The stock of Fargo Co. is selling for $85. The next annual dividend is expected to be $4.25 and is expected to grow at a rate of 7%. The corporate tax rate is 30%. What is the firm's cost of common equity?

a.

7.0%

b.

8.4%.

c.

12.0%.

d.

5.0%

Choice "c" is correct. Under the discounted cash flow (DCF) method, the cost of equity is computed as:

Cost of equity

=

Expected dividend / Current share price + Growth rate

=

$4.25 / $85 + 0.07

=

0.05 + 0.07

=

0.12

Choice "b" is incorrect. The proposed solution is incorrect because the cost of equity is not computed on an after-tax basis. Dividends are not tax deductible.

Choice "a" is incorrect. The growth rate of the stock (7%) does not, by itself, represent the cost of equity capital. The proposed solution excludes the costs of dividends.

Choice "d" is incorrect. The dividend rate of the stock (5%) does not, by itself, represent the cost of equity capital. The proposed solution excludes the costs of growth.

Which of the following statements is correct regarding the weighted-average cost of capital (WACC)?

a.

An increase in the WACC increases the value of the company.

b.

WACC is always equal to the company's borrowing rate.

c.

One of a company's objectives is to minimize the WACC.

d.

A company with a high WACC is attractive to potential shareholders.

Choice "c" is correct. The optimal capital structure is the mix of financing instruments that produces the lowest WACC.

Choice "d" is incorrect. The opposite is true. A low WACC would indicate to potential shareholders that the company is being managed to produce the highest stockholder value.

Choice "a" is incorrect. The opposite is true. The mixture of debt and equity securities that produce the lowest WACC maximizes the value of the company.

Choice "b" is incorrect. The company's borrowing rate is a component of the WACC. Be careful of always, all, never, etc., answer choices. These answers are usually incorrect answer choices.

The capital structure of a firm includes bonds with a coupon rate of 12% and an effective interest rate of 14%. The corporate tax rate is 30%. What is the firm's net cost of debt?

a.

9.8%

b.

12.0%

c.

8.4%

d.

14.0%

Choice "a" is correct. The net cost of debt is computed as the effective interest rate net of tax, or 14% × .70 = 9.8%. The question is trying to trick the candidate into using the coupon rate of 12% rather than the effective interest rate. The coupon rate is used only if it is the same as the effective interest rate and there are no flotation costs.

Choice "c" is incorrect. The net cost of debt is computed as the effective interest rate net of tax, or 14% × .70 = 9.8%, not the coupon rate of 12% × .70 = 8.4%.

Choice "b" is incorrect. The net cost of debt is computed as the effective interest rate net of tax, or 14% × .70 = 9.8%, not the coupon rate of 12% by itself. The cost of debt is computed on an after-tax basis and uses the effective interest rate instead of the coupon rate.

Choice "d" is incorrect. The net cost of debt is computed as the effective interest rate net of tax, or 14% × .70 = 9.8%, not the effective interest rate of 14% by itself. The cost of debt is computed on an after-tax basis.

Which one of the following factors might cause a firm to increase the debt in its financial structure?

a.

A decrease in the times interest earned ratio.

b.

An increase in the corporate income tax rate.

c.

Increased economic uncertainty.

d.

An increase in the price/earnings ratio.

Choice "b" is correct. An increase in the corporate income tax rate might cause a firm to increase the debt in its financial structure because interest is tax deductible, while dividends are not tax deductible.

Choice "c" is incorrect. Increased economic uncertainty would cause a firm to decrease debt (and interest cost).

Choice "d" is incorrect. An increase in the price/earnings ratio would encourage the issuance of equity rather than debt.

Choice "a" is incorrect. A decrease in the times interest earned ratio indicates that earnings have declined compared with interest, and that more debt would be unwise (and more difficult to negotiate).

The benefits of debt financing over equity financing are likely to be highest in which of the following situations?

a.

High marginal tax rates and many noninterest tax benefits.

b.

High marginal tax rates and few noninterest tax benefits.

c.

Low marginal tax rates and few noninterest tax benefits.

d.

