Chapter 14

Question 1

Textile Mills borrows money at a rate of 13.5 percent. This interest rate is referred to as the:

Answer 1

cost of debt

Question 2

The average of a firm’s cost of equity and aftertax cost of debt that is weighted based on the firm’s capital structure is called the:

Answer 2

weighted average cost of capital

Question 3

When a manager develops a cost of capital for a specific project based on the cost of capital for another firm which has a similar line of business as the project, the manager is utilizing the __________ approach.

Answer 3

pure play

Question 4

A firm’s cost of capital:

a) will decrease as the risk level of the firm increases
b) for a specific project is primarily dependent upon the source of funds used for the project
c) is independent of the firm’s capital structure
d) should be applied as the discount rate for any project considered by the firm
e) depends upon how the funds raised are going to be spent

Answer 4

e) depends upon how the funds raised are going to be spent

Question 5

The weighted average cost of capital for a wholesaler:

a) is equivalent to the aftertax cost of the firm’s liabilities
b) should be used as the required return when analyzing potential acquisition of a retail outlet
c) is the return investors require on the total assets of the firm
d) remains constant when the debt-equity ratio changes
e) is unaffected by changes in corporate tax rates

Answer 5

c) is the return investors require on the total assets of the firm

Question 6

What is the primary determinant of a firm’s cost of capital?

Answer 6

use of the funds

Question 7

Scholastic Toys is considering developing and distributing a new board game for children. The project is similar in risk to the firm’s current operations. The firm maintains a debt-equity ratio of 0.40 and retains all profits to fund the firm’s rapid growth. How should the firm determine its cost of equity?

a) by adding the market risk premium to the aftertax cost of debt
b) by multiplying the market risk premium by (1 - 0.40)
c) by using the dividend growth model
d) by using the capital asset pricing model
e) by averaging the costs based on the dividend growth model and the capital asset pricing model

Answer 7

d) by using the capital asset pricing model

Question 8

All else constant, which one of the following will increase a firm’s cost of equity if the firm computes that cost using the security market line approach? Assume the firm currently pays an annual dividend of $1 a share and has a beta of 1.2.

a) a reduction in the dividend amount
b) an increase in the dividend amount
c) a reduction in the market rate of return
d) a reduction in the firm’s beta
e) a reduction in the risk-free rate

Answer 8

e) a reduction in the risk-free rate

Question 9

A firm’s overall cost of equity is:

a) is generally less that the firm’s WACC given a leveraged firm
b) unaffected by changes in the market risk premium
c) highly dependent upon the growth rate and risk level of the firm
d) generally less than the firm’s aftertax cost of debt
e) inversely related changes in the firm’s tax rate

Answer 9

c) highly dependent upon the growth rate and risk level of the firm

Question 10

The cost of equity for a firm:

a) tends to remain static for firms with increasing levels of risk
b) increases as the unsystematic risk of the firm increases
c) ignores the firm’s risks when that cost is based on the dividend growth model
d) equals the risk-free rate plus the market-risk premium
e) equals the firm’s pretax weighted average cost of capital

Answer 10

c) ignores the firm’s risks when that cost is based on the dividend growth model

Question 11

The dividend growth model can be used to compute the cost of equity for a firm in which of the following situations?
I. firms that have a 100 percent retention ratio
II. firms that pay a constant dividend
III. firms that pay an increasing dividend
IV. firms that pay a decreasing dividend

a) I and II only
b) I and III only
c) II and III only
d) I, II, and III only
e) II, III, and IV only

Answer 11

e) II, III, and IV only

Question 12

The dividend growth model:

a) is only as reliable as the estimated rate of growth
b) can only be used if the historical dividend information is available
c) considers the risk that future dividends may vary from their estimated values
d) applies only when a firm is currently paying dividends
e) uses a beta to measure the systematic risk of a firm

Answer 12

a) is only reliable as the estimated rate of growth

Question 13

Which of the following statements related to the SML approach to equity valuation is correct? Assume the firm uses debt in its capital structure.

