Foundations of Finance, 7e (Keown)
Chapter 9 The Cost of Capital
9.1 Learning Objective 1
True or False
1) In order to create value a corporation must earn a rate of return on its invested capital that is
higher than the market's required rate of return on that invested capital.
Answer: TRUE
Diff: 1
Keywords: Required Rate of Return, Invested Capital
2) The cost of capital is the rate that must be earned on an investment project if the project is to
increase the value of the common shareholders’ investment.
Answer: TRUE
Diff: 1
Keywords: Cost of Capital, Shareholder Value
3) The firm’s cost of capital may also be referred to as the firm’s opportunity cost of capital.
Answer: TRUE
Diff: 1
Keywords: Cost of Capital, Opportunity Cost of Capital
4) The firm’s cost of capital is important when evaluation the firm’s overall value, but should not
be used to evaluate individual projects which have their own unique characteristics.
Answer: FALSE
Diff: 1
Keywords: Cost of Capital
5) The cost of debt increases relative to the investor's required return due to flotation costs, but
decreases relative to the investor's required return due to the tax deductibility of interest.
Answer: TRUE
Diff: 1
Keywords: Cost of Debt, Flotation Costs, Taxes, Interest
Multiple Choice
1) Higher flotation costs will result in all of the following except:
A) higher after-tax cost of debt
B) higher weighted average cost of capital
C) higher cost of retained earnings
D) higher cost of common equity when new common shares are sold
Answer: C
Diff: 1
Keywords: Flotation Costs, Cost of Retained Earnings
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9.2 Learning Objective 2
True or False
1) Flotation costs cause a corporation's cost of capital to be lower than its investors' required
returns.
Answer: FALSE
Diff: 1
Keywords: Flotation Costs, Cost of Capital, Required Returns
2) The cost of a particular source of capital (debt, preferred stock, common stock) is equal to the
investor's required rate of return after adjusting for the effects of both flotation costs and
corporate taxes.
Answer: TRUE
Diff: 1
Keywords: Cost of Capital, Flotation Costs, Corporate Taxes
3) The cost of debt capital is obtained by substituting the net proceeds per bond for the bond
price in the bond valuation equation and solving for the required return.
Answer: TRUE
Diff: 2
Keywords: Cost of Debt
4) The cost of preferred stock is equal to the preferred stock dividend divided by the net proceeds
per preferred share.
Answer: TRUE
Diff: 1
Keywords: Cost of Preferred Stock, Net Proceeds, Flotation Costs
5) A corporation's cost of common equity may be estimated using either a dividend valuation
model or the capital asset pricing model.
Answer: TRUE
Diff: 1
Keywords: Cost of Common Equity, Dividend Growth Model, Capital Asset Pricing Model
6) Corporations have two costs of common equity, one for retained earnings and one if the
company issues new common stock.
Answer: TRUE
Diff: 1
Keywords: Cost of Common Equity, Retained Earnings
7) The Capital Asset Pricing Model may be used to estimate the cost of retained earnings.
Answer: TRUE
Diff: 1
Keywords: Capital Asset Pricing Model, Cost of Retained Earnings
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8) A reasonable estimate of the market risk premium based on historical data and expert opinion
is between 5% and 7%.
Answer: TRUE
Diff: 1
Keywords: Market Risk Premium, Capital Asset Pricing Model
9) The market risk premium remains constant over time because the risk free rate of return
moves inversely with beta.
Answer: FALSE
Diff: 1
Keywords: Market Risk Premium, Capital Asset Pricing Model
10) A firm's cost of capital is the required rate of return on the firm's average project.
Answer: TRUE
Diff: 1
Keywords: Cost of Capital, Required Return
11) The firm financed completely with equity capital has a cost of capital equal to the required
return on common stock.
Answer: TRUE
Diff: 1
Keywords: Cost of Capital, Required Return on Common Stock
12) The after-tax cost of equity equals one minus the marginal tax rate times the required rate of
return on common stock.
Answer: FALSE
Diff: 1
Keywords: Cost of Common Equity
13) If preferred stock pays a $5 annual dividend and sells for $50 the cost of preferred stock
financing is 10% since dividends are not tax deductible and preferred stock is sold without
flotation costs.
Answer: FALSE
Diff: 1
Keywords: Cost of Preferred Stock, Flotation Costs
14) Other things equal, management should retain profits only if the company's investments
within the firm are at least as attractive as the stockholders' other investment opportunities.
Answer: TRUE
Diff: 1
Keywords: Cost of Retained Earnings, Shareholder Value
15) Financing with new common stock is generally more costly than financing with retained
earnings due to increasing tax rates.
Answer: FALSE
Diff: 1
Keywords: Cost of New Common Stock, Cost of Retained Earnings
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16) The firm's best financial structure is determined by finding the capital structure that
minimizes the firm's cost of capital.
Answer: TRUE
Diff: 1
Keywords: Capital Structure, Cost of Capital
17) The required return of a preferred stockholder, rps, is higher than the cost of preferred stock
for the corporation because stockholder’s must pay federal taxes on their dividend income.
Answer: FALSE
Diff: 1
Keywords: Required Return on Preferred Stock, Cost of Preferred Stock
18) Investors require higher rates of return to compensate for purchasing power losses resulting
from inflation.
Answer: TRUE
Diff: 1
Keywords: Required Returns, Inflation
19) A security with a reasonably stable price will have a lower required rate of return than a
security with an unstable price.
Answer: TRUE
Diff: 1
Keywords: Required Return, Variability of Returns
20) The cost of internal common equity is already on an after-tax basis since dividends paid to
common stockholders are not tax deductible.
Answer: TRUE
Diff: 1
Keywords: Cost of Retained Earnings
21) A short-term T-bill's rate of return should be used in the CAPM formula to determine the
cost of equity capital regardless of the length of the project under consideration.
Answer: FALSE
Diff: 1
Keywords: Capital Asset Pricing Model, Risk-free Rate of Return
22) The capital asset pricing model uses three variables to evaluate required returns on common
equity: the risk free rate, the beta coefficient, and the market risk premium.
Answer: TRUE
Diff: 1
Keywords: CAPM
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23) The investor's required rate of return will equal the firm's cost of capital if corporate
transactions costs are taken into account.
Answer: FALSE
Diff: 1
Keywords: Cost of Capital, Required Rate of Return
24) The cost of debt measures the cost of a bank loan, while the cost of preferred stock is used as
a proxy for the cost of a new bond issue.
Answer: FALSE
Diff: 1
Keywords: Cost of Debt, Cost of Preferred Stock, Bonds
25) Preferred dividends are paid with before-tax dollars because the dividend rate is known,
whereas common stock dividends are paid with after-tax dollars.
