Answer Options:
a. Each stock’s expected return should equal its realized return as seen by the marginal investor.
b. Each stock’s expected return should equal its required return as seen by the marginal investor.
c. All stocks should have the same expected return as seen by the marginal investor.
d. The expected and required returns on stocks and bonds should be equal.
e. All stocks should have the same realized return during the coming year.
Answer: b. Each stock’s expected return should equal its required return as seen by the marginal investor.
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 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: 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: 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 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: 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: “Capital” is sometimes defined as funds supplied to a firm by investors.
Answer Options:
a. True
b. False
Answer: a. 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: In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project.
Answer Options:
a. True
b. False
Answer: False
Question: The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: “The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 – F).”
Answer Options:
a. True
b. False
Answer: False
Question: Which of the following statements is CORRECT?
Answer Options:
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
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 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: LaPango Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?
Answer Options:
a. Project B, which is of below-average risk and has a return of 8.5%.
b. Project C, which is of above-average risk and has a return of 11%.
c. Project A, which is of average risk and has a return of 9%.
d. None of the projects should be accepted.
e. All of the projects should be accepted.
Answer: a
Question: If a stock’s market price exceeds its intrinsic value as seen by the marginal investor, then the investor will sell the stock until its price has fallen down to the level of the investor’s estimate of the intrinsic value.
Answer Options:
a. True
b. False
Answer: a. True
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: For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is CORRECT?
Answer Options:
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
Question: The cost of debt, rd, is normally less than rs, so rd(1 – T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 – T).
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: 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: 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. An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity.
d. The relevant WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm’s target capital structure.
e. Beta measures market risk, which is generally the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. However, this is not true unless all of the firm’s stockholders are well diversified.
Answer: d