Exam 9: The Cost of Capital

A) r_e > r_s > WACC > r_d.
B) WACC > r_e > r_s > r_d.
C) r_d > r_e > r_s > WACC.
D) WACC > r_d > r_s > r_e.
E) r_s > r_e > r_d > WACC.

Correct Answer

verified

Show Answer

Correct Answer

verified

Show Answer

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

Correct Answer

verified

Show Answer

Correct Answer

verified

Show Answer

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

Correct Answer

verified

Show Answer

A) 10.69%
B) 11.25%
C) 11.84%
D) 12.43%
E) 13.05%

Correct Answer

verified

Show Answer

A) 0.57%
B) 0.63%
C) 0.70%
D) 0.77%
E) 0.85%

Correct Answer

verified

Show Answer

Correct Answer

verified

Show Answer

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

Correct Answer

verified

Show Answer

Correct Answer

verified

Show Answer

A) 12.60%
B) 13.10%
C) 13.63%
D) 14.17%
E) 14.74%

Correct Answer

verified

Show Answer

A) The flotation costs associated with issuing new common stock increase.
B) The company's beta increases.
C) Expected inflation increases.
D) The flotation costs associated with issuing preferred stock increase.
E) The market risk premium declines.

Correct Answer

verified

Show Answer

A) The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes.
B) 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.
C) Because no flotation costs are required to obtain capital as reinvested earnings, the cost of reinvested earnings is generally lower than the after-tax cost of debt.
D) Higher flotation costs tend to reduce the cost of equity capital.
E) 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.

Correct Answer

verified

Show Answer

Correct Answer

verified

Show Answer

Correct Answer

verified

Show Answer

A) All else equal, an increase in a company's stock price will increase its marginal cost of reinvested earnings (not newly issued stock) , r_s.
B) All else equal, an increase in a company's stock price will increase its marginal cost of new common equity, r_e.
C) Since the money is readily available, the after-tax cost of reinvested earnings (not newly issued stock) is usually much lower than the after-tax cost of debt.
D) If a company's tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall.
E) When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation.

Correct Answer

verified

Show Answer

A) When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.
B) 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 as measured by the CAPM.
C) 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 reinvested earnings to take care of its equity financing and hence must issue new stock.
D) Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC.
E) When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.

Correct Answer

verified

Show Answer

A) 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.
B) 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.
C) 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.
D) The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm's cost of equity capital.
E) 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.

Correct Answer

verified

Show Answer