Chapter 13 Test bank – Static Key
1.
Capital structure refers to a firm’s mix of long-term debt and equity financing.
2.
The company cost of capital is the expected rate of return that investors demand from the company’s assets and operations.
3.
The company cost of capital is the minimum acceptable rate of return for any project the firm undertakes.
4.
tax savings on interest payments.
The weighted-average cost of capital is the expected rate of return on a portfolio of all the firm’s securities, adjusted for the
5.
If a project has a zero NPV when the expected cash flows are discounted at the weighted–average cost of capital, then the
project’s cash flows are just sufficient to give debtholders and shareholders the return they require.
6.
A firm’s cost of capital should be computed using the book weights of each financing source.
7.
There are two costs of debt finance. The explicit cost of debt is the rate of interest that bondholders demand. But there is also
an implicit cost, because higher levels of debt increase the required rate of return to equity.
8.
The weighted-average cost of capital is the return the company needs to earn after tax in order to satisfy all its security
holders.
9.
If the firm decreases its debt ratio, both the debt and the equity will become riskier. The debtholders and equityholders will
require a higher return to compensate for the increased risk.
10.
A firm’s weighted-average cost of capital will generally increase if the firm lowers its debt-equity ratio.
11.
Preferred stock should be ignored when computing a firm’s weighted-average cost of capital.
12.
Both the capital asset pricing model and the dividend discount model can be used to determine the cost of equity financing.
13.
The cost of equity will generally increase for risky firms when the risk-free rate of return increases.
14.
Interest tax shields are available to the firm on debt and preferred stock but not on common equity.
15.
New projects should be undertaken by firms only if they have the same risk as existing assets.
16.
Projects that have a zero NPV when the cash flows are discounted at the WACC will provide just sufficient returns to
creditors and shareholders.
17.
As a firm increases its debt ratio, debtholders are likely to demand higher rates of return.
18.
An increase in a firm’s debt ratio will have no effect on the required rate of return for equity holders.
19.
A firm’s cost of capital should be used as the discount rate for every new project the firm considers.
20.
The mix of a company’s short-term financing is referred to as its capital structure.
21.
To a company, the cost of interest payments on its bonds is reduced by the amount of tax savings generated by that interest.
22.
the WACC.
The interest tax shield generated by a project’s actual equity financing is accounted for by using the after-tax cost of equity in
23.
the firm’s WACC.
Assuming a project has the same risk and financing as the firm, it will have a positive NPV if its rate of return is greater than
24.
For healthy firms, the expected return on their bonds is close to their yield to maturity.
25.
One way to estimate the expected return on bonds is to find the yield to maturity on recently-issued bonds with similar
characteristics and risks.
26.
The WACC is the rate of return that the firm must expect to earn on its average-risk investments in order to provide an
acceptable return to its security holders.
27.
When using the WACC as a discount rate, it is often adjusted upward for riskier projects and downward for safer projects.
28.
A change in the company’s capital structure will change the amount of taxes paid but will not change the WACC.
29.
Capital structure decisions refer to the:
30.
What is the debt ratio of a firm that has outstanding $15 million in bonds and equity with a market value of $35 million?
31.
To calculate the present value of a business, the firm’s free cash flows should be discounted at the firm’s:
32.
The weighted-average cost of capital for a firm with a 65/35 debt/equity split, 8% pre-tax cost of debt, 15% cost of equity,
and a 35% tax rate is:
33.
The weighted-average cost of capital for a firm with a 40/60 debt/equity split, 8% cost of debt, 15% cost of equity, and a
34% tax rate is:
34.
Why is debt financing said to include a tax shield for the company?
35.
If the after-tax cost of debt is 10%, what is the pretax cost for a firm in the 35% tax bracket?
36.
What is a firm’s weighted-average cost of capital for a firm that is financed 45% by debt? The debt has a 10% required return
and the equity has a 17% required return. The tax rate is 35%.
37.
What is the WACC for a firm with 50% debt and 50% equity that pays 12% on its debt, 20% on its equity, and has a 40% tax
rate?
38.
Company X has 2 million shares of common stock outstanding with a book value of $2 per share. The stock trades for $3 per
share. It also has $2 million in face value of debt that trades at 90% of face value. What is the debt ratio that should be used
to calculate WACC?
39.
If the tax rate is 35%, what is the cost of preferred stock that sells for $10 per share and pays a $1.20 dividend?
40.
A firm is financed 55% by common stock, 10% by preferred stock and 35% by debt. The required return is 15% on the
common, 10% on the preferred, and 8% on the debt. If the tax rate is 35% what is the WACC?
41.
A project requires an investment of $10 million and offers an annual after-tax cash flow of $1,250,000 indefinitely. If the
firm’s WACC is 12.5% and the project is riskier than the firm’s average projects, should it be accepted%?
42.
How much will a firm need in cash flow before tax and interest to satisfy debtholders and equityholders if the tax rate is
40%, there is $10 million in common stock requiring a 12% return, and $6 million in bonds requiring an 8% return?
43.
How much will a firm need in cash flow before tax and interest to satisfy debtholders and equityholders if the tax rate is
35%, there is $13 million in common stock requiring a 10% return, and $6 million in bonds requiring a 6% return?
44.
Which one of the following statements is incorrect?
45.
What will be the effect of using the book value of debt in WACC decisions if interest rates have decreased substantially
since a firm’s long-term bonds were issued?
46.
A firm has 12,000 shares of common stock outstanding with a book value of $20 per share and a market value of $39. There
are 5,000 shares of preferred stock with a book value of $22 and a market value of $26. There is a $400,000 face value bond
issue outstanding that is selling at 87% of par. What weight should be placed on the preferred stock when computing the
firm’s WACC?
47.
What would you estimate as the cost of equity if a stock sells for $40, pays a $4.25 dividend, and is expected to grow at a
constant rate of 5%?
48.
What is the expected growth rate in dividends for a firm in which shareholders require an 18% rate of return and the dividend
yield is 10%?
49.
What dividend is paid on preferred stock if investors require a 9% rate of return and the stock has a market value of $54 per
share and a book value of $50 per share?
0.09 = dividend / $54; Dividend = $4.86
50.
If a firm earns the WACC on its assets, then:
51.
As debt is added to the capital structure, the:
52.
An implicit cost of increasing the proportion of debt in a firm’s capital structure is that:
53.
A firm is considering a project that will generate perpetual cash flows of $50,000 per year beginning next year. The project
has the same risk as the firm’s overall operations. If the firm‘s WACC is 12%, and its debt–to-equity ratio is 1.33, what is the
most it could pay for the project and still earn its required rate of return?
54.
A firm’s WACC:
55.
Other things equal, which of the following will decrease the WACC of a firm that has both debt and equity in its capital
structure?
56.
Calculate a firm’s WACC given that the total value of the firm is $2 million, $600,000 of which is debt, the pre-tax cost of
debt is 10%, and the cost of equity is 15%. The firm pays no taxes.
57.
A firm has a debt-to-equity ratio of 1/4. The WACC is 18.6%, and the pretax cost of debt is 9.4%. What is the cost of
common equity if the tax rate is 34%?