Chapter 11 The Cost of Capital

Business risk is the risk to the firm of being unable

to cover operating costs.
Your Answer: True

CORRECT

2.

The target capital
structure is the desired
optimal mix of debt and
equity financing that
most firms attempt to
achieve and maintain.
Your Answer: False

Correct Answer: True


Incorrect. This is a 'must
know' definition.

3.

The cost of capital is the
rate of return a firm
must earn on
investments in order to
leave share price
unchanged.
Your Answer: False

Correct Answer: True


Incorrect. The cost of
capital is the rate of
return a firm must earn
to maintain the market
value of its shares.

4.

The specific cost of each
source of financing is the
after-tax cost of
obtaining the financing
using the historically-
based cost reflected by
the existing financing on
the firm's books.
Your Answer: False

CORRECT

5.

The net proceeds used in
calculating the cost of
long-term debt are funds
actually received from
the sale after paying for
flotation costs.
Your Answer: False

Correct Answer: True


Incorrect. The net
proceeds after deducting
the various costs of
issue are used in the
calculation.

6.

When the net proceeds
from sale of a bond
equals its par value, the
before-tax cost would
just equal the coupon
interest rate.
Your Answer: False

Correct Answer: True


Incorrect. This is
something that should
be permanently
embedded in your
knowledge bank on
finance.

7.

The cost of preference
shares is typically higher
than the cost of long-
term debt (bonds)
because the cost of
long-term debt (interest)
is tax deductible.
Your Answer: True

CORRECT

8.

The cost of ordinary
share equity may be
measured using either
the constant growth
valuation model or the
capital asset pricing
model.
Your Answer: False

Correct Answer: True


Incorrect. They are
alternative valuation
models.

9.

The constant growth
model uses the market
price as a reflection of
the expected risk-return
preference of investors
in the marketplace.
Your Answer: False

Correct Answer: True


Incorrect. This question
is the application of
material you should
know from Chapter 7.

10.

The cost of retained
earnings is always lower
than the cost of a new
issue of ordinary shares
due to the absence of
flotation costs when
financing projects with
retained earnings.
Your Answer: True

CORRECT

11.

Using the capital asset
pricing model (CAPM),
the cost of ordinary
shares equity is the
return required by
investors as
compensation for the
firm's non-diversifiable
risk.
Your Answer: False

Correct Answer: True


Incorrect. This is
something that should
be permanently
embedded in your
knowledge bank on
finance.

12.

Use of the capital asset
pricing model (CAPM) in
measuring the cost of
ordinary shares equity
differs from the constant
growth valuation model
in that it directly
considers the firm's risk
as reflected by beta.
Your Answer: False

Correct Answer: True


Incorrect. This is
something that should
be permanently
embedded in your
knowledge bank on
finance.

13.

The weighted average
cost that reflects the
inter-relationship of
financing decisions can
be obtained by
weighting the cost of
each source of financing
by its target proportion
in the firm's capital
structure.
Your Answer: False

Correct Answer: True


Incorrect. This is
something that should
be permanently
embedded in your
knowledge bank on
finance.

14.

In computing the
weighted average cost of
capital, the weights used
are either book value or
market value weights
based on actual capital
structure proportions.
Your Answer: True

CORRECT

15.

At any given time, the
firm's financing costs
and investment returns
will be affected by the
volume of financing and
investment undertaken.
Your Answer: True

CORRECT

16.

A firm's investment
opportunities schedule is
a ranking of investment
possibilities from best
(highest return) to worst
(lowest return).
Your Answer: True

CORRECT

17.

The larger the volume of
new financing, the
greater the risk and,
thus, the higher the
financing costs.
Your Answer: True

CORRECT

18.

The investment
opportunity schedule
(IOS) is the graph that
relates the firm's
weighted average cost of
capital (WACC) to the
level of total new
financing.
Your Answer: False

CORRECT

19.

As the cumulative
amount of money
invested in a firm's
capital projects
increases, its returns on
the projects will
increase.
Your Answer: False

CORRECT

20.

According to the firm's
owner wealth
maximisation goal, the
firm should accept
projects up to the point
where the marginal
return on its investment
is equal to its weighted
marginal cost of capital.
Your Answer: False

Correct Answer: True


Incorrect. This is an
important principle that
you should commit to
memory.
The ______ is the rate of return a firm must
earn on its investments in projects in order
to maintain the market value of its stock.
Your Answer: internal rate of return

Correct Answer: cost of capital


Incorrect. The internal rate of
return is the point where the
NPV equals zero.

2.

______ is the risk to the firm of
being unable to cover financial
obligations.
Your Answer: Total risk

Correct Answer: Financial risk


Incorrect. This is a 'must know'
definition.

