FINA 365 Final Exam (HW Questions)

Which of the following is NOT true regarding a firm's cost of debt?

A firm's cost of equity is generally easier to calculate than a firm's cost of debt.

The firm is considering two projects A and B. Both projects have conventional cash flows. Project A has beta of 1.0 and it has an IRR (promised return) of 13.0%. Project B has a beta of 1.5 and it has an IRR of 15.0%. If the risk-free rate is 5.25% and the market risk premium is 7.0%, which project(s) should the firm take? (note: these are not mutually exclusive projects)

A only

Suppose that two firms, A and B, are considering the same project which has the same risk as firm B's overall operations. The project has an IRR of 14.0% (i.e. 14% is a promised return) . Firm A has a beta of 1.4, while firm B's beta is 1.1. If the risk-free rate is 5.25% and the market risk premium is 7.0%, which firm(s) should take the project?

Both A and B

The equity risk derived from the firm's operating activities is called ____________ risk.

Business

Book value capital structure weights should be used to calculate the WACC rather than market value weights.

False

The interest tax shield is risk-free.

False

Assume there are no personal or corporate income taxes and that the firm's WACC is unaffected by changes in the firm's capital structure. Which of the following is true? I. A firm's cost of equity depends on the firm's business and financial risks. II. The value of the firm is dependent on its capital structure. III. The cost of equity increases as the firm's leverage decreases. IV. The cost of equity is independent of the firm's leverage.

I Only (A firm's cost of equity depends on the firm's business and financial risks)

Assume there are no personal or corporate income taxes and that the firm's WACC is unaffected by its capital structure. Which of the following is true? I. A firm's cost of equity depends on the firm's business and financial risks. II. The value of the firm is dependent on its capital structure. III. The cost of equity increases as the firm's leverage decreases.

I Only ( A firm's cost of equity depends on the firm's business and financial risks)

The optimal capital structure is the mixture of debt and equity which: I. Maximizes the value of the firm. II. Minimizes the firm's weighted average cost of capital. III. Maximizes the market price of the firm's bonds.

I and II only (Maximizes the value of the firm) (Maximizes the market price of the firm's bonds)

The interest rate that should be used when evaluating a capital investment project is sometimes called the ___________________. I. internal rate of return II. appropriate discount rate III. cost of capital

II and III (Appropriate Discount Rate and Cost of Capital)

Assume there are no corporate or personal taxes. According to M&M Proposition:

II, the cost of equity rises as the firm increases its use of debt financing.

Which of the following statements regarding leverage is false?

If things go poorly for the firm, increased leverage provides greater returns to shareholders (as measured by ROE and EPS).

Which of the following is NOT accurate regarding financial leverage?

Increasing financial leverage will always increase the EPS for stockholders.

Which of the following is false about dividend growth model when estimating the cost of equity?

It applies only to firms whose dividend growth rate fluctuates significantly. It applies only to companies which are not currently paying dividends. It does not use discounted cash flow techniques

You need to calculate the cost of equity capital for a firm that is traded on the New York Stock Exchange. Which of the following would likely be least helpful to you?

Knowledge of the stock's price six months ago.

According to __________ , the value of the firm is independent of its capital structure.

M&M Proposition I without taxes

Which of the following is false about the WACC

The WACC is the appropriate discount rate for all new projects of the firm. The optimal capital structure is the one that maximizes the WACC. The WACC is virtually impossible to calculate for a firm with multiple divisions. Since discount rates and firm value move in the same direction, minimizing the WACC will minimize the value of the firm.

Firm's Cost of Debt

The cost of debt must be adjusted lower due to the firm's tax deductibility of interest expense. The firm's cost of debt based on its past borrowing is known as its embedded debt cost. It is possible to determine a firm's cost of debt by using the SML. The coupon rate on outstanding debt is not necessarily the firm's current cost of debt.

Which of the following is true about the dividend growth model when estimating the cost of equity?

The estimated cost of equity is highly sensitive to the estimated growth rate of dividends

You need to calculate the cost of equity capital for a firm that is traded on the New York Stock Exchange. Which of the following would likely be helpful to you?

The rate of return on stocks of similar risk. An investment publication that provides an estimate of the firm's beta. An investment survey that projects future dividend growth rates for the firm. A data set containing dividends paid for the past ten years.

Which of the following statements regarding leverage is true?

The ultimate effect of leverage depends on the firm's EBIT. As a firm levers up, shareholders are exposed to greater risk. The benefits of leverage will not be as great in a firm with substantial accumulated losses or other types of tax shields compared to a firm without many tax shields. Beyond a certain point, the costs of financial distress outweigh the benefits of leverage.

Which of the following is true about the WACC?

The value of the firm will be maximized when the WACC is minimized.

Financial distress costs decrease the attractiveness of debt financing, all else the same.

True

Financial risk is derived from the event that bondholders will assume control of the firm in the event of default.

True

Most firms in the United States maintain relatively low debt/equity ratios.

True

The cost of equity is the return that equity investors require on their investment in the firm. The cost of equity can be found by either the dividend growth approach or the SML approach. The cost of debt is the return that lenders require on the firm's debt. If the firm has preferred stock in its capital structure, the cost of preferred stock should be included in the cost of capital.

True

The systematic risk of the firm's equity has two parts: business risk and financial risk.

True

Financial Leverage:

Whenever a firm's debt increases faster than its equity, financial leverage increases. Leverage is most beneficial when EBIT is relatively high. Investors can undo the effects of the firm's capital structure by using homemade leverage. The level of financial leverage that produces the highest firm value is the one most beneficial to stockholders.

All else the same, the financial leverage of a firm will _________________-.

decrease as the firm's retained earnings account grows

These days the stock market is worried that Federal Reserve is expected to take actions that cause the risk-free rate to increase. If all else the same, including the level of market required return, we would expect a firm's cost of equity to ____________________.

either increase or decrease if we are using the SML, but we can't determine which without information about the firm's beta.

According to the static theory of capital structure, ____________________.

the value of the firm in M&M with taxes is overstated by the amount of financial distress costs

Which of the following correctly completes the following: M&M I with taxes shows ___________________________________.

there is a linear relationship between the amount of debt in a levered firm and its value