IMANET IMANET Certifications IMANET-CMA Questions & Answers

• Question 751:

  In referring to the graph of a firm's cost of capital, if e is the current position, which one of the following statements best explains the saucer or U-shaped curve?

  

  A. The cost of capital is almost always favorably' influenced by increases in financial leverage

  B. The cost of capital is almost always negative' influenced by increases in financial leverage.

  C. The financial markets will penalize firms that borrow even in moderate amounts

  D. Use of at least some debt financing will enhance the value of the firm.

  Correct Answer: D

  The U-shaped curie indicates that the cost of capital is quite high when the debt-to-equity ratio is quite low. As debt increases, the cost of capital declines as long as the cost of debt is less than that of equity. Eventually, the decline in the cost of capital levels off because the cost of debt ultimately rises as more debt is used. Additional increases in debt (relative to equity) will then increase the cost of capital. The implication is that some debt is present in the optimal capital structure because the cost of capital initially declines when debt is added. However, a point is reached at which debt becomes excessive and the cost of capital begins to rise.

• Question 752:

  A firm seeking to optimize its capital budget has calculated its marginal cost of capital and projected rates of return on several potential projects. The optimal capital budget is determined by

  A. Calculating the point at which marginal cost of capital meets the projected rate of return, assuming that the most profitable projects are accepted first.

  B. Calculating the point at which average marginal cost meets average projected rate of return, assuming the largest projects are accepted first.

  C. Accepting all potential projects with projected rates of return exceeding the lowest marginal cost of capital

  D. Accepting all potential projects with projected rates of return lower than the highest marginal cost of capital.

  Correct Answer: A

  In economics, a basic principle is that a firm should increase output until marginal cost equals marginal revenue. Similarly, the optimal capital budget is determined by calculating the point at which marginal cost of capital (which increases as capital requirements increase) and marginal efficiency of investment (which decreases if the most profitable projects are accepted first) intersect.

• Question 753:

  A firm's optimal capital structure

  A. Minimizes the firm's tax liability.

  B. Minimizes the firm's risk.

  C. Maximizes the firm's degree of financial leverage

  D. Maximizes the price of the firm's stock.

  Correct Answer: D

  Standard financial theory states that the optimal capital structure of a firm is the permanent, long-term financing of the firm represented by long-term debt, preferred stock, and common stock, Capital structure is distinguished from financial structure, which includes short-term debt plus the long-term accounts. The optimal capital structure minimizes the weighted-average cost of capital and thereby maximizes the value of the firm reflected in its stock price.

• Question 754:

  The interest rate on the bonds is greater to Rogers. Inc. for the second alternative consisting of pure debt than it is for the first alternative consisting of both debt and equity because the

  A. Diversity of the combination alternative creates greater risk for the investor.

  B. Pure debt alternative would flood the market and be more difficult to sell.

  C. Pure debt alternative carries the risk of increasing the probability of default,

  D. Combination alternative carries the risk of increasing dividend payments.

  Correct Answer: C

  As a larger proportion of an entity's capital is provided by debt, the debt becomes riskier and more expensive. Hence, it requires a higher interest rate

• Question 755:

  The after-tax cost of the common stock proposed in Rogers' first financing alternative would be

  A. 16.00%

  B. 16.53%

  C. 16.60%

  D. 17.16%

  Correct Answer: D

• Question 756:

  Assuming the after-tax cost of common stock is 15%, the after-tax weighted marginal cost of capital for Rogers' first financing alternative consisting of bonds, preferred stock, and common stock would be

  A. 7.285%

  B. 8725%

  C. 10.375%

  D. 11.700%

  Correct Answer: C

• Question 757:

  The after-tax weighted marginal cost of capital for Rogers' second financing alternative consisting solely of bonds would be

  A. 5.13%

  B. 5.40%

  C. 6.27%

  D. 6.60%

  Correct Answer: D

  The cost of the bonds equals the interest rate times one minus the tax rate, or 66O% [11% x (100% -40%)]. Rogers. Inc. operates a chain of restaurants located in the Southeast. The company has steadily grown to its present size of 48 restaurants. The board of directors recently approved a large-scale remodeling of the restaurant, and the company is now considering two financing alternatives.

