Question 1

The weighted average cost of capital represents the minimum required rate of return on a capital-budgeting project and is found by multiplying the cost of each capital structure component by its appropriate weight and summing the terms.

Accepted Answer

This statement accurately describes the calculation of the weighted average cost of capital (WACC). By multiplying the cost (or required rate of return) of each component of a company's capital structure (e.g. debt, equity) by its weight (proportionate share of the overall capital structure), you can determine the overall WACC for the company. This WACC represents the minimum required rate of return needed to justify investing in a new capital project, as it reflects the average cost of financing the project via debt and equity funding.

Question 2

Flotation costs include:

Accepted Answer

Flotation costs include all the above-mentioned expenses, i.e., the cost of printing shares, legal and accounting costs, and investment banker fees.

Question 3

Because the cost of capital is used to evaluate future investment proposals,it is important to flotation costs because such costs would be incurred if a firm were to raise new capital to fund proposed projects.

Accepted Answer

Flotation costs refer to the expenses incurred by a firm when it raises new capital, such as fees paid to investment banks, underwriters, and other professionals. These costs reduce the net amount of funds that are raised and increase the cost of capital. Thus, it is important to consider flotation costs when evaluating investment proposals because they impact the cash inflows and outflows associated with the project and affect the overall profitability of the investment.

Question 4

The EPS/EBIT indifference level represents the level of EBIT at which the firm would be indifferent between two different capital structures because they both result in the same level of EPS.

Accepted Answer

The EPS/EBIT indifference level is the point where the level of EBIT is the same for two different capital structures, resulting in the same level of earnings per share (EPS). Therefore, the statement is true.

Question 5

Which of the following is not used in the weighted average cost of capital equation?

Accepted Answer

The answer of Which of the following is not used...

Question 6

Which of the following is a correct way to calculate degree of combined leverage?

Accepted Answer

The correct way to calculate degree of combined leverage is by multiplying the degree of operating leverage (DOL) by the degree of financial leverage (DFL). This gives us an idea of the overall leverage of a company and the impact of changes in sales on the earnings per share.

Question 7

When retained earnings are used up and new common stock is issued,we know that the cost of:

Accepted Answer

When retained earnings are used up and new common stock is issued, it means the company is resorting to external financing to fund its operations. This can lead to an increase in the cost of equity as investors may demand higher returns to compensate for the higher risk involved.

Question 8

The internal growth rate measures how quickly a firm can grow when it uses both internal equity and debt financing to keep its capital structure constant over time.

Accepted Answer

The internal growth rate measures how quickly a firm can grow using only reinvested earnings (internal financing), not considering external financing options like debt or equity issuance.

Question 9

What should be the relation between the target capital structure for a firm and the firm's optimum capital structure?

Accepted Answer

The target capital structure is what a firm aims to achieve in the long run and is considered optimal for minimizing the cost of capital and maximizing the firm's value. Therefore, the target and optimum capital structures should ideally be the same.

Question 10

The sustainable growth rate measures how quickly a firm can grow when it uses both internal equity and debt financing to keep its capital structure constant over time.

Accepted Answer

The sustainable growth rate is the rate at which a firm can grow using internal sources of funds while maintaining a constant capital structure. It does not take into account the use of debt financing.

Question 11

In estimating the cost of equity,the rate of return on U.S.Treasury bills is often used as a proxy for the risk free rate of return.

Accepted Answer

This is because U.S. Treasury bills are considered to be virtually risk-free as they are backed by the full faith and credit of the U.S. government. Therefore, the rate of return on U.S. Treasury bills provides a good estimate of the risk-free rate of return.

Question 12

A company experienced a 12 % increase in earnings before interest and taxes and a 3 % increase in sales.What is the degree of operating leverage for this company?

Accepted Answer

Degree of operating leverage (DOL) = % change in earnings before interest and taxes (EBIT) / % change in sales.

DOL = 12%/3% = 4. Therefore, the correct choice is C.

Question 13

For any firm's given growth strategy,its dividend decision directly affects its capital structure decision.

Accepted Answer

Dividend decision affects the amount of retained earnings which in turn affects the firm's capital structure decision. A higher dividend payout means lower retained earnings and thus higher need for external financing which can affect the firm's capital structure.

Question 14

The EPS/EBIT indifference level represents the level of Assets at which the firm would be indifferent between two different capital structures because they both result in the same level of EPS.

Accepted Answer

The EPS/EBIT indifference level represents the level of EBIT (Earnings Before Interest and Taxes) at which the firm would be indifferent between two different capital structures because they both result in the same level of earnings per share (EPS), not Assets.

Question 15

The weighted average cost of capital represents the maximum required rate of return on a capital-budgeting project and is found by multiplying the cost of each capital structure component by its appropriate weight and summing the terms.

Accepted Answer

The answer of The weighted average cost of capital represents...

Question 16

Smith Company has a degree of operating leverage of 5,while Johnson Company has a degree of operating leverage of 2.Supplied with this knowledge,pick the response below that is most typical of Johnson Company.

Accepted Answer

A lower degree of operating leverage, like Johnson Company's, typically indicates a more conservative approach with lower fixed costs and less risk.

Question 17

The pecking order hypothesis implies that firm's have no optimal debt/equity ratios.

Accepted Answer

The pecking order hypothesis suggests that firms prioritize financing through internal funds, followed by debt, and lastly equity. This means that the optimal debt/equity ratio for a firm is constantly changing based on its current financial situation and access to internal funding and debt financing. Therefore, there is no set optimal debt/equity ratio for firms under this hypothesis.

Question 18

In calculating the cost of new common stock using the constant dividend growth model,it is important that the __________ are subtracted from the price of the stock.

Accepted Answer

Flotation costs, which are the expenses associated with issuing new stock, need to be subtracted from the price of the stock in order to calculate the true cost of new common stock. This is because these costs reduce the amount of money the company actually receives from the sale of the stock, and therefore should not be included in the calculation of the stock's cost.

Question 19

The degree of combined leverage shows us to what degree a percentage change in sales will cause a percentage change in:

Accepted Answer

The degree of combined leverage measures the sensitivity of earnings per share (EPS) to changes in sales, combining both operating and financial leverage effects.

Question 20

Of the components shown below,which is least likely to be of value in calculating the cost of preferred stock?

Accepted Answer

The book value of a preferred share is the accounting value of the share, which may not reflect the current market value or the value of the preferred stock to investors. The other components - flotation costs per share, dividends per share, and initial market price per share - are more directly related to the cost of preferred stock.

Quiz 18: Capital Structure and the Cost of Capital