Chapter 7
COST OF CAPITAL
1. Poor capital structure decisions can result in a high cost of capital,
FALSE
thereby making some unacceptable investments acceptable.
2. Due to its secondary position relative to equity, suppliers of debt capital
face greater risk and therefore must be compensated with higher FALSE
expected returns than suppliers of equity capital.
3. The payment of a stock dividend is a shifting of funds between capital
TRUE
accounts rather than a use of funds.
4. The target capital structure is the desired optimal mix of debt and equity
TRUE
financing that most firms attempt to achieve and maintain.
5. The cost of capital is the rate of return a firm must earn on investments
FALSE
in order to leave share price unchanged.
6. The cost of each type of capital depends on the risk-free cost of that type
TRUE
of funds, the business risk of the firm, and the financial risk of the firm.
7. The cost of capital acts 'as a major link between the firm's long-term
investment decisions and the wealth of the owners as determined by FALSE
investors in the marketplace.
8. The cost of common stock equity can be thought of as the "magic
number" that is used to decide whether a proposed corporate investment FALSE
will increase or decrease the firm's stock price.
9. The cost of capital is a static concept; it is not affected by economic and
FALSE
firm specific factors such as business risk and financial risk.
10. The cost of new common stock is normally greater than any other long-
TRUE
term financing cost.
11. In computing the weighted average cost of capital, the historic weights
are either book value or market value weights based on actual capital TRUE
structure proportions.
12. Since retained earnings is a more expensive source of financing than debt
and preferred stock, the weighted average cost of capital will fall once FALSE
retained earnings have been exhausted.
13. Firm's capital structure is the mix of the short-term debt, long-term debt,
FALSE
and equity maintained by the firm.
14. The target capital structure is the desired optimal mix of debt and equity
TRUE
financing that most firms attempt to achieve and maintain.
15. The cost of capital is the rate of return a firm must earn on investments
TRUE
in order to leave share price unchanged.
16. The cost of capital is used to decide whether a proposed corporate
TRUE
investment will increase or decrease the firm's stock price.
17. The cost of capital reflects the cost of funds over the long run measured
TRUE
at a given point in time, based on the best information available.
18. The cost of common stock equity may be measured using either the TRUE

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constant growth valuation model or the capital asset pricing model.

19. A firm can retain more of its earnings if it can convince its stockholders
TRUE
that it will earn at least their required return on the reinvested funds.
20. In computing the cost of retained earnings, the net proceeds represents
the amount of money retained net of any underpricing and/or flotation FALSE
costs.
21. One measure of the cost of common stock equity is the rate at which
investors discount the expected dividends of the firm to determine its TRUE
share value.
22. The constant growth model uses the market price as a reflection of the
TRUE
expected risk-return preference of investors in the marketplace.
23. The cost of common stock equity capital represents the return required
by existing shareholders on their investment in order to leave the market TRUE
price of the firm's outstanding share unchanged.
24. The cost of retained earnings is always lower than the cost of a new issue
of common stock due to the absence of flotation costs when financing TRUE
projects with retained earnings.
25. Since the net proceeds from sale of new common stock will be less than
the current market price, the cost of new issues will always be less than FALSE
the cost of existing issues.
26. The Gordon model is based on the premise that the value of a share of
stock is equal to sum of all future dividends it is expected to provide over FALSE
an infinite time horizon.
27. The weighted average cost that reflects the interrelationship of financing
decisions can be obtained by weighing the cost of each source of financing TRUE
by its target proportion in the firm's capital structure.
28. In computing the weighted average cost of capital, the historic weights
are either book value or market value weights based on actual capital TRUE
structure proportions.
29. In computing the weighted average cost of capital, the target weights are
either book value or market value weights based on actual capital FALSE
structure proportions.
30. In computing the weighted average cost of capital, from a strictly
theoretical point of view, the preferred weighing scheme is target market TRUE
value proportions.

