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COST OF CAPITAL

THEORY

1. All of the following statements are correct except:

a. The matching of asset and liability maturities is considered desirable because this strategy

minimizes interest rate risk.

b. Default risk refers to the inability of the firm to pay off its maturing obligations.

c. The matching of assets and liability maturities lowers default risk.

d. An increase in the payables deferral period will lead to a reduction in the need to non-

spontaneous funding.

a. Increase the level of working capital.

b. Change the composition of working capital to include more liquid assets.

c. Increase the amount of short-term borrowing.

d. Increase the amount of equity financing.

3. A firm’s financial risk is a function of how it manages and maintains its debt. Which one of

the following sets of ratios characterizes the firm with the greatest amount of financial risk?

A. High debt-to-equity ratio, high interest coverage ratio, stable return on equity.

B. Low debt-to-equity ratio, low interest coverage ratio, volatile return on equity.

C. High 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.

4. Which of the following classes of securities are listed in order from lowest risk/opportunity

for return to highest risk/opportunity for return? (E)

A. U.S. Treasury bonds; corporate first mortgage bonds; corporate income bonds; preferred

stock.

B. Corporate income bonds; corporate mortgage bonds; convertible preferred stock;

subordinated debentures.

C. Common stock; corporate first mortgage bonds; corporate second mortgage bonds;

corporate income bonds.

D. Preferred stock; common stock; corporate mortgage bonds; corporate debentures.

5. 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 1.5?

A. 3% increase B. 1.5% increase C. No change D. 1.5% decrease.

6. Cost of capital is

a. The amount the company must pay for its plant assets.

b. The dividends a company must pay on its equity securities.

c. The cost the company must incur to obtain its capital resources.

d. The cost the company is charged by investment bankers who handle the issuance of

equity or long-term debt securities.

a. The stated interest paid on a bank loan.

b. Assets that are considered obsolete that maintain a net book value.

c. Decelerated depreciation.

d. Lending funds to a supplier at a lower-than-market rate in exchange for receiving the

supplier’s products at a discount.

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8. The theory underlying the cost of capital is primarily concerned with the cost of

A. Long-term funds and old funds.

B. Short-term funds and new funds.

C. Long-term funds and new funds.

D. Any combination of old or new, short-term or long-term funds.

9. Management knowledge of the cost of capital is useful for each of the following except

a. Making capital investment decisions.

b. Managing working capital.

c. Setting the maximum rate of return on new investments.

d. Evaluating performance.

10. 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. principal payments on debt are deductible for tax purposes.

c. the cost of capital is a deductible expense for tax purposes.

d. dividend payments to stockholders are deductible for tax purposes.

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 firm's equity capital at which the market value of the firm will remain

unchanged.

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

financing is (are) the

a. Increase in the cost of debt as the debt-to-equity ratio increases.

b. Increases in the cost of debt and 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.

13. In computing the cost of capital, the cost of debt capital is determined by

a. Annual interest payment divided by the proceeds from debt issuance.

b. Interest rate times (1 – the firm’s tax rate)

c. Annual interest payment divided by the book value of the debt.

d. The capital asset pricing model.

14. 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

A. The diversity of the combination alternative creates greater risk for the investor.

B. The pure debt alternative would flood the market and be more difficult to sell.

C. The pure debt alternative carries the risk of increasing the probability of default.

D. The combination alternative carries the risk of increasing dividend payments.

15. If a $1,000 bond sells for $1,125, which of the following statements are correct?

I. The market rate of interest is greater than the coupon rate on the bond.

II. The coupon rate on the bond is greater than the market rate of interest.

III. The coupon rate and the market rate are equal.

IV. The bond sells at a premium.

V. The bond sells at a discount.

a. I and IV. b. I and V. c. II and IV. d. II and V.

16. Companies experience changes in interest expenses, variable cost per unit, quantity of units

sold, and fixed costs. Their degree of operating leverage is not affected by the change in

A. Interest expenses. C. Quantity of units sold.

B. Variable cost per unit. D. Fixed costs.

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17. If the return on total assets is 10% and if the return on common stockholders’ equity is 12%

then

a. The after-tax cost of long-term debt is probably greater than 10%.

b. The after-tax cost of long-term debt is 12%.

c. Leverage is negative.

d. The after-tax cost of long-term debt is probably less than 10%.

