Chapter 10 - BUS 361 Sample Test
1. The coupon rate on existing debt is usually:
a. a good estimate of the before-tax cost of new debt.
b. always higher than the before-tax cost of new debt
c. always lower than the before-tax cost of new debt
d. none of the above statements are true
2. The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project.
3. Marginal Incorporated has determined that its before-tax cost of debt is 10.0%. Its cost of preferred stock is 11.0%. Its cost of internal equity is 15.0%, and its cost of external equity is 16.9%. Currently, the firm's capital structure consists of 32% debt, 14% preferred stock, and 54% common equity. The firm's marginal tax rate is 39%. What is the firm's weighted average cost of capital if it will be able to use retained earnings to fund the equity portion of its capital budget?
4. When calculating the component cost of debt for capital budgeting purposes for profitable, tax-paying firms, the tax adjustment:
a. reduces the component cost of debt
b. does not affect the component cost of debt
c. increases the component cost of debt
5. Average Corporation's currently outstanding 19.0% coupon bonds have a yield-to-maturity of 16.86%. Average believes it could issue at par new bonds that would provide a similar yield-to-maturity. If its marginal tax rate is 30%, what is the firm's component cost of debt for purposes of calculating the WACC (ignore flotation costs)?
6. The cost of new common stock (external equity) is generally higher than the cost of retained earnings (internal equity) because of:
a. tax effects.
b. investors' required returns.
c. flotation costs.
d. coupon payments
7. Average Corporation's stock currently sells for $59.00 per share, it is expected to pay a dividend of $5.40 next year, its growth rate is a constant 6.0%, and the company will incur a flotation cost of 14.0% of the market value if it sells new common stock. The firm's tax is 40%. What is the firm's cost of common equity if it must issue new stock?
8. Which of the following will increase a company's retained earnings break point?
a. An increase in its net income.
b. An increase in its dividend payout.
c. An increase in the amount of equity in its capital structure.
d. All of the
statements above are correct.
9. Of the three measures of project risk (stand-alone, corporate, and market), market risk is theoretically the most relevant measure.
10. A firm's capital structure policy affects its weighted average cost of capital.
11. If the expected rate of return on a given capital project lies above the SML, the project should be accepted even if its beta is above the beta of the firm's average project.
12. Since retained earnings are generated by the firm:
a. there is no component cost for these funds.
b. the funds have a positive cost that is more than new equity issues.
c. the funds have
a positive cost that is less than new equity issues.
13. Average Corporation's stock currently sells for $67.00 per share, its last dividend was $5.50, its growth rate is a constant 4.0%, and the company will incur a flotation cost of 13.0% of the market value if it sells new common stock. The firm's tax is 40%. What is the firm's cost of retained earnings?
14. The Barabas Company has an equal amount of low-risk projects, average-risk projects, and high-risk projects. Barabas estimates that the overall company's WACC is 12 percent. This is also the correct cost of capital for the company's average-risk projects. The company's CFO argues that, even though the company's projects have different risks, the cost of capital for each project should be the same because the company obtains its capital from the same sources. If the company follows the CFO's advice, what is likely to happen over time?
a. The company will take on too many low-risk projects and reject too many high-risk projects.
b. The company will take on too many high-risk projects since the return for the high risk projects will generally exceed the average WACC that is based on a mixture of all three types of projects. The company will reject too many low-risk projects since the return for the low risk project will generally be less than the average WACC that is based on a mixture of all three types of projects.
c. Things will
generally even out over time, and therefore, the risk of the firm should remain
constant over time.
15. Average Corporation's stock currently sells for $42.00 per share, its last dividend was $5.10, its growth rate is a constant 4.0%, and the company will incur a flotation cost of 11.0% of the market value if it sells new common stock. The firm's tax is 40%. What is the firm's cost of common equity if it must issue new stock?