45
CHAPTER 7
TYPES AND COSTS OF FINANCIAL CAPITAL
True-False Questions
F. 1. The accounting emphasis on accrued revenue and expenses and
depreciation is the same emphasis as that of finance managers.
the required capital gains to complement dividends. However, evaluation
methods exist to determine this value by financial managers.
(interest and principal) and dividend capital costs.
F. 4. Public financial markets are markets for the creation, sale and trade of
illiquid securities having less standardized negotiated features.
very high during the maturity stage of its life cycle.
high to moderate during the rapid-growth stage of its life cycle.
T. 7. First-round financing during a venture’s survival stage comes primarily
from venture capitalists and investment banks.
investment bankers.
rapid-growth stage of their life cycles.
T. 10. A venture’s “riskiness” in terms of the likelihood of poor performance or
failure decreases as it moves from its development stage through to its rapid–
growth stage.
of inflation, risk, illiquidity, and any other factors determining the appropriate
interest rate.
Chapter 7: Types and Costs of Financial Capital
46
inflation risk.
goods being purchased.
T. 15. “Default–risk” is the risk that a borrower will not pay the interest and/or
the principal on a loan.
default risk business customers.
F. 17. Bond ratings reflect the inflation risk of a firm’s bonds.
default risk is constant is called the term structure of interest rates.
to time to maturity is called the yield curve.
liquid assets.
F. 21. Subordinated debt is secured by a venture’s assets, while senior debt has
an inferior claim to a venture’s assets.
more mature ventures.
venture investment, and can be assumed by debt, equity, and founding
investors.
F. 24. A venture with a higher expected return relative to other ventures will
necessarily have a higher standard deviation or returns.
than small-company stocks.
return relative to its expected return.
the-counter.
Chapter 7: Types and Costs of Financial Capital
47
T. 28. Typically, the stocks of closely held corporations aren’t publicly traded.
while the over–the-counter market is comprised of a network of brokers and
dealers that interact electronically.
the number of shares outstanding.
stock is called the market risk premium.
T. 32. The weighted average cost of capital is simply the blended, or weighted
cost of raising equity and debt capital.
have been higher for government bonds than for corporate common stocks.
T. 34. Over the past 90 or so years in the U.S., average annual rates of return
have been higher for small–company stocks relative to large-company stocks.
year periods ending in 2014 were about the same as the returns on the S&P 500
stocks.
ending in 2014 were more than three times the returns on the S&P 500 stocks.
Multiple-Choice Questions
standardized contract features such as stocks and bonds?
a. private financial market
b. derivatives market
c. commodities market
d. real estate market
e. public financial market
illiquid, non-standardized contracts such as bank loans and direct placement of
debt?
a. primary market
b. secondary market
c. options market
Chapter 7: Types and Costs of Financial Capital
48
d. private financial market
e. public financial market
a. interest on debt
b. dividends on stock
c. collateral on equity
d. a and b
e. a, b, and c
a. real rate
b. nominal rate
c. risk-free rate
d. prime rate
e. inflation rate
rate expected on a risk-free loan?
a. real rate
b. nominal rate
c. risk-free rate
d. prime rate
e. inflation rate
free of default risk?
a. real rate
b. nominal rate
c. risk-free rate
d. prime rate
e. inflation rate
highest quality customers?
a. real rate
b. nominal rate
c. risk-free rate
d. prime rate
e. inflation rate
a. inflation premium
b. default risk premium
c. liquidity premium
Chapter 7: Types and Costs of Financial Capital
49
d. maturity premium
e. interest rate premium
the probability that a borrower will not be able to repay interest and principal
on a loan is known as?
a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity premium
e. investment risk premium
compensate them for a debt instrument which cannot be converted to cash
quickly at its existing value is called?
a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity premium
e. investment risk premium
term debt is called?
a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity premium
e. investment risk premium
2%, inflation premium is 6%, the default risk on similar debt is 3%, and the
liquidity premium is 2%. What is the nominal interest rate on this venture’s
debt capital?
a. 13%
b. 14%
c. 15%
d. 16%
e. 17%
firm. Its cost of borrowing is 6%, its tax rate is 40%, and its cost of equity
capital is 8%. What is the venture’s weighted average cost of capital?
a. 8.0%
b. 7.2%
c. 7.0%
Chapter 7: Types and Costs of Financial Capital
50
d. 6.2%
e. 6.0%
profit of $1,200, total financial capital including both debt and equity of
$9,000, a tax rate of 40%, and a WACC of 10%. What is your venture’s EVA?
