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O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of equity from retained earnings based on the CAPM?


A) 11.30%
B) 11.64%
C) 11.99%
D) 12.35%
E) 12.72%

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

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Scanlon Inc.'s CFO hired you as a consultant to help her estimate the cost of capital. You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30. Based on the CAPM approach, what is the cost of equity from retained earnings?


A) 9.67%
B) 9.97%
C) 10.28%
D) 10.60%
E) 10.93%

F) C) and D)
G) C) and E)

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Which of the following statements is CORRECT?


A) The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity.
B) The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average after-tax cost of all the firm's outstanding debt.
C) Suppose some of a publicly-traded firm's stockholders are not diversified; they hold only the one firm's stock. In this case, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firm's intrinsic value.
D) The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity.
E) The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm's cost of equity capital.

F) C) and D)
G) A) and B)

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Safeco Company and Risco Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Safeco having a WACC of 10% and Risco a WACC of 12%. Safeco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Safeco project. Risco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Risco project. Now assume that the two companies merge and form a new company, Safeco/Risco Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is CORRECT?


A) If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.
B) If evaluated using the correct post-merger WACC, Project X would have a negative NPV.
C) After the merger, Safeco/Risco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y.
D) Safeco/Risco's WACC, as a result of the merger, would be 10%.
E) After the merger, Safeco/Risco should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%.

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

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If expectations for long-term inflation rose, but the slope of the SML remained constant, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Therefore, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt.

A) True
B) False

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Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant) . What is the cost of equity from retained earnings based on the DCF approach?


A) 9.42%
B) 9.91%
C) 10.44%
D) 10.96%
E) 11.51%

F) A) and B)
G) C) and D)

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To help finance a major expansion, Castro Chemical Company sold a noncallable bond several years ago that now has 20 years to maturity. This bond has a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000. If the firm's tax rate is 40%, what is the component cost of debt for use in the WACC calculation?


A) 4.35%
B) 4.58%
C) 4.83%
D) 5.08%
E) 5.33%

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

Correct Answer

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Which of the following statements is CORRECT?


A) The discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever.
B) If the calculated beta underestimates the firm's true investment risk--i.e., if the forward-looking beta that investors think exists exceeds the historical beta--then the CAPM method based on the historical beta will produce an estimate of rs and thus WACC that is too high.
C) Beta measures market risk, which is, theoretically, the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. This is true even if not all of the firm's stockholders are well diversified.
D) An advantage shared by both the DCF and CAPM methods when they are used to estimate the cost of equity is that they are both "objective" as opposed to "subjective," hence little or no judgment is required.
E) The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach.

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

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Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?


A) Long-term debt.
B) Accounts payable.
C) Retained earnings.
D) Common stock.
E) Preferred stock.

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

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In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project.

A) True
B) False

Correct Answer

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You were recently hired by Scheuer Media Inc. to estimate its cost of capital. You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.00% (constant) ; and F = 5.00%. What is the cost of equity raised by selling new common stock?


A) 10.77%
B) 11.33%
C) 11.90%
D) 12.50%
E) 13.12%

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

Correct Answer

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The reason why retained earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm's common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should pay those earnings out to its investors. Thus, the cost of retained earnings is based on the opportunity cost principle.

A) True
B) False

Correct Answer

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