Question 1

The constant growth model uses the market price as a reflection of the expected risk-return preference of investors in the marketplace.

Accepted Answer

The constant growth model, also known as the Gordon Growth Model, uses the market price and expected dividend growth rate to estimate the required rate of return of investors. The model assumes that investors require a certain return on their investment and that this return is reflected in the market price. Therefore, the market price is used as a reflection of the expected risk-return preference of investors in the marketplace.

Question 2

According to the firm's owner wealth maximization goal, the firm should accept projects up to the point where the marginal return on its investment is equal to its weighted marginal cost of capital.

Accepted Answer

This statement is consistent with the principle of maximizing shareholder wealth, which suggests that a firm should invest in any project that provides a return higher than the cost of capital used to fund it, as long as there are no other constraints or negative consequences. By choosing projects with a positive net present value, the firm can create value for its owners and increase their wealth over time. The marginal return on investment refers to the additional cash flows generated by a project, while the weighted marginal cost of capital represents the opportunity cost of using funds from different sources, weighted by their respective proportions in the capital structure. By equating these two variables, the firm can determine the optimal level of investment and avoid underinvesting or overinvesting. However, this assumes that the firm is acting in a perfectly efficient market and has complete information about the costs and benefits of each project, which may not always hold in practice.

Question 3

The breaking point is the level of total new financing at which the cost of one of the financing components rises.

Accepted Answer

The breaking point is the level of total new financing at which the cost of one of the financing components (such as debt or equity) rises, making it more expensive to obtain additional financing beyond that point.

Question 4

Use of the Capital Asset Pricing Model (CAPM) in measuring the cost of common stock equity differs from the constant growth valuation model in that it directly considers the firm's risk as reflected by beta.

Accepted Answer

The CAPM takes into account the risk of a company as reflected by its beta, whereas the constant growth valuation model assumes a constant growth rate without directly considering the risk.

Question 5

A firm can retain more of its earnings if it can convince its stockholders that it will earn at least their required return on the reinvested funds.

Accepted Answer

This statement is true. If a firm can convince its stockholders that it will earn at least their required return on the reinvested funds, the stockholders will be willing to allow the firm to retain more of its earnings for reinvestment purposes. This is because they believe that the firm can create value with the reinvested funds and generate a better return than they would receive by receiving dividends or selling their shares.

Question 6

Preferred stock represents a special type of ownership interest in the firm and, thus, the preferred stockholders must receive their stated dividends prior to the distribution of any earnings to common stockholders and bondholders.

Accepted Answer

The answer of Preferred stock represents a special type of...

Question 7

The investment opportunity schedule (IOS) is the graph that relates the firm's weighted average cost of capital (WACC) to the level of total new financing.

Accepted Answer

The investment opportunity schedule (IOS) is a graph that shows the expected returns of potential investment projects, not the relationship between WACC and total new financing.

Question 8

The acceptance of projects beginning with those having the greatest positive difference between IRR and the weighted average cost of capital, Ka, down to the point at which IRR just equals ka should result in the maximum total NPV for all independent projects accepted.

Accepted Answer

This is known as the IRR ranking method, where projects are selected based on their IRRs in descending order until the point where the IRR equals the required rate of return (in this case, the weighted average cost of capital). This method results in the maximum total NPV for all independent projects accepted.

Question 9

A firm has an equity beta of 1.3. If the market risk premium is 6% and the long-term Government of Canada bond rate is 6%, the firm's cost of equity is 12%.

Accepted Answer

The calculation of cost of equity using the Capital Asset Pricing Model (CAPM) formula is:
Cost of Equity = Risk-Free Rate + (Equity Beta * Market Risk Premium)
= 6% + (1.3 * 6%) = 13.8%
Therefore, the statement is false.

Question 10

The Gordon model is based on the premise that the value of a share of stock is equal to the sum of all future dividends it is expected to provide over an infinite time horizon.

Accepted Answer

The answer of The Gordon model is based on the...

Question 11

The cost of capital is the rate of return a firm must earn on investments in order to leave share price unchanged.

