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FUNDAMENTALS OF FINANCIAL MANAGEMENT 
09 – The Cost of Capital 
 
Test Bank 
Page 1 of 11 
 
CAPITAL COMPONENTS 
1. Which of the following is not considered a capital component for the purpose of calculating the 
weighted average cost of capital (WACC) as it applies to capital budgeting? (E) 
A. Long-term debt. 
C. Accounts payable and accruals. 
B. Common stock. 
D. Preferred stock. 
 
2. For a typical firm with a given capital structure, which of the following is correct?  (Note: All rates are 
after taxes.) (E) 
A. kd > ke > ks > WACC. 
D. ke > ks > WACC > kD. 
B. ks > ke > kd > WACC. 
E. None of the statements above is correct. 
C. WACC > ke > ks > kD. 
 
3. Which of the following statements is most correct? (E) 
A. 
If a company’s tax rate increases but the yield to maturity of its noncallable bonds remains the 
same, the company’s marginal cost of debt capital used to calculate its weighted average cost 
of capital will fall. 
B. All else equal, an increase in a company’s stock price will increase the marginal cost of 
retained earnings, ks. 
C. All else equal, an increase in a company’s stock price will increase the marginal cost of issuing 
new common equity, kE. 
D. Statements a and b are correct. 
E. Statements b and c are correct. 
 
4. Which of the following statements is most correct? (E) 
A. Since the money is readily available, the cost of retained earnings is usually a lot cheaper than 
the cost of debt financing. 
B. When calculating the cost of preferred stock, a company needs to adjust for taxes, because 
preferred stock dividends are tax deductible. 
C. When calculating the cost of debt, a company needs to adjust for taxes, because interest 
payments are tax deductible. 
D. Statements a and b are correct. 
E. Statements b and c are correct. 
 
5. Which of the following statements is most correct?  
A. 
In the weighted average cost of capital calculation, we must adjust the cost of preferred stock 
for the tax exclusion of 70 percent of dividend income. 
B. We ideally would like to use historical measures of the component costs from prior financings 
in estimating the appropriate weighted average cost of capital. 
C. The cost of a new equity issuance (ke) could possibly be lower than the cost of retained 
earnings (ks) if the market risk premium and risk-free rate decline by a substantial amount. 
D. Statements b and c are correct. 
E. None of the statements above is correct. 
 
6. Which of the following statements is most correct? 
A. The cost of retained earnings is the rate of return stockholders require on a firm’s common 
stock. 
B. The component cost of preferred stock is expressed as kp(1 - T), because preferred stock 
dividends are treated as fixed charges, similar to the treatment of debt interest. 
C. The bond-yield-plus-risk-premium approach to estimating a firm’s cost of common equity 
involves adding a subjectively determined risk premium to the market risk-free bond rate. 
D. The higher the firm’s flotation cost for new common stock, the more likely the firm is to use 
preferred stock, which has no flotation cost. 
E. None of the statements above is correct. 
 
7. Which of the following statements is most correct? 
A. Suppose a firm is losing money and thus, is not paying taxes, and that this situation is 
expected to persist for a few years whether or not the firm uses debt financing.  Then the firm’s 
after-tax cost of debt will equal its before-tax cost of debt. 
B. The component cost of preferred stock is expressed as kp(1 - T), because preferred stock 
dividends are treated as fixed charges, similar to the treatment of debt interest. 
C. The reason that a cost is assigned to retained earnings is because these funds are already 
earning a return in the business; the reason does not involve the opportunity cost principle. 
D. The bond-yield-plus-risk-premium approach to estimating a firm’s cost of common equity 
involves adding a subjectively determined risk premium to the market risk-free bond rate. 
E. None of the statements above is correct. 
 
Internal vs. external common equity 
8. A firm estimates that its proposed capital budget will force it to issue new common stock, which has 
a greater cost than the cost of retained earnings.  The firm, however, would like to avoid issuing 
costly new common stock.  Which of the following steps would mitigate the firm’s need to raise new 
common stock? (E) 
A. 
Increasing the company’s dividend payout ratio for the upcoming year. 
B. Reducing the company’s debt ratio for the upcoming year. 
C. 
Increasing the company’s proposed capital budget. 
D. All of the statements above are correct. 
E. None of the statements above is correct. 
FUNDAMENTALS OF FINANCIAL MANAGEMENT 
09 – The Cost of Capital 
 
Test Bank 
Page 2 of 11 
 
 
COST OF EQUITY ESTIMATION 
Discounted Cash Flow (DCF) Approach 
9. Which of the following factors in the discounted cash flow (DCF) approach to estimating the cost of 
common equity is the least difficult to estimate? (E) 
A. Expected growth rate, g. 
B. Dividend yield, D1/P0. 
C. Required return, ks. 
D. Expected rate of return, k̂s . 
E. All of the above are equally difficult to estimate. 
 
Cost of capital estimation 
10. Which of the following statements is correct? 
A. The cost of capital used to evaluate a project should be the cost of the specific type of 
financing used to fund that project. 
B. The cost of debt used to calculate the weighted average cost of capital is based on an average 
of the cost of debt already issued by the firm and the cost of new debt. 
C. One problem with the CAPM approach in estimating the cost of equity capital is that if a firm’s 
stockholders are, in fact, not well diversified, beta may be a poor measure of the firm’s true 
investment risk. 
D. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method of 
estimating a firm’s cost of equity capital. 
E. The cost of equity capital is generally easier to measure than the cost of debt, which varies 
daily with interest rates, or the cost of preferred stock since preferred stock is issued 
infrequently. 
 
