Quiz Chapter 10 Answer Key.doc

CHAPTER 10 THE COST OF CAPITAL Multiple Choice: Problems Component cost of retained earnings: CAPM Answer: a EASY . Heino Inc. hired you as a consultant to help them estimate their cost of capital. You have been provided with the following data: rRF = 5.0%; RPM = 5.0%; and b = 1.1. Based on the CAPM approach, what is the cost of equity from retained earnings? a. 10.50% b. 10.71% c. 10.88% d. 11.03% Component cost of retained earnings: DCF, D1 Answer: d EASY . Rhino Inc. hired you as a consultant to help them estimate their cost of capital. You have been provided with the following data: D1 = $1.30; P0 = $40.00; and g = 7% (constant). Based on the DCF approach, what is the cost of equity from retained earnings? a. 9.66% b. 9.84% c. 9.97% d. 10.25% WACC Answer: d EASY . You were hired as a consultant to Keys Company, and you were provided with the following data: Target capital structure: 40% debt, 10% preferred, and 50% common equity. The after-tax cost of debt is 4.00%, the cost of preferred is 7.50%, and the cost of retained earnings is 11.50%. The firm will not be issuing any new stock. What is the firm?s WACC? a. 7.55% b. 7.73% c. 7.94% d. 8.10% Component cost of retained earnings: DCF, D0 Answer: b MEDIUM . Assume that Mary Brown Inc. hired you as a consultant to help it estimate the cost of capital. You have been provided with the following data: D0 = $1.20; P0 = $40.00; and g = 7% (constant). Based on the DCF approach, what is Brown's cost of equity from retained earnings? a. 10.06% b. 10.21% c. 10.37% d. 10.54% WACC Answer: a MEDIUM . You were hired as a consultant to Locke Company, and you were provided with the following data: Target capital structure: 40% debt, 10% preferred, and 50% common equity. The interest rate on new debt is 7.5%, the yield on the preferred is 7.0%, the cost of retained earnings is 11.50%, and the tax rate is 40%. The firm will not be issuing any new stock. What is the firm?s WACC? a. 8.25% b. 8.38% c. 8.49% d. 8.61% Cost of retained earnings: risk premium, CAPM, and DCF Answer: b HARD . Malko Inc. hired you as a consultant to help them estimate their cost of capital. You have been provided with the following data. (1): rd = yield on the firm?s bonds = 6.5% and risk premium over own debt cost = 4%. (2) rRF = 5.5%, RPM = 5.5%, and b = 1.0. (3) D1 = $1.20; P0 = $40.00 and g = 7% (constant). You were asked to estimate the cost of equity based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates. What is this difference? a. 0.90% b. 1.00% c. 1.10% d. 1.20% Capital components Answer: d EASY . Which of the following is not a capital component when calculating the weighted average cost of capital (WACC)? a. Long-term debt. b. Common stock. c. Retained earnings. d. Accounts payable. Capital components Answer: c MEDIUM . Which of the following statements is CORRECT? a. Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock. b. When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation. c. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are tax deductible by the paying corporation. d. If a company?s beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence needs to issue new stock. WACC Answer: b MEDIUM . Which of the following statements is CORRECT? a. The WACC as used in capital budgeting is an estimate of a company?s before-tax cost of capital. b. There is an ?opportunity cost? associated with using retained earnings?they are not ?free.? c. The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets. d. The percentage flotation costs associated with issuing new common equity are typically smaller than the flotation costs for new debt. WACC Answer: c MEDIUM . Which of the following statements about the cost of capital is CORRECT? a. A change in a company?s target capital structure cannot affect its WACC. b. WACC calculations should be based on the before-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 decrease. d. Flotation costs associated with issuing new common stock normally lead to a decrease in the WACC. Capital components Answer:d MEDIUM . Which of the following statements is CORRECT? a. In the WACC calculation, we must adjust the cost of preferred stock (the market yield) because 70% of the dividends received by corporate investors are excluded from their taxable income. b. We should use historical measures of the component costs from prior financings when estimating a company?s WACC for capital budgeting purposes. c. The cost of new equity (re) could possibly be lower than the cost of retained earnings (rs) if the market risk premium, risk-free rate, and the company?s beta all decline by a sufficiently large amount. d. The cost of retained earnings is the rate of return stockholders require on a firm?s common stock. CHAPTER 10 ANSWERS AND SOLUTIONS . Component cost of retained earnings: CAPM Answer: a EASY . Component cost of retained earnings: DCF, D1 Answer: e EASY . WACC Answer: d EASY . Component cost of retained earnings: DCF, D0 Answer: b MEDIUM . WACC Answer: a MEDIUM . Cost of retained earnings: risk premium, CAPM, and DCF Answer: b HARD . Capital components Answer: d EASY . Capital components Answer: c MEDIUM Statement c is true, because interest payments on debt are tax deductible. The other statements are false. . WACC Answer: b MEDIUM . WACC Answer: c MEDIUM Statement c is true, because if the tax rate increases the tax deductibility benefits of debt financing increase, resulting in a lower WACC. The other statements are false. . Capital components Answer: e MEDIUM Page PAGE 2 Chapter 10: The Cost of Capital Chapter 10: The Cost of Capital Page PAGE 1