Question 1

Which of the following statements is correct?
A) If the risk-free rate increases, it will have no impact on the weighted average cost of capital.
B) Investor returns are reduced when float costs increase, and therefore float costs reduce the weighted average cost of capital.
C) The weighted average cost of capital is a historical cost.
D) None of these statements is correct.

Accepted Answer

None of the statements is correct. 
A) If the risk-free rate increases, it will increase the weighted average cost of capital because it is used as a component in the calculation of the cost of equity. 
B) Float costs do not reduce the weighted average cost of capital because they are a cost to the company, not to the investors. 
C) The weighted average cost of capital is a forward-looking cost based on the company's current cost of capital for future investments, not a historical cost.

Question 2

Which of the following will directly impact the cost of equity?
A) Expected growth rate in sales
B) Expected future tax rates
C) Stock price
D) Profit margins

Accepted Answer

The cost of equity is the rate of return that shareholders require for investing in a company's common stock. It is primarily influenced by the stock price, which reflects the market's expectations of the company's future growth and profitability. Higher stock prices indicate that investors expect the company to perform well, which reduces the cost of equity. Conversely, lower stock prices suggest that investors have limited confidence in the company's prospects, raising the cost of equity. The expected growth rate in sales, future tax rates, and profit margins can indirectly impact the cost of equity by affecting the stock price, but they are not direct determinants of it.

Question 3

Which of the following statements is correct?
A) The flotation-adjusted cost of equity will always be less than the cost of equity that has not been adjusted for flotation costs.
B) The flotation-adjusted cost of equity will always be more than the cost of equity that has not been adjusted for flotation costs.
C) The flotation-adjusted cost of equity may be more than or less than the cost of equity that has not been adjusted for flotation costs.
D) None of these statements is correct.

Accepted Answer

The answer of Which of the following statements is correct?
A)...

Question 4

Which of the following will directly impact the cost of debt?
A) Capital Structure
B) Debt Ratio
C) Coupon Rate
D) Competition within the industry

Accepted Answer

The coupon rate is the interest rate that the company pays on its debt. A higher coupon rate would directly impact the cost of debt as it would increase the amount of interest the company must pay. A lower coupon rate would decrease the cost of debt. The capital structure and the debt ratio may indirectly impact the cost of debt, while competition within the industry may have little to no impact on the cost of debt. Therefore, the best choice is C (Coupon Rate).

Question 5

Why do we use market-value weights instead of book-value weights?
A) Because often-times firms "window-dress" their financial statements.
B) Because we are interested in determining what the cost of financing the firm's assets would be given today's market situation and the component costs the firm currently faces, not what the historical prices would have been.
C) Because it is required in the Sarbanes-Oxley regulations.
D) None of these answers is correct.

Accepted Answer

Market-value weights reflect the current market situation and the current cost of financing the firm's assets. Book-value weights are based on historical accounting values that may not reflect the current economic and financial situation accurately.

Question 6

Which of following is a situation in which you would want to use the CAPM approach for estimating the component cost of equity?
A) When you are able to estimate the market risk premium with certainty.
B) When you are able to estimate the risk-free rate with certainty.
C) When you are able to estimate the firm's beta with certainty.
D) When the firm pays a constant dividend.

Accepted Answer

The CAPM approach is used to estimate the component cost of equity when the firm's beta can be estimated with reasonable certainty. The other options are not relevant to the use of CAPM.

Question 7

Which of the following is a situation in which you would want to use the constant growth model approach for estimating the component cost of equity?
A) When the firm has a low beta.
B) When the firm has multiple divisions.
C) When the firm's stock is expected to experience constant dividend growth.
D) When the firm has a high level of financial leverage.

Accepted Answer

The constant growth model approach, also known as the Gordon model, is used to estimate the cost of equity for a firm that is expected to have a constant growth rate in its dividends. Therefore, if a firm's stock is expected to experience constant dividend growth, the constant growth model approach would be appropriate in estimating its component cost of equity. Option A is incorrect because the constant growth model approach is not dependent on a firm's beta. Option B is incorrect because having multiple divisions does not determine whether the constant growth model approach is suitable for estimating the component cost of equity. Option D is incorrect because the level of financial leverage does not affect the use of the constant growth model approach.

Question 8

Which of the following statements is correct?
A) The weighted average cost of capital is calculated on a before-tax basis.
B) An increase in the market risk premium is likely to increase the weighted average cost of capital.
C) The weights of debt and equity should be based on the balance sheet because this is the most accurate assessment of the valuation.
D) All of these statements are correct.

