Question 1

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 statement is true as estimating the growth rate is a critical component of the DCF method and can greatly impact the calculated cost of equity. The uncertainty of the growth rate can in turn lead to uncertainty in the estimation of r_s.

Question 2

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 3

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 sequence starts with the highest rate, which typically would be the cost of equity (rS) under extreme scenarios (e.g., high business risk and high financial leverage), followed by a slightly lower cost of equity under less extreme scenarios. The Weighted Average Cost of Capital (WACC) is generally lower than the cost of equity because it also includes the cost of debt, which is cheaper due to tax shields. The lowest rate is for the scenario with the lowest risk (e.g., low business risk and low financial leverage).

Question 4

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

The statement is true. When the expected dividend growth rate is zero, the cost of external equity capital from issuing new stock can be calculated using the formula r_e = r_s / (1-F). But if there is expected dividend growth rate, then a different formula must be used to calculate the cost of external equity capital.

Question 5

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 the data required for calculations in the CAPM model, DCF model, and bond-yield-plus-risk-premium method is not available for privately owned companies whose stock is not traded in public markets.

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

Accepted Answer

The formula provided mixes elements that are not typically combined in calculating the cost of equity. The cost of equity is generally calculated using models like the Capital Asset Pricing Model (CAPM) or the Dividend Discount Model (DDM), which do not factor in the tax treatment of preferred dividends in this manner. The exclusion of 70% of preferred dividends from taxable income affects the cost of debt or the overall cost of capital calculation, not directly the cost of equity.

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

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 obtain the interest rate on new long-term debt from the bond-yield-plus-risk-premium method, the risk premium added may not be appropriate which creates uncertainty in determining the cost of equity.

Question 9

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

When calculating the weighted average cost of capital (WACC), accounts payable is not considered a capital component. WACC accounts for the cost of long-term debt, preferred stock, common stock, and retained earnings. Accounts payable, on the other hand, is a short-term liability and is not factored into WACC.

Question 10

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

The increase in the slope of the SML would have a greater impact on the required rate of return on equity, resulting in an increase in the use of debt and a decrease in the use of equity. However, if firms use a lot more debt, it would increase the riskiness of both debt and equity, which would limit the shift toward debt.

Question 11

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 12

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 in turn reduce the overall WACC. The other choices would increase the cost of equity or debt, or have no effect on the WACC.

Question 13

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 important to adjust the cost of capital based on the risk of the project or division in order to accurately evaluate the potential return on investment. Using the same cost of capital for all projects or divisions can lead to incorrect investment decisions.

Question 14

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 reliable, it may not always provide an accurate estimate. The other two methods may also be useful in certain situations and can provide additional insights.

Question 15

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 amount of funding from debt and reduce the need for new common stock. This is because debt is a cheaper source of financing than equity (new common stock). Increasing the dividend payout ratio (A) would actually decrease the amount of retained earnings, which would increase the need for new common stock. Increasing the proposed capital budget (C) would also increase the need for more financing, including new common stock. Reducing short-term bank debt (D) would have no effect on the need for new common stock, as it is a short-term liability and not a long-term source of financing. Reducing the percentage of debt in the target capital structure (E) would increase the reliance on equity financing, thereby increasing the need for new common stock.

Question 16

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 17

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 it is often appropriate to use all three methods for estimating the cost of common stock from retained earnings and end up using a judgmental estimate when calculating the WACC.

Question 18

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. The cost of debt (r_d) is typically lower than the cost of equity (r_s), and when factoring in the tax benefits of debt (1-T), the after-tax cost of debt is even lower. Therefore, when calculating the weighted average cost of capital (WACC), the cost of debt (adjusted for taxes) will typically be lower than the WACC. However, if a company is completely debt financed, then the WACC would be equal to the cost of debt (adjusted for taxes).

Question 19

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 accurately describes the potential problems with estimating the cost of equity using the CAPM model.

Question 20

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 definition is incorrect. The correct formula for the cost of external equity capital raised by issuing new common stock is r_e = r_s + (r_s - RF) * (1 - F), where RF is the risk-free rate.

Quiz 11: 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 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.

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.

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

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).

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)."

Quiz 11: 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 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.

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.

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

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).

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 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)."