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 values

The capital asset pricing model approach to equity valuation:

Assumes the reward-to-risk ratio is constant

A group of individuals got together and purchased all of the outstanding shares of common stock of DLSmith, Inc. What is the return that these individuals require on this investment called?

Cost of equity

The cost of equity for a firm with a debt-equity ratio of .35:

Ignores the firm's risks when that 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 cost of preferred stock

Is equal to the dividend yield.

The weighted average cost of capital for a wholesaler:

Is the return investors require on the total assets of the firm

Which one of the following statements is correct?

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

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 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 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

The discount rate assigned to an individual project should be based on the:

The risks associated with the use of the funds required by the project

The flotation cost for a firm is computed as:

The weighted average of the flotation costs associated with each form of financing

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