Duval Inc. uses only equity capital, and it has two equally-sized divisions.

  Division A’s cost of

capital is 10.0%, Division B’s cost is 14.0%, and the corporate (composite) WACC is 12.0%.  All of
Division A’s projects are equally risky, as are all of Division B's projects.  However, the projects
of Division A are less risky than those of Division B.  Which of the following projects should the
firm accept?

A Division B project with a 13%

return.

A Division B project with a 12% return.

A Division A project with an 11% return.

A Division A project with a 9% return.

Assume that you have been hired as a consultant by CGT, a major producer of chemicals and
plastics, including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's
weighted average cost of capital.  The balance sheet and some other information are provided
below.

The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year,
7.25% bonds with semiannual payments are selling for $875.00.  The beta is 1.25, the yield on a
6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%.  The required
return on the stock market is 11.50%, but the market has had an average annual return of
14.50% during the past 5 years.  The firm's tax rate is 40%.

Which of the following is the best estimate for the weight of debt for use in calculating the
WACC?

18.67%

19.60%

20.58%

21.61%

Schalheim Sisters Inc. has always paid out all of its earnings as dividends, hence the firm has no
retained earnings.  This same situation is expected to persist in the future.  The company uses
the CAPM to calculate its cost of equity, its target capital structure consists of common stock,
preferred stock, and debt.  Which of the following events would REDUCE its WACC?

The market risk premium

declines.

The flotation costs associated with issuing new common stock

increase.

The company’s beta increases.

Expected inflation increases.

Weaver Chocolate Co. expects to earn $3.50 per share during the current year, its expected
dividend payout ratio is 65%, its expected constant dividend growth rate is 6.0%, and its
common stock currently sells for $32.50 per share.  New stock can be sold to the public at the
current price, but a flotation cost of 5% would be incurred.  What would be the cost of equity
from new common stock?

12.70%

13.37%

14.04%

14.74%
The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the
market price of the preferred stock.  No adjustment is needed for taxes because preferred
dividends, unlike interest on debt, are not deductable by the issuing firm.

 True

 False

For capital budgeting and cost of capital purposes, the firm should always consider retained
earnings as the first source of capital--i.e., use these funds first--because retained earnings have
the cheapest cost to the firm.

 True

 False

When discussing weighing schemes for calculating the weighted average cost of capital,
________.

market value weights are preferred over book value weights and target weights are preferred
over historical weights

book value weights are preferred over market value weights and target weights are preferred
over historical weights

book value weights are preferred over market value weights and historical weights are
preferred over target weights

market value weights are preferred over book value weights and historical weights are
preferred over target weights

The cost of capital used in capital budgeting should reflect the average cost of the various
sources of investor-supplied funds a firm uses to acquire assets.

 True

 False
For a typical firm, which of the following sequences is CORRECT?  All rates are after taxes, and
assume that the firm operates at its target capital structure.

rs : Cost of equities- new stock issuance

re : Cost of equities- retained earnings
rd : Cost of debts
WACC: Weigthed average costs of capital

rs > re > rd > WACC.

re > rs > WACC > rd.
WACC > re > rs > rd.
rd > re > rs > WACC.

Assume that you are a consultant to Broske Inc., and you have been provided with the following
data:  D1 = $0.67; P0 = $27.50; and g = 8.00% (constant).  What is the cost of equity from
retained earnings based on the DCF approach?
9.42%

9.91%

10.44%

10.96%

Assume that you have been hired as a consultant by CGT, a major producer of chemicals and
plastics, including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's
weighted average cost of capital.  The balance sheet and some other information are provided
below.
The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year,
7.25% bonds with semiannual payments are selling for $875.00.  The beta is 1.25, the yield on a
6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%.  The required
return on the stock market is 11.50%, but the market has had an average annual return of
14.50% during the past 5 years.  The firm's tax rate is 40%.

1a)Based on the CAPM, what is the firm's cost of equity?

11.15%

11.73%

12.35%

13.00%

1b)What is the best estimate of the after-tax cost of debt?

4.64%

4.88%

5.14%

5.40%
1c) What is the best estimate of the firm's WACC?

10.85%

11.19%

11.53%

11.88%

The firm's cost of external equity raised by issuing new stock is the same as the required rate of
return on the firm's outstanding common stock.

 True

 False

The constant-growth valuation model is based on the premise that the value of a share of
common stock is ________.

the sum of the dividends and expected capital appreciation

determined based on an industry standard P/E multiple

determined by using a measure of relative risk called correlation coefficient

equal to the present value of all expected future dividends

O'Brien Inc. has the following data:  rRF = 5.00%; RPM = 6.00%; and b = 1.05.  What is the firm's
cost of equity from retained earnings based on the CAPM?

11.30%

11.64%

11.99%

12.35%
One of the circumstances in which the Gordon growth valuation model for estimating the value
of a share of stock should be used is ________.

declining dividends

an erratic dividend stream

the lack of data on dividend payments

a steady growth rate in dividends

Debt is generally the least expensive source of capital. This is primarily due to ________.

the fixed interest payments

the priority of claims on assets and earnings in the event of liquidation

the tax deductibility of interest payments

the secured nature of a debt obligatio

If a corporation has an average tax rate of 40 percent, the approximate annual, after-tax cost of
debt for a 10-year, 8 percent, $1,000 par value bond selling at $1,150 is ________.

3.6 percent

4.8 percent

6 percent

8 percent

To help finance a major expansion, Castro Chemical Company sold a noncallable bond several
years ago that now has 20 years to maturity.  This bond has a 9.25% annual coupon, paid
semiannually, sells at a price of $1,075, and has a par value of $1,000.  If the firm's tax rate is
40%, what is the component cost of debt for use in the WACC calculation?

4.35%

4.58%

4.83%

5.08%

The before-tax cost of debt, which is lower than the after-tax cost, is used as the component

cost of debt for purposes of developing the firm's WACC.

 True

 False

Which of the following statements is CORRECT?

When calculating the cost of preferred stock, a company needs to adjust for taxes, because
preferred stock dividends are deductible by the paying corporation.

All else equal, an increase in a company’s stock price will increase its marginal cost of retained
earnings.

Since the money is readily available, the after-tax cost of retained earnings is usually much
lower than the after-tax cost of debt.
If a company’s tax rate increases, the after-tax cost of its debt will fall.

Bosio Inc.'s perpetual preferred stock sells for $97.50 per share, and it pays an $8.50 annual
dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of
0%.  What is the company's cost of preferred stock for use in calculating the WACC?

8.72%

9.08%

9.44%

9.82%

Which of the following statements is CORRECT?

The WACC as used in capital budgeting is an estimate of a company’s before-tax cost of

capital.

The percentage flotation cost associated with issuing new common equity is typically smaller
than the flotation cost for new debt.

The WACC as used in capital budgeting is an estimate of the cost of all the capital a company
has raised to acquire its assets.

There is an “opportunity cost” associated with using retained earnings, hence they are not
“free.”

The cost of common stock equity is ________.

the cost of the guaranteed stated dividend expected by the stockholders

the rate at which investors discount the expected dividends of the firm to determine its share
value

the after-tax cost of the interest obligations

the historical cost of floating the stock issue