Chapter 09

March 26, 2018 | Author: Sum Khor | Category: Cost Of Capital, Preferred Stock, Stocks, Dividend, Capital Structure


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Foundations of Finance, 7e (Keown) Chapter 9 The Cost of Capital 9.1 Learning Objective 1 True or False 1) In order to create value a corporation must earn a rate of return on its invested capital that is higher than the market's required rate of return on that invested capital. Answer: TRUE Diff: 1 Keywords: Required Rate of Return, Invested Capital 2) The cost of capital is the rate that must be earned on an investment project if the project is to increase the value of the common shareholders’ investment. Answer: TRUE Diff: 1 Keywords: Cost of Capital, Shareholder Value 3) The firm’s cost of capital may also be referred to as the firm’s opportunity cost of capital. Answer: TRUE Diff: 1 Keywords: Cost of Capital, Opportunity Cost of Capital 4) The firm’s cost of capital is important when evaluation the firm’s overall value, but should not be used to evaluate individual projects which have their own unique characteristics. Answer: FALSE Diff: 1 Keywords: Cost of Capital 5) The cost of debt increases relative to the investor's required return due to flotation costs, but decreases relative to the investor's required return due to the tax deductibility of interest. Answer: TRUE Diff: 1 Keywords: Cost of Debt, Flotation Costs, Taxes, Interest Multiple Choice 1) Higher flotation costs will result in all of the following except: A) higher after-tax cost of debt B) higher weighted average cost of capital C) higher cost of retained earnings D) higher cost of common equity when new common shares are sold Answer: C Diff: 1 Keywords: Flotation Costs, Cost of Retained Earnings 1 Copyright © 2011 Pearson Education, Inc. 9.2 Learning Objective 2 True or False 1) Flotation costs cause a corporation's cost of capital to be lower than its investors' required returns. Answer: FALSE Diff: 1 Keywords: Flotation Costs, Cost of Capital, Required Returns 2) The cost of a particular source of capital (debt, preferred stock, common stock) is equal to the investor's required rate of return after adjusting for the effects of both flotation costs and corporate taxes. Answer: TRUE Diff: 1 Keywords: Cost of Capital, Flotation Costs, Corporate Taxes 3) The cost of debt capital is obtained by substituting the net proceeds per bond for the bond price in the bond valuation equation and solving for the required return. Answer: TRUE Diff: 2 Keywords: Cost of Debt 4) The cost of preferred stock is equal to the preferred stock dividend divided by the net proceeds per preferred share. Answer: TRUE Diff: 1 Keywords: Cost of Preferred Stock, Net Proceeds, Flotation Costs 5) A corporation's cost of common equity may be estimated using either a dividend valuation model or the capital asset pricing model. Answer: TRUE Diff: 1 Keywords: Cost of Common Equity, Dividend Growth Model, Capital Asset Pricing Model 6) Corporations have two costs of common equity, one for retained earnings and one if the company issues new common stock. Answer: TRUE Diff: 1 Keywords: Cost of Common Equity, Retained Earnings 7) The Capital Asset Pricing Model may be used to estimate the cost of retained earnings. Answer: TRUE Diff: 1 Keywords: Capital Asset Pricing Model, Cost of Retained Earnings 2 Copyright © 2011 Pearson Education, Inc. 8) A reasonable estimate of the market risk premium based on historical data and expert opinion is between 5% and 7%. Answer: TRUE Diff: 1 Keywords: Market Risk Premium, Capital Asset Pricing Model 9) The market risk premium remains constant over time because the risk free rate of return moves inversely with beta. Answer: FALSE Diff: 1 Keywords: Market Risk Premium, Capital Asset Pricing Model 10) A firm's cost of capital is the required rate of return on the firm's average project. Answer: TRUE Diff: 1 Keywords: Cost of Capital, Required Return 11) The firm financed completely with equity capital has a cost of capital equal to the required return on common stock. Answer: TRUE Diff: 1 Keywords: Cost of Capital, Required Return on Common Stock 12) The after-tax cost of equity equals one minus the marginal tax rate times the required rate of return on common stock. Answer: FALSE Diff: 1 Keywords: Cost of Common Equity 13) If preferred stock pays a $5 annual dividend and sells for $50 the cost of preferred stock financing is 10% since dividends are not tax deductible and preferred stock is sold without flotation costs. Answer: FALSE Diff: 1 Keywords: Cost of Preferred Stock, Flotation Costs 14) Other things equal, management should retain profits only if the company's investments within the firm are at least as attractive as the stockholders' other investment opportunities. Answer: TRUE Diff: 1 Keywords: Cost of Retained Earnings, Shareholder Value 15) Financing with new common stock is generally more costly than financing with retained earnings due to increasing tax rates. Answer: FALSE Diff: 1 Keywords: Cost of New Common Stock, Cost of Retained Earnings 3 Copyright © 2011 Pearson Education, Inc. is higher than the cost of preferred stock for the corporation because stockholder’s must pay federal taxes on their dividend income. Risk-free Rate of Return 22) The capital asset pricing model uses three variables to evaluate required returns on common equity: the risk free rate. Answer: FALSE Diff: 1 Keywords: Capital Asset Pricing Model. rps. Answer: TRUE Diff: 1 Keywords: Required Return. Inc. and the market risk premium. Answer: TRUE Diff: 1 Keywords: CAPM 4 Copyright © 2011 Pearson Education. Answer: TRUE Diff: 1 Keywords: Cost of Retained Earnings 21) A short-term T-bill's rate of return should be used in the CAPM formula to determine the cost of equity capital regardless of the length of the project under consideration. the beta coefficient. Answer: TRUE Diff: 1 Keywords: Capital Structure. Cost of Capital 17) The required return of a preferred stockholder. . Variability of Returns 20) The cost of internal common equity is already on an after-tax basis since dividends paid to common stockholders are not tax deductible. Answer: TRUE Diff: 1 Keywords: Required Returns.16) The firm's best financial structure is determined by finding the capital structure that minimizes the firm's cost of capital. Cost of Preferred Stock 18) Investors require higher rates of return to compensate for purchasing power losses resulting from inflation. Answer: FALSE Diff: 1 Keywords: Required Return on Preferred Stock. Inflation 19) A security with a reasonably stable price will have a lower required rate of return than a security with an unstable price. Bonds 25) Preferred dividends are paid with before-tax dollars because the dividend