1) 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.
2) MM’s dividend irrelevance theory says that while dividend policy does not affect a
firm’s value, it can affect the cost of capital.
3) The inventory turnover ratio and days sales outstanding (DSO) are two ratios that are
used to assess how effectively a firm is managing its assets.
4) Significant variations in accounting methods among firms make meaningful ratio
comparisons between firms more difficult than if all firms used similar accounting
methods.
5) Sensitivity analysis measures a project’s stand-alone risk by showing how much the
project’s NPV (or IRR) is affected by a small change in one of the input variables, say
sales. Other things held constant, with the size of the independent variable graphed on
the horizontal axis and the NPV on the vertical axis, the steeper the graph of the
relationship line, the more risky the project, other things held constant.
6) Two firms with identical capital intensity ratios are generating the same amount of
sales. However, Firm A is operating at full capacity, while Firm B is operating below
capacity. If the two firms expect the same growth in sales during the next period, then
Firm A is likely to need more additional funds than Firm B, other things held constant.
7) A decline in a firm’s inventory turnover ratio suggests that it is managing its
inventory more efficiently and also that its liquidity position is improving, i.e., it is
becoming more liquid.
8) Firms pay a low interest rate on spontaneous liabilities so these funds are its cheapest
source of capital. Consequently, the firm should make arrangements with its suppliers
to use as much of this credit as possible.
9) A foreign currency will, on average, depreciate against the U.S. dollar at a percentage
rate approximately equal to the amount by which its inflation rate exceeds that of the
United States.