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, and 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 result in a decrease in the cost of equity, which would in turn decrease the WACC. The other options would either increase the cost of equity (B and C) or have no effect on the WACC (D and E).

Question 2

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 3

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

Accepted Answer

This statement is true according to the constant dividend growth model, where the cost of external equity (re) is equal to (rs/1-F) when the expected dividend growth rate is zero.

Question 4

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

Since the firm is privately owned and its stock is not traded in public markets, we cannot access the necessary data to estimate the cost of equity using traditional models such as the CAPM, DCF, or bond-yield-plus-risk-premium methods. This makes it challenging to estimate the cost of equity for a private company.

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 is true because the risk premium is subject to interpretation and can vary depending on different factors and perspectives. Therefore, the estimated cost of equity using this method may not be entirely accurate or reliable.

Question 6

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 DCF method is widely used in practice.

Accepted Answer

The statement falsely claims that only the DCF method is widely used in practice. In fact, all three methods (CAPM, DCF, and bond-yield-plus-risk-premium) are used in practice to estimate the cost of common stock from retained earnings.

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, 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 8

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 decrease the weighted average cost of capital (WACC).

Accepted Answer

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

Question 9

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

The statement is false. While the CAPM method is widely used and considered reliable, it is not always accurate. The other methods, such as the DCF and bond-yield-plus-risk-premium, also have their own strengths and limitations and can provide accurate estimates depending on the specific circumstances.

Question 10

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 divisions and projects within a firm may have varying levels of risk, so it is appropriate to use different risk-adjusted costs of capital for different capital budgeting projects.

Question 11

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 allow Bankston to rely more on debt financing rather than equity financing, thus reducing the need to issue new common stock. Choices A, C, D and E would not have a direct impact on the need to issue new common stock. Increasing the dividend payout ratio would increase the amount of funds paid out to shareholders, thus increasing the need for additional equity financing. Increasing the proposed capital budget would increase the need for additional financing, which could not be fully met through retained earnings alone. Reducing short-term bank debt would have no direct impact on the need for equity financing. Finally, reducing the percentage of debt in the target capital structure would increase the reliance on equity financing, thus increasing the need to issue new common stock.

Question 12

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).

Accepted Answer

This statement is true. Since the cost of debt is normally less than the cost of equity, rd(1 - T) will usually be lower than rs. However, the WACC takes into account the proportion of debt and equity financing, so as long as the firm is not completely debt financed, the WACC will be higher than rd(1 - T).

Question 13

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

Question 14

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 and not long-term financing for the company. The other options, long-term debt, retained earnings, common stock, and preferred stock, are all sources of long-term capital for the company and are included in the calculation of WACC.

Question 15

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 formula provided is incorrect. The correct formula for the cost of external equity capital is: re = rs(1 + F) where F is the percentage flotation cost required to sell the new stock.

Question 16

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(0.30)(0.50) + rps(1 - T)(0.70)(0.50).

Accepted Answer

The preferred dividend exclusion is a benefit to the holder of the preferred, not the issuer; hence, this statement is not true. It actually is just nonsense anyway!

Question 17

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 critical in the DCF method and can greatly influence the estimation of the cost of equity. This uncertainty can lead to a degree of subjectivity and potential inaccuracy in the final value of rs.

Question 18

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 19

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

This is because the required rate of return on equity is more sensitive to changes in the slope of the SML than the interest rate on long-term debt. The increase in the slope of the SML indicates a higher risk premium, which would result in a higher required rate of return on equity. This would make equity financing more expensive and lead firms to use more debt. However, if firms use too much debt, it could increase their overall risk and limit the shift toward debt financing.

Question 20

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.

Quiz 9: The Cost of Capital