1.

The cost of capital acts as a major link between the firm’s long-term
investment decisions and the wealth of the owners as determined by
investors in the marketplace.

2. The cost of capital can be thought of as the rate of return required by

the market suppliers of capital in order to attract their funds to the
firm.

3. Business risk is the risk to the firm of being unable to cover required
financial obligations.

4. Holding risk constant, the implementation of projects with a rate of

return above the cost of capital will decrease the value of the firm, and
vice versa.

5. The specific cost of each source of financing is the after-tax cost of

obtaining the financing using the historically based cost reflected by
the existing financing on the firm’s books.

6. When the net proceeds from the sale of a bond equal its par value, the
before-tax cost would just equal the coupon interest rate.

7. The amount of preferred stock dividends that must be paid each year
may be stated in dollars (i.e., x-dollar preferred stock) or as a
percentage of the firm’s earnings (i.e., x-percent preferred stock).

8. The cost of preferred stock is typically higher than the cost of long-
term debt (bonds) because the cost of long-term debt (interest) is tax
deductible.

9. The constant growth model uses the market price as a reflection of the
expected risk-return preference of investors in the marketplace.

10. The cost of common stock equity capital represents the return
required by existing shareholders on their investment in order to leave
the market price of the firm’s outstanding shares unchanged.

11. The cost of retained earnings is always lower than the cost of a
new issue of common stock due to the absence of flotation costs when
financing projects with retained earnings.

12. Since the net proceeds from the sale of new common stock will
be less than the current market price, the cost of new issues will
always be less than the cost of existing issues.

13. The Gordon model is based on the premise that the value of a
share of stock is equal to the sum of all future dividends it is expected
to provide over an infinite time horizon.

14. The cost of retained earnings to the firm is the same as the cost
of an equivalent fully subscribed issue of additional common stock.

15. Using the Capital Asset Pricing Model (CAPM), the cost of
common stock equity is the return required by investors as
compensation for the firm’s nondiversifiable risk.

16. Use of the Capital Asset Pricing Model (CAPM) in measuring the
cost of common stock equity differs from the constant growth valuation
model in that it directly considers the firm’s risk as reflected by beta.
 17. When the constant growth valuation model is used to find the
cost of common stock equity capital, it can easily be adjusted for
flotation costs to find the cost of new common stock; the Capital Asset
Pricing Model (CAPM) does not provide a simple adjustment
mechanism.

18. The cost of new common stock is normally greater than any
other long-term financing cost.

19. The capital asset pricing model describes the relationship

between the required return, or the cost of common stock equity
capital, and the nonsystematic risk of the firm as measured by the beta
coefficient.

20. Since retained earnings is a more expensive source of financing

than debt and preferred stock, the weighted average cost of capital will
fall once retained earnings have been exhausted.

21. A firm may face increases in the weighted average cost of capital
either when retained earnings have been exhausted or due to
increases in debt, preferred stock, and common equity costs as
additional new funds are required.

22. The acceptance of projects beginning with those having the

greatest positive difference between IRR and the weighted average
cost of capital (Ka), down to the point at which IRR just equals Ka
should result in the maximum total NPV for all independent projects
accepted.

23. As the cumulative amount of money invested in a firm’s capital

projects increases, its returns on the projects will increase.

24. While the return will increase with the acceptance of more
projects, the weighted marginal cost of capital will increase because
greater amounts of financing will be required.

25. According to the firm’s owner wealth maximization goal, the firm
should accept projects up to the point where the marginal return on its
investment is equal to its weighted marginal cost of capital.

26. The cost of common stock equity can be thought of as the

“magic number” that is used to decide whether a proposed corporate
investment will increase or decrease the firm’s stock price.

27. In using the cost of capital, it is important that it reflects the

historical cost of raising funds over the long run.

28. The weighted marginal cost of capital is the firm’s weighted

average cost of capital associated with the next dollar of total new
financing.

Multiple Choice Questions:

1. The approximate before-tax cost of debt for a 15-year, 10 percent,

$1,000 par value bond selling at $950 is:

o (a) 10 percent.

o (b) 10.6 percent.

o (c) 12 percent.
 o (d) 15.4 percent.

