline of the crowdfunding, whether the firm will accept investments in excess of
the target amount, and information about the company’s financial condition, such as
(1) financial statements that are based on the company’s tax returns and reviewed or
audited by an independent CPA; (2) a description of the business and the use of the
proceeds from crowdfunding; (3) information about officers, directors, and owners of
20% or more of the company; and (4) material related party transactions.

Question: 51 What kind of platform can a company use to raise funds through crowdfunding?

I. Any crowdfunding platform.

II. A crowdfunding platform registered with the SEC.
III. Any internal company program.

A. II only.
Answer (A) is correct.
According to Regulation Crowdfunding, companies choosing to use crowdfunding
must use a crowdfunding platform registered with the SEC.

B. I only.

C. II and III only.

D. I and III only.

Question: XX A company raising funds under Regulation Crowdfunding must disclose

 I. The crowdfunding deadline
II. Information about the company’s financial condition
III. Financial statements that have been audited by an internal auditor
IV. The price of the securities

A. I, II, III, and IV.

B. I, II, and IV only.

Answer (B) is correct.
According to Regulation Crowdfunding, companies are required to provide certain
disclosures including the price of the securities, the target crowdfunding amount, the
deadline of the crowdfunding, whether the firm will accept investments in excess of
the target amount, and information about the company’s financial condition, such as
(1) financial statements that are based on the company’s tax returns and reviewed or
audited by an independent CPA; (2) a description of the business and the use of the
proceeds from crowdfunding; (3) information about officers, directors, and owners of
20% or more of the company; and (4) material related party transactions. The
disclosed financial statements should be reviewed or audited by an independent CPA,
not an internal auditor.

C. II, III, and IV only.

D. I and III only.

Question: 52 Which companies are not eligible to issue securities through crowdfunding?

I. Foreign companies.
II. Companies that have raised $100,000 through crowdfunding offerings in the
current 12-month period.
III. Companies that have failed to comply with the reporting requirements under
Regulation Crowdfunding.

A. I, II, and III.

B. II and III only.

C. I and III only.

Answer (C) is correct.
Some companies are not eligible to issue securities through crowdfunding. These
companies include foreign companies, certain investment companies, and companies
that have failed to comply with the reporting requirements under Regulation
Crowdfunding. A company may raise a maximum aggregate amount of $1,070,000
through crowdfunding offerings in a 12-month period. Thus, a company that has
 raised $100,000 is eligible to raise more money through crowdfunding offerings.

D. I only.

Question: 53 Bates Corp. has $100,000 in bonds payable with a fair market value of $120,000. It also
has 1,000 shares of common stock issued at $50 per share with a fair market value of
$80 per share. What amount represents the corporation’s market capitalization?

A. $80,000
Answer (A) is correct.
The market capitalization of a company is equal to the shares of common stock
outstanding times the fair market value per share. Thus, Bates has a market
capitalization of $80,000 (1,000 × $80).

B. $180,000

C. $50,000

D. $170,000

Question: 54 A stock priced at $50 per share is expected to pay $5 in dividends and trade for $60 per
share in one year. What is the expected return on this stock?

A. 10%

B. 20%

C. 30%
Answer (C) is correct.
The expected return on a stock is the sum of expected dividends and appreciation in
stock price divided by initial stock price. The stock has an expected dividend and
appreciation in stock price of $5 and $10, respectively. Therefore, the expected return
on the stock is 30% [($5 + $10) ÷ $50].

D. 25%

Question: 55 Dividends are equal to $5, and the current share price is $50. Dividends are expected to
grow at 2% forever. According to the dividend growth model, what is the investor’s
required rate of return?

A. 8.2%

B. 10.0%

C. 12.2%
Answer (C) is correct.
The dividend growth model assumes that dividends per share and price per share
 increase at the same constant rate (which can be positive or negative). The required
rate of return (the cost of common stock) can be derived from the dividend growth
model.
D1
r= +g
P0

P0 = Current stock price per share

D1 = Dividends per share expected next year
r = Required rate of return (discount rate)
g = Growth rate (constant)

Required rate of $5 × (1 + 2%)

= + 2%
return $50
=12.2%

D. 12.0%

Question: 56 Sharif Co. has total debt of $420,000 and equity of $700,000. Sharif is seeking capital to
fund an expansion. Sharif is planning to issue an additional $300,000 in common stock
and is negotiating with a bank to borrow additional funds. The bank requires a debt-to-
equity ratio of .75. What is the maximum additional amount Sharif will be able to
borrow?

A. $525,000

B. $750,000

C. $330,000
Answer (C) is correct.
Sharif will have $1 million ($700,000 + $300,000) in total equity. The debt-to-equity
restriction allows up to $750,000 ($1,000,000 × .75) in debt. Sharif already has
$420,000 in debt, so the additional borrowing cannot exceed $330,000 ($750,000 –
$420,000).

D. $225,000

Question: 57 A company currently has 1,000 shares of common stock outstanding with zero debt. It
has the choice of raising an additional $100,000 by issuing 9% long-term debt or issuing
500 shares of common stock. The company has a 40% tax rate. What level of earnings
before interest and taxes (EBIT) would result in the same earnings per share (EPS) for
the two financing options?

