Name: ________________________ Class: ___________________ Date: __________ ID: A

Petoskey Ch 10

____ 1. "Capital" is sometimes defined as funds supplied to a firm by investors.

____ 2. 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.

____ 3. The component costs of capital are market-determined variables in the sense that they are based on investors'
required returns.

____ 4. The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends
received by a corporation may be excluded from the receiving corporation's taxable income.

____ 5. Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest
payments associated with them, and no flotation costs are required to raise them, but capital raised by selling
new stock or bonds does have a cost.

____ 6. The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external
equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of
investors, and other factors.

____ 7. The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock,
which has no flotation cost, and retained earnings, whose cost is the average return on the assets that are
acquired.

____ 8. The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM
method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the DCF method is
widely used in practice.

____ 9. The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM
method, the DCF method, and the bond-yield-plus-risk-premium method. Since we cannot be sure that the
estimate obtained with any of these methods is correct, it is often appropriate to use all three methods, then
consider all three estimates, and end up using a judgmental estimate when calculating the WACC.

____ 10. When estimating the cost of equity by use of the DCF method, the biggest potential problem is to determine
the growth rate that investors use when they estimate a stock's expected future rate of return. This problem
leaves us unsure of the true value of rs.

____ 11. Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital
markets. They then provide funds to their different divisions for investment in capital projects. The
divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is
conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.

____ 12. The cost of debt, rd, is normally less than rs, so rd(1 - T) will normally be much less than rs. Therefore, as long
as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be
greater than rd(1 - T).

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Name: ________________________ ID: A

____ 13. The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held
constant.

____ 14. If expectations for long-term inflation rose, but the slope of the SML remained constant, this would have a
greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for
most firms. Therefore, the percentage point increase in the cost of equity would be greater than the increase
in the interest rate on long-term debt.

____ 15. If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact
on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms.
Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of
equity. However, other things would not stay constant if firms used a lot more debt, as that would increase
the riskiness of both debt and equity and thus limit the shift toward debt.

____ 16. Which of the following is NOT a capital component when calculating the weighted average cost of capital
(WACC)for use in capital budgeting?
a. Long-term debt.
b. Accounts payable.
c. Retained earnings.
d. Common stock.
e. Preferred stock.

____ 17. Which of the following statements is CORRECT?

a. When calculating the cost of preferred stock, a company needs to adjust for taxes,
because preferred stock dividends are deductible by the paying corporation.
b. All else equal, an increase in a company’s stock price will increase its marginal cost of
retained earnings, rs.
c. All else equal, an increase in a company’s stock price will increase its marginal cost of
new common equity, re.
d. Since the money is readily available, the after-tax cost of retained earnings is usually
much lower than the after-tax cost of debt.
e. If a company’s tax rate increases but the YTM on its noncallable bonds remains the
same, the after-tax cost of its debt will fall.

____ 18. Which of the following statements is CORRECT?

a. The WACC as used in capital budgeting is an estimate of a company’s before-tax cost of
capital.
b. The percentage flotation cost associated with issuing new common equity is typically
smaller than the flotation cost for new debt.
c. 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.
d. There is an “opportunity cost” associated with using retained earnings, hence they are
not “free.”
e. The WACC as used in capital budgeting would be simply the after-tax cost of debt if the
firm plans to use only debt to finance its capital budget during the coming year.

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Name: ________________________ ID: A

____ 19. Cranberry Corp. has two divisions of equal size: a computer manufacturing division and a data processing
division. Its CFO believes that stand-alone data processor companies typically have a WACC of 8%, while
stand-alone computer manufacturers typically have a 12% WACC. He also believes that the data processing
and manufacturing divisions have the same risk as their typical peers. Consequently, he estimates that the
composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the data
processing division and a 12% hurdle rate for the manufacturing division. However, the CFO disagrees, and
he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is
CORRECT?
a. While the decision to use just one WACC will result in its accepting more projects in the
manufacturing division and fewer projects in its data processing division than if it
followed the consultant’s recommendation, this should not affect the firm’s intrinsic
value.
b. The decision not to adjust for risk means, in effect, that it is favoring the data processing
division. Therefore, that division is likely to become a larger part of the consolidated
company over time.
c. The decision not to adjust for risk means that the company will accept too many projects
in the manufacturing division and too few in the data processing division. This will lead
to a reduction in the firm’s intrinsic value over time.
d. The decision not to risk adjust means that the company will accept too many projects in
the data processing business and too few projects in the manufacturing business. This
will lead to a reduction in its intrinsic value over time.
e. The decision not to risk adjust means that the company will accept too many projects in
the manufacturing business and too few projects in the data processing business. This
may affect the firm’s capital structure but it will not affect its intrinsic value.

