Deck 14: Cost of Capital

Question 1

As a means of determining a firm's cost of equity financing for an investment, a weakness in the dividend growth model is that the model is highly dependent upon the accuracy of the beta assigned to the firm.

Answer 1

False

Question 2

A potential problem associated with the use of the dividend growth model to compute the cost of equity is that Everything needed for the model is directly observable except the current dividend.

Answer 2

False

Question 3

The cost of equity is affected by the market risk premium.

Answer 3

True

Question 4

Given the following: the risk-free rate is 8% and the market risk premium is 8.5%. Project I should be accepted if the firm's beta is 1.2.

Question 5

Given the following: the risk-free rate is 8% and the market risk premium is 8.5%. Project II should be accepted if the firm's beta is 1.2.

Question 6

As a means of determining a firm's cost of equity financing for an investment, a weakness in the dividend growth model is that the model can only be used by dividend-paying firms.

Question 7

As a means of determining a firm's cost of equity financing for an investment, a weakness in the dividend growth model is that the model is highly sensitive to the growth rate of the firm.

Question 8

A potential problem associated with the use of the dividend growth model to compute the cost of equity is that the approach explicitly considers risk.

Question 9

Suppose that new information regarding future inflation in Canada causes investors to become less risk averse. The SML approach indicates that, all else equal, firm cost of capital will increase.

Question 10

A firm's overall cost of equity is unaffected by changes in the market risk premium.

Question 11

A potential problem associated with the use of the dividend growth model to compute the cost of equity is that the estimated cost of equity is sensitive to the estimated dividend growth rate.

Question 12

A firm's overall cost of equity is an estimate only.

Question 13

A firm's overall cost of equity is directly observable in the financial markets.

Question 14

The cost of equity is affected by the growth rate of the firm.

Question 15

A firm's overall cost of equity is highly dependent upon the growth rate and risk level of a firm.

Question 16

In general, for the purpose of estimating the cost of preferred stock, one can ignore the current level of common stock dividends.

Question 17

The cost of equity is affected by dividend increases or decreases.

Question 18

The cost of equity is affected by the risk level of the firm.

Question 19

Given the following: the risk-free rate is 8% and the market risk premium is 8.5%. Project III should be accepted if the firm's beta is 1.2.

Question 20

As a means of determining a firm's cost of equity financing for an investment, a weakness in the dividend growth model is that it fails to specifically address the risk level of the investment.

Question 21

For the purpose of estimating the firm's cost of capital, one cannot look only at the coupon rate on the firm's existing debt.

Question 22

The after-tax cost of debt generally increases when a firm's bond rating increases.

Question 23

The after-tax cost of debt generally increases when bond prices decline.

Question 24

One variable that the security market line approach depends on to estimate the expected return on a risky asset is the Marginal tax rate.

Question 25

The SML approach generally assumes that the reward-to-risk ratio is constant.

Question 26

Ignoring taxes, if a firm issues debt at par, then the cost of debt is equal to its yield to maturity.

Question 27

Ignoring taxes, if a firm issues debt at par, then the YTM cannot be computed.

Question 28

A decrease in the reward for bearing systematic risk will always decrease a firm's cost of equity, when calculated using the SML approach.

Question 29

It is considered unlikely that the dividend growth and the SML approaches will result in different estimates of the cost of equity for a given firm

Question 30

The after-tax cost of debt generally increases when the market rate of interest increases.

Question 31

The cost of debt is affected by investors' risk tolerance level.

Question 32

The cost of debt is affected by the coupon rate of a firm's outstanding bonds.

Question 33

Ignoring taxes, if a firm issues debt at par, then the cost of debt is equal to its coupon rate.

Question 34

One variable that the security market line approach depends on to estimate the expected return on a risky asset is the Risk-free rate of return.

Question 35

The after-tax cost of debt generally increases when tax rates decrease.

Question 36

The cost of debt is affected by marginal tax rate.

Question 37

One variable that the security market line approach depends on to estimate the expected return on a risky asset is the Systematic risk of the asset.

Question 38

One variable that the security market line approach depends on to estimate the expected return on a risky asset is the Market risk premium.

Question 39

For the purpose of estimating the firm's cost of debt for a project, one could observe the yield-to-maturity on recently issued bonds with a similar rating and term-to-maturity.