A. An EBIT of $27,000 would result in EPS of $7.20 for both.

B. An EBIT of $(10,800) would result in EPS of $(7.92) for both.

C. An EBIT of $27,000 would result in EPS of $10.80 for both.
Answer (C) is correct.
EPS = net income ÷ weighted average shares of common stock outstanding. If new
debt is issued EPS = [(1 – tax rate) × (EBIT – interest)] ÷ weighted average
outstanding shares, interest expense will be $9,000 per year ($100,000 face amount ×
9% coupon rate); if new common stock is issued EPS = [EBIT × (1 – tax rate)] ÷
weighted average outstanding shares, interest expense will continue to be zero. To
solve the EBIT that would result in the same EPS for the two financing options, the
following equation should be solved:
[(1 – 0.4) × (EBIT – $9,000)] ÷ 1,000=[EBIT × (1 – 0.4)] ÷ (1,000 + 500)

[0.6 × (EBIT – $9,000)] ÷ 1,000=(0.6 × EBIT) ÷ 1,500

(0.6EBIT – $5,400) × 1.5=0.6EBIT

0.9EBIT – $8,100=0.6EBIT

0.3EBIT=$8,100

EBIT=$27,000

Common

Debt Shares

Earnings before interest and taxes $27,000 $27,000

Minus: Interest expense (9,000) 0

Earnings before taxes $18,000 $27,000

Minus: Income tax expense (40%) (7,200) (10,800)

Income available to common shareholders $10,800 $16,200

 Divided by: Common shares ÷ 1,000 ÷ 1,500
outstanding

Earnings per share $ 10.80 $ 10.80

D. An EBIT of $(18,000) would result in EPS of $(7.20) for both.

Question: 58 The relationship of the total debt to the total equity of a corporation is a measure of

A. Break even.

B. Profitability.

C. Liquidity.

D. Creditor risk.
Answer (D) is correct.
The debt-to-equity ratio is a measure of risk to creditors. It indicates how much equity
is available to absorb losses before the interests of debt holders are impaired. The less
leveraged the firm, the safer the creditors’ interests.

Question: 59If the ratio of total liabilities to equity increases, a ratio that must also increase is

A. Total liabilities to total assets.

Answer (A) is correct.
Because total assets equal the sum of liabilities and equity, a factor that increases the liabilities-to-equity
ratio also increases the liabilities-to-assets ratio.

B. The current ratio.

C. Return on equity.

D. Times interest earned.

Fact Pattern: The data presented below show actual figures for selected accounts of McKeon Company
for the fiscal year ended May 31, Year 1, and selected budget figures for the Year 2 fiscal year. McKeon’s
controller is in the process of reviewing the Year 1 figures and calculating some key ratios based on the
actual figures. (Round all calculations to three decimal places if necessary.)
5/31/Year 2 5/31/Year 1

Current assets $210,000 $180,000

 Noncurrent assets 275,000 255,000
Current liabilities 78,000 85,000
Long-term debt 75,000 30,000
Common stock ($30 par 300,000 300,000
value)
Retained earnings 32,000 20,000
Year 1
Operations

Sales* $350,000
Cost of goods sold 160,000
Interest expense 3,000
Income taxes (40% rate) 48,000
Dividends declared and paid in Year 1 60,000
Administrative expense 67,000
*All sales are credit sales.
Current Assets

5/31/Year 2 5/31/Year 1

Cash $ 20,000 $10,000

Accounts 100,000 70,000

receivable

Inventory 70,000 75,000

Prepaid expenses 20,000 20,000

Question: 60 McKeon Company’s debt ratio for Year 2 is

A. 0.352

B. 0.315
Answer (B) is correct.
The debt ratio is equal to the total debt at year end divided by total assets at year
end. Total debt at year end is $153,000 ($78,000 current liabilities + $75,000 long-
term debt). Total assets equal $485,000 ($210,000 current assets + $275,000
noncurrent assets). Thus, the debt ratio is .315 ($153,000 ÷ $485,000).

C. 0.237

D. 0.264
Fact Pattern:
Selected data from Ostrander Corporation’s financial statements for the years indicated are presented in
thousands.

Year 2 Operations December 31

Net credit sales $4,175 Year 2 Year 1

Cost of goods sold 2,880
Interest expense 50 Cash $ 32 $ 28
Income tax 120 Trading securities 169 172
Gain on disposal of a segment Accounts receivable (net) 210 204
(net of tax) 210 Merchandise inventory 440 420
Administrative expense 950 Tangible fixed assets 480 440
Net income 385 Total assets 1,397 1,320
Current liabilities 370 368
Total liabilities 790 750
Common stock 226 210
outstanding
Retained earnings 381 360
Question: XX The total debt-to-equity ratio for Ostrander Corporation
in Year 2 is

A. 1.30
Answer (A) is correct.
Total equity consists of the $226 of capital stock
and $381 of retained earnings, or $607. Debt is
given as the $790 of total liabilities. Thus, the
ratio is 1.30 ($790 ÷ $607).

B. 2.07

C. 0.77

D. 3.49

Question: 61 A company has income after tax of $5.4 million, interest expense of $1 million for the
year, depreciation expense of $1 million, and a 40% tax rate. What is the company’s
times-interest-earned ratio?

A. 5.4

B. 10.0
Answer (B) is correct.
The times-interest-earned ratio is earnings before interest and taxes divided by interest
expense. The after-tax income is given as $5.4 million. Therefore, the before-tax
income is $9 million ($5.4 million ÷ 0.6). Adding the $1 million interest expense
results in $10 million earnings before interest and taxes. This amount divided by the
 $1 million interest expense results in a times-interest-earned ratio of 10.0 ($10 million
÷ $1 million).

C. 7.4

D. 6.4

Question: 62 Southern Corp. has a debt-to-equity ratio of 1.75 and total assets of $275 million.
Southern is considering issuing another $20 million of debt and another $20 million of
equity. What will be Southern’s debt-to-equity ratio after the issuance?

