Answer Options:
a. True
b. False
Answer: True
Question: 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.
Answer Options:
a. True
b. False
Answer: False
Question: Which of the following statements is CORRECT?
Answer Options:
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.
Answer: 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.
Question: 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.
Answer Options:
a. True
b. False
Answer: True
Question: 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.
Answer Options:
a. True
b. False
Answer: False
Question: 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 no cost to the firm.
Answer Options:
a. True
b. False
Answer: False
Question: Which of the following statements is CORRECT?
Answer Options:
a. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.
b. When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.
c. Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM.
d. If a company’s beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence must issue new common stock.
Answer: A. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.
Question: When working with the CAPM, which of the following factors can be determined with the most precision?
Answer Options:
a. The market risk premium (RPM).
b. The beta coefficient, bi, of a relatively safe stock.
c. The most appropriate risk-free rate, RRF.
d. The expected rate of return on the market, rM.
e. The beta coefficient of “the market,” which is the same as the beta of an average stock.
Answer: E. The beta coefficient of “the market,” which is the same as the beta of an average stock.
Question: LaPango Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?
Answer Options:
a. Project B, which is of below-average risk and has a return of 8.5%.
b. Project C, which is of above-average risk and has a return of 11%.
c. Project A, which is of average risk and has a return of 9%.
d. None of the projects should be accepted.
e. All of the projects should be accepted.
Answer: A. Project B, which is of below-average risk and has a return of 8.5%.
Question: 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.
Answer Options:
a. True
b. False
Answer: False
Question: In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project.
Answer Options:
a. True
b. False
Answer: False
Question: The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm’s common stock.
Answer Options:
a. True
b. False
Answer: True