Question 1

Which three of the following could result if the cost of capital as a discount rate is too high?
A) Shareholders will miss out on value- enhancing opportunities.
B) Firms will not grow as they should.
C) Investment will be constrained.
D) Bank lending is likely to fall as a proportion of investment levels.

Accepted Answer

If the cost of capital as a discount rate is too high, firms may miss out on valuable investment opportunities, resulting in lower levels of growth. Additionally, the high cost of capital may constrain investment, as companies may have difficulty finding cost-effective ways to fund new projects. Finally, if investment levels are constrained, bank lending may fall as a proportion of overall investment levels.

Question 2

What does the X represent in the formula X= d1   p
, if d1 is the annual preference dividend and kp
Is the investors' required rate of return?
A) Price- productivity ratio
B) Rate of return on preference shares
C) Preference share ratio
D) Price of (perpetual) preference shares

Accepted Answer

The X in the formula represents the price of perpetual preference shares, which is what the investor is calculating using the annual preference dividend (d1) and their required rate of return (kp). Therefore, the correct answer is D, as it refers directly to the calculation being done.

Question 3

Which three of the following factors have the greatest impact on the cost of debt?
A) The benefit derived from interest being tax deductible
B) The risk of default
C) The prevailing interest rates
D) The level to which equity is classed as tradable

Accepted Answer

The benefits derived from the interest being tax deductible and the prevailing interest rates have significant impacts on the cost of debt. Moreover, the risk of default affects the cost of debt since riskier debt instruments carry higher interest rates to compensate investors for the risk of default. The level to which equity is classed as tradable may impact the cost of equity, but it does not have a direct impact on the cost of debt. Therefore, option D is not relevant to the question.

Question 4

Which three of the following are among the difficulties encountered when computing required rates of return?
A) Obtaining the riskfree rate
B) Estimating the equity risk premium
C) Creating a maximised gearing level
D) The unreliability of the CAPM's beta

Accepted Answer

Creating a maximised gearing level (choice C) is not a difficulty encountered when computing required rates of return. It is more related to financing decisions rather than the estimation of required rates of return. Obtaining the riskfree rate (choice A), estimating the equity risk premium (choice B), and the unreliability of the CAPM's beta (choice D) are all common difficulties encountered when computing required rates of return.

Question 5

What is meant by the term 'cost of capital'?
A) The rate of return that a company has to offer finance providers to induce them to buy and hold a financial security
B) The rate of return that a company has to offer shareholders as dividends
C) The rate of return that a company has to offer purchasers of bonds to induce them to buy and hold a financial security
D) The rate of return that a company has to pay for its capital investments

Accepted Answer

Cost of capital refers to the rate of return that a company has to offer finance providers to induce them to buy and hold a financial security such as bonds, loans, or stocks. It is the cost that a company has to incur to attract funds for its operations and growth.

Question 6

What is RP in the formula kD = rf + RP ?
A) Risk- free rate
B) Market rate
C) Risk premium
D) Cost of debt capital

Accepted Answer

RP stands for risk premium, which is the additional return required by an investor to compensate for the risk taken on a particular investment. It is added to the risk-free rate (rf) to determine the required rate of return (kD) for a company's debt capital. The market rate (B) and cost of debt capital (D) are not directly related to the formula for kD = rf + RP.

Question 7

Which statement describes the rate of return expected when lending funds to a firm as compared with the rate when lending to a reputable state?
A) It must be lower because a lender to a firm cannot expect to not to be exposed to any risk.
B) It must be higher because a lender to a state cannot expect not to be exposed to any risk.
C) It must be lower because the term lengths will generally be shorter.
D) It must be higher because a lender to a firm cannot expect not to be exposed to any risk.

Accepted Answer

Lending to a firm typically involves higher risk compared to lending to a reputable state due to the greater likelihood of default by the firm. Therefore, lenders demand a higher rate of return to compensate for this increased risk.

