02_COST OF CAPITAL

QUIZZER 1

1. The difference between the required rate of return on a given risky investment and that on
a riskless investment with the same expected return is
a. Risk premium.
b. Coefficient of variation.
c. Standard deviation.
d. Beta- coefficient.

2. Which of the following is applied in determining the value of a stock using the dividend
growth model?
a. The firm’s capital structure
b. The firm’s cash flow
c. The firm’s liquidity
d. The investors required rate of return on a firm’s stock

3. Assume that nominal rates just increased substantially but the expected future dividends
for a company over the long run is not affected. As a result of the increase in nominal
interest rates, the company’s stock price should
a. Increase
b. Decrease
c. Stay constant
d. Change, but in no obvious direction

4. A firm must select from among several methods of financing arrangements when meeting
its capital requirements. To acquire additional growth capital while attempting to
maximize earnings per share, a firm should normally
a. Attempt to increase both debt and equity in equal proportions, which preserves a
stable capital structure and maintains investor confidence.
b. Select debt over equity initially, even though increased debt is accompanied by
interest costs and a degree of risk.
c. Select equity over debt initially, which minimize risk and avoid interest costs.
d. Discontinue dividends and use current cash flow, which avoids the cost and risk
of increased debt and the dilution of EPS through increased equity.

5. The theory underlying the cost of capital is primarily concerned with the cost of
a. Long-term funds and old funds.
b. Short-term funds and new funds.
c. Long-term funds and new funds.
d. Short-term funds and old funds.

6. A higher degree of operating leverage compared with the industry average implies that
the firm
a. Has higher variable costs.
b. Has profit that is more sensitive to changes in sales volume.
c. Is more profitable.
d. Is less risky.

7. When calculating the cost of capital, the cost assigned to retained earnings should be
a. Zero
b. Lower than the cost of external common equity
c. Equal to the cost of external common equity
d. Higher than the cost of external common equity
 8. If B corporation’s bonds are currently yielding 8% in the marketplace, why is the firm’s
cost of debt lower?
a. Market interest rates have increased
b. Additional debt can be issued more cheaply than the original debts
c. There should be no difference; cost of debt is the same as the bond’s market
yield.
d. Interest is deductible for tax purposes.

9. In general, it is more expensive for a company to finance with equity capital than with
debt capital because
a. Long-term bonds have a maturity date and must therefore be repaid in the future
b. Investor are exposed to greater risk
c. Equity capital is in greater demand than debt capital
d. Dividends fluctuate to a greater extent than interest rates.

10. PM Company has announced that it plans to finance future investment so that firm will
achieve an optimum capital structure. Which one of the following corporate objective is
consistent with this announcement?
a. Maximize EPS
b. Minimize cost of debt
c. Maximize the net worth of the firm
d. Minimize the cost of equity

Question 11 through 13 are based on the following information.

C Company currently sells 400,000 bottles of perfume each year. Each unit costs P0.84 to
produce and sells for P1.00. Fixed costs are P28,000 per year. The firm has annual interest
expense of P6,000 preferred stock dividends of P2,000 per year, and a 40% tax rate.

11. The degree of operating leverage for C Company is

a. 2.40
b. 1.78
C. 1.35
d. 1.2

12. If C Company did not have preferred stock, the degree of total leverage would
a. Decrease in proportion to a decrease in financial leverage.
b. Increase in proportion to an increase in financial leverage
c. Remain the same
d. Decrease but not be proportional to the decrease in financial leverage.

13. The degree of financial leverage for C Company is

a. 2.4
b. 1.78
c. 1.35
d. 2.30

Questions 14 through 17 are based on the following information.

F 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 F Corporation is provided.

 The market price of common stock is P60 per share
 The dividend next year is expected to be P3 per share
  Expected growth in dividend 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 P3 million.
 The firm has a 40% marginal tax rate.

14. The after-tax cost of the new bond issue is

a. 4%
b. 6%
c. 10%
d. 14%

15. The cost of using retained earnings for financing is

a. 5%
b. 9%
c. 10%
d. 15%

16. If the company must assume a 20% flotation cost on new stock issuances, what is the cost of
new common stock?
a. 6.25%
b. 15%
c. 16.25%
d. 10%

17. The maximum capital expansion that can be supported in the coming year without resorting
to external equity financing is
a. P2,000,000
b. P3,000,000
c. P5,000,000
d. P8,000,000

Questions 18 through 19 are based on the following additional information.

(Use the same data in items 14 to 17). 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%.

18. If capital expansion needs to be P7 million for the coming year, what is the after-tax
weighted average cost of capital?
a. 11.14%
b. 12.74%
c. 13.6%
d. 16%

19. What is the marginal cost od capital for any projected capital expansion in excess of P7
million?
a. 10%
b. 12.74%
c. 13.6%
d. 16%

20. A preferred stock is sold for P101 per share, has a face value of P100 per share underwriting
fees of P5 per share, and annual dividends of P10 per share. If the tax rate is 40%, the cost of
funds (capital) for the preferred stock is
a. 4.2%
b. 6.2%
 c. 10.0%
d. 10.4%

Questions 21 through 24 are based on Win Inc. which is interested in measuring its overall cost
of capital and has gathered the following data. Under the terms described below, the company
can sell unlimited amounts of all instruments.

 Win can raise cash by selling P1,000, 8% 20-year bonds with annual interest payments.
In selling the issue, an average premium of P30 per bond would be received, and the firm
must pay flotation cost of P30 per bond. The after-tax cost of funds is estimated to be
4.8%.

 Win can sell 8% preferred stock at P105 per share. The cost of issuing and selling the
preferred stock is expected to be P5 per share.

 Win’s common stock is currently selling for P100 per share. The firm expects to pay cash
dividends of P7 per share next year, and the dividends are expected to remain constant.
The stock will have to be underpriced by P3 per share, and flotation cost are expected to
amount to P5 per share.

 Win expects to have available P100,000 of retained earnings in the coming year; once
these retained earnings are exhausted, the firm use new common stock as the form of
common stock equity financing.

Win’s preferred capital structure is

Long-term debt 30%
Preferred stock 20%
Common stock 50%

21. The cost of funds from the sale of common stock for Win, Inc. is
a. 7.0%
b. 7.6%
c. 7.4%
d. 8.1%

22. The cost of funds from retained earnings for Win, Inc. is
a. 7.0%
b. 7.6%
c. 7.4%
d. 8.1%

23. If Win, Inc. needs a total of P200,000, the firm’s weighted average cost of capital would be
a. 19.8%
b. 4.8%
c. 6.5%
d. 6.8%

24. If Win, Inc. needs a total of P1,000,000, the firms weighted average cost of capital would be
a. 6.8%
b. 4.8%
c. 6.5%
d. 27.4%

25. Global company has P150 par value preferred stock with a market price of P120 a share. The
organization pays P15 per share annual dividend. Global’s current marginal tax rate is 40%.
Looking to the future, the company anticipates maintaining its current capital structure. What is
the component cost of preferred stock to Global?
 a. 4%
b. 5%
c. 10%
d. 12.5%

26. The common stock of the Nicolas Corporation is currently selling at P80 per share. The
company intends to pay a P4 per share dividend next year. With the expectation that the dividend
will grow at 5% perpetually, what will the market’s required return on investment be for Nicolas
common stock?
a. 5%
b. 5.25%
c. 7.5%
d. 10%