Chapter11TheCostofCapital181

Chapter11
TheCostofCapital

.1 Learning Goals
1. Understandthekeyassumptions,thebasicconcept,andthespecificsourcesofcapitalassociated
withthecostofcapital.

2. Determinethecostoflongtermdebtandthecostofpreferredstock.

3. Calculatethecostofcommonstockequityandconvertitintothecostofretainedearningsandthe
costofnewissuesofcommonstock.

4. Calculatetheweightedaveragecostofcapital(WACC)anddiscussalternativeweightingschemes
andeconomicvalueadded(EVA).

5. Describetheproceduresusedtodeterminebreakpointsandtheweightedmarginalcostofcapital
(WMCC).

6. Explaintheweightedmarginalcostofcapital(WMCC)anditsusewiththeinvestmentopportunities
schedule(IOS)tomakefinancing/investmentdecisions.

.2 True/False
1. Businessriskistherisktothefirmofbeingunabletocoveroperatingcosts.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:1
Topic:BusinessRisk

2. Thetargetcapitalstructureisthedesiredoptimalmixofdebtandequityfinancingthatmostfirms
attempttoachieveandmaintain.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:1
Topic:TargetCapitalStructure

3. Thecostofcapitalistherateofreturnafirmmustearnoninvestmentsinordertoleaveshareprice
unchanged.
Answer: TRUE
LevelofDifficulty:1
182GitmanPrinciplesofFinance,EleventhEdition
LearningGoal:1
Topic:BasicConceptofCostofCapital
 Chapter11TheCostofCapital183
4. Thecostofcapitalisusedtodecidewhetheraproposedcorporateinvestmentwillincreaseor
decreasethefirmsstockprice.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:1
Topic:BasicConceptofCostofCapital

5. Thecostofcapitalreflectsthecostoffundsoverthelongrunmeasuredatagivenpointintime,
basedonthebestinformationavailable.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:1
Topic:BasicConceptofCostofCapital

6. Thecostofeachtypeofcapitaldependsontheriskfreecostofthattypeoffunds,thebusinessrisk
ofthefirm,andthefinancialriskofthefirm.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:1
Topic:BasicConceptofCostofCapital

7. Thecostofcapitalactsasamajorlinkbetweenthefirmslongterminvestmentdecisionsandthe
wealthoftheownersasdeterminedbyinvestorsinthemarketplace.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:1
Topic:BasicConceptofCostofCapital

8. Thecostofcapitalcanbethoughtofastherateofreturnrequiredbythemarketsuppliersofcapital
inordertoattracttheirfundstothefirm.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:1
Topic:BasicConceptofCostofCapital

9. Businessriskistherisktothefirmofbeingunabletocoverrequiredfinancialobligations.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:1
Topic:BusinessRisk

10. Holdingriskconstant,theimplementationofprojectswitharateofreturnabovethecostofcapital
willdecreasethevalueofthefirm,andviceversa.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:1
Topic:BasicConceptofCostofCapital
184GitmanPrinciplesofFinance,EleventhEdition
11. Thespecificcostofeachsourceoffinancingistheaftertaxcostofobtainingthefinancingusingthe
historicallybasedcostreflectedbytheexistingfinancingonthefirmsbooks.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:1
Topic:BasicConceptofCostofCapital

12. Ingeneral,floatationcostsincludetwocomponents,underwritingcostsandadministrativecosts.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:2
Topic:FlotationCosts

13. Flotationcostsreducethenetproceedsfromthesaleofabondwhethersoldatapremium,ata
discount,oratitsparvalue.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:2
Topic:FlotationCosts

14. Thenetproceedsusedincalculationofthecostoflongtermdebtarefundsactuallyreceivedfrom
thesaleafterpayingforflotationcostsandtaxes.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:2
Topic:FlotationCosts

15. Sincepreferredstockisaformofownership,thestockwillnevermature.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:2
Topic:CostofPreferredStock

16. Preferredstockrepresentsaspecialtypeofownershipinterestinthefirmand,thus,thepreferred
stockholdersmustreceivetheirstateddividendspriortothedistributionofanyearningstocommon
stockholdersandbondholders.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:2
Topic:CostofPreferredStock

17. Whenthenetproceedsfromsaleofabondequalitsparvalue,thebeforetaxcostwouldjustequal
thecouponinterestrate.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
Topic:CostofLongTermDebt
 Chapter11TheCostofCapital185
18. Theamountofpreferredstockdividendsthatmustbepaideachyearmaybestatedindollars(i.e.,
xdollarpreferredstock)orasapercentageofthefirmsearnings(i.e.,xpercentpreferredstock).
Answer: FALSE
LevelofDifficulty:2
LearningGoal:2
Topic:CostofPreferredStock

19. Thecostofpreferredstockistypicallyhigherthanthecostoflongtermdebt(bonds)becausethe
costoflongtermdebt(interest)istaxdeductible.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:2
Topic:CostofPreferredStockComparedtoLongTermDebt

20. Thecostofcommonstockequitymaybemeasuredusingeithertheconstantgrowthvaluation
modelorthecapitalassetpricingmodel.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:3
Topic:CostofCommonStockEquity

21. Afirmcanretainmoreofitsearningsifitcanconvinceitsstockholdersthatitwillearnatleasttheir
requiredreturnonthereinvestedfunds.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:3
Topic:CostofCommonStockEquity

22. Incomputingthecostofretainedearnings,thenetproceedsrepresentstheamountofmoney
retainednetofanyunderpricingand/orflotationcosts.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:3
Topic:CostofRetainedEarnings

23. Thecostofcommonstockequityistherateatwhichinvestorsdiscounttheexpecteddividendsof
thefirmtodetermineitssharevalue.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:3
Topic:CostofCommonStockEquity

24. Theconstantgrowthmodelusesthemarketpriceasareflectionoftheexpectedriskreturn
preferenceofinvestorsinthemarketplace.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:3
Topic:ConstantGrowthModel
186GitmanPrinciplesofFinance,EleventhEdition
25. Thecostofcommonstockequitycapitalrepresentsthereturnrequiredbyexistingshareholderson
theirinvestmentinordertoleavethemarketpriceofthefirmsoutstandingshareunchanged.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:3
Topic:CostofCommonStockEquity

26. Thecostofretainedearningsisalwayslowerthanthecostofanewissueofcommonstockdueto
theabsenceofflotationcostswhenfinancingprojectswithretainedearnings.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:3
Topic:CostofRetainedEarnings

27. Sincethenetproceedsfromsaleofnewcommonstockwillbelessthanthecurrentmarketprice,the
costofnewissueswillalwaysbelessthanthecostofexistingissues.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:3
Topic:CostofNewCommonStockEquity

28. TheGordonmodelisbasedonthepremisethatthevalueofashareofstockisequaltosumofall
futuredividendsitisexpectedtoprovideoveraninfinitetimehorizon.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:3
Topic:ConstantGrowthModel

29. Thecostofretainedearningstothefirmisthesameasthecostofanequivalentfullysubscribed
issueofadditionalcommonstock.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:3
Topic:CostofRetainedEarnings

30. UsingtheCapitalAssetPricingModel(CAPM),thecostofcommonstockequityisthereturn
requiredbyinvestorsascompensationforthefirmsnondiversifiablerisk.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:3
Topic:CapitalAssetPricingModel

31. UseoftheCapitalAssetPricingModel(CAPM)inmeasuringthecostofcommonstockequity
differsfromtheconstantgrowthvaluationmodelinthatitdirectlyconsidersthefirmsriskas
reflectedbybeta.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:3
Topic:CapitalAssetPricingModel
 Chapter11TheCostofCapital187
32. Whentheconstantgrowthvaluationmodelisusedtofindthecostofcommonstockequitycapital,it
caneasilybeadjustedforflotationcoststofindthecostofnewcommonstock;theCapitalAsset
PricingModel(CAPM)doesnotprovideasimpleadjustmentmechanism.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:3
Topic:CAPMandConstantGrowthModel

33. Thecostofnewcommonstockisnormallygreaterthananyotherlongtermfinancingcost.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:3
Topic:CostofNewCommonStockEquity

34. Thecapitalassetpricingmodeldescribestherelationshipbetweentherequiredreturn,orthecostof
commonstockequitycapital,andthenonsystematicriskofthefirmasmeasuredbythebeta
coefficient.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:3
Topic:CapitalAssetPricingModel

35. Theweightedaveragecostthatreflectstheinterrelationshipoffinancingdecisionscanbeobtained
byweighingthecostofeachsourceoffinancingbyitstargetproportioninthefirmscapital
structure.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:4
Topic:TargetMarketValueWeights

36. Incomputingtheweightedaveragecostofcapital,thehistoricweightsareeitherbookvalueor
marketvalueweightsbasedonactualcapitalstructureproportions.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:4
Topic:MarketValueversusBookValueWeights

