Cost of Capital

TESTBANK
Long Term Financing Decisions
1.) It is the rate that a firm must earn on the projects in which it invests to maintain the
market value of its stock.
a. stock price c. internal rate of return

b. cost of capital d. net present value
Answer: b
Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)
2.) It is the risk to the firm of being unable to cover operating costs is assumed to be
unchanged. This assumption means that the firms acceptance of a given project does not
affect its ability to meet operating costs.
a. business risk c. financial risk

b. economic risk d. accounting risk
Answer: a
3.) It is the risk to the firm of being unable to cover required financial obligations (interest,
lease payments, preferred stock dividends) is assumed to be unchanged. This
assumption means that projects are financed in such a way that the firms ability to meet
required financing costs is unchanged.
a. business risk c. financial risk

b. economic risk d. accounting risk
Answer: c
4.) The after-tax cost of today of raising long-term funds through borrowing.
a. cost of common stock c. cost of preferred stock

b. cost of retained earnings d. cost of long-term debt
Answer: d

5.) The ratio of the preferred stock dividend to the firms net proceeds from the sale of
preferred stock; calculated by dividing the annual dividend, by the net proceeds from the
sale of the preferred stock.

Answer: c
6.) The return required on the stock by investors in the marketplace.

Answer: a
7.) The same as the cost of an equivalent fully subscribed issue of additional common stock,
which is equal to common stock equity.

Answer: b
8.) It reflects the expected average future cost of funds over the long run; found by weighting
the cost of each specific type of capital by its proportion in the firms capital structure.
a. cost of capital c. weighted average cost of capital

b. weighted average d. average cost
Answer: c
9.) Weights that use accounting values to measure the proportion of each type of capital in
the firms financial structure.
a. market value weights c. target weights

b. book value weights d. historical weights
Answer: b
10.) Weights that use market values to measure the proportion of each type of capital in the
firms financial structure.

Answer: a
11.) It can either be book or market value weights based on actual capital structure
proportions.

Answer: d
12.) It can either be based on book or market values; reflect the firms desired capital
structure proportions. Firms using these weights establish such proportion on the basis of
the optimal capital structure they wish to achieve.

Answer: c
13.) It is concerned with the relationship between the firms sales revenue and its
earnings before interest and taxes or EBIT.
a. total leverage c. operating leverage

b. financial leverage d. capital structure
Answer: c

14.) It is concerned with the relationship between the firms sales revenue and earning
per share (EPS).

Answer: a
15.) It is concerned with the relationship between the firms EBIT and its common stock
earnings per share.

Answer: b
16.) The mix of long-term debt and equity maintained by the firm.

Answer: d
17.) The capital structure at which the weighted average cost of capital is minimized, thereby
maximizing the firms value.
a. cost of capital c. capital structure

b. weighted average cost of capital d. optimal capital structure
Answer: d
18.) Results from the use of fixed-cost assets or funds to magnify returns to the firms
owners.
a. leverage c. operating leverage

Answer: a
19.) Indicates the level of operations necessary to cover all operating costs and the
profitability associated with various levels of sales.
a. breakeven point c. operating breakeven point

b. breakeven analysis d. operating costs
Answer: b
20.) The level of sales necessary to cover all operating costs.
a. breakeven point c. operating breakeven point

b. breakeven analysis d. operating costs
Answer: c
21.) The yield to maturity of a bond is:
a. The discount rate in a present-value equation that equates the market price of a bond
with present value of its future debt-service obligations.
b. The average annual rate of return an investor expects to receive from buying and
holding the bond until maturity.
c. Equal to the coupon rate if the bond sells at par value.
d. All of the above.
Answer: d
Source: Elenita Balatbat Cabrera, Management Advisory Services Reviewer, 2000 Edition.
22.) For a given company, the cost of prefferd stock is less than the cost of common stock
because:
a. Dividends paid on preferred stock are tax deductible expenses for the company while
dividends paid on common stock are paid out of after-tax earnings.
b. Preferred stock represents a less risky source of funds from the companys viewpoint
than common stock.
c. Investors expect cash flows from common stock have a higher degree of uncertainty
that the expected cash flows from preferred stock.
Answer: c
23.) For a given company, Investors required return on the companys common stock is:
a. Equal to the companys cost of retained earnings

b. Equal to the companys cost of new common stock if inflation costs are zero.
c. Always less that the cost of new common stock if inflation costs are not zero.
Answer: d
24.) Which of the following situations should never occur:
a. Within the company, the required return on common equity is less than the required
return on preferred stock.
b. The required return on one companys common stock is lower than the required yield
on another companys preferred stock.
c. Within one company, the cost of debt is less than the cost of equity.
d. a and b.
Answer: a
25.) GBF Co. is preparing to float a new issue of bonds. The bonds will have the following
characteristics:
Coupon rate 8.4%

