Chapter 9 - Finance Management
Which of the following statements is CORRECT? a. A cost should be assigned to reinvested earnings due to the opportunity cost principle, which refers to the fact that the firm's stockholders would themselves expect to earn a return on earnings that were distributed rather than retained and reinvested. b. No cost should be assigned to reinvested earnings because the firm does not have to pay anything to raise them. They are generated as cash flows by operating assets that were raised in the past; hence, they are "free." c. Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into the foreseeable future. In this case, the firm's before-tax and after-tax costs of debt for purposes of calculating the WACC will both be equal to the interest rate on the firm's currently outstanding debt, provided that debt was issued during the past 5 years. d. If a firm has enough reinvested earnings to fund its capital budget for the coming year, then there is no need to estimate either a cost of equity or a WACC. e. The component cost of preferred stock is expressed as rp(1 − T). This follows because preferred stock dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes.
a. A cost should be assigned to reinvested earnings due to the opportunity cost principle, which refers to the fact that the firm's stockholders would themselves expect to earn a return on earnings that were distributed rather than retained and reinvested.
Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting? a. Accounts payable. b. Common stock "raised" by reinvesting earnings. c. Common stock raised by new issues. d. Preferred stock. e. Long-term debt.
a. Accounts payable.
Which of the following statements is CORRECT? a. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes. b. If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject. c. Because no flotation costs are required to obtain capital as reinvested earnings, the cost of reinvested earnings is generally lower than the after-tax cost of debt. d. Higher flotation costs tend to reduce the cost of equity capital. e. Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.
b. If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.
The Tierney Group has two divisions of equal size: an office furniture manufacturing division and a data processing division. Its CFO believes that stand-alone data processor companies typically have a WACC of 9%, while stand-alone furniture manufacturers typically have a 13% WACC. She also believes that the data processing and manufacturing divisions have the same risk as their typical peers. Consequently, she estimates that the composite, or corporate, WACC is 11%. A consultant has suggested using a 9% hurdle rate for the data processing division and a 13% hurdle rate for the manufacturing division. However, the CFO disagrees, and she has assigned an 11% WACC to all projects in both divisions. Which of the following statements is CORRECT? a. The decision not to adjust for risk means, in effect, that it is favoring the data processing division. Therefore, that division is likely to become a larger part of the consolidated company over time. b. The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division. This will lead to a reduction in the firm's intrinsic value over time. c. The decision not to risk-adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business. This will lead to a reduction in its intrinsic value over time. d. The decision not to risk-adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business. This may affect the firm's capital structure but it will not affect its intrinsic value. e. While the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant's recommendation, this should not affect the firm's intrinsic value.
b. The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division. This will lead to a reduction in the firm's intrinsic value over time.
Which of the following statements is CORRECT? a. We should use historical measures of the component costs from prior financings that are still outstanding when estimating a company's WACC for capital budgeting purposes. b. The cost of new equity (re) could possibly be lower than the cost of reinvested earnings (rs) if the market risk premium, risk-free rate, and the company's beta all decline by a sufficiently large amount. c. A firm's cost of reinvesting earnings is the rate of return stockholders require on a firm's common stock. d. The component cost of preferred stock is expressed as rp(1 − T), because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt. e. In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income.
c. A firm's cost of reinvesting earnings is the rate of return stockholders require on a firm's common stock.
Which of the following statements is CORRECT? a. WACC calculations should be based on the before-tax costs of all the individual capital components. b. Flotation costs associated with issuing new common stock normally reduce the WACC. c. If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline. d. An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing. e. A change in a company's target capital structure cannot affect its WACC.
c. If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline.
Which of the following statements is CORRECT? a. The dividend growth model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the dividend growth model's logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain. b. The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm's own cost of debt and its risk premium, can be found by using standardized and objective procedures. c. Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity. d. The dividend growth model model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield. e. Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs⎯beta, the risk-free rate, and the market risk premium⎯can be estimated with little error.
c. Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity.
Which of the following statements is CORRECT? Assume a company's target capital structure is 50% debt and 50% common equity. a. The WACC is calculated on a before-tax basis. b. The WACC exceeds the cost of equity. c. The cost of equity is always equal to or greater than the cost of debt. d. The cost of reinvested earnings typically exceeds the cost of new common stock. e. The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet.
c. The cost of equity is always equal to or greater than the cost of debt.
Which of the following statements is CORRECT? a. The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average after-tax cost of all the firm's outstanding debt. b. Suppose some of a publicly-traded firm's stockholders are not diversified; they hold only the one firm's stock. In this case, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firm's intrinsic value. c. The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity. d. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm's cost of equity capital. e. The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity.
c. The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity.
Which of the following statements is CORRECT? a. The WACC is calculated using a before-tax cost for debt that is equal to the interest rate that must be paid on new debt, along with the after-tax costs for common stock and for preferred stock if it is used. b. An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity. c. The relevant WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm's target capital structure. d. Beta measures market risk, which is generally the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. However, this is not true unless all of the firm's stockholders are well diversified. e. The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the interest rate on the company's own long-term bonds. The size of the risk premium for bonds with different ratings is published daily in The Wall Street Journal.
c. The relevant WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm's target capital structure.
Which of the following statements is CORRECT? a. The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt. b. The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets. c. There is an "opportunity cost" associated with using reinvested earnings, hence they are not "free." d. The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year. e. The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital.
c. There is an "opportunity cost" associated with using reinvested earnings, hence they are not "free."
Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely a. become less risky over time, and this will maximize its intrinsic value. b. accept too many low-risk projects and too few high-risk projects. c. become more risky and also have an increasing WACC. Its intrinsic value will not be maximized. d. continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital. e. become riskier over time, but its intrinsic value will be maximized.
c. become more risky and also have an increasing WACC. Its intrinsic value will not be maximized.
Which of the following statements is CORRECT? a. The after-tax cost of debt usually exceeds the after-tax cost of equity. b. For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock. c. Retained earnings that were generated in the past and are reported on the firm's balance sheet are available to finance the firm's capital budget during the coming year. d. The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital. e. The WACC is calculated using before-tax costs for all components.
d. The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital.
Careco Company and Audaco Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Careco having a WACC of 10% and Audaco a WACC of 12%. Careco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Careco project. Audaco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Audaco project. Now assume that the two companies merge and form a new company, Careco/Audaco Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is CORRECT? a. If evaluated using the correct post-merger WACC, Project X would have a negative NPV. b. After the merger, Careco/Audaco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y. c. Careco/Audaco's WACC, as a result of the merger, would be 10%. d. After the merger, Careco/Audaco should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%. e. If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.
e. If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.
. The Anderson Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 12%. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO's position is accepted, what is likely to happen over time? a. The company will take on too many low-risk projects and reject too many high-risk projects. b. Things will generally even out over time, and, therefore, the firm's risk should remain constant over time. c. The company's overall WACC should decrease over time because its stock price should be increasing. d. The CEO's recommendation would maximize the firm's intrinsic value. e. The company will take on too many high-risk projects and reject too many low-risk projects.
e. The company will take on too many high-risk projects and reject too many low-risk projects.
Which of the following statements is CORRECT? a. When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation. b. Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM. c. If a company's beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough reinvested earnings to take care of its equity financing and hence must issue new stock. d. Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC. e. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.
e. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.
