Question 1

If the expected dividend growth rate is zero,then the cost of external equity capital raised by issuing new common stock (re)is equal to 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).If the expected growth rate is not zero,then the cost of external equity must be found using a different formula.

Accepted Answer

A) True 
 B)False

Question 2

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

Accepted Answer

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.F) B) and E)
G) C) and E)

Question 3

The reason why retained earnings have a cost equal to rs is because investors think they can (i.e. ,expect to)earn rs on investments with the same risk as the firm's common stock,and if the firm does not think that it can earn rs on the earnings that it retains,it should pay those earnings out to its investors.Thus,the cost of retained earnings is based on the opportunity cost principle.

Accepted Answer

A) True 
 B)False

Question 4

If expectations for long-term inflation rose,but the slope of the SML remained constant,this would have a greater impact on the required rate of return on equity,rs,than on the interest rate on long-term debt,rd,for most firms.Therefore,the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt.

Accepted Answer

A) True 
 B)False

Question 5

Weaver Chocolate Co.expects to earn $3.50 per share during the current year,its expected dividend payout ratio is 65%,its expected constant dividend growth rate is 6.0%,and its common stock currently sells for $55.00 per share.New stock can be sold to the public at the current price,but a flotation cost of 5% would be incurred.What would be the cost of equity from new common stock? Do not round your intermediate calculations.

Accepted Answer

A)   10.35%
B)   12.42%
C)   11.49%
D)   10.77%
E)   10.66%F) B) and D)
G) A) and D)

Question 6

Keys Printing plans to issue a $1,000 par value,20-year noncallable bond with a 7.00% annual coupon,paid semiannually.The company's marginal tax rate is 40.00%,but Congress is considering a change in the corporate tax rate to 25.00%.By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted? Do not round your intermediate calculations.

Accepted Answer

A)   0.92%
B)   1.30%
C)   1.26%
D)   0.93%
E)   1.05%F) B) and C)
G) A) and E)

Question 7

Norris Enterprises,an all-equity firm,has a beta of 2.0.The chief financial officer is evaluating a project with an expected return of 14%,before any risk adjustment.The risk-free rate is 5%,and the market risk premium is 4%.The project being evaluated is riskier than the firm's average project,in terms of both its beta risk and its total risk.Which of the following statements is CORRECT?

Accepted Answer

A)   The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.
B)   The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return.
C)   Riskier-than-average projects should have their expected returns increased to reflect their higher risk.Clearly,this would make the project acceptable regardless of the amount of the adjustment.
D)   The accept/reject decision depends on the firm's risk-adjustment policy.If Norris' policy is to increase the required return on a riskier-than-average project to 3% over rs,then it should reject the project.
E)   Capital budgeting projects should be evaluated solely on the basis of their total risk.Thus,insufficient information has been provided to make the accept/reject decision.F) A) and D)
G) A) and C)

Question 8

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?

Accepted Answer

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.F) A) and E)
G) A) and D)

Question 9

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)   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.F) C) and D)
G) B) and C)

Question 10

Scanlon Inc.'s CFO hired you as a consultant to help her estimate the cost of capital.You have been provided with the following data: rRF = 4.10%;RPM = 5.25%;and b = 1.70.Based on the CAPM approach,what is the cost of equity from retained earnings?

Accepted Answer

A)   15.24%
B)   12.63%
C)   10.03%
D)   13.94%
E)   13.03%F) B) and D)
G) B) and C)

Question 11

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 12

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 50% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

Accepted Answer

A) True 
 B)False

Question 13

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 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.F) A) and B)
G) C) and D)

Question 14

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 15

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.

Accepted Answer

A) True 
 B)False

Question 16

Sapp Trucking's balance sheet shows a total of noncallable $45 million long-term debt with a coupon rate of 7.00% and a yield to maturity of 6.00%.This debt currently has a market value of $50 million.The balance sheet also shows that the company has 10 million shares of common stock,and the book value of the common equity (common stock plus retained earnings) is $65 million.The current stock price is $24.50 per share;stockholders' required return,rs,is 14.00%;and the firm's tax rate is 25%.The CFO thinks the WACC should be based on market value weights,but the president thinks book weights are more appropriate.What is the difference between these two WACCs?

Accepted Answer

A)   2.62%
B)   2.28%
C)   1.87%
D)   2.19%
E)   3.11%F) B) and D)
G) A) and D)

Question 17

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?

Accepted Answer

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.F) All of the above
G) C) and D)

Question 18

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.

Accepted Answer

A) True 
 B)False

Question 19

You were recently hired by Scheuer Media Inc.to estimate its cost of capital.You obtained the following data: D1 = $1.75;P0 = $95.00;g = 7.00% (constant) ;and F = 5.00%.What is the cost of equity raised by selling new common stock?

Accepted Answer

A)   8.22%
B)   7.60%
C)   8.76%
D)   8.94%
E)   10.01%F) B) and E)
G) A) and D)

Question 20

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) C) and D)
G) B) and E)

Exam 11: The Cost of Capital

Correct Answer
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Correct Answer
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Correct Answer
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Scanlon Inc.'s CFO hired you as a consultant to help her estimate the cost of capital.You have been provided with the following data: r_RF = 4.10%;RP_M = 5.25%;and b = 1.70.Based on the CAPM approach,what is the cost of equity from retained earnings?

Correct Answer
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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?

Correct Answer
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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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You were recently hired by Scheuer Media Inc.to estimate its cost of capital.You obtained the following data: D₁ = $1.75;P₀ = $95.00;g = 7.00% (constant) ;and F = 5.00%.What is the cost of equity raised by selling new common stock?

Correct Answer
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Correct Answer
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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.

Correct Answer
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Correct Answer
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The cost of preferred stock to a firm must be adjusted to an after-tax figure because 50% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

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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Which of the following statements is CORRECT?

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 r_s.

Correct Answer
verified

Correct Answer
verified

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

Correct Answer
verified

Exam 11: The Cost of Capital

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Scanlon Inc.'s CFO hired you as a consultant to help her estimate the cost of capital.You have been provided with the following data: rRF = 4.10%;RPM = 5.25%;and b = 1.70.Based on the CAPM approach,what is the cost of equity from retained earnings?

Correct AnswerverifiedShow Answer

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?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

You were recently hired by Scheuer Media Inc.to estimate its cost of capital.You obtained the following data: D1 = $1.75;P0 = $95.00;g = 7.00% (constant) ;and F = 5.00%.What is the cost of equity raised by selling new common stock?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 50% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

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

Correct AnswerverifiedShow Answer

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

Correct AnswerverifiedShow Answer

Correct Answer
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Correct Answer
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Correct Answer
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Scanlon Inc.'s CFO hired you as a consultant to help her estimate the cost of capital.You have been provided with the following data: r_RF = 4.10%;RP_M = 5.25%;and b = 1.70.Based on the CAPM approach,what is the cost of equity from retained earnings?

Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

You were recently hired by Scheuer Media Inc.to estimate its cost of capital.You obtained the following data: D₁ = $1.75;P₀ = $95.00;g = 7.00% (constant) ;and F = 5.00%.What is the cost of equity raised by selling new common stock?

Correct Answer
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Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
verified

Correct Answer
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Correct Answer
verified

Correct Answer
verified

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 r_s.

Correct Answer
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Correct Answer
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Correct Answer
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