Quiz 2: Cost of Capital - Quiz

1. A company has $5 million in debt outstanding with a coupon rate of 12%. Currently the yield to
maturity (YTM) on these bonds is 14%. If the firm's tax rate is 40%, what is the company's after-
tax cost of debt?

A. 5.6% B. 8.4% C. 14.0%

2. The cost of preferred stock is equal to:

A. the preferred stock dividend divided by its par value
B. [(1 - tax rate) times the preferred stock dividend] divided by price
C. the preferred stock dividend divided by its market price

3. A company's $100, 8% preferred is currently selling for $85. What is the company's cost of
preferred equity?

A. 8.0% B. 9.4% C. 10.8%

3. The expected dividend is $2.50 for a share of stock priced at $25. What is the cost of equity if the
long-term growth in dividends is projected to be 8%?

A. 15% B. 16% C. 18%

4. An analyst gathered the following data about a company:

Capital structure Required rate of return

30% debt 10% for debt
20% preferred stock 11% for preferred stock
50% common stock 18% for common stock

Assuming a 40% tax rate, what after-tax rate of return must the company earn on its investments?

A. 13.0% B. 14.2% C. 18.0%

5. A company is planning a $50 million expansion. The expansion is to be financed by selling $20
million in new debt and $30 million in new common stock. The before-tax required return on debt
is 9% and 14% for equity. If the company is in the 40% tax bracket, the company's marginal cost
of capital is closest to:

A. 7.2% B. 10.6% C. 12.0%

Use the following data to answer Questions 7 through 10

• The company has a target capital structure of 40% debt and 60% equity.
• Bonds with face value of $1,000 pay a 10% coupon (semiannual), mature in 20 years, and sell
for $849.54 with a yield to maturity of 12%.
• The company stock beta is 1.2.
• Risk-free rate is 10%, and market risk premium is 5%.
• The company is a constant-growth firm that just paid a dividend of $2, sells for $27 per share,
and has a growth rate of 8%.
• The company's marginal tax rate is 40%.
7. The company's after-tax cost of debt is:
 A. 7.2% B. 8.0% C. 9.1%

8. The company's cost of equity using the capital asset pricing model (CAPM) approach is:

A. 16.0% B) 16.6% C) 16.9%

9. The company's cost of equity using the dividend discount model is:

A. 15.4% B) 16.0% C) 16.6%

10. The company's WACC (using the cost of equity from CAPM) is closest to:

A. 12.5% B) 13.0% C) 13.5%

11. What happens to a company's weighted average cost of capital (WACC) if the firm's corporate tax
rate increases and if the Federal Reserve causes an increase in the risk-free rate, respectively?
(Consider the events independently, and assume a beta of less than one. WACC will:

Tax rate increase Increase in risk-free rate

A. Decrease Increase
B. Decrease Decrease
C. Increase Increase

12. Given the following information on a company's capital structure, what is the company's weighted
average cost of capital? The marginal tax rate is 40%.

Type of capital Bonds Percent of capital structure Before-tax component cost

Bonds 40% 7.5%
Preferred stock 5% 11%
Common stock 55% 15%

A) 10.0% B) 10.6% C) 11.8%

13. Derek Ramsey is an analyst with Bullseye Corporation, a major U.S.-based discount retailer.
Bullseye is considering opening new stores in Brazil and wants to estimate its cost of equity
capital for this investment. Ramsey has found that:
• The yield on a Brazilian government 10-year U.S. dollar-denominated bond is 7.2%.
• A 10-year U.S. Treasury bond has a yield of 4.9%.
• The annualized standard deviation of the Sao Paulo Bovespa stock index in the most recent
year is 24%.
• The annualized standard deviation of Brazil's U.S. dollar-denominated 10-year government
bond over the last year was 18%.
• The appropriate beta to use for the project is 1.3.
• The market risk premium is 6%.
• The risk-free interest rate is 4.5%.

Which of the following choices is closest to the appropriate country risk premium for Brazil and the
cost of equity that Ramsey should use in his analysis?

Country risk premium for Brazil Cost of equity for project

 A) 2.5% 15.6%
B) 2.5% 16.3%
C) 3.1% 16.3%

14. Manigault Industries currently has assets on its balance sheet of $200 million that are financed
with 70% equity and 30% debt. The executive management team at Manigault is considering a
major expansion that would require raising additional capital. Rosannna Stallworth, the CFO of
Manigault, has put together the following schedule for the costs of debt and equity:

Amount of new debt After Tax Cost of Debt Amount of new equity Cost of Equity
($millions) ($millions)
0 to 49 4.0% 0 to 99 7.0%
50 to 99 4.2% 100 to 199 8.0%
100 to 149 4.5% 200 to 299 9.0%
In a presentation to Manigault's Board of Directors, Stallworth makes the following statements:

Statement 1: If we maintain our target capital structure of 70% equity and 30% debt, the break point
at which our cost of equity will increase to 8.0% is $185 million in new capital.
Statement 2: If we want to finance total assets of $450 million, our marginal cost of capital will
increase to 7.56%.

Are Stallworth's Statements 1 and 2 most likely correct or incorrect?

Statement 1 Statement 2
A. Correct Correct
B. Incorrect Correct
C. Incorrect Incorrect

15. Black Pearl Yachts is considering a project that requires a $180,000 cash outlay and is expected to
produce cash flows of $50,000 per year for the next five years. Black Pearl's tax rate is 25%, and
the before-tax cost of debt is 8%. The current share price for Black Pearl's stock is $56 and the
expected dividend next year is $2.80 per share. Black Pearl's expected growth rate is 5%. Assume
that Black Pearl finances the project with 60% equity and 40% debt, and the flotation cost for
equity is 4.0%. Which of the following choices is closest to the dollar amount of the flotation costs
and the NPV for the project, assuming that flotation costs are accounted for properly?

Dollar amount of flotation costs NPV of project

A. $4,320 $17,548
B. $4,320 $13,228
C. $7,200 $17,548

16. Jay Company has a debt-to-equity ratio of 2.0. Jay is evaluating the cost of equity for a project in
the same line of business as Cass Company and will use the pure-play method with Cass as the
comparable firm. Cass has a beta of 1.2 and a debt-to-equity ratio of 1.6. The project beta most
likely:
A. Will be less than Jay Company's beta.
B. Will be greater than Jay Company's beta.
C. Could be greater than or less than Jay Company's beta.