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Chapter 015 Cost of Capital Multiple Choice Questions The return shareholders require on their investment in a firm is called the: a dividend yield B cost of equity c capital gains yield d cost of capital e income return SECTION: 15.2 TOPIC: COST OF EQUITY TYPE: DEFINITIONS The return lenders require on loaned funds to a firm is called the: a coupon rate b current yield C cost of debt d capital gains yield e cost of capital SECTION: 15.3 TOPIC: COST OF DEBT TYPE: DEFINITIONS The weighted average of a firm's cost of equity and aftertax cost of debt is called the: a reward to risk ratio b weighted capital gains rate c pure play cost of capital d subjective cost of capital E weighted average cost of capital SECTION: 15.4 TOPIC: WACC TYPE: DEFINITIONS 15-1 Chapter 015 Cost of Capital When a manager develops a cost of capital for a specific project based on the cost of capital for another firm which has a similar line of business as the project, the manager is utilizing the _ approach a subjective risk B pure play c divisional cost of capital d capital adjustment e security market line SECTION: 15.5 TOPIC: PURE PLAY APPROACH TYPE: DEFINITIONS The cost of capital: a will decrease as the risk level of a firm increases b is primarily dependent upon the source of the funds used for a project c implies a project will produce a positive net present value only when the rate of return on the project is less than the predetermined cost of capital d remains constant for all projects undertaken by the same firm E depends on how the funds are going to be utilized SECTION: 15.1 TOPIC: COST OF CAPITAL TYPE: CONCEPTS The overall cost of capital for a retail store: a is equivalent to the aftertax cost of the firm's liabilities b should be used as the required return when analyzing a potential acquisition of a wholesale distributor C reflects the return investors require on the total assets of the firm d remains constant when the debt-equity ratio changes e is unaffected by changes in corporate tax rates SECTION: 15.1 TOPIC: COST OF CAPITAL TYPE: CONCEPTS 15-2 Chapter 015 Cost of Capital The cost of capital primarily depends on the: a debt-equity ratio b applicable tax rate c cost of equity financing d cost of debt E use of the funds SECTION: 15.1 TOPIC: COST OF CAPITAL TYPE: CONCEPTS Davis Entertainment is considering developing and distributing a new board game for children The project is similar in risk to the firm's current operations The firm maintains a debt-equity ratio of 45 and retains all profits to fund the firm's rapid growth How should the firm determine its cost of equity? a by adding the market risk premium to the aftertax cost of debt b by treating the common stock as if it were preferred stock c by using the dividend growth formula D by using the security market line approach e by averaging the cost determined by both the dividend growth formula and the security market line approach SECTION: 15.2 TOPIC: COST OF EQUITY TYPE: CONCEPTS All else constant, which one of the following will increase a firm's cost of equity if the firm computes that cost using the security market line approach? Assume the firm currently pays an annual dividend of $2.10 a share and has a beta of 1.1 a a reduction in the dividend amount b an increase in the dividend amount c a reduction in the market risk premium d a reduction in the firm's beta E an increase in the market rate of return SECTION: 15.2 TOPIC: COST OF EQUITY TYPE: CONCEPTS 15-3 Chapter 015 Cost of Capital 10 A firm's overall cost of equity is: a directly observable in the financial markets b unaffected by changes in the market risk premium C highly dependent upon the growth rate and risk level of the firm d generally less than the firm's aftertax cost of debt e inversely related to change in the firm's tax rate SECTION: 15.2 TOPIC: COST OF EQUITY TYPE: CONCEPTS 11 The cost of equity for a firm is: a dependent upon the firm's debt-equity ratio B based on