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Exam 9: The Cost of Capital

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Question 51

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Which of the following is a source of long-term funds?

A) commercial paper
B) retained earnings
C) factoring
D) money market instruments

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Question 52

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

A) market value weights are preferred over book value weights and target weights are preferred over historical weights
B) book value weights are preferred over market value weights and target weights are preferred over historical weights
C) book value weights are preferred over market value weights and historical weights are preferred over target weights
D) market value weights are preferred over book value weights and historical weights are preferred over target weights

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Question 53

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A firm's flotation cost can be calculated by weighting the cost of each source of financing by its relative proportion in a firm's target capital structure.

The capital asset pricing model is used to calculate the effect of increase in prices of capital assets due to inflation.

The cost of new common stock financing is higher than the cost of retained earnings due to ________.

The cost of preferred stock is the ratio of the preferred stock dividend to a firm's total earnings.

The cost of capital is used to decide whether a proposed corporate investment will increase or decrease a firm's stock price.

Table 9.2 A firm has determined its optimal structure which is composed of the following sources and target market value proportions. Debt: The firm can sell a 15-year, $1,000 par value, 8 percent bond for $1,050. A flotation cost of 2 percent of the face value would be required in addition to the premium of $50. Common Stock: A firm's common stock is currently selling for $75 per share. The dividend expected to be paid at the end of the coming year is $5. Its dividend payments have been growing at a constant rate for the last five years. Five years ago, the dividend was $3.10. It is expected that to sell, a new common stock issue must be underpriced $2 per share and the firm must pay $1 per share in flotation costs. Additionally, the firm has a marginal tax rate of 40 percent. -The firm's cost of a new issue of common stock is ________. (See Table 9.2)

In computing the cost of retained earnings, the net proceeds represents the amount of money retained net of any underpricing and/or flotation costs.

Table 9.2 A firm has determined its optimal structure which is composed of the following sources and target market value proportions. Debt: The firm can sell a 15-year, $1,000 par value, 8 percent bond for $1,050. A flotation cost of 2 percent of the face value would be required in addition to the premium of $50. Common Stock: A firm's common stock is currently selling for $75 per share. The dividend expected to be paid at the end of the coming year is $5. Its dividend payments have been growing at a constant rate for the last five years. Five years ago, the dividend was $3.10. It is expected that to sell, a new common stock issue must be underpriced $2 per share and the firm must pay $1 per share in flotation costs. Additionally, the firm has a marginal tax rate of 40 percent. -The weighted average cost of capital up to the point when retained earnings are exhausted is ________. (See Table 9.2)

The weighted average cost that reflects the interrelationship of financing decisions can be obtained by weighing the cost of each source of financing by the target proportion in a firm's capital structure.

The weighted average cost of capital refers to the cost of capital required for one additional dollar of financing.

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 ________.

The cost of capital reflects the cost of funds over the long run measured at a given point in time, based on the best information available.

The cost of common stock equity is ________.

The net proceeds used in calculation of the cost of long-term debt are funds actually received from the sale after paying for flotation costs and taxes.

A firm has issued preferred stock at its $125 per share par value. The stock will pay a $15 annual dividend. The cost of issuing and selling the stock was $4 per share. The cost of the preferred stock is ________.

A firm may face increase in the weighted average cost of capital either when retained earnings have been exhausted or due to increases in debt, preferred stock, and common equity costs as additional new funds are required.

Since retained earnings is a more expensive source of financing than debt and preferred stock, the weighted average cost of capital will fall once retained earnings have been exhausted.

Weights that use accounting values to measure the proportion of each type of capital in a firm's financial structure are called market value weights.