The Cost of Capital

Topics: Dividend yield, Net present value, Weighted average cost of capital Pages: 20 (6125 words) Published: June 7, 2013
Chapter 8

The Cost of Capital

236

CHAPTER 8—THE COST OF CAPITAL
TRUE/FALSE
1. Capital refers to items on the right-hand side of a firm's balance sheet.

2. The component costs of capital are market-determined variables in as much as they are based on investors' required returns.

3. The cost of debt is equal to one minus the marginal tax rate multiplied by the coupon rate on outstanding debt.

4. The cost of issuing preferred stock by a corporation must be adjusted to an after-tax figure because of the 70 percent dividend exclusion provision for corporations holding other corporations' preferred stock.

5. The firm's cost of external equity capital is the same as the required rate of return on the firm's outstanding common stock.

6. The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.

7. The cost of equity capital from the sale of new common stock (ke) is generally equal to the cost of equity capital from retention of earnings (ks), divided by one minus the flotation cost as a percentage of sales price (1 - F).

8. Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, but capital raised by selling new stock or bonds does have a cost.

9. The weighted average cost of capital increases if the total funds required call for an amount of equity in excess of what can be obtained as retained earnings.

10. The marginal cost of capital (MCC) is the cost of the last dollar of new capital that the firm raises, and the marginal cost declines as more and more of a specific type of capital is raised during a given period.

11. Even if a firm obtains all of its common equity from retained earnings, its MCC schedule might still increase if very large amounts of new capital are needed.

Chapter 8

The Cost of Capital

237

12. There is a jump, or break, in a firm's MCC schedule each time the firm runs out of a particular source of capital at a particular cost. For example, a firm may use up its 10 percent debt and can then issue more debt only if it offers a higher rate to investors.

13. The correct discount rate for a firm to use in capital budgeting, assuming that new investments are of the same degree of risk as the firm's existing assets, is its marginal cost of capital.

14. The firm's cost of capital represents the maximum rate of return that a firm can earn from its capital budgeting projects to ensure that the value of the firm increases.

15. The cost of capital is the firm's average cost funds given what the market demands be paid to attract the funds.

16. The cost of capital used in capital budgeting must be determined using the specific financing used to fund that particular project.

17. A firm's capital structure has no impact on the firm's weighted average cost of capital.

18. Each component cost of particular types of capital is identical for each source of funds found in a firm's capital structure.

19. The after tax cost of debt is used to calculate the weighted average cost of capital since we are concerned with the after-tax cash flows of the firm.

20. Tax adjustments to the cost of preferred stock must be made when determining the cost of capital since dividend expenses on preferred stocks are tax deductible.

21. If a firm cannot invest retained earnings and earn at least the cost of equity, it should pay these funds to shareholders and let them invest directly in other assets that do provide this return.

22. Long-term capital gains are taxed at a lower rate than dividends for most stockholders leading companies to pay out dividends rather than use retained earnings to fund capital projects.

23. Flotation costs associated with issuing new equity cause the cost of external...
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