CH9 TB THE COST OF CAPITAL Flashcards
Holding risk constant, the implementation of projects with a rate of return above the cost of capital will decrease the value of a firm, and vice versa.
T/F
FALSE
The cost of common stock equity refers to the cost of the next dollar of financing necessary to finance a new investment opportunity.
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FALSE
The target capital structure is the desired optimal mix of debt and equity financing that firms attempt to achieve and maintain.
T/F
TRUE
The cost of capital is the rate of return a firm must meet or exceed on investments to increase the firm’s value.
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TRUE
The cost of capital is used to decide whether a proposed corporate investment will increase or decrease firm’s stock price.
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TRUE
The cost of capital reflects the cost of financing and is the minimum rate of return that a project must earn to increase firm value
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TRUE
The cost of capital acts as a major link between a firm’s long-term investment decisions and the wealth of the firm’s owners as determined by the market value of their shares.
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TRUE
The cost of capital of each source of financing is the after-tax cost of obtaining the financing using the historically based cost reflected by the existing financing on the firm’s books.
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FALSE
A firm’s flotation cost can be calculated by weighting the cost of each source of financing by its relative proportion in a firm’s target capital structure.
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FALSE
WACC
The cost of capital is a static concept and it is not affected by economic and firm-specific factors such as business risk and financial risk.
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FALSE
The cost of capital is a dynamic concept and it is affected by economic and firm-specific factors such as business risk and financial risk.
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TRUE
In using the cost of capital, it is important that it reflects the historical cost of raising funds over the long run.
T/F
FALSE
The ________ is the rate of return that a firm must earn on its investments in order to maintain the market value of its stock.
A) yield to maturity
B) cost of capital
C) internal rate of return
D) modified internal rate of return
B
The ________ is the rate of return required by the market suppliers of capital in order to attract their funds to the firm.
A) yield to maturity
B) internal rate of return
C) cost of capital
D) modified internal rate of return
C
Although a firm’s existing mix of financing sources may reflect its target capital structure, it is ultimately ________.
A) the internal rate of return that is relevant for evaluating the firm’s future investment opportunities
B) the marginal cost of capital that is relevant for evaluating the firm’s future investment opportunities
C) the risk-free rate of return that is relevant for evaluating the firm’s future investment opportunities
D) the risk-free rate of return that is relevant for evaluating the firm’s future financing opportunities
B
The ________ is a weighted average of the cost of funds which reflects the interrelationship of financing decisions.
A) internal rate of return
B) sunk cost
C) cost of capital
D) risk-free rate
C
The ________ is the firm’s desired optimal mix of debt and equity financing.
A) book value
B) market value
C) cost of capital
D) target capital structure
D
In order to recognize the interrelationship between financing and investments, a firm should use ________ when evaluating an investment.
A) the least costly source of financing
B) the most costly source of financing
C) the weighted average cost of all financing sources
D) the current opportunity cost
C
The four basic sources of long-term funds for a firm are ________.
A) current liabilities, long-term debt, common stock, and preferred stock
B) current liabilities, long-term debt, common stock, and retained earnings
C) long-term debt, paid-in capital in excess of par, common stock, and retained earnings
D) long-term debt, common stock, preferred stock, and retained earnings
D
Most firms finance their activities with a blend of debt and equity.
T/F
TRUE
If you purchased the same percentage of each type of security that a firm issued, the expected return on that portfolio of securities would equal the firm’s weighted average cost of capital.
T/F
TRUE
Which of the following is true of long-term funds?
A) They provide an easy way to reduce financing costs because they are relatively cheaper than short-term funds.
B) They are a type of investment fund which invests in money market investments of high quality and low risk.
C) They are the sources that supply the financing necessary to support a firm’s capital budgeting activities.
D) They are the funds available to a business on the basis of inventory held and require detailed inventory tracking
C
Which type of long-term funding is used by the fewest number of firms in the United States?
A) long-term debt
B) preferred stock
C) retained earnings
D) common stock
D
A firm finances its activities with both debt (that costs 8%) and equity (that costs 14%). The firm can borrow additional funds at 8% if it so desires. A financial analyst at this firm argues that the firm should undertake any investment that earns a return of at least 8% because such investments will enable the firm to pay debtholders what they desire, and any earnings above 8% will go to stockholders. If a firm decides to make investments based on this logic it will ________.
