Question 1: 2B4-LS01

What is the weighted average cost of capital (WACC) for a firm given the information in the chart?

29%. 10%. 9.7%. 9%.

The formula for determining the cost of capital is:

Where:

ka = cost of capital (expressed as a percentage)

p = proportional amount of total capital structure

k = cost of an element in the capital structure

n = different types of financing Question 2:

2B4-LS05

Which of the following methods of calculating the cost of equity reflects a market value approach?

Weighted average method. Dividend growth model. Capital asset pricing model. Historical rate of return.

The underlying logic of the dividend growth model is that market price of a stock equals the cash flow of expected future incomes (both dividends and market price appreciation)

discounted to their present value. This means that when the present value of the future cash flows equals the market price, the discount rate equals the cost of equity capital. An underlying assumption is that cash flows will grow at a constant compound rate.

Question 3: 2B4-LS09

Joint Products Inc., a corporation with a 40% marginal tax rate, plans to issue $1,000,000 of 8% preferred stock in exchange for $1,000,000 of its 8% bonds currently outstanding. The firm's total liabilities and equity are equal to $10,000,000. The effect of this exchange on the firm's weighted average cost of capital is likely to be:

*Source: Retired ICMA CMA Exam Questions.

an increase, since a portion of the debt payments are tax deductible. a decrease, since a portion of the debt payments are tax deductible.

no change, since it involves equal amounts of capital in the exchange and both instruments have the same rate.

a decrease, since preferred stock payments do not need to be made each year, whereas debt payments must be made.

This effect would increase the firm's weighted average cost of capital since the portion of debt payments are tax deductible. Preferred stock dividends are not tax deductible.

Question 4: 2B4-LS02

What is the weighted average cost of capital (WACC) for a firm given the information in the chart?

8%. 12%. 9%. 8.8%.

= 0.30(6%) + 0.35(8%) + 0.35(12%) = 8.8% Where:

ka = cost of capital (expressed as a percentage)

p = proportional amount of total capital structure

k = cost of an element in the capital structure

n = different types of financing Question 5:

2B4-LS10

In calculating the component costs of long-term funds, the appropriate cost of retained earnings, ignoring flotation costs, is equal to:

*Source: Retired ICMA CMA Exam Questions.

the same as the cost of preferred stock.

the weighted average cost of capital for the firm. the cost of common stock.

zero, or no cost.

The appropriate cost of retained earnings, ignoring flotation costs when calculating the component costs of long-term funds is equal to the cost of common stock.

Question 6: 2B4-LS08

Which of the following, when considered individually, would generally have the effect of increasing a firm's cost of capital?

I. The firm reduces its operating leverage. II. The corporate tax rate is increased.

III. The firm pays off its only outstanding debt. IV. The Treasury Bond yield increases.

*Source: Retired ICMA CMA Exam Questions.

I, III and IV. III and IV. II and IV. I and III.

The firm paying off its only outstanding debt and the Treasury Bond yield increasing would cause the firm's cost of capital to increase. The cost of capital is the weighted average cost of debt (after-tax), preferred stock, retained earnings, and common stock. Paying off the debt reduces the debt portion which has the lowest cost while leaving the more expensive portions intact. Therefore, the cost of capital would increase.

Question 7: 2B4-LS07

Which of the following statements differentiates debt capital from equity capital?

Debt capital is a function of stock issues; equity capital is a function of receivables, inventories, and payables.

Debt capital is derived from retained earnings; equity capital is derived from the issuance of notes, bonds, or loans.

Debt capital is a function of receivables, inventories, and payables; equity capital is a function of stock issues.

Debt capital is derived from the issuance of interest-bearing instruments; equity capital is derived from permanent investments by shareholders.

Corporations derive capital from essentially two sources: lenders and shareholders. Debt capital is derived from the issuance of interest-bearing instruments such as notes, bonds, or loans. Equity capital is derived from permanent investments by shareholders, either as paid-in capital or as retained earnings.

