Question 1

Adams Inc.has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05.What is the firm's cost of common from reinvested earnings based on the CAPM?

Accepted Answer

A)  11.30% 
B)  11.64% 
C)  11.99% 
D)  12.35% 
E)  12.72% 
A)  11.30% 
B)  11.64% 
C)  11.99% 
D)  12.35% 
E)  12.72%

Question 2

Granby Foods' (GF)balance sheet shows a total of $25 million long-term debt with a coupon rate of 8.50%.The yield to maturity on this debt is 8.00%,and the debt has a total current market value of $27 million.The company has 10 million shares of stock,and the stock has a book value per share of $5.00.The current stock price is $20.00 per share,and stockholders' required rate of return,rs,is 12.25%.The company recently decided that its target capital structure should have 35% debt,with the balance being common equity.The tax rate is 40%.Calculate WACCs based on book,market,and target capital structures.What is the sum of these three WACCs?

Accepted Answer

A)  28.36% 
B)  29.54% 
C)  30.77% 
D)  32.00% 
E)  33.28% 
A)  28.36% 
B)  29.54% 
C)  30.77% 
D)  32.00% 
E)  33.28%

Question 3

If the expected dividend growth rate is zero,then the cost of external equity capital raised by issuing new common stock (re)is equal to the cost of equity capital from retaining earnings (rs)divided by one minus the percentage flotation cost required to sell the new stock, (1 - F).If the expected growth rate is not zero,then the cost of external equity must be found using a different formula.

Accepted Answer

A) True 
 B)False

Question 4

Exhibit 9.1
The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.
   
The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%.
-Refer to Exhibit 9.1.Which of the following is the best estimate for the weight of debt for use in calculating the firm's WACC?

Accepted Answer

A)  18.67% 
B)  19.60% 
C)  20.58% 
D)  21.61% 
E)  22.69% 
A)  18.67% 
B)  19.60% 
C)  20.58% 
D)  21.61% 
E)  22.69%

Question 5

The Anderson Company has equal amounts of low-risk,average-risk,and high-risk projects.The firm's overall WACC is 12%.The CFO believes that this is the correct WACC for the company's average-risk projects,but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects.The CEO disagrees,on the grounds that even though projects have different risks,the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources.If the CEO's position is accepted,what is likely to happen over time?

Accepted Answer

A)  The company will take on too many low-risk projects and reject too many high-risk projects. 
B)  Things will generally even out over time, and, therefore, the firm's risk should remain constant over time. 
C)  The company's overall WACC should decrease over time because its stock price should be increasing. 
D)  The CEO's recommendation would maximize the firm's intrinsic value. 
E)  The company will take on too many high-risk projects and reject too many low-risk projects. 
A)  The company will take on too many low-risk projects and reject too many high-risk projects. 
B)  Things will generally even out over time, and, therefore, the firm's risk should remain constant over time. 
C)  The company's overall WACC should decrease over time because its stock price should be increasing. 
D)  The CEO's recommendation would maximize the firm's intrinsic value. 
E)  The company will take on too many high-risk projects and reject too many low-risk projects.

Question 6

The cost of external equity capital raised by issuing new common stock (re)is defined as follows,in words: "The cost of external equity equals the cost of equity capital from retaining earnings (rs),divided by one minus the percentage flotation cost required to sell the new stock, (1 - F)."

Accepted Answer

A) True 
 B)False

Question 7

With its current financial policies,Flagstaff Inc.will have to issue new common stock to fund its capital budget.Since new stock has a higher cost than reinvested earnings,Flagstaff would like to avoid issuing new stock.Which of the following actions would REDUCE its need to issue new common stock?

Accepted Answer

A)  Increase the percentage of debt in the target capital structure. 
B)  Increase the proposed capital budget. 
C)  Reduce the amount of short-term bank debt in order to increase the current ratio. 
D)  Reduce the percentage of debt in the target capital structure. 
E)  Increase the dividend payout ratio for the upcoming year. 
A)  Increase the percentage of debt in the target capital structure. 
B)  Increase the proposed capital budget. 
C)  Reduce the amount of short-term bank debt in order to increase the current ratio. 
D)  Reduce the percentage of debt in the target capital structure. 
E)  Increase the dividend payout ratio for the upcoming year.

Question 8

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.

Accepted Answer

A) True 
 B)False

Question 9

When working with the CAPM,which of the following factors can be determined with the most precision?

Accepted Answer

A)  The beta coefficient, bi, of a relatively safe stock. 
B)  The most appropriate risk-free rate, rRF. 
C)  The expected rate of return on the market, rM. 
D)  The beta coefficient of "the market," which is the same as the beta of an average stock. 
E)  The market risk premium (RPM). 
A)  The beta coefficient, bi, of a relatively safe stock. 
B)  The most appropriate risk-free rate, rRF. 
C)  The expected rate of return on the market, rM. 
D)  The beta coefficient of "the market," which is the same as the beta of an average stock. 
E)  The market risk premium (RPM).