Low marginal tax rates and many noninterest tax benefits.

Choice "b" is correct. The benefits of debt financing over equity financing are likely to be highest if marginal tax rates are high (because interest on debt is deductible for tax purposes) and if there are few noninterest tax benefits (because there is little or no reason to depart from debt financing).

Choice "c" is incorrect. The benefits of debt financing over equity financing are likely to be highest if marginal tax rates are high, not low (because interest on debt is deductible for tax purposes), and if there are few noninterest tax benefits.

Choice "a" is incorrect. The benefits of debt financing over equity financing are likely to be highest if marginal tax rates are high (because interest on debt is deductible for tax purposes) and if there are few, not many, noninterest tax benefits.

Choice "d" is incorrect. The benefits of debt financing over equity financing are likely to be highest if marginal tax rates are high, not low (because interest on debt is deductible for tax purposes), and if there are few, notmany, noninterest tax benefits.

The optimal capitalization for an organization usually can be determined by the:

a.

Maximum degree of financial leverage (DFL).

b.

Intersection of the marginal cost of capital and the marginal efficiency of investment.

c.

Maximum degree of total leverage (DTL).

d.

Lowest total weighted-average cost of capital (WACC).

The theory underlying the cost of capital is primarily concerned with the cost of:

a.

Long-term funds and new funds.

b.

Long-term funds and old funds.

c.

Short-term funds and new funds.

d.

Any combination of old or new, short-term or long-term funds.

Choice "d" is correct. The cost of capital considers the cost of all funds, whether they are short-term, long-term, new or old.

Choices "b", "c", and "a" are incorrect, per above.

Capital investments require balancing risk and return. Managers have a responsibility to ensure that the investments that they make in their own firms increase shareholder value. Managers have met that responsibility if the return on the capital investment:

a.

Exceeds the rate of return associated with the firm's beta factor.

b.

Is less than the prime rate of return.

c.

Is greater than the prime rate of return.

d.

Is less than the rate of return associated with the firm's beta factor.

Choice "a" is correct. A capital investment whose rate of return exceeds the rate of return associated with the firm's beta factor will increase the value of the firm.

Choice "d" is incorrect. A capital investment whose rate of return is less than the rate of return associated with the firm's beta factor will decrease the value of the firm.

Choice "c" is incorrect. The return on a capital investment in relation to the prime rate of return will not necessarily indicate if the investment increases or decreases the value of the company without knowing the relative risk of the firm in relation to the market and its relationship to the prime rate.

Choice "b" is incorrect. The return on a capital investment in relation to the prime rate of return will not necessarily indicate if the investment increases or decreases the value of the company without knowing the relative risk of the firm in relation to the market and its relationship to the prime rate.

The three elements needed to estimate the cost of equity capital for use in determining a firm's weighted-average cost of capital are:

a.

Current dividends per share, expected growth rate in earnings per share, and current market price per share of common stock.

b.

Current dividends per share, expected growth rate in dividends per share, and current market price per share of common stock.

c.

Current earnings per share, expected growth rate in earnings per share, and current book value per share of common stock.

d.

Current earnings per share, expected growth rate in dividends per share, and current market price per share of common stock.

Choice "b" is correct. The three elements needed to estimate the cost of equity capital are:

Current dividends per share (D)

Expected growth rate in dividends (G) and

Current market price per share of common stock (P)

The question asks the candidate to identify the three elements needed to estimate the cost of equity capital for use in determining a firm's weighted average cost of capital. The cost of equity capital is defined by the following mathematical expression where the cost of capital or return (R) is:

R = D1 / (P + G)

Note that to obtain D1 in the above formula, multiply D0 by (1 + G).

Which of the following rates is most commonly compared to the internal rate of return to evaluate whether to make an investment?

a.

Prime rate of interest.

b.

Long-term rate on U.S. Treasury bonds.

c.

Short-term rate on U.S. Treasury bonds.

d.

Weighted-average cost of capital.

Choice "d" is correct. The weighted-average cost of capital is frequently used as the hurdle rate within capital budgeting techniques. Investments that provide a return that exceeds the weighted-average cost of capital should continuously add to the value of the firm.