Question 8: 2B4-CQ04

An accountant for Stability Inc. must calculate the weighted average cost of capital (WACC) of the corporation using the following information.

What is the WACC of Stability?

17%. 13.4%. 10.36%. 11.5%.

WACC = (weight of long-term debt)(after-tax cost of long-term debt) + (weight of common stock)(cost of common stock) + (weight of retained earnings)(cost of retained earnings) The total of long-term debt, common stock, and retained earnings = $10,000,000 +

$10,000,000 + $5,000,000 = $25,000,000. From this information, the weight of long-term debt, common stock, and retained earnings can be determined as:

Weight for long-term debt = ($10,000,000) / ($25,000,000) = 0.4 Weight for common stock = ($10,000,000) / ($25,000,000) = 0.4. Weight for retained earnings = ($5,000,000 / $25,000,000) = 0.2 WACC = (0.4)(0.08) + (0.4)(0.18) + (0.2)(0.15) = 0.134, or 13.4% Question 9:

2B4-CQ02

Angela Company's capital structure consists entirely of long-term debt and common equity. The cost of capital for each component is shown below.

Angela pays taxes at a rate of 40%. If Angela's weighted average cost of capital is 10.41%, what proportion of the company's capital structure is in the form of long-term debt?

55%. 34%. 45%. 66%.

Angela's weighted average cost of capital (WACC) is given at 10.41%. The formula to calculate the WACC is:

WACC = (weighted cost of debt, or wi)(after-tax cost of debt) + (1 − wi)(cost of common equity)

Where: wi = the company's weighted cost (or portion) of debt

The after-tax cost of debt is calculated as follows: After-tax cost of debt = (1 − tax rate)(% cost of debt)

After-tax cost of debt = (1 − 0.4)(0.08) = 0.6(0.08) = 0.048, or 4.8%

This amount can then be substituted into the WACC formula and rearranged to solve for wi as:

10.41% = 4.8%(wi) + (1 − wi)(15%)

−4.59% = −10.2%(wi)

wi =−4.59% / −10.2% = 45%.

Question 10: 2B4-AT02

A preferred stock is sold for $101 per share, has a face value of $100 per share, underwriting fees of $5 per share, and annual dividends of $10 per share. If the tax rate is 40%, the cost of funds (capital) for the preferred stock is:

5.2%. 6.2%. 10%. 10.4%.

The cost of preferred stock is calculated by taking the preferred stock dividend and dividing it by its net price (price less flotation costs).

Cost of preferred stock = (preferred stock price) / (net price)

Cost of preferred stock = ($10) / ($101 - $5) = $10 / $96 = 0.104, or 10.4% Question 11:

2B4-CQ06

Following is an excerpt from Albion Corporation's balance sheet.

Albion's bonds are currently trading at $1,083.34, reflecting a yield to maturity of 8%. The
preferred stock is trading at $125 per share. Common stock is selling at $16 per share, and
Albion's treasurer estimates that the firm's cost of equity is 17%. If Albion's effective income tax
**rate is 40%, what is the firm's current cost of capital?**

13.9%. 11.9%. 13.1%. 14.1%.

The weighted average cost capital (WACC) is calculated as:

WACC = (weight of long-term debt)(after-tax cost of long-term debt) + (weight of common stock)(cost of common stock) + (weight of preferred stock)(cost of preferred stock)

The after-tax cost of debt if calculated as:

After-tax cost of debt = (1 − tax rate)(before-tax cost of debt) After-tax cost of debt = (1 − 0.4)(0.08) = 0.048, or 4.8% The cost of preferred stock is calculated as:

Cost of preferred stock = (dividend on preferred stock, per share) / (price of preferred stock) Dividend per share on preferred stock = (0.12)(10,000,000 / 100,000) = $12

Cost of preferred stock = ($12) / ($125) = 0.096 or 9.6%

The total of long-term debt, preferred stock, and common stock = $32,500,200 + $12,500,000 + $80,000,000 = $125,000,200 .

