7) How frequently do most irms update their cost of capital?
A) Rarely, if ever
B) At least once a year
C) Daily
D) Only when there are major changes in the irm’s capital structure
Question Status: Previous edition
Objective: 14.4 Calculate a irm’s weighted average cost of capital.
Keywords: cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeof
8) The highest cost of capital at which a project can reach break-even NPV is the project’s
A) component cost of capital.
B) cost of common equity.
C) project-speciic cost of capital.
D) internal rate of return.
Question Status: New question
Objective: 14.4 Calculate a irm’s weighted average cost of capital.
Keywords: opportunity cost
Principles: Principle 2: There Is a Risk-Return Tradeof
9) The WACC should be computed using
A) balance sheet weights and target yields.
B) weights based on the irm’s ideal capital structure and target yields on debt and equity.
C) market weights and opportunity costs to the irm.
D) market weights and opportunity costs to investors.
Question Status: Previous edition
Objective: 14.4 Calculate a irm’s weighted average cost of capital.
Keywords: Weighted Average Cost of Capital (WACC)
Principles: Principle 2: There Is a Risk-Return Tradeof
10) The opportunity cost of securities issued by a irm is determined by
A) the rate of return investors could earn on riskless securities.
B) the rate of return on the irm’s next best investment opportunity.
C) the rate of return investors could obtain on similar securities.
D) the weighted average rate of return on all securities issued by the irm.
Question Status: Previous edition
Objective: 14.4 Calculate a irm’s weighted average cost of capital.
Keywords: opportunity cost
Principles: Principle 2: There Is a Risk-Return Tradeof
11) Which of the following statements regarding calculating a irm’s cost of capital is
correct?
A) The after-tax cost of debt is generally more expensive than the after-tax cost of
preferred stock.
B) Since retained earnings are readily available, the cost of retained earnings is generally
lower than the cost of debt.
C) If a company’s beta increases, this will increase the cost of capital.
31
D) The level of general economic conditions will determine whether a irm should utilize an
arithmetic average cost of capital or a weighted average cost of capital.
Question Status: Previous edition
Objective: 14.4 Calculate a irm’s weighted average cost of capital.
Keywords: cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeof
12) A company has a capital structure that consists of 50% debt and 50% equity. Which of
the following is generally true?
A) The weighted average cost of capital is less than the cost of equity inancing.
B) The cost of equity inancing is greater than the cost of debt inancing.
C) The weighted average cost of capital is calculated on a before-tax basis.
D) Both A and B.
Question Status: Previous edition
Objective: 14.4 Calculate a irm’s weighted average cost of capital.
Keywords: Weighted Average Cost of Capital (WACC)
Principles: Principle 2: There Is a Risk-Return Tradeof
13) Which of the following circumstances would invalidate the constant cost of capital
assumption?
A) the project will be inanced entirely with debt.
B) The irm know that it’s marginal tax rate will change from 25% to 34% next year.
C) the project will be inanced entirely from retained earnings.
D) the price of the company’s stock is extremely volatile.
Question Status: New question
Objective: 14.4 Calculate a irm’s weighted average cost of capital.
Keywords: Weighted Average Cost of Capital (WACC)
Principles: Principle 2: There Is a Risk-Return Tradeof
32
14) A strong stock market and reasonably good earnings have caused the price of the irm’s
common stock to increase by 25%.
A) This will have no efect on the irm’s cost of capital.
B) All thing’s equal, this will increase the irm’s cost of capital.
C) All thing’s equal, this will lower the irm’s cost of capital.
D) This will only afect the cost of capital if the irm uses CAPM to compute the cost of
equity.
Question Status: New question
Objective: 14.4 Calculate a irm’s weighted average cost of capital.
Keywords: cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeof
15) The weighted cost of capital assumes that the company maintains a constant debt to
equity ratio.
Question Status: Previous edition
Objective: 14.4 Calculate a irm’s weighted average cost of capital.
Keywords: Weighted Average Cost of Capital (WACC)
Principles: Principle 2: There Is a Risk-Return Tradeof
16) In most instances, as the amount of debt rises, the common stockholders will decrease
their required rate of return.
Question Status: Previous edition
Objective: 14.4 Calculate a irm’s weighted average cost of capital.
Keywords: opportunity cost
Principles: Principle 2: There Is a Risk-Return Tradeof
17) All things equal, as the tax rate increases, the incentive to use more debt inancing
increases.
Question Status: Previous edition
Objective: 14.4 Calculate a irm’s weighted average cost of capital.
Keywords: cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeof
18) As long as the irm issues no new debt, changes in interest rates will have no efect on
the cost of capital.
Question Status: New question
Objective: 14.4 Calculate a irm’s weighted average cost of capital.
Keywords: cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeof
19) National Gridlock’s capital structure consisted of $125 million of debt and $250 million
of equity before it issued bonds to borrow an additional $125 million. The new funds will be
used to inance infrastructure improvements and expansion. The company believes that the
project will generate enough cash to retire 1/5 of the bonds each year. How do the
33
borrowing and the repayment plan afect the discount rate(s) that should be used to
evaluate this project?