Term to maturity 10 years
Face value P1,000
Issue price P900.30
GBF
s marginal tax rate is 34%. The coupon payments are paid semiannually. GBFs cost of
debt (ki) for this bond issue will be nearest:
a. 5.0% c. 3.3%
b. 1.7% d. 6.6%
Answer: d
At 6.6% the present value of the maturity of the bonds (P1,000) plus the present value of
the semi-annual interest payments will equal P900.30.
26.) DRW, Inc. is preparing to issue preferred stock. The preferred stock will have a P100
par value and will pay P8 per year in dividends. DRWs marginal tax rate is 34%.
Flotation cost for the new issue will be P2.38 per share. The issue price is expected to be
P96.50 per share. Based on this information, DRWs cost of preferred stock is nearest:
a. 5.3% c. 5.6%
b. 8.5% d. 8.0%
Answer: b
P8 / (P96.50-P2.38) = 8.5%
Use this information for questions 27 and 28.

Ames Co. is preparing to issue new common stock. Ames stock is currently selling in the market
for P50. Very recently, the stock paid a dividend of P2 per share. Dividend are expected to gorw
at 10% per year through the foreseeable future. Floatation costs on the new issue will be P3 per
share. Ames marginal tax rate is 34%. Assume that the new stock can be sold to investors at the
current price of the price existing shares.
27.) Based on the information given above, Ames cost of retained earnings is nearest:
a. 4.4% c. 14.0%
b. 4.7% d. 14.4%
Answer: d
[(P2 x 110%) / P50] + 10% = 14.4%
28.) Based on the information given above, Ames cost of new common stock is nearest:
a. 8.33% c. 14.68%
b. 14.40% d. 14.25%
Answer: c
[(P2 x 110%) / (P50 - P3] + 10% = 14.68%
29.) GMR Corporation is preparing to issue common stock. The Chief Financial Officer is
attempting to estimate GMRs cost of new common stock. The next dividend is expected
to be P4.25 and will be paid one year from now. The current market price reflects an
18% expected annual return to investors. Dividends are expected to grow at a constant
8% per year. Flotation cost costs on the new issue will be P1.25 per share. GMR;s cost
of new common stock is nearest.
a. 18.30% c. 18.00%
b. 19.25% d. 19.44%
Answer: a
P4.25 / (18% - 8%) = P42.50 P4.25 / (P42.50 P1.25) + 8% = 18.3%
30.) RMG Corporation is preparing to issue common stock. The Chief Financial Officer is
attempting to estimate RMGs cost of new common stock. The next dividend is expected
to be P3.70 and will be paid one year from now. Dividends are expected to grow at a
constant 7% per year. Flotation cost costs on the new issue will be P2.25 per share.
RMGs Beta coefficient is 1.5, the risk-fee rate is 7.5%, and the expected return on the
DJ Industrial Average is 12.5%. Based on this information, RMGs cost of new common
stock is nearest.
a. 8.4% c. 13.7%
b. 12.5% d. 15.4%
Answer: d
P3.70 / (15% - 7%) = P46.25 P3.70 / (P46.25 P2.25) + 7% = 15.4%
The following data apply to items 31-34.

Williams Inc. is interested in measuring its overall cost of capital and has gathered the following
data. Under the terms described below, the company can sell unlimited amounts of all
instruments.
Williams can raise cash by selling P1,000, 8 percent, 20-year bonds with annual interest
payments. In selling the issue, an average premium of P30 per bond would be received,
and the firm must pay flotation costs of P30 per bond. The after-tax cost of funds as
estimated to be 4.8 percent.
Williams can sell 8 percent preferred stock at par value, P105 per share. The cost of
issuing and selling the preferred stock is expected to be P5 per share.
Williams common stock is currently selling for P100 per share. The firm expects to pay
cash dividends of P7 per share next year, and the dividends are expected to remain
constant. The stock will have to be under priced by P3 per share, and flotation costs are
expected to amount to P5 per share.
Williams expects to have available P100,000 of retained earnings in the coming year;
once these retained earnings are exhausted, the firm will use new common stock as the
form of common stock equity financing.
Williams desired capital structure is

Long term debt 30%
Preferred stock 20
Common stock 50
31.) The cost of funds from the sale of common stock for Williams Inc. is
a. 7.0 percent c. 7.4 percent

b. 7.6 percent d. 8.1 percent
Answer: b
P7 / (P100 - P3 P5) = 7.6%
32.) The cost of funds from retained earnings for Williams Inc. is