Question 10

The cost of capital used in capital budgeting should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets.

Accepted Answer

A) True 
 B)False

Question 11

Which of the following statements is CORRECT?

Accepted Answer

A)  If the calculated beta underestimates the firm's true investment risk- i.e., if the forward-looking beta that investors think exists exceeds the historical beta- then the CAPM method based on the historical beta will produce an estimate of rs and thus WACC that is too high. 
B)  Beta measures market risk, which is, theoretically, the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. This is true even if not all of the firm's stockholders are well diversified. 
C)  An advantage shared by both the DCF and CAPM methods when they are used to estimate the cost of equity is that they are both "objective" as opposed to "subjective," hence little or no judgment is required. 
D)  The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach. 
E)  The discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever. 
A)  If the calculated beta underestimates the firm's true investment risk- i.e., if the forward-looking beta that investors think exists exceeds the historical beta- then the CAPM method based on the historical beta will produce an estimate of rs and thus WACC that is too high. 
B)  Beta measures market risk, which is, theoretically, the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. This is true even if not all of the firm's stockholders are well diversified. 
C)  An advantage shared by both the DCF and CAPM methods when they are used to estimate the cost of equity is that they are both "objective" as opposed to "subjective," hence little or no judgment is required. 
D)  The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach. 
E)  The discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever.

Question 12

Which of the following statements is CORRECT?

Accepted Answer

A)  The WACC is calculated using a before-tax cost for debt that is equal to the interest rate that must be paid on new debt, along with the after-tax costs for common stock and for preferred stock if it is used. 
B)  An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity. 
C)  The relevant WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm's target capital structure. 
D)  Beta measures market risk, which is generally the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. However, this is not true unless all of the firm's stockholders are well diversified. 
E)  The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the interest rate on the company's own long-term bonds. The size of the risk premium for bonds with different ratings is published daily in The Wall Street Journal. 
A)  The WACC is calculated using a before-tax cost for debt that is equal to the interest rate that must be paid on new debt, along with the after-tax costs for common stock and for preferred stock if it is used. 
B)  An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity. 
C)  The relevant WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm's target capital structure. 
D)  Beta measures market risk, which is generally the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. However, this is not true unless all of the firm's stockholders are well diversified. 
E)  The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the interest rate on the company's own long-term bonds. The size of the risk premium for bonds with different ratings is published daily in The Wall Street Journal.

Question 13

You were recently hired by Garrett Design,Inc.to estimate its cost of common equity.You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.00% (constant); and F = 5.00%.What is the cost of equity raised by selling new common stock?

Accepted Answer

A)  10.77% 
B)  11.33% 
C)  11.90% 
D)  12.50% 
E)  13.12% 
A)  10.77% 
B)  11.33% 
C)  11.90% 
D)  12.50% 
E)  13.12%

Question 14

To help estimate its cost of common equity,Maxwell and Associates recently hired you.You have obtained the following data: D0 = $0.90; P0 = $27.50; and g = 7.00% (constant).Based on the DCF approach,what is the cost of common from reinvested earnings?

Accepted Answer

A)  9.29% 
B)  9.68% 
C)  10.08% 
D)  10.50% 
E)  10.92% 
A)  9.29% 
B)  9.68% 
C)  10.08% 
D)  10.50% 
E)  10.92%

Question 15

Perpetual preferred stock from Franklin Inc.sells for $97.50 per share,and it pays an $8.50 annual dividend.If the company were to sell a new preferred issue,it would incur a flotation cost of 4.00% of the price paid by investors.What is the company's cost of preferred stock for use in calculating the WACC?

Accepted Answer

A)  8.72% 
B)  9.08% 
C)  9.44% 
D)  9.82% 
E)  10.22% 
A)  8.72% 
B)  9.08% 
C)  9.44% 
D)  9.82% 
E)  10.22%

Question 16

The reason why reinvested earnings have a cost equal to rs is because investors think they can (i.e.,expect to)earn rs on investments with the same risk as the firm's common stock,and if the firm does not think that it can earn rs on the earnings that it retains,it should distribute those earnings to its investors.Thus,the cost of reinvested earnings is based on the opportunity cost principle.

Accepted Answer

A) True 
 B)False

Question 17

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method,the DCF method,and the bond-yield-plus-risk-premium method.However,only the DCF method is widely used in practice.

Accepted Answer

A) True 
 B)False

Question 18

Which of the following statements is CORRECT?