estimates derived from financial models c equivalent to a leveraged firm's cost of capital d equal to the risk-free rate of return plus the market risk premium e equal to the firm's pretax weighted average cost of capital SECTION: 15.2 TOPIC: COST OF EQUITY TYPE: CONCEPTS 12 The dividend growth model: a can be used to estimate the cost of equity for any corporation b is applicable only to firms that pay a constant dividend c is unaffected by the estimated rate of dividend growth D can be applied to firms that are reducing their dividend amount e considers the risk level of the firm SECTION: 15.2 TOPIC: DIVIDEND GROWTH MODEL TYPE: CONCEPTS 15-4 Chapter 015 Cost of Capital 13 The dividend growth model: A is only as reliable as the estimated rate of growth b can only be used if historical dividend information is available c considers the risk that future dividends may vary from their estimated values d applies only when a firm is currently paying dividends e uses beta to measure the systematic risk of a firm SECTION: 15.2 TOPIC: DIVIDEND GROWTH MODEL TYPE: CONCEPTS 14 The market risk premium: A can vary over time b is equal to the risk premium for a security minus the market rate of return c is equal to zero for a risk-free asset d is equal to the risk-free rate multiplied by the beta of a firm e is constant over time SECTION: 15.2 TOPIC: SECURITY MARKET LINE APPROACH TYPE: CONCEPTS 15 Which of the following statements are correct concerning the security market line (SML) approach to determining the cost of equity for a firm? I The SML approach considers the amount of unsystematic risk associated with a firm II The SML approach can be applied to more firms than the dividend growth model can III The SML approach considers only future information IV The SML approach assumes the reward-to-risk ratio is constant a I and III only B II and IV only c III and IV only d I, II, and III only e I, II, III, and IV SECTION: 15.2 TOPIC: SECURITY MARKET LINE APPROACH TYPE: CONCEPTS 15-5 Chapter 015 Cost of Capital 16 The pre-tax cost of debt for a firm: A is based on the yield to maturity on the firm's outstanding bonds b is equal to the coupon rate for the latest bond issue c is equivalent to the current yield on the outstanding bonds of the firm d is based on the yield to maturity that existed when the currently outstanding bonds were originally issued e has to be estimated as it cannot be directly observed in the market SECTION: 15.3 TOPIC: COST OF DEBT TYPE: CONCEPTS 17 The aftertax cost of debt generally increases when: I a firm's bond rating increases II the market rate of interest increases III tax rates decrease IV bond prices rise a I and III only B II and III only c I, II, and III only d II, III, and IV only e I, II, III, and IV SECTION: 15.3 TOPIC: COST OF DEBT TYPE: CONCEPTS 18 The cost of preferred stock is computed the same as the: a pre-tax cost of debt b return on an annuity c aftertax cost of debt D return on a perpetuity e cost of an irregular growth common stock SECTION: 15.3 TOPIC: COST OF PREFERRED STOCK TYPE: CONCEPTS 15-6 Chapter 015 Cost of Capital 19 The cost of preferred stock: A is equal to the dividend yield b is equal to the yield to maturity c is highly dependent on the dividend growth rate d varies directly with the stock's price e is relatively difficult to determine SECTION: 15.3 TOPIC: COST OF PREFERRED STOCK TYPE: CONCEPTS 20 The capital structure weights used in computing the weighted average cost of capital: a are based on the book values of total debt and total equity B are based on the market value of the firm's debt and equity securities c are computed using the book value of the long-term debt and the book value of equity d remain constant over time unless the firm issues new securities e are restricted to the firm's debt and common stock SECTION: 15.4 TOPIC: CAPITAL STRUCTURE WEIGHTS TYPE: CONCEPTS 21 DTK, Inc uses both preferred and common stock as well as long-term debt to finance its operations An increase in which one of