Choice "c" is incorrect. The short-term rate on U.S. Treasury bonds represents the risk-free rate of return and would not be appropriate for use as a hurdle rate, in most instances.

Choice "a" is incorrect. The prime rate of interest represents the rate offered by banks to their most credit worthy debtors. The prime rate of return would not necessarily consider the risk-specific return required for a particular company's IRR and would not be appropriate as a hurdle rate.

Choice "b" is incorrect. The long-term rate on U.S. Treasury bonds represents a risk-free rate of return and would not necessarily consider the risk-specific return required for a particular company's IRR and would not be appropriate as a hurdle rate.

The cost of debt most frequently is measured as:

a.

Actual interest rate minus tax savings.

b.

Actual interest rate plus a risk premium.

c.

Actual interest rate.

d.

Actual interest rate adjusted for inflation.

Choice "a" is correct. Actual interest rates minus tax savings is the most frequently used measure for cost of debt (kdt). After-tax interest fully considers both the costs and tax shield advantages of financing charges which reduce the cost of debt to its most relevant amount.

Choice "c" is incorrect. Actual interest does not consider the relevant tax shielding impact of interest deductibility.

Choice "d" is incorrect. Actual interest adjusted for inflation does not consider the relevant tax shielding impact of interest deductibility on the annual cash outflows associated with debt. In addition, the inflation is already a component of the interest rate added by the lender.

Choice "b" is incorrect. Actual interest plus a risk premium does not consider the relevant tax shielding impact of interest deductibility on the annual cash outflows associated with debt. In addition, the risk premium is already a component of the interest rate added by the lender.

Larson Corp. issued $20 million of long-term debt in the current year. What is a major advantage to Larson with the debt issuance?

a.

The reduced earnings per share possible through financial leverage.

b.

The relatively low after-tax cost due to the interest deduction.

c.

The increased financial risk resulting from the use of the debt.

d.

The reduction of Larson's control over the company.

Choice "b" is correct. Debt is generally the least expensive component of a company's capital structure. Debt typically commands a lower return than equity since debt contemplates a full return of principal over a specific period compared to equity that has no such guarantee and exposes the investor/creditor to lower risks. In addition, interest payments on debt are tax deductible, creating a tax shield for the debtor company. Lower rates reduced further by a tax shield give debt an advantage over equity financing.

Choice "a" is incorrect. Financial leverage presumes higher returns and earnings per share (EPS) as a result of issuing debt. Presuming increased net income because of the debt financed investment; EPS will increase since the number of shares issued and outstanding (the denominator) will not increase.

Choice "c" is incorrect. There is greater financial risk when debt is used, but this is not an advantage.

Choice "d" is incorrect. The use of debt financing does not decrease control of the company. The use of equity financing decreases control of the company.

When calculating a company's cost of common stock, an analyst evaluates the following four components: risk-free rate, stock's beta coefficient, rate of return on the market portfolio, and required rate of return on the company's stock. Which of the following measurement models is being used?

a.

Weighted marginal cost of capital.

b.

Overall cost of capital.

c.

Constant growth.

d.

Capital asset pricing.

Choice "d" is correct. The CAPM (capital asset pricing model) is one of the methods used to calculate the required rate of return on retained earnings (equity). The model is calculated as follows:

Cost of retained earnings = Risk-free rate + [Beta × (Market return – Risk-free rate)]

Choice "c" is incorrect. The constant growth model uses components such as the current stock price, dividends, growth rate, and required rate of return.

Choice "a" is incorrect. The weighted marginal cost of capital looks at both major components of a company's capital structure (debt and equity), weights them by their percentage of the capital structure, and multiplies each by their respective marginal costs.

Choice "b" is incorrect. The overall cost of capital is another name for the weighted average cost of capital (WACC), which takes each component of a firm's capital structure, weights it by its respective percentage of the overall capital structure, and multiplies each by its respective cost.

If Brewer Corporation's bonds are currently yielding 8 percent in the marketplace, why would the firm's cost of debt be lower?

a.

There is a mixture of old and new debt.

b.

