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THEORY Cost of Capital - Basic Concepts

Risk & Return 5. Cost of capital is
1. All of the following statements are correct except: A. The amount the company must pay for its plant assets.
A. The matching of assets and liability maturities lowers default risk. B. The dividends a company must pay on its equity securities.
B. Default risk refers to the inability of the firm to pay off its maturing obligations. C. The cost the company must incur to obtain its capital resources.
C. An increase in the payables deferral period will lead to a reduction in the need to non- D. The cost the company is charged by investment bankers who handle the issuance of
spontaneous funding. equity or long-term debt securities.
D. The matching of asset and liability maturities is considered desirable because this strategy
minimizes interest rate risk. 6. All of the following are examples of imputed costs except
A. Decelerated depreciation.
2. Which of the following would increase risk? B. The stated interest paid on a bank loan.
A. Increase the level of working capital. C. Assets that are considered obsolete that maintain a net book value.
B. Increase the amount of equity financing. D. Lending funds to a supplier at a lower-than-market rate in exchange for receiving the
C. Increase the amount of short-term borrowing. suppliers products at a discount.
D. Change the composition of working capital to include more liquid assets.
7. The theory underlying the cost of capital is primarily concerned with the cost of
3. A firms financial risk is a function of how it manages and maintains its debt. Which one of the A. Long-term funds and old funds.
following sets of ratios characterizes the firm with the greatest amount of financial risk? B. Short-term funds and new funds.
A. High debt-to-equity ratio, high interest coverage ratio, stable return on equity. C. Long-term funds and new funds.
B. High debt-to-equity ratio, low interest coverage ratio, volatile return on equity. D. Any combination of old or new, short-term or long-term funds.
C. Low debt-to-equity ratio, low interest coverage ratio, volatile return on equity.
D. Low debt-to-equity ratio, high interest coverage ratio, stable return on equity. 8. Management knowledge of the cost of capital is useful for each of the following except
A. Evaluating performance.
Marketable Securities Management
B. Managing working capital.
4. Which of the following classes of securities are listed in order from lowest risk/opportunity for
C. Making capital investment decisions.
return to highest risk/opportunity for return?
D. Setting the maximum rate of return on new investments.
A. Preferred stock; common stock; corporate mortgage bonds; corporate debentures.
B. U.S. Treasury bonds; corporate first mortgage bonds; corporate income bonds; preferred
Cost of Debt
stock.
9. The explicit cost of debt financing is the interest expense. The implicit cost(s) of debt financing
C. Corporate income bonds; corporate mortgage bonds; convertible preferred stock;
is (are) the
subordinated debentures.
A. Increase in the cost of debt as the debt-to-equity ratio increases.
D. Common stock; corporate first mortgage bonds; corporate second mortgage bonds;
B. Increase in the cost of equity as the debt-to-equity ratio decreases.
corporate income bonds.
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C. Increases in the cost of debt and equity as the debt-to-equity ratio increases. D. after-tax rate of interest for bonds and stated annual dividend rate less the expected
D. Decrease in the weighted-average cost of capital as the debt-to-equity ratio increases. earnings per share for preferred stock

10. In computing the cost of capital, the cost of debt capital is determined by Dividend Growth Model
A. Interest rate times (1 the firms tax rate) 14. When calculating the cost of capital, the cost assigned to retained earnings should be
B. The capital asset pricing model. A. Zero.
C. Annual interest payment divided by the book value of the debt. B. Equal to the cost of external common equity.
D. Annual interest payment divided by the proceeds from debt issuance. C. Lower than the cost of external common equity.
D. Higher than the cost of external common equity.
11. The interest rate on the bonds is greater for the second alternative consisting of pure debt than
it is for the first alternative consisting of both debt and equity because Capital Asset Pricing Model
A. The pure debt alternative would flood the market and be more difficult to sell. 15. According to the capital asset pricing model (CAPM), the relevant risk of a security is its
B. The pure debt alternative carries the risk of increasing the probability of default. A. Company-specific risk. C. Systematic risk.
C. The diversity of the combination alternative creates greater risk for the investor. B. Diversifiable risk. D. Total risk.