Cost of equity estimation 
11. Which of the following statements is correct? 
A. Although some methods of estimating the cost of equity capital encounter severe difficulties, 
the CAPM is a simple and reliable model that provides great accuracy and consistency in 
estimating the cost of equity capital. 
B. The DCF model is preferred over other models to estimate the cost of equity because of the 
ease with which a firm’s growth rate is obtained. 
C. The bond-yield-plus-risk-premium approach to estimating the cost of equity is not always 
accurate but its advantages are that it is a standardized and objective model. 
D. Depreciation-generated funds are an additional source of capital and, in fact, represent the 
largest single source of funds for some firms. 
E. None of the statements above is correct. 
 
CAPM cost of equity estimation 
12. In applying the CAPM to estimate the cost of equity capital, which of the following elements is not 
subject to dispute or controversy? 
A. The expected rate of return on the market, kM. 
B. The stock’s beta coefficient, bi. 
C. The risk-free rate, kRF. 
D. The market risk premium (RPM). 
E. All of the above are subject to dispute. 
 
CAPM and DCF estimation 
13. Which of the following statements is most correct? 
A. Beta measures market risk, but if a firm’s stockholders are not well diversified, beta may not 
accurately measure stand-alone risk. 
B. 
If the calculated beta underestimates the firm’s true investment risk, then the CAPM method 
will overestimate ks. 
C. The discounted cash flow method of estimating the cost of equity can’t be used unless the 
growth component, g, is constant during the analysis period. 
D. An advantage shared by both the DCF and CAPM methods of estimating the cost of equity 
capital, is that they yield precise estimates and require little or no judgment. 
E. None of the statements above is correct. 
 
WEIGHTED-AVERAGE COST OF CAPITAL 
14. Which of the following statements is most correct? (E) 
A. The WACC measures the after-tax cost of capital. 
B. The WACC measures the marginal cost of capital. 
C. There is no cost associated with using retained earnings. 
D. Statements a and b are correct. 
E. All of the statements above are correct. 
 
15. Which of the following statements about the cost of capital is incorrect? (E) 
A. A company’s target capital structure affects its weighted average cost of capital. 
B. Weighted average cost of capital calculations should be based on the after-tax costs of all the 
individual capital components. 
C. 
If a company’s tax rate increases, then, all else equal, its weighted average cost of capital will 
increase. 
D. Flotation costs can increase the weighted average cost of capital. 
E. An increase in the risk-free rate is likely to increase the marginal costs of both debt and equity 
FUNDAMENTALS OF FINANCIAL MANAGEMENT 
09 – The Cost of Capital 
 
Test Bank 
Page 3 of 11 
 
financing. 
 
16. Campbell Co. is trying to estimate its weighted average cost of capital (WACC).  Which of the 
following statements is most correct? (E) 
A. The after-tax cost of debt is generally cheaper than the after-tax cost of preferred stock. 
B. Since retained earnings are readily available, the cost of retained earnings is generally lower 
than the cost of debt. 
C. 
If the company’s beta increases, this will increase the cost of equity financing, even if the 
company is able to rely on only retained earnings for its equity financing. 
D. Statements a and b are correct. 
E. Statements a and c are correct. 
 
17. Which of the following statements is most correct? 
A. The weighted average cost of capital for a given capital budget level is a weighted average of 
the marginal cost of each relevant capital component that makes up the firm’s target capital 
structure. 
B. The weighted average cost of capital is calculated on a before-tax basis. 
C. An increase in the risk-free rate is likely to increase the marginal costs of both debt and equity 
financing. 
D. Statements a and c are correct. 
E. All of the statements above are correct. 
 
18. Which of the following statements is correct? 
A. The WACC should include only after-tax component costs.  Therefore, the required rates of 
return (or “market rates”) on debt, preferred, and common equity (kd, kp, and ks) must be 
adjusted to an after-tax basis before they are used in the WACC equation. 
B. The cost of retained earnings is generally higher than the cost of new common stock. 
C. Preferred stock is riskier to investors than is debt. Therefore, if someone told you that the 
market rates showed kd > kp for a given company, that person must have made a mistake. 
D. 
If a company with a debt ratio of 50 percent were suddenly exempted from all future income 
taxes, then, all other things held constant, this would cause its WACC to increase. 
E. None of the statements above is correct. 
 
19. Which of the following statements is most correct? 
A. An increase in flotation costs incurred in selling new stock will increase the cost of retained 
earnings. 
B. The WACC should include only after-tax component costs.  Therefore, the required rates of 
return (or “market rates”) on debt, preferred, and common equity (kd, kp, and ks) must be 
adjusted to an after-tax basis before they are used in the WACC equation. 
C. An increase in a firm’s corporate tax rate will increase the firm’s cost of debt capital, as long as 
the yield to maturity on the company’s bonds remains constant or falls. 
D. Statements b and c are correct. 
E. None of the statements above is correct. 
 
20. Which of the following statements is most correct? 
A. Since stockholders do not generally pay corporate taxes, corporations should focus on before-
tax cash flows when calculating the weighted average cost of capital (WACC). 
B. All else equal, an increase in flotation costs will increase the cost of retained earnings. 
C. When calculating the weighted average cost of capital, firms should rely on historical costs 
rather than marginal costs of capital. 
D. Statements a and b are correct. 
E. None of the statements above is correct. 
 
