Question 1

The SML approach can be applied to more firms than the dividend growth model can.

Accepted Answer

A) True 
 B)False  True

Question 2

What are the consequences of using a discount rate that is higher or lower than the firm's true required return?

Accepted Answer

As a general rule, if the discount rate used is too high, the firm will tend to accept unprofitable projects and reject profitable projects, becoming riskier over time. If the rate is too low, again, the firm will tend to accept unprofitable projects, but whether or not the firm becomes riskier over time depends on what type of projects are ultimately accepted.

Question 3

Which of the following is NOT a legitimate reason why it is generally considered easier to estimate the cost of preferred stock than it is to estimate the cost of common stock?

Accepted Answer

A)  Preferred stock generally carries with it a fixed dividend payment. 
B)  Preferred stock is often rated for default risk. 
C)  The cost of preferred stock can be calculated as a perpetuity based on the fixed dividend payment and the present stock price. 
D)  Calculation of the cost of preferred stock does not require any information about future preferred dividends. 
E)  The cost of preferred stock is simply equal to its dividend yield. 
A)  Preferred stock generally carries with it a fixed dividend payment. 
B)  Preferred stock is often rated for default risk. 
C)  The cost of preferred stock can be calculated as a perpetuity based on the fixed dividend payment and the present stock price. 
D)  Calculation of the cost of preferred stock does not require any information about future preferred dividends. 
E)  The cost of preferred stock is simply equal to its dividend yield. D

Question 4

Discount Retailers has an overall beta of.96 and a cost of equity of 10.4 % for the firm overall. The firm is financed solely by common stock. Division A within the firm has an estimated beta of 1.13 and is the riskiest of all of the firm's divisions What is an appropriate cost of capital for division A if the market risk premium is 5 %?

Accepted Answer

A)  9.84 % 
B)  11.03 % 
C)  11.18 % 
D)  11.25 % 
E)  12.24 % 
A)  9.84 % 
B)  11.03 % 
C)  11.18 % 
D)  11.25 % 
E)  12.24 %

Question 5

Nexum Inc. has a target debt-equity ratio of 1.25. Its WACC is 9.2%, and the tax rate is 35%. If Nexum's cost of equity is 14%, what is its pre-tax cost of debt?

Accepted Answer

A)  6.45% 
B)  7.35% 
C)  8.25% 
D)  9.15% 
E)  10.05% 
A)  6.45% 
B)  7.35% 
C)  8.25% 
D)  9.15% 
E)  10.05%

Question 6

Suppose that Topstone Industries has a cost of equity of 14% and a cost of debt of 9%. If the target debt/equity ratio is 75%, and the tax rate is 34%, what is Topstone's weighted average cost of capital (WACC)?

Accepted Answer

A)  6.6% 
B)  7.9% 
C)  8.4% 
D)  10.5% 
E)  10.9% 
A)  6.6% 
B)  7.9% 
C)  8.4% 
D)  10.5% 
E)  10.9%

Question 7

Hartley, Inc. needs to purchase equipment for its 2,000 drive-ins nationwide. The total cost of the equipment is $2 million. It is estimated that the after-tax cash inflows from the project will be $210,000 annually in perpetuity. Hartley has a market value debt-to-assets ratio of 40%. The firm's cost of equity is 13%, its pre-tax cost of debt is 8%, and the flotation costs of debt and equity are 2% and 8%, respectively. The tax rate is 34%. Assume the project is of similar risk to the firm's existing operations.

After considering flotation costs, what is the NPV of the proposed project?

Accepted Answer

A)  -$2,957 
B)  $428 
C)  $2,091 
D)  $7,072 
E)  $178,675 
A)  -$2,957 
B)  $428 
C)  $2,091 
D)  $7,072 
E)  $178,675

Question 8

A firm that uses its WACC as a cutoff without considering project risk tends to accept negative NPV projects over time.

Accepted Answer

A) True 
 B)False

Question 9

The risk premium for a firm is based on the:

Accepted Answer

A)  Firm's dividend history and growth rate. 
B)  Firm's level of risk relative to the market and the firm's rate of growth. 
C)  Risk-free rate of return and the growth rate of the firm. 
D)  Market risk premium and the firm's level of risk relative to the market. 
E)  Market risk premium and the risk-free rate of return. 
A)  Firm's dividend history and growth rate. 
B)  Firm's level of risk relative to the market and the firm's rate of growth. 
C)  Risk-free rate of return and the growth rate of the firm. 
D)  Market risk premium and the firm's level of risk relative to the market. 
E)  Market risk premium and the risk-free rate of return.