A) decline to make investments that it should undertake
B) undertake investments that it should decline
C) make only those investment decisions that increase shareholder value
D) have exorbitant interest expenses
B
Which of the following is a source of long-term funds?
A) commercial paper
B) retained earnings
C) factoring
D) money market instruments
B
A firm finances its activities with both debt (that costs 8%) and equity (that costs 14%). The firm can borrow additional funds at 8% if it so desires. A financial analyst at this firm argues that the firm should undertake only those investments that earn a return of at least 14% because only those investments will increase shareholder value If a firm decides to make investments based on this logic it will ________.
A) decline to make investments that it should undertake
B) undertake investments that it should decline
C) make only those investment decisions that increase shareholder value
D) maximize its stock price
A
The marginal cost of capital is a relevant cost of capital for evaluating a firm’s future investment opportunities.
T/F
TRUE
Generally the least expensive source of long-term capital is ________.
A) retained earnings
B) preferred stock
C) long-term debt
D) common stock
C
In general, floatation costs include two components, underwriting costs and administrative costs.
T/F
TRUE
Flotation costs reduce the net proceeds from the sale of a bond whether sold at a premium, at a discount, or at its par value.
T/F
TRUE
The net proceeds used in calculation of the cost of long-term debt are funds actually received from the sale after paying for flotation costs and taxes.
T/F
TRUE
When the net proceeds from sale of a bond equal its par value, the before-tax cost would just equal the coupon interest rate.
T/F
TRUE
From a bond issuer’s perspective, the IRR on a bond’s cash flows is its yield to maturity (YTM); from the investor’s perspective, the IRR on a bond’s cash flows is the cost to maturity
T/F
FALSE
The cost to maturity that a firm pays on its existing bonds equals the rate of return required by the market.
T/F
FALSE
Yield to maturity
The weighted average cost of capital represents the annual before-tax percentage cost of the debt.
T/F
FALSE
A tax adjustment must be made in determining the cost of ________.
A) long-term debt
B) common stock
C) preferred stock
D) retained earnings
A
The ________ from the sale of a security are the funds actually received from the sale after ________.
A) gross proceeds; adding the after-tax costs
B) gross proceeds; reducing the flotation costs
C) net proceeds; reducing the flotation costs
D) net proceeds; adding the after-tax costs
C
The specific cost of each source of long-term financing is based on ________ and ________ costs.
A) before-tax; historical
B) after-tax; historical
C) before-tax; book value
D) after-tax; current
D
When determining the after-tax cost of a bond, the face value of the issue must be adjusted to the net proceeds amounts by considering ________.
A) the risks
B) the flotation costs
C) the approximate returns
D) the taxes
B
Debt is generally the least expensive source of capital. This is primarily due to ________.
A) debt’s fixed interest payments and finite maturity
B) the tax deductibility of dividends paid to shareholders
C) debt being less risky than equity and interest payments being tax deductible
D) the secured nature of a debt obligation
C
Recently the corporate tax law in the U.S. changed so that firms that previously faced a marginal tax rate of close to 40% now pay tax at a flat rate of 21%. Holding everything else constant, this reduction in the tax rate faced by corporations ________.
A) increased the after-tax cost of debt
B) decreased the after-tax cost of debt
C) did not change the after-tax cost of debt
D) increased the value of the deduction for interest expense
A
Since preferred stock is a form of ownership, it has no maturity date.
T/F
TRUE
Preferred stockholders must receive their stated dividends prior to the distribution of any earnings to common stockholders and bondholders.
T/F
FALSE
The amount of preferred stock dividends that must be paid each year may be stated in dollars or as a percentage of the firm’s earnings.
T/F
FALSE
percentage of par
The cost of preferred stock is typically higher than the cost of long-term debt (bonds) because the cost of long-term debt (interest) is tax deductible.
T/F
TRUE
The cost of preferred stock is the ratio of the preferred stock dividend to a firm’s net proceeds from the sale of the preferred stock.
T/F
TRUE
The cost of preferred stock is the ratio of the preferred stock dividend to a firm’s total earnings.