A. 1.63
Answer (A) is correct.
The first step is determining the initial amount of Debt (D) and Equity (E). Assets (A)
= D + E, and the debt-to-equity ratio is D ÷ E. These two equations can be applied as
follows:
D ÷ E=1.75
D=1.75E
A=D + E
$275 million=1.75E + E
$275 million=2.75E
$100 million=E
D ÷ $100 million=1.75
D=$175 million

If Southern Corp. issues another $20 million of debt and another $20 million of
equity,

E = $100 million + $20 million = $120 million

D = $175 million + $20 million = $195 million

Thus, the debt-to-equity ratio after issuance of new debt and new equity is 1.63 ($195
million ÷ $120 million).

B. 1.46

C. 1.75

D. 1.95

Question: 63 Which of the following quantitative factors, when compared to its industry average,
could be an indicator of potential corporate failure?

A. High fixed cost to total cost structure.

 Answer (A) is correct.
A company with high fixed costs could indicate the potential of corporate failure
because decreases in sales volume can produce disproportionately higher declines in
profits.

B. High fixed assets to noncurrent liabilities.

C. High retained earnings to total assets.

D. High cash flow to total liabilities.

Question: 64 A corporation has $50,000 in equity and a debt-to-total-assets ratio of 0.5. The firm
wants to reduce this ratio to 0.2 by selling new common stock and using the proceeds
to repay principal on outstanding long-term debt. What amount of additional equity
financing must the corporation obtain to accomplish this objective?

A. $100,000

B. $80,000

C. $20,000

D. $30,000
Answer (D) is correct.
Using the equation total assets = liabilities + equity and a debt-to-total-assets ratio of
0.5, set x = total assets. Thus, x = 0.5x + $50,000. Solving for x, x = $100,000. Since
the debt-to-total-assets ratio is reduced to 0.2 and total assets equal $100,000,
liabilities equal $20,000. The new equation using a debt-to-total-assets ratio of 0.2 is
$100,000 = $20,000 + equity; thus, equity = $80,000. To achieve a debt-to-total-assets
ratio of 0.2, the corporation must increase equity by $30,000 ($80,000 – $50,000).

Question: 65 Given the income statement provided below, what is the times-interest-earned ratio for
V Corp.?

Net revenue $ 6,000,000

COGS (4,200,000)

Operating income $ 1,800,000

Interest expense (600,000)

 Taxable income $ 1,200,000

Tax expense (40%) (480,000)

Net income $ 720,000

A. 1.2

B. 10.0

C. 3.0
Answer (C) is correct.
The times-interest-earned ratio equals income (earnings) before interest expense
(interest) divided by interest expense (EBIT ÷ Interest expense). EBIT equals
operating income. The times-interest-earned ratio therefore is 3.0 ($1,800,000
operating income ÷ $600,000 interest expense).

D. 2.0

Question: 66 At the end of the current year, B Co. had total assets of $2,500,000, current liabilities of
$500,000, and long-term liabilities of $750,000. What is B Co.’s debt-to-equity ratio?

A. 2.0

B. 5.0

C. 1.0
Answer (C) is correct.
The debt-to-equity ratio equals total debt divided by shareholders’ equity. B’s equity
is $1,250,000 ($2,500,000 total assets – $500,000 current liabilities – $750,000
noncurrent liabilities). Accordingly, the debt-to-equity ratio is 1.0 ($1,250,000 total
debt ÷ $1,250,000 shareholders’ equity).

D. 0.5

Question: 67 The following information was taken from Culver Co.’s financial statements for the
current year ending December 31:

Current assets $11,000,000

Noncurrent assets 14,000,000

 Total stockholders’ equity 10,000,000

Total operating expenses 20,000,000

What was Culver’s debt ratio as of December 31?

A. 50%

B. 60%
Answer (B) is correct.
The total debt ratio (also called the debt to total assets ratio) reports the total debt
burden carried by a firm per dollar of assets. Culver Co. has total assets of
$25,000,000 ($11,000,000 current assets + $14,000,000 noncurrent assets) and total
debt of $15,000,000 ($25,000,000 total assets – $10,000,000 total stockholders’
equity). The debt ratio, then, is calculated as follows:
Debt ratio=Total debt ÷ Total assets

=$15,000,000 ÷ $25,000,000

=60%

C. 40%

D. 250%

Question: 68 Shank Co. has a debt-to-asset ratio of 0.4 and $6,000,000 equity. Shank is seeking
capital to fund a construction project costing $6,500,000 and is considering funding the
project by both bank borrowings and additional common stock issuance. The current
debt covenant requires Shank to fund any project by incurring a maximum of 30% debt.
If Shank funds the project with the maximum permitted debt, the debt-to-equity ratio will
be

A. 0.41

B. 0.56
Answer (B) is correct.
Given a debt-to-asset ratio of 0.4, the current debt-to-equity ratio is two-thirds [0.4 ÷
(1 – 0.4)]. Thus, the current debt is $4,000,000 [$6,000,000 × (2 ÷ 3)]. To fund the
project by incurring a maximum of 30% debt, Shank must borrow $1,950,000
($6,500,000 × 30%) and issue equity of $4,550,000 ($6,500,000 × 70%). The debt-to-
equity ratio after funding the new project therefore is 0.56 [($4,000,000 + $1,950,000)
÷ ($6,000,000 + $4,550,000)].

