Question 1

Burnham Brothers Inc.has no retained earnings since it has always paid out all of its earnings as dividends.This same situation is expected to persist in the future.The company uses the CAPM to calculate its cost of equity,and its target capital structure consists of common stock,preferred stock,and debt.Which of the following events would REDUCE its WACC?
A)The flotation costs associated with issuing new common stock increase.
B)The company's beta increases.
C)Expected inflation increases.
D)The flotation costs associated with issuing preferred stock increase.
E)The market risk premium declines.

Accepted Answer

A decrease in the market risk premium would reduce the company's cost of equity as calculated by the CAPM, which in turn would reduce the weighted average cost of capital (WACC).

Question 2

Suppose the debt ratio (D/TA)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 decrease the weighted average cost of capital (WACC).

Accepted Answer

The answer of Suppose the debt ratio (D/TA)is 50%,the interest...

Question 3

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

Accepted Answer

By definition, both the market and an average stock have betas of 1.0. Since we know this to be the case, we can obviously determine beta for the market or an average stock with precision.

Question 4

If the expected dividend growth rate is zero,then the cost of external equity capital raised by issuing new common stock (r_e)is equal to the cost of equity capital from retaining earnings (r_s)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. However, if the expected growth rate is not zero, then a different formula is required to calculate the cost of external equity.

Question 5

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

Accepted Answer

Accounts payable is not a capital component as it represents short-term liabilities that do not require a cost of capital calculation. The other options (B, C, D, and E) all represent sources of financing that require a cost of capital calculation for use in capital budgeting.

Question 6

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 r_s.

Accepted Answer

The statement is true. While the bond-yield-plus-risk-premium method can give us an estimate of the cost of equity, the risk premium used may not be completely accurate, making it difficult to determine the true value of r_s.

Question 7

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 lower...

Question 8

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): 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

None of the methods always provides accurate and reliable estimates. With the CAPM, we don't know the beta that investors are using, we are not totally sure of what r_RF to use, and we don't know if the CAPM is truly correct.

Question 9

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 r_s.

Accepted Answer

Estimating the growth rate correctly is crucial in determining the cost of equity through the DCF method, and any uncertainty in this estimation can lead to an inaccurate estimate of r_s.

Question 10

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): 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

Unfortunately, this is true.

Question 11

With its current financial policies,Flagstaff Inc.will have to issue new common stock to fund its capital budget.Since new stock has a higher cost than reinvested earnings,Flagstaff would like to avoid issuing new stock.Which of the following actions would REDUCE its need to issue new common stock?
A)Increase the percentage of debt in the target capital structure.
B)Increase the proposed capital budget.
C)Reduce the amount of short-term bank debt in order to increase the current ratio.
D)Reduce the percentage of debt in the target capital structure.
E)Increase the dividend payout ratio for the upcoming year.

Accepted Answer

Statement a is correct, because if more debt is used, then less equity will be needed to fund the capital budget, so the need for a stock issue would be reduced.

Question 12

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method,the DCF method,and the bond-yield-plus-risk-premium method.However,only the DCF method is widely used in practice.

Accepted Answer

All three methods (CAPM, DCF, and bond-yield-plus-risk-premium) are used in practice for estimating the cost of common stock from reinvested earnings, not just the DCF method. Each method has its own set of assumptions and applications, making them suitable for different scenarios.

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 within different divisions of the firm.

Question 14

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

True, but data on comparable publicly owned firms can often be obtained and used as proxies for private firms.

Question 15

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)r_e > r_s > WACC > r_d. B)WACC > r_e > r_s > r_d. C)r_d > r_e > r_s > WACC. D)WACC > r_d > r_s > r_e. E)r_s > r_e > r_d > WACC.

Accepted Answer

The correct sequence reflects that the cost of equity (rS) is higher than the weighted average cost of capital (WACC), which in turn is higher than the cost of debt (rD), due to the tax shield benefits of debt financing and the higher risk associated with equity.

