TYBCOM SEM 5|| Financial Management|| Cost of Capital MCQ

 

Financial Management

Video : MCQ of Cost of Capital

1. Suppose that a firm has 20% debts and 80% equity in its capital structure. The cost of debts and cost of equity are assumed to be 10% and 15% respectively, What is the overall cost of capital?

1. 11%

2. 12%

3. 13%

4. 14%

Correct Answer: Option 4 

Solution:

A firm’s Weighted Average Cost of Capital (WACC) represents its blended cost of capital across all sources, including common shares, preferred shares, and debt.

The cost of each type of capital is weighted by its percentage of total capital and they are added together.

WACC = (10 x 0.20) + (15 x 0.80)

∴ WACC = 2 + 12

∴WACC = 14%

The overall cost of capital is 14%.

Thus, option 4 is the correct answer.

3. Redeemable preference shares of Rs. 2,00,000 are to be redeemed at par for which fresh equity shares of Rs. 80,000 are issued at a discount of 10%. What amount should be transferred to Capital Redemption Reserve Account?

1. Rs. 2,00,000


2. Rs. 1,20,000


3. Rs. 1,28,000


4. Rs. 72,000

Correct Answer: Option 3 (Solution Below)

Solution:

Transfer To Capital Redemption Reserve Account = Preference shares redemption amount – Fresh equity shares amount 

= 200000 - (80000 - 8000)

= 200000 - 7200

= Rs. 1,28,000. 

Therefore, if Redeemable preference shares of Rs. 2,00,000 are to be redeemed at par for which fresh equity shares of Rs. 80,000 are issued at a discount of 10% the amount to be transferred to Capital Redemption Reserve Account will be Rs. 1,28,000.

4. Which of the following is an implicit cost of increasing proportion of debt of a company ?

1. P.E. Ratio of the company would increase


2. Rate of return of the company would decrease.


3. Tax - shield would not be available on new debts.


4. Equity shareholders would demand higher return

Correct Answer: Option 4 (Solution Below)

Solution:

Implicit cost is opportunity cost or hidden cost and it does not require an actual outflow of money. Implicit cost occurs when a company uses resources that belong to the owner like capital and inventories, etc.

The implicit cost of increasing the proportion of debt of a company is equity shareholders would demand higher returns due to the following reasons:

• The return on equity given to the shareholders is the money given to the owners as a percentage of the money they have invested in the company. 
• In the long-run debt is cheaper than equity as debt gives tax benefits to the company.
• So when the company increases the proportion of debt, the higher returns are calculated by dividing the earnings of the company after deducting the taxes by the equity of the total number of shareholders in the company.
• Equity shareholders will thereafter demand higher returns on their investment.
• The formula for Return On Equity (ROE) = Net Income / Shareholder's equity.

Therefore, Equity shareholders would demand a higher return is an implicit cost of increasing the proportion of debt of a company.  

Debt Financing Advantages and Disadvantages:

Advantages	Disadvantages
Retain control over the business	Qualification requirements like a good credit rating to receive money
Various tax advantages	Collateral risk of assets
Easy to make plans for finance	Hard to have the financial discipline to repay on time

5. Cost of Equity Share Capital is more than cost of Debt because :

1. Equity shares are not easily saleable.


2. Equity shares do not provide the fixed dividend rate.


3. Generally the face value of equity shares is less than the face value of debentures.


4. Equity shares have high risk than debts.

Correct Answer: Option 4 (Solution Below)

Solution:

Cost of equity share capital refers to the rate of return which is paid to the shareholders for their investment, to compensate for the risk they undertake.

Cost of debt is the amount of interest rate a company has to pay on its debts i.e. loans, bonds, credit card interests, etc.

Cost of Equity share is usually more than cost of Debt because:

• The debt is secured against the securities and has a fixed return on interest resulting in less risk.
• In the cost of equity share capital, there is the uncertainty of dividend and repayment of capital.
• Thus, equity shares are considered as of high risk than debts. 