the following will increase the capital structure weight of the debt, all else equal? a market price of the common stock b number of shares of preferred stock outstanding c book value of the outstanding shares of common stock D number of bonds outstanding e number of shares of stock outstanding SECTION: 15.4 TOPIC: CAPITAL STRUCTURE WEIGHTS TYPE: CONCEPTS 15-7 Chapter 015 Cost of Capital 22 The aftertax cost of debt: a varies inversely to market interest rates b will generally exceed the cost of equity if the relevant tax rate is zero c is equal to the pre-tax cost of debt d is directly related to the cost of equity E has a greater effect on a firm's cost of capital when the debt-equity ratio increases SECTION: 15.3 TOPIC: WEIGHTED AVERAGE COST OF CAPITAL TYPE: CONCEPTS 23 The weighted average cost of capital for a firm is dependent upon the firm's: I level of systematic risk II debt-equity ratio III preferred dividend amount IV outstanding bonds' yield to maturity a I and III only b II and IV only c I, II, and IV only d I, III, and IV only E I, II, III, and IV SECTION: 15.4 TOPIC: WEIGHTED AVERAGE COST OF CAPITAL TYPE: CONCEPTS 24 The weighted average cost of capital for a firm is the: a discount rate which the firm should apply to all of the projects it undertakes B rate of return a firm must earn on its existing assets to maintain the current value of its stock c coupon rate the firm should expect to pay on its next bond issue d maximum rate which the firm should require on any projects it undertakes e required rate which every project's internal rate of return must exceed SECTION: 15.4 TOPIC: WEIGHTED AVERAGE COST OF CAPITAL TYPE: CONCEPTS 15-8 Chapter 015 Cost of Capital 25 Which one of the following statements is correct concerning the weighted average cost of capital (WACC)? A The WACC may decrease as a firm's debt-equity ratio increases b When computing the WACC, the weight assigned to the preferred stock is based on the coupon rate multiplied by the par value of the stock c A firm's WACC will decrease as the corporate tax rate decreases d The weight of the common stock used in the computation of the WACC is based on the number of shares outstanding multiplied by the book value per share e The WACC will remain constant unless a firm retires some of its debt SECTION: 15.4 TOPIC: WEIGHTED AVERAGE COST OF CAPITAL TYPE: CONCEPTS 26 If a firm uses its WACC as the discount rate for all of the projects it undertakes then the firm will tend to: I reject some positive net present value projects II accept some negative net present value projects III favor high risk projects over low risk projects IV maintain its current level of risk a I and III only b III and IV only C I, II, and III only d I, II, and IV only e I, II, III, and IV SECTION: 15.4 TOPIC: WEIGHTED AVERAGE COST OF CAPITAL TYPE: CONCEPTS 15-9 Chapter 015 Cost of Capital 27 Swanson & Sons has two separate divisions Each division is in a separate line of business Division A is the largest division and represents 65 percent of the firm's overall sales Division A is also the riskier of the two divisions Division B is the smaller and least risky of the two When management is deciding which of the various divisional projects should be accepted, the managers should: a allocate more funds to Division A since it is the largest of the two divisions b fund all of Division B's projects first since they tend to be less risky and then allocate the remaining funds to the Division A projects that have the highest net present values c allocate the company's funds to the projects with the highest net present values based on the firm's weighted average cost of capital D assign appropriate, but differing, discount rates to each project and then select the projects with the highest net present values e fund the highest net present value projects from each division based on an allocation of 65 percent of the funds to Division A and 35 percent of the funds to Division B SECTION: 15.5 TOPIC: DIVISIONAL COST