Chapter 015 Cost of Capital
Multiple Choice Questions
1. The return shareholders require on their investment in a firm is called the:
a. dividend yield.
B. cost of equity.
c. capital gains yield.
d. cost of capital.
e. income return.
SECTION: 15.2
TOPIC: COST OF EQUITY
TYPE: DEFINITIONS
2. The return lenders require on loaned funds to a firm is called the:
a. coupon rate.
b. current yield.
C. cost of debt.
d. capital gains yield.
e. cost of capital.
SECTION: 15.3
TOPIC: COST OF DEBT
TYPE: DEFINITIONS
3. The weighted average of a firm's cost of equity and aftertax cost of debt is called the:
a. reward to risk ratio.
b. weighted capital gains rate.
c. pure play cost of capital.
d. subjective cost of capital.
E. weighted average cost of capital.
SECTION: 15.4
TOPIC: WACC
TYPE: DEFINITIONS
15-1
Chapter 015 Cost of Capital
4. When a manager develops a cost of capital for a specific project based on the cost of
capital for another firm which has a similar line of business as the project, the manager is
utilizing the _____ approach.
a. subjective risk
B. pure play
c. divisional cost of capital
d. capital adjustment
e. security market line
SECTION: 15.5
TOPIC: PURE PLAY APPROACH
TYPE: DEFINITIONS
5. The cost of capital:
a. will decrease as the risk level of a firm increases.
b. is primarily dependent upon the source of the funds used for a project.
c. implies a project will produce a positive net present value only when the rate of return on
the project is less than the predetermined cost of capital.
d. remains constant for all projects undertaken by the same firm.
E. depends on how the funds are going to be utilized.
SECTION: 15.1
TOPIC: COST OF CAPITAL
TYPE: CONCEPTS
6. The overall cost of capital for a retail store:
a. is equivalent to the aftertax cost of the firm's liabilities.
b. should be used as the required return when analyzing a potential acquisition of a
wholesale distributor.
C. reflects the return investors require on the total assets of the firm.
d. remains constant when the debt-equity ratio changes.
e. is unaffected by changes in corporate tax rates.
SECTION: 15.1
TOPIC: COST OF CAPITAL
TYPE: CONCEPTS
15-2
Chapter 015 Cost of Capital
7. The cost of capital primarily depends on the:
a. debt-equity ratio.
b. applicable tax rate.
c. cost of equity financing.
d. cost of debt.
E. use of the funds.
SECTION: 15.1
TOPIC: COST OF CAPITAL
TYPE: CONCEPTS
8. Davis Entertainment is considering developing and distributing a new board game for
children. The project is similar in risk to the firm's current operations. The firm maintains a
debt-equity ratio of .45 and retains all profits to fund the firm's rapid growth. How should
the firm determine its cost of equity?
a. by adding the market risk premium to the aftertax cost of debt
b. by treating the common stock as if it were preferred stock
c. by using the dividend growth formula
D. by using the security market line approach
e. by averaging the cost determined by both the dividend growth formula and the security
market line approach.
SECTION: 15.2
TOPIC: COST OF EQUITY
TYPE: CONCEPTS
9. All else constant, which one of the following will increase a firm's cost of equity if the
firm computes that cost using the security market line approach? Assume the firm currently
pays an annual dividend of $2.10 a share and has a beta of 1.1.
a. a reduction in the dividend amount
b. an increase in the dividend amount
c. a reduction in the market risk premium
d. a reduction in the firm's beta
E. an increase in the market rate of return
SECTION: 15.2
TOPIC: COST OF EQUITY
TYPE: CONCEPTS
15-3
Chapter 015 Cost of Capital
10. A firm's overall cost of equity is:
a. directly observable in the financial markets.
b. unaffected by changes in the market risk premium.
C. highly dependent upon the growth rate and risk level of the firm.
d. generally less than the firm's aftertax cost of debt.
e. inversely related to change in the firm's tax rate.
SECTION: 15.2
TOPIC: COST OF EQUITY
TYPE: CONCEPTS
11. The cost of equity for a firm is:
a. dependent upon the firm's debt-equity ratio.
B. based on estimates derived from financial models.
c. equivalent to a leveraged firm's cost of capital.
d. equal to the risk-free rate of return plus the market risk premium.
e. equal to the firm's pretax weighted average cost of capital.
SECTION: 15.2
TOPIC: COST OF EQUITY
TYPE: CONCEPTS
12. The dividend growth model:
a. can be used to estimate the cost of equity for any corporation.
b. is applicable only to firms that pay a constant dividend.
c. is unaffected by the estimated rate of dividend growth.
D. can be applied to firms that are reducing their dividend amount.
e. considers the risk level of the firm.
SECTION: 15.2
TOPIC: DIVIDEND GROWTH MODEL
TYPE: CONCEPTS
15-4
Chapter 015 Cost of Capital
13. The dividend growth model:
A. is only as reliable as the estimated rate of growth.
b. can only be used if historical dividend information is available.
c. considers the risk that future dividends may vary from their estimated values.
d. applies only when a firm is currently paying dividends.
e. uses beta to measure the systematic risk of a firm.
SECTION: 15.2
TOPIC: DIVIDEND GROWTH MODEL
TYPE: CONCEPTS
14. The market risk premium:
A. can vary over time.
b. is equal to the risk premium for a security minus the market rate of return.
c. is equal to zero for a risk-free asset.
d. is equal to the risk-free rate multiplied by the beta of a firm.
e. is constant over time.
SECTION: 15.2
TOPIC: SECURITY MARKET LINE APPROACH
TYPE: CONCEPTS
15. Which of the following statements are correct concerning the security market line
(SML) approach to determining the cost of equity for a firm?
I. The SML approach considers the amount of unsystematic risk associated with a firm.
II. The SML approach can be applied to more firms than the dividend growth model can.
III. The SML approach considers only future information.
IV. The SML approach assumes the reward-to-risk ratio is constant.
a. I and III only
B. II and IV only
c. III and IV only
d. I, II, and III only
e. I, II, III, and IV
SECTION: 15.2
TOPIC: SECURITY MARKET LINE APPROACH
TYPE: CONCEPTS
15-5
Chapter 015 Cost of Capital
16. The pre-tax cost of debt for a firm:
A. is based on the yield to maturity on the firm's outstanding bonds.
b. is equal to the coupon rate for the latest bond issue.
c. is equivalent to the current yield on the outstanding bonds of the firm.
d. is based on the yield to maturity that existed when the currently outstanding bonds were
originally issued.
e. has to be estimated as it cannot be directly observed in the market.