Answer: a
P7 / P100 = 7%
33.) If Williams Inc. needs a total of P200,000, the firms weighted average cost of capital
would be

Answer: c
LT Debt 30% 4.8% 1.4%

PS 20 8.0 1.6
CS 50 7.0 3.5
6.5%
34.) If Williams Inc. needs a total of P1,000,000, the firms weighted average cost of capital
would be

Answer: a
LT Debt 30% 4.8% 1.4%

PS 20 8.0 1.6
CS 50 7.6 3.8
6.8%
35.) The overall cost of capital is the
a. rate of return on assets that covers the costs associated with the funds employed.
b. average rate of return a firm earns on its assets.
c. minimum rate a firm must earn on high risk projects.
d. cost of the firms equity capital at which the market value of the firm will remain
unchanged.
(CMA Adapted)
Answer: a
36.) If Golda Corporations bonds are currently yielding 8 percent in the marketplace, why
would the firms cost of debt be lower?
a. Market interest rates have increased

b. Additional debt can be issued more cheaply than the original debt.
c. There should be no difference; cost of debt is the same as the bonds market yield.
d. Interest is deductible for tax purposes.
(CMA Adapted)
Answer: d
37.) The theory underlying the cost of capital is primarily concerned with the cost of
a. long-term funds and old finds.

b. short-term funds and new funds.
c. long-term funds and new funds.
d. short-term funds and old funds.
Answer: c
38.) A preferred stock is sold for P101 per share, has a face value of P100 per share,
underwriting fees of P5 per share, and annual dividends of P10 per share. If the tax rate
is 40 percent, the cost of funds (capital) for the preferred stock is

Answer: d
P10 / (P101 P5) = 10.4%
39.) Which one of a firms sources of new capital usually has the lowest after-tax cost?
a. Retained earnings c. Preferred stock

b. Bonds d. Common stock
Answer: b
40.) Using the Capital Asset Pricing Model (CAPM), the required rate of return for a firm
with a beta of 1.25 when the market return is 14 percent and the risk-free rate is 6
percent is

Answer: d
6% + (14% - 6%) (1.25) = 16%
41.) Which one of the following statements is correct when comparing bond financing
alternatives?
a. A bond with a call provision typically has a lower yield to maturity than a similar
bond without a call provision.
b. A convertible bond must be converted to common stock prior to its maturity.
c. A call provision is generally considered detrimental to the investor.
d. A call premium requires the investor to pay an amount greater than par at the time
of purchase.
Answer: c
42.) Maybelle Corporation has 6,000 shares of 5 percent, cumulative, P100 par value
preferred stock outstanding and 200,000 shares of common stock outstanding.
Maybelles Board of Directors last declared dividends for the year ended May 31, 19x3,
and there were no dividends in arrears. For the year May 31, 19X5, Maybelle had net
income of P1,750,000. The Board of Directors is declaring a dividend for common
shareholders equivalent to 20 percent of net income. The total amount of dividends to be
paid by Maybelle at May 31, 19x% is
a. P350,000 c. 206,000
b. P380,000 d. 410,000
Answer: d
The following data apply to items 43 and 44.
Shen Corporation
Statement of Financial Position
December 31, 19x4
(Pesos in millions)
Assets
Current assets P 75
Plant and equipment 250
Total assets P325
Liabilities and shareholders equity

Current liabilities P 46
Long term debt (12%) 64
Common equity:
Common stock, P1 par 10
Additional paid in capital 100
Retained earnings 105
Total liabilities and SHE P325
Additional Data
The long-term debt was originally issued at par (P1,000/ bond) and is currently trading at
P1,250 per bond.
Shen Corporation can now issue debt at 150 basis points over Metro Manila treasury
stock.
The current risk-free rate is 7 percent.
Martins common stock is currently selling at P32 per share.
The expected market return is currently 15 percent.
The beta value for Shen is 1.25.
Shens effective corporate income tax rate is 40 percent.
43.) Shen Corporations current net cost of debt is

Answer: c
(7% + 1.5%) (60%) = 5.1%
44.) Using the Capital Asset Pricing Model (CAPM), Shen Corporations current cost of
common equity is

Answer: d
7% + (15% - 7%) (1.25%) = 17%
45.) The Dizon Corporation has an outstanding one-year bank loan of P300,000 at a stated
interest rate of 8 percent. In addition, Dizon is required to maintain a 20 percent
compensating balance in its checking account. Assuming the company would normally
maintain zero balance in its checking account, the effective interest rate on the loan is

Answer: d
8% / (100% - 20%) = 10%
46.) Elan Corporation is considering borrowing P100,000 from a bank for one year at a stated
interest rate of 9 percent. What is the effective interest rate of Elan if this borrowing is in
the form of a discounted note?

