FIN 306- CH. 12

10. 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 A. II only B. I and III only C. II and IV only D. I and II only E. I, II, and III only

D

14. Which one of the following will increase the cost of equity, all else held constant? A. Increase in the dividend growth rate B. Decrease in beta C. Decrease in future dividends D. Increase in stock price E. Decrease in market risk premium

A

24. Which one of the following statements is correct? Assume the pre-tax cost of debt is less than the cost of equity. A. A firm may change its capital structure if the government changes its tax policies. B. A decrease in the dividend growth rate increases the cost of equity. C. A decrease in the systematic risk of a firm will increase the firm's cost of capital. D. A decrease in a firm's debt-equity ratio will decrease the firm's cost of capital. E. The cost of preferred stock decreases when the tax rate increases.

A

29. All else constant, the weighted average cost of capital for a risky, levered firm will decrease if: A. the firm's bonds start selling at a premium rather than at a discount. B. the market risk premium increases. C. the firm replaces some of its debt with preferred stock. D. corporate taxes are eliminated. E. the dividend yield on the common stock increases.

A

32. 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: A. automatically gives preferential treatment in the allocation of funds to its riskiest division. B. encourages the division managers to only recommend their most conservative projects. C. maintains the current risk level and capital structure of the firm. D. automatically maximizes the total value created for its shareholders. E. allocates capital funds evenly amongst its divisions.

A

13. 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 A. II only B. III only C. I and II only D. II and III only E. I and IV only

B

17. Which one of the following will decrease the aftertax cost of debt for a firm? A. Decrease in the firm's beta B. Increase in tax rates C. Increase in the risk-free rate of return D. Decrease in the market price of the debt E. Decrease in a bond's yield-to-maturity

B

18. All else constant, an increase in a firm's cost of debt: A. could be caused by an increase in the firm's tax rate. B. will result in an increase in the firm's cost of capital. C. will lower the firm's weighted average cost of capital. D. will lower the firm's cost of equity. E. will increase the firm's capital structure weight of debt.

B

2. 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: A. pure play cost. B. cost of debt. C. weighted average cost of capital. D. subjective cost. E. cost of equity.

B

20. Which one of the following statements is correct? A. An increase in the market value of preferred stock will increase a firm's weighted average cost ofcapital. B. The cost of preferred stock is unaffected by the issuer's tax rate. C. Preferred stock is generally the cheapest source of capital for a firm. D. The cost of preferred stock remains constant from year to year. E. Preferred stock is valued using the capital asset pricing model.

B

22. The aftertax cost of which of the following are affected by a change in a firm's tax rate? I. preferred stock II. debt III. equity IV. capital A. I and III only B. II and IV only C. I, II, and IV only D. II, III, and IV only E. I, II, III, and IV

B

27. Which one of the following statements is correct, all else held constant? A. Beta is used to compute the return on equity and the standard deviation is used to compute the return on preferred. B. A decrease in a firm's WACC will increase the attractiveness of the firm's investment options. C. The aftertax cost of debt increases when the market price of a bond increases. DIf you have both the dividend growth and the security market line's costs of equity, you should use the . higher of the two estimates when computing WACC. E. WACC is only applicable to firms that issue both common and preferred stock.

B

3. The weighted average cost of capital is defined as the weighted average of a firm's: A. return on its investments. B. cost of equity and its aftertax cost of debt. C. pretax cost of debt and equity securities. D. bond coupon rates. E. dividend and capital gains yields.

B

30. A firm that uses its weighted average cost of capital as the required return for all of its investments will: A. maintain a constant value for its shareholders. B. increase the risk level of the firm over time. C. make the best possible accept and reject decisions related to those investments. D. find that its cost of capital declines over time. E. accept only the projects that add value to the firm's shareholders.

B

31. 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: A. require the highest rate of return from division X since it has been in existence the longest. B. assign the highest cost of capital to division Z because it is most likely the riskiest of the three divisions. C. use the firm's WACC as the cost of capital for division Z as it provides analysis for the entire firm. D use the firm's WACC as the cost of capital for divisions A and B because they are part of the revenue- producing operations of the firm. E. allocate capital funds evenly amongst the divisions to maintain the current capital structure of the firm.

B

38. 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? A. Boone Brothers' cost of capital B. Ace Builders' cost of capital C. Average of Boone Brothers' and Ace Builders' cost of capital D. Lower of Boone Brothers' or Ace Builders' cost of capital E. Higher of Boone Brothers' or Ace Builders' cost of capital

B

1. 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? A. Weighted average cost of capital B. Pure play cost C. Cost of equity D. Subjective cost E. Cost of debt

C

15. 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 A. I only B. I and III only C. I and IV only D. II and III only E. II and IV only

C

16. Which one of the following is the pre-tax cost of debt? A. Average coupon rate on the firm's outstanding bonds B. Coupon rate on the firm's latest bond issue C. Weighted average yield-to-maturity on the firm's outstanding debt D. Average current yield on the firm's outstanding debt E. Annual interest divided by the market price per bond for the latest bond issue

C

21. Which one of the following will affect the capital structure weights used to compute a firm's weighted average cost of capital? A. Decrease in the book value of a firm's equity B. Decrease in a firm's tax rate C. Increase in the market value of the firm's common stock D. Increase in the market risk premium E. Increase in the firm's beta

C

34. Which one of the following is the primary determinant of an investment's cost of capital? A. Life of investment B. Initial cash outlay C. Level of risk D. Source of funds used for the investment E. Investment's net present value

C

37. 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. A. Management decides to issue new stock to finance the project. B. The initial cash outlay requirement is reduced. C. She learns the project is riskier than previously believed. D. The aftertax cost of debt just decreased. E. The project's life is shortened.