37. Incomputingtheweightedaveragecostofcapital,thetargetweightsareeitherbookvalueormarket
valueweightsbasedonactualcapitalstructureproportions.
Answer: FALSE
LevelofDifficulty:1
LearningGoal:4
Topic:MarketValueversusBookValueWeights
188GitmanPrinciplesofFinance,EleventhEdition
38. Incomputingtheweightedaveragecostofcapital,fromastrictlytheoreticalpointofview,the
preferredweighingschemeistargetmarketvalueproportions.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:4
Topic:TargetMarketValueWeights

39. Theweightedaveragecostofcapital(WACC)reflectstheexpectedaveragefuturecostoffunds
overthelongrun.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:4
Topic:WeightedAverageCostofCapital

40. Sinceretainedearningsisamoreexpensivesourceoffinancingthandebtandpreferredstock,the
weightedaveragecostofcapitalwillfallonceretainedearningshavebeenexhausted.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:4
Topic:WeightedMarginalCostofCapital

41. Afirmmayfaceincreasesintheweightedaveragecostofcapitaleitherwhenretainedearningshave
beenexhaustedorduetoincreasesindebt,preferredstock,andcommonequitycostsasadditional
newfundsarerequired.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:4
Topic:WeightedMarginalCostofCapital

42. Theweightedmarginalcostofcapitalisthefirmsweightedaveragecostofcapitalassociatedwith
itsnextdollaroftotalfinancing.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:5
Topic:WeightedMarginalCostofCapital

43. Theweightedmarginalcostofcapitalscheduleisagraphthatrelatesthefirmsweightedaverage
costofcapitaltotheleveloftotalnewfinancing.
Answer: TRUE
LevelofDifficulty:1
LearningGoal:5
Topic:WeightedMarginalCostofCapital

44. Atanygiventime,thefirmsfinancingcostsandinvestmentreturnswillbeaffectedbythevolume
offinancingandinvestmentundertaken.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:5
Topic:WeightedMarginalCostofCapital
 Chapter11TheCostofCapital189
45. Asthevolumeoffinancingincreases,thecostsofthevarioustypesoffinancingwilldecrease,
reducingthefirmsweightedaveragecostofcapital.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:5
Topic:WeightedMarginalCostofCapital

46. Theweightedmarginalcostofcapitalisanincreasingfunctionoftheleveloftotalnewfinancing.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:5
Topic:WeightedMarginalCostofCapital

47. Thebreakingpointistheleveloftotalnewfinancingatwhichthecostofoneofthefinancing
componentsrises.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:5
Topic:WMCCBreakPoints

48. Afirmsinvestmentopportunitiesscheduleisarankingofinvestmentpossibilitiesfrombest
(highestreturn)toworst(lowestreturn).
Answer: TRUE
LevelofDifficulty:1
LearningGoal:6
Topic:InvestmentOpportunitiesSchedule

49. Thelargerthevolumeofnewfinancing,thegreatertheriskand,thus,thehigherthefinancingcosts.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:6
Topic:WeightedMarginalCostofCapital

50. Theinvestmentopportunityschedule(IOS)isthegraphthatrelatesthefirmsweightedaveragecost
ofcapital(WACC)totheleveloftotalnewfinancing.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:6
Topic:WMCCandIOS

51. TheacceptanceofprojectsbeginningwiththosehavingthegreatestpositivedifferencebetweenIRR
andtheweightedaveragecostofcapital,K a,downtothepointatwhichIRRjustequalskashould
resultinthemaximumtotalNPVforallindependentprojectsaccepted.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:6
Topic:WMCCandIOS
190GitmanPrinciplesofFinance,EleventhEdition
52. Asthecumulativeamountofmoneyinvestedinafirmscapitalprojectsincreases,itsreturnsonthe
projectswillincrease.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:6
Topic:WMCCandIOS

53. Whilethereturnwillincreasewiththeacceptanceofmoreprojects,theweightedmarginalcostof
capitalwillincreasebecausegreateramountsoffinancingwillberequired.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:6
Topic:WMCCandIOS

54. Accordingtothefirmsownerwealthmaximizationgoal,thefirmshouldacceptprojectsuptothe
pointwherethemarginalreturnonitsinvestmentisequaltoitsweightedmarginalcostofcapital.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:6
Topic:WMCCandIOS

55. Thecostofcapitalcanbethoughtofasthemagicnumberthatisusedtodecidewhethera
proposedcorporateinvestmentwillincreaseordecreasethefirmsstockprice.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:1
Topic:BasicConceptofCostofCapital

56. Thecostofcommonstockequitycanbethoughtofasthemagicnumberthatisusedtodecide
whetheraproposedcorporateinvestmentwillincreaseordecreasethefirmsstockprice.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:1
Topic:BasicConceptofCostofCapital

57. Thecostofcapitalisastaticconcept;itisnotaffectedbyeconomicandfirmspecificfactorssuchas
businessriskandfinancialrisk.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:1
Topic:BasicConceptofCostofCapital

58. Thecostofcapitalisadynamicconcept;itisaffectedbyeconomicandfirmspecificfactorssuchas
businessriskandfinancialrisk.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:1
Topic:BasicConceptofCostofCapital
 Chapter11TheCostofCapital191
59. Inusingthecostofcapital,itisimportantthatitreflectsthehistoricalcostofraisingfundsoverthe
longrun.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:1
Topic:BasicConceptofCostofCapital

60. Fromabondissuersperspective,theIRRonabondscashflowsisitscosttomaturity;fromthe
investorsperspective,theIRRonabondscashflowsistheyieldtomaturity(YTM).
Answer: TRUE
LevelofDifficulty:3
LearningGoal:2
Topic:CostofLongTermDebt

61. Fromabondissuersperspective,theIRRonabondscashflowsisitsyieldtomaturity(YTM);
fromtheinvestorsperspective,theIRRonabondscashflowsisthecosttomaturity.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:2
Topic:CostofLongTermDebt

62. NicoTradingCorporationisconsideringissuinglongtermdebt.Thedebtwouldhavea30year
maturityanda10percentcouponrate.Inordertoselltheissue,thebondsmustbeunderpricedata
discountof5percentoffacevalue.Inaddition,thefirmwouldhavetopayflotationcostsof5
percentoffacevalue.Thefirmstaxrateis35percent.Giventhisinformation,theaftertaxcostof
debtforNicoTradingwouldbe7.26percent.
Answer: TRUE
LevelofDifficulty:4
LearningGoal:2
Topic:CostofLongTermDebt(Equation11.2)

63. NicoTradingCorporationisconsideringissuinglongtermdebt.Thedebtwouldhavea30year
maturityanda10percentcouponrate.Inordertoselltheissue,thebondsmustbeunderpricedata
discountof5percentoffacevalue.Inaddition,thefirmwouldhavetopayflotationcostsof5
percentoffacevalue.Thefirmstaxrateis35percent.Giventhisinformation,theaftertaxcostof
debtforNicoTradingwouldbe11.17percent.
Answer: FALSE
LevelofDifficulty:4
LearningGoal:2
Topic:CostofLongTermDebt(Equation11.2)

64. NicoTradingCorporationisconsideringissuingpreferredstock.Thepreferredstockwouldhavea
parvalueof$75andapreferreddividendof7.5percentofpar.Inordertoissuethestock,Nico
tradingwouldhavetopayflotationcostsof6percentofparvalue.Giventhisinformation,Nico
Tradingscostofpreferredstockwouldbe7.98percent.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:2
Topic:CostofPreferredStock(Equation11.3)
192GitmanPrinciplesofFinance,EleventhEdition
65. NicoTradingCorporationisconsideringissuingpreferredstock.Thepreferredstockwouldhavea
parvalueof$75andapreferreddividendof7.5percentofpar.Inordertoissuethestock,Nico
tradingwouldhavetopayflotationcostsof6percentofparvalue.Giventhisinformation,Nico
Tradingscostofpreferredstockwouldbe7.5percent.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:2
Topic:CostofPreferredStock(Equation11.3)

66. ThecostofretainedearningsforTangshanMiningwouldbe16.64percentifthefirmjustpaida
dividendof$4.00,thestockpriceis$50.00,dividendsareexpectedtogrowat8percentindefinitely,
andflotationcostsare$5.00pershare.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:3
Topic:CostofRetainedEarnings(Equation11.5)

67. ThecostofretainedearningsforTangshanMiningwouldbe17.60percentifthefirmjustpaida
dividendof$4.00,thestockpriceis$50.00,dividendsareexpectedtogrowat8percentindefinitely,
andflotationcostsare$5.00pershare.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:3
Topic:CostofRetainedEarnings(Equation11.5)

68. ThecostofnewcommonstockequityforTangshanMiningwouldbe17.60percentifthefirmjust
paidadividendof$4.00,thestockpriceis$50.00,dividendsareexpectedtogrowat8percent
indefinitely,andflotationcostsare$5.00pershare.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:3
Topic:CostofNewCommonStockEquity(Equation11.8andEquation11.8a)

69. ThecostofretainedearningsequityforTangshanMiningwouldbe18.00percentiftheexpected
returnonU.S.TreasuryBillsis5.00percent,themarketriskpremiumis10.00percent,andthe
firmsbetais1.3.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:3
Topic:CostofRetainedEarnings(Equation11.6)