Accepted Answer

A)  The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the DCF model's logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain. 
B)  The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm's own cost of debt and its risk premium, can be found by using standardized and objective procedures. 
C)  Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity. 
D)  The DCF model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield. 
E)  Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs- beta, the risk-free rate, and the market risk premium - can be estimated with little error. 
A)  The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the DCF model's logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain. 
B)  The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm's own cost of debt and its risk premium, can be found by using standardized and objective procedures. 
C)  Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity. 
D)  The DCF model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield. 
E)  Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs- beta, the risk-free rate, and the market risk premium - can be estimated with little error.

Question 19

Avery Corporation's target capital structure is 35% debt,10% preferred,and 55% common equity.The interest rate on new debt is 6.50%,the yield on the preferred is 6.00%,the cost of common from reinvested earnings is 11.25%,and the tax rate is 40%.The firm will not be issuing any new common stock.What is Avery's WACC?

Accepted Answer

A)  8.15% 
B)  8.48% 
C)  8.82% 
D)  9.17% 
E)  9.54% 
A)  8.15% 
B)  8.48% 
C)  8.82% 
D)  9.17% 
E)  9.54%

Question 20

When estimating the cost of equity by use of the DCF method,the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return.This problem leaves us unsure of the true value of rs.

Accepted Answer

A) True 
 B)False

Exam 9: The Cost of Capital

Adams Inc.has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05.What is the firm's cost of common from reinvested earnings based on the CAPM?

The cost of external equity capital raised by issuing new common stock (re)is defined as follows,in words: "The cost of external equity equals the cost of equity capital from retaining earnings (rs),divided by one minus the percentage flotation cost required to sell the new stock, (1 - F)."

With its current financial policies,Flagstaff Inc.will have to issue new common stock to fund its capital budget.Since new stock has a higher cost than reinvested earnings,Flagstaff would like to avoid issuing new stock.Which of the following actions would REDUCE its need to issue new common stock?

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.

When working with the CAPM,which of the following factors can be determined with the most precision?

The cost of capital used in capital budgeting should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

You were recently hired by Garrett Design,Inc.to estimate its cost of common equity.You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.00% (constant); and F = 5.00%.What is the cost of equity raised by selling new common stock?

To help estimate its cost of common equity,Maxwell and Associates recently hired you.You have obtained the following data: D0 = $0.90; P0 = $27.50; and g = 7.00% (constant).Based on the DCF approach,what is the cost of common from reinvested earnings?

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method,the DCF method,and the bond-yield-plus-risk-premium method.However,only the DCF method is widely used in practice.

Which of the following statements is CORRECT?

When estimating the cost of equity by use of the DCF method,the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return.This problem leaves us unsure of the true value of rs.

An Overview of Financial Management and the Financial Environment

Financial Statements, cash Flow, and Taxes

Analysis of Financial Statements

Time Value of Money

Bonds, bond Valuation, and Interest Rates

Risk and Return

Valuation of Stocks and Corporations

Financial Options and Applications in Corporate Finance

The Basics of Capital Budgeting: Evaluating Cash Flows

Cash Flow Estimation and Risk Analysis

Corporate Valuation and Financial Planning

Agency Conflicts and Corporate Governance

Distributions to Shareholders: Dividends and Repurchases

Capital Structure Decisions

Supply Chains and Working Capital Management

Multinational Financial Management

Public and Private Financing: Initial Offerings, seasoned Offerings, and Investment Banks

Extension 18 A: Rights Offerings

Lease Financing

Hybrid Financing: Preferred Stock, warrants, and Convertibles

Dynamic Capital Structures

Mergers and Corporate Control

Enterprise Risk Management

Bankruptcy, reorganization, and Liquidation

Portfolio Theory and Asset Pricing Models

Real Options

Providing and Obtaining Credit

Advanced Issues in Cash Management and Inventory Control

Pension Plan Management

Financial Management in Not For Profit Businesses

Filters

Adams Inc.has the following data: r_RF = 5.00%; RP_M = 6.00%; and b = 1.05.What is the firm's cost of common from reinvested earnings based on the CAPM?

The cost of external equity capital raised by issuing new common stock (r_e)is defined as follows,in words: "The cost of external equity equals the cost of equity capital from retaining earnings (r_s),divided by one minus the percentage flotation cost required to sell the new stock, (1 - F)."

You were recently hired by Garrett Design,Inc.to estimate its cost of common equity.You obtained the following data: D₁ = $1.75; P₀ = $42.50; g = 7.00% (constant); and F = 5.00%.What is the cost of equity raised by selling new common stock?

To help estimate its cost of common equity,Maxwell and Associates recently hired you.You have obtained the following data: D₀ = $0.90; P₀ = $27.50; and g = 7.00% (constant).Based on the DCF approach,what is the cost of common from reinvested earnings?

When estimating the cost of equity by use of the DCF method,the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return.This problem leaves us unsure of the true value of r_s.