Format: True/False

Learning Objective: LO 1

Level of Difficulty: Easy

1. Unique risk is the only risk that investors require compensation for bearing.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Easy

2. Utilizing the CAPM to estimate the cost of capital for a project is difficult in practice

because analysts do not have the stock returns from individual projects that are

necessary to use in a regression analysis for estimating a project's beta.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 4

Level of Difficulty: Medium

3. Using the firm's overall cost of capital to evaluate a project's cash flows is problematic

in that the firm is a collection of projects, with the possibility that each project has a

different level of risk than the other projects currently working for the firm.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

4. If a firm finances the purchase of an asset with cash, then it has zero financial cost to

the firm.

A) True

B) False

Ans: B

Page 1

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Easy

5. The finance balance sheet is based on market values, just like the accounting balance

sheet.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Medium

6. If the market value of a firm's assets are greater than the book value of a firm's assets

then the book value of the firm's liabilities and equity must be less than the market

value of the firm's liabilities and equity.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Medium

7. The beta of the firm is equal to the weighted-average sum of the betas of the individual

projects that the firm is currently operating.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Medium

8. Due to the magic of diversification, the risk associated with the assets of the firm must

be less than the risk associated with the financing, or debt and equity, that the firm is

utilizing for its assets.

A) True

B) False

Ans: B

Page 2

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Medium

9. A firm is currently taking on two projects with an individual cost of capital of 10

percent and 12 percent for each of the projects. That means that the before-tax cost of

capital for the firm must be between 10 and 12 percent.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Medium

10. If one observes the market quoted price of a debt security where the expected cash

flows of that security are known, then one can calculate the current cost of that security

to the firm.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Medium

11. Estimates of security returns will be reliable in all types of markets, including those

deemed less efficient than others.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

12. Long-term debt typically describes debt that will mature in two years or more.

A) True

B) False

Ans: A

Page 3

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

13. Long-term debt is generally viewed as a permanent financing source for the firm.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

14. With respect to the cost of capital, we are generally interested in the cost of a source of

financing on a particular date.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Medium

15. If a firm is interested in the current cost of its debt obligations, then it can simply look

at the contractual rate of interest due lenders on those obligations.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Medium

16. Milton Corp. issued bonds 10 years ago with a coupon rate of 10 percent at a price of

$1,000. The current price of the bonds is $980. The before-tax cost of the debt to the

firm is still 10 percent.

A) True

B) False

Ans: B

Page 4

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

17. The yield to maturity for a semiannual coupon paying bond will accurately reflect the

actual current annual cost of the debt.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

18. The yield to maturity for an annual coupon paying bond will accurately reflect the

actual current annual pretax cost of the debt.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

19. The current cost of bank debt can be determined by asking the firm's banker.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Medium

20. The issuance costs of new debt securities can be ignored since those costs will not be

reflected in the yield to maturity of the debt in the future.

A) True

B) False

Ans: B

Page 5

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Medium

21. If a firm is subject to income taxes, then the after-tax cost of debt for the firm will be

less than the before-tax cost of debt.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Medium

22. The cost of equity for the firm must take the cost of preferred stock (if any has been

issued) that the firm has outstanding into account.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Medium

23. The correct Treasury rate to use in calculating the cost of equity (when using the

CAPM) for a firm is a short-term rate.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Medium

24. When trying to estimate the cost of equity for a firm using the CAPM, it is possible to

find the beta of a comparable, publicly traded firm whose primary business is closely

related to the firm at hand.

A) True

B) False

Ans: A

Page 6

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Easy

25. The market risk premium for the future is always perfectly known, and it is 6.51

percent.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Medium

26. If a firm is currently paying common share dividends to investors and those dividends

are expected to grow at a low but steady rate in the future, then the cost of common

equity for the firm can be determined by also using the current price of the firm's

common shares.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Easy

27. The current cost of preferred equity can be found by taking the ratio of the dividend to

the current price of preferred shares.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Easy

28. The CAPM can only be used to determine the cost of common equity.

A) True

B) False

Ans: B

Page 7

Format: True/False

Learning Objective: LO 4

Level of Difficulty: Medium

29. The proportions of debt and equity used to determine the weighted average cost of

capital for the firm is based on the market value of debt and equity outstanding.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 4

Level of Difficulty: Medium

30. The correctly calculated weighted-average cost of capital for the firm can be used to

discount the cash flows for any new project that the firm may undertake in the future.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 4

Level of Difficulty: Medium

31. The estimated cost of capital financial managers use for efficiency projects tends to be

higher than the cost of capital used to evaluate new projects.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 4

Level of Difficulty: Medium

32. When using a single rate, such as the WACC, to discount cash flows for all projects of a

particular company, the discount rate could lead to accepting projects that will actually have

a negative NPV.

A) True

B) False

Ans: A

Page 8

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

33. Firms have no way to directly estimate the discount rate that reflects the risk of

A) a publicly traded security.

B) its debt securities.

C) the incremental cash flows from a particular project.

D) none of the above.

Ans: C

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

34. A firm's overall cost of capital is

A) equal to its cost debt.

B) a weighted average of the costs of capital for the collection of individual projects that the

firm is working on.

C) best measured by the cost of capital of the riskiest projects that the firm is working on.

D) none of the above.

Ans: B

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Easy

35. The finance balance sheet is

A) the same as the accounting balance sheet, but it is based on market values.

B) the same as the accounting balance sheet, but it does not have to balance.

C) based on cash rather than accrual accounting.

D) net income.

Ans: A

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

36. The value of the cash flows that the assets of the firm are expected to generate must

equal

A)

the value of the cash flows claimed by the equity investors.

B)

the value of the cash flows claimed by the debt investors.

C)

the value of the cash flows claimed by both the equity and debt investors.

D)

the revenue produced by the firm.

Ans: C

Page 9

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Easy

37. The beta for a firm can be estimated by

A) adding up the betas of the individual projects of the firm.

B) taking the weighted average of the beta for the individual projects of the firm.

C) taking the simple average of the beta for the individual projects of the firm.

D) None of the above.

Ans: B

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Easy

38. The firm can be viewed as

A) a portfolio of individual projects, each with their own risks, cost of capital, and returns.

