Question 1

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 a capital component and is not used when calculating the WACC. The components typically used are long-term debt, retained earnings, common stock, and preferred stock.

Question 2

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

By increasing the percentage of debt in the target capital structure, Bankston can reduce its reliance on issuing new common stock since debt has a lower cost than equity. Increasing the dividend payout ratio would actually increase the amount of cash that needs to be raised, which would further increase Bankston's need to issue new common stock. Increasing the proposed capital budget would also increase its need to issue new common stock. Lastly, reducing short-term bank debt would not necessarily reduce the need to issue new common stock.

Question 3

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 for the cost of external equity capital is incorrect. The correct formula is: re = rs(1 + F)/(1 - T), where F is the percentage flotation cost and T is the tax rate.

Question 4

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 decrease in the market risk premium would decrease the cost of equity, which would in turn decrease the overall WACC. None of the other choices would result in a decrease in the WACC.

Question 5

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 clearly states that there are three methods for estimating the cost of common stock from retained earnings and that using all three methods and then making a judgmental estimate for WACC is appropriate due to the uncertainty of each method's accuracy.

Question 6

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 formula provided incorrectly combines the cost of equity (rs) and the cost of preferred stock (rps) in a manner that does not accurately reflect how the cost of equity is calculated. The cost of equity typically does not directly factor in the tax exclusion on preferred dividends received. The cost of equity is concerned with the return required by equity investors (common shareholders), and the cost of preferred stock is a separate component that considers the return required by preferred shareholders. The tax treatment of preferred dividends received by a corporation affects the corporation's net income, not directly the cost of equity or preferred stock calculation.

Question 7

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 text mistakenly states that only the DCF method is widely used in practice, when in fact, all three methods (CAPM, DCF, and bond-yield-plus-risk-premium) are commonly used for estimating the cost of common stock from retained earnings.

Question 8

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

The statement is true. An increase in the slope of the SML would lead to 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. This would lead to an increase in the use of debt and a decrease in the use of equity. However, if firms use too much debt, it would increase their overall riskiness and limit the shift towards debt.

Question 9

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 10

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

This is true according to the Gordon Model, which assumes a constant growth rate in dividends.

Question 11

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 correct sequence is re > rs > WACC > rd. This is because the cost of equity (re) is typically higher than the cost of retained earnings (rs) due to flotation costs associated with new equity. The weighted average cost of capital (WACC) is lower than both re and rs because it is a weighted average of the cost of equity, the cost of retained earnings, and the after-tax cost of debt (rd), with debt usually being the cheapest source of financing.

Question 12

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

The statement is true. Since the cost of debt is typically lower than the cost of equity, the use of debt in a firm's capital structure will lower the overall WACC. However, as the proportion of debt in the capital structure increases, so does the risk of financial distress, which will push up the cost of equity and increase the overall WACC. Therefore, as long as the firm is not completely debt financed, the WACC will normally be greater than the after-tax cost of debt (rd(1-T)).

Question 13

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 when working with the CAPM. This is because it is calculated using historical data and is a measure of systematic risk based on the market as a whole, rather than specific to an individual stock or asset. Other factors, such as the market risk premium, risk-free rate, and expected return on the market, involve more subjective assumptions and are therefore less precise.

Question 14

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 15

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 calculate the interest rate on new long-term debt using the bond-yield-plus-risk-premium method, the risk premium is based on subjective factors and can vary depending on the company and industry. Therefore, it is difficult to be certain that the risk premium added is appropriate, leading to uncertainty in the estimation of the cost of equity (rs).

Question 16

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

While the CAPM method is a commonly used and widely accepted method for estimating the cost of common stock from retained earnings, it is not always accurate or reliable. The other two methods mentioned, the DCF method and the bond-yield-plus-risk-premium method, can also provide useful estimates depending on the specific context and assumptions used.

Question 17

When estimating the cost of equity by use of the DCF method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return. This problem leaves us unsure of the true value of rs.

Accepted Answer

This statement is true. Determining the growth rate that investors use in estimating a stock's future rate of return is a crucial part of the DCF method, and the uncertainty around this estimation can lead to uncertainty around the estimate of the cost of equity (rs).

Question 18

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 19

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

This is because all the methods mentioned require publicly available information, which is generally not available for privately owned firms.

Question 20

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

Since divisions and projects within a firm may have varying levels of risk, it is appropriate to use different risk-adjusted costs of capital for each project to account for the varying levels of risk.

Quiz 9: The Cost of Capital