C

41. 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. Another brick-and-mortar store that also sells online B. A wholesale toy distributor C. A toy store that only sells online D. The oldest online retailer of any product E. Derek's own store

C

42. Kelly's uses the firm's weighted average cost of capital (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? A. Firm beta B. Date for project commencement C. Risk level of project D. Division within the firm that will be assigned to manage the project E. Current debt-equity ratio

C

43. 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? A. Assign every project a rate equal to the firm's cost of equity B. Assign every firm a random rate that varies between the firm's cost of debt and its cost of equity C. Assign every project a rate equal to the firm's WACC plus or minus a subjective adjustment D. Determine the best pure play rate for each project E. Assign every project a rate equal to the market rate of return at the time of the proposal

C

5. 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? A. Pure play approach B. Divisional rating C. Subjective approach D. Straight WACC approach E. Equity rating

C

8. Which one of the following statements is correct related to the dividend growth model approach to computing the cost of equity? A. The rate of growth must exceed the required rate of return. B. The rate of return must be adjusted for taxes. C.The annual dividend used in the computation must be for year one if you are using today's stock price to compute the return. D. The cost of equity is equal to the return on the stock plus the risk-free rate. E. The cost of equity is equal to the return on the stock multiplied by the stock's beta.

C

9. 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 WACC? A. 12.4 percent because it is lower than 18.7 percent B. 18.7 percent because it is higher than 12.4 percent C. The arithmetic average of 12.4 percent and 18.7 percent D. The arithmetic average of 12.4 percent, 13.5 percent, and 18.7 percent E. 13.5 percent

C

11. 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 A. II only B. I and II only C. I and III only D. II and IV only E. I, II, III, and IV

D

19. The cost of preferred stock: A. increases when a firm's tax rate decreases. B. is constant over time. C. is unaffected by changes in the market price. D. is equal to the stock's dividend yield. E. increases as the price of the stock increases.

D

23. Which one of the following statements is correct concerning capital structure weights? A. Target rates are less relevant to a project than are historical rates. B. The weights are unaffected when a bond issue matures. C. An increase in the debt-equity ratio will increase the weight of the common stock. D. The repurchase of preferred stock will increase the weight of debt. E. The issuance of additional shares of common stock will increase the weight of the preferred stock.

D

25. 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? A. Cost of equity B. Internal rate of return C. Aftertax cost of debt D. Weighted average cost of capital E. Debt-equity ratio

D

28. 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? A. Increasing the firm's tax rate B. Issuing new bonds at par C. Redeeming shares of common stock D. Increasing the firm's beta E. Increasing the debt-equity ratio

D

33. Kurt, who is a divisional manager, continually brags that his division's required return for its projects is one 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? A. Kurt tends to overestimate the projected cash inflows on his projects. B. Kurt tends to underestimate the variable costs of his projects. C. Kurt has the most efficiently managed division. D. Kurt's division is less risky than the other divisions. E. Kurt's projects are generally financed with debt while the other divisions' projects are financed with equity.

D

35. The cost of capital for a project depends primarily on which one of the following? A. Source of funds used for the project B. Division within the firm that undertakes the project C. Project's modified internal rate of return D. How the project uses its funds E. Project's fixed costs

D

36. 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. A. 40 B. 60 C. 80 D. 100 E. 110

D

39. 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? A. Firm size B. Firm location C. Firm experience D. Firm operations E. Firm management

D

6. 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? A. Amount of debt used to finance the project B. Use, or lack thereof, of preferred stock to finance the project C. Mix of funds used to finance the project D. Risk level of the project E. Length of the project's life

D

7. Black Stone Furnaces wants to build a new facility. The cost of capital for this investment is primarily dependent upon which one of the following? A. Firm's overall source of funds B. Source of the funds used to build the facility C. Current tax rate D. The nature of the investment E. Firm's historical average rate of return

D

12. In an efficient market, the cost of equity for a risky firm does which one of the following according to the security market line? A. Produces a return that will be less than the market rate but higher than the risk-free rate B. Equals the market rate of return for all stocks C. Has a maximum cost equal to the market rate of return D. Decreases as the beta of the firm's stock increases E. Increases in direct relation to the stock's systematic risk

E

26. Which one of the following statements is accurate for a levered firm? A. WACC should be used as the required return for all proposed investments. B. A firm's WACC will decrease whenever the firm's tax rate decreases. C. An increase in the market risk premium will decrease a firm's WACC. D. The subjective approach totally ignores a firm's own WACC. E. A reduction in the risk level of a firm will tend to decrease the firm's WACC.

E

4. 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? A. Equity approach B. Aftertax approach C. Subjective approach D. Market play E. Pure play approach

E

40. When using the pure play approach for a proposed investment, a firm is primarily seeking a rate of return which: A. is based on the actual source of funds that will be used to fund the project. B. creates a positive net present value for the project. C. reflects the size and life of the project. D. most closely correlates with the proposed investment's internal rate of return. E. best matches the risk level of the proposed investment.

E

44. The computation of which one of the following requires assigning every proposed investment to a particular risk class? A. Pure play cost of capital B. Cost of equity C. Aftertax cost of debt D. WACC E. Subjective cost of capital

E