Question 1

Which of these makes this a true statement? The WACC formula:

Accepted Answer

The WACC formula takes into account the after-tax costs of debt financing, which is reflected in the overall weight assigned to debt in the calculation. This is because interest payments on debt are tax-deductible, lowering the actual cost of debt financing for the company. Option A is incorrect because taxes do affect the WACC formula. Option C is incorrect because it uses pre-tax costs rather than after-tax costs. Option D is incorrect because the WACC formula takes into account all capital costs, including financing costs.

Question 2

An average of which of the following will give a fairly accurate estimate of what a project's beta will be?

Accepted Answer

B

Question 3

Which of these makes this a true statement? When determining the appropriate weights used in calculating a WACC,it should reflect:

Accepted Answer

The appropriate weights used in calculating a WACC should reflect the relative sizes of the total market capitalizations for each kind of security that the firm issues. This is because the market capitalization reflects the current market value of the securities and takes into account factors such as market sentiment, which can impact the cost of capital. Using total book capitalization, as in option A, would not reflect the current market value of the securities. Option C and D are incorrect as the WACC calculation requires both the after-tax cost of debt and after-tax cost of equity, and not just one or the other.

Question 4

Which of the following makes this a true statement? If the new project does significantly increase the firm's overall risk:

Accepted Answer

Common stockholders bear the highest risk in a firm and are thus most affected by any increase in overall risk. Bondholders have priority in receiving payment and preferred stockholders have a fixed dividend payment, making them less exposed to the firm's risk.

Question 5

Which of these statements is true regarding divisional WACC?

Accepted Answer

Divisional WACC should be used to evaluate new projects because it takes into account the different risks and funding costs of each division. Using a simple firm-wide WACC would give an unfair advantage to projects that present more risk than the firm's average beta. Therefore, statement B is true. Statements A, C, and D are incorrect.

Question 6

Which of these are fees paid by firms to investment bankers for issuing new securities?

Accepted Answer

Flotation costs are fees paid by firms to investment bankers for issuing new securities. Interest expense refers to the cost of borrowing money, seller financing charges are fees paid by buyers for the privilege of paying for goods over time, and user fees are charges for the use of a particular service or product.

Question 7

Which statement makes this a false statement? When a firm pays commissions to underwriting firms that float the issuance of new stock:

Accepted Answer

The answer of Which statement makes this a false statement?...

Question 8

Which of these is an estimated WACC computed using some sort of proxy for the average equity risk of the projects in a particular division?

Accepted Answer

Divisional WACC is computed using a proxy for the average equity risk of the projects in a particular division, allowing for more accurate investment appraisal within different parts of a company.

Question 9

When firms use multiple sources of capital,they need to calculate the appropriate discount rate for valuing their firm's cash flows as:

Accepted Answer

When firms use multiple sources of capital, they should use a weighted average cost of capital (WACC) to calculate the appropriate discount rate for valuing their firm's cash flows. This is because the cost of each type of capital (debt and equity) varies and has a different weight in the company's overall capital structure. Therefore, the WACC is calculated as the weighted average of the cost of each separate capital component (i.e., debt and equity) based on their respective weights.

Question 10

An objective approach to calculating divisional WACCs would be done by:

Accepted Answer

The most objective approach to calculating divisional WACCs involves computing the average beta per division, using these figures for each division in the CAPM formula, and then constructing divisional WACCs. This approach takes into account the risk profile of each division and results in a more accurate estimation of the required return for each division's projects. Choice A involves subjective opinions and is therefore less objective, while choice B and D do not account for the risk profile of each division.

Question 11

When calculating the weighted average cost of capital,weights are based on:

Accepted Answer

The weights used in calculating the weighted average cost of capital (WACC) are based on the market values of a company's securities. This is because the market values reflect the current market perceptions of the company's value and risk, and thus are a more accurate reflection of the relative importance of each component of the WACC formula (i.e. debt, equity, preferred stock). Book values may not reflect the true value of a company's assets and liabilities, and market betas are a separate concept related to measuring the systematic risk of a security. Book weights are not an option.

Question 12

Any debt and preferred stock components of capital should:

Accepted Answer

Debt and preferred stock are part of a company's overall capital structure and are not specific to individual projects. Therefore, it is appropriate to use the firmwide WACC (weighted average cost of capital) figure to calculate the cost of debt and preferred stock.

Question 13

Which of these completes this statement to make it true? The constant growth model is:

Accepted Answer

The constant growth model, also known as the Gordon Growth Model, assumes that a company will grow at a constant rate indefinitely. It is most appropriate for companies with stable growth rates that can be reasonably expected to continue into the future, making it only suitable for a limited number of stocks.

Question 14

Which of the following is a principle of capital budgeting which states that the calculations of cash flows should remain independent of financing?

Accepted Answer

The separation principle states that capital budgeting decisions should be based solely on the expected future cash flows of the project and should not consider the method of financing. This principle ensures that the project's profitability is evaluated solely based on the cash flows generated by the project itself, not the financing used to fund it. Option A refers to accounting standards and is not specific to capital budgeting, Option B is incorrect as there is no such principle in capital budgeting, and Option D refers to the weighted average cost of capital, which considers financing costs.

Question 15

Which of the following statements is true?

Accepted Answer

The cost of capital is the minimum return the firm requires to undertake a project. If the new project is riskier than the firm's existing projects, then it implies that the investors will demand a higher return to compensate for the higher risks involved. Therefore, the firm should charge a higher cost of capital for the new project to ensure that it generates a return higher than the cost of capital.

Question 16

Which of the following is a true statement?

Accepted Answer

Yield to maturity (YTM) is the actual rate of return anticipated on a bond if it is held until maturity and is an estimate of the before-tax cost of debt.

Question 17

Which of the following makes this a true statement? Ideally,when searching for a beta for a new line of business:

Accepted Answer

When searching for a beta for a new line of business, it is ideal to find other firms engaged in the proposed new line of business and use their betas as proxies (A), to find at least three or four pure-play proxies for a more accurate estimate (B), and in some cases, even one or two closely resembling proxies might be sufficient if they closely match the proposed project's line of business (C). Therefore, all the provided options contribute to making a true statement about the ideal approach to finding a beta for a new line of business.

Question 18

Which of the following is a true statement regarding the appropriate tax rate to be used in the WACC?

Accepted Answer

The appropriate tax rate to be used in the WACC is the weighted average of the marginal tax rates that would have been paid on the taxable income shielded by the interest deduction. This is because the interest deduction reduces the firm's taxable income, and therefore the tax rate used should reflect the tax savings from the interest deduction. The marginal tax rate would be used to determine the tax savings from the last dollar of interest expense. Taking the weighted average of the marginal tax rates provides a more accurate representation of the tax savings from the interest deduction.

Question 19

When we adjust the WACC to reflect flotation costs,this approach:

Accepted Answer

The answer of When we adjust the WACC to reflect...

Question 20

Which of these statements is true regarding calculating weights for WACC?

Accepted Answer

When calculating WACC for the firm, we use the entire market value of equity, preferred stock, and debt, as this reflects the true cost of each source of capital to the company. However, when calculating WACC for a specific project, we would use the specific weights for that project, which may be based on the book value or market value of each source of capital, depending on the circumstances.

Quiz 11: Calculating the Cost of Capital