Question 1

The beta of the company is equal to the weighted-average sum of the betas of the individual projects that the company is currently operating.

Accepted Answer

The beta of a company is a measure of its systematic risk, or the risk that cannot be diversified away. It is calculated as the weighted-average sum of the betas of the individual projects that the company is currently operating. The weights are the proportions of the company's total assets that are invested in each project.

Question 2

The finance balance sheet is based on market values, just like the accounting balance sheet.

Accepted Answer

The finance balance sheet is based on fair values, which may differ from market values. The accounting balance sheet, on the other hand, is based on historical cost or a lower of cost or market valuation.

Question 3

The issuance costs of new debt securities can be ignored since those costs will not be reflected in the yield to maturity of the debt in the future.

Accepted Answer

The issuance costs of new debt securities should not be ignored as they can affect the yield to maturity. This is because the costs are deducted from the proceeds received by the company from the issuance, which reduces the total amount available to pay interest and principal. As a result, the yield to maturity calculation should take into account the impact of issuance costs on the cash flows associated with the bond.

Question 4

Milton Company issued bonds 10 years ago with a coupon rate of 10 percent at a price of $1,000. The current price of the bonds is $980. The before-tax cost of the debt to the company is still 10 percent.

Accepted Answer

The current price of the bonds being lower than the face value indicates that the yield (or market interest rate) is now higher than the bond's coupon rate of 10 percent. Therefore, the before-tax cost of the debt to the company is now higher than 10 percent.

Question 5

Unique risk is the only risk that investors require compensation for bearing.

Accepted Answer

According to the Capital Asset Pricing Model (CAPM), investors require compensation only for the unique risk associated with an investment, which cannot be diversified away through portfolio diversification. This unique risk is also known as systematic risk or market risk. Therefore, the statement is true.

Question 6

The current cost of bank debt can be determined by asking the company's banker.

Accepted Answer

The company's banker is the best source of information regarding the current cost of bank debt.

Question 7

Using the company's overall cost of capital to evaluate a project's cash flows is problematic in that the company is a collection of projects, with the possibility that each project has a different level of risk than the other projects currently working for the company.

Accepted Answer

The statement is true. Using the company's overall cost of capital to evaluate a project's cash flows assumes that all projects have the same risk level, which is not always the case. Each project may have a different level of risk, and therefore, may require a different required rate of return. This is why project-specific cost of capital is often used for more accurate evaluation.

Question 8

Long-term debt typically describes debt that will mature in two years or more.

Accepted Answer

Long-term debt refers to debt that will mature in two years or more, while short-term debt will mature within less than two years.

Question 9

The cost of equity for the company must take the cost of preference share (if any has been issued) that the company has outstanding into account.

Accepted Answer

The cost of equity calculation considers all sources of financing, including preference shares (if any). Preference shares are considered as a form of equity financing and their cost is included in the calculation of the overall cost of equity for the company. Therefore, it is true that the cost of equity for the company must take the cost of preference share (if any has been issued) into account.

Question 10

If a company is interested in the current cost of its debt obligations, then it can simply look at the contractual rate of interest due lenders on those obligations.

Accepted Answer

The contractual rate of interest may not reflect the current market conditions or the effective interest rate, which includes other factors like fees and changes in credit risk.

Question 11

If a company finances the purchase of an asset with cash, then it has zero financial cost to the company.

Accepted Answer

Even if a company uses cash to finance the purchase of an asset, there is an opportunity cost for holding onto that cash instead of using it for other investments or operations. Therefore, there is a financial cost to the company for choosing to use cash for the purchase instead of another financing option.

Question 12

The yield to maturity for an annual coupon paying bond will accurately reflect the actual current annual pretax cost of the debt.

Accepted Answer

The yield to maturity takes into account the current market price of the bond, the coupon rate, and the time remaining until maturity. As such, it reflects the overall annual pretax cost of the debt to investors purchasing the bond.

Question 13

If the market value of a company's assets is greater than the book value of a company's assets then the book value of the company's liabilities and equity must be less than the market value of the company's liabilities and equity.

Accepted Answer

This statement is true according to the accounting equation which is Assets = Liabilities + Equity. If the market value of assets is greater than their book value, then the total equity of the company will be higher than the value stated in the financial statements, which means that the market value of both liabilities and equity will also be greater than their book value.

Question 14

Long-term debt is generally viewed as a permanent financing source for the company.

Accepted Answer

Long-term debt typically refers to loans and other financing arrangements that extend beyond one year. Unlike short-term debt, which is often used to address short-term needs or to manage cash flow, long-term debt is typically seen as a more permanent source of financing. It can be used to fund large capital investments, expansion efforts, and other long-term initiatives that require significant funding commitments over time. As a result, long-term debt is generally viewed as a longer-term, more stable form of financing for companies compared to other types of debt or equity financing.

Question 15

If a company is subject to income tax, then the after-tax cost of debt for the company will be less than the before-tax cost of debt.

Accepted Answer

The after-tax cost of debt is calculated by subtracting the tax rate from the before-tax cost of debt. Since the interest payments on debt are tax-deductible, the company will have a lower tax burden and therefore a lower after-tax cost of debt.

Question 16

A company is currently taking on two projects with an individual cost of capital of 10 percent and 12 percent for each of the projects. That means that the before-tax cost of capital for the company must be between 10 and 12 percent.

Accepted Answer

Just because a company is taking on projects with a cost of capital of 10% and 12%, it doesn't mean that the before-tax cost of capital for the company must lie between 10% and 12%. The overall cost of capital for a company depends on various factors and can be influenced by factors like market conditions, credit rating, industry outlook, etc. Therefore, we cannot make a definitive statement about the before-tax cost of capital for the company based on the cost of capital for individual projects.

Question 17

With respect to the cost of capital, we are generally interested in the cost of a source of financing on a particular date.

Accepted Answer

The cost of capital refers to the cost of a particular source of financing at a specific point in time. Therefore, we are generally interested in determining the cost of each source of financing on a particular date.

Question 18

Estimates of security returns will be reliable in all types of markets, including those deemed less efficient than others.

Accepted Answer

Estimates of security returns may not be reliable in less efficient markets. Inefficient markets may have less available information and may be more affected by unpredictable external factors, which can make it more difficult to accurately estimate returns.

Question 19

If one observes the market quoted price of a debt security where the expected cash flows of that security are known, then one can calculate the current cost of that security to the company.

Accepted Answer

The market quoted price of a debt security reflects the market's expectation of future cash flows from that security. By knowing the expected cash flows, one can use the market price to calculate the current cost of the security to the company.

Question 20

The yield to maturity for a semiannual coupon paying bond will accurately reflect the actual current annual cost of the debt.

Accepted Answer

The yield to maturity (YTM) is calculated by factoring in the coupon payments and maturity value of the bond. Since the YTM considers the semiannual coupon payments, it accurately reflects the actual current annual cost of the debt. Therefore, the statement is true.

Quiz 13: The Cost of Capital