Question 1

Which of the following statements is CORRECT?

Accepted Answer

A)  we should use historical measures of the component costs from prior financings that are still outstanding when estimating a company's wacc for capital budgeting purposes. 
B)  the cost of new equity (re) could possibly be lower than the cost of reinvested earnings (rs) if the market risk premium, risk-free rate, and the company's beta all decline by a sufficiently large amount. 
C)  a firm's cost of reinvesting earnings is the rate of return stockholders require on a firm's common stock. 
D)  the component cost of preferred stock is expressed as rp(1 σ t), because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt. 
E)  in the wacc calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income. 
A)  we should use historical measures of the component costs from prior financings that are still outstanding when estimating a company's wacc for capital budgeting purposes. 
B)  the cost of new equity (re) could possibly be lower than the cost of reinvested earnings (rs) if the market risk premium, risk-free rate, and the company's beta all decline by a sufficiently large amount. 
C)  a firm's cost of reinvesting earnings is the rate of return stockholders require on a firm's common stock. 
D)  the component cost of preferred stock is expressed as rp(1 σ t), because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt. 
E)  in the wacc calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income. C

Question 2

Weatherall Enterprises has no debt or preferred stockσit is an all-equity firmσand has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than an average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT?

Accepted Answer

A)  the project should definitely be rejected because its expected return (before risk adjustment) is less than its required return. 
B)  riskier-than-average projects should have their expected returns increased to reflect their higher risk. clearly, this would make the project acceptable regardless of the amount of the adjustment. 
C)  the accept/reject decision depends on the firm's risk-adjustment policy. if weatherall's policy is to increase the required return on a riskier-than-average project to 3% over rs, then it should reject the project. 
D)  capital budgeting projects should be evaluated solely on the basis of their total risk. thus, insufficient information has been provided to make the accept/reject decision. 
E)  the project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return. 
A)  the project should definitely be rejected because its expected return (before risk adjustment) is less than its required return. 
B)  riskier-than-average projects should have their expected returns increased to reflect their higher risk. clearly, this would make the project acceptable regardless of the amount of the adjustment. 
C)  the accept/reject decision depends on the firm's risk-adjustment policy. if weatherall's policy is to increase the required return on a riskier-than-average project to 3% over rs, then it should reject the project. 
D)  capital budgeting projects should be evaluated solely on the basis of their total risk. thus, insufficient information has been provided to make the accept/reject decision. 
E)  the project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return. C

Question 3

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, rs, than on the interest rate on long-term debt, rd, 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

A) True 
 B)False  False

Question 4

If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.

Accepted Answer

A) True 
 B)False

Question 5

Which of the following statements is CORRECT? Assume a company's target capital structure is 50% debt and 50% common equity.

Accepted Answer

A)  the wacc is calculated on a before-tax basis. 
B)  the wacc exceeds the cost of equity. 
C)  the cost of equity is always equal to or greater than the cost of debt. 
D)  the cost of reinvested earnings typically exceeds the cost of new common stock. 
E)  the interest rate used to calculate the wacc is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet. 
A)  the wacc is calculated on a before-tax basis. 
B)  the wacc exceeds the cost of equity. 
C)  the cost of equity is always equal to or greater than the cost of debt. 
D)  the cost of reinvested earnings typically exceeds the cost of new common stock. 
E)  the interest rate used to calculate the wacc is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet.

Question 6

In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project.

Accepted Answer

A) True 
 B)False

Question 7

The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

Accepted Answer

A) True 
 B)False

Question 8

Which of the following statements is CORRECT?

Accepted Answer

A)  wacc calculations should be based on the before-tax costs of all the individual capital components. 
B)  flotation costs associated with issuing new common stock normally reduce the wacc. 
C)  if a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline. 
D)  an increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing. 
E)  a change in a company's target capital structure cannot affect its wacc. 
A)  wacc calculations should be based on the before-tax costs of all the individual capital components. 
B)  flotation costs associated with issuing new common stock normally reduce the wacc. 
C)  if a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline. 
D)  an increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing. 
E)  a change in a company's target capital structure cannot affect its wacc.

Question 9

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost.

Accepted Answer

A) True 
 B)False

Question 10

Careco Company and Audaco Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Careco having a WACC of 10% and Audaco a WACC of 12%. Careco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Careco project. Audaco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Audaco project.σσNow assume that the two companies merge and form a new company, Careco/Audaco Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is CORRECT?

Accepted Answer

A)  if evaluated using the correct post-merger wacc, project x would have a negative npv. 
B)  after the merger, careco/audaco would have a corporate wacc of 11%. therefore, it should reject project x but accept project y. 
C)  careco/audaco's wacc, as a result of the merger, would be 10%. 
D)  after the merger, careco/audaco should select project y but reject project x. if the firm does this, its corporate wacc will fall to 10.5%. 
E)  if the firm evaluates these projects and all other projects at the new overall corporate wacc, it will probably become riskier over time. 
A)  if evaluated using the correct post-merger wacc, project x would have a negative npv. 
B)  after the merger, careco/audaco would have a corporate wacc of 11%. therefore, it should reject project x but accept project y. 
C)  careco/audaco's wacc, as a result of the merger, would be 10%. 
D)  after the merger, careco/audaco should select project y but reject project x. if the firm does this, its corporate wacc will fall to 10.5%. 
E)  if the firm evaluates these projects and all other projects at the new overall corporate wacc, it will probably become riskier over time.

Question 11

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?

Accepted Answer

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. 
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.

