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MCQs on Cost of Capital

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1. Bankston Corporation forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Since new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock?
a. Increase the dividend payout ratio for the upcoming year.
b. Increase the percentage of debt in the target capital structure.
c. Increase the proposed capital budget.
d. Reduce the amount of short-term bank debt in order to increase the current ratio.
e. Reduce the percentage of debt in the target capital structure.

2. LaPango Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?

a. Project B, which is of below-average risk and has a return of 8.5%.
b. Project C, which is of above-average risk and has a return of 11%.
c. Project A, which is of average risk and has a return of 9%.
d. None of the projects should be accepted.
e. All of the projects should be accepted.

3. Which of the following statements is CORRECT?
a. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation.
b. All else equal, an increase in a company's stock price will increase its marginal cost of retained earnings, rs.
c. All else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re.
d. Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt.
e. If a company's tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall. 4. 4) Which of the following statements is CORRECT?
a. Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.
b. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes.
c. If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.
d. Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt.
e. Higher flotation costs tend to reduce the cost of equity capital.

5. Cranberry Corp. has two divisions of equal size: a computer manufacturing division and a data processing division. Its CFO believes that stand-alone data processor companies typically have a WACC of 8%, while stand-alone computer manufacturers typically have a 12% WACC. He also believes that the data processing and manufacturing divisions have the same risk as their typical peers. Consequently, he estimates that the composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the data processing division and a 12% hurdle rate for the manufacturing division. However, the CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is CORRECT?
a. While the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant's recommendation, this should not affect the firm's intrinsic value.
b. The decision not to adjust for risk means, in effect, that it is favoring the data processing division. Therefore, that division is likely to become a larger part of the consolidated company over time.
c. The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division. This will lead to a reduction in the firm's intrinsic value over time.
d. The decision not to risk-adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business. This will lead to a reduction in its intrinsic value over time.
e. The decision not to risk adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business. This may affect the firm's capital structure but it will not affect its intrinsic value.

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1. Bankston Corporation forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Since new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock?

a. Increase the dividend payout ratio for the upcoming year.
b. Increase the percentage of debt in the target capital structure.
c. Increase the proposed capital budget.
d. Reduce the amount of short-term bank debt in order to increase the current ratio.
e. Reduce the percentage of debt in the target capital structure.

Answer: b. Increase the percentage of debt in the target capital structure.

With increased percentage of debt more of capital budget would come from debt and less from equity

2. LaPango Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?

a. Project B, which is of below-average risk and has a return of 8.5%.
b. Project C, which is of above-average risk and has a return of 11%.
c. Project A, which is of average risk and has a return of 9%.
d. None of the projects should be accepted.
e. All of the projects should be accepted.

Answer: a. Project B, which is of below-average risk and has a return of 8.5%.

Risk Required Return Actual Return
A Average 10% 9% Do not Accept
B Below Average 8% 8.50% Accept
C Above Average 12% 11% Do not ...

Solution Summary

Answers multiple choice questions on cost of capital.

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Finance Problems

Which of the following component costs is expressed on an after-tax basis in the calculation of a firm's cost of capital?

a.
cost of debt

b.
cost of preferred stock

c.
cost of common equity

d.
b and c

e.
all of the above

The component cost of a firm's preferred stock consists of

a.
the current dividend yield.

b.
the expected growth rate of dividends.

c.
dividends expressed as a percent of par value.

d.
a and b

Which of the following would increase the WACC?

a.
an increase in flotation costs

b.
a decrease in tax rates

c.
a decrease in preferred dividends

d.
Both a & b

e.
All of the above

8. If a project comes with its own funding offered at a rate lower than the cost of capital, the capital budgeting analysis should be conducted using

a.
the offered rate because it is appropriate to match sources and uses of funding whenever possible.

b.
the cost of capital because to do otherwise would be unfair to departments whose projects don't happen to have separate funding

c.
the cost of capital because doing otherwise leads to irrational capital budgeting decisions

d.
an average of the offered rate and the cost of capital because that gives the best measure of the effect of the offer on the firm

Show solution and answer to this question below

15. A firm's correctly computed capital structure is 30% debt, 20% preferred stock, and 50% equity. If retained earnings of $1 million are expected, how much capital will have been raised when retained earnings are exhausted and new common equity must be issued?

a.
$1,428,571

b.
$1,000,000

c.
$2,000,000

d.
$3,333,333

Show solution and answer to this question below

If a firm's EBIT changes by 20% and it has a degree of financial leverage (DFL) of 2.0, what is the expected change in earnings per share (EPS)?

a.
20%

b.
40%

c.
50%

d.
60%

According to the MM model of capital structure, the present value of the tax shield is offset by potential __________, resulting in an optimal capital structure.

a.
bankruptcy costs

b.
interest expense

c.
operating costs

d.
a and b

Show solution and answer to this question below

Assume the following facts about a company:

Capital (000s)

EBIT (000s)
$1,000

Debt
-
Less Interest Expense
-

Equity
$3,000
EBT
$1,000

Total Capital
$3,000
Taxes @ 40%
400

Shares @ $10 = 300

Earnings after Tax
$ 600

What will be the company's new EPS if it borrows money at 10% interest and uses it to retire stock until capital is 40% debt? The stock can be purchased at its book value of $10 per share.

a.
$3.33

b.
$4.89

c.
$2.93

d.
none of the above

Show solution and answer to this question below

Khandker Motors finances 40% of its total capital with debt. The cost of debt is 11%. The firm is in the 37% tax bracket and earned an operating profit of $2.5 million dollars. If the Khandker's total capital amounts to $22 million and its book value per share is $20, what is the firm's earnings per share?

a.
$0.85

b.
$0.88

c.
$1.43

d.
$1.46

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Zahn Enterprises pays $3 million annually to its bondholders and $7.5 million annual to its stockholders. The required rates of return are 9 percent and 15 percent, respectively, by the bondholders and stockholders. What is the value of Zahn Enterprises?

a.
$1.40 million

b.
$10.50 million

c.
$16.66 million

d.
$83.33 million

Shareholder needs or preferences that may influence the dividend decision include:

a.
the need for current income support oneself

b.
a preference for price appreciation because current income isn't needed

c.
a preference for capital gains over ordinary income.

d.
all of the above

Various management actions provide investors with clues as to the future prospects for the firm. Which of the following actions by management contains the most important economic information for common stock investors?

a.
A 20 percent increase in cash dividends per share.

b.
A 100 percent stock dividend

c.
A 2-for-1 stock split.

d.
a, b, and c are equally important.

Which statement related to the signaling effect of dividends is true?

a.
The signaling effect can explain why an increase in the dividend is often followed by an increase in stock price.

b.
The signaling effect is a reason a firm may follow a constant or steadily increasing dividend policy.

c.
Changes in dividends can be interpreted as a signal from management about changes in the company's future earnings.

d.
all of the above.

Show solution and answer to this question below

A firm's balance sheet discloses cash of $300,000, other assets of $700,000, liabilities of $500,000, preferred stock of $100,000, common stock of $200,000, and retained earnings of $200,000. What is the maximum cash dividend the firm can pay?

a.
$100,000

b.
$300,000

c.
$200,000

d.
$500,000

In dividend reinvestment plans, stockholders receive additional shares instead of cash dividends. Shareholders

a.
are not taxed at the time of the dividend because they received no cash

b.
must pay tax on the full value of the new shares at the time they are sold

c.
must pay tax in the year of the dividend on the value used to buy the new shares

d.
must pay tax on the dividend amount when the shares are sold.

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