3.

The cost of capital reflects the
cost of funds:
Your Answer: over a short-
run time
period.

Correct Answer: over a long-
run time
period.



Incorrect. The investment
decision is long-term so the cost
of funds is a long-term
consideration.

4.

The ______ is the firm's desired
optimal mix of debt and equity
financing.
Your Answer: market value

Correct Answer: target capital
structure

Incorrect. The correct answer is
target capital structure. This is a
'must know' definition.

5.

A tax adjustment must be made
in determining the cost of_____.
Your Answer: preference
shares.

Correct Answer: long-term
debt.

Incorrect. This is a component of
equity. Only interest charged
debt is tax deductible.

6.

The before-tax cost of debt for a
firm that has a 40 per cent
marginal tax rate is 12 per cent.
The after-tax cost of debt is:
Your Answer: 4.8 per cent.

Correct Answer: 7.2 per cent.


Incorrect. Refer to Formula 11.2
on page 434.

7.

When determining the after-tax
cost of a bond, the face value of
the issue must be adjusted to
the net proceeds amounts by
considering:
Your Answer: the risk.

Correct Answer: the flotation
costs.

Incorrect. This does not affect
the determination of net
proceeds.

8.

If a corporation has an average
tax rate of 40 per cent, the
approximate, annual, after-tax
cost of debt for a 15-year, 12
per cent, $1 000 par value bond,
selling at $950 is:
Your Answer: 10.6 per
cent.

Correct Answer: 7.6 per cent.


Incorrect. This is a simple
calculation. You must be able to
answer this type of question
without thinking about how to
perform the calculation.

9.

The cost of ordinary shares
equity may be estimated by
using the:
Your Answer: net present
value
method.

Correct Answer: Gordon
model.

Incorrect. There are two
methods used to determine the
cost of ordinary shares, but this
is not one of them.

10.

The constant growth valuation
model - the Gordon model - is
based on the premise that the
value of an ordinary shares is:
Your Answer: equal to the
present value of
all expected
future dividends.

CORRECT

11.

A firm has a beta of 1.2. The
market return equals 14 per cent
and the risk-free rate of return
equals six per cent. The
estimated cost of ordinary
shares equity is:
Your Answer: 15.6 per cent.

CORRECT

12.

Using the capital asset pricing
model, the cost of ordinary
shares equity is the return
required by investors as
compensation for:
Your Answer: the specific
risk of the
firm.

Correct Answer: the firm's
non-
diversifiable
risk.



Incorrect. The CAPM model uses
a beta that is a measure of the
firm's non-diversifiable risk.

13.

Since retained earnings are
viewed as a fully subscribed
issue of additional ordinary
shares, the cost of retained
earnings is:
Your Answer: equal to the
cost of new
ordinary
share equity.

Correct Answer: less than the
cost of new
ordinary
share equity.



Incorrect. Flotation costs reduce
the net proceeds received by the
firm, which increases the cost of
capital.

14.

Given that the cost of ordinary
share equity is 18 per cent,
dividends are $1.50 per share,
and the price of the stock is
$12.50 per share, what is the
annual growth rate of dividends?
Your Answer: five per cent

Correct Answer: six per cent


Incorrect. Using Formula 11.6 on
page 437, substitute the values
given and calculate.

15.

Generally the least expensive
source of long-term capital is:
Your Answer: retained
earnings.

Correct Answer: long-term
debt.

Incorrect. Long-term debt is
cheaper because of the tax
deductibility of the interest
payments.

16.

Weighting schemes for
calculating the weighted average
cost of capital include all of the
following EXCEPT:
Your Answer: market value
weights.

Correct Answer: optimal
value
weights.



Incorrect. Weights can be
calculated on the basis of book
value or market value and using
historic or target weights.

17.

The preferred capital structure
weights to be used in the
weighted average cost of capital
are:
Your Answer: nominal
weights.

Correct Answer: market
weights.

Incorrect. Although book values
can be used, market value
weights are the preferred basis.

18.

As the volume of financing
increases, the costs of the
various types of financing will
______, ______ the firm's
weighted average cost of capital.
Your Answer: decrease;
raising

Correct Answer: increase;
raising

Incorrect. This is a 'must know'
definition.

19.

The ______ is the level of total
financing at which the cost of
one of the financing components
rises.
Your Answer: weighted
average cost
of capital

Correct Answer: breaking
point

Incorrect. This is a 'must know'
definition.

20.

As a source of financing, once
retained earnings have been
exhausted, the weighted average
cost of capital will:
Your Answer: decrease.

Correct Answer: increase.


Incorrect. The WACC will rise
with the addition of more
expensive new ordinary shares.