Answer: FALSE
Diff: 1
Keywords: Preferred Dividends, Common Dividends, Taxes
26) An increase in a corporation's marginal tax rate will cause the corporation's after tax cost of
debt to increase, other things remaining the same.
Answer: FALSE
Diff: 1
Keywords: Cost of Debt, Taxes
27) Because investors like dividends, the higher the company's dividend growth rate, the lower
the company's cost of common equity.
Answer: FALSE
Diff: 2
Keywords: Cost of Common Equity, Dividend Growth Rate
28) An increase in a corporation's marginal tax rate will decrease the corporation's cost of debt,
but have no impact on its cost of preferred stock or cost of common equity.
Answer: TRUE
Diff: 2
Keywords: Cost of Debt, Cost of Preferred Stock, Cost of Common Equity, Marginal Tax Rate
Multiple Choice
1) Two factors that cause the investor's required rate of return to differ from the company's cost
of capital are:
A) taxes and risk.
B) transactions costs and risk.
C) taxes and transactions costs.
D) risk and opportunity cost differences.
Answer: B
Diff: 1
Keywords: Cost of Capital, Taxes, Transactions Costs
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2) Two considerations that cause a corporation's cost of capital to be different than its investors'
required returns are
A) corporate taxes and flotation costs.
B) individual taxes and corporate taxes.
C) individual taxes and dividends.
D) corporate taxes and the earned income tax credit.
Answer: A
Diff: 1
Keywords: Cost of Capital, Required Rate of Return, Taxes, Flotation Costs
3) Due to changes in regulatory requirements, the transactions costs associated with selling
corporate securities increased by $1 per share. This change will
A) cause the cost of capital to decrease.
B) cause the cost of capital to increase.
C) have no effect on the cost of capital because transactions costs are expensed immediately.
D) cause the cost of capital to decrease only if investors may be billed for part of the increase in
transactions costs.
Answer: B
Diff: 1
Keywords: Flotation Costs, Cost of Capital
4) Jones Distributing Corp. can sell common stock for $27 per share and its investors require a
17% return. However, the administrative or flotation costs associated with selling the stock
amount to $2.70 per share. What is the cost of capital for Jones Distributing if the corporation
raises money by selling common stock?
A) 27.00%
B) 18.89%
C) 18.33%
D) 17.00%
Answer: B
Diff: 2
Keywords: Cost of Capital, Flotation Costs
5) A company has preferred stock that can be sold for $21 per share. The preferred stock pays an
annual dividend of 3.5% based on a par value of $100. Flotation costs associated with the sale of
preferred stock equal $1.25 per share. The company's marginal tax rate is 35%. Therefore, the
cost of preferred stock is:
A) 18.87%.
B) 17.72%.
C) 14.26%.
D) 12.94%.
Answer: B
Diff: 2
Keywords: Cost of Preferred Stock, Flotation Costs, Net Proceeds
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6) Asian Trading Company paid a dividend yesterday of $5 per share (D0 = $4). The dividend is
expected to grow at a constant rate of 8% per year. The price of Asian Trading Company's stock
today is $29 per share. If Asian Trading Company decides to issue new common stock, flotation
costs will equal $2.50 per share. Asian Trading Company's marginal tax rate is 35%. Based on
the above information, the cost of retained earnings is:
A) 28.38%.
B) 24.12%.
C) 26.62%.
D) 31.40%.
Answer: C
Diff: 2
Keywords: Cost of Retained Earnings
7) Asian Trading Company paid a dividend yesterday of $5 per share (D0 = $4). The dividend is
expected to grow at a constant rate of 8% per year. The price of Asian Trading Company's stock
today is $29 per share. If Asian Trading Company decides to issue new common stock, flotation
costs will equal $2.50 per share. Asian Trading Company's marginal tax rate is 35%. Based on
the above information, the cost of new common stock is:
A) 28.38%.
B) 24.12%.
C) 26.62%.
D) 31.40%.
Answer: A
Diff: 2
Keywords: Cost of New Common Stock
8) In general, which of the following rankings, from highest to lowest cost, is most accurate?
A) cost of new common stock, cost of preferred stock, cost of debt, cost of retained earnings
B) cost of debt, cost of preferred stock, cost of new common stock, cost of retained earnings
C) cost of new common stock, cost of retained earnings, cost of preferred stock, cost of debt
D) cost of preferred stock, cost of new common stock, cost of retained earnings, cost of debt
Answer: C
Diff: 1
Keywords: Cost of New Common Stock, Cost of Retained Earnings, Cost of Preferred Stock,
Cost of Debt
9) The risk free rate of return is 2.5% and the market risk premium is 8%. Penn Trucking has a
beta of 2.2 and a standard deviation of returns of 28%. Penn Trucking's marginal tax rate is 35%.
Analysts expect Penn Trucking's dividends to grow by 6% per year for the foreseeable future.
Using the capital asset pricing model, what is Penn Trucking's cost of retained earnings?
A) 16.4%
B) 17.7%
C) 19.6%
D) 20.1%
Answer: D
Diff: 2
Keywords: Capital Asset Pricing Model, Cost of Retained Earnings
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10) A company has preferred stock with a current market price of $18 per share. The preferred
stock pays an annual dividend of 4% based on a par value of $100. Flotation costs associated
with the sale of preferred stock equal $1.50 per share. The company's marginal tax rate is 40%.
Therefore, the cost of preferred stock is:
A) 28.80%.
B) 24.24%.
C) 22.22%.
D) 14.55%.
Answer: B
Diff: 2
Keywords: Cost of Preferred Stock, Flotation Costs, Net Proceeds
11) KayCee Manufacturing Company paid a dividend yesterday of $3.50 per share. The dividend
is expected to grow at a constant rate of 10% per year. The price of KayCee's common stock
today is $40 per share. If KayCee decides to issue new common stock, flotation costs will equal
$4.00 per share. Kaycee's marginal tax rate is 35%. Based on the above information, the cost of
retained earnings is:
A) 26.41%.
B) 20.09%.
C) 19.63%.
D) 17.55%.
Answer: C
Diff: 2
Keywords: Cost of Retained Earnings
12) KayCee Manufacturing Company paid a dividend yesterday of $3.50 per share. The dividend
is expected to grow at a constant rate of 10% per year. The price of KayCee's common stock
today is $40 per share. If Kaycee decides to issue new common stock, flotation costs will equal
$4.00 per share. Kaycee's marginal tax rate is 35%. Based on the above information, the cost of
new common stock is:
A) 26.41%.
B) 20.09%.
C) 19.63%.
D) 17.55%.