D. The combination alternative carries the risk of increasing dividend payments.
16. An investor uses the capital asset pricing model (CAPM) to evaluate the risk-return
12. If a $1,000 bond sells for $1,125, which of the following statements are correct? relationship on a portfolio of stocks held as an investment. Which of the following would not be
I. The market rate of interest is greater than the coupon rate on the bond. used to estimate the portfolio's expected rate of return?
II. The coupon rate on the bond is greater than the market rate of interest. A. Standard deviation of the market returns.
III. The coupon rate and the market rate are equal. B. Interest rate for the safest possible investment.
IV. The bond sells at a premium. C. Expected rate of return on the market portfolio.
V. The bond sells at a discount. D. Expected risk premium on the portfolio of stocks.
A. I and IV. C. II and IV.
B. I and V. D. II and V. 17. If the return on the market portfolio is 10% and the risk-free rate is 5%, what is the effect on a
company's required rate of return on its stock of an increase in the beta coefficient from 1.2 to
Cost of Preferred Stock 1.5?
13. The basis for measuring the cost of capital derived from bonds and preferred stock, A. No change C. 1.5% increase
respectively, is the B. 1.5% decrease. D. 3% increase
A. after-tax rate of interest for bonds and stated annual dividend rate for preferred stock
B. pretax rate of interest for bonds and stated annual dividend rate for preferred stock
C. pretax rate of interest for bonds and stated annual dividend rate less the expected
earnings per share for preferred stock

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Weighted-Average Cost of Capital A. cost of debt outstanding

18. The weighted average cost of capital represents the
A. equivalent units of capital used by the organization.
B. overall cost of capital from all organization financing sources.
C. overall cost of dividends plus interest paid by the organization.
D. cost of bonds, preferred stock, and common stock divided by the three sources.
19. The overall cost of capital is the
A. Average rate of return a firm earns on its assets.
B. Minimum rate a firm must earn on high-risk projects.
C. Rate of return on assets that covers the costs associated with the funds employed.
D. Cost of the firm's equity capital at which the market value of the firm will remain
unchanged.
20. The three elements needed to estimate the cost of equity capital for use in determining a firm's
weighted-average cost of capital are
A. Current dividends per share, expected growth rate in dividends per share, and current
book value per share of common stock.
B. Current earnings per share, expected growth rate in earnings per share, and current book
value per share of common stock.
C. Current earnings per share, expected growth rate in dividends per share, and current
market price per share of common stock.
D. Current dividends per share, expected growth rate in dividends per share, and current
market price per share of common stock.
21. Which of the following is not considered a capital component for the purpose of calculating the
weighted average cost of capital as it applies to capital budgeting?
A. Common stock. C. Preferred stock.
B. Long-term debt. D. Short-term debt.
22. The weighted-average cost of capital approach to decision making is not directly affected by
the:
B. value of the common stock
C. current budget for expansion.
D. proposed mix of debt, equity, and existing funds used to implement the project
23. The pre-tax cost of capital is higher than the after-tax cost of capital because
A. interest expense is deductible for tax purposes.
B. the cost of capital is a deductible expense for tax purposes.
C. principal payments on debt are deductible for tax purposes.
D. dividend payments to stockholders are deductible for tax purposes.
24. A company has made the decision to finance next year's capital projects through debt rather
than additional equity. The benchmark cost of capital for these projects should be
A. The cost of equity financing.
B. The weighted-average cost of capital.
C. The after-tax cost of new-debt financing.
D. The before-tax cost of new-debt financing.
25. If the return on total assets is 10% and if the return on common stockholders equity is 12%
then
A. Leverage is negative.
B. The after-tax cost of long-term debt is 12%.
C. The after-tax cost of long-term debt is probably less than 10%.
D. The after-tax cost of long-term debt is probably greater than 10%.
26. When calculating a firm's cost of capital, all of the following are true except that
A. All costs should be expressed as after-tax costs.
B. The time value of money should be incorporated into the calculations.
C. The cost of capital of a firm is the weighted average cost of its various financing
components.
D. The calculation of the cost of capital should focus on the historical costs of alternative
forms of financing rather than market or current costs.