2. If a corporation has an average tax rate of 40 percent, the approximate

annual after-tax cost of debt for a 15-year, 12 percent, $1,000 par
value bond selling at $950 is:

o (a) 10 percent.

o (b) 10.6 percent.

o (c) 7.6 percent.

o (d) 6.0 percent.

3. If a corporation has an average tax rate of 40 percent, the approximate

annual after-tax cost of debt for a 10-year, 8 percent, $1,000 par value
bond selling at $1,150 is:

o (a) 3.6 percent.

o (b) 4.8 percent.

o (c) 6 percent.

o (d) 8 percent.

4. The approximate before-tax cost of debt for a 10-year, 8 percent,

$1,000 par value bond selling at $1,150 is:

o (a) 6 percent.

o (b) 8.3 percent.

o (c) 8.8 percent.

o (d) 9 percent.

5. The approximate after-tax cost of debt for a 20-year, 7 percent, $1,000

par value bond selling at $960 (assume a marginal tax rate of 40
percent) is:

o (a) 4.41 percent.

o (b) 5.15 percent.

o (c) 7 percent.

o (d) 7.35 percent.

6. Debt is generally the least expensive source of capital. This is primarily

due to:

o (a) fixed interest payments.

o (b) its position in the priority of claims on assets and earnings in

the event of liquidation.

o (c) the tax deductibility of interest payments.

o (d) the secured nature of a debt obligation.

7. A firm has determined it can issue preferred stock at $115 per share
par value. The stock will pay a $12 annual dividend. The cost of issuing
and selling the stock is $3 per share. The cost of the preferred stock is:

o (a) 6.4 percent.

 o (b) 10.4 percent.

o (c) 10.7 percent.

o (d) 12 percent.

8. The cost of common stock equity is:

o (a) the cost of the guaranteed stated dividend.

o (b) the rate at which investors discount the expected dividends

of the firm.

o (c) the after-tax cost of the interest obligations.

o (d) the historical cost of floating the stock issue.

9. Firms underprice new issues of common stock for the following

reason(s):

o (a) When the market is in equilibrium, additional demand for

shares can be achieved only at a lower price.

o (b) When additional shares are issued, each share’s percent of

ownership in the firm is diluted, thereby justifying a lower share
value.

o (c) Many investors view the issuance of additional shares as a

signal that management is using common stock equity financing
because it believes that the shares are currently overpriced.

o (d) All of the above.

10. Circumstances in which the constant growth valuation model—

the Gordon model—for estimating the value of a share of stock should
be used include:

o (a) declining dividends.

o (b) an erratic dividend stream.

o (c) the lack of dividends.

o (d) a steady growth rate in dividends.

11. A firm has common stock with a market price of $25 per share
and an expected dividend of $2 per share at the end of the coming
year. The growth rate in dividends has been 5 percent. The cost of the
firm’s common stock equity is:

o (a) 5 percent.

o (b) 8 percent.

o (c) 10 percent.

o (d) 13 percent.
A firm has determined its optimal structure which is composed of the following sources and target
market value proportions.

Table 11.2
Target
Source of Capital Market
Proportions
Long-term debt 60%
Common stock 40
equity

Debt: The firm can sell a 15-year, $1,000 par value, 8 percent bond for $1,050. A flotation cost of
2 percent of the face value would be required in addition to the premium of $50.
Common Stock: A firm’s common stock is currently selling for $75 per share. The dividend
expected to be paid at the end of the coming year is $5. Its dividend payments have been growing at a
constant rate for the last five years. Five years ago, the dividend was $3.10. It is expected that to sell,
a new common stock issue must be underpriced $2 per share and the firm must pay $1 per share in
flotation costs. Additionally, the firm has a marginal tax rate of 40 percent.

11. The firm’s before-tax cost of debt is (See Table 11.2.)

(a) 7.7 percent.
(b) 10.6 percent.
(c) 11.2 percent.
(d) 12.7 percent.

