Chapter 15 Cost of Capital
Chapter 15 Quiz A Student Name _________________________
Student ID ____________
________ 1.
All else equal, the weighted average cost of capital for a firm will generally decrease when the:
a. tax rate decreases.
b. debt-equity ratio increases.
c. cost of equity increases.
d. market value of equity increases.
________ 2.
The security market line approach:
a. can only be used by firms which pay regular dividends.
b. considers both the total risk associated with a stock and the risk-free rate of return.
c. considers the systematic risk of a stock as compared to that of the overall market.
d. values a security based on the risk-free rate and the amount of unsystematic risk inherent in a security.
________ 3.
The managers of Gotham Enterprises are evaluating a new project and decided to base the required rate of
return for the project on Bristol Industries cost of capital. Bristol Industries is not owned or controlled by
Gotham Enterprises. The managers are employing a strategy known as:
a. the subjective approach.
b. pure play.
c. weighting the cost of capital
d. the divisional cost of capital.
________ 4.
Big Boy Equipment, Inc. is expected to pay an annual dividend in the amount of $1.45 a share next year. This
dividend is expected to increase by 4 percent annually. The company’s stock is currently selling for $32.20
per share. What is the cost of equity?
a. 4.50 percent
b. 4.68 percent c. 8.50 percent d. 8.68 percent
________ 5.
The Shoe Co. has a beta of .96. The risk-free rate of return is 4.6 percent and the expected return on the
market is 13.5 percent. What is the cost of equity?
a. 12.96 percent
b. 13.14 percent c. 15.64 percent d. 17.56 percent
________ 6.
The 8 percent preferred stock of Snowmobiles, Inc. is currently selling for $55.25 per share. If the par value
is $100, what is the cost of preferred stock to the firm?
a. 3.62 percent
b. 8.00 percent c. 14.48 percent d. 16.00 percent
________ 7.
The Textile Co. has a bond outstanding that matures in 10 years, carries a 6 percent coupon, and pays interest
annually. The bond has a market value of $1,037.69. The company has a corporate tax rate of 34 percent.
What is the aftertax cost of debt?
a. 3.63 percent
b. 3.96 percent c. 5.50 percent d. 6.00 percent
________ 8.
Al’s Wooden Sheds has a cost of equity of 11 percent and a pre-tax cost of debt of 7 percent. The firm
maintains a debt-equity ratio of .5 and has a tax rate of 35 percent. What is the firm’s weighted average
cost of capital?
a. 7.13 percent
b. 8.42 percent c. 8.85 percent d. 9.16 percent
________ 9.
The Cola Co. is an all equity company that distributes soft drinks. The Cola Co. has 50,000 shares of stock
outstanding at a market price of $22.56 per share and has a beta of 1.2. The Cola Co. is considering
expanding into the potato chip and snack market. Potatoes and More is an all equity company that is
currently involved with the snack foods market. Potatoes and More has 100,000 shares of stock outstanding at
a market price of $38.10 per share. The beta of Potatoes and More is 1.3. The risk-free rate of return is 4
percent and the market risk premium is 8 percent. What discount rate should The Cola Co. use to evaluate its
expansion project?
a. 8.8 percent
b. 9.2 percent
c. 13.6 percent d. 14.4 percent
15-1
Chapter 15 Cost of Capital
________ 10. Woodcutters, Inc. has 20,000 shares of common stock outstanding at a market price of $16 a share. There are
7,000 shares of 8 percent preferred stock outstanding at a market price of $32 a share. The firm has 500 bonds
outstanding with a face value of $1,000 and a market price of $980. The firm’s tax rate is 34 percent. What
weight should be assigned to the cost of common stock when computing the weighted average cost of
capital?
a. 22 percent
b. 31 percent
c. 47 percent
d. 53 percent
15-2
Chapter 15 Cost of Capital
Chapter 15 Quiz A
1.
2.
3.
4.
5.
6.
