Chapter 14 Flashcards
Textile Mills borrows money at a rate of 13.5 percent. This interest rate is referred to as the:
cost of debt
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:
weighted average cost of capital
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.
pure play
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
e) depends upon how the funds raised are going to be spent
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
c) is the return investors require on the total assets of the firm
What is the primary determinant of a firm’s cost of capital?
use of the funds
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
d) by using the capital asset pricing model
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
e) a reduction in the risk-free rate
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
c) highly dependent upon the growth rate and risk level of the firm
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
c) ignores the firm’s risks when that cost is based on the dividend growth model
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
e) II, III, and IV only
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
a) is only reliable as the estimated rate of growth
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
c) The model is dependent upon a reliable estimate of the market risk premium
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
e) II, III, and IV only
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
a) is based on the current yield to maturity of the firm’s outstanding bonds
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
b) II and III only
The cost of preferred stock is computed the same as the:
return on a perpetuity
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
a) is equal to the dividend yield
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
b) are based on the market value of the firm’s debt and equity
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
c) The firm’s cost of equity is unaffected by a change in the firm’s tax rate.
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
e) has a greater effect on a firm’s cost of capital when the debt-equity ratio increases
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
e) I, II, III, and IV
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
b) rate of return a firm must earn on its existing assets to maintain the current value of its stock
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
a) The WACC should decrease as the firm’s debt-equity ratio increases