B) a collection of equity shares comprising it.

C) a collection of debt instruments financing it.

D) none of the above.

Ans: A

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

39. In order for a firm to estimate its cost of debt capital by observing the price of its debt

instruments,

A) the firm must depend on markets being reasonably efficient.

B) the debt must be privately held.

C) the beta of the debt must be greater than the beta of the firm's equity.

D) None of the above.

Ans: A

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

40. If markets are not reasonably efficient, then

A) the estimates of expected returns are not needed.

B) the need for a discount rate to analyze project cash flows is not needed.

C) estimates of expected returns that were based on security prices will not be reliable.

D) none of the above.

Ans: C

Page 10

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

41. When estimating the cost of debt capital for the firm, we are primarily interested in

A) the cost of short-term debt.

B) the cost of long-term debt.

C) the coupon rate of the debt.

D) none of the above.

Ans: B

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

42. Long-term debt typically describes

A) debt with a maturity greater than one year.

B) only coupon debt.

C) publicly traded debt.

D) none of the above.

Ans: A

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

43. Which of the following need to be excluded from the calculation of the firm's amount

of permanent debt?

A) Long-term debt

B) Revolving lines of credit

C) Mortgage debt

D) None of the above

Ans: B

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

44. When analyzing a firm's cost of debt, we are typically interested in

A) the cost of the debt on the date that the analysis is being completed.

B) the coupon rate on the firm's bonds.

C) the risk-free rate plus half a percent.

D) none of the above.

Ans: A

Page 11

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

45. If a firm has bonds outstanding and the firm would like to calculate the current cost of

debt for the bonds, then the firm would

A) use the coupon rate of the bonds to estimate the cost.

B) use the current yield to maturity of the bonds to estimate the cost.

C) use the current coupon yield of the bonds to estimate the cost.

D) none of the above.

Ans: B

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

46. A bond has a coupon rate of 6 percent and the bond makes semiannual coupon

payments. The dollar amount of coupon interest received every six months is

A) $60.

B) $30.

C) $30 plus or minus the prorate portion of the discount or premium that the bond was

purchased for.

D) none of the above.

Ans: B

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

47. Bond issuance costs include

A) investment banking fees.

B) legal fees.

C) accountant fees.

D) all of the above.

Ans: D

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

48. Income taxes have the effect of

A) increasing the cost of debt.

B) decreasing the cost of debt.

C) decreasing the cost of capital for the firm.

D) both b and c are correct.

Ans: B

Page 12

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Medium

49. The appropriate risk-free rate to use when calculating the cost of equity for a firm is

A) a long-term Treasury rate.

B) a short-term Treasury rate.

C) a 50/50 mix of short-term and long-term Treasury rates.

D) none of the above.

Ans: A

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Medium

50. The average risk-premium for the market from 1926 to 2009 was

A) 8.00%.

B) 7.50%.

C) 6.01%.

D) 6.51% + the Treasury rate.

Ans: C

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Medium

51. The recommended model to estimate the cost of common equity for a firm is

A) a one-stage constant growth model.

B) a multistage growth model.

C) the CAPM.

D) none of the above.

Ans: C

Format: Multiple Choice

Learning Objective: LO 4

Level of Difficulty: Hard

52. In order to use the WACC to evaluate a future project's flows, which of the following

must hold?

A) The project will be financed with the same proportion of debt and equity as the firm.

B) The systematic risk of the project is the same as the overall systematic risk of the firm.

C) The project must be viable.

D) a and b above.

Ans: D

Page 13

Format: Multiple Choice

Learning Objective: LO 4

Level of Difficulty: Hard

53. Overall cost of capital: If the market risk premium is currently 6 percent and the riskfree rate of return is 4 percent, then what is the expected return on a common share with

a beta equal to 2?

A) 8.0%

B) 10.0%

C) 12.0%

D) 16.0%

Ans: D

Feedback:

E(Ri) = Rrf + βi [E(Rm) – Rrf] = 0.04 + 2.0 [0.06] = 0.04 + 0.12 = 0.16

Format: Multiple Choice

Learning Objective: LO 4

Level of Difficulty: Hard

54. Overall cost of capital: What is the beta of a firm whose equity has an expected return

of 21.3 percent when the risk-free rate of return is 7.0 percent and the expected return

on the market is 18.0 percent?

A) 0.79

B) 1.30

C) 1.57

D) none of the above

Ans: B

Feedback:

E(Ri) = Rrf + βi [E(Rm) – Rrf] ==> 0.213 = 0.07 + βi [0.18 – 0.07] ==> βi= 1.30

Format: Multiple Choice

Learning Objective: LO 4

Level of Difficulty: Hard

55. Overall cost of capital: Stryder, Inc., has 3 million shares outstanding at a current

price of $15 per share. The book value of the shares is $10 per share. The firm also has

$30 million in par value of bonds outstanding. The bonds are selling at a price equal to

101 percent of par. What is the market value of the firm?

A) $30.0 million

B) $45.0 million

C) $75.0 million

D) $75.3 million

Ans: D

Feedback:

MV of assets = MV of liabilities + MV of equity

= (1.01 x $30,000,000) + (3,000,000 x

15)

= $75,300,000

Page 14

Format: Multiple Choice

Learning Objective: LO 4

Level of Difficulty: Hard

56. How firms estimate their cost of capital: The Diverse Co. has invested 40 percent of

the firm's assets in a project with a beta of 0.4 and the remaining assets in a project with

a beta of 1.8. What is the beta of the firm?

A) 0.96

B) 1.24

C) 1.28

D) None of the above

Ans: B

Feedback:

2

β n Asset portfolio = ∑ xi βi = 0.4(0.4) + 0.6(1.8) = 1.24

i =1

Format: Multiple Choice

Learning Objective: LO 4

Level of Difficulty: Hard

57. How firms estimate their cost of capital: You are analyzing the cost of capital for a

firm that is financed with 65 percent equity and 35 percent debt. The cost of debt

capital is 8 percent, while the cost of equity capital is 20 percent for the firm. What is

the overall cost of capital for the firm?