OF CAPITAL TYPE: CONCEPTS 28 If a firm applies its overall cost of capital to all its proposed projects, then the divisions within the firm will tend to: a receive less funding if they represent the riskiest operations of the firm b avoid risky projects so that they will receive more funding c become less risky over time based on the projects that are accepted d have equal probabilities of receiving funding for their projects E propose higher risk projects than if separate discount rates were applied to each project SECTION: 15.5 TOPIC: DIVISIONAL COST OF CAPITAL TYPE: CONCEPTS 15-10 Chapter 015 Cost of Capital 67 The Woodsburg Co maintains a debt-equity ratio of 60 and has a tax rate of 35 percent The firm does not issue preferred stock The firm's pre-tax cost of debt is 8.75 percent Woodsburg Co has 20,000 shares of stock outstanding with a beta of and a market price of $30 The current market risk premium is percent and the current risk-free rate is percent Last month, Woodsburg Co issued an annual dividend in the amount of $1.25 per share Dividends are expected to grow at percent indefinitely Using an average expected cost of equity, what is Woodsburg's weighted average cost of capital? a 6.0 percent B 7.0 percent c 7.9 percent d 8.1 percent e 9.5 percent AACSB TOPIC: ANALYTIC SECTION: 15.4 TOPIC: WEIGHTED AVERAGE COST OF CAPITAL TYPE: PROBLEMS 15-35 Chapter 015 Cost of Capital 68 Great Sound Music, Inc has 20,000 shares of common stock outstanding at a market price of $26 a share This stock was originally issued at $19 per share The firm also has a bond issue outstanding with a total face value of $300,000 which is selling for 97 percent of face value The cost of equity is 10 percent while the aftertax cost of debt is percent The firm has a beta of 1.2 and a tax rate of 35 percent What is Great Sound's weighted average cost of capital? a 7.07 percent b 7.58 percent c 7.83 percent d 8.16 percent E 8.21 percent WACC = [($520,000 / $811,000) 08206 = 8.21 percent 10] + [($291,000 / $811,000) 05] = 06412 + 01794 = AACSB TOPIC: ANALYTIC SECTION: 15.4 TOPIC: WEIGHTED AVERAGE COST OF CAPITAL TYPE: PROBLEMS 69 Choice Golf Equipment has a beta of 1.2 and a cost of equity of 13 percent The risk-free rate of return is percent Choice is considering a project with a beta of An appropriate discount rate for the project is: a 7.2 percent b 8.0 percent c 9.0 percent D 10.0 percent e 10.8 percent .13 = 04 + (1.2 mrp); mrp = 075; RProject = 04 + (.8 AACSB TOPIC: ANALYTIC SECTION: 15.4 TOPIC: PROJECT COST OF CAPITAL TYPE: PROBLEMS 15-36 075) = 10 = 10.0 percent Chapter 015 Cost of Capital 70 Backyard Tavern has a beta of 1.5 and a cost of equity of 13.2 percent The risk-free rate of return is 4.2 percent Backyard is considering a project with a beta of 1.7 and a project life of eight years An appropriate discount rate for the project is: a 10.80 percent b 12.16 percent C 14.40 percent d 15.84 percent e 18.00 percent .132 = 042 + (1.5 mrp); mrp = 06; RProject = 042 + (1.7 06) = 144 = 14.40 percent AACSB TOPIC: ANALYTIC SECTION: 15.4 TOPIC: PROJECT COST OF CAPITAL TYPE: PROBLEMS 71 Hilltop, Inc has a capital structure which is based on 30 percent debt, 10 percent preferred stock, and 60 percent common stock The pre-tax cost of debt is percent, the cost of preferred is percent, and the cost of common stock is 11 percent The company's tax rate is 34 percent The company is considering a project that is equally as risky as the overall firm This project has initial costs of $250,000 and cash inflows of $94,000 a year for three years What is the projected net present value of this project? a $15,823.76 B $12,414.07 c $9,127.53 d $1,083.19 e $15,823.76 AACSB TOPIC: ANALYTIC SECTION: 15.4 TOPIC: CAPITAL BUDGETING PROBLEM TYPE: PROBLEMS 15-37 Chapter 015 Cost of Capital 72 Bertelli's is analyzing a project with an initial cost of $55,000 and cash inflows of $33,000 a year for two years This project is an extension of the firm's current operations and thus is equally