Question 1

Debt financing is made up of explicit and implicit costs which are:

Accepted Answer

Debt financing involves an interest rate that bondholders demand, which is an explicit cost. Additionally, debt financing also results in a higher required return on equity (ROE) due to the increased financial risk, which is an implicit cost. Therefore, option B is the correct choice.

Question 2

With respect to the WACC:

Accepted Answer

The WACC is a benchmark discount rate, but it needs to be adjusted based on the riskiness of the project. Therefore, C is the correct choice. A is incorrect as the WACC may not be appropriate for all projects. B is incorrect as the WACC is not used to value all new projects, only those that are similar in risk to the company's overall operations. D is incorrect as adjustments need to be made to the WACC based on the project's riskiness.

Question 3

The company cost of capital is the return that is expected on a portfolio of the company's:

Accepted Answer

The company cost of capital is the return expected on a portfolio of the company's existing securities, which includes both equity and debt.

Question 4

Which of the following changes would tend to increase the company cost of capital for a traditional firm?

Accepted Answer

Decreasing the proportion of debt financing would decrease the financial risk and increase the creditworthiness of the firm, which would ultimately lead to a decrease in the cost of capital. Therefore, the opposite action of decreasing the proportion of equity financing would increase the cost of capital. Increasing the market value of debt may have a minimal effect as it only affects the debt portion of the capital structure. Similarly, decreasing the market value of equity would also have a minimal effect.

Question 5

What dividend is paid on preferred stock if investors require a 9% rate of return and the stock has a market value of $54.00 per share and a book value of $50.00 per share?

Accepted Answer

9% rate of return is the same as the 9% required dividend yield on preferred stock.

Dividend/Price = 9%

Dividend = Price x 9%

Dividend = $54 x 9% = $4.86

Therefore, the dividend paid on the preferred stock is $4.86 per share. The best choice is D.

Question 6

One flaw with using a higher discount rate to account for flotation costs is:

Accepted Answer

Using a higher discount rate to account for flotation costs assumes that cash flows will grow at a constant rate, which may not be accurate for all projects.

Question 7

What is the company cost of capital for a firm financed with 30% debt if the debt requires a 10% return and equity requires a 16% return?

Accepted Answer

The company cost of capital can be calculated using the weighted average cost of capital (WACC) formula, where WACC = (% of debt x cost of debt) + (% of equity x cost of equity). Plugging in the given values, WACC = (0.3 x 0.10) + (0.7 x 0.16) = 0.03 + 0.112 = 0.142 or 14.2%. Therefore, the best choice is C.

Question 8

Calculate a firm's WACC given that the total value of the firm is $2,000,000, $600,000 of which is debt, the cost of debt and equity is 10% and 15% respectively, and the firm pays no taxes:

Accepted Answer

The WACC is calculated as 0.10(600,000/2,000,000) + 0.15(1,400,000/2,000,000) = 0.10(0.3) + 0.15(0.7) = 0.03 + 0.105 = 0.135 or 13.5%.

Question 9

For a company that pays no corporate taxes, its WACC will be equal to:

Accepted Answer

The answer of For a company that pays no corporate...

Question 10

In general, equity is considered a _____ investment than debt, because payments on debt are _______.

Accepted Answer

Equity is considered riskier than debt because debt payments, such as interest and principal, are typically guaranteed by the company, meaning they have a legal obligation to pay them before any returns are given to equity holders.

Question 11

As debt is added to the capital structure, the:

Accepted Answer

As debt is added to the capital structure, the implied cost of debt can be expected to rise. This is because the more debt a company has, the riskier it becomes for lenders. Lenders will then demand a higher rate of return to compensate for the increased risk. This increase in the cost of debt will also increase the overall WACC. Therefore, both B and D are not correct choices. A is also inaccurate as the WACC continually declining is not a result of adding debt to the capital structure.

Question 12

Which of the following statements is correct for a firm that is 55% debt-financed and the value of equity equals $58 million?

Accepted Answer

Since the firm is 55% debt-financed, the debt-to-equity ratio is 55:45. Let's assume the total value of the firm is "V". Therefore, the value of debt (D) is 55/45 times the value of equity (E).
D/E = 55/45
D/E = 1.22
Now we can use the given value of equity to calculate the total value of the firm.
E = $58 million
V = E + D
V = $58 million + $70.76 million (D = 1.22E)
V = $128.76 million
Therefore, the firm is valued at approximately $129 million (option B). The value of debt can be calculated as D = 55/45 x $58 million = $70.76 million.

Question 13

If a firm has three times as much equity as debt in its capital structure, then the firm has:

Accepted Answer

The firm has 3 times as much equity as debt, so if debt is x, equity is 3x. Therefore, total capital is 4x, and x (debt) is 25% of the total.

Question 14

What will happen to the required return on assets as a result of changing to a more debt-intensive capital structure?

Accepted Answer

The answer of What will happen to the required return...

Question 15

Higher flotation costs will result when:

Accepted Answer

Higher flotation costs occur when a firm feels market pressure from selling additional stock, as it may need to offer the stock at a lower price or incur higher costs to attract investors.

Question 16

If a firm has twice as much equity as debt in its capital structure, then the firm has:

Accepted Answer

The answer of If a firm has twice as much...

Question 17

An implicit cost of increasing the proportion of debt in a firm's capital structure is that:

Accepted Answer

When a firm increases its proportion of debt in its capital structure, the riskiness of the firm increases. This will cause equity holders to demand a higher rate of return to compensate for the increased risk. This is known as the cost of equity.

Question 18

If a company's cost of capital is less than the required return on equity, then the firm:

Accepted Answer

If a company's cost of capital is less than the required return on equity, it implies that the cost of debt is lower than the required return on equity. This typically implies that the company has debt in its capital structure, which is cheaper compared to equity financing. Therefore, the company can lower its overall cost of capital by using more debt in its capital structure.

Question 19

If a firm earns the WACC as an average return on its average-risk assets, then:

Accepted Answer

If a firm earns the WACC as an average return on its average-risk assets, then it is earning the minimum required rate of return for all investors. This includes both equity holders and bondholders, as the WACC represents the cost of capital for the entire firm, taking into account both sources of financing. If the firm’s investments are generating returns that are equal to or greater than the WACC, then it is investing in positive NPV projects. Therefore, the correct answer is C, all investors will earn their minimum required rate of return.

Question 20

for a firm that pays no corporate taxes, changing its capital structure will:

Accepted Answer

Since the firm pays no corporate taxes, there will be no tax advantages or disadvantages associated with changing its capital structure. Therefore, changing the capital structure will not affect the cash flows or the risk of the cash flows.

Quiz 13: The Weighted-Average Cost of Capital and Company Valuation