Question 1

A firm has a return on equity of 12.4 percent according to the dividend growth model and a return of 18.7 percent according to the capital asset pricing model. The market rate of return is 13.5 percent. What rate should the firm use as the cost of equity when computing the firm's WACC?

Accepted Answer

The firm should use the arithmetic average of the two estimates (12.4% and 18.7%) to balance the different perspectives provided by the dividend growth model and the capital asset pricing model.

Question 2

Which one of the following will decrease the aftertax cost of debt for a firm?

Accepted Answer

B

Question 3

Which one of the following statements is correct related to the dividend growth model approach to computing the cost of equity?

Accepted Answer

The dividend growth model approach to computing the cost of equity involves using the expected future dividends and dividend growth rate to estimate the stock's price, and then solving for the required rate of return or cost of equity. In this approach, the annual dividend used in the computation must be for year one if you are using today's stock price to compute the return. This is because the dividend growth rate is based on the next dividend payment, which is usually the one paid in the next year. The rate of growth does not need to exceed the required rate of return, and the rate of return does not need to be adjusted for taxes. The cost of equity is not equal to the return on the stock plus the risk-free rate or the return on the stock multiplied by the stock's beta in the dividend growth model approach.

Question 4

In an efficient market, the cost of equity for a risky firm does which one of the following according to the security market line?

Accepted Answer

According to the security market line, the cost of equity for a risky firm increases in direct relation to the stock's systematic risk, which is measured by beta. This implies that as the risk of the firm increases, investors will require a higher return in order to hold the stock, which will result in a higher cost of equity. Therefore, option E is the correct answer.

Question 5

Which one of the following statements is correct?

Accepted Answer

The cost of preferred stock is calculated as the dividend rate divided by the net proceeds after issuance costs. It is not affected by the issuer's tax rate because preferred stock dividends are not tax-deductible.

Question 6

Farmer's Supply, Inc. is considering opening a clothing store, which would be a new line of business for the firm. Management has decided to use the cost of capital of a similar clothing store as the discount rate that should be used to evaluate this proposed expansion. Which one of the following terms is used to describe the approach Farmer's Supply is taking to establish an appropriate discount rate for the project?

Accepted Answer

Farmer's Supply is using the pure play approach, which involves using the cost of capital of a publicly traded company that operates solely in the same industry or business line as the proposed project. In this case, Farmer's Supply is considering opening a clothing store, so they are using the cost of capital of a similar clothing store as their discount rate. This approach is widely used in capital budgeting to estimate the appropriate discount rate to evaluate a new project.

Question 7

The cost of preferred stock:

Accepted Answer

The cost of preferred stock is the dividend yield, which is the annual dividend payment divided by the market price per share. It is not affected by changes in the market price or the firm's tax rate. Therefore, the cost of preferred stock is constant over time, as long as the dividend payment remains the same.

Question 8

The weighted average cost of capital is defined as the weighted average of a firm's:

Accepted Answer

The weighted average cost of capital (WACC) is the average rate of return a company expects to pay to all its investors (shareholders and debt holders) to finance its assets. It is a calculation of the cost of capital, where each category of capital (debt, equity, preferred shares) is proportionately weighted. The cost of equity and cost of after-tax debt are both important components of the WACC calculation.

Question 9

All else constant, an increase in a firm's cost of debt:

Accepted Answer

An increase in the cost of debt will increase the firm's cost of capital because debt is a component of the firm's overall capital structure. As the cost of debt increases, the overall cost of capital will increase as well. Choices A, C, D, and E are incorrect because they do not accurately reflect the impact of an increase in the cost of debt.

Question 10

All else constant, which of the following will increase the aftertax cost of debt for a firm? I. increase in the yield to maturity of the firm's outstanding debt
II) decrease in the yield to maturity of the firm's outstanding debt
III) increase in the firm's tax rate
IV) decrease in the firm's tax rate

Accepted Answer

An increase in the yield to maturity (I) increases the cost of debt, and a decrease in the firm's tax rate (IV) reduces the tax shield, effectively increasing the aftertax cost of debt.

