[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.

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

a.k_d
> k_e > k_s > WACC.

b.k_s
> k_e > k_d > WACC.

c.WACC >
k_e > k_s > k_d.

d.k_e
> k_s > WACC > k_d.

e.None of
the statements above is correct.

[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, k_s.

c.All else
equal, an increase in a company’s stock price will increase the marginal cost
of issuing new common equity, k_e.

d.Statements
a and b are correct.

e.Statements
b and c are correct.

[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.

[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, k_s.

d.Expected rate of return, .gif”>.

e.All of the
above are equally difficult to estimate.

Answer: d

[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.

[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.

[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 if the company is able to rely on only retained earnings for its equity
financing.

d.Statements
a and b are correct.

e.Statements
a and c are correct.

[ix]. Wyden
Brothers has no retained earnings. The
company uses the CAPM to calculate the cost of equity capital. The company’s capital structure consists of
common stock, preferred stock, and debt.
Which of the following events will reduce the company’s WACC?

a.A
reduction in the market risk premium.

b.An
increase in the flotation costs associated with issuing new common stock.

c.An
increase in the company’s beta.

d.An
increase in expected inflation.

e.An
increase in the flotation costs associated with issuing preferred stock.

Answer: c

[x]. Which of
the following statements is most correct?

a.The WACC is a measure of the before-tax cost of
capital.

b.Typically the after-tax cost of debt financing exceeds the after-tax
cost of equity financing.

c.The WACC measures the marginal after-tax cost
of capital.

d.Statements a and b are correct.

e.Statements b and c are correct.

Answer: a

[xi]. A company
has a capital structure that consists of 50 percent debt and 50 percent
equity. Which of the following
statements is most correct?

a.The cost of equity financing is greater than or equal to the cost of
debt financing.

b.The WACC exceeds the cost of equity financing.

c.The WACC is calculated on a before-tax basis.

d.The WACC represents the cost of capital based on historical
averages. In that sense, it does not represent the marginal cost of capital.

e.The cost of retained earnings exceeds the cost of issuing new common
stock.

Answer: e

[xii]. A firm
estimates that its proposed capital budget will force it to issue new common
stock, which has a greater cost than the cost of retained earnings. The firm, however, would like to avoid
issuing costly new common stock. Which
of the following steps would mitigate the firm’s need to raise new common
stock?

a.Increasing the company’s dividend payout ratio
for the upcoming year.

b.Reducing the company’s debt ratio for the
upcoming year.

c.Increasing the company’s proposed capital
budget.

d.All of the statements above are correct.

e.
None of the
statements above is correct.

[xiii].Dick Boe
Enterprises, an all-equity firm, has a corpor­ate beta coefficient of 1.5. The financial manager is evaluating a proj­ect
with an expected return of 21 percent, before any risk adjustment. The risk-free rate is 10 percent, and the
required rate of return on the market is 16 percent. The project being evaluated is risk­ier than
Boe’s average project, in terms of both beta risk and total risk. Which of the following statements is most
correct?

a.The
project should be accepted since its expected return (before risk adjustment)
is greater than its required return.

b.The
project should be rejected since its expected return (before risk adjustment)
is less than its re­quired return.

c.The
accept/reject decision depends on the risk-adjustment policy of the firm. If the firm’s policy were to reduce a
riskier-than-average project’s expected return by 1 percentage point, then the
project should be accepted.

d.Riskier-than-average
projects should have their expected returns increased to reflect their added
riskiness. Clearly, this would make the
project acceptable regardless of the amount of the adjustment.

e.Projects
should be evaluated on the basis of their total risk alone. Thus, there is
insuffi­cient information in the problem to make an accept/reject decision.

[xiv]. A company
estimates that an average-risk project has a WACC of 10 percent, a
below-average risk project has a WACC of 8 percent, and an above-average risk
project has a WACC of 12 percent. Which
of the following independent projects should the company accept?

a.Project A
has average risk and a return of 9 percent.

b.Project B
has below-average risk and a return of 8.5 percent.

c.Project C
has above-average risk and a return of 11 percent.

d.All of the
projects above should be accepted.

e.None of
the projects above should be accepted.

[xv]. Conglomerate
Inc. consists of 2 divisions of equal size, and Conglomerate is 100 percent
equity financed. Division A’s cost of
equity capital is 9.8 percent, while Division B’s cost of equity capital is 14
percent. Conglomerate’s composite WACC
is 11.9 percent. Assume that all
Division A projects have the same risk and that all Division B projects have
the same risk. However, the projects in
Division A are not the same risk as those in Division B. Which of the following projects should
Conglomerate accept?

a.Division A project with an 11 percent return.

b.Division B
project with a 12 percent return.

c.Division B
project with a 13 percent return.

d.Statements
a and c are correct.

e.Statements
b and d are correct.

[xvi]. Which of
the following will increase a company’s retained earnings break point?

a.An
increase in its net income.

b.An
increase in its dividend payout.

c.An increase
in the amount of equity in its capital structure.

d.An
increase in its capital budget.

e.All of the
statements above are correct.

[xvii].Which of
the following actions will increase the retained earnings break point?

a.An
increase in the dividend payout ratio.

b.An
increase in the debt ratio.

c.An
increase in the capital budget.

d.An
increase in flotation costs.

e.All
of the statements above are correct.

[xviii]. Which
of the following statements is most correct?

a.Since debt
capital is riskier than equity capital, the cost of debt is always greater than
the WACC.

b.Because of
the risk of bankruptcy, the cost of debt capital is always higher than the cost
of equity capital.

c.If a
company assigns the same cost of capital to all of its projects regardless of
the project’s risk, then it follows that the company will generally reject too
many safe projects and accept too many risky projects.

d.Because
you are able to avoid flotation costs, the cost of retained earnings is
generally lower than the cost of debt.

e.Higher
flotation costs tend to reduce the cost of equity capital.