SECTION: 15.3
TOPIC: COST OF DEBT
TYPE: CONCEPTS
17. The aftertax cost of debt generally increases when:
I. a firm's bond rating increases.
II. the market rate of interest increases.
III. tax rates decrease.
IV. bond prices rise.
a. I and III only
B. II and III only
c. I, II, and III only
d. II, III, and IV only
e. I, II, III, and IV
SECTION: 15.3
TOPIC: COST OF DEBT
TYPE: CONCEPTS
18. The cost of preferred stock is computed the same as the:
a. pre-tax cost of debt.
b. return on an annuity.
c. aftertax cost of debt.
D. return on a perpetuity.
e. cost of an irregular growth common stock.
SECTION: 15.3
TOPIC: COST OF PREFERRED STOCK
TYPE: CONCEPTS
15-6
Chapter 015 Cost of Capital
19. The cost of preferred stock:
A. is equal to the dividend yield.
b. is equal to the yield to maturity.
c. is highly dependent on the dividend growth rate.
d. varies directly with the stock's price.
e. is relatively difficult to determine.
SECTION: 15.3
TOPIC: COST OF PREFERRED STOCK
TYPE: CONCEPTS
20. The capital structure weights used in computing the weighted average cost of capital:
a. are based on the book values of total debt and total equity.
B. are based on the market value of the firm's debt and equity securities.
c. are computed using the book value of the long-term debt and the book value of equity.
d. remain constant over time unless the firm issues new securities.
e. are restricted to the firm's debt and common stock.
SECTION: 15.4
TOPIC: CAPITAL STRUCTURE WEIGHTS
TYPE: CONCEPTS
21. DTK, Inc. uses both preferred and common stock as well as long-term debt to finance its
operations. An increase in which one of the following will increase the capital structure
weight of the debt, all else equal?
a. market price of the common stock
b. number of shares of preferred stock outstanding
c. book value of the outstanding shares of common stock
D. number of bonds outstanding
e. number of shares of stock outstanding
SECTION: 15.4
TOPIC: CAPITAL STRUCTURE WEIGHTS
TYPE: CONCEPTS
15-7
Chapter 015 Cost of Capital
22. The aftertax cost of debt:
a. varies inversely to market interest rates.
b. will generally exceed the cost of equity if the relevant tax rate is zero.
c. is equal to the pre-tax cost of debt.
d. is directly related to the cost of equity.
E. has a greater effect on a firm's cost of capital when the debt-equity ratio increases.
SECTION: 15.3
TOPIC: WEIGHTED AVERAGE COST OF CAPITAL
TYPE: CONCEPTS
23. The weighted average cost of capital for a firm is dependent upon the firm's:
I. level of systematic risk.
II. debt-equity ratio.
III. preferred dividend amount.
IV. outstanding bonds' yield to maturity.
a. I and III only
b. II and IV only
c. I, II, and IV only
d. I, III, and IV only
E. I, II, III, and IV
SECTION: 15.4
TOPIC: WEIGHTED AVERAGE COST OF CAPITAL
TYPE: CONCEPTS
24. The weighted average cost of capital for a firm is the:
a. discount rate which the firm should apply to all of the projects it undertakes.
B. rate of return a firm must earn on its existing assets to maintain the current value of its
stock.
c. coupon rate the firm should expect to pay on its next bond issue.
d. maximum rate which the firm should require on any projects it undertakes.
e. required rate which every project's internal rate of return must exceed.
SECTION: 15.4
TOPIC: WEIGHTED AVERAGE COST OF CAPITAL
TYPE: CONCEPTS
15-8
Chapter 015 Cost of Capital
25. Which one of the following statements is correct concerning the weighted average cost
of capital (WACC)?
A. The WACC may decrease as a firm's debt-equity ratio increases.
b. When computing the WACC, the weight assigned to the preferred stock is based on the
coupon rate multiplied by the par value of the stock.
c. A firm's WACC will decrease as the corporate tax rate decreases.
d. The weight of the common stock used in the computation of the WACC is based on the
number of shares outstanding multiplied by the book value per share.
e. The WACC will remain constant unless a firm retires some of its debt.
SECTION: 15.4
TOPIC: WEIGHTED AVERAGE COST OF CAPITAL
TYPE: CONCEPTS
26. If a firm uses its WACC as the discount rate for all of the projects it undertakes then the
firm will tend to:
I. reject some positive net present value projects.
II. accept some negative net present value projects.
III. favor high risk projects over low risk projects.
IV. maintain its current level of risk.
a. I and III only
b. III and IV only
C. I, II, and III only
d. I, II, and IV only
e. I, II, III, and IV
SECTION: 15.4
TOPIC: WEIGHTED AVERAGE COST OF CAPITAL
TYPE: CONCEPTS
15-9
Chapter 015 Cost of Capital
27. Swanson & Sons has two separate divisions. Each division is in a separate line of
business. Division A is the largest division and represents 65 percent of the firm's overall
sales. Division A is also the riskier of the two divisions. Division B is the smaller and least
risky of the two. When management is deciding which of the various divisional projects
should be accepted, the managers should:
a. allocate more funds to Division A since it is the largest of the two divisions.
b. fund all of Division B's projects first since they tend to be less risky and then allocate the
remaining funds to the Division A projects that have the highest net present values.
c. allocate the company's funds to the projects with the highest net present values based on
the firm's weighted average cost of capital.
D. assign appropriate, but differing, discount rates to each project and then select the
projects with the highest net present values.
e. fund the highest net present value projects from each division based on an allocation of 65
percent of the funds to Division A and 35 percent of the funds to Division B.
SECTION: 15.5
TOPIC: DIVISIONAL COST OF CAPITAL
TYPE: CONCEPTS
28. If a firm applies its overall cost of capital to all its proposed projects, then the divisions
within the firm will tend to:
a. receive less funding if they represent the riskiest operations of the firm.
b. avoid risky projects so that they will receive more funding.
c. become less risky over time based on the projects that are accepted.
d. have equal probabilities of receiving funding for their projects.
