CHAPTER 9—THE COST OF CAPITAL
TRUE/FALSE
1. “Capital” is sometimes defined as funds supplied to a firm by investors.
2. The cost of capital used in capital budgeting should reflect the average cost of the various sources of
long-term funds a firm uses to acquire assets.
3. The component costs of capital are market-determined variables in the sense that they are based on
investors’ required returns.
4. Suppose you are the president of a small, publicly-traded corporation. Since you believe that your
firm’s stock price is temporarily depressed, all additional capital funds required during the current year
will be raised using debt. In this case, the appropriate marginal cost of capital for use in capital
budgeting during the current year is the after-tax cost of debt.
5. The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of
debt for purposes of developing the firm’s WACC.
6. The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on
all outstanding debt.
7. The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.
8. The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends
received by a corporation may be excluded from the receiving corporation’s taxable income.
9. The cost of perpetual preferred stock is found as the preferred’s annual dividend divided by the market
price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike
interest on debt, is not deductible by the issuing firm.
10. The cost of common equity obtained by retaining earnings is the rate of return the marginal
stockholder requires on the firm’s common stock.
11. For capital budgeting and cost of capital purposes, the firm should always consider reinvested earnings
as the first source of capital⎯i.e., use these funds first⎯because reinvested earnings have no cost to
the firm.
12. Funds acquired by the firm through retaining earnings have no cost because there are no dividend or
interest payments associated with them, and no flotation costs are required to raise them, but capital
raised by selling new stock or bonds does have a cost.
13. The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of
external equity raised by selling new issues of common stock, depending on tax rates, flotation costs,
the attitude of investors, and other factors.
14. The firm’s cost of external equity raised by issuing new stock is the same as the required rate of return
on the firm’s outstanding common stock.
15. The higher the firm’s flotation cost for new common equity, the more likely the firm is to use preferred
stock, which has no flotation cost, and reinvested earnings, whose cost is the average return on the
assets that are acquired.
16. For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is
obtained in accordance with its target capital structure, which for many firms means partly as debt,
partly as preferred stock, and partly common equity.
17. In general, firms should use their weighted average cost of capital (WACC) to evaluate capital
budgeting projects because most projects are funded with general corporate funds, which come from a
variety of sources. However, if the firm plans to use only debt or only equity to fund a particular
project, it should use the after-tax cost of that specific type of capital to evaluate that project.
18. If a firm’s marginal tax rate is increased, this would, other things held constant, lower the cost of debt
used to calculate its WACC.
19. The reason why reinvested 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 distribute those earnings to its
investors. Thus, the cost of reinvested earnings is based on the opportunity cost principle.
20. When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to
use long-term or short-term rates for rRF, (2) whether or not the historical beta is the beta that investors
use when evaluating the stock, and (3) how to measure the market risk premium, RPM. These problems
leave us unsure of the true value of rs.
21. When estimating the cost of equity by use of the DCF method, the single biggest potential problem is
to determine the growth rate that investors use when they estimate a stock’s expected future rate of
return. This problem leaves us unsure of the true value of rs.
22. 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.
23. The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in
words: “The cost of external equity equals 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).”
24. 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.
25. Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is
16%, and the tax rate is 40%. An increase in the debt ratio to 60% would decrease the weighted
average cost of capital (WACC).
26. Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the
capital markets. They then provide funds to their different divisions for investment in capital projects.
The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it
is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting
projects.
27. 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.
28. The cost of debt, rd, is normally less than rs, so rd(1 − T) will normally be much less than rs. Therefore,
as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will
normally be greater than rd(1 − T).
29. The lower the firm’s tax rate, the lower will be its after-tax cost of debt and also its WACC, other
things held constant.
30. The text identifies three methods for estimating the cost of common stock from reinvested earnings
(not newly issued stock): the CAPM method, the DCF method, and the bond-yield-plus-risk-premium
method. However, only the DCF method is widely used in practice.
