Chapter 12

All of the following are true EXCEPT: a. The claims of preferred stockholders on the firm's earnings are junior to those of debt- holders. b. The risk of recapitalization increases a firm's required rate of return. c. Long-term state government securities are always less risky than corporate long-term securities of the same maturity. d. The cost of capital to the firm is equal to the equilibrium rate of return demanded by investors in the capital markets for securities with that degree of risk

c. Long-term state government securities are always less risky than corporate long-term securities of the same maturity.

The CAPM assumes that the only risk of concern to the investor is ____, which is measured by ____. a. Unsystematic risk, beta b. Systematic risk, the return to the market portfolio c. Systematic risk, beta d. Unsystematic risk, the return to the market portfolio

c. Systematic risk, beta

If a firm is losing money then the after-tax cost of debt is a. equal to kd (1 - T) b. found by trial and error c. equal to the pretax cost of debt d. equal to the yield to first call date

c. equal to the pretax cost of debt

For firms subject to the 34% marginal tax rate, the after-tax cost of ____ is roughly two-thirds the cost of preferred stock. a. retained earnings b. new common stock c. long-term debt d. retained earnings and new common stock

c. long-term debt

Rank in ascending order (lowest to highest) the relative riskiness of the various types of corporate and government securities. a. common stock, preferred stock, corporate debt, long-term government debt b. corporate debt, long-term government debt, preferred stock, common stock c. long-term government debt, corporate debt, preferred stock, common stock d. corporate debt, preferred stock, long-term government debt, common stock

c. long-term government debt, corporate debt, preferred stock, common stock

The optimal capital budget is determined by comparing the expected project returns to the company's a. computed break points b. cost of equity schedule c. marginal cost of capital schedule d. optimal opportunity curve

c. marginal cost of capital schedule

The cost of external equity is greater than the cost of internal equity because a. it decreases the earnings per share b. it increases the market price of the stock c. of the flotation costs d. dividends are increased

c. of the flotation costs

There are four major components that determine the risk premium. They include all the following except a. interest rate risk b. business risk c. reinvestment rate risk d. financial risk

c. reinvestment rate risk

The historic beta of a firm is of little use as a forecast of the firm's future systematic risk characteristics when a. the firm is growing at a rate of 7-10 percent a year b. the firm is expanding an existing product line c. the firm is expanding into a new product line d. all of these answers are correct

c. the firm is expanding into a new product line

If a firm sells assets, generating cash flows, the cost of these funds is ____. a. the firm's cost of equity b. the firm's cost of cash flows c. the firm's weighted cost of capital d. zero

c. the firm's weighted cost of capital

Investors can form earnings growth expectations from various sources, including a. potential sales growth. b. current earnings and retention rates. c. assumed product development. d. investors' required rate of return.

b. current earnings and retention rates.

The total return to stockholders, ke, is composed of the a. opportunity cost plus a risk premium b. dividend yield plus the price appreciation of the security c. opportunity cost plus an inflation premium d. dividend yield minus the risk premium

b. dividend yield plus the price appreciation of the security

During the 1980s, the cost of capital for U.S. firms averaged about 3.3 percentage points higher than Japanese firms. During 1990 this disadvantage may have disappeared due to: a. higher exports to the U.S. b. higher real interest rates in Japan c. larger shareholder interest d. higher Japanese stock market

b. higher real interest rates in Japan

The optimal capital budget is indicated by the point at which the ____ and the ____ intersect. a. depreciation schedule; investment opportunity schedule b. investment opportunity curve; marginal cost of capital curve c. investment opportunity curve; average cost of capital curve d. efficient portfolio curve; marginal cost of capital curve

b. investment opportunity curve; marginal cost of capital curve

The most appropriate weights to use in calculating a firm's cost of capital are the proportions of the components in the firm's ____ capital structure. a. historical average b. long-range target c. current d. industry average

b. long-range target

For a company that is not planning to change its target capital structure, the proportions of debt and equity used in calculating the weighted cost of capital should be based on the current ____ weights of the individual components. a. book value b. market value c. replacement value d. accounting value

b. market value

The required rate of return on any security consists of a a. risk premium plus an expected inflation rate b. risk free rate plus a risk premium c. inflation rate plus a marketability premium d. risk free rate plus an inflation premium

b. risk free rate plus a risk premium

Break points can be determined by dividing the amount of funds available from each financing source at a fixed cost by the ____ proportion for that financing source. a. weighted capital structure b. target capital structure c. economic capital structure d. divisional capital structure

b. target capital structure

If a firm will use only equity funds during the current capital budgeting period then the ____ is the correct capital cost to use for computing the cost of funds for the firm. a. cost of equity capital b. weighted cost of funds c. historical cost of funds d. all of these answers are correct

b. weighted cost of funds

The optimal capital budget occurs at the point where two curves intersect. Which of the following is/are one of those curves? I. Weighted marginal cost of capital curve II. Investment opportunity curve a. I only b. II only c. Both I and II d. Neither I nor II

c. Both I and II

Which of the following statements regarding the cost of capital is/are correct? I. The weighted cost of capital is the discount rate used when computing the net present value. II. The after-tax cost of capital is weighted by the proportions of the capital components in the firm's long-range target capital structure. a. I only b. II only c. Both I and II d. Neither I nor II

c. Both I and II

The cost of common stock equity may be estimated by using which of the following? a. Earnings curve b. Dupont analysis c. Capital asset pricing model d. Price/Earnings ratio

c. Capital asset pricing model

The cost of debt must account for all of the following inputs EXCEPT: a. Bond ratings. b. Issuance costs. c. flotation costs. d. The tax rate.

a. Bond ratings.

