Part I Concepts

Instruction: Shade the letter that corresponds to your answer. Use the answer sheet above.

1. Which of these statements are pertinent to cost of capital?

1. It is the return that investors demand for a given level of risk.
2. It may be employed as a benchmark for the evaluation of performance.
3. For investments decisions, it must be based on the current or prospective cost of the various capital
components rather on their historical costs.
4. It may also be used in acquisition analysis, liquidation studies and source of financing decisions.
5. It may differ from the hurdle rate used to reflect the alternative risk attributed to a specific project,
decision, or business unit.

a. All five statements. c. Statements 1,2,3 and 4 only.

b. Statements 1,2 and 3 only. d. Statements 1,2,4 and 5 only.

2. EF Company has made the decision it finance nest years capital projects through debt rather than additional
equity. The benchmark cost of capital for these projects should be.
a. The before-tax costs of new-debt financing.
b. The after-tax costs of new-debt financing.
c. The cost of equity financing.
d. The weighted-average cost of capital.

2. The minimum return that a project must earn for a company in order to leave the value of the company
unchanged is the.

a. Current borrowing rate. c. Discount rate.

b. Capitalization rate. d. Cost of capital.
a.
3. A firm must select from among several methods of financing arrangements when meeting its capital
requirements. To acquire additional growth capital while attempting to maximize earnings per share, a firm
should normally.
a. Attempt to increase both debt and equity in equal proportions, which preserves a stable capital structure
and maintains investors confidence.
b. Select debt over equity initially, even through increased debt is accompanied by interest cost and a
degree of risk.
c. Select equity over debt initially, which minimizes risk and avoids the interest costs.
d. Discontinue dividends and use current cash flow, which avoids the cost and risk of increased debt and
the dilution of EPS through increased equity.
b.
4. A firms capital structure
a. Minimizes the firms tax liability. leverage.
b. Minimizes firms risk. d. Maximizes the price of the firms stock.
c. Maximizes the firms degree of financial
e.
5. If K is the cost of debt and t is the marginal tax rate, the after-tax cost of debt. ki, is the best represented by
the formula
f. a. ki = k/t c. ki = k(t)
g. b. ki = k/(1-t). d. ki = k(1-t)
h.
6. The three elements needed to estimate the cost of equity capital for use in determining a firm's weighted-
average cost of capital are
a. Current dividends per share, expected growth rate in dividends per share, and, current book value per
share of common stock.
b. Current earnings per share, expected growth rate in dividends per share, and current market price per
share of common stock.
c. Current earnings per share, expected growth rate in earnings per share, and current book value per share
of common stock.
d. Current dividends per share, expected growth rate in dividends per share, the current market
price per share of common its.
i.
7. The explicit cost of debt financing is the interest expense. The implicit cost (s) of debt financing is (are) the
a. Increase in the cost of debt as the debt-to-equity ratio increases.
b. Increases in the cost of debt and equity as the debt-to-equity ratio increases.
c. Increase in the cost of equity as the debt-to-equity ratio decrease.
 d. Decrease in the weighted-average cost of capital as the debt-to-equity ratio increase.
j.
8. All of the following are examples of imputed costs except.
a. The stated interest paid on a bank loan.
b. The use of the firms internal cash funds to purchase assets.
c. Assets that are considered obsolete that maintain a net book value.
d. Decelerated depreciation
k.
9. Assume that nominal interest has just increased substantially but that the expected future dividends for a
company over the long run were not affected. As a result of the increase in nominal interest rates, the
companys stock price should
a. Increase c. Decrease
b. Stay constant d. Change, but in no obvious direction.
e.
10. In general, it is more expensive for a company to finance with equity capital than in debt capital because.
a. Long-term bonds have a maturity date and must therefore be repaid in the future.
b. Investors are exposed to greater risk with equity capital
c. Equity capital is in greater demand than debt capital
d. Dividends fluctuate to a greater extent than interest rates.
f.
11. If company has a higher dividend-payout ratio, then, if all else is equal, it will have
a. A higher marginal cost of capital c. A higher investment opportunity schedule.
b. A lower marginal cost of capital d. A lower investment opportunity schedule.
e.
12. The expected return on Natter Corporations stock is 14%. The stocks dividend is expected to grow at a
constant rate of 8%, and it currently sells for P50 a share. Which of the following statements is CORRECT?
f. a. The stocks dividend yield is 7%.
g. b. The stocks dividend yield is 8%.
h. c. The current dividend per share is P4.00.
i. d. The stock price is expected to be P54 a share one year from now.
j.
13. Which of the following statements is CORRECT?