____ 20. Which of the following statements is CORRECT?

a. The cost of capital used to evaluate a project should be the cost of the specific type of
financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used
to finance the project or the cost of equity if the project will be financed with equity.
b. The after-tax cost of debt that should be used as the component cost when calculating the
WACC is the average after-tax cost of all the firm’s outstanding debt.
c. Suppose some of a publicly-traded firm’s stockholders are not diversified; they hold only
the one firm’s stock. In this case, the CAPM approach will result in an estimated cost of
equity that is too low in the sense that if it is used in capital budgeting, projects will be
accepted that will reduce the firm’s intrinsic value.
d. The cost of equity is generally harder to measure than the cost of debt because there is no
stated, contractual cost number on which to base the cost of equity.
e. The bond-yield-plus-risk-premium approach is the most sophisticated and objective
method for estimating a firm’s cost of equity capital.

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Name: ________________________ ID: A

____ 21. Which of the following statements is CORRECT?

a. The bond-yield-plus-risk-premium approach to estimating the cost of common equity
involves adding a risk premium to the interest rate on the company’s own long-term
bonds. The size of the risk premium for bonds with different ratings is published daily in
The Wall Street Journal.
b. The WACC is calculated using a before-tax cost for debt that is equal to the interest rate
that must be paid on new debt, along with the after-tax costs for common stock and for
preferred stock if it is used.
c. An increase in the risk-free rate is likely to reduce the marginal costs of both debt and
equity.
d. The relevant WACC can change depending on the amount of funds a firm raises during a
given year. Moreover, the WACC at each level of funds raised is a weighted average of
the marginal costs of each capital component, with the weights based on the firm’s target
capital structure.
e. Beta measures market risk, which is generally the most relevant risk measure for a
publicly-owned firm that seeks to maximize its intrinsic value. However, this is not true
unless all of the firm’s stockholders are well diversified.

____ 22. Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D1 =
$0.67; P0 = $42.50; and g = 8.00% (constant). What is the cost of equity from retained earnings based on the
DCF approach?
a. 11.30%
b. 9.58%
c. 9.96%
d. 11.68%
e. 7.95%

____ 23. 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
$50.00 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?
a. 10.79%
b. 12.73%
c. 10.68%
d. 9.28%
e. 13.38%

____ 24. The CFO of Lenox Industries hired you as a consultant to help estimate its cost of capital. You have
obtained the following data: (1) rd = yield on the firm’s bonds = 7.00% and the risk premium over its own
debt cost = 4.00%. (2) rRF = 5.00%, RPM = 6.00%, and b = 1.45. (3) D1 = $1.20, P0 = $35.00, and g = 8.00%
(constant). You were asked to estimate the cost of equity based on the three most commonly used methods
and then to indicate the difference between the highest and lowest of these estimates. What is that
difference?
a. 2.70%
b. 2.13%
c. 2.92%
d. 3.11%
e. 2.59%

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Name: ________________________ ID: A

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.
Assets
Current assets $38,000,000
Net plant, property, and equipment $101,000,000
Total assets $139,000,000
Liabilities and Equity
Accounts payable $10,000,000
Accruals $9,000,000
Current liabilities $19,000,000
Long-term debt (40,000 bonds, $1,000 par value) $40,000,000
Total liabilities $59,000,000
Common stock (10,000,000 shares) $30,000,000
Retained earnings $50,000,000
Total shareholders' equity $80,000,000
Total liabilities and shareholders' equity $139,000,000

The stock is currently selling for $15.00 per share, and its noncallable $1,000 par value, 20-year, 7.25%
bonds with semiannual payments are selling for $1,150.00. The beta is 1.35, 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%.