Question 11

Which of the following features are advantages of the dividend growth model? I. easy to understand
II) model simplicity
III) constant dividend growth rate
IV) model's applicability to all common stocks

Accepted Answer

Advantages of the dividend growth model include its simplicity and ease of understanding, which are represented by options I and II. Additionally, the constant dividend growth rate (option III) is a key feature of the model. However, the model is not applicable to all common stocks, so option IV is not correct.

Question 12

Which of the following are weaknesses of the dividend growth model? I. market risk premium fluctuations
II) lack of dividends for some firms
III) reliance on historical beta
IV) sensitivity of model to dividend growth rate

Accepted Answer

The dividend growth model is sensitive to the dividend growth rate and cannot be used for firms that do not pay dividends.

Question 13

Kate is the CFO of a major firm and has the job of assigning discount rates to each project that is under consideration. Kate's method of doing this is to assign an incrementally higher rate as the risk level of the project increases over that of the current firm. Likewise, she assigns lower rates as the risk level declines. Which one of the following approaches is Kate using to assign the discount rates?

Accepted Answer

Kate is using a subjective approach to assign discount rates based on her own judgment of the risk level of each project. The pure play approach involves comparing a project to similar projects in the same industry, while the divisional rating involves assigning different discount rates to different segments or divisions within the same firm. The straight WACC approach uses a single discount rate for all projects based on the firm's weighted average cost of capital, while the equity rating involves assigning a discount rate based on the risk level of the firm's equity.

Question 14

Lester lent money to The Corner Store by purchasing bonds issued by the store. The rate of return that he and the other lenders require is referred to as the:

Accepted Answer

The rate of return required by lenders, such as Lester, is referred to as the cost of debt. This is because the lenders are providing funds through debt instruments, such as bonds, and they expect to earn a return on their investment in the form of interest payments. The other options listed, such as pure play cost, weighted average cost of capital, subjective cost, and cost of equity, may be related to the cost of capital, but they are not specifically related to the cost of debt.

Question 15

Which of the following will increase the cost of equity for a firm with a beta of 1.1? I. decrease in the security's beta
II) decrease in the market risk premium
III) decrease in the risk-free rate
IV) increase in the risk-free rate

Accepted Answer

The answer of Which of the following will increase the...

Question 16

Which one of the following will increase the cost of equity, all else held constant?

Accepted Answer

The answer of Which one of the following will increase...

Question 17

Katie owns 100 shares of ABC stock. Which one of the following terms is used to refer to the return that Katie and the other shareholders require on their investment in ABC?

Accepted Answer

The return that shareholders require on their investment is referred to as the cost of equity. Choice A, weighted average cost of capital, includes the cost of both debt and equity financing. Pure play cost and subjective cost are not commonly used terms in finance. The cost of debt refers to the cost incurred by a company from borrowing money.

Question 18

Which one of the following is the pre-tax cost of debt?

Accepted Answer

The pre-tax cost of debt is measured by the weighted average yield-to-maturity on the firm's outstanding debt. This is because the yield-to-maturity takes into account not only the coupon rate (annual interest payment as a percentage of face value), but also the market price of the bond (which affects the total return an investor receives). The average coupon rate (A), coupon rate on the latest bond issue (B), and average current yield (D) are useful metrics in analyzing a firm's debt, but do not capture the pre-tax cost of debt. The annual interest divided by market price for the latest bond issue (E) is the current yield, which is less informative than the yield-to-maturity.

Question 19

Ted is trying to decide what cost of capital he should assign to a project. Which one of the following should be his primary consideration in this decision?

Accepted Answer

The risk level of the project should be the primary consideration when determining the cost of capital. Higher-risk projects will require a higher cost of capital to compensate investors for the increased risk. The amount of debt, use of preferred stock, mix of funds, and length of the project's life can all impact the cost of capital to some extent, but they are secondary considerations to the risk level of the project.

Question 20

Black Stone Furnaces wants to build a new facility. The cost of capital for this investment is primarily dependent upon which one of the following?

Accepted Answer

The cost of capital for an investment is primarily dependent on the nature of the investment, as different projects may have different risk profiles and thus require different rates of return.

Quiz 12: Cost of Capital