Question 1

Using a company's cost of capital to evaluate a project is
I.always correct;
II.always incorrect;
III.correct for projects that have average risk compared to the firm's other assets

Accepted Answer

Using a company's cost of capital to evaluate a project is correct for projects that have average risk compared to the firm's other assets. This is because the cost of capital reflects the required return for projects with similar risk profiles to the company's existing operations.

Question 2

The market value of XYZ Corporation's common stock is $40 million and the market value of its risk-free debt is $60 million. The beta of the company's common stock is 0.8 and the expected market risk premium is 10 percent. If the Treasury bill rate is 6 percent, what is the firm's cost of capital? (Assume no taxes.)

Accepted Answer

The firm's cost of capital can be calculated using the Weighted Average Cost of Capital (WACC) formula, which in this case simplifies to account for equity and risk-free debt only, without taxes. The cost of equity (E) can be calculated using the Capital Asset Pricing Model (CAPM): E = Risk-free rate + Beta * Market risk premium = 6% + 0.8 * 10% = 14%. The cost of debt (D) is the Treasury bill rate, which is risk-free in this context, so D = 6%. The weights of equity (We) and debt (Wd) in the firm's capital structure are 40% (40 million / 100 million) and 60% (60 million / 100 million), respectively. Thus, WACC = We*E + Wd*D = 0.4*14% + 0.6*6% = 5.6% + 3.6% = 9.2%.

Question 3

The cost of capital for a project depends on

Accepted Answer

The cost of capital for a project depends on the use of the capital (the project) as it determines the risk associated with the project and the required return on investment. However, the company's cost of capital, industry cost of capital, and the company's level of debt financing may also influence the cost of capital for the project.

Question 4

The company cost of capital is the appropriate discount rate for a firm's

Accepted Answer

The company cost of capital represents the average risk of all projects undertaken by a firm. Therefore, it is most appropriate for average-risk projects. Using a higher discount rate for high-risk projects will result in higher expected returns but also higher uncertainty and risk. Using a lower discount rate for low-risk projects would result in lower expected returns but also lower uncertainty and risk. Risk-free projects would not require any discount rate as they have no risk.

Question 5

If a firm uses the same company cost of capital for evaluating all projects, which situation(s)will likely occur?
I.The firm will reject good low-risk projects;
II.The firm will accept poor high-risk projects;
III.The firm will correctly accept projects with average risk

Accepted Answer

The answer of If a firm uses the same company...

Question 6

Company A's historical returns for the past three years are 6 percent, 15 percent, and 15 percent. Similarly, the market portfolio's returns were 10 percent, 10 percent, and 16 percent. Calculate the beta for Stock A.

Accepted Answer

The answer of Company A's historical returns for the past...

Question 7

If a firm uses a project-specific cost of capital for evaluating all projects, which situation(s)will likely occur?
I.The firm will accept poor low-risk projects.
II.The firm will reject good high-risk projects.
III.The firm will correctly accept projects with average risk.

Accepted Answer

The answer of If a firm uses a project-specific cost...

Question 8

A firm's cost of equity can be estimated using the
I.discounted cash-flow (DCF)approach;
II.capital asset pricing model (CAPM);
III.arbitrage pricing theory

Accepted Answer

All three methods, DCF, CAPM, and arbitrage pricing theory, can be used to estimate a firm's cost of equity.

Question 9

The market value of Charter Cruise Company's equity is $15 million and the market value of its debt is $5 million. If the required rate of return on the equity is 20 percent and that on its debt is 8 percent, calculate the company's cost of capital. (Assume no taxes.)

Accepted Answer

Weighted Average Cost of Capital (WACC) = (Equity/Total capital) * Cost of Equity + (Debt/Total capital) * Cost of Debt

Given, 
Market value of Equity = $15 million 
Market value of Debt = $5 million 
Cost of Equity = 20% 
Cost of Debt = 8%

Total capital = Equity + Debt = $15 million + $5 million = $20 million

Therefore, 
WACC = [(15/20) * 20%] + [(5/20) * 8%] = 17%

Question 10

The market value of Cable Company's equity is $60 million and the market value of its debt is $40 million. If the required rate of return on the equity is 15 percent and that on its debt is 5 percent, calculate the company's cost of capital. (Assume no taxes.)