A) 12.2%

B) 14.0%

C) 15.8%

D) 20.0%

Ans: C

Feedback:

kFirm = xDebt kDebt + xEquity kEquity = (0.35 x 0.08) + (0.65 x 0.2) = 0.158

Page 15

Format: Multiple Choice

Learning Objective: LO 4

Level of Difficulty: Hard

58. How firms estimate their cost of capital: You are analyzing the cost of capital for a

firm that is financed with $300 million of equity and $200 million of debt. The cost of

debt capital for the firm is 9 percent, while the cost of equity capital is 19 percent. What

is the overall cost of capital for the firm?

A) 13.0%

B) 14.0%

C) 15.0%

D) 16.0%

Ans: C

Feedback:

xDebt = 200/500 = 0.4, xEquity = 300/500 = 0.6

kFirm = xDebt kDebt + xEquity kEquity = (0.4 x 0.09) + (0.6 x 0.19) = 0.15

Format: Multiple Choice

Learning Objective: LO 4

Level of Difficulty: Medium

59. How firms estimate their cost of capital: The WACC for a firm is 19.75 percent. You

know that the firm is financed with $75 million of equity and $25 million of debt. The

cost of debt capital is 7 percent. What is the cost of equity for the firm?

A) 19.75%

B) 24.00%

C) 32.50%

D) 58.00%

Ans: B

Feedback:

xDebt = 25/100 = 0.25, xEquity = 75/100 = 0.75

kFirm = xDebt kDebt + xEquity kEquity ==> .1975 = (0.25 x 0.07) + (0.75 x kEquity) ==>

kEquity = 0.2400

Page 16

Format: Multiple Choice

Learning Objective: LO 4

Level of Difficulty: Medium

60. How firms estimate their cost of capital: The WACC for a firm is 13.00 percent. You

know that the firm's cost of debt capital is 10 percent and the cost of equity capital is

20%. \

What proportion of the firm is financed with debt?

A) 30%

B) 33%

C) 50%

D) 70%

Ans: D

Feedback:

xDebt = Y, xEquity = (1 – Y)

kFirm = xDebt kDebt + xEquity kEquity ==> 0.13= (Y x 0.1) + ((1 – Y) x 0.20) ==>

Y = 0.7

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

61. The cost of debt: Bellamee, Inc., has semiannual bonds outstanding with five years to

maturity and are priced at $920.87. If the bonds have a coupon rate of 7 percent, then

what is the YTM for the bonds?

A) 4.5%

B) 7.0%

C) 9.0%

D) 9.2%

Ans: C

Feedback:

Using the formula for pricing bonds, we have

$920.87 = $35 x PVIFA(YTM / 2,10) + $1, 000 x PVIF (YTM / 2,10)

and after solving for YTM / 2 = 4.5%, we find that YTM = 9.0%.

Note that we assume semi − annual coupons for the bond .

Page 17

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

62. The cost of debt: Dynamo Corporation has semiannual bonds outstanding with 12

years to maturity and are currently priced at $1,080.29. If the bonds have a coupon rate

of 8 percent, then what is the equivalent annual return (EAR) to the investor for

purchasing the bonds at the described price?

A) 3.5%

B) 7.00%

C) 7.12%

D) 8.00%

Ans: C

Feedback:

Using the formula for pricing bonds, we have

$1, 080.29 = $40 x PVIFA(YTM / 2, 24) + $1,000 x PVIF (YTM / 2, 24)

and after solving for YTM / 2 = 3.5%, we find that YTM = 7.0%.

Note that we assume semi − annual coupons for the bond .

0.07 2

Now, we adjust for EAR : (1 +

) − 1 = 0.0712 = 7.12%

2

Page 18

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

63. The cost of debt: Beckham Corporation has semiannual bonds outstanding with 13

years to maturity and are currently priced at $746.16. If the bonds have a coupon rate of

8.5 percent, then what is the after-tax cost of debt for Beckham if its marginal tax rate is

35%? Assume that your calculation is made as on Wall Street.

A) 6.250%

B) 8.125%

C) 12.500%

D) 12.890%

Ans: B

Feedback:

Using the formula for pricing bonds, we have

$746.16 = $42.50 x PVIFA(YTM / 2, 26) + $1, 000 x PVIF (YTM / 2, 26)

and after solving for YTM / 2 = 6.25%, we find that YTM = 12.50%.

Note that we assume semi − annual coupons for the bond .

Now, we adjust taxes :12.50% x (1 − 0.35) = 8.125%

Page 19

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

64. The cost of debt: PackMan Corporation has semiannual bonds outstanding with nine

years to maturity and are currently priced at $754.08. If the bonds have a coupon rate of

7.25 percent, then what is the after-tax cost of debt for Beckham if its marginal tax rate

is 30 percent? Complete the calculation as is done on Wall Street.

A) 7.050%

B) 8.225%

C) 11.750%

D) 12.095%

Ans: A

Feedback:

Using the formula for pricing bonds, we have

$754.08 = $36.25 x PVIFA(YTM / 2,18) + $1, 000 x PVIF (YTM / 2,18)

and after solving for YTM / 2 = 5.875%, we find that YTM = 11.75%.

Note that we assume semi − annual coupons for the bond .

Now, we adjust taxes :11.75% x (1 − 0.3) = 8.225%

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Hard

65. The cost of equity: Jacque Ewing Drilling, Inc., has a beta of 1.3 and is trying to

calculate its cost of equity capital. If the risk-free rate of return is 8 percent and the

expected return on the market is 12 percent, then what is the firm's after-tax cost of

equity capital if the firm's marginal tax rate is 40 percent?

A) 7.92%

B) 13.20%

C) 15.57%

D) 23.60%

Ans: B

Feedback:

The equation for the CAPM is : E ( Ri ) = Rrf + β i E ( Rm ) − Rrf .

If βi = 1.3, Rrf = 0.08, and E ( Rm ) = 0.12, then we have

E ( Ri ) = 0.08 + 1.3 [ 0.08 − 0.12] = 0.132 = 13.20%

Page 20

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Hard

66. The cost of equity: TeleNyckel, Inc., has a beta of 1.4 and is trying to calculate its cost

of equity capital. If the risk-free rate of return is 9 percent and the market risk premium

is 5 percent, then what is the firm's after-tax cost of equity capital if the firm's marginal

tax rate is 30 percent?