Answer: B
Diff: 2
Keywords: Cost of New Common Stock, Flotation Costs
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13) The risk free rate of return is 3% and the expected return on the market portfolio is 14%.
Starship Enterprises has a beta of 2.0 and a standard deviation of returns of 26%. Starship's
marginal tax rate is 35%. Analysts expect Starship's net income to grow by 12% per year for the
next 5 years. Using the capital asset pricing model, what is Starship Enterprises' cost of retained
earnings?
A) 18.6%
B) 21.2%
C) 22.8%
D) 25.0%
Answer: D
Diff: 2
Keywords: Capital Asset Pricing Model, Cost of Retained Earnings
14) Jiffy Co. expects to pay a dividend of $3.00 per share in one year. The current price of Jiffy
common stock is $60 per share. Flotation costs are $3.00 per share when Jiffy issues new stock.
What is the cost of internal common equity (retained earnings) if the long-term growth in
dividends is projected to be 8 percent indefinitely?
A) 13 percent
B) 14 percent
C) 15 percent
D) 16 percent
Answer: A
Diff: 1
Keywords: Cost of Retained Earnings
15) The average cost associated with each additional dollar of financing for investment projects
is:
A) the incremental return.
B) the marginal cost of capital.
C) CAPM required return.
D) the component cost of capital.
Answer: B
Diff: 1
Keywords: Marginal Cost of Capital
16) A firm's cost of capital is influenced by:
A) the current ratio.
B) par value of common stock.
C) capital structure.
D) net income.
Answer: C
Diff: 1
Keywords: Cost of Capital
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17) Clanton Company is financed 75 percent by equity and 25 percent by debt. If the firm
expects to earn $30 million in net income next year and retain 40% of it, how large can the
capital budget be before common stock must be sold?
A) $7.5 million
B) $12.0 million
C) $15.5 million
D) $16.0 million
Answer: C
Diff: 2
Keywords: Capital Structure, Capital Budget
18) The cost of new preferred stock is equal to:
A) the preferred stock dividend divided by the market price.
B) the preferred stock dividend divided by its par value.
C) (1 - tax rate) times the preferred stock dividend divided by net price.
D) preferred stock dividend divided by the net selling price of preferred.
Answer: D
Diff: 2
Keywords: Cost of New Preferred Stock
19) In general, the least expensive source of capital is:
A) debt
B) new common stock.
C) preferred stock
D) retained earnings.
Answer: A
Diff: 2
Keywords: Cost of Capital, Sources of Capital
20) The cost of external equity capital is greater than the cost of retained earnings because of:
A) flotation costs on new equity.
B) increasing marginal tax rates.
C) higher dividends.
D) greater risk for shareholders.
Answer: A
Diff: 2
Keywords: Flotation Costs, Cost of New Common Stock, Cost of Retained Earnings
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21) Seafood Products Corp. is expected to pay a dividend of $2.60 next year. Dividends are
expected to grow at a constant rate of 8% per year, and the stock price is currently $20.00. New
stock can be sold at this price subject to flotation costs of 15%. The company's marginal tax rate
is 35%. Compute the cost of internal equity (retained earnings) and the cost of external equity
(new common stock), respectively.
A) 0, 21.00%
B) 8.00%, 23.29%
C) 21.00%, 23.29%
D) 23.00%, 25.48%
Answer: C
Diff: 2
Keywords: Cost of Retained Earnings, Cost of New Common Stock
22) DEF Company's preferred stock is currently selling for $28.00, and pays a perpetual annual
dividend of $2.00 per share. Underwriters of a new issue of preferred stock would charge $3 per
share in flotation costs. The firm's tax rate is 40%. Compute the cost of new preferred stock for
DEF.
A) 4.80%
B) 7.14%
C) 8.00%
D) 9.15%
Answer: C
Diff: 2
Keywords: Cost of New Preferred Stock, Flotation Costs
23) Atlas Corporation wishes to estimate its cost of retained earnings. The firm's beta is 1.3. The
rate on 6-month T-bills is 2%, and the return on the S&P 500 index is 15%. What is the
appropriate cost for retained earnings in determining the firm's cost of capital?
A) 17.0%
B) 19.5%
C) 18.9%
D) 22.1%
Answer: C
Diff: 2
Keywords: Capital Asset Pricing Model, Cost of Capital
24) In capital budgeting analysis, when computing the weighted average cost of capital, the
CAPM approach is typically used to find which of the following:
A) Market value weight of equity
B) Pretax component cost of debt
C) After-tax component cost of debt
D) Component cost of internal equity
Answer: D
Diff: 1
Keywords: Capital Asset Pricing Model, Cost of Retained Earnings
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25) The cost of retained earnings is less than the cost of new common stock because:
A) marginal tax brackets increase.
B) flotation costs are incurred when new stock is issued.
C) dividends are not tax deductible.
D) accounting rules allow a deduction when using retained earnings.
Answer: B
Diff: 2
Keywords: Flotation Costs, Cost of Retained Earnings, Cost of New Common Stock
26) Which of the following differentiates the cost of retained earnings from the cost of newlyissued common stock?
A) The cost of the pre-emptive rights held by existing shareholders.
B) The greater marginal tax rate faced by the now-larger firm.
C) The flotation costs incurred when issuing new securities.
D) The larger dividends paid to the new common stockholders.
Answer: C
Diff: 1
Keywords: Flotation Costs, Cost of Retained Earnings, Cost of New Common Stock
27) Five Rivers Casino is undergoing a major expansion. The expansion will be financed by
issuing new 15-year, $1,000 par, 9% annual coupon bonds. The market price of the bonds is
$1,070 each. Five Rivers flotation expense on the new bonds will be $50 per bond. Five Rivers
marginal tax rate is 35%. What is the yield to maturity on the newly-issued bonds?
A) 6.95%
B) 7.99%
C) 8.17%
D) 9.82%
Answer: C
Diff: 2
Keywords: Yield to Maturity
28) Five Rivers Casino is undergoing a major expansion. The expansion will be financed by
issuing new 15-year, $1,000 par, 9% annual coupon bonds. The market price of the bonds is
$1,070 each. Gamblers flotation expense on the new bonds will be $50 per bond. Gamblers
marginal tax rate is 35%. What is the pre-tax cost of debt for the newly-issued bonds?
A) 8.76%
B) 8.12%
C) 7.49%
D) 10.25%
Answer: A
Diff: 2
Keywords: Pre-tax Cost of Debt, Flotation Costs
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29) General Bill's will issue preferred stock to finance a new artillery line. The firm's existing
preferred stock pays a dividend of $4.00 per share and is selling for $40 per share. Investment
bankers have advised General Bill that flotation costs on the new preferred issue would be 5% of
the selling price. The General's marginal tax rate is 30%. What is the relevant cost of new
preferred stock?
