CHAPTER 14

1. Assume a firm utilizes the security market line approach to determine the cost of equity. If the firm currently pays an annual dividend of $2.40 per share and has a beta of 1.42, all else constant, which of the following actions will decrease the firm's cost of equity?

A decrease in the firm's beta

1. Assume a firm utilizes the security market line approach to determine the cost of equity. If the firm currently pays an annual dividend of $3.36 per share and has a beta of 1.38, all else constant, which of the following actions will increase the firm's cost of equity?

A decrease in the risk-free rate

1. The cost of capital depends primarily on the source of the funds, not the use

False

1. The percent of investment that the project costs can be referred to as all of the following, except:

Free cash flow

most of time firms internally generated cash flow is sufficient to cover the equity portion of their capital spending, so only the debt portion must be raised externally

Internal equity

1. Which of the following statements regarding the cost of preferred stock is accurate?

It equals the dividend yield.

Which of the following statements regarding the weighted average cost of capital is accurate?

It is the return investors require on the total assets of the firm.

1. With respect to capital project analysis, which of the following statements is accurate?

Overall, a company makes better decisions when it uses the subjective approach than when it uses its WACC as the discount rate for all projects.

1. Assume a manager determines the cost of capital for a specific project based on the cost of capital at another firm with a line of business that is similar to the project. Accordingly, the manager is using the ________ approach.

Pure play

•is the use of WACC that is unique to a particular project, based on companies in similar lines of business.

Pure play approach

1. The cost of preferred stock is equivalent to the:

Rate of return on a perpetuity.

1. A firm's target capital structure represents:

a fixed debt-equity ratio that the company attempts to maintain.

1. Velasquez Manufacturing has two vastly different lines of business: Alpha and Omega. The Alpha line is the riskiest of the two, and accounts for 72 percent of the firm's sales. When deciding which project proposals should be accepted, the managers should:

assign appropriate, but differing, discount rates to each business line and then select the projects with the highest net present values.

When using the subjective approach to project analysis, a firm:

assigns discount rates to projects based on the discretion of the senior managers of a firm.

Is the return that lenders require on the firm's debt. It is the interest rate a firm must pay on new borrowing, and we can observe interest rates in the financial markets

cost of debt

1. Wright Market Research is able to borrow money at a rate of 6.8 percent per year. This interest rate is called the:

cost of debt.

is the return that equity investors require on their investment in the firm

cost of equity

is equal to the dividend yield on the preferred stock

cost of preferred stock

will reflect both its cost of debt capital and its cost of equity capital

firm's cost of capital

1. For any given capital project proposal, the discount rate should be based on the:

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

1. Okonjo Economics has a debt-equity ratio of .38. All of the firm's outstanding shares were purchased by a small number of investors. The return these investors require is called the:

Cost of equity.

there are two common ways to estimate cost of equity

Dividends growth model and CAPM

1. The coupon rate on the firm's outstanding debt can be used as a substitute for the cost of debt.

FALSE

Due to the challenges that exist in objectively establishing discount rates for individual projects, firms often adopt an approach that involves making subjective adjustments to the overall WACC

The subjective approach:

1. The required return of preferred stock is equal to the ________ ________ on the preferred stock.

Dividend yield

1. Since preferred stock has a fixed dividend paid every period forever, it is essentially a perpetuity.

TRUE

1. Which of the following is the main advantage of using the dividend growth model to estimate a firm's cost of equity?

The simplicity of the model.

1. What is the subjective approach?

Using a WACC that involves making subjective adjustments based upon the project

1. What is the pure play approach?

Using a WACC that is based on companies in similar lines of business.