Principles of Finance - (Fin 3301) Student name:

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Quiz – Capital Budgeting – Cost of Capital

1. A company has the following data associated with it:

 A target capital structure of 10% preferred stock, 50% common equity and 40% debt.
 Outstanding 20-year annual pay 6% coupon bonds selling for $894.
 Common stock selling for $45 per share that is expected to grow at 8% and expected to
pay a $2 dividend one year from today.
 Their $100 par preferred stock currently sells for $90 and is earning 5%.
 The company's tax rate is 40%.
What is the after-tax cost of debt capital and after-tax cost of preferred stock?
Debt capital Preferred stock
A. 4.5% 3.3%
B. 4.2% 5.6%
C. 4.2% 3.3%
2. The expected dividend one year from today is $2.50 for a share of stock priced at $22.50.
The long-term growth in dividends is projected at 8%. The cost of common equity is closest
to:
A. 18.0%.
B. 19.1%.
C. 15.6%.

3. Which of the following statements about the internal rate of return (IRR) for a project with
the following cash flow pattern is CORRECT?
 Year 0: -$ 2,000
 Year 1: $10,000
 Year 2: -$ 10,000
A. It has a single IRR of approximately 38%.
B. No IRRs can be calculated.
C. It has two IRRs of approximately 38% and 260%. (Change of signs)

4. The 6% semiannual coupon, 7-year notes of Woodbine Transportation, Inc. trade for a price
of 94.54. What is the company's after-tax cost of debt capital if its marginal tax rate is 30%?
A. 4.9%.
B. 2.1%.
C. 4.2%.

Cpt YTM,

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5. An analyst has gathered the following data about a company with a 12% cost of capital:
Project P Project Q
Cost $15,000 $25,000
Life 5 years 5 years
Cash inflows $5,000/year $7,500/year
If Projects P and Q are mutually exclusive, what should the company do? (GO WITH
HIGHEST NPV)
A. Accept Project Q and reject Project P.
B. Reject both Project P and Project Q.
C. Accept Project P and reject Project Q.

6. A company has the following data associated with it:

 A target capital structure of 10% preferred stock, 50% common equity and 40% debt.
 Outstanding 20-year annual pay 6% coupon bonds selling for $894.
 Common stock selling for $45 per share that is expected to grow at 8% and expected to pay a
$2 dividend one year from today.
 Their 5%, $100 par preferred stock currently sells for $90.
 The company's tax rate is 40%.
What is the weighted average cost of capital (WACC)? (cpt preferred equity..)
A. 8.5%.
B. 10.3%.
C. 9.2%.

7. Julius, Inc., is in a 40% marginal tax bracket. The firm can raise as much capital as needed in
the bond market at a cost of 10%. The preferred stock has a fixed dividend of $4.00. The
price of preferred stock is $31.50. The after-tax costs of debt and preferred stock are closest
to:
Debt Preferred stock
A. 6.0% 7.6%
B. 10.0% 7.6%
C. 6.0% 12.7%

8. Which of the following statements about NPV and IRR is NOT correct?
A. The NPV will be positive if the IRR is less than the cost of capital.
B. The IRR can be positive even if the NPV is negative.
C. When the IRR is equal to the cost of capital, the NPV equals zero.

9. When calculating the weighted average cost of capital (WACC) an adjustment is made for
taxes because:
A. equity is risky.
B. the interest on debt is tax deductible.
C. equity earns higher return than debt.

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10. An analyst gathered the following information for ABC Company, which has a target capital
structure of 70% common equity and 30% debt:
 Dividend yield 3.50%
 Expected market return 9.00%
 Risk-free rate 4.00%
 Tax rate 40%
 Beta 0.90
 Bond yield-to-maturity 8.00%
ABC's weighted-average cost of capital is closest to:
A. 6.9%.
B. 7.4%.
C. 8.4%.
Ke = 4% + 0.9(9%-4%)
11. Polington Aircraft Co. just announced a sale of 30 aircraft to Cuba, a project with a net
present value of $10 million. Investors did not anticipate the sale because government
approval to sell to Cuba had never before been granted. The share price of Polington should:
A. increase by the project NPV divided by the number of common shares outstanding.
B. increase by the NPV × (1 - corporate tax rate) divided by the number of common shares
outstanding.
C. not necessarily change because new contract announcements are made all the time.

12. A firm has $100 in equity and $300 in debt. The firm recently issued bonds at the market
required rate of 9%. The firm's beta is 1.125, the risk-free rate is 6%, and the expected return
in the market is 14%. Assume the firm is at their optimal capital structure and the firm's tax
rate is 40%. What is the firm's weighted average cost of capital (WACC)?
A. 5.4%.
B. 8.6%.
C. 7.8%.

13. The underlying cause of ranking conflicts between the net present value (NPV) and internal
rate of return (IRR) methods is the underlying assumption related to the:
A. Initial cost.
B. cash flow timing.
C. reinvestment rate.

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14. The following information applies to a corporation:
 The company has $200 million of equity and $100 million of debt.
 The company recently issued bonds at 9%.
 The corporate tax rate is 30%.
 The company's beta is 1.125.
If the risk-free rate is 6% and the expected return on the market portfolio is 14%, the company's
after-tax weighted average cost of capital is closest to:
A. 12.1%.
B. 11.2%.
C. 10.5%.

15. A company has a target capital structure of 40% debt and 60% equity. The company is a
constant growth firm that just paid a
16. dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8%.
17. The company's bonds pay 10% coupon (semi-annual payout), mature in 20 years, and sell for
$849.54.
 The company's stock beta is 1.2.
 The company's marginal tax rate is 40%.
 The risk-free rate is 10%.
 The market risk premium is 5%.
The cost of equity using the capital asset pricing model (CAPM) approach and the discounted
cash flow approach is:
CAPM Discounted cash flow
A. 16.0% 16.0%
B. 16.0% 15.4%
C. 16.6% 15.4%

18. If central bank actions caused the risk-free rate to increase, what is the most likely change to
cost of debt and equity capital?
A. Both decrease.
B. One increase and one decrease.
C. Both increase.

19. Which of the following statements regarding the internal rate of return (IRR) is most
accurate? The IRR:
A. can lead to multiple IRR rates if the cash flows extend past the payback period.
B. assumes that the reinvestment rate of the cash flows is the cost of capital.

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C. and the net present value (NPV) method lead to the same accept/reject decision for
independent projects.
Scratch Paper