FINANCE 361: EXAM 3 UPDATED ACTUAL QUESTIONS AND CORRECT ANSWERS

FINANCE 361: EXAM 3 UPDATED ACTUAL QUESTIONS
AND CORRECT ANSWERS

Question:
1. True or false: The component costs of capital are market-determined variables in the sense that they are
based on investors' required returns
Answer:
True

Question:
2. T or F: The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost
of debt for purposes of developing the firm's WACC.
Answer:
False

Question:
3. T or F: The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon
rate on all outstanding debt.
Answer:
False

Question:
4. T or F: The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new
debt
Answer:
True

Question:
5. True or False: The cost of perpetual preferred stock is found as the preferred's annual dividend divided
by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends,
unlike interest on debt, are not deductible by the issuing firm
Answer:
True

Question:
6. True or False: For capital budgeting and cost of capital purposes, the firm should always consider
retained earnings as the first source of capital (i.e., use these funds first) because retained earnings have no
cost to the firm.
Answer:
False

Question:
7. T or F: If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of
debt used to calculate its WACC.

, Answer:
True

Question:
8. T or F: The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other
things held constant.
Answer:
False

Question:
9. Which of the following is NOT a capital component when calculating the weighted average cost of
capital (WACC) for use in capital budgeting?
a. Long-term debt. b. Accounts payable. c. Common stock.
d. Preferred stock
Answer:
B. accounts payable

Question:
10. Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A's cost of capital
is
10.0%, Division B's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A's
projects are equally risky, as are all of Division B's projects. However, the projects of Division A are less
risky than those of Division B. Which of the following projects should the firm accept?
a. A Division B project with a 13% return. b. A Division B project with a 12% return.
c. A Division A project with an 11% return. d. A Division A project with a 9% return.
e. A Division B project with an 11% return.
Answer:
C

Question:
11. Which of the following statements is CORRECT?
a. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are
deductible by the paying corporation.
b. When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid
on preferred stock are deductible by the paying corporation.
c. Because of tax effects, an increase in the risk-free rate will have a greater effect on the aftertax cost of
debt than on the cost of common stock as measured by the CAPM.
d. If a company's beta increases, this will increase the cost of equity used to calculate the WACC, but only
if the company does not have enough retained earnings to take care of its equity financing and hence must
issue new stock.
e. Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's
WACC.
Answer:
A