Answer Choices:
a. A change in a company’s target capital structure cannot affect its WACC.
b. WACC calculations should be based on the before-tax costs of all the individual capital components.
c. Flotation costs associated with issuing new common stock normally reduce the WACC.
d. If a company’s tax rate increases, then, all else equal, its weighted average cost of capital will decline.
e. An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.
Answer: d. If a company’s tax rate increases, then, all else equal, its weighted average cost of capital will decline.
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.
a. True
b. False
Answer Choices:
a. True
b. False
Answer: b. False
Question: Schalheim Sisters Inc. has always paid out all of its earnings as dividends, hence the firm has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC?
a. The market risk premium declines.
b. The flotation costs associated with issuing new common stock increase.
c. The company’s beta increases.
d. Expected inflation increases.
e. The flotation costs associated with issuing preferred stock increase.
Answer Choices:
a. The market risk premium declines.
b. The flotation costs associated with issuing new common stock increase.
c. The company’s beta increases.
d. Expected inflation increases.
e. The flotation costs associated with issuing preferred stock increase.
Answer: a. The market risk premium declines.
Question: Assuming that their NPVs based on the firm’s cost of capital are equal, the NPV of a project whose cash flows accrue relatively rapidly will be more sensitive to changes in the discount rate than the NPV of a project whose cash flows come in later in its life.
Answer Choices:
a. True
b. False
Answer: b. False
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?
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 Choices:
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: A basic rule in capital budgeting is that if a project’s NPV exceeds its IRR, then the project should be accepted.
Answer Choices:
a. True
b. False
Answer: b. False
Question: Because “present value” refers to the value of cash flows that occur at different points in time, a series of present values of cash flows should not be summed to determine the value of a capital budgeting project.
Answer Choices:
a. True
b. False
Answer: b. False
Question: Which of the following statements is CORRECT?
Answer Choices:
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. There is an “opportunity cost” associated with using retained earnings, hence they are not “free.”
Question: Which of the following statements is CORRECT?
Answer Choices:
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. Its cost of retained earnings is the rate of return stockholders require on a firm’s common stock.
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.
a. True
b. False
Answer Choices:
a. True
b. False
Answer: a. 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.
a. True
b. False
Answer Choices:
a. True
b. False
Answer: b. False