Finance Practice Quiz 3
1. The target capital structure is the mix of debt, preferred stock, and common equity the firm plans to raise to fund its future projects. True or false?

2. Which of the following notations is the one for the component cost of retained earnings?
3. All else equal, which of the following is most likely to increase a company’s retained earnings breakpoint?





4. Suppose you must estimate the cost of equity for a firm, and you have the following data: rRF = 5.0%; rM – rRF = 4%; b = 0.9; D1 = $2.00; P0 = $50.00; g = 5%; and rd = the firm’s bond yield = 5.8%. What is this firm’s cost of equity using the CAPM approach?
5. One drawback of the bondyieldplusriskpremium approach is that it assumes that every company has the same cost of equity capital, regardless of its risk. True or false?

6. The cost of depreciationgenerated funds is approximately equal to the WACC calculated from retained earnings, preferred stock, and debt. True or false?

7. Among the following factors that affect the cost of capital, which can the firm most directly control?


8. Since the market has a hard time evaluating the risk of individual projects, corporate managers should not use a higher cost of capital to evaluate riskier projects. True or false?

9. Assume Company XYZ finances its capital projects using only longterm debt and common equity. Consequently, its capital structure consists of only longterm debt and common equity. If XYZ’s market value of equity exceeds its book value and its bonds sell at par value, its marketbased capital structure has a higher percentage of debt than the capital structure calculated using its accountingbased values. True or false?

10. A firm’s target capital structure consists of 10% debt and 90% common equity. It’s tax rate = 40%; rd = 6.5%; and rs = 9.5%. Assuming that the firm will not be issuing new stock, what is its WACC?
11. A company has outstanding longterm bonds with a face value of $1,000, a 7% coupon, and a 9% yield to maturity. If the company’s tax rate is 30%, what would its aftertax cost of debt be?
12. Suppose you must estimate the cost of equity for a firm, and you have the following data: rRF = 5.0%; rM – rRF = 4%; b = 0.9; D1 = $2.00; P0 = $50.00; g = 5%; and rd = the firm’s bond yield = 5.8%. What is this firm’s cost of equity using the bondyieldplusriskpremium approach? Assume a 3% judgmental risk premium in your calculation.
13. A firm has the following data: target capital structure of 50% debt and 50% common equity; tax rate = 40%; rd = 7.5%; and rs = 12%. Assume the firm will not be issuing new stock. What is this firm’s WACC?
14. When calculating the cost of capital, it is important to consider taxes. Consequently, the cost of preferred stock is the dividend yield on preferred stock multiplied by one minus the company’s tax rate. True or false?

15. The relevant beforetax cost of debt is the marginal cost of debt, which is the interest rate on new debt. True or false?

16. Barlett Co. has two divisions. Its risky division, Division R, has a WACC = 12%, while its safer division, Division S, has a WACC = 8%. Since the two divisions are the same size, the company’s composite WACC is 10%. A typical Division S project has a 9% expected return. Since the project’s return exceeds the division’s WACC, the company should accept the project even though its return is less than the company’s composite WACC. True or false?

17. Myers Corporation’s stock currently trades at $40 a share. Investors estimate that the yearend dividend will be $2.00 a share and that its dividend will grow at 5% a year (i.e., D1 = $2.00 and g = 5%). The company needs to issue new stock in order to fund its upcoming projects, and investment bankers estimate that the flotation cost will be 4%. What is Myers’ cost of new external equity?
18. All else equal, higher dividend payout ratios increase the amount of retained earnings available, which in turn reduces the likelihood that a firm will incur flotation costs. True or false?

19. A company’s perpetual preferred stock pays a $4.50 annual dividend per share, and it currently sells for $60 per share. If the company were to sell a new preferred issue, what would the cost of that capital be? Ignore flotation costs.
20. Suppose you must estimate the cost of equity for a firm, and you have the following data: rRF = 5.0%; rM – rRF = 4%; b = 0.9; D1 = $2.00; P0 = $50.00; g = 5%; and rd = the firm’s bond yield = 5.8%. What is this firm’s cost of equity using the DCF approach?
21. A company has outstanding longterm bonds with a face value of $1,000, a 7% coupon, and a 9% yield to maturity. If the company were to issue new debt, what is a reasonable estimate of the interest rate (rd) on that debt?
22.
The aftertax cost of debt is higher than its beforetax cost because of the tax disadvantages of debt financing. True or false?
