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1. Which of the following statements best explains why a rising ratio of debt-to-total assets increases the cost of debt?

A. As the ratio increases, creditors require higher interest rates to compensate them for higher default

risk.

B. As total assets decline in relation to a stable debt level, equity declines.

C. As debt increases, the contribution of more expensive equity financing decreases.

D. If debt remains constant while the ratio increases, rising assets must be finance with more expensive

equity financing.

2. If the net present values of two mutually exclusive investments are positive, a firm should select

A. both investments.

B. neither investment.

C. the investment with the higher present value.

D. the investment with the higher net present value.

3. The flotation costs of issuing new securities

A. decrease the cost of capital.

B. encourage the retention of earnings.

C. encourage external financing.

D. don’t affect the cost of capital.

4. Which of the following statements about the cost of debt is correct?

A. The cost of debt is equal to the firm’s interest rate.

B. The cost of debt is greater than the cost of equity.

C. The cost of debt is less than the cost of equity.

D. The cost of debt is greater than the cost of preferred stock.5.

The optimal capital structure involves

5. The optimal capital structure involves

A. minimizing the cost of all funds.

B. maximizing the cost of all funds.

C. minimizing the weighted average of the cost of funds.

D. maximizing the weighted average of the cost of funds.

6. The internal rate of return and net present value methods of capital budgeting assume that the cash

flows are reinvested at the

A. cost of capital.

B. internal rate of return.

C. cost of capital for IRR and the internal rate of return for NPV.

D. cost of capital for NPV and the internal rate of return for IRR.

Use the information in the following table to answer Questions 7, 8, 9, 10, and 11.

Coupon Rate = 7 percent Marginal Tax Rate = 35 percent

Average Tax Rate = 32 percent Common Stock dividend (D0) = $6

Price of Common Stock = $80 Preferred Stock dividend = $4

Price of preferred stock = $50 Growth rate of common stock dividend = 6

percent

Bond yield risk premium = 7 percent Risk-free rate of return = 6 percent

Return on market = 12 percent Beta = 1.2

7. According to the information provided in the table, what is the cost of debt?

A. 2.45 percent C. 6.25 percent

B. 4.55 percent D. 7.0 percent

* *

8. According to the information in the table, what is the cost of preferred stock?

A. 8 percent C. 10 percent

B. 9 percent D. 12 percent

9. According to the information in the table, what is the cost of equity using the capital asset pricing

model (CAPM)?

A. 12 percent C. 13.95 percent

B. 13.2 percent D. 14.4 percent

10. According to the information in the table, what is the cost of equity using the bond yield plus risk

premium method?

A. 12 percent C. 13.95 percent

B. 13.2 percent D. 14 percent

11. According to the information in the table, what is the cost of equity using the expectedgrowth

method?

A. 12 percent C. 13.95 percent

B. 13.2 percent D. 14.4 percent

12. A firm should make an investment if the present value of the cash inflows on the investment is

A. less than zero.

B. greater than zero.

C. less than the cost of the investment.

D. greater than the cost of the investment.

13. Which of the following statements about retained earnings is correct?

A. Retained earnings have no cost.

B. Retained earnings are the firm’s cheapest source of funds.

C. Retained earnings have the same cost as new shares of stock.

D. Retained earnings are cheaper than the cost of new shares.

Use the following information to complete Questions 14, 15, 16, and 17.

A firm has two investment opportunities. Each investment costs $2,000, and the firm’s cost of capital is

8 percent. The cash flows of each investment are shown in the following table:

Cash Flow of Investment A Cash Flow of Investment B

Year 1 $1800 $900

Year 2 $600 $900

Year 3 $500 $900

Year 4 $400 $900

14. According to the information in the table, the NPV for Investment A is

A. $871. C. $2,871.

B. $1,300. D. $3,300.

15. According to the information in the table, the NPV for Investment B is

A. $980. C. $2,980.

B. $1,600. D. $3,600.

16. Based on the information in the table, if the investments are mutually exclusive, the firm should

select

A. neither investment.

B. both investments.

C. the higher-NPV investment.

D. the higher-payback investment.

17. Based on the information in the table, if the investments are independent, the firm should select

A. the higher IRR investment.

B. all investments with an IRR that’s greater than 8 percent.

C. all investments with an IRR that’s less than 8 percent.

D. only one investment if the IRR is greater than 8 percent.

18. A firm should reject an investment if the internal rate of return (IRR) on the investment is

A. greater than the cost of capital. C. greater than the interest rate.

B. less than the cost of capital. D. less than the interest rate.

19. The net present value of an investment will be higher if

A. the cost of capital is higher.

B. there’s no salvage value.

C. the cost of the investment is lower.

D. a firm uses straight-line depreciation.

20. Which of the following statements about the marginal cost of capital is correct?

A. The marginal cost of capital is a firm’s cost of debt and equity finance.

B. The marginal cost of capital is constant once the optimal capital structure is determined.

C. The marginal cost of capital declines as flotation costs alter equity financing.

D. The marginal cost of capital refers to the cost of additional funds.

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