Factors influencing WACC 
21. Wyden Brothers has no retained earnings.  The company uses the CAPM to calculate the cost of 
equity capital.  The company’s capital structure consists of common stock, preferred stock, and 
debt.  Which of the following events will reduce the company’s WACC? (E) 
A. A reduction in the market risk premium. 
B. An increase in the flotation costs associated with issuing new common stock. 
C. An increase in the company’s beta. 
D. An increase in expected inflation. 
E. An increase in the flotation costs associated with issuing preferred stock. 
 
WACC and capital components 
22. Which of the following statements is most correct? (E) 
A. The WACC is a measure of the before-tax cost of capital. 
B. Typically the after-tax cost of debt financing exceeds the after-tax cost of equity financing. 
C. The WACC measures the marginal after-tax cost of capital. 
D. Statements a and b are correct. 
E. Statements b and c are correct. 
 
23. A company has a capital structure that consists of 50 percent debt and 50 percent equity.  Which of 
the following statements is most correct? (E) 
A. The cost of equity financing is greater than or equal to the cost of debt financing. 
B. The WACC exceeds the cost of equity financing. 
C. The WACC is calculated on a before-tax basis. 
FUNDAMENTALS OF FINANCIAL MANAGEMENT 
09 – The Cost of Capital 
 
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D. The WACC represents the cost of capital based on historical averages. In that sense, it does 
not represent the marginal cost of capital. 
E. The cost of retained earnings exceeds the cost of issuing new common stock. 
 
24. Which of the following statements is correct? 
A. Because we often need to make comparisons among firms that are in different income tax 
brackets, it is best to calculate the WACC on a before-tax basis. 
B. 
If a firm has been suffering accounting losses and is expected to continue suffering such 
losses, and therefore its tax rate is zero, it is possible that its after-tax component cost of 
preferred stock as used to calculate the WACC will be less than its after-tax component cost of 
debt. 
C. Normally, the cost of external equity raised by issuing new common stock is above the cost of 
retained earnings.  Moreover, the higher the growth rate is relative to the dividend yield, the 
more the cost of external equity will exceed the cost of retained earnings. 
D. The lower a company’s tax rate, the greater the advantage of using debt in terms of lowering 
its WACC. 
E. None of the statements above is correct. 
 
RISK AND PROJECT SELECTION 
SML and capital budgeting 
25. Using the Security Market Line concept in capital budgeting, which of the following is correct? (M) 
A. 
If the expected rate of return on a given capital project lies above the SML, the project should 
be accepted even if its beta is above the beta of the firm’s average project. 
B. 
If a project’s return lies below the SML, it should be rejected if it has a beta greater than the 
firm’s existing beta but accepted if its beta is below the firm’s beta. 
C. 
If two mutually exclusive projects’ expected returns are both above the SML, the project with 
the lower risk should be accepted. 
D. 
If a project’s expected rate of return is greater than the expected rate of return on an average 
project, it should be accepted. 
E. None of the statements above is correct. 
 
Divisional Risk, Cost of Capital & Project Selection 
Risk-adjusted cost of capital 
26. Sunshine Inc. has two divisions.  50 percent of the firm’s capital is invested in Division A, which has 
a beta of 0.8.  The other 50 percent of the firm’s capital is invested in Division B, which has a beta 
of 1.2.  The company has no debt, and it is 100 percent equity financed. The risk-free rate is 6 
percent and the market risk premium is 5 percent.  Sunshine assigns different hurdle rates to each 
division, and these hurdle rates are based on each division’s market risk.  Which of the following 
statements is most correct? (E) 
A. Sunshine’s composite WACC is 11 percent. 
B. Division B has a lower weighted average cost of capital than Division A. 
C. 
If Sunshine assigned the same hurdle rate to each division, this would lead the firm to select 
too many projects in Division A and reject too many projects in Division B. 
D. Statements a and b are correct. 
E. Statements a and c are correct. 
 
27. Kemp Consolidated has two divisions of equal size: a computer division and a restaurant division.  
Stand-alone restaurant companies typically have a cost of capital of 8 percent, while stand-alone 
computer companies typically have a 12 percent cost of capital.  Kemp’s restaurant division has the 
same risk as a typical restaurant company, and its computer division has the same risk as a typical 
computer company.  Consequently, Kemp estimates that its composite corporate cost of capital is 
10 percent. The company’s consultant has suggested that they use an 8 percent hurdle rate for the 
restaurant division and a 12 percent hurdle rate for the computer division.  However, Kemp has 
chosen to ignore its consultant, and instead, chooses to assign a 10 percent cost of capital to all 
projects in both divisions.  Which of the following statements is most correct? 
A. While Kemp’s decision to not risk adjust its cost of capital will lead it to accept more projects in 
its computer division and fewer projects in its restaurant division, this should not affect the 
overall value of the company. 
B. Kemp’s decision to not risk adjust means that it is effectively subsidizing its restaurant division, 
which means that its restaurant division is likely to become a larger part of the overall company 
over time. 
C. Kemp’s decision to not risk adjust means that the company will accept too many projects in the 
computer business and too few projects in the restaurant business.  This will lead to a 
reduction in the overall value of the company. 
D. Statements a and b are correct. 
E. Statements b and c are correct. 
 
28. The Barabas Company has an equal amount of low-risk projects, average-risk projects, and high-
risk projects.  Barabas estimates that the overall company’s WACC is 12 percent.  This is also the 
correct cost of capital for the company’s average-risk projects.  The company’s CFO argues that, 
even though the company’s projects have different risks, the cost of capital for each project should 
be the same because the company obtains its capital from the same sources.  If the company 
follows the CFO’s advice, what is likely to happen over time? 
A. The company will take on too many low-risk projects and reject too many high-risk projects. 
B. The company will take on too many high-risk projects and reject too many low-risk projects. 
C. Things will generally even out over time, and therefore, the risk of the firm should remain 
FUNDAMENTALS OF FINANCIAL MANAGEMENT 
09 – The Cost of Capital 
 
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constant over time. 
D. Statements a and c are correct. 
E. Statements b and c are correct. 
 