T/F
FALSE
The cost of common stock equity may be measured using either the constant-growth valuation model
or the capital asset pricing model.
T/F
TRUE
The constant-growth model uses the market price as a reflection of the expected risk-return preference
of investors in the marketplace.
T/F
TRUE
The cost of common stock equity capital represents the return required by existing shareholders on
their investment.
T/F
TRUE
The cost of retained earnings is always lower than the cost of a new issue of common stock due to the absence of flotation costs when financing projects with retained earnings.
T/F
TRUE
In computing the cost of retained earnings, the net proceeds represents the amount of money retained net of any underpricing and/or flotation costs.
T/F
FALSE
The cost of retained earnings is generally higher than both the cost of debt and cost of preferred stock.
T/F
TRUE
Cost of retained earnings = cost of common stock
One measure of the cost of common stock equity is the rate at which investors discount the expected common stock dividends of the firm to determine its share value.
T/F
TRUE
The Gordon model is based on the premise that the value of a share of stock is equal to the sum of all future dividends it is expected to provide over an infinite time horizon.
T/F
FALSE
Using the Capital Asset Pricing Model (CAPM), the cost of common stock equity is the return required by investors as compensation for a firm’s nondiversifiable risk
T/F
TRUE
Use of the capital asset pricing model (CAPM) in measuring the cost of common stock equity differs from the constant-growth valuation model in that it directly considers the firm’s risk as reflected by beta
T/F
TRUE
When the constant-growth valuation model is used to find the cost of common stock equity capital, it can easily be adjusted for flotation costs to find the cost of new common stock; the capital asset pricing model (CAPM) does not provide a simple adjustment mechanism.
T/F
TRUE
The cost of new common stock is normally greater than any other long-term financing cost.
T/F
TRUE
The capital asset pricing model describes the relationship between the required return, or the cost of common stock equity capital, and the nonsystematic risk of a firm as measured by the beta coefficient.
T/F
FALSE
Systematic (undiversifiable risk)
The capital asset pricing model is used to calculate the effect of increase in prices of capital assets due to inflation.
T/F
FALSE
The Gordon model assumes that the value of a share of stock equals the future value of the current price of share that it is expected to remain constant over an infinite time horizon.
T/F
FALSE
According to the CAPM, the required return of an asset is the sum of risk-free rate of return and beta times the risk premium.
T/F
TRUE
The cost of equity for Tangshan Mining would be roughly 10 percent if the expected return on U.S. Treasury Bills is 2 percent, the market risk premium is 6 percent, and the firm’s beta is 1.33.
T/F
TRUE
(6%*1.33)+2%
The cost of retained earnings will always equal the cost of preferred stock.
T/F
FALSE
Common stock
The cost of common stock equity is ________.
A) the cost of the guaranteed stated dividend expected by the stockholders
B) the rate at which investors discount the expected dividends of the firm to determine its share value
C) the after-tax cost of the interest obligations
D) the historical cost of floating the stock issue
B
The cost of common stock equity may be estimated by using the ________.
A) yield curve
B) break-even analysis
C) Gordon model
D) DuPont analysis
C
The cost of common stock equity may be estimated by using the ________.
A) yield curve
B) capital asset pricing model
C) break-even analysis
D) DuPont analysis
B
The cost of retained earnings is ________.
A) less than the cost of debt
B) equal to the cost of a new issue of common stock
C) equal to the cost of common stock equity
D) irrelevant to the investment/financing decision
C
A corporation that uses both debt and equity in its capital structure has concluded that the risk premium it must pay on its common stock is too high. To decrease this, the firm can ________.
A) increase the proportion of long-term debt to decrease the cost of capital
B) increase the proportion of short-term debt to decrease the cost of capital
C) decrease the proportion of common stock equity to decrease financial risk
D) increase the proportion of common stock equity to decrease financial risk
D
The constant-growth valuation model is based on the premise that the value of a share of common stock is ________.
A) the sum of the dividends and expected capital appreciation
B) determined based on an industry standard P/E multiple
C) determined by using a measure of relative risk called correlation coefficient
D) equal to the present value of all expected future dividends
D
In calculating the cost of common stock equity, the model which describes the relationship between
the required return and the nondiversifiable risk of the firm is ________.