rate is known. Answer: FALSE Diff: 1 Keywords: Cost of Debt. but have no impact on its cost of preferred stock or cost of common equity. . Answer: B Diff: 1 Keywords: Cost of Capital. Transactions Costs 5 Copyright © 2011 Pearson Education. Dividend Growth Rate 28) An increase in a corporation's marginal tax rate will decrease the corporation's cost of debt. Cost of Preferred Stock. whereas common stock dividends are paid with after-tax dollars. Cost of Common Equity. D) risk and opportunity cost differences. the lower the company's cost of common equity. Answer: FALSE Diff: 2 Keywords: Cost of Common Equity. Cost of Preferred Stock.23) The investor's required rate of return will equal the firm's cost of capital if corporate transactions costs are taken into account. Required Rate of Return 24) The cost of debt measures the cost of a bank loan. Taxes. other things remaining the same. Answer: FALSE Diff: 1 Keywords: Cost of Capital. Taxes 27) Because investors like dividends. B) transactions costs and risk. Answer: FALSE Diff: 1 Keywords: Preferred Dividends. while the cost of preferred stock is used as a proxy for the cost of a new bond issue. Marginal Tax Rate Multiple Choice 1) Two factors that cause the investor's required rate of return to differ from the company's cost of capital are: A) taxes and risk. Taxes 26) An increase in a corporation's marginal tax rate will cause the corporation's after tax cost of debt to increase. the higher the company's dividend growth rate. Common Dividends. C) taxes and transactions costs. Answer: TRUE Diff: 2 Keywords: Cost of Debt. Answer: FALSE Diff: 1 Keywords: Cost of Debt. Inc. the cost of preferred stock is: A) 18.87%. Taxes.5% based on a par value of $100. Flotation Costs 3) Due to changes in regulatory requirements. B) 17. This change will A) cause the cost of capital to decrease.00% B) 18. Therefore.72%.89% C) 18. The company's marginal tax rate is 35%. the transactions costs associated with selling corporate securities increased by $1 per share. Required Rate of Return. B) individual taxes and corporate taxes. The preferred stock pays an annual dividend of 3. C) individual taxes and dividends. .70 per share. Answer: A Diff: 1 Keywords: Cost of Capital. Flotation Costs 5) A company has preferred stock that can be sold for $21 per share.33% D) 17. However.25 per share. Cost of Capital 4) Jones Distributing Corp.2) Two considerations that cause a corporation's cost of capital to be different than its investors' required returns are A) corporate taxes and flotation costs. Net Proceeds 6 Copyright © 2011 Pearson Education.00% Answer: B Diff: 2 Keywords: Cost of Capital. Answer: B Diff: 2 Keywords: Cost of Preferred Stock.26%. B) cause the cost of capital to increase. Flotation Costs. Answer: B Diff: 1 Keywords: Flotation Costs. D) cause the cost of capital to decrease only if investors may be billed for part of the increase in transactions costs. What is the cost of capital for Jones Distributing if the corporation raises money by selling common stock? A) 27. the administrative or flotation costs associated with selling the stock amount to $2. C) 14. D) 12. Flotation costs associated with the sale of preferred stock equal $1. D) corporate taxes and the earned income tax credit. C) have no effect on the cost of capital because transactions costs are expensed immediately. can sell common stock for $27 per share and its investors require a 17% return.94%. Inc. D) 31. If Asian Trading Company decides to issue new common stock. The dividend is expected to grow at a constant rate of 8% per year. Cost of Debt 9) The risk free rate of return is 2. The price of Asian Trading Company's stock today is $29 per share. cost of preferred stock.2 and a standard deviation of returns of 28%. cost of debt. C) 26. cost of retained earnings C) cost of new common stock. which of the following rankings. Cost of Preferred Stock. cost of preferred stock. cost of debt D) cost of preferred stock.40%. Answer: A Diff: 2 Keywords: Cost of New Common Stock 8) In general. flotation costs will equal $2. Inc. Analysts expect Penn Trucking's dividends to grow by 6% per year for the foreseeable future.62%.7% C) 19. cost of new common stock.12%. Based on the above information. D) 31. Penn Trucking's marginal tax rate is 35%.62%. cost of retained earnings B) cost of debt.4% B) 17.38%. Penn Trucking has a beta of 2.50 per share. Using the capital asset pricing model. the cost of retained earnings is: A) 28.6) Asian Trading Company paid a dividend yesterday of $5 per share (D0 = $4). Asian Trading Company's marginal tax rate is 35%. The dividend is expected to grow at a constant rate of 8% per year. Asian Trading Company's marginal tax rate is 35%. Cost of Retained Earnings. cost of retained earnings. cost of preferred stock.1% Answer: D Diff: 2 Keywords: Capital Asset Pricing Model. cost of retained earnings.6% D) 20. B) 24. If Asian Trading Company decides to issue new common stock.5% and the market risk premium is 8%. B) 24.12%. cost of new common stock. Answer: C Diff: 2 Keywords: Cost of Retained Earnings 7) Asian Trading Company paid a dividend yesterday of $5 per share (D0 = $4). is most accurate? A) cost of new common stock.50 per share.40%. what is Penn Trucking's cost of retained earnings? A) 16. C) 26. cost of debt Answer: C Diff: 1 Keywords: Cost of New Common Stock. from highest to lowest cost. the cost of new common stock is: A) 28. . Cost of Retained Earnings 7 Copyright © 2011 Pearson Education. flotation costs will equal $2. The price of Asian Trading Company's stock today is $29 per share. Based on the above information.38%. 50 per share. Kaycee's marginal tax rate is 35%. Kaycee's marginal tax rate is 35%.63%.09%. The dividend is expected to grow at a constant rate of 10% per year.09%. If KayCee decides to issue new common stock.55%.22%. . Inc.50 per share. B) 24. C) 19. the cost of retained earnings is: A) 26.63%. Flotation Costs 8 Copyright © 2011 Pearson Education. Answer: B Diff: 2 Keywords: Cost of Preferred Stock. the cost of new common stock is: A) 26. the cost of preferred stock is: A) 28.55%. Answer: B Diff: 2 Keywords: Cost of New Common Stock. If Kaycee decides to issue new common stock. flotation costs will equal $4. Based on the above information. Answer: C Diff: 2 Keywords: Cost of Retained Earnings 12) KayCee Manufacturing Company paid a dividend yesterday of $3. C) 19.41%.00 per share. D) 14. Therefore. flotation costs will equal $4. The company's marginal tax rate is 40%.50 per share. The price of KayCee's common stock today is $40 per share. D) 17. The price of KayCee's common stock today is $40 per share. D) 17. The preferred stock pays an annual dividend of 4% based on a par value of $100. B) 20. Based on the above information.80%. C) 22. Flotation Costs. Flotation costs associated with the sale of preferred stock equal $1.24%.55%.10) A company has preferred stock with a current market price of $18 per share.00 per share. B) 20. Net Proceeds 11) KayCee Manufacturing Company paid a dividend yesterday of $3. The dividend is expected to grow at a constant rate of 10% per year.41%. 