____ 25. Which of the following is the best estimate for the weight of debt for use in calculating the WACC?
a. 29.34%
b. 23.47%
c. 28.87%
d. 25.11%
e. 20.42%

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Petoskey Ch 10
Answer Section

1. ANS: T PTS: 1 DIF: EASY NAT: Reflective thinking

LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (10-1) Capital
2. ANS: T PTS: 1 DIF: EASY NAT: Reflective thinking
LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (10-1) Cost of capital
3. ANS: T PTS: 1 DIF: EASY NAT: Reflective thinking
LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (10-2) Component capital costs
4. ANS: F PTS: 1 DIF: EASY NAT: Reflective thinking
LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (10-4) Cost of preferred
5. ANS: F PTS: 1 DIF: EASY NAT: Reflective thinking
LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (10-5) Cost of retained earnings
6. ANS: F PTS: 1 DIF: EASY NAT: Reflective thinking
LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (10-5) Cost of retained earnings
7. ANS: F PTS: 1 DIF: EASY NAT: Reflective thinking
LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (Comp.) Flotation and capital
8. ANS: F
None of the methods always provides accurate and reliable estimates. With the CAPM, we don't know the
beta that investors are using, we are not totally sure of what rRF to use, and we don't know if the CAPM is
truly correct.

PTS: 1 DIF: MEDIUM NAT: Reflective thinking

LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (10-5) Cost of equity estimates
9. ANS: T
Unfortunately, this is true.

PTS: 1 DIF: MEDIUM NAT: Reflective thinking

LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (10-5) Cost of equity estimates
10. ANS: T
Unfortunately, this is true.

PTS: 1 DIF: MEDIUM NAT: Reflective thinking

LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (10-5) Cost of equity estimates
11. ANS: T PTS: 1 DIF: MEDIUM NAT: Reflective thinking
LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (10-9) Risk-adjusted capital cost

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 ID: A

12. ANS: T PTS: 1 DIF: MEDIUM NAT: Reflective thinking

LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (Comp.) WACC
13. ANS: F PTS: 1 DIF: MEDIUM NAT: Reflective thinking
LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (Comp.) Taxes, rd(1 - T), and WACC
14. ANS: F
Increased inflation results in a parallel upward shift in the SML, which means equal percentage increases in
the required returns on debt and equity.

PTS: 1 DIF: MEDIUM NAT: Reflective thinking

LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (Comp.) Inflation effects
15. ANS: T PTS: 1 DIF: MEDIUM NAT: Reflective thinking
LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (Comp.) Inflation effects
16. ANS: B PTS: 1 DIF: EASY NAT: Analytic skills
LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (10-2) Capital components
17. ANS: E PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (Comp.) Capital components
18. ANS: D PTS: 1 DIF: MEDIUM NAT: Analytic skills
LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (Comp.) WACC
19. ANS: C
By not making the risk adjustment, the firm will accept too many projects in the manufacturing division and
too few in the data processing division. As a result, the company will become riskier overall, raising its cost
of capital. Investors will discount the firm's cash flows at a higher rate, and the firm’s intrinsic value will
fall. Therefore, statement c is true and all other statements are false.

PTS: 1 DIF: HARD NAT: Analytic skills

LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (10-9) Risk-adjusted capital cost
20. ANS: D PTS: 1 DIF: HARD NAT: Analytic skills
LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (Comp.) Cost of capital
21. ANS: D PTS: 1 DIF: HARD NAT: Analytic skills
LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (Comp.) WACC

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22. ANS: B
D1 $0.67
P0 $42.50
g 8.00%

rs = D1/P0 + g 9.58%

PTS: 1 DIF: EASY NAT: Analytic skills

LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (10-5) Cost of RE: DCF
23. ANS: A
Expected EPS1 $3.50
Payout ratio 65%
Expected dividend, D1 = EPS × Payout $2.275
Current stock price $50.00
g 6.00%
F 5.00%

re = D1/(P0 × (1 - F)) + g 10.79%

PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (10-6) Cost of new common
24. ANS: A
Bond yield 7.00%
Risk premium 4.00%
rs 11.00%

rRF 5.00%
RPM 6.00%
b 1.45
rs 13.70%

rs 12.50%
D1 $1.20
P0 $35.00
g 8.00%
rs 11.43%

Max 13.70%
Min 11.00%
Difference 2.70%

PTS: 1 DIF: HARD NAT: Analytic skills

LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (10-5) Risk premium, CAPM, and DCF

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25. ANS: B
Bond price $1,150.00
Number of bonds 40,000
MV of debt = D $46,000,000
Stock price = P0 $15.00
Shares outstanding 10,000,000
MV of equity = E $150,000,000
Total MV = D + E $196,000,000

Weight debt = wd = D/Total MV 23.47%

PTS: 1 DIF: MEDIUM NAT: Analytic skills

LOC: Students will acquire knowledge of capital budgeting and the cost of capital.
TOP: (10-7) Weights for WACC