Online Test 3: Cost of Capital

1. Which of the following is the least appropriate method for an external analyst to use to estimate a company’s
target capital structure for determining the weighted average cost of capital (WACC)?
A. Using averages of comparable companies’ capital structure
B. Using the company’s current capital structure at book value weights
C. Using statements made by the company’s management regarding capital structure policy

2. When computing the weighted average cost of capital (WACC) and assuming a fixed-rate noncallable bond is
currently selling above par value, the before-tax cost of debt is closest to the:
A. coupon rate
B. current yield.
C. yield to maturity.

3. A firm with a marginal tax rate of 40% has a weighted average cost of capital of 7.11%. The before-tax cost of
debt is 6%, and the cost of equity is 9%. The weight of equity in the firm's capital structure is closest to:
A. 79%.
B. 37%.
C. 65%.

4. A class of noncallable, nonconvertible preferred stock was issued at $45.00 per share with a dividend of $5.25.
The preferred stock is now trading at $60.00 per share. Earnings of the company are growing at 3.00%. The cost of
preferred stock is closest to:
A. 5.8%.
B. 8.8%.
C. 11.7%.

5. A company‘s optimal capital budget is best described as the amount of new capital required to undertake all
projects with an internal rate of return greater than the:
A. marginal cost of capital.
B. cost of retained earnings.
C. weighted average cost of capital.

6. Waynesboro Industries is considering issuing a 10-year, option-free, semiannual coupon bond with a 9% coupon
rate The bond is expected to sell at 95% of par value. If the company‘s marginal tax rate is 30%, then the after-tax
cost of debt is closest to:
A. 6.30%.
B. 6.86%.
C. 9.00%.
7. Staunton Manufacturing is considering issuing nonconvertible, noncallable fixed-rate perpetual preferred stock
with a $6 annual dividend. The preferred stock is expected to sell for $40. If the company‘s marginal tax rate is 30%
then the after-tax cost of preferred stock is closest to;
A. 6.67%.
B. 10.5%.
C. 15.0%.

8. An analyst gathered the following information about Afton, Inc., and the market:
Current market price per share of common stock €32.00
Most recent dividend per share paid on common stock €2.40
Expected dividend payout rate 40%
Expected return on equity (ROE) 15%
Beta for the common stock 1.5
Expected return on the market portfolio 12%
Risk-free rate of return 4%

Using the dividend discount model approach, the cost of common equity is closest to:
A. 16.0%.
B. 16.5%.
C. 17.2%.

9. An analyst gathers the following information about the capital structure and before-tax component costs for a
company. The company’s marginal tax rate is 40 percent.
Capital component Book Value (000) Market Value (000) Component cost
Debt $100 $80 8%
Preferred stock $20 $20 10%
Common stock $100 $200 12%
The company’s weighted average cost of capital (WACC) is closest to:
A. 8.55%.
B. 9.95%.
C. 10.80%.

10. A company is considering issuing a 10-year, option-free, semiannual coupon bond with a 9 percent coupon rate.
The bond is expected to sell at 95 percent of par value. If the company’s marginal tax rate is 30 percent, then the
after-tax cost of debt is closest to:
A. 6.30%.
B. 6.86%.
C. 9.80%.
11. An analyst gathers the following information about the cost and availability of raising various amounts of new
debt and equity capital for a company:
Amount of new debt Cost of debt Amount of new equity Cost of
(in millions) (after tax) (in millions) equity
≤ €4.0 4% ≤ €5.0 13%
> €4.0 5% > €5.0 15%
The company’s target capital structure is 60 percent equity and 40 percent debt. If the company raises €9.5 million in
new financing, the marginal cost of capital is closest to:
A. 9.8%.
B. 10.6%.
C. 11.0%.

12. A company is determining the cost of debt for use in its weighted average cost of capital. It has recently issued
a 10-year, 6 percent semi-annual coupon bond for $864. The bond has a maturity value of $1,000. If the marginal tax
rate is 35 percent, the cost of debt (%) they should use in their calculation is closest to:
A. 2.6.
B. 3.9.
C. 5.2.