70. ThecostofretainedearningsequityforTangshanMiningwouldbe18.00percentiftheexpected
returnonU.S.TreasuryBillsis5.00percent,themarketreturnis10.00percent,andthefirmsbeta
is1.3.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:3
Topic:CostofRetainedEarnings(Equation11.6)
 Chapter11TheCostofCapital193
71. Weightsthatuseaccountingvaluestomeasuretheproportionofeachtypeofcapitalinthefirms
financialstructurearecalledmarketvalueweights.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:4
Topic:AlternativeWeightingSchemes

72. Weightsthatuseaccountingvaluestomeasuretheproportionofeachtypeofcapitalinthefirms
financialstructurearecalledbookvalueweights.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:4
Topic:AlternativeWeightingSchemes

73. Historicalweightsareeitherbookvalueormarketvalueweightsbasedontheactualhistorical
capitalstructureproportions.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:4
Topic:AlternativeWeightingSchemes

74. Targetweightsareeitherbookvalueormarketvalueweightsbasedontheactualhistoricalcapital
structureproportions.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:4
Topic:AlternativeWeightingSchemes

75. Targetweightsareeitherbookvalueormarketvalueweightsbasedondesiredcapitalstructure
proportions.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:4
Topic:AlternativeWeightingSchemes

76. Economicvalueaddedisthedifferencebetweenaninvestmentsnetoperatingprofitaftertaxesand
thecostoffundsusedtofinancetheinvestment,whichisfoundbymultiplyingthedollaramountof
thefundsusedtofinancetheinvestmentbythefirmsweightedaveragecostofcapital.
Answer: TRUE
LevelofDifficulty:3
LearningGoal:4
Topic:EconomicValueAdded

77. Theinvestmentoperatingscheduleisthedifferencebetweenaninvestmentsnetoperatingprofit
aftertaxesandthecostoffundsusedtofinancetheinvestment,whichisfoundbymultiplyingthe
dollaramountofthefundsusedtofinancetheinvestmentbythefirmsweightedaveragecostof
capital.
Answer: FALSE
LevelofDifficulty:3
LearningGoal:4
194GitmanPrinciplesofFinance,EleventhEdition
Topic:EconomicValueAdded
 Chapter11TheCostofCapital195
78. Thebreakpointistheleveloftotalnewfinancingatwhichthecostofoneofthefinancing
componentsrises,therebycausinganupwardshiftintheweightedmarginalcostofcapital.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:5
Topic:BreakingPoints

79. Theinvestmentopportunitypointistheleveloftotalnewfinancingatwhichthecostofoneofthe
financingcomponentsrises,therebycausinganupwardshiftintheweightedmarginalcostof
capital.
Answer: FALSE
LevelofDifficulty:2
LearningGoal:5
Topic:BreakingPoints

80. Theweightedmarginalcostofcapitalisthefirmsweightedaveragecostofcapitalassociatedwith
thenextdollaroftotalnewfinancing.
Answer: TRUE
LevelofDifficulty:2
LearningGoal:5
Topic:WeightedMarginalCostofCapital

.3 Multiple Choice Questions

1. The_________istherateofreturnafirmmustearnonitsinvestmentsinprojectsinorderto
maintainthemarketvalueofitsstock.
(a) netpresentvalue
(b) costofcapital
(c) internalrateofreturn
(d) grossprofitmargin
Answer: B
LevelofDifficulty:1
LearningGoal:1
Topic:BasicConceptofCostofCapital

2. The_________istherateofreturnrequiredbythemarketsuppliersofcapitalinordertoattract
theirfundstothefirm.
(a) yieldtomaturity
(b) internalrateofreturn
(c) costofcapital
(d) grossprofitmargin
Answer: C
LevelofDifficulty:1
LearningGoal:1
Topic:BasicConceptofCostofCapital
196GitmanPrinciplesofFinance,EleventhEdition
3. _________istherisktothefirmofbeingunabletocoveroperatingcosts.
(a) Totalrisk
(b) Businessrisk
(c) Financialrisk
(d) Diversifiablerisk
Answer: B
LevelofDifficulty:1
LearningGoal:1
Topic:BusinessRisk

4. _________istherisktothefirmofbeingunabletocoverfinancialobligations.
(a) Totalrisk
(b) Businessrisk
(c) Financialrisk
(d) Diversifiablerisk
Answer: C
LevelofDifficulty:1
LearningGoal:1
Topic:FinancialRisk

5. Thecostofcapitalreflectsthecostoffunds
(a) overashortruntimeperiod.
(b) atagivenpointintime.
(c) overalongruntimeperiod.
(d) atcurrentbookvalues.
Answer: C
LevelofDifficulty:1
LearningGoal:1
Topic:BasicConceptofCostofCapital

6. Thefourbasicsourcesoflongtermfundsforthebusinessfirmare
(a) currentliabilities,longtermdebt,commonstock,andpreferredstock.
(b) currentliabilities,longtermdebt,commonstock,andretainedearnings.
(c) longtermdebt,paidincapitalinexcessofpar,commonstock,andretainedearnings.
(d) longtermdebt,commonstock,preferredstock,andretainedearnings.
Answer: D
LevelofDifficulty:1
LearningGoal:1
Topic:ComparingtheCostofVariousSourcesofCapital
 Chapter11TheCostofCapital197
7. Firmstypicallyraiselongtermfunds
(a) onlyattheinceptionofthefirm.
(b) onacontinuousbasis.
(c) inlumpsumsasneeded.
(d) inproportiontothecapitalmixtureofthetargetcapitalstructure.
Answer: C
LevelofDifficulty:1
LearningGoal:1
Topic:BasicConceptofCostofCapital

8. Thefirmsoptimalmixofdebtandequityiscalledits
(a) optimalratio.
(b) targetcapitalstructure.
(c) maximumwealth.
(d) maximumbookvalue.
Answer: B
LevelofDifficulty:1
LearningGoal:1
Topic:TargetCapitalStructure

9. Thecostofeachtypeofcapitaldependsonthe
(a) riskfreecostofthattypeoffunds.
(b) businessriskofthefirm.
(c) financialriskofthefirm.
(d)Alloftheabove.
Answer: D
LevelofDifficulty:2
LearningGoal:1
Topic:BasicConceptofCostofCapital

10. The_________isaweightedaverageofthecostoffundswhichreflectstheinterrelationshipof
financingdecisions.
(a) riskpremium
(b) nominalcost
(c) costofcapital
(d) riskfreerate
Answer: C
LevelofDifficulty:2
LearningGoal:1
Topic:BasicConceptofCostofCapital
198GitmanPrinciplesofFinance,EleventhEdition
11. The_________isthefirmsdesiredoptimalmixofdebtandequityfinancing.
(a) bookvalue
(b) marketvalue
(c) costofcapital
(d) targetcapitalstructure
Answer: D
LevelofDifficulty:2
LearningGoal:1
Topic:TargetCapitalStructure

12. Thecosttoacorporationofeachtypeofcapitalisdependentupon
(a) theriskfreerateofbondsplusthebusinessriskofthefirm.
(b) theriskfreerateofeachtypeofcapitalplusthebusinessriskofthefirm.
(c) theriskfreerateofeachtypeofcapitalplusthefinancialriskofthefirm.
(d) theriskfreerateofeachtypeofcapitalplusthebusinessriskandthefinancialriskofthefirm.
Answer: D
LevelofDifficulty:3
LearningGoal:1
Topic:BasicConceptofCostofCapital

13. Thespecificcostofeachsourceoflongtermfinancingisbasedon_________and_________
costs.
(a) beforetax;historical
(b) aftertax;historical
(c) beforetax;bookvalue
(d) aftertax;current
Answer: D
LevelofDifficulty:3
LearningGoal:1
Topic:BasicConceptofCostofCapital

14. Inordertorecognizetheinterrelationshipbetweenfinancingandinvestments,thefirmshoulduse
_________whenevaluatinganinvestment.
(a) theleastcostlysourceoffinancing
(b) themostcostlysourceoffinancing
(c) theweightedaveragecostofallfinancingsources
(d) thecurrentopportunitycost
Answer: C
LevelofDifficulty:3
LearningGoal:1
Topic:BasicConceptofCostofCapital
 Chapter11TheCostofCapital199
15. Acorporationhasconcludedthatitsfinancialriskpremiumistoohigh.Inordertodecreasethis,the
firmcan
(a) increasetheproportionoflongtermdebttodecreasethecostofcapital.
(b) increaseshorttermdebttodecreasethecostofcapital.
(c) decreasetheproportionofcommonstockequitytodecreasefinancialrisk.
(d) increasetheproportionofcommonstockequitytodecreasefinancialrisk.
Answer: D
LevelofDifficulty:4
LearningGoal:1
Topic:FinancialRisk

16. The_________fromthesaleofasecurityarethefundsactuallyreceivedfromthesaleafter
_________,orthetotalcostsofissuingandsellingthesecurity,whichhavebeensubtractedfrom
thetotalproceeds.
(a) grossproceeds;theaftertaxcosts
(b) grossproceeds;theflotationcosts
(c) netproceeds;theflotationcosts
(d) netproceeds;theaftertaxcosts
Answer: C
LevelofDifficulty:1
LearningGoal:2
Topic:FlotationCosts