The weights of each of these components can be calculated as follows: Weight of long-term debt = $32,500,200 / $125,000,200 = 0.26

Weight of preferred stock = $12,500,000 / $125,000,200 = 0.10 Weight of common stock = $80,000,000 / $125,000,200 = 0.64 The WACC can now be calculated as:

WACC = (0.26)(0.048) + (0.10)(0.096) + (0.64)(0.17) = 0.0125 + 0.0096 + 0.1088 = 0.1309, or 13.1%.

Question 12: 2B4-CQ05

Kielly Machines Inc. is planning an expansion program estimated to cost $100 million. Kielly is going to raise funds according to its target capital structure shown below.

Kielly had net income available to common shareholders of $184 million last year of which 75% was paid out in dividends. The company has a marginal tax rate of 40%.

Additional data:

The before-tax cost of debt is estimated to be 11%.

The after-tax cost of retained earnings is estimated to be 16%. What is Kielly's weighted average cost of capital (WACC)?

14%. 12.22%. 13%. 13.54%.

Kielly had net income available to common shareholders of $184 million last year, of which 75% was paid out in dividends. That would mean that the remaining portion of 25% would remain as retained earnings available for investment.

Retained earnings, available for investment = (0.25)($184,000,000) = $46,000,000

The $46,000,000 in retained earnings is equal to 46% of the $100,000,000 in investment funds needed. Therefore, no issue of common stock is needed.

The WACC is calculated as:

WACC = (weight of long-term debt)(after-tax cost of long-term debt) + (weight of preferred stock)(cost of preferred stock) + (weight of retained earnings)(cost of retained earnings) The after-tax cost of debt if calculated as:

After-tax cost of debt = (1 − tax rate)(before-tax cost of debt) After-tax cost of debt = (1 − 0.4)(0.11) = 0.066, or 6.6% Therefore, the WACC can be calculated as follows: WACC = (0.3)(0.066) + (0.24)(0.12) + (0.46)(0.16)

WACC = .0198 + 0.0288 + 0.0736 = 0.1222, or 12.22%. Question 13:

2B4-AT01

**The level of safety stock in inventory management depends on all of the following except the:**

cost of running out of inventory. cost to reorder stock.

level of uncertainty in lead time for stock shipments. level of uncertainty of the sales forecast.

The purpose of a safety or buffer stock is to minimize the sum of the cost of stock-outs and the costs of carrying the buffer. Its level is independent of ordering costs.

Question 14: 2B4-AT04

Hi-Tech Inc. has determined that it can minimize its weighted average cost of capital (WACC) by using a debt to equity ratio of 2:3. If the firm's cost of debt is 9% before taxes, the cost of equity is estimated to be 12% before taxes, and the tax rate is 40%, what is the firm's WACC?

6.48%. 9.36%. 7.92%. 10.80%.

With a debt to equity ratio of 2 to 3, the company is using 2 parts debt to 3 parts equity when financing asset purchases. As such, debt represents 2/5 and equity represents 3/5 of the financing approach. To determine a company's WACC, use the following formula:

WACC = wiki + wjkj

Where:

wi = proportion of total permanent capital represented by debt

ki = after-tax cost of debt component

wj = proportion of total permanent capital represented by equity

kj = after-tax cost of equity component

(2 / 5) × (9% × (1 − 40%)) + ((3 / 5) × 12%) = 9.36%. Question 15:

2B4-CQ01

The Hatch Sausage Company is projecting an annual growth rate for the foreseeable future of 9%. The most recent dividend paid was $3.00 per share. New common stock can be issued at $36 per share. Using the constant growth model, what is the approximate cost of capital for retained earnings?

19.88%. 18.08%. 9.08%. 17.33%.

