Question 1

The ratio of long-term debt to GDP for non-financial U.S. corporations declined drastically during the late 1990s.

Accepted Answer

During the late 1990s, the ratio of long-term debt to GDP for non-financial U.S. corporations generally increased or remained stable rather than declining drastically. This period was characterized by economic expansion and increased borrowing by corporations to finance growth and acquisitions.

Question 2

There is no opportunity cost associated with retained earnings.

Accepted Answer

Retained earnings represent the earnings that could have been paid out as dividends, so the opportunity cost associated with retained earnings is the foregone opportunity to distribute these profits to shareholders. Therefore, there is an opportunity cost associated with retained earnings.

Question 3

Firm value is calculated by adding expected cash flow to the firm's cost of capital under each capital structure.

Accepted Answer

Firm value is calculated by discounting expected cash flows by the firm's cost of capital under each capital structure, not by adding them.

Question 4

The cost of debt represents the minimum acceptable rate of return to a firm on a project of average risk.

Accepted Answer

The cost of debt represents the cost of borrowing money, not the minimum acceptable rate of return on a project. The cost of capital, which includes both debt and equity, represents the minimum acceptable rate of return on a project of average risk.

Question 5

The minimum required rate of return is a weighted average of the firm's cost of various sources of capital.

Accepted Answer

The minimum required rate of return, also known as the cost of capital, is calculated using a weighted average of the costs of different sources of capital such as debt, equity, and preferred stock. This helps determine the minimum return the company needs to earn on its investments in order to satisfy its investors and maintain or increase its stock price.

Question 6

The ratio of debt to stock market equity has generally been lowest for the largest of U.S. firms.

Accepted Answer

Large firms often have greater access to financing options and can rely on their market position and reputation to secure lower rates on debt, making their debt-to-equity ratio lower than smaller firms.

Question 7

The cost of capital should be estimated from the historical cost of raising debt and equity capital.

Accepted Answer

The cost of capital should not be estimated based solely on historical costs, as market conditions and risks may have changed over time. Instead, the cost of capital should be based on current market data and the perceived risks associated with a particular investment or project.

Question 8

Firms have three sources of common equity, retained earnings, new stock issues, and new bond issues.

Accepted Answer

Firms have two primary sources of common equity: retained earnings and new stock issues. New bond issues are a source of debt financing, not equity.

Question 9

Repurchasing common stock decreases a firm's debt to equity ratio.

Accepted Answer

Repurchasing common stock reduces equity by decreasing the number of outstanding shares, which can actually increase a firm's debt to equity ratio if the firm has debt, as the equity portion of the ratio decreases while the debt remains constant.

Question 10

The firm's unadjusted cost of debt financing equals the yield to maturity on new debt issues.

Accepted Answer

The unadjusted cost of debt financing is typically equal to the yield to maturity on new debt issues because this is the rate at which the firm can borrow new funds. However, adjustments may be made to this rate based on the specific terms of the debt, such as any call provisions or credit enhancements.

Question 11

A lower weighted average cost of capital gives lower project NPVs.

Accepted Answer

A lower weighted average cost of capital (WACC) decreases the discount rate applied in NPV calculations, typically resulting in higher, not lower, project NPVs.

Question 12

The firm's optimum debt/equity mix maximizes the firm's cost of capital, which in turn will help the firm to maximize shareholder wealth.

Accepted Answer

The firm's optimum debt/equity mix minimizes the firm's cost of capital, not maximizes it. Lowering the cost of capital helps to maximize shareholder wealth.

Question 13

A nonoptimal capital structure may lead the firm to reject some capital budgeting projects that could have increased shareholder wealth with an optimal financing mix.

Accepted Answer

A nonoptimal capital structure may result in higher cost of capital and potential financial distress, which can lead to the rejection of otherwise profitable projects due to lack of funding. An optimal capital structure, on the other hand, can enhance the firm's ability to undertake value-creating opportunities while maximizing shareholder wealth.

Question 14

The weighted average cost of capital is used so project acceptance is not subject to how it is to be financed.

Accepted Answer

The weighted average cost of capital (WACC) takes into account the cost of all financing sources, including debt and equity, and provides a single discount rate that can be used to evaluate the feasibility of a project. By using WACC as the discount rate, project acceptance is not subject to the specifics of how it will be financed, as the same discount rate is applied regardless of financing mix.

Question 15

Minimum cash flow ∕ Investment = Maximum rate of return.

Accepted Answer

Minimum cash flow / Investment gives a basic return ratio, but the maximum rate of return is typically calculated using more complex methods such as Internal Rate of Return (IRR) or Net Present Value (NPV), which consider the time value of money and cash flow over the entire investment period.

Question 16

The firm's optimum debt/equity mix minimizes the firm's cost of capital, which in turn will help the firm to maximize shareholder wealth.

Accepted Answer

This statement is true because finding the optimal debt/equity mix can help the firm achieve the lowest possible cost of capital, which will increase the value of the firm and benefit shareholders. However, it is important to note that too much debt can also increase financial risk and potentially harm shareholder wealth, so finding the optimal mix is crucial.

Question 17

The firm's capital structure is the mix of debt and equity used to finance its assets.

Accepted Answer

The capital structure of a firm refers to the way in which it finances its assets through a combination of debt and equity.

Question 18

The required return, the cost of capital, and the discount rate are actually three distinctively different concepts.

Accepted Answer

The required return, the cost of capital, and the discount rate are often used interchangeably in finance to represent the expected return necessary to undertake an investment or project, reflecting the risk and the time value of money.

Question 19

A nonoptimal capital structure may lead to higher financing costs.

Accepted Answer

A nonoptimal capital structure means that a company has not found the most efficient mix of debt and equity financing. This can lead to higher financing costs as the company may be paying higher interest rates on its debt, or may have to issue more shares at a lower price to raise equity capital. This can ultimately result in a lower return on investment for shareholders.

Question 20

The minimum acceptable rate of return for a project is the return that generates sufficient cash flow to pay investors their expected return.

Accepted Answer

The minimum acceptable rate of return, also known as the hurdle rate, is the rate of return needed to make an investment viable. It is the rate of return that must be achieved in order to satisfy the investors' expectations and compensate them for the risks they take.

Quiz 18: Capital Structure and the Cost of Capital