17. Ataxadjustmentmustbemadeindeterminingthecostof_________.
(a) longtermdebt
(b) commonstock
(c) preferredstock
(d) retainedearnings
Answer: A
LevelofDifficulty:1
LearningGoal:2
Topic:CostofLongTermDebt

18. Thebeforetaxcostofdebtforafirmwhichhasa40percentmarginaltaxrateis12percent.The
aftertaxcostofdebtis
(a) 4.8percent.
(b) 6.0percent.
(c) 7.2percent.
(d) 12percent.
Answer: C
LevelofDifficulty:1
LearningGoal:2
Topic:CostofLongTermDebt(Equation11.2)
200GitmanPrinciplesofFinance,EleventhEdition
19. Whatisthedividendonan8percentpreferredstockthatcurrentlysellsfor$45andhasafacevalue
of$50pershare?
(a) $3.33
(b) $3.60
(c) $4.00
(d) $5.00
Answer: C
LevelofDifficulty:1
LearningGoal:2
Topic:CostofPreferredStock(Equation11.3)

20. Afirmhasissued10percentpreferredstock,whichsoldfor$100pershareparvalue.Thecostof
issuingandsellingthestockwas$2pershare.Thefirmsmarginaltaxrateis40percent.Thecostof
thepreferredstockis
(a) 3.9percent.
(b) 6.1percent.
(c) 9.8percent.
(d) 10.2percent.
Answer: D
LevelofDifficulty:2
LearningGoal:2
Topic:CostofPreferredStock(Equation11.3)

21. Afirmhasissuedpreferredstockatits$125pershareparvalue.Thestockwillpaya$15annual
dividend.Thecostofissuingandsellingthestockwas$4pershare.Thecostofthepreferred
stockis
(a) 7.2percent.
(b) 12percent.
(c) 12.4percent.
(d) 15percent.
Answer: C
LevelofDifficulty:2
LearningGoal:2
Topic:CostofPreferredStock(Equation11.3)

22. Whendeterminingtheaftertaxcostofabond,thefacevalueoftheissuemustbeadjustedtothenet
proceedsamountsbyconsidering
(a) therisk.
(b) theflotationcosts.
(c) theapproximatereturns.
(d) thetaxes.
Answer: B
LevelofDifficulty:2
LearningGoal:2
Topic:CostofLongTermDebt
 Chapter11TheCostofCapital201
23. Theapproximatebeforetaxcostofdebtfora15year,10percent,$1,000parvaluebondsellingat
$950is
(a) 10percent.
(b) 10.6percent.
(c) 12percent.
(d) 15.4percent.
Answer: B
LevelofDifficulty:3
LearningGoal:2
Topic:CostofLongTermDebt(Equation11.1)

24. Ifacorporationhasanaveragetaxrateof40percent,theapproximate,annual,aftertaxcostofdebt
fora15year,12percent,$1,000parvaluebond,sellingat$950is
(a) 10percent.
(b) 10.6percent.
(c) 7.6percent.
(d) 6.0percent.
Answer: C
LevelofDifficulty:3
LearningGoal:2
Topic:CostofLongTermDebt(Equation11.1andEquation11.2)

25. Ifacorporationhasanaveragetaxrateof40percent,theapproximateannual,aftertaxcostofdebt
fora10year,8percent,$1,000parvaluebondsellingat$1,150is
(a) 3.6percent.
(b) 4.8percent.
(c) 6percent.
(d) 8percent.
Answer: A
LevelofDifficulty:3
LearningGoal:2
Topic:CostofLongTermDebt(Equation11.1andEquation11.2)

26. Theapproximatebeforetaxcostofdebtfora10year,8percent,$1,000parvaluebondsellingat
$1,150is
(a) 6percent.
(b) 8.3percent.
(c) 8.8percent.
(d) 9percent.
Answer: A
LevelofDifficulty:3
LearningGoal:2
Topic:CostofLongTermDebt(Equation11.1andEquation11.2)
202GitmanPrinciplesofFinance,EleventhEdition
27. Theapproximateaftertaxcostofdebtfora20year,7percent,$1,000parvaluebondsellingat
$960(assumeamarginaltaxrateof40percent)is
(a) 4.41percent.
(b) 5.15percent.
(c) 7percent.
(d) 7.35percent.
Answer: A
LevelofDifficulty:3
LearningGoal:2
Topic:CostofLongTermDebt(Equation11.1andEquation11.2)

28. Debtisgenerallytheleastexpensivesourceofcapital.Thisisprimarilydueto
(a) fixedinterestpayments.
(b) itspositioninthepriorityofclaimsonassetsandearningsintheeventofliquidation.
(c) thetaxdeductibilityofinterestpayments.
(d) thesecurednatureofadebtobligation.
Answer: C
LevelofDifficulty:3
LearningGoal:2
Topic:CostofLongTermDebt

29. Afirmhasdetermineditcanissuepreferredstockat$115pershareparvalue.Thestockwillpaya
$12annualdividend.Thecostofissuingandsellingthestockis$3pershare.Thecostofthe
preferredstockis
(a) 6.4percent.
(b) 10.4percent.
(c) 10.7percent.
(d) 12percent.
Answer: C
LevelofDifficulty:3
LearningGoal:2
Topic:CostofPreferredStock(Equation11.3)

30. Thecostofcommonstockequityis
(a) thecostoftheguaranteedstateddividend.
(b) therateatwhichinvestorsdiscounttheexpecteddividendsofthefirm.
(c) theaftertaxcostoftheinterestobligations.
(d) thehistoricalcostoffloatingthestockissue.
Answer: B
LevelofDifficulty:1
LearningGoal:3
Topic:CostofCommonStockEquity
 Chapter11TheCostofCapital203
31. Thecostofcommonstockequitymaybeestimatedbyusingthe
(a) yieldcurve.
(b) netpresentvaluemethod.
(c) Gordonmodel.
(d) DuPontanalysis.
Answer: C
LevelofDifficulty:1
LearningGoal:3
Topic:ConstantGrowthModel

32. Thecostofcommonstockequitymaybeestimatedbyusingthe
(a) yieldcurve.
(b) capitalassetpricingmodel.
(c) internalrateofreturn.
(d) DuPontanalysis.
Answer: B
LevelofDifficulty:1
LearningGoal:3
Topic:CapitalAssetPricingModel

33. Thecostofretainedearningsis
(a) zero.
(b) equaltothecostofanewissueofcommonstock.
(c) equaltothecostofcommonstockequity.
(d) irrelevanttotheinvestment/financingdecision.
Answer: C
LevelofDifficulty:1
LearningGoal:3
Topic:CostofRetainedEarnings

34. Thecostofnewcommonstockfinancingishigherthanthecostofretainedearningsdueto
(a) flotationcostsandunderpricing.
(b) flotationcostsandoverpricing.
(c) flotationcostsandcommissioncosts.
(d) commissioncostsandoverpricing.
Answer: A
LevelofDifficulty:2
LearningGoal:3
Topic:CostofNewCommonStockEquity
204GitmanPrinciplesofFinance,EleventhEdition
35. TheconstantgrowthvaluationmodeltheGordonmodelisbasedonthepremisethatthevalueof
ashareofcommonstockis
(a) thesumofthedividendsandexpectedcapitalappreciation.
(b) determinedbasedonanindustrystandardP/Emultiple.
(c) determinedbyusingameasureofrelativeriskcalledbeta.
(d) equaltothepresentvalueofallexpectedfuturedividends.
Answer: D
LevelofDifficulty:2
LearningGoal:3
Topic:ConstantGrowthModel

36. Incalculatingthecostofcommonstockequity,themodelhavingthestrongertheoretical
foundationis
(a) theconstantgrowthmodel.
(b) theGordonmodel.
(c) thevariablegrowthmodel.
(d) thecapitalassetpricingmodel.
Answer: D
LevelofDifficulty:2
LearningGoal:3
Topic:CAPMversusConstantGrowthModel

37. Afirmhasabetaof1.2.Themarketreturnequals14percentandtheriskfreerateofreturnequals
6percent.Theestimatedcostofcommonstockequityis
(a) 6percent.
(b) 7.2percent.
(c) 14percent.
(d) 15.6percent.
Answer: D
LevelofDifficulty:2
LearningGoal:3
Topic:CapitalAssetPricingModel(Equation11.6)

38. Onemajorexpenseassociatedwithissuingnewsharesofcommonstockis
(a) underwritingfees.
(b) legalfees.
(c) registrationfees.
(d) underpricing.
Answer: D
LevelofDifficulty:2
LearningGoal:3
Topic:FlotationCosts
 Chapter11TheCostofCapital205
39. Firmsunderpricenewissuesofcommonstockforthefollowingreason(s).
(a) Whenthemarketisinequilibrium,additionaldemandforsharescanbeachievedonlyata
lowerprice.
(b) Whenadditionalsharesareissued,eachsharespercentofownershipinthefirmisdiluted,
therebyjustifyingalowersharevalue.
(c) Manyinvestorsviewtheissuanceofadditionalsharesasasignalthatmanagementisusing
commonstockequityfinancingbecauseitbelievesthatthesharesarecurrentlyoverpriced.
(d) Alloftheabove.
Answer: D
LevelofDifficulty:3
LearningGoal:3
Topic:UnderpricingNewCommonStockEquity