E. propose higher risk projects than if separate discount rates were applied to each project.
SECTION: 15.5
TOPIC: DIVISIONAL COST OF CAPITAL
TYPE: CONCEPTS
15-10
Chapter 015 Cost of Capital
29. The discount rate assigned to an individual project should be based on:
a. the firm's weighted average cost of capital.
b. the actual sources of funding used for the project.
c. an average of the firm's overall cost of capital for the past five years.
d. the current risk level of the overall firm.
E. the risks associated with the use of the funds utilized for the project.
SECTION: 15.5
TOPIC: PROJECT COST OF CAPITAL
TYPE: CONCEPTS
15-11
Chapter 015 Cost of Capital
30. Assigning discount rates to individual projects based on the risk level of each project:
A. may cause the firm's overall weighted average cost of capital to either increase or
decrease over time.
b. will prevent the firm's overall cost of capital from changing over time.
c. will cause the firm's overall cost of capital to decrease over time.
d. decreases the value of the firm over time.
e. negates the firm's goal of creating the most value for the shareholders.
SECTION: 15.5
TOPIC: PROJECT COST OF CAPITAL
TYPE: CONCEPTS
31. The cost of capital assigned to an individual project should be that rate which:
a. corresponds to the risk level of the firm's division which has responsibility for the project.
B. is relevant to the intended use of the funds.
c. equals the firm's WACC unless the pure play approach is utilized.
d. is the firm's current weighted average cost of capital.
e. represents the actual sources of funds used for the project.
SECTION: 15.5
TOPIC: PROJECT COST OF CAPITAL
TYPE: CONCEPTS
32. Wayne's of New York specializes in clothing for female executives living and working
in the financial district of New York City. Allen's of PA. specializes in clothing for women
who live and work in the rural areas of Western Pennsylvania. Both firms are currently
considering expanding their clothing line to encompass working women in the rural upstate
region of New York state. Wayne's currently has a cost of capital of 11 percent while Allen's
cost of capital is 9 percent. The expansion project has a projected net present value of
$36,900 at a 9 percent discount rate and a net present value of $13,200 at an 11 percent
discount rate. Which firm or firms should expand into rural New York state?
a. Wayne's only
b. Allen's only
C. both Wayne's and Allen's
d. neither Wayne's nor Allen's
e. cannot be determined from the information provided
SECTION: 15.5
TOPIC: PURE PLAY APPROACH
TYPE: CONCEPTS
15-12
Chapter 015 Cost of Capital
33. The Jasper Mountain Co. specializes in back-country camping facilities across the
nation. The Plan It Co. specializes in making travel reservations and promoting vacation
travel. Jasper has an aftertax cost of capital of 12 percent and Plan It has an aftertax cost of
capital of 10 percent. Both firms are considering building wilderness campgrounds
complete with their own lakes and numerous mountain trails. The estimated net present
value of such a project is estimated at $113,000 at a discount rate of 10 percent
and
$64,500 at a 12 percent discount rate. Which firm or firms, if either, should accept
this project?
a. Jasper only
b. Plan It only
c. both Jasper and Plan It
D. neither Jasper nor Plan It
e. cannot be determined without further information
SECTION: 15.5
TOPIC: PURE PLAY APPROACH
TYPE: CONCEPTS
34. The subjective approach to project analysis:
a. is used only when the firm is an all-equity firm.
b. uses the WACC of firm X as the basis for the discount rate for a project under
consideration by firm Y.
C. assigns discount rates to projects based on the discretion of the senior managers of a firm.
d. allows managers to randomly adjust the discount rate assigned to a project once the
project's beta has been determined.
e. applies a lower discount rate to projects that are financed with internal rather than external
equity.
SECTION: 15.5
TOPIC: SUBJECTIVE APPROACH
TYPE: CONCEPTS
15-13
Chapter 015 Cost of Capital
35. When a firm uses the subjective approach to assign discount rates to projects, the firm's
managers:
I. will assign its highest discount rate to those projects which are mandated by the
government.
II. risk accepting projects that should have been rejected.
III. assign the highest discount rates to those projects the managers personally prefer.
IV. generally make better decisions than they would if they applied the firm's weighted
average cost of capital to all projects.
a. I and III only
B. II and IV only
c. I, II, and III only
d. II, III, and IV only
e. I, II, III, and IV
SECTION: 15.5
TOPIC: SUBJECTIVE APPROACH
TYPE: CONCEPTS
15-14
Chapter 015 Cost of Capital
36. When a firm has flotation costs equal to 6 percent of the funding need, project analysts
should:
a. increase the project's discount rate to offset these expenses by multiplying the firm's
WACC by 1.06.
b. increase the project's discount rate to offset these expenses by dividing the firm's WACC
by (1 .06).
c. add 6 percent to the firm's WACC to get the discount rate for the project.
d. increase the initial project cost by multiplying that cost by 1.06.
E. increase the initial project cost by dividing that cost by (1 .06).
SECTION: 15.6
TOPIC: FLOTATION COSTS AND WACC
TYPE: CONCEPTS
37. The flotation cost for a firm is computed as:
a. the arithmetic average of the flotation costs of both debt and equity.
B. the weighted average of the flotation costs associated with each form of financing.
c. the geometric average of the flotation costs associated with each form of financing.
d. one-half of the flotation cost of debt plus one-half of the flotation cost of equity.
e. a weighted average based on the book values of the firm's debt and equity.
SECTION: 15.6
TOPIC: FLOTATION COSTS AND WACC
TYPE: CONCEPTS
38. Incorporating flotation costs into the initial cash flow of a project will:
a. cause the project to be improperly evaluated.
b. increase the net present value of the project.
c. increase the project's internal rate of return.
D. increase the initial cash outflow of the project thereby lowering the project's net present
value.
e. affect the net present value but the direction of that impact cannot be determined.
SECTION: 15.6
TOPIC: FLOTATION COSTS AND NPV
TYPE: CONCEPTS
15-15
Chapter 015 Cost of Capital
39. Flotation costs should:
a. be ignored when analyzing a project because flotation costs are not an actual cost of the
project.
b. be averaged over the life of the project thereby reducing the cash flows for each year of
the project.
c. only be considered when two projects have the same net present value.
