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?
A) The market risk premium declines.
B) The flotation costs associated with issuing new common stock increase.
C) The company's beta increases.
D) Expected inflation increases.
E) The flotation costs associated with issuing preferred stock increase.

Accepted Answer

The CAPM formula includes the market risk premium as a component, but it is not directly affected by the other choices listed. A decrease in the market risk premium would lead to a lower cost of equity, which in turn would lower the overall WACC for the company.

Question 2

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 beta, stock price, and risk premium are all publicly available information that can only be obtained for companies whose stocks are traded in public markets. As a result, it is challenging to estimate the cost of equity for a private firm.

Question 3

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 for the cost of external equity capital is incorrect. The correct formula is: re = rs(1 + f), where rs is the cost of equity from retained earnings and f is the percentage flotation cost.

Question 4

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 interest rate on new long-term debt by looking at existing bonds, it can be difficult to determine an appropriate risk premium to add to this rate to arrive at the cost of equity. Different companies and industries may require different risk premiums, and even within the same company, the appropriate risk premium may vary over time. Therefore, the true value of rs may be uncertain when using this method.

Question 5

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 end up using a judgmental estimate when calculating the WACC.

Question 6

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

The answer of Suppose the debt ratio is 50%, the...

Question 7

When working with the CAPM, which of the following factors can be determined with the most precision?
A) The market risk premium (RPM ).
B) The beta coefficient, bi, of a relatively safe stock.
C) The most appropriate risk-free rate, rRF.
D) The expected rate of return on the market, rM .
E) The beta coefficient of "the market," which is the same as the beta of an average stock.

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 8

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.
A) rs > re > rd > WACC.
B) re > rs > WACC > rd.
C) WACC > re > rs > rd.
D) rd > re > rs > WACC.
E) WACC > rd > rs > re.

Accepted Answer

The answer of For a typical firm, which of the...

Question 9

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 10

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 accepted and commonly used method for estimating the cost of common stock from retained earnings, it is not the only accurate and reliable method. The DCF method and bond-yield-plus-risk-premium method can also provide accurate and reliable estimates when used appropriately.

Question 11

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. When the expected dividend growth rate is zero, the cost of external equity capital raised by issuing new common stock is equal to the cost of equity capital from retaining earnings divided by one minus the percentage flotation cost required to sell the new stock. This is known as the constant growth model or the Gordon Model. If the expected growth rate is not zero, then a different formula (such as the dividend discount model) must be used to calculate the cost of external equity.

Question 12

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?
A) Long-term debt.
B) Accounts payable.
C) Retained earnings.
D) Common stock.
E) Preferred stock.

Accepted Answer

Accounts payable is not considered a capital component when calculating the weighted average cost of capital (WACC) because it is a short-term liability and not a long-term source of capital. Long-term debt, retained earnings, common stock, and preferred stock are all considered capital components and included when calculating the WACC.

Question 13

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 as the divisions and projects may vary in terms of risk.

Question 14

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

This statement is true. The growth rate is a critical component in the DCF method, and if it is not accurately estimated, it can lead to an incorrect estimate of the cost of equity (rs).

Question 15

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 16

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 common issues faced when using the CAPM model and can impact the accuracy of the estimated cost of equity.

Question 17

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?
A) Increase the dividend payout ratio for the upcoming year.
B) Increase the percentage of debt in the target capital structure.
C) Increase the proposed capital budget.
D) Reduce the amount of short-term bank debt in order to increase the current ratio.
E) Reduce the percentage of debt in the target capital structure.

Accepted Answer

Increasing the percentage of debt in the target capital structure would decrease Bankston's need to issue new common stock because debt has a lower cost than issuing new equity. This would enable Bankston to meet its capital budget requirements without incurring significant additional costs. Increasing the dividend payout ratio (A) would actually reduce the amount of retained earnings available for investment, increasing the need for new equity. Increasing the proposed capital budget (C) would exacerbate the issue by further increasing the total amount of financing required. Reducing short-term bank debt (D) and/or reducing the percentage of debt in the target capital structure (E) would also have the opposite effect of reducing the amount of debt financing available to Bankston.

Question 18

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

If investors' aversion to risk increases, the slope of the SML will increase, leading to a higher required rate of return on equity (rs) and a potentially smaller impact on the interest rate on long-term debt (rd). This would make debt financing relatively less expensive compared to equity financing, leading to an increase in the use of debt and a decrease in the use of equity. However, if a firm were to increase its use of debt significantly, it would also increase its financial risk, which could limit the shift toward debt financing.

Question 19

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 20

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 because the cost of debt is usually lower than the cost of equity, and the tax shield from interest payments can further decrease the after-tax cost of debt. Since the WACC takes into account the cost of both debt and equity, and the firm is not entirely debt financed, the WACC will likely be higher than the after-tax cost of debt.

Quiz 10: The Cost of Capital