Question 1

To attract capital from outside investors, a firm must offer potential investors an expected return that is commensurate with the level of risk that they can bear.

Accepted Answer

This is true because investors are willing to take on higher levels of risk if there is a potential for higher returns, but they won't invest if the expected return doesn't match the risk level.

Question 2

Epiphany is an all-equity firm with an estimated market value of $500 000. The firm sells $200 000 of debt and uses the proceeds to purchase outstanding equity. Compute the weight in equity and the weight in debt after the proposed financing and repurchase of equity.

Accepted Answer

After the firm sells $200,000 of debt and uses this to repurchase equity, the total market value of the firm remains $500,000 ($300,000 in equity + $200,000 in debt). Therefore, the weight in equity is $300,000 / $500,000 = 0.6, and the weight in debt is $200,000 / $500,000 = 0.4.

Question 3

Epiphany is an all-equity firm with an estimated market value of $400 000. The firm sells $300 000 of debt and uses the proceeds to purchase outstanding equity. Compute the weight in equity and the weight in debt after the proposed financing and repurchase of equity.

Accepted Answer

After the firm sells $300,000 of debt and uses it to repurchase equity, the total market value of the firm becomes $400,000 (since the firm's value doesn't change by financing activities under the Modigliani-Miller theorem, assuming no taxes or bankruptcy costs). The new equity value is $400,000 - $300,000 = $100,000. Therefore, the weight in equity is $100,000 / $400,000 = 0.25, and the weight in debt is $300,000 / $400,000 = 0.75.

Question 4

Brisbane Broncos Limited has raised all its capital via equity rather than debt. Such a firm is also referred to as a(n)________ firm.

Accepted Answer

An unlevered firm is one that has raised its entire capital through equity and has no outstanding debt obligations. This means that there is no use of leverage or borrowed funds in the firm's capital structure.

Question 5

Financial managers need to use all sources of financing in order to determine the cost of capital.

Accepted Answer

Financial managers need to consider all sources of financing, including equity, debt, and retained earnings, to determine the cost of capital for their firm. This allows for a comprehensive analysis of the different costs associated with each source of financing and helps managers make informed decisions about how to fund their operations. Ignoring one or more sources of financing can lead to an incomplete or inaccurate assessment of the cost of capital, which can have significant implications for a firm's financial performance in the long term.

Question 6

For an unlevered firm, the cost of capital for the firm can be determined by using the:

Accepted Answer

The cost of capital for an unlevered firm can be determined using the Capital Asset Pricing Model (CAPM). CAPM considers the risk-free rate of return, market risk premium, and the beta of the firm to calculate the cost of equity, which is considered the cost of capital for an unlevered firm.

Question 7

Epiphany is an all-equity firm with an estimated market value of $300 000. The firm sells $100 000 of debt and uses the proceeds to purchase outstanding equity. Compute the weight in equity and the weight in debt after the proposed financing and repurchase of equity.

Accepted Answer

After the firm sells $100,000 of debt and uses it to repurchase equity, the total market value of the firm becomes $200,000 in equity ($300,000 original equity - $100,000 used to repurchase equity) and $100,000 in debt. Therefore, the weight in equity is $200,000 / ($200,000 + $100,000) = 0.67, and the weight in debt is $100,000 / ($200,000 + $100,000) = 0.33.

Question 8

The firm's overall cost of capital that is a blend of the costs of the different sources of capital is known as the firm's:

Accepted Answer

The weighted average cost of capital (WACC) takes into account the cost of all sources of financing for a company, including debt, preferred stock, and equity. It is calculated by taking the proportion of each type of financing and multiplying it by the corresponding cost of that financing, then adding them together. This gives a blended rate that reflects the overall cost of capital for a company. Therefore, the best choice is D - weighted average cost of capital.

Question 9

One should use accounting-based book values rather than market values of debt and equity to determine the weights for the different sources of capital.

Accepted Answer

Market values of debt and equity are preferred over book values because they more accurately reflect the current cost of capital and the investment community's perception of the company's value and risk.