Question Status: Previous edition
Objective: 14.4 Calculate a irm’s weighted average cost of capital.
Keywords: cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeof
20) Why is it important to use market-based weights rather than balance sheet weights
when estimating a company’s weighted average cost of capital
Question Status: Previous edition
Objective: 14.4 Calculate a irm’s weighted average cost of capital.
Keywords: cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeof
34
14.5 Estimating Project Costs of Capital
1) Pilgrim’s WACC is 12%. It has one opportunity to invest in a high risk project with an
expected rate of return of 25%. It has another opportunity to lease a building to a
government agency. The expected rate of return on the lease is 10%.
A) Pilgrim should deinitely accept the high risk project and reject the leasing arrangement.
B) Ideally, Pilgrim would discount the cash lows from each project at a rate appropriate to
its risk.
C) Pilgrim should deinitely accept both projects.
D) Pilgrim should inance the lease with all debt and the high risk project with all equity.
Question Status: Previous edition
Objective: 14.5 Discuss the pros and cons of using multiple, risk-adjusted discount rates. Describe
the divisional cost of capital as a viable alternative for irms with multiple divisions.
Keywords: project cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeof
2) Plimoth Plantation’s overall WACC is 11%. It has an opportunity to accept a project that
involves nearly riskless cash lows, but will earn only 7%. This project will require a
signiicant portion of the irm’s capital. If Plimoth accepts this project
A) the value of the company will fall because it’s WACC will fall.
B) the value of the company will fall because it’s average rate of return on investments will
fall.
C) the value of the company will rise because its WACC will fall.
D) both it’s average rate of return and its WACC should fall.
Question Status: Previous edition
Objective: 14.5 Discuss the pros and cons of using multiple, risk-adjusted discount rates. Describe
the divisional cost of capital as a viable alternative for irms with multiple divisions.
Keywords: project cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeof
35
3) Alio e Olio has restaurants throughout the United States, Canada, and Western Europe.
It is considering a proposal to open several restaurants in major cities of India and China.
A) Alio e Olio should use the company‘s overall WACC to evaluate all proposals.
B) Alio e Olio should use a lower discount rate for new ventures to be sure it does not miss
out on opportunities.
C) Alio e Olio should evaluate projects in diferent regions at discount rates that relect the
risk inherent in those projects.
D) Alio e Olio should adjust the discount rate for speciic regions to relect the speciic
sources of funding used.
Question Status: Previous edition
Objective: 14.5 Discuss the pros and cons of using multiple, risk-adjusted discount rates. Describe
the divisional cost of capital as a viable alternative for irms with multiple divisions.
Keywords: project cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeof
4) In theory using the same discount rate to evaluate all projects can lead to
A) rejection of low risk projects that should be accepted.
B) acceptance of high risk projects that should be rejected.
C) control of eforts by employees with a vested interested in a project to manipulate the
discount rate.
D) all of the above.
Question Status: Previous edition
Objective: 14.5 Discuss the pros and cons of using multiple, risk-adjusted discount rates. Describe
the divisional cost of capital as a viable alternative for irms with multiple divisions.
Keywords: project cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeof
5) Lott Bros Developers evaluates a great many small to medium size projects each year.
Some are riskier than others. Lott Bros should probably
A) allow individual project managers to estimate their own discount rates.
B) try to identify the speciic funding sources for each project.
C) use the company’s overall WACC for all projects.
D) spend a great deal of time and money to estimate discount rates for each project.
Question Status: Previous edition
Objective: 14.5 Discuss the pros and cons of using multiple, risk-adjusted discount rates. Describe
the divisional cost of capital as a viable alternative for irms with multiple divisions.
Keywords: project cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeof
36
6) Survey literature indicates that separate project costs of capital
A) are used by less than half of major companies.
B) are used by more than 75% of major companies.
C) are used by nearly all major companies.
D) are almost never used by major companies.
Question Status: Previous edition
Objective: 14.5 Discuss the pros and cons of using multiple, risk-adjusted discount rates. Describe
the divisional cost of capital as a viable alternative for irms with multiple divisions.
Keywords: project cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeof
7) Estimating a divisional cost of capital by comparing the division to a similar free-
standing company is known as
A) Divisional Average Cost of Capital approach (DACC).
B) Segmental Capital Structure approach. (SCS).
C) the “pure play” approach.
D) Project Speciic Approach (PSA).
Question Status: Previous edition
Objective: 14.5 Discuss the pros and cons of using multiple, risk-adjusted discount rates. Describe
the divisional cost of capital as a viable alternative for irms with multiple divisions.
Keywords: project cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeof
8) The “pure play” approach to estimating a divisions WACC involves
A) computing the value of the division if it were to be spun of as a separate company.
B) comparisons to free standing irms with businesses similar to the division.
C) “deleveraging” the division so that only the cost of equity is considered.
D) using the company’s WACC to estimate the value added by the division.
Question Status: Previous edition
Objective: 14.5 Discuss the pros and cons of using multiple, risk-adjusted discount rates. Describe
the divisional cost of capital as a viable alternative for irms with multiple divisions.
Keywords: project cost of capital
Principles: Principle 2: There Is a Risk-Return Tradeof
37