Project Selection 
29. If a company uses the same cost of capital for evaluating all projects, which of the following results 
is likely? 
A. Accepting poor, high-risk projects. 
D. Accepting no projects. 
B. Rejecting good, low-risk projects. 
E. Answers a and b are correct. 
C. Accepting only good, low-risk projects. 
 
30. If a typical U.S. company uses the same cost of capital to evaluate all projects, the firm will most 
likely become 
A. Riskier over time, and its value will decline. 
B. Riskier over time, and its value will rise. 
C. Less risky over time, and its value will rise. 
D. Less risky over time, and its value will decline. 
E. There is no reason to expect its risk position or value to change over time as a result of its use 
of a single discount rate. 
 
31. Conglomerate Inc. consists of 2 divisions of equal size, and Conglomerate is 100 percent equity 
financed.  Division A’s cost of equity capital is 9.8 percent, while Division B’s cost of equity capital is 
14 percent.  Conglomerate’s composite WACC is 11.9 percent.  Assume that all Division A projects 
have the same risk and that all Division B projects have the same risk.  However, the projects in 
Division A are not the same risk as those in Division B.  Which of the following projects should 
Conglomerate accept? (E) 
A. Division A project with an 11 percent return. 
B. Division B project with a 12 percent return. 
C. Division B project with a 13 percent return. 
D. Statements a and c are correct. 
E. Statements b and d are correct. 
 
32. Smith Electric Co. and Ferdinand Water Co. are the same size and have the same capital 
structure.  Smith Electric Co. is riskier than Ferdinand and has a WACC of 12 percent.  Ferdinand 
Water Co. is safer than Smith and has a WACC of 10 percent.  Ferdinand Water Co. is considering 
Project X. Project X has an IRR of 10.5 percent, and has the same risk as a typical project 
undertaken by Ferdinand Water Co.  Smith Electric Co. is considering Project Y.  Project Y has an 
IRR of 11.5 percent, and has the same risk as a typical project undertaken by Smith Electric Co. 
Now assume that Smith Electric Co. and Ferdinand Water Co. merge to form a new company, 
Leeds United Utilities.  The merger has no impact on the cash flows or risk of either Project X or 
Project Y.  Leeds United Utilities’ CFO is trying to establish hurdle rates for the new company’s 
projects that accurately reflect the risk of each project. (That is, he is using risk-adjusted hurdle 
rates.)  Which of the following statements is most correct? 
A. Leeds United Utilities’ weighted average cost of capital is 11 percent. 
B. Project X has a positive NPV. 
C. After the merger, Leeds United Utilities should select Project X and reject Project Y. 
D. Statements a and b are correct. 
E. All of the statements above are correct. 
 
Division WACCs and risk 
33. Pearson Plastics has two equal-sized divisions, Division A and Division B. The company estimates 
that if the divisions operated as independent companies Division A would have a cost of capital of 8 
percent, while Division B would have a cost of capital of 12 percent.  Since the two divisions are the 
same size, Pearson’s composite weighted average cost of capital (WACC) is 10 percent.  In the past, 
Pearson has assigned separate hurdle rates to each division based on their relative risk.  Now, 
however, Pearson has chosen to use the corporate WACC, which is currently 10 percent, for both 
divisions.  Which of the following is likely to occur as a result of this change?  Assume that this change 
is likely to have no effect on the average risk of each division and market conditions remain 
unchanged. 
A. Over time, the overall risk of the company will increase. 
B. Over time, Division B will become a larger part of the overall company. 
C. Over time, the company’s corporate WACC will increase. 
D. Statements a and c are correct. 
E. All of the statements above are correct. 
 
Project Risk, Cost of Capital and Project Selection 
Beta and project risk 
34. Which of the following statements is correct? 
A. A relatively risky future cash outflow should be evaluated using a relatively low discount rate. 
B. 
If a firm’s managers want to maximize the value of the stock, they should concentrate 
exclusively on projects’ market, or beta, risk. 
C. 
If a firm evaluates all projects using the same cost of capital, then the riskiness of the firm as 
measured by its beta will probably decline over time. 
D. 
If a firm has a beta that is less than 1.0, say 0.9, this would suggest that its assets’ returns are 
negatively correlated with the returns of most other firms’ assets. 
E. None of the statements above is correct. 
FUNDAMENTALS OF FINANCIAL MANAGEMENT 
09 – The Cost of Capital 
 
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35. If the firm is being operated so as to maximize shareholder wealth, and if our basic assumptions 
concerning the relationship between risk and return are true, then which of the following should be 
true? (M) 
A. 
If the beta of the asset is larger than the firm’s beta, then the required return on the asset is less than 
the required return on the firm. 
B. 
If the beta of the asset is smaller than the firm’s beta, then the required return on the asset is greater than 
the required return on the firm. 
C. 
If the beta of the asset is greater than the firm’s beta prior to the addition of that asset, then the 
firm’s beta after the purchase of the asset will be smaller than the original firm’s beta. 
D. 
If the beta of an asset is larger than the firm’s beta prior to the addition of that asset, then the 
required return on the firm will be greater after the purchase of that asset than prior to its 
purchase. 
E. None of the statements above is correct. 
 