18. The basis for measuring the cost of capital derived from bonds and preferred stock,

respectively, is the

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 less the expected earnings

per share for preferred stock

C. pretax rate of interest for bonds and stated annual dividend rate for preferred stock

D. after-tax rate of interest for bonds and stated annual dividend rate less the expected

earnings per share for preferred stock

19. The market value of a firm’s outstanding common shares will be higher, everything else

equal, if

a. Investors have a lower required return on equity.

b. Investors expect lower dividend growth.

c. Investors have longer expected holding periods.

d. Investors have shorter expected holding periods.

20. When calculating the cost of capital, the cost assigned to retained earnings should be

A. Zero.

B. Lower than the cost of external common equity.

C. Equal to the cost of external common equity.

D. Higher than the cost of external common equity.

21. 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 dividends per share, and current

market price per share of common stock.

C. Current earnings pers share, expected growth rate in earnings per share, and current book

value 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.

22. An investor uses the capital asset pricing model (CAPM) to evaluate the risk-return

relationship on a portfolio of stocks held as an investment. Which of the following would not

be used to estimate the portfolio's expected rate of return?

A. Expected risk premium on the portfolio of stocks.

B. Interest rate for the safest possible investment.

C. Expected rate of return on the market portfolio.

D. Standard deviation of the market returns.

23. According to the capital asset pricing model (CAPM), the relevant risk of a security is its

A. Company-specific risk. C. Systematic risk.

B. Diversifiable risk. D. Total risk.

a. cost of bonds, preferred stock, and common stock divided by the three sources.

b. equivalent units of capital used by the organization.

c. overall cost of capital from all organization financing sources.

d. overall cost of dividends plus interest paid by the organization.

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25. 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. Long-term debt. b. Common stock. c. Short-term debt. d. Preferred stock.

26. When calculating a firm's cost of capital, all of the following are true except that

A. The cost of capital of a firm is the weighted average cost of its various financing

components.

B. The calculation of the cost of capital should focus on the historical costs of alternative

forms of financing rather than market or current costs.

C. All costs should be expressed as after-tax costs.

D. The time value of money should be incorporated into the calculations.

27. 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 before-tax cost of new-debt financing.

B. The after-tax cost of new-debt financing.

C. The cost of equity financing.

D. The weighted-average cost of capital.

28. The weighted-average cost of capital approach to decision making is not directly affected by

the:

A. proposed mix of debt, equity, and existing funds used to implement the project

B. value of the common stock

C. cost of debt outstanding

D. current budget for expansion.

29. Which class of leverage causes earnings before interest and taxes to be more sensitive to

changes in sales?

A. Credit. B. Financial. C. Operating. D. Intrinsic.

30. A firm with a higher degree of operating leverage when compared to the industry average

implies that the

A. Firm has higher variable costs.

B. Firm's profits are more sensitive to changes in sales volume.

C. Firm is more profitable.

D. Firm is less risky.

A. Increases a firm's assets. C. Increases a firm's interest coverage ratio.

B. Increases a firm's financial leverage. D. Dilutes a firm's earnings per share.

32. Which of the changes in leverage would apply to a company that substantially increases its

investment in fixed assets as a proportion of total assets and replaces some of its long-term

debt with equity?

A. B. C. D.

Financial Leverage Increase Decrease Increase Decrease

Operating Leverage Decrease Increase Increase Decrease

Problems

1. Based on the following information about stock price increases and decreases, make an

estimate of the stock's beta: Month 1 = Stock +1.5%, Market +1.1%; Month 2 = Stock

+2.0%, Market +1.4%; Month 3 = Stock -2.5%, Market -2.0%.

A. Beta is greater than 1.0. C. Beta equals 1.0

B. Beta is less than 1.0. D. There is no consistent pattern of returns.

2. What is the yield to maturity on Fox Inc.'s bonds if its after-tax cost of debt is 9% and its tax

rate is 34%?

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A. 5.94% B. 9% C. 13.64% D. 26.47%

3. Maylar Corporation has sold $50 million 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. 4.87%. C. 12.00%. D. 7.09%.

4. The MNO Company believes that it can sell long-term bonds with a 6% coupon but at a price

that gives a yield-to-maturity of 9%. If such bonds are part of next year’s financing plans,

which of the following should be used for bonds in their after-tax (40%) cost-of-capital

calculation?

A. 3.6% B. 5.4% C. 4.2% D. 6%

5. Ambry Inc. is going to use an underwriter to sell its preferred stock. Four underwriters have

given estimates (below) on their fees and the selling price of the stock, as well as the

expected dividend for each:

Fees Selling Price Dividends

Underwriter 1 $5 $101 $10

Underwriter 2 7 102 11

Underwriter 3 3 97 7

Underwriter 4 3 98 8

Which underwriter will produce the lowest cost of funds for the preferred stock?

