FIN3403 Chapter 14
All else constant, which one of the following will increase a firm's cost of equity if the firm computes that cost using the security market line approach? Assume the firm currently pays an annual dividend of $1 a share and has a beta of 1.2.
A reduction in the risk-free rate
The capital structure weights used in computing a firm's weighted average cost of capital:
Are based on the market values of the firm's debt and equity securities
Preston Industries has two separate divisions. Each division is in a separate line of business. Division A is the largest division and represents 70 percent of the firm's overall sales. Division A is also the riskier of the two divisions. Division B is the smaller and least risky of the two. When management is deciding which of the various divisional projects should be accepted, the managers should:
Assign appropriate, but differing, discount rates to each project and then select the projects with the highest net present value
The subjective approach to project analysis:
Assigns discount rates to projects based on the discretion of the senior managers of a firm
The capital asset pricing model approach to equity valuation:
Assumes the reward-to-risk ratio is constant
Wilderness Adventures specializes in back-country tours and resort management. Travel Excitement specializes in making travel reservations and promoting vacation travel. Wilderness Adventures has an after tax cost of capital of 13 percent and Travel Excitement has an after tax cost of capital of 11 percent. Both firms are considering investing in new web sites that will enhance online reservations. The estimated net present value of such a project is estimated at $87,000 at a discount rate of 11 percent and -$12,500 at a 13 percent discount rate. Which firm or firms, if either, should accept this project?
Both wilderness Adventures and Travel Excitement
High Adventure is considering a new project that is similar in risk to the firm's current operations. The firm maintains a debt-equity ratio of .55 and retains all profits to fund the firm's rapid growth. How should the firm determine its cost of equity?
By using the capital asset pricing model
Textile Mills borrows money at a rate of 13.5 percent. This interest rate is referred to as the:
Cost of Debt
A group of individuals got together and purchased all of the outstanding shares of common stock of DL Smith, Inc. What is the return that these individuals require on this investment called?
Cost of Equity
Which one of these will increase a firm's aftertax cost of debt?
Decrease in the firm's tax rate
A firm's cost of capital:
Depends upon how the funds raised are going to be spent
When computing the adjusted cash flow from assets the tax amount is calculated as:
EBIT x Tc
The dividend growth model cannot be used to compute the cost of equity for a firm that:
Has a retention ratio of 100%
A firm's overall cost of equity is
Highly dependent upon the risk level of the firm.
The cost of equity for a firm with a debt-equity ratio of .35:
Ignores the firm's risks when the cost is based on the dividend growth model
Incorporating flotation costs into the analysis of a project will:
Increase the initial cash outflow of the project
When a firm has flotation costs equal to 6.8 percent of the funding need, project analysts should:
Increase the initial project cost by dividing that cost by (1 - .068)
The pretax cost of debt:
Is based on the current yield to maturity of the firm's outstanding bonds
The cost of preferred stock:
Is equal to the dividend yield
The aftertax cost of debt:
Is highly dependent upon the firm's tax rate
The dividend growth model:
Is only as reliable as the estimated rate of growth
The weighted average cost of capital for a wholesaler:
Is the return investors require on the total assets of the firm
If a firm uses its WACC as the discount rate for all of the projects it undertakes, then the firm will tend to do all of the following except:
Lower the average risk level of the firm over time
Assigning discount rates to individual projects based on the risk level of each project:
May cause the firm's overall weighted average cost of capital to either increase or decrease over time
Jenner's is a multi division firm that uses its overall WACC as the discount rate for all proposed projects. Each division is in a separate line of business and each presents risks unique to those lines. Given this, a division within the firm will tend to:
Prefer higher risk projects over lower risk projects
When a manager develops a cost of capital for a specific project based on the cost of capital for another firm that has a similar line of business as the project, the manager is utilizing the _____ approach.
Pure Play
The weighted average cost of capital for a firm with debt is the:
Rate of return a firm must earn on its existing assets to maintain the current value of its stock
The cost of preferred stock is computed the same as the:
Rate of return on a perpetuity
The discount rate assigned to an individual project should be based on the:
Risks associated with the use of the funds required by the project.
The weighted average cost of capital for a firm can depend on all of the following except the:
Standard deviation of the firm's common stock
Which one of the following statements related to WACC is correct for a firm that uses debt in its capital structure?
The WACC should decrease as the firm's debt-equity ratio increases
Black River Tours has a capital structure of 55 percent common stock, 5 percent preferred stock, and 40percent debt. The firm has a 30 percent dividend payout ratio, a beta of 1.21, and a tax rate of 34 percent. Given this, which one of the following statements is correct?
The firm's cost of equity is unaffected by a change in the firm's tax rate
Which one of the following statements related to the capital asset pricing model approach to equity valuation is correct? Assume the firm uses debt in its capital structure.
The model is dependent upon a reliable estimate of the market risk premium
Why does the tax amount need adjusted when valuing a firm using the cash flow from assets approach?
The tax effect of the interest expense must be removed
The flotation cost for a firm is computed as:
The weighted average of the flotation costs associated with each form of financing
True or False : A project that is unacceptable today might be acceptable tomorrow given a change in the market returns
True
True or False : Overall, a firm makes better decisions when it uses the subjective approach than when it uses its WACC as the discount rate for all projects.
True
Which one of the following is the primary determinant of a firm's cost of capital?
Use of the funds
The average of a firm's cost of equity and after tax cost of debt that is weighted based on the firm's capital structure is called the:
Weighted Average Cost of Capital
Flotation costs for a levered firm should be:
Weighted and included in the initial cash flow