13. A company wants to determine the cost of equity to use in the calculation of its weighted average cost of capital.
The CFO has gathered the following information:

Rate of return on 3-month Treasury bills 3.0%

Rate of return on 10-year Treasury bonds 3.5%
Market equity risk premium 6.0%
The company’s estimated beta 1.6
The company’s after-tax cost of debt 8.0%
Risk premium of equity over debt 4.0%
Corporate tax rate 35%
Using the bond-yield-plus-risk-premium approach, the cost of equity (%) for the company is closest to:
A. 12.0.
B. 16.3.
C. 18.3.

14. A twenty-year $1,000 fixed rate non-callable bond with 8% annual coupons currently sells for $1,105.94.
Assuming a 30% marginal tax rate and an additional risk premium for equity relative to debt of 5%, the cost of equity
using the bond-yield-plus-risk-premium approach is closest to:
A. 9.9%.
B. 12.0%.
C. 13.0%.
15. A company’s $100 par value preferred stock with a dividend rate of 9.5% per year is currently priced at
$103.26 per share. The company's earnings are expected to grow at an annual rate of 5% for the foreseeable future.
The cost of the company’s preferred stock is closest to:
A. 9.2%.
B. 9.5%.
C. 9.7%.

16. Which is least likely to be a component of a developing country’s equity premium?

A. Sovereign yield spread
B. Annualized standard deviation of the developing country’s equity index
C. Annualized standard deviation of the sovereign bond market in terms of the developing country’s currency

17. The following information is available for a firm.

Market Risk Premium: 7.0%
Risk-free Rate: 2.0%
Comparable Firm Return: 10.4%
Comparable Firm Debt-to-Equity Ratio: 1.0
Comparable Firm Tax Rate: 40.0%

The firm’s unlevered beta is closest to:

A. 0.75.
B. 1.05.
C. 1.20.

18. An analyst gathered the following information to estimate the cost of equity for JI Inc. located in Fiji.
Exhibit 1
Risk free rate 3.2%
Market risk premium 5.5%
Beta 1.3
U.S. 10-year T-bond yield 2.84%
Fiji’s 10-year dollar denominated Govt. bond yield 10.81%
Annualized SD of Fiji’s stock market 44%
Annualized SD of Fiji’s dollar denominated bond 37%
The sovereign yield spread and JI Inc.’s cost of equity are closest to:
A. 7.97% and 18.51% respectively.
B. 9.48% and 19.83% respectively.
C. 7.97% and 22.67% respectively.

19. When a reliable current market price for a firm’s debt is not available, the cost of debt can be estimated using
the:
A. matrix pricing model.
B. coupon rate of the same bonds.
C. interest expense of the firm’s income statement.
20. Which of the following statements is most likely correct regarding the impact of taxes on the cost of capital?
A. Interest costs serve to reduce a company’s cost of debt.
B. Cost of equity may require adjustments for taxes if preferred stock is part of the capital structure.
C. The weighted average cost of capital reflects a required rate of return after adjusting all its components for
taxation.

21. Which of the following is least likely to be a component of a developing country’s equity premium?
A Annualized standard deviation of the developing country’s equity index
B Sovereign yield spread
C Annualized standard deviation of the sovereign bond market in terms of the developing country’s currency

22. When computing the weighted average cost of capital (WACC) and assuming a fixed-rate non-callable bond is
currently selling above par value, the before-tax cost of debt is closest to the:
A coupon rate.
B yield to maturity.
C current yield.

23. A firm’s before-tax costs of debt, preferred stock, and equity are 12%, 17%, and 20%, respectively. Assuming
equal funding from each source and a marginal tax rate of 40%, the weighted average cost of capital (%) is closest to:
A 14.7%.
B 9.8%.
C 13.9%.

24. Skylark Manufacturers is situated in a developing country where equity markets have been always been highly
volatile with unstable equity market returns. In addition, political turmoil has often mandated temporary halts in market
trading. As a consequence, the Skylark stock has rarely generated stable performance. Carl Jung, a potential investor
is attempting to determine Skylark’s cost of equity and the most appropriate method to derive this estimate. Which of
the following statements most accurately characterizes a consequence of the chosen method to estimate Skylark’s cost
of equity?
A. The dividend discount model approach will generate the most stable equity risk premium estimate.
B. The arithmetic mean estimate for equity risk premium generated by the historical approach will exceed the
geometric mean estimate.
C. The CAPM approach will adequately factor sources of priced risk such as macro-economic and company-specific
factors affecting the Skylark stock.