Question 10

When a firm has flotation costs equal to 6 % of the funding need, it should:

Accepted Answer

A)  Increase the weighted average cost of capital (WAC
C)  to offset these expenses by multiplying the WACC by 1.06. 
B)  Increase the weighted average cost of capital (WAC
C)  to offset these expenses by dividing the WACC by (1 -.06). 
C)  Add 6 % to the weighted average cost of capital to get the discount rate for the project. 
D)  Increase the initial project cost by multiplying that cost by 1.06. 
E)  Increase the initial project cost by dividing that cost by (1 -.06). 
A)  Increase the weighted average cost of capital (WAC
C)  to offset these expenses by multiplying the WACC by 1.06. 
B)  Increase the weighted average cost of capital (WAC
C)  to offset these expenses by dividing the WACC by (1 -.06). 
C)  Add 6 % to the weighted average cost of capital to get the discount rate for the project. 
D)  Increase the initial project cost by multiplying that cost by 1.06. 
E)  Increase the initial project cost by dividing that cost by (1 -.06).

Question 11

Peter's Audio Shop has a cost of debt of 7 %, a cost of equity of 11 %, and a cost of preferred stock of 8 %. The firm has 104,000 shares of common stock outstanding at a market price of $20 a share. There are 40,000 shares of preferred stock outstanding at a market price of $34 a share. The bond issue has a total face value of $500,000 and sells at 102 % of face value. The company's tax rate is 34 %. What is the weighted average cost of capital for Peter's Audio Shop?

Accepted Answer

A)  6.14 % 
B)  6.54 % 
C)  8.60 % 
D)  9.14 % 
E)  9.45 % 
A)  6.14 % 
B)  6.54 % 
C)  8.60 % 
D)  9.14 % 
E)  9.45 %

Question 12

Flotation costs refer to the:

Accepted Answer

A)  Initial costs incurred on day one of a new project. 
B)  Interest rate imposed on the firm's debt. 
C)  Required rate of return which is necessary for a project to be accepted. 
D)  Dividends which shareholders expect when they purchase shares of the firm's stock. 
E)  Costs incurred by a firm when new issues of securities are sold. 
A)  Initial costs incurred on day one of a new project. 
B)  Interest rate imposed on the firm's debt. 
C)  Required rate of return which is necessary for a project to be accepted. 
D)  Dividends which shareholders expect when they purchase shares of the firm's stock. 
E)  Costs incurred by a firm when new issues of securities are sold.

Question 13

The common stock of Big Birds Unlimited has a required return of 8 % and a growth rate of 4 %. The last annual dividend was $.60 a share. What is the current price of this stock?

Accepted Answer

A)  $7.50 
B)  $7.80 
C)  $10.00 
D)  $15.00 
E)  $15.60 
A)  $7.50 
B)  $7.80 
C)  $10.00 
D)  $15.00 
E)  $15.60

Question 14

The amount of equity financing as a % of the total financing is considered, directly or indirectly, in the weighted average cost of capital.

Accepted Answer

A) True 
 B)False

Question 15

In using the ___________ approach, we place projects into risk classes in order to assign discount rates.

Accepted Answer

A)  Subjective. 
B)  Capital analysis. 
C)  Pure play. 
D)  SML. 
E)  Yield play. 
A)  Subjective. 
B)  Capital analysis. 
C)  Pure play. 
D)  SML. 
E)  Yield play.

Question 16

Flotation costs:

Accepted Answer

A)  Reduce each of the cash inflows for a project. 
B)  Represent a recovery item at the end of a project. 
C)  Should be ignored as they are a financing cost, not a project cost. 
D)  Increase a project's cost of capital. 
E)  Should be included as an initial cash outflow of the project. 
A)  Reduce each of the cash inflows for a project. 
B)  Represent a recovery item at the end of a project. 
C)  Should be ignored as they are a financing cost, not a project cost. 
D)  Increase a project's cost of capital. 
E)  Should be included as an initial cash outflow of the project.

Question 17

The market risk premium:

Accepted Answer

A)  Varies over time as both the risk-free rate of return and the market rate of return vary. 
B)  Plus the risk-free rate of return equals the cost of capital for any firm with a beta of zero. 
C)  Is equal to one % for a risk-free asset. 
D)  Is equal to the risk-free rate of return multiplied by the beta of a firm. 
E)  Is modified by the standard deviation when computing the cost of equity. 
A)  Varies over time as both the risk-free rate of return and the market rate of return vary. 
B)  Plus the risk-free rate of return equals the cost of capital for any firm with a beta of zero. 
C)  Is equal to one % for a risk-free asset. 
D)  Is equal to the risk-free rate of return multiplied by the beta of a firm. 
E)  Is modified by the standard deviation when computing the cost of equity.