D. be included in the initial cost of a project before the net present value of the project is
computed.
e. be ignored totally when internal equity funding is utilized.
SECTION: 15.6
TOPIC: FLOTATION COSTS AND NPV
TYPE: CONCEPTS
40. Cameron Industries is expected to pay an annual dividend of $1.30 a share next month.
The market price of the stock is $24.80 and the growth rate is 3 percent. What is the firm's
cost of equity?
a. 7.58 percent
b. 7.91 percent
C. 8.24 percent
d. 8.40 percent
e. 8.76 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.2
TOPIC: COST OF EQUITY
TYPE: PROBLEMS
15-16
Chapter 015 Cost of Capital
41. Photo Imaging, Inc. has paid annual dividends of $1.00, $1.05, $1.10, and $1.18 per
share over the last four years, respectively. The stock is currently selling for $38 a share.
What is this firm's cost of equity?
a. 8.79 percent
B. 8.96 percent
c. 10.38 percent
d. 10.53 percent
e. 11.79 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.2
TOPIC: COST OF EQUITY
TYPE: PROBLEMS
42. Sundial Enterprises common stock is currently priced at $33.20 a share. The company
just paid $1.40 per share as their annual dividend. The dividends have been increasing by 3
percent annually and are expected to continue doing so. What is the cost of equity for
Sundial Enterprises?
a. 7.22 percent
B. 7.34 percent
c. 7.49 percent
d. 7.61 percent
e. 7.82 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.2
TOPIC: COST OF EQUITY
TYPE: PROBLEMS
15-17
Chapter 015 Cost of Capital
43. The common stock of Jack's Hardware has a growth rate of 2 percent and a required
return of 9 percent. If the current price of the stock is $24.67 what was the amount of the last
dividend paid?
A. $1.69
b. $1.73
c. $2.18
d. $2.22
e. $2.26
D1 = [(.09
.02)
$24.67] = $1.7269; D0 = $1.7269 / 1.02 = $1.69
AACSB TOPIC: ANALYTIC
SECTION: 15.2
TOPIC: COST OF EQUITY
TYPE: PROBLEMS
44. The Lucini Co. has paid annual dividends of $.70, $.74, $.86, $.96, and $1.02 over the
past five years respectively. What is the average dividend growth rate?
a. 6.25 percent
b. 7.96 percent
C. 9.95 percent
d. 10.35 percent
e. 13.27 percent
($.74 - $.70) / $.70 = .05714
($.86 - $.74) / $.74 = .16216
($.96 - $.86) / $.86 = .11628
($1.02 - $.96) / $.96 = .0625
g = (.05714 + .16216 + .11628 + .0625) / 4 = .09952 = 9.95 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.2
TOPIC: COST OF EQUITY
TYPE: PROBLEMS
15-18
Chapter 015 Cost of Capital
45. Ronald's Fast Food just paid their annual dividend of $1.05 a share. The stock has a
market price of $26 and a beta of 1.15. The return on the U.S. Treasury bill is 3 percent and
the market risk premium is 7 percent. What is the cost of equity?
a. 7.50 percent
b. 7.60 percent
c. 9.15 percent
D. 11.05 percent
e. 11.50 percent
Re = .03 + (1.15
.07) = .1105 = 11.05 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.2
TOPIC: COST OF EQUITY
TYPE: PROBLEMS
46. Old Country Lemonade has a beta of .9, a stock price of $28, and recently paid an annual
dividend of $1.10 a share. The dividend growth rate is 3 percent. The market has an 11
percent rate of return and a risk premium of 7 percent. What is the average expected cost of
equity for Old Country Lemonade?
a. 7.05 percent
B. 8.67 percent
c. 9.13 percent
d. 10.30 percent
e. 11.33 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.2
TOPIC: COST OF EQUITY
TYPE: PROBLEMS
15-19
Chapter 015 Cost of Capital
47. HBS, Inc. has a growth rate of 6 percent and is equally as risky as the market. The stock
is currently selling for $15 a share. The overall stock market has a 12 percent rate of return
and a risk premium of 9 percent. What is the expected rate of return on HBS's stock?
a. 6 percent
b. 9 percent
C. 12 percent
d. 15 percent
e. 18 percent
Re = (.12
.09) + (1.00
.09) = 12.00 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.2
TOPIC: COST OF EQUITY
TYPE: PROBLEMS
48. The Collection Co. has a current beta of 1.6. The market risk premium is 7 percent and
the risk-free rate of return is 3 percent. By how much will the cost of equity increase if the
company expands their operations such that their company beta rises to 1.9?
a. 0.30 percent
b. 0.90 percent
c. 1.50 percent
D. 2.10 percent
e. 2.70 percent
Increase in cost of equity = (1.9
1.6)
.07 = 2.10 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.2
TOPIC: COST OF EQUITY
TYPE: PROBLEMS
15-20
Chapter 015 Cost of Capital
49. The Lawson Company has a seven-year bond outstanding with a 6 percent coupon.
Interest payments are paid semi-annually. The face amount of the bond is $1,000. This bond
is currently selling for 101 percent of its face value. What is the company's pre-tax cost of
debt?
a. 4.33 percent
b. 4.49 percent
c. 5.68 percent
D. 5.82 percent
e. 5.91 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.3
TOPIC: COST OF DEBT
TYPE: PROBLEMS
50. The Fine Leather Co. has bonds outstanding that mature in nine years, have a 7 percent
coupon, and pay interest annually. These bonds have a face value of $1,000 and a current
market price of $1,080. What is the company's aftertax cost of debt if their tax rate is 35
percent?
a. 2.04 percent
B. 3.79 percent
c. 5.83 percent
d. 7.58 percent
e. 8.12 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.3
TOPIC: AFTERTAX COST OF DEBT
TYPE: PROBLEMS
15-21
Chapter 015 Cost of Capital
51. The Fix-it Shop has zero coupon bonds outstanding that mature in three years. The
bonds have a face value of $1,000 and a current market price of $860. What is the company's
pre-tax cost of debt?