as risky as the current firm The firm uses only debt and common stock to finance their operations and maintains a debt-equity ratio of 35 The aftertax cost of debt is percent and the cost of equity is 11 percent The tax rate is 34 percent What is the projected net present value of this project? A $2,501 b $2,854 c $2,913 d $3,011 e $3,418 AACSB TOPIC: ANALYTIC SECTION: 15.4 TOPIC: CAPITAL BUDGETING PROBLEM TYPE: PROBLEMS 15-38 Chapter 015 Cost of Capital 73 Orson, Inc uses one-third common stock and two-thirds debt to finance their operations The aftertax cost of debt is percent and the cost of equity is 12 percent The management of Orson, Inc is considering a project that will produce a cash inflow of $48,000 in the first year The cash inflows will then grow at percent per year thereafter What is the maximum amount the firm can initially invest in this project to avoid a negative net present value for the project? a $800,000 b $900,000 c $1,000,000 d $1,100,000 E $1,200,000 AACSB TOPIC: ANALYTIC SECTION: 15.4 TOPIC: CAPITAL BUDGETING PROBLEM TYPE: PROBLEMS 15-39 Chapter 015 Cost of Capital 74 Keller's Korner is considering a new project they consider to be a little riskier than their current operations Thus, management has decided to add an additional 2.5 percent to their company's overall cost of capital when evaluating this project The project has an initial cash outlay of $30,000 and projected cash inflows of $12,000 in year one, $20,000 in year two, and $8,000 in year three The firm uses 40 percent debt and 60 percent common stock as their capital structure The company's cost of equity is 14 percent while the aftertax cost of debt for the firm is percent What is the projected net present value of the new project? A $1,467.38 b $2,360.46 c $2,783.50 d $3,904.59 e $3,561.58 AACSB TOPIC: ANALYTIC SECTION: 15.4 TOPIC: CAPITAL BUDGETING PROBLEM TYPE: PROBLEMS 75 The Warren Corporation has an overall cost of equity of 9.5 percent and a beta of 1.3 The firm is financed 100 percent with common stock The risk-free rate of return is percent What is an appropriate cost of capital for a division within the firm that has an estimated beta of 85? a 5.75 percent b 6.50 percent C 7.25 percent d 8.50 percent e 9.50 percent 095 = 03 + 1.3mrp; mrp = 05; ReDivision = 03 + (.85 AACSB TOPIC: ANALYTIC SECTION: 15.5 TOPIC: DIVISIONAL COST OF CAPITAL TYPE: PROBLEMS 15-40 05) = 7.25 percent Chapter 015 Cost of Capital 76 Production Unlimited has an overall beta of 92 and a cost of equity of 10.8 percent for the firm overall The firm is 100 percent financed with common stock Division A within the firm has an estimated beta of 1.47 and is the riskiest of all of the firm's operations What is an appropriate cost of capital for division A if the market risk premium is percent? a 9.9 percent b 11.6 percent C 14.1 percent d 15.9 percent e 16.7 percent 108 = rf + (.92 06); rf = 0528; ReDivision = 0528 + (1.47 06) = 14.1 percent AACSB TOPIC: ANALYTIC SECTION: 15.5 TOPIC: DIVISIONAL COST OF CAPITAL TYPE: PROBLEMS 77 Company A and Company B are separate firms that are both considering a diamond exploration project Company A is in the precious gem mining business and has an aftertax cost of capital of 13 percent Company B is in the precious gem retail business Company B's aftertax cost of capital is 10 percent The project under consideration has initial costs of $315,000 and anticipated annual cash inflows of $57,000 a year for ten years Which firm(s), if either, should accept this project? a Company A only b Company B only c both Company A and Company B D neither Company A or Company B e cannot be determined without further information Neither Company A nor Company B should accept this project as the applicable WACC for the project is 13 percent AACSB TOPIC: ANALYTIC SECTION: 15.5 TOPIC: PURE PLAY APPROACH TYPE: PROBLEMS 15-41 Chapter 015 Cost of Capital 78 Cooper Enterprises sells outdoor swimming pools and currently has an aftertax cost of capital of 12 percent Reinhold's