CHAPTER 10: THE COST OF CAPITAL
1.
“Capital” is sometimes defined as funds supplied to a firm by investors.
a.
True
b.
False
2.
The cost of capital used in capital budgeting should reflect the average cost of the various sources of investor-
supplied funds a firm uses to acquire assets.
a.
True
b.
False
3.
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.
a.
True
b.
False
4.
The component costs of capital are market-determined variables in the sense that they are based on investors’
required returns.
a.
True
b.
False
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.
a.
True
b.
False
6.
The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all
outstanding
debt.
a.
True
b.
False
7.
The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.
a.
True
b.
False
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.
a.
True
b.
False
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, are
not
deductible by the issuing firm.
a.
True
b.
False
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.
a.
True
b.
False
11.
For capital budgeting and cost of capital purposes, the firm should always consider retained earnings as the first
source of capital (i.e., use these funds first) because retained earnings have no cost to the firm.
a.
True
b.
False
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.
a.
True
b.
False
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.
a.
True
b.
False
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.
a.
True
b.
False
15.
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.
a.
True
b.
False
16.
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 retained earnings, whose cost is the average return on the assets that are
acquired.
a.
True
b.
False
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.
a.
True
b.
False
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.
a.
True
b.
False
19.
The reason why retained 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 pay those earnings out to its investors. Thus, the cost of retained
earnings is based
on the opportunity cost principle.
a.
True
b.
False
20.
The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM
method, the DCF method, and the bond–yield-plus–risk–premium method. However, only the DCF method is
widely
used in practice.
a.
True
b.
False
21.
The text identifies three methods for estimating the cost of common stock from retained earnings: 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.
a.
True
b.
False
22.
The text identifies three methods for estimating the cost of common stock from retained earnings: 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.
a.
True
b.
False
23.
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.
a.
True
b.
False
24.
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.
a.
True
b.
False
25.
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.
a.
True
b.
False
26.
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.
a.
True
b.
False
27.
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).”
a.
True
b.
False
28.
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.
a.
True
b.
False
29.
Suppose the debt ratio 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 have to decrease the weighted average cost of capital
(WACC).
a.
True
b.
False
30.
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.
a.
True
b.
False
31.
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).
a.
True
b.
False
32.
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.
a.
True
b.
False
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).
a.
True
b.
False
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.
a.
True
b.
False
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.
a.
True
b.
False
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.
Long-term debt.
b.
Accounts payable.
c.
Retained earnings.
d.
Common stock.
e.
Preferred stock.
37.
Bankston Corporation forecasts that if all of its existing financial policies are followed, its proposed capital budget
would be so large that it would have to issue new common stock. Since new stock has a higher cost than
retained
earnings, Bankston would like to avoid issuing new stock. Which of the following actions would
REDUCE its need to
issue new common stock?
a.
Increase the dividend payout ratio for the upcoming year.
b.
Increase the percentage of debt in the target capital structure.
c.
Increase the proposed capital budget.
d.
Reduce the amount of short-term bank debt in order to increase the current ratio.
e.
Reduce the percentage of debt in the target capital structure.
38.
Schalheim Sisters Inc. has always paid out all of its earnings as dividends, hence the firm has no retained
earnings.
This same situation is expected to persist in the future. The company uses the CAPM to calculate its
cost of equity,
its target capital structure consists of common stock, preferred stock, and debt. Which of the
following events would
REDUCE its WACC?
a.
The market risk premium declines.
b.
The flotation costs associated with issuing new common stock increase.
c.
The company’s beta increases.
d.
Expected inflation increases.
e.
The flotation costs associated with issuing preferred stock increase.
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.
rs > re > rd > WACC.
b.
re > rs > WACC > rd.
c.
WACC > re > rs > rd.
d.
rd > re > rs > WACC.
e.
WACC > rd > rs > re.
40.
When working with the CAPM, which of the following factors can be determined with the most precision?
a.
The market risk premium (RPM ).
b.
The beta coefficient, bi, of a relatively safe stock.
c.
The most appropriate risk-free rate, rRF.
d.
The expected rate of return on the market, rM
.
e.
The beta coefficient of “the market,” which is the same as the beta of an average stock.
41.
Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A’s cost of capital is 10.0%,
Division B’s cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A’s projects are
equally
risky, as are all of Division B’s projects. However, the projects of Division A are less risky than those of
Division B.
Which of the following projects should the firm accept?
a.
A Division B project with a 13% return.
b.
A Division B project with a 12% return.
c.
A Division A project with an 11% return.
d.
A Division A project with a 9% return.
e.
A Division B project with an 11% return.
42.
LaPango 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 B, which is of below-average risk and has a return of 8.5%.
b.
Project C, which is of above-average risk and has a return of 11%.
c.