Question 8

On what basis do most UK firms identify their risk free rate?
A) Rate of inflation
B) Medium- term UK government bonds
C) Real rate of interest (including inflation)
D) Short- term UK government bonds

Accepted Answer

Most UK firms identify their risk-free rate based on medium-term UK government bonds as they are considered to have minimal credit risk and are relatively stable. Inflation and short-term bonds may not accurately reflect the long-term risk-free rate. Real rate of interest is also a consideration, but it is usually calculated by adjusting the nominal risk-free rate for inflation.

Question 9

What does the symbol kD represent in the formula WACC = kDWE + kEWD ?
A) The market value of debt
B) The market/debt equivalent
C) The weighting applied to debt
D) The cost of debt

Accepted Answer

The symbol kD represents the cost of debt in the formula WACC = kDWE + kEWD.

Question 10

Which of the following would you expect to have the lowest level of risk- return?
A) A Treasury Bill
B) An internet start- up share
C) A Marks and Spencer share
D) A high- yield bond

Accepted Answer

Treasury bills are considered one of the safest investments as they are backed by the government and have a low risk of default. However, they also have a lower return compared to other types of investments such as stocks or high-yield bonds.

Question 11

When should short- term debt be included when calculating WACC?
A) Always
B) Only for a public, listed company
C) Only for a private company
D) Never

Accepted Answer

Short-term debt should always be included when calculating WACC because it represents the cost of capital for the company's short-term financing needs. Ignoring short-term debt can lead to an inaccurate calculation of WACC, which can have implications for investment decisions and financial performance.

Question 12

What is the effect of financial distress and taxation on gearing?
A) Both push for increased gearing.
B) Both constrain gearing.
C) The tax constrains gearing; financial distress pushes for increased gearing.
D) The tax pushes for increased gearing; financial distress constrains gearing.

Accepted Answer

Tax benefits on debt interest encourage companies to increase gearing, while the costs associated with financial distress (e.g., bankruptcy risk) discourage high levels of debt, thus constraining gearing.

Question 13

The average market return is 6 per cent and the risk- free return is 4 per cent. If beta for a particular share is 1.5, what is the required rate of return on the shares?
A) 7%
B) 6%
C) 21%
D) 12%

Accepted Answer

The required rate of return on the shares is 7%. This is because the required rate of return is equal to the risk-free rate plus the beta of the share multiplied by the market risk premium. In this case, the risk-free rate is 4%, the beta of the share is 1.5, and the market risk premium is 6% - 4% = 2%. Therefore, the required rate of return is 4% + 1.5 * 2% = 7%.

Question 14

Modigliani and Miller concluded that there is no point in adjusting the debt or equity proportions in choosing the capital structure of the firm, but which two important factors did they ignore?
A) Taxation
B) Financial distress
C) Inflation
D) Interest

Accepted Answer

Modigliani and Miller ignored two important factors in their conclusion- taxation and financial distress. Taxation is an essential factor to consider while deciding the capital structure, as debt allows for tax deductions, whereas equity does not. Financial distress can also impact the capital structure as too much debt can lead to bankruptcy or default. Inflation and interest rates are also crucial factors to consider, but they were not ignored by Modigliani and Miller.

Question 15

Yven has capital of £2m, three- quarters from shareholders who require a rate of return of 10 per cent and one- quarter from lenders, who require an 8 per cent return. If, as a result of considering tax, kDAT = 6%, what is the WACC?
A) 8.5%
B) 6.75%
C) 4%
D) 9%

Accepted Answer

The answer of Yven has capital of £2m, three- quarters...

Question 16

Which two of the following are implicit assumptions when estimating the equity risk premium?
A) There has been no systematic change in the risk aversion of investors over time.
B) Historical returns are so unreliable that they should be ignored.
C) The index being used as a benchmark has had an average riskiness that has not changed in a systematic way over time.
D) The risk premium is now so small that it can be ignored.