A) 11.20%

B) 10.60%

C) 15.14%

D) 16.00%

Ans: D

Feedback:

The equation for the CAPM is : E ( Ri ) = Rrf + β i E ( Rm ) − Rrf .

If βi = 1.4, Rrf = 0.09, and E ( Rm ) − Rrf = 0.05, then we have

E ( Ri ) = 0.09 + 1.4 [ 0.05] = 0.16 = 16.00%

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Medium

67. The cost of equity: RadicalVenOil, Inc., has a cost of equity capital equal to 22.8

percent. If the risk-free rate of return is 10 percent and the expected return on the

market is 18 percent, then what is the firm's beta if the firm's marginal tax rate is 35

percent?

A) 1.0

B) 1.28

C) 1.60

D) 4.10

Ans: C

Feedback:

The equation for the CAPM is : E ( Ri ) = Rrf + β i E ( Rm ) − Rrf .

If E ( Ri ) = 0.228, Rrf = 0.10, and E ( Rm ) = 0.18, then we have

0.228 = 0.10 + βi [ 0.18 − 0.10] ===> β i = 1.60

Page 21

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Medium

68. The cost of equity: Gangland Water Guns, Inc., is expected to pay a dividend of $2.10

one year from today. If the firm's growth in dividends is expected to remain at a flat 3

percent forever, then what is the cost of equity capital for Gangland if the price of its

common shares is currently $17.50?

A) 12.00%

B) 14.65%

C) 15.00%

D) 15.36%

Ans: C

Feedback:

Since the price of common shares is given as well as the exp ected growth in dividends

and the next exp ected dividend , we can use the following :

D

$2.10

kcs = 1 + g =

+ 0.03 = 0.15 = 15%

P0

$17.50

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Hard

69. The cost of equity: UltraFlex Diving Boards, Inc., is just paid a dividend of $1.50. If

the firm's growth in dividends is expected to remain at a flat 4 percent forever, then

what is the cost of equity capital for Ultra Flex Diving Boards if the price of its

common shares is currently $26.00?

A) 5.77%

B) 6.00%

C) 9.77%

D) 10.00%

Ans: D

Feedback:

Since the price of common shares is given as well as the exp ected growth in dividends

and the last paid dividend , we can use the following :

D × (1 + g )

D

$1.50 × 1.04

kcs = 1 + g = 0

+g=

+ 0.04 = 0.10 = 10%

P0

P0

$26.00

Page 22

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Hard

70. The cost of equity: Rubber Chicken, Inc., was paid a dividend of $1.87 last year. If the

firm's growth in dividends is expected to be 10 percent next year and then zero

thereafter, then what is the cost of equity capital for Rubber Chicken if the price of its

common shares is currently $25.71?

A) 7.27%

B) 8.00%

C) 18.00%

D) The problem is not solvable with the information that is given.

Ans: B

Feedback:

Since the price of common shares is given as well as the exp ected growth in dividends

and the last paid dividend , we can use the following :

D × (1 + g )

D

$1.87 × 1.1

kcs = 1 + g = 0

+g=

+ 0 = 0.08 = 8%

P0

P0

$25.71

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Hard

71. The cost of equity: The Dedus Shoes, Inc., has common shares with a price of $28.76

per share. The firm paid a dividend of $1.00 yesterday, and dividends are expected to

grow at 10 percent for two years and then at 5 percent thereafter. What is the implied

cost of common equity capital for Dedus?

A) 7.00%

B) 8.00%

C) 9.00%

D) 10.00%

Ans: C

Feedback:

We can use the common stock pricing equation to solve for the cos t of

common equity capital :

$1.00 ( 1.1) ( 1.05 )

$1.00(1.1) $1.00(1.1) 2

$28.76 =

+

+

; Trial and error gives us kcs = 0.09

2

2

( 1 + kcs )

( 1 + kcs )

( kcs − 0.05 ) ( 1 + kcs )

2

Page 23

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Medium

72. The cost of equity: Tranquility, Inc., has common shares with a price of $18.37 per

share. The firm paid a dividend of $1.50 yesterday, and dividends are expected to grow

at 9 percent for three years and then at 2 percent thereafter. What is the implied cost of

common equity capital for Tranquility?

A) 9%

B) 10%

C) 11%

D) 12%

Ans: D

Feedback:

We can use the common stock pricing equation to solve for the cost of common equity

capital:

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Medium

73. The cost of equity: Oasis, Inc., has common shares with a price of $21.12 per share.

The firm is expected to pay a dividend of $1.75 one year from today, and dividends are

expected to grow at 10 percent for two years after that and then at 5 percent thereafter.

What is the implied cost of common equity capital for Oasis?

A) 13%

B) 14%

C) 15%

D) 16%

Ans: B

Feedback:

We can use the common stock pricing equation to solve for the cos t of

common equity capital :

$1.75 $1.75(1.10) $1.75(1.10) 2 $1.75 ( 1.10 ) ( 1.05 )

$21.12 =

+

+

+

;

3

3

( 1 + kcs ) ( 1 + kcs ) 2

( 1 + kcs )

( kcs − 0.05) ( 1 + kcs )

2

Trial and error gives us kcs = 0.14

Page 24

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Hard

74. The cost of preferred equity: Billy's Goat Coats has a preferred share issue

outstanding with a current price of $38.89. The firm last paid a dividend on the issue of

$3.50 per share. What is the firm's cost of preferred equity?

A) 7%

B) 8%

C) 9%

D) 10%

Ans: C

Feedback:

We start with the pricing equation for preferred shares and rearrange to solve for

the cos t of preferred equity :

k ps =

D $3.50

=

= 0.09

P0 $38.89

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Medium

75. The cost of equity: Wally's War Duds has a preferred share issue outstanding with a

current price of $26.57. The firm is expected to pay a dividend of $1.86 per share a year

from today. What is the firm's cost of preferred equity?