Answer: d
9% / (100% - 9%) = 9.89%

Analen Company presently sells 400,000 bottles of perfume each year. Each bottle costs P.84 to
produce and sells for P1.00. Fixed costs are P28,000 per year. The firm has annual interest
expense of P6,000, preferred stock dividends of 2,000 per year, and a 40 percent tax rate. Analen
uses the following formulas to determine the companys leverage.
Operating leverage = [Q (S VC)] / [Q (S VC) FC]

Financial leverage = EBIT / EBIT I [P / (1 t)]
Total leverage = [Q (S VC)] / Q (S VC) FC I [P / (1 t)]
Where: Q = Quantity
FC = Fixed cost
VC = Variable cost
S = Selling price
I = Interest expense
P = Preferred dividends
t = Tax rate
EBIT = Earnings before interest and taxes
47.) The degree of operating leverage for Analen Company is
a. 2.4 c. 1.35
b. 1.78 d. 1.2
Answer: b
48.) The degree of financial leverage for Analen Company is
a. 2.4 c. 1.35
b. 1.78 d. 1.2
Answer: c
49.) If Analen Company did not have preferrd stock, the degree of total leverage would
a. decrease in proportion to a decrease in financial leverage.

b. increase in proportion to an increase in financial leverage.
c. remain the same.
d. decrease bit not be proportional to the decrease in financial leverage.
Answer: a
50.) Pelagio Corporation has sold P50 million of P1,000 par value, 12 percent coupon bonds.
The bonds were sold at a discount and the corporation received P985 per bond. If the
corporate tax rate is 40 percent, the after-tax cost of these bonds for the first year
(rounded to the nearest hundredth percent) is

Answer: a
P120 (60%) / P985 = 7.31%
51.) Horario Corporation is selling P25 million of cumulative, non-participating preferred

stock. The issue will have a par value of P65 per share with a dividend rate of 6 percent.
The issue will be sold to investors for P68 per share and issuance cost will be P4 per
share. The cost of preferred stock to Horario is

Answer: d
P65 x 6% = P3.90 Dividends P3.90 / (P68 P4) = 6.09%
52.) Anabel Inc. is planning to use retained earnings to finance anticipated capital
expenditures. The beta coefficient for Anabels stock is 1.15, the risk-free rate of interest
is 8.5 percent, and the market return is estimated at 12.4 percent. If a new issue of
common stock was used in this model, the flotation costs would be 7 percent. By using
the Capital Asset Pricing Model equation [R = RF + (RM RF)], the cost of using
retained earnings to finance the capital expenditures is
Answer: b
8.5% + 1.15 (12.4% - 8.5%) = 12.99%
53.) Mariday Inc. paid a cash dividend to its common shareholders over the past twelve
months of P2.20 per share. The current market value of the common stock is P40 per
share and investors are investors are anticipating the common dividend to grow at a rate
of 6 percent annually. The costs to issue new common stock will be 5 percent of the
market value. The cost of a new common stock issue will be

Answer: d
[P2.20 (1.06) / 40 (1 - .05)] + 6% = 12.14%
54.) 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 percent debt and 70
percent equity. This change would increase the beta on the stock to 1.05, and the after-
tax cost of debt will be 7.5 percent. The expected return on equity is 16 percent, and the
risk-free rate is 6 percent. Should Datacomps 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. Yes, because the weighted average cost of capital will decrease.
d. No, because the weighted average cost of capital will increase.
Answer: c
WACC (present)
E: 6% + (16% - 6%) (.95) = 5.5%
WACC (proposed)
D: 7.5% x 30% = 2.25%
E: [6% + (16% - 6%) (1.05)] x 70% = 11.55
13.80%
55.) A company obtained a short-term bank loan of P500,000 at an annual interest rate of
eight percent. As a condition of the loan, the company is required to maintain a
compensating balance of P100,000 in its checking account. The checking account earns
interest at an annual rate of three percent. Ordinarily, the company maintains a balance
of P50,000 in its account for transaction purposes. What is the effective interest rate of
the loan?

