QUIZ- COST OF CAPITAL

1. The overall (weighted average) cost of capital is composed of a weighted average of _

a) The cost of common equity and the cost of debt
b) The cost of common equity and the cost of preferred stock
c) The cost of preferred stock and the cost of debt
d) The cost of common equity, the cost of preferred stock, and the cost of debt

3. What is the overall (weighted average) cost of capital in the following situation? The
firm has Rs10 million in long-term debt, Rs2 million in preferred stock, and Rs 8 million
in common equity -- all at market values. The before-tax cost for debt, preferred stock,
and common equity forms of capital are 8%, 9%, and 15%, respectively. Assume a 40%
tax rate.
a) 6.40% b) 6.54% c) 9.30% d) 10.90%

4. For which of the following costs is it generally necessary to apply a tax adjustment to
a yield measure?

a) Cost of debt c) Cost of preferred stock

b) Cost of common equity d) Cost of retained earnings

5. Which of the following is not a recognized approach for determining the cost of
equity?
a) Dividend discount model approach
b) Before-tax cost of preferred stock plus risk premium approach
c) Capital-asset pricing model approach
d) Before-tax cost of debt plus risk premium approach

7. Jacques Fauxpas is attempting to determine his company's weighted-average cost of

capital. His first step was to determine the required rates of return for his company's long-
term debt, preferred stock, and common stock. He then adjusted these required rates of
return by multiplying each return by one minus the company's marginal tax rate. Jacques
is planning on using these three adjusted required return figures as his component costs of
capital. How is Jacques doing so far?

a) All three of Jacques' components cost figures are incorrect.

b) All three component cost figures are correct.
c) Only the required return (yield) on preferred stock and debt should have been
adjusted for taxes.
d) Only the required return (yield) on debt should have been adjusted for taxes.

8. What is the difference between economic profit and accounting profit?

a) Economic profit includes a charge for all providers of capital while accounting
profit includes only a charge for debt.
b) Economic profit covers the profit over the life of the firm, while accounting profit
only covers the most recent accounting period.
c) Accounting profit is based on current accepted accounting rules while economic
profit is based on cash flows.
d) All of the above are correct.

10. A company that has more than half of its voting shares owned by another company is
generally referred to as a __________ of the other firm.

a) Joint-venture partner b) Proxy c) Subsidiary d) Division

 1) The capital structure of Vikas Ltd. as follows:
Source Book Value Market Value

Equity share capital 10,00,000 20,00,000 (200% of book value)

Retained earnings 5,00,000 7,00,000 (Just par)
14% Preference share capital 7,00,000 6,00,000 (Just par)
12% Debentures 6,00,000

After tax, cost of capital of these different sources is Equity share capital 18%, Retained
earnings 15%, Preference share capital 14%, and debenture 8%. Calculate the weighted
average cost of capital of the company.

2) Good health Ltd. has a gearing of 30%. Cost of equity is computed at 21% and the
cost of debt 14%. The tax rate is 40%. Calculate WACC of the company.

3) Hindustan Chemical Ltd. has a paid up equity capital 6, 00,000 equity shares of
Rs.10 each. The current MP of share is Rs 24. During the current year, the
company has declared a dividend of Rs 6/share. The company has also previously
issued 14% preference shares of Rs.10 each aggregating Rs 30 lakhs and 13%
50,000 debentures of Rs 100 each. The company’s corporate tax rate is 40%, the
growth in dividends on equity share is expected at 5%. In case of preference share
the company has received only 95% of the face value of share after deducting
issue expenses. Calculate WACC of the company.

4) The detail of dividend paid by Cool Ltd. on existing equity share of Rs 10 each
for the past 6 years is given below:

Year Dividend/ share Year Dividend/ share

1995 1.05 1998 1.21
1996 1.10 1999 1.27
1997 1.16 2000 1.34

5) The MP of equity share is Rs. 40. It is expected to maintain a fixed dividend payout ratio
in the future. The company has issued new equity share of Rs.0.50/share. The expected
dividend to be declared for the current year is Rs. 1.40. Compute cost of equity

6) The shares of Campbell Ltd. are selling at Rs.24/ share. The firm has paid dividend of
Rs 24/share. The firm paid the dividend of Rs 1.30/share last year. The estimated g of the
company is approx. 5%/year. Determine the cost of equity capital of the company.
8). The capital structure of Foster Medical (given in terms of both book value and market
value) is as follows: Book Value Market Value After-tax Cost
Bonds Rs15,000,000 & Rs13,000,000 @ 7.0%
Preferred stock 2,000,000 & 2,500,000 @ 9.0%
Common equity 9,000,000 & 18,500,000 @14.0%
Retained Earnings 4,000,000 _________
Total Rs 30,000,000 & Rs 34,000,000

a. What is the weighted average cost of capital using both Book Value and Market Value
calculations for Foster Medical?
b. What is theoretically the best weighting method? Why?

Answers to Quiz
1) The cost of common equity, the cost of preferred stock, and the cost of debt

2) 9.30%

3) Cost of debt

4) 15.0%

5) Only the required return (yield) on debt should have been adjusted for taxes.

6) Economic profit includes a charge for all providers of capital while accounting
profit includes only a charge for debt.

7) Different projects should have different required rates of return because they are
not alike with respect to risk.

8) Subsidiary

9) The component cost of debt is based on the firm's component cost of debt.