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Exam 9: Cost of Capital

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Question 51

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Which of the following statements is CORRECT?

A) Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.
B) The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes.
C) If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.
D) Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt.
E) Higher flotation costs tend to reduce the cost of equity capital.

F) A) and E)
G) A) and D)

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Question 52

Multiple Choice

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Which of the following statements is CORRECT?

A) Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates.In particular, academics and corporate finance people generally agree that its key inputs--beta, the risk-free rate, and the market risk premium--can be estimated with little error.
B) The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity.This is because of the DCF model's logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain.
C) The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm's own cost of debt and its risk premium, can be found by using standardized and objective procedures.
D) Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity.However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another.If all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity.
E) The DCF model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield.

F) A) and C)
G) B) and E)

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Question 53

Multiple Choice

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working with the CAPM, which of the following factors can be determined with the most precision?

were hired as a consultant to Quigley Company, whose target capital structure is 35% debt, 10% preferred, and 55% common equity.The interest rate on new debt is 6.50%, the yield on the preferred is 6.00%, the cost of common from retained earnings is 11.25%, and the tax rate is 40%.The firm will not be issuing any new common stock.What is Quigley's WACC?

Schalheim Sisters Inc.has always paid out all of its earnings as dividends; hence, the firm has no retained earnings.This same situation is expected to persist in the future.The company uses the CAPM to calculate its cost of equity, and its target capital structure consists of common stock, preferred stock, and debt.Which of the following events would REDUCE its WACC?

M's earnings and stock price tend to move up and down with other firms in the S&P 500, while Firm W's earnings and stock price move counter cyclically with M and other S&P companies.Both M and W estimate their costs of equity using the CAPM, they have identical market values, their standard deviations of returns are identical, and they both finance only with common equity.Which of the following statements is CORRECT?

cost of debt, rd, is normally less than rs, so rd

"Capital" is sometimes defined as funds supplied to a firm by investors.

Several years ago the Jakob Company sold a $1,000 par value, noncallable bond that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually.The bond currently sells for $925 and the company's tax rate is 40%.What is the component cost of debt for use in the WACC calculation?

Bosio Inc.'s perpetual preferred stock sells for $97.50 per share, and it pays an $8.50 annual dividend.If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors.What is the company's cost of preferred stock for use in calculating the WACC?

text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method.Since we cannot be sure that the estimate obtained with any of these methods is correct, it is often appropriate to use all three methods, then consider all three estimates, and end up using a judgmental estimate when calculating the WACC.

cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.