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 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: 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: 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: 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 rf, (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.
Answer Options
a. True
b. False
Answer: True
Question: Which of the following statements is CORRECT?
Answer Options
a. 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.
b. 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.
c. The cost of new equity (re) could possibly be lower than the cost of retained earnings (rs) if the market risk premium, risk-free rate, and the company’s beta all decline by a sufficiently large amount.
d. Its cost of retained earnings is the rate of return stockholders require on a firm’s common stock.
e. The component cost of preferred stock is expressed as rp(1 – T), because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt.
Answer: d
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
Question: “Capital” is sometimes defined as funds supplied to a firm by investors.
Answer Options
a. True
b. False
Answer: True
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: a. True
Question: The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation’s taxable income.
Answer Options
a. True
b. False
Answer: False
Question: Which of the following statements is CORRECT?
Answer Options
a. The discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever.
b. The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the DCF model’s logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain.
c. The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm’s own cost of debt and its risk premium, can be found by using standardized and objective procedures.
d. Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker’s confidence in the estimated cost of equity.
e. The DCF model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield.
Answer: d
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 is 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.
Answer Options
a. True
b. False
Answer: True
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.
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: 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.
Answer Options
a. True
b. False
Answer: 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: a. True
Question: For capital budgeting and cost of capital purposes, the firm should always consider retained earnings as the first source of capital (i.e., use these funds first) because retained earnings have no cost to the firm.
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: 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. 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: 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 CAPM method always provides an accurate and reliable estimate.
Answer Options
a. True
b. False
Answer: False
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.
Answer Options
a. True
b. False
Answer: True
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