a) The model considers a firm’s rate of growth
b) The model only applies to non-dividend paying firms
c) The model is dependent upon a reliable estimate of the market risk premium
d) The model generally produces the same cost of equity as the dividend growth model
e) This approach generally produces a cost of equity that equals the firm’s overall cost of capital

Answer 13

c) The model is dependent upon a reliable estimate of the market risk premium

Question 14

Which of the following statements are correct?
I. The SML approach is dependent upon a reliable measure of a firm’s unsystematic risk.
II The SML approach can be applied to firms that retain all of their earnings
III. The SML approach assumes a firm’s future risks are similar to its past risks
IV. The SML approach assumes the reward-to-risk ratio is constant.

a) I and III only
b) II and IV only
c) III and IV only
d) I, II, and III only
e) II, III, and IV only

Answer 14

e) II, III, and IV only

Question 15

The pretax cost of debt:

a) is based on the current yield to maturity of the firm’s outstanding bonds
b) is equal to the coupon rate on the latest bonds issued by a firm
c) is equivalent to the average current yield on all of a firm’s outstanding bonds
d) is based on the original yield to maturity on the latest bonds issued by a firm
e) has to be estimated as it cannot be directly observed in the market

Answer 15

a) is based on the current yield to maturity of the firm’s outstanding bonds

Question 16

The aftertax cost of debt generally increases when:
I. a firm’s bond rating increases
II. the market rate of interest increases
III. tax rates decrease
IV. bond prices rise

a) I and III only
b) II and III only
c) I, II, and III only
d) II, III, and IV only
e) I, II, III, and IV

Answer 16

b) II and III only

Question 17

The cost of preferred stock is computed the same as the:

Answer 17

return on a perpetuity

Question 18

The cost of a preferred stock:

a) is equal to the dividend yield
b) is equal to the yield to maturity
c) is highly dependent on the individual growth rate
d) is independent of the stock’s price
e) decreases when tax rates increase

Answer 18

a) is equal to the dividend yield

Question 19

The capital structure weights used in computing the weighted average cost of capital:

a) are based on the book values of total debt and total equity
b) are based on the market value of the firm’s debt and equity securities
c) are computed using the book value of the long-term debt and book value of equity
d) remain constant over time unless the firm issues new securities
e) are restricted to the firm’s debt and common stock

Answer 19

b) are based on the market value of the firm’s debt and equity

Question 20

Morris Industries has a capital structure of 55 percent common stock, 10 percent preferred stock, and 45 percent debt. The firm has a 60 percent dividend payout ratio, a beta of 0.89 and a tax rate of 38 percent. Given this, which of the following statements is correct?

a) The aftertax cost of debt will be greater than the current yield-to-maturity on the firm’s bonds
b) The firm’s cost of preferred is most likely less than the firm’s actual cost of debt
c) The firm’s cost of equity is unaffected by a change in the firm’s tax rate
d) The cost of equity can only be estimated using the SML approach.
e) The firm’s weighted average cost of capital will remain constant as long as the capital structure remains constant

Answer 20

c) The firm’s cost of equity is unaffected by a change in the firm’s tax rate.

Question 21

The aftertax cost of debt:

a) varies inversely to the changes in market interest rates
b) will generally exceed the cost of equity if the relevant tax rate is zero
c) will generally equal the cost of preferred if the tax rate is zero
d) is unaffected by changes in the market rate of interest
e) has a greater effect on a firm’s cost of capital when the debt-equity ratio increases

Answer 21

e) has a greater effect on a firm’s cost of capital when the debt-equity ratio increases

Question 22

The weighted average cost of capital for a firm may be dependent upon the firm's:
I. rate of growth
II. debt-equity ratio
III. preferred dividend payment
IV. retention ratio

a) I and III only
b) II and IV only
c) I, II, and IV only
d) I, III, and IV only
e) I, II, III, and IV

Answer 22

e) I, II, III, and IV

Question 23

The weighted average cost of capital for a firm is the:

a) discount rate at which the firm should apply to all the projects it undertakes
b) rate of return a firm must earn on its existing assets to maintain the current value of its stock
c) coupon rate the firm should expect to pay on its next bond issue
d) minimum discount rate the firm should require on any new project
e) rate of return shareholders should expect to earn on their investment in this firm