C. 0.55

D. 0.36

Question: 69 The capital structure of a firm includes bonds with a coupon rate of 12% and an
 effective interest rate is 14%. The corporate tax rate is 30%. What is the firm’s net cost
of debt?

A. 8.4%

B. 9.8%
Answer (B) is correct.
Because of the tax deductibility of interest payments, the cost of debt equals the
effective interest rate times one minus the marginal tax rate. The effective rate is used
rather than the coupon rate (stated rate) because the effective rate is the actual cost of
the amount borrowed. Thus, the net cost of debt is 9.8% [14% × (1.0 – .30)].

C. 14%

D. 12%

Question: 70 Global Company Press has $150 par-value preferred stock with a market price of $120
a share. The organization pays a $15 per share annual dividend. Global’s current
marginal tax rate is 40%. Looking to the future, the company anticipates maintaining its
current capital structure. What is the component cost of preferred stock to Global?

A. 12.5%
Answer (A) is correct.
The component cost of preferred stock is the dividend divided by the market price
(also called the dividend yield). No tax adjustment is necessary because dividends are
not deductible. Given that the market price is $120 when the dividend is $15, the
component cost of preferred capital is 12.5% ($15 ÷ $120).

B. 5%

C. 10%

D. 4%

Question: 71 Maloney, Inc.’s $1,000 par-value preferred stock paid its $100 per share annual
dividend on April 4 of the current year. The preferred stock’s current market price is
$960 a share on the date of the dividend distribution. Maloney’s marginal tax rate
(combined federal and state) is 40%, and the firm plans to maintain its current capital
structure. The component cost of preferred stock to Maloney would be closest to

A. 6%

B. 10.4%
Answer (B) is correct.
The component cost of preferred stock is equal to the dividend yield, i.e., the cash
dividend divided by the market price of the stock. (Dividends on preferred stock are
not deductible for tax purposes; therefore, there is no adjustment for tax savings.) The
 annual dividend on preferred stock is $100 when the price of the stock is $960. The
result is a cost of capital of about 10.4% ($100 ÷ $960).

C. 10%

D. 6.25%

Question: 72 What is the after-tax cost of preferred stock that sells for $5 per share and offers a
$0.75 dividend when the tax rate is 35%?

A. 9.75%

B. 15%
Answer (B) is correct.
The component cost of preferred stock is the dividend yield, i.e., the cash dividend
divided by the market price of the stock ($.75 ÷ $5.00 = 15%). Preferred dividends
are not deductible for tax purposes.

C. 5.25%

D. 10.50%

Question: XX A company recently issued 9% preferred stock. The preferred stock sold for $40 a share
with a par of $20. The cost of issuing the stock was $5 a share. What is the company’s
cost of preferred stock?

A. 10.3%

B. 9.0%

C. 5.1%
Answer (C) is correct.
The rate of return demanded by holders of preferred stock equals its component cost.
The component cost of preferred stock equals the cash dividend divided by the net
proceeds received. The cash dividend equals $1.80 ($20 par × 9%), and the net
proceeds equal $35 ($40 selling price – $5 issue cost). Thus, the cost of preferred
stock is 5.1% ($1.80 ÷ $35).

D. 4.5%

Question: 73 Cox Company has sold 1,000 shares of $100 par, 8% preferred stock at an issue price
of $92 per share. Stock issue costs were $5 per share. Cox pays taxes at the rate of
40%. What is Cox’s cost of preferred stock capital?

A. 8.70%

B. 8.25%
 C. 9.20%
Answer (C) is correct.
Because the dividends on preferred stock are not deductible for tax purposes, the
effect of income taxes is ignored. Thus, the relevant calculation is to divide the $8
annual dividend by the quantity of funds received from the issuance. In this case, the
funds received equal $87 ($92 proceeds – $5 issue costs). Thus, the cost of capital is
9.2% ($8 ÷ $87).

D. 8.00%

Question: 74 If k is the cost of debt and t is the marginal tax rate, the after-tax cost of debt, k i, is best
represented by the formula

A. ki = k(t)

B. ki= k ÷ (1 – t)

C. ki= k ÷ t

D. ki = k(1 – t)
Answer (D) is correct.
The after-tax cost of debt is the cost of debt times the quantity one minus the tax rate.
For example, the after-tax cost of a 10% bond is 7% [10% × (1 – 30%)] if the tax rate
is 30%.

Question: 75 The cost of debt most frequently is measured as

A. Actual interest rate plus a risk premium.

B. Actual interest rate.

C. Actual interest rate adjusted for inflation.

D. Actual interest rate minus tax savings.

Answer (D) is correct.
The cost of debt most frequently is measured as the after-tax interest rate on the debt.
Therefore, the component cost is equal to the effective rate multiplied by 1 minus the
marginal tax rate.

Question: 76 A company issued common stock and preferred stock. Projected growth rate of the
common stock is 5%. The current quarterly dividend on preferred stock is $1.60. The
current market price of the preferred stock is $80 and the current market price of the
common stock is $95. What is the expected rate of return on the preferred stock?

A. 2%

B. 7%
 C. 13%

D. 8%
Answer (D) is correct.
The expected rate of return on the preferred stock is calculated by dividing the
dividend on preferred stock by the market price of preferred stock. Therefore, the
expected rate of return is 8% [($1.60 quarterly dividend × 4 quarters) ÷ $80].

Question: 77 An analyst expects a company to pay a dividend of $5 with a dividend growth rate of
3%. The inflation rate is expected to fall from 5% per year to 3% per year. As a result of
the change in the inflation premium, the company’s

A. Cost of equity will likely remain stable.

B. Cost of equity will likely decrease.

Answer (B) is correct.
Inflation is a sustained increase in the general level of prices. If the inflation rate
decreases from 5% to 3%, the cost of equity will likely decrease as well.