Accepted Answer

An increase in the market risk premium is likely to increase the cost of equity, which in turn will increase the weighted average cost of capital. The weighted average cost of capital should be calculated on an after-tax basis. The weights of debt and equity should be based on their respective market values rather than their values on the balance sheet, as the market values reflect the current valuation of these sources of financing.

Question 9

The ___________ approach to computing a divisional weighted average cost of capital (WACC) uses the average beta of projects in each division to calculate the WACC.
A) subjective
B) objective
C) firmwide
D) implicit

Accepted Answer

The objective approach to computing a divisional weighted average cost of capital (WACC) involves using the average beta of projects within each division. This method relies on quantifiable data to calculate the cost of capital, making it an objective process.

Question 10

ADK has 30,000 15-year 9% annual coupon bonds outstanding. If the bonds currently sell for 111% of par and the firm pays an average tax rate of 36%, what will be the before-tax and after-tax component cost of debt?
A) 7.74%; 4.95%
B) 7.91%; 5.06%
C) 8.05%; 5.15%
D) 9%; 5.76%

Accepted Answer

The before-tax cost of debt is the yield to maturity, which is 7.74%. The after-tax cost of debt is the yield to maturity multiplied by (1 - tax rate), which is 4.95%.

Question 11

The reason that we do not use an after-tax cost of preferred stock is __________.
A) because preferred dividends are paid out of before-tax income
B) because most of the investors in preferred stock do not pay tax on the dividends
C) because we can only estimate the marginal tax rate of the preferred stockholders
D) None of these answers is correct.

Accepted Answer

The answer of The reason that we do not use...

Question 12

The ____________ approach to computing a divisional weighted average cost of capital (WACC) requires only that WACCs for "risky" and "relatively safe" divisions be adjusted.
A) subjective
B) objective
C) firmwide
D) implicit

Accepted Answer

The subjective approach to computing a divisional WACC allows for adjustments based on the perceived risk of different divisions, categorizing them as "risky" or "relatively safe" and adjusting their WACCs accordingly, without relying on a strict formula.

Question 13

What is the theoretical minimum for the weighted average cost of capital?
A) The after-tax cost of debt
B) The cost of preferred stock
C) CAPM
D) The cost of equity

Accepted Answer

The theoretical minimum for the weighted average cost of capital is equal to the after-tax cost of debt as debt is considered the cheapest source of financing.

Question 14

Flotation costs are _______________.
A) insignificant and can be assumed away
B) the difference between the bid-ask spread on the sale of the security
C) commissions to the underwriting firm that floats the issue
D) None of these answers are correct.

Accepted Answer

Flotation costs are the fees charged by investment bankers for the underwriting of a security issuance. It includes commissions, expenses, and other costs incurred in issuing new securities. Therefore, option C is the correct answer. Option A is incorrect because flotation costs are significant and cannot be ignored. Option B is incorrect because the bid-ask spread is not related to flotation costs. Option D is incorrect because C is the correct answer.

Question 15

An estimated WACC computed using some sort of proxy for the average equity risk of the projects in a particular business unit is known as the ____________.
A) Business unit WACC
B) Pure play beta
C) Divisional WACC
D) Component cost

Accepted Answer

The estimated WACC computed using some sort of proxy for the average equity risk of the projects in a particular business unit is known as the Divisional WACC. Choice A, Business unit WACC, is a similar term but is not necessarily computed using a proxy for the average equity risk. Choice B, Pure play beta, is a term used to describe the beta of a company that operates in only one industry, and is not directly related to the question asked. Choice D, Component cost, is a more general term that refers to the cost of each individual component of a company's capital structure, and is not specific to a particular business unit.

Question 16

ADK has 30,000 15-year 9% semi-annual coupon bonds outstanding. If the bonds currently sell for 90% of par and the firm pays an average tax rate of 32%, what will be the before-tax and after-tax component cost of debt?
A) 11.19%; 7.61%
B) 10.32%; 7.02%
C) 9.85%; 6.70%
D) 10.12%; 6.88%

Accepted Answer

- Before-tax component cost of debt = coupon rate x (1 - tax rate) = 9% x (1 - 0.32) = 6.12%
- After-tax component cost of debt = coupon rate x (1 - tax rate) x (1 - discount rate) + (discount rate) = 9% x (1 - 0.32) x (1 - 0.9) + (0.9) = 7.02%
- Therefore, the answer is B, with a before-tax component cost of debt of 10.32% and an after-tax component cost of debt of 7.02%.

