10.1) Cost of capital Answer: a Diff: E
. The cost of capital should reflect the average cost of the various sources of long-term funds a firm uses to support its assets.
a. True
b. False
(10.1) Capital Answer: a Diff: E
. Capital can be defined as the funds supplied by investors.
a. True
b. False
(10.1) Component costs of capital Answer: a Diff: E
. The component costs of capital are market-determined variables in as much as they are based on investors' required returns.
a. True
b. False
(10.2) Cost of debt Answer: b Diff: E
. The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC.
a. True
b. False
(10.2) Cost of debt Answer: b Diff: E
. The cost of debt is equal to one minus the marginal tax rate multiplied by the coupon rate on outstanding debt.
a. True
b. False
(10.3) Cost of preferred stock Answer: b Diff: E
. 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.
a. True
b. False
(10.4) Cost of common stock Answer: a Diff: E
. The cost of common stock is the rate of return stockholders require on the firm's common stock.
a. True
b. False
(10.4) Retained earnings Answer: b Diff: E
. In capital budgeting and cost of capital analyses, the firm should always consider retained earnings as the first source of capital, since this is a free source of funding to the firm.
a. True
b. False
(10.4) Retained earnings Answer: b Diff: E
. 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.
a. True
b. False
(10.4) Cost of internal equity Answer: b Diff: E
. The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.
a. True
b. False
(10.4) Cost of external equity Answer: b Diff: E
. The firm's cost of external equity capital is the same as the required rate of return on the firm's outstanding common stock.
a. True
b. False
(10.4) Cost of external equity Answer: b Diff: E
. The cost of equity capital from the sale of new common stock (re) is generally equal to the cost of equity capital from retention of earnings (rs), divided by one minus the flotation cost as a percentage of sales price (1 - F).
a. True
b. False
(10.4) Flotation cost and capital choice Answer: b Diff: E
. The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock which has no flotation cost and retained earnings whose cost is the average return on assets.
a. True
b. False
(10.10) Cost of capital Answer: b Diff: E
. You are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. Thus, the appropriate marginal cost of capital for the current year is the after-tax cost of debt.
a. True
b. False
Medium:
(10.2) After-tax cost of debt Answer: b Diff: M
. It is not possible for a firm's use of debt to increase but its after-tax cost of debt to decline.
a. True
b. False
(10.2) After-tax cost of debt Answer: a Diff: M
. A firm going from a lower to a higher tax bracket could increase its use of debt, yet actually wind up with a lower after-tax cost of debt.
a. True
b. False
(10.4) Cost of equity Answer: b Diff: M
. Since 70 percent of preferred dividends received by a corporation is excluded from taxable income, the component cost of equity for a company which pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be
Cost of equity = rs(0.30)(0.50) + rps(1 - T)(0.70)(0.50).
a. True
b. False
(10.5) Inflation effects Answer: b Diff: M
. 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. In other words, 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
(10.10) WACC Answer: c Diff: M
. Suppose the debt ratio (D/TA) is 10 percent, the current cost of debt is 8 percent, the current cost of equity is 16 percent, and the tax rate is 40 percent. An increase in the debt ratio to 20 percent would decrease the weighted average cost of capital.
a. True
b. False
c. More information is needed to determine the effect on the WACC.
(10.10) WACC Answer: a Diff: M
. The cost of debt, rd, is always less than rs, so rd(1 - T) will certainly be less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital will always be greater than rd(1 - T).
a. True
b. False
(10.10) WACC and tax rate Answer: b Diff: M
. The lower the firm's tax rate, the lower will be the firm's after-tax cost of debt and WACC, other things held constant.
a. True
b. False
(10.10) Specific source capital cost Answer: b Diff: M
. Firms should use their weighted average cost of capital (WACC) when they are funding their capital projects with a variety of sources. However, when the firm plans on using only debt or only equity to fund a particular project, it should use the after-tax cost of the specific source of capital to evaluate that project.
a. True
b. False