Question 1

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 = r_s(0.30)(0.50)+ r_ps(1 − T)(0.70)(0.50).

Accepted Answer

The answer of Since 70% of the preferred dividends received...

Question 2

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 r_s.

Accepted Answer

The growth rate estimation is a critical factor in the DCF method, and the uncertainty around it can lead to an unreliable estimation of the cost of equity.

Question 3

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 r_s.

Accepted Answer

The statement is true. While we can estimate the interest rate on new long-term debt using the bond-yield-plus-risk-premium method, the risk premium we add may not be appropriate or accurate, making it difficult to determine the true value of r_s.

Question 4

Suppose the debt ratio 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 have to decrease the weighted average cost of capital (WACC).

Accepted Answer

The answer of Suppose the debt ratio is 50%,the interest...

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.However,only the CAPM method always provides an accurate and reliable estimate.

Accepted Answer

While the CAPM method can provide a reliable estimate in certain circumstances, no single method can always provide an accurate estimate of the cost of common stock from retained earnings. Each method has its own advantages and limitations, and different methods may be more appropriate for different companies or situations.

Question 6

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,r_s,than on the interest rate on long-term debt,r_d,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

This statement is true as an increase in the slope of the SML would mean that investors are demanding a higher return for a given level of risk. This would primarily impact the required rate of return on equity, as equity investments are generally considered riskier than debt investments. As a result, firms may choose to increase their use of debt financing, which could have implications for the riskiness of both debt and equity.

Question 7

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,its target capital structure consists of common stock,preferred stock,and debt.Which of the following events would REDUCE its WACC?

Accepted Answer

Only a decrease in the market risk premium would reduce the company's cost of equity, which would, in turn, reduce its WACC. None of the other events listed would have a direct impact on the WACC.

Question 8

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 the stock of a privately-owned firm is not traded publicly, we cannot measure its beta, observe its stock price or know the risk premium, making it difficult to estimate the cost of equity using commonly used methods like CAPM, DCF, and bond-yield-plus-risk-premium method.

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

The statement correctly identifies three potential problems in estimating the cost of equity by use of the CAPM and acknowledges that these problems can leave us unsure of the true value of r_s.

Question 10

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

This statement is true as companies raise funds at the corporate level and then allocate it to different divisions for investment in various capital projects which may vary in risk. Thus, using different risk-adjusted costs of capital for different projects is conceptually correct.

Question 11

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 Corporation can reduce its need to issue new common stock. This is because debt is a cheaper source of financing than equity, and increasing the proportion of debt in the capital structure can improve the company's overall cost of capital. This will allow Bankston to fund its proposed capital budget without having to issue as much new common stock. Increasing the dividend payout ratio (A) and increasing the proposed capital budget (C) would likely increase the need for new common stock, while reducing short-term bank debt (D) may not have a significant impact on the need for new stock. Reducing the percentage of debt in the target capital structure (E) would also likely increase the need for new common stock.

Question 12

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 lower...

Question 13

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

Accepted Answer

This statement is true because the cost of debt, after tax, is lower than the cost of equity. Therefore, when calculating the weighted average cost of capital (WACC), a firm's debt proportion will contribute to reducing the WACC.

Question 14

If the expected dividend growth rate is zero,then the cost of external equity capital raised by issuing new common stock (r_e)is equal to the cost of equity capital from retaining earnings (r_s)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 statement is true. When the expected dividend growth rate is zero, the cost of external equity capital raised by issuing new common stock is equal to the cost of equity capital from retaining earnings divided by one minus the percentage flotation cost required to sell the new stock. This is based on the assumption that investors view retained earnings and new stock issuances as equivalent sources of financing, and that the only difference between the two is the flotation cost associated with new issuances. If the expected growth rate is not zero, then a different formula must be used to calculate the cost of external equity capital.

Question 15

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 to compare the cost of each financing option to the weighted average cost of capital (WACC). - First, we compare the cost of issuing new stock (rS) to the cost of internal equity (eS) and the cost of issuing debt (rD) to the cost of internal debt (dS). - Then, we compare the cost of each financing option to the WACC. The correct sequence, based on this logic, is: r_e > r_s > WACC > r_d. This is because the cost of issuing new stock (rS) is typically higher than the cost of internal equity (eS), but lower than the WACC. The cost of issuing debt (rD) is typically lower than the WACC, but higher than internal debt (dS). Therefore, the best choice is B.

Question 16

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 as it is a current liability and not a source of long-term financing. The other options (long-term debt, retained earnings, common stock, preferred stock) are all sources of long-term financing and therefore considered capital components when calculating the WACC.

Question 17

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,r_s,than on the interest rate on long-term debt,r_d,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

The answer of If expectations for long-term inflation rose,but the...

Question 18

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

Accepted Answer

The statement is incorrect. The cost of external equity capital raised by issuing new common stock is defined as the cost of equity capital from issuing new shares, which is higher than the cost of equity capital from retaining earnings due to the flotation costs associated with issuing new shares. Therefore, the correct formula is r_e = r_s * (1/(1-F)).

Question 19

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

Accepted Answer

The answer of When working with the CAPM,which of the...

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 mentions that all three methods can be used and a judgmental estimate should be made based on considering all three estimates when calculating the WACC.

Quiz 10: The Cost of Capital

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 r_s.

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 r_s.

Suppose the debt ratio 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 have to decrease the weighted average cost of capital (WACC).

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.

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.

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

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.

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

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

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

Quiz 10: The Cost of Capital

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.

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.

Suppose the debt ratio 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 have to decrease the weighted average cost of capital (WACC).

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.

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.

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).

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.

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

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)."

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

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 r_s.

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 r_s.

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

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