25. A company’s $100 par value preferred stock with a dividend rate of 9.5% per year is currently priced at $103.26
per share. The company’s earnings are expected to grow at an annual rate of 5% for the foreseeable future. The cost
of the company’s preferred stock is closest to:
A 9.5%.
B 9.2%.
C 9.7%.
26. Ester Miguel is using data concerning a publicly traded comparable to determine the asset beta for a privately
traded company. The beta of the publicly traded stock is 1.8 while debt-to-equity ratios and marginal tax rates are 0.4
and 30%, respectively. The privately traded corporation has a D/E ratio of 0.7 and a marginal tax rate of 25%.
Using the pure play method, the beta used to estimate the cost of capital for a project undertaken by the private
entity having an identical risk and financing structure as its company is closest to:
A. 1.41.
B. 2.10.
C. 2.14.

27. Rector Incorporated is a manufacturing firm with a capital structure comprising of equity and debt. The current
market value of equity is $2.0 million and the beta of the stock is 1.2. The company has $4 million face value of bonds
outstanding, which pay semi-annual coupons at an annual rate of 8%. The yield-to-maturity is 9% and the remaining term
to maturity is 5 years. The corporate pays tax at a rate of 25%. The equity risk premium and risk-free rate is 4% and
2%, respectively. Rector Incorporated’s weighted average cost of capital (WACC) is closest to:
A. 4.55%.
B. 6.77%.
C. 7.59%.

28. Bill Somers, an equity analyst, is evaluating the stock of Westmore Associates. Somers has collected the
following data with respect to the Westmore stock and equity market:

Exhibit:
Data Concerning the Market and Westmore Associates’ Stock
Current dividend per share $3.50
Return on equity 5%
Earnings per share $7.50
Market required rate of return 8%
Risk-free rate 3%
Forecasted next period’s price per share $25.50
Current price per share $22.35
The cost of equity (re) using the discounted dividend model (DDM) is closest to:
A. 16.76%.
B. 18.36%.
C. 18.74%.

29. Which of the following statements inaccurately illustrates the impact of taxes on the cost of capital?
A. The cost of debt is adjusted for the tax shield.
B. The before and after-tax cost of preferred stock is always identical.
C. Estimating cost of equity is particularly challenging as taxes influence dividend income and capital gains.
30. Glec Corp issued noncallable, nonconvertible preferred stock at an original price of $38.50. The dividend yield
quoted on the stock is 5% while dividend per share is equal to $1.50. Glec’s weighted average cost of capital is 10%.
The preferred stock’s current price per share is closest to:
A. $30.00.
B. $38.50.
C. $150.00

31. The shape of the marginal cost of capital schedule can least likely be attributable to:

A. economies of scale in raising new capital.

B. methodology used in estimating flotation costs.
C. debt covenants restricting issuance of new debt.

32. Smithline Corp.’s total market value of equity equals $45 million while the market value of debt equals $30 million.
The relevant tax rate for the corporation is 30% while the equity beta is 1.893. Smithline Corp’s unlevered beta is
closest to:
A. 1.29.
B. 1.89.
C. 2.78.

33. Which of the following statements is most likely correct with respect to the break point on the marginal cost of
capital schedule? It represents the point:
A. of optimal capital budget.
B. where the marginal cost of capital is lowest.
C. where a company’s marginal cost of capital changes.

34. An analyst is assessing the capital structure of an automobile company. Exhibit 1 displays key information about
the company’s vitals.
Exhibit:
Five year average preferred dividend $4.50/share

Current preferred dividend $5.50/share

Current stock price $60/share

Market risk premium 7.0%

Stock beta 1.45

Risk-free rate 4.0%

Tax rate 40%

Debt/equity 0%

% of preferred stock in the capital structure 25%

The company’s WACC is closest to:

A. 11.99%.
B. 12.49%.
C. 12.90%.
35. A manufacturing firm issues a semi‐annual coupon bond to finance a new project. The bond has a par value of
$1,000, offers a coupon rate of 9%, and will mature in 15 years. Given that the bond’s current market value is
$1,020.63, and the applicable tax rate is 35%, the company’s after‐tax cost of debt is closest to:
A. 4.38%.
B. 8.75%.
C. 5.69%.