sells pool decks and has an aftertax cost of capital of percent Cooper Enterprises is considering adding pool decks as part of their sales lineup They estimate that sales from these decks could become 15 percent of their overall sales The initial cash outlay for this project is $75,000 The expected net cash inflows are $14,000 a year for eight years What is the net present value of this project to Cooper Enterprises? a -12,177.50 b -$5,453.04 C $2,487.47 d $4,979.00 e $14,110.59 AACSB TOPIC: ANALYTIC SECTION: 15.5 TOPIC: PURE PLAY APPROACH TYPE: PROBLEMS 79 Buy From Us owns a chain of retail stores that sell home furniture Crafton, Inc is one of the furniture manufacturers that Buy From Us uses to stock their stores Buy From Us has a beta of 1.16 and Crafton has a beta of 1.28 The risk-free rate of return is percent and the market risk premium is percent What should Buy From Us use as the project cost of capital if they want to consider manufacturing the products they sell? a 7.64 percent b 8.12 percent c 9.73 percent d 11.12 percent E 11.96 percent Re=.03 + (1.28 07) = 11.96 percent AACSB TOPIC: ANALYTIC SECTION: 15.5 TOPIC: PURE PLAY APPROACH TYPE: PROBLEMS 15-42 Chapter 015 Cost of Capital 80 The Wendell Co uses 40 percent common stock, 30 percent preferred stock, and 30 percent debt as their capital structure The flotation costs are percent for debt, percent for preferred stock, and percent for common stock The corporate tax rate is 35 percent What is the weighted average flotation cost? a 6.0 percent b 6.4 percent c 6.9 percent d 7.1 percent E 7.4 percent Average flotation cost = (.40 7.4 percent 08) + (.30 09) + (.30 05) = 032 + 027 +.015= 074 = AACSB TOPIC: ANALYTIC SECTION: 15.6 TOPIC: FLOTATION COST AND WEIGHTED AVERAGE COST OF CAPITAL TYPE: PROBLEMS 81 The Warren Co has a capital structure which is based on 20 percent debt, 35 percent preferred stock, and 45 percent common stock The flotation costs are percent for common stock, 10 percent for preferred stock, and percent for debt The corporate tax rate is 34 percent What is the weighted average flotation cost? a 6.79 percent b 7.55 percent c 8.21 percent D 8.55 percent e 9.05 percent Average flotation cost = (.45 = 8.55 percent 09) + (.35 10) + (.20 AACSB TOPIC: ANALYTIC SECTION: 15.6 TOPIC: FLOTATION COST TYPE: PROBLEMS 15-43 05) = 0405 + 035 + 01 = 0855 Chapter 015 Cost of Capital 82 Harmon, Inc has a debt-equity ratio of 80 The firm is analyzing a new project which requires an initial cash outlay of $300,000 for new equipment The flotation cost for new equity is percent and for debt 4.5 percent What is the initial cost of the project including the flotation costs? a $317,125 b $320,856 c $321,000 D $322,581 e $325,912 AACSB TOPIC: ANALYTIC SECTION: 15.6 TOPIC: FLOTATION COST TYPE: PROBLEMS 83 Your boss would like you to evaluate a project which requires $164,000 in external financing The flotation cost of equity is 12 percent and the flotation cost of debt is percent You wish to maintain a debt-equity ratio of 55 What is the initial cost of the project including the flotation costs? a $177,226 b $178,552 c $179,606 d $180,337 E $181,248 AACSB TOPIC: ANALYTIC SECTION: 15.6 TOPIC: FLOTATION COST TYPE: PROBLEMS 15-44 Chapter 015 Cost of Capital 84 Parker United is considering a project which requires an initial investment of $380,000 The firm maintains a debt-equity ratio of 40 The flotation cost of debt is percent and the flotation cost of equity is 11 percent Parker United has sufficient internally generated equity to cover the equity cost of this project What is the initial cost of the project including the flotation costs? A $386,628 b $396,048 c $411,009 d $420,221 e $433,333 AACSB TOPIC: ANALYTIC SECTION: 15.6 TOPIC: INTERNAL EQUITY AND FLOTATION COST TYPE: PROBLEMS 15-45 Chapter 015 Cost of Capital 85 West Minster Properties is considering a project which has an initial start up cost of $840,000 The firm maintains a debt-equity ratio of 60 The flotation cost of debt is percent