Answer Options:
a. increase
b. decrease
c. fluctuate less than before
d. fluctuate more than before
e. possibly increase, possibly decrease, or possibly remain constant
Answer: e. possibly increase, possibly decrease, or possibly remain constant
Question: From an investor’s perspective, a firm’s preferred stock is generally considered to be less risky than its common stock but more risky than its bonds. However, from a corporate issuer’s standpoint, these risk relationships are reversed: bonds are the most risky for the firm, preferred is next, and common is least risky.
Answer Options:
a. True
b. False
Answer: a. True
Question: Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A’s cost of capital is 10.0%, Division B’s cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A’s projects are equally risky, as are all of Division B’s projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept?
Answer Options:
a. A Division B project with a 13% return.
b. A Division B project with a 12% return.
c. A Division A project with an 11% return.
d. A Division A project with a 9% return.
e. A Division B project with an 11% return.
Answer: c
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: 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: 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: Stocks A and B have the same price and are in equilibrium, but Stock A has the higher required rate of return. Which of the following statements is CORRECT? a. If Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be higher than Stock B’s. b. Stock B must have a higher dividend yield than Stock A. c. Stock A must have a higher dividend yield than Stock B. d. If Stock A has a higher dividend yield than Stock B, its expected capital gains yield must be lower than Stock B’s. e. Stock A must have both a higher dividend yield and a higher capital gains yield than Stock B.
Answer Options:
a. If Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be higher than Stock B’s.
b. Stock B must have a higher dividend yield than Stock A.
c. Stock A must have a higher dividend yield than Stock B.
d. If Stock A has a higher dividend yield than Stock B, its expected capital gains yield must be lower than Stock B’s.
e. Stock A must have both a higher dividend yield and a higher capital gains yield than Stock B.
Answer: a. If Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be higher than Stock B’s.
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. Since we cannot be sure that the estimate obtained with any of these methods is correct, it is often appropriate to use all three methods, then consider all three estimates, and end up using a judgmental estimate when calculating the WACC.
Answer Options:
a. True
b. False
Answer: True
Question: Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?
Answer Options:
a. Long-term debt.
b. Accounts payable.
c. Retained earnings.
d. Common stock.
e. Preferred stock.
Answer: b. Accounts payable
Question: Two conditions are used to determine whether or not a stock is in equilibrium: (1) Does the stock’s market price equal its intrinsic value as seen by the marginal investor, and (2) does the expected return on the stock as seen by the marginal investor equal this investor’s required return? If either of these conditions, but not necessarily both, holds, then the stock is said to be in equilibrium.
Answer Options:
a. True
b. False
Answer: b. False
Question: The cost of capital used in capital budgeting should reflect the average cost of the various sources of investor-supplied funds a firm uses to acquire assets.
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: For a stock to be in equilibrium, two conditions are necessary: (1) The stock’s market price must equal its intrinsic value as seen by the marginal investor and (2) the expected return as seen by the marginal investor must equal this investor’s required return.
Answer Options:
a. True
b. False
Answer: a. True
Question: The MacMillen Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm’s overall WACC is 12%. The CFO believes that this is the correct WACC for the company’s average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO’s position is accepted, what is likely to happen over time?
Answer Options:
a. The company will take on too many high-risk projects and reject too many low-risk projects.
b. The company will take on too many low-risk projects and reject too many high-risk projects.
c. Things will generally even out over time, and, therefore, the firm’s risk should remain constant over time.
d. The company’s overall WACC should decrease over time because its stock price should be increasing.
e. The CEO’s recommendation would maximize the firm’s intrinsic value.
Answer: a
Question: Cranberry Corp. has two divisions of equal size: a computer manufacturing division and a data processing division. Its CFO believes that stand-alone processor companies typically have a WACC of 8%, while stand-alone computer manufacturers typically have a 12% WACC. He also believes that the data processing and manufacturing divisions have the same risk as their typical peers. Consequently, he estimates that the composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the data processing division and a 12% hurdle rate for the manufacturing division. However, the CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is CORRECT?
