Deck 7: Types and Costs of Financial Capital

Question 1

The real interest rate (RR)is the interest one would face in the absence of inflation, risk, illiquidity, and any other factors determining the appropriate interest rate.

Answer 1

True

Question 2

The prime rate is the interest rate charged by banks to their highest default-risk business customers.

Answer 2

False

Question 3

Formal historical accounting procedures include explicit records of debt (interest and principal)and dividend capital costs.

Answer 3

True

Question 4

A venture's riskiness in terms of the likelihood of poor performance or failure decreases as it moves from its development stage to its rapid-growth stage.

Question 5

Bond ratings reflect the inflation risk of a firm's bonds.

Question 6

The risk-free interest rate is the interest rate on debt that is virtually free of inflation risk.

Question 7

Startup financing usually comes from entrepreneurs, business angels, and investment bankers.

Question 8

The relationship between real interest rates and time to maturity when default risk is constant is called the term structure of interest rates.

Question 9

The graph of the term structure of interest rates, which plots interest rates to time to maturity, is called the yield curve.

Question 10

First-round financing during a venture's survival stage comes primarily from venture capitalists and investment banks.

Question 11

Traditional accounting does not focus on the implicit cost of equity that is the required capital gains to complement dividends. However, evaluation methods exist to determine this value by financial managers.

Question 12

A nominal interest rate is an observed or stated interest rate.

Question 13

Liquidity premiums reflect the risk associated with firms that possess few liquid assets.

Question 14

The accounting emphasis on accrued revenue and expenses and depreciation is the same emphasis as that of finance managers.

Question 15

Public financial markets are markets for the creation, sale, and trade of illiquid securities having less standardized negotiated features.

Question 16

A venture's riskiness in terms of poor performance or failure is usually high to moderate during the rapid-growth stage of its life cycle.

Question 17

Commercial banks provide liquidity-stage financing for ventures in the rapid-growth stage of their life cycles.

Question 18

Inflation premium is the rising prices not offset by increasing quality of goods being purchased.

Question 19

A venture's riskiness in terms of poor performance or failure is usually very high during the maturity stage of its life cycle.

Question 20

Default risk is the risk that a borrower will not pay the interest and/or the principal on a loan.

Question 21

EVA is a financial assessment of a venture's environmental value analysis.

Question 22

Closely held corporations are corporations whose stock is publicly traded.

Question 23

Early-stage ventures tend to have large amounts of senior debt relative to more mature ventures.

Question 24

Components used to calculate the after-tax WACC do not include an equity rate.

Question 25

The weighted average cost of capital is simply the blended, or weighted, cost of raising equity and debt capital.

Question 26

Over the long run (90 or so years)in the United States, average annual rates of return have been higher for small-company stocks relative to large-company stocks.

Question 27

Typically, the stocks of closely held corporations aren't publicly traded.

Question 28

The coefficient of variation measures the standard deviation of a venture's return relative to its expected return.

Question 29

The excess average return of long-term government bonds over common stock is called the market risk premium.

Question 30

Investment risk is the chance or probability of financial loss on one's venture investment, and can be assumed by debt, equity, and founding investors.

Question 31

Market cap is determined by multiplying a firm's current stock price by the number of shares outstanding.

Question 32

Closely held corporations are those companies whose stock is traded over the counter.

Question 33

A venture with a higher expected return relative to other ventures will necessarily have a higher standard deviation or returns.

Question 34

Subordinated debt is secured by a venture's assets, while senior debt has an inferior claim to a venture's assets.

Question 35

Organized exchanges have physical locations where trading takes place, while the over-the-counter market is comprised of a network of brokers and dealers that interact electronically.

Question 36

Venture capital holding period returns (multistages)for the 20-year period ending in 2018 were more than three times the returns on the Dow Jones Industrial Average Index.

Question 37

Late- and expansion-stage U.S. venture capital for most holding periods have lower returns than early-stage U.S. venture capital.

Question 38

Over the long run (90 or so years)in the United States, average annual rates of return have been higher for government bonds than for corporate common stocks.