Question 16

The cost of external equity capital raised by issuing new common stock (r_e)is defined as follows,in words: "The cost of external equity equals the cost of equity capital from retaining earnings (r_s),divided by one minus the percentage flotation cost required to sell the new stock, (1 − F)."

Accepted Answer

The total shareholders' equity is incorrectly listed as \$0,000,000; it should be the sum of common stock (\$30,000,000) and retained earnings (\$50,000,000), which equals \$80,000,000.

Question 17

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,r_s,than on the interest rate on long-term debt,r_d,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

This is because the required rate of return on equity,r_s, is more sensitive to changes in the slope of the SML than the interest rate on long-term debt,r_d. As a result, an increase in the slope of the SML would lead to a greater increase in the required rate of return on equity and thus shift the balance between debt and equity financing towards debt. However, the use of excessive debt would also increase the riskiness of both debt and equity and thus limit the shift towards debt.

Question 18

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 = r_s(0.30)(0.50)+ r_ps(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 19

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,r_s,than on the interest rate on long-term debt,r_d,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 20

The cost of debt,r_d,is normally less than r_s,so r_d(1 − T)will normally be much less than r_s.Therefore,as long as the firm is not completely debt financed,the weighted average cost of capital (WACC)will normally be greater than r_d(1 − T).

Accepted Answer

This statement is true. The cost of debt is typically lower than the cost of equity, and when adjusted for taxes (1-T), it is even lower. Therefore, when a firm has both debt and equity in its capital structure, the weighted average cost of capital (WACC) will be higher than the after-tax cost of debt.

Quiz 11: Determining the Cost of Capital

Suppose the debt ratio (D/TA)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 decrease the weighted average cost of capital (WACC).

When working with the CAPM,which of the following factors can be determined with the most precision?

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

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 r_s.

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.

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): 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.

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 r_s.

With its current financial policies,Flagstaff Inc.will have to issue new common stock to fund its capital budget.Since new stock has a higher cost than reinvested earnings,Flagstaff would like to avoid issuing new stock.Which of the following actions would REDUCE its need to issue new common stock?

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method,the DCF method,and the bond-yield-plus-risk-premium method.However,only the DCF method is widely used in practice.

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.

The cost of external equity capital raised by issuing new common stock (r_e)is defined as follows,in words: "The cost of external equity equals the cost of equity capital from retaining earnings (r_s),divided by one minus the percentage flotation cost required to sell the new stock, (1 − F)."

The cost of debt,r_d,is normally less than r_s,so r_d(1 − T)will normally be much less than r_s.Therefore,as long as the firm is not completely debt financed,the weighted average cost of capital (WACC)will normally be greater than r_d(1 − T).

Quiz 11: Determining the Cost of Capital

Suppose the debt ratio (D/TA)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 decrease the weighted average cost of capital (WACC).

When working with the CAPM,which of the following factors can be determined with the most precision?

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

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.

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.

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): 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.

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.

With its current financial policies,Flagstaff Inc.will have to issue new common stock to fund its capital budget.Since new stock has a higher cost than reinvested earnings,Flagstaff would like to avoid issuing new stock.Which of the following actions would REDUCE its need to issue new common stock?

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method,the DCF method,and the bond-yield-plus-risk-premium method.However,only the DCF method is widely used in practice.

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.

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)."

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).

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 r_s.

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 r_s.

The cost of external equity capital raised by issuing new common stock (r_e)is defined as follows,in words: "The cost of external equity equals the cost of equity capital from retaining earnings (r_s),divided by one minus the percentage flotation cost required to sell the new stock, (1 − F)."

The cost of debt,r_d,is normally less than r_s,so r_d(1 − T)will normally be much less than r_s.Therefore,as long as the firm is not completely debt financed,the weighted average cost of capital (WACC)will normally be greater than r_d(1 − T).