Project A, which is of average risk and has a return of 9%.
d.
None of the projects should be accepted.
e.
All of the projects should be accepted.
43.
Norris Enterprises, an all-equity firm, 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 the firm’s 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 accepted because its expected return (before any risk adjustments) is greater
than its required return.
b.
The project should definitely be rejected because its expected return (before risk adjustment) is less than its
required return.
c.
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.
d.
The accept/reject decision depends on the firm’s risk-adjustment policy. If Norris’ policy is to increase the
required return on a riskier-than-average project to 3% over rS, then it should reject the project.
e.
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.
44.
The MacMillen 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 high-risk projects and reject too many low-risk projects.
b.
The company will take on too many low-risk projects and reject too many high-risk projects.
c.
Things will generally even out over time, and, therefore, the firm’s risk should remain constant over time.
d.
The company’s overall WACC should decrease over time because its stock price should be increasing.
e.
The CEO’s recommendation would maximize the firm’s intrinsic value.
45.
If a typical U.S. company 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 riskier over time, but its intrinsic value will be maximized.
b.
become less risky over time, and this will maximize its intrinsic value.
c.
accept too many low-risk projects and too few high-risk projects.
d.
become more risky and also have an increasing WACC. Its intrinsic value will not be maximized.
e.
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.
46.
Which of the following statements is CORRECT?
a.
When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock
dividends are deductible by the paying corporation.
b.
All else equal, an increase in a company’s stock price will increase its marginal cost of retained earnings, rs.
c.
All else equal, an increase in a company’s stock price will increase its marginal cost of new common equity,
re.
d.
Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the
after-tax cost of debt.
e.
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.
47.
Which of the following statements is CORRECT?
a.
When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are
deductible by the paying corporation.
b.
When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on
preferred stock are deductible by the paying corporation.
c.
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.
d.
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 retained earnings to take care of its equity financing and hence must issue
new stock.
e.
Higher flotation costs reduce investors’ expected returns, and that leads to a reduction in a company’s
WACC.
48.
Which of the following statements is CORRECT?
a.
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.
b.
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.
c.
The cost of new equity (re) could possibly be lower than the cost of retained earnings (rs) if the market risk
premium, risk-free rate, and the company’s beta all decline by a sufficiently large amount.
d.
Its cost of retained earnings is the rate of return stockholders require on a firm’s common stock.
e.
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.
49.
Which of the following statements is CORRECT?
a.
The WACC as used in capital budgeting is an estimate of a company’s before-tax cost of capital.
b.
The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation
cost for new debt.
c.
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.
d.
There is an “opportunity cost” associated with using retained earnings, hence they are not “free.”
e.
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.
50.
Which of the following statements is CORRECT?
a.
A change in a company’s target capital structure cannot affect its WACC.
b.
WACC calculations should be based on the before-tax costs of all the individual capital components.
c.
Flotation costs associated with issuing new common stock normally reduce the WACC.
d.
If a company’s tax rate increases, then, all else equal, its weighted average cost of capital will decline.
e.
An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.
51.
Which of the following statements is CORRECT?
a.
The WACC is calculated using before-tax costs for all components.
b.
The after-tax cost of debt usually exceeds the after-tax cost of equity.
c.
For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible
preferred stock.
d.
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.
e.
The WACC that should be used in capital budgeting is the firm’s marginal, after-tax cost of capital.
52.
For a company whose target capital structure calls for 50% debt and 50% common equity, which of the
following
statements is CORRECT?
a.
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.
b.
The WACC is calculated on a before-tax basis.
c.
The WACC exceeds the cost of equity.
d.
The cost of equity is always equal to or greater than the cost of debt.
e.
The cost of retained earnings typically exceeds the cost of new common stock.
53.
Which of the following statements is CORRECT?
a.
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.
b.
The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in
fact pay taxes.
c.
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.
d.
Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is
generally lower than the after-tax cost of debt.
e.
Higher flotation costs tend to reduce the cost of equity capital.
54.
Which of the following statements is CORRECT?
a.
The “break point” as discussed in the text refers to the point where the firm’s tax rate increases.
b.
The “break point” as discussed in the text refers to the point where the firm has raised so much capital that it
is simply unable to borrow any more money.
c.
The “break point” as discussed in the text refers to the point where the firm is taking on investments that are
so risky the firm is in serious danger of going bankrupt if things do not go exactly as planned.
d.
The “break point” as discussed in the text refers to the point where the firm has raised so much capital that it
has exhausted its supply of additions to retained earnings and thus must raise equity by issuing stock.
e.
The “break point” as discussed in the text refers to the point where the firm has exhausted its supply of
additions to retained earnings and thus must begin to finance with preferred stock.
55.
Cranberry Corp. has two divisions of equal size: a computer manufacturing division and a data processing
division.
