1. "Capital" is sometimes defined as funds supplied to a firm by investors.
T
2. The cost of capital used in capital budgeting should reflect the average cost of
the various sources of long-term funds a firm uses to acquire assets.
T
3. The component costs of capital are market-determined variables in the sense
that they are based on investors' required returns.
T
4. Suppose you are the president of a small, publicly-traded corporation. Since
you believe that your firm's stock price is temporarily depressed, all additional
capital funds required during the current year will be raised using debt. In this
case, the appropriate marginal cost of capital for use in capital budgeting during
the current year is the after-tax cost of debt.
F
5. The before-tax cost of debt, which is lower than the after-tax cost, is used as
the component cost of debt for purposes of developing the firm's WACC.
F
6. The cost of debt is equal to one minus the marginal tax rate multiplied by the
average coupon rate on all outstanding debt.
F
,7. The cost of debt is equal to one minus the marginal tax rate multiplied by the
interest rate on new debt.
T
8. 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.
F
9. The cost of perpetual preferred stock is found as the preferred's annual
dividend divided by the market price of the preferred stock. No adjustment is
needed for taxes because preferred dividends, unlike interest on debt, is not
deductible by the issuing firm.
T
10. The cost of common equity obtained by retaining earnings is the rate of
return the marginal stockholder requires on the firm's common stock.
T
11. For capital budgeting and cost of capital purposes, the firm should always
consider reinvested earnings as the first source of capital⎯i.e., use these funds
first⎯because reinvested earnings have no cost to the firm.
F
12. 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.
,F
13. 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.
F
14. The firm's cost of external equity raised by issuing new stock is the same as
the required rate of return on the firm's outstanding common stock.
F
15. 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 reinvested
earnings, whose cost is the average return on the assets that are acquired.
F
16. For capital budgeting and cost of capital purposes, the firm should assume
that each dollar of capital is obtained in accordance with its target capital
structure, which for many firms means partly as debt, partly as preferred stock,
and partly common equity.
T
17. 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.
, ANS: F
In general, this statement is false, because the firm should be viewed as an ongoing entity, and
using debt (or equity) to fund a given project will change the capital structure, and this factor
should be recognized by basing the cost of capital for all projects on a target capital structure.
Under some special circumstances, where a project is set up as a separate entity, then "project
financing" may be used, and only the project's specific situation is considered. This is a specific
situation, however, and not the "in general" case.
18. If a firm's marginal tax rate is increased, this would, other things held
constant, lower the cost of debt used to calculate its WACC.
T
19. The reason why reinvested earnings have a cost equal to rs is because
investors think they can (i.e., expect to) earn rs on investments with the same risk
as the firm's common stock, and if the firm does not think that it can earn rs on
the earnings that it retains, it should distribute those earnings to its investors.
Thus, the cost of reinvested earnings is based on the opportunity cost principle.
T
20. When estimating the cost of equity by use of the CAPM, three potential
problems are (1) whether to use long-term or short-term rates for rRF, (2)
whether or not the historical beta is the beta that investors use when evaluating
the stock, and (3) how to measure the market risk premium, RPM. These
problems leave us unsure of the true value of rs.
T
21. When estimating the cost of equity by use of the DCF method, the single
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.
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