Question 1

Which of the following statements is CORRECT?

Accepted Answer

A) The "break point" as discussed in the text refers to the point where the firm's tax rate increases. 
B) The "break point" as discussed in the text refers to the point where the firm has raised so much capital that it is simply unable to borrow any more money. 
C) The "break point" as discussed in the text refers to the point where the firm is taking on investments that are so risky the firm is in serious danger of going bankrupt if things do not go exactly as planned. 
D) The "break point" as discussed in the text refers to the point where the firm has raised so much capital that it has exhausted its supply of additions to retained earnings and thus must raise equity by issuing stock. 
E) The "break point" as discussed in the text refers to the point where the firm has exhausted its supply of additions to retained earnings and thus must begin to finance with preferred stock. 
A) The "break point" as discussed in the text refers to the point where the firm's tax rate increases. 
B) The "break point" as discussed in the text refers to the point where the firm has raised so much capital that it is simply unable to borrow any more money. 
C) The "break point" as discussed in the text refers to the point where the firm is taking on investments that are so risky the firm is in serious danger of going bankrupt if things do not go exactly as planned. 
D) The "break point" as discussed in the text refers to the point where the firm has raised so much capital that it has exhausted its supply of additions to retained earnings and thus must raise equity by issuing stock. 
E) The "break point" as discussed in the text refers to the point where the firm has exhausted its supply of additions to retained earnings and thus must begin to finance with preferred stock.

Question 2

Which of the following statements is CORRECT?

Accepted Answer

A) 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 or is available online. 
B) 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. 
C) An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity. 
D) 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. 
E) 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. 
A) 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 or is available online. 
B) 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. 
C) An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity. 
D) 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. 
E) 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.

Question 3

Which of the following statements is CORRECT?

Accepted Answer

A) The WACC is calculated using before-tax costs for all components. 
B) The after-tax cost of debt usually exceeds the after-tax cost of equity. 
C) For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock. 
D) Retained earnings that were generated in the past and are reported on the firm's balance sheet are available to finance the firm's capital budget during the coming year. 
E) The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital. 
A) The WACC is calculated using before-tax costs for all components. 
B) The after-tax cost of debt usually exceeds the after-tax cost of equity. 
C) For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock. 
D) Retained earnings that were generated in the past and are reported on the firm's balance sheet are available to finance the firm's capital budget during the coming year. 
E) The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital.

Question 4

Eakins Inc.'s common stock currently sells for $45.00 per share,the company expects to earn $2.75 per share during the current year,its expected payout ratio is 70%,and its expected constant growth rate is 6.00%.New stock can be sold to the public at the current price,but a flotation cost of 8% would be incurred.By how much would the cost of new stock exceed the cost of retained earnings?

Accepted Answer

A) 0.09% 
B) 0.19% 
C) 0.37% 
D) 0.56% 
E) 0.84% 
A) 0.09% 
B) 0.19% 
C) 0.37% 
D) 0.56% 
E) 0.84%

Question 5

Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets.They then provide funds to their different divisions for investment in capital projects.The divisions may vary in risk,and the projects within the divisions may also vary in risk.Therefore,it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.

Accepted Answer

A) True 
 B)False

Question 6

For a typical firm,which of the following sequences is CORRECT? All rates are after taxes,and assume that the firm operates at its target capital structure.

Accepted Answer

A) rs > re > rd > WACC. 
B) re > rs > WACC > rd. 
C) WACC > re > rs > rd. 
D) rd > re > rs > WACC. 
E) WACC > rd > rs > re. 
A) rs > re > rd > WACC. 
B) re > rs > WACC > rd. 
C) WACC > re > rs > rd. 
D) rd > re > rs > WACC. 
E) WACC > rd > rs > re.

Question 7

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

Accepted Answer

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

Question 8

The cost of debt,rd,is normally less than rs,so rd(1 − T)will normally be much less than rs.Therefore,as long as the firm is not completely debt financed,the weighted average cost of capital (WACC)will normally be greater than rd(1 − T).

Accepted Answer

A) True 
 B)False

Question 9

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

Question 10

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

Accepted Answer

A) True 
 B)False

Question 11

The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

Accepted Answer

A) True 
 B)False

Question 12

Safeco Company and Risco Inc are identical in size and capital structure.However,the riskiness of their assets and cash flows are somewhat different,resulting in Safeco having a WACC of 10% and Risco a WACC of 12%.Safeco is considering Project X,which has an IRR of 10.5% and is of the same risk as a typical Safeco project.Risco is considering Project Y,which has an IRR of 11.5% and is of the same risk as a typical Risco project. ​
Now assume that the two companies merge and form a new company,Safeco/Risco Inc.Moreover,the new company's market risk is an average of the pre-merger companies' market risks,and the merger has no impact on either the cash flows or the risks of Projects X and Y.Which of the following statements is CORRECT?

Accepted Answer

A) If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time. 
B) If evaluated using the correct post-merger WACC, Project X would have a negative NPV. 
C) After the merger, Safeco/Risco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y. 
D) Safeco/Risco's WACC, as a result of the merger, would be 10%. 
E) After the merger, Safeco/Risco should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%. 
A) If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time. 
B) If evaluated using the correct post-merger WACC, Project X would have a negative NPV. 
C) After the merger, Safeco/Risco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y. 
D) Safeco/Risco's WACC, as a result of the merger, would be 10%. 
E) After the merger, Safeco/Risco should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%.