C. Stock price will likely remain stable.

D. Stock price will likely decrease.

Question: 78 Sen Corp., a publicly-traded, mid-cap company, wanted to obtain $30 million in new
capital to expand its Iowa plant. Cost of capital was a factor in making the decision. Sen
Corp. could either issue new preferred stock or new debentures. Sen Corp.’s
underwriter estimated that preferred stock should have an annual dividend payout of $6
and an issue price of $103 per share. The debentures should have a coupon interest
rate of 9% and an issue price of $101. Sen Corp.’s marginal income tax rate was 40%.
Which of the following approaches describes Sen Corp.’s best strategy?

A. Sen Corp. should issue the debentures since the after-tax cost of debt (5.347%) would
be less than the cost of equity (5.825%).
Answer (A) is correct.
The best financing strategy is the least costly approach. Because interest payments are
tax-deductible, the cost of debt (e.g., debentures) is calculated after tax. Accordingly,
the after-tax cost of debt is calculated as follows: Effective rate × (1 – Marginal tax
rate). If debt is issued at face value, the effective rate equals the coupon rate.
However, if debt is issued at a premium or discount, the effective rate equals the
coupon payment divided by the issue price. A debenture is issued at a premium
(discount) if its issue price is greater (less) than $100. Here, the debentures are issued
at a premium price of $101. Thus, the after-tax cost of the debentures is 5.347% [($9
÷ $101) × (1 – 40%)]. By contrast, the cost of preferred stock is calculated as follows:
Cash divided on preferred stock ÷ Market price of preferred stock. Thus, the cost of
preferred stock is 5.825% ($6 ÷ $103). Because the after-tax cost of the debentures is
less than the cost of preferred stock, the debentures should be issued.

B. Sen Corp. should issue the preferred stock because the cost of equity (5.825%)
is less than the cost of debt (9%).
 C. Sen Corp. should issue the debentures since the after-tax cost of debt (5.347%) would
be less than the cost of equity (6%).

D. Sen Corp. should issue the preferred stock because the cost of equity (6%) is less than
the cost of debt (9%).

Question: 79The optimal capitalization for an organization usually can be determined by the

A. Lowest total weighted-average cost of capital (WACC).

Answer (A) is correct.
The cost of capital is a weighted average of the various debt and equity components of an organization’s
cost structure. The weighted-average cost of capital weights the percentage cost of each component by
the percentage of that component in the financial structure. The optimal capital structure minimizes the
weighted-average cost of capital and thereby maximizes the value of the firm’s stock.

B. Intersection of the marginal cost of capital and the marginal efficiency of investment.

C. Maximum degree of total leverage (DTL).

D. Maximum degree of financial leverage (DFL).

Question: 80 A company has the following financial information:

Proportion of

Source of capital capital structure Cost of capital

Long-term debt 60% 7.1%

Preferred stock 20% 10.5%

Common stock 20% 14.2%

To maximize shareholder wealth, the company should accept projects with returns
greater than what percent?

A. 10.6%

B. 7.1%

C. 9.2%
Answer (C) is correct.
The company should not accept projects that have a lower return than the after-tax
weighted-average cost of capital, calculated as follows:

Component Weighted
 Weight Cost Cost

Long-term debt 60% × 7.1% = 4.26%

Preferred stock 20% × 10.5% = 2.10%

Common 20% × 14.2% = 2.84%

equity

Totals 100% 9.20%

D. 14.2%

Question: 81 ABC Co. had debt with a market value of $1 million and an after-tax cost of financing of
8%. ABC also had equity with a market value of $2 million and a cost of equity capital of
9%. ABC’s weighted-average cost of capital would be

A. 8.5%

B. 8.0%

C. 8.7%
Answer (C) is correct.
ABC’s weighted-average cost of capital can be calculated as follows:
Market Component Weighted

Value Weight Cost Cost

Debt $1,000,000 33.33%× 8% = 2.67%

Equity 2,000,000 66.67%× 9% = 6.00%

 Totals $3,000,000 100.00% 8.67%

The weight of debt is calculated by taking the value of debt and dividing it by the total
value of debt and equity [$1,000,000 ÷ ($1,000,000 + $2,000,000)] or $1 million ÷ $3
million = 33.33%.

The weight of equity is calculated by taking the value of equity and dividing it by the
total value of debt and equity [$2,000,000 ÷ ($1,000,000 + $2,000,000)] or $2 million
÷ $3 million = 66.67%.

D. 9.0%

Question: 82 A company with a combined federal and state tax rate of 30% has the following capital
structure:

Pretax

Cost of

Weight Instrument Capital

40% Bonds 10%

50% Common stock 10%

10% Preferred stock 20%

What is the weighted-average after-tax cost of capital for this company?

A. 8.2%

B. 9.8%
Answer (B) is correct.
The after-tax cost of long-term debt is 7% [10% × (1.0 – .30)]. The company’s
weighted-average cost of capital can thus be calculated as follows:
Component Weighted

Weight Cost Cost

Bonds 40% × 7% = 2.8%

 Common 50% × 10% = 5.0%
equity

Preferred stock 10% × 20% = 2.0%

Totals 100% 9.8%

C. 3.3%

D. 7.7%

Question: 83 The theory underlying the cost of capital is primarily concerned with the cost of

A. Long-term funds and new funds.

Answer (A) is correct.
The theory underlying the cost of capital is based primarily on the cost of long-term
funds and the acquisition of new funds. The reason is that long-term funds are used to
finance long-term investments. For an investment alternative to be viable, the return
on the investment must be greater than the cost of the funds used. The objective in
short-term borrowing is different. Short-term loans are used to meet working capital
needs and not to finance long-term investments.

