Exam 9: The Cost of Capital

A) If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it should accept and to accept some risky projects that it should reject.
B) Because of the risk of bankruptcy, the cost of debt is always higher than the cost of equity capital.
C) Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt.
D) Higher flotation costs tend to reduce the cost of equity capital.

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A

A) 7.51%
B) 7.90%
C) 8.32%
D) 8.76%

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A) w_c = 68.2% w_d = 31.8%
B) w_c = 69.9% w_d = 30.1%
C) w_c = 71.6% w_d = 28.4%
D) w_c = 73.4% w_d = 26.6%

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A

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A) If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms' assets.
B) If a firm's managers want to maximize the value of the stock, they should, in theory, concentrate on project risk as measured by the standard deviation of the project's expected future cash flows.
C) If a firm evaluates all projects using the same cost of capital, and the CAPM is used to help determine that cost, then its risk as measured by beta will probably decline over time.
D) Project A has a standard deviation of expected returns of 20%, while Project B's standard deviation is only 10%. A's returns are negatively correlated with both the firm's other assets and the returns on most stocks in the economy, while B's returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital.

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A) 4.08%
B) 5.58%
C) 6.00%
D) 3.00%

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A) Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, then decision makers can have more confidence in the estimated cost of equity.
B) The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the DCF model's logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain.
C) The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm's own cost of debt and its risk premium, can be found by using standardized and objective procedures.
D) Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs-beta, the risk-free rate, and the market risk premium-can be estimated with little error.

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A) The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.
B) The project should definitely be rejected because its expected return (before risk adjustments) is less than its required return.
C) Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment.
D) The accept/reject decision depends on the firm's risk-adjustment policy. If Nelson's policy is to increase the required return on a riskier-than-average project to 3% over r_S, then it should reject the project.

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D

A) 11.24%
B) 11.83%
C) 12.42%
D) 13.04%

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A) 9.27%
B) 9.65%
C) 10.04%
D) 10.44%

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A) An increase in the flotation cost required to sell a new issue of stock will increase the cost of retained earnings.
B) An increase in a firm's tax rate will increase the component cost of debt, provided the YTM on the firm's bonds is not affected.
C) When the WACC is calculated, it should reflect the cost of new common stock, retained earnings, preferred stock, long-term debt, and short-term bank loans if the firm normally finances with bank debt, and accounts payable if the firm normally has accounts payable on its balance sheet.
D) If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the after-tax cost of debt.

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A) The lower the floatation costs, the lower the required rate of return.
B) The higher the floatation costs, the higher the required rate of return.
C) Floatation costs do not affect the required rate of return on preferred equity.
D) None of the above are correct.

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A) The cost of debt component of the WACC is equal to 1 minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.
B) The cost of debt component of the WACC is equal to 1 minus the marginal tax rate multiplied by the yield-to-maturity on the firm's outstanding debt.
C) The cost of debt component of the WACC is equal to 1 plus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.
D) The cost of debt component of the WACC is equal to 1 minus the marginal tax rate multiplied by the average duration on all outstanding debt.

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A) The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the interest rate on the company's own long-term bonds. The size of the risk premium for bonds with different ratings is published daily in The Wall Street Journal.
B) The WACC is calculated using a before-tax cost for debt equal to the interest rate that must be paid on new debt, along with the after-tax costs for common stock and for preferred stock if it is used.
C) An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity.
D) The WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm's target capital structure.

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A) When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.
B) When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.
C) Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock.
D) If a company's beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence needs to issue new stock.

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A) 7.34%
B) 7.72%
C) 8.13%
D) 8.56%

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A) 8.35%
B) 8.70%
C) 9.06%
D) 9.42%

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A) 8.25%
B) 8.69%
C) 9.14%
D) 9.62%

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