Answer: d
56.) An automated clearinghouse (ACH) electronic transfer is a(n)
a. electronic payment to a companys account at a concentration bank.

b. check that must be immediately cleared by the Bangko Sentral.
c. computer-generated deposit ticket verifying deposit of funds.
d. check-like instrument drawn against the payor and not against the bank.
Answer: a
57.) Assume that each day a company writes and receives checks totaling P10,000. If it takes
five days for the checks to clear and be deducted from the companys account, and only
four days for the deposits to clear, what is the float?
a. P10,000 c. P(10,000)
b. P0 d. P50,000
Answer: a

WXY Telecom is considering a project for the coming year which will cost P50 million. WXY
plans to use the following combination of debt and equity to finance the investment.
Issue P15 million of 20-year bonds at price 101, with a coupon rate of 8 percent, and
flotation costs of 2 percent to par.
Use P35 million of funds generated from earnings.
The equity market is expected to earn 12 percent. The treasury bonds are currently yielding 5
percent. The beta coefficient for WXY is estimated to be .60. WXY is subject to an effective
corporate income tax rate of 40 percent.
58.) The before-tax cost of WXYs planned debt financing, net of flotation costs, in the first
year is

Answer: b
8% / (101% - 2%) = 8.08%
59.) Without prejudice to your answer to item 58, assume that the after-tax cost of debt is 7
percent and the cost of equity is 12 percent. Determine the weighted average cost of
capital.

Answer: a
8% x 30% = 2.1%
12% x 70% = 8.4%
10.5%
60.) The Capital Asset Pricing Model (CAPM) computes the expected return on a security by
adding the risk-free rate of return to the incremental yield of the expected market return
which is adjusted by the companys beta. Compute WXYs expected rate of return.

Answer: a
5% + (12% - 5%) (.6) = 9.20%

Currently, Warren Industries can sell 15-year, $1,000-par-value bonds paying annual interest at
12% coupon rate. As a result of current interest rates, the bonds can be sold for $1,010 each;
flotation costs of $30 per bond will be incurred in this process. The firm is in the 40% tax
bracket.
61.) Find the net proceeds from sale of the bond.
a. $1,010 c. $1,000
b. $980 d. $950
Answer: b
62.) Use the approximation formula to estimate the after-tax costs of the debt.
a. 7.36% after tax c. 8.00% after tax

b. 7.32% after tax d. 8.30% after tax
Answer: a

J&M Corporation common stock has a beta, b, of 1.2. The risk-free rate is 6%, and the market
return is 11%.
63.) Determine the risk premium on J&M common stock.
a. 3% c. 6%
b. 5% d. 4%
Answer: c
64.) Determine the required return that J&M common stock should provide.
a. 8% c. 12%
b. 10% d. 12.5%
Answer: c

Ross Textiles wishes to measure its cost of common stock equity. The firms stock is currently
selling for $57.50. The firm expects to pay a $3.40 dividend at the end of the year (2004). The
dividends for the past 5 years are shown in the following table.
Year Dividend
2003 $3.10
2002 2.92
2001 2.60
2000 2.30
1999 2.12
After under pricing and flotation costs, the firm expects to net $52 per share on a new
issue.
65.) Using the constant-growth valuation model, determine the cost of retained earnings.
a. 15.91% c. 15.80%
b. 15.99% d. 15.75%
Answer: a
66.) Using the constant-growth valuation model, determine the cost of new common stock.
a. 16.50% c. 16.45%
b. 16.40% d. 16.54%
Answer: d

Equity Lightning Corp. wishes to explore the effect on its cost of capital of the rate at which the
company pays taxes. The firm wishes to maintain a capital structure of 30% debt, 10% preferred
stock, and 60% common stock. The cost of financing with retained earnings is 14%, the cost of
preferred stock financing is 9%, and the before-tax cost of debt financing is 11%. Calculate the
weighted average cost of capital (WACC) given the tax rate assumptions.
67.) Tax rate = 40%
a. 11.28% c. 11.17%
b. 11.45% d. 11.54%
Answer: a
68.) Tax rate = 35%
a. 11.28% c. 11.17%
b. 11.45% d. 11.54%
Answer: b

Afrer careful analysis, Dexter Brothers has determined that its optimal capital structure is
composed of the sources and target market weights shown in the following table.
Source of capital Target market value weight

LT debt 30%
Preferred stock 15
Common stock equity 55
Total 100%
The cost of debt is estimated to be 7.2%; the cost of preferred stock is estimated to be 13.5%; the
cost of retained earnings is estimated to be 16.0%; and the cost of new common stock estimated
to be 18.0%. All of these are after-tax rates. The companys debt represents 25%, the preferred
stock represents 10%, and the common stock equity represents 65% of total capital on the basis
of the market values of the three components. The company expects to have a significant amount
of retained earnings available and does not expect to sell any common stock.
69.) Calculate the weighted average cost of capital on the basis of historical market value
weights.
a. 13.55% c. 13.75%
b. 13.45% d. 13.00%
Answer: a
70.) Calculate the weighted average cost of capital on the basis of target market value
weights.
a. 13.505% c. 13.759%
b. 12.645% d. 12.985%
Answer: d
71.) Grainer Corp., a supplier of fitness equipment, is trying to decide whether to undertake
any or all of the proposed projects in its investment opportunities schedule (IOS). The
firms cost of capital schedule and investment opportunity schedules follow.
Cost of Capital Schedule
Range of new financing Source Weight After-tax cost
0 - $600,000 Debt .50 6.3%
Preferred Stock .10 12.5
Common stock .40 15.3
$600,000 - $1,000,000 Debt .50 6.3%