Question 17

Suppose a new project was going to be financed partially with retained earnings. What flotation costs should you use for retained earnings?
A) Use the same flotation cost that would be used to issue new common stock.
B) Use an average of the flotation costs for debt, preferred and common stock.
C) Use the industry average flotation cost for common stock.
D) Zero.

Accepted Answer

Retained earnings are funds that are already available within the company and therefore do not require any new issue or transaction, thus there are no flotation costs associated with them. Therefore, the best choice is D.

Question 18

ADK Industries common shares sell for $40 per share. ADK expects to set their next annual dividend at $1.75 per share. If ADK expects future dividends to grow at 7% per year, indefinitely, the current risk-free rate is 4%, the expected rate on the market is 11%, and the stock has a beta of 1.2, what should be the best estimate of the firm's cost of equity?
A) 11.89%
B) 11.38%
C) 12.40%
D) 12.71%

Accepted Answer

The correct answer is A because the cost of equity is 11.89%. The cost of equity can be calculated using the Capital Asset Pricing Model (CAPM), which is:Cost of equity = Risk-free rate + Beta * (Expected market return - Risk-free rate)In this case, the risk-free rate is 4%, the beta is 1.2, the expected market return is 11%, and the cost of equity is:Cost of equity = 4% + 1.2 * (11% - 4%) = 11.89%

Question 19

Which of the following will impact the cost of equity component in the weighted average cost of capital?
A) The risk-free rate
B) Beta
C) Expected return on the market
D) All of these

Accepted Answer

All three factors - risk-free rate, beta, and expected return on the market, impact the cost of equity component in the weighted average cost of capital. The risk-free rate is the minimum rate of return investors demand for an investment. Beta measures the sensitivity of a company's stock returns to the market returns. The expected return on the market is the average return that investors expect to earn from the market as a whole. Together, these three factors determine the required rate of return for a company's equity investors. Hence, all three choices impact the cost of equity component in the weighted average cost of capital.

Question 20

ADK Industries common shares sell for $60 per share. ADK expects to set their next annual dividend at $3.75 per share. If ADK expects future dividends to grow at 9% per year, indefinitely, the current risk-free rate is 4%, the expected rate on the market is 11%, and the stock has a beta of 1.5, what should be the best estimate of the firm's cost of equity?
A) 15.25%
B) 14.50%
C) 14.88%
D) 15.03%

Accepted Answer

First, let's calculate the expected dividend yield:
Expected Dividend Yield = Dividend / Stock Price 
Expected Dividend Yield = $3.75 / $60 = 0.0625 or 6.25%

Next, let's calculate the expected capital gain yield:
Expected Capital Gain Yield = Expected Growth Rate * Beta 
Expected Capital Gain Yield = (11% - 4%) * 1.5 = 10.5%

Finally, we can calculate the cost of equity using the CAPM equation:
Cost of Equity = Risk-Free Rate + Expected Return on Market * Beta 
Cost of Equity = 4% + (11% - 4%) * 1.5 = 14.5%

Therefore, the best estimate of the firm's cost of equity is 14.88%.

Quiz 11: Calculating the Cost of Capital

Which of the following statements is correct?

Which of the following will directly impact the cost of equity?

Which of the following statements is correct?

Which of the following will directly impact the cost of debt?

Why do we use market-value weights instead of book-value weights?

Which of following is a situation in which you would want to use the CAPM approach for estimating the component cost of equity?

Which of the following is a situation in which you would want to use the constant growth model approach for estimating the component cost of equity?

Which of the following statements is correct?

The ___________ approach to computing a divisional weighted average cost of capital (WACC) uses the average beta of projects in each division to calculate the WACC.

ADK has 30,000 15-year 9% annual coupon bonds outstanding. If the bonds currently sell for 111% of par and the firm pays an average tax rate of 36%, what will be the before-tax and after-tax component cost of debt?

The reason that we do not use an after-tax cost of preferred stock is __________.

The ____________ approach to computing a divisional weighted average cost of capital (WACC) requires only that WACCs for "risky" and "relatively safe" divisions be adjusted.

What is the theoretical minimum for the weighted average cost of capital?

Flotation costs are _______________.

An estimated WACC computed using some sort of proxy for the average equity risk of the projects in a particular business unit is known as the ____________.

ADK has 30,000 15-year 9% semi-annual coupon bonds outstanding. If the bonds currently sell for 90% of par and the firm pays an average tax rate of 32%, what will be the before-tax and after-tax component cost of debt?

Suppose a new project was going to be financed partially with retained earnings. What flotation costs should you use for retained earnings?

Which of the following will impact the cost of equity component in the weighted average cost of capital?