A. Underwriter 1. B. Underwriter 2. C. Underwriter 3. D. Underwriter 4.

6. 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 Gravy’s marginal cost of capital?

A. P45 million. B. P30 million. C. P20 million. D. P18 million.

7. Allison Engines Corporation has established a target capital structure of 40 percent debt and

60 percent common equity. The current market price of the firm’s stock is P 0 = $28; its last

dividend was D0 = $2.20, and its expected dividend growth rate is 6 percent. What will

Allison’s marginal cost of retained earnings, ks, be?

a. 15.8% b. 13.9% c. 7.9% d. 14.3%

8. Doris Corporation's stock has a market price of $20.00 and pays a constant dividend of

$2.50. What is the required rate of return on its stock?

A. 13.0% B. 12.5% C. 12.0% D. 11.5%

9. The ABC Company is expected to have a constant annual growth rate of 5 percent. It has a

price per share of P32 and pays an expected dividend of P2.40. Its competitor, the DEF

Company is expected to have a growth rate of 10%, has a price per share of P72, and pays an

expected P4.80/share dividend. The required rates of return on equity for the two companies

are:

A. B. C. D.

ABC 13.8% 9.6% 12.5% 16.2%

DEF 15.4% 8.6% 16.7% 18.2%

10. Frostfell Airlines is expected to pay an upcoming dividend of $3.29. The company's dividend

is expected to grow at a steady, constant rate of 5% well into the future. Frostfell currently

has 1,600,000 shares of common stock outstanding. If the required rate of return for Frostfell

is 12%, what is the best estimate for the current price of Frostfell's common stock?

A. $65.80 B. $62.51 C. $47.00 D. $27.41

11. 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

investors are anticipating the common dividend to grow at a rate of 6% annually. The cost to

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issue new common stock will be 5% of the market value. The cost of a new common stock

issue will be

A. 11.50% B. 11.79% C. 11.83% D. 12.14%

12. What return on equity do investors seem to expect for a firm with a $50 share price, an

expected dividend of $5.50, a beta of .9, and a constant growth rate of 4.5%?

A. 15.05% B. 15.50% C. 15.95% D. 16.72%

13. 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

of 4 percent per year. The company has insufficient retained earnings to fund capital projects

and must, therefore, issue new common stock. The new stock has an estimated flotation cost

of $3 per share. What is the company’s cost of equity capital?

a. 10.14% b. 9.21% c. 9.45% d. 9.32%

14. The DCL Corporation is preparing to evaluate the capital expenditure proposals for the

coming year. Because the firm employs discounted cash flow methods of analyses, the cost

of capital for the firm must be estimated. The following information for DCL Corporation is

provided.

Market price of common stock is $50 per share.

The dividend next year is expected to be $2.50 per share.

Expected growth in dividends is a constant 10%.

New bonds can be issued at face value with a 13% coupon rate.

The current capital structure of 40% long-term debt and 60% equity is considered to

be optimal.

Anticipated earnings to be retained in the coming year are $3 million.

The firm has a 40% marginal tax rate.

If the firm must assume a 10% flotation cost on new stock issuances, what is the cost of new

common stock?

A. 14.50%. B. 15.56%. C. 15.32%. D. 15.50%.

15. Fitzgerald is interested in investing in a corporation with a low cost of equity capital. By

using the dividend growth model, which of the following corporations has the lowest cost of

equity capital?

Stock Price Dividend Growth Rate

C.S. Inc. $25 $5 8%

Lewis Corp. 30 3 10%

Screwtape Inc. 20 4 6%

Wormwood Corp. 28 7 7%

A. C.S. Inc. C. Screwtape Inc.

B. Lewis Corp. D. Wormwood Corp.

16. The common stock of Anthony Steel has a beta of 1.20. The risk-free rate is 5 percent and the

market risk premium (kM - kRF) is 6 percent. Assume the firm will be able to use retained

earnings to fund the equity portion of its capital budget. What is the company’s cost of

retained earnings, ks?

a. 7.0% b. 7.2% c. 11.0% d. 12.2%

17. Colt, Inc. is planning to use retained earnings to finance anticipated capital expenditures. The

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

flotation costs would be 7%. By using the Capital Asset Pricing Model (CAPM) equation [R

= RF + ß(RM - RF)], the cost of using retained earnings to finance the capital expenditures is

A. 13.21% B. 12.99% C. 12.40% D. 14.26%

18. 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

an expected return of 12.4%. What must be the expected return on the market and the risk-

free rate of return, to be consistent with the capital asset pricing model?