7.
b
c
b
c
b
c
a
8. c
9. d
10. b
Answers
Re = ($1.45 / $32.20) + .04 = .08503 = 8.50 percent
Re = .046 + .96 × (.135 − .046) = .13144 = 13.14 percent
Rp = (.08  $100) / $55.25 = .1448 = 14.48 percent
Enter
10
-1,037.69
60
1000
N
I/Y
PV
PMT
FV
Solve for
5.50
Aftertax cost of debt = .055 × (1 − .34) = 3.63 percent
WACC = [(1 / 1.5)  .11] + [(.5 / 1.5)  .07  (1  .35)] = .07333 + .015167= .08850 = 8.85 percent
Discount rate. = .04 + (1.3 × .08) = 14.4 percent
Equity: 20,000  $16 = $320,000; Preferred = 7,000  $32 = $224,000; Debt = $980 × 500 = $490,000; Total =
$320,000 + $224,000 + $490,000 = $1,034,000; Weight Equity = $320,000 / $1,034,000 = .3095 = 31 percent
15-3
Chapter 15 Cost of Capital
Chapter 15 Quiz B Student Name _________________________
Student ID ____________
________ 1.
If a firm uses its overall weighted average cost of capital as the discount rate for all of its proposed
projects, then the firm will tend to:
a. correctly accept and reject projects.
b. become riskier over time.
c. favor the lowest risk projects.
d. reject the riskiest projects, as it should.
________ 2.
If market interest rates increase, then the cost of capital for a leveraged firm will tend to:
a. remain unchanged.
b. increase.
c. decrease.
d. change but the direction of that change depends on the debt-equity level of the firm.
________ 3.
Highland Log grows and harvests timber for the construction industry. WV Log Homes designs and produces
log home kits that are ready for delivery to a new home site. Highland Log has a cost of capital of 11 percent
while WV Log Homes cost of capital is 14 percent. Both Highland Log and WV Log Homes are
considering expanding into the design and production of log barn kits. The initial cost of the expansion
project is $156,000 and the projected cash inflows are $45,000 a year for 5 years. Which firm, or firms, if
either, should expand into the log barn kits?
a. Highland Log only
b. WV Log Homes only
c. both Highland Log and WV Log Homes
d. neither Highland Log nor WV Log Homes
________ 4.
Snowmobiles, Inc. is currently selling 9 percent preferred stock at $66.87 per share. If the par value is $100,
what is the cost of preferred stock to the firm?
a. 6.73 percent
b. 9.00 percent c. 12.23 percent d. 13.46 percent
________ 5.
The Textile Co. has an annual bond outstanding that matures in 8 years and carries a 7 percent coupon. The
bond has a market value of $1,030.44. The company has a corporate tax rate of 35 percent. What is the
aftertax cost of debt?
a. 2.28 percent
b. 4.23 percent c. 5.76 percent d. 6.50 percent
________ 6.
The Shoe Co. has a beta of 1.29. The risk-free rate of return is 4.3 percent and the expected return on the
market is 12.5 percent. What is the cost of equity?
a. 10.58 percent
b. 14.88 percent c. 16.13 percent d. 20.43 percent
________ 7.
Equipment, Inc. is expected to pay an annual dividend of $1.60 a share next year. This dividend is
expected to increase by 2 percent annually. The company’s stock is currently selling for $25.31 per share.
