a. True
b. False
Answer Choices:
a. True
b. False
Answer: b. False
Question: For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is CORRECT?
Answer Choices:
a. 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.
b. The WACC is calculated on a before-tax basis.
c. The WACC exceeds the cost of equity.
d. The cost of equity is always equal to or greater than the cost of debt.
e. The cost of retained earnings typically exceeds the cost of new common stock.
Answer: d. The cost of equity is always equal to or greater than the cost of debt.
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.
a. True
b. False
Answer Choices:
a. True
b. False
Answer: b. False
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
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 Choices:
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 lower the firm’s tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant.
a. True
b. False
Answer Choices:
a. True
b. False
Answer: b. 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 Choices:
a. If the firm evaluates these projects and all other projects at the new overall company WACC, projects will become riskier over time.
b. If evaluated using the correct post-merger WACC, Project X would have a negative NPV.
c. After the merger, SafeCo/Risco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept 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 the firm evaluates these projects and all other projects at the new overall company WACC, projects will become riskier over time.
Question: Which of the following statements is CORRECT?
Answer Choices:
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: Which of the following statements is CORRECT?
Answer Choices:
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: Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets. They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.
a. True
b. False
Answer Choices:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT?
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 Choices:
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. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.
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?
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 Choices:
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. A Division A project with an 11% return.
Question: The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm’s common stock.
a. True
b. False
Answer Choices:
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?
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 Choices:
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 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.
a. True
b. False
Answer Choices:
a. True
b. False
Answer: a. True
Question: If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the DCF model, and we don’t know what the risk premium for use in the bond-yield-plus-risk-premium method. All this makes it especially difficult to estimate the cost of equity for a private company.
a. True
b. False
Answer Choices:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT?
Answer Choices:
a. Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.
b. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes.
c. If a company assigns the same cost of capital to all of its projects regardless of each project’s risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.
d. Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt.
e. Higher flotation costs tend to reduce the cost of equity capital.
Answer: c. If a company assigns the same cost of capital to all of its projects regardless of each project’s risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.
Question: Which of the following statements is CORRECT?
Answer Choices:
Answer: a. Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a widely accepted method and is therefore the best method to use.
Correct Answer:
Question: Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?
a. Long-term debt.
b. Accounts payable.
c. Retained earnings.
d. Common stock.
e. Preferred stock.
Answer Choices:
a. Long-term debt.
b. Accounts payable.
c. Retained earnings.
d. Common stock.
e. Preferred stock.
Answer: b. Accounts payable.
Question: Which of the following statements is CORRECT?
Answer Choices:
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. 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.