40. CircumstancesinwhichtheconstantgrowthvaluationmodeltheGordonmodelforestimating
thevalueofashareofstockshouldbeusedinclude
(a) decliningdividends.
(b) anerraticdividendstream.
(c) thelackofdividends.
(d) asteadygrowthrateindividends.
Answer: D
LevelofDifficulty:3
LearningGoal:3
Topic:ConstantGrowthModel

41. Afirmhascommonstockwithamarketpriceof$25pershareandanexpecteddividendof$2per
shareattheendofthecomingyear.Thegrowthrateindividendshasbeen5percent.Thecostofthe
firmscommonstockequityis
(a) 5percent.
(b) 8percent.
(c) 10percent.
(d) 13percent.
Answer: D
LevelofDifficulty:3
LearningGoal:3
Topic:ConstantGrowthModel(Equation11.5)
206GitmanPrinciplesofFinance,EleventhEdition
42. Afirmhascommonstockwithamarketpriceof$55pershareandanexpecteddividendof$2.81
pershareattheendofthecomingyear.Thedividendspaidontheoutstandingstockoverthepast
fiveyearsareasfollows:

Year Dividend
1 $2.00
2 2.14
3 2.29
4 2.45
5 2.62

Thecostofthefirmscommonstockequityis
(a) 4.1percent.
(b) 5.1percent.
(c) 12.1percent.
(d) 15.4percent.
Answer: C
LevelofDifficulty:3
LearningGoal:3
Topic:ConstantGrowthModel(Equation11.5)

43. Usingthecapitalassetpricingmodel,thecostofcommonstockequityisthereturnrequiredby
investorsascompensationfor
(a) thespecificriskofthefirm.
(b) thefirmsdiversifiablerisk.
(c) pricevolatilityofthestock.
(d) thefirmsnondiversifiablerisk.
Answer: D
LevelofDifficulty:3
LearningGoal:3
Topic:CapitalAssetPricingModel
 Chapter11TheCostofCapital207
44. Afirmhascommonstockwithamarketpriceof$100pershareandanexpecteddividendof$5.61
pershareattheendofthecomingyear.Anewissueofstockisexpectedtobesoldfor$98,with$2
persharerepresentingtheunderpricingnecessaryinthecompetitivecapitalmarket.Flotationcosts
areexpectedtototal$1pershare.Thedividendspaidontheoutstandingstockoverthepastfive
yearsareasfollows:

Year Dividend
1 $4.00
2 4.28
3 4.58
4 4.90
5 5.24

Thecostofthisnewissueofcommonstockis
(a) 5.8percent.
(b) 7.7percent.
(c) 10.8percent.
(d) 12.8percent.
Answer: D
LevelofDifficulty:3
LearningGoal:3
Topic:ConstantGrowthModel(Equation11.8andEquation11.8a)

45. Sinceretainedearningsareviewedasafullysubscribedissueofadditionalcommonstock,thecost
ofretainedearningsis
(a) lessthanthecostofnewcommonstockequity.
(b) equaltothecostofnewcommonstockequity.
(c) greaterthanthecostofnewcommonstockequity.
(d) notrelatedtothecostofnewcommonstockequity.
Answer: A
LevelofDifficulty:3
LearningGoal:3
Topic:CostofRetainedEarnings

46. Incomparingtheconstantgrowthmodelandthecapitalassetpricingmodel(CAPM)tocalculate
thecostofcommonstockequity,
(a) theconstantgrowthmodelignoresrisk,whiletheCAPMdirectlyconsidersriskasreflectedin
thebeta.
(b) theCAPMdirectlyconsidersriskasreflectedinthebeta,whiletheconstantgrowthmodeluses
themarketpriceasareflectionoftheexpectedriskreturnpreferenceofinvestors.
(c) theCAPMdirectlyconsidersriskasreflectedinthebeta,whiletheconstantgrowthmodeluses
dividendexpectationsasareflectionofrisk.
(d) theCAPMindirectlyconsidersriskasreflectedinthemarketreturn,whiletheconstantgrowth
modelusesdividendexpectationsasareflectionofrisk.
Answer: B
LevelofDifficulty:4
LearningGoal:3
Topic:CAPMversusConstantGrowthModel
208GitmanPrinciplesofFinance,EleventhEdition
47. Incalculatingthecostofcommonstockequity
(a) theuseofthecapitalassetpricingmodel(CAPM)isoftenpreferred,becausethedatarequired
aremorereadilyavailable.
(b) theuseoftheCAPMispreferred,becauseitmoredirectlycalculatesrisk.
(c) theuseoftheconstantgrowthvaluationmodelisoftenpreferred,becausethedatarequiredare
morereadilyavailable.
(d) theuseoftheconstantgrowthvaluationmodelisoftenpreferred,becauseithasastronger
theoreticalfoundation.
Answer: C
LevelofDifficulty:4
LearningGoal:3
Topic:CAPMversusConstantGrowthModel
48. Giventhatthecostofcommonstockis18percent,dividendsare$1.50pershare,andthepriceof
thestockis$12.50pershare,whatistheannualgrowthrateofdividends?
(a) 4percent.
(b) 5percent.
(c) 6percent.
(d) 8percent.
Answer: C
LevelofDifficulty:4
LearningGoal:3
Topic:ConstantGrowthModel(Equation11.5)

49. Generally,theorderofcost,fromtheleastexpensivetothemostexpensive,forlongtermcapitalof
acorporationis
(a) newcommonstock,retainedearnings,preferredstock,longtermdebt.
(b) commonstock,preferredstock,longtermdebt,shorttermdebt.
(c) preferredstock,retainedearnings,commonstock,newcommonstock.
(d) longtermdebt,preferredstock,retainedearnings,newcommonstock.
Answer: D
LevelofDifficulty:1
LearningGoal:4
Topic:ComparingtheCostofVariousSourcesofCapital

50. Generallytheleastexpensivesourceoflongtermcapitalis
(a) retainedearnings.
(b) preferredstock.
(c) longtermdebt.
(d) shorttermdebt.
Answer: C
LevelofDifficulty:1
LearningGoal:4
Topic:ComparingtheCostofVariousSourcesofCapital
 Chapter11TheCostofCapital209
51. Weighingschemesforcalculatingtheweightedaveragecostofcapitalincludeallofthefollowing
EXCEPT
(a) bookvalueweights.
(b) optimalvalueweights.
(c) marketvalueweights.
(d) targetweights.
Answer: B
LevelofDifficulty:1
LearningGoal:4
Topic:AlternativeWeightingSchemes

52. Thepreferredcapitalstructureweightstobeusedintheweightedaveragecostofcapitalare
(a) marketweights.
(b) nominalweights.
(c) historicweights.
(d) targetweights.
Answer: D
LevelofDifficulty:1
LearningGoal:4
Topic:TargetMarketValueWeights

53. Whendiscussingweighingschemesforcalculatingtheweightedaveragecostofcapital,the
preferencescanbestatedas
(a) marketvalueweightsarepreferredoverbookvalueweightsandtargetweightsarepreferred
overhistoricweights.
(b) bookvalueweightsarepreferredovermarketvalueweightsandtargetweightsarepreferred
overhistoricweights.
(c) bookvalueweightsarepreferredovermarketvalueweightsandhistoricweightsarepreferred
overtargetweights.
(d) marketvalueweightsarepreferredoverbookvalueweightsandhistoricweightsarepreferred
overtargetweights.
Answer: A
LevelofDifficulty:3
LearningGoal:4
Topic:AlternativeWeightingSchemes
210GitmanPrinciplesofFinance,EleventhEdition
54. Afirmhasdetermineditscostofeachsourceofcapitalandoptimalcapitalstructure,whichis
composedofthefollowingsourcesandtargetmarketvalueproportions:

TargetMarket
SourceofCapital Proportions AfterTaxCost
Longtermdebt 40% 6%
Preferredstock 10 11
Commonstockequity 50 15

Theweightedaveragecostofcapitalis
(a) 6percent.
(b) 10.7percent.
(c) 11percent.
(d) 15percent.
Answer: C
LevelofDifficulty:3
LearningGoal:4
Topic:WeightedAverageCostofCapital(Equation11.9)

55. Afirmhasdetermineditscostofeachsourceofcapitalandoptimalcapitalstructure,whichis
composedofthefollowingsourcesandtargetmarketvalueproportions:

TargetMarket AfterTax
SourceofCapital Proportions Cost
Longtermdebt 45% 5%
Preferredstock 10 14
Commonstockequity 45 22
 Chapter11TheCostofCapital211
Ifthefirmweretoshifttowardamoreleveragedcapitalstructure(i.e.,agreaterpercentageofdebt
inthecapitalstructure),theweightedaveragecostofcapitalwould
(a) increase.
(b) remainunchanged.
(c) decrease.
(d) notbeabletobedetermined.
Answer: C
LevelofDifficulty:3
LearningGoal:4
Topic:WeightedAverageCostofCapital(Equation11.9)