and the flotation cost of equity is 13 percent The firm has sufficient internally generated equity to cover the equity cost of this project What is the initial cost of the project including the flotation costs? A $865,979 b $872,418 c $876,082 d $803,104 e $811,216 AACSB TOPIC: ANALYTIC SECTION: 15.6 TOPIC: INTERNAL EQUITY AND FLOTATION COST TYPE: PROBLEMS 15-46 Chapter 015 Cost of Capital Essay Questions 86 Explain the role of the weighted average cost of capital as it affects the decision to accept or reject a project Assuming a project is equally as risky as a firm's current operations, the WACC is used as the discount rate to evaluate the NPV of a project Therefore, having an accurate WACC is necessary to correctly determine if a project should be accepted or rejected If a project has a different risk level than the firm's current operations, then the firm's WACC should not be used as the project's discount rate without further adjustment to that rate AACSB TOPIC: REFLECTIVE THINKING SECTION: 15.1 AND 15.4 TOPIC: WACC 87 What are some advantages to the subjective approach and why you think that approach is utilized? The subjective approach allows management to adjust the discount rate for individual projects based upon their evaluation of the risks associated with a particular project as compared to the overall current risk level of the firm To try and determine a more accurate estimate of the appropriate discount rate might encounter costs that would outweigh any potential benefit Thus, the subjective approach is used because it allows for discount rate adjustments in a cost effective manner AACSB TOPIC: REFLECTIVE THINKING SECTION: 15.5 TOPIC: SUBJECTIVE APPROACH 15-47 Chapter 015 Cost of Capital 88 Give an example of a situation where a firm should adopt the pure play approach to determine the cost of capital for a project Student examples will vary but should illustrate a project that is unrelated to the current operations of Firm A The example should explain why the WACC of Firm B, which is engaged in the type of operations Firm A is considering, should be used as the basis for setting the discount rate for the proposed project AACSB TOPIC: REFLECTIVE THINKING SECTION: 15.5 TOPIC: PURE PLAY AND SUBJECTIVE APPROACHES 15-48 Chapter 015 Cost of Capital 89 Suppose your boss comes to you and asks you to re-evaluate a capital budgeting project The first evaluation was in error, he explains, because it ignored flotation costs To correct for this, he asks you to evaluate the project using a higher cost of capital Is your boss' approach correct? Why or why not? Your boss is confused since it is the use of funds, and not the source of funds, that determines the cost of capital Flotation costs should be included in the initial cash flow for a project and not in the cost of capital AACSB TOPIC: REFLECTIVE THINKING SECTION: 15.6 TOPIC: FLOTATION COSTS 90 Explain how the use of internal equity rather than external equity affects the analysis of a project Internal equity avoids the flotation costs associated with raising external equity Therefore, by utilizing internal equity rather than external equity, the initial cost of the project is decreased Decreasing the initial cost increases the NPV of the project AACSB TOPIC: REFLECTIVE THINKING SECTION: 15.6 TOPIC: INTERNAL EQUITY AND FLOTATION COSTS 15-49 ... of the firm d remains constant when the debt-equity ratio changes e is unaffected by changes in corporate tax rates SECTION: 15.1 TOPIC: COST OF CAPITAL TYPE: CONCEPTS 15-2 Chapter 015 Cost of... on the yield to maturity on the firm's outstanding bonds b is equal to the coupon rate for the latest bond issue c is equivalent to the current yield on the outstanding bonds of the firm d is based... WEIGHTS TYPE: CONCEPTS 21 DTK, Inc uses both preferred and common stock as well as long-term debt to finance its operations An increase in which one of the following will increase the capital structure
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