a. 2.55 percent
b. 5.09 percent
C. 5.16 percent
d. 10.31 percent
e. 10.40 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.3
TOPIC: COST OF DEBT
TYPE: PROBLEMS
52. Your company has a bond issue outstanding with twelve years to maturity. These bonds
have a $1,000 face value, a 6 percent coupon, and pay interest semi-annually. The bonds are
currently quoted at 95 percent of face value. What is your company's pre-tax cost of debt if
the tax rate is 34 percent?
a. 3.97 percent
b. 4.36 percent
C. 6.61 percent
d. 7.04 percent
e. 8.73 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.3
TOPIC: COST OF DEBT
TYPE: PROBLEMS
15-22
Chapter 015 Cost of Capital
53. Ellie's Boutique has a bond issue outstanding that matures in fourteen years. The bonds
pay interest semi-annually. Currently, the bonds are quoted at 98 percent of face value and
carry an 8 percent coupon. The firm's tax rate is 35 percent. What is the firm's aftertax cost
of debt?
a. 2.88 percent
B. 5.36 percent
c. 5.45 percent
d. 8.24 percent
e. 10.72 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.3
TOPIC: AFTERTAX COST OF DEBT
TYPE: PROBLEMS
54. The outstanding bonds of Toy Land, Inc. are priced at $1010 and mature in ten years.
These bonds have a 5 percent coupon and pay interest annually. The firm's tax rate is 34
percent. What is the firm's aftertax cost of debt?
a. 3.01 percent
B. 3.22 percent
c. 3.35 percent
d. 4.87 percent
e. 5.08 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.3
TOPIC: AFTERTAX COST OF DEBT
TYPE: PROBLEMS
15-23
Chapter 015 Cost of Capital
55. Madeline's Miniatures has a zero coupon bond issue outstanding that matures in eleven
years. The bonds are selling at 53 percent of par value. The company's tax rate is 35 percent.
What is the company's aftertax cost of debt?
a. 2.99 percent
B. 3.86 percent
c. 4.16 percent
d. 5.94 percent
e. 7.72 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.3
TOPIC: AFTERTAX COST OF DEBT
TYPE: PROBLEMS
56. Lloyd's Lumberyard has a 9 percent preferred stock outstanding that is currently selling
for $54 a share. The market rate of return is 11 percent and the firm's tax rate is 35 percent.
What is Lloyd's cost of preferred stock?
a. 8.23 percent
b. 10.83 percent
c. 12.67 percent
D. 16.67 percent
e. 17.33 percent
Rp = (.09
$100) / $54 = 16.67 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.3
TOPIC: COST OF PREFERRED
TYPE: PROBLEMS
15-24
Chapter 015 Cost of Capital
57. The Long Brothers pay $7 as the annual dividend on their preferred stock. Currently,
this stock has a market value per share of $66 and a book value per share of $47. What is the
cost of preferred stock?
a. 7.00 percent
B. 10.61 percent
c. 14.00 percent
d. 14.89 percent
e. 18.42 percent
Rp = $7 / $66 = 10.61 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.3
TOPIC: COST OF PREFERRED
TYPE: PROBLEMS
58. Antonio's Pizzeria has 8 percent preferred stock outstanding that sells for $71 a share.
This stock was originally issued at $58 per share. What is Antonio's cost of preferred stock?
a. 8.00 percent
b. 10.50 percent
C. 11.27 percent
d. 13.79 percent
e. 16.00 percent
Rp = (.08
$100) / $71 = 11.27 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.3
TOPIC: COST OF PREFERRED
TYPE: PROBLEMS
15-25
Chapter 015 Cost of Capital
59. The Seasing Company has 1,500 bonds outstanding that are selling for $1,060 each. The
company also has 5,000 shares of preferred stock at a market price of $32 each. The
common stock is priced at $26 a share and there are 36,000 shares outstanding. What is the
weight of the common stock as it relates to the firm's weighted average cost of capital?
a. 6 percent
B. 35 percent
c. 41 percent
d. 54 percent
e. 60 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.4
TOPIC: CAPITAL STRUCTURE WEIGHTS
TYPE: PROBLEMS
60. Highpark Industrial has a $500,000 bond issue outstanding that is selling at 96 percent
of face value. Highpark also has 6,500 shares of preferred stock and 22,000 shares of
common stock outstanding. The preferred stock has a market price of $50 a share compared
to a price of $35 a share for the common stock. What is the weight of the preferred stock as
it relates to the firm's weighted average cost of capital?
a. 9 percent
b. 13 percent
c. 17 percent
D. 21 percent
e. 26 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.4
TOPIC: CAPITAL STRUCTURE WEIGHTS
TYPE: PROBLEMS
15-26
Chapter 015 Cost of Capital
61. Jefferson Enterprises has 700,000 shares of common stock outstanding at a market price
of $18 a share. The company also has 20,000 bonds outstanding that are quoted at 104
percent of face value. What weight should be given to the debt when Jefferson Enterprises
computes their weighted average cost of capital?
a. 31 percent
b. 38 percent
c. 50 percent
D. 62 percent
e. 69 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.4
TOPIC: CAPITAL STRUCTURE WEIGHTS
TYPE: PROBLEMS
15-27
Chapter 015 Cost of Capital
62. The Basket Weavers Company has 100,000 bonds outstanding that are selling at par
value. Bonds with similar characteristics are yielding 7.5 percent. The company also has 1
million shares of 10.5 percent preferred stock outstanding and 5 million shares of common
stock outstanding. The preferred stock sells for $56 per share. The common stock has a beta
of 1.2 and sells for $38 a share. The U.S. Treasury bill is yielding 3 percent and the return on
the market is 12 percent. The corporate tax rate is 34 percent. What is Basket Weaver's
weighted average cost of capital?
a. 10.71 percent
B. 12.04 percent
c. 12.78 percent
d. 14.02 percent
e. 14.85 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.4
TOPIC: WEIGHTED AVERAGE COST OF CAPITAL
TYPE: PROBLEMS
15-28
Chapter 015 Cost of Capital
63. Sam's Souvenir Shop has a cost of debt of 8 percent, a cost of equity of 12 percent, and a
cost of preferred stock of 9 percent. The firm has 116,000 shares of common stock
outstanding at a market price of $24 a share. There are 51,000 shares of preferred stock
outstanding at a market price of $38 a share. The bond issue has a face value of $900,000
and a market quote of 105. The company's tax rate is 35 percent. What is the weighted
average cost of capital for Sam's Souvenir Shop?