2% C) 22. B) the marginal cost of capital.6% B) 21. The current price of Jiffy common stock is $60 per share. Answer: B Diff: 1 Keywords: Marginal Cost of Capital 16) A firm's cost of capital is influenced by: A) the current ratio. Using the capital asset pricing model.00 per share in one year. expects to pay a dividend of $3. Answer: C Diff: 1 Keywords: Cost of Capital 9 Copyright © 2011 Pearson Education.8% D) 25. D) the component cost of capital.13) The risk free rate of return is 3% and the expected return on the market portfolio is 14%. Analysts expect Starship's net income to grow by 12% per year for the next 5 years. Inc. Flotation costs are $3. Cost of Retained Earnings 14) Jiffy Co. C) CAPM required return. what is Starship Enterprises' cost of retained earnings? A) 18.0 and a standard deviation of returns of 26%. Starship's marginal tax rate is 35%. Starship Enterprises has a beta of 2.0% Answer: D Diff: 2 Keywords: Capital Asset Pricing Model. What is the cost of internal common equity (retained earnings) if the long-term growth in dividends is projected to be 8 percent indefinitely? A) 13 percent B) 14 percent C) 15 percent D) 16 percent Answer: A Diff: 1 Keywords: Cost of Retained Earnings 15) The average cost associated with each additional dollar of financing for investment projects is: A) the incremental return. . D) net income. C) capital structure. B) par value of common stock.00 per share when Jiffy issues new stock. 0 million C) $15. . If the firm expects to earn $30 million in net income next year and retain 40% of it. Answer: D Diff: 2 Keywords: Cost of New Preferred Stock 19) In general. C) (1 . Answer: A Diff: 2 Keywords: Cost of Capital. Capital Budget 18) The cost of new preferred stock is equal to: A) the preferred stock dividend divided by the market price.tax rate) times the preferred stock dividend divided by net price. Sources of Capital 20) The cost of external equity capital is greater than the cost of retained earnings because of: A) flotation costs on new equity. B) the preferred stock dividend divided by its par value. C) higher dividends. the least expensive source of capital is: A) debt B) new common stock. C) preferred stock D) retained earnings. Inc.5 million B) $12. Cost of New Common Stock.0 million Answer: C Diff: 2 Keywords: Capital Structure. Cost of Retained Earnings 10 Copyright © 2011 Pearson Education.17) Clanton Company is financed 75 percent by equity and 25 percent by debt. D) preferred stock dividend divided by the net selling price of preferred. B) increasing marginal tax rates. D) greater risk for shareholders. Answer: A Diff: 2 Keywords: Flotation Costs.5 million D) $16. how large can the capital budget be before common stock must be sold? A) $7. Cost of New Common Stock 22) DEF Company's preferred stock is currently selling for $28.60 next year.00. The firm's tax rate is 40%.15% Answer: C Diff: 2 Keywords: Cost of New Preferred Stock. is expected to pay a dividend of $2. New stock can be sold at this price subject to flotation costs of 15%. The company's marginal tax rate is 35%.00%.80% B) 7. Dividends are expected to grow at a constant rate of 8% per year.29% C) 21. .21) Seafood Products Corp. 21. Underwriters of a new issue of preferred stock would charge $3 per share in flotation costs. and pays a perpetual annual dividend of $2. A) 4. What is the appropriate cost for retained earnings in determining the firm's cost of capital? A) 17. and the stock price is currently $20.00 per share.00% D) 9.00%.1% Answer: C Diff: 2 Keywords: Capital Asset Pricing Model.0% B) 19.29% D) 23. Compute the cost of new preferred stock for DEF.3. the CAPM approach is typically used to find which of the following: A) Market value weight of equity B) Pretax component cost of debt C) After-tax component cost of debt D) Component cost of internal equity Answer: D Diff: 1 Keywords: Capital Asset Pricing Model.00% B) 8. Compute the cost of internal equity (retained earnings) and the cost of external equity (new common stock). Cost of Retained Earnings 11 Copyright © 2011 Pearson Education. 23.9% D) 22.00. Inc.00%. Cost of Capital 24) In capital budgeting analysis. Flotation Costs 23) Atlas Corporation wishes to estimate its cost of retained earnings. The rate on 6-month T-bills is 2%. A) 0.14% C) 8. and the return on the S&P 500 index is 15%.48% Answer: C Diff: 2 Keywords: Cost of Retained Earnings. when computing the weighted average cost of capital. 23.5% C) 18. 25. The firm's beta is 1. respectively. 12% C) 7. The market price of the bonds is $1. B) flotation costs are incurred when new stock is issued.070 each.82% Answer: C Diff: 2 Keywords: Yield to Maturity 28) Five Rivers Casino is undergoing a major expansion. D) The larger dividends paid to the new common stockholders. C) dividends are not tax deductible.070 each. The expansion will be financed by issuing new 15-year. What is the pre-tax cost of debt for the newly-issued bonds? A) 8.99% C) 8. Flotation Costs 12 Copyright © 2011 Pearson Education. 9% annual coupon bonds.000 par. Cost of New Common Stock 26) Which of the following differentiates the cost of retained earnings from the cost of newlyissued common stock? A) The cost of the pre-emptive rights held by existing shareholders. $1. Five Rivers marginal tax rate is 35%. Cost of Retained Earnings.17% D) 9. Answer: C Diff: 1 Keywords: Flotation Costs. $1. B) The greater marginal tax rate faced by the now-larger firm. D) accounting rules allow a deduction when using retained earnings.95% B) 7.25% Answer: A Diff: 2 Keywords: Pre-tax Cost of Debt. Gamblers flotation expense on the new bonds will be $50 per bond. Gamblers marginal tax rate is 35%. The expansion will be financed by issuing new 15-year. Five Rivers flotation expense on the new bonds will be $50 per bond. Cost of New Common Stock 27) Five Rivers Casino is undergoing a major expansion.000 par. Cost of Retained Earnings. Inc. What is the yield to maturity on the newly-issued bonds? A) 6. C) The flotation costs incurred when issuing new securities.49% D) 10. The market price of the bonds is $1. 