Deck 14: Cost of Capital

Question 1

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.

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 The estimated cost of equity is sensitive to the estimated dividend growth rate.

Answer 2

True

Question 3

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

Answer 3

True

Question 4

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

Question 5

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

Question 6

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

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 dependent upon the accuracy of the beta
assigned to 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

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

Question 10

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

Question 11

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 12

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 13

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 14

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

Question 15

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 16

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 17

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 18

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

Question 19

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

Question 20

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.

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

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 23

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

Question 24

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 25

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 26

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

Question 27

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

Question 28

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

Question 29

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

Question 30

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 31

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

Question 32

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

Question 33

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

Question 34

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 35

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

Question 36

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

Question 37

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

Question 38

The cost of debt is affected by marginal tax rate.

Question 39

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 40

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 41

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

Question 42

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 43

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

Question 44

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

Question 45

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 46

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

Question 47

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 48

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 49

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

Question 50

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

Question 51

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 52

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

Question 53

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

Question 54

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

Question 55

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 56

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 57

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

Question 58

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 59

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

Question 60

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

Question 61

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

Question 62

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.

Question 63

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

Question 64

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

Question 65

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

Question 66

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

Question 67

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

Question 68

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

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

Question 71

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

Question 72

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

Question 73

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

Question 74

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

Question 75

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

Question 76

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

Question 77

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

Question 78

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

Question 79

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

Question 80

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