Therefore, the Cost of Equity Share Capital is more than the cost of Debt because Equity shares have high risk than debts.

Cost of Equity Share (Ke) Formula For Dividend Companies: Ke = DPS/MPS + r,

Where, DPS = Dividend Per Share, MPS = Market Price per Share, r = Growth rate of Dividend.

Cost of Debt (Kd) Formula:

• Pre-tax formula: Kd = (Total Interest Cost Occurred / Total Debt)*100
• Post-tax formula: Kd = [(Total Interest Cost Occurred * (1- Effective tax rate) / Total Debt]*10

6. Which of the sources of finance has an implicit cost of capital?

1. Equity share capital

2. Preference share capital

3. Debentures

4. Retained earnings

Correct Answer: Option 4 (Solution Below)

Solution:

Implicit costs 

1. They are a specific type of opportunity cost: the cost of resources already owned by the firm that could have been put to some other use.
2. For example, an entrepreneur who owns a business could use her labor to earn income at a job.
3. Implicit cost is that cost that has already been occurred but is not shown or reported as a separate expense.
4. Its an opportunity cost that arises when a company uses internal sources towards a project without any compensation for the utilization of the resource.
5. Retained earnings is an internal source.

Explicit Cost:

1. Explicit costs are out-of-pocket costs for a firm—for example, payments for wages and salaries, rent, or materials.

• The implicit cost of retained earnings is the return that could have been earned by the investors, had the profit been distributed to them.
• Except for the retained earning, all other sources of funds have explicit costs of capital.

7. The current market price of a company's share is Rs. 90 and the expected dividend per share next year is Rs. 4.5. If the dividend is expected to grow at a constant rate of 8%, the shareholder's required rate of return will be

1. 8%


2. 5%


3. 20%


4. 13%

Correct Answer: Option 4 (Solution Below)

Solution:

The required rate of return is the minimum return an investor will accept for owning a company's stock, as compensation for a given level of risk associated with holding the stock. The RRR is also used in corporate finance to analyze the profitability of potential investment projects.

Shareholder's Required Return = (D1/P0 * 100) + G

Where, D1 = Expected Dividend For Next Year

             P0 = Current Market Price Of Share

             G   = Growth Rate

Shareholder's Required Return = (4.5/90 * 100) + 8 = 5 + 8 = 13%

Therefore, if the current market price of a company's share is Rs. 90 and the expected dividend per share next year is Rs. 4.5. If the dividend is expected to grow at a constant rate of 8%, the shareholder's required rate of return will be 13%.

8. A company issues 10% irredeemable preference shares. The face value per share is Rs. 100, but the issue price is Rs. 95. What is the cost of preference share?

1. 10.63%


2. 10.73%


3. 10.83%


4. 10.53%

Correct Answer: Option 4 (Solution Below)

Solution:

Cost Of Preference Share = Annual Dividend Of Preference Shares / Market Price Of The Preference Stock 

                                           = 100 * 10% / 95

                                           = 10 / 95 

                                           = 0.10526 = 10.53%

9. Assertion A): According to Net Income (NI) approach, capital structure decision is relevant in the valuation of firm.

Reason R): A firm can change its total value and its overall cost of capital by change in the degree of leverage in its capital structure.

In the context of the above two statements, which one of the following options is correct?

1. Both A) and R) are correct and R) is the right explanation of A)


2. Both A) and R) are correct and R) is not the right explanation of A)


3. Both A) and R) are incorrect


4. A) is correct and R) is not correct

Correct Answer: Option 1 (Solution Below)

Solution:

Net Income (NI) Theory:

According to this approach, capital structure decision is relevant to the valuation of the firm in as much as a change in the pattern of capitalization brings about a corresponding change in the overall cost of capital and the total value of the firm. This theory, also known as fixed 'ke' theory, was propounded by David Durand.

The critical assumptions of this theory are:

1. There are no corporate taxes.
2. The debt content does not change the risk perception of the investors.
3. The cost of debt is less than the cost of equity.