  o The first alternative would consist of

  o Bonds that would have a 9% coupon rate and reissued at their base amount would net $19.2 million after a 4% flotation cost

  o Preferred stock with a stated rate of 6% that would yield $4.8 million after a 4% flotation cost

  o Common stock that would yield $24 million after a 5% flotation cost o The second alternative would consist of a public offering of bonds that would have an 11% market rate and would net $48 million after flotation costs. Rogers' current capital structure, which is considered optimal, consists of 40% long-term debt, 10% preferred stock, and 50% common stock. The current market value of the common stock is $30 per share, and the common stock dividend during the past 12 months was $3 per share Investors are expecting the growth rate of dividends to equal the historical rate of 6%. Rogers is subject to an effective income tax rate of 40%.

• Question 758:

  Which of the following is true regarding the calculation of a firms cost of capital?

  A. The cost of capital of a firm is the weighted-average cost of its various financing components

  B. All costs should be expressed as pre-tax costs

  C. The time value of money should be excluded from the calculations.

  D. The cost of capital is the cost of equity.

  Correct Answer: A

  The cost of capital of a firm is the current, weighted-average, after-tax cost of the firm's various financing components. Historical costs are irrelevant. Rogers. Inc. operates a chain of restaurants located in the Southeast. The company has steadily grown to its present size of 48 restaurants. The board of directors recently approved a large-scale remodeling of the restaurant, and the company is now considering two financing alternatives. The first alternative would consist of o Bonds that would have a 9% coupon rate and reissued at their base amount would net $19.2 million after a 4% flotation cost Preferred stock with a stated rate of 6% that would yield $4.8 million after a 4% flotation cost Common stock that would yield $24 million after a 5% flotation cost o The second alternative would consist of a public offering of bonds that would have an 11% market rate and would net $48 million alter flotation costs. Rogers' current capital structure, which is considered optimal, consists of 40% long-term debt, 10% preferred stock, and 50% common stock. The current market value of the common stock is $30 per share, and the common stock dividend during the past 12 months was $3 per share. Investors are expecting the growth rate of dividends to equal the historical rate of 6%. Rogers is subject to an effective income tax rate of 40%

• Question 759:

  When calculating a firm's cost of capital, all of the following are true except that

  A. The cost of capital of a firm is the weighted average cost of its various financing components.

  B. The calculation of the cost of capital should focus on the historical costs of alternative forms of financing rather than market or current costs.

  C. All costs should be expressed as after-tax costs.

  D. The time value of money should be incorporated into the calculations.

  Correct Answer: B

  The cost of capital of a firm is the current, weighted average, after-tax cost of the firm's various financing components Historical costs are irrelevant.

• Question 760:

  The DCL Corporation is preparing to evaluate the capital expenditure proposals for the coming year.

  Because the firm employs discounted cash flow methods of analyses. the cost of capital for the firm must

  be estimated. The following information for DCL Corporation is provided.

  Market price of common stock is $50 per share.

  The dividend next year is expected to be $2.50 per share.

  Expected growth in dividends is a constant 10%.

  New bonds can be issued at face value with a 13% coupon rate.

  The current capital structure of 40% long-term debt and 60% equity is considered to be optimal

  Anticipated earnings to be retained in the coming year are $3 million.

  The firm has a 40% marginal tax rate.

  If the firm must assume a 10% flotation cost on new stock issuances. what is the cost of new common

  stock?

  A. 1611%.

  B. 15.56%.

  C. 15.05%.

  D. 15.00%.

  Correct Answer: B

  The formula to determine the cost of retained earnings, with the additional flotation cost entered into the calculation, is Cost of new common stock = {D, + [P x (1 -- Flotation cost)]} + G Where: Di = next dividend Po = current price G = growth rate in dividends per share (but the model assumes that the dividend-payout ratio, retention rate, and therefore the EPS growth rate are constant). This yields a cost of new common stock of 15.56%. Cost of new common stock = {$2.50 ` [$50.00 x (1.0-- 0..1)] + 01 = ($2.50 + $45.00) + 01 = 0.0556 + 0.1 = 0.1556