A) 6.50%

B) 7.00%

C) 7.50%

D) 8.00%

Ans: B

Feedback:

We start with the pricing equation for preferred shares and rearrange to solve for

the cos t of preferred equity :

k ps =

D $1.86

=

= 0.07

P0 $26.57

Page 25

Learning Objective: LO 1

Level of Difficulty: Easy

1. Unique risk is the only risk that investors require compensation for bearing.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Easy

2. Utilizing the CAPM to estimate the cost of capital for a project is difficult in practice

because analysts do not have the stock returns from individual projects that are

necessary to use in a regression analysis for estimating a project's beta.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 4

Level of Difficulty: Medium

3. Using the firm's overall cost of capital to evaluate a project's cash flows is problematic

in that the firm is a collection of projects, with the possibility that each project has a

different level of risk than the other projects currently working for the firm.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

4. If a firm finances the purchase of an asset with cash, then it has zero financial cost to

the firm.

A) True

B) False

Ans: B

Page 1

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Easy

5. The finance balance sheet is based on market values, just like the accounting balance

sheet.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Medium

6. If the market value of a firm's assets are greater than the book value of a firm's assets

then the book value of the firm's liabilities and equity must be less than the market

value of the firm's liabilities and equity.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Medium

7. The beta of the firm is equal to the weighted-average sum of the betas of the individual

projects that the firm is currently operating.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Medium

8. Due to the magic of diversification, the risk associated with the assets of the firm must

be less than the risk associated with the financing, or debt and equity, that the firm is

utilizing for its assets.

A) True

B) False

Ans: B

Page 2

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Medium

9. A firm is currently taking on two projects with an individual cost of capital of 10

percent and 12 percent for each of the projects. That means that the before-tax cost of

capital for the firm must be between 10 and 12 percent.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Medium

10. If one observes the market quoted price of a debt security where the expected cash

flows of that security are known, then one can calculate the current cost of that security

to the firm.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Medium

11. Estimates of security returns will be reliable in all types of markets, including those

deemed less efficient than others.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

12. Long-term debt typically describes debt that will mature in two years or more.

A) True

B) False

Ans: A

Page 3

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

13. Long-term debt is generally viewed as a permanent financing source for the firm.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

14. With respect to the cost of capital, we are generally interested in the cost of a source of

financing on a particular date.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Medium

15. If a firm is interested in the current cost of its debt obligations, then it can simply look

at the contractual rate of interest due lenders on those obligations.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Medium

16. Milton Corp. issued bonds 10 years ago with a coupon rate of 10 percent at a price of

$1,000. The current price of the bonds is $980. The before-tax cost of the debt to the

firm is still 10 percent.

A) True

B) False

Ans: B

Page 4

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

17. The yield to maturity for a semiannual coupon paying bond will accurately reflect the

actual current annual cost of the debt.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

18. The yield to maturity for an annual coupon paying bond will accurately reflect the

actual current annual pretax cost of the debt.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

19. The current cost of bank debt can be determined by asking the firm's banker.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Medium

20. The issuance costs of new debt securities can be ignored since those costs will not be

reflected in the yield to maturity of the debt in the future.

A) True

B) False

Ans: B

Page 5

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Medium

21. If a firm is subject to income taxes, then the after-tax cost of debt for the firm will be

less than the before-tax cost of debt.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Medium

22. The cost of equity for the firm must take the cost of preferred stock (if any has been

issued) that the firm has outstanding into account.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Medium

23. The correct Treasury rate to use in calculating the cost of equity (when using the

CAPM) for a firm is a short-term rate.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Medium

24. When trying to estimate the cost of equity for a firm using the CAPM, it is possible to

find the beta of a comparable, publicly traded firm whose primary business is closely

related to the firm at hand.

A) True

B) False

Ans: A

Page 6

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Easy

25. The market risk premium for the future is always perfectly known, and it is 6.51

percent.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Medium

26. If a firm is currently paying common share dividends to investors and those dividends

are expected to grow at a low but steady rate in the future, then the cost of common

equity for the firm can be determined by also using the current price of the firm's

common shares.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Easy

27. The current cost of preferred equity can be found by taking the ratio of the dividend to

the current price of preferred shares.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Easy

28. The CAPM can only be used to determine the cost of common equity.

A) True

B) False

Ans: B

Page 7

Format: True/False

Learning Objective: LO 4

Level of Difficulty: Medium

29. The proportions of debt and equity used to determine the weighted average cost of

capital for the firm is based on the market value of debt and equity outstanding.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 4

Level of Difficulty: Medium

30. The correctly calculated weighted-average cost of capital for the firm can be used to

discount the cash flows for any new project that the firm may undertake in the future.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 4

Level of Difficulty: Medium

31. The estimated cost of capital financial managers use for efficiency projects tends to be

higher than the cost of capital used to evaluate new projects.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 4

Level of Difficulty: Medium

32. When using a single rate, such as the WACC, to discount cash flows for all projects of a

particular company, the discount rate could lead to accepting projects that will actually have

a negative NPV.

A) True

B) False

Ans: A

Page 8

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

33. Firms have no way to directly estimate the discount rate that reflects the risk of

A) a publicly traded security.

B) its debt securities.

C) the incremental cash flows from a particular project.

D) none of the above.

Ans: C

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

34. A firm's overall cost of capital is

A) equal to its cost debt.

B) a weighted average of the costs of capital for the collection of individual projects that the

firm is working on.

C) best measured by the cost of capital of the riskiest projects that the firm is working on.

D) none of the above.

Ans: B

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Easy

35. The finance balance sheet is

A) the same as the accounting balance sheet, but it is based on market values.

B) the same as the accounting balance sheet, but it does not have to balance.

C) based on cash rather than accrual accounting.

D) net income.

Ans: A

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

36. The value of the cash flows that the assets of the firm are expected to generate must

equal

A)

the value of the cash flows claimed by the equity investors.

B)

the value of the cash flows claimed by the debt investors.

C)

the value of the cash flows claimed by both the equity and debt investors.

D)

the revenue produced by the firm.

Ans: C

Page 9

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Easy

37. The beta for a firm can be estimated by

A) adding up the betas of the individual projects of the firm.

B) taking the weighted average of the beta for the individual projects of the firm.

C) taking the simple average of the beta for the individual projects of the firm.

D) None of the above.

Ans: B

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Easy

38. The firm can be viewed as

A) a portfolio of individual projects, each with their own risks, cost of capital, and returns.