$1,000,000 and above Debt .50 6.3%

Investment Opportunities Schedule

Investment Opportunity Internal rate of Return Cost
Project H 14.5% $200,000
Project G 13.0 700,000
Project K 12.8 500,000
Project M 11.4 600,000
Determine the WACC for 0 to $600,000 and $600,001 to $1,000,000.
a. 10.25% and 10.69% c. 10.52% and 10.96%

b. 10.96% and 10.52% d. 10.69% and 10.25%
Answer: c

Barry Carter is considering opening a record store. He wants to estimate the number of CDs he
must sell to break even. The CDs will be sold for $13.98 each, variable operating costs are
$10.48 per CD, and annual fixed operating costs are $73,500.
72.) Find the operating breakeven point in number of CDs.
a. 21,000 CDs c. 25,000 CDs

b. 22,000 CDs d. 24,000 CDs
Answer: a
73.) Calculate the total operating cots at the breakeven volume found in number 71.
a. $293,550 c. $239,580
b. $293,580 d. $230,000
Answer: b

Molly Jasper and her sister, Caitlin Peters, got into the novelties business almost by accident.
Molly, a talented sculptor, often made little figurines as gifts for friends. Occasionally, she and
Caitlin would set up a booth at a crafts fair and sell a few of the figurines along with jewelry that
Caitlin made. Little by little, demand for the figurines, now called Mollycaits, grew and the
sisters began to reproduce some of the favorites in resin, using molds of the originals. The day
came when a buyer for a major department store offered them a contract to produce 1,500
figurines of various designs for $10,000. Molly and Caitlin realized that it was time to get down
to business. To make bookkeeping simpler, Molly had priced all the figurines at $8.00. Variable
operating costs amounted to an average of $6.00 per unit. In order to produce the order, Molly
and Caitlin would have to rent industrial facilities for a month, which would cost them $4,000.
74.) Calculate Mollycaits operating breakeven point.
a. 2,500 figures c. 1,400 figures

b. 1,800 figures d. 2,000 figures
Answer: d
75.) Calculate Mollycaits EBIT on the department store order.
a. - $1,000 c. - $1,550
b. - $3,000 d. - $2,000
Answer: b
76.) If Molly renegotiates the contract at a price of $10.00, what will the EBIT be?
a. $1,000 c. $2,000
b. $2,500 d. $2,800
Answer: c

Grey Products has fixed operating costs of $380,000, variable operating costs of $16 per unit,
and a selling price of $63.50 per unit.
77.) Calculate the operating breakeven point in units.
a. 8,000 units c. 6,000 units

b. 10,000 units d. 7,000 units
Answer: a
78.) Calculate the firms EBIT at 10,000 units.
a. $91,000 c. $96,000
b. $95,000 d. $92,000
Answer: b
79.) Use the formula for degree of operating leverage to determine the DOL at 10,000 units.
a. 5.00 c. 6.00
b. 4.00 d. 3.00
Answer: a
80.) Northwestern Savings and Loan has a current capital structure consisting of $250,000 of
16% (annual interest) debt and 2,000 shares of common stock. The firm pays taxes at the
rate of 40%. Using $80,000 of EBIT as a base, calculate the degree of financial leverage
(DFL).
a. 3 c. 1
b. 2 d. 4
Answer: b

Carolina Fastener, Inc., makes patented marine bulkhead latch that wholesales for $6.00. Each
latch has variable operating costs of $3.50. Fixed operating costs are $50,000 per year. The firm
pays $13,000 interest and preferred dividends of $7, 000 per year. At this point, the firm is
selling 30,000 latches a year and is taxed at 40%.
81.) Calculate Carolina Fasteners operating breakeven point.
a. 21,000 latches c. 20,000 latches

b. 25,000 latches d. 22,000 latches
Answer: c
82.) On the basis of the firms current sales of 30,000 units per year and its interest and
preferred dividend costs, calculate its EBIT and net profits.
a. $6,155 c. $7,200
b. $5,000 d. $9,000
Answer: c
83.) Calculate the firms degree of total leverage (DTL).
a. 235.45 c. 279.95
b. 215.40 d. 225.24
Answer: d
84.) Wren Manufacturing is in the process of analyzing its investment decision-making

procedures. The two projects evaluated by the firm during the past month were projects
263 and 264. The basic variables surrounding each project analysis using the IRR
decision technique and the resulting decision actions are summarized in the following
table.
Basic variables Project 263 Project 264