31. The text identifies three methods for estimating the cost of common stock from reinvested earnings
(not newly issued stock): the CAPM method, the DCF method, and the bond-yield-plus-risk-premium
method. However, only the CAPM method always provides an accurate and reliable estimate.
32. The text identifies three methods for estimating the cost of common stock from reinvested earnings
(not newly issued stock): 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.
33. Since 70% of the preferred dividends received by a corporation are excluded from taxable income, the
component cost of equity for a company that pays half of its earnings out as common dividends and
half as preferred dividends should, theoretically, be
Cost of equity = rs(0.30)(0.50) + rps(1 − T)(0.70)(0.50).
34. 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.
35. If investors’ aversion to risk rose, causing the slope of the SML to increase, 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. Other things held constant, this would lead to an increase in the use of debt and a decrease
in the use of equity. However, other things would not stay constant if firms used a lot more debt, as
that would increase the riskiness of both debt and equity and thus limit the shift toward debt.
MULTIPLE CHOICE
36. Which of the following is NOT a capital component when calculating the weighted average cost of
capital (WACC) for use in capital budgeting?
a.
Accounts payable.
b.
Common stock “raised” by reinvesting earnings.
c.
Common stock raised by new issues.
d.
Preferred stock.
e.
Long-term debt.
37. With its current financial policies, Flagstaff Inc. will have to issue new common stock to fund its
capital budget. Since new stock has a higher cost than reinvested earnings, Flagstaff would like to
avoid issuing new stock. Which of the following actions would REDUCE its need to issue new
common stock?
a.
Increase the percentage of debt in the target capital structure.
b.
Increase the proposed capital budget.
c.
Reduce the amount of short-term bank debt in order to increase the current ratio.
d.
Reduce the percentage of debt in the target capital structure.
e.
Increase the dividend payout ratio for the upcoming year.
38. Burnham Brothers Inc. has no retained earnings since it has always paid out all of its earnings as
dividends. This same situation is expected to persist in the future. The company uses the CAPM to
calculate its cost of equity, and its target capital structure consists of common stock, preferred stock,
and debt. Which of the following events would REDUCE its WACC?
a.
The flotation costs associated with issuing new common stock increase.
b.
The company’s beta increases.
c.
Expected inflation increases.
d.
The flotation costs associated with issuing preferred stock increase.
e.
The market risk premium declines.
39. For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and
assume that the firm operates at its target capital structure.
a.
re > rs > WACC > rd.
b.
WACC > re > rs > rd.
c.
rd > re > rs > WACC.
d.
WACC > rd > rs > re.
e.
rs > re > rd > WACC.
40. When working with the CAPM, which of the following factors can be determined with the most
precision?
a.
The beta coefficient, bi, of a relatively safe stock.
b.
The most appropriate risk-free rate, rRF.
c.
The expected rate of return on the market, rM.
d.
The beta coefficient of “the market,” which is the same as the beta of an average stock.
e.
The market risk premium (RPM).
41. Bloom and Co. has no debt or preferred stock⎯it uses only equity capital, and has two equally-sized
divisions. Division X’s cost of capital is 10.0%, Division Y’s cost is 14.0%, and the corporate
(composite) WACC is 12.0%. All of Division X‘s projects are equally risky, as are all of Division Y’s
projects. However, the projects of Division X are less risky than those of Division Y. Which of the
following projects should the firm accept?
a.
A Division Y project with a 12% return.
b.
A Division X project with an 11% return.
c.
A Division X project with a 9% return.
d.
A Division Y project with an 11% return.
e.
A Division Y project with a 13% return.
42. Taylor 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?
a.
Project C, which is of above-average risk and has a return of 11%.
b.
Project A, which is of average risk and has a return of 9%.
c.
None of the projects should be accepted.
d.
All of the projects should be accepted.
e.
Project B, which is of below-average risk and has a return of 8.5%.