Question 39

Private equity investors are owners of proprietorships, partners in partnerships, and owners in closely held corporations.

Question 40

Historically, large-company stocks have averaged higher long-term returns than small-company stocks.

Question 41

Over the long run (90 or so years), the average annual rates of return in the United States have been highest for which of the following securities?

A)five-year government bonds
B)twenty-year corporate bonds
C)large-company stocks
D)small-company stocks

Question 42

Which of the following describes the interest rate on debt that is virtually free of default risk?

A)real rate
B)nominal rate
C)risk-free rate
D)inflation rate

Question 43

The additional interest rate premium required to compensate the lender for the probability that a borrower will not be able to repay interest and principal on a loan is known as a(n):

A)inflation premium
B)default risk premium
C)liquidity premium
D)maturity premium

Question 44

Which of the following is not a component in determining the cost of debt?

A)inflation premium
B)default risk premium
C)maturity premium
D)interest rate premium

Question 45

A venture's riskiness in terms of possible poor performance or failure would be considered to be very high in which of the following life cycle stages?

A)startup stage
B)survival stage
C)rapid-growth stage
D)early-maturity stage

Question 46

Which of the following markets involve liquid securities with standardized contract features such as stocks and bonds?

A)private financial market
B)commodities market
C)real estate market
D)public financial market

Question 47

Which of the following venture life cycle stages would involve seasoned financing rather than venture financing?

A)development stage
B)startup stage
C)rapid-growth stage
D)early-maturity stage

Question 48

EVA equals net operating profit after taxes minus after-tax dollar cost of financial capital used.

Question 49

Which of the following describes the observed or stated interest rate?

A)real rate
B)nominal rate
C)risk-free rate
D)prime rate

Question 50

Suppose the real risk-free rate of interest is 4%, the maturity risk premium is 2%, the inflation premium is 6%, the default risk on similar debt is 3%, and the liquidity premium is 2%. What is the nominal interest rate on this venture's debt capital?

A)14%
B)15%
C)16%
D)17%

Question 51

Which of the following "premiums" is not typically included in the rate on U.S. Treasury securities?

A)liquidity premium
B)default risk premium
C)market risk premium
D)inflation premium

Question 52

Over the long run (90 or so years), the variability (standard deviation)of average annual rates of return in the United States have been lowest for which of the following securities?

A)five-year government bonds
B)twenty-year corporate bonds
C)large-company stocks
D)small-company stocks

Question 53

Which of the following components is not used when estimating the cost of risky debt capital?

A)real interest rate
B)inflation premium
C)default risk premium
D)market risk premium

Question 54

Which of the following describes the interest rate charged by banks to their highest-quality customers?

A)real rate
B)nominal rate
C)risk-free rate
D)prime rate

Question 55

The added interest rate charged due to the inherent increased risk in long-term debt is called a(n):

A)inflation premium
B)default risk premium
C)liquidity premium
D)maturity premium

Question 56

Which of the following describes the interest rate in addition to the inflation rate expected on a risk-free loan?

A)real rate
B)nominal rate
C)risk-free rate
D)prime rate

Question 57

The word "risk" developed from the early Italian word "risicare" and means:

A)"don't care"
B)"take a chance"
C)"to dare"
D)"to gamble"

Question 58

The risk-free interest rate is the sum of:

A)a real rate of interest and an inflation premium
B)a real rate of interest and a default risk premium
C)an inflation premium and a default risk premium
D)a liquidity premium and a maturity premium

Question 59

Which of the following markets involve direct two-party negotiations over illiquid, nonstandardized contracts such as bank loans and direct placement of debt?

A)secondary market
B)options market
C)private financial market
D)public financial market

Question 60

The additional premium added to the real interest rate by lenders to compensate them for a debt instrument which cannot be converted to cash quickly at its existing value is called a(n):

A)inflation premium
B)default risk premium
C)liquidity premium
D)maturity premium

Question 61

Estimate a firm's NOPAT based on the following information: net sales = $2,000,000; EBIT = $600,000; net income = $20,000; and effective tax rate = 30%.