Project cost of capital 
36. Louisiana Enterprises, an all-equity firm, is considering a new capital investment.  Analysis has 
indicated that the proposed investment has a beta of 0.5 and will generate an expected return of 7 
percent.  The firm currently has a required return of 10.75 percent and a beta of 1.25.  The 
investment, if undertaken, will double the firm’s total assets.  If kRF is 7 percent and the market 
return is 10 percent, should the firm undertake the investment?  (Choose the best answer.) (E) 
A. Yes; the expected return of the asset (7%) exceeds the required return (6.5%). 
B. Yes; the beta of the asset will reduce the risk of the firm. 
C. No; the expected return of the asset (7%) is less than the required return (8.5%). 
D. No; the risk of the asset (beta) will increase the firm’s beta. 
E. No; the expected return of the asset is less than the firm’s required return, which is 10.75%. 
 
37. Assume you are the director of capital budgeting for an all-equity firm. The firm’s current cost of 
equity is 16 percent; the risk-free rate is 10 percent; and the market risk premium is 5 percent.  You 
are considering a new project that has 50 percent more beta risk than your firm’s assets currently 
have, that is, its beta is 50 percent larger than the firm’s existing beta.  The expected return on the 
new project is 18 percent.  Should the project be accepted if beta risk is the appropriate risk 
measure?  Choose the correct statement. (M) 
A. Yes; its expected return is greater than the firm’s cost of capital. 
B. Yes; the project’s risk-adjusted required return is less than its expected return. 
C. No; a 50 percent increase in beta risk gives a risk-adjusted required return of 24 percent. 
D. No; the project’s risk-adjusted required return is 2 percentage points above its expected return. 
E. No; the project’s risk-adjusted required return is 1 percentage point above its expected return. 
 
Project Selection 
38. Dick Boe Enterprises, an all-equity firm, has a corporate beta coefficient of 1.5.  The financial 
manager is evaluating a project with an expected return of 21 percent, before any risk adjustment.  
The risk-free rate is 10 percent, and the required rate of return on the market is 16 percent.  The 
project being evaluated is riskier than Boe’s average project, in terms of both beta risk and total 
risk.  Which of the following statements is most correct? (E) 
A. The project should be accepted since its expected return (before risk adjustment) is greater 
than its required return. 
B. The project should be rejected since its expected return (before risk adjustment) is less than its 
required return. 
C. The accept/reject decision depends on the risk-adjustment policy of the firm.  If the firm’s policy 
were to reduce a riskier-than-average project’s expected return by 1 percentage point, then the 
project should be accepted. 
D. Riskier-than-average projects should have their expected returns increased to reflect their 
added riskiness.  Clearly, this would make the project acceptable regardless of the amount of 
the adjustment. 
E. Projects should be evaluated on the basis of their total risk alone. Thus, there is insufficient 
information in the problem to make an accept/reject decision. 
 
39. A company estimates that an average-risk project has a WACC of 10 percent, a below-average risk 
project has a WACC of 8 percent, and an above-average risk project has a WACC of 12 percent.  
Which of the following independent projects should the company accept? (E) 
A. Project A has average risk and a return of 9 percent. 
B. Project B has below-average risk and a return of 8.5 percent. 
C. Project C has above-average risk and a return of 11 percent. 
D. All of the projects above should be accepted. 
E. None of the projects above should be accepted. 
 
Pure play method 
40. Which of the following methods involves calculating an average beta for firms in a similar business 
and then applying that beta to determine a project’s beta? (M) 
A. Risk premium method. 
D. CAPM method. 
B. Pure play method. 
E. Statements b and c are correct. 
C. Accounting beta method. 
 
41. Interstate Transport has a target capital structure of 50 percent debt and 50 percent common 
equity.  The firm is considering a new independent project that has a return of 13 percent and is not 
FUNDAMENTALS OF FINANCIAL MANAGEMENT 
09 – The Cost of Capital 
 
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related to transportation.  However, a pure play proxy firm has been identified that is exclusively 
engaged in the new line of business.  The proxy firm has a beta of 1.38.  Both firms have a 
marginal tax rate of 40 percent, and Interstate’s before-tax cost of debt is 12 percent.  The risk-free 
rate is 10 percent and the market risk premium is 5 percent. The firm should (M) 
A. Reject the project; its return is less than the firm’s required rate of return on the project of 16.9 
percent. 
B. Accept the project; its return is greater than the firm’s required rate of return on the project of 
12.05 percent. 
C. Reject the project; its return is only 13 percent. 
D. Accept the project; its return exceeds the risk-free rate and the before-tax cost of debt. 
E. Be indifferent between accepting or rejecting; the firm’s required rate of return on the project 
equals its expected return. 
 
RETAINED EARNINGS BREAK POINT 
42. Which of the following will increase a company’s retained earnings break point? (E) 
A. An increase in its net income. 
B. An increase in its dividend payout. 
C. An increase in the amount of equity in its capital structure. 
D. An increase in its capital budget. 
E. All of the statements above are correct. 
 
43. Which of the following actions will increase the retained earnings break point? (E) 
A. An increase in the dividend payout ratio. 
B. An increase in the debt ratio. 
C. An increase in the capital budget. 
D. An increase in flotation costs. 
E. All of the statements above are correct. 
 