43. Weatherall Enterprises has no debt or preferred stock⎯it is an all-equity firm⎯and 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 an average project, in terms of both its beta risk and its total risk. Which of the following
statements is CORRECT?
a.
The project should definitely be rejected because its expected return (before risk
adjustment) is less than its required return.
b.
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.
c.
The accept/reject decision depends on the firm’s risk-adjustment policy. If Weatherall’s
policy is to increase the required return on a riskier-than-average project to 3% over rS,
then it should reject the project.
d.
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.
e.
The project should definitely be accepted because its expected return (before any risk
adjustments) is greater than its required return.
44. The Anderson Company has equal amounts of low-risk, average-risk, and high-risk projects. The
firm’s overall WACC is 12%. The CFO believes that this is the correct WACC for the company’s
average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for
higher-risk projects. The CEO disagrees, on the grounds that even though projects have different risks,
the WACC used to evaluate each project should be the same because the company obtains capital for
all projects from the same sources. If the CEO’s position is accepted, what is likely to happen over
time?
a.
The company will take on too many low-risk projects and reject too many high-risk
projects.
b.
Things will generally even out over time, and, therefore, the firm’s risk should remain
constant over time.
c.
The company’s overall WACC should decrease over time because its stock price should be
increasing.
d.
The CEO’s recommendation would maximize the firm’s intrinsic value.
e.
The company will take on too many high-risk projects and reject too many low-risk
projects.
45. Suppose Acme Industries 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
a.
become less risky over time, and this will maximize its intrinsic value.
b.
accept too many low-risk projects and too few high-risk projects.
c.
become more risky and also have an increasing WACC. Its intrinsic value will not be
maximized.
d.
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.
e.
become riskier over time, but its intrinsic value will be maximized.
46. Which of the following statements is CORRECT?
a.
All else equal, an increase in a company’s stock price will increase its marginal cost of
reinvested earnings (not newly issued stock), rs.
b.
All else equal, an increase in a company’s stock price will increase its marginal cost of
new common equity, re.
c.
Since the money is readily available, the after-tax cost of reinvested earnings (not newly
issued stock) is usually much lower than the after-tax cost of debt.
d.
If a company’s tax rate increases but the YTM on its noncallable bonds remains the same,
the after-tax cost of its debt will fall.
e.
When calculating the cost of preferred stock, a company needs to adjust for taxes, because
preferred stock dividends are deductible by the paying corporation.
47. Which of the following statements is CORRECT?
a.
When calculating the cost of preferred stock, companies must adjust for taxes, because
dividends paid on preferred stock are deductible by the paying corporation.
b.
Because of tax effects, an increase in the risk-free rate will have a greater effect on the
after-tax cost of debt than on the cost of common stock as measured by the CAPM.
c.
If a company’s beta increases, this will increase the cost of equity used to calculate the
WACC, but only if the company does not have enough reinvested earnings to take care of
its equity financing and hence must issue new stock.
d.
Higher flotation costs reduce investors’ expected returns, and that leads to a reduction in a
company’s WACC.
e.
When calculating the cost of debt, a company needs to adjust for taxes, because interest
payments are deductible by the paying corporation.
48. Which of the following statements is CORRECT?
a.
We should use historical measures of the component costs from prior financings that are
still outstanding when estimating a company’s WACC for capital budgeting purposes.
b.
The cost of new equity (re) could possibly be lower than the cost of reinvested earnings (rs)
if the market risk premium, risk-free rate, and the company’s beta all decline by a
sufficiently large amount.
c.
A firm’s cost of reinvesting earnings is the rate of return stockholders require on a firm’s
common stock.
d.
The component cost of preferred stock is expressed as rp(1 − T), because preferred stock
dividends are treated as fixed charges, similar to the treatment of interest on debt.
e.
In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to
reflect the fact that 70% of the dividends received by corporate investors are excluded
from their taxable income.