The cost of capital for retained earnings, using the Constant Dividend Growth Model (Gordon's Model) is calculated as:

Cost of capital, retained earnings = (next dividend) / (net price of common stock) + (constant growth rate)

In this case, the next dividend is calculated by taking the current dividend of $3.00 per share and multiplying it by one plus the constant growth rate, as:

Value of next dividend = $3(1 + 0.09) = $3.27

Therefore, the cost of capital for retained earnings can be calculated as:

Cost of capital, retained earnings = ($3.27 / $36) + (0.09) = 0.0908 + 0.09 = 0.1808, or 18.08%.

Question 16: 2B4-AT07

Williams Inc. is interested in measuring its overall cost of capital and has gathered the

following data. Under the terms described below, the company can sell unlimited amounts of all instruments.

Williams can raise cash by selling $1,000, 8%, 20-year bonds with annual interest payments. In selling the issue, an average premium of $30 per bond would be

received, and the firm must pay floatation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8%.

Williams can sell 8% preferred stock at par value, $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share.

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 floatation 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.

Williams preferred capital structure is

7.6%. 8.1%. 7%. 7.4%.

Using the constant dividend growth model (Gordon's model), the cost of retained earnings (Ke)

is calculated by taking the next dividend payment and dividing it by the net price plus the constant dividend growth rate. There is no dividend growth rate for Williams.

For Williams, Ke = $7/$100 = 0.07, or 7.0%.

Question 17: 2B4-AT05

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

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

Use $35 million of funds generated from earnings.

The equity market is expected to earn 12%. U.S. treasury bonds are currently yielding 5%. The beta coefficient for DQZ is estimated to be .60. DQZ is subject to an effective corporate income tax rate of 40%.

Assume that the after-tax cost of debt is 7% and the cost of equity is 12%. Determine the weighted average cost of capital (WACC).

10.5%. 9.5%. 8.5%. 15.8%.

The formula to calculate the WACC is as: Ka = p1k1+p2k2+ . . . pnkn

Where:

ka = cost of capital (expressed as a percentage)

k = cost of an element in the capital structure

n = different types of financing (each with its own cost and proportion in the capital structure) The WACC (Ka) is the weighted average costs of debt, preferred stock, retained earnings, and

common stock sales. The cost of retained earnings is the cost of internal equity while the cost of common stock is the cost of external equity.

Ka for DQZ is 10.5%, which is calculated by taking the weighted cost of debt (2.1%), plus the

weighted cost of equity (8.4%).

The 2.1% weighted cost of debt is calculated as: ($15million/$50million)(0.07) = (0.3)(0.07) = 0.021.

The 8.4% weighted cost of equity is calculated by taking the proportionate weight of equity and dividing it by the cost of equity, as follows:

($35million/$50million)(0.12) = (0.7)(0.12) = 0.084.

The sum of the weighted average cost of debt and the weighted average cost of equity is then: 0.021 + 0.084 = 0.105 (10.5%).

Question 18: 2B4-CQ03

The management of Old Fenske Company (OFC) has been reviewing the company's financing arrangements. The current financing mix is $750,000 of common stock, $200,000 of preferred stock ($50 par) and $300,000 of debt. OFC currently pays a common stock cash dividend of $2. The common stock sells for $38, and dividends have been growing at about 10% per year. Debt currently provides a yield to maturity to the investor of 12%, and preferred stock pays a dividend of 9% to yield 11%. Any new issue of securities will have a flotation cost of

approximately 3%. OFC has retained earnings available for the equity requirement. The company's effective income tax rate is 40%. Based on this information, the cost of capital for retained earnings is:

16%. 15.8%. 14.2%. 9.5%.

The cost of capital for retained earnings using the Constant Dividend Growth Model (Gordon's Model) is calculated as follows:

Cost of capital, retained earnings = (next dividend) / (net price of the common stock) + (constant growth rate)

The next dividend is calculated by taking the current dividend per share and multiplying it by one plus the constant growth rate.