Additional debt can be issued more cheaply that the original debt.

c.

Interest is deductible for tax purposes.

d.

Market interest rates have increased.

Choice "c" is correct. Because interest expense is a tax deduction, the cost to Brewer is lower than the market yield rate on debt.

Choice "d" is incorrect. If market interest rates increase, then Brewer's bonds would have to be offered at a discount to stay competitive with the market. This discount would increase (not lower) Brewer's cost of debt.

Choice "b" is incorrect. Issuance of cheaper additional debt will lower future cost of debt, but have no impact on current cost of debt.

Choice "a" is incorrect. Presumably, the 8% yield already includes new and old debt.

Which one of a firm's sources of new capital usually has the lowest after tax cost?

a.

Preferred stock.

b.

Bonds.

c.

Retained earnings.

d.

Common stock.

Choice "b" is correct. Because debt is a cheaper source of financing than equity, bonds will be the cheapest form of financing. In addition, the company issuing bonds receives a tax deduction for interest paid. This further reduces the cost of bond financing.

Choices "c", "a", and "d" are incorrect, per explanation above.

The overall cost of capital is the:

a.

Minimum rate a firm must earn on high-risk projects.

b.

Rate of return on assets that covers the costs associated with the funds employed.

c.

Maximum rate of return on assets.

d.

Cost of the firm's equity capital at which the market value of the firm will remain unchanged.

Choice "b" is correct. Firms must at least earn a return rate on investments equal to their cost of capital, or the investments are losing money and, therefore, decreasing the value of the firm.

Choices "a" and "c" are incorrect, per the above explanations.

Choice "d" is incorrect. The cost of equity capital is measured by the capital asset pricing model.

A company uses its company-wide cost of capital to evaluate new capital investments. What is the implication of this policy when the company has multiple operating divisions, each having unique risk attributes and capital costs?

a.

High-risk divisions will under-invest in high-risk projects.

b.

Low-risk divisions will over-invest in low-risk projects.

c.

High-risk divisions will over-invest in new projects and low risk divisions will under-invest in new projects.

d.

Low-risk divisions will over-invest in new projects and high risk divisions will under-invest in new projects.

Choice "c" is correct. A company-wide cost of capital averages risks to arrive at required return for investments. The company-wide cost of capital will be lower than the cost of capital specific to high-risk projects and higher than the cost-of-capital specific to low-risk projects. If a company is comprised of multiple divisions with unique risk characteristics, higher risk divisions will automatically beat the threshold for investments and invest in higher risk projects that beat the company wide average. Meanwhile, their lower risk counterparts will find it hard to achieve the risk return that beats the average (artificially inflated) returns that are driven by higher risk divisions and will under invest in new projects.

Choice "a" is incorrect. A company-wide cost of capital averages risks to arrive at a required return for investments. The company-wide cost of capital will be lower than the cost of capital specific to high-risk projects and higher than the cost-of-capital specific to low-risk projects. If a company is comprised of multiple divisions with unique risk characteristics, higher risk divisions will automatically beat the threshold for investments and invest in higher risk projects that beat the company wide average.

Choice "b" is incorrect. A company-wide cost of capital averages risks to arrive at required return for investments. The company-wide cost of capital will be lower than the cost of capital specific to high-risk projects and higher than the cost-of-capital specific to low-risk projects. If a company is comprised of multiple divisions with unique risk characteristics, lower risk divisions will find it hard to achieve the risk return that beats the average (artificially inflated) returns that are driven by higher risk divisions and thereby under invest in new projects.

Choice "d" is incorrect. A company-wide cost of capital averages risks to arrive at required return for investments. The company-wide cost of capital will be lower than the cost of capital specific to high-risk projects and higher than the cost-of-capital specific to low-risk projects. If a company is comprised of multiple divisions with unique risk characteristics, higher risk divisions will automatically beat the threshold for investments and invest in more, not less, higher risk projects that beat the company wide average. Meanwhile, their lower risk counterparts will find it hard to achieve the risk return that beats the average (artificially inflated) returns that are driven by higher risk divisions and thereby invest less and not more new projects.