Business Finance

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CHAPTER 9
THE COST OF CAPITAL
(Difficulty: E = Easy, M = Medium, and T = Tough)

Multiple Choice: Conceptual

Easy:

Capital componentsAnswer: c Diff: E
[i].Which of the following is not considered a capital component for the purpose of calculating the weighted average cost of capital (WACC) as it applies to capital budgeting?

a.Long-term debt.
b.Common stock.
c.Accounts payable and accruals.
d.Preferred stock.

Capital componentsAnswer: d Diff: E
[ii].For a typical firm with a given capital structure, which of the following is correct? (Note: All rates are after taxes.)

a.kd > ke > ks > WACC.
b.ks > ke > kd > WACC.
c.WACC > ke > ks > kd.
d.ke > ks > WACC > kd.
e.None of the statements above is correct.

Capital componentsAnswer: a Diff: E
[iii].Which of the following statements is most correct?

a.If a company’s tax rate increases but the yield to maturity of its noncallable bonds remains the same, the company’s marginal cost of debt capital used to calculate its weighted average cost of capital will fall. b.All else equal, an increase in a company’s stock price will increase the marginal cost of retained earnings, ks. c.All else equal, an increase in a company’s stock price will increase the marginal cost of issuing new common equity, ke. d.Statements a and b are correct.

e.Statements b and c are correct.

Capital componentsAnswer: c Diff: E
[iv].Which of the following statements is most correct?

a.Since the money is readily available, the cost of retained earnings is usually a lot cheaper than the cost of debt financing. b.When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are tax deductible. c.When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are tax deductible. d.Statements a and b are correct.

e.Statements b and c are correct.

DCF cost of equity estimationAnswer: b Diff: E
[v].Which of the following factors in the discounted cash flow (DCF) approach to estimating the cost of common equity is the least difficult to estimate?

a.Expected growth rate, g.
b.Dividend yield, D1/P0.
c.Required return, ks.
d.Expected rate of return, [pic].
e.All of the above are equally difficult to estimate.

WACCAnswer: d Diff: E
[vi].Which of the following statements is most correct?

a.The WACC measures the after-tax cost of capital.
b.The WACC measures the marginal cost of capital.
c.There is no cost associated with using retained earnings. d.Statements a and b are correct.
e.All of the statements above are correct.

WACCAnswer: c Diff: E
[vii].Which of the following statements about the cost of capital is incorrect?

a.A company’s target capital structure affects its weighted average cost of capital. b.Weighted average cost of capital calculations should be based on the after-tax costs of all the individual capital components. c.If a company’s tax rate increases, then, all else equal, its weighted average cost of capital will increase. d.Flotation costs can increase the weighted average cost of capital. e.An increase in the risk-free rate is likely to increase the marginal costs of both debt and equity financing.

WACCAnswer: e Diff: E

[viii].Campbell Co. is trying to estimate its weighted average cost of capital (WACC). Which of the following statements is most correct?

a.The after-tax cost of debt is generally cheaper than the after-tax cost of preferred stock. b.Since retained earnings are readily available, the cost of retained earnings is generally lower than the cost of debt. c.If the company’s beta increases, this will increase the cost of equity financing, even...
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