9% annual coupon bonds. Answer: B Diff: 2 Keywords: Flotation Costs.76% B) 8.25) The cost of retained earnings is less than the cost of new common stock because: A) marginal tax brackets increase. . The stock sells for $45.33% B) 11. The General's marginal tax rate is 30%. The firm's existing preferred stock pays a dividend of $4.53% Answer: C Diff: 2 Keywords: Cost of Retained Earnings 13 Copyright © 2011 Pearson Education. Investment bankers have advised General Bill that flotation costs on the new preferred issue would be 5% of the selling price. What is the relevant cost of new preferred stock? A) 7.? A) 11.51% C) 11.37% C) 10.00% B) 7. The existing common stock just paid a $1. What is the cost of retained earnings for Kelly Corp.53% Answer: D Diff: 2 Keywords: Cost of New Common Stock.00% Answer: D Diff: 2 Keywords: Cost of New Preferred Stock.29) General Bill's will issue preferred stock to finance a new artillery line.53% E) 15.51% C) 11. and dividends are expected to grow at a constant rate 8% indefinitely.33% B) 11. What is the cost of new common stock be for Kelly Corp. Flotation Costs 30) Kelly Corporation will issue new common stock to finance an expansion.00 per share and is selling for $40 per share. Inc. and flotation expenses of 5% of the selling price will be incurred on new shares.79% E) 12. . Flotation Costs 31) Kelly Corporation will issue new common stock to finance an expansion.? A) 11. and flotation expenses of 5% of the selling price will be incurred on new shares. The existing common stock just paid a $1.50 dividend.60% D) 11.60% D) 11.79% E) 12.00% D) 10.50 dividend. The stock sells for $45. and dividends are expected to grow at a constant rate 8% indefinitely. 78% D) 12. C) an increase in the after-tax cost of debt. What is the cost of Royal's retained earnings? A) 5. Flotation Costs. D) The cost of a particular source of capital is equal to the investor's required rate of return after adjusting for the effects of both flotation costs and corporate taxes. and dividends are expected to grow at a 6% annual rate.09% Answer: D Diff: 2 Keywords: Cost of New Common Stock 14 Copyright © 2011 Pearson Education. value-maximizing firms maintain debt ratios of close to 100% B) Corporations that are 100% equity financed will have a much lower weighted average cost of capital because the lack of debt lowers their risk of bankruptcy C) The source of capital with the lowest after-tax cost is preferred stock. Flotation costs on new stock sales are 5% of the selling price.32) Which of the following statements is most correct? A) Because the cost of debt is lower than the cost of equity. Flotation costs on new stock sales are 5% of the selling price.45% C) 11.73% B) 11. because it is a hybrid security. and dividends are expected to grow at a 6% annual rate.45% C) 11. D) an increase in the cost of common equity. The last dividend was $1. part debt and part equity. an increase in beta results in A) an increase in the cost of retained earnings. whether or not the funds come from retained earnings or newly issued common stock. Cost of Common Equity 34) Royal Mediterranean Cruise Line's common stock is selling for $22 per share. B) an increase in the cost of newly issued common stock .20. Transactions Costs 33) All else equal. Answer: D Diff: 1 Keywords: Cost of Capital. . Inc. Answer: D Diff: 1 Keywords: Beta.78% D) 12. What is the cost of Royal's new common stock? A) 5. The last dividend was $1.73% B) 11.20.09% Answer: C Diff: 2 Keywords: Cost of Retained Earnings 35) Royal Mediterranean Cruise Line's common stock is selling for $22 per share. What is the cost of preferred financing? Answer: $3. After-tax cost of existing debt c. Frequency = 2. Inc. Answer: 3% + (8%)(2.000 that will pay $60 every six months. a.00.12. with a beta equal to 2.35) = 6.8 and a standard deviation of returns of 32%.8) = 25.18% × (1-.4% Diff: 2 Keywords: Cost of Retained Earnings. The risk free rate of return is 3% and the market risk premium is 8%.28 Cost of internal common equity = $4. .07 = $4.35) = 5.857%% Diff: 1 Keywords: Cost of Preferred Stock 3) NewLinePhone Corp. NewLinePhone’s marginal tax rate is 35%.12. Flotation costs on new debt will be 4% of the selling price. YTM = 9. and Basis = 0) b. Yield to maturity of debt b.) Diff: 2 Keywords: Yield to Maturity. Alarm Systems Corporation has a marginal tax rate of 35%. except the Pr is 117.00 × 1. Use the capital asset pricing model to estimate NewLinePhone’s cost of retained earnings. What is the cost of new common equity? Answer: a. Cost of New Common Stock.12857 =12.97% c. If the firm has a 35% marginal tax bracket. Cost of new common equity = $4.220. What is the cost of internal common equity? b.60 and sells for $28.28/$38 + . Capital Asset Pricing Model 4) Dickerson Corporation’s common stock is currently selling for $38. is very risky.Essay 1) New Jet Airlines plans to issue 14-year bonds with a par value of $1. Flotation costs of 4% will be incurred when new stock is sold. compute the following: a.18% (Using Yield Function in Excel with rate =.07 = 18. After-tax cost of debt = 9.73% Diff: 2 Keywords: Cost of Retained Earnings. Flotation Costs 15 Copyright © 2011 Pearson Education. D1 = $4. The bonds have a market price of $1.73% × (1-. After-tax cost of new debt Answer: a. Redemption = 100. After-tax Cost of New Debt.80. After-tax Cost of Existing Debt.220 less flotation costs of $48.26% b.00 per share. Last year's dividend was $4. After-tax cost of new debt = 9.28/($38 × . based on a net price of $1. Flotation Costs 2) Alarm Systems Corporation’s preferred stock pays a dividend of $3.07 = 18.60/$28 = . Pr = 122. Investors expect dividends to grow at an annual rate of 7 percent indefinitely.33% (The pre-tax cost is determined as in part a.96) + . dividends are expected to grow at a 6 percent rate far into the future.049 = 12. Calculate the weighted marginal cost of capital at an investment level of $12 million. Kd = 9(1 .89% D1 = $1. Management desires to increase its plant and equipment during the coming year by $12 million.6 × 11.0 million New common stock $3. Inc. What amount of new common stock must be sold if the existing capital structure is to be maintained? b.94% + 0.50. . Answer: a.049 = $1. The firm just paid a dividend of $1..4 × 5. the cost of external equity capital Answer: a.56% MCC = 0. Common stock is currently selling for $50 per share. Flotation costs for new shares will be 6% of the selling price.000.049 = 13. Equity needed = $12 million × 0.94) + .6 = $7. Dividends per share are anticipated to grow at the same rate in the future as they have over the past three years. Calculate the following: a.94% Knc = $2.57/$20 + . The company plans to finance 40 percent of the expansion with debt and the remaining 60 percent with equity capital.57/($20 × . and flotation costs for new common stock will amount to $5 per share.5) Last year Gator Getters.50/$45 + 0.2 million b. the cost of retained earnings b. Cost of New Common Stock. had $50 million in total assets.34) = 5.000.50 × 1. Cost of external equity = $1.30. Marginal Cost of Capital 6) The common stock for El Viss Company currently sells for $20 per share. The marginal corporate tax rate is 34 percent. Bond financing will be at a 9 percent rate and will be sold at its par value. Furthermore.57 Cost of retained earnings = $1. g = 4.75% b.06 = 11. Inc.56% = 9. Internal funding available from additions to retained earnings is $4.31% Diff: 2 Keywords: After-tax Cost of Debt. The expected dividend next year for Gator is $2. Cost of New Common Stock 16 Copyright © 2011 Pearson Education. a.50.25% Diff: 2 Keywords: Cost of Retained Earnings. and the dividend three years ago was $1.2 million Less additions to R/E 4. After-tax cost of new debt = 8. What will be the after-tax cost of new debt for the bond? Answer: 9. Compute the following: a.000 par value bond that pays a 7% annual coupon.44% Diff: 2 Keywords: After-tax Cost of Debt.44% Diff: 1 Keywords: Cost of Preferred Stock 17 Copyright © 2011 Pearson Education.60 after issuance costs. Gibson is in the 34% tax bracket.00/$25.80.84/$16. . Cost of New Preferred Stock 9) Sutter Corporation's common stock is selling for $16.000 par value bond with an 8% annual interest coupon rate that matures in 11 years. The yield to maturity on the firm’s bonds b. The expected flotation cost per bond is $42.34) = 5.34) = 5% c. What is the cost of capital for new preferred stock? Answer: $1.75 dividend. The net price of the stock after issuance costs is $15. The firm’s after-tax cost of existing debt c. preferred stock respectively? Answer: Cost of existing preferred stock = $3. YTM = 7.50 = 10. Inc..00/$27. Last year Sutter paid a dividend of $.75/$15.80 a share.00 per share. Investors are willing to pay $972.. What is the cost of internal equity? Answer: D1 = $. and the firm is in the 34% tax bracket.84 Cost of internal equity = $.50 a share.30.29% Diff: 2 Keywords: After-tax Cost of Debt.02% × (1 .30 = 11.72% Diff: 2 Keywords: Cost of Existing Preferred Stock. What is the cost of existing. and flotation costs will be 9%.57% b. Flotation Costs 11) The preferred stock of Wells Co.80 × 1.57% × (1 . Yield to Maturity.80 + .34) = 6. Investors are expecting Sutter's dividends to grow at an annual rate of 5% per year. After-tax cost of existing debt = 7.91% Cost of new preferred stock = $3.05 = 10% Diff: 2 Keywords: Cost of Retained Earnings 10) Gibson Industries is issuing a $1.60 = 11.05 = $. and new. The firm nets $25.76% × (1 . The stock pays an annual dividend of $3.. The company expects investors to pay $942 for the 20-year bond. Flotation Costs 8) Toto and Associates' preferred stock is selling for $27.7) A company is going to issue a $1. The firm’s after-tax cost of new debt Answer: a. sells for $17 and pays a $1. 71% Cost of new equity = $1.3 Learning Objective 3 True or False 1) A company's cost of capital is equal to a weighted average of its investors' required returns.95) + . What is Toombes’ cost of retained earnings.1 = 12. to a lower cost source of capital. respectively? Answer: D1 = $3. Dividends last year were $3.12) Glenna Gayle common stock sells for $55.50/$55 + .36% Cost of new equity = $3.49/$55 + . Flotation costs will be 5% of the market price. Cost of New Common Stock. such as common equity.06 = $3. is issuing new common stock at a market price of $55. Firm Value 18 Copyright © 2011 Pearson Education.30 × 1. Investors' Required Returns 2) A corporation may lower its cost of capital by shifting a portion of its total financing from a higher cost source of capital. What is the cost of internal equity. we would expect the price of its common stock to remain unchanged.50/($55 × .1 = $1. and dividends paid last year were $1.49/($55 × . Flotation costs on issuing stock will be 8% of the market price. Inc. and new equity.50 Cost of retained earnings = $3. Answer: FALSE Diff: 1 Keywords: Cost of Capital.35.1 = 12.30 per share and are expected to grow at a rate of 6%. and new equity. Answer: TRUE Diff: 1 Keywords: Weighted Average Cost of Capital 3) The best financial structure is determined by finding the debt and equity mix that maximizes the firm's cost of capital.49 Cost of internal equity = $1.06 = 12.35 × 1. Inc. .06 = 12. Flotation Costs 9.94% Diff: 2 Keywords: Cost of Retained Earnings. respectively for Glenna Gayle? Answer: D1 = $1. Answer: FALSE Diff: 1 Keywords: Optimal Capital Structure. Cost of Capital 4) If a firm were to earn exactly its cost of capital. Cost of New Common Stock.92) + .70% Diff: 2 Keywords: Cost of Retained Earnings. such as debt. The dividends are predicted to have a 10% growth rate. Answer: TRUE Diff: 1 Keywords: Cost of Capital. Flotation Costs 13) Toombes. . Answer: TRUE Diff: 1 Keywords: Weighted Cost of Capital 10) Using the weighted cost of capital as a cutoff rate assumes that future investments will be financed so as to maintain the firm's target degree of financial leverage. Inc. Answer: FALSE Diff: 1 Keywords: Cost of Capital. Target Capital Structure 11) The market value weights are preferred when calculating a firm's weighted average cost of capital. Answer: TRUE Diff: 1 Keywords: Weighted Average Cost of Capital 19 Copyright © 2011 Pearson Education. (2) the capital structure mix. Tax Rate 6) The average cost of capital is the appropriate rate to use when evaluating new investments. Risk 7) Once the weighted average cost of capital (WACC) is determined then all projects of average risk will be compared to the original WACC regardless of the size of the capital budget. even though the new investments may be in a higher risk class. Answer: TRUE Diff: 1 Keywords: Weighted Cost of Capital 9) Using the weighted cost of capital as a cutoff rate assumes that the riskiness of the project being evaluated is similar to the riskiness of the company's existing assets. Answer: FALSE Diff: 1 Keywords: Weighted Average Cost of Capital 8) The mixture of financing sources used by a firm will vary from year to year. Answer: FALSE Diff: 1 Keywords: Average Cost of Capital.5) If a firm's tax rate increases then its weighted average cost of capital increases also. Answer: TRUE Diff: 1 Keywords: Market Value Weights. Weighted Average Cost of Capital 12) A firm's weighted average cost of capital is a function of (1) the individual costs of capital. and (3) the level of financing necessary to make the investment. Answer: TRUE Diff: 1 Keywords: Weighted Cost of Capital. so many firms use target capital structure proportions when calculating the firm's weighted average cost of capital. Answer: D Diff: 1 Keywords: Weighted Average Cost of Capital 2) Cost of capital is: A) the coupon rate of debt. C) the internal rate of return for new investments. C) the rate of return that must be earned on additional investment if firm value is to remain unchanged. . Required