49. Which of the following statements is CORRECT?
a.
The percentage flotation cost associated with issuing new common equity is typically
smaller than the flotation cost for new debt.
b.
The WACC as used in capital budgeting is an estimate of the cost of all the capital a
company has raised to acquire its assets.
c.
There is an “opportunity cost” associated with using reinvested earnings, hence they are
not “free.”
d.
The WACC as used in capital budgeting would be simply the after-tax cost of debt if the
firm plans to use only debt to finance its capital budget during the coming year.
e.
The WACC as used in capital budgeting is an estimate of a company’s before-tax cost of
capital.
50. Which of the following statements is CORRECT?
a.
WACC calculations should be based on the before-tax costs of all the individual capital
components.
b.
Flotation costs associated with issuing new common stock normally reduce the WACC.
c.
If a company’s tax rate increases, then, all else equal, its weighted average cost of capital
will decline.
d.
An increase in the risk-free rate will normally lower the marginal costs of both debt and
equity financing.
e.
A change in a company’s target capital structure cannot affect its WACC.
51. Which of the following statements is CORRECT?
a.
The after-tax cost of debt usually exceeds the after-tax cost of equity.
b.
For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost
of non-convertible preferred stock.
c.
Retained earnings that were generated in the past and are reported on the firm’s balance
sheet are available to finance the firm’s capital budget during the coming year.
d.
The WACC that should be used in capital budgeting is the firm’s marginal, after-tax cost
of capital.
e.
The WACC is calculated using before-tax costs for all components.
52. Which of the following statements is CORRECT? Assume a company’s target capital structure is 50%
debt and 50% common equity.
a.
The WACC is calculated on a before-tax basis.
b.
The WACC exceeds the cost of equity.
c.
The cost of equity is always equal to or greater than the cost of debt.
d.
The cost of reinvested earnings typically exceeds the cost of new common stock.
e.
The interest rate used to calculate the WACC is the average after-tax cost of all the
company’s outstanding debt as shown on its balance sheet.
53. Which of the following statements is CORRECT?
a.
The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the
company does in fact pay taxes.
b.
If a company assigns the same cost of capital to all of its projects regardless of each
project’s risk, then the company is likely to reject some safe projects that it actually should
accept and to accept some risky projects that it should reject.
c.
Because no flotation costs are required to obtain capital as reinvested earnings, the cost of
reinvested earnings is generally lower than the after-tax cost of debt.
d.
Higher flotation costs tend to reduce the cost of equity capital.
e.
Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is
riskier than equity, and thus the after-tax cost of debt is always greater than the cost of
equity.
54. The Tierney Group has two divisions of equal size: an office furniture manufacturing division and a
data processing division. Its CFO believes that stand-alone data processor companies typically have a
WACC of 9%, while stand-alone furniture manufacturers typically have a 13% WACC. She also
believes that the data processing and manufacturing divisions have the same risk as their typical peers.
Consequently, she estimates that the composite, or corporate, WACC is 11%. A consultant has
suggested using a 9% hurdle rate for the data processing division and a 13% hurdle rate for the
manufacturing division. However, the CFO disagrees, and she has assigned an 11% WACC to all
projects in both divisions. Which of the following statements is CORRECT?
a.
The decision not to adjust for risk means, in effect, that it is favoring the data processing
division. Therefore, that division is likely to become a larger part of the consolidated
company over time.
b.
The decision not to adjust for risk means that the company will accept too many projects
in the manufacturing division and too few in the data processing division. This will lead to
a reduction in the firm’s intrinsic value over time.
c.
The decision not to risk-adjust means that the company will accept too many projects in
the data processing business and too few projects in the manufacturing business. This will
lead to a reduction in its intrinsic value over time.
d.
The decision not to risk-adjust means that the company will accept too many projects in
the manufacturing business and too few projects in the data processing business. This may
affect the firm’s capital structure but it will not affect its intrinsic value.
e.