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A. Market is 14%; risk-free is 6%. C. Market is 14%; risk-free is 4%.

B. Market is 12.4%; risk-free is 0%. D. Market is 14%; risk-free is 1.6%.

19. 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 1.5?

A. 3% increase B. 1.5% increase C. No change D. 1.5% decrease

20. An investor was expecting a 15% return on his portfolio with beta of 1.25 before the market

risk premium increased from 6% to 9%. Based on this change, what return will now be

expected on the portfolio?

A. 15.00% B. 18.00% C. 18.75% D. 22.50%

21. What happens to expected portfolio return if the portfolio beta increases from 1.0 to 2.0, the

risk-free rate decreases from 5% to 4%, and the market risk premium remains at 8%?

A. It increases from 12% to 19%. C. It increases from 13% to 20%.

B. It increases from 13% to 16%. D. It remains unchanged.

22. 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 inflows of $12,000 per year for 10 years. In addition, this project will have an after-tax

salvage value of $20,000 at the end of Year 10. If the risk-free rate is 5 percent, the return on

an average stock is 10 percent, and the beta of this project is 1.80, then what is the project's

NPV?

A. $10,655 B. $3,234 C. -$37,407 D. -$32,012

23. The expected returns, standard deviations, and beta coefficients of four stocks are given

below:

Expected Return Standard Deviation Beta Coefficient

M 18% .65 .9

N 20% .9 1.2

O 20% .4 1.5

Q 21% 1.2 1.7

Given an expected return on the market portfolio of 18% and a risk-free rate of 12%, which

stock(s) is(are) overvalued or undervalued?

A. M and N are undervalued; O and Q are overvalued.

B. M is undervalued; N, O, and Q are overvalued.

C. M, N, O, and Q are overvalued.

D. M, N, O, and Q are undervalued.

24. 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 company’s 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 company’s growth rate?

a. 2.68% b. 3.44% c. 4.64% d. 6.75%

25. A company has $650,000 of 10% debt outstanding and $500,000 of equity financing. The

required return of the equity holders is 15%, and there are no retained earnings currently

available for investment purposes. If new outside equity is raised, it will cost the firm 16%.

New debt would have a before-tax cost of 9%, and the corporate tax rate is 50%. When

calculating the marginal cost of capital, the company should assign a cost of <List A> to

equity capital and <List B> to the after-tax cost of debt financing.

A. B. C. D.

List A 15% 15% 16% 16%

List B 4.5% 5.0% 4.5% 5.0%

26. A company has $1 million in shareholders' equity and $2 million in debt equity (8% bonds).

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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% B. 12% C. 15% D. 26.4%

27. What is the weighted average cost of capital for a firm with 40% debt, 20% preferred stock,

and 40% common equity if the respective costs for these components are 8% after-tax, 13%

after-tax, and 17% before-tax? The firm's tax rate is 35%.

A. 10.22% B. 10.52% C. 11.48% D. 12.60%

28. 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. Yes, because the weighted-average cost of capital will decrease.

D. No, because the weighted-average cost of capital will increase.

29. 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 company’s debt is

11 percent. The preferred stock pays an annual dividend of $2 and sells for $20 a share. The

company’s common stock trades at $30 a share, and its current dividend (D0) 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 company’s tax rate?

a. 30.33% b. 32.87% c. 35.75% d. 38.12%

30. Wiley’s new financing will be in proportion to the market value of its present financing,

shown below.

Book Value ($000 Omitted)

Long-term debt $7,000

Preferred stock (100 shares) 1,000

Common stock (200 shares) 7,000

The firms’ bonds are currently selling at 80% of par, generating a current market yield of 9%,

and the corporation has a 40% tax rate. The preferred stock is selling at its par value and

pays a 6% dividend. The common stock has a current market value of $40 and is expected to

pay a $1.20 per share dividend this fiscal year. Dividend growth is expected to be 10% per

year. Wiley’s weighted-average cost of capital is (round your calculations to tenths of a

percent)

a. 13.0% b. 8.3% c. 9.6% d. 9.0%

31. A company has determined that its optimal capital structure consists of 40 percent debt and

60 percent equity. Assume the firm will not have enough retained earnings to fund the equity

portion of its capital budget. Also, assume the firm accounts for flotation costs by adjusting

the cost of capital. Given the following information, calculate the firm’s weighted average

cost of capital.

kd = 8% P0 = $25

Net income = $40,000 Growth = 0%

Payout ratio = 50% Shares outstanding = 10,000

Tax rate = 40% Flotation cost on additional equity = 15%

a. 7.60% b. 8.05% c. 11.81% d. 13.69%

32. Dobson Dairies has a capital structure that consists of 60 percent long-term debt and 40

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percent common stock. The company’s CFO has obtained the following information:

• The before-tax yield to maturity on the company’s bonds is 8 percent.