B) a collection of equity shares comprising it.

C) a collection of debt instruments financing it.

D) none of the above.

Ans: A

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

39. In order for a firm to estimate its cost of debt capital by observing the price of its debt

instruments,

A) the firm must depend on markets being reasonably efficient.

B) the debt must be privately held.

C) the beta of the debt must be greater than the beta of the firm's equity.

D) None of the above.

Ans: A

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

40. If markets are not reasonably efficient, then

A) the estimates of expected returns are not needed.

B) the need for a discount rate to analyze project cash flows is not needed.

C) estimates of expected returns that were based on security prices will not be reliable.

D) none of the above.

Ans: C

Page 10

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

41. When estimating the cost of debt capital for the firm, we are primarily interested in

A) the cost of short-term debt.

B) the cost of long-term debt.

C) the coupon rate of the debt.

D) none of the above.

Ans: B

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

42. Long-term debt typically describes

A) debt with a maturity greater than one year.

B) only coupon debt.

C) publicly traded debt.

D) none of the above.

Ans: A

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

43. Which of the following need to be excluded from the calculation of the firm's amount

of permanent debt?

A) Long-term debt

B) Revolving lines of credit

C) Mortgage debt

D) None of the above

Ans: B

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

44. When analyzing a firm's cost of debt, we are typically interested in

A) the cost of the debt on the date that the analysis is being completed.

B) the coupon rate on the firm's bonds.

C) the risk-free rate plus half a percent.

D) none of the above.

Ans: A

Page 11

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

45. If a firm has bonds outstanding and the firm would like to calculate the current cost of

debt for the bonds, then the firm would

A) use the coupon rate of the bonds to estimate the cost.

B) use the current yield to maturity of the bonds to estimate the cost.

C) use the current coupon yield of the bonds to estimate the cost.

D) none of the above.

Ans: B

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

46. A bond has a coupon rate of 6 percent and the bond makes semiannual coupon

payments. The dollar amount of coupon interest received every six months is

A) $60.

B) $30.

C) $30 plus or minus the prorate portion of the discount or premium that the bond was

purchased for.

D) none of the above.

Ans: B

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

47. Bond issuance costs include

A) investment banking fees.

B) legal fees.

C) accountant fees.

D) all of the above.

Ans: D

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

48. Income taxes have the effect of

A) increasing the cost of debt.

B) decreasing the cost of debt.

C) decreasing the cost of capital for the firm.

D) both b and c are correct.

Ans: B

Page 12

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Medium

49. The appropriate risk-free rate to use when calculating the cost of equity for a firm is

A) a long-term Treasury rate.

B) a short-term Treasury rate.

C) a 50/50 mix of short-term and long-term Treasury rates.

D) none of the above.

Ans: A

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Medium

50. The average risk-premium for the market from 1926 to 2009 was

A) 8.00%.

B) 7.50%.

C) 6.01%.

D) 6.51% + the Treasury rate.

Ans: C

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Medium

51. The recommended model to estimate the cost of common equity for a firm is

A) a one-stage constant growth model.

B) a multistage growth model.

C) the CAPM.

D) none of the above.

Ans: C

Format: Multiple Choice

Learning Objective: LO 4

Level of Difficulty: Hard

52. In order to use the WACC to evaluate a future project's flows, which of the following

must hold?

A) The project will be financed with the same proportion of debt and equity as the firm.

B) The systematic risk of the project is the same as the overall systematic risk of the firm.

C) The project must be viable.

D) a and b above.

Ans: D

Page 13

Format: Multiple Choice

Learning Objective: LO 4

Level of Difficulty: Hard

53. Overall cost of capital: If the market risk premium is currently 6 percent and the riskfree rate of return is 4 percent, then what is the expected return on a common share with

a beta equal to 2?

A) 8.0%

B) 10.0%

C) 12.0%

D) 16.0%

Ans: D

Feedback:

E(Ri) = Rrf + βi [E(Rm) – Rrf] = 0.04 + 2.0 [0.06] = 0.04 + 0.12 = 0.16

Format: Multiple Choice

Learning Objective: LO 4

Level of Difficulty: Hard

54. Overall cost of capital: What is the beta of a firm whose equity has an expected return

of 21.3 percent when the risk-free rate of return is 7.0 percent and the expected return

on the market is 18.0 percent?

A) 0.79

B) 1.30

C) 1.57

D) none of the above

Ans: B

Feedback:

E(Ri) = Rrf + βi [E(Rm) – Rrf] ==> 0.213 = 0.07 + βi [0.18 – 0.07] ==> βi= 1.30

Format: Multiple Choice

Learning Objective: LO 4

Level of Difficulty: Hard

55. Overall cost of capital: Stryder, Inc., has 3 million shares outstanding at a current

price of $15 per share. The book value of the shares is $10 per share. The firm also has

$30 million in par value of bonds outstanding. The bonds are selling at a price equal to

101 percent of par. What is the market value of the firm?

A) $30.0 million

B) $45.0 million

C) $75.0 million

D) $75.3 million

Ans: D

Feedback:

MV of assets = MV of liabilities + MV of equity

= (1.01 x $30,000,000) + (3,000,000 x

15)

= $75,300,000

Page 14

Format: Multiple Choice

Learning Objective: LO 4

Level of Difficulty: Hard

56. How firms estimate their cost of capital: The Diverse Co. has invested 40 percent of

the firm's assets in a project with a beta of 0.4 and the remaining assets in a project with

a beta of 1.8. What is the beta of the firm?

A) 0.96

B) 1.24

C) 1.28

D) None of the above

Ans: B

Feedback:

2

β n Asset portfolio = ∑ xi βi = 0.4(0.4) + 0.6(1.8) = 1.24

i =1

Format: Multiple Choice

Learning Objective: LO 4

Level of Difficulty: Hard

57. How firms estimate their cost of capital: You are analyzing the cost of capital for a

firm that is financed with 65 percent equity and 35 percent debt. The cost of debt

capital is 8 percent, while the cost of equity capital is 20 percent for the firm. What is

the overall cost of capital for the firm?