Question 18

The costs incurred by the firm when new issues of stocks or bonds are sold are called:

Accepted Answer

A)  Required rates of return. 
B)  Costs of capital. 
C)  Flotation costs. 
D)  Capital structure weights. 
E)  Costs of equity and debt. 
A)  Required rates of return. 
B)  Costs of capital. 
C)  Flotation costs. 
D)  Capital structure weights. 
E)  Costs of equity and debt.

Question 19

Which of the following best defines the term weighted average cost of capital (WACC)?

Accepted Answer

A)  The weighted average of the costs of debt and equity. 
B)  Net income after interest and taxes divided by average common shareholders' equity. 
C)  Use of a WACC that is unique to a particular project. 
D)  Performance measure based on WACC. 
E)  Base case net present value of a project's operating cash flows plus present value of any financing benefits. 
A)  The weighted average of the costs of debt and equity. 
B)  Net income after interest and taxes divided by average common shareholders' equity. 
C)  Use of a WACC that is unique to a particular project. 
D)  Performance measure based on WACC. 
E)  Base case net present value of a project's operating cash flows plus present value of any financing benefits.

Question 20

Topstone Industries is expected to pay a dividend of $2.10 per share in one year. This dividend, along with the firm's earnings, is expected to grow at a rate of 5% forever. If the current market price for a share of Topstone is $38.62, what is the cost of equity?

Accepted Answer

A)  6.00% 
B)  10.44% 
C)  10.71% 
D)  11.00% 
E)  11.22% 
A)  6.00% 
B)  10.44% 
C)  10.71% 
D)  11.00% 
E)  11.22%

Exam 14: Cost of Capital

The SML approach can be applied to more firms than the dividend growth model can.

What are the consequences of using a discount rate that is higher or lower than the firm's true required return?

Which of the following is NOT a legitimate reason why it is generally considered easier to estimate the cost of preferred stock than it is to estimate the cost of common stock?

Nexum Inc. has a target debt-equity ratio of 1.25. Its WACC is 9.2%, and the tax rate is 35%. If Nexum's cost of equity is 14%, what is its pre-tax cost of debt?

Suppose that Topstone Industries has a cost of equity of 14% and a cost of debt of 9%. If the target debt/equity ratio is 75%, and the tax rate is 34%, what is Topstone's weighted average cost of capital (WACC)?

A firm that uses its WACC as a cutoff without considering project risk tends to accept negative NPV projects over time.

The risk premium for a firm is based on the:

When a firm has flotation costs equal to 6 % of the funding need, it should:

Flotation costs refer to the:

The common stock of Big Birds Unlimited has a required return of 8 % and a growth rate of 4 %. The last annual dividend was $.60 a share. What is the current price of this stock?

The amount of equity financing as a % of the total financing is considered, directly or indirectly, in the weighted average cost of capital.

In using the ___________ approach, we place projects into risk classes in order to assign discount rates.

Flotation costs:

The market risk premium:

The costs incurred by the firm when new issues of stocks or bonds are sold are called:

Which of the following best defines the term weighted average cost of capital (WACC)?

Topstone Industries is expected to pay a dividend of $2.10 per share in one year. This dividend, along with the firm's earnings, is expected to grow at a rate of 5% forever. If the current market price for a share of Topstone is $38.62, what is the cost of equity?

Introduction to Corporate Finance

Financial Statements, Cash Flow, and Taxes

Working With Financial Statements

Long-Term Financial Planning and Corporate Growth

Introduction to Valuation: the Time Value of Money

Discounted Cash Flow Valuation

Interest Rates and Bond Valuation

Stock Valuation

Net Present Value and Other Investment Criteria

Making Capital Investment Decisions

Project Analysis and Evaluation

Lessons From Capital Market History

Return, Risk, and the Security Market Line

Raising Capital

Financial Leverage and Capital Structure Policy

Dividends and Dividend Policy

Short-Term Finance and Planning

Cash and Liquidity Management

Credit and Inventory Management

International Corporate Finance

Leasing

Mergers and Acquisitions

Enterprise Risk Management

Options and Corporate Securities

Behavioural Finance: Implications for Financial Management

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