Question 1

In general,firms should use their weighted average cost of capital (WACC)to evaluate capital budgeting projects because most projects are funded with general corporate funds,which come from a variety of sources.However,if the firm plans to use only debt or only equity to fund a particular project,it should use the after-tax cost of that specific type of capital to evaluate that project.

Accepted Answer

In general,this statement is false,because the firm should be viewed as an ongoing entity,and using debt (or equity)to fund a given project will change the capital structure,and this factor should be recognized by basing the cost of capital for all projects on a target capital structure.Under some special circumstances,where a project is set up as a separate entity,then "project financing" may be used,and only the project's specific situation is considered.This is a specific situation,however,and not the "in general" case.

Question 2

For capital budgeting and cost of capital purposes,the firm should assume that each dollar of capital is obtained in accordance with its target capital structure,which for many firms means partly as debt,partly as preferred stock,and partly common equity.

Accepted Answer

For accurate capital budgeting and estimating the cost of capital, it is necessary to assume that the capital is raised based on the firm's target capital structure, which typically consists of a mix of debt, preferred stock, and common equity. This helps in determining the appropriate cost of capital and making investment decisions accordingly.

Question 3

The cost of equity raised by retaining earnings can be less than,equal to,or greater than the cost of external equity raised by selling new issues of common stock,depending on tax rates,flotation costs,the attitude of investors,and other factors.

Accepted Answer

False

Question 4

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock.No adjustment is needed for taxes because preferred dividends,unlike interest on debt,is not deductible by the issuing firm.

Accepted Answer

The statement is true. Preferred dividends are not deductible by the issuing firm, so no adjustment is needed for taxes when calculating the cost of perpetual preferred stock.

Question 5

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.

Accepted Answer

This statement is true. The cost of debt is reduced by the tax deduction for interest payments, which is equal to the marginal tax rate. So the after-tax cost of debt is equal to (1 - marginal tax rate) x interest rate on new debt.

Question 6

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

The cost of common equity obtained by retaining earnings is also known as the retained earnings cost of equity, and it represents the rate of return required by the marginal shareholder who chooses to reinvest their dividends in the company instead of receiving cash payouts. This cost is typically lower than the cost of issuing new common stock or preferred stock.

Question 7

The cost of capital used in capital budgeting should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets.

Accepted Answer

This statement is true. The cost of capital used in capital budgeting is the weighted average cost of the different sources of long-term funds a firm uses to acquire assets, such as debt, equity, or preferred stock. This helps the firm determine the minimum rate of return necessary to justify its investment in a project.

Question 8

The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

Accepted Answer

The cost of external equity raised by issuing new stock is typically higher than the required rate of return on the firm's outstanding common stock. This is because new investors may require a higher return to invest in the company, as they are taking on additional risk by investing in a new security.

Question 9

When estimating the cost of equity by use of the CAPM,three potential problems are (1)whether to use long-term or short-term rates for r_RF, (2)whether or not the historical beta is the beta that investors use when evaluating the stock,and (3)how to measure the market risk premium,RP_M.These problems leave us unsure of the true value of r_s.

Accepted Answer

Unfortunately,this is true.

Question 10

The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

Accepted Answer

The component costs of capital, such as the cost of debt and cost of equity, are determined by the market and reflect the returns required by investors for investing in that particular security or asset.

Question 11

For capital budgeting and cost of capital purposes,the firm should always consider reinvested earnings as the first source of capital- i.e.,use these funds first- because reinvested earnings have no cost to the firm.

Accepted Answer

The answer of For capital budgeting and cost of capital...

Question 12

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them,and no flotation costs are required to raise them,but capital raised by selling new stock or bonds does have a cost.

Accepted Answer

Even though retained earnings do not involve direct payments like dividends or interest, they are not cost-free. They represent an opportunity cost, as shareholders could have received these funds as dividends and invested them elsewhere for a return.

Question 13

If a firm's marginal tax rate is increased,this would,other things held constant,lower the cost of debt used to calculate its WACC.

Accepted Answer

The answer of If a firm's marginal tax rate is...

Question 14

The reason why reinvested earnings have a cost equal to r_s is because investors think they can (i.e.,expect to)earn r_s on investments with the same risk as the firm's common stock,and if the firm does not think that it can earn r_s on the earnings that it retains,it should distribute those earnings to its investors.Thus,the cost of reinvested earnings is based on the opportunity cost principle.

Accepted Answer

The statement accurately summarizes the reasoning behind the cost of reinvested earnings. It is based on the principle of opportunity cost, where investors expect to earn a certain rate of return on investments with similar risk levels. If a firm cannot meet or exceed this expected rate of return on retained earnings, it should distribute them to investors. Therefore, the cost of reinvested earnings is equal to the expected rate of return that investors could earn elsewhere.

Question 15

The higher the firm's flotation cost for new common equity,the more likely the firm is to use preferred stock,which has no flotation cost,and reinvested earnings,whose cost is the average return on the assets that are acquired.

Accepted Answer

The total shareholders' equity should not be \$0; it is the sum of common stock and retained earnings, which should be \$80,000,000 (\$30,000,000 + \$50,000,000).

Question 16

"Capital" is sometimes defined as funds supplied to a firm by investors.

Accepted Answer

This definition of "capital" is correct. It refers to the money that investors provide to a company for investment or use in operations.

Question 17

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

The cost of debt is calculated as the average coupon rate on all outstanding debt multiplied by (one minus the marginal tax rate), not the other way around. This formula accounts for the tax deductibility of interest expenses.

Question 18

The before-tax cost of debt,which is lower than the after-tax cost,is used as the component cost of debt for purposes of developing the firm's WACC.

Accepted Answer

The after-tax cost of debt, which takes into account the tax shield from interest payments, is used as the component cost of debt for purposes of developing the firm's WACC.

Question 19

Suppose you are the president of a small,publicly-traded corporation.Since you believe that your firm's stock price is temporarily depressed,all additional capital funds required during the current year will be raised using debt.In this case,the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt.

Accepted Answer

The answer of Suppose you are the president of a...

Question 20

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

Accepted Answer

The answer of The cost of preferred stock to a...

Quiz 9: The Cost of Capital