A) 7.00%
B) 7.37%
C) 10.00%
D) 10.53%
E) 15.00%
Answer: D
Diff: 2
Keywords: Cost of New Preferred Stock, Flotation Costs
30) Kelly Corporation will issue new common stock to finance an expansion. The existing
common stock just paid a $1.50 dividend, and dividends are expected to grow at a constant rate
8% indefinitely. The stock sells for $45, and flotation expenses of 5% of the selling price will be
incurred on new shares. What is the cost of new common stock be for Kelly Corp.?
A) 11.33%
B) 11.51%
C) 11.60%
D) 11.79%
E) 12.53%
Answer: D
Diff: 2
Keywords: Cost of New Common Stock, Flotation Costs
31) Kelly Corporation will issue new common stock to finance an expansion. The existing
common stock just paid a $1.50 dividend, and dividends are expected to grow at a constant rate
8% indefinitely. The stock sells for $45, and flotation expenses of 5% of the selling price will be
incurred on new shares. What is the cost of retained earnings for Kelly Corp.?
A) 11.33%
B) 11.51%
C) 11.60%
D) 11.79%
E) 12.53%
Answer: C
Diff: 2
Keywords: Cost of Retained Earnings
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32) Which of the following statements is most correct?
A) Because the cost of debt is lower than the cost of equity, value-maximizing firms maintain
debt ratios of close to 100%
B) Corporations that are 100% equity financed will have a much lower weighted average cost of
capital because the lack of debt lowers their risk of bankruptcy
C) The source of capital with the lowest after-tax cost is preferred stock, because it is a hybrid
security, part debt and part equity.
D) The cost of a particular source of capital is equal to the investor's required rate of return after
adjusting for the effects of both flotation costs and corporate taxes.
Answer: D
Diff: 1
Keywords: Cost of Capital, Flotation Costs, Transactions Costs
33) All else equal, an increase in beta results in
A) an increase in the cost of retained earnings.
B) an increase in the cost of newly issued common stock .
C) an increase in the after-tax cost of debt.
D) an increase in the cost of common equity, whether or not the funds come from retained
earnings or newly issued common stock.
Answer: D
Diff: 1
Keywords: Beta, Cost of Common Equity
34) Royal Mediterranean Cruise Line's common stock is selling for $22 per share. The last
dividend was $1.20, and dividends are expected to grow at a 6% annual rate. Flotation costs on
new stock sales are 5% of the selling price. What is the cost of Royal's retained earnings?
A) 5.73%
B) 11.45%
C) 11.78%
D) 12.09%
Answer: C
Diff: 2
Keywords: Cost of Retained Earnings
35) Royal Mediterranean Cruise Line's common stock is selling for $22 per share. The last
dividend was $1.20, and dividends are expected to grow at a 6% annual rate. Flotation costs on
new stock sales are 5% of the selling price. What is the cost of Royal's new common stock?
A) 5.73%
B) 11.45%
C) 11.78%
D) 12.09%
Answer: D
Diff: 2
Keywords: Cost of New Common Stock
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Essay
1) New Jet Airlines plans to issue 14-year bonds with a par value of $1,000 that will pay $60
every six months. The bonds have a market price of $1,220. Flotation costs on new debt will be
4% of the selling price. If the firm has a 35% marginal tax bracket, compute the following:
a. Yield to maturity of debt
b. After-tax cost of existing debt
c. After-tax cost of new debt
Answer:
a. YTM = 9.18% (Using Yield Function in Excel with rate =.12, Pr = 122, Redemption = 100,
Frequency = 2, and Basis = 0)
b. After-tax cost of debt = 9.18% × (1-.35) = 5.97%
c. After-tax cost of new debt = 9.73% × (1-.35) = 6.33% (The pre-tax cost is determined as in
part a, except the Pr is 117.12, based on a net price of $1,220 less flotation costs of $48.80.)
Diff: 2
Keywords: Yield to Maturity, After-tax Cost of Existing Debt, After-tax Cost of New Debt,
Flotation Costs
2) Alarm Systems Corporation’s preferred stock pays a dividend of $3.60 and sells for $28.00.
Alarm Systems Corporation has a marginal tax rate of 35%. What is the cost of preferred
financing?
Answer: $3.60/$28 = .12857 =12.857%%
Diff: 1
Keywords: Cost of Preferred Stock
3) NewLinePhone Corp. is very risky, with a beta equal to 2.8 and a standard deviation of returns
of 32%. The risk free rate of return is 3% and the market risk premium is 8%. NewLinePhone’s
marginal tax rate is 35%. Use the capital asset pricing model to estimate NewLinePhone’s cost
of retained earnings.
Answer: 3% + (8%)(2.8) = 25.4%
Diff: 2
Keywords: Cost of Retained Earnings, Capital Asset Pricing Model
4) Dickerson Corporation’s common stock is currently selling for $38. Last year's dividend was
$4.00 per share. Investors expect dividends to grow at an annual rate of 7 percent indefinitely.
Flotation costs of 4% will be incurred when new stock is sold.
a. What is the cost of internal common equity?
b. What is the cost of new common equity?
Answer:
a. D1 = $4.00 × 1.07 = $4.28
Cost of internal common equity = $4.28/$38 + .07 = 18.26%
b. Cost of new common equity = $4.28/($38 × .96) + .07 = 18.73%
Diff: 2
Keywords: Cost of Retained Earnings, Cost of New Common Stock, Flotation Costs
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5) Last year Gator Getters, Inc. had $50 million in total assets. Management desires to increase
its plant and equipment during the coming year by $12 million. The company plans to finance 40
percent of the expansion with debt and the remaining 60 percent with equity capital. Bond
financing will be at a 9 percent rate and will be sold at its par value. Common stock is currently
selling for $50 per share, and flotation costs for new common stock will amount to $5 per share.
The expected dividend next year for Gator is $2.50. Furthermore, dividends are expected to grow
at a 6 percent rate far into the future. The marginal corporate tax rate is 34 percent. Internal
funding available from additions to retained earnings is $4,000,000.
a. What amount of new common stock must be sold if the existing capital structure is to be
maintained?
b. Calculate the weighted marginal cost of capital at an investment level of $12 million.
Answer: a.
Equity needed = $12 million × 0.6 = $7.2 million
Less additions to R/E
4.0 million
New common stock
$3.2 million
b.
