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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. Weighted-average cost of capital is the expected rate of return on a portfolio of all the
firm's securities, adjusted for tax savings related to interest payments.
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 equity holders will require a higher return to compensate for the increased risk.
10. A firm's 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 calculated at the WACC will provide 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
equityholders.
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 interest tax shield generated by a project's actual equity financing is accounted for by
using the after-tax cost of equity in the WACC.
23. 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 the firm's WACC.
24. For most healthy firms, the YTM on their bonds is the rate of return investors expect from
holding their bonds to maturity.
25. One way to check the accuracy of the expected return on bonds is to compare the
expected return to the YTM 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 appears to be the targeted debt ratio of a firm that issues $15 million in bonds and
$35 million in equity to finance its new capital projects?
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 would be:
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 would be:
34. Why is debt financing said to include a tax shield for the company?
35. What is the pretax cost of debt for a firm in the 35% tax bracket that has a 10% aftertax
cost of debt?
36. How much is added to a firm's weighted-average cost of capital for 45% debt financing
with a required rate of return of 10% and a tax rate of 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 at 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 par. What is the weight of debt for WACC purposes?
39. What is the after-tax cost of preferred stock that sells for $10 per share and offers a
$1.20 dividend when the tax rate is 35%?
40. What is the WACC for a firm using 55% equity with a required return of 15%, 35% debt
with a required return of 8%, 10% preferred stock with a required return of 10%, and a tax rate of
35%?
41. Should a project be accepted if it offers an annual after-tax cash flow of $1,250,000
indefinitely, costs $10 million, is riskier than the firm's average projects, and the firm's WACC is
12.5%?