Its CFO believes that stand-alone data processor companies typically have a WACC of 8%, while
stand-alone
computer manufacturers typically have a 12% WACC. He also believes that the data processing
and manufacturing
divisions have the same risk as their typical peers. Consequently, he estimates that the
composite, or corporate,
WACC is 10%. A consultant has suggested using an 8% hurdle rate for the data
processing division and a 12%
hurdle rate for the manufacturing division. However, the CFO disagrees, and he
has assigned a 10% WACC to all
projects in both divisions. Which of the following statements is CORRECT?
a.
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.
b.
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.
c.
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.
d.
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.
e.
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.
56.
Safeco Company and Risco Inc are identical in size and capital structure. However, the riskiness of their assets
and
cash flows are somewhat different, resulting in Safeco having a WACC of 10% and Risco a WACC of
12%.
Safeco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Safeco
project.
Risco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Risco
project.
Now assume that the two companies merge and form a new company, Safeco/Risco 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 the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably
become riskier over time.
b.
If evaluated using the correct post-merger WACC, Project X would have a negative NPV.
c.
After the merger, Safeco/Risco would have a corporate WACC of 11%. Therefore, it should reject Project X
but accept Project Y.
d.
Safeco/Risco’s WACC, as a result of the merger, would be 10%.
e.
After the merger, Safeco/Risco should select Project Y but reject Project X. If the firm does this, its
corporate WACC will fall to 10.5%.
57.
Which of the following statements is CORRECT?
a.
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.
b.
A cost should be assigned to retained 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 paid out rather
than retained and reinvested.
c.
No cost should be assigned to retained 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.”
d.
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.
e.
If a firm has enough retained 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.
58.
Which of the following statements is CORRECT?
a.
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.
b.
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.
c.
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.
d.
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.
e.
The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a
firm’s cost of equity capital.
59.
Which of the following statements is CORRECT?
a.
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.
b.
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.
c.
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.
d.
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.
e.
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.
60.
Which of the following statements is CORRECT?
a.
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.
b.
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.
c.
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.
d.
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.
e.
The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-
premium approach.
61.
Which of the following statements is CORRECT?
a.
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 or is available online.
b.
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.
c.
An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity.
d.
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.
e.
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.
62.
Which of the following statements is CORRECT?
a.
Since the costs of internal and external equity are related, an increase in the flotation cost required to sell a
new issue of stock will increase the cost of retained earnings.
b.
Since its stockholders are not directly responsible for paying a corporation’s income taxes, corporations should
focus on before-tax cash flows when calculating the WACC.
c.
An increase in a firm’s tax rate will increase the component cost of debt, provided the YTM on the firm’s
bonds is not affected by the change in the tax rate.
d.
When the WACC is calculated, it should reflect the costs of new common stock, retained earnings, preferred
stock, long-term debt, short-term bank loans if the firm normally finances with bank debt, and accounts
payable if the firm normally has accounts payable on its balance sheet.
e.
If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and
therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the
after-tax cost of debt.
63.
Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is
seeking to maximize shareholder wealth.
a.
If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are
negatively correlated with the returns on most other firms’ assets.
b.
If a firm’s managers want to maximize the value of the stock, they should, in theory, concentrate on project
risk as measured by the standard deviation of the project’s expected future cash flows.
c.
If a firm evaluates all projects using the same cost of capital, and the CAPM is used to help determine that
cost, then its risk as measured by beta will probably decline over time.
d.
Projects with above-average risk typically have higher-than-average expected returns. Therefore, to maximize
a firm’s intrinsic value, its managers should favor high-beta projects over those with lower betas.
e.
Project A has a standard deviation of expected returns of 20%, while Project B’s standard deviation is only
10%. A’s returns are negatively correlated with both the firm’s other assets and the returns on most stocks in
the economy, while B’s returns are positively correlated. Therefore, Project A is less risky to a firm and
should be evaluated with a lower cost of capital.
64.
Firm M’s earnings and stock price tend to move up and down with other firms in the S&P 500, while Firm W’s
earnings and stock price move counter cyclically with M and other S&P companies. Both M and W estimate
their
costs of equity using the CAPM, they have identical market values, their standard deviations of returns are
identical,
and they both finance only with common equity. Which of the following statements is CORRECT?
a.
M should have the lower WACC because it is like most other companies, and investors like that fact.
b.
M and W should have identical WACCs because their risks as measured by the standard deviation of returns
are identical.
c.
If M and W merge, then the merged firm MW should have a WACC that is a simple average of M’s and W’s
WACCs.
d.
Without additional information, it is impossible to predict what the merged firm’s WACC would be if M and W
merged.
e.
Since M and W move counter cyclically to one another, if they merged, the merged firm’s WACC would be
less than the simple average of the two firms’ WACCs.