Kd = 9(1 - .34) = 5.94%
Knc = $2.50/$45 + 0.06 = 11.56%
MCC = 0.4 × 5.94% + 0.6 × 11.56% = 9.31%
Diff: 2
Keywords: After-tax Cost of Debt, Cost of New Common Stock, Marginal Cost of Capital
6) The common stock for El Viss Company currently sells for $20 per share. The firm just paid a
dividend of $1.50, and the dividend three years ago was $1.30. Dividends per share are
anticipated to grow at the same rate in the future as they have over the past three years. Flotation
costs for new shares will be 6% of the selling price. Calculate the following:
a. the cost of retained earnings
b. the cost of external equity capital
Answer:
a. g = 4.89% D1 = $1.50 × 1.049 = $1.57
Cost of retained earnings = $1.57/$20 + .049 = 12.75%
b. Cost of external equity = $1.57/($20 × .94) + .049 = 13.25%
Diff: 2
Keywords: Cost of Retained Earnings, Cost of New Common Stock
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7) A company is going to issue a $1,000 par value bond that pays a 7% annual coupon. The
company expects investors to pay $942 for the 20-year bond. The expected flotation cost per
bond is $42, and the firm is in the 34% tax bracket. Compute the following:
a. The yield to maturity on the firm’s bonds
b. The firm’s after-tax cost of existing debt
c. The firm’s after-tax cost of new debt
Answer:
a. YTM = 7.57%
b. After-tax cost of existing debt = 7.57% × (1 - .34) = 5%
c. After-tax cost of new debt = 8.02% × (1 - .34) = 5.29%
Diff: 2
Keywords: After-tax Cost of Debt, Yield to Maturity, Flotation Costs
8) Toto and Associates' preferred stock is selling for $27.50 a share. The firm nets $25.60 after
issuance costs. The stock pays an annual dividend of $3.00 per share. What is the cost of
existing, and new, preferred stock respectively?
Answer: Cost of existing preferred stock = $3.00/$27.50 = 10.91%
Cost of new preferred stock = $3.00/$25.60 = 11.72%
Diff: 2
Keywords: Cost of Existing Preferred Stock, Cost of New Preferred Stock
9) Sutter Corporation's common stock is selling for $16.80 a share. Last year Sutter paid a
dividend of $.80. Investors are expecting Sutter's dividends to grow at an annual rate of 5% per
year. What is the cost of internal equity?
Answer: D1 = $.80 × 1.05 = $.84
Cost of internal equity = $.84/$16.80 + .05 = 10%
Diff: 2
Keywords: Cost of Retained Earnings
10) Gibson Industries is issuing a $1,000 par value bond with an 8% annual interest coupon rate
that matures in 11 years. Investors are willing to pay $972, and flotation costs will be 9%.
Gibson is in the 34% tax bracket. What will be the after-tax cost of new debt for the bond?
Answer: 9.76% × (1 - .34) = 6.44%
Diff: 2
Keywords: After-tax Cost of Debt, Flotation Costs
11) The preferred stock of Wells Co. sells for $17 and pays a $1.75 dividend. The net price of the
stock after issuance costs is $15.30. What is the cost of capital for new preferred stock?
Answer: $1.75/$15.30 = 11.44%
Diff: 1
Keywords: Cost of Preferred Stock
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12) Glenna Gayle common stock sells for $55, and dividends paid last year were $1.35. Flotation
costs on issuing stock will be 8% of the market price. The dividends are predicted to have a 10%
growth rate. What is the cost of internal equity, and new equity, respectively for Glenna Gayle?
Answer: D1 = $1.35 × 1.1 = $1.49
Cost of internal equity = $1.49/$55 + .1 = 12.71%
Cost of new equity = $1.49/($55 × .92) + .1 = 12.94%
Diff: 2
Keywords: Cost of Retained Earnings, Cost of New Common Stock, Flotation Costs
13) Toombes, Inc. is issuing new common stock at a market price of $55. Dividends last year
were $3.30 per share and are expected to grow at a rate of 6%. Flotation costs will be 5% of the
market price. What is Toombes’ cost of retained earnings, and new equity, respectively?
Answer: D1 = $3.30 × 1.06 = $3.50
Cost of retained earnings = $3.50/$55 + .06 = 12.36%
Cost of new equity = $3.50/($55 × .95) + .06 = 12.70%
Diff: 2
Keywords: Cost of Retained Earnings, Cost of New Common Stock, Flotation Costs
9.3 Learning Objective 3
True or False
1) A company's cost of capital is equal to a weighted average of its investors' required returns.
Answer: FALSE
Diff: 1
Keywords: Cost of Capital, Investors' Required Returns
2) A corporation may lower its cost of capital by shifting a portion of its total financing from a
higher cost source of capital, such as common equity, to a lower cost source of capital, such as
debt.
Answer: TRUE
Diff: 1
Keywords: Weighted Average Cost of Capital
3) The best financial structure is determined by finding the debt and equity mix that maximizes
the firm's cost of capital.
Answer: FALSE
Diff: 1
Keywords: Optimal Capital Structure, Cost of Capital
4) If a firm were to earn exactly its cost of capital, we would expect the price of its common
stock to remain unchanged.
Answer: TRUE
Diff: 1
Keywords: Cost of Capital, Firm Value
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5) If a firm's tax rate increases then its weighted average cost of capital increases also.
Answer: FALSE
Diff: 1
Keywords: Cost of Capital, Tax Rate
6) The average cost of capital is the appropriate rate to use when evaluating new investments,
even though the new investments may be in a higher risk class.
Answer: FALSE
Diff: 1
Keywords: Average Cost of Capital, Risk
7) Once the weighted average cost of capital (WACC) is determined then all projects of average
risk will be compared to the original WACC regardless of the size of the capital budget.
Answer: FALSE
Diff: 1
Keywords: Weighted Average Cost of Capital
8) The mixture of financing sources used by a firm will vary from year to year, so many firms
use target capital structure proportions when calculating the firm's weighted average cost of
capital.
Answer: TRUE
Diff: 1
Keywords: Weighted Cost of Capital
9) Using the weighted cost of capital as a cutoff rate assumes that the riskiness of the project
being evaluated is similar to the riskiness of the company's existing assets.
Answer: TRUE
Diff: 1
Keywords: Weighted Cost of Capital
10) Using the weighted cost of capital as a cutoff rate assumes that future investments will be
financed so as to maintain the firm's target degree of financial leverage.
Answer: TRUE
Diff: 1
Keywords: Weighted Cost of Capital, Target Capital Structure
11) The market value weights are preferred when calculating a firm's weighted average cost of
capital.
Answer: TRUE
Diff: 1
Keywords: Market Value Weights, Weighted Average Cost of Capital
12) A firm's weighted average cost of capital is a function of (1) the individual costs of capital,
(2) the capital structure mix, and (3) the level of financing necessary to make the investment.