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Securities Valuation 32. Which of the changes in leverage would apply to a company that substantially increases its
27. The market value of a firms outstanding common shares will be higher, everything else equal, investment in fixed assets as a proportion of total assets and replaces some of its long-term
if debt with equity?
A. Investors expect lower dividend growth. A. B. C. D.
B. Investors have a lower required return on equity. Financial Leverage Increase Decrease Increase Decrease
C. Investors have longer expected holding periods. Operating Leverage Decrease Increase Increase Decrease
D. Investors have shorter expected holding periods.
Problems
DOL + DFL = DTL Cost of Debt
28. Which class of leverage causes earnings before interest and taxes to be more sensitive to 1. What is the yield to maturity on Fox Inc.'s bonds if its after-tax cost of debt is 9% and its tax
changes in sales? rate is 34%?
A. Credit. C. Intrinsic. A. 5.94% C. 13.64%
B. Financial. D. Operating. B. 9% D. 26.47%
29. Companies experience changes in interest expenses, variable cost per unit, quantity of units 2. Maylar Corporation has sold $50 million of $1,000 par value, 12% coupon bonds. The bonds
sold, and fixed costs. Their degree of operating leverage is not affected by the change in were sold at a discount and the corporation received $985 per bond. If the corporate tax rate is
A. Interest expenses. C. Quantity of units sold. 40%, the after-tax cost of these bonds for the first year (rounded to the nearest hundredth
B. Fixed costs. D. Variable cost per unit. percent) is
A. 4.87%. C. 7.31%.
30. A firm with a higher degree of operating leverage when compared to the industry average B. 7.09%. D. 12.00%.
implies that the 3. The MNO Company believes that it can sell long-term bonds with a 6% coupon but at a price
A. Firm is less risky. that gives a yield-to-maturity of 9%. If such bonds are part of next years financing plans,
B. Firm is more profitable. which of the following should be used for bonds in their after-tax (40%) cost-of-capital
C. Firm has higher variable costs. calculation?
D. Firm's profits are more sensitive to changes in sales volume. A. 3.6% C. 5.4%
31. The purchase of treasury stock with a firm's surplus cash B. 4.2% D. 6%
A. Increases a firm's assets.
B. Dilutes a firm's earnings per share. Cost of Preferred Stock
C. Increases a firm's financial leverage. 4. Doris Corporation's stock has a market price of $20.00 and pays a constant dividend of $2.50.
D. Increases a firm's interest coverage ratio. What is the required rate of return on its stock?
A. 11.5% C. 12.5%
B. 12.0% D. 13.0%
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5. Ambry Inc. is going to use an underwriter to sell its preferred stock. Four underwriters have A. 15.05% C. 15.95%
given estimates (below) on their fees and the selling price of the stock, as well as the expected B. 15.50% D. 16.72%
dividend for each:
Fees Selling Price Dividends 9. Frostfell Airlines is expected to pay an upcoming dividend of $3.29. The company's dividend is
Underwriter 1 $5 $101 $10 expected to grow at a steady, constant rate of 5% well into the future. Frostfell currently has
Underwriter 2 7 102 11 1,600,000 shares of common stock outstanding. If the required rate of return for Frostfell is
Underwriter 3 3 97 7 12%, what is the best estimate for the current price of Frostfell's common stock?
Underwriter 4 3 98 8 A. $27.41 C. $62.51
Which underwriter will produce the lowest cost of funds for the preferred stock? B. $47.00 D. $65.80
