FINC 318 Ch. 12

Kurt, who is a divisional manager, continually brags that his division's required return for its projects is 1 percent lower than the return required for any other division of the firm. Which one of the following most likely contributes the most to the lower rate requirement for Kurt's division?

Kurt's division is less risky than other divisions

Derek's is a brick-and-mortar toy store. The firm is considering expanding its operations to include Internet sales. Which one of the following would be the best firm to use in a pure play approach to analyzing this proposed expansion?

a toy store that sells online only

A firm has multiple divisions of similar nature, yet varying degrees of risk. Which one of the following would be the most appropriate, yet relatively easy, means of assigning discount rates to each of its proposed investments?

assign every project a rate equal to the firm's WACC plus or minus a subjective adjustment

Old Town Industries has three divisions. Division X has been in existence the longest and has the most stable sales. Division Y has been in existence for five years and is slightly less risky than the overall firm. Division Z is the research and development side of the business. When allocating funds, the firm should probably:

assign the highest cost of capital to Division Z because it is most likely the riskiest of the three divisions

Farmer's Supply, Inc. is considering opening a clothing store, which would be a new line of business for the firm. Management has decided to use the cost of capital of a similar clothing store as the discount rate that should be used to evaluate this proposed expansion. Which one of the following terms is used to describe the approach Farmer's Supply is taking to establish an appropriate discount rate for the project?

pure play approach

Ted is trying to decide what cost of capital he should assign to a project. Which one of the following should be his primary consideration in this decision?

risk level of the project

Kelly's uses the firm's WACC as the required return for some of its projects. For other projects, the firms uses a rate equal to WACC plus 1 percent, while another set of projects is assigned rates equal to WACC minus some amount. Which one of the following factors should be the key factor the firm uses to determine the amount of the adjustment it will make when assigning the project a discount rate?

risk of level of project

Which one of the following is most apt to cause a wise manager to increase a project's cost of capital? Assume the firm is levered.

she learns the project is riskier than previously believed

Kate is the CFO of a major firm and has the job of assigning discount rates to each project that is under consideration. Kate's method of doing this is to assign an incrementally higher rate as the risk level of the project increases over that of the current firm. Likewise, she assigns lower rates as the risk level declines. Which one of the following approaches is Kate using to assign the discount rates?

subjective approach

The computation of which one of the following requires assigning every proposed investment to a particular risk class?

subjective cost of capital

Which one of the following statements is correct related to the dividend growth model approach to computing the cost of equity?

the annual dividend used in the computation must be for year 1 if you are using today's stock price to compute the return

Which one of the following statements is correct?

the cost of preferred stock is unaffected by the issuer's tax rate

All else constant, the weighted average cost of capital for a risky, levered firm will decrease if

the firm's bonds start selling at a premium rather than at a discount

Black Stone Furnaces wants to build a new facility. The cost of capital for this investment is primarily dependent on which one of the following?

the nature of the investment

Which one of the following statements is correct concerning capital structure weights?

the repurchase of preferred stock will increase the weigh of debt

Which one of the following represents the rate of return a firm must earn on its assets if it is to maintain the current value of its securities?

weighted average cost of capital

Which one of the following is the pretax cost of debt?

weighted average yield to maturity on the firm's outstanding debt

All else constant, an increase in a firm's cost of debt:

will result in an increase in the firm's cost of capital

Which one of the following is the primary determinant of an investment's cost of capital?

level of risk

Marine Expeditors has three divisions. Division A is the core of the business and represents 80 percent of the firm's operations. Division B is involved only with contractual short-term projects and therefore has about 8 percent less risk than Division A. Division C develops and markets new products and is about 12 percent riskier than Division A and about equal in size to Division B. The manager of Division A has suggested that the operations of his division be increased by 10 percent next year. The proposed project should probably be assigned a required return that is equal to _____ percent of the firm's weighted average cost of capital.

100

Boone Brothers remodels homes and replaces windows. Ace Builders constructs new homes. If Boone Brothers considers expanding into new home construction, it should evaluate the expansion project using which one of the following as the required return for the project?

Ace Builders' cost of capital

Which of the following features are advantages of the dividend growth model? I. Easy to understand II. Model simplicity III. Constant dividend growth rate IV. Model's applicability to all common stocks

I and II only

All else constant, which of the following will increase the aftertax cost of debt for a firm? I. Increase in the yield to maturity of the firm's outstanding debt II. Decrease in the yield to maturity of the firm's outstanding debt III. Increase in the firm's tax rate IV. Decrease in the firm's tax rate

I and IV only

The aftertax cost of which of the following is affected by a change in a firm's tax rate? I. Preferred stock II. Debt III. Equity IV. Capital

II and IV only

Which of the following are weaknesses of the dividend growth model? I. Market risk premium fluctuations II. Lack of dividends for some firms III. Reliance on historical beta IV. Sensitivity of model to dividend growth rate

II and IV only

Which of the following will increase the cost of equity for a firm with a beta of 1.1? I. Decrease in the security's beta II. Decrease in the market risk premium III. Decrease in the risk-free rate IV. Increase in the risk-free rate

III only

A firm has a return on equity of 12.4 percent according to the dividend growth model and a return of 18.7 percent according to the capital asset pricing model. The market rate of return is 13.5 percent. What rate should the firm use as the cost of equity when computing the firm's weighted average cost of capital (WACC)?

The arithmetic average of 12.4 percent and 18.7 percent

Which one of the following statements is correct, all else held constant?

a decrease in a firm's WACC will decrease the attractiveness of the firm's investment options

Which one of the following statements is correct? Assume the pretax cost of debt is less than the cost of equity.

a firm may change its capital structure if the government changes its tax policies

Which one of the following statements is accurate for a levered firm?

a reduction in the risk level of a firm will tend to decrease the firm's WACC

A firm uses its weighted average cost of capital to evaluate the proposed projects for all of its varying divisions. By doing so, the firm:

automatically gives preferential treatment in the allocation of funds to its riskiest division

When using the pure play approach for a proposed investment, a firm is primarily seeking a rate of return that:

best matches the risk level of the proposed investment

Lester lent money to The Corner Store by purchasing bonds issued by the store. The rate of return that he and the other lenders require is referred to as the:

cost of debt

Katie owns 100 shares of ABC stock. Which one of the following terms is used to refer to the return that Katie and the other shareholders require on their investment in ABC?

cost of equity

The weighted average cost of capital is defined as the weighted average of a firm's:

cost of equity and its aftertax cost of debt

You need to use the pure play approach to assign a cost of capital to a proposed investment. Which one of the following characteristics should you most concentrate on as you search for an appropriate pure play firm?

firm operations

The cost of capital for a project depends primarily on which one of the following?

how the project uses its funds

In an efficient market, the cost of equity for a risky firm does which one of the following according to the security market line?

increase in direct relation to the stock's systematic risk

Which one of the following will decrease the aftertax cost of debt for a firm?

increase in tax rate

Which one of the following will increase the cost of equity, all else held constant?

increase in the dividend growth rate

Which one of the following will affect the capital structure weights used to compute a firm's weighted average cost of capital?

increase in the market value of the firm's common stock

A firm that uses its weighted average cost of capital as the required return for all of its investments will:

increase the risk level of the firm over time

A firm has a cost of equity of 13 percent, a cost of preferred of 11 percent, and an aftertax cost of debt of 6 percent. Given this, which one of the following will increase the firm's weighted average cost of capital?

increasing the firm's beta

The cost of preferred stock:

is equal to the stock's dividend yield