Question 1

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 lower the cost of equity (as calculated using the CAPM) and therefore lower the weighted average cost of capital (WACC). None of the other events listed would directly reduce the WACC.

Question 2

Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A's cost of capital is 10.0%, Division B's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A's projects are equally risky, as are all of Division B's projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept?

Accepted Answer

When using a corporate WACC for project evaluation, we assume that the projects are of average risk for the firm. Therefore, Division A projects should use a discount rate of 10%, which is lower than the corporate WACC of 12%. The Division A project with an 11% return exceeds its cost of capital and should be accepted. All other options have returns that are below their respective cost of capital and should be rejected.

Question 3

Suppose the debt ratio (D/TA) 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 (D/TA) is 50%,...

Question 4

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 represents short-term liabilities that are not used to finance long-term investments. The other options listed (long-term debt, retained earnings, common stock, preferred stock) are all capital components that would be included in the calculation of WACC.

Question 5

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, rs, than on the interest rate on long-term debt, rd, 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

Increased inflation results in a parallel upward shift in the SML, which means equal percentage increases in the required return on debt and equity.

Question 6

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...

Question 7

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 and then use a judgmental estimate when calculating the WACC.

Question 8

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 can finance a larger portion of its capital budget through debt rather than equity. This would reduce the need to issue new common stock and thus avoid the higher cost associated with issuing new equity. Alternatively, increasing the dividend payout ratio (A) or increasing the proposed capital budget (C) would likely increase the need for new equity, while reducing short-term bank debt (D) or reducing the percentage of debt in the target capital structure (E) would have little to no effect on the need for new equity.

Question 9

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, rs, than on the interest rate on long-term debt, rd, 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

An increase in the slope of the SML would lead to a greater increase in the required rate of return on equity compared to the interest rate on debt. This would lead to a shift towards more debt and less equity, but this shift could be limited due to increased risk associated with using more debt.

Question 10

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).”

Accepted Answer

The answer of The cost of external equity capital raised...

Question 11

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. It is necessary to use different risk-adjusted costs of capital for different capital budgeting projects because the divisions and projects may vary in risk. This ensures that the projects are evaluated based on their potential return relative to their risk, which helps in making better investment decisions.

Question 12

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 regarded as reliable, all three methods can provide reasonable estimates depending on the specific situation and assumptions made. The accuracy of these methods may be affected by factors such as market conditions, company-specific risks, and availability of data.

Question 13

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 all of these methods rely on publicly available information, and if the firm is not public, we do not have access to this information.

Question 14

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 market data and can be calculated with mathematical precision. The other factors such as the market risk premium, risk-free rate, and expected rate of return on the market depend on various subjective factors and can be subject to estimation errors. The beta coefficient of a relatively safe stock may also have a degree of uncertainty due to the stock's unique characteristics and the limitations of the CAPM model in predicting stock returns accurately.

Question 15

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 rRF, (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, RPM. These problems leave us unsure of the true value of rs.

Accepted Answer

These three potential problems with using the CAPM to estimate the cost of equity are well documented and can affect the accuracy of the estimated rs. Therefore, there is some uncertainty about the true value of rs.

Question 16

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...

Question 17

LaPango Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?

Accepted Answer

The answer of LaPango Inc. estimates that its average-risk projects...

Question 18

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.

Accepted Answer

The growth rate assumption is a critical and subjective input in the DCF method, and it can have a significant impact on the estimated cost of equity (rs). Because investors may have different growth rate expectations, it is difficult to determine the "true" growth rate that should be used in the calculation. Therefore, there is a potential for error when estimating the cost of equity using the DCF method.

Question 19

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.

Accepted Answer

The statement is true. While we can estimate the market interest rate for new long-term debt by looking at the yields on existing bonds, there is some subjectivity in determining the appropriate risk premium to add to this rate in order to arrive at the cost of equity (rs). Different analysts may use different risk premiums depending on their assessment of the company's specific risk factors, and there is no objective "right" answer to this question. Therefore, while the bond-yield-plus-risk-premium method can provide a reasonable estimate of rs, we cannot be completely sure that the resulting value is accurate.

Question 20

If the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common stock If the expected growth rate is not zero, then the cost of external equity must be found using a different formula.

Accepted Answer

When the expected dividend growth rate is zero, the cost of external equity capital (also known as the cost of common equity) can be calculated using the dividend capitalization model, which does not consider the growth rate of dividends. However, if the expected growth rate is not zero, a different model such as the dividend discount model or the capital asset pricing model must be used to calculate the cost of equity.

Quiz 11: Cost of Capital