Question 1

Which of the following statements is CORRECT?

Accepted Answer

A)   Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs--beta, the risk-free rate, and the market risk premium--can be estimated with little error.
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) A) and B)
F) All of the above

Question 2

"Capital" is sometimes defined as funds supplied to a firm by investors.

Accepted Answer

A) True 
 B)False

Question 3

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.

Accepted Answer

A) True 
 B)False

Question 4

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.

Accepted Answer

A) True 
 B)False

Question 5

The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

Accepted Answer

A) True 
 B)False

Question 6

A. Butcher Timber Company hired your consulting firm to help them estimate the cost of common equity. The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of common can be estimated using a risk premium of 3.85% over a firm's own cost of debt. What is an estimate of the firm's cost of common from retained earnings?

Accepted Answer

A)   12.60%
B)   13.10%
C)   13.63%
D)   14.17%
E)   14.74%F) C) and D)
G) B) and E)

Question 7

Since 70% of the preferred dividends received by a corporation are excluded from taxable income, the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be
Cost of equity = rs(0.30)(0.50) + rps(1 - T)(0.70)(0.50).

Accepted Answer

A) True 
 B)False

Question 8

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC)  for use in capital budgeting?

Accepted Answer

A)   Long-term debt.
B)   Accounts payable.
C)   Retained earnings.
D)   Common stock.
E)   Preferred stock.F) None of the above
G) A) and E)

Question 9

Which of the following statements is CORRECT?

Accepted Answer

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.
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) A) and B)
F) B) and D)

Question 10

Daves Inc. recently hired you as a consultant to estimate the company's WACC. You have obtained the following information. (1)  The firm's noncallable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $1,000, and a market price of $1,050.00. (2)  The company's tax rate is 40%. (3)  The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock's beta is 1.20. (4)  The target capital structure consists of 35% debt and the balance is common equity. The firm uses the CAPM to estimate the cost of common stock, and it does not expect to issue any new shares. What is its WACC?

Accepted Answer

A)   7.16%
B)   7.54%
C)   7.93%
D)   8.35%
E)   8.79%F) A) and E)
G) None of the above

Question 11

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.

Accepted Answer

A) True 
 B)False

Question 12

Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

Accepted Answer

A) True 
 B)False

Question 13

Trahan Lumber Company hired you to help estimate its cost of common equity. You obtained the following data: D1 = $1.25; P0 = $27.50; g = 5.00% (constant) ; and F = 6.00%. What is the cost of equity raised by selling new common stock?

Accepted Answer

A)   9.06%
B)   9.44%
C)   9.84%
D)   10.23%
E)   10.64%F) B) and C)
G) A) and D)

Question 14

Which of the following statements is CORRECT?

Accepted Answer

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)   If the calculated beta underestimates the firm's true investment risk--i.e., if the forward-looking beta that investors think exists exceeds the historical beta--then the CAPM method based on the historical beta will produce an estimate of rs and thus WACC that is too high.
C)   Beta measures market risk, which is, theoretically, the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. This is true even if not all of the firm's stockholders are well diversified.
D)   An advantage shared by both the DCF and CAPM methods when they are used to estimate the cost of equity is that they are both "objective" as opposed to "subjective," hence little or no judgment is required.
E)   The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach.F) B) and C)
G) None of the above

Question 15

Assume that you are on the financial staff of Vanderheiden Inc., and you have collected the following data: The yield on the company's outstanding bonds is 7.75%; its tax rate is 40%; the next expected dividend is $0.65 a share; the dividend is expected to grow at a constant rate of 6.00% a year; the price of the stock is $15.00 per share; the flotation cost for selling new shares is F = 10%; and the target capital structure is 45% debt and 55% common equity. What is the firm's WACC, assuming it must issue new stock to finance its capital budget?

Accepted Answer

A)   6.89%
B)   7.26%
C)   7.64%
D)   8.04%
E)   8.44%F) All of the above
G) A) and B)

Question 16

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?

Accepted Answer

A)   If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably 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%.F) A) and D)
G) A) and C)

Question 17

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.

Accepted Answer

A) True 
 B)False

Question 18

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 rRF,
(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.

Accepted Answer

A) True 
 B)False

Question 19

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.

Accepted Answer

A) True 
 B)False

Question 20

Several years ago the Jakob Company sold a $1,000 par value, noncallable bond that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually. The bond currently sells for $925 and the company's tax rate is 40%. What is the component cost of debt for use in the WACC calculation?

Accepted Answer

A)   4.28%
B)   4.46%
C)   4.65%
D)   4.83%
E)   5.03%F) A) and C)
G) C) and D)

Exam 9: The Cost of Capital

Correct Answer
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Correct Answer
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Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

Correct Answer
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Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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Trahan Lumber Company hired you to help estimate its cost of common equity. You obtained the following data: D1 = $1.25; P0 = $27.50; g = 5.00% (constant) ; and F = 6.00%. What is the cost of equity raised by selling new common stock?

Correct Answer
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Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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Correct Answer
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"Capital" is sometimes defined as funds supplied to a firm by investors.

Correct Answer
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Correct Answer
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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.

Correct Answer
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Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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Correct Answer
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Correct Answer
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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.

Correct Answer
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Correct Answer
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The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

Correct Answer
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Correct Answer
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Exam 9: The Cost of Capital

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Trahan Lumber Company hired you to help estimate its cost of common equity. You obtained the following data: D1 = $1.25; P0 = $27.50; g = 5.00% (constant) ; and F = 6.00%. What is the cost of equity raised by selling new common stock?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

"Capital" is sometimes defined as funds supplied to a firm by investors.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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.

Correct AnswerverifiedShow Answer

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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