Question 1

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the DCF method is widely used in practice.

Accepted Answer

The answer of The text identifies three methods for estimating...

Question 2

If expectations for long-term inflation rose, but the slope of the SML remained constant, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Therefore, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt.

Accepted Answer

Increased inflation results in a parallel upward shift in the SML, which means equal percentage increases in the required return on debt and equity.

Question 3

Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets. They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.

Accepted Answer

It is important to use different risk-adjusted costs of capital for different capital budgeting projects because divisions and projects may vary in risk.

Question 4

Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A's cost of capital is 10.0%, Division B's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A's projects are equally risky, as are all of Division B's projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept?

Accepted Answer

A Division A project with an 11% return should be accepted because it exceeds Division A's cost of capital of 10%.

Question 5

If the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common stock (re) is equal to the cost of equity capital from retaining earnings (rs) divided by one minus the percentage flotation cost required to sell the new stock, (1 - F). If the expected growth rate is not zero, then the cost of external equity must be found using a different formula.

Accepted Answer

The statement is correct. When the expected dividend growth rate is zero, the cost of external equity capital raised by issuing new common stock (re) is equal to the cost of equity capital from retaining earnings (rs) divided by one minus the percentage flotation cost required to sell the new stock, (1 - F).

Question 6

For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure.

Accepted Answer

The answer of For a typical firm, which of the...

Question 7

The cost of debt, rd, is normally less than rs, so rd(1 - T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 - T).

Accepted Answer

This statement is true because the WACC takes into account both the cost of debt and the cost of equity, weighted by their respective proportions in the company's capital structure. Since rs is normally greater than rd, the cost of equity has a greater impact on the WACC than the cost of debt. Therefore, even if the cost of debt is reduced by the tax shield (rd(1-T)), the overall effect on the WACC will be limited if the company has a significant amount of equity financing.

Question 8

The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant.

Accepted Answer

The answer of The lower the firm's tax rate, the...

Question 9

When working with the CAPM, which of the following factors can be determined with the most precision?

Accepted Answer

The beta coefficient of "the market," which is the same as the beta of an average stock, can be determined with the most precision as it is based on historical market data and can be calculated with mathematical precision. The other factors such as the market risk premium, risk-free rate, and expected rate of return on the market depend on various subjective factors and can be subject to estimation errors. The beta coefficient of a relatively safe stock may also have a degree of uncertainty due to the stock's unique characteristics and the limitations of the CAPM model in predicting stock returns accurately.

Question 10

Bankston Corporation forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Since new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock?

Accepted Answer

Increasing the percentage of debt in the target capital structure would reduce the need to issue new common stock because it allows the company to finance more of its capital budget with debt rather than equity.

Question 11

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the CAPM method always provides an accurate and reliable estimate.

Accepted Answer

The text does not state that only the CAPM method always provides an accurate and reliable estimate. It is mentioned that the CAPM method is widely used and can provide a reliable estimate, but the other two methods (DCF and bond-yield-plus-risk-premium) can also be used under certain circumstances.

Question 12

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

Accepted Answer

Accounts payable is not considered a capital component when calculating the WACC as it is a form of short-term financing and not a long-term source of capital. The remaining options (long-term debt, retained earnings, common stock, and preferred stock) are all forms of capital that can be included in the calculation of WACC.

Question 13

Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

Accepted Answer

The answer of Suppose the debt ratio (D/TA) is 50%,...

Question 14

If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the DCF model, and we don't know what the risk premium is for use in the bond-yield-plus-risk- premium method. All this makes it especially difficult to estimate the cost of equity for a private company.

Accepted Answer

Since a privately owned firm's stock is not traded in public markets, we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the DCF model, and we don't know what the risk premium is for use in the bond-yield-plus-risk- premium method. As a result, the cost of equity for a private company is tough to determine.

Question 15

The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 - F)."

Accepted Answer

The formula stated in the question is incorrect. The formula for the cost of external equity capital raised by issuing new common stock is: re = D1 ÷ (P0 × (1 − F)) + g, where D1 represents the expected dividends per share in the coming year, P0 represents the current market price per share, F represents the percentage flotation cost required to sell the new stock, and g represents the expected growth rate of the company's earnings and dividends.

Question 16

Schalheim Sisters Inc. has always paid out all of its earnings as dividends; hence, the firm has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, and its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC?

Accepted Answer

A decline in the market risk premium would reduce the cost of equity, thereby reducing the WACC.

Question 17

When estimating the cost of equity by use of the bond-yield-plus-risk- premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs.

Accepted Answer

The statement is true. While we can estimate the interest rate on new long-term debt, the risk premium we add may not accurately reflect the true level of risk, leading to uncertainty in the true value of the cost of equity (rs).

Question 18

Since 70% of the preferred dividends received by a corporation are excluded from taxable income, the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be
Cost of equity = rs(0.30)(0.50) + rps(1 - T)(0.70)(0.50).

Accepted Answer

The preferred dividend exclusion is a benefit to the holder of the preferred, not the issuer; hence, this statement is not true. It actually is just nonsense anyway!

Question 19

If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity. However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit the shift toward debt.

Accepted Answer

An increase in the slope of the SML (security market line) would lead to a higher required rate of return on equity, as equity is generally considered more risky than debt. This would lead to firms using more debt and less equity to finance their operations. However, using too much debt would increase the overall riskiness of the firm and may limit the ability to shift toward debt.

Question 20

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. Since we cannot be sure that the estimate obtained with any of these methods is correct, it is often appropriate to use all three methods, then consider all three estimates, and end up using a judgmental estimate when calculating the WACC.

Accepted Answer

The text states that it is often appropriate to use all three methods for estimating the cost of common stock and then use judgment to arrive at a final estimate for the WACC.

Quiz 9: The Cost of Capital