A. Underwriter 1. C. Underwriter 3.
B. Underwriter 2. D. Underwriter 4. 10. Newmass, Inc. paid a cash dividend to its common shareholders over the past 12 months of
$2.20 per share. The current market value of the common stock is $40 per share, and
Cost of Retained Earnings Dividend Growth Model investors are anticipating the common dividend to grow at a rate of 6% annually. The cost to
6. Allison Engines Corporation has established a target capital structure of 40 percent debt and issue new common stock will be 5% of the market value. The cost of a new common stock
60 percent common equity. The current market price of the firms stock is P0 = $28; its last issue will be
dividend was D0 = $2.20, and its expected dividend growth rate is 6 percent. What will A. 11.50% C. 11.83%
Allisons marginal cost of retained earnings, ks, be? B. 11.79% D. 12.14%
A. 7.9% C. 14.3%
B. 13.9% D. 15.8% 11. Blair Brothers stock currently has a price of $50 per share and is expected to pay a year-end
dividend of $2.50 per share (D1 = $2.50). The dividend is expected to grow at a constant rate
7. The ABC Company is expected to have a constant annual growth rate of 5 percent. It has a of 4 percent per year. The company has insufficient retained earnings to fund capital projects
price per share of P32 and pays an expected dividend of P2.40. Its competitor, the DEF and must, therefore, issue new common stock. The new stock has an estimated flotation cost
Company is expected to have a growth rate of 10%, has a price per share of P72, and pays an of $3 per share. What is the companys cost of equity capital?
expected P4.80/share dividend. The required rates of return on equity for the two companies A. 9.21% C. 9.45%
are: B. 9.32% D. 10.14%
A. B. C. D.
12. The DCL Corporation is preparing to evaluate the capital expenditure proposals for the coming
ABC 9.6% 12.5% 13.8% 16.2% year. Because the firm employs discounted cash flow methods of analyses, the cost of capital
DEF 8.6% 16.7% 15.4% 18.2% for the firm must be estimated. The following information for DCL Corporation is provided.
Market price of common stock is $50 per share.
Cost of Common Stock Dividend Growth Model The dividend next year is expected to be $2.50 per share.
8. What return on equity do investors seem to expect for a firm with a $50 share price, an Expected growth in dividends is a constant 10%.
expected dividend of $5.50, a beta of .9, and a constant growth rate of 4.5%?
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New bonds can be issued at face value with a 13% coupon rate. 15. The common stock of Anthony Steel has a beta of 1.20. The risk-free rate is 5 percent and the
The current capital structure of 40% long-term debt and 60% equity is considered to market risk premium (kM - kRF) is 6 percent. Assume the firm will be able to use retained
be optimal. earnings to fund the equity portion of its capital budget. What is the companys cost of retained
Anticipated earnings to be retained in the coming year are $3 million. earnings, ks?
The firm has a 40% marginal tax rate. A. 7.0% C. 11.0%
If the firm must assume a 10% flotation cost on new stock issuances, what is the cost of new B. 7.2% D. 12.2%
common stock?
A. 14.50%. C. 15.50%. 16. Colt, Inc. is planning to use retained earnings to finance anticipated capital expenditures. The
B. 15.32%. D. 15.56%. beta coefficient for Colt's stock is 1.15, the risk-free rate of interest is 8.5%, and the market
return is estimated at 12.4%. If a new issue of common stock were used in this model, the
13. Fitzgerald is interested in investing in a corporation with a low cost of equity capital. By using flotation costs would be 7%. By using the Capital Asset Pricing Model (CAPM) equation [R =
the dividend growth model, which of the following corporations has the lowest cost of equity RF + (RM - RF)], the cost of using retained earnings to finance the capital expenditures is
capital? A. 12.40% C. 13.21%
Stock Price Dividend Growth Rate B. 12.99% D. 14.26%
C.S. Inc. $25 $5 8%
Lewis Corp. 30 3 10% 17. Stock J has a beta of 1.2 and an expected return of 15.6%, and stock K has a beta of 0.8 and
Screwtape Inc. 20 4 6% an expected return of 12.4%. What must be the expected return on the market and the risk-
Wormwood Corp. 28 7 7% free rate of return, to be consistent with the capital asset pricing model?
A. C.S. Inc. C. Screwtape Inc. A. Market is 12.4%; risk-free is 0%. C. Market is 14%; risk-free is 4%.
B. Lewis Corp. D. Wormwood Corp. B. Market is 14%; risk-free is 1.6%. D. Market is 14%; risk-free is 6%.

Cost of Common Stock Capital Asset Pricing Model 18. If the return on the market portfolio is 10% and the risk-free rate is 5%, what is the effect on a
14. Based on the following information about stock price increases and decreases, make an company's required rate of return on its stock of an increase in the beta coefficient from 1.2 to
estimate of the stock's beta: Month 1 = Stock +1.5%, Market +1.1%; Month 2 = Stock +2.0%, 1.5?
