FIN 300 Exam 3 || Guaranteed Pass.
Which is lower for a given company: the cost of debt or the cost of equity? correct answers The
cost of debt is always less than the cost of equity for a given firm. This is because the debt
investor is taking a lower risk than the equity investor and therefore the required rate of return is
lower.
When a company issues new securities, how do flotation costs affect the cost of raising that
capital? correct answers When a company issues new securities flotation costs increase the cost
of raising the capital. The company receives a smaller amount of the proceeds from the new
issues, the greater the flotation costs.
What does the "weight" refer to in the weighted average cost of capital? correct answers The
weight referred to in weighted average cost of capital refers to the portion of the total capital
raised by the firm that comes from a given source such as debt, preferred stock or equity.
How do tax considerations affect the cost of debt and the cost of equity? correct answers Because
interest on debt is tax deductible to the issuing firm, the higher the tax rate the lower the after tax
cost of debt financing. Tax considerations do not enter into the cost of equity calculation since
dividends paid to stockholders are not tax deductible to the firm.
What is the investment opportunity schedule (IOS)? How does it help financial managers make
business decisions? correct answers The investment opportunity schedule shows graphically
proposed capital budgeting projects depicting the IRR and dollar amount of investment for each
project. This helps the financial manager make business decisions since the investment
opportunity schedule and the marginal cost of capital schedule can be plotted together, with those
projects on the IOS schedule above the MCC being acceptable.
What is a marginal cost of capital schedule (MCC)? Is the schedule always a horizontal line?
Explain. correct answers The marginal cost of capital schedule is a graphic depiction of the
weighted average cost of capital at different levels of financing. The MCC schedule is not always
a horizontal line. For many firms the MCC schedule increases, usually at discreet intervals, as
the amount of funds to be raised increases.
, For a given IOS and MCC, how do financial managers decide which proposed capital budgeting
projects to accept, and which to reject? correct answers For a given IOS and MCC, all
independent projects that plot on the IOS above the MCC are accepted. Those projects on the
IOS below the MCC are rejected.
What would be the after-tax cost of debt for a company with a YTM of 7% and a tax rate of 20%
correct answers YTM = 7% X (1 - .20) = 5.6
Calculate the After-tax cost of debt for a loan with an annual interest rate of 10% and an interest
subsidy tax rate of 22% correct answers 10% X (1 - .22) = 7.8
A firm is issuing new bonds that pay 8 percent annual interest. The market required annual rate
of return on these bonds is 13 percent. The firm has an interest subsidy rate of 25 percent.
a. What is the before-tax cost of debt?
b. What is the after-tax cost of debt? correct answers A. 13% (Market required rate)
B. 13% X (1 - .25) = 9.75
A company can sell preferred stock for $26 per share, and each share of stock is expected to pay
a dividend of $2. If the flotation cost per share of stock is $0.75, what would be the estimate of
the cost of capital from this source? correct answers kp = $2/($26 - $0.75) = $2/$25.25 = 7.92%
El Norte Industries will issue $100 Par, 12% preferred Stock. The market price is expected to be
$89 per share. El Norte must pay flotation costs of 5% of the market price. What is El Norte's
cost of preferred stock? correct answers kp = $100 X 0.12/($89 - ($89 X 0.05)) = $12/($89 -
$4.45) = 14.19%
Twister Corporation is expected to pay a dividend of $7 per share one year from now on its
common stock, which has a current market price of $143. Twister's dividends are expected to
grow at 13 percent.
A. Calculate the cost of the company's retained earnings.
Which is lower for a given company: the cost of debt or the cost of equity? correct answers The
cost of debt is always less than the cost of equity for a given firm. This is because the debt
investor is taking a lower risk than the equity investor and therefore the required rate of return is
lower.
When a company issues new securities, how do flotation costs affect the cost of raising that
capital? correct answers When a company issues new securities flotation costs increase the cost
of raising the capital. The company receives a smaller amount of the proceeds from the new
issues, the greater the flotation costs.
What does the "weight" refer to in the weighted average cost of capital? correct answers The
weight referred to in weighted average cost of capital refers to the portion of the total capital
raised by the firm that comes from a given source such as debt, preferred stock or equity.
How do tax considerations affect the cost of debt and the cost of equity? correct answers Because
interest on debt is tax deductible to the issuing firm, the higher the tax rate the lower the after tax
cost of debt financing. Tax considerations do not enter into the cost of equity calculation since
dividends paid to stockholders are not tax deductible to the firm.
What is the investment opportunity schedule (IOS)? How does it help financial managers make
business decisions? correct answers The investment opportunity schedule shows graphically
proposed capital budgeting projects depicting the IRR and dollar amount of investment for each
project. This helps the financial manager make business decisions since the investment
opportunity schedule and the marginal cost of capital schedule can be plotted together, with those
projects on the IOS schedule above the MCC being acceptable.
What is a marginal cost of capital schedule (MCC)? Is the schedule always a horizontal line?
Explain. correct answers The marginal cost of capital schedule is a graphic depiction of the
weighted average cost of capital at different levels of financing. The MCC schedule is not always
a horizontal line. For many firms the MCC schedule increases, usually at discreet intervals, as
the amount of funds to be raised increases.
, For a given IOS and MCC, how do financial managers decide which proposed capital budgeting
projects to accept, and which to reject? correct answers For a given IOS and MCC, all
independent projects that plot on the IOS above the MCC are accepted. Those projects on the
IOS below the MCC are rejected.
What would be the after-tax cost of debt for a company with a YTM of 7% and a tax rate of 20%
correct answers YTM = 7% X (1 - .20) = 5.6
Calculate the After-tax cost of debt for a loan with an annual interest rate of 10% and an interest
subsidy tax rate of 22% correct answers 10% X (1 - .22) = 7.8
A firm is issuing new bonds that pay 8 percent annual interest. The market required annual rate
of return on these bonds is 13 percent. The firm has an interest subsidy rate of 25 percent.
a. What is the before-tax cost of debt?
b. What is the after-tax cost of debt? correct answers A. 13% (Market required rate)
B. 13% X (1 - .25) = 9.75
A company can sell preferred stock for $26 per share, and each share of stock is expected to pay
a dividend of $2. If the flotation cost per share of stock is $0.75, what would be the estimate of
the cost of capital from this source? correct answers kp = $2/($26 - $0.75) = $2/$25.25 = 7.92%
El Norte Industries will issue $100 Par, 12% preferred Stock. The market price is expected to be
$89 per share. El Norte must pay flotation costs of 5% of the market price. What is El Norte's
cost of preferred stock? correct answers kp = $100 X 0.12/($89 - ($89 X 0.05)) = $12/($89 -
$4.45) = 14.19%
Twister Corporation is expected to pay a dividend of $7 per share one year from now on its
common stock, which has a current market price of $143. Twister's dividends are expected to
grow at 13 percent.
A. Calculate the cost of the company's retained earnings.
