Cma-P3-Su09

Front 1

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- maximum rate of return on assets.

Back 1

The overall cost of capital is the rate of return on assets that covers the costs associated with the funds employed.

A firm's overall cost of capital is a weighted-average of the costs of the different sources of funds that the firm uses to finance its assets. These sources are usually some combination of debt and equity. Cost of capital usually refers to the cost of long-term sources of funds, such as long-term debt, preferred stock, and common stock. A firm must pay a return to the suppliers of all of these sources of funds. Theoretically, the minimum return that a firm must earn to keep the value of its stock from declining is equal to the weighted-average cost of capital. If a firm earns less than this on its total assets, then there are not enough earnings to pay the suppliers of funds what they expect to receive. Since interest costs are fixed and must be paid first, common stockholders are the ones who will usually suffer a shortfall in returns. If common stockholders do not receive at least the minimum return they require for the risk they are taking by holding common stock, then the value of their investment decreases and the value of their stock falls.

Front 2

Morton Company needs to pay a supplier's invoice of $50,000 and wants to take a cash discount of 2/10 net 40. The firm can borrow the money for 30 days at 12% per annum plus a 10% compensating balance.

Assuming that Morton Company borrows the money on the last day of the discount period and repays it 30 days later, the effective interest rate on the loan is:


A- 13.61%.
B- 13.33%.
C- 13.20%.
D- 1348%

Back 2

B is correct.

Morton Co. must borrow $54,444 ($49,000 plus compensating balance of 10% of loan). To calculate: $49,000 represents 90% of the loan.
$49,000 ÷ .90 = $54,444. Algebraically, if ×= amount of loan, then .9x = $49,000, and ×= $54,444.

Breakdown of loan proceeds:
Cash needed for payment to vendor

$49,000 90% To Vendor
5,444 10% Com Bal
------- ----
54,444 100% lOan

Interest at 12% per annum on this amount for 30 days, totals:


The effective yield is then (annualized):
$544.44 ÷ $49,000 × 12 months = 13.33%

The invoice total less the cash discount ($50,000 - 2%) is $49,000. This amount is used in this calculation because that is the amount required to pay the supplier's invoice.

Front 3

Acme Corporation is selling $25,000,000 of cumulative, nonparticipating preferred stock. The issue will have a par value of $65 per share with a dividend rate of 6%. The issue will be sold to investors for $68 per share and issuance costs will be $4 per share. The cost of preferred stock to Acme is:


A- 5.42%.
B- 5.74%.
C- 6.00%.
D- 6.09%.

Back 3

Use the Gordon Growth Model to calculate the cost of capital:

Capital cost Ks =

Next Dividend
---------------------------- Growth Rate
Mkt Price (1-flotation cost)

D
Ks = ------ + G
P(1-F)

Here, the dividend = 6% of par value of $65 so D = $3.90. We have the net proceeds of the stock sale rather than the flotation cost as a
percentage. The net proceeds to Acme are $64 per share, and no dividend growth is mentioned. Thus, the formula reduces to:

Ks = 3.90 ÷ 64 = 6.09%

Front 4

Bonds Cost

Maylar Corporation has sold $50,000,000 of $1,000 par value, 12% coupon bonds. The bonds were sold at a discount and the corporation
received $985 per bond. If the corporate tax rate is 40%, the after-tax cost of these bonds for the first year (rounded to the nearest hundredth percent) is:


A- 7.31%.
B- 12.18%.
C- 12.00%.
D- 7.09%.

Back 4

A is correct.

1- Calculate interest amount by multiplying stated rate with Par Value.

2- Divide the interest amount with market value

3- Multiply with marginal tax rate (1-tax rate)

Interest payment per year = $120

Before-tax cost = 120/985 = .1218

fter-tax cost = .1218 x (1-40%) = 7.31%

Note the use of the $985 proceeds, not the par value, in this calculation.

Front 5

Williams, Inc., is interested in measuring its overall cost of capital and has gathered the following data. Under the terms described as follows, the company can sell unlimited amounts of all instruments.

Williams' common stock is currently selling for $100 per share. The firm expects to pay cash dividends of $7 per share next year, and the
dividends are expected to remain constant. The stock will have to be underpriced by $3 per share, and flotation costs are expected to amount to $5 per share.

Back 5

B is correct

The cost of funds from the sale of common stock is 7.6%.

The cost to the firm of selling new common stock can be determined using the Gordon Model (dividend capitalization model). This formula
states:

kcm = (D1 / (PO-u-f)) + g
= (7/(100-3-5) + 0 = 7/92
= 7.6%

where kcm = the cost, in percentage, of issuing new common stock

D1 = the dividend the firm is expected to pay next year

PO = the current market price of the stock

u = the dollar amount of underpricing per share from the
market price needed to sell the new issue
f = the flotation cost per share paid to the investment

g = the expected annual growth rate in dividends, in percentage

Front 6

Garo Company, a retail store, is considering foregoing sales discounts to delay using its cash. Supplier credit terms are 2/10, net 30. Assuming a 360-day year, what is the annual cost of credit if the cash discount is taken and Garo pays net 30?