____ refers to the variability in the firm's operating earnings. a. Business risk b. Financial risk c. Marketability risk d. Interest rate risk

a. Business risk

The cost of internal equity is cheaper than the cost of external equity. Which of the following statements is/are correct? I. External equity may incur expenses which are deducted from the capital received for the sale of the security. II. Corporations generally discount the price of the securities that are sold to the public in order to raise capital. a. I only b. II only c. Both I and II d. Neither I nor II

a. I only

There are two primary ways that capital is raised. Which of the following statements is/are correct? I. Capital is raised internally by using retained earnings. II. Capital is raised externally by selling fixed assets. a. I only b. II only c. Both I and II d. Neither I nor II

a. I only

Which of the following statements (if any) is (are) true concerning companies that do not pay dividends? a. The cost of equity capital can be estimated using the Capital Asset Pricing Model. b. The cost of equity capital is equal to the growth short-term rate of earnings per share. c. The dividend capitalization model can be used to determine an accurate cost of equity capital. d. The cost of equity capital cannot be determined by using the CAPM, the risk premium on debt approach, or by estimating ke for comparable dividend-paying stocks in their industry.

a. The cost of equity capital can be estimated using the Capital Asset Pricing Model.

Which of the following is not a typical source of debt funds for a small firm? a. investment banking firms b. commercial finance companies c. Small Business Administration d. leasing companies

a. investment banking firms

If a firm adopts a large proportion of above-average-risk investment projects that are not offset by below-average-risk investment projects a. its cost of capital will rise b. the average risk premium for the firm will decline c. the risk-free rate will increase as more risk is added d. its cost of capital will fall

a. its cost of capital will rise

A firm can raise up to $700 million for investment from a mixture of debt, preferred stock and retained equity. Above $700 million, the firm must issue new common stock. Assuming that debt costs and preferred stock costs remain unchanged, the marginal cost of capital for amounts up to $700 million will be ____ the marginal cost of capital for amounts over $700 million. a. less than b. equal to c. greater than d. cannot be determined from the information given

a. less than

Historic average capital costs are ____ new (marginal) resource allocation decisions. a. not relevant for making b. very useful when making c. necessary for making d. the relevant costs for making

a. not relevant for making

If a preferred stock is callable, then the calculation of the cost of preferred stock financing is a. similar to that for bonds b. equal to Dp/Pn c. equal to Dp less flotation costs d. less than Dp/Pn

a. similar to that for bonds

The cost of capital is a. the rate of return required by investors in the firm's securities b. the minimum rate of return required on new investments of high risk undertaken by the firm c. approximately 10 percent for most firms d. concerned with plant and equipment only

a. the rate of return required by investors in the firm's securities

Studies analyzing the historical returns earned by common stock investors have found that the returns from average risk common stock investments over the years have averaged (arithmetically) ____ percentage points ____ than the returns on Treasury bills. a. 6 to 8, higher b. 1 to 2, lower c. 3 to 4, higher d. 8 to 9, higher

d. 8 to 9, higher

Retained earnings are a cheaper source of funds than the sale of new equity because a. retention defers the payment of taxable dividends to shareholders b. there are no flotation costs c. new shares are usually priced below current market price d. all the above

d. all the above

Small firms are reluctant to obtain capital through the sale of common stock because of: a. potential loss of voting control b. high issuance costs c. high cost of debt d. both the potential loss of voting control and the high issuance costs

d. both the potential loss of voting control and the high issuance costs

Rank in ascending order (lowest to highest) investors' required rates of return on the various types of corporate securities. a. preferred stock, corporate debt, common stock b. common stock, preferred stock, corporate debt c. preferred stock, common stock, corporate debt d. corporate debt, preferred stock, common stock

d. corporate debt, preferred stock, common stock

The constant growth valuation model approach to calculating the cost of equity assumes that a. earnings and dividends grow at a constant rate, but stock price growth is indeterminate b. the growth rate is greater than or equal to ke c. dividends are constant d. earnings, dividends, and stock price will grow at a constant rate

d. earnings, dividends, and stock price will grow at a constant rate

The major components that determine the risk premium on a specific security at any point in time include all of the following except a. business risk b. financial risk c. interest rate risk d. real rate of return risk

d. real rate of return risk

The Institutional Brokers' Estimate Service (IBES) summarizes analysts' ____. a. short-term earnings forecasts b. long-term earnings growth rates c. bankruptcy forecasts d. short-term earnings forecasts and long-term earnings growth rates

d. short-term earnings forecasts and long-term earnings growth rates

In determining the cost of debt, several factors must be considered. All of the following are those factors EXCEPT: a. the firm's before-tax cost of debt b. the firm's tax rate c. flotation costs d. the firm's growth rate of dividends

d. the firm's growth rate of dividends

All of the following methods may be used to determine the cost of equity capital (ke) for a non-dividend-paying stock except a. the risk premium on debt approach b. the Capital Asset Pricing Model approach c. comparing with similar dividend-paying stocks in the industry d. the simulation with growth expectations approach

d. the simulation with growth expectations approach

The cost of depreciation-generated funds is equal to a. the cost of equity capital b. zero, because depreciation is a non-cash expense c. the investment opportunity cost d. the weighted cost of capital

d. the weighted cost of capital

The cost of equity capital for non-dividend paying stocks can be determined by a. using the Capital Asset Pricing Model b. estimating ke for comparable dividend-paying stocks in their industry c. forecasting the liquidation proceeds from the sale of the company's assets. d. using the CAPM and by estimating ke for comparable dividend-paying stocks in their industry

d. using the CAPM and by estimating ke for comparable dividend-paying stocks in their industry