Chapter 9

Question 1

Component Costs

Answer 1

the required rate of return on each capital component

Question 2

weighted average cost of capital

Answer 2

the cost of capital used to analyze capital budgeting decisions is found as a weighted average of the carious component costs

Question 3

capital is provided by

Answer 3

investors

Question 4

accounts payable and accruals arise from _____, not from ____

Answer 4

operating decisions, not financing decisions

Question 5

who are re and rs most relevant to

Answer 5

rs is more common for well established firms who obtain all new equity as retained earnings. re is rarely relevant except for very young, rapidly growing firms

Question 6

New or marginal debt

Answer 6

used as rd

Question 7

historical or embedded rate

Answer 7

average rate on previously issued debt

Question 8

what decisions is the embedded cost important for

Answer 8

to determine the rate of return that a public utility should be allowed to earn

Question 9

is rd equal to the company’s cost of debt

Answer 9

no, interest payments are deductible, which means the government in effect pays part of the total cost

Question 10

project financing

Answer 10

a special situation in which a large project, such as an oil refinery, is financed with debt plus other securities that have a specific claim on the project’s cash flows

Question 11

How is project financing different from usual debt offerings

Answer 11

debt does not have a claim on all of the corporation’s cash flows

Question 12

Why is no tax adjustment used when calculating the cost of preferred stock?

Answer 12

preferred dividends are not tax deductible so the company bears their full cost

Question 13

Why do firms usually have every intention of paying preferred dividends even though they aren’t mandatory?

Answer 13

1. they cannot pay dividends on their common stock
2. they will find it difficult to raise additional funds in the capital markets
3. in some cases preferred stockholders can take control of the firm

Question 14

companies can raise common equity in two ways

Answer 14

1. by selling new issued shares to the public 2. by retaining and reinvesting earnings

Question 15

why do few firms with moderate or slow growth issue new shares of common stock through public offerings?

Answer 15

1. flotation costs can be high
2. investors perceive new issuings as a negative signal about the value of the company
   3 . even without the signaling effect, and increase in the supply of stock puts pressure on the stock price, forcing the company to sell the new stock at a lower price than before the new issue

Question 16

what is the signaling effect

Answer 16

investors percieve issuance of common stock as a negative signal about the true value of the company’s stock. they believe that managers have superior knowledge about future prospects and are most likely to issue new stock when they believe the current stock price is greater than intrinsic value

Question 17

opportunity cost

Answer 17

the earnings that could have been paid out as dividends or used to repurchase stock, and in either case stockholders would have received funds that they could reinvest in other securities

Question 18

What is the general rule about reinvesting instead of paying dividends

Answer 18

the firm should earn on its reinvested earnings at least as much as its stockholders themselves could earn on alternative investments of equivalent risk, or rs

Question 19

Steps to using the Capital Asset Pricing Model

Answer 19

1. estimate the risk free rate (rRF) 2. estimate the current market risk premium RPm 3. estimate the stocks beta coefficient, bi, which measures the stock’s relative risk 4. use formula

Question 20

Current market risk preium rpm

Answer 20

required return on the market minus the risk free rate

Question 21

why is it okay to use the rate on 10 year treasury bonds as the risk free rate

Answer 21

1. stock are long term securities so stocks will reflect long term inflation 2. short term treasury bills are more volatile than long term treasury bond rates and are more volatile than rs 3. CAPM is supposed to measure the required ror over a particular holding period

Question 22

historical growth rates

Answer 22

if earnings and dividend growth rates have been relatively stable in the past, and if investors expect these trends to continue, then the past realized growth may be used as an estimate of the expected future growth rate

Question 23

Retention growth model

Answer 23

the more firms retain and reinvest, the higher the earned rate of return on those retained earnings, the larger their growth rate

Question 24

payout ratio

Answer 24

percent of net income that the firm pays out in dividends

Question 25

retention ratio

Answer 25

the compliment of the payout ratio

Question 26

Why is the cost of new common equity higher than cost of equity for companies who rely on reinvestin a large portions of earnings than issuing common stock

Answer 26

because of flotation costs involved in issuing new stock

Question 27

Factors that affect WACC that the firm cannot control

Answer 27

1. the state of financial markets, including stock prices and level of interest rates 2. investors aversion to risk and thus the market risk premium 3. tax rates as set by congress

Question 28

stock and bond markets and WACC

Answer 28

if interest rates in the economy rise the costs of debt and equity will increase. firm will have to pay bondholders a higher interest rate. also increases cost of equity

Question 29

Three factors that affect WACC that firms can control

Answer 29

1. its capital structure policy 2. its dividend policy 3. its investment (capital budget) policy

Question 30

stand alone risk

Answer 30

variability of the projects expected returns

Question 31

corporate, or within firm risk

Answer 31

variability the project contributes to the corporations returns, giving consideration to the fact that the project represents only one asset of the firms portfolio of assets so some of its risks will be diversified awa

Question 32

market, or beta risk

Answer 32

the risk of the project as seen by a well diversified stockholder who owns many different stocks

Question 33

4 mistakes to avoid

Answer 33

1. never base the cost of debt on the coupon rate on a firm’s existing debt 2. when estimating the market risk premium for the CAPM method, never use the historical average return on stocks with the current reurn on bonds 3. never use the current book value capial sructure to obtain the weights when estimating the wacc 4. always remember the capital components are funds that come from investors