A) the constant-growth model
B) the NPV model
C) the variable growth model
D) the capital asset pricing model
D
One major expense associated with issuing new shares of common stock is ________.
A) coupon payment
B) sunk cost
C) overvaluation
D) underpricing
D
One of the circumstances in which the Gordon growth valuation model for estimating the value of a share of stock should be used is ________.
A) declining dividends
B) an erratic dividend stream
C) the lack of data on dividend payments
D) a steady growth rate in dividends
D
Using the capital asset pricing model, the cost of common stock equity is the return required by investors as compensation for ________.
A) the specific risk of a firm
B) a firm’s unsystematic risk
C) price volatility of the stock
D) a firm’s nondiversifiable risk
D
In comparing the constant-growth model and the capital asset pricing model (CAPM) to calculate the cost of common stock equity, ________.
A) the CAPM ignores risk, while the constant-growth model directly considers risk as reflected in the beta
B) the CAPM directly considers risk as reflected in the beta, while the constant-growth model uses the market price as a reflection of the expected risk-return preference of investors
C) the CAPM directly considers risk as reflected in the beta, while the constant growth model uses dividend expectations as a reflection of risk
D) the CAPM indirectly considers risk as reflected in the market return, while the constant growth model uses dividend expectations as a reflection of risk
B
The cost of new common stock financing is higher than the cost of retained earnings due to ________.
A) flotation costs and underpricing
B) flotation costs and overpricing
C) flotation costs and commission costs
D) commission costs and overpricing
A
Since retained earnings are viewed as a fully subscribed issue of additional common stock, the cost of retained earnings is ________.
A) less than the cost of new common stock equity
B) equal to the cost of new common stock equity
C) greater than the cost of new common stock equity
D) not related to the cost of new common stock equity
A
The weighted average cost that reflects the interrelationship of financing decisions can be obtained by weighing the cost of each source of financing by the target proportion in a firm’s capital structure.
T/F
TRUE
The weighted average cost of capital (WACC) reflects the expected average cost of the different forms of capital that a firm uses.
T/F
TRUE
Since retained earnings is a more expensive source of financing than debt and preferred stock, the weighted average cost of capital will fall once retained earnings have been exhausted.
T/F
FALSE
In computing the weighted average cost of capital, the weights are either book value or market value weights based on actual capital structure proportions.
T/F
FALSE
actual/target structure proportions
In computing the weighted average cost of capital the preferred weighting scheme is generally based on the market values of each source of capital.
T/F
TRUE
Weights that use accounting values to measure the proportion of each type of capital in a firm’s financial structure are called market value weights.
T/F
FALSE
Book value weights
Weights that use accounting values to measure the proportion of each type of capital in a firm’s financial structure are called book value weights.
T/F
TRUE
A company’s target weights refer to the desired mix of debt and equity, based on market values of each capital source, rather than the current mix of debt and equity.
T/F
TRUE
The weights used in weighted average cost of capital must be ________.
A) greater than 50%
B) nonnegative
C) less than zero
D) zero
B
When the market values of a firm’s securities have been changing dramatically, the firm may want to calculate its WACC based on ________.
A) book value weights
B) nominal weights
C) historic weights
D) target weights
D
When discussing weighing schemes for calculating the weighted average cost of capital, ________.
A) market value weights are preferred over book value weights and target weights are preferred over historical weights
B) book value weights are preferred over market value weights and target weights are preferred over historical weights
C) book value weights are preferred over market value weights and historical weights are preferred over target weights
D) market value weights are preferred over book value weights and historical weights are preferred over target weights
A
A certain firm originally had capital structure weights of 50% debt and 50% common equity. Since establishing those weights, the firm’s stock price has risen dramatically. The firm has done no additional borrowing. Assume that nothing else in the economy has changed (e.g., interest rates, tax rates, and other macroeconomic factors remain constant). Because the firm’s stock price has increased a great deal, ________.
A) the firm’s cost of equity has increased
B) the firm’s cost of debt has increased
C) the firm’s WACC has decreased
D) the firm’s cost of equity has decreased
D
If a firm’s stock price increases and everything else remains constant, the proportion of debt in the firm’s capital structure will fall.
T/F
TRUE