[xix]. Which of the
following statements is most correct?

a.Higher
flotation costs reduce investor returns, and therefore reduce a company’s WACC.

b.The WACC
represents the historical cost of capital and is usually calculated on a
before-tax basis.

c.The cost
of retained earnings is zero because retained earnings are readily available
and do not require the payment of flotation costs.

d.All of the
statements above are correct.

e.None of
the statements above is correct.

[xx]. Which of
the following statements is most correct?

a.In the
weighted average cost of capital calculation, we must adjust the cost of
preferred stock for the tax exclusion of 70 percent of dividend income.

b.We ideally
would like to use historical measures of the component costs from prior
financings in estimating the appropriate weighted average cost of capital.

c.The cost
of a new equity issuance (k_e) could possibly be lower than the cost
of retained earnings (k_s) if the market risk premium and risk-free
rate decline by a substantial amount.

d.Statements
b and c are correct.

e.None of
the statements above is correct.

[xxi]. Which of
the following statements is most correct?

a.The cost
of retained earnings is the rate of return stockholders require on a firm’s
common stock.

b.The
component cost of preferred stock is expressed as k_p(1 – T), because
preferred stock dividends are treated as fixed charges, similar to the
treatment of debt interest.

c.The
bond-yield-plus-risk-premium approach to estimating a firm’s cost of common
equity involves adding a subjectively determined risk premium to the market
risk-free bond rate.

d.The higher
the firm’s flotation cost for new common stock, the more likely the firm is to
use preferred stock, which has no flotation cost.

e.None of
the statements above is correct.

[xxii].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.

b.The cost
of debt used to calculate the weighted average cost of capital is based on an
average of the cost of debt already issued by the firm and the cost of new
debt.

c.One
problem with the CAPM approach in estimating the cost of equity capital is that
if a firm’s stockholders are, in fact, not well diversified, beta may be a poor
measure of the firm’s true investment risk.

d.The
bond-yield-plus-risk-premium approach is the most sophisticated and objective
method of estimating a firm’s cost of equity capital.

e.The cost
of equity capital is generally easier to measure than the cost of debt, which
varies daily with interest rates, or the cost of preferred stock since
preferred stock is issued infrequently.

[xxiii]. Which of
the following statements is correct?

a.Although
some methods of estimating the cost of equity capital encounter severe
difficulties, the CAPM is a simple and reliable model that provides great
accuracy and consistency in estimating the cost of equity capital.

b.The DCF
model is preferred over other models to estimate the cost of equity because of
the ease with which a firm’s growth rate is obtained.

c.The
bond-yield-plus-risk-premium approach to estimating the cost of equity is not
always accurate but its advantages are that it is a standardized and objective
model.

d.Depreciation-generated
funds are an additional source of capital and, in fact, represent the largest
single source of funds for some firms.

e.None of
the statements above is correct.

[xxiv].In applying
the CAPM to estimate the cost of equity capital, which of the following
elements is not subject to dispute or controversy?

a.The
expected rate of return on the market, k_M.

b.The
stock’s beta coefficient, b_i.

c.The
risk-free rate, k_RF.

d.The market
risk premium (RP_M).

e.All of the
above are subject to dispute.

[xxv]. Which of
the following statements is most correct?

a.Beta
measures market risk, but if a firm’s stockholders are not well diversified,
beta may not accurately measure stand-alone risk.

b.If the
calculated beta underestimates the firm’s true investment risk, then the CAPM
method will overestimate k_s.

c.The
discounted cash flow method of estimating the cost of equity can’t be used
unless the growth component, g, is constant during the analysis period.

d.An
advantage shared by both the DCF and CAPM methods of estimating the cost of
equity capital, is that they yield precise estimates and require little or no
judgement.

e.None of
the statements above is correct.

[xxvi].Which of
the following statements is most correct?

a.The
weighted average cost of capital for a given capital budget level is a weighted
average of the marginal cost of each relevant capital component that makes up
the firm’s target capital structure.

b.The
weighted average cost of capital is calculated on a before-tax basis.

c.An
increase in the risk-free rate is likely to increase the marginal costs of both
debt and equity financing.

d.Statements
a and c are correct.

e.All of the
statements above are correct.

[xxvii]. Which of
the following statements is correct?

a.The WACC
should include only after-tax component costs.
Therefore, the required rates of return (or “market rates”) on debt,
preferred, and common equity (k_d, k_p, and k_s)
must be adjusted to an after-tax basis before they are used in the WACC
equation.

b.The cost
of retained earnings is generally higher than the cost of new common stock.

c.Preferred
stock is riskier to investors than is debt. Therefore, if someone told you that
the market rates showed k_d>_{kp for a given
company, that person must have made a mistake.}

d.If a
company with a debt ratio of 50 percent were suddenly exempted from all future
income taxes, then, all other things held constant, this would cause its WACC to
increase.

e.None of
the statements above is correct.

[xxviii]. Which of
the following statements is most correct?

a.An
increase in flotation costs incurred in selling new stock will increase the
cost of retained earnings.

b.The WACC
should include only after-tax component costs.
Therefore, the required rates of return (or “market rates”) on debt,
preferred, and common equity (k_d, k_p, and k_s)
must be adjusted to an after-tax basis before they are used in the WACC
equation.

c.An
increase in a firm’s corporate tax rate will increase the firm’s cost of debt
capital, as long as the yield to maturity on the company’s bonds remains
constant or falls.

d.Statements
b and c are correct.

e.None of
the statements above is correct.