Question 1

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 indeed potential problems with estimating the cost of equity using the CAPM and can lead to uncertainty in the true value of rs.

Question 2

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

Determining the growth rate is a key input in the DCF method, and variations in this assumption can greatly impact the estimated value of rs. Thus, it is a potential problem in accurately calculating the true cost of equity.

Question 3

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, the cost of external equity capital raised by issuing new common stock would be the same as the dividend yield (i.e., the expected dividend divided by the current stock price). However, if the expected growth rate is not zero, the cost of external equity must be calculated using the dividend discount model or another formula that takes into account the expected growth rate.

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

A privately owned firm without publicly traded stock makes it challenging to estimate the cost of equity due to the unavailability of key inputs required for various valuation models.

Question 5

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

It is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects that vary in risk.

Question 6

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 7

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 is true because the WACC takes into account both the cost of debt and the cost of equity, and since the cost of equity (rs) is typically higher than the cost of debt (rd), the overall WACC will be higher than rd(1 - T).

Question 8

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 there are three methods for estimating the cost of common stock from retained earnings, and that it is often appropriate to use all three and then make a judgmental estimate.

Question 9

Suppose the debt ratio 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 to 60% would increase the cost of equity due to higher financial risk, and the weighted average cost of capital (WACC) would remain unchanged or even increase. Therefore, it is false that an increase in the debt ratio to 60% would decrease the WACC.

Question 10

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 have a greater impact on the required rate of return on equity than on the interest rate on long-term debt. This would lead to an increase in the use of debt and a decrease in the use of equity, but a shift towards excessive debt would increase the riskiness of both debt and equity, limiting the shift towards debt.

Question 11

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 has its advantages, it is not always accurate and reliable. The DCF method and the bond-yield-plus-risk-premium method can also provide reasonable estimates, depending on the specific circumstances of the company and the market.

Question 12

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 13

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 cost of external equity capital raised by issuing new common stock (re) is actually defined as follows: "The cost of external equity equals the expected dividend yield on the new stock (D1/P0) plus the expected capital gains yield (g), minus the percentage flotation cost required to sell the new stock (F)."

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

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 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

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 result in a lower cost of equity, which would then lower the overall WACC.

Question 18

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 are not a capital component as they are considered a short-term liability and not a source of long-term funding. The other options listed (long-term debt, retained earnings, common stock, and preferred stock) are all sources of long-term capital that factor into the calculation of WACC.

Question 19

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

As increasing the percentage of debt in the target capital structure will increase the amount of debt financing, it will reduce the need for issuing new common stock. This is because debt has a lower cost of capital compared to equity, and increasing debt financing will reduce the overall cost of capital. Additionally, increasing the dividend payout ratio, increasing the proposed capital budget, reducing the amount of short-term bank debt, or reducing the percentage of debt in the target capital structure will not necessarily reduce the need for issuing new common stock.

Question 20

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. While we can easily determine the interest rate on new long-term debt, determining the appropriate risk premium to add is more subjective and can vary depending on different factors, such as the company's industry, financial performance, and overall market conditions. Therefore, while using the bond-yield-plus-risk-premium method can provide a rough estimate of the cost of equity, it may not give us an entirely accurate or reliable figure.

Quiz 10: The Cost of Capital