Answer: TRUE
Diff: 1
Keywords: Weighted Average Cost of Capital
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13) A company's capital structure mix is based on the proportion of fixed versus variable costs in
its optimal production process.
Answer: FALSE
Diff: 1
Keywords: Capital Structure
Multiple Choice
1) A firm's weighted average cost of capital is determined using all of the following inputs
except:
A) the firm's capital structure.
B) the amount of capital necessary to make the investment.
C) the firm's after tax cost of debt.
D) the probability distribution of expected returns.
Answer: D
Diff: 1
Keywords: Weighted Average Cost of Capital
2) Cost of capital is:
A) the coupon rate of debt.
B) a hurdle rate set by the board of directors.
C) the rate of return that must be earned on additional investment if firm value is to remain
unchanged.
D) the average cost of the firm's assets.
Answer: C
Diff: 1
Keywords: Cost of Capital
3) Cost of capital is commonly used interchangeably with all of the following terms except
A) the firm's required rate of return.
B) the hurdle rate for new investments.
C) the internal rate of return for new investments.
D) the firm's opportunity cost of funds.
Answer: C
Diff: 1
Keywords: Cost of Capital, Required Rate of Return, Hurdle Rate, Opportunity Cost of Funds
20
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4) Jones Company has a target capital structure of 30% debt, 15% preferred stock, and 55%
common equity. The company's after-tax cost of debt is 7%, its cost of preferred stock is 11%, its
cost of retained earnings is 15%, and its cost of new common stock is 16%. The company stock
has a beta of 1.5 and the company's marginal tax rate is 35%. What is the company's weighted
average cost of capital if retained earnings are used to fund the common equity portion?
A) 11.20%
B) 12.00%
C) 13.80%
D) 14.45%
Answer: B
Diff: 2
Keywords: Weighted Average Cost of Capital
5) J & B Corp. is investing in a major capital budgeting project that will require the expenditure
of $16 million. The money will be raised by issuing $2 million of bonds, $4 million of preferred
stock, and $10 million of new common stock. The company estimates is after-tax cost of debt to
be 7%, its cost of preferred stock to be 9%, the cost of retained earnings to be 14%, and the cost
of new common stock to be 17%. What is the weighted average cost of capital for this project?
A) 12.20%
B) 13.12%
C) 13.75%
D) 14.23%
Answer: C
Diff: 2
Keywords: Weighted Average Cost of Capital
6) Acme Conglomerate Corporation operates three divisions. One division involves significant
research and development, and thus has a high-risk cost of capital of 15%. The second division
operates in business segments related to Acme's core business, and this division has a cost of
capital of 10% based upon its risk. Acme's core business is the least risky segment, with a cost of
capital of 8%. The firm's overall weighted average cost of capital of 11% has been used to
evaluate capital budgeting projects for all three divisions. This approach will
A) favor projects in the core business division because that division is the least risky.
B) favor projects in the related businesses division because the cost of capital for this division is
the closest to the firm's weighted average cost of capital.
C) favor projects in the research and development division because the higher risk projects look
more favorable if a lower cost of capital is used to evaluate them.
D) not favor any division over the other because they all use the same company-wide weighted
average cost of capital.
Answer: C
Diff: 1
Keywords: Weighted Average Cost of Capital, Risk-Return Tradeoff
21
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7) Joe’s Discount Club currently has a weighted average cost of capital of 12%. Joe’s has been
growing rapidly over the past several years, selling common stock in each year to finance its
growth. However, due to difficult economic times this year, Joe’s decides to cut its dividend and
increase its retained earnings so that the common equity portion of its capital structure will
include only retained earnings and no new common stock will be sold. Joe’s weighted average
cost of capital this year should be
A) zero, since no new stock will be sold.
B) less than 12%.
C) equal to 12%.
D) greater than 12%.
Answer: B
Diff: 1
Keywords: Weighted Average Cost of Capital
8) Higgins Office Corp. plans to maintain its optimal capital structure of 40 percent debt, 10
percent preferred stock, and 50 percent common equity indefinitely. The required return on each
component source of capital is as follows: debt--8 percent; preferred stock--12 percent; common
equity--16 percent. Assuming a 40 percent marginal tax rate, what after-tax rate of return must
Higgins Office Corp. earn on its investments if the value of the firm is to remain unchanged?
A) 12.40 percent
B) 12.00 percent
C) 11.12 percent
D) 10.64 percent
Answer: C
Diff: 2
Keywords: Weighted Average Cost of Capital
9) SkyHigh Airlines has five possible investment projects for the coming year. Each project is
indivisible. They are:
Project Investment (million)
A
$6
B
$10
C
$9
D
$4
E
$3
IRR
18%
15%
20%
12%
24%
SkyHigh's weighted marginal cost of capital schedule is 12 percent for up to $6 million of
investment; 16 percent for between $6 million and $18 million of investment; and above $18
million the weighted cost of capital is 18 percent. The optimal capital budget is:
A) $12 million.
B) $18 million.
C) $23 million.
D) $28 million.
Answer: B
Diff: 2
Keywords: Weighted Average Cost of Capital, Optimal Capital Budget
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10) The ABC Company is planning a $64 million expansion. The expansion is to be financed by
selling $25.6 million in new debt and $38.4 million in new common stock. The before-tax
required rate of return on debt is 9 percent and the required rate of return on equity is 14 percent.
If the company is in the 35 percent tax bracket, what is the firm's cost of capital?
A) 8.92%
B) 9.89%
C) 11.50%
D) 10.74%
Answer: D
Diff: 2
Keywords: Weighted Average Cost of Capital
11) Burns and Nuble is considering an investment in a project which would require an initial
outlay of $350,000 and produce expected cash flows in years 1-5 of $95,450 per year. You have
determined that the current after-tax cost of the firm's capital (required rate of return) for each
source of financing is as follows:
Cost of Long-Term Debt7%
Cost of Preferred Stock11%
Cost of Common Stock15%
Long term debt currently makes up 25% of the capital structure, preferred stock 15%, and
common stock 60%. What is the net present value of this project?
A) -$9,306
B) $2,149
C) $5,983
D) $11,568
Answer: A
Diff: 2
Keywords: Net Present Value, Weighted Average Cost of Capital
12) For a typical corporation, which of the following capital structures will result in the lowest
weighted average cost of capital?
A) 40% debt, 20% preferred stock, 40% common equity
B) 50% debt, 10% preferred stock, 40% common equity
C) 60% debt, 10% preferred stock, 30% common equity
D) 60% debt, 15% preferred stock, 25% common equity
Answer: D
Diff: 2
Keywords: Capital Structure, Weighted Average Cost of Capital
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13) Given the following information on S & G Inc.'s capital structure, compute the company's
weighted average cost of capital.