Market +1.4%; Month 3 = Stock -2.5%, Market -2.0%. A. No change C. 1.5% increase
A. Beta equals 1.0 B. 1.5% decrease D. 3% increase
B. Beta is less than 1.0.
C. Beta is greater than 1.0. 19. An investor was expecting a 15% return on his portfolio with beta of 1.25 before the market
D. There is no consistent pattern of returns. risk premium increased from 6% to 9%. Based on this change, what return will now be
expected on the portfolio?
A. 15.00% C. 18.75%
B. 18.00% D. 22.50%

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20. What happens to expected portfolio return if the portfolio beta increases from 1.0 to 2.0, the The firms bonds are currently selling at 80% of par, generating a current market yield of 9%,
risk-free rate decreases from 5% to 4%, and the market risk premium remains at 8%? and the corporation has a 40% tax rate. The preferred stock is selling at its par value and
A. It remains unchanged. C. It increases from 13% to 20%. pays a 6% dividend. The common stock has a current market value of $40 and is expected to
B. It increases from 12% to 19%. D. It increases from 13% to 16%. pay a $1.20 per share dividend this fiscal year. Dividend growth is expected to be 10% per
year. Wileys weighted-average cost of capital is (round your calculations to tenths of a
21. The expected returns, standard deviations, and beta coefficients of four stocks are given percent)
below: A. 8.3% C. 9.6%
Expected Return Standard Deviation Beta Coefficient B. 9.0% D. 13.0%
M 18% .65 .9
N 20% .9 1.2 24. Dobson Dairies has a capital structure that consists of 60 percent long-term debt and 40
O 20% .4 1.5 percent common stock. The companys CFO has obtained the following information:
Q 21% 1.2 1.7 The before-tax yield to maturity on the companys bonds is 8 percent.
Given an expected return on the market portfolio of 18% and a risk-free rate of 12%, which The companys common stock is expected to pay a $3.00 dividend at year end (D1 =
stock(s) is(are) overvalued or undervalued? $3.00), and the dividend is expected to grow at a constant rate of 7 percent a year. The
A. M, N, O, and Q are overvalued. common stock currently sells for $60 a share.
B. M, N, O, and Q are undervalued. Assume the firm will be able to use retained earnings to fund the equity portion of its
C. M is undervalued; N, O, and Q are overvalued. capital budget.
D. M and N are undervalued; O and Q are overvalued. The companys tax rate is 40 percent.
What is the companys weighted average cost of capital (WACC)?
Weighted-Average Cost of Capital A. 8.03% C. 9.34%
22. What is the weighted average cost of capital for a firm with 40% debt, 20% preferred stock, B. 7.68% D. 12.00%
and 40% common equity if the respective costs for these components are 8% after-tax, 13% 25. A company has determined that its optimal capital structure consists of 40 percent debt and 60
after-tax, and 17% before-tax? The firm's tax rate is 35%. percent equity. Assume the firm will not have enough retained earnings to fund the equity
A. 10.22% C. 11.48% portion of its capital budget. Also, assume the firm accounts for flotation costs by adjusting the
B. 10.52% D. 12.60% cost of capital. Given the following information, calculate the firms weighted average cost of
capital.
23. Wileys new financing will be in proportion to the market value of its present financing, shown kd = 8% P0 = $25
below. Net income = $40,000 Growth = 0%
Book Value ($000 Omitted) Payout ratio = 50% Shares outstanding = 10,000
Long-term debt $7,000 Tax rate = 40% Flotation cost on additional equity = 15%
Preferred stock (100 shares) 1,000 A. 7.60% C. 11.81%
Common stock (200 shares) 7,000
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B. 8.05% D. 13.69%
26. Company X is interested in calculating it weighted-average cost of capital. Company X has a
current financial structure that is composed of 50% debt, 40% common stock, and 10%
preferred stock. Ignore the effects of cost of retained earnings. The beta of Company X stock
is 0.7, and the current risk-free rate of return is 4%. The market risk premium is 6%. The
preferred dividend on Company X preferred stock is set at $2.25, and the net issuance price
per share (which happens to be the same as the current price per share) of preferred stock is
$30. Debt issued by Company X yields an 11% stated interest rate to investors. The marginal
tax rate for Company X is 40%. What is the weighted-average cost of capital for Company X?