Accepted Answer

First, we need to calculate the weight of equity and debt in the company's capital structure:

Weight of equity = $60 million / ($60 million + $40 million) = 0.6 or 60%
Weight of debt = $40 million / ($60 million + $40 million) = 0.4 or 40%

Next, we can use the weighted average cost of capital (WACC) formula to calculate the company's cost of capital:

WACC = (Weight of equity x Required rate of return on equity) + (Weight of debt x Required rate of return on debt)

WACC = (0.6 x 0.15) + (0.4 x 0.05) = 0.09 or 9%

Therefore, the company's cost of capital is 9%.

Question 11

One calculates the after-tax weighted average cost of capital (WACC)using which of the following formulas?

Accepted Answer

The correct formula to calculate WACC is WACC = (rD * (1-Tc) * D/V) + (rE * E/V), where rD is the cost of debt, Tc is the corporate tax rate, rE is the cost of equity, D is the total debt, E is the total equity, and V is the sum of D and E. Option D is the only formula that matches this formula. Therefore, the answer is D.

Question 12

The market value of Charcoal Corporation's common stock is $20 million, and the market value of its risk-free debt is $5 million. The beta of the company's common stock is 1.25, and the market risk premium is 8 percent. If the Treasury bill rate is 5 percent, what is the company's cost of capital? (Assume no taxes.)

Accepted Answer

The answer of The market value of Charcoal Corporation's common...

Question 13

Which of the following types of projects has the lowest unique risk?

Accepted Answer

Cost improvements typically involve incremental changes to existing processes or practices and do not involve as much uncertainty or unique risk as speculative ventures, new product development, or expansions of existing business.

Question 14

Which of the following types of projects generally have the highest total risk?

Accepted Answer

Speculative ventures tend to have the highest total risk because they involve investing in new and untested ideas, products or services. There is a higher degree of uncertainty regarding market demand, competition, and profitability, which increases the overall risk of the project. Conversely, the other options listed involve either building on existing success or using known technology, which reduces overall risk.

Question 15

A firm might categorize its projects into
I.cost improvements;
II.expansion projects (existing business);
III.new products;
IV.speculative ventures

Accepted Answer

Firms often categorize their projects into various types to better manage and allocate resources. These categories can include cost improvements (aimed at reducing expenses), expansion projects (focused on growing the existing business), new products (development and launch of new offerings), and speculative ventures (projects with uncertain outcomes but potential high rewards). All these categories are common ways firms organize their project portfolios.

Question 16

Which of the following types of projects has average total risk?

Accepted Answer

Expansions of existing businesses typically have average total risk because they involve building on a successful business model and an established customer base, minimizing the risk of failure. The other options listed have higher levels of risk: speculative ventures involve high risk and potential high rewards, new products involve high uncertainty and may fail to meet market demand, and cost improvements entail some risk of failure if they do not result in the expected savings.

Question 17

The hurdle rate for capital budgeting decisions is

Accepted Answer

The hurdle rate for capital budgeting decisions is the minimum rate of return that a company requires before investing in any project. This rate is typically equal to the cost of capital, which is the average cost of financing a company's assets. Therefore, the answer is A, the cost of capital. The other options, such as the cost of debt, equity, or risk-free rate, may be relevant in specific scenarios but are not the overall hurdle rate for capital budgeting decisions.

Question 18

The cost of capital is the same as the cost of equity for firms that are financed

Accepted Answer

The cost of capital refers to the overall amount of money that firms pay to finance their operations, including both debt and equity. The cost of equity, on the other hand, refers specifically to the return that investors require to provide capital to the firm. If a firm is financed entirely by equity (i.e. it has no debt), then the cost of capital will be the same as the cost of equity.

Question 19

A firm's cost of equity can be estimated using the

Accepted Answer

The Fama-French three-factor model, capital asset pricing model (CAPM), and arbitrage pricing theory (APT) are all methods that can be used to estimate a firm's cost of equity, each incorporating different factors and assumptions to assess the expected returns of an equity investment.

Question 20

The company cost of capital, when the firm has both debt and equity financing, is called the

Accepted Answer

The weighted average cost of capital (WACC) takes into account both the cost of debt and the cost of equity financing, and is therefore the appropriate measure for the company's cost of capital. The cost of debt (A) and cost of equity (B) are important factors in calculating the WACC, but are not sufficient on their own to determine the company's cost of capital. Return on equity (ROE) (D) is a measure of the profitability of equity financing, but does not take into account the cost of debt or the overall cost of capital for the company.

Quiz 9: Risk and the Cost of Capital

Using a company's cost of capital to evaluate a project is I.always correct; II.always incorrect; III.correct for projects that have average risk compared to the firm's other assets