Answer 23

b) rate of return a firm must earn on its existing assets to maintain the current value of its stock

Question 24

Which one of the following statements is correct for a firm that uses debt in its capital structure?

a) The WACC should decrease as the firm’s debt-equity ratio increases
b) When computing the WACC, the weight assigned to the preferred stock is based on the coupon rate multiplied by the par value of the preferred
c) The firm’s WACC will decrease as the corporate tax rate decreases
d) The weight of the common stock used in the computation of the WACC is based on the number of shares outstanding multiplied by the book value per share
e) The WACC will remain constant unless a firm retires some of its debt

Answer 24

a) The WACC should decrease as the firm’s debt-equity ratio increases

Question 25

If a firm uses its WACC as the discount rate for all of the projects it undertakes then the firm will tend to:
I. reject some positive net present value projects
II. accept some negative net present value projects
III. favor high risk projects over low risk projects
IV. increases its overall level of risk over time

a) I and III only
b) III and IV only
c) I, II, and III only
d) I, II, and IV only
e) I, II, III, and IV

Answer 25

e) I, II, III, and IV

Question 26

Preston Industries has two separate divisions. Each division is in a separate line of business. Division A is the largest division and represents 70 percent of the firm’s overall sales. Division A is also the riskier of the two divisions. Division B is the smaller and least risky of the two. When management is deciding which of the various projects should be accepted, the managers should:

a) allocate more funds to Division A since it is the largest of the two divisions
b) fund all of Division B’s projects first since they tend to be lest risky and then allocate the remaining funds to the Division A projects that have the highest net present values
c) allocate the company’s funds to the projects with the highest net present values based on the firm’s weighted average cost of capital
d) assign appropriate, but differing, discount rates to each project and then select the projects with the highest net present values
e) fund the highest net present value projects from each division based on the allocation of 70 percent of the funds to Division A and 30 percent of the funds to Division B.

Answer 26

d) assign appropriate, but differing, discount rates to each project and then select the projects with the highest net present values

Question 27

Markley and Stearns is a multi-divisional firm that uses its WACC as the discount rate for all proposed projects. Each division is in a separate line of business and each presents risks unique to those lines. Given this, a division within the firm will tend to:

a) receive less project funding if its line of business is riskier then that of the other divisions
b) avoid risky projects so it can receive more project funding
c) become less risky over time based on the projects that are accepted
d) have equal probability of receiving funding as compared to the other divisions
e) prefer higher risk projects over lower risk projects

Answer 27

e) prefer higher risk projects over lower risk projects

Question 28

The discount rate assigned to an individual project should be based on:

a) the firm’s weighted average cost of capital
b) the actual sources of funding used for the project
c) an average of the firm’s overall cost of capital for the past five years
d) the current risk level of the overall firm
e) the risks associated with the use of the funds required by the project

Answer 28

e) the risks associated with the use of the funds required by the project

Question 29

Assigning discount rates to individual projects based on the risk level of each project:

a) may cause the firm’s overall weighted average cost of capital to either increase or decrease over time
b) will prevent the firm’s overall cost of capital from changing over time
c) will cause the firm’s overall cost of capital to decrease over time
d) decreases the value of the firm over time
e) negates the firm’s goal of creating the most value for the shareholders

Answer 29

a) may cause the firm’s overall weighted average cost of capital to either increase or decrease over time

Question 30

Which one of the following statements is correct?

a) Firms should accept low risk projects prior to funding high risk projects.
b) Making subjective adjustments to a firm’s WACC when determining project discount rates unfairly punishes low-risk divisions within a firm
c) A project that is unacceptable today might be acceptable tomorrow given a change in market returns
d) The pure play method is most frequently used for projects involving the expansion of a firm’s current operations
e) Firms that elect to use the pure play method for determining a discount rate for a project cannot subjectively adjust the pure play rate.