COMPREHENSIVE 
44. Which of the following statements is most correct? (E) 
A. Since debt capital is riskier than equity capital, the cost of debt is always greater than the 
WACC. 
B. Because of the risk of bankruptcy, the cost of debt capital is always higher than the cost of 
equity capital. 
C. 
If a company assigns the same cost of capital to all of its projects regardless of the project’s 
risk, then it follows that the company will generally reject too many safe projects and accept too 
many risky projects. 
D. Because you are able to avoid flotation costs, the cost of retained earnings is generally lower 
than the cost of debt. 
E. Higher flotation costs tend to reduce the cost of equity capital. 
 
45. Which of the following statements is most correct? (E) 
A. Higher flotation costs reduce investor returns, and therefore reduce a company’s WACC. 
B. The WACC represents the historical cost of capital and is usually calculated on a before-tax 
basis. 
C. The cost of retained earnings is zero because retained earnings are readily available and do 
not require the payment of flotation costs. 
D. All of the statements above are correct. 
E. None of the statements above is correct. 
 
 
 
1. 
Capital components 
Answer: c  Diff: E 
2. 
Capital components 
Answer: d  Diff: E 
3. 
Capital components 
Answer: a  Diff: E 
The debt cost used to calculate a firm’s WACC is kd(1 - T).  If kd remains constant but T 
increases, then the term (1 - T) decreases and the value of the entire equation, kd(1 - T), 
decreases.  Statement b is false; if a company’s stock price increases, and all else remains 
constant, then the dividend yield decreases and ks decreases.  This can be seen from the 
equation ks = D1/P0 + g.  Statement c is false for the same reason.  The cost of issuing new 
common stock is ke = D1/[P0(1 - F)] + g.  If P0 increases but there’s no change in the flotation 
cost, ke will decrease. 
 
4. 
Capital components 
Answer: c  Diff: E 
Retained earnings are just another form of equity.  When the company has retained earnings, 
they can do one of two things--reinvest it or pay it out as dividends.  If the firm reinvests the 
earnings, it needs to earn a return that is at least as high as the ks of the stock.  Otherwise, 
investors would be happier receiving the dividends and investing them in something that will 
earn ks.  Therefore, statement a is false.  Some of the preferred stock dividends are excluded 
from taxation when another company owns them.  It makes no tax difference to the company 
that pays the dividends, since dividends come out of after-tax dollars.  Therefore, statement b 
is false.  Interest payments are tax deductible. Therefore, statement c is true. 
5. 
Capital components 
Answer: e  Diff: M 
Statement e is the correct answer.  Unlike interest expense on debt, preferred dividends are 
not deductible, hence there are no tax savings associated with the use of preferred stock.  The 
component costs of WACC should reflect the costs of new financing, not historical measures.  
FUNDAMENTALS OF FINANCIAL MANAGEMENT 
09 – The Cost of Capital 
 
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The cost of issuing new equity is always greater than the cost of retained earnings. 
 
6. 
Capital components 
Answer: a  Diff: M 
Statement a is true; the other statements are false.  Preferred stock dividends are not tax 
deductible; therefore, the cost of preferred stock is only kp. The risk premium in the bond-yield-
plus-risk premium approach would be added to the firm’s cost of debt, not the risk-free rate.  
Preferred stock also has flotation costs. 
 
7. 
Miscellaneous concepts Answer: a  Diff: M 
8. 
Internal vs. external common equity 
Answer: e  Diff: E 
Statements a through c will increase the need to raise new common stock; therefore, 
statement e is the correct answer. 
 
 
9. 
DCF cost of equity estimation 
Answer: b  Diff: E 
10. 
Cost of capital estimation Answer: c  Diff: M 
11. 
Cost of equity estimation Answer: d  Diff: M 
12. 
CAPM cost of equity estimation 
Answer: e  Diff: M 
13. 
CAPM and DCF estimation 
Answer: a  Diff: M 
14. 
WACC Answer: d  Diff: E 
 
The correct answer is statement d because statements a and b are correct.  Statement c is 
false.  Shareholders can either receive a dividend or they can let you reinvest in the company. 
 If they receive a dividend, they can invest that money and earn a return on it. Consequently, if 
the company keeps the money as retained earnings and reinvests in projects, it had better 
earn a return on that money. Therefore, there is a cost associated with using retained 
earnings. 
 
15. 
WACC Answer: c  Diff: E 
Statement c is the correct choice.  A tax rate increase would lead to a decrease in the after-tax 
cost of debt and, consequently, the firm’s WACC would decrease. 
 
 
16. WACC Answer: e  Diff: E 
The preferred stock dividend is not tax deductible like the interest payment on debt.  Therefore, 
there 
is 
no 
tax 
benefit 
from 
preferred 
stock.  
Statement a is true.  Retained earnings are equity, and equity will have a higher cost than debt.  
 
Therefore, statement b is false.  If the beta increases, investors will require a higher rate of return 
to hold or buy the stock.  Therefore, the cost of equity will go up, and statement c is true.  
Because statements a and c are true, the correct choice is statement e. 
 
17. 
WACC Answer: d  Diff: M 
Both statements a and c are true; therefore, statement d is the correct choice.  Statement a 
recites the definition of the weighted average cost of capital.  Statement c is correct because kd 
= 
kRF 
+ 
LP 
+ 
MRP 
+ 
DRP 
while  
ks = kRF + (kM - kRF)b.  If kRF increases then the values for kd and ks will increase. 
 
18. 
WACC Answer: d  Diff: M 
If a firm paid no income taxes, its cost of debt would not be adjusted downward, hence the 
component cost of debt would be higher than if T were greater than 0.  With a higher 
component cost of debt, the WACC would increase.  Of course, the company would have 
higher earnings, and its cash flows from a given project would be high, so the higher WACC 
would not impede its investments, that is, its capital budget would be larger than if it were 
taxed. 
 