56. Asthevolumeoffinancingincreases,thecostsofthevarioustypesoffinancingwill_________,
_________thefirmsweightedaveragecostofcapital.
(a) increase,lowering
(b) increase,raising
(c) decrease,lowering
(d) decrease,raising
Answer: B
LevelofDifficulty:3
LearningGoal:4
Topic:WeightedMarginalCostofCapital
212GitmanPrinciplesofFinance,EleventhEdition
Afirmhasdetermineditsoptimalcapitalstructurewhichiscomposedofthefollowingsourcesandtarget
marketvalueproportions.
Table11.1
TargetMarket
SourceofCapital Proportions
Longtermdebt 20%
Preferredstock 10
Commonstockequity 70
 Chapter11TheCostofCapital213
Debt:Thefirmcansella12year,$1,000parvalue,7percentbondfor$960.Aflotationcostof
2percentofthefacevaluewouldberequiredinadditiontothediscountof$40.
PreferredStock:Thefirmhasdetermineditcanissuepreferredstockat$75pershareparvalue.
Thestockwillpaya$10annualdividend.Thecostofissuingandsellingthestockis$3pershare.
CommonStock:Afirmscommonstockiscurrentlysellingfor$18pershare.Thedividend
expectedtobepaidattheendofthecomingyearis$1.74.Itsdividendpaymentshavebeengrowing
ataconstantrateforthelastfouryears.Fouryearsago,thedividendwas$1.50.Itisexpectedthat
tosell,anewcommonstockissuemustbeunderpriced$1pershareinfloatationcosts.
Additionally,thefirmsmarginaltaxrateis40percent.

57. Thefirmsbeforetaxcostofdebtis(SeeTable11.1.)
(a) 7.7percent.
(b) 10.6percent.
(c) 11.2percent.
(d) 12.7percent.
Answer: A
LevelofDifficulty:4
LearningGoal:4
Topic:CostofLongTermDebt(Equation11.1)
58. Thefirmsaftertaxcostofdebtis(SeeTable11.1.)
(a) 3.25percent.
(b) 4.6percent.
(c) 8percent.
(d) 8.13percent.
Answer: B
LevelofDifficulty:4
LearningGoal:4
Topic:CostofLongTermDebt(Equation11.2)
59. Thefirmscostofpreferredstockis(SeeTable11.1.)
(a) 7.2percent.
(b) 8.3percent.
(c) 13.3percent.
(d) 13.9percent.
Answer: D
LevelofDifficulty:4
LearningGoal:4
Topic:CostofPreferredStock(Equation11.3)
214GitmanPrinciplesofFinance,EleventhEdition
60. Thefirmscostofanewissueofcommonstockis(SeeTable11.1.)
(a) 7percent.
(b) 9.08percent.
(c) 13.2percent.
(d) 14.4percent.
Answer: C
LevelofDifficulty:4
LearningGoal:4
Topic:CostofNewCommonStockEquity(Equation11.8andEquation11.8a)

61. Thefirmscostofretainedearningsis(SeeTable11.1.)
(a) 10.2percent.
(b) 13.9percent.
(c) 12.4percent.
(d) 13.6percent.
Answer: C
LevelofDifficulty:4
LearningGoal:4
Topic:CostofRetainedEarnings(Equation11.5)

62. Theweightedaveragecostofcapitaluptothepointwhenretainedearningsareexhaustedis(See
Table11.1.)
(a) 7.5percent.
(b) 8.65percent.
(c) 10.4percent.
(d) 11.0percent.
Answer: D
LevelofDifficulty:4
LearningGoal:4
Topic:WeightedMarginalCostofCapital(Equation11.9)

63. Theweightedaveragecostofcapitalafterallretainedearningsareexhaustedis(SeeTable11.1.)
(a) 13.6percent.
(b) 11.0percent.
(c) 11.55percent.
(d) 10.4percent.
Answer: C
LevelofDifficulty:4
LearningGoal:4
Topic:WeightedMarginalCostofCapital(Equation11.9)
 Chapter11TheCostofCapital215
Afirmhasdetermineditsoptimalstructurewhichiscomposedofthefollowingsourcesandtargetmarket
valueproportions.

Table11.2
TargetMarket
SourceofCapital Proportions
Longtermdebt 60%
Commonstockequity 40

Debt:Thefirmcansella15year,$1,000parvalue,8percentbondfor$1,050.Aflotationcostof
2percentofthefacevaluewouldberequiredinadditiontothepremiumof$50.
CommonStock:Afirmscommonstockiscurrentlysellingfor$75pershare.Thedividend
expectedtobepaidattheendofthecomingyearis$5.Itsdividendpaymentshavebeengrowingat
aconstantrateforthelastfiveyears.Fiveyearsago,thedividendwas$3.10.Itisexpectedthatto
sell,anewcommonstockissuemustbeunderpriced$2pershareandthefirmmustpay$1pershare
inflotationcosts.Additionally,thefirmhasamarginaltaxrateof40percent.

64. Thefirmsbeforetaxcostofdebtis(SeeTable11.2.)
(a) 7.7percent.
(b) 10.6percent.
(c) 11.2percent.
(d) 12.7percent.
Answer: A
LevelofDifficulty:4
LearningGoal:4
Topic:CostofLongTermDebt(Equation11.1)

65. Thefirmsaftertaxcostofdebtis(SeeTable11.2.)
(a) 4.6percent.
(b) 6percent.
(c) 7percent.
(d) 7.7percent.
Answer: A
LevelofDifficulty:4
LearningGoal:4
Topic:CostofLongTermDebt(Equation11.2)
216GitmanPrinciplesofFinance,EleventhEdition
66. Thefirmscostofanewissueofcommonstockis(SeeTable11.2.)
(a) 10.2percent.
(b) 14.3percent.
(c) 16.7percent.
(d) 17.0percent.
Answer: D
LevelofDifficulty:4
LearningGoal:4
Topic:CostofNewCommonStockEquity(Equation11.8andEquation11.8a)

67. Thefirmscostofretainedearningsis(SeeTable11.2.)
(a) 10.2percent.
(b) 14.3percent.
(c) 16.7percent.
(d) 17.0percent.
Answer: C
LevelofDifficulty:4
LearningGoal:4
Topic:CostofRetainedEarnings(Equation11.5)

68. Theweightedaveragecostofcapitaluptothepointwhenretainedearningsareexhaustedis(See
Table11.2.)
(a) 6.8percent.
(b) 7.7percent.
(c) 9.44percent.
(d) 11.29percent.
Answer: C
LevelofDifficulty:4
LearningGoal:4
Topic:WeightedMarginalCostofCapital(Equation11.9)

69. Assumingthefirmplanstopayoutallofitsearningsasdividends,theweightedaveragecostof
capitalis(SeeTable11.2.)
(a) 9.6percent.
(b) 10.9percent.
(c) 11.6percent.
(d) 12.1percent.
Answer: A
LevelofDifficulty:4
LearningGoal:4
Topic:WeightedMarginalCostofCapital(Equation11.9)
 Chapter11TheCostofCapital217
Table11.3
BalanceSheet
GeneralTalcMines
December31,2003
Assets
CurrentAssets
Cash $25,000
AccountsReceivable 120,000
Inventories 300,000
TotalCurrentAssets $445,000
NetFixedAssets $500,000
TotalAssets $945,000

LiabilitiesandStockholdersEquity
CurrentLiabilities
AccountsPayable $80,000
NotesPayable 350,000
Accruals 50,000
TotalCurrentLiabilities $480,000
LongTermDebts(150bondsissuedat$1,000par) 150,000
TotalLiabilities $630,000
StockholdersEquityCommonStock(7,200sharesoutstanding) $180,000
RetainedEarnings 135,000
TotalStockholdersEquity $315,000
TotalLiabilitiesandStockholdersEquity $945,000

70.

SourceofCapital AfterTaxCost
Longtermdebt 8%
Commonstockequity 19

Giventhisaftertaxcostofeachsourceofcapital,theweightedaveragecostofcapitalusingbook
weightsforGeneralTalcMinesis(SeeTable11.3.)
(a) 11.6percent.
(b) 15.5percent.
(c) 16.6percent.
(d) 17.5percent.
Answer: B
LevelofDifficulty:4
LearningGoal:4
Topic:WeightedAverageCostofCapital(Equation11.9)
218GitmanPrinciplesofFinance,EleventhEdition
71. GeneralTalcMineshascompiledthefollowingdataregardingthemarketvalueandcostofthe
specificsourcesofcapital.