36. A privately traded enterprise has an asset beta of 1.45. Increasing the degree of financial leverage will most
likely produce an equity beta which is closest to:
A. 1.00.
B. 1.45.
C. 1.89.

37. Which of the following statements most accurately demonstrates the correct treatment of floatation costs?
Flotation costs:
A. associated with debt issuance are included in the cost of capital.
B. associated with equity issuance are included in the cost of capital.
C. are reflected by adjusting the net present value of the project it is intended to finance.

38. ABC Company currently has a debt‐to‐equity ratio of 0.3. Its target debt‐to‐equity ratio is 0.4. The risk‐free
rate is 6%, and expected equity market return is 12%. ABC is considering a project that has a beta of 1.2. Given that
the company’s after‐tax cost of debt is 7%, and the applicable tax rate is 40%, the WACC that should be used in
evaluating this project is closest to:
A. 10.63%.
B. 11.43%.
C. 11.77%.

39. The sovereign yield spread for Country UVW is currently 5.3% and the yield on 10-year US treasuries is 3.2%.
The annualized standard deviation of Country UVW’s stock market is 19.1%, which is much higher than the annualized
standard deviation of Country UVW’s 10-year USD sovereign bonds of 7.6%. If the expected return on Country UVW’s
stock market is 13.2%, their country risk premium is closest to:
A. 5.3%
B. 13.3%
C. 26.5%
40. Ryan Myers, a financial analyst, has been appointed the task of developing a valuation estimate for Colors Fashion
Label (CFL), a private, U.S. based firm operating in the fashion industry of the country. Myers gathered the following
information to aid his analysis:
• The long-term yield on U.S. government bonds is 3.5%.
• The historical equity risk premium in the U.S. is 5.6%.
• A comparable firm has a beta of 1.35, a debt-to-equity ratio of 1.20, and a tax rate of 40%.
• CFL’s tax rate is 33%.
• CFL’s Debt/Equity ratio is 0.75.
Given the aforementioned information, Myers estimate of CFL’s cost of equity should be closest to:
A. 7.896%.
B. 9.874%.
C. 10.105%.

41. Given the following information about a firm:

• debt-to-equity ratio of 50%
• tax rate of 40%
• cost of debt of 8%
• cost of equity of 13%, the firm’s weighted average cost of capital (WACC) is closest to:
A. 7.5%.
B. 8.9%.
C. 10.3%.

42. A firm’s estimated costs of debt, preferred stock, and common stock are 12%, 17%, and 20%, respectively.
Assuming equal funding from each source and a 40% tax rate, the weighted average cost of capital is closest to:
A. 13.9%.
B. 14.7%.
C. 16.3%.

43. A company has an equity beta of 1.4 and is 60% funded with debt. Assuming a tax rate of 35%, the company’s
asset beta is closest to:
A. 0.71.
B. 0.98.
C. 1.01.
44. Consider a company facing the costs of capital given in the table below:

If the company raises capital according to its target capital structure proportions of 40 percent debt and 60 percent
equity, which of the following is not a break point for its marginal cost of capital?
A. €5 million,
B. €10 million
C. €15 million

45. Ron Collins is the CFO of Allied Canadian Breweries Ltd. He wants to determine the capital structure that will
result in the lowest cost of capital for Allied. He has access to the following information:
The minimum rate at which the company can borrow is the 12-month Libor rate plus a premium that varies with the
debt-to-capital ratio [D/(D+ E)] as given below:

The current 12-month Libor is 2.8 percent.