k. a. Preferred stockholders have a priority over bondholders in the event of bankruptcy to the
income, but not to the proceeds in a liquidation.
l. b. The preferred stock of a given firm is generally less risky to investors than the same firms
common stock.
m. c. Corporations cannot buy the preferred stocks of other corporations.
n. d. Preferred dividends are not generally cumulative.
o.
14. Which of the following statements is CORRECT?
p. a. A major disadvantage of financing with preferred stock is that preferred stockholders typically
have supernormal voting rights.
q. b. Preferred stock is normally expected to provide steadier, more reliable income to investors
than the same firms common stock, and, as a result, the expected after-tax yield on the preferred
is lower than the after-tax expected return on the common stock.
r. c. The preemptive right is a provision in all corporate charters that gives preferred stockholders the
right to purchase (on a pro rata basis) new issues of preferred stock.
s. d. One of the disadvantages to a corporation of owning preferred stock is that 70% of the
dividends received represent taxable income to the corporate recipient, whereas interest income earned
on bonds would be tax free.
t.
15. Which of the following statements is CORRECT?
u. a. If a company has two classes of common stock, Class A and Class B, the stocks may pay
different dividends, but under all state charters the two classes must have the same voting rights.
v. b. The preemptive right gives stockholders the right to approve or disapprove of a merger between
their company and some other company.
w. c. The preemptive right is a provision in the corporate charter that gives common
stockholders the right to purchase (on a pro rata basis) new issues of the firm's common stock.
x. d. The stock valuation model, P0 = D1/(rs - g), cannot be used for firms that have negative growth
rates.
y.
16. Gary, Inc. is planning to use retained earrings to finance anticipated capital expenditures. The beta
coefficient for Gary's stock is 1.157. The risk free rate of interest is 8.5%, and the market return is estimated
at 12.4%. If a new issue of common stock where used in the model, the flotation costs would be 7%.By
 using the capital asset pricing model (CAPM) equation [R = RF + (RM RF)], the cost of using retained
earnings to finance the capital expenditures is
a. 13.21% c. 12.99%
b. 12.40% d. 14.26%
e.
17. KG Inc. has the following mix of funds and costs:
f. Type Amount Cost
g. Debt P150,000 18%
h. Preferred stock 500,000 15
i. Common equity 700,000 12
j. Total funds P1,350,000
k.
l. What is KGs cost of capital?
a. 13.78% c. 12.22%
b. 15.22% d. 13.22%
e.
18. Newmass, Inc. paid cash dividends to its common shareholders over the past 12 months at P2.20 per share.
The current market value of the common stocks is P40 per share and investors are anticipating the common
dividends to grow at a rate of 6% annually. The cost to issue new common stocks will be 5% of the market
value. The cost of new common stock will be
a. 11.50% c. 7.9%
b. 11 .83% d. 2.14%
e.
19. Schnusenberg Corporation just paid a dividend of D0 = P0.75 per share, and that dividend is expected to
grow at a constant rate of 6.50% per year in the future. The company's beta is 1.25, the required return on
the market is 10.50%, and the risk-free rate is 4.50%. What is the company's current stock price?
f. a. P14.52 h. c. P15.26
g. b. P14.89 i. d. P15.64
j.
20. Goode Inc.'s stock has a required rate of return of 11.50%, and it sells for P25.00 per share. Goode's
dividend is expected to grow at a constant rate of 7.00%. What was the last dividend, D0?
k. a. P0.95 m. c. P1.16
l. b. P1.05 n. d. P1.27
o.
21. Francis Inc.'s stock has a required rate of return of 10.25%, and it sells for P57.50 per share. The dividend is
expected to grow at a constant rate of 6.00% per year. What is the expected year-end dividend, D 1?
p. a. P2.20 r. c. P2.69
q. b. P2.44 s. d. P2.96
t.
22. Sorenson Corp.s expected year-end dividend is D1 = P1.60, its required return is rs = 11.00%, its dividend
7
yield is 6.00%, and its growth rate P is expected to be constant in the future. What is Sorenson's expected
stock price in 7 years, i.e., what is ?
u. a. P37.52 w. c. P41.37
v. b. P39.40 x. d. P43.44
y.
23. The Francis Company is expected to pay a dividend of D1 = P1.25 per share at the end of the year, and that
dividend is expected to grow at a constant rate of 6.00% per year in the future. The company's beta is 1.15,
the market risk premium is 5.50%, and the risk-free rate is 4.00%. What is the company's current stock
price?
z. a. P28.90 ab. c. P30.36
aa. b. P29.62 ac. d. P31.12
ad.
24. The Isberg Company just paid a dividend of P0.75 per share, and that dividend is expected to grow at a
constant rate of 5.50% per year in the future. The company's beta is 1.15, the market risk premium is
5.00%, and the risk-free rate is 4.00%. What is the company's current stock price, P 0?
ae. a. P18.62 ag. c. P19.56
af. b. P19.08 ah. d. P20.05
ai.
25. Whited Inc.'s stock currently sells for P35.25 per share. The dividend is projected to increase at a constant
rate of 4.75% per year. The required rate of return on the stock, r s, is 11.50%. What is the stock's expected
price 5 years from now?
aj. a. P40.17 al. c. P42.26
ak. b. P41.20 am.d. P44.46
an.