Multiple choice questions relating to cost of capital
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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
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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
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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
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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
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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.
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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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1. 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
Since interest is tax deductible, there fore cost of debt is expressed on an after tax basis.
Answer a.
2.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
Answer c. Since the dividends are fixed and are expressed as a percent of par value.
3. 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
Answer d. An increase in floatation cost would reduce the amount of money collected and hence would increase the cost. Debt cost is after tax cost and a reduction in tax rate would increase the after tax cost since the multiplying factor is (1-tax rate).
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
Answer d. Since the WACC would change when the new capital is raised in a different proportion and at a different rate
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