Question 10

A company has a book value of $8 billion of equity and a face value of $12 billion of debt. What are the weights in debt and equity that are used for calculating the WACC?

Accepted Answer

The weights for calculating WACC should be based on market values, not book values or face values. Without market values, the weights cannot be determined.

Question 11

The total market value of Downunder Minerals is $10 billion. The company has a market value of $7 billion of equity and a face value of $10 billion of debt. What are the weights in equity and debt that are used for calculating the WACC?

Accepted Answer

The weights of equity and debt are calculated by dividing their market and face values respectively by the total market value of the company. Hence, the weight of equity is 7/10 = 0.7 and the weight of debt is 10/10 = 1. The sum of the weights must be 1, so the weight of equity and debt would be 0.7 and 0.3 respectively. Therefore, the answer is C.

Question 12

We use market values rather than book values because the cost of capital is based on investors' current assessment of the value of the firm and not the assessment of accounting-based book values.

Accepted Answer

Market values reflect the current assessment of the firm's value by investors, which is a more accurate reflection of the cost of capital than book values that are based on accounting measurements.

Question 13

As a firm increases its level of debt relative to its level of equity, the firm is decreasing its leverage.

Accepted Answer

As a firm increases its level of debt relative to its level of equity, it is actually increasing its leverage, not decreasing it. This is because debt is a form of leverage, as it allows a firm to use borrowed funds to invest and potentially earn higher returns. However, increased leverage also comes with increased risk, as the firm will have to pay interest on its debt and may struggle to make payments if its investments don't perform well.

Question 14

The relative proportion of debt, equity and other securities that a firm has outstanding constitute its:

Accepted Answer

The definition given in the question matches the description of capital structure, which refers to the way a company finances its operations and growth through a combination of debt and equity securities. The current ratio and asset ratio, on the other hand, are specific financial ratios that measure a company's ability to pay its current obligations and the extent to which its assets are financed by debt, respectively. Therefore, the correct answer is B.

Question 15

The book value of equity of a firm is $100 million and the market value of equity is $200 million. The face value of debt of the firm is $50 million and the market value of debt is $60 million. What is the market value of assets of the firm?

Accepted Answer

The market value of assets of the firm can be found by adding the market value of equity and the market value of debt. So, Market value of assets = Market value of equity + Market value of debt = $200 million + $60 million = $260 million.

Question 16

Assume JBH has debt with a book value of $20 million, trading at 120% of par value. The firm has book equity of $20 million, and 2 million shares trading at $18 per share. What weights should JBH use in calculating its WACC?

Accepted Answer

The answer of Assume JBH has debt with a book...

Question 17

A firm's sources of financing, which usually consists of debt and equity, represent its capital.

Accepted Answer

A firm's capital typically consists of both debt and equity, which are the two primary sources of financing.

Question 18

A company has a market value of $8 billion of equity and a market value of $12 billion of debt. What are the weights in equity and debt that are used for calculating the WACC?

Accepted Answer

To calculate the weights, we need to divide the market value of equity and debt by their sum:
Equity weight = $8 billion / ($8 billion + $12 billion) = 0.4 or 40%
Debt weight = $12 billion / ($8 billion + $12 billion) = 0.6 or 60%
Therefore, the correct choice is B, with equity weight of 0.4 and debt weight of 0.6.

Question 19

'Leverage' is the amount of ________ on a firm's balance sheet.

Accepted Answer

Leverage refers to the use of debt to finance a firm's operations or investments. Therefore, the amount of debt on a firm's balance sheet is the factor that determines its leverage. Equity and preferred stock represent sources of financing that do not increase a firm's leverage. Therefore, options A and B are incorrect. Option D is also not correct as leverage is a factor on a firm's balance sheet.

Question 20

A levered firm is one that has ________ outstanding.

Accepted Answer

A levered firm is one that has debt outstanding. Leverage refers to the use of debt to finance a firm's operations or investments. By using debt, a firm can increase its potential returns, but also increases its risk of financial distress. Therefore, the term "levered" implies that the firm has debt on its balance sheet.

Quiz 13: The Cost of Capital