Answer 30

c) A project that is unacceptable today might be acceptable tomorrow given a change in market returns

Question 31

Phil’s is a sit-down restaurant that specializes in home-cooked meals. Theresa’s is a walk in deli that specializes in specialty soups and sandwiches. Both firms are currently considering expanding their operations during the summer months by offering pre-wrapped donuts, sandwiches, and wraps at a local beach. Phil’s currently has a WACC of 14 percent, while Theresa’s WACC is 10 percent. The expansion project has a projected net present value of $12,600 at a 10 percent discount rate and a net present value of -$2,080 at a 14 percent discount rate. Which firm or firms should expand and offer food at the local beach during the summer months?

a) Phil’s only
b) Theresa’s only
c) both Phil’s and Theresa’s
d) neither Phil’s nor Theresa’s
e) cannot be determined from the information provided

Answer 31

c) both Phil’s and Theresa’s

Question 32

Wilderness Adventures specializes in back-country tours and resort management. Travel Excitement specializes in making travel reservations and promoting vacation travel. Wilderness Adventures has an aftertax cost of capital of 13 percent and Travel Excitement has an aftertax cost of capital of 11 percent. Both firms are considering building wilderness campgrounds complete with man-made lakes and hiking trails. The estimated net present value of such a project is estimated at $87,000 at a discount rate of 11 percent and -$12,500 at a 13 percent discount rate. Which firm or firms, if either, should accept this project?

a) Wilderness Adventures only
b) Travel Excitement only
c) both Wilderness Adventures and Travel Excitement
d) neither Wilderness Adventures nor Travel Excitement
e) cannot be determined without further information

Answer 32

d) neither Wilderness Adventures nor Travel Excitement

Question 33

The subjective approach to project analysis:

a) is used only when a firm has an all-equity capital structure
b) uses the WACC of firm X as the basis for the discount rate for a project under consideration by firm Y
c) assigns discount rates to projects based on the discretion of the senior managers of a firm
d) allows managers to randomly adjust the discount rate assigned to a project once the project’s beta has been determined
e) applies a lower discount rate to projects that are financed totally with equity as compared to those that are partially financed with debt

Answer 33

c) assigns discount rates to projects based on the discretion of the senior managers of a firm

Question 34

Which one of the following statements is correct?

a) The subjective approach assesses the risk of each project and assigns an adjustment factor that is unique just for the project
b) Overall, a firm makes better decisions when it uses the subjective approach than when it uses its WACC as the discount rate for all projects
c) Firms will correctly accept or reject every project if they adopt the subjective approach
d) Mandatory projects should only be accepted if they produce a positive NPV when the firm’s WACC is used as the discount rate
e) The pure play approach should only be used with low-risk projects

Answer 34

b) Overall, a firm makes better decisions when it uses the subjective approach than when it uses its WACC as the discount rate for all projects

Question 35

When a firm has flotation costs equal to 7 percent of the funding need, project analysts should:

a) increase the project’s discount rate to offset these expenses by multiplying the firm’s WACC by 1.07
b) increase the project’s discount rate to offset these expenses by dividing the firm’s WACC by (1 - 0.07)
c) add 7 percent to the firm’s WACC to get the discount rate for the project
d) increase the initial project cost by multiplying that cost by 1.07
e) increase the initial project cost by dividing that cost by (1 - 0.07)

Answer 35

e) increase the initial project cost by dividing that cost by (1 - 0.07)

Question 36

The flotation cost for firm is computed as:

Answer 36

the weighted average of the flotation costs associated with each form of financing

Question 37

Incorporating flotation costs into the analysis of a project will:

a) cause the project to be improperly evaluated
b) increase the net present value of the project
c) increase the project’s rate of return
d) increase the initial cash outflow of the project
e) have no effect on the present value of the project

Answer 37

d) increase the initial cash outflow of the project

Question 38

Flotation costs for a levered firm should:

a) be ignored when analyzing a project because they are not an actual project cost
b) be spread over the life of a project thereby reducing the cash outflow for each year of the project
c) only be considered when two projects are mutually exclusive
d) be weighted and included in the initial cash flow
e) be totally ignored when internal equity funding is utilized

Answer 38

d) be weighted and included in the initial cash flow

Question 39

A group on individuals got together and purchased all of the outstanding shares of common stock of DL Smith, Inc. What is the return that these individuals requires on this investment called?

Answer 39

cost of equity