Chapter 9

Question 1

Represents the firms cost of financing and is the minimum rate of return that a project must earn to increase firm value.

Answer 1

Cost of capital

Question 2

Investments with a rate of return _____ cost of capital will increase the value of the firm. In contrast, projects with a rate of return _____ cost of capital decrease the firm value.

Answer 2

Increase, decrease

Question 3

Acts as a major link between the firms long term investment decisions and the wealth of the firms owners as determined by the market value of their shares.

Answer 3

Cost of capital

Question 4

By weighting the cost of each source of financing by its relative proportion in the firms target capital structure, the firm can obtain a

Answer 4

Weighted average cost of capital.

Question 5

Process of evaluating and selecting long term investments.

Answer 5

Capital budgeting.

Question 6

Four basic sources of long term capital for firms:

Answer 6

Long term debt, preferred stock, common stock and retained earnings.

Question 7

Financing cost associated with new funds raised through long term borrowing.

Answer 7

Cost of long term debt

Question 8

Funds actually received by the firm from the sale of a security.

Answer 8

Net proceeds

Question 9

Total costs of issuing and selling a security.

Answer 9

Flotation costs

Question 10

Flotation costs include two components

Answer 10

Underwriting costs and administrative costs

Question 11

Compensation earned by investment bankers for selling the security

Answer 11

Underwriting costs

Question 12

Issuer expenses such as legal and accounting costs.

Answer 12

Administrative costs

Question 13

Rate of return the firm must pay on new borrowing.

Answer 13

Before tax cost of debt

Question 14

Must account for the tax savings created by debt and solve for cost of long term debt on an after tax basis. Can be found by multiplying the before tax cost by (1-tax rate)

Answer 14

After tax cost of debt

Question 15

When dividends are stated as __________ the stock is often referred to as x dollar preferred stocks.

Answer 15

Preferred stock dividend.

Question 16

Sometimes preferred stock dividends are stated as _____________. This rate represents the percentage of the stocks par, or face value that equals the annual dividend.

Answer 16

Annual percentage rate.

Question 17

Ratio of preferred stock dividend to the firms net proceeds from the sale of preferred stock.

Answer 17

Cost of preferred stock

Question 18

Return required on the stock by investors in the marketplace.

Answer 18

Cost of common stock

Question 19

2 types of common stock financing:

Answer 19

Retained earnings and new issues of common stock.

Question 20

Rate of which investors discount the expected dividends of the firm to determine its share value.

Answer 20

Cost of common stock equity

Question 21

Assumed that the value of a share of stock equals the present value of all future dividends (assumed to grow at a constant growth) that it is expected to provide over an infinite time horizon.

Answer 21

Constant growth valuation (Gordon growth) model

Question 22

Describes the relationship between the required return and the nondiversifiable risk of the firm as measured by the beta coefficient

Answer 22

Capital asset pricing model (CAPM)

Question 23

The CAPM technique differs from the constant growth valuation model in that it directly considers the firms ____ as reflected by beta, in determining the required return or cost of common stock equity.

Answer 23

Risk

Question 24

When the constant growth valuation model is used to find the cost of common stock equity, it can easily be adjusted for _______ to find the cost of new common stock.

Answer 24

Flotation costs.

Question 25

The same as cost of an equivalent fully subscribed issue of additional common stock, which is equal to the cost of common stock equity

Answer 25

Cost of retained earnings

Question 26

Cost of common stock, net underpricing and associated flotation costs.

Answer 26

Cost of a new issue of common stock

Question 27

Stock sold at a price below its current market price

Answer 27

Underpriced

Question 28

The cost of new issues will always be greater than the cost of ____ issues, which is equal to the cost of retained earnings.

Answer 28

Existing

Question 29

The cost of new common stock is normally greater than

Answer 29

Any other long term financing cost

Question 30

Reflects the expected average future cost of capital over the long run; found by weighting the cost of each specific type of capital by its proportion in the firms capital structure.

Answer 30

Weighted average cost of capital (WACC)

Question 31

Weights that use accounting values to measure the proportion of each type of capital in the firms financial structure.

Answer 31

Book value weights

Question 32

Weights that use market values to measure the proportion of each type of capital in the firms financial structure.

Answer 32

Market value weights

Question 33

Either book or market value weights based on actual capital structure proportions.

Answer 33

Historical weights

Question 34

Either book or market value weights based on desired capital structure proportions

Answer 34

Target weights