• The company’s common stock is expected to pay a $3.00 dividend at year end (D1 =

$3.00), and the dividend is expected to grow at a constant rate of 7 percent a year. The

common stock currently sells for $60 a share.

• Assume the firm will be able to use retained earnings to fund the equity portion of its

capital budget.

• The company’s tax rate is 40 percent.

What is the company’s weighted average cost of capital (WACC)?

a. 12.00% b. 8.03% c. 9.34% d. 7.68%

33. 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 company’s 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 company’s tax

rate is 40 percent. Bradshaw uses the CAPM to determine its cost of equity. What is the beta

on Bradshaw’s stock?

a. 1.07 b. 1.48 c. 0.10 d. 1.35

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. 0.0743 b. 0.0820 c. 0.0660 d. 0.0733

35. For a firm with a degree of operating leverage of 3.5, an increase in sales of 6% will

A. Increase pre-tax profits by 3.5%. C. Increase pre-tax profits by 21%.

B. Decrease pre-tax profits by 3.5%. D. Increase pre-tax profits by 1.71%.

36. In its first year of operations, a firm had $50,000 of fixed operating costs. It sold 10,000

units at a $10 unit price and incurred variable costs of $4 per unit. If all prices and costs will

be the same in the second year and sales are projected to rise to 25,000 units, what will the

degree of operating leverage (the extent to which fixed costs are used in the firm’s

operations) be in the second year?

a. 1.25 b. 1.50 c. 2.0 d. 6.0

37. This year, Nelson Industries increased earnings before interest and taxes (EBIT) by 17%.

During the same period, net income after tax increased by 42%. The degree of financial

leverage that existed during the year is

A. 1.70. B. 4.20. C. 2.47. D. 5.90.

38. A company has unit sales of 300,000, the unit variable cost is $1.50, the unit sales price is

$2.00, and the annual fixed costs are $50,000. Furthermore, the annual interest expense is

$20,000, and the company has no preferred stock. Accordingly, the degree of total leverage is

A. 1.875 B. 1.50 C. 1.25 D. 1.20

A new company requires $1 million of financing and is considering two arrangements as shown

in the table below:

Amount of Amount of Before-Tax

Arrangement Equity Raised Debt Financing Cost of Debt

#1 $700,000 $300,000 8% per annum

#2 $300,000 $700,000 10% per annum

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In the first year of operations, the company is expected to have sales revenues of $500,000, cost

of sales of $200,000, and general and administrative expenses of $100,000. The tax rate is 30%,

and there are no other items on the income statement. All earnings are paid out as dividends at

year-end.

39. If the cost of equity is 12%, the weighted-average cost of capital under arrangement #1, to

the nearest full percentage point, would be

A. 8% B. 10% C. 11% D. 12%

40. Which of the following statements comparing the two financing arrangements is true?

A. The company will have a higher expected gross margin under arrangement #1.

B. The company will have a higher degree of operating leverage under arrangement #2.

C. The company will have higher interest expense under arrangement #1.

D. The company will have higher expected tax expense under arrangement #1.

41. Under financing arrangement #2, the degree of financial leverage (DFL), rounded to two

decimal places, would be

A. 1.09 B. 1.14 C. 1.32 D. 1.54

42. The return on equity will be <List A> and the debt ratio will be <List B> under arrangement

#2, as compared with arrangement #1.

A. B. C. D.

List A Higher Higher Lower Lower

List B Higher Lower Higher Lower

ANSWER SHEET

Theory Problem

1. A 16. A 31. B 1. A 16. D 31. A

2. C 17. D 32. B 2. C 17. B 32. D

3. C 18. A 3. A 18. A 33. D

4. A 19. A 4. B 19. B 34. D

5. B 20. B 5. C 20. C 35. C

6. C 21. D 6. A 21. C 36. B

7. A 22. A 7. D 22. D 37. C

8. C 23. C 8. B 23. A 38. A

9. C 24. C 9. C 24. C 39. B

10. A 25. C 10. C 25. C 40. D

11. A 26. B 11. D 26. D 41. D

12. B 27. D 12. B 27. D 42. A

13. B 28. D 13. D 28. C

14. C 29. C 14. B 29. B

15. C 30. B 15. B 30. C

MSQ-10

Page 10

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