While the decision to use just one WACC will result in its accepting more projects in the
manufacturing division and fewer projects in its data processing division than if it
followed the consultant’s recommendation, this should not affect the firm’s intrinsic value.
55. Careco Company and Audaco Inc are identical in size and capital structure. However, the riskiness of
their assets and cash flows are somewhat different, resulting in Careco having a WACC of 10% and
Audaco a WACC of 12%. Careco is considering Project X, which has an IRR of 10.5% and is of the
same risk as a typical Careco project. Audaco is considering Project Y, which has an IRR of 11.5%
and is of the same risk as a typical Audaco project.
Now assume that the two companies merge and form a new company, Careco/Audaco Inc. Moreover,
the new company’s market risk is an average of the pre-merger companies’ market risks, and the
merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following
statements is CORRECT?
a.
If evaluated using the correct post-merger WACC, Project X would have a negative NPV.
b.
After the merger, Careco/Audaco would have a corporate WACC of 11%. Therefore, it
should reject Project X but accept Project Y.
c.
Careco/Audaco’s WACC, as a result of the merger, would be 10%.
d.
After the merger, Careco/Audaco should select Project Y but reject Project X. If the firm
does this, its corporate WACC will fall to 10.5%.
e.
If the firm evaluates these projects and all other projects at the new overall corporate
WACC, it will probably become riskier over time.
56. Which of the following statements is CORRECT?
a.
A cost should be assigned to reinvested earnings due to the opportunity cost principle,
which refers to the fact that the firm’s stockholders would themselves expect to earn a
return on earnings that were distributed rather than retained and reinvested.
b.
No cost should be assigned to reinvested earnings because the firm does not have to pay
anything to raise them. They are generated as cash flows by operating assets that were
raised in the past; hence, they are “free.”
c.
Suppose a firm has been losing money and thus is not paying taxes, and this situation is
expected to persist into the foreseeable future. In this case, the firm’s before-tax and after-
tax costs of debt for purposes of calculating the WACC will both be equal to the interest
rate on the firm’s currently outstanding debt, provided that debt was issued during the past
5 years.
d.
If a firm has enough reinvested earnings to fund its capital budget for the coming year,
then there is no need to estimate either a cost of equity or a WACC.
e.
The component cost of preferred stock is expressed as rp(1 − T). This follows because
preferred stock dividends are treated as fixed charges, and as such they can be deducted by
the issuer for tax purposes.
57. Which of the following statements is CORRECT?
a.
The after-tax cost of debt that should be used as the component cost when calculating the
WACC is the average after-tax cost of all the firm’s outstanding debt.
b.
Suppose some of a publicly-traded firm’s stockholders are not diversified; they hold only
the one firm’s stock. In this case, the CAPM approach will result in an estimated cost of
equity that is too low in the sense that if it is used in capital budgeting, projects will be
accepted that will reduce the firm’s intrinsic value.
c.
The cost of equity is generally harder to measure than the cost of debt because there is no
stated, contractual cost number on which to base the cost of equity.
d.
The bond-yield-plus-risk-premium approach is the most sophisticated and objective
method for estimating a firm’s cost of equity capital.
e.
The cost of capital used to evaluate a project should be the cost of the specific type of
financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used
to finance the project or the cost of equity if the project will be financed with equity.
58. Which of the following statements is CORRECT?
a.
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.
b.
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.
c.
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.
d.
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.
e.
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.
59. Which of the following statements is CORRECT?
a.
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.
b.
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.
c.
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.
d.
The specific risk premium used in the CAPM is the same as the risk premium used in the
bond-yield-plus-risk-premium approach.
e.
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.
60. Which of the following statements is CORRECT?
a.
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.
b.
An increase in the risk-free rate is likely to reduce the marginal costs of both debt and
equity.
c.
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.
d.
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.
e.
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.