Cost $64,000 $58,000
Life 15 years 15 years
IRR 8% 15%
Least-cost financing
Source Debt Equity
Cost (after-tax) 7% 16%
Decision
Action Accept Reject
Reject 8% IRR > 7% cost 15% IRR < 16% cost
a. 11.6% c. 12.9%
b. 12.4% d. 13.7%
Answer: b

For each of the following $1,000 par-value bonds, assuming annual interest payment and a 40%
tax rate:
Bond Life Underwriting Discount (-) or Coupon
fee premium (+) interest rate
A 20 years $25 -$20 9%
B 22 20 - 60 11
85.) Calculate the after-tax cost to maturity using the approximation formula for Bond A.
a. 5.20% c. 5.94%
b. 5.71% d. 5.66%
Answer: d
86.) For Bond B.
a. 7.20% c. 7.10%
b. 7.15% d. 7.18%
Answer: c

Webster Company has compiled the information shown in the following table.
Source of capital Book value Market value After-tax

cost
Long-term debt $4,000,000 $3,840,000 6.0%
Preferred stock 40,000 60,000 13.0
Common stock equity 1,060,000 3,000,000 17.0
Totals $5,100,000 $6,900,000
87.) Calculate the weighted average cost of capital using the book value weights.
a. 8.344% c. 8.560%
b. 8.721% d. 8.212%
Answer: a
88.) Calculate the weighted average cost of capital using the market value weights.
a. 10.902% c. 11.002%
b. 10.854% d. 10.866%
Answer: b

89.) Edna Recording Studios, Inc., reported earnings available to common stock of
$4,200,000 last year. From that, the company paid a dividend of $1.26 on each of its
1,000,000 common shares outstanding. The capital structure of the company includes
40% debt, 10% preferred stock, and 50% common stock. It is taxed at a rate of 40%. The
company can issue $2.00 dividend preferred stock for a market price of $25.00 per
share. Flotation costs would amount to $3.00 per share. What is the cost of preferred
stock financing?
a. 9.2% c. 9.4%
b. 9.1% d. 9.6%
Answer: b

Lang Enterprises is interested in measuring its overall cost of capital. Current investigation has
gathered the following data. The firm is in the 40% tax bracket.
Debt The firm can raise an unlimited amount of debt by selling $1,000 par-value, 8% coupon
interest rate, 20-year bonds on which annual interest payments will be made. To sell the issue, an
average discount of $30 per bond would have to be given. The firm also must pay floatation
costs of $30 per bond.
Preferred stock The firm can sell 8% preferred stock at its $95-per-share par value. The
cost of issuing and selling the preferred stock is expected to be $5 per share. An unlimited
amount of preferred stock can be sold under these terms.
Common stock The firms common stock is currently selling for $90 per share. The firm
expects to pay cash dividends of $7 per share next year. The firms dividends have been growing
at an annual rate of 6%, and this is expected to continue into the future. The stock must be
underpriced by $7 per share, and flotation costs are expected to amount to $5 per share. The firm
can sell an unlimited amount of new common stock under these terms.
Retained earnings When measuring this cost, the firm does not concern itself with the tax
bracket or brokerage fees of owners. It expects to have available $100,000 of retained earnings in
the coming year; once these retained earnings are exhausted, the firm will use new common
stock as the form of common stock equity financing.
Source of capital Weight

Long-term debt 30%
Preferred stock 20
Total 100%
The firms capital structure weights used in calculating its weighted average cost of capital are
shown in the table above. (Round answer to the nearest .1%)
90.) Calculate the single breaking point associated with the firms financial situation. (Hint:
This point results from exhaustion of the firms retained earnings.)
a. $250,000 c. $200,000
b. $200,500 d. $210,000
Answer: c
91.) Calculate the weighted average cost of capital associated with total new financing below
the breaking point calculated in (88).
a. 11.5% c. 9.8%
b. 10.1% d. 9.3%
Answer: b
92.) Calculate the weighted average cost of capital associated with total new financing above
the breaking point calculated in (88).
a. 10.7% c. 10.2%
b. 10.5% d. 10.6%
Answer: a

Cartwell Products has complied the data shown in the following table for the current cost of its
three basic sources of capital long-term debt, preferred stock, and common stock equity for
various ranges of new financing.
Source of capital Range of new financing After-tax

cost
Long-term debt $0 to $320,000 6%
$320,000 and above 8
Preferred stock $0 and above 17%
Common stock equity $0 to $200,000 20%
$200,000 and above 24
The companys capital structure weights used in calculating its weighted average cost of capital
are shown in the following table.
Source of capital Weight

