FIN 221 Chapt. 10 Intro Exercises

The CAPM/SML and Discounted Cash Flow approaches to estimating the cost of retained earnings will be the same under which of the following conditions? a. The company's common stock price is in equilibrium. b. The company's preferred stock price is in equilibrium. c. The company's common stock is undervalued. d. None of the above.

a. The company's common stock price is in equilibrium.

Basu Inc. uses only equity capital, and it has two equally-sized divisions. Division A's cost of capital is 10.0%, Division B's cost is 14.0%, and the composite WACC is 12.0%. All of Division A's projects have the same risk, and all Division B projects are also equally risky. However, the projects in Division A do not have the same risk as those in Division B. Which of the following projects should Basu accept? a. A Division A project with a 9% return. b. A Division A project with an 11% return. c. A Division B project with a 13% return. d. A Division B project with a 12% return. e. A Division B project with an 11% return.

b. A Division A project with an 11% return.

Which of the following factors that influence WACC are beyond the corporation's control? a. Investment policy b. Tax rates c. Capital structure d. Dividend policy

b. Tax rates

Which of the following statements is CORRECT? a. If a firm has enough retained earnings to fund its capital budget, then there is no need to estimate a cost of equity when determining the WACC. b. 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. c. A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firm's stockholders could themselves earn a return on earnings if they were paid out rather than retained and reinvested. d. 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 will both be equal to the interest rate on the firm's currently outstanding debt, which was issued during the past 5 years. e. No cost should be assigned to retained 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. A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firm's stockholders could themselves earn a return on earnings if they were paid out rather than retained and reinvested.

Which of the following statements about the cost of capital is CORRECT? a. A change in a company's target capital structure cannot affect its WACC. b. Flotation costs associated with issuing new common stock normally lead to a decrease in the WACC. c. If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decrease. d. WACC calculations should be based on the before-tax costs of all the individual capital components. e. An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.

c. If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decrease.

Which of the following would be a reasonable estimate for a company's before-tax cost of debt? a. The interest rate charged on a bank loan that the company received last year. b. The current yield on the company's existing bonds. c. The yield to maturity on the company's existing bonds. d. The coupon rate on the company's existing bonds.

c. The yield to maturity on the company's existing bonds.

Which of the following is not an input in a company's WACC? a. Retained earnings b. Long-term debt. c. Preferred stock d. Accounts payable

d. Accounts payable

Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation. a. If a firm's managers want to maximize the value of the stock, they should, in theory, concentrate on project risk as measured by the standard deviation of the project's expected future cash flows. b. If a firm evaluates all projects using the same cost of capital, then its risk will probably decline over time. c. Projects with more than average risk typically have higher than average expected returns. Therefore, to maximize a firm's intrinsic value, its managers should favor high beta projects over low beta projects. d. Project A has a standard deviation of expected returns of 20%, while Project B's standard deviation is only 10%. A's returns are negatively correlated with the firm's other assets and with returns on most stocks in the economy, while B's returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital. e. If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms' assets.

d. Project A has a standard deviation of expected returns of 20%, while Project B's standard deviation is only 10%. A's returns are negatively correlated with the firm's other assets and with returns on most stocks in the economy, while B's returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital.

Which of the following statements is CORRECT? a. 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 debt interest. b. We should use historical measures of the component costs from prior financings when estimating a company's WACC for capital budgeting purposes. c. The cost of new equity (re) could possibly be lower than the cost of retained earnings (rs) if the market risk premium, risk-free rate, and the company's beta all decline by a sufficiently large amount. d. The cost of retained earnings is the rate of return stockholders require on a firm's common stock. e. In the WACC calculation, we must adjust the cost of preferred stock (the market yield) because 70% of the dividends received by corporate investors are excluded from their taxable income.

d. The cost of retained earnings is the rate of return stockholders require on a firm's common stock.

Which of the following should Fortune Brands use as the WACC for an average risk project within its Titliest Golf division? a. A rate slightly lower than Titliest Golf's divisional WACC.Adjusting WACC b. Fortune Brands corporate WACC. c. A rate slightly higher than Fortune Brands corporate WACC. d. Titliest Golf's divisional WACC.

d. Titliest Golf's divisional WACC.

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. c. Higher flotation costs reduce investor returns, and that leads to a reduction in a company's WACC. d. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation. e. 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 retained earnings to take care of its equity financing and hence needs to issue new stock.

d. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.

For a typical firm, which of the following is correct? All rates are after taxes, and assume the firm operates at its target capital structure. a. WACC > re > rs > rd. b. rs > re > rd > WACC. c. rd > re > rs > WACC. d. re > rs > WACC > rd. e. WACC > rd > rs > re.

d. re > rs > WACC > rd.

Nachman Corporation forecasts that if all of its existing financial policies are adhered to, its proposed capital budget would be so large that it would have to issue new common stock. Since new stock has a higher cost than of retained earnings, Nachman would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock? a. Increase the proposed capital budget. b. Reduce the percentage of debt in the target capital structure. c. Increase the dividend payout ratio for the upcoming year. d. Reduce the amount of short term bank debt in order to increase the current ratio. e. Increase the percentage of debt in the target capital structure.

e. Increase the percentage of debt in the target capital structure.

Which of the following statements is CORRECT? a. The WACC as used in capital budgeting will be the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year. b. The percentage flotation costs associated with issuing new common equity are typically smaller than the flotation costs for new debt. c. The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital. d. 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. e. There is an "opportunity cost" associated with using retained earnings-they are not "free."

e. There is an "opportunity cost" associated with using retained earnings-they are not "free."