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1. The ________ is the rate of return required by the market suppliers of capital in order
to attract their funds to the firm.
a) yield to maturity b) internal rate of return
c) cost of capital d) gross profit margin
2. The cost of capital reflects the cost of funds
a) over a short-run time period. b) at a given point in time.
c) over a long-run time period. d) at current book values.
3. The four basic sources of long-term funds for the business firm are
a) current liabilities, long-term debt, b) current liabilities, long-term debt,
common stock, and preferred stock. common stock, and retained
earnings.
c) long-term debt, paid-in capital in d) long-term debt, common stock,
excess of par, common stock, and preferred stock, and retained
retained earnings. earnings.
4. The firm's optimal mix of debt and equity is called its
a) optimal ratio. b) target capital structure.
c) maximum wealth. d) maximum book value.
5. The cost of each type of capital depends on the
a) risk-free cost of that type of funds. b) business risk of the firm.
c) financial risk of the firm. d) all of the above.
6. The ________ is a weighted average of the cost of funds which reflects the
interrelationship of financing decisions.
a) risk premium b) nominal cost
c) cost of capital d) risk-free rate
7. The ________ is the firm's desired optimal mix of debt and equity financing.
e) book value f) market value
g) cost of capital h) target capital structure
8. The ________ from the sale of a security are the funds actually received from the sale
after ________, or the total costs of issuing and selling the security, which have been
subtracted from the total proceeds.
a) gross proceeds; the after-tax costs b) gross proceeds; the flotation costs
c) net proceeds; the flotation costs d) net proceeds; the after-tax costs
9. A tax adjustment must be made in determining the cost of
a) long-term debt. b) common stock.
c) preferred stock. d) retained earnings.
10. The before-tax cost of debt for a firm which has a 40 percent marginal tax rate is 12
percent. The after-tax cost of debt is
a) 4.8 percent. b) 6.0 percent.
c) 7.2 percent. d) 12 percent.
11. When determining the after-tax cost of a bond, the face value of the issue must be
adjusted to the net proceeds amounts by considering
a) the risk. b) the flotation costs.
c) the approximate returns. d) the taxes.
12. The approximate before-tax cost of debt for a 15-year, 10 percent, $1,000 par value
bond selling at $950 is

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a) 10 percent. b) 10.6 percent.

c) 12 percent. d) 15.4 percent.
13. If a corporation has an average tax rate of 40 percent, the approximate, annual, after-tax
cost of debt for a 15-year, 12 percent, $1,000 par value bond, selling at $950 is
a) 10 percent b) 10.6 percent
c) 7.6 percent d) 6.0 percent.
14. Debt is generally the least expensive source of capital. This is primarily due to
a) fixed interest payments. b) its position in the priority of claims
on assets and earnings in the event of
liquidation.
c) the tax deductibility of interest d) the secured nature of a debt
payments. obligation.
15. Nico Trading Corporation is considering issuing long-term debt. The debt would have a
30 year maturity and a 10 percent coupon rate. In order to sell the issue, the bonds must
be underpriced at a discount of 5 percent of face value. In addition, the firm would have
to pay flotation costs of 5 percent of face value. The firm's tax rate is 35 percent. Given
this information, the after tax cost of debt for Nico Trading would be
a) 7.26%. b) 11.17%.
c) 10.00%. d) none of the above.
16. The cost of common stock equity is
a) the cost of the guaranteed stated b) the rate at which investors
dividend. discount the expected dividends of
the firm.
c) the after-tax cost of the interest d) the historical cost of floating the
obligations. stock issue.
17. The cost of common stock equity may be estimated by using the
a) yield curve. b) net present value method.
c) Gordon model. d) DuPont analysis.
18. The cost of common stock equity may be estimated by using the
a) yield curve. b) capital asset pricing model.
c) internal rate of return. d) DuPont analysis.
19. The cost of retained earnings is
a) zero. b) equal to the cost of a new issue of
common stock.
c) equal to the cost of common stock d) irrelevant to the
equity. investment/financing decision.
20. The cost of new common stock financing is higher than the cost of retained earnings
due to
a) flotation costs and underpricing. b) flotation costs and overpricing.
c) flotation costs and commission d) commission costs and overpricing.
costs.

25  Adapted By Dr Selim