Question 40

An increase in the firm's beta will always decrease a firm's cost of equity, when calculated using the SML approach.

Question 41

A firm that uses its WACC as a cutoff without considering project risk will likely see its WACC rise over time.

Question 42

The BongoBongo Drum Co. uses debt and equity in its capital structure and has positive earnings. An increase in the firm's debt rating from BBB to A would decrease the firm's WACC.

Question 43

The interest rate that should be used when evaluating a capital investment project is sometimes called the cost of capital.

Question 44

The market value of a firm that invests in projects providing a return equal to its WACC will not change over time.

Question 45

The weighted average cost of capital for a firm is dependent upon the firm's level of risk.

Question 46

By using a firm's WACC to analyze all potential investments, we risk incorrectly accepting some unsuitable projects.

Question 47

The cost of debt is affected by the current yield-to-maturity of the firm's bonds.

Question 48

If a firm uses its WACC as the discount rate for all of the projects it undertakes, then the firm will tend to become riskier over time.

Question 49

By using a firm's WACC to analyze all potential investments, we risk incorrectly accepting some suitable projects.

Question 50

If a firm uses its WACC as the discount rate for all of the projects it undertakes, then the firm will tend to reject some positive net present value projects.

Question 51

It is generally better to base estimates of the WACC on book value weights of debt and equity since market values, particularly those for equity, tend to fluctuate widely.

Question 52

The cost of capital is also known as the appropriate discount rate

Question 53

If a firm uses its WACC as the discount rate for all of the projects it undertakes, then the firm will tend to accept some negative net present value projects.

Question 54

A firm may have to rely upon a competitor's cost of capital to ascertain the appropriate required return for a project.

Question 55

If a firm uses its WACC as the discount rate for all of the projects it undertakes, then the firm will tend to favor low risk projects over high risk projects.

Question 56

The BongoBongo Drum Co. uses debt and equity in its capital structure and has positive earnings. A decrease in investor risk aversion would decrease the firm's WACC.

Question 57

The interest rate that should be used when evaluating a capital investment project is sometimes called the appropriate discount rate.

Question 58

For a profitable firm, an increase in its marginal tax rate will increase its weighted average cost of capital.

Question 59

The interest rate that should be used when evaluating a capital investment project is sometimes called the internal rate of return.

Question 60

The BongoBongo Drum Co. uses debt and equity in its capital structure and has positive earnings. A decrease in the corporate tax rate would decrease the firm's WACC.

Question 61

A firm that uses its WACC as a cutoff without considering project risk tends to become less risky over time.

Question 62

The amount of equity financing as a % of the total financing is considered, directly or indirectly, in the weighted average cost of capital.

Question 63

Ignoring the risk level of a project can cause a firm to reject a profitable project.

Question 64

The cost of capital is the same as the WACC for projects with equal risk to the firm as a whole.

Question 65

The cost of capital depends primarily on the use of funds, not the source.

Question 66

The marginal tax rate of the firm is considered, directly or indirectly, in the weighted average cost of capital.

Question 67

The use of the funds is more important than the source of funds in determining the cost of capital.

Question 68

The SML approach considers the amount of systematic risk associated with an individual firm.

Question 69

The weighted average cost of capital for a firm is dependent upon the firm's coupon rate on the preferred stock.

Question 70

The cost of capital for a project should exclude any tax considerations.

Question 71

The risk tolerance level of investors is considered, directly or indirectly, in the weighted average cost of capital.

Question 72

The cost of capital is an opportunity cost that depends on the use of the funds, not the source

Question 73

The weighted average cost of capital for a firm is dependent upon the firm's debt-equity ratio.

Question 74

The SML approach can be applied to more firms than the dividend growth model can.

Question 75

The weighted average cost of capital for a firm is dependent upon the firm's tax rate.

Question 76

The risk-free rate of return is considered, directly or indirectly, in the weighted average cost of capital.

Question 77

A decrease in the amount of systematic risk will always decrease a firm's cost of equity, when calculated using the SML approach.

Question 78

The cost of capital is the same thing as the required rate of return

Question 79

A firm that uses its WACC as a cutoff without considering project risk tends to accept negative NPV projects over time.

Question 80

An advantage to using the SML approach for calculating the cost of equity it that unlike the dividend growth model, the SML approach is not sensitive to the estimates used as inputs in the model.