Chapter 14 Cost of Capital

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. Increase in the dividend growth rate

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

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. D. If 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. A decrease in a firm's WACC will increase the attractiveness of the firm's investment options.

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. III only

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. Increase in tax rates

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

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. A toy store that only sells online

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. I and IV only

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. She learns the project is riskier than previously believed.

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

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. Risk level of the project

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

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. Increases in direct relation to the stock's systematic risk

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. Pure play approach

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. best matches the risk level of the proposed investment.

Which of the following is a correct statement about the Weighted Average Cost of Capital WACC: I- The WACC uses the after-tax cost of debt II- The higher the tax-rate the lower the WACC III- The cost of debt is the after tax coupon rate for a bond a- I and II b- I and III c- II and III d- I , II and III

a- I and II

The cost of debt for a firm will decrease for: a- an increase in tax rates b- an increase in the risk premium c- a decrease in the bond rating of a firm d- an increase in the risk level of the firm

a- an increase in tax rates

The cost of capital depends primarily on: a- the use of funds b- firm's historical rates of return c- current tax rate d- source of the funds

a- the use of funds

The return that stockholders require on their investment in a firm is referred to as the: a- equity ratio b- cost of equity c- dividend d- weighted average cost of capital

b- cost of equity

The proportional cost of equity plus the proportional after-tax cost of debt is called the: a- portfolio weight b- debt-equity ratio c- capital structure weight d- weighted average cost of capital

b- debt-equity ratio

The minimum rate of return that the firm must earn on a new project with risk level similar to that of the firm is given by: a- the cost of equity b- the weighted average cost of capital c- the bond coupon rate d- the return on asset ROA

b- the weighted average cost of capital

The cost of debt is based on the: a- initial expected return of the firm's existing debt b- current beta of the firm and the risk premium c- historical average return of the debt d- creditor's required rate on new debt

d- creditor's required rate on new debt