SourceofCapital AfterTaxCost
Longtermdebt 8%
Commonstockequity 19

Marketpricepershareofcommonstock$50
Marketvalueoflongtermdebt$980perbond
Theweightedaveragecostofcapitalusingmarketvalueweightsis(SeeTable11.3.)
(a) 11.7percent.
(b) 13.5percent.
(c) 15.8percent.
(d) 17.5percent.
Answer: C
LevelofDifficulty:4
LearningGoal:4
Topic:WeightedAverageCostofCapital(Equation11.9)

72. The_________istheleveloftotalfinancingatwhichthecostofoneofthefinancingcomponents
rises.
(a) weightedaveragecostofcapital
(b) weightedmarginalcostofcapital
(c) targetcapitalstructure
(d) breakingpoint
Answer: D
LevelofDifficulty:1
LearningGoal:5
Topic:WMCCBreakingPoint

73. Asasourceoffinancing,onceretainedearningshavebeenexhausted,theweightedaveragecostof
capitalwill
(a) increase.
(b) remainthesame.
(c) decrease.
(d) changeinanundetermineddirection.
Answer: A
LevelofDifficulty:2
LearningGoal:5
Topic:WeightedMarginalCostofCapital
 Chapter11TheCostofCapital219
74. Afirmexpectstohaveavailable$500,000ofearningsinthecomingyear,whichitwillretainfor
reinvestmentpurposes.Giventhefollowingtargetcapitalstructure,atwhatleveloftotalnew
financingwillretainedearningsbeexhausted?

TargetMarket
SourceofCapital Proportions
Longtermdebt 40%
Preferredstock 10
Commonstockequity 50

(a) $500,000.
(b) $800,000.
(c) $1,000,000.
(d) $1,500,000.
Answer: C
LevelofDifficulty:3
LearningGoal:5
Topic:WMCCBreakingPoint(Equation11.10)

75. Acorporationexpectstohaveearningsavailabletocommonshareholders(netprofitsminus
preferreddividends)of$1,000,000inthecomingyear.Thefirmplanstopay40percentofearnings
availableincashdividends.Ifthefirmhasatargetcapitalstructureof40percentlongtermdebt,10
percentpreferredstock,and50percentcommonstockequity,whatcapitalbudgetcouldthefirm
supportwithoutissuingnewcommonstock?
(a) $2,000,000.
(b) $600,000.
(c) $1,200,000.
(d) $800,000.
Answer: C
LevelofDifficulty:4
LearningGoal:5
Topic:WMCCBreakingPoint(Equation11.10)

76. The_________isascheduleorgraphrelatingthefirmsweightedaveragecostofcapitaltothe
levelofnewfinancing.
(a) weightedaveragecostofcapital
(b) weightedmarginalcostofcapital
(c) targetcapitalstructure
(d) breakingpoint
Answer: B
LevelofDifficulty:1
LearningGoal:6
Topic:WMCCandIOS
220GitmanPrinciplesofFinance,EleventhEdition
77. Theinvestmentopportunityschedule(IOS)is
(a) asetofdecisioncriteriafordeterminingtheacceptabilityofcapitalprojects.
(b) adeterminationoftheweightedaveragecostofcapitalatvariousincrementsoffinancing.
(c) aninternalrateofreturnrankingofcapitalprojectsfrombesttoworst.
(d) alistofinvestmentopportunitiesavailabletothefirm.
Answer: C
LevelofDifficulty:1
LearningGoal:6
Topic:WMCCandIOS

78. Afirmhasdetermineditscostofeachsourceofcapitalandoptimalcapitalstructurewhichis
composedofthefollowingsourcesandtargetmarketvalueproportions.

TargetMarket
SourceofCapital Proportions AfterTaxCost
LongtermDebt 35% 9%
PreferredStock 10 14
CommonStockEquity 55 20

Thefirmisconsideringaninvestmentopportunity,whichhasaninternalrateofreturnof10percent.
Theproject
(a) shouldnotbeconsideredbecauseitsinternalrateofreturnislessthanthecostoflongterm
debt.
(b) shouldbeconsideredbecauseitsinternalrateofreturnisgreaterthanthecostofdebt.
(c) shouldnotbeconsideredbecauseitsinternalrateofreturnislessthantheweightedaveragecost
ofcapital.
(d) shouldbeconsideredbecauseitsinternalrateofreturnisgreaterthantheweightedaveragecost
ofcapital.
Answer: C
LevelofDifficulty:2
LearningGoal:6
Topic:WMCCandIOS(Equation11.9)

79. Theweightedmarginalcostofcapitalis_________functionoftotalfinancingindollars;the
internalrateofreturnonindividualprojectsis_________functionofthetotalcapitalinvestmentin
dollars.
(a) anincreasing;anincreasing
(b) adecreasing;anincreasing
(c) adecreasing;adecreasing
(d) anincreasing;adecreasing
Answer: D
LevelofDifficulty:3
LearningGoal:6
Topic:WMCCandIOS
 Chapter11TheCostofCapital221
80. Theinvestmentopportunityschedulecombinedwiththeweightedmarginalcostofcapitalindicates
(a) thoseprojectsthatafirmshouldselect.
(b) thoseprojectsthatwillresultinthehighestcashflows.
(c) whichprojectsareacceptablegiventhefirmscostofcapital.
(d) whichcombinationofprojectswillfitwithinthefirmscapitalbudget.
Answer: C
LevelofDifficulty:3
LearningGoal:6
Topic:WMCCandIOS

81. Inordertorecognizetheinterrelationshipbetweenfinancingandinvestments,thefirmshoulduse
_________whenevaluatinganinvestment.
(a) theleastcostlysourceoffinancing
(b) themostcostlysourceoffinancing
(c) theweightedaveragecostofallfinancingsources
(d) thecurrentopportunitycost
Answer: C
LevelofDifficulty:3
LearningGoal:6
Topic:WMCCandIOS

82. Aprojectsrateofreturnshouldbe_________thantheweightedmarginalcostoffinancing.The
cumulativeacceptanceofprojects_________theweightedmarginalcostofcapital.
(a) less;increases
(b) less;decreases
(c) greater;increases
(d) greater;decreases
Answer: C
LevelofDifficulty:3
LearningGoal:6
Topic:WMCCandIOS

83. Accordingtotheinvestmentopportunityschedule(IOS),asthecumulativeamountofmoney
investedinaprojectincreases,thereturnontheprojectswill
(a) decrease.
(b) increase.
(c) remainunchanged.
(d) notbeafactor.
Answer: A
LevelofDifficulty:3
LearningGoal:6
Topic:WMCCandIOS
222GitmanPrinciplesofFinance,EleventhEdition
84. Thewealthmaximizinginvestmentdecisionforafirmoccurswhen
(a) thecostofcapitalequalsthereturnontheproject.
(b) theweightedmarginalcostofcapitalislessthantheinvestmentopportunityschedule.
(c) theweightedcostofcapitalexceedsthemarginalcostofcapital.
(d) theweightedmarginalcostofcapitalequalstheinvestmentopportunityschedule.
Answer: D
LevelofDifficulty:3
LearningGoal:6
Topic:WMCCandIOS

85. Inutilizingtheinvestmentopportunityscheduleandtheweightedmarginalcostofcapital,acapital
projectwillbe
(a) acceptableaslongasthemarginalreturnequalsorexceedstheaveragecostofcapitaloverall
levelsofneededfunding.
(b) unacceptableifthemarginalreturnequalstheweightedmarginalcostofcapital.
(c) unacceptableifthemarginalreturnequalsorexceedstheweightedmarginalcostofcapital.
(d) acceptableaslongasthemarginalreturnequalsorexceedstheweightedmarginalcostof
capital.
Answer: D
LevelofDifficulty:4
LearningGoal:6
Topic:WMCCandIOS

86. Thecostutilizedinmakingcapitalbudgetingdecisionsgivenaninvestmentopportunityscheduleis
(a) theweightedaveragecostofallneededfinancingforfunding.
(b) thesimpleaverageofthecostofthelastincrementalamountoffinancing.
(c) theweightedaveragecostofthelastincrementalamountoffinancing.
(d) theweightedaveragecostofallbondsissuedthatarerelatedtothecapitalbudget.
Answer: C
LevelofDifficulty:4
LearningGoal:6
Topic:WMCCandIOS

87. Aninvestmentopportunity/costschedule
(a) rankscapitalprojectsbynetpresentvalue,fromhighesttolowest,andthencomparesthe
discountratetothemarginalcostofcapital.
(b) rankscapitalprojectsbyinternalrateofreturnfromthehighesttolowestandmarginalcost
fromlowesttohighest,andthencomparesthemarginalreturntothemarginalcost.
(c) rankscapitalprojectsbyinternalrateofreturnfromlowesttohighestandmarginalcostfrom
highesttolowest,andthencomparesthemarginalreturntothemarginalcost.
(d) rankscapitalprojectsbynetpresentvalue,andthencomparesthemarginalreturntothecost.
Answer: B
LevelofDifficulty:4
LearningGoal:6
Topic:WMCCandIOS
 Chapter11TheCostofCapital223
88. Afirmscurrentinvestmentopportunityscheduleandtheweightedmarginalcostofcapitalschedule
areshownbelow.