The theory works like this. “As the proposition of cheaper debt funds in the capital structure increases, the weighted average cost of capital decreases and approaches the cost of debt. This theory recommends 100% debt financing is optimal capital structure.

The following are the strengths of the NI approach:

1. it tries to explain the effects of borrowings on the overall cost of capital.
2. It explains and emphasizes favorable financial leverage.
3. However, the theory ignores risk consideration.

Thus, Both A) and R) are correct and R) is the right explanation of A.

10.  Match the items of the following two lists and suggest the correct code:

List – I	List – II
a. Pay-back Rate of Return	i. Discounted Cash Flow Technique
b. Internal Rate of Return	ii. Compounded values of investments and returns
c. Benefit-Cost Ratio	iii. Crude method for project evaluation
d. Net Terminal Value Method	iv. Varying sized projects evaluation

Options:

1. a-ii b-iii c-i d-iv


2. a-iii b-i c-iv d-ii


3. a-i b-iv c-ii d-iii


4. a-iv b-ii c-iii d-i

Correct Answer: Option 2 (Solution Below)

Solution:

List - I	Answer
a. Pay-back Rate of Return	It is the time required to recover the funds invested initially. This method is used to evaluate a project whose payback period is minimum.
b. Internal Rate of Return	It is used to estimate the rate of return of the investment after accounting for all discounted cash flows together with the time value of money.
c. Benefit-Cost Ratio	It is used to determine the overall value of money for undertaking the evaluation of different sized projects.
d. Net Terminal Value Method	This method is used in valuing a company by taking the sum of all cash flows from an investment on a specified rate of return. In other words, compounded values of investments and returns.

Therefore, from the above explanation, it is clear that option 2) is the correct answer. 

11. Which of the following is not an assumption of the capital asset pricing model 

(CAPM)?

(a) The capital Market is efficient

(b) Investors lend or borrow at a risk-free rate of return

(c) Investors do not have the same expectations about the risk and return 

(d) Investor’s decisions are based on a single-time period

Ans:c

12. Which of the following sources of funds is related to Implicit Cost of Capital?

(a) Equity Share Capital,

(b) Preference Share Capital,

(c) Debentures,

(d) Retained earnings.

Ans: D

13. Which of the following cost of capital require to adjust tax?

(a) Cost of Equity Shares,

(b) Cost of Preference Shares,

(c) Cost of Debentures,

(d) Cost of Retained Earnings.

Ans:c

14. Marginal Cost of capital is the cost of:

(a) Additional Revenue,

(b) Additional Funds,

(c) Additional Interests, 

(d) None of the above.

Ans: B

15. In order to calculate Weighted Average Cost of Capital, weights may be based on:

(a) Market Values,

(b) Target Values

(c) Book Values,

(d) Anyone.

Ans:D

16. Firm’s Cost of Capital is the average cost of :

(a) All sources of finance,

(b) All Borrowings,

(c) All share capital,

(d) All Bonds & Debentures.

Ans: A

17. Cost of equity share or debt is called ___
(A) Related cost of capital
(B) Easy to calculate the cost of capital
(C) Specific cost of capital
(D) Burden on the shareholder

Answer:
(C) Specific cost of capital

18. In which of the cost of the following method of equity capital is computed by dividing the dividend by market price per share or net proceeds per share?
(A) Price Earning Method
(B) Adjusted Price Method
(C) Adjusted Dividend Method
(D) Dividend Yield Method

Answer:
(D) Dividend Yield Method

19. In weighted average cost of capital, a company can affect its capital cost through____
1. Policy of capital structure
2. Policy of dividends
3. Policy of investment,
Select the correct answer from the options given below:
(A) 1 only
(B) 2 & 3
(C) 1 & 3
(D) All 1, 2 & 3

Answer:

(D) All 1, 2 & 3

20.The cost of equity share or debt is called specific cost of capital. When specific costs are combined, then we arrive at –

(A) Maximum rate of return
(B) Internal rate of return
(C) Overall cost of capital
(D) Accounting rate of return

Answer:
(C) Overall cost of capital