Rate of Return. Opportunity Cost of Funds 20 Copyright © 2011 Pearson Education. D) the probability distribution of expected returns. Answer: C Diff: 1 Keywords: Cost of Capital 3) Cost of capital is commonly used interchangeably with all of the following terms except A) the firm's required rate of return. D) the firm's opportunity cost of funds. D) the average cost of the firm's assets. B) the hurdle rate for new investments. B) the amount of capital necessary to make the investment. C) the firm's after tax cost of debt. Answer: FALSE Diff: 1 Keywords: Capital Structure Multiple Choice 1) A firm's weighted average cost of capital is determined using all of the following inputs except: A) the firm's capital structure. B) a hurdle rate set by the board of directors. Answer: C Diff: 1 Keywords: Cost of Capital.13) A company's capital structure mix is based on the proportion of fixed versus variable costs in its optimal production process. Inc. Hurdle Rate. What is the company's weighted average cost of capital if retained earnings are used to fund the common equity portion? A) 11. Inc. and $10 million of new common stock. The company's after-tax cost of debt is 7%. One division involves significant research and development.20% B) 13.5 and the company's marginal tax rate is 35%. Answer: C Diff: 1 Keywords: Weighted Average Cost of Capital.12% C) 13. Risk-Return Tradeoff 21 Copyright © 2011 Pearson Education. The company estimates is after-tax cost of debt to be 7%. $4 million of preferred stock. 15% preferred stock. and its cost of new common stock is 16%. D) not favor any division over the other because they all use the same company-wide weighted average cost of capital. and thus has a high-risk cost of capital of 15%. What is the weighted average cost of capital for this project? A) 12. C) favor projects in the research and development division because the higher risk projects look more favorable if a lower cost of capital is used to evaluate them.75% D) 14. The company stock has a beta of 1.20% B) 12. .4) Jones Company has a target capital structure of 30% debt. The second division operates in business segments related to Acme's core business.80% D) 14. and 55% common equity. with a cost of capital of 8%. its cost of preferred stock is 11%. and the cost of new common stock to be 17%. is investing in a major capital budgeting project that will require the expenditure of $16 million.45% Answer: B Diff: 2 Keywords: Weighted Average Cost of Capital 5) J & B Corp. This approach will A) favor projects in the core business division because that division is the least risky. the cost of retained earnings to be 14%. B) favor projects in the related businesses division because the cost of capital for this division is the closest to the firm's weighted average cost of capital.00% C) 13. its cost of preferred stock to be 9%. Acme's core business is the least risky segment. its cost of retained earnings is 15%. and this division has a cost of capital of 10% based upon its risk.23% Answer: C Diff: 2 Keywords: Weighted Average Cost of Capital 6) Acme Conglomerate Corporation operates three divisions. The firm's overall weighted average cost of capital of 11% has been used to evaluate capital budgeting projects for all three divisions. The money will be raised by issuing $2 million of bonds. B) $18 million. since no new stock will be sold. C) equal to 12%. . D) $28 million. However. B) less than 12%. Each project is indivisible. D) greater than 12%. plans to maintain its optimal capital structure of 40 percent debt. what after-tax rate of return must Higgins Office Corp. common equity--16 percent. 16 percent for between $6 million and $18 million of investment. and above $18 million the weighted cost of capital is 18 percent.00 percent C) 11. Optimal Capital Budget 22 Copyright © 2011 Pearson Education. The required return on each component source of capital is as follows: debt--8 percent. earn on its investments if the value of the firm is to remain unchanged? A) 12. C) $23 million. Joe’s decides to cut its dividend and increase its retained earnings so that the common equity portion of its capital structure will include only retained earnings and no new common stock will be sold. 10 percent preferred stock. They are: Project Investment (million) A $6 B $10 C $9 D $4 E $3 IRR 18% 15% 20% 12% 24% SkyHigh's weighted marginal cost of capital schedule is 12 percent for up to $6 million of investment. Joe’s weighted average cost of capital this year should be A) zero. Answer: B Diff: 2 Keywords: Weighted Average Cost of Capital. selling common stock in each year to finance its growth.7) Joe’s Discount Club currently has a weighted average cost of capital of 12%. The optimal capital budget is: A) $12 million. and 50 percent common equity indefinitely.12 percent D) 10. Joe’s has been growing rapidly over the past several years. preferred stock--12 percent. due to difficult economic times this year. Assuming a 40 percent marginal tax rate.40 percent B) 12.64 percent Answer: C Diff: 2 Keywords: Weighted Average Cost of Capital 9) SkyHigh Airlines has five possible investment projects for the coming year. Inc. Answer: B Diff: 1 Keywords: Weighted Average Cost of Capital 8) Higgins Office Corp. 92% B) 9. which of the following capital structures will result in the lowest weighted average cost of capital? A) 40% debt. . 40% common equity C) 60% debt. Weighted Average Cost of Capital 12) For a typical corporation. Inc. 40% common equity B) 50% debt. 25% common equity Answer: D Diff: 2 Keywords: Capital Structure. You have determined that the current after-tax cost of the firm's capital (required rate of return) for each source of financing is as follows: Cost of Long-Term Debt7% Cost of Preferred Stock11% Cost of Common Stock15% Long term debt currently makes up 25% of the capital structure. 30% common equity D) 60% debt.000 and produce expected cash flows in years 1-5 of $95. If the company is in the 35 percent tax bracket.6 million in new debt and $38. The expansion is to be financed by selling $25. and common stock 60%. The before-tax required rate of return on debt is 9 percent and the required rate of return on equity is 14 percent.10) The ABC Company is planning a $64 million expansion. What is the net present value of this project? A) -$9. 10% preferred stock.50% D) 10.568 Answer: A Diff: 2 Keywords: Net Present Value. 15% preferred stock.89% C) 11. what is the firm's cost of capital? A) 8. preferred stock 15%. Weighted Average Cost of Capital 23 Copyright © 2011 Pearson Education.149 C) $5.983 D) $11.4 million in new common stock.450 per year. 20% preferred stock.74% Answer: D Diff: 2 Keywords: Weighted Average Cost of Capital 11) Burns and Nuble is considering an investment in a project which would require an initial outlay of $350.306 B) $2. 