A)$600,000
B)$420,000
C)$150,000
D)$70,000

Question 62

Your venture has net income of $600, taxable income of $1,000, operating profit of $1,200, total financial capital (including both debt and equity) of $9,000, a tax rate of 40%, and a WACC of 10%. What is your venture's EVA?

A)$400,000
B)$200,000
C)-$20,000
D)-$180,000

Question 63

Venture investors generally use which of the following target rate ranges to discount the projected cash flows of ventures in the development stage of their life cycles:

A)12%-15%
B)20%-30%
C)25%-35%
D)40%-60%

Question 64

Venture capital holding period returns (all stages)for the 20-year period ending in 2018 were approximately:

A)99%
B)21%
C)10%
D)7%

Question 65

Calculate the weighted average cost of capital (WACC)based on the following information: the equity multiplier is 1.66; the interest rate on debt is 13%; the required return to equity holders is 22%; and the tax rate is 35%.

A)11.5%
B)13.9%
C)15.0%
D)16.6%

Question 66

A venture has raised $4,000 of debt and $6,000 of equity to finance its firm. Its cost of borrowing is 6%, its tax rate is 40%, and its cost of equity capital is 8%. What is the venture's weighted average cost of capital?

A)7.2%
B)7.0%
C)6.2%
D)6.0%

Question 67

Use the SML model to calculate the cost of equity for a firm based on the following information: the firm's beta is 1.5; the risk-free rate is 5%; and the market risk premium is 2%.

A)8.0%
B)9.5%
C)10.0%
D)12.0%

Question 68

Calculate the after-tax WACC based on the following information: nominal interest rate on debt = 12%; cost of common equity = 25%; common equity = $700,000; interest-bearing debt = $300,000; and tax rate = 25%.

A)15.0%
B)16.4%
C)20.2%
D)22.8%

Question 69

Venture investors generally use which of the following target rate ranges to discount the projected cash flows of ventures in the startup stage of their life cycles:

A)20%-30%
B)25%-35%
C)30%-50%
D)40%-60%

Question 70

Estimate a firm's economic value added (EVA) based on the following information: NOPAT = $400,000; amount of financial capital used = $1,600,000; and WACC = 19%.

A)$26,000
B)$36,000
C)$96,000
D)$54,000

Question 71

The difference between average annual returns on common stocks and returns on long-term government bonds is called a:

A)default risk premium
B)maturity premium
C)risk-free premium
D)market risk premium

Question 72

Which of the following types of "premiums" would not be associated with corporate bonds?

A)investment risk premium
B)default risk premium
C)liquidity premium
D)maturity premium

Question 73

Venture capital holding period returns (all stages)for the 10-year period ending in 2018 were approximately:

A)25%
B)18%
C)13%
D)8%

Question 74

What has been the approximate long-run (90 or so years)average annual rate of return on publicly traded small-company stocks?

A)10%
B)17%
C)25%
D)30%

Question 75

Which of the following types of financing would be associated with the highest target compound rate of return on venture equity capital?

A)public and seasoned financing
B)second-round and mezzanine financing
C)first-round financing
D)seed financing

Question 76

Calculate the after-tax WACC based on the following information: nominal interest rate on debt = 16%; cost of common equity = 30%; equity to value = 60%; debt to value = 40%; and tax rate = 25%.

A)10.0%
B)16.0%
C)19.8%
D)22.8%

Question 77

Find a venture's economic value added (EVA) based on the following information: EBIT = $200,000; financial capital used = $500,000; WACC = 20%; and effective tax rate = 30%.

A)$20,000
B)$30,000
C)$40,000
D)$50,000

Question 78

The cost of equity for a firm is 20%. If the real interest rate is 5%, the inflation premium is 3%, and the market risk premium is 2%, what is the investment risk premium for the firm?

A)10%
B)12%
C)13%
D)15%

Question 79

Calculate the weighted average cost of capital (WACC)based on the following information: the capital structure weights are 50% debt and 50% equity; the interest rate on debt is 10%; the required return to equity holders is 20%; and the tax rate is 30%.

A)7.0%
B)10.0%
C)13.5%
D)17.5%