a. 9.18 percent
B. 9.84 percent
c. 10.32 percent
d. 12.59 percent
e. 14.94 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.4
TOPIC: WEIGHTED AVERAGE COST OF CAPITAL
TYPE: PROBLEMS
15-29
Chapter 015 Cost of Capital
64. Blue Ribbon, Inc. wants to have a weighted average cost of capital of 10 percent. The
firm has an aftertax cost of debt of 4 percent and a cost of equity of 12 percent. What
debt-equity ratio is needed for the firm to achieve their targeted weighted average cost of
capital?
a. .25
B. .33
c. .50
d. .67
e. .75
.10 = [We
We = 1
.12] + [(1 We) .04) = .12We + .04 .04We; .06 = .08We;We =.75; Wd = 1
.75 = .25; Debt-equity ratio = .25 / .75 = .33
AACSB TOPIC: ANALYTIC
SECTION: 15.4
TOPIC: WEIGHTED AVERAGE COST OF CAPITAL
TYPE: PROBLEMS
15-30
Chapter 015 Cost of Capital
65. Cruiseliners, Inc. has 230,000 shares of common stock outstanding at a market price of
$40 a share. Next quarter, Cruiseliners' is expected to pay an annual dividend in the amount
of $1.80 per share. The dividend growth rate is 3 percent. Cruiseliners' also has 8,000 bonds
outstanding with a face value of $1,000 per bond. The bonds carry a 9 percent coupon, pay
interest annually, and mature in 5.093 years. The bonds are selling at 102 percent of face
value. The company's tax rate is 35 percent. What is Cruiseliners' weighted average cost of
capital?
a. 5.4 percent
B. 6.6 percent
c. 7.5 percent
d. 8.5 percent
e. 9.6 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.4
TOPIC: WEIGHTED AVERAGE COST OF CAPITAL
TYPE: PROBLEMS
15-31
Chapter 015 Cost of Capital
66. McKean, Inc. has a debt-equity ratio of .70 and a tax rate of 34 percent. The firm does
not issue preferred stock. The cost of equity is 12 percent and the aftertax cost of debt is 6
percent. What is McKean's weighted average cost of capital?
a. 7.3 percent
b. 7.9 percent
c. 8.5 percent
d. 8.7 percent
E. 9.5 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.4
TOPIC: WEIGHTED AVERAGE COST OF CAPITAL
TYPE: PROBLEMS
15-32
Chapter 015 Cost of Capital
67. The Woodsburg Co. maintains a debt-equity ratio of .60 and has a tax rate of 35 percent.
The firm does not issue preferred stock. The firm's pre-tax cost of debt is 8.75 percent.
Woodsburg Co. has 20,000 shares of stock outstanding with a beta of .9 and a market price
of $30. The current market risk premium is 7 percent and the current risk-free rate is 3
percent. Last month, Woodsburg Co. issued an annual dividend in the amount of $1.25 per
share. Dividends are expected to grow at 2 percent indefinitely. Using an average expected
cost of equity, what is Woodsburg's weighted average cost of capital?
a. 6.0 percent
B. 7.0 percent
c. 7.9 percent
d. 8.1 percent
e. 9.5 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.4
TOPIC: WEIGHTED AVERAGE COST OF CAPITAL
TYPE: PROBLEMS
15-33
Chapter 015 Cost of Capital
68. Great Sound Music, Inc. has 20,000 shares of common stock outstanding at a market
price of $26 a share. This stock was originally issued at $19 per share. The firm also has a
bond issue outstanding with a total face value of $300,000 which is selling for 97 percent of
face value. The cost of equity is 10 percent while the aftertax cost of debt is 5 percent. The
firm has a beta of 1.2 and a tax rate of 35 percent. What is Great Sound's weighted average
cost of capital?
a. 7.07 percent
b. 7.58 percent
c. 7.83 percent
d. 8.16 percent
E. 8.21 percent
WACC = [($520,000 / $811,000)
= .08206 = 8.21 percent
.10] + [($291,000 / $811,000)
.05] = .06412 + .01794
AACSB TOPIC: ANALYTIC
SECTION: 15.4
TOPIC: WEIGHTED AVERAGE COST OF CAPITAL
TYPE: PROBLEMS
69. Choice Golf Equipment has a beta of 1.2 and a cost of equity of 13 percent. The risk-free
rate of return is 4 percent. Choice is considering a project with a beta of .8. An appropriate
discount rate for the project is:
a. 7.2 percent.
b. 8.0 percent.
c. 9.0 percent.
D. 10.0 percent.
e. 10.8 percent.
.13 = .04 + (1.2
mrp); mrp = .075; RProject = .04 + (.8
AACSB TOPIC: ANALYTIC
SECTION: 15.4
TOPIC: PROJECT COST OF CAPITAL
TYPE: PROBLEMS
15-34
.075) = .10 = 10.0 percent
Chapter 015 Cost of Capital
70. Backyard Tavern has a beta of 1.5 and a cost of equity of 13.2 percent. The risk-free rate
of return is 4.2 percent. Backyard is considering a project with a beta of 1.7 and a project life
of eight years. An appropriate discount rate for the project is:
a. 10.80 percent.
b. 12.16 percent.
C. 14.40 percent.
d. 15.84 percent.
e. 18.00 percent.
.132 = .042 + (1.5
mrp); mrp = .06; RProject = .042 + (1.7
.06) = .144 = 14.40 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.4
TOPIC: PROJECT COST OF CAPITAL
TYPE: PROBLEMS
71. Hilltop, Inc. has a capital structure which is based on 30 percent debt, 10 percent
preferred stock, and 60 percent common stock. The pre-tax cost of debt is 8 percent, the cost
of preferred is 9 percent, and the cost of common stock is 11 percent. The company's tax rate
is 34 percent. The company is considering a project that is equally as risky as the overall
firm. This project has initial costs of $250,000 and cash inflows of $94,000 a year for three
years. What is the projected net present value of this project?
a. $15,823.76
B. $12,414.07
c. $9,127.53
d. $1,083.19
e. $15,823.76
AACSB TOPIC: ANALYTIC
SECTION: 15.4
TOPIC: CAPITAL BUDGETING PROBLEM
TYPE: PROBLEMS
15-35
Chapter 015 Cost of Capital
72. Bertelli's is analyzing a project with an initial cost of $55,000 and cash inflows of
$33,000 a year for two years. This project is an extension of the firm's current operations
and thus is equally as risky as the current firm. The firm uses only debt and common stock to
finance their operations and maintains a debt-equity ratio of .35. The aftertax cost of debt is
6 percent and the cost of equity is 11 percent. The tax rate is 34 percent. What is the
projected net present value of this project?