Type of
Capital
Percent of
Capital Structure
Bonds
Preferred Stock
Common Stock (Internal Only)
40%
5%
55%
Before-Tax
Component Cost
7.5%
11%
15%
The company's marginal tax rate is 40%.
A) 13.3%
B) 7.1%
C) 10.6%
D) 10%
Answer: C
Diff: 2
Keywords: Weighted Average Cost of Capital
14) Which of the following causes a firm's cost of capital (WACC) to differ from an investor's
required rate of return on the company's common stock?
A) The fact that the risk free rate of interest has increased.
B) The incurrence of flotation costs when new securities are issued.
C) The market risk premium exceeds 12%.
D) None of the above — the WACC and required return are the same
Answer: B
Diff: 2
Keywords: Weighted Average Cost of Capital, Taxes, Flotation Costs
15) Which of the following should not be considered when calculating a firm's WACC?
A) Cost of preferred stock
B) After-tax cost of bonds
C) Cost of common stock
D) Cost of carrying inventory
Answer: D
Diff: 1
Keywords: Weighted Average Cost of Capital
16) Which of the following should NOT be considered when calculating a firm's WACC?
A) After-tax YTM on a firm's bonds
B) After-tax cost of accounts payable
C) Cost of newly issued preferred stock
D) Cost of newly issued common stock
Answer: B
Diff: 1
Keywords: Weighted Average Cost of Capital
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17) Clothier, Inc. has a target capital structure of 40% debt and 60% common equity, and has a
40% marginal tax rate. If Clothier's yield to maturity on bonds is 7.5% and investors require a
15% return on Clothier's common stock, what is the firm's weighted average cost of capital?
A) 7.20%
B) 10.80%
C) 12.00%
D) 12.25%
Answer: B
Diff: 2
Keywords: Weighted Average Cost of Capital
18) Milton Parker has a capital structure that consists of $7 million of debt, $2 million of
preferred stock, and $11 million of common equity, based upon current market values. Parker's
yield to maturity on its bonds is 7.4%, and investors require an 8% return on Parker's preferred
and a 14% return on Parker's common stock. If the tax rate is 35%, what is Parker's WACC?
A) 7.21%
B) 8.12%
C) 10.18%
D) 12.25%
Answer: C
Diff: 2
Keywords: Weighted Average Cost of Capital, Capital Structure
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Essay
1) Meacham Corp. wants to issue bonds with a 9% coupon rate, a face value of $1,000, and 12
years to maturity. Meacham estimates that the bonds will sell for $1,090 and that flotation costs
will equal $15 per bond. Meacham Corp. common stock currently sells for $30 per share.
Meacham can sell additional shares by incurring flotation costs of $3 per share. Meacham paid a
dividend yesterday of $4.00 per share and expects the dividend to grow at a constant rate of 5%
per year. Meacham also expects to have $12 million of retained earnings available for use in
capital budgeting projects during the coming year. Meacham’s capital structure is 40% debt and
60% common equity. Meacham’s marginal tax rate is 35%.
a. Calculate the after-tax cost of debt assuming Meacham’s bonds are its only debt.
b. Calculate the cost of retained earnings.
c. Calculate the cost of new common stock.
d. Calculate the weighted average cost of capital assuming Meacham’s total capital budget is
$30 million.
Answer:
a. YTM with Net Proceeds = $1,075 is 8.0%. After-tax cost of debt = 8.0%(1 - .35) = 5.2%
b. (($4.00(1.05))/$30) + 5% = 19%
c. (($4.00(1.05))/($30 - $3)) + 5% = 20.56%
d. At $30 million, debt = $12 million and common equity = $18 million. Available retained
earnings are $12 million, so new common stock will equal $6 million.
WACC = (.4)(5.2%) + (.4)(19%) + (.2)(20.56%) = 13.79%
Diff: 3
Keywords: Weighted Average Cost of Capital, Cost of Debt, Cost of Retained Earnings, Cost of
New Common Stock, Capital Structure
2) Office Clean Corporation has a capital structure consisting of 30 percent debt and 70 percent
common equity. Assuming the capital structure is optimal, what amount of total investment can
be financed by a $35 million addition to retained earnings without selling new common stock?
Answer: Capital budget = $35Million / .7 = $50Million
Diff: 2
Keywords: Optimal Capital Structure, Total Capital Budget
9.4 Learning Objective 4
True or False
1) Calculating the cost of capital for divisions within a company is not recommended because the
data is too fragmented and all divisions are part of the same company in any case.
Answer: FALSE
Diff: 1
Keywords: Divisional Costs of Capital
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2) The after-tax cost of debt is equal to one minus the marginal tax rate times the yield to
maturity on the firm's outstanding debt.
Answer: TRUE
Diff: 1
Keywords: After-tax Cost of Debt, Yield to Maturity
3) If the before-tax cost of debt is 7% and the firm has a 40% marginal tax rate, the after-tax cost
of debt is 2.8%.
Answer: FALSE
Diff: 1
Keywords: After-tax Cost of Debt
Multiple Choice
1) A corporate bond has a face value of $1,000 and a coupon rate of 5%. The bond matures in 15
years and has a current market price of $925. If the corporation sells more bonds it will incur
flotation costs of $25 per bond. If the corporate tax rate is 35%, what is the after-tax cost of debt
capital?
A) 3.74%
B) 4.45%
C) 5.29%
D) 6.78%
Answer: A
Diff: 2
Keywords: After-tax Cost of Debt, Flotation Costs, Bond Valuation
2) A corporate bond has a face value of $1,000 and a coupon rate of 9%. The bond matures in 14
years and has a current market price of $946. If the corporation sells more bonds it will incur
flotation costs of $26 per bond. If the corporate tax rate is 35%, what is the after-tax cost of debt
capital?
A) 5.57%
B) 6.56%
C) 8.18%
D) 7.31%
Answer: B
Diff: 2
Keywords: After-tax Cost of Debt, Flotation Costs, Bond Valuation
27
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3) Kendall, Inc. has $15 million of outstanding bonds with a coupon rate of 10 percent. The yield
to maturity on these bonds is 12.5 percent. If the firm's tax rate is 30 percent, what is relevant
cost of debt financing to Kendall, Inc.?
A) 13.75 percent
B) 8.75 percent
C) 7.00 percent
D) 3.75 percent
Answer: B
Diff: 2
Keywords: After-tax Cost of Debt, Yield to Maturity
4) Porky Pine Co. is issuing a $1,000 par value bond that pays 8.5% interest annually. Investors
are expected to pay $1,100 for the 12-year bond. Porky will pay $50 per bond in flotation costs.
