Cost of Capital 1. Management of Kelly, Inc. uses CAPM to calculate the estimated cost of common equity. Which of the following would reduce the fi rm’s estimated cost of common equity? a. A reduction in the risk-free rate. b. An increase in the fi rm’s beta. c. An increase in expected inflation. d. An increase in the risk-free interest rate. 2. A stock’s dividend is expected to grow at a constant rate of 5 percent a year. Which of the following statements is most correct? a. The expected return on the stock is 5 percent a year. b. The stock’s dividend yield is 5 percent. c. The stock’s price one year from now is expected to be 5 percent higher. d. Statements a and c are correct. e. All of the statements above are correct. 3. Stock X and Stock Y sell for the same price in today’s market. Stock X has a required return of 12 percent. Stock Y has a required return of 10 percent. Stock X’s dividend is expected to grow at a constant rate of 6 percent a year, while Stock Y’s dividend is expected to grow at a constant rate of 4 percent. Assume that the market is in equilibrium and expected returns equal required returns. Which of the following statements is most correct? a. Stock X has a higher dividend yield than Stock Y. b. Stock Y has a higher dividend yield than Stock X. c. One year from now, Stock X’s price is expected to be higher than Stock Y’s price. d. Statements a and c are correct. e. Statements b and c are correct. 4. Which of the following statements is most correct? a. One of the advantages to the firm associated with preferred stock financing rather than common stock financing is that control of the firm is not diluted. b. Preferred stock provides steadier and more reliable income to investors than common stock. c. One of the advantages to the firm of financing with preferred stock is that 70 percent of the dividends paid out are tax deductible. d. Statements a and c are correct. e. Statements a and b are correct. 5. Which of the following statements is most correct? a. One of the advantages to the firm associated with preferred stock financing rather than common stock financing is that control of the firm is not diluted. b. Preferred stock provides steadier and more reliable income to investors than common stock. c. One of the advantages to the firm of financing with preferred stock is that 70 percent of the dividends paid out are tax deductible. d. Statements a and c are correct. e. Statements a and b are correct. 6. Which of the following statements is most correct? a. If a company’s tax rate increases but the yield to maturity of its noncallable bonds remains the same, the company’s marginal cost of debt capital used to calculate its weighted average cost of capital will fall. b. All else equal, an increase in a company’s stock price will increase the marginal cost of retained earnings, ks. c. All else equal, an increase in a company’s stock price will increase the marginal cost of issuing new common equity, ke. d. Statements a and b are correct. e. Statements b and c are correct. 7. 8. 9. Which of the following statements is most correct? a. The WACC measures the after-tax cost of capital. b. The WACC measures the marginal cost of capital. c. There is no cost associated with using retained earnings. d. Statements a and b are correct. e. All of the statements above are correct. A firm estimates that its proposed capital budget will force it to issue new common stock, which has a greater cost than the cost of retained earnings. The firm, however, would like to avoid issuing costly new common stock. Which of the following steps would mitigate the firm’s need to raise new common stock? a. Increasing the company’s dividend payout ratio for the upcoming year. b. Reducing the company’s debt ratio for the upcoming year. c. Increasing the company’s proposed capital budget. d. All of the statements above are correct. e. None of the statements above is correct. Which of the following statements is most correct? a. Since debt capital is riskier than equity capital, the cost of debt is always greater than the WACC. b. Because of the risk of bankruptcy, the cost of debt capital is always higher than the cost of equity capital. c. If a company assigns the same cost of capital to all of its projects regardless of the project’s risk, then it follows that the company will generally reject too many safe projects and accept too many risky projects. d. Because you are able to avoid flotation costs, the cost of retained earnings is generally lower than the cost of debt. e. Higher flotation costs tend to reduce the cost of equity capital. Capital Structure and Leverage 10. 11. 12. If nominal interest rates increase substantially but expected future earnings and dividend growth for a fi rm over the long run are not expected to change, the fi rm’s stock price will a. Increase. b. Decrease. c. Stay constant. d. Change, but in no determinable direction. Which of the following statements is most correct? a. A firm’s business risk is solely determined by the financial characteristics of its industry. b. The factors that affect a firm’s business risk are determined partly by industry characteristics and partly by economic conditions. Unfortunately, these and other factors that affect a firm’s business risk are not subject to any degree of managerial control. c. One of the benefits to a firm of being at or near its target capital structure is that financial flexibility becomes much less important. d. The firm’s financial risk may have both market risk and diversifiable risk components. e. None of the statements above is correct. From the information below, select the optimal capital structure for Minnow Entertainment Company. a. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50. b. Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90. c. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20. d. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40. e. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00. 13. 14. 15. Which of the following statements best describes the optimal capital structure? a. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s earnings per share (EPS). b. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s stock price. c. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s weighted average cost of capital (WACC). d. Statements a and b are correct. e. Statements b and c are correct. Which of the following is likely to encourage a company to use more debt in its capital structure? a. An increase in the corporate tax rate. b. An increase in the personal tax rate. c. A decrease in the company’s degree of operating leverage. d. Statements a and c are correct. e. All of the statements above are correct. Which of the following statements is likely to encourage a firm to increase its debt ratio in its capital structure? a. Its sales become less stable over time. b. Its corporate tax rate declines. c. Management believes that the firm’s stock is overvalued. d. Statements a and b are correct. e. None of the statements above is correct. Problem 1 Assume that a bond was issued for P750 assuming par value of P900. Stated interest rate is 8% maturing in 10 years. What is the required rate of return for this bond using YTM? What is the current yield of the bond? Required: Determine the after-tax cost of debt under the above independent scenarios. Assume 40% tax rate. Problem 2 Future Industries common stock is expected to pay an annual dividend of P1.80 per share. The required return on the common stock is 12%. Required: Estimate the value of the common stock under each of the following dividend growth rate assumptions: 1. Dividends are expected to grow at an annual rate of 0 to infinity. 2. Dividends are expected to grow at a constant rate of 4% to infinity 3. Dividends are expected to grow at a constant annual rate of 4% to infinity and with flotation Problem 3 England Corporation is preparing to evaluate capital expenditure proposals for the coming year. Because the firm employs discounted cash flow methods, the cost of capital for the firm must be estimated. The following information for England Corporation is provided: The market price of common stock is 60 per share. The dividend next year is expected to be P 3 per share. Expected growth in dividends is a constant 10%. New bonds can be issued at face value with a 10% coupon rate. The current capital structure of 40% long-term debt and 60% equity is considered to be optimal. Anticipated earnings to be retained in the coming year are P 3 million The firm has a 40% marginal tax rate. 1. What is the after-tax cost of the new bond issue? 2. What is the cost of using retained earnings for financing? 3. If the company must assume a 20% flotation cost on new stock issuances, what is the cost of new common stock? 4. What is the maximum capital expansion that can be supported in the coming year without resorting to external equity financing? 5. Assume that the after-tax cost of debt financing is 10%, the cost of retained earnings is 14%, and the cost of new common stock is 16%. If capital expansion needs to be P 7 million for the coming year, what is the after-tax weighted-average cost of capital? 6. Assume that after-tax cost of debt is 10%, the cost of retained earnings is 14%, and the cost of new common stock is 16%. What is the marginal cost of capital for a projected capital expansion in excess of P 7 million?