19. 
WACC Answer: e  Diff: M 
Statement e is the correct answer.  An increase in flotation costs has no effect on the cost of 
retained earnings.  Since interest is tax deductible, while preferred and common dividends are 
not, only the cost of debt used in the WACC equation must be adjusted by multiplying by (1 - 
T).  An increase in the firm’s corporate tax rate reduces the after-tax component cost of debt. 
 
 
20. 
WACC Answer: e  Diff: M 
Statement e is the correct answer.  After-tax cash flows must be considered in order to account 
for the tax deductibility of interest payments on corporate debt.  An increase in flotation costs will 
leave the cost of retained earnings unchanged, but will raise the cost of new equity issues. The 
marginal, not the embedded, cost of capital is the relevant cost of capital. 
 
21. 
Factors influencing WACC 
Answer: a  Diff: E 
Statement a is true; the other statements are false.  If RPM decreases, the cost of equity will be 
reduced.  Answers b through e will all increase the company’s WACC. 
 
22. 
WACC and capital components 
Answer: c  Diff: E 
WACC measures the marginal after-tax cost of capital; therefore, statement a is false.  The 
FUNDAMENTALS OF FINANCIAL MANAGEMENT 
09 – The Cost of Capital 
 
Test Bank 
Page 9 of 11 
 
 
after-tax cost of debt financing is less than the after-tax cost of equity financing; therefore, 
statement b is false.  The correct choice is statement c. 
 
23. 
WACC and capital components 
Answer: a  Diff: E 
Statement a is true; the other statements are false.  Statement b is false; WACC is an average 
of debt and equity financing.  Since debt financing is cheaper and is adjusted downward for 
taxes, it should, when averaged with equity, cause the WACC to be less than the cost of equity 
financing.  Statement c is false; WACC is calculated on an after-tax basis.  Statement d is 
false; the WACC is based on marginal, not embedded, costs.  Statement e is false; the cost of 
issuing new common stock is greater than the cost of retained earnings. 
 
24. 
WACC and capital components 
Answer: b  Diff: M 
Because corporations can exclude dividends for tax purposes, preferred stock often has a before-
tax market return that is less than the issuing company’s before-tax cost of debt.  Then, if the 
issuer’s tax rate is zero, its component cost of preferred would be less than its after-tax cost of 
debt. 
 
9A-25. SML and capital budgeting 
Answer: a  Diff: M 
9A-26. Risk and divisional costs of capital Answer: a  Diff: E  N 
The correct answer is statement A.  The composite WACC will be the average of the two 
divisional WACCs.  Since there is no debt, the WACC = ks.  There is no cost of equity given, 
but it can be calculated from the beta, the risk-free rate, and the market risk premium using 
CAPM.  The beta of the entire company is the weighted average of the two divisions’ betas 
(0.5 × 0.8 + 0.5 × 1.2 = 1.0).  The firm’s cost of equity will be equal to 11% (ks = kRF + 
(RPM)b = 6% + 5% × 1.0 = 11%).  Therefore, the WACC is 11%, and statement a is correct. 
 Division B has a higher beta, therefore its cost of capital will be higher than A’s.  Therefore, 
statement b is false.  If both divisions were assigned the same hurdle rate, this rate would 
reflect the required return on projects with a beta of 1.0.  Since Division A’s average projects 
have a beta of 0.8, they would tend to have a lower return.  Therefore, fewer of them would 
meet the hurdle rate of 11%, and the company would choose too few of them.  Conversely, 
the company would choose too many projects in Division B.  Therefore, statement c is false. 
 
27. 
Risk-adjusted cost of capital 
Answer: c  Diff: M 
By Kemp not making the risk adjustment, it is true that the company will accept more projects 
in the computer division, and fewer projects in the restaurant division.  However, this will make 
the company riskier overall, raising its cost of equity.  Investors will discount their cash flows at 
a higher rate, and the company’s value will fall.  In addition, some of the computer projects 
 
might not exceed the appropriate risk-adjusted hurdle rate, and will actually be negative NPV 
projects, further destroying value. Therefore, statement a is false.  Because fewer of the 
restaurant projects will be accepted, the restaurant division will become a smaller part of the 
overall company.  Therefore, statement b is false.  As explained above, statement c is true. 
 
28. 
Risk-adjusted cost of capital 
Answer: b  Diff: M 
By not risk adjusting the cost of capital, the firm will tend to reject low-risk projects since their 
returns will be lower than the average cost of capital, and it will take on high-risk projects since 
their returns will be higher than the average cost of capital. 
 
29. 
Risk-adjusted cost of capital 
Answer: e  Diff: M 
30. 
Risk-adjusted cost of capital 
Answer: a  Diff: M 
31. 
Divisional risk Answer: a  Diff: E  N 
The correct answer is statement A.  Division A should accept only projects with a return 
greater than 9.8 percent, and Division B should accept only projects with a return greater than 
14 percent.  Only statement a fits this criteria.  The company’s composite WACC is irrelevant 
in the decision. 
 
32. 
Divisional risk and project selection 
Answer: e  Diff: M  N 
The correct answer is statement e.  Statement a is correct; the firms have the same size and 
capital structure, so the WACC of the merged company is just a simple average of their 
separate WACCs.  Statement b is correct; Project X has an IRR of 10.5% and its appropriate 
cost of capital is 10%, therefore, the project has a positive net present value.  Statement c is 
also correct; Project X should be accepted because of the previous argument.  Project Y 
should be rejected because it has an 11.5% return and its appropriate cost of capital is 12%.  
Therefore, statement e is the correct choice. 
 