What is the cost of equity?
a. 6.32 percent
b. 6.45 percent c. 8.32 percent d. 8.45 percent
________ 8.
Your firm has a cost of equity of 10 percent and a pre-tax cost of debt of 6 percent. The firm maintains a
debt-equity ratio of .6 and has a tax rate of 35 percent. What is your firm’s weighted average cost of capital?
a. 6.34 percent
b. 7.56 percent c. 7.71 percent d. 8.26 percent
________ 9.
Cola, Inc. is an all equity firm that distributes soft drinks. Cola, Inc. has 60,000 shares of stock outstanding at
a market price of $32.19 per share and has a beta of 1.3. Cola, Inc. is considering expanding into the potato
chip and snack market. Potatoes and More is an all equity company that is currently involved with the snack
foods market. Potatoes and More has 80,000 shares of stock outstanding at a market price of $42.30 per
share. The beta of Potatoes and More is 1.2. The risk-free rate of return is 5 percent and the market risk
premium is 8.5 percent. What discount rate should The Cola Co. use to evaluate its expansion project?
a. 7.25 percent
b. 8.25 percent c. 12.20 percent d. 15.20 percent
15-4
Chapter 15 Cost of Capital
________ 10. Woodcutters, Inc. has 10,000 shares of common stock outstanding at a price of $18 a share. There are 9,000
shares of 7 percent preferred stock outstanding at a price of $22 a share. The firm has 400 bonds outstanding
with a face value of $1,000 each that are selling at 99 percent of face value. The tax rate is 34 percent. What
weight should be assigned to the common stock when computing the weighted average cost of capital?
a. 23.26 percent
b. 26.32 percent c. 49.19 percent d. 51.37 percent
15-5
Chapter 15 Cost of Capital
Chapter 15 Quiz B
1.
2.
Answers
b
b
1
NPV  $156,000  $45,000 
1
1  .145
3.
d
 $1,511.36
.14
The appropriate discount rate for the project is 14 percent. At 14 percent, the project has a negative NPV. Neither
firm should accept the project.
4.
5.
d
b
6.
7.
8.
9.
10.
b
c
c
d
a
Rp = (.09  $100) / $66.87 = .1346 = 13.46 percent
Enter
8
-1,030.44
70
1000
N
I/Y
PV
PMT
FV
Solve for
6.50
Aftertax cost of debt = .065 × (1 − .35) = 4.23 percent
Re = .043 + 1.29 × (.125 − .043) = .14878 = 14.88 percent
Re = ($1.60 / $25.31) + .02 = .0832 = 8.32 percent
WACC = [(1 / 1.6)  .10) + [(.6 / 1.6)  .06  (1  .35)] = .0625 + .014625 = .077125 = 7.71 percent
WACCPotato & More = .05 + (1.2 × .085) = .152 = 15.2 percent
Equity: 10,000  $18 = $180,000; Preferred = 9,000  $22 = $198,000; Debt = ($1,000 × 400)  .99 = $396,000;
Total = $180,000 + $198,000 + $396,000 = $774,000; Weight Equity = $180,000 / $774,000 = .23256 = 23.26
percent
15-6
Chapter 15 Cost of Capital
Chapter 15 Quiz C Student Name _________________________
Student ID ____________
________ 1.
Which of the following will tend to increase a leveraged firm’s cost of capital?
a. decrease in interest rates by the Federal Reserve
b. decrease in the tax rate
c. increase in the debt-equity ratio
d. decrease in the cost of preferred stock
________ 2.
When Data Tech applies the cost of capital of Wyoming Computers to a project, it is using the _____
approach.
a. pure play
b. security market line
c. subjective
d. weighted market return
________ 3.
Swenson & Sons is a retail outlet that offers reading materials such as magazines and newspapers to the
general public. Sit ‘n Sip is a delicatessen that sells various flavored coffees and teas along with fresh
sandwiches. Swenson & Sons has a cost of capital of 12.5 percent while Sit ‘n Sip’s cost of capital is 14
percent. Swenson & Sons is considering expanding so that it can offer drinks and sandwiches to its patrons.