A) 12.2%

B) 14.0%

C) 15.8%

D) 20.0%

Ans: C

Feedback:

kFirm = xDebt kDebt + xEquity kEquity = (0.35 x 0.08) + (0.65 x 0.2) = 0.158

Page 15

Format: Multiple Choice

Learning Objective: LO 4

Level of Difficulty: Hard

58. How firms estimate their cost of capital: You are analyzing the cost of capital for a

firm that is financed with $300 million of equity and $200 million of debt. The cost of

debt capital for the firm is 9 percent, while the cost of equity capital is 19 percent. What

is the overall cost of capital for the firm?

A) 13.0%

B) 14.0%

C) 15.0%

D) 16.0%

Ans: C

Feedback:

xDebt = 200/500 = 0.4, xEquity = 300/500 = 0.6

kFirm = xDebt kDebt + xEquity kEquity = (0.4 x 0.09) + (0.6 x 0.19) = 0.15

Format: Multiple Choice

Learning Objective: LO 4

Level of Difficulty: Medium

59. How firms estimate their cost of capital: The WACC for a firm is 19.75 percent. You

know that the firm is financed with $75 million of equity and $25 million of debt. The

cost of debt capital is 7 percent. What is the cost of equity for the firm?

A) 19.75%

B) 24.00%

C) 32.50%

D) 58.00%

Ans: B

Feedback:

xDebt = 25/100 = 0.25, xEquity = 75/100 = 0.75

kFirm = xDebt kDebt + xEquity kEquity ==> .1975 = (0.25 x 0.07) + (0.75 x kEquity) ==>

kEquity = 0.2400

Page 16

Format: Multiple Choice

Learning Objective: LO 4

Level of Difficulty: Medium

60. How firms estimate their cost of capital: The WACC for a firm is 13.00 percent. You

know that the firm's cost of debt capital is 10 percent and the cost of equity capital is

20%. \

What proportion of the firm is financed with debt?

A) 30%

B) 33%

C) 50%

D) 70%

Ans: D

Feedback:

xDebt = Y, xEquity = (1 – Y)

kFirm = xDebt kDebt + xEquity kEquity ==> 0.13= (Y x 0.1) + ((1 – Y) x 0.20) ==>

Y = 0.7

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

61. The cost of debt: Bellamee, Inc., has semiannual bonds outstanding with five years to

maturity and are priced at $920.87. If the bonds have a coupon rate of 7 percent, then

what is the YTM for the bonds?

A) 4.5%

B) 7.0%

C) 9.0%

D) 9.2%

Ans: C

Feedback:

Using the formula for pricing bonds, we have

$920.87 = $35 x PVIFA(YTM / 2,10) + $1, 000 x PVIF (YTM / 2,10)

and after solving for YTM / 2 = 4.5%, we find that YTM = 9.0%.

Note that we assume semi − annual coupons for the bond .

Page 17

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

62. The cost of debt: Dynamo Corporation has semiannual bonds outstanding with 12

years to maturity and are currently priced at $1,080.29. If the bonds have a coupon rate

of 8 percent, then what is the equivalent annual return (EAR) to the investor for

purchasing the bonds at the described price?

A) 3.5%

B) 7.00%

C) 7.12%

D) 8.00%

Ans: C

Feedback:

Using the formula for pricing bonds, we have

$1, 080.29 = $40 x PVIFA(YTM / 2, 24) + $1,000 x PVIF (YTM / 2, 24)

and after solving for YTM / 2 = 3.5%, we find that YTM = 7.0%.

Note that we assume semi − annual coupons for the bond .

0.07 2

Now, we adjust for EAR : (1 +

) − 1 = 0.0712 = 7.12%

2

Page 18

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

63. The cost of debt: Beckham Corporation has semiannual bonds outstanding with 13

years to maturity and are currently priced at $746.16. If the bonds have a coupon rate of

8.5 percent, then what is the after-tax cost of debt for Beckham if its marginal tax rate is

35%? Assume that your calculation is made as on Wall Street.

A) 6.250%

B) 8.125%

C) 12.500%

D) 12.890%

Ans: B

Feedback:

Using the formula for pricing bonds, we have

$746.16 = $42.50 x PVIFA(YTM / 2, 26) + $1, 000 x PVIF (YTM / 2, 26)

and after solving for YTM / 2 = 6.25%, we find that YTM = 12.50%.

Note that we assume semi − annual coupons for the bond .

Now, we adjust taxes :12.50% x (1 − 0.35) = 8.125%

Page 19

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

64. The cost of debt: PackMan Corporation has semiannual bonds outstanding with nine

years to maturity and are currently priced at $754.08. If the bonds have a coupon rate of

7.25 percent, then what is the after-tax cost of debt for Beckham if its marginal tax rate

is 30 percent? Complete the calculation as is done on Wall Street.

A) 7.050%

B) 8.225%

C) 11.750%

D) 12.095%

Ans: A

Feedback:

Using the formula for pricing bonds, we have

$754.08 = $36.25 x PVIFA(YTM / 2,18) + $1, 000 x PVIF (YTM / 2,18)

and after solving for YTM / 2 = 5.875%, we find that YTM = 11.75%.

Note that we assume semi − annual coupons for the bond .

Now, we adjust taxes :11.75% x (1 − 0.3) = 8.225%

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Hard

65. The cost of equity: Jacque Ewing Drilling, Inc., has a beta of 1.3 and is trying to

calculate its cost of equity capital. If the risk-free rate of return is 8 percent and the

expected return on the market is 12 percent, then what is the firm's after-tax cost of

equity capital if the firm's marginal tax rate is 40 percent?

A) 7.92%

B) 13.20%

C) 15.57%

D) 23.60%

Ans: B

Feedback:

The equation for the CAPM is : E ( Ri ) = Rrf + β i E ( Rm ) − Rrf .

If βi = 1.3, Rrf = 0.08, and E ( Rm ) = 0.12, then we have

E ( Ri ) = 0.08 + 1.3 [ 0.08 − 0.12] = 0.132 = 13.20%

Page 20

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Hard

66. The cost of equity: TeleNyckel, Inc., has a beta of 1.4 and is trying to calculate its cost

of equity capital. If the risk-free rate of return is 9 percent and the market risk premium

is 5 percent, then what is the firm's after-tax cost of equity capital if the firm's marginal

tax rate is 30 percent?