Question 12

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

Accepted Answer

A)  accounts payable. 
B)  common stock "raised" by reinvesting earnings. 
C)  common stock raised by new issues. 
D)  preferred stock. 
E)  long-term debt. 
A)  accounts payable. 
B)  common stock "raised" by reinvesting earnings. 
C)  common stock raised by new issues. 
D)  preferred stock. 
E)  long-term debt.

Question 13

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

A) True 
 B)False

Question 14

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?

Accepted Answer

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. 
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.

Question 15

The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.

Accepted Answer

A) True 
 B)False

Question 16

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

Accepted Answer

A) True 
 B)False

Question 17

When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to use long-term or short-term rates for rRF, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and (3) how to measure the market risk premium, RPM. These problems leave us unsure of the true value of rs.

Accepted Answer

A) True 
 B)False

Question 18

To help them estimate the company's cost of capital, Smithco has hired you as a consultant. You have been provided with the following data: D1 = $1.45; P0 = $22.50; and gL = 6.50% (constant). Based on the dividend growth approach, what is the cost of common from reinvested earnings?

Accepted Answer

A)  11.10% 
B)  11.68% 
C)  12.30% 
D)  12.94% 
E)  13.59% 
A)  11.10% 
B)  11.68% 
C)  12.30% 
D)  12.94% 
E)  13.59%

Question 19

Which of the following statements is CORRECT?

Accepted Answer

A)  all else equal, an increase in a company's stock price will increase its marginal cost of reinvested earnings (not newly issued stock), rs. 
B)  all else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re. 
C)  since the money is readily available, the after-tax cost of reinvested earnings (not newly issued stock) is usually much lower than the after-tax cost of debt. 
D)  if a company's tax rate increases but the ytm on its noncallable bonds remains the same, the after-tax cost of its debt will fall. 
E)  when calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation. 
A)  all else equal, an increase in a company's stock price will increase its marginal cost of reinvested earnings (not newly issued stock), rs. 
B)  all else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re. 
C)  since the money is readily available, the after-tax cost of reinvested earnings (not newly issued stock) is usually much lower than the after-tax cost of debt. 
D)  if a company's tax rate increases but the ytm on its noncallable bonds remains the same, the after-tax cost of its debt will fall. 
E)  when calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation.

Question 20

Which of the following statements is CORRECT?Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.

Accepted Answer

A)  if a firm's managers want to maximize the value of their firm's stock, they should, in theory, concentrate on project risk as measured by the standard deviation of the project's expected future cash flows. 
B)  if a firm evaluates all projects using the same cost of capital, and the capm is used to help determine that cost, then its risk as measured by beta will probably decline over time. 
C)  projects with above-average risk typically have higher than average expected returns. therefore, to maximize a firm's intrinsic value, its managers should favor high-beta projects over those with lower betas. 
D)  project a has a standard deviation of expected returns of 20%, while project b's standard deviation is only 10%. a's returns are negatively correlated with both the firm's other assets and the returns on most stocks in the economy, while b's returns are positively correlated. therefore, project a is less risky to a firm and should be evaluated with a lower cost of capital. 
E)  if a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms' assets. 
A)  if a firm's managers want to maximize the value of their firm's stock, they should, in theory, concentrate on project risk as measured by the standard deviation of the project's expected future cash flows. 
B)  if a firm evaluates all projects using the same cost of capital, and the capm is used to help determine that cost, then its risk as measured by beta will probably decline over time. 
C)  projects with above-average risk typically have higher than average expected returns. therefore, to maximize a firm's intrinsic value, its managers should favor high-beta projects over those with lower betas. 
D)  project a has a standard deviation of expected returns of 20%, while project b's standard deviation is only 10%. a's returns are negatively correlated with both the firm's other assets and the returns on most stocks in the economy, while b's returns are positively correlated. therefore, project a is less risky to a firm and should be evaluated with a lower cost of capital. 
E)  if a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms' assets.

Exam 11: Determining the Cost of Capital

Which of the following statements is CORRECT?

If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.

Which of the following statements is CORRECT? Assume a company's target capital structure is 50% debt and 50% common equity.

The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

Which of the following statements is CORRECT?

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost.

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

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 cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

To help them estimate the company's cost of capital, Smithco has hired you as a consultant. You have been provided with the following data: D1 = $1.45; P0 = $22.50; and gL = 6.50% (constant). Based on the dividend growth approach, what is the cost of common from reinvested earnings?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.

An Overview of Financial Management and the Financial Environment

Risk and Return-Part I

Risk and Return-Part II

Bond Valuation

Financial Options

Accounting for Financial Management

Analysis of Financial Statements

Basic Stock Valuation

Corporate Valuation and Financial Planning

Corporate Governance

Capital Budgeting: Decision Criteria

Capital Budgeting-Estimating Cash Flows and Analyzing Risk

Real Options

Distributions to Shareholders-Dividends and Repurchases

Capital Structure Decisions

Dynamic Capital Structures and Corporate Valuation

Initial Public Offerings-Investment Banking: and Financial Restructuring

Lease Financing

Hybrid Financing Preferred Stock-Warrants and Convertibles

Supply Chains and Working Capital Management

Providing and Obtaining Credit

Other Topics in Working Capital Management

Enterprise Risk Management

Bankruptcy-Reorganization and Liquidation

Mergers and Corporate Control

Multinational Financial Management

Time Value of Money

Basic Financial Tools: A review

Pension Plan Management

Financial Management in Not for Profit Businesses

Filters