chapter 11 fin300

Which of the following is true of a break point on a firm's marginal cost of capital (MCC) schedule?

A break point (BP) is defined as the last dollar of new total capital that can be raised before an increase in the firm's weighted average cost of capital (WACC) occurs.

which of the following statements about the marginal cost of capital is correct? Assume everything else is equal

An increase in the tax rate will decrease a firm's marginal cost of debt. The weighted average cost of capital is the weighted average of the after-tax cost of debt, the cost of preferred stock, and the cost of common equity. Because the cost of debt capital is computed on an after-tax basis, an increase in the tax rate will decrease the marginal cost of debt capital.

The marginal cost of capital (MCC) schedule generally rises, which implies that the weighted average cost of capital

As a company raises larger and larger amounts of funds during a given time period, the costs of those funds begin to rise, and as this occurs, the weighted average cost of capital (WACC) of each new dollar also rises. Thus, companies cannot raise unlimited amounts of capital at a constant cost. At some point, the cost of each new dollar will increase, no matter what its source—debt, preferred stock, or common equity

rdT =

Bondholders' required rate of return (YTM) - Tax savings

r ps (cost of preferred stock) =

D ps/[P0(1-F)]

re (the cost of issuing new equity). =

D1 / [P0(1-F)] + g

T/F: For a particular firm, depending on tax rates, flotation costs, and the attitude of investors, the cost of new common equity, re, can be less than, equal to, or greater than its before-tax cost of debt, rd.

False bc The cost of external equity capital is similar to the cost of retained earnings except it is higher because the firm incurs flotation costs when it issues new common stock

invest when IRR _____ WACC

IRR>WACC

Which of the following statements is correct about using the capital asset pricing model (CAPM) to determine a firm's component costs of capital

The capital asset pricing model (CAPM) assumes investors are well diversified, whereas the discounted cash flow (DCF) approach assumes the firm grows at a constant growth rate.

Which of the following is a major assumption that is embedded in the capital asset pricing model (CAPM), which is often used to estimate the cost of retained earnings, rs?

The capital asset pricing model (CAPM) assumes investors are well diversified.

T/F:Because the value of a firm's stock depends on the after-tax cash flows it generates during its life, after-tax component costs of capital (i.e., the after-tax cost of debt) are used when computing a firm's weighted average cost of capital (WACC).

True bc The actual cost of debt must be adjusted to account for the tax savings associated with interest payment

Under normal circumstances, the weighted average cost of capital (WACC) is used as the firm's required rate of return because:

as long as the firm's investments earn returns greater than its WACC, the value of the firm will not decrease.

The average rate of return that investors require to provide funds to the firm in the form of debt is the ________.

average yield to maturity (YTM) on the firm's bonds

The value of any asset—real or financial—is based on the _____ and the _____.

cash flow expected to be generated by the asset; the rate of return required by investors

Which of the following cost of capital measures must be adjusted to account for tax savings

cost of debt aka debts yield to maturity

T/F: A firm's after-tax cost of debt is always greater than its cost of retained earnings.

false

T/F: Even if a firm obtains all of its common equity financing from retained earnings, its marginal cost of capital (MCC) schedule would not increase if very large amounts of new capital are raised.

false

T/F: For a particular firm, the before-tax cost of debt is less than the after-tax cost of debt because the firm must pay taxes on the interest its bondholders receive.

false

To determine the actual cost of using debt, a firm must adjust its bonds' average yield to maturity for the fact that _____.

interest payments on debt represent a tax deductible expense to the firm

If a project's _____ exceeds the firm's weighted average cost of capital (WACC), its net present value (NPV) will be positive.

internal rate of return (IRR)

A graph of the capital budgeting projects a firm is evaluating ranked in the order of their internal rates of return is called a(n) ____

investment opportunity schedule (IOS)

A firm should continue to invest in capital budgeting projects until its marginal cost of capital is equal to the:

marginal return (internal rate of return, IRR) generated by the last project purchased.

The weighted average cost of capital of a firm represents the:

minimum rate of return a firm must earn on average-risk investments to maintain its current value

is tax adjustment made when calculating r ps

no

retained earnings break point =

retained earnings/Proportion of common equity = net income * (1-dividend payout ratio)/(1-debt ratio)

According to the bond-yield-plus-risk-premium approach, a firm's cost of retained earnings, rs, can be estimated by adding a risk premium of 3 to 5 percentage points to:

the before-tax interest rate on the firm's own long-term debt, rd.

T/F: A firm's cost of external equity capital (cost of issuing new stock) is similar to the cost of retained earnings, except it is higher because the firm incurs flotation costs when it issues new common stock.

true

T/F: All else equal, an increase in the corporate tax rate will result in a decrease in the firm's weighted average cost of capital.

true

T/F: The marginal cost of capital (MCC) is the weighted average cost of the last dollar of new capital that the firm raises. The MCC generally increases as greater amounts of a specific type of capital are raised during a given period.

true