The market risk premium is 5 percent, and unleveraged beta is 0.9.
The risk-free rate is 3 percent.
The company’s tax rate is 36 percent.
The WACC for a target capital structure consisting an equal amount of debt and equity is closest to:
A. 7.04%
B. 7.14%
C. 7.37%
46. Consider a company facing the costs of capital given in the table below:

The company raises capital according to its target capital structure of equal amount of debt and equity. If it chooses to
raise 16M, its marginal cost of capital is closest to:
A. 5.0%
B. 5.5%
C. 6.0%

47. Consider a project that requires a €60M initial cash outlay and is expected to produce cash flows of €10M each
year for 10 years. Suppose the company’s marginal tax rate is 40 percent and that the before-tax cost of debt is 5
percent. Furthermore, suppose that the company’s dividend next period is €1, the current price of the stock is €20, and
the expected growth rate is 5 percent. Assume the company will finance the project with 40 percent debt and 60
percent equity. The flotation costs are 5 percent of the new equity capital and are tax-deductible. If flotation costs are
part of the initial cash outlay cash flows, the project’s NPVs are closest to:
A. 8.5 M
B. 9M
C. 9.5M
48. KEG currently operates in 10 countries, with the previous year's global revenues at €5.6 billion. Recently, KEG’s
CFO announced plans for expansion into North Korea under the leadership of the company’s rising star: Dr. Jasper-
Avenger Dumbo. KEG’s global annual free cash flow to the firm is €500 million and earnings are €400 million. Cash flow
are estimated to level off at a 2 percent rate of growth. KEG’s after-tax free cash flow to the firm on the North Korean
project for next three years is, respectively, €48 million, €52 million, and €54.4 million. KEG recently announced a
dividend of €4.00 per share of stock. The North Korean plant is expected to sell only to customers within North Korea
for the first three years. KEG’s planned financing of the required €100 million with a €80 million public offering of 10-
year debt in France and the remainder with an equity offering.

Additional information:
Equity risk premium, France 4.82 percent
Risk-free rate of interest, France 4.25 percent
Industry debt-to-equity ratio 0.3
Market value of KEG’s debt €900 million
Market value of KEG’s equity €2.4 billion
KEG’s equity beta 1.3
KEG’s before-tax cost of debt 9.25 percent
North Korea’s country risk premium
(it has a rating of “Z99999”, which I made up 100 percent
and is much lower than the lowest possible credit rating of D)
Corporate tax rate 37.5 percent
Interest payments each year Level

The North Korean project’s net present value calculated using the equity beta without and with the country risk
premium are, respectively:
A. 73.3%.
B. 77.6%.
C. 82.5%.
49. While covering the initial public offerings, you want to estimate the company’s cost of capital. Its industry has
grown at 26 percent per year for the previous three years. Large companies dominate the market, but sizable “pure-
play” companies such as ABC, DEF, and GHI also compete. Each of these competitors is domiciled in a different country,
but they all have shares of stock that trade on the US NASDAQ. The debt ratio of the industry has risen slightly in
recent years.
Market Value Market Value
Sales in Equity Share Price
Company Equity in Debt in Tax Rate
Millions ($) Beta ($)
Millions ($) Millions ($)
Relevant Ltd. 752 3,800 0.0 1.702 23 percent 42
ABJ, Inc. 843 2,150 6.5 2.800 23 percent 24
Opus Software Pvt. Ltd. 211 972 13.0 3.400 23 percent 13
Based on the company’s preliminary prospectus for the IPO, you know that the company intends to issue 1 million new
shares at $8. Its current capital structure consists of a $2.4 million five-year non-callable bond issue and 1 million
common shares. Additional information follows:
$2.4 million five-year bonds, coupon of 12.5 percent, with a market value of $2.156
Currently outstanding bonds
million
Risk-free rate of interest 5.25 percent
Estimated equity risk
7 percent
premium
Tax rate 23 percent
The company’s WACC is closest to:
A 21.5%.
B 22%.
C 22.5%.

50. Michael wants to calculate the WACC for a company which has $6 million worth of debt outstanding with an
interest rate of 7%. The company is expected to issue new debt at an interest rate of 8%. Assuming a tax rate of 40%,
the company’s after‐tax cost of debt to be used in calculating the WACC is closest to:
A. 4.2%.
B. 7%.
C. 4.8%.