10% preferred stock. D) None of the above — the WACC and required return are the same Answer: B Diff: 2 Keywords: Weighted Average Cost of Capital.5% 11% 15% The company's marginal tax rate is 40%. A) 13.3% B) 7. . compute the company's weighted average cost of capital. B) The incurrence of flotation costs when new securities are issued. Taxes. Type of Capital Percent of Capital Structure Bonds Preferred Stock Common Stock (Internal Only) 40% 5% 55% Before-Tax Component Cost 7.'s capital structure. Flotation Costs 15) Which of the following should not be considered when calculating a firm's WACC? A) Cost of preferred stock B) After-tax cost of bonds C) Cost of common stock D) Cost of carrying inventory Answer: D Diff: 1 Keywords: Weighted Average Cost of Capital 16) Which of the following should NOT be considered when calculating a firm's WACC? A) After-tax YTM on a firm's bonds B) After-tax cost of accounts payable C) Cost of newly issued preferred stock D) Cost of newly issued common stock Answer: B Diff: 1 Keywords: Weighted Average Cost of Capital 24 Copyright © 2011 Pearson Education.1% C) 10. Inc.13) Given the following information on S & G Inc. C) The market risk premium exceeds 12%.6% D) 10% Answer: C Diff: 2 Keywords: Weighted Average Cost of Capital 14) Which of the following causes a firm's cost of capital (WACC) to differ from an investor's required rate of return on the company's common stock? A) The fact that the risk free rate of interest has increased. what is the firm's weighted average cost of capital? A) 7. has a target capital structure of 40% debt and 60% common equity.25% Answer: B Diff: 2 Keywords: Weighted Average Cost of Capital 18) Milton Parker has a capital structure that consists of $7 million of debt.20% B) 10.25% Answer: C Diff: 2 Keywords: Weighted Average Cost of Capital.17) Clothier. Inc. what is Parker's WACC? A) 7.00% D) 12. Inc. based upon current market values. $2 million of preferred stock. Parker's yield to maturity on its bonds is 7.5% and investors require a 15% return on Clothier's common stock.21% B) 8. and has a 40% marginal tax rate.12% C) 10.80% C) 12.4%. If the tax rate is 35%. and $11 million of common equity. Capital Structure 25 Copyright © 2011 Pearson Education. and investors require an 8% return on Parker's preferred and a 14% return on Parker's common stock. If Clothier's yield to maturity on bonds is 7. .18% D) 12. 7 = $50Million Diff: 2 Keywords: Optimal Capital Structure. (($4.56%) = 13. a.79% Diff: 3 Keywords: Weighted Average Cost of Capital.2% b.Essay 1) Meacham Corp.56% d.090 and that flotation costs will equal $15 per bond. Assuming the capital structure is optimal. YTM with Net Proceeds = $1. Capital Structure 2) Office Clean Corporation has a capital structure consisting of 30 percent debt and 70 percent common equity. Calculate the cost of new common stock. common stock currently sells for $30 per share. Calculate the cost of retained earnings. Meacham’s capital structure is 40% debt and 60% common equity. Total Capital Budget 9.05))/($30 .00 per share and expects the dividend to grow at a constant rate of 5% per year. Meacham can sell additional shares by incurring flotation costs of $3 per share. . Cost of New Common Stock. At $30 million.2)(20. a face value of $1.000. wants to issue bonds with a 9% coupon rate. Answer: a. Cost of Debt.4)(5.35) = 5.00(1. Cost of Retained Earnings. Available retained earnings are $12 million.4 Learning Objective 4 True or False 1) Calculating the cost of capital for divisions within a company is not recommended because the data is too fragmented and all divisions are part of the same company in any case. c. Meacham estimates that the bonds will sell for $1.2%) + (. debt = $12 million and common equity = $18 million. After-tax cost of debt = 8. Meacham Corp. what amount of total investment can be financed by a $35 million addition to retained earnings without selling new common stock? Answer: Capital budget = $35Million / . b.$3)) + 5% = 20. Answer: FALSE Diff: 1 Keywords: Divisional Costs of Capital 26 Copyright © 2011 Pearson Education. Calculate the weighted average cost of capital assuming Meacham’s total capital budget is $30 million. so new common stock will equal $6 million.075 is 8. Calculate the after-tax cost of debt assuming Meacham’s bonds are its only debt. WACC = (.0%.0%(1 .4)(19%) + (.. and 12 years to maturity.05))/$30) + 5% = 19% c. (($4. Meacham also expects to have $12 million of retained earnings available for use in capital budgeting projects during the coming year. Meacham paid a dividend yesterday of $4.00(1. d. Meacham’s marginal tax rate is 35%. Inc. If the corporation sells more bonds it will incur flotation costs of $25 per bond.57% B) 6. .2) The after-tax cost of debt is equal to one minus the marginal tax rate times the yield to maturity on the firm's outstanding debt.29% D) 6. Answer: TRUE Diff: 1 Keywords: After-tax Cost of Debt. The bond matures in 15 years and has a current market price of $925.45% C) 5. Inc.56% C) 8. If the corporate tax rate is 35%. Answer: FALSE Diff: 1 Keywords: After-tax Cost of Debt Multiple Choice 1) A corporate bond has a face value of $1. Yield to Maturity 3) If the before-tax cost of debt is 7% and the firm has a 40% marginal tax rate. The bond matures in 14 years and has a current market price of $946. Bond Valuation 27 Copyright © 2011 Pearson Education.31% Answer: B Diff: 2 Keywords: After-tax Cost of Debt.000 and a coupon rate of 9%. what is the after-tax cost of debt capital? A) 3. If the corporation sells more bonds it will incur flotation costs of $26 per bond.78% Answer: A Diff: 2 Keywords: After-tax Cost of Debt.74% B) 4. Bond Valuation 2) A corporate bond has a face value of $1.18% D) 7. Flotation Costs. what is the after-tax cost of debt capital? A) 5. the after-tax cost of debt is 2. Flotation Costs.8%. If the corporate tax rate is 35%.000 and a coupon rate of 5%. Durocorp is planning to invest in a project that will necessitate raising new capital.23% B) 4.? A) 13. After-tax Cost of Debt 28 Copyright © 2011 Pearson Education.5 percent.70% D) 7. Flotation Costs 5) All the following variables are used in computing the cost of debt except: A) maturity value of the debt.55% C) 4.68% D) 15. . what is relevant cost of debt financing to Kendall.5% interest annually. Inc. The equity will be provided by internally generated funds so no new outside equity will be issued. D) risk-free rate. is issuing a $1. with a coupon rate of 10%. compute the firm's cost of capital.45% Answer: C Diff: 2 Keywords: After-tax Cost of Debt. has $15 million of outstanding bonds with a coupon rate of 10 percent. If the required rate of return on the