Answer Options:
a. The component cost of preferred stock is expressed as rp(1 – T). This follows because preferred stock dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes.
b. A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firm’s stockholders would themselves expect to earn a return on earnings that were paid out rather than retained and reinvested.
c. No cost should be assigned to retained earnings because the firm does not have to pay anything to raise them. They are generated as cash flows by operating assets that were raised in the past, hence they are “free.”
d. Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into the foreseeable future. In this case, the firm’s before-tax and after-tax costs of debt for purposes of calculating the WACC will both be equal to the interest rate on the firm’s currently outstanding debt, provided that debt was issued during the past 5 years.
e. If a firm has enough retained earnings to fund its capital budget for the coming year, then there is no need to estimate either a cost of equity or a WACC.
Answer: B. A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firm’s stockholders would themselves expect to earn a return on earnings that were paid out rather than retained and reinvested.
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 and Project Y.
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. If evaluated using the correct post-merger WACC, Project X would have a negative NPV.
Question: When estimating the cost of equity by use of the DCF method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock’s expected future rate of return. This problem leaves us unsure of the true value of rs.
Answer Options:
a. True
b. False
Answer: True
Question: Which of the following statements is CORRECT?
Answer Options:
a. The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the interest rate on the company’s own long-term bonds. The size of the risk premium for bonds with different ratings is published daily in The Wall Street Journal or is available online.
b. The WACC is calculated using a before-tax cost for debt that is equal to the interest rate that must be paid on new debt, along with the after-tax costs for common stock and for preferred stock if it is used.
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. 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.
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: D. become more risky and also have an increasing WACC. Its intrinsic value will not be maximized.
Question: The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.
Answer Options:
a. True
b. False
Answer: True
Question: When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs.
Answer Options:
a. True
b. False
Answer: True
Question: For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity.
Answer Options:
a. True
b. False
Answer: True
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: 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. The company will take on too many high-risk projects and reject too many low-risk projects.
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: 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., it is 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. 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.
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 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: Which of the following statements is CORRECT?
Answer Options:
a. Since the costs of internal and external equity are related, an increase in the flotation cost required to sell a new issue of stock will increase the cost of retained earnings.
b. Since its stockholders are not directly responsible for paying a corporation’s income taxes, corporations should focus on before-tax cash flows when calculating the WACC.
c. An increase in a firm’s tax rate will increase the component cost of debt, provided the YTM on the firm’s bonds is not affected by the change in the tax rate.
d. When the WACC is calculated, it should reflect the costs of new common stock, retained earnings, preferred stock, long-term debt, short-term bank loans if the firm normally finances with bank debt, and accounts payable if the firm normally has accounts payable on its balance sheet.
e. If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the after-tax cost of debt.
Answer: E. If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the after-tax cost of debt.
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: False
Question: Which of the following statements is CORRECT?
Answer Options:
a. The WACC is calculated using before-tax costs for all components.
b. The after-tax cost of debt usually exceeds the after-tax cost of equity.
c. For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock.
d. Retained earnings that were generated in the past and are reported on the firm’s balance sheet are available to finance the firm’s capital budget during the coming year.
e. The WACC that should be used in capital budgeting is the firm’s marginal, after-tax cost of capital.
Answer: E. The WACC that should be used in capital budgeting is the firm’s marginal, after-tax cost of capital.
Question: The cost of perpetual preferred stock is found as the preferred’s annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, are not deductible by the issuing firm.
Answer Options:
a. True
b. False
Answer: True