12. The firm’s after-tax cost of debt is (See Table 11.2.)

(a) 4.6 percent.
(b) 6 percent.
(c) 7 percent.
(d) 7.7 percent.

13. The firm’s cost of a new issue of common stock is (See Table 11.2.)
(a) 10.2 percent.
(b) 14.3 percent.
(c) 16.7 percent.
(d) 17.0 percent.

14. The firm’s cost of retained earnings is (See Table 11.2.)

(a) 10.2 percent.
(b) 14.3 percent.
(c) 16.7 percent.
(d) 17.0 percent.

15 The weighted average cost of capital up to the point when retained earnings are exhausted is (See
Table 11.2.)
(a) 6.8 percent.
(b) 7.7 percent.
(c) 9.44 percent.
(d) 11.29 percent.

16. Assuming the firm plans to pay out all of its earnings as dividends, the weighted average cost of
capital is (See Table 11.2.)
(a) 9.6 percent.
(b) 10.9 percent.
(c) 11.6 percent.
(d) 12.1 percent.
Table 11.3
Balance Sheet
General Talc Mines
December 31, 2003
Assets
Current Assets
Cash $25,000
Accounts Receivable 120,000
Inventories 300,000
Total Current Assets $445,000
Net Fixed Assets $500,000
Total Assets $945,000

Liabilities and Stockholders’ Equity

Current Liabilities
Accounts Payable $80,000
Notes Payable 350,000
Accruals 50,000
Total Current Liabilities $480,000
Long-Term Debts(150 bonds issued at $1,000 par) 150,000
Total Liabilities $630,000
Stockholders’ Equity Common Stock (7,200 shares $180,000
outstanding)
Retained Earnings 135,000
Total Stockholders’ Equity $315,000
Total Liabilities and Stockholders’ Equity $945,000

17

Source of Capital After-Tax

Cost
Long-term debt 8%
Common stock 19
equity

Given this after-tax cost of each source of capital, the weighted average cost of capital using book
weights for General Talc Mines is (See Table 11.3.)
(a) 11.6 percent.
(b) 15.5 percent.
(c) 16.6 percent.
(d) 17.5 percent.
18 General Talc Mines has compiled the following data regarding the market value and cost of the
specific sources of capital.

Source of Capital After-Tax

Cost
Long-term debt 8%
Common stock 19
equity

Market price per share of common stock $50

Market value of long-term debt $980 per bond
The weighted average cost of capital using market value weights is (See Table 11.3.)
(a) 11.7 percent.
(b) 13.5 percent.
(c) 15.8 percent.
(d) 17.5 percent.

19. A firm expects to have available $500,000 of earnings in the coming year, which it will retain for
reinvestment purposes. Given the following target capital structure, at what level of total new
financing will retained earnings be exhausted?

Target
Source of Capital Market
Proportions
Long-term debt 40%
Preferred stock 10
Common stock equity 50
 (a) $500,000.
(b) $800,000.
(c) $1,000,000.
(d) $1,500,000.

20. A firm’s current investment opportunity schedule and the weighted marginal cost of capital
schedule are shown below.

Investment Initial
Opportunity IRR Investment
Schedule
A 15% 200,000
B 12 300,000
C 19 100,000
D 10 400,000
E 16 300,000

Weighted Marginal Cost of Capital

Range of Total New WMCC
Financing
$0–$250,000 7.5%
250,001–500,000 8.9
500,001–1,000,000 10.0
1,000,001–1,500,000 12.0

The investment opportunities which should be selected are

(a) A, B, C, and D.
(b) A, B, C, and E.
(c) A, B, D, and E.
(d) B, C, D, and E.

21 Nico Trading Corporation is considering issuing long-term debt. The debt would have a 30 year
maturity and a 10 percent coupon rate. In order to sell the issue, the bonds must be underpriced at a
discount of 5 percent of face value. In addition, the firm would have to pay flotation costs of 5
percent of face value. The firm’s tax rate is 35 percent. Given this information, the after tax cost of
debt for Nico Trading would be
(a) 7.26%.
(b) 11.17%.
(c) 10.00%.
(d) none of the above