firm's stock is 22% and its marginal tax rate is 35%.3) Kendall. C) number of years to maturity. Inc. Yield to Maturity 4) Porky Pine Co. The yield to maturity on these bonds is 12. Investors are expected to pay $1.75 percent Answer: B Diff: 2 Keywords: After-tax Cost of Debt. B) market price of the debt.00% B) 18.55% Answer: B Diff: 2 Keywords: Weighted Average Cost of Capital.100 for the 12-year bond.000 par value bond that pays 8. New debt will be issued at a beforetax yield of 14%.75 percent C) 7. If the firm's tax rate is 30 percent. Porky will pay $50 per bond in flotation costs.75 percent B) 8. A) 18. What is the after-tax cost of new debt if the firm is in the 35% tax bracket? A) 8.00 percent D) 3.13% C) 19. Answer: D Diff: 2 Keywords: After-tax Cost of Debt 6) Durocorp has a target capital structure of 30% debt and 70% equity. Inc. A) 2. The firm can issue bonds at a price of $950.97% D) 11. new bonds will net the company $966 in proceeds. Determine the appropriate after-tax cost of new debt for Triplin to use in a capital budgeting analysis. A new issue of $1. After $12 per bond flotation costs.18 with no flotation costs. is expected to grow at a constant annual rate of 5% per year indefinitely.81% Answer: C Diff: 2 Keywords: After-tax Cost of Debt. but can issue new common stock at a price of $45.70.87% C) 7.5% Which of the above projects should the company take on? A) Project 3 only B) Projects 1 and 2 C) Projects 1 and 3 D) Projects 1.000 8. Flotation Costs 9) Mars Car Company has a capital structure made up of 40% debt and 60% equity and a tax rate of 30%.00 before $15 flotation costs.62% B) 4. .00 per share. What is the appropriate cost of capital to use in analyzing this project? A) 3. The next expected dividend on the stock is $2. The company can issue new equity at a before-tax cost of 16% and its marginal tax rate is 34%.000.50% D) 7.000.8% Answer: B Diff: 2 Keywords: After-tax Cost of Debt. The company has the following independent investment projects available: Project Initial Outlay IRR 1 $100.000 10% 2 $ 10.63% B) 8. The dividend for Mars Co. Flotation costs on new equity will be $7. It can issue 10-year bonds with an annual coupon rate of 7% and a par value of $1. Cost of New Common Stock 29 Copyright © 2011 Pearson Education.7) Ewer Firm will finance a proposed investment by issuing new securities while maintaining its optimal capital structure of 60% debt and 40% equity. Weighted Average Cost of Capital 8) Triplin Corporation's marginal tax rate is 35%.5% 3 $ 50.000 12. The firm has no internal equity available for investment at this time. 2 and 3 Answer: C Diff: 2 Keywords: Optimal Capital Budget. The 10-year bonds will have an annual coupon rate of 8% and a face value of $1. Cost of New Common Stock. After-tax Cost of Debt.000 par bonds maturing in 20 years can be issued with a coupon of 9% at a price of $1.098. Inc.77% C) 9. or divisional costs of capital? A) Not all divisions have equal risk and the firm might accept projects whose returns are higher than are deemed appropriate. C) result in maximization of shareholder wealth. 9% annual coupon bonds. $1. Answer: D Diff: 2 Keywords: Weighted Average Cost of Capital. Weighted Average Cost of Capital 30 Copyright © 2011 Pearson Education. D) A and B above. Answer: C Diff: 2 Keywords: Divisional Costs of Capital. Accept/Reject Decision 2) Why should firms that own and operate multiple businesses that have different risk characteristics use business-specific.5 Learning Objective 5 Multiple Choice 1) Using the weighted average cost of capital as the required rate of return for every project will: A) cause a firm to reject projects that should have been accepted. C) Not all lines of business have equal risk and it is likely that the firm will accept projects whose returns are unacceptably low in relation to the risk involved. B) cause a firm to accept projects that were too risky.10) Five Rivers Casino is undergoing a major expansion. The expansion will be financed by issuing new 15-year.070 each. . Inc. B) Not all business divisions have equal risk and the firm will likely become less risky in the future.69% C) 8. What is the relevant cost of the new bonds for capital budgeting purposes? A) 5. D) Use of the same weighted average cost of capital for all divisions may result in too much money being allocated to the least risky division. The market price of the bonds is $1.45% D) 4. Five Rivers marginal tax rate is 35%.82% Answer: B Diff: 2 Keywords: After-tax Cost of Debt 9. Five Rivers flotation expense on the new bonds will be $50 per bond.000 par.14% B) 5. Nominal Interest Rates. Answer: A Diff: 2 Keywords: International Fisher Effect 31 Copyright © 2011 Pearson Education.000 pounds in Great Britain for 4% interest. the U.S.02% B) 4. A) 5. D) differences in currency exchange rates between the two countries. Alternatively. B) $1. Assuming capital markets are efficient.16% C) 4. is: A) $1. estimate the expected inflation rate in the United States if inflation in Great Britain is expected to be zero. Answer: TRUE Diff: 1 Keywords: Interest Rate Parity Theory. D) $1. C) $1.S dollars in the United States and pay 8% interest. company can borrow 12.50. differences in observed nominal interest rates in two countries should equal differences in the expected rates of inflation in the two countries. If the current exchange rate is 1 EURO = $1. paying back 12. company can borrow an equivalent amount of U.480 pounds in one year. then the future exchange rate in one year.575. . C) differences in the federal funds rates between the two countries.385.425.6 Learning Objective 6 True or False 1) According to interest rate parity theory.9.S. Inc. while the interest rate on a one year security in German is 8%.431. Answer: A Diff: 2 Keywords: Interest Rate Parity Theory 3) The interest rate on a one year security in the United States is 3%.85% Answer: D Diff: 2 Keywords: Interest Rate Parity Theory 2) The interest rate parity theorem suggests that differences in observed nominal rates of interest in two countries should equal A) differences in the expected rates of inflation between the two countries.00% D) 3. according to the international Fisher effect. B) differences in the risk free rates of return between the two countries. Inflation Multiple Choice 1) A U. Answer: A Diff: 2 Keywords: Interest Rate Parity. Arbitrage 32 Copyright © 2011 Pearson Education. . C) inflation is the same in all industrialized countries. Inc. B) central banks ensure the relationship holds to protect currency values.4) Interest rate parity exists because A) there are investors who stand ready to engage in arbitrage. D) transactions costs and taxes make markets inefficient.
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