Accepted Answer

The answer of The cost of capital is the rate...

Question 12

Since the net proceeds from sale of new common stock will be less than the current market price, the cost of new issues will always be less than the cost of existing issues.

Accepted Answer

The statement is incorrect. The cost of new issues may be higher than the cost of existing issues due to underwriting fees and other costs associated with the issuance of new shares. Additionally, the current market price is not always an accurate indicator of the true value of a company's shares.

Question 13

An investor has expectations of a $4 dividend next year with future dividends growing at 6% in perpetuity. If the investor is willing to pay $80 for the stock, the investor's expected return is 11%.

Accepted Answer

To calculate the expected return, we use the dividend discount model formula:

Expected Return = (Dividend/Price) + Dividend Growth
Expected Return = (4/80) + 0.06
Expected Return = 0.05 + 0.06
Expected Return = 0.11 or 11%

Since the expected return matches the investor's willingness to pay for the stock, the statement is true.

Question 14

The cost of preferred stock is typically higher than the cost of long-term debt (bonds) because the cost of long-term debt (interest) is tax deductible.

Accepted Answer

The cost of long-term debt (bonds) is tax-deductible, making the after-tax cost of debt lower than the cost of preferred stock, which is not tax-deductible. Therefore, the cost of preferred stock is typically higher than the cost of long-term debt.

Question 15

A firm may face increases in the weighted average cost of capital either when retained earnings have been exhausted or due to increases in debt, preferred stock, and common equity costs as additional new funds are required.

Accepted Answer

When a firm exhausts its retained earnings, it may need to raise additional funds through debt, preferred stock, or common equity. As the firm raises more funds through these sources, the cost of each source may increase, leading to an overall increase in the weighted average cost of capital. Therefore, the statement is true.

Question 16

Using the Capital Asset Pricing Model (CAPM), the cost of common stock equity is the return required by investors as compensation for the firm's nondiversifiable risk.

Accepted Answer

The statement correctly describes the CAPM. The CAPM is a financial model used to estimate the expected return on an investment based on the risk of that investment compared to the overall stock market. The cost of common stock equity is a key component of the CAPM calculation and reflects the return required by investors as compensation for the firm's nondiversifiable risk.

Question 17

Generally, the order of cost, from the least expensive to the most expensive, for long-term capital ofa corporation is
A) preferred stock, retained earnings, common stock, new common stock.
B) common stock, preferred stock, long-term debt, short-term debt.
C) new common stock, retained earnings, preferred stock, long-term debt.
D) long-term debt, preferred stock, retained earnings, new common stock.

Accepted Answer

Long-term debt is usually the cheapest form of long-term capital because it typically has the lowest cost of capital. Preferred stock is often more expensive than debt, and new common stock is typically the most expensive form of capital due to the high cost of issuing new shares. Retained earnings fall in between preferred stock and common stock in terms of cost. Therefore, the correct order of cost is long-term debt, preferred stock, retained earnings, new common stock.

Question 18

At any given time, the firm's financing costs and investment returns will be affected by the volume of financing and investment undertaken.

Accepted Answer

This is true because financing costs are incurred when a firm takes on debt, and investment returns are earned when a firm invests in projects or assets. The amount of financing and investment that a firm undertakes will impact the level of financing costs and investment returns it incurs. For example, if a firm takes on a large amount of debt to finance its investments, its financing costs will be higher and its investment returns will need to be higher to cover those costs. Conversely, if a firm invests a smaller amount of money, its financing costs will be lower and its investment returns may be lower as well.

Question 19

As the volume of financing increases, the costs of the various types of financing will decrease, reducing the firm's weighted average cost of capital.

Accepted Answer

As the volume of financing increases, the costs of financing may increase due to higher risk and potential dilution of equity, which can increase the firm's weighted average cost of capital.

Question 20

In general, flotation costs include two components, underwriting costs and administrative costs.

Accepted Answer

Flotation costs typically include both underwriting costs (such as fees paid to investment banks) and administrative costs (such as legal and accounting fees).

Quiz 9: The Cost of Capital