A. 0.0660 C. 0.0743
B. 0.0733 D. 0.0820
27. Grateway Inc. has a weighted average cost of capital of 11.5 percent. Its target capital
structure is 55 percent equity and 45 percent debt. The company has sufficient retained
earnings to fund the equity portion of its capital budget. The before-tax cost of debt is 9
percent, and the companys tax rate is 30 percent. If the expected dividend next period (D 1) is
$5 and the current stock price is $45, what is the companys growth rate?
A. 2.68% C. 4.64%
B. 3.44% D. 6.75%
28. A company has $1 million in shareholders' equity and $2 million in debt equity (8% bonds). Its
after-tax weighted-average cost of capital is 12%, but it uses 15% as the hurdle rate in capital
budgeting decisions. During the past year, its operating income before tax and interest was
$500,000. Its tax rate is 40%. What is the company's cost of equity capital?
A. 8% C. 15%
B. 12% D. 26.4%
29. Bradshaw Steel has a capital structure with 30 percent debt (all long-term bonds) and 70
percent common equity. The yield to maturity on the companys long-term bonds is 8 percent,
and the firm estimates that its overall composite WACC is 10 percent. The risk-free rate of
interest is 5.5 percent, the market risk premium is 5 percent, and the companys tax rate is 40
percent. Bradshaw uses the CAPM to determine its cost of equity.
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What is the beta on Bradshaws stock?
A. 0.10 C. 1.35
B. 1.07 D. 1.48
30. Heavy Metal Corp. is a steel manufacturer that finances its operations with 40 percent debt, 10
percent preferred stock, and 50 percent equity. The interest rate on the companys debt is 11
percent. The preferred stock pays an annual dividend of $2 and sells for $20 a share. The
companys common stock trades at $30 a share, and its current dividend (D 0) of $2 a share is
expected to grow at a constant rate of 8 percent per year. The flotation cost of external equity
is 15 percent of the dollar amount issued, while the flotation cost on preferred stock is 10
percent. The company estimates that its WACC is 12.30 percent. Assume that the firm will not
have enough retained earnings to fund the equity portion of its capital budget. What is the
companys tax rate?
A. 30.33% C. 35.75%
B. 32.87% D. 38.12%
31. Datacomp Industries, which has no current debt, has a beta of .95 for its common stock.
Management is considering a change in the capital structure to 30% debt and 70% equity. This
change would increase the beta on the stock to 1.05, and the after-tax cost of debt will be
7.5%. The expected return on equity is 16%, and the risk-free rate is 6%. Should Datacomp's
management proceed with the capital structure change?
A. No, because the cost of equity capital will increase.
B. Yes, because the cost of equity capital will decrease.
C. No, because the weighted-average cost of capital will increase.
D. Yes, because the weighted-average cost of capital will decrease.
Retained Earnings Breakpoint, Marginal Cost of Capital & Optimal Capital Budget
32. Gravy Company expects earnings of P30 million next year. Its dividend payout ratio is 40%,
and its debt/equity ratio is 1.50. Gravy uses no preferred stock.
At what amount of financing will there be a break point in Gravys marginal cost of capital?
A. P18 million. C. P30 million.
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B. P20 million. D. P45 million. B. Increase pre-tax profits by 1.71%. D. Increase pre-tax profits by 21%.
33. A company has $650,000 of 10% debt outstanding and $500,000 of equity financing. The 37. This year, Nelson Industries increased earnings before interest and taxes (EBIT) by 17%.
required return of the equity holders is 15%, and there are no retained earnings currently During the same period, net income after tax increased by 42%. The degree of financial
available for investment purposes. If new outside equity is raised, it will cost the firm 16%. New leverage that existed during the year is
debt would have a before-tax cost of 9%, and the corporate tax rate is 50%. When calculating A. 1.70. C. 4.20.
the marginal cost of capital, the company should assign a cost of <List A> to equity capital and B. 2.47. D. 5.90.