Answer Options:
a. While the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant’s recommendation, this should not affect the firm’s intrinsic value.
b. The decision not to adjust for risk means, in effect, that it is favoring the data processing division. Therefore, that division is likely to become a larger part of the consolidated company over time.
c. The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division. This will lead to a reduction in the firm’s intrinsic value over time.
d. The decision not to risk-adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business. This will lead to a reduction in its intrinsic value over time.
e. The decision not to risk adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business. This may affect the firm’s capital structure but it will not affect its intrinsic value.
Answer: c
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: SafeCo Company and Risco Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in SafeCo having a WACC of 10% and Risco a WACC of 12%. SafeCo is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical SafeCo project. Risco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Risco project. Now assume that the two companies merge and form a new company, SafeCo/Risco 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?
Answer Options:
a. If evaluated using the correct post-merger WACC, Project X would have a negative NPV.
b. After the merger, SafeCo/Risco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y.
c. After the merger, SafeCo/Risco would have a corporate WACC of 11%. Therefore, it should reject Project X.
d. SafeCo/Risco’s WACC, as a result of the merger, would be 10%.
e. After the merger, SafeCo/Risco should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%.
Answer: a
Question: The firm’s cost of external equity raised by issuing new stock is the same as the required rate of return on the firm’s outstanding common stock.
Answer Options:
a. True
b. False
Answer: False
Question: The preemptive right is important to shareholders because it a. allows managers to buy additional shares below the current market price. b. will result in higher dividends per share. c. is included in every corporate charter. d. protects the current shareholders against a dilution of their ownership interests. e. protects bondholders, and thus enables the firm to issue debt with a relatively low interest rate.
Answer Options:
a. allows managers to buy additional shares below the current market price.
b. will result in higher dividends per share.
c. is included in every corporate charter.
d. protects the current shareholders against a dilution of their ownership interests.
e. protects bondholders, and thus enables the firm to issue debt with a relatively low interest rate.
Answer: d. protects the current shareholders against a dilution of their ownership interests.
Question: Which of the following statements is CORRECT, assuming stocks are in equilibrium?
Answer Options:
a. The dividend yield on a constant growth stock must equal its expected total return minus its expected capital gains yield.
b. Assume that the required return on a given stock is 13%. If the stock’s dividend is growing at a constant rate of 5%, its expected dividend yield is 5% as well.
c. A stock’s dividend yield can never exceed its expected growth rate.
d. A required condition for one to use the constant growth model is that the stock’s expected growth rate exceeds its required rate of return.
e. Other things held constant, the higher a company’s beta coefficient, the lower its required rate of return.
Answer: a. The dividend yield on a constant growth stock must equal its expected total return minus its expected capital gains yield.
Question: If in the opinion of a given investor a stock’s expected return exceeds its required return, this suggests that the investor thinks a. the stock is experiencing supernormal growth. b. the stock should be sold. c. the stock is a good buy. d. management is probably not trying to maximize the price per share. e. dividends are not likely to be declared.
Answer Options:
a. the stock is experiencing supernormal growth
b. the stock should be sold
c. the stock is a good buy
d. management is probably not trying to maximize the price per share
e. dividends are not likely to be declared
Answer: c. the stock is a good buy
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: b. False
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: “Capital” is sometimes defined as funds supplied to a firm by investors.
Answer Options:
a. True
b. False
Answer: True
Question: Two constant growth stocks are in equilibrium, have the same price, and have the same required rate of return. Which of the following statements is CORRECT? a. The two stocks must have the same dividend per share. b. If one stock has a higher dividend yield, it must also have a lower dividend growth rate. c. If one stock has a higher dividend yield, it must also have a higher dividend growth rate. d. The two stocks must have the same dividend growth rate. e. The two stocks must have the same dividend yield.
Answer Options:
a. The two stocks must have the same dividend per share.
b. If one stock has a higher dividend yield, it must also have a lower dividend growth rate.
c. If one stock has a higher dividend yield, it must also have a higher dividend growth rate.
d. The two stocks must have the same dividend growth rate.
e. The two stocks must have the same dividend yield.
Answer: b. If one stock has a higher dividend yield, it must also have a lower dividend growth rate.