B. Short-term funds and new funds.

C. Long-term funds and old funds.

D. Short-term funds and old funds.

Question: 84 An accountant for Stability, Inc., must calculate the weighted-average cost of capital of
the corporation using the following information.

Component

Cost

Accounts payable $35,000,00 -0-

0

Long-term debt 10,000,000 8%

Common stock 10,000,000 15%

Retained earnings 5,000,000 18%

 What is the weighted average cost of capital of Stability?

A. 12.80%
Answer (A) is correct.
Because the effect of income taxes is ignored in this situation, the stated rate on the
firm’s long-term debt is considered to be its effective rate. The weighted-average cost
of capital (WACC) can thus be calculated as follows:
Carrying Amount Cost of Weighted Cost
Weight Capital

Long-term debt $10,000,000 40% × 8% = 3.2%

Common stock 10,000,000 40% × 15% = 6.0%

Retained earnings 5,000,000 20% × 18% = 3.6%

Totals $25,000,000 100% 12.8%

B. 10.25%

C. 8.00%

D. 6.88%

Question: 85 What is the weighted-average cost of capital for a firm using 65% common equity with a
return of 15%, 25% debt with a return of 6%, 10% preferred stock with a return of 10%,
and a tax rate of 35%?

A. 11.275%

B. 12.250%

C. 11.725%
Answer (C) is correct.
The cost for common equity capital is given as 15%, and preferred stock is 10%. The
before-tax rate for debt is given as 6%, which translates to an after-tax cost of 3.9%
[6% × (1.0 – .35)]. The rates are weighted as follows:
Component Weighted

Component Weight Cost Cost

Long-term debt 25% × 3.9% = .975%

 Preferred stock 10% × 10.0% = 1.000%

Common stock 65% × 15.0% = 9.750%

11.725%

D. 10.333%

Question: 86What is the weighted-average cost of capital for a firm with equal amounts of debt and equity
financing, a 15% company cost of equity capital, a 35% tax rate, and a 12% coupon rate on its debt that is selling at
par value?

A. 8.775%

B. 11.40%
Answer (B) is correct.
The 12% debt coupon rate is reduced by the 35% tax shield, resulting in a cost of debt of 7.8% [12% ×
(1.0 – .35)]. The company’s weighted-average cost of capital can thus be calculated as follows:
Component Weight

Weight Cost Cost

Equity 50% × 15% = 7.5%

Debt 50% × 7.8% = 3.9%

100% 11.4%

C. 9.60%

D. 13.50%

Question: 87 An entity has a tax rate of 35% and a capital structure consisting of 40% noncurrent
debt, 20% preferred stock, and 40% common equity. The before-tax cost of capital for
these components are 8%, 13%, and 17%, respectively. What is the entity’s weighted-
 average cost of capital?

A. 12.60%

B. 10.52%

C. 11.48%
Answer (C) is correct.
The WACC is calculated by multiplying the cost of capital for each component by its
percentage of total capital and adding the products. However, an adjustment is needed
for the cost of debt because it is tax deductible.
Noncurrent debt (1.0 – .35) × 8% × 40% 2.08%
=

Preferred stock 13% × 20% = 2.60%

Common stock 17% × 40% = 6.80%

11.48%

D. 10.22%

Question: 88 Scrunchy-Tech, Inc., has determined that it can minimize its weighted-average cost of
capital (WACC) by using a debt-equity ratio of 2/3. If the firm’s cost of debt is 9% before
taxes, the cost of equity is estimated to be 12% before taxes, and the tax rate is 40%,
what is the firm’s WACC?

A. 7.92%

B. 9.36%
Answer (B) is correct.
A firm’s weighted-average cost of capital (WACC) is derived by weighting the (after-
tax) cost of debt of 5.4% [9% × (1 – 40%)] and cost of equity of 12%. The tax rate
does not affect the cost of equity. Scrunchy-Tech’s WACC can be calculated as
follows:
Component

Component Weight Cost Totals

Debt 40% × 5.4% = 2.16%

Equity 60% × 12.0% = 7.20%

 100% 9.36%

C. 6.48%

D. 10.80%

Question: 89 A firm’s target or optimal capital structure is consistent with which one of the following?

A. Minimum weighted-average cost of capital.

Answer (A) is correct.
Ideally, a firm will have a capital structure that minimizes its weighted-average cost
of capital. This requires a balancing of both debt and equity capital and their
associated risk levels.

B. Minimum risk.

C. Minimum cost of debt.

D. Maximum earnings per share.

Fact Pattern: Dzyubenko Co. reported these data at year end:

Pre-tax operating income$ 4,000,000

Current assets 4,000,000

Long-term assets 16,000,000

Current liabilities 2,000,000

Long-term liabilities 5,000,000

The long-term debt has an interest rate of 8%, and its fair value equaled its book value at year-end. The
fair value of the equity capital is $2 million greater than its book value. Dzyubenko’s income tax rate is
25%, and its cost of equity capital is 10%.
Question: 90 What is Dzyubenko’s weighted-average cost of capital (WACC)?

