Question 1

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 2

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 3

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 because it represents short-term debt owed to suppliers, and is not a permanent source of financing. The other options (long-term debt, retained earnings, common stock, and preferred stock) represent long-term sources of financing for a company and are considered capital components.

Question 4

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 lead to a decrease in the cost of equity, which would lower the overall WACC. The other events listed would either increase the cost of equity, cost of debt, or both, resulting in a higher WACC.

Question 5

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

This statement is true. The bond-yield-plus-risk-premium method estimates the cost of equity by adding a risk premium to the yield on long-term bonds. While we may have a good idea of the interest rate on new long-term debt, the risk premium we add is a subjective estimate and may not accurately reflect the true risk associated with the company's equity. Therefore, there is some uncertainty in the true value of rs.

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 = rs

Accepted Answer

The statement is false, as the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should include both the cost of common equity and the cost of preferred equity, which may have differing tax implications. Therefore, the formula for cost of equity in this scenario would be: Cost of equity = (D1/P0) + g for common equity and Cost of equity = (Pref Dividend/Net Proceeds of Preferred Stock) for preferred equity.

Question 7

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 are all potential problems that can impact the accuracy of estimating the cost of equity using the CAPM, which can leave us unsure of the true value of rs.

Question 8

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

If the expected dividend growth rate is zero, then the cost of external equity capital is equal to the current dividend yield. However, if the expected growth rate is not zero, then the cost of external equity must be found using the dividend discount model or the capital asset pricing model.

Question 9

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 used in the DCF method is a crucial factor in determining the cost of equity. The estimate of future growth can vary greatly and can lead to uncertainty in the calculation of rs.

Question 10

The cost of debt, rd, is normally less than rs, so rd

Accepted Answer

This is generally true because lenders require a lower rate of return than equity investors, as they have a lower level of risk.

Question 11

The cost of external equity capital raised by issuing new common stock "

Accepted Answer

The statement is incomplete. The cost of external equity capital refers to the expenses associated with raising new funds through issuing new common stock, which typically includes underwriting fees, legal fees, and other issuance costs.

Question 12

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

Different capital budgeting projects may have different levels of risk and therefore, to ensure that capital is allocated efficiently, it is appropriate to use different risk-adjusted costs of capital for each project. This allows for a more accurate analysis of each project's potential returns and helps to ensure that capital is allocated to the projects that offer the best returns relative to their risk.

Question 13

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 rely more on debt financing and reduce its reliance on more expensive equity financing (i.e., issuing new common stock). This would reduce the need to issue new stock and help Bankston avoid that cost. A higher dividend payout ratio, increasing the proposed capital budget, reducing short-term bank debt, and reducing the percentage of debt in the target capital structure would not directly address the issue of avoiding the higher cost of issuing new common stock.

Question 14

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 result in a higher required rate of return on equity, which would lead to an increase in the use of debt and a decrease in the use of equity. However, if firms use too much debt, it would increase the overall riskiness of the company, which would limit the shift towards debt. Therefore, the statement is true.

Question 15

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 then use a judgmental estimate when calculating the WACC.

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...

Question 17

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

The statement is true. Without publicly traded stock, we cannot measure beta or observe stock price for use in valuation models. Additionally, we may not have access to information needed to determine the risk premium for the bond-yield-plus-risk-premium method.

Question 18

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 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 a widely used and reliable approach for estimating the cost of common stock, the DCF method and bond-yield-plus-risk-premium method can also provide accurate estimates when applied appropriately. It ultimately depends on the specific circumstances and available data.

Question 20

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

An increase in the debt ratio would increase the cost of debt and the cost of equity, resulting in an increase in the WACC. Therefore, the statement is false.

Quiz 10: Cost of Capital