33. 
Division WACCs and risk Answer: e  Diff: M 
If the company uses the 10 percent WACC, it will turn down all projects with a return of less 
than 10 percent but more than 8 percent.  Thus, these “safer” projects will no longer be taken, 
and the company will increase the proportion of risky projects it undertakes.  Therefore, 
statement a is true.  If Division A’s projects have lower returns than Division B’s because they 
have less risk, fewer and fewer projects will be accepted from Division A and more projects will 
be accepted from Division B.  Therefore, Division B will grow and Division A will shrink. 
Therefore, statement b is true.  If the company becomes riskier, then its cost of equity will 
increase causing WACC to increase.  Therefore, statement c is true.  Because all of the 
statements are true, the correct choice is statement e. 
FUNDAMENTALS OF FINANCIAL MANAGEMENT 
09 – The Cost of Capital 
 
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34. 
Beta and project risk 
Answer: a  Diff: M 
9A-35. Risk and project betas 
Answer: d  Diff: M 
9A-36. Project cost of capital 
Answer: c  Diff: E 
Calculate the required return, ks, and compare to the expected return, s
k̂
. 
s
k̂
 
= 
7%. 
ks 
= 
kRF + (kM - kRF)b = 7% + (10% - 7%)0.5 = 8.5%. 
ks 
> 
s
k̂
; 8.5% > 7.0%; reject the investment. 
 
9A-37. Project cost of capital 
Answer: e  Diff: M 
Calculate the beta of the firm, and use to calculate project beta: 
ks = 0.16  = 0.10 + (0.05)bFirm.  bFirm = 1.2. 
bProject = (bFirm)1.5. (bProject is 50% greater than current bFirm) 
bProject = (1.2)1.5 = 1.8. 
 
Calculate required return on project, kProject, and compare to expected return: 
Project:  kProject = 0.10 + (0.05)1.8 = 0.19 = 19%.  Expected return = 0.18 = 18%.  Since the 
required return is one percentage point greater than the expected return, the firm should not 
accept the new project. 
 
 
 
 
 
 
 
38. 
Risk and project selection Answer: c  Diff: E 
ks = 10% + (16% - 10%)1.5 = 10% + 9% = 19%. 
Expected return = 21%.  21% - Risk adjustment 1% = 20%. 
Risk-adjusted return = 20% > ks = 19%.  Thus, the project should be selected. 
 
39. 
Risk and project selection Answer: b  Diff: E 
The project whose return is greater than its risk-adjusted cost of capital should be selected.  
Only Project B meets this criteria. 
 
9B-40. Pure play method 
Answer: b  Diff: M 
9B-41. Pure play method 
Answer: b  Diff: M 
 
Calculate the required return, ks, and use to calculate the WACC: 
ks = 10% + 1.38(5%) = 16.9%. 
WACC = 0.5(12.0%)(0.6) + 0.5(16.9%) = 12.05%. 
Compare expected project return, Project
k̂
, to WACC: 
But Project
k̂
 = 13.0%. 
Accept the project since 
WACC
k̂Project >
:  13.0% > 12.05%. 
42. 
Retained earnings break point 
Answer: a  Diff: E 
Statement a is true; an increase in net income will increase the retained earnings break point.  
Statements b and c will serve to lower the break point.  Statement b will result in less earnings 
being retained, so the retained earnings break point will be reduced. Statement c will result in 
more earnings being needed, so the retained earnings break point will be reduced.  Statement 
d will have no effect on the retained earnings break point. 
 
43. 
Retained earnings break point 
Answer: b  Diff: E 
Statement a is false; increasing the dividend payout will result in the firm running out of 
retained earnings earlier.  Statement b is true; a higher debt ratio means that retained earnings 
are a smaller portion of the funding mix and, therefore, retained earnings will go further. 
Statement c will have no effect on the retained earnings break point, as is the case for 
statement d. 
 
44. 
Miscellaneous cost of capital concepts 
Answer: c  Diff: E  N 
The correct answer is statement c.  Debt is usually safer than equity because it has promised 
payments over the life of the debt.  So, the cost of debt is typically below the WACC.  So, 
statement a is incorrect.  If bankruptcy occurs, debt holders may get something.  Equity 
holders will get nothing!  So, the cost of debt is again typically below the cost of equity. So, 
statement b is incorrect.  Statement c is correct.  Statement d is incorrect.  The cost of retained 
earnings is generally equal to the required return on equity, which exceeds the cost of debt. 
Higher flotation costs increase the cost of equity.  So statement e is incorrect. 
 
45. 
Miscellaneous concepts Answer: e  Diff: E 
Flotation costs do not reduce investor returns; they reduce the amount of the company’s 
proceeds.  This drives the company’s cost of equity, and thus its WACC, higher.  Therefore, 
statement a is false.  The WACC is based on marginal costs and incorporates taxes.  
Consequently, statement b is false. Retained earnings have no flotation costs but the company 
still must earn a return on them, so they are not without a cost.  Investors expect a required 
rate of return, and if they don’t receive it, they would prefer that the company pay out retained 
FUNDAMENTALS OF FINANCIAL MANAGEMENT 
09 – The Cost of Capital 
 
Test Bank 
Page 11 of 11 
 
 
earnings as dividends, so that they can then invest in something that does give them their 
expected return.  Thus, retained earnings have a cost. Therefore, statement c is false.  Since 
statements a, b, and c are false, the correct choice is statement e.