A. 9%
Answer (A) is correct.
The WACC is an after-tax rate determined using the fair values of the sources of long-
term funds. Thus, the appropriate cost of debt is 6% [(1.0 – .25 tax rate) × 8%]
because interest is tax deductible. However, the given equity rate (10%) is not
adjusted because distributions to shareholders are not deductible. The fair value of
long-term debt is given as $5 million. The book value of equity must be $13 million
($20 million of assets – $7 million of liabilities), and its fair value is $15 million ($13
million + $2 million). Accordingly, the WACC is calculated as follows:
 WACC=

B. 8.89%

C. 10%

D. 8%

Question: 91 Which of the following items represents a business risk in capital structure decisions?

A. Cash flow.
Answer (A) is correct.
Business risk is the risk that the cash flow of an issuer will be impaired because of
adverse economic conditions, making it difficult for the issuer to meet its operating
expenses. Thus, cash is relevant to capital structure decisions because the use of debt
may bankrupt a corporation that does not have sufficient cash flows to make the
periodic interest payments.

B. Management preferences.

C. Timing of information.

D. Contractual obligations.

Question: 92 A company has the following target capital structure and costs:

Proportion Pretax

of Capital Cost of

Structure Capital

Debt 30% 10%

Common stock 60% 12%

 Preferred stock 10% 10%
The company’s marginal tax rate is 30%. What is the company’s weighted-average cost
of capital?

A. 7.84%

B. 9.30%

C. 10.30%
Answer (C) is correct.
A firm’s weighted-average cost of capital is a single, composite rate of return on its
combined components of capital. The component cost of debt is the after-tax interest
rate on the debt because the interest payments are tax deductible. To solve for the
weighted-average cost of capital, the cost of each type of capital must be multiplied
by the weight of the capital. The after-tax cost of debt is 7% [10% × (1.0 – .30)]. The
calculation is as follows:
Target
Component Weight Component Cost Weighted Cost

Debt 30% × 7% = 2.1%

Common stock 60% × 12% = 7.2%

Preferred stock 10% × 10% = 1.0%

100% 10.3%

D. 11.20%

Question: XX The target capital structure of Traggle Co. is 50% debt, 10% preferred equity, and 40%
common equity. The interest rate on debt is 6%, the yield on the preferred equity is 7%,
the cost of common equity is 11.5%, and the tax rate is 40%. Traggle does not
anticipate issuing any new stock. What is Traggle’s weighted-average cost of capital?

A. 6.77%

B. 8.30%

C. 6.50%

D. 7.10%
Answer (D) is correct.
A firm’s weighted-average cost of capital is a single, composite rate of return on its
 combined components of capital. The component cost of debt is the after-tax interest
rate on the debt because the interest payments are tax deductible. The after-tax cost of
debt is 3.6% [6% × (1.0 – .40)]. The weighted-average cost of capital is calculated as
follows:
Target Weight Component Cost Weighted Cost

Debt 50% × 3.6% = 1.8%

Preferred 10% × 7.0% = 0.7%

equity

Common 40% × 11.5% = 4.6%

equity

Totals 100% 7.1%

Question: 93 Which of the following statements is correct regarding the weighted-average cost of
capital (WACC)?

A. WACC is always equal to the company’s borrowing rate.

B. An increase in the WACC increases the value of the company.

C. One of a company’s objectives is to minimize the WACC.

Answer (C) is correct.
Standard financial theory provides a model for the optimal capital structure of every
firm. According to the model, shareholder wealth-maximization results from
minimizing the WACC. Thus, one of a company’s objectives is to minimize the
WACC.

D. A company with a high WACC is attractive to potential shareholders.

Question: 94 Angela Company’s capital structure consists entirely of long-term debt and common
equity. The pretax cost of capital for each component is shown below.

Long-term debt 8%

Common equity15%

Angela pays taxes at a rate of 40%. If Angela’s weighted average cost of capital is
10.41%, what proportion of the company’s capital structure is in the form of long-term
debt?
 A. 55%

B. 45%
Answer (B) is correct.
WACC=[Debt weight × Cost of debt × (1 – Tax rate)] + (Equity weight × Cost of
equity)
.1041=[Debt weight × .08 × (1 – 40%)] + (Equity weight × .15)
.1041=(Debt weight × .048) + (Equity weight × .15)
Because debt weight + equity weight = 1, equity weight = 1 – debt weight.
.1041=(Debt weight × .048) + [(1 – Debt weight) × .15]
.1041 – .=.048 Debt weight – .15 Debt weight
15
–.0459=–.102 Debt weight
.45=Debt weight

C. 34%

D. 66%

Question: 95 Kielly Machines, Inc., is planning an expansion program estimated to cost $100 million.
Kielly is going to raise funds according to its target capital structure shown below.

Debt .30

Preferred stock .24

Common equity.46

Kielly had net income available to common shareholders of $184 million last year of
which 75% was paid out in dividends. The company has a marginal tax rate of 40%.

Additional data

 The before-tax cost of debt is estimated to be 11%.

 The market yield of preferred stock is estimated to be 12%.
 The after-tax cost of common stock is estimated to be 16%.

What is Kielly’s weighted-average cost of capital?

A. 14.00%

B. 13.00%

C. 12.22%
Answer (C) is correct.
The effective rate for Kielly’s debt is the after-tax cost [11% × (1.0 – .40 tax rate) =
 6.6%]. The weighted-average cost of capital (WACC) therefore can be calculated as
follows:
Carrying Amount Weight Cost of Capital Weighted Cost

Debt $ 30,000,000 30% × 6.6% = 1.98%

Preferred stock 24,000,000 24% × 12.0% = 2.88%

Common 46,000,000 46% × 16.0% = 7.36%

equity

Totals $100,000,000 100% 12.22%

D. 13.54%

Question: 96 Following is an excerpt from Albion Corporation’s balance sheet.