51. Consider the following statements:

Statement 1: Betas are believed to revert toward zero over time.
Statement 2: Betas are affected by the choice of market index used in the regression model.
Which of the following is most likely?
A. Only Statement 1 is correct.
B. Only Statement 2 is correct.
C. Both statements are incorrect.
52. A company that wants to determine its cost of equity gathers the following information:
Rate of return on 3-month Treasury bills 3.0%
Rate of return on 10-year Treasury bonds 3.5%
Market risk premium 6.0%
The company’s equity beta 1.6
Dividend growth rate 8.0%
Corporate tax rate 35%
Using the capital asset pricing model (CAPM) approach, the cost of equity (%) for the company is closest to:
A 12.6%.
B 7.5%.
C 13.1%.

53. Which method of calculating the firm’s cost of equity is most likely to incorporate the long-run return
relationship between the firm’s stock and the market portfolio?
A Capital asset pricing model
B Dividend discount model
C Bond yield plus risk premium approach

54. When estimating the NPV for a project with a risk level higher than the company’s average risk level, an analyst
will most likely discount the project’s cash flows by a rate that is:
A determined by the firm’s target capital structure.
B below the WACC.
C above the WACC.

55. The cost of which source of capital most likely requires adjustment for taxes in the calculation of a firm’s
weighted average cost of capital?
A Common stock
B Preferred stock
C Bonds.

56. A company’s data are provided in the following table:

Cost of debt 10%
Cost of equity 16%
Debt-to-equity ratio (D/E) 50%
Tax rate 30%
The weighted average cost of capital (WACC) is closest to:
A 14.0%.
B 11.5%.
C 13.0%.
57. Debt is generally:
A. less costly than preferred or common stock.
B. more costly than preferred or common stock.
C. less costly than preferred stock but more costly than common stock.

58. Hodges Corporation is planning to raise $12 million new capital while maintaining the current capital structure of
the firm which is 35% debt, 8% preferred stock and the rest is equity. The company’s before tax cost of debt is 9%,
cost of preferred stock is 11%, and cost of equity is 16%. If the company’s weighted average cost of capital is 12.05%,
its marginal tax rate is closest to:
A. 35.0%
B. 40.0%
C. 45.5%

59. C-Green Inc. recently issues a bond to finance its new project. The bond sells at
$1,120 and offers 5-year, $1,000 face value, 3.5 percent semi-annual coupon
bond. C-Green’s marginal tax rate is 35.5%.
Michelle Vick, a management accountant at C-Green Inc., has been asked by her
finance director to calculate the C-Green’s after-tax cost of debt using the yield-to-maturity approach.
C-Green’s after-tax cost of debt is closest to:
A. 1.91%
B. 2.96%
C. 5.37%

60. Which of the following statements about the component costs of capital is /east accurate?
A) The cost of common equity is the required rate of return on common stock.
B) The cost of preferred stock is the preferred dividend divided by the preferred's par value.
C) The after-tax cost of debt is based on the expected yield to maturity on newly issued debt.

61. Jay Construction Company is considering whether to accept a new bridge-building project. Jay will use the pure-
play method to estimate the cost of capital for the project, using Cass Bridge Builders as a comparable company. To
calculate the project beta, Jay should:
A) estimate Cass's cost of equity capital and apply it to the project.
B) use the CAPM equation, substituting Cass's equity beta for its own.
C) adjust Cass's equity beta for any difference in leverage between Cass and Jay.

62. MaryMore Inc. is planning to issue bonds to finance a new project. It offers $1,000 par 5-year, 7% semi-annual
coupon payment bond. The bond is currently trading at $1,150. The firm’s current costs of preferred equity and common
equity are 4% and 5.5% respectively and marginal tax rate is 34%. The firm’s project cost of debt is closest to:
A. 2.43%.
B. 3.68%.
C. 11.93%.

63. A project’s beta is least likely to be exposed to:

A. Business risk.
B. Financial risk.
C. Default risk.
64. Which of the following approaches is least likely to be used in determining a company’s cost of debt?
A. Yield to maturity approach
B. Pure‐play approach
C. Debt rating approach