a. $400,000
b. $200,000
c. $ 0
d. ($180,000)
e. ($300,000)
a. a real rate of interest and an inflation premium
b. a real rate of interest and a default risk premium
c. an inflation premium and a default risk premium
d. a default risk premium and a liquidity premium
e. a liquidity premium and a maturity premium
discount the projected cash flows of ventures in the “startup” stage of their life
cycles: a. 20%
b. 25%
c. 40%
d. 50%
cost of risky debt capital?
a. real interest rate
b. inflation premium
c. default risk premium
d. market risk premium
e. liquidity premium
short-term U.S. treasuries?
a. liquidity premium
b. default risk premium
c. market risk premium
d. b and c
e. a, b, and c
means:
Chapter 7: Types and Costs of Financial Capital
51
a. don’t care
b. take a chance
c. to dare
d. to gamble
returns on long–term government bonds is called a:
a. default risk premium
b. maturity premium
c. risk-free premium
d. liquidity premium
e. market risk premium
traded small company stocks since the mid-1920s?
a. 10%
b. 16%
c. 25%
d. 30%
e. 40%
discount the projected cash flows of ventures in the “development” stage of
their life cycles:
a. 15%
b. 20%
c. 25%
d. 40%
e. 50%
“premiums.”
a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity premium
e. all of the above
f. none of the above
financing rather than venture financing?
a. Development stage
b. Startup stage
c. Survival stage
d. Rapid-growth stage
Chapter 7: Types and Costs of Financial Capital
52
e. Maturity stage
would be considered to be “very high” in which of the following life cycle
stages:
a. Startup stage
b. Survival stage
c. Rapid-growth stage
d. Maturity stage
highest target compound rate of return?
a. public and seasoned financing
b. second-round and mezzanine financing
c. first-round financing
d. startup financing
e. seed financing
inflation premium is 3%, and the market risk premium is 2%, what is the
investment risk premium for the firm?
a. 10%
b. 12%
c. 13%
d. 15%
following information: the firm’s beta is 1.5; the risk free rate is 5%; the
market risk premium is 2%.
a. 4.5%
b. 8.0%
c. 9.5%
d. 10.5%
following information: the capital structure weights are 50% debt and 50%
equity; the interest rate on debt is 10%; the required return to equity holders is
20%; and the tax rate is 30%.
a. 7%
b. 10%
c. 13.5%
d. 17.5%
e. 20%
Chapter 7: Types and Costs of Financial Capital
53
following information: the equity multiplier is 1.66; the interest rate on debt is
13%; the required return to equity holders is 22%; and the tax rate is 35%.
a. 11.5%
b. 13.9%
c. 15.0%
d. 16.6%
nominal interest rate on debt = 16%; cost of common equity = 30%; equity to
value = 60%; debt to value = 40%; and a tax rate = 25%.
a. 10%
b. 16%
c. 19.8%
d. 22.8%
e. 30%
nominal interest rate on debt = 12%; cost of common equity = 25%; common
equity = $700,000; interest–bearing debt = $300,000; and a tax rate = 25%.
a. 15%
b. 16.4%
c. 20.2%
d. 22.8%
e. 30%
have been highest for which of the following securities?
a. Five-year government bonds
b. Twenty–year corporate bonds
c. Large-company stocks
d. Small–company stocks
annual rates of return in the U.S. have been lowest for which of the following
securities?
a. Five-year government bonds
b. Twenty–year corporate bonds
c. Large-company stocks
d. Small–company stocks
ending in 2014, were approximately:
a. 34%
b. 25%
Chapter 7: Types and Costs of Financial Capital
54
c. 14%
d. 7%
ending in 2014, were approximately:
a. 20%
b. 15%
c. 10%
d. 5%
Supplemental Problems related to Chapter 7 Appendix A (and Chapter 4
Appendix A)
$600,000; Net income = $20,000; and Effective tax rate = 30%.
a. $600,000
b. $420,000
c. $150,000
d. $70,000
e. $40,000
$400,000; amount of financial capital used = $1,600,000; and WACC = 19%.
a. $26,000
b. $36,000
c. $96,000
d. $54,000
e. $64,000
information: EBIT = $200,000; financial capital used = $500,000; WACC =
20%; effective tax rate = 30%.
a. $20,000
b. $25,000
c. $30,000
d. $40,000
e. $50,000