The expansion project has a positive NPV at a 12.5 percent discount rate and a negative NPV as a 14
percent rate. Given this, should Swenson & Sons expand its operations?
a. yes
b. no
c. only if they merge with Sit ‘n Sip
________ 4.
The Shoe Co. has a beta of .87. The risk-free rate of return is 3.9 percent and the expected return on the
market is 10 percent. What is the cost of equity?
a. 5.31 percent
b. 8.70 percent c. 9.21 percent d. 12.60 percent
________ 5.
Lites Co. is expected to pay an annual dividend of $2.20 a share next year. This dividend is expected to
increase by 5 percent annually. The company’s stock is currently selling for $53.20 per share. What is the
cost of equity?
a. 4.14 percent
b. 4.34 percent c. 9.14 percent d. 9.34 percent
________ 6.
Snowmobiles, Inc. is currently selling 8 percent preferred stock at $70.12 per share. If the par value is $100,
what is the cost of preferred stock to the firm?
a. 4.00 percent
b. 8.00 percent c. 11.41 percent d. 22.81 percent
________ 7.
The Textile Co. has an annual bond outstanding that matures in 8 years and carries an 8 percent coupon. The
bond has a market value of $971.80. The company has a corporate tax rate of 35 percent. What is the aftertax
cost of debt?
a. 4.25 percent
b. 5.53 percent c. 8.00 percent d. 8.50 percent
________ 8.
Woodcutters, Inc. has 30,000 shares of common stock outstanding at a market price of $27 a share. There are
15,000 shares of 8 percent preferred stock outstanding at a market price of $35 a share. The firm has 700
bonds outstanding with a face value of $1,000 each that are selling at 101 percent of face value. The firm’s
tax rate is 34 percent. What weight should be assigned to the debt when computing the weighted average cost
of capital?
a. 26.47 percent
b. 28.62 percent c. 31.39 percent d. 34.62 percent
________ 9.
Your firm has a cost of equity of 14 percent and a pre-tax cost of debt of 9 percent. The firm maintains a
debt-equity ratio of .7 and has a tax rate of 35 percent. What is the firm’s weighted average cost of capital?
a. 7.83 percent
b. 8.68 percent c. 10.64 percent d. 11.56 percent
________ 10. The Cola Co. is an all equity firm that distributes soft drinks. The Cola Co. has 40,000 shares of stock
outstanding at a market price of $58.25 per share. The beta of The Cola Co. is 1.4. The Cola Co. is planning
an expansion project to start manufacturing potato chips. Potato Manufacturers, Inc. is an all equity firm
that currently produces potato chips. Potato Manufacturers, Inc. has 30,000 shares of stock outstanding at a
market price of $41.39 per share. The beta of Potato Manufacturers, Inc. is 1.2. The risk-free rate of return is
4 percent and the market risk premium is 8.5 percent. What cost of capital should The Cola Co. use to
evaluate the expansion project?
a. 9.40 percent
b. 10.3 percent c. 14.2 percent d. 15.9 percent
15-7
Chapter 15 Cost of Capital
Chapter 15 Quiz C
1.
2.
3.
4.
5.
6.
7.
b
a
b
c
c
c
b
8.
d
9. c
10. c
Answers
The relevant discount rate is 14 percent.
Re = .039 + .87 × (.10 − .039) = .09207 = 9.21 percent
Re = ($2.20 / $53.20) + .05 = .09135 = 9.14 percent
Rp = (.08  $100) / $70.12 = .1141 = 11.41 percent
Enter
8
-971.80
80
1000
N
I/Y
PV
PMT
FV
Solve for
8.50
Aftertax cost of debt = .085 × (1 − .35) = 5.53 percent
Common: 30,000  $27 = $810,000; Preferred = 15,000  $35 = $525,000; Debt = ($1,000 × 700)  1.01 =
$707,000; Total = $810,000 + $525,000 + $707,000 = $2,042,000; Weight Debt = $707,000 / $2,042,000 = .3462=
34.62 percent
WACC = [(1 / 1.7)  .14) + [(.7 / 1.7)  .09  (1  .35)] = .08235 + .02409 = .10644 = 10.64 percent
WACCPotato Manufacturers, Inc. = .04 + (1.2 × .085) = 14.2 percent
15-8