A- 20.0%
B- 24.0%
C- 24.5%
D- 36.7%

Back 6

D is correct

The lost discount of holding onto money for an additional 20 days (2/10 means 2% discount if paid in 10 days) is 2% for those 20 days.

However, the trick is to realize that the principal on which the 2% is compared is really less 2% (e.g., if a $100 invoice is paid in 10 days with terms of 2/10, the amount paid is $98).

The 2% discount ($2) is really potential interest that could be charged on the principal amount of $98. This results in an interest rate that is
really 2/98 or 2.041% for 20 days.

The 30 in 2/10 net 30 means the total amount of the invoice must be paid in 30 days. If the discount is not taken, the cash is held onto for an additional 20 days (30 - 10 = 20). In a 360-day year, 20 days represents 18 periods. 18 times 2.041% equals 36.738%, or 36.7%.

Front 7

Cost of Retained Earnings

Williams, Inc., is interested in measuring its overall cost of capital and has gathered the following data. Under the terms described as follows, the company can sell unlimited amounts of all instruments.

Williams' common stock is currently selling for $100 per share. The firm expects to pay cash dividends of $7 per share next year, and the
dividends are expected to remain constant. The stock will have to be underpriced by $3 per share, and flotation costs are expected to amount
to $5 per share.

Williams 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.

Back 7

Cost of Retained Earnings

A is correct

The cost of retained earnings, using the Gordon Model, ignores flotation costs and underpricing, since the firm does not need to issue new
stock. However, it must earn a return for the owners of the retained earnings, that is, the existing shareholders, as follows:

krm = (D1/PO ) + g, or krm = 7/100 + 0% = 7.0%

where krm = the cost, in percentage, of using existing equity in the form of retained earnings

D1 = the estimated dividend that will be paid next year
PO = the current market price of the stock
g = the estimated annual growth rate in dividends, in percentage

Front 8

The purchase of treasury stock with a firm's surplus cash increases a firm's:


A- assets.
B- financial leverage.
C- equity.
D- interest coverage ratio.

Back 8

B is correct

The firm's increases because the debt-to-equity ratio increases (as a result of the decrease in total stockholders' equity).

Front 9

Bonds

DQZ Telecom is considering a project for the coming year which will cost $50,000,000. DQZ plans to use the following combination of debt and equity to finance the investment:

Issue $15,000,000 of 20-year bonds at a price of 101, with a coupon rate of 8%, and flotation costs of 2% of par.

Back 9

Bonds Cost of Capital.

1- Interest Amount (100*8%) = 8
2- Effective Amount 101-2 = 99
Cost = 8/99 = 8.08%

or

DQZ Telecom must pay interest at the coupon rate of 8% on $15,000,000. This amounts to $1,200,000.
The money DQZ has received in this transaction comes from $15,000,000 in bonds sold at a premium prices of 101 which means DQZ received $15,150,000 ($15,000,000 × 1.01).

Out of this amount, DQZ had to pay 2% of $15,000,000 ($300,000) in flotation costs.
That means DQZ had effective use of $14,850,000 ($15,150,000 - $300,000). $1,200,000 interest paid on $14,850,000 reflects an 8.08% effective interest rate ($1,200,000 ÷ $14,850,000).

Front 10

For 20X1, Nelson Industries increased earnings before interest and taxes by 17%. During the same period, net income after tax increased by 42%. The degree of financial leverage that existed during 20X1 is:


A- 1.70.
B- 4.20.
C- 2.47.
D- 1.68.

Back 10

C is correct

The degree of financial leverage:

The degree of financial leverage:

% change in net income
---------------------------------------------
% change in operating income

= 42 / 17 = 2.47

Front 11

The explicit cost of debt financing is the interest expense. The implicit cost(s) of debt financing is (are) the:


A- increases in the cost of debt and equity as the debt-to-equity ratio increases.
B- decrease in the cost of equity as the debt-to-equity ratio increases.
C- increase in the cost of equity as the debt-to-equity ratio decreases.
D- decrease in the weighted-average cost of capital as the debt-to-equity ratio increases.

Back 11

A is correct.

Implicit costs are those which are not based on a contract or agreement, but which nevertheless must be taken into consideration in any
business decision. Here, both debt equity cost to the firm will increase as the debt-to-equity ratio increases and investments in loans to the firm become riskier.

Front 12

Planning for investment decisions usually requires computation of weighted-average cost of capital. The cost of debt, retained earnings, new external common stock equity, and preferred stock are factored into the weighted average. Which of the sources mentioned is an opportunity cost?

A- Common stock
B- Debt
C- Preferred stock
D- Retained earnings

Back 12

D is correct.

Retained earnings is not a real cost; it is an opportunity cost reflecting the rate of return that could be earned by shareholders if they used the funds in similarly risky investments elsewhere.