A. $2,501
b. $2,854
c. $2,913
d. $3,011
e. $3,418
AACSB TOPIC: ANALYTIC
SECTION: 15.4
TOPIC: CAPITAL BUDGETING PROBLEM
TYPE: PROBLEMS
15-36
Chapter 015 Cost of Capital
73. Orson, Inc. uses one-third common stock and two-thirds debt to finance their operations.
The aftertax cost of debt is 6 percent and the cost of equity is 12 percent. The management
of Orson, Inc. is considering a project that will produce a cash inflow of $48,000 in the first
year. The cash inflows will then grow at 4 percent per year thereafter. What is the maximum
amount the firm can initially invest in this project to avoid a negative net present value for
the project?
a. $800,000
b. $900,000
c. $1,000,000
d. $1,100,000
E. $1,200,000
AACSB TOPIC: ANALYTIC
SECTION: 15.4
TOPIC: CAPITAL BUDGETING PROBLEM
TYPE: PROBLEMS
15-37
Chapter 015 Cost of Capital
74. Keller's Korner is considering a new project they consider to be a little riskier than their
current operations. Thus, management has decided to add an additional 2.5 percent to their
company's overall cost of capital when evaluating this project. The project has an initial
cash outlay of $30,000 and projected cash inflows of $12,000 in year one, $20,000 in year
two, and $8,000 in year three. The firm uses 40 percent debt and 60 percent common stock
as their capital structure. The company's cost of equity is 14 percent while the aftertax cost
of debt for the firm is 7 percent. What is the projected net present value of the new project?
A. $1,467.38
b. $2,360.46
c. $2,783.50
d. $3,904.59
e. $3,561.58
AACSB TOPIC: ANALYTIC
SECTION: 15.4
TOPIC: CAPITAL BUDGETING PROBLEM
TYPE: PROBLEMS
75. The Warren Corporation has an overall cost of equity of 9.5 percent and a beta of 1.3.
The firm is financed 100 percent with common stock. The risk-free rate of return is 3
percent. What is an appropriate cost of capital for a division within the firm that has an
estimated beta of .85?
a. 5.75 percent
b. 6.50 percent
C. 7.25 percent
d. 8.50 percent
e. 9.50 percent
.095 = .03 + 1.3mrp; mrp = .05; ReDivision = .03 + (.85
AACSB TOPIC: ANALYTIC
SECTION: 15.5
TOPIC: DIVISIONAL COST OF CAPITAL
TYPE: PROBLEMS
15-38
.05) = 7.25 percent
Chapter 015 Cost of Capital
76. Production Unlimited has an overall beta of .92 and a cost of equity of 10.8 percent for
the firm overall. The firm is 100 percent financed with common stock. Division A within the
firm has an estimated beta of 1.47 and is the riskiest of all of the firm's operations. What is
an appropriate cost of capital for division A if the market risk premium is 6 percent?
a. 9.9 percent
b. 11.6 percent
C. 14.1 percent
d. 15.9 percent
e. 16.7 percent
.108 = rf + (.92
.06); rf = .0528; ReDivision = .0528 + (1.47
.06) = 14.1 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.5
TOPIC: DIVISIONAL COST OF CAPITAL
TYPE: PROBLEMS
77. Company A and Company B are separate firms that are both considering a diamond
exploration project. Company A is in the precious gem mining business and has an aftertax
cost of capital of 13 percent. Company B is in the precious gem retail business. Company
B's aftertax cost of capital is 10 percent. The project under consideration has initial costs of
$315,000 and anticipated annual cash inflows of $57,000 a year for ten years. Which
firm(s), if either, should accept this project?
a. Company A only
b. Company B only
c. both Company A and Company B
D. neither Company A or Company B
e. cannot be determined without further information
Neither Company A nor Company B should accept this project as the applicable WACC for
the project is 13 percent.
AACSB TOPIC: ANALYTIC
SECTION: 15.5
TOPIC: PURE PLAY APPROACH
TYPE: PROBLEMS
15-39
Chapter 015 Cost of Capital
78. Cooper Enterprises sells outdoor swimming pools and currently has an aftertax cost of
capital of 12 percent. Reinhold's sells pool decks and has an aftertax cost of capital of 9
percent. Cooper Enterprises is considering adding pool decks as part of their sales lineup.
They estimate that sales from these decks could become 15 percent of their overall sales.
The initial cash outlay for this project is $75,000. The expected net cash inflows are $14,000
a year for eight years. What is the net present value of this project to Cooper Enterprises?
a. -12,177.50
b. -$5,453.04
C. $2,487.47
d. $4,979.00
e. $14,110.59
AACSB TOPIC: ANALYTIC
SECTION: 15.5
TOPIC: PURE PLAY APPROACH
TYPE: PROBLEMS
79. Buy From Us owns a chain of retail stores that sell home furniture. Crafton, Inc. is one
of the furniture manufacturers that Buy From Us uses to stock their stores. Buy From Us has
a beta of 1.16 and Crafton has a beta of 1.28. The risk-free rate of return is 3 percent and the
market risk premium is 7 percent. What should Buy From Us use as the project cost of
capital if they want to consider manufacturing the products they sell?
a. 7.64 percent
b. 8.12 percent
c. 9.73 percent
d. 11.12 percent
E. 11.96 percent
Re=.03 + (1.28
.07) = 11.96 percent
AACSB TOPIC: ANALYTIC
SECTION: 15.5
TOPIC: PURE PLAY APPROACH
TYPE: PROBLEMS
15-40
Chapter 015 Cost of Capital
80. The Wendell Co. uses 40 percent common stock, 30 percent preferred stock, and 30
percent debt as their capital structure. The flotation costs are 5 percent for debt, 9 percent for
preferred stock, and 8 percent for common stock. The corporate tax rate is 35 percent. What
is the weighted average flotation cost?