Accepted Answer

The implicit assumption when estimating the equity risk premium is that there has been no systematic change in the risk aversion of investors over time and that the index being used as a benchmark has had an average riskiness that has not changed in a systematic way over time. Historical returns are not ignored, as they are used to estimate the risk premium, and the risk premium is not assumed to be so small that it can be ignored.

Question 17

What is the fundamental formula of the Gordon growth model?
A) kE = P1 - g
B) kE = d1 - g
C) kE = d1 + g
D) kE = P1 + g
D P P d

Accepted Answer

The correct formula for the Gordon growth model is kE = (d1/P0) + g, where kE is the required rate of return, d1 is the dividend for the next period, P0 is the current price, and g is the expected growth rate of dividends. None of the options match this formula exactly, but option C is the closest with kE = d1 + g, as it assumes the investor is able to accurately predict the future dividend payments and growth rate. Options A and D are incorrect because they use P1 instead of P0, which represents the future price instead of the current price. Option B is incorrect because it only includes the dividend for the next period and does not account for future growth.

Question 18

Which three of the following are thought to be the factors that most affect fundamental beta?
A) Operating gearing
B) The type of business
C) The number of SBUs
D) Financial gearing

Accepted Answer

Fundamental beta is affected by operating gearing, financial gearing, and the type of business. The number of SBUs is not a factor that affects fundamental beta.

Question 19

The cost of equity capital, kE, is calculated using the formula kE = rf + RP. What does rf represent?
A) Cost of debt capital
B) Risk premium
C) Risk- free rate
D) Market rate

Accepted Answer

rf represents the risk-free rate, which is the rate of return that can be earned without taking on any risk. This is often based on the return of a government bond or treasury bill.

Question 20

Which of the following are the main forms of capital available to firms?
A) Equity and foreign currency
B) Convertible bonds and equity
C) Equity and debt
D) Non- convertible bonds and debt

Accepted Answer

The main forms of capital available to firms are equity (ownership) and debt (borrowed funds). Choice A is incorrect because foreign currency may be a component of a firm's assets, but it is not a form of capital. Choice B is incorrect because convertible bonds are a type of debt that can be converted into equity, so they are not a separate form of capital. Choice D is incorrect because non-convertible bonds are a type of debt, and debt was already included in Choice C.

Quiz 19: Dividend Policy

Which three of the following could result if the cost of capital as a discount rate is too high?

What does the X represent in the formula X= d1 p , if d1 is the annual preference dividend and kp Is the investors' required rate of return?

Which three of the following factors have the greatest impact on the cost of debt?

Which three of the following are among the difficulties encountered when computing required rates of return?

What is meant by the term 'cost of capital'?

What is RP in the formula kD = rf + RP ?

Which statement describes the rate of return expected when lending funds to a firm as compared with the rate when lending to a reputable state?

On what basis do most UK firms identify their risk free rate?

What does the symbol kD represent in the formula WACC = kDWE + kEWD ?

Which of the following would you expect to have the lowest level of risk- return?

When should short- term debt be included when calculating WACC?

What is the effect of financial distress and taxation on gearing?

The average market return is 6 per cent and the risk- free return is 4 per cent. If beta for a particular share is 1.5, what is the required rate of return on the shares?

Modigliani and Miller concluded that there is no point in adjusting the debt or equity proportions in choosing the capital structure of the firm, but which two important factors did they ignore?

Yven has capital of £2m, three- quarters from shareholders who require a rate of return of 10 per cent and one- quarter from lenders, who require an 8 per cent return. If, as a result of considering tax, kDAT = 6%, what is the WACC?

Which two of the following are implicit assumptions when estimating the equity risk premium?

What is the fundamental formula of the Gordon growth model?

Which three of the following are thought to be the factors that most affect fundamental beta?

The cost of equity capital, kE, is calculated using the formula kE = rf + RP. What does rf represent?

Which of the following are the main forms of capital available to firms?