Long-term debt 40%
Preferred stock 20
Total 100%
93.) Determine the breaking points (levels of total new financing) at which the firms
weighted average cost of capital will change.
a. $500,000 and $700,000 c. $500,000 and $800,000

b. $600,000 and $800,000 d. $800,000 and $900,000
Answer: c
94.) Calculate the weighted average cost of capital of over $800,000 range of total new
financing.
a. 15.9% c. 16.8%
b. 16.0% d. 16.2%
Answer: d
95.) Southland Industries has $60,000 of 17% (annual interest) bonds outstanding, 1,500
shares of preferred stock paying an annual dividend of $5 per share, and 4,000 shares of
common stock outstanding. Assuming that the firm has a 40% tax rate, compute
earnings per share (EPS) for $24,600 EBIT.
a. $0.375 c. $0.420
b. $0.415 d. $0.330
Answer: a
96.) Wells and Associates has EBIT of $67,500. Interest costs are $22,500, and the firm has
15,000 shares of common stock outstanding, Assume a 40% tax rate. Use the degree of
financial leverage (DFL) formula to calculate the DFL for the firm.
a. 1.3 c. 1.5
b. 1.9 d. 1.7
Answer: c
97.) Play-More Toys produces inflatable beach balls, selling 400,000 balls a year. Each ball
produced has a variable operating cost of $0.84 and sells for $1.00. Fixed operating costs
are $28,000. The firm has annual interest charges of $6,000, preferred dividends of
$2,000, and a 40% tax rate. Calculate the operating breakeven point in units
a. 190,000 units c. 185,000 units
b. 175,000 units d. 193,000 units
Answer: b

Charter Enterprises currently has $1 million in total assets and is totally equity financed. It is
contemplating a change in capital structure.
98.) Compute the amount of debt that would be outstanding if the firm were to shift to 40%
debt ratio.
a. Debt $300,000 c. Debt $600,000

b. Debt $400,000 d. Debt $200,000
Answer: b
99.) Compute the amount of equity that would be outstanding if the firm were to shift to 40%
debt ratio.
a. Equity $700,000 c. Equity $600,000

b. Equity $300,000 d. Equity $500,000
Answer: c
100.) Medallion Cooling Systems, Inc., has total assets of $10,000,000, EBIT of $2,000,000,
preferred dividends of $200,000 and is taxed at a rate of 40%. In an effort to determine
the optimal capital structure, the firm has assembled data on the cost of debt, the number
of common shares for various levels of indebtedness, and the overall required return on
investment:
Capital structure Cost of Number of Required

debt ratio debt common shares return
0% 0% 200,000 12%
15 8 170,000 13
30 9 140,000 14
45 12 110,000 16
60 15 80,000 20
Calculate earnings per share at 30% level of indebtedness.
a. $5.75 c. $5.50
b. $5.56 d. $5.99
Answer: d

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What factors determine a firm's weighted average cost of capital?

TESTBANK

Long Term Financing Decisions

a. stock price c. internal rate of return

Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

a. business risk c. financial risk

Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

a. business risk c. financial risk

Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

a. cost of common stock c. cost of preferred stock

Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

a. cost of common stock c. cost of preferred stock

Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

6.) The return required on the stock by investors in the marketplace.

a. cost of common stock c. cost of preferred stock

Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

a. cost of common stock c. cost of preferred stock

Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

a. cost of capital c. weighted average cost of capital

Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

a. market value weights c. target weights

Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

a. market value weights c. target weights

Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

a. market value weights c. target weights

Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

a. market value weights c. target weights

Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

a. total leverage c. operating leverage

Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

a. total leverage c. operating leverage

Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

a. total leverage c. operating leverage

Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

a. total leverage c. operating leverage

Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

a. cost of capital c. capital structure

Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

a. leverage c. operating leverage

a. breakeven point c. operating breakeven point

Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

20.) The level of sales necessary to cover all operating costs.

a. breakeven point c. operating breakeven point

Source: (Lawrence J. Gitman, Principles of Managerial Finance, 10th Edition)

21.) The yield to maturity of a bond is:

a. Equal to the companys cost of retained earnings

24.) Which of the following situations should never occur:

Coupon rate 8.4%

Use this information for questions 27 and 28.

[(P2 x 110%) / P50] + 10% = 14.4%

[(P2 x 110%) / (P50 - P3] + 10% = 14.68%

P4.25 / (18% - 8%) = P42.50 P4.25 / (P42.50 P1.25) + 8% = 18.3%

P3.70 / (15% - 7%) = P46.25 P3.70 / (P46.25 P2.25) + 7% = 15.4%

The following data apply to items 31-34.

Williams desired capital structure is

a. 7.0 percent c. 7.4 percent