<List B> to the after-tax cost of debt financing.
A. B. C. D. 38. A company has unit sales of 300,000, the unit variable cost is $1.50, the unit sales price is
List A 15% 15% 16% 16% $2.00, and the annual fixed costs are $50,000. Furthermore, the annual interest expense is
List B 4.5% 5.0% 4.5% 5.0% $20,000, and the company has no preferred stock. Accordingly, the degree of total leverage is
A. 1.20 C. 1.50
Capital Budgeting B. 1.25 D. 1.875
34. Computechs is an all-equity firm that is analyzing a potential mass communications project
which will require an initial, after-tax cash outlay of $100,000, and will produce after-tax cash Comprehensive
inflows of $12,000 per year for 10 years. In addition, this project will have an after-tax salvage Questions 39 through 42 are based on the following information.
value of $20,000 at the end of Year 10. If the risk-free rate is 5 percent, the return on an A new company requires $1 million of financing and is considering two arrangements as shown in
average stock is 10 percent, and the beta of this project is 1.80, then what is the project's the table below:
NPV? Amount of Amount of Before-Tax
A. $3,234 C. -$32,012 Arrangement Equity Raised Debt Financing Cost of Debt
B. $10,655 D. -$37,407 #1 $700,000 $300,000 8% per annum
#2 $300,000 $700,000 10% per annum
DOL + DFL = DTL In the first year of operations, the company is expected to have sales revenues of $500,000, cost
35. In its first year of operations, a firm had $50,000 of fixed operating costs. It sold 10,000 units of sales of $200,000, and general and administrative expenses of $100,000. The tax rate is 30%,
at a $10 unit price and incurred variable costs of $4 per unit. If all prices and costs will be the and there are no other items on the income statement. All earnings are paid out as dividends at
same in the second year and sales are projected to rise to 25,000 units, what will the degree year-end.
of operating leverage (the extent to which fixed costs are used in the firms operations) be in
the second year? 39. If the cost of equity is 12%, the weighted-average cost of capital under arrangement #1, to the
A. 1.25 C. 2.0 nearest full percentage point, would be
B. 1.50 D. 6.0 A. 8% C. 11%
B. 10% D. 12%
36. For a firm with a degree of operating leverage of 3.5, an increase in sales of 6% will
A. Decrease pre-tax profits by 3.5%. C. Increase pre-tax profits by 3.5%.

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MANAGEMENT ADVISORY SERVICES HILARIO TAN

Theory Problem
40. Which of the following statements comparing the two financing arrangements is true? 1. D 26. D 1. C 26. B
A. The company will have higher interest expense under arrangement #1. 2. C 27. B 2. C 27. C
B. The company will have higher expected tax expense under arrangement #1. 3. B 28. D 3. C 28. D
C. The company will have a higher expected gross margin under arrangement #1. 4. B 29. A 4. C 29. C
D. The company will have a higher degree of operating leverage under arrangement #2. 5. C 30. D 5. C 30. B
6. B 31. C 6. C 31. D
41. Under financing arrangement #2, the degree of financial leverage (DFL), rounded to two 7. D 32. B 7. B 32. D
decimal places, would be 8. D 8. B 33. C
A. 1.09 C. 1.32 9. C 9. B 34. C
B. 1.14 D. 1.54 10. A 10. D 35. B
11. B 11. B 36. D
42. The return on equity will be <List A> and the debt ratio will be <List B> under arrangement #2,
12. C 12. D 37. B
as compared with arrangement #1.
13. A 13. B 38. D
A. B. C. D.
14. C 14. C 39. B
List A Higher Higher Lower Lower
15. C 15. D 40. B
List B Higher Lower Higher Lower
16. D 16. B 41. D
17. C 17. D 42. A
18. B 18. C
19. C 19. C
20. D 20. C
21. D 21. D
22. C 22. D
23. A 23. C
24. B 24. B
25. C 25. A

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