A) 11.20%

B) 10.60%

C) 15.14%

D) 16.00%

Ans: D

Feedback:

The equation for the CAPM is : E ( Ri ) = Rrf + β i E ( Rm ) − Rrf .

If βi = 1.4, Rrf = 0.09, and E ( Rm ) − Rrf = 0.05, then we have

E ( Ri ) = 0.09 + 1.4 [ 0.05] = 0.16 = 16.00%

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Medium

67. The cost of equity: RadicalVenOil, Inc., has a cost of equity capital equal to 22.8

percent. If the risk-free rate of return is 10 percent and the expected return on the

market is 18 percent, then what is the firm's beta if the firm's marginal tax rate is 35

percent?

A) 1.0

B) 1.28

C) 1.60

D) 4.10

Ans: C

Feedback:

The equation for the CAPM is : E ( Ri ) = Rrf + β i E ( Rm ) − Rrf .

If E ( Ri ) = 0.228, Rrf = 0.10, and E ( Rm ) = 0.18, then we have

0.228 = 0.10 + βi [ 0.18 − 0.10] ===> β i = 1.60

Page 21

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Medium

68. The cost of equity: Gangland Water Guns, Inc., is expected to pay a dividend of $2.10

one year from today. If the firm's growth in dividends is expected to remain at a flat 3

percent forever, then what is the cost of equity capital for Gangland if the price of its

common shares is currently $17.50?

A) 12.00%

B) 14.65%

C) 15.00%

D) 15.36%

Ans: C

Feedback:

Since the price of common shares is given as well as the exp ected growth in dividends

and the next exp ected dividend , we can use the following :

D

$2.10

kcs = 1 + g =

+ 0.03 = 0.15 = 15%

P0

$17.50

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Hard

69. The cost of equity: UltraFlex Diving Boards, Inc., is just paid a dividend of $1.50. If

the firm's growth in dividends is expected to remain at a flat 4 percent forever, then

what is the cost of equity capital for Ultra Flex Diving Boards if the price of its

common shares is currently $26.00?

A) 5.77%

B) 6.00%

C) 9.77%

D) 10.00%

Ans: D

Feedback:

Since the price of common shares is given as well as the exp ected growth in dividends

and the last paid dividend , we can use the following :

D × (1 + g )

D

$1.50 × 1.04

kcs = 1 + g = 0

+g=

+ 0.04 = 0.10 = 10%

P0

P0

$26.00

Page 22

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Hard

70. The cost of equity: Rubber Chicken, Inc., was paid a dividend of $1.87 last year. If the

firm's growth in dividends is expected to be 10 percent next year and then zero

thereafter, then what is the cost of equity capital for Rubber Chicken if the price of its

common shares is currently $25.71?

A) 7.27%

B) 8.00%

C) 18.00%

D) The problem is not solvable with the information that is given.

Ans: B

Feedback:

Since the price of common shares is given as well as the exp ected growth in dividends

and the last paid dividend , we can use the following :

D × (1 + g )

D

$1.87 × 1.1

kcs = 1 + g = 0

+g=

+ 0 = 0.08 = 8%

P0

P0

$25.71

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Hard

71. The cost of equity: The Dedus Shoes, Inc., has common shares with a price of $28.76

per share. The firm paid a dividend of $1.00 yesterday, and dividends are expected to

grow at 10 percent for two years and then at 5 percent thereafter. What is the implied

cost of common equity capital for Dedus?

A) 7.00%

B) 8.00%

C) 9.00%

D) 10.00%

Ans: C

Feedback:

We can use the common stock pricing equation to solve for the cos t of

common equity capital :

$1.00 ( 1.1) ( 1.05 )

$1.00(1.1) $1.00(1.1) 2

$28.76 =

+

+

; Trial and error gives us kcs = 0.09

2

2

( 1 + kcs )

( 1 + kcs )

( kcs − 0.05 ) ( 1 + kcs )

2

Page 23

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Medium

72. The cost of equity: Tranquility, Inc., has common shares with a price of $18.37 per

share. The firm paid a dividend of $1.50 yesterday, and dividends are expected to grow

at 9 percent for three years and then at 2 percent thereafter. What is the implied cost of

common equity capital for Tranquility?

A) 9%

B) 10%

C) 11%

D) 12%

Ans: D

Feedback:

We can use the common stock pricing equation to solve for the cost of common equity

capital:

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Medium

73. The cost of equity: Oasis, Inc., has common shares with a price of $21.12 per share.

The firm is expected to pay a dividend of $1.75 one year from today, and dividends are

expected to grow at 10 percent for two years after that and then at 5 percent thereafter.

What is the implied cost of common equity capital for Oasis?

A) 13%

B) 14%

C) 15%

D) 16%

Ans: B

Feedback:

We can use the common stock pricing equation to solve for the cos t of

common equity capital :

$1.75 $1.75(1.10) $1.75(1.10) 2 $1.75 ( 1.10 ) ( 1.05 )

$21.12 =

+

+

+

;

3

3

( 1 + kcs ) ( 1 + kcs ) 2

( 1 + kcs )

( kcs − 0.05) ( 1 + kcs )

2

Trial and error gives us kcs = 0.14

Page 24

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Hard

74. The cost of preferred equity: Billy's Goat Coats has a preferred share issue

outstanding with a current price of $38.89. The firm last paid a dividend on the issue of

$3.50 per share. What is the firm's cost of preferred equity?

A) 7%

B) 8%

C) 9%

D) 10%

Ans: C

Feedback:

We start with the pricing equation for preferred shares and rearrange to solve for

the cos t of preferred equity :

k ps =

D $3.50

=

= 0.09

P0 $38.89

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Medium

75. The cost of equity: Wally's War Duds has a preferred share issue outstanding with a

current price of $26.57. The firm is expected to pay a dividend of $1.86 per share a year

from today. What is the firm's cost of preferred equity?

A) 6.50%

B) 7.00%

C) 7.50%

D) 8.00%

Ans: B

Feedback:

We start with the pricing equation for preferred shares and rearrange to solve for

the cos t of preferred equity :

k ps =

D $1.86

=

= 0.07

P0 $26.57

Page 25

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