a. 6.0 percent
b. 6.4 percent
c. 6.9 percent
d. 7.1 percent
E. 7.4 percent
Average flotation cost = (.40
7.4 percent
.08) + (.30
.09) + (.30
.05) = .032 + .027 +.015= .074 =
AACSB TOPIC: ANALYTIC
SECTION: 15.6
TOPIC: FLOTATION COST AND WEIGHTED AVERAGE COST OF CAPITAL
TYPE: PROBLEMS
81. The Warren Co. has a capital structure which is based on 20 percent debt, 35 percent
preferred stock, and 45 percent common stock. The flotation costs are 9 percent for common
stock, 10 percent for preferred stock, and 5 percent for debt. The corporate tax rate is 34
percent. What is the weighted average flotation cost?
a. 6.79 percent
b. 7.55 percent
c. 8.21 percent
D. 8.55 percent
e. 9.05 percent
Average flotation cost = (.45
= 8.55 percent
.09) + (.35
.10) + (.20
AACSB TOPIC: ANALYTIC
SECTION: 15.6
TOPIC: FLOTATION COST
TYPE: PROBLEMS
15-41
.05) = .0405 + .035 + .01 = .0855
Chapter 015 Cost of Capital
82. Harmon, Inc. has a debt-equity ratio of .80. The firm is analyzing a new project which
requires an initial cash outlay of $300,000 for new equipment. The flotation cost for new
equity is 9 percent and for debt 4.5 percent. What is the initial cost of the project including
the flotation costs?
a. $317,125
b. $320,856
c. $321,000
D. $322,581
e. $325,912
AACSB TOPIC: ANALYTIC
SECTION: 15.6
TOPIC: FLOTATION COST
TYPE: PROBLEMS
83. Your boss would like you to evaluate a project which requires $164,000 in external
financing. The flotation cost of equity is 12 percent and the flotation cost of debt is 5
percent. You wish to maintain a debt-equity ratio of .55. What is the initial cost of the
project including the flotation costs?
a. $177,226
b. $178,552
c. $179,606
d. $180,337
E. $181,248
AACSB TOPIC: ANALYTIC
SECTION: 15.6
TOPIC: FLOTATION COST
TYPE: PROBLEMS
15-42
Chapter 015 Cost of Capital
84. Parker United is considering a project which requires an initial investment of $380,000.
The firm maintains a debt-equity ratio of .40. The flotation cost of debt is 6 percent and the
flotation cost of equity is 11 percent. Parker United has sufficient internally generated
equity to cover the equity cost of this project. What is the initial cost of the project including
the flotation costs?
A. $386,628
b. $396,048
c. $411,009
d. $420,221
e. $433,333
AACSB TOPIC: ANALYTIC
SECTION: 15.6
TOPIC: INTERNAL EQUITY AND FLOTATION COST
TYPE: PROBLEMS
15-43
Chapter 015 Cost of Capital
85. West Minster Properties is considering a project which has an initial start up cost of
$840,000. The firm maintains a debt-equity ratio of .60. The flotation cost of debt is 8
percent and the flotation cost of equity is 13 percent. The firm has sufficient internally
generated equity to cover the equity cost of this project. What is the initial cost of the project
including the flotation costs?
A. $865,979
b. $872,418
c. $876,082
d. $803,104
e. $811,216
AACSB TOPIC: ANALYTIC
SECTION: 15.6
TOPIC: INTERNAL EQUITY AND FLOTATION COST
TYPE: PROBLEMS
15-44
Chapter 015 Cost of Capital
Essay Questions
86. Explain the role of the weighted average cost of capital as it affects the decision to
accept or reject a project.
Assuming a project is equally as risky as a firm's current operations, the WACC is used as
the discount rate to evaluate the NPV of a project. Therefore, having an accurate WACC is
necessary to correctly determine if a project should be accepted or rejected. If a project has a
different risk level than the firm's current operations, then the firm's WACC should not be
used as the project's discount rate without further adjustment to that rate.
AACSB TOPIC: REFLECTIVE THINKING
SECTION: 15.1 AND 15.4
TOPIC: WACC
87. What are some advantages to the subjective approach and why do you think that
approach is utilized?
The subjective approach allows management to adjust the discount rate for individual
projects based upon their evaluation of the risks associated with a particular project as
compared to the overall current risk level of the firm. To try and determine a more accurate
estimate of the appropriate discount rate might encounter costs that would outweigh any
potential benefit. Thus, the subjective approach is used because it allows for discount rate
adjustments in a cost effective manner.
AACSB TOPIC: REFLECTIVE THINKING
SECTION: 15.5
TOPIC: SUBJECTIVE APPROACH
15-45
Chapter 015 Cost of Capital
88. Give an example of a situation where a firm should adopt the pure play approach to
determine the cost of capital for a project.
Student examples will vary but should illustrate a project that is unrelated to the current
operations of Firm A. The example should explain why the WACC of Firm B, which is
engaged in the type of operations Firm A is considering, should be used as the basis for
setting the discount rate for the proposed project.
AACSB TOPIC: REFLECTIVE THINKING
SECTION: 15.5
TOPIC: PURE PLAY AND SUBJECTIVE APPROACHES
15-46
Chapter 015 Cost of Capital
89. Suppose your boss comes to you and asks you to re-evaluate a capital budgeting project.
The first evaluation was in error, he explains, because it ignored flotation costs. To correct
for this, he asks you to evaluate the project using a higher cost of capital. Is your boss'
approach correct? Why or why not?
Your boss is confused since it is the use of funds, and not the source of funds, that
determines the cost of capital. Flotation costs should be included in the initial cash flow for
a project and not in the cost of capital.
AACSB TOPIC: REFLECTIVE THINKING
SECTION: 15.6
TOPIC: FLOTATION COSTS
90. Explain how the use of internal equity rather than external equity affects the analysis of
a project.
Internal equity avoids the flotation costs associated with raising external equity. Therefore,
by utilizing internal equity rather than external equity, the initial cost of the project is
decreased. Decreasing the initial cost increases the NPV of the project.
AACSB TOPIC: REFLECTIVE THINKING
SECTION: 15.6
TOPIC: INTERNAL EQUITY AND FLOTATION COSTS
15-47