Next dividend = (current dividend)(1 + constant growth rate)

Next dividend = ($2.00 per share)(1 + 10%) = $2(1.1) = $2.20 per share The cost of capital for retained earnings can then be calculated:

Cost of capital, retained earnings = ($2.20 / $38) + (0.1) = 0.058 + 0.1 = 0.158, or 15.8%. Question 19:

2B4-AT08

Williams Inc. is interested in measuring its overall cost of capital and has gathered the

following data. Under the terms described below, the company can sell unlimited amounts of all instruments.

Williams can raise cash by selling $1,000, 8%, 20-year bonds with annual interest payments. In selling the issue, an average premium of $30 per bond would be

received, and the firm must pay floatation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8%.

Williams can sell 8% preferred stock at par value, $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share.

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 floatation 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.

Williams preferred capital structure is

If Williams Inc. needs a total of $200,000, the firm's weighted average cost of capital(WACC) would be:

6.6%. 4.8%. 7.3%.

6.8%.

The WACC (rounded to one decimal place) is 6.6%. The formula to calculate the WACC is: Ka = p1k1 + p2k2 + . . . pnkn

Where:

ka = cost of capital (expressed as a percentage)

k = cost of an element in the capital structure

p = proportion that element comprises of the total capital structure

n = different types of financing (each with its own cost and proportion in the capital structure) The WACC (Ka) is the weighted average costs of debt, preferred stock and retained earnings.

The cost of debt is 4.8% and its weight is 0.3 (or 30%).

The cost of preferred stock is the preferred stock dividend divided by its net price (price less flotation costs) which is [0.08 ($105)] / ($105−$5) = (8.4/100) = .084 (or 8.4%).

The weight for preferred stock is 0.2 (or 20%).

Using the constant dividend growth model (Gordon's model), the cost of retained earnings (Ke)

is calculated by taking the next dividend payment and dividing it by the net price plus the constant dividend growth rate. There is no dividend growth rate for Williams.

For Williams, Ke = $7/$100 = 0.07 (or 7%).

The weight for retained earnings is 0.5 (or 50%).

Therefore, Ka = 0.3(0.048) + 0.2(0.084) + 0.5(0.07) = 0.0144 + 0.0168 + 0.035 = 0.0662 (6.6%

rounded). Question 20: 2B4-AT03

Williams Inc. is interested in measuring its overall cost of capital and has gathered the

following data. Under the terms described below, the company can sell unlimited amounts of all instruments.

Williams can raise cash by selling $1,000, 8%, 20-year bonds with annual interest payments. In selling the issue, an average premium of $30 per bond would be

received, and the firm must pay floatation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8%.

Williams can sell 8 percent preferred stock at par value, $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share.

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 floatation 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.

Williams preferred capital structure is

If Williams Inc. needs a total of $1,000,000, the firm's weighted average cost of capital (WACC) would be:

9.1%. 4.8%. 6.5%. 6.9%.

The WACC (rounded to one decimal place) is 6.9%. The formula to calculate the WACC is as: Ka = p1k1 + p2k2 + . . . pnkn

Where:

ka = cost of capital (expressed as a percentage)

p = proportion that element comprises of the total capital structure k = cost of an element in the capital structure

n = different types of financing (each with its own cost and proportion in the capital structure) The WACC (Ka) is the weighted average costs of debt, preferred stock, retained earnings, and

common stock sales.

The cost of debt is 4.8% and its weight is 0.3 (30%).

The cost of preferred stock is the preferred stock dividend divided by its net price (price less flotation costs) which is 0.08($105)/($105−$5) = $8.4/$100 = .084 (or 8.4%).

The cost of retained earnings is the cost of internal equity. The cost of common stock is the cost of external equity.

Using the constant dividend growth model (Gordon's model), the cost of retained earnings (Ke)

is calculated by taking the next dividend payment and dividing it by the net price plus the constant dividend growth rate. There is no dividend growth rate for Williams.

For Williams , Kee = $7 / ($100−$3−$5) = $7 / $92 = .076 (or 7.6%).

