Question 1

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 conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects, as the risk levels of the different divisions and projects may vary.

Question 2

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

This is true because the bond-yield-plus-risk-premium method involves adding a risk premium to the interest rate on long-term debt to estimate the cost of equity. However, the appropriate risk premium is subjective and can vary depending on the company and market conditions, making the estimated cost of equity uncertain.

Question 3

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 4

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

This statement is true. The growth rate assumption used in the DCF method can have a significant impact on the estimated cost of equity, and it can be challenging to accurately predict the future growth rate that investors will use in their return expectations. This uncertainty can result in a range of possible values for the cost of equity estimate, making it difficult to determine the true value of r_s.

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 states that using all three methods and then making a judgmental estimate is often appropriate when calculating the WACC.

Question 6

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 is a true statement. The formula for calculating the cost of external equity capital when the expected dividend growth rate is zero is r_e = r_s / (1 - F). If the expected growth rate is not zero, the formula for calculating the cost of external equity capital is r_e = (D1 / P0) + g + (F / (1 - F)).

Question 7

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 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 lower...

Question 9

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 increase the use of debt financing instead of equity financing, which would decrease the need to issue new common stock. Increasing the dividend payout ratio, increasing the proposed capital budget, reducing short-term bank debt, or reducing the percentage of debt in the target capital structure would not affect the need to issue new common stock.

Question 10

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 stocks are not traded in public markets, it is difficult to measure its beta for the CAPM model, observe its stock price for the DCF model, and determine the risk premium for the bond-yield-plus-risk-premium method. Therefore, it is challenging to estimate the cost of equity for a private company.

Question 11

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 total shareholders' equity is incorrectly listed as \$0,000,000; it should be the sum of common stock (\$30,000,000) and retained earnings (\$50,000,000), which equals \$80,000,000.

Question 12

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 13

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

A decrease in the market risk premium would decrease the cost of equity, which would result in a lower WACC. The other options would increase the cost of equity or the cost of debt, resulting in a higher WACC.

Question 14

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

These are potential problems when estimating the cost of equity using the CAPM method, and they can lead to uncertainties in the true value of r_s.

Question 15

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 a liability, not a capital component, and therefore is not included in the calculation of WACC. The other options (long-term debt, retained earnings, common stock, and preferred stock) are all capital components that are used in the calculation of WACC.

Question 16

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 data and can be calculated with a high degree of accuracy. The other factors listed may be subject to more uncertainty or variability.

Question 17

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 following...

Question 18

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

A higher slope of the SML would increase the required rate of return on equity more than the interest rate on long-term debt. This would lead to an increase in the use of debt and a decrease in the use of equity, although using too much debt would increase risk and limit the shift toward debt.

Question 19

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 commonly used and considered one of the most reliable methods for estimating the cost of common stock, its accuracy can be affected by assumptions and market conditions. The DCF and bond-yield-plus-risk-premium methods can also provide reliable estimates when used appropriately.

Question 20

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

The statement is correct. As the cost of debt is usually lower than the cost of equity, and the cost of debt is tax-deductible, the weighted average cost of capital (WACC) will be higher than the cost of debt adjusted for taxes. This is because the proportion of debt in the capital structure will decrease the WACC, but the proportion of equity, with a higher cost of capital, will increase it.

Quiz 10: The Cost of Capital

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.

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.

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 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)."

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).

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

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

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.

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 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).

Quiz 10: The Cost of Capital

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.

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.

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 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)."

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).

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

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

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.

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 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).

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.

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.

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)."

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).