Question 1

Assume Lavender Corporation has a market value of $4 billion of equity and a market value of $19.8 billion of debt. What are the weights in equity and debt that are used for calculating the WACC?

Accepted Answer

C) Weight in debt equals market value of debt divided by market value of debt plus equity. Similarly, weight in equity is market value of equity divided by market value of debt plus equity.
Weight in equity = $4 billion / ($4 + $19.8) billion = 0.168;
Weight in debt = $19.8 billion / ($4 + $19.8) billion = 0.832

Question 2

A firm's overall cost of capital that is a blend of the costs of the different sources of capital is known as the firm's ________.

Accepted Answer

The firm's overall cost of capital that is a blend of the costs of the different sources of capital is known as the weighted average cost of capital (WACC). It takes into account the cost of equity, debt, and preferred stock, and weights them according to their proportion in the firm's capital structure.

Question 3

A levered firm is one that has ________ outstanding.

Accepted Answer

A levered firm is one that has debt outstanding. This means the company has borrowed money and has to pay interest on that debt, which affects its profitability and financial risk.

Question 4

A firm raised all its capital via equity rather than debt. Such a firm is also referred to as a(n) ________ firm.

Accepted Answer

An unlevered firm is one that raises all its capital through equity financing, meaning that it has no debt.

Question 5

Epiphany is an all-equity firm with an estimated market value of $400,000. The firm sells $225,000 of debt and uses the proceeds to purchase outstanding equity. Compute the weight in equity and the weight in debt after the proposed financing and repurchase of equity.

Accepted Answer

B) Weight in debt = Debt raised / Market value of the firm
Weight in debt = $225,000 / $400,000 = 0.56
Weight in equity = 1- Weight in debt
Weight in equity = 1 - 0.56 = 0.44

Question 6

Assume the total market value of General Motors (GM) is $10 billion. GM has a market value of $6 billion of equity and a face value of $12 billion of debt. What are the weights in equity and debt that are used for calculating the WACC?

Accepted Answer

B) Weight in debt equals market value of debt divided by market value of debt plus equity. Similarly, weight in equity is market value of equity divided by market value of debt plus equity.
Equity = $6 million / $10 million = 0.60; Debt = ($10 million - $6 million) / $10 million = 0.40

Question 7

Epiphany is an all-equity firm with an estimated market value of $500,000. The firm sells $150,000 of debt and uses the proceeds to purchase outstanding equity. Compute the weight in equity and the weight in debt after the proposed financing and repurchase of equity.

Accepted Answer

D) Weight in debt = Debt raised / Market value of firm
Weight in equity = 1 - Weight in debt
Weight in debt = $150,000 / $500,000 = 0.30
Weight in equity = 1 - 0.30 = 0.70

Question 8

As a firm increases its level of debt relative to its level of equity, the firm is ________.

Accepted Answer

As the level of debt increases relative to equity, the firm is increasing its leverage. This is because the amount of debt financing is increasing, which leads to higher interest payments and increases the financial risk of the company.

Question 9

To attract capital from outside investors, a firm must offer potential investors an expected return that is commensurate with the level of risk that they can bear.

Accepted Answer

This statement is true. Investors will only be willing to invest in a firm if they believe that the potential return is worth the risk they are taking. The higher the risk, the higher the expected return must be in order to attract investors.

Question 10

Assume JUP has debt with a book value of $24 million, trading at 120% of par value. The firm has book equity of $28 million, and 2 million shares trading at $20 per share. What weights should JUP use in calculating its WACC?

Accepted Answer

A) Market Value Debt = $24 million × 120% = $28.8 million
Market Value Equity = 2 million × $20 = $40 million
Total Market Value = $68.8 million
Weight of debt = $28.8 million / $68.8 million = 41.86%
Weight of equity = $40 million / $68.8 million = 58.14%

Question 11

Leverage is the amount of ________ on a firm's balance sheet.

Accepted Answer

Leverage refers to the use of debt to finance a firm's operations or investments. Therefore, the amount of debt on a firm's balance sheet is its leverage.

Question 12

The relative proportion of debt, equity, and other securities that a firm has outstanding constitute its ________.

Accepted Answer

Capital structure refers to the mix of debt, equity, and other securities used by a company to finance its operations and growth. It is a crucial decision for management as it can impact the company's risk and profitability. The other answer choices (asset ratio, current ratio, and retained earnings) do not accurately describe the proportion of debt and equity in a company's capital structure.

Question 13

For an unlevered firm, the cost of capital can be determined by using the ________.

Accepted Answer

The Capital Asset Pricing Model (CAPM) can be used to determine the cost of capital for an unlevered firm by considering the risk-free rate, market risk premium, and the firm's beta. Yield on traded debt, dividend yield, and preferred stock yield are more relevant for levered firms when determining the cost of capital.

Question 14

Assume Bismuth Electronics has a book value of $6 billion of equity and a face value of $19.7 billion of debt. The market values of equity and debt are $2.5 billion and $18.5 billion. A Wall Street financial analyst determines values of equity and debt as $3 billion and $20 billion. Which of the following values should be used for calculating the firm's WACC?

Accepted Answer

Market values of equity and debt should be used for calculating the firm's Weighted Average Cost of Capital (WACC) because they reflect the current cost of financing.

Question 15

One should use accounting-based book values rather than market values of debt and equity to determine the weights for the different sources of capital.

Accepted Answer

Market values of debt and equity are preferred over book values because they more accurately reflect the current cost of capital and the investment community's perception of the firm's value and risk.

Question 16

A firm's sources of financing, which usually consists of debt and equity, represent its ________.

Accepted Answer

A firm's sources of financing, which includes debt and equity, represent its capital.

Question 17

Epiphany is an all-equity firm with an estimated market value of $300,000. The firm sells $250,000 of debt and uses the proceeds to purchase outstanding equity. Compute the weight in equity and the weight in debt after the proposed financing and repurchase of equity.

Accepted Answer

C) Weight in debt = Debt raised / Market value of firm
Weight in equity = 1 - Weight in debt
Weight in debt = $250,000 / $300,000 = 0.83
Weight in equity = 1 - 0.83 = 0.17

Question 18

Financial managers must determine their firm's overall cost of capital based on all sources of financing.

Accepted Answer

Financial managers are responsible for evaluating and determining the cost of capital for a company, which includes all sources of funding, such as equity, debt, and hybrid securities.

Question 19

The book value of a firm's equity is $100 million and its market value of equity is $200 million. The face value of its debt is $50 million and its market value of debt is $60 million. What is the market value of assets of the firm?

Accepted Answer

C) Market value of debt plus market value of equity gives market value of assets.
$200 + $60 = $260 million

Question 20

The after-tax cost of equity is ________ the pretax cost of equity.

Accepted Answer

The after-tax cost of equity is the same as the pretax cost of equity because the cost of equity does not get a tax deduction, unlike the cost of debt.

Quiz 13: The Cost of Capital