What is the after-tax cost of new debt if the firm is in the 35% tax bracket?
A) 8.23%
B) 4.55%
C) 4.70%
D) 7.45%
Answer: C
Diff: 2
Keywords: After-tax Cost of Debt, Flotation Costs
5) All the following variables are used in computing the cost of debt except:
A) maturity value of the debt.
B) market price of the debt.
C) number of years to maturity.
D) risk-free rate.
Answer: D
Diff: 2
Keywords: After-tax Cost of Debt
6) Durocorp has a target capital structure of 30% debt and 70% equity. Durocorp is planning to
invest in a project that will necessitate raising new capital. New debt will be issued at a beforetax yield of 14%, with a coupon rate of 10%. The equity will be provided by internally generated
funds so no new outside equity will be issued. If the required rate of return on the firm's stock is
22% and its marginal tax rate is 35%, compute the firm's cost of capital.
A) 18.00%
B) 18.13%
C) 19.68%
D) 15.55%
Answer: B
Diff: 2
Keywords: Weighted Average Cost of Capital, After-tax Cost of Debt
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7) Ewer Firm will finance a proposed investment by issuing new securities while maintaining its
optimal capital structure of 60% debt and 40% equity. The firm can issue bonds at a price of
$950.00 before $15 flotation costs. The 10-year bonds will have an annual coupon rate of 8%
and a face value of $1,000. The company can issue new equity at a before-tax cost of 16% and
its marginal tax rate is 34%. What is the appropriate cost of capital to use in analyzing this
project?
A) 3.63%
B) 8.77%
C) 9.97%
D) 11.81%
Answer: C
Diff: 2
Keywords: After-tax Cost of Debt, Cost of New Common Stock, Weighted Average Cost of
Capital
8) Triplin Corporation's marginal tax rate is 35%. It can issue 10-year bonds with an annual
coupon rate of 7% and a par value of $1,000. After $12 per bond flotation costs, new bonds will
net the company $966 in proceeds. Determine the appropriate after-tax cost of new debt for
Triplin to use in a capital budgeting analysis.
A) 2.62%
B) 4.87%
C) 7.50%
D) 7.8%
Answer: B
Diff: 2
Keywords: After-tax Cost of Debt, Flotation Costs
9) Mars Car Company has a capital structure made up of 40% debt and 60% equity and a tax rate
of 30%. A new issue of $1,000 par bonds maturing in 20 years can be issued with a coupon of
9% at a price of $1,098.18 with no flotation costs. The firm has no internal equity available for
investment at this time, but can issue new common stock at a price of $45. The next expected
dividend on the stock is $2.70. The dividend for Mars Co. is expected to grow at a constant
annual rate of 5% per year indefinitely. Flotation costs on new equity will be $7.00 per share.
The company has the following independent investment projects available:
Project Initial Outlay IRR
1
$100,000
10%
2
$ 10,000
8.5%
3
$ 50,000
12.5%
Which of the above projects should the company take on?
A) Project 3 only
B) Projects 1 and 2
C) Projects 1 and 3
D) Projects 1, 2 and 3
Answer: C
Diff: 2
Keywords: Optimal Capital Budget, After-tax Cost of Debt, Cost of New Common Stock
29
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10) Five Rivers Casino is undergoing a major expansion. The expansion will be financed by
issuing new 15-year, $1,000 par, 9% annual coupon bonds. The market price of the bonds is
$1,070 each. Five Rivers flotation expense on the new bonds will be $50 per bond. Five Rivers
marginal tax rate is 35%. What is the relevant cost of the new bonds for capital budgeting
purposes?
A) 5.14%
B) 5.69%
C) 8.45%
D) 4.82%
Answer: B
Diff: 2
Keywords: After-tax Cost of Debt
9.5 Learning Objective 5
Multiple Choice
1) Using the weighted average cost of capital as the required rate of return for every project will:
A) cause a firm to reject projects that should have been accepted.
B) cause a firm to accept projects that were too risky.
C) result in maximization of shareholder wealth.
D) A and B above.
Answer: D
Diff: 2
Keywords: Weighted Average Cost of Capital, Accept/Reject Decision
2) Why should firms that own and operate multiple businesses that have different risk
characteristics use business-specific, or divisional costs of capital?
A) Not all divisions have equal risk and the firm might accept projects whose returns are higher
than are deemed appropriate.
B) Not all business divisions have equal risk and the firm will likely become less risky in the
future.
C) Not all lines of business have equal risk and it is likely that the firm will accept projects
whose returns are unacceptably low in relation to the risk involved.
D) Use of the same weighted average cost of capital for all divisions may result in too much
money being allocated to the least risky division.
Answer: C
Diff: 2
Keywords: Divisional Costs of Capital, Weighted Average Cost of Capital
30
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9.6 Learning Objective 6
True or False
1) According to interest rate parity theory, differences in observed nominal interest rates in two
countries should equal differences in the expected rates of inflation in the two countries.
Answer: TRUE
Diff: 1
Keywords: Interest Rate Parity Theory, Nominal Interest Rates, Inflation
Multiple Choice
1) A U.S. company can borrow 12,000 pounds in Great Britain for 4% interest, paying back
12,480 pounds in one year. Alternatively, the U.S. company can borrow an equivalent amount of
U.S dollars in the United States and pay 8% interest. Assuming capital markets are efficient,
estimate the expected inflation rate in the United States if inflation in Great Britain is expected to
be zero.
A) 5.02%
B) 4.16%
C) 4.00%
D) 3.85%
Answer: D
Diff: 2
Keywords: Interest Rate Parity Theory
2) The interest rate parity theorem suggests that differences in observed nominal rates of interest
in two countries should equal
A) differences in the expected rates of inflation between the two countries.
B) differences in the risk free rates of return between the two countries.
C) differences in the federal funds rates between the two countries.
D) differences in currency exchange rates between the two countries.
Answer: A
Diff: 2
Keywords: Interest Rate Parity Theory
3) The interest rate on a one year security in the United States is 3%, while the interest rate on a
one year security in German is 8%. If the current exchange rate is 1 EURO = $1.50, then the
future exchange rate in one year, according to the international Fisher effect, is:
A) $1.431.
B) $1.425.
C) $1.575.
D) $1.385.
Answer: A
Diff: 2
Keywords: International Fisher Effect
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4) Interest rate parity exists because
A) there are investors who stand ready to engage in arbitrage.
B) central banks ensure the relationship holds to protect currency values.
C) inflation is the same in all industrialized countries.
D) transactions costs and taxes make markets inefficient.
Answer: A
Diff: 2
Keywords: Interest Rate Parity, Arbitrage
32
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