Question 1

How is the rate of interest of a floating- rate debt normally expressed?

Accepted Answer

The rate of interest of a floating-rate debt is normally expressed as a margin over a benchmark such as the bank base rate. This means that the interest rate on the debt will vary as the benchmark rate changes. The margin is set at the time of initial sale of the debt and remains fixed throughout the life of the debt, while the benchmark rate varies.

Question 2

Which three of the following are difficulties encountered in implementing WACC?

Accepted Answer

A) The CAPM's beta is an element in calculating the cost of equity and is often difficult to estimate accurately.
B) Obtaining a reliable risk-free rate is challenging because it involves finding an investment with no risk of default, which is difficult to find in reality.
C) Estimating the equity risk premium requires making assumptions about future market conditions and analyzing historical trends, which can be unreliable. 
D) While calculating the existing rate of gearing is important in determining the overall WACC, it is generally less challenging than the other factors mentioned.

Question 3

In the formula kE = rf + fi(rm - rf), what is beta based on?

Accepted Answer

Beta is based on the covariance of the share with the market, which measures the sensitivity of a stock's returns to market movements. Option B and options A and C are not relevant to the calculation of beta.

Question 4

What does the term d1 represent in the formula kE = d1 + g ?

Accepted Answer

The answer of What does the term d1 represent in...

Question 5

A particular (perpetual) preference share has an annual preference dividend of 50p, and the investors' required rate of return is 8 per cent. What is the cost of the preference share?

Accepted Answer

The cost of a perpetual preference share is calculated by dividing the annual dividend by the required rate of return. Here, 50p / 0.08 = 625p.

Question 6

Which of the following best shows how market capitalisation is calculated?

Accepted Answer

Market capitalisation is the total value of a company's outstanding shares of stock. It is calculated by multiplying the current share price by the number of shares issued to investors. Therefore, option B is the best choice as it directly provides the required calculation.

Question 7

Which three of the following correctly relate to the formula P = di ?  kE - g

Accepted Answer

The answer of Which three of the following correctly relate...

Question 8

Which three of the following statements correctly describe the situation regarding retained earnings?

Accepted Answer

Retained earnings are indeed seen as belonging to the shareholders since they represent the portion of the net income that was not paid out as dividends. They are a crucial source of long-term finance for many corporations because they can be used to reinvest in the business without the need to incur debt or issue new shares. Retained earnings are also part of the equity of the firm, as they contribute to the owners' claim on the company's assets.

Question 9

What is meant by the term 'the cost of retained earnings'?

Accepted Answer

The cost of retained earnings refers to the opportunity cost of the return that shareholders could have earned if they had invested their money elsewhere, such as in the stock market. The expected returns required by shareholders buying new shares in the firm represents this opportunity cost.

Question 10

Which two of the following describe the two stages of estimating the relevant risk premium on a firm's equity?

Accepted Answer

The two stages involve first estimating the average risk premium investors demand over the risk-free rate for average-risk shares (D), and then adjusting this premium to reflect the specific risk level of the company's shares (A).

Question 11

Which two of the following statements best apply to views on the cost of capital?

Accepted Answer

The statement "The shareholder wants an expected return appropriate for the risk, when compared with other investments" applies to the perspective of the shareholder, who wants to earn a return that compensates them for the risk they take on by investing in the company's shares. The statement "The firm wants to know the cost, in terms of expected return, needed to induce purchase and retention of shares" applies to the perspective of the firm, which wants to understand the cost of capital from the investor's standpoint and ensure that they offer a return that is attractive enough to induce investment in the company's shares. Statements A and D do not accurately reflect common views on the cost of capital.

Question 12

Which formula would you use if you needed to find the value of WACC for three types of finance?

Accepted Answer

The correct formula for calculating the Weighted Average Cost of Capital (WACC) when considering three types of finance (equity, debt, and preferred stock) is: WACC = kEWE + kDATWD + kpWp. This formula accounts for the cost of equity (kE), the cost of debt (kD), and the cost of preferred stock (kp), each weighted by their respective proportions in the total capital structure (WE, WD, Wp).

Question 13

Which two of the following types of information would most usefully help you to quickly estimate an approximate required rate of return for a bond?

Accepted Answer

The risk class of the bond and rates payable for bonds of different credit ratings help estimate the required rate of return by providing insight into the bond's risk and comparable market rates.

Question 14

Which of the following is the most obvious problem with using the fundamental beta approach?

Accepted Answer

The fundamental beta approach involves adjusting a company's historical beta to reflect changes in its business, financial policy, or economic conditions. The most obvious problem with this approach is determining exactly how much to adjust beta, as there's no precise formula or universally accepted method for making these adjustments.

Question 15

For a particular share the dividend to be paid in the first year is 50p, the current price is 400p, and the rate at which the dividend stream is expected to grow is 2 per cent. What is the expected rate of return on the shares?

Accepted Answer

The answer of For a particular share the dividend to...

Question 16

Which three of the following factors have the greatest effects on the cost of debt?

Accepted Answer

A) The benefit derived from interest being tax deductible reduces the net cost of debt for the borrower, making it an important factor in determining the cost of debt.
B) The prevailing interest rates directly affect the cost of borrowing; the higher the interest rates, the higher the cost of debt.
D) The risk of default and expected rate of recovery of money lent in the event of default can significantly increase the cost of debt for the borrower, as lenders may require a higher interest rate to compensate for the higher risk.

Question 17

What name is given to the ratio of a company's level of long- term debt to its equity capital?

Accepted Answer

The name given to the ratio of a company's level of long-term debt to its equity capital is gearing.

Question 18

What is X in the formula X = di ?  Pp

Accepted Answer

The answer of What is X in the formula X...

Question 19

What of the following best describe the approaches analysts typically take when calculating the cost of capital?

Accepted Answer

Personal judgement aided by a theoretical framework is the most common approach analysts take when calculating the cost of capital. This is because the cost of capital is a complex and subjective concept, and there is no single "correct" way to calculate it. Analysts must therefore use their own judgement to determine which factors to consider and how to weight them. However, they can also use theoretical frameworks to help them make these decisions.

Question 20

The introduction of tax benefit pushes the bias towards very high gearing levels to obtain lower WACC and higher value. What is the main reason why we do not observe such high gearing in real- world companies?

Accepted Answer

The answer of The introduction of tax benefit pushes the...

Quiz 19: Dividend Policy