Question 13

Suppose the debt ratio is 50%,the interest rate on new debt is 8%,the current cost of equity is 16%,and the tax rate is 40%.An increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC).

Accepted Answer

A) True 
 B)False

Question 14

Which of the following statements is CORRECT?

Accepted Answer

A) 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. 
B) 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. 
C) 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. 
D) 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. 
E) The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach. 
A) 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. 
B) 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. 
C) 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. 
D) 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. 
E) The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach.

Question 15

Several years ago the Jakob Company sold a $1,000 par value,noncallable bond that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually.The bond currently sells for $925,and the company's tax rate is 40%.What is the component cost of debt for use in the WACC calculation?

Accepted Answer

A) 4.28% 
B) 4.46% 
C) 4.65% 
D) 4.83% 
E) 5.03% 
A) 4.28% 
B) 4.46% 
C) 4.65% 
D) 4.83% 
E) 5.03%

Question 16

Sorensen Systems Inc.is expected to pay a $2.50 dividend at year end (D1 = $2.50),the dividend is expected to grow at a constant rate of 5.50% a year,and the common stock currently sells for $52.50 a share.The before-tax cost of debt is 7.50%,and the tax rate is 40%.The target capital structure consists of 45% debt and 55% common equity.What is the company's WACC if all the equity used is from retained earnings?

Accepted Answer

A) 7.07% 
B) 7.36% 
C) 7.67% 
D) 7.98% 
E) 8.29% 
A) 7.07% 
B) 7.36% 
C) 7.67% 
D) 7.98% 
E) 8.29%

Question 17

Assume that Kish Inc.hired you as a consultant to help estimate its cost of capital.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 equity from retained 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 18

The text identifies three methods for estimating the cost of common stock from retained earnings:
 the CAPM method,the DCF method,and the bond-yield-plus-risk-premium method.However,only the CAPM method always provides an accurate and reliable estimate.

Accepted Answer

A) True 
 B)False

Question 19

A.Butcher Timber Company hired your consulting firm to help them estimate the cost of equity.The yield on the firm's bonds is 8.75%,and your firm's economists believe that the cost of equity can be estimated using a risk premium of 3.85% over a firm's own cost of debt.What is an estimate of the firm's cost of equity from retained earnings?

Accepted Answer

A) 12.60% 
B) 13.10% 
C) 13.63% 
D) 14.17% 
E) 14.74% 
A) 12.60% 
B) 13.10% 
C) 13.63% 
D) 14.17% 
E) 14.74%

Question 20

Norris Enterprises,an all-equity firm,has a beta of 2.0.The chief financial officer is evaluating a project with an expected return of 14%,before any risk adjustment.The risk-free rate is 5%,and the market risk premium is 4%.The project being evaluated is riskier than the firm's average project,in terms of both its beta risk and its total risk.Which of the following statements is CORRECT?

Accepted Answer

A) The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return. 
B) The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return. 
C) Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment. 
D) The accept/reject decision depends on the firm's risk-adjustment policy. If Norris' policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project. 
E) Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision. 
A) The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return. 
B) The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return. 
C) Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment. 
D) The accept/reject decision depends on the firm's risk-adjustment policy. If Norris' policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project. 
E) Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision.

Exam 10: The Cost of Capital

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

For a typical firm,which of the following sequences is CORRECT? All rates are after taxes,and assume that the firm operates at its target capital structure.

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

The cost of debt,rd,is normally less than rs,so rd(1 − T)will normally be much less than rs.Therefore,as long as the firm is not completely debt financed,the weighted average cost of capital (WACC)will normally be greater than rd(1 − T).

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

Suppose the debt ratio is 50%,the interest rate on new debt is 8%,the current cost of equity is 16%,and the tax rate is 40%.An increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC).

Which of the following statements is CORRECT?

Several years ago the Jakob Company sold a $1,000 par value,noncallable bond that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually.The bond currently sells for $925,and the company's tax rate is 40%.What is the component cost of debt for use in the WACC calculation?

Assume that Kish Inc.hired you as a consultant to help estimate its cost of capital.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 equity from retained earnings?

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method,the DCF method,and the bond-yield-plus-risk-premium method.However,only the CAPM method always provides an accurate and reliable estimate.

An Overview of Financial Management

Financial Markets and Institutions

Financial Statements, cash Flow, and Taxes

Analysis of Financial Statements

Time Value of Money

Interest Rates

Bonds and Their Valuation

Risk and Rates of Return

Stocks and Their Valuation

The Basics of Capital Budgeting

Cash Flow Estimation and Risk Analysis

Real Options and Other Topics in Capital Budgeting

Capital Structure and Leverage

Distributions to Shareholders: Dividends and Share Repurchases

Working Capital Management

Financial Planning and Forecasting

Derivatives and Risk Management

Multinational Financial Management

Hybrid Financing: Preferred Stock, leasing, warrants, and Convertibles

Mergers and Acquisitions

Continuous Compounding and Discounting

Zero Coupon Bonds

Bankruptcy and Reorganization

Calculating Beta Coefficients

Using the Capm to Estimate the Risk-Adjusted Cost of Capital

Techniques for Measuring Beta Risk

Degree of Leverage

Filters

The cost of debt,r_d,is normally less than r_s,so r_d(1 − T)will normally be much less than r_s.Therefore,as long as the firm is not completely debt financed,the weighted average cost of capital (WACC)will normally be greater than r_d(1 − T).

Assume that Kish Inc.hired you as a consultant to help estimate its cost of capital.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 equity from retained earnings?