Therefore, Ka = 0.3(0.048) + 0.2(0.084) + 0.1(0.07) + 0.4(0.076) = 0.0144 + 0.0168 + 0.007 +

0.0304 = 0.0686 (or 6.9% rounded). Question 21:

2B4-CQ07

Thomas Company's capital structure consists of 30% long-term debt, 25% preferred stock, and 45% common equity. The cost of capital for each component is shown below.

If Thomas pays taxes at the rate of 40%, what is the company's after-tax weighted average cost of capital (WACC)?

11.9%. 9.84%. 10.94%. 7.14%.

The WACC is calculated as:

WACC = (weight of long-term debt)(after-tax cost of long-term debt) + (weight of preferred stock)(cost of preferred stock) + (weight of common equity)(cost of common equity)

The after-tax cost of debt is calculated as:

After-tax cost of debt = (1 − tax rate)(before-tax cost of debt)

After-tax cost of debt = (1 − 0.4)(0.08) = (0.6)(0.08) = 0.048, or 4.8%

Therefore, WACC = (0.3)(0.048) + (0.25)(0.11) + (0.45)(0.15) = 0.0144 + 0.0275 + 0.0675 = 0.1094, or 10.94%.

Question 22: 2B4-LS06

**Which of the following statements best describes how a corporation determines its cost of **
capital?

The cost is derived only from permanent investments by shareholders. The cost is a function of the issuance of interest-bearing instruments.

The cost is derived from determining the cost of each component in a firm's capital structure. The cost is a function of temporary (short-term) sources of financing.

Determining the cost of each component in a firm's capital structure is the first step in

calculating the cost of capital. This involves determining the cost of debt, the cost of preferred stock, the cost of common equity, and/or any other methods of financing.

Question 23: 2B4-LS03

**Which of the following statements about the cost of debt is incorrect?**

Interest costs may be calculated in various ways.

A weighted average of yields-to-maturity should be used to calculate the cost of debt when one or more types of debt are involved.

The cost of debt should be considered on a before-tax basis.

The market value of debt is generally used when calculating the cost of capital.

Since the interest payments on corporate debt are a tax-deductible expense, the cost of debt should be considered on an after-tax basis.

Question 24: 2B4-LS04

A firm plans to use the historical rate of return to determine the cost of equity capital. In order
**to use the historical rate, all of the following conditions should existexcept which of the **

following?

The firm's performance will hold steady. Interest rates will not significantly change. Investor attitude toward risk will not change.

Expected future cash flows will be discounted to present values.

The historical method implies that (1) the firm's performance will not significantly change in the future, (2) no significant changes in interest rates will occur, and (3) investor attitude toward risk will not change. The historical method is relatively easy to calculate, but the limitation is that the future rarely remains the same as the past.

Question 25: 2B4-AT06

Williams Inc. is interested in measuring its overall cost of capital and has gathered the

Williams can sell 8% preferred stock at par value, $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share.

Williams preferred capital structure is

The cost of funds from the sale of common stock for Williams Inc. is:

7.4%. 7%. 8.1%. 7.6%.

Using the constant dividend growth model (Gordon's model), the cost of the sale of common stock (Ke) is calculated by taking the next dividend payment and dividing it by the net price

(price less discount, less flotation costs) plus the constant dividend growth rate. There is no dividend growth rate for Williams.

Question 26: 2B4-AT09

Osgood Products has announced that it plans to finance future investments so that the firm will achieve an optimum capital structure. Which one of the following corporate objectives is

consistent with this announcement?

Minimize the cost of debt. Maximize earnings per share. Minimize the cost of equity.

Maximize the net value of the firm.

The goal of the firm is to maximize shareholder wealth. Shareholder wealth is the value of the firm. It is also the present value of the firm's future cash flows at the marginal

weighted-average cost of capital (Ka). The smaller Ka is, the higher the present value. The optimal capital

structure for the firm is the one that minimizes Ka, and, therefore, maximizes the value of the