Answer Options
a. The “break point” as discussed in the text refers to the point where the firm’s tax rate increases.
b. The “break point” as discussed in the text refers to the point where the firm has raised so much capital that it is simply unable to borrow any more money.
c. The “break point” as discussed in the text refers to the point where the firm is taking on investments that are so risky the firm is in serious danger of going bankrupt if things do not go exactly as planned.
d. The “break point” as discussed in the text refers to the point where the firm has raised so much capital that it has exhausted its supply of additions to retained earnings and thus must raise equity by issuing stock.
e. The “break point” as discussed in the text refers to the point where the firm has exhausted its supply of additions to retained earnings and thus must begin to finance with preferred stock.
Answer: d
Question: The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm’s WACC.
Answer Options
a. True
b. False
Answer: False
Question: The higher the firm’s flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and retained earnings, whose cost is the average return on the assets that are acquired.
Answer Options
a. True
b. False
Answer: False
Question: 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.
Answer Options
a. True
b. False
Answer: True
Question: If a typical U.S. company correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely
Answer Options
a. become riskier over time, but its intrinsic value will be maximized.
b. become less risky over time, and this will maximize its intrinsic value.
c. accept too many low-risk projects and too few high-risk projects.
d. become more risky and also have an increasing WACC. Its intrinsic value will not be maximized.
e. continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital.
Answer: c
Question: A firm is considering a 10-year project that is expected to generate annual cash flows of $117,499.00 during the life of the project. The project requires an initial investment of $1,037,237 and the cost of capital is 7.56%. What is the IRR of the project?
Answer: 11.29%
Question: The component costs of capital are market-determined variables in the sense that they are based on investors’ required returns.
Answer Options
a. True
b. False
Answer: True
Question: Which of the following statements is CORRECT?
Answer Options
a. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.
b. When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.
c. Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM.
d. If a company’s beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence must issue new stock.
Answer: a
Question: LaPango Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?
Answer Options
a. Project B, which is of below-average risk and has a return of 8.5%.
b. Project C, which is of above-average risk and has a return of 11%.
c. Project A, which is of average risk and has a return of 9%.
d. None of the projects should be accepted.
e. All of the projects should be accepted.
Answer: a
Question: Which of the following statements is CORRECT?
Answer Options
a. The WACC as used in capital budgeting is an estimate of a company’s before-tax cost of capital.
b. The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt.
c. The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets.
d. There is an “opportunity cost” associated with using retained earnings, hence they are not “free.”
e. The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year.
Answer: d
Question: The reason why retained earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm’s common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should pay those earnings out to its investors. Thus, the cost of retained earnings is based on the opportunity cost principle.
Answer Options
a. True
b. False
Answer: True
Question: 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.
Answer Options
a. True
b. False
Answer: False
Question: Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm’s stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt.
Answer Options
a. True
b. False
Answer: a. True
Question: Genex Communications is evaluating a new project. The initial investment required is $855,352.50 and the cost of capital is 10%. Expected cash flows over the next four years are as follows:
Year 1: $200,000
Year 2: $400,000
Year 3: $400,000
Year 4: $700,000
What is the IRR of the project?
Answer: 12.89%
Question: Bankston Corporation forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Since new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock?
Answer Options
a. Increase the dividend payout ratio for the upcoming year.
b. Increase the percentage of debt in the target capital structure.
c. Increase the proposed capital budget.
d. Reduce the amount of short-term bank debt in order to increase the current ratio.
e. Reduce the percentage of debt in the target capital structure.
Answer: b. Increase the percentage of debt in the target capital structure
Question: Which of the following statements is CORRECT?
Answer Options
a. The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., if the after-tax cost of debt if debt is to be used to finance the project, or the cost of equity if the project will be financed with equity.
b. The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average after-tax cost of all the firm’s outstanding debt.
c. Suppose some of a publicly-traded firm’s stockholders are not diversified; they hold only the one firm’s stock. In this case, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firm’s intrinsic value.
d. The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity.
e. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm’s cost of equity capital.
Answer: d
Question: The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: “The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 – F).”
Answer Options
a. True
b. False
Answer: False
Question: The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the DCF method is widely used in practice.
Answer Options
a. True
b. False
Answer: False
Question: The cost of debt, rd, is normally less than rs, so rd(1 – T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 – T).
Answer Options
a. True
b. False
Answer: True