Investment Initial
OpportunitySchedule IRR Investment
A 15% 200,000
B 12 300,000
C 19 100,000
D 10 400,000
E 16 300,000

WeightedMarginalCostofCapital
RangeofTotalNewFinancing WMCC
$0$250,000 7.5%
250,001500,000 8.9
500,0011,000,000 10.0
1,000,0011,500,000 12.0

Theinvestmentopportunitieswhichshouldbeselectedare
(a) A,B,C,andD.
(b) A,B,C,andE.
(c) A,B,D,andE.
(d) B,C,D,andE.
Answer: B
LevelofDifficulty:4
LearningGoal:6
Topic:WMCCandIOS(Equation11.9andEquation11.10)

89. NicoTradingCorporationisconsideringissuinglongtermdebt.Thedebtwouldhavea30year
maturityanda10percentcouponrate.Inordertoselltheissue,thebondsmustbeunderpricedata
discountof5percentoffacevalue.Inaddition,thefirmwouldhavetopayflotationcostsof5
percentoffacevalue.Thefirmstaxrateis35percent.Giventhisinformation,theaftertaxcostof
debtforNicoTradingwouldbe
(a) 7.26%.
(b) 11.17%.
(c) 10.00%.
(d) noneoftheabove
Answer: A
LevelofDifficulty:3
LearningGoal:2
Topic:CostofLongTermDebt(Equation11.1andEquation11.2)
224GitmanPrinciplesofFinance,EleventhEdition
90. TangshanMiningisconsideringissuinglongtermdebt.Thedebtwouldhavea30yearmaturityand
a12percentcouponrateandmakesemiannualcouponpayments.Inordertoselltheissue,the
bondsmustbeunderpricedatadiscountof2.5percentoffacevalue.Inaddition,thefirmwould
havetopayflotationcostsof2.5percentoffacevalue.Thefirmstaxrateis33percent.Giventhis
information,theaftertaxcostofdebtforNicoTradingwouldbe
(a) 6.38%.
(b) 12.76%.
(c) 4.98%.
(d) 8.55%.
Answer: D
LevelofDifficulty:4
LearningGoal:2
Topic:CostofLongTermDebt(Equation11.1andEquation11.2)

91. TangshanMiningisconsideringissuingpreferredstock.Thepreferredstockwouldhaveaparvalue
of$75,anda5.50percentdividend.WhatisthecostofpreferredstockforTangshanifflotation
costswouldamountto5.5percentofparvalue?
(a) 5.50%.
(b) 5.27%.
(c) 7.73%.
(d) 5.82%.
Answer: D
LevelofDifficulty:3
LearningGoal:2
Topic:CostofPreferredStock(Equation11.3)

92. WhatwouldbethecostofnewcommonstockequityforTangshanMiningifthefirmjustpaida
dividendof$4.25,thestockpriceis$55.00,dividendsareexpectedtogrowat8.5percent
indefinitely,andflotationcostsare$6.25pershare?
(a) 17.96%.
(b) 16.88%.
(c) 9.46%.
(d) noneoftheabove
Answer: A
LevelofDifficulty:3
LearningGoal:3
Topic:CostofNewCommonStockEquity(Equation11.8andEquation11.8a)
93. WhatwouldbethecostofretainedearningsequityforTangshanMiningiftheexpectedreturnon
U.S.TreasuryBillsis5.00percent,themarketriskpremiumis10.00percent,andthefirmsbetais
1.3?
(a) 11.5%
(b) 18.0%
(c) 10.0%
(d) noneoftheabove
Answer: B
LevelofDifficulty:3
LearningGoal:3
 Chapter11TheCostofCapital225
Topic:CostofRetainedEarnings(Equation11.6)
226GitmanPrinciplesofFinance,EleventhEdition

.4 Essay Questions
1. Afirmhasdetermineditsoptimalcapitalstructure,whichiscomposedofthefollowingsourcesand
targetmarketvalueproportions:

TargetMarket
SourceofCapital Proportions
Longtermdebt 30%
Preferredstock 5
Commonstockequity 65

Debt:Thefirmcansella20year,$1,000parvalue,9percentbondfor$980.Aflotationcostof2
percentofthefacevaluewouldberequiredinadditiontothediscountof$20.
PreferredStock:Thefirmhasdetermineditcanissuepreferredstockat$65pershareparvalue.
Thestockwillpayan$8.00annualdividend.Thecostofissuingandsellingthestockis$3per
share.
CommonStock:Thefirmscommonstockiscurrentlysellingfor$40pershare.Thedividend
expectedtobepaidattheendofthecomingyearis$5.07.Itsdividendpaymentshavebeengrowing
ataconstantrateforthelastfiveyears.Fiveyearsago,thedividendwas$3.45.Itisexpectedthatto
sell,anewcommonstockissuemustbeunderpricedat$1pershareandthefirmmustpay$1per
shareinflotationcosts.Additionally,thefirmsmarginaltaxrateis40percent.

Calculatethefirmsweightedaveragecostofcapitalassumingthefirmhasexhaustedallretained
earnings.
Answer: ki5.6%
kp12.9%
kn21.34%
ka(0.3)(5.6)(0.05)(12.9)(0.65)(21.34)16.20%
LevelofDifficulty:3
LearningGoal:4
Topic:WeightedMarginalCostofCapital(Equation11.9)

2. PromoPakhascompiledthefollowingfinancialdata:

SourceofCapital BookValue MarketValue Cost

Longtermdebt $10,000,000 $8,500,000 5.0%
Preferredstock 1,000,000 1,500,000 14.0
Commonstockequity 9,000,000 15,000,000 20.0
$20,000,000 $25,000,000

(a) Calculatetheweightedaveragecostofcapitalusingbookvalueweights.
(b) Calculatetheweightedaveragecostofcapitalusingmarketvalueweights.
 Chapter11TheCostofCapital227
Answers:
(a)
Longtermdebt 50%
Preferredstock 5
Commonstockequity 45
100%

ka(0.5)(5)(0.05)(14)(0.45)(20)2.50.7912.2%
(b)
Longtermdebt 34%
Preferredstock 6
Commonstockequity 60
100%
ka(0.34)(5)(0.06)(14)(0.60)(20)1.70.841214.5%
LevelofDifficulty:4
LearningGoal:4
Topic:WACCUnderAlternativeWeightingSchemes(Equation11.9)

NorthSeaOilhascompiledthefollowingdatarelativetocurrentcostsofitsbasicsourcesofexternal
capitallongtermdebt,preferredstock,andcommonstockequityforvariantrangesoffinancing.
Table11.4
SourceofCapital Cost RangeofTotalNewFinancing
Longtermdebt 7% $0$2,000,000
8 $2,000,001$3,000,000
10 $3,000,001andabove
Preferredstock 19% $0$960,000
21 $960,001andabove
Commonstock 20% $0$700,000
24 $700,001$1,600,000
26 $1,600,001$2,200,000
30 $2,200,001andabove

Thefirmexpectstohave$350,000ofcurrentretainedearningsinthecomingyearatacostof20percent;
oncetheseretainedearningsareexhausted,thefirmwillissuenewcommonstock.Thecompanystarget
capitalstructureproportionsareusedincalculatingtheweightedaveragecostofcapitalfollow.

SourceofCapital TargetCapitalStructure
Longtermdebt 0.25
Preferredstock 0.25
Commonstockequity 0.50

3. Calculatethefirmscostofcapitalpriortoexhaustingthefirmsavailablecurrentretainedearnings.
(SeeTable11.4.)
Answer: ka(7)(0.25)(19)(0.25)(20)(0.50)16.5%.
LevelofDifficulty:4
LearningGoal:6
Topic:WMCCandBreakingPoints(Equation11.9andEquation11.10)
228GitmanPrinciplesofFinance,EleventhEdition
4. Calculatethefirmscostofcapitalfor$2,000,000oftotalnewfinancing.(SeeTable11.4.)
Answer: ka(7)(0.25)(21)(0.25)(26)(0.50)20%.
LevelofDifficulty:4
LearningGoal:6
Topic:WMCCandBreakingPoints(Equation11.9andEquation11.10)

5. Giventhefollowinginformationontheavailableinvestmentopportunitiesbelow,determinewhich
projectsshouldbeselected.(SeeTable11.4.)

Investment Initial InternalRate

Opportunity Investment ofReturn
A 400,000 22%
B 500,000 21
C 400,000 19
D 400,000 17
E 600,000 16
F 700,000 16

Answer: ProjectsA,B,andC.
LevelofDifficulty:4
LearningGoal:6
Topic:WMCCandIOS

6. Acorporationisconsideringacapitalprojectforthecomingyear.
The project has an internal rate of return of 14 percent. If the firm has the following target capital
structure and costs, what should their decision be and why?

SourceofCapital Proportion AfterTaxCost

Longtermdebt 0.40 10%
Preferredstock 0.10 15%
Commonstockequity 0.50 20%
Answers:ka(0.40)(10%)(0.10)(15%)(0.50)(20%)15.5%
Theyshouldrejectthisproject,becausetheweightedaveragecostofcapitalis15.5
percentandtheinternalrateofreturnis14percent.
LevelofDifficulty:4
LearningGoal:6
Topic:WMCCandIOS(Equation11.9)