Long-term debt (9% effective interest rate) $30,000,000

Preferred stock (100,000 shares, 12% dividend) 10,000,000

Common stock (5,000,000 shares outstanding) 60,000,000

The market value of Albion’s debt and equity is equal to the carrying amount. Albion’s
treasurer estimates that the firm’s cost of common equity is 17% and cost of preferred
stock is 12%. If Albion’s effective income tax rate is 40%, what is the firm’s cost of
capital?

A. 13.0%
Answer (A) is correct.
The effective rate for Albion’s debt is the after-tax cost [9% × (1.0 – .40 tax rate) =
5.4%]. The weighted-average cost of capital (WACC) can thus be calculated as
follows:
Market Value Weight Cost of Capital Weighted Cost

Long-term debt$ 30,000,000 30% × 5.4% = 1.6%

Preferred stock 10,000,000 10% × 12.0% = 1.2%

Common stock 60,000,000 60% × 17.0% = 10.2%

 Totals $100,000,000 100 13.0%
%

B. 14.1%

C. 13.9%

D. 12.6%

Question: 97 Thomas Company’s capital structure consists of 30% long-term debt, 25% preferred stock, and
45% common equity. The cost of capital for each component is shown below.

Long-term debt 8%

Preferred stock 11%

Common equity15%

If Thomas pays taxes at the rate of 40%, what is the company’s after-tax weighted-average
cost of capital?

A. 7.14%

B. 11.90%

C. 9.84%

D. 10.94%
Answer (D) is correct.
The effective rate for Thomas’ debt is the after-tax cost [8% × (1.0 – .40 tax rate) =
4.8%]. The weighted-average cost of capital (WACC) can thus be calculated as
follows:
Weight Cost of Capital Weighted Cost

Long-term debt 30% × 4.8% = 1.44%

Preferred stock 25% × 11.0% = 2.75%

Common 45% × 15.0% = 6.75%

equity
 Totals 100% 10.94%

Question: 98 Osgood Products has announced that it plans to finance future investments so that the
firm will achieve an optimum capital structure. Which one of the following corporate
objectives is consistent with this announcement?

A. Minimize the cost of equity.

B. Maximize the net worth of the firm.

Answer (B) is correct.
Financial structure is the composition of the financing sources of the assets of a firm.
Traditionally, the financial structure consists of current liabilities, long-term debt,
retained earnings, and stock. For most firms, the optimum structure includes a
combination of debt and equity. Debt is cheaper than equity, but excessive use of debt
increases the firm’s risk and drives up the weighted-average cost of capital.

C. Maximize earnings per share.

D. Minimize the cost of debt.

Question: 99 Joint Products, Inc., a corporation with a 40% marginal tax rate, plans to issue
$1,000,000 of 8% preferred stock in exchange for $1,000,000 of its 8% bonds currently
outstanding. The firm’s total liabilities and equity are equal to $10,000,000. The effect of
this exchange on the firm’s weighted-average cost of capital is likely to be

A. A decrease, since preferred stock payments do not need to be made each year, whereas
debt payments must be made.

B. An increase, since a portion of the debt payments are tax deductible.

Answer (B) is correct.
The payment of interest on bonds is tax-deductible, whereas dividends on preferred
stock must be paid out of after-tax earnings. Thus, when bonds are replaced in the
capital structure with preferred stock, an increase in the cost of capital is likely,
because there is no longer a tax shield.

C. A decrease, since a portion of the debt payments are tax deductible.

D. No change, since it involves equal amounts of capital in the exchange and both
instruments have the same rate.

Question: 100 A company is trying to determine the cost of capital for a major expansion project. A
survey of commercial lenders indicates that cost of debt is currently 8% based on the
company’s debt ratio of 40%. The company complies with this requirement and has
determined that a stock issuance would require a 10% return in order to attract
investors. Which of the following is the company’s cost of capital?
 A. 8.8%

B. 10.8%

C. 18.0%

D. 9.2%
Answer (D) is correct.
Because the company’s capital structure consists of both debt and equity, it must
determine its cost of capital by calculating the weighted-average cost of capital
(WACC). WACC is calculated as follows:
WACC = [Cost of debt × Debt ratio × (1 – Tax rate)*] + (Cost of equity × Equity
ratio)

= 8% × 40% + [10% × (1 – 40%)]

= 8% × 40% + (10% × 60%)

= 9.2%

* Because no tax rate-related information is given, the after-tax consideration should

be omitted from the calculations for this question.

Question: XX The capital structure of Merritt Co. is 20% common equity and debt equal to 80%. The
cost of common equity is 10% and the pretax cost of debt is 5%. Merritt’s tax rate is
21%. What is Merritt’s weighted-average cost of capital?

A. 7.50%

B. 5.16%
Answer (B) is correct.
Given a capital structure of 20% equity and a cost of equity of 10%, the equity
component of the cost of capital is 2% (20% × 10%). Regarding the debt component,
the pretax cost of debt is 5%. However, an adjustment must be made to consider the
tax effects of interest deduction. Thus, the after-tax cost of debt is 3.95% [5% × (1 –
21%)]. Given a capital structure consisting of 80% debt, the total after-tax cost of debt
component is 3.16% (